Saturday, May 12, 2018

The Closing Bell

The Closing Bell


Statistical Summary

   Current Economic Forecast
2018 estimates (revised)

Real Growth in Gross Domestic Product                          1.5-2.5%
                        Inflation                                                                          +1.5-2%
                        Corporate Profits                                                                10-15%

   Current Market Forecast
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                      21691-26646
Intermediate Term Uptrend                     13178-29383
Long Term Uptrend                                  6410-29847
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2504-3275
                                    Intermediate Term Uptrend                         1271-3086
                                    Long Term Uptrend                                     905-2963
2018 Year End Fair Value                                       1700-1720         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          59%
            High Yield Portfolio                                     55%
            Aggressive Growth Portfolio                        55%

The Trump economy is providing a slight upward bias to equity valuations.   The data flow this week was mixed: above estimates: month to date retail chain store sales, weekly jobless claims, April CPI, April import/export prices; below estimates: weekly mortgage and purchase applications, the preliminary May consumer sentiment reading, March consumer credit growth; in line with estimates: April PPI, ex food and energy, March wholesale inventories/sales.

              No primary indicators were released this week.  So I am rating the week a neutral. Score: in the last 135 weeks, forty-five were positive, sixty-three negative and twenty-seven neutral.

As I noted on Friday, I do believe that those inflation numbers have significance.  Certainly for the consumer.  But they also could give the Fed a bit more wiggle room when it comes to tightening monetary policy.  At this point there are two questions:

(1)   is inflation low because the economy is not as strong as many believe or because of some longer term secular reason?  The answer, in my opinion, is both.  The economy is not growing as fast many believe; and it is doing so because of a misguided fiscal policy that has loaded so much debt on the economy that servicing it absorbs almost all of the net increase in productivity,

(2)    will, in fact, the Fed slowdown the unwind of QE or [a] is it more intent on shrinking its balance sheet in anticipation of the next recession and/or [b] will the current flattening of the yield curve plus the move up in longer term rates even give it that option?  My answer is one that you know---in its history, the Fed has botched every [I mean every] transition from easy to tight money, it is already doing it this time as well.

Overseas, Chinese inflation numbers were good but the stats out of the EU remain negative.  As you know, I have removed ‘global synchronized growth’ as a positive factor supporting our US economic forecast.

Most of the political news was of the international variety: Trump getting the US out of the Iran nuclear deal, the US/North Korean summit moving forward.  Unfortunately, also in the mix is the bubbling pot of Trump/Mueller/Stormy Daniels/Russia love stew.  I have no idea where this whole thing ends up; but at this moment, it is becoming an increasing distraction from the business of the state.  Mostly, that is a good thing.  The more time our ruling class indulges in self-flagellation, the less time it has to screw with you and me.  My concern is that this ends in another impeachment circus which historically has never been good for the Markets.

Our (new and improved) forecast:

A pick up in the long term secular economic growth rate based on less government regulation.  As a result, I raised that growth forecast. There is the potential that Trump’s trade negotiations could also lead to an improvement in our long term secular growth rate---though that has yet to be determined.  On the other hand, the tax cut and spending bills as they are now constituted are negative for long term growth (you know my thesis: at the current high level of national debt, the cost of servicing the debt more than offsets any stimulative benefit) and could potentially offset any positives from deregulation and trade.

On a cyclical basis, the economy appears to have lost any steam it might have had, after having achieved one of the longest growth cycles in history.  In the short term that will overwhelm any benefit to the long term secular growth rate. 

       The negatives:

(1)   a vulnerable global banking system.  

(2)   fiscal/regulatory policy. 

It was a quiet week for real news, though developments are occurring.  Trade negotiations continue between the US and its NAFTA partners.  It appears that much effort is being expended by all parties to reach an agreement.  I count that as a hopeful positive.

Trade negotiations also continue between the US and China.  While the narrative, in this case, hasn’t sounded as upbeat as with NAFTA, I suspect that the China has a heavy hand in the potential US/North Korea d├ętente.  If the Donald succeeds in obtaining a meaningful agreement with Un, it wouldn’t surprise me to see substantial progress in the US/China talks.

On the domestic front, the Donald announced a plan for reducing drug costs.  As you probably know, healthcare is a big chunk of the economy and it is one of the primary sources of inflation [i.e. rising health costs].  So if this initiative bears fruit, it will be yet another plus for the economy.  That said, it is far too soon to make any predictions about its ultimate impact on the economy; but the potential is there.

Congressional leaders are also promising to rescind some spending measures---this after foisting a trillion dollar budget deficit on American electorate just months ago.  Economically speaking, given the current size of those rescissions, this is an act of tilting at windmills.  Though I am sure it will make for great soundbites in the upcoming elections.
Finally, there is the possible disruptive effect of the aforementioned ruling class soap opera that has managed to grow into this malignant, amorphous tar baby that includes such wildly diverse components as Russian collusion and sex with porn stars.   

The good news is that it gives the late night hosts plenty of material and keeps our reigning elite’s collective eye on something other than perpetrating mischief on the electorate. 

The bad news is……..oh gee, what was that?  Ah…….another potential impeachment process?   But wait, isn’t that also good economic news---again allowing us plebeians to dodge more harmful fiscal tomfoolery.  Unfortunately, it could be bad news for the Markets.

So a pretty upbeat week.  The problem remains too much national debt and too large a budget deficit.

The math of the debt bomb (medium and a must read):

(3)   the potential negative impact of central bank money printing:  The key point here is that [a] the Fed has inflated bank reserves far beyond any comparable level in history and [b] while this hasn’t been an economic problem to date, {i} it still has to withdraw all those reserves from the system without creating any disruptions---a task that I regularly point out it has proven inept at in the past and {ii} it has created or is creating asset bubbles in the stock market as well as in the auto, student and mortgage loan markets.  

The central bank news this week came from overseas: the Bank of England met and left rates and its QE policy unchanged.  However, unlike its counterpart across the Channel, it admitted that economic growth sucked.  So don’t expect any monetary tightening from the Brits. But then, who cares?  Given the lack of success of QE to date, I can’t imagine how continuing the process will be of any economic benefit. 

That said, the Fed has already started to unwind US QE, putting our monetary policy at odds with the most other central banks.  I am not sure how that conflict in monetary policies works itself out in the global asset markets, particularly with respect to the timing of the reversal of the mispricing and misallocation of assets; but I believe that ultimately it will impact Markets negatively. 

(4)   geopolitical risks:  the good news is that North Korea seems to be willing to give up its bellicose ways---‘seems’ being the operative word.  Remember, these guys have jerked us off before.  The bad news is that tensions in the Middle East have escalated with Trump opting the US out of the Iranian nuclear deal.  I don’t see this as an existential threat to the US; but it doesn’t take much imagination to see a conflict that could push oil prices much higher.

(5)   economic difficulties around the globe.  The international data this week was mixed with most of the bad news still emanating from Europe.

[a] March German industrial orders fell more than anticipated but industrial production was above consensus; April UK retail sales were disappointing, May EU investor confidence slipped,

[b] April Chinese CPI and PPI came in lower than expected.

            Bottom line:  the US long term secular economic growth rate could improve based on increasing deregulation.  In addition, if the success of the trade negotiations with South Korea can be repeated with NAFTA and China, which appears increasingly likely, then a fairer trading regime would almost certainly be an additional plus for the US long term secular economic growth rate.  ‘If’ remains the operative word; plus we need to see the shape of any new agreement before changing our forecast. 

At the same time, those long term positives are being offset by a totally irresponsible fiscal policy.  The original tax cut, a second proposed new improved tax cut, increased deficit spending and a potentially big infrastructure bill will negatively impact economic growth and inflation, in my opinion. The current level of the national debt and budget deficit are simply too high to allow the additional economic growth; and the current spending rescission proposal is too small to have any effect.  I believe that a bigger deficit/debt=slower growth and a higher deficit spending=inflation, even if they are the result of a tax cut and/or infrastructure spending.  Hence, this is a negative for the long term secular growth rate of the economy.

It is important to note that the negative impact that a rapidly growing national debt and budget deficit have on economic growth is not just long term in nature.  There is also a short term effect on Fed policy (via the increase in interest rates) which has its own problem extricating itself from its irresponsible venture into QE. 

As a result, the central bank is in a no win situation: [a] if I am wrong about the economy and it accelerates and the Fed does nothing, it risks inflation, [b] in fact even if economic doesn’t pick up, with LIBOR and long term US rates continuing to rise and the yield curve flattening, the Fed may not even have the option of doing nothing, [c] in either event, if it moves forward with the unwind of QE, it will begin the unwinding of the mispricing and misallocation of global assets.

The Market-Disciplined Investing

The Averages (DJIA 24831, S&P 2737) had another good day on Friday. Breadth continued to improve but volume was down, again (not a good sign).   The S&P ended above its 100 day moving average for a second day (now resistance; if it closes above that level on Monday, it will revert to support); the Dow finished right on its 100 day moving average.  Both remained above their 200 day moving averages.  The DJIA closed in a short term trading range but in intermediate and long term uptrends.  The S&P is in uptrends across all timeframes. 

At the moment, it seems likely that both of the indices will move above their 100 day moving averages.  If so, the short term technical outlook will be positive with an objective of their former all-time highs.    Longer term, the assumption is that equity prices will continue to rise.
                The VIX was down, ending below its 100 day moving average as well as its 200 day moving average for the third day (now support; but if it remains there through the close on Monday, it will revert to resistance).  It also finished below the lower boundary of its short term trading range for the second day; if it remains there through the close on Monday, it will reset to a downtrend.  Clearly, the VIX is trading in line with a surging Market.

The long Treasury was up, continuing its bounce off the lower boundary of its long term uptrend.   However, it is right on a minor resistance level.  Assuming it successfully challenges that level, TLT is still facing serious overhead resistance from its 100 and 200 day moving averages and the upper boundary of a short term downtrend.

The dollar declined fractionally, but remained close to the upper boundary of its newly reset intermediate term trading range and above its 100 and 200 day moving averages (now support).
GLD was off slightly, but still finished above its 200 day moving average (now support) and in a newly reset short term trading range.  In addition, it is approaching its 100 day moving average (now resistance).
Bottom line: once the Averages clear their 100 day moving averages, the next visible resistance level is their former all-time highs.  I see no reason why those levels won’t be tested.

The other indicators that I follow aren’t breaking resistance (support) levels.  TLT backed off the lower boundary of its long term uptrend, the dollar felled back from the upper boundary of its intermediate term trading range.  That continues to point to a narrative that includes an improving economy but with little inflationary pressure.  Goldilocks.

Fundamental-A Dividend Growth Investment Strategy

The DJIA and the S&P are well above ‘Fair Value’ (as calculated by our Valuation Model).  However, ‘Fair Value’ could be positively impacted based on a new set of regulatory policies which would lead to improvement in the historically low long term secular growth rate of the economy.  A further increase could come if Trump’s drive for fairer trade is successful.  On the other hand, a soaring national debt and budget deficit are negatives to long term growth and, hence, ‘Fair Value’.

Moreover, on a short term basis, the continuous undershooting of economic growth markers suggests that any benefit from enhanced corporate spending stemming from the tax bill was short lived.  Plus neither a second round of tax cuts nor additional infrastructure spending, in my opinion, will improve the outlook for economic growth, given the current stratospheric level of debt. On the other hand, the current pathetic attempt to rescind some spending measures is almost meaningless in the economic scheme of things though clearly it will make for great headlines as the elections approach. As a result, I believe that current consensus economic growth expectations are too optimistic as well as any stock valuation based on that inaccuracy.

Meanwhile, my operating scenario is that the positive impact of deregulation and a potential improvement from better trade deals could very well be offset by the likelihood of subdued growth and higher inflation resulting from an irresponsible fiscal policy (expanding the national debt and the budget deficit to the point at which the cost of servicing the debt/deficit negates any benefit from tax cuts or infrastructure spending).  I needn’t be repetitive here; but:  

(1)    the budget deficit and national debt are already too high to render either deficit spending or tax cuts an effective growth stimulant.  Making them bigger will only make things worse. I believe that Street estimates for economic and profit growth will prove too optimistic and valuations will have to adjust when that reality becomes manifest, and

(2)   even worse for the Market is the need for the Fed to normalize monetary policy,   ending QE.  Indeed, as I noted above, if long rates continue to rise it may be forced to do irrespective of its own economic forecast.  Since QE led to the gross mispricing and misallocation of assets, the process of unwinding it, in my opinion, would not be good for the Markets because they are the only thing that benefitted from QE.
Bottom line: a new regulatory regime plus an improvement in our trade policies should have a positive impact on secular growth.  On the other hand, I believe that fiscal policy will have an opposite effect on economic growth.  Making matters worse, monetary policy, sooner or later, will have to correct the mispricing and misallocation of assets---and that will be a negative for the Market.

Our Valuation Model assumptions may be changing depending on the aforementioned economic tradeoffs impacting our Economic Model.  However, even if tax reform proves to be a positive, the math in our Valuation Model still shows that equities are way overpriced.  That math is simple: the P/E now being paid for the historical long term secular growth rate of earnings is far above the norm.

                As a long term investor, with equity valuations at historical highs, I would want to own some cash in my Portfolio and, if I didn’t have any, I would use any price strength to sell a portion of my winners and all of my losers.
                As a reminder, my Portfolio’s cash position didn’t reach its current level as a result of the Valuation Models estimate of Fair Value for the Averages.  Rather I apply it to each stock in my Portfolio and when a stock reaches its Sell Half Range (overvalued), I reduce the size of that holding.  That forces me to recognize a portion of the profit of a successful investment and, just as important, build a reserve to buy stocks cheaply when the inevitable decline occurs.

DJIA             S&P

Current 2018 Year End Fair Value*              13860             1711
Fair Value as of 5/31/18                                  13536            1669
Close this week                                               24831            2737

* Just a reminder that the Year End Fair Value number is based on the long term secular growth of the earning power of productive capacity of the US economy not the near term   cyclical influences.  The model is now accounting for somewhat below average secular growth for the next 3 to 5 years. 

The Portfolios and Buy Lists are up to date.

Steve Cook received his education in investments from Harvard, where he earned an MBA, New York University, where he did post graduate work in economics and financial analysis and the CFA Institute, where he earned the Chartered Financial Analysts designation in 1973.  His 50 years of investment experience includes institutional portfolio management at Scudder. Stevens and Clark and Bear Stearns, managing a risk arbitrage hedge fund and an investment banking boutique specializing in funding second stage private companies.  Through his involvement with Strategic Stock Investments, Steve hopes that his experience can help other investors build their wealth while avoiding tough lessons that he learned the hard way.

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