The Closing Bell
7/14/18
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 13399-29599
Long Term Uptrend 6410-29847
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2566-3337
Intermediate
Term Uptrend 1291-3106
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 quite positive: above estimates: weekly mortgage/purchase
applications, month to date retail chain store sales, weekly jobless claims, May
wholesale inventories/sales, the July small business optimism index, June CPI,
the June budget deficit, June import prices; below estimates: May consumer
credit, June PPI, July preliminary consumer sentiment; in line with estimates:
na.
There were no primary
indicators reported. I rate this week a plus. Score: in the last 144 weeks, fifty
were positive, sixty-seven negative and twenty-seven neutral.
The data
continues to provide both positive and negative signals; though we are on a two
week streak of upbeat numbers. That is
not much of a trend. But it does support
the notion that second quarter economy growth will be better than first
quarter. I agree with that; but I don’t believe
that this means the US economy is now experiencing some kind lift off. It will take a good deal more positive stats
before I alter my forecast of an economy slowing improving economy but laboring
to do so.
My skepticism
arises from (1) the brevity of the current economy growth pick up, (2) the
overhanging burden of high and rising level debt in all economic sectors [which
have to be serviced with cash flow that would otherwise go to cap ex and wages],
(3) the outcome of trade negotiations.
As you know, I am hopeful about a positive outcome from the latter. But that hasn’t happened yet; and until it
does, I am not getting jiggy with it.
Overseas, the numbers
remain dismal. The EU lowered its 2018 GDP growth forecast; the Japanese yield
curve is flattening---a traditional precursor to recession; and Chinese credit
growth is slowing. As I noted
previously, the ‘synchronized global expansion’ is yesterday’s story; and that
means our own economy loses that as a tailwind.
Trade remains
front and center on the economic stage. Late
in the week, Trump kicked up the tariffs on Chinese goods to $200 billion. If implemented and reciprocated that will
have an impact on growth. So a big risk
in my forecast is some sort of trade war. On the other hand, a positive result
would be a plus for the long term secular growth rate of 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, 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.
The
negatives:
(1)
a vulnerable global banking system.
The Chinese banking system is developing heartburn as
overall liquidity shrinks (medium:
(2)
fiscal/regulatory policy.
The
outcome of current trade negotiations are an important variable in our long
term secular economic growth rate forecast.
So far, those negotiations have been largely in public and have included
lots of Trumpian aggressive rhetoric. That
tactic has led to much criticism---which may prove correct. My only observation is that playing patty
cake with our trade partners in the past did little to correct inequities. So
maybe a different approach is needed. Plus I will reiterate the thesis that
Trump’s strategy is more than just getting lower tariffs on US exports; he is
attempting to reset the post WWII political/trading regime---with which I agree.
The main
headlines this week were focused on:
[a]
China---where Trump really cranked up the volume by imposing $200 billion in
additional tariffs on Chinese goods. If
he follows through with this threat that is going to smart. And the Chinese will not likely turn the
other cheek which would not be good for the US.
What bothers me about these particular negotiations is that the focus
has been on tariffs with little being said about the most egregious Chinese
infraction: theft of US intellectual property.
In my opinion, a settlement that only includes some tariff reductions
would be a failure---even though some tariff relief would be a plus.
[b]
EU/NATO. Trump pressed our European
allies to take more responsibility for their own defense---at this moment with
uncertain results. I have noted that I think
that this issue is interrelated with trade; so its resolution will likely
impact all the outcome of trade negotiations.
Despite
heartburn inducing headlines, I continue to be hopeful of a positive outcome;
and if it is, I think that it will be a plus for the long term secular growth
of the US economy. If a trade war
results, there will be pain.
One other
thing occurred this week that could have a significant impact on Trump’s deregulatory
push; and that is the nomination of Bret Kavanaugh to the Supreme Court. This judge has a very pro-business leaning in
his judgments and would likely advance the Donald’s efforts. The below post is to an opponent of Kavanaugh,
so read it in that context.
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.
(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 demise of global
QE appears to be moving forward. This
week, the Fed took the extraordinary step of introducing a ‘new’ construct of
the yield curve [as opposed to the real yield curve] in order to justify a
continuing tightening of monetary policy at a time when the real yield curve
suggests the opposite. I believe that this reflects the Fed concerns
that its QE policy was a bust [economically speaking], that it has severely
distorted the pricing of risk and that it is concerned about the consequences
of both. Most specifically near term,
that it needs to unwind as much of QE as possible before the next economic
downturn hits so that it has policy tools to combat that downturn.
‘To be sure, I love it since I believe that
the gross misallocation and mispricing of assets created by QEInfinity has to
be corrected as a precondition for the capital markets return to
efficiency. But that involves Market
pain---which means this is not a widely held view.’
In other
central bank news,
[a] the
Japanese yield curve is flattening {a generally accepted signal that a
recession is in the works} in the midst of the most aggressive QE policy in
history among the major economic powers.
So the Bank of Japan is now facing the exact problem our own Fed {see
above} is trying to avoid, i.e. it has no policy levers left to combat an
economic downturn,
[b] the ECB
released the minutes of its most recent meeting which showed that its plans for
unwinding QE are on track---as long as there is no sign of economic weakness. The problem with that is that there plenty of
signs of economic weakness as I have documented in these notes. So it seems to be taking a page from our own
Fed’s current playbook: ignore the data, hype the rhetoric and pray hard that
it can unwind enough QE before a recession hits so that it has policy room to
combat it.
You can see the
central banks’ dilemma: They believe
that their QE policies worked in terms to stimulating economic activity
following the financial crisis. Therefore
with the signs of a recession increasing, they believe that they have to unwind
enough QE in order to have firepower when the recession comes. But they can’t say a recession is coming
because according to their logic, if they did, they would have to cease
unwinding QE. Their hubris created this
mess. Hopefully, humility will be result.
My thesis
remains that {i} QE 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 its
unwinding will not be Market friendly.
(4) geopolitical
risks: North Korea sent a very upbeat
letter to Trump this week, raising hopes that a settlement can be reached. However, I believe that this is all
intermeshed with the China trade negotiations.
So Kim’s friendly attitude will likely last only so long as the US and
China can work out a trade agreement.
(5)
economic difficulties around the globe. Not a lot of stats released this week.
[a] July German economic sentiment was terrible,
[b] June Chinese CPI was up, in
line;.
But, as noted
above, there were macroeconomic signs that all is not well in the global
economy: EU lowering its growth forecast, the Japanese yield curve flattening,
the Chinese credit shrinking.
Bottom
line: On a secular basis, 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; 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. 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 will be surely be above that of the first quarter,
helped along by the tax cuts. At the
moment, the Market seems to be expecting that growth is accelerating and will
persist. I take issue with both those assumptions,
based not only on the falloff in global activity but also the lack of consistency
in our own data.
The
Market-Disciplined Investing
Technical
The Averages
(DJIA 25019, S&P 2801) had another good day on slightly better volume and
improved breadth. The Dow continued to
trade above its 100 day moving average (now support), above its 200 day moving
average (now support) and within a short term trading range. The S&P ended above both moving averages,
in uptrends across all timeframes and above the minor resistance from its June
high for a second day. The assumption has
to be that it will now challenge its all-time high (2874).
VIX declined 3%,
finishing below its 100 day moving average (now resistance), below its 200 day
moving average (now resistance), within a short term trading range and appears
headed for a challenge of the May/June double bottom---which would be logical
if the Averages are going to assault their highs.
The long
Treasury was up ¼ %, ending well above its 100 and 200 day moving averages, in
a long term uptrend and above the upper boundary of its short term downtrend
(if it remains there through the close on Tuesday, it will reset to a trading
range).
The
dollar was down fractionally, but stayed above both moving averages and in a
short term uptrend. In addition, its 100
day moving average has crossed above its 200 day moving average---which
technicians consider a good sign of further momentum to the upside.
Gold
was down ½ %, continuing to trade below both moving averages and near the lower
boundary of its short term downtrend. The only possible positive is that it is
nearing minor support offered by its December 2017 low.
Bottom
line: the technical position of the indices continues to improve as the S&P
pushed above June highs---the only real negative being that both 100 day moving
averages continue to fall toward their 200 day moving averages. The assumption remains that stock prices are
going higher. TLT, UUP and GLD continue
to perform like investors are betting on a relatively positive US economy
versus the rest of the world’s economy. The
only problem, in my opinion, is that doing less poorly than the rest of the
world is not a reason for stocks to advance when they are already near historic
high valuations.
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. We have had two weeks in a row of upbeat data. Even though these numbers likely manifest a
better second quarter, so what? Everyone
accepts that growth will pick up in Q2.
But it hardly supports the thesis that the secular economic growth rate is
rising; and that ultimately that is what gets plugged into my Economic/Valuation
Models. True, those stats could be a
signal that longer term growth is improving; but ‘could be’ are the operative
words. I am not going to change a
forecast based on a fortnight’s worth of numbers.
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
will accelerate. My thesis remains that
the financing burden now posed by the massive US deficit and debt has and will
continue to constrain economic as well as profitability growth,
Another must read
article from Jeffrey Snider: https://www.realclearmarkets.com/articles/2018/07/13/theres_been_no_recovery_and_there_cant_be_one_103348.html
(2)
the success of current trade negotiations. If Trump is able to create a fairer political/trade
regime, it would almost certainly be a positive for secular earnings growth. However, the reverse 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. The immediate problem is that as
the risk of recession increases, the banks may be losing control of their own
narrative. Certainly, the Bank of Japan
is being backed into a corner in which it has lost its ability to respond to an
economic downturn. The Fed, and to a
lesser extent, the ECB have at least started to create some room for policy
responses. However, in my opinion, they
have waited too long [as they always have].
The
central banks’ problem is that they believe QE worked and therefore they need to
tighten monetary policy in order to have policy options to combat the next
recession. What they are missing is that
QE did diddily for the economy and that the longer they tighten the greater the
impact on the Markets which will start to correct the real damage that QE has
wrought---the misallocation and pricing of assets [risk]. And that won’t be good for equity prices.
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 25019
2801
* 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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