The Closing Bell
8/4/18
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 2590-3361
Intermediate
Term Uptrend 1298-3112 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 very slightly positive: above estimates: June pending
home sales, May Case Shiller home price index, second quarter employment cost
index, July ADP private payroll report, month to date retail chain store sales,
July consumer confidence, July Chicago PMI, July Dallas Fed manufacturing
index, June core price index; below estimates: weekly mortgage/purchase
applications, July light vehicle sales, July manufacturing and services PMI’s,
the July ISM manufacturing and nonmanufacturing indices, June factory orders,
the June trade deficit; in line with estimates: June personal income, June
personal spending, weekly jobless claims, June/July nonfarm payrolls, May/June
construction spending.
However, the primary
indicators were very slightly negative: June personal income (0), July personal
spending (0), May/June construction spending, June/July nonfarm payrolls (0), and
June factory orders (-). So I rate this
week a wash. Score: in the last 147 weeks, fifty were positive, sixty-nine
negative and twenty-eight neutral.
Despite this
week’s overall stats slight tilt to the positive, primary indicators were
anything but robust---which I think is a lot more important than the total
score. In other words, there is still
very limited data to support the notion that the US economy is experiencing
some kind lift off.
Update on big
four economic indicators.
The numbers from
overseas this week were again disappointing.
So 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 FOMC and
Bank of England met this week and reaffirmed a move toward more restrictive
monetary policies. In addition, the Bank
of Japan continued to confuse everyone regarding their intent for QE. Late in the week, the Chinese dramatically
increased reserve requirements (tightening money supply); but there is some
question as to whether this was just a part of the trade negotiating process
with the US. Nonetheless, that leaves
most central banks (who knows what the Japanese are doing) inching toward the
unwinding of QE.
Our (new and
improved) forecast:
A pick up in the
long term secular economic growth rate based on less government regulation. 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.
Another distressing example of how the financial system is
being gamed (medium):
(2)
fiscal/regulatory policy.
This
week, trade remained in the headlines as:
[a] the
China/US dispute stepped to the top of the list. In light of ongoing talks between the two
parties, Trump did delay the imposition of tariffs for a week. Then poked the Chinese in the eye by
threatening to increase those tariffs from 10% to 25%. The Chinese responded in kind. First, halting the slide of the yuan; then
threatening to raise tariff rates,
List of
US products on China’s tariff hit list (medium):
https://www.zerohedge.com/news/2018-08-03/here-full-list-us-products-will-be-hit-new-chinese-tariffs
***overnight,
Chinese will not honor sanctions against Iran (medium):
[b] the
good news is that the incoming president of Mexico said that he expected an
agreement with the US shortly,
As you
know, I believe that {i} the Donald is right in attempting to reset the post
WWII political/trading regime, but that said {ii} the outcome of current negotiations are an important variable in our
long term secular economic growth rate forecast.
At the
moment, the only thing that has changed is the increase in tariffs, which is
definitely not good for the global economy.
The hope, of course, is that his strategy will produce a fairer deal for
the US. However, 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 Trump announce that he is considering indexing the
capital gains tax to inflation. I noted
earlier that I like this move on a long term basis. However, our immediate problem is a runaway
budget deficit/national debt at the exact point in time when it should be
shrinking. So I give him an A for effort but an F for execution, if this measure
goes through.
Unfortunately,
that is not the only negative facing us with respect to the budget. Remember last week, congress is working on a
2019 budget with an even larger deficit than 2018. This week, the Treasury put an exclamation
point on this issue, raising its estimate for the US calendar year budget
deficit to $1.33 trillion.
Oh,
dear.
(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.
Lots of developments
in this arena:
[a] the FOMC
met, left rates unchanged but upgraded their forecast on the economy,
indicating the likelihood of two more rate hikes this year and a continuation
of the unwinding of its balance sheet,
[b] the Bank of
England raised rates and the accompanying commentary was more hawkish than
expected,
[c] the Bank of
Japan provided the entertainment {and much confusion} for week. Following its regular scheduled meeting, it
announced that it would leave rates unchanged but would make some ‘adjustments’
to how it managed its yield curve. The
Market interpreted that as a signal of tightening and began dumping bonds. Initially, the BOJ did nothing but later
stepped in to calm the Markets. However,
it didn’t use its normal procedures which the Market read as a sign that the
BOJ would let rates rise but at a more measured pace. Yeah, another version of the green apple two
step. At this point, I don’t think
anyone knows exactly what the policy is but it seems likely that traders will
test the limits of any tightening.
This latest
move in the long Japanese bond is not as big a deal as many are making it
(medium):
Counterpoint:
Finally, as I noted above, the Chinese initiated a big move toward
tightening. This would be significant if
it weren’t for the possibility that it was just a maneuver in the trade war
with the US. At present, I am not giving
this move much weight.
At the moment,
global bond markets are reading the above as a general move toward tighter global
monetary policy. I think it a bit too
soon for that assumption since {i} the ECB is still a bit hazy on its moves,
{ii} ditto with the BOJ, {iii} I am not sure of the Chinese motive for tightening
and {iv} most important, there hasn’t been a sufficient move in rates to really
stampede the bond market. Until that
happens, we won’t know the central banks reaction, i.e. will they chicken out
and resume easing. All we can do is wait
and see.
If you believe,
as I do, that ending QE will cause little economic impact but major pain for
the Markets, this was not a good week.
(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.
This can’t help
(medium):
(5)
economic difficulties around the globe. Another week of sub-par results:
[a] the EU reported second quarter GDP growth slowed
while CPI and CPI, ex food and energy came in hotter than forecast; the July EU
composite PMI was in line; June retail sales were below consensus; the July UK
manufacturing PMI was above estimates while its services PMI was below,
[b] the July Chinese manufacturing PMI came in below
expectations
Bottom
line: on a secular basis, the US long
term economic growth rate could improve based on decreasing regulation. 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.
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 25462, S&P 2840) had a good day on lower volume but better breadth. They remain strong technically and the Dow is
back above its June high. However, (1) its
100 DMA is right on its 200 DMA and moving lower and (2) VIX remains range
bound since mid-July between its 200 DMA and the lower boundary of its short
term trading---which is providing no directional information.
The major
technical story continues to be the pin action of TLT (increase in interest
rates). Friday, it closed right on its
100 DMA (putting that challenge in question) and the lower boundary of its long
term uptrend (putting that challenge in question). That places both challenges on hold but does
not negate them. A plus day on Monday,
however, will negate them; a down day will re-start the challenge clock.
The
dollar continued to rally, remains technically strong and appears to be
confirming a move to higher rates. GLD was
up, but still has the ugliest chart around and is also pointing towards higher
rates.
Bottom
line: the Averages remain quite strong
technically speaking, though some cracks exist.
The assumption remains that they are going to challenge their all-time
highs.
TLT’s
performance has potentially important negative fundamental as well as technical
implications. Despite the indeterminate
close yesterday, my time and distance discipline is still in effect. We just have to wait until Monday for
clarity. That said, the dollar and GLD are
suggesting that they were anticipating higher interest rates. Stay tuned.
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, the economic stats [at least as I view them] are portraying a growing
economy but at a labored rate. ‘Strong’
is not the word to describe it. 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 or the promise of some grand reorientation of trade.
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. To that end, the comments by the Mexican president
were clearly promising. On the other,
China and the US continue to lob grenades at each other, the feigning measures by
both parties to imply a willingness to compromise notwithstanding. I remain hopeful that the Donald’s current
negotiating strategy will pay off; however, the risks and rewards associated
with failure and success are very high.
Either outcome would almost surely have an impact on corporate earnings
and, probably, on stock prices,
(3)
the rate at which the global central banks unwind
QE. That remains a somewhat muddled picture
this week. On the plus side, the Fed and
the Bank of England are proceeding with a tightening in their respective
monetary policies. On the other hand, the BOJ appears to want to
begin raising rates, but is more afraid of the Market reaction than our own
Fed. In addition, China really threw the
global bond markets a curve ball when it staged a dramatic turnaround in its
monetary policy---implying a big step towards tightening. But as I have noted, this move may have more
to do with trade negotiations than reigning in an expansionary monetary policy.
Thus,
the global economy is facing a confusing and somewhat contradictory array of
monetary policy moves. I have little
confidence is projecting a path for global QE in that environment; but I remain
convinced that [a] it has done and will continue to do harm to the global
economy in terms of the mispricing and misallocation of assets, [b] sooner or
later that mispricing will be reversed and [c] 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 development 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 8/31/18 13733
1694
Close this week 25462
2840
* 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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