Saturday, May 19, 2018

The Closing Bell

The Closing Bell


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%

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

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.


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 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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