The Closing Bell
9/8/18
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 13604-29809
Long Term Uptrend 6410-29847
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2627-3398
Intermediate
Term Uptrend 1308-3122 Long Term Uptrend 905-3065
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 mixed: above estimates: weekly purchase applications,
month to date retail chain store sales, weekly jobless claims, August
manufacturing PMI, August ISM manufacturing and nonmanufacturing indices, the
July trade deficit; below estimates: weekly mortgage applications, the August
ADP private payroll report, July construction spending, August services PMI,
July factory orders, revised Q2 productivity; in line with estimates: revised
Q2 unit labor costs, July/August nonfarm payroll and the unemployment rate.
Primary
indicator were largely negative: July construction spending (-), July factory
orders (-), revised second quarter productivity (-) and July/August nonfarm
payrolls (0). So I rate this week a negative. Score: in the last 152 weeks, fifty-one were
positive, seventy-one negative and thirty mixed.
One note on Friday’s employment
report. While the talking heads were
mostly upbeat about the number, I thought it mixed at best: (1) the July
reading was revised down by more than the August stat beat expectations, (2)
the average increase in employment over the last three months has been less than
needed to absorb the natural growth of the labor force---hardly a robust
datapoint. Clearly, I am less jiggy than
the chattering class.
And:
The numbers from
overseas this week were mixed, continuing the trend of mixed to negative stats. That means our own economy is losing that as
a tailwind.
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; and there has been positive
developments on that score with the new US/Mexico trade agreement. Unfortunately, if negotiations with Canada,
the EU, China and now Japan aren’t fruitful, 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
again, there was some upbeat news on this front with the proposed freezing of
federal employee salaries and improvements in the budgeting process.
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.
Update on the big
our economic indicators (medium):
The
negatives:
(1)
a vulnerable global banking system.
The overseas
dollar funding problems [the necessity to buy dollars to service/refinance
current dollar denominated debt] continue to grow as more countries are having
problems. This issue impacts the banks
because they own a major portion of the debt that is being serviced/refinanced. If that debt goes into default, then the
banks’ balance sheets/capital account takes a direct hit and that would in turn
[a] impede lending and [b] weaken their solvency, making their own debt more
difficult to service/refinance.
Not helping
matters, S&P decided to revise its rating system for Chinese credits,
basically giving the same rating to an entity as the Chinese government gives
it---irrespective of balance sheet strength, level of profitability, etc. In short, mask the true creditworthiness of
the entity [remember the rating services’ error with mortgage backed
securities].
The global
economy has had crises brought on by dollar funding problems twice in the last
thirty years. The results were not
pretty. To date, we are not in as
extreme a circumstance; but we are clearly moving in that direction.
(2)
fiscal/regulatory policy.
This
week, politics dominated the headlines until Friday. Lost in the shuffle were:
[a]
Trump’s action to freeze federal employee pay,
[b] the
congressional GOP proposals to improve the budgeting process {separate votes on
each portion of the budget},
[c] additional
details on the new improved second tax bill: {i} make the individual tax cuts
permanent---while this won’t undo the damage done to the deficit/debt by the
first tax bill, at least, it won’t make it worse, and {ii} ease rules on
retirement savings---that is a potential plus for the deficit/debt in that if
retirement savings can be increased, it could allow some room to the rein
back/slow the grow of social security benefits.
While I
do not believe these measures are sufficient to offset the enormous and
growing deficit/debt problem, they, at
least, don’t make it worse.
But on Friday,
trade again became the lead story as [a] Trump didn’t impose the $200 billion
in tariffs on China that he has threatened, but [b] upped the ante by saying
that he would impose additional $267 billion in tariffs {$467 billion in
total}. For some reason, investors
ignored Trump’s initial inaction---which I interpreted as meaning progress was
being made in US/Chinese trade talks---but zeroed in on the second---which I also
interpreted as a not so subtle message to the Chinese not to be wasting our
time. In short, I thought this all good
news. Mr. Market disagreed.
(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
misallocation of assets problem is now showing up as an emerging market dollar
funding problem. As a brief review, this
problem has arisen because when the Fed was pursuing QEInfinity, there were
lots of dollars that could be borrowed cheaply by less creditworthy entities
[like emerging market countries]. Now
that the Fed is tightening, there are fewer dollars available to
service/refinance those loans. That
drives up the price of dollars, making it even more difficult/costly to
service/refinance those loans [this is a prime example of the misallocation of
assets]. The longer this circumstance
persists, the more likely that one or more countries default on a loan, which,
as I noted above, then echoes through the global banking system. At that point, things get serious.
And:
NY Fed head says
that he is not worried about inverting the yield curve. Bear in mind, this guy has been a leading
dove. Also bear in mind that ‘this time
is never different’, i.e. the Fed has never, ever in its history successfully
managed a transition from easy to tight money.
As you know, I
believe that ending QE will have little impact on the US economy but cause pain
for the Markets whenever and however it unwinds.
The math of
quantitative tightening (QT) (medium):
The yield curve
and bank profitability (medium and a must read):
(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].
Viewed through
that prism, we got some good news as [a] nothing appears to have come up about
‘the Wall’ or US immigration policy in the US/Mexico trade talks/agreement and
[b] North Korea and the US exchanged vows of love this week in spite of the
looming imposition of additional tariffs on Chinese goods.
(5)
economic difficulties around the globe. Another week of sub-par results:
[a] August EU manufacturing and services PMI’s and Q3
GDP were all in line; July German factory orders fell dramatically for the
second month in a row,
[b] August Chinese Caixin services PMI was below
estimates.
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 though
clearly the US/Mexico agreement is a positive step.
At the same
time, these long term positives are being offset by a totally irresponsible
fiscal policy though I do have to take the proposed second tax cut bill off the
list of egregious measures. The original
tax cut, increased deficit spending, a potentially big infrastructure bill and
funding the bureaucracy of a new arm of military (space force) will negatively impact
economic growth and inflation, in my opinion. Until evidence proves otherwise, my thesis
remains that cost of servicing the current level of the national debt and
budget deficit is 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 25916, S&P 2871) were down on Friday.
Volume rose. Breadth was
weak. However, the Averages remain
strong technically; and my assumption is that they will challenge the upper
boundaries of their long term uptrends (29807, 3065).
The VIX was up
again, closing above its 100 DMA for a third day, reverting to support and
above its 200 DMA (now resistance; if it remains there through the close on
Wednesday, it will revert to support)---if it successfully challenges this
level, we have to entertain the idea that stocks may be going lower.
TLT got pounded,
closing (1) below its 100 DMA [now support; if it remains there through the
close next Tuesday, it will revert to resistance], (2) below its 200 DMA [now
support; if it remains there through the close on Wednesday, it will revert to
resistance], [3] the lower boundary of its long term uptrend [if it remains
there through the close on Thursday, the trend will reset to a trading range]
and broke out of the long pennant formation.
Remember though that TLT has briefly pushed below the lower boundary of
its long term uptrend four times in the last year; so we need some follow
through to the downside before assuming that prices are headed much lower.
The dollar rose,
and remains technically strong. That is
not likely to change as long as dollar funding problems continue in the
emerging markets.
GLD was down and continues
to have the ugliest chart on the block.
Bottom line: despite a schizophrenic week in stock
trading, the indices remain strong and I continue to believe that they will
challenge the upper boundaries of their long term uptrends. The dollar will likely remain strong until
the dollar funding problems are resolved.
The bond crowd may be changing their long term perspective. The successful challenge of TLT’s long term
uptrend will be significant, technically speaking. And if it occurs, that will likely provide
additional strength to the dollar and weakness in GLD.
Friday in the charts.
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. Taking the second quarter GDP number by itself,
it would be easy enough to project increasing growth, mom’s apple pie, free
love and nickel beer into the future.
But I can’t do that. The tax cuts
almost assuredly had a significant effect on Q2 growth. But:
[a] that
was a one-time shot in the arm. Unless
it alters investing and consumption behavior on a more permanent basis, it is
meaningless in terms of future growth,
[b] and
so far, the data don’t support the thesis that the economy is experiencing any
kind of lift off. Indeed, third quarter
results so far indicate softening back toward the former modest rate of growth.
My
conclusion remains that while the economy is growing, it simply isn’t growing
as rapidly as many think. On the other
hand, as you know, 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 if the rest of the world slows. But it is not likely that its growth rate will
accelerate.
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. Clearly, the US/Mexico agreement is a step in
that direction. However, Canada appears
to be resisting joining the pact [though I believe that it ultimately will], the
Donald has spurned advances by the EU, seems intent on hammering China again
and added Japan to the list of countries that he wants to revise trade
agreements. I remain hopeful that his 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. At present, it is happening. Given the recent comments from various Fed
members, it seems likely to continue at least in the US. Further, the bond boys look like they are
becoming convinced that rates are going up---though that is not a certainty at
the moment. I have little confidence is
projecting a path for rest of the global central banks; but I remain convinced
that [a] QE 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/misallocation will be reversed---and the dollar funding problem is
the first material sign that it is happening 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 the current economic/corporate profit scenario which includes an
acceleration of economic growth [which 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 9/30/18 13764
1698
Close this week 25916
2871
* 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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