The Closing Bell
6/16/18
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 13325-29530
Long Term Uptrend 6410-29847
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2539-3310
Intermediate
Term Uptrend 1281-3096
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 positive: above estimates: May retail sales, month to date
retail chain store sales, weekly unemployment claims, the June (preliminary)
consumer sentiment, May small business optimism index, April business
inventories/sales, NY Fed manufacturing index; below estimates: weekly mortgage
and purchase applications, May industrial production, May PPI, the May budget
deficit, May import/export prices; in line with estimates: May CPI.
However, the
primary indicators were mixed: May retail sales (+) and May industrial
production (-). Based on volume, I rate
this week positive. Score: in the last 140 weeks, forty-eight were positive,
sixty-five negative and twenty-seven neutral.
The data
continues to provide both positive and negative signals---something to be
expected in an economy that is growing but is laboring to do so. There is no question that the overall second
quarter numbers have shown a pick up from first quarter; and if that trend
continues well into the third quarter then I will likely raise our 2018 growth
forecast.
Holding me back
from doing that right now is (1) we don’t know how enduring the improvement in
the second quarter stats are. They were
almost certainly impacted by the tax cuts; but given the current high and
rising level debt in all economic sectors, I am not sure how long the spurt of
optimism can last and (2) the outcome of trade negotiations could have a
significant effect on growth. The
uncertainty around this issue is currently higher than it should be; but it is
there nonetheless. My conclusion hasn’t
changed. ‘While it is too soon to be considering a revision in our forecast, it (the
recent data) could be signaling an
improvement in the cyclical growth rate of the economy.’
Overseas, the negative
stats continued. Clearly nothing that is a plus for the US economy.
The trade
negotiations turned into a food fight with the US imposing or threatening to
impose tariffs on all on major trading partner and vice versa. I covered this
extensively last week so I won’t repeat myself except for the bottom line: a
trade war represents a significant risk to the long term secular growth of the
US and our trading partners. On the
other hand if this is precedent to a new trading regime more reflective of
current economic/political realities (which by the way I would applaud), then
it will be a plus--- though getting there could cause some heartburn.
The
international political headlines were upbeat, trumpeting an historic deal with
North Korea. Unfortunately, this was
basically ‘a letter of intent’ with no promises made. I keep coming back to the historic pattern of
the North Koreans which is to feign agreement then renege later. My guess is that it will be a long time
before we know whether or not this a positive.
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 second quarter numbers are going to be better than the first, though
there is insufficient evidence at this moment to indicate a strong follow
through. So my current assumption
remains intact---an economy struggling to grow. (must read):
The
negatives:
(1)
a vulnerable global banking system. Nothing new this week except (must read):
(2)
fiscal/regulatory policy.
The principal
news this week was on trade, starting with the G7 meeting and then evolving into
a tariff threat extravaganza. You know
my bottom line. But for the moment I want
to step back a bit and take 30,000 foot view of what I think Trump is trying to
do.
It is
easy enough to attribute the goings on to the Donald’s ‘art of the deal’
strategy. And certainly that is
involved. But I think that there is more
happening than just a trade negotiation.
In my opinion, Trump is attempting to recast the post WWII economic paradigm. For seven decades, the accepted model was for
the US to provide a defense umbrella for Europe and Japan and fund their
economic convalescence, part of which was allowing trade protection for their
recovering industries.
Well
guess what? That show is over. The US rebuilt Germany, it reunified it, the
German economy is smoking yet it doesn’t pay for a reasonable portion of the
burden of its defense; and it is pissing and moaning about a trade regime that
is more balanced.
Don’t
even get me started on France.
Mexico
wants the US to build plants to employ its burgeoning population and for those
that it can’t get a job, it wants the US to take them in, give them a job plus
health care and schooling so that they can send money back home instead of spending
it here.
China
has been stealing our intellectual property for decades and no one has had the
balls to make a stand.
There is
something wrong with this picture. And I
believe Trump is trying to correct some of the inequities. Chances are that he won’t get it all right;
and the process will be painful. But it
will be a start and that is better than nothing.
Unfortunately,
this says nothing about an equally big problem to which Trump has contributed:
too much national debt and too large a budget deficit which will usurp investment
dollars that would otherwise be used for increased productivity.
(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.
Four central
banks met this week.
[a] the Fed:
raised rates ¼ %, indicated that there were two more increases coming in 2018
and stated that its balance sheet will continue to shrink on schedule. I covered this in Thursday’s Morning Call, so
I won’t be repetitive except for the bottom line: not likely a negative for the
economy but may prove to be the trigger for the unwinding of asset mispricing
and misallocation. Indeed, my thesis has
always been that the Fed has waited far too long to unwind QE,
[b] the ECB: not
only did it leave rates unchanged but it extended the time period for any
hike. However, it also said that it will
decrease its bond purchases beginning in September 2018 and end them in
December 2018 though it will continue to reinvest the proceeds of maturing
bonds. Markets read the lack of a rate
hike as dovish; however, I think the ending of its bond purchase program is more
important because it has been the excess liquidity spawned by global QE that
has led to the massive mispricing and misallocation of assets. This would be another step in correcting that
costly experiment.
[c] the Bank
of China: markets were expecting a rate hike which didn’t happen, apparently
out of concern over slowing economic growth---which many believe is the result
of a tightening of credit {liquidity}.
Meaning the Chinese too are shrinking money supply,
[d] the Bank
of Japan: left interest rates unchanged and failed to mention its bond buying
program. There had been indications that
it might be allowing its balance sheet to shrink. So far there hasn’t been any substantiating
evidence. So I am not sure what the absence
of comment means, if anything.
So ever so
slowly, global QE is coming to a well-deserved end. My thesis remains that {i} it did little to
assist the economic recovery following the financial crisis; so it is unlikely to
be a major negative as it winds down. But {ii} it created a massive mispricing
and misallocation of assets; and that will be impacted.
Part and
parcel of that end is the funding problems that arise in foreign countries and
marginal business (misallocation of assets) because the Treasury is now having
to sell {i} all the bonds that the Fed isn’t buying, {ii} all the bonds that
the Fed is not reinvesting in and {iii} all the bonds it needs to fund the growing
budget deficit. That is taking a lot of
liquidity out of the Markets; and as the budget deficit grows and the Fed
unwinds its balance sheet, even more liquidity will be absorbed. At some point, some company, some bank or
some country will be unable to finance or refinance its debt and the repricing
of risk will begin in earnest.
The central bank party is already over
(medium):
(4) geopolitical
risks:
[a] the North
Korea/US summit produced a lot of splashy headlines but few results, unless you
count the promises of Un---which I don’t.
[b] the new
Italian PM basically backed off any threat to leave the EU. That eases tensions somewhat but does not
solve that country’s bank solvency problem.
As I have noted before, because so many of the EU members’ central banks
own the paper of other EU members, an Italian banking crisis would not be
limited to just Italy. That said, the
ECB is second only to the Bank of Japan in its willingness to throw
unparalleled amounts of liquidity to any country that would endanger the EU
banking system.
(5)
economic difficulties around the globe. The international data this week was negative.
[a] April UK and
EU industrial production were terrible; May UK CPI hit a one month low; June
German investor sentiment declined,
[b] May Chinese
industrial output, fixed asset investment and retail sales were disappointing,
In short, the
much heralded global synchronized expansion is yesterday’s story; its
importance being the lack of any positive contribution to US growth.
Bottom
line: the US long term secular economic growth
rate could improve based on increasing deregulation. In addition, if trade negotiations with China,
NAFTA and the EU prove successful 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.
On the other
hand on a cyclical basis, growth in the second quarter will be above that of
the first quarter, helped along by the tax cuts. The issue for me is the strength of follow through. Until more evidence proves otherwise, my
thesis remains that the current level of the national debt and budget deficit
are simply too high to allow any meaningful pick up the long term secular economic
growth.
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. Part
of that problem is the growing dollar funding issue in the emerging markets
which could lead to further damage to global growth as well as the
international financial system.
The
Market-Disciplined Investing
Technical
The Averages
(DJIA 25090, S&P 2779) had a volatile day (not unusual for a quad witching
Friday) ending down. Volume was huge
(also not unusual for a major expiration day); breadth was negative. Both finished above their 100 and 200 day
moving averages (now support). The Dow
is in a short term trading range, the S&P in a short term uptrend. Longer term, the assumption is that stocks
are moving higher.
The VIX surprisingly declined
1 % (it is usually up on a down Market day), ending below its 100 and 200 day
moving averages (now resistance) and in a short term downtrend---suggesting
better times for stocks.
The long
Treasury was up slightly, finishing above its 100 day moving average and the
lower boundary of its long term uptrend but below its 200 day moving average
and in a short term downtrend. Its pin action
over the last two days seems to indicate that the turmoil in trade is driving
investors to it as a safety trade. That
said, to achieve any additional upside momentum, it is facing the
aforementioned resistance levels.
The dollar was
down pennies, closing well above both moving averages and in a short term
uptrend. Like TLT, it seems to be
currently acting as a safety trade.
On the other
hand, GLD, which has long been a safety trade, got pulverized, ending below its
100 and 200 day moving averages and below the lower boundary of its newly reset
short term trading range. I have no
explanation for this performance.
Bottom line: trade
worries appeared foremost in all investors’ minds on Friday; although GLD’s action
totally confuses me. That said, I think
stocks held very well, while TLT and UUP didn’t exhibit frantic buying. After a week heavily ladened with important economic
developments, much of them negative, the price action in stocks suggest more
upside.
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’ is being 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:
(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 data. To be sure, the second quarter numbers will
look better than the first. But follow
through is important. Until the stats show
more consistency to the upside, the burden of proof remains on those in the
positive camp. My thesis remains that the financing burden now posed by the
massive US deficit and debt has and will continue to constrain growth,
(2)
the success of current trade negotiations. If Trump is able to create a fairer trade
regime, it would almost certainly be a positive for secular growth. However, the converse is also true; and at
the moment, the outcome is becoming increasing uncertain as tariff threats fill
the air,
(3)
the rate at which the global central banks unwind
QE. The optimists believe that they will
tighten only to the extent as to not disrupt the Markets. Of course, the Markets haven’t been disturbed
yet. But with the global funding needs
growing [more supply] and the US, ECB and China central banks tightening [less
demand], it may not be that long before that occurs. The question is, when it does, will it be too
late to stop the repricing of risk.
I have
maintained all along that given the Fed’s [and other central banks] overly
aggressive pursuit of QE, it would sooner or later be presented with a Hobson’s
choice: continue to unwind QE in the face of the financial difficulties of
marginal borrowers or reverse it and create even more parasites for the economy
to support. I continue to believe that
at some point the Fed will have no good alternative to tightening and when that
occurs, 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 6/30/18 13600
1677
Close this week 25090
2779
* 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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