The
Closing Bell
10/20/18
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 13703-29908
Long Term Uptrend 6410-29847
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2671-3442
Intermediate
Term Uptrend 1318-3133 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 negative: above estimates: weekly jobless claims, September
industrial production, the October NY and Philly Fed manufacturing indices;
below estimates: weekly mortgage and purchase applications, September housing
starts/building permits, September existing home sales, the October housing
market index, month to date retain chain store sales, September retail sales,
US FY 2018 budget deficit; in line with estimates: August business
inventories/sales, September leading economic indicators.
Primary
indicators were also negative. September industrial production (+), September
housing starts (-), September existing home sales (-), September retail sales
(-) and the September leading economic indicators (0). I am giving a negative rating. Score: in the last 158 weeks, fifty-two were
positive, seventy-two negative and thirty-four neutral.
Several important
developments this week; all covered in more detail later:
(1)
the latest FOMC minutes indicated that the Fed will
continue to tighten monetary policy,
(2)
Trump ordered his cabinet to institute 5% across the
board spending cuts,
(3)
third quarter earnings season is off to a much better
start than I had anticipated.
Overseas, the
economic data was mixed---better than negative which it has been of late. Still the point is that the US economy is not
being helped by any global growth.
Our forecast:
A pick up in what
is now a below average long term secular economic growth rate based on less
government regulation with possible minor help from the recent agreements with
Mexico/Canada/South Korea. There is the potential that (1) Trump’s trade
negotiations with Japan, the EU and China and (2) possible spending cuts could
also lead to a further improvement in our long term secular growth rate. However, much more needs to be done for this
factor to be a significant positive.
My fiscal thesis
remains that at the current high level of national debt, the cost of servicing
the debt more than offsets any stimulative benefit of tax cuts---subject to some
revision if the spending cuts take place.
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.
From last week:
I re-introduced
this subject a couple of weeks ago, altering it slightly to incorporate the
entire financial system, specifically the shadow banking system [nonbank loans
from hedge funds, finance companies, etc.].
The reason being [a] the tremendous growth in this segment of the
financial market [b] the weak credit standards currently demanded by the
lending institutions, i.e. a lot of nonrecourse and covenant lite loans, and
[c] the use of derivatives by the lenders to hedge their bets. Recall that this was one of the main problems
in the 2008/2009 crisis. I am not
suggesting that conditions can deteriorate as significantly as they did back
then. But they don’t have to in order to
result in liquidity/solvency problems.
(2)
fiscal/regulatory policy.
Ironically,
following my ‘turd in the punchbowl’ comment about fiscal irresponsibility last
week, the Donald stunned [at least me] this week in ordering his cabinet
members to implement an across the board 5% spending cut. You know that irresponsible fiscal policy
[i.e. mounting deficits and debt] has been one of my main concerns since I
started this blog. The reason was
simple: the usurpation by the government of funds that could be better spent on
investment and consumption. Later, the
study by Rogoff and Reinhart supported this notion showing that once a nation’s
debt has reached 90% of GDP, the cost of servicing the debt stifled economic
growth. When the GOP passed the tax
cuts, my thesis was that the increase in the deficit/debt would offset the
benefits of the cut.
Hence, this
move by Trump to begin reining in government spending is clearly a plus. Of course, it still has to occur and it can’t
be filled with accounting gimmicks. So
we have to wait to see just how serious this administration is about those
cuts. Further, even if they do take
place, it will happen in the discretionary part of the budget which is smaller
than the nondiscretionary side [entitlements]---which in turn has no spending
limits. Rather it is driven by inflation [cost of living adjustments] and
demographics [an aging population]. Here is where the real work needs to be
done.
I am not trying
to discount Trumps efforts because they will have a positive effect on the long
term secular growth rate of the economy.
But I am simply saying that they are a great start but more is required
on entitlements in order to really alleviate the constraining effects of an
ever expanding deficit/debt.
I would also
note than on a short term basis, any cuts in government spending is going to
adversely impact the revenues/profits of big time government contractors.
On a minor
note, Trump also said that he was considering abandoning a shipping treaty with
China in which the shipping rates from China to the US were greatly discounted
from the shipping rates from the US to China.
He is clearly increasing pressure on the Xi ahead of a scheduled meeting
at the G20 next month. I have said
before that I don’t see the Chinese doing anything before the November
elections. How those turn out could have
an impact on the Chinese negotiating position.
Until we know the outcome of spending cut plan my bottom
line remains: once the national debt reaches a certain size in relation to GDP
[and the US has already 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 asset bubbles in the stock market as well as
in the auto, student and mortgage loan markets.
The headline
this week was the release of the minutes from the last FOMC meeting. There was nothing really new, including that the
Fed would continue to tighten the money supply.
Still that seemed to generate some restlessness among the natives who
apparently are unconvinced. Which brings
us back to the $64,000 question for the Market right now: does Powell really mean that the Fed will
continue to tighten money, irrespective of its impact on the Market?
As you know, my opinion since the inception
of QEII was that it was a major mistake for the [Bernanke/Yellen] Fed to add
the stabilization of financial markets as a third objective to its
congressionally mandated goals of containing inflation and unemployment. It destroyed price [risk] discovery and led
to the gross mispricing and misallocation of assets. If that regime is over then sooner or later
price discovery will return.
As a footnote, remember ECB started the
unwinding of its own QE on October 1st. Although my assumption is that Draghi et al
will run for the hills [cease unwinding] at the first sign of trouble.
You know my bottom line: the unwinding of QE will have little effect on
the US economy but will reverse the gross mispricing and misallocation of
assets.
(4) geopolitical
risks: the denuclearization of North
Korea seems to be moving forward [‘seems’ being the operative word] though
Syria remains a flash point. Both risks; neither on the front burner. I add the Khashoggi assassination to the list
without having a clue to the potential outcome.
(5)
economic difficulties around the globe. The stats this week were mixed:
[a] October German investor sentiment was negative;
August UK unemployment was 4.0%, in line but September retail sales declined
0.3% versus estimates of up 0.3%; September EU auto sales were down 23%,
[b] third
quarter Chinese GDP rose 1.6%, in line; retail sales were up 9.2% versus
expectations of up 9.1%; fixed asset investments were up 5.4% versus 5.3%;
industrial output +.5% versus +.53%.
In addition, there are potential negative economic as well
as political fallouts from Brexit and the budget fight between Italy and the EU---though
recall all the hand wringing over Greece a couple of years ago came to naught. To be sure, the UK and Italy have much
bigger economies than Greece; so any negative consequences would be more
impactful. But I am going to let the
political process get further down the road before I start worrying about the
economic fallout.
Latest on Brexit.
And
Latest out of Italy.
Moody’s cuts Italy’s credit rating.
Bottom
line: on a secular basis, the US is
growing at an historically below average secular rate although I assume decreased
regulation, the likely successful completion of the NAFTA 2.0 agreement and
Trump’s spending cuts (assuming implementation) will improve that rate somewhat.
Certainly on a
cyclical basis, removing the uncertainty of no NAFTA treaty should help return economic
conditions to what they were before. The
same is equally true if Trump is successful in revising the trade agreements
with the EU, Japan and China. ‘If’ being
the operative word, especially as it applies to China where it looks like the
current standoff will prove protracted.
At the same
time, these long term positives are being offset by a totally irresponsible
fiscal policy. To be sure, the
aforementioned spending cuts would be a great start to correcting this
problem. But the out of control entitlement
spending has to be addressed before the growing deficit/debt can be restrained.
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. On the other
hand, this earnings season is off to start that points to a much better end
result than I have been expecting. If
this continues, it would be a sign that the overall third quarter results may
be better than my estimates.
The Market-Disciplined
Investing
Technical
The Averages
(DJIA 25444, S&P 2767) turned in a mixed performance Friday (Dow up,
S&P down). Volume rose but breadth
was mixed. The S&P finished right on
its 200 DMA for a second day. At the
moment, it appears that investors lack the conviction to push stocks in either
direction. So we wait for follow
through.
The VIX was up fractionally,
retaining its positive chart---meaning it is a negative for stocks.
The long bond
was down again, remaining in short term and very short term downtrends and
below both moving averages. Still a
negative technical picture.
The dollar fell
back slightly but continues to have a positive technical standing. However, it has failed to advance to a
challenge of its August high for a second time---a bit of a negative. Still I continue to believe that UUP will
move higher as long as the dollar funding problem persists.
GLD rose nine
cents but still finished below its 100 DMA (now resistance). After resetting its short term trend to a
trading range, there has just been no follow through to the upside.
Bottom line: the bulls and bears continue
to duke it out around the S&P 200 DMA; so until it confirms a break either
below its 200 DMA or above its 100 DMA and the upper boundary of its very short
term downtrend, it makes sense to assume that the aforementioned battle will be
waged between those two levels.
There are still
two positive seasonal factors at work (1) stocks have traditionally traded
higher in the months of November and December (2) this earnings season is off
to a very upbeat start; if that continues, it should provide additional
buoyancy to stock prices.
The long bond
and the dollar both continued to act like rates are going higher. Gold remains in never, never land.
Friday in the charts.
Chinese stocks
And:
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 and the potential pluses from trade and
spending cuts 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; and if this quarter earnings season continues to come in better
than expected, that would indicate that, at least, some of the strength spilled
over into the third quarter and would indicate the need for more optimism. Nevertheless,
[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] to date, third
quarter macroeconomic indicators have not supported the notion that the economy
continues to grow at the second quarter rate and [d] the already announced
forward {sales and earnings} guidance from many companies has begun to decline
{autos, construction, airlines, packaging}.
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.
However, I am open to altering that outlook based on better growth numbers
resulting from tax cuts, spending cuts and the successful completion of
multiple trade agreements.
Counterpoint.
That
said, I never forecast that the economy is going into a recession. And while there clearly is some probability
of a pickup in the long term secular growth rate of the economy [deregulation,
trade, spending cuts], I am not going to change a forecast, beyond what I have
already done, based on the dataflow to date or the promises of some grand
reorientation of trade or spending cuts.
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/Canada and South Korean
agreements are a step in that direction.
But there is general agreement [except within the Administration] that
these revised treaties will barely move the needle on the secular growth rate
of the economy; though certainly there be a cyclical effect from the removal of
uncertainty.
However,
the US remains at loggerheads with 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 optimistic that the Donald’s
current negotiating strategy will pay off; hopefully with better results than
NAFTA 2.0. 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 continues to raise rates, its forward
guidance is to expect more hikes and a continuation of the run off of its
balance sheet. Perhaps most telling are the comments from various FOMC members
that the Fed is no longer reacting with any sensitivity to the
Markets---assuming they really mean it.
I have
opined that this would drive the after effects of QE, i.e. the return to price
discovery and the correction of the mispricing and misallocation of
assets. And, the Market aside, we are
starting to see those after effects in the dollar funding problems in foreign
economies. On top of that, the ECB has commenced the unwinding of its own QE
policy which will only add to the global liquidity problem.
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 [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 remain at record highs [at least as
calculated by my Valuation Model] 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.
Finally [a] interest rates are up---raising the
discount rate at which earnings and dividends are valued, [b] the Fed continues
to shrink money supply and that is causing dollar funding indigestion not only
in the emerging market but also seems to spreading to the developed markets; as
important, Powell has made clear that he expects to continue to tighten whatever
happens to the Markets---a massive change in attitude from the Bernanke/Yellen
regimes, [c] corporations have record levels of debt, especially in the lower
rated credit segment and [d] are starting to lower profit expectations, [e]
finally…..the bugaboo from the last financial crisis, i.e. derivatives, has
reappeared with all its associated counterparty risks.
Bottom line: a
new regulatory regime plus an improvement in our trade policies along with
proposed spending cuts 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 10/31/18 13796
1702
Close this week 25444
2767
* 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.
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