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.
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
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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