Saturday, September 29, 2018

The Closing Bell


The Closing Bell

9/29/18


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                     13649-29854
Long Term Uptrend                                  6410-29847
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2650-3421
                                    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 slightly negative: above estimates: weekly mortgage and purchase applications, September consumer confidence, month to date retail chain store sales, August durable goods orders, the September Richmond Fed manufacturing index; below estimates: September consumer sentiment, August Chicago Fed national activity index, the September Chicago PMI, the September Dallas Fed manufacturing index, final second quarter GDP, PCE and corporate profits, the August trade deficit; in line with estimates: August personal income and spending. August new home sales, weekly jobless claims.
           
The primary indicator were mixed: August durable goods orders (+), final Q2 GDP, PCE and corporate profits (-), August new home sales (0) and August personal income/spending (0).  Accordingly, I rate this week a neutral.   Score: in the last 155 weeks, fifty-one were positive, seventy-one negative and thirty-three mixed.
                         
 Update on big four economic indicators.

                  One brief comment.  We have gotten a string of weeks in which the data was mixed. I think this portrays exacting the scenario in my forecast: an economy growing but working hard to do so and certainly on no upward trajectory of its long term secular growth rate.

There were only a few numbers from overseas this week and they were all negative. That means our own economy is losing that as a tailwind.

Our forecast:

A pick up in what is now a below average 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,  The agreements with Mexico and South Korea are steps in that direction.   However, much more needs to be done for this factor to be a positive.

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).

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 growing slowly but not accelerating.  

       The negatives:

(1)   a vulnerable global banking [financial] system.  

While the Fed has done its job in forcing banks to be more prudent in their lending, one of the [unintended?] consequences is that it has to the creation of a brand new lending industry which has taken up where the banks left off, i.e. making high risk loans [shadow banking].  This aided and abetted by plentiful QE cheap money [misallocation of assets].  I have no idea when or even whether this ends poorly, but it is a growing part of the global financial system and, hence, must be accounted for in assessing the risk of defaults/solvency. (must read):


(2)   fiscal/regulatory policy. 

Good news and bad news on the trade front.  On the former, the US and South Korea signed a new trade agreement.  As to the latter, the Trump versus the governments in Canada and China food fight goes on.  In the case of China, each side keeps upping the ante, moving from an escalation in tariffs to Trump accusing the Chinese of election interference and the Chinese lowering tariffs on goods imported from other countries and pronouncing the US a trade bully.  Despite this US/Chinese public standoff, there are signs that both parties are acting less aggressively than they might otherwise.

Here is a bit of cognitive dissonance on the US/Mexico deal---it ain’t done yet.

The Wall Street Journal on Chinese theft of US technology (must read):

I don’t want to be too Pollyannaish about this.  But I continue to believe that the Donald will ultimately be successful in his effort to re-set the post WWII political/trade regime and the end result will be a plus for the economy.  However, if not, the outcome will be a negative.  So it is important to recognize that either outcome will be impactful.

And how can one discuss fiscal policy without touching on the subject of deficit spending.  This week the senate passed a continuing resolution locking the US into an ever increasing deficit/debt.

You know my bottom line: once the national debt reaches a certain size in relation to GDP [and the US has attained that dubious honor] the cost of servicing that debt offsets any benefits to growth that might come from tax cuts/infrastructure spending.

(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 main headline this week was the FOMC meeting, its closing statement and the subsequent Fed chair Powell press conference.  I covered this in Thursday’s Morning Call, so I won’t repeat myself.  But the bottom line is [a] the Fed Funds rate was increased and more hikes are expected, [b]  the Fed believes that the economy, employment and inflation continue perform in line with its forecast, and importantly [c] Powell suggested that the Fed was less knowledgeable and powerful than previously regimes contended and [d] equities prices might be stretched. 

To be fair, the last two points are subject some interpretation.  So I wouldn’t characterize them as compelling evidence that quantitative tightening will continue irrespective of future developments.  But I am noting a seeming change in, at least, the Fed chair’s attitude and that could be signaling a new less active/fine tuning and Market friendly Fed.
                                     https://www.zerohedge.com/news/2018-09-28/global-liquidity-eroding-fast-nothing-breaking-yet

The other development was the raising of target interest rates by the Banks of Hong Kong, India and the Philippines, all fighting the ongoing dollar funding problem.        https://www.realclearmarkets.com/articles/2018/09/28/central_bankers_cant_even_get_the_small_things_right_103430.html


As you know, my thesis is that ending QE will have little impact on the US economy but cause pain for the Markets whenever and however it unwinds. (must read):
 

(4)   geopolitical risks:  the denuclearization of North Korea seems to be moving forward [‘seems’ being the operative word] though Syria remains a flash point and Trump continues to hammer on Iran. 

This can’t be good.  EU joins Russian and China to dodge US sanctions against Iran.


(5)   economic difficulties around the globe.  The stats this week were negative:

[a] September EU economic confidence and the UK current account deficit were a disappointment,

[b] second quarter Chinese GDP growth slowed.

            Bottom line:  on a secular basis, the US is growing at an historically below average secular rate although I assume decreased regulation will improve that rate somewhat.  In addition, if Trump is successful in revising the post WWII political/trade regime, it would almost certainly be an additional plus. ‘If’ remains the operative word though clearly some progress is being made.

At the same time, these long term positives are being offset by a totally irresponsible fiscal policy.  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 push the deficit/debt higher, negatively impacting 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 26458, S&P 2913) were basically flat on the day.  Volume was up; breadth mixed.  They remain technically very strong.    My assumption is that they will challenge the upper boundaries of their long term uptrends (29807, 3065).

The VIX was down another 2 ¼ % on the day, a larger decline than is usual for a flat Market---an additional indication of the VIX trading in a confusing, atypical non-inverse relationship with stocks.  However, at the moment, it is still at the lower end of its short term trading range and that is something of a positive for equity prices.

The long bond declined on heavy volume.  As you know, when TLT broke below the lower boundary of its long term uptrend, I believed that move lower could continue for both technical and fundamental reasons.  That assumption is in question based on the long bond’s rally this week.  Plus I remain somewhat confused by this given that the dollar and gold seemed to interpret the Fed chairman Powell’s statement following the FOMC meeting as somewhat hawkish.  So bottom line is that I am confused.

The dollar was up, ending above the upper boundary of its very short term downtrend for a second day, negating that trend.  I continue to believe that UUP will move higher as long as the dollar funding problem persists.  But that aforementioned confusing pin action in TLT and GLD has me questioning that belief.

GLD was down ½ %, recovering much of Thursday’s loss.  While it is back in a developing very short term trading range, it remains an ugly chart.  A lot more work is needed to get this sick puppy out of the hospital.

          Bottom line: the indices remain technically strong. I continue to believe that they will challenge the upper boundaries of their long term uptrends.

         The pin action in the long bond, the dollar, the VIX and gold are all acting somewhat atypical.  That doesn’t necessarily mean something negative is occurring.  It is just that a change seems to be in the air; and I think we need to be alert to it.
               
                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), the improved regulatory environment notwithstanding.  At the moment, the important factors bearing on Fair Value (corporate profitability and the rate at which it is discounted) are:

(1)   the extent to which the economy is growing.  Clearly, the second quarter GDP number propelled by the tax cuts was a sign of improved growth.  Nevertheless, that is a single stat and in no way implies a trend.  Indeed, [a] most Street estimates for third quarter GDP growth are lower than that of Q2, [b] the Fed’s forecast for longer term growth shows a gradual decline back toward what has been a below average secular growth rate and [c] the forward {sales and earnings} guidance from many companies has begun to decline.

Unless those tax cuts alter investing and consumption behavior on a more permanent basis, Q2 growth will likely prove to be the peak growth rate of this economic cycle.  Furthermore, the effect that those tax cuts are, at least presently, having on the deficit/debt are just as meaningful, in my opinion, as any growth implications, to wit, financing the deficit and servicing of debt will constrain growth.

My conclusion remains that while the economy has experienced a pop in its cyclical growth resulting from the tax cuts, it simply can’t and won’t sustain that growth rate on a secular basis and will gradually revert back to the pre-tax cut, below average (less than 2%) rate.  To be clear, I am not saying that the economy is 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, beyond what I have already done, based on the dataflow to date or the promise of some grand reorientation of trade.

Also, lest we forget, the growth rate in rest of the global economy has slowed and will not be helped by the decelerating effects of the dollar funding problems in the emerging market.  That can’t be good for our own prospects.  It is certainly possible, even probable, that the US can continue to grow as the rest of the world slows.  But it is not likely that its second quarter growth rate will be maintained.  

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 and South Korean agreements are a step in that direction. 

However, the US remains at loggerheads with Canada and China.  Plus Trump is insisting on a changes in the terms of our trade agreements with Japan and Europe.  So there is much to be done before altering any assumptions about an improvement in economic growth.

Nonetheless, my bottom line is that I, perhaps foolishly, 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.  At present, it is happening.  The Fed raised rates again this week and its forward guidance was to expect more hikes and a continuation of the run off of its balance sheet. In addition, the ECB is on track to cease bond purchases by the end of this year.  While not removing excess liquidity in the global money supply, it will not be contributing to it.  And that is a start.  Plus there are hints from the Banks of China and Japan that some tightening is occurring or will occur in the near future.  Finally, the emerging markets continue to experience dollar funding issues---clear evidence that global money supply is shrinking and interest rates are rising.

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 generally accepted 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                                               26458            2913

* 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.








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