7/28/18
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 13488-29683
Long Term Uptrend 6410-29847
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2581-3352
Intermediate
Term Uptrend 1295-3109 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 slightly negative: above estimates: month to date
retail chain store sales, weekly jobless claims, July consumer sentiment, the
July Richmond Fed manufacturing index; below estimates: June existing home
sales, June new home sales, mortgage/purchase applications, June durable goods
orders, the June trade deficit; in line with estimates: the May/June Chicago
Fed national activity index, the July flash PMI’s, second quarter GDP.
However, the primary
indicators were very negative: June new home sales (-), June existing home
sales (-), June durable goods orders (-) and second quarter GDP (0). So I
rate this week a negative. Score: in the last 146 weeks, fifty were positive,
sixty-nine negative and twenty-seven neutral.
A note on the
GDP number. Yes, it was good (+4.1%) and
hence a positive. But the universe knew that it would outpace the first quarter
reading. However, it was below consensus
(+4.2%) and didn’t come close to the 5% whisper number. In addition, the GDP deflator was well above
estimates which is sure to keep the Fed on the track of raising rates and
unwinding its balance sheet. Finally,
there were a number of unusual one off numbers related to exports and
inventories which will likely materially impact subsequent revisions.
So the economic data
continues to provide both positive and negative signals---there is no
consistent trend at all. While the second
quarter GDP read was definitely better than first quarter, I don’t believe that
it points to a US economy that is now experiencing some kind lift off.
No significant
stats from overseas this week; but the overall trend continues to suggest that the
‘synchronized global expansion’ theme is over; and that means our own economy loses
that as a tailwind.
The ECB met this
week and reaffirmed its intent to leave rates unchanged at least thorough 2019
but to begin unwinding is QE at the end of this year. In addition, the Bank of Japan is providing a
few laughs as it attempts to obfuscate its goal to begin tightening. Meanwhile,
the Chinese are pumping money into their financial system in an effort to stave
off the negative consequences of a potential trade war with the US.
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. Unfortunately, the reverse would also be
true. In addition, 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, while the second quarter numbers were definitely better than the first, there
is insufficient evidence at this moment to indicate a strong follow through. So my current assumption remains intact---an
economy struggling to grow.
The
negatives:
(1)
a vulnerable global banking system.
Loan covenant protection is at the weakest level in a
decade (medium and a must read):
(2)
fiscal/regulatory policy.
This
week, trade remained center stage:
[a] of
course, the number one item was the cease fire between the US and EU. Lots of promises were made but no
concessions. The good news is that this
puts an end, at least temporarily, to all the saber rattling. Hopefully, it will lead to a meaningful
reorientation of this trading regime. ‘Hopefully’
being the operative word.
More cognitive dissonance (medium):
[b] with
respect to the Chinese, they insisted that they weren’t devaluing their currency
{yeah, right} but began an aggressive expansion of fiscal policy which {like
the devaluation that they supposedly aren’t doing} is designed to offset the
effects of increased tariffs. They also
appear to be considering boycotting US branded products,
Trump
responded by announcing subsidies to those products being impacted by Chinese tariffs {which as I pointed out
in Wednesday’s Morning Call means that he is now taxing consumers to subsidize
the negative effect of his trade policy which were supposed to lower consumer
prices}. However, the largest factor in
reaching some accommodation with the Chinese may be the threat of a new trading
relationship between the US and EU which would target some of China’s more
egregious trade policies,
As you
know, I believe the outcome of current trade negotiations are an important
variable in our long term secular economic growth rate forecast. This week’s US/EU announcement is hopefully a
signal that the Donald’s ‘art of the deal’ negotiating style is starting to pay
off and that his attempt to reset the post WWII political/trade regime will
succeed. However, as I noted above,
right now all there is, is hope. We need
to see concrete results before getting jiggy about the potential growth benefits
of a fairer trade system.
Unfortunately,
none of this says anything 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. And that only got worse
this week as the house is preparing another budget busting appropriations bill.
(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 Fed remains
on course to raise interest rates and unwind its balance sheet, at least until
those policies start effecting the economy [Markets?].
The ECB met
this week, left rates unchanged and reiterated that it would begin unwinding
its version of QE in December 2018.
Japan continued
to struggle with how it might begin a tightening process but make it appear as
though it isn’t---with little luck to date.
On the other
hand, the Chinese are aggressively expanding both monetary and fiscal policies
in an attempt to offset the blow that US tariffs will deal to their
economy. Ultimately, though, that too
will have to end. Chinese companies and
citizens are already highly leveraged with lots of very risky debt. Adding to that burden will only exacerbate China’s
liquidity and solvency issues.
However, short term
that means that there is a growing divergence in major central bank monetary
policies. I am not smart enough to know
how this ends, but it will almost surely introduce more volatility in the
global economies/inflation as well as the Markets.
If you believe,
as I do, that ending QE will cause little economic impact but major pain for
the Markets, this is not great news.
(4) geopolitical
risks: since political risk is so
tightly enmeshed with the trade negotiations, it seems impossible to separate
the two [i.e. North Korea with China, immigration with Mexico and NATO funding
with the EU]. About the only thing I can
say is that the risks are higher than before Trump started down his current
path.
In addition,
the saber rattling between the US and Iran is escalating---the most immediate
economic threat being a sizable reduction in oil supplies to the world.
(5)
economic difficulties around the globe. No notable stats released this week.
Bottom
line: on a secular basis, the US long
term economic growth rate could improve based on increasing deregulation. In addition, if Trump is successful in
revising the post WWII political/trade regime, it would almost certainly be an
additional plus for the US long term secular economic growth rate. ‘If’ remains the operative word; though
clearly this week’s developments with the EU improve the odds of a favorable
outcome.
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. 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 in long
term secular economic growth.
Cyclically,
growth in the second quarter sped up, helped along by the tax cuts. At the moment, the Market seems to be
expecting that acceleration to persist.
I take issue with that assumption, based not only on the falloff in
global activity but also the lack of consistency in our own data and the never
ending expansion of debt.
The
Market-Disciplined Investing
Technical
The Averages
(DJIA 25451, S&P 2818) sold off---not surprising in that they were in
overbought territory. Volume was up but
breadth weakened. However, the Dow
continued to trade above its 100 day moving average (now support), above its
200 day moving average (now support), within a short term trading range and
above its June high. The S&P ended
above both moving averages and in uptrends across all timeframes. With the indices now in sync, the assumption is
that they are on their way to challenging their all-time highs.
VIX jumped 7 ½%
but remained below both moving averages and in a narrow trading range near the
lower boundary of its short term trading range.
But it doesn’t seem to want to challenge that lower boundary.
The long
Treasury was up slightly, bouncing off the lower boundary of its long term
uptrend and its 100 day moving average, negating Thursday’s break. It remained below its 200 day moving average (now
resistance) and caught between the declining upper boundary of its short term
downtrend and the rising lower boundary of its long term uptrend; though, at present,
it is closer to the latter and it is losing technical strength. A break of this developing pennant pattern
has directional import.
The
dollar was off pennies, finishing above both moving averages and in a short
term uptrend. Further indications of
strength are (1) its 100 DMA trading above its 200 DMA and (2) UUP has now made
two higher lows.
Gold
was up slightly. It closed below both
moving averages (its 100 day moving average has now crossed below its 200 day
moving average---not a technical plus) and in a short term downtrend. Its pin action suggests that it will
challenge the lower boundary of its intermediate term trading range (roughly 10
points lower).
Bottom
line: on the one hand, having traded
into overbought territory, it isn’t unusual that the Averages would selloff. On the other hand, the bulk of an upbeat second
quarter earnings season is behind us, second quarter GDP printed with a four
handle and Trump is taking (the first of many I assume) a victory lap on the
US/EU trade cease fire; so I would think that investors could muster a bit more
enthusiasm. Granted the FANG stocks had
a rough reporting season and that almost certainly had a dampening effect on
sentiment.
Based on the
indices charts today, my assumption is that they go higher. However, cutting the legs out from under the
Market leaders gives me pause. Follow
through.
UUP and GLD are
definitely pointing to relative strong US economy. The long Treasury seems to be trying but
successfully challenging the lower boundary of its long term uptrend is needed
to confirm that scenario.
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 should 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. Despite the well anticipated second quarter
GDP read, overall this week’s data was negative; in fact very negative given
that three primary indicators disappointed.
My conclusion is that the economy simply isn’t growing as rapidly as
many think; and to the extent that second quarter growth was an improvement
over the first, there is certainly no evidence of sustainability.
On the
other hand, I have never thought that the economy was going into a recession. And while there clearly is some probability
of a meaningful pick up in the long term secular growth rate of the economy
[deregulation, trade], I am not going to change a forecast based on the dataflow
to date.
Also,
lest we forget, the economic growth rate in rest of the global is starting to
slow; and that can’t be good for our own prospects. It is certainly possible, even probable, that
the US can continue to growth in this environment. But it is not likely that its growth rate is accelerating.
My
thesis remains that the financing burden now posed by the massive [and growing]
US deficit and debt has and will continue to constrain economic as well as
profitability growth.
In
short, the economy is not a negative but it not a positive at current valuation
levels.
(2)
the success of current trade negotiations. If Trump is able to create a fairer political/trade
regime, it would almost certainly be a plus for secular earnings growth. This
week’s cease fire with the EU brings hope that this will be the case. Although I have documented plenty of
naysayers to that proposition.
Unfortunately, if the Donald fails, the reverse is also true,
(3)
the rate at which the global central banks unwind
QE. That remains a somewhat muddled picture this week as:
[a] the
Bank of China continues to expand its money supply as part of an attempt to
offset the hurt being laid on it by the Trump tariffs,
[b] it is
increasingly obvious, even to the Japanese, that their version of QEInfinity
has been a failure. The BOJ meets next
week and rumors are that it wants to take its first tightening step. Unfortunately, the Japanese bond market is
having a hissy fit. So this week the BOJ
has been trying weasel bond investors into believing that tightening really won’t
have the consequences that it almost surely will. Stay tuned on how it manages this situation,
[c] the
ECB met this week and confirmed that it will begin drawing down it balance
sheet in December,
[d] the
Fed has already confirmed its policy of raising rates and unwinding its balance
sheet. (must read)
Thus,
the global economy is now experiencing dueling QE policies among the largest central
banks on the planet. In that environment, I have little confidence is
projecting a path for global QE going forward; but I remain convinced that it
has done and will continue to do harm to the global economy in terms of the
mispricing and misallocation of assets, that sooner or later that mispricing
will be reversed and, given the fact that the Markets were the prime
beneficiaries of QE, they will be the ones that take the pain of its demise.
(4)
finally, valuations themselves are at record highs
based on an economic/corporate profit scenario that I consider wishful
thinking. Even if I am wrong, there is
no room in those valuations for an adverse outcome which we will inevitably
get.
Bottom line: a
new regulatory regime plus an improvement in our trade policies should have a
positive impact on secular growth and, hence, equity valuations. 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 7/31/18 13643
1682
Close this week 25451
2818
* 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.
