The Closing Bell
5/19/18
We are off for our annual anniversary beach trip. Back on the 29th.
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 13210-29415
Long Term Uptrend 6410-29847
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2512-3283
Intermediate
Term Uptrend 1274-3089
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%
Economics/Politics
The Trump
economy is providing a slight upward bias to equity valuations. The
data flow this week was positive: above estimates: month to date retail chain
store sales, May housing market index, April industrial production, May NY and
Philadelphia Fed manufacturing indices, May business inventories/sales; below
estimates: weekly mortgage and purchase applications, April housing starts,
weekly jobless claims; in line with estimates: April retail sales, April
leading economic indicators.
Several primary
indicators were released this week: April industrial production (+), April
housing starts (-), April retail sales (0) and April leading economic indicators
(0). While the primary indicators were flat, given the slightly higher number
of positive indicators, I am rating this week a plus---but just barely. Score:
in the last 136 weeks, forty-six were positive, sixty-three negative and
twenty-seven neutral.
Overseas, the
data flow continued negative, calling ever more into question the ‘global
synchronized growth’ narrative. As you
know, I have already removed this as a positive factor supporting our US
economic forecast.
The important
fiscal developments this week were the rise in interest rates and the
dollar. Or more specifically the
economic forces driving that pin action.
And here there is disagreement/confusion. On the one hand, the optimists are assuming
this phenomena is the result of a slow but steady improvement in economic
growth which will, in turn, not force the Fed into a more aggressive tightening
policy than already stated.
The less
optimistic (of which I am one) read the economic dataflow as depicting little
growth (though not a recession). Some in
this camp believe that inflationary pressures are increasing and that will
force the Fed to up the ante on tightening.
I am not sure of this. But it
doesn’t matter. Because I do believe
that the Fed will push harder on its withdrawal from QE because there is little
sign of inflation. I told you it was
confusing.
Most of the
political news was of the international variety: North Korea suddenly playing
hard to get---in line with past performances.
The NAFTA and Chinese trade discussions seemingly on life support. Plus the apparent demotion of Peter Navarro
as Trump’s leading trade advisor---a positive development as I discussed in
Thursday’s Morning Call.
Unfortunately, the Trump/Mueller/Stormy
Daniels/Russia mess is like having a case of herpes---we have to carry it
around like a bad piece of luggage. ‘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. It now appears as though the Volcker rule
[limiting banks’ proprietary trading activity] is about to be
disassembled. One day, I believe that I
am going to be writing in this note that history has repeated itself once
again.
(2)
fiscal/regulatory policy.
It was a
quiet week for real news, though developments are occurring. The most important of which was the
aforementioned sidelining of Peter Navarro.
Hopefully that will produce some positive results because the headline
news on NAFTA and Chinese trade negotiations are rather dismal even if I
include Trump’s backpedaling on the ZTE Electronics’ decision.
And then
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.
And now
it appears that the s**t will get even deeper (medium):
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
problem remains too much national debt and too large a budget deficit---of which the cost of servicing will use up
productivity impeding economic growth.
(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.
As you are well
aware, the Fed has started to unwind US QE thereby beginning the process of
reversing the mispricing and misallocation of assets. I believe that ultimately it will impact
Markets negatively.
(4) geopolitical
risks: the bad news is that North Korea is
pulling one of its usual stunts, suspending talks with the South and threatening
to withdraw from negotiations on denuclearization. To quote myself ‘Remember, these guys have jerked us off before’. The really bad news is that tensions not only
in the Middle East but with our allies 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 mostly
bad.
[a] first quarter
German GDP was below estimates; April EU inflation was well below the ECB
target,
[b] April
Chinese industrial production was above consensus while retail sales and fixed
investments were below,
[c] first
quarter Japanese GDP declined; April CPI was less than anticipated.
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, 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. The degree to which these opposing forces
offset each other is the $64,000 question to which I currently have no answer.
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 fiscal in nature. There is also an 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
Technical
The Averages
(DJIA 24715, S&P 2712) had a quiet Friday, ending nearly flat on the day
(Dow up, S&P down). Volume declined
and breadth was mixed. The S&P
remained above its 100 day moving average (now support); but the Dow remained
below its 100 day moving average (now resistance)---that challenge has to be successfully
made in order for either index to have clear sailing to their former all-time
highs. But that still seems likely.
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. Longer term, the
assumption is that equity prices will continue to rise.
The VIX finished lower,
ending below its 100 and 200 day moving averages (now resistance). It also finished in a short term downtrend. All this suggests a bias to the upside for
equities.
The long
Treasury was up ¾ %, but still closed below the lower boundary of its long term
uptrend for the fourth day; if it remains there through the close next Monday,
it will reset to a trading range. It
continues below its 100 and 200 day moving averages and within a short term
downtrend.
And:
The dollar was
up again, finishing above on the upper boundary of its newly reset intermediate
term trading range (if it remains there through the close next Monday, it will
reset to an uptrend). It also ended
above its 100 and 200 day moving averages (now support).
GLD was up
fractionally, ending below its 100 day moving average (now resistance), below
its 200 day moving average for a fourth day, reverting to resistance and in a
short term downtrend.
Bottom line: the
long Treasury is on the verge of resetting its long term trend as is the dollar
with its intermediate term trend. Meanwhile,
GLD has already reset its short term trend from a trading range to a
downtrend. Clearly these indices are
pointing to a change in the economic fundamentals determining their valuations.
The optimists
believe that these indicators are telling us that the economy is picking up
stream and will continue to grow into the foreseeable future. And they may be right. I would simply point to their rather selective
choice of economic data to base this opinion on. Plus they quote all the studies that show a
recession is nowhere near in sight---to which I reply that in the half a dozen
recessions that I have lived through, no one knew when they started until well
after the fact because of the many revisions that take place.
To be clear, our
forecast is not for a recession. It is
for more sluggish, labored growth which higher interest rates and a strong
dollar will only make worse.
As I said in yesterday’s
Morning Call, only one of these scenario will prove correct. But it may take some time before we know
which one.
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’.
At the moment,
the important factors bearing on corporate profitability and equity valuations
are the same as those impacting bonds, the dollar and gold:
(1)
the extent to which the economy is growing. The optimists are out there but to date they
have questionable support, in my opinion, from the reported numbers. That is not to say, that there won’t be
improvement, but rather the burden of proof is on those in the positive
camp. Playing on the answer to this
question is balancing the potential positives from deregulation, trade,
healthcare and tax cuts with the negatives of a budget and national balance
sheet that are out of control,
Earnings
growth, especially the portion that is reinvested in cap spending (or not) is
an important thing to watch. Here is a
look a 2018 projections (medium and a must read):
(2)
the rate at which the Fed unwinds QE. The optimists believe that it will tighten
only to the extent as to not disrupt the Markets. The problem with that assumption is that long
rates and the dollar are rising which may leave the Fed with little choice with
regards to increasing short rates. And
as the Fed gets deeper into the unwind of QE, so does the unwind of asset
mispricing and misallocation.
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 24715
2712
* 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
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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