The Closing Bell
7/21/18
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 13413-29608
Long Term Uptrend 6410-29847
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2572-3343
Intermediate
Term Uptrend 1292-3107 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 positive: above estimates: weekly jobless
claims, the July NY and Philly Fed manufacturing indices, May business
inventories/sales; below estimates: weekly mortgage/purchase applications, June
housing starts, month to date retail chain store sales; in line with estimates:
July housing index, June retail sales, June industrial production, May/June
leading economic indicators.
However, the primary
indicators were slightly negative: June housing starts (-), June retail sales
(0), June industrial production (0) and May/June leading economic indicators
(0). And, there were negative aspects to
June retail sales (ex autos and gas, they were down) and June industrial
production (the May number was revised down significantly). So I rate this week a negative. Score: in the
last 145 weeks, fifty were positive, sixty-eight negative and twenty-seven
neutral.
The economic data
continues to provide both positive and negative signals---there is no
consistent trend at all. So while I
continue to believe that second quarter economy growth will be better than first
quarter, I don’t believe that the US economy is now experiencing some kind lift
off.
Overseas, there
was little data. 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 Fed captured
some headlines this week, though they were of little import. Powell testified twice before congress; and
the Fed released its latest Beige Book.
The bottom line being that the Fed’s economic narrative remains the same
which means the Fed Funds rate will continue to be raised and the Fed’s balance
sheet unwound---unless the economic (Market?) numbers turn negative.
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.
Paulson, Geithner, Bernanke warn the US banking system is
still not as strong as it needs to be (medium):
(2)
fiscal/regulatory policy.
This
week, five countries initiated retaliatory tariffs against the US which then
filed a complaint with the World Trade Organization. The EU said it was preparing a new list of US
products on which it will impose tariffs.
Plus
China continues to devalue the yuan [thereby making Chinese imports to the US
cheaper, offsetting the rise in tariffs].
And the
Donald responses:
[a]
threatening to impose tariffs on the whole of Chinese imports to the US.
[b]
blaming the Fed for the rise in the dollar {making US exports more expensive and therefore likely to
shrink}. I covered this in Friday’s
Morning Call so I won’t repeat myself except to say that it is not his place to
take on the Fed {as much as I complain about it} and he is wrong on the
economics of his accusation in any case.
Aside from being embarrassed for him, I worry that he will undermine his
own good intentions with behavior like this.
As you
know, I believe 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, have included lots of Trumpian aggressive rhetoric and have been
notably unsuccessful. That said, I
applaud the Donald’s attempt to reset the post WWII political/trade regime. It
needed to occur. Frankly, the US can’t
afford to continue in its role as the global benefactor---our national debt and
current deficit being an obvious reason. Sooner or later, I believe that our
allies/trading partners will have to compromise for the simple reason that they
can’t afford not to. The question is
will they do it the easy way or the hard way.
That is what will determine the magnitude and extent of the pain.
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 it keeps getting worse (medium):
(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 I noted
above the Powell congressional testimony plus the narrative of the latest Beige
Book confirmed that the Fed is moving forward with its rate hikes. As always, the caveat is that this policy is
intact only so long as the numbers justify it.
That’s fair enough.
The problem is [a]
that data is not nearly as strong as it is made out to be {I am not saying the
economy is weak; it is just not as robust as the Fed portrays it}, [b] as I
noted last week, it is having to massage the stats on the yield curve in order
to justify its policy, and [c] it is not the economy that is the concern of the
Fed anyway. It is the Market that it is
worried about.
As you know, my
thesis is that the Fed’s primary concern is 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.
Furthermore, 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 appreciated view.
Complicating
the picture is the recent move by the Chinese government to loosen credit and
devalue the yuan. I understand this move
as a tactic in the face off with Trump on trade. However, it serves to keep global QE alive
and well; and as such, further delays the inevitable.
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 (as
evidence of that, I would point to the latest Japanese data which showed year
over year inflation up 0.8% versus its target of 2.0%). But {ii} it created a
massive mispricing and misallocation of assets; and its unwinding will not be
Market friendly.
(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.
(5)
economic difficulties around the globe. Not a lot of stats released this week: Q2
Chinese GDP was in line, June retail sales were better than expected while
industrial production was worse.
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; and 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 25058, S&P 2801) were down fractionally on lower volume and deteriorating
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. There
is a bit of cognitive dissonance: the S&P has made fourth successively higher
highs while the Dow failed. Plus it has
been unable to challenge its former high.
At the moment, I don’t think that this is all that important. So I continue to assume the indices will now
challenge their all-time high.
VIX was flat on
Friday, having spent the week in a narrow trading range near the lower boundary
of its short term trading range. It
doesn’t seem to want to challenge that lower boundary which would mean that
stocks are in for some congestive trading.
The long
Treasury got hammered after having made three attempts to bust above the upper
boundary of its short term downtrend and ending right on its 200 day moving
average. Follow through.
The
dollar was down, bouncing off its former resistance high. That said, it remains
above both moving averages and in a short term uptrend.
Gold
rallied but continues to trade below both moving averages. The only bright spot, if that is what you
would call it, is that it managed close above the lower boundary of its short
term downtrend.
Bottom
line: despite Thursday and Friday’s pin
action the technical position of the indices is strong. The
assumption remains that stock prices are going higher. TLT and UUP both had notable counter trend
moves on Friday. The question is follow
through. GLD remains the ugly duck
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. After two weeks of upbeat data, we again got
evidence that despite all the optimism, the economy simply isn’t growing as
rapidly as many think; and to the extent that second quarter growth will be an
improvement over the first, there is certainly no evidence of sustainability. As you know, I have never thought that the
economy was going into a recession and I agree that second quarter will show a
pickup in growth. But while there
clearly is some probability of a meaningful pick up in the long term secular
growth rate of the economy, 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
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.
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. 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. That became a lot more muddled this
week, as [a] the Bank of China opened the credit spigot as part of an attempt
to offset the hurt being laid on it by the Trump tariffs, [b] it became increasingly
obvious that the Japanese version of QEInfinity has been a failure. And in an apparent attempt mimic our Fed, is
undertaking a study on how to manipulate its yield curve {recall that the Fed has just invented a new
yield curve to justify its policies} and [c] the Fed confirmed its policy of
raising rates and unwinding its balance sheet. 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. 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 25058
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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