The Closing Bell
11/3/18
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 13752-29957
Long Term Uptrend 6410-29847
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2689-3460
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: the October ADP private
payroll report, October nonfarm
payrolls, month to date retail chain store sales, August/September construction
spending, September factory orders, the October Dallas manufacturing index;
below estimates: weekly mortgage and purchase applications, weekly jobless
claims, September personal income, third quarter employment cost index, October
Chicago PMI, the October Markit manufacturing PMI, the October ISM
manufacturing index, third quarter productivity and unit labor costs, the
September trade deficit; in line with estimates: the Case Shiller home price
index, revised September/October consumer confidence, September personal spending.
However, the primary
indicators were positive. October nonfarm payrolls (+), August/September construction
spending (+), September factory orders (+), September personal income (-), September
personal spending (0). While I am a bit
conflicted about a call, in the interest of not trying to talk my book, I am
giving the week a positive rating. Score:
in the last 160 weeks, fifty-three were positive, seventy-two negative and
thirty-five neutral.
Overseas, the
economic data returned to negative. So the US economy is not being helped by
any global growth.
There
was very few economic/political developments that would impact my
forecast. The only one being the
potential for meaningful trade talks between the US and China. How much of this seeming change in attitude
is purely political is as yet unknown.
Both sides need some short term relief, so cynicism shouldn’t be taken
lightly. The good news is that we won’t
have to wait long to know the truth.
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.
Where will the
credit crunch pinch first (must read):
(2)
fiscal/regulatory policy.
DC was on the
campaign trail this week; so virtually no news other than ignorable promises
and the potential easing of the trade standoff with China---which also has a
decent probability of being ignorable.
My bottom line: 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. (must read)
(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 only
central bank/monetary policy headline this week was the meeting of the Bank of
Japan which left interest rates and QE unchanged---putting it clearly at odds
with the Fed and the ECB. The big
question is, how will conflicting central bank monetary policies impact global
liquidity? Stay tuned because I have no
clue.
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.
The ECB’s epic
failure (must read):
(4) geopolitical
risks: Brexit, Italy, Syria, Khashoggi:
all simmering but nothing boiling over.
(5)
economic difficulties around the globe. The stats this week were negative:
[a] third quarter EU GDP was below estimates;
September German retail sales were lousy, the October UK manufacturing PMI was
below consensus,
[b] the October
Chinese manufacturing and nonmanufacturing indices were less than anticipated;
its October Caixin {small business} manufacturing PMI came slightly above
forecast.
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.
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 recently announced middle class tax
cuts as well as 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.
The Market-Disciplined
Investing
Technical
The Averages
(DJIA 25270, S&P 2723) took a rest on Friday. However, the technical picture for both index
didn’t change. The Dow ended below its
100 DMA (now resistance) but above its 200 DMA for a second day (now resistance;
if it remains there through the close next Tuesday, it will revert to support).
The S&P
finished below both moving averages, above the upper boundary of its very short
term downtrend, voiding that trend and above the lower boundary of its short
term uptrend.
As positive as this all seems, the technical
saw is that the indices still need to close Wednesday’s gap open. Unfortunately, there is no time horizon on
when the fill will take place. So prices
can go higher before closing the gap; but still assume that S&P ~2681/Dow ~24892
are going to be revisited in the not too distant future.
Volume rose,
remaining elevated; breadth was mixed.
The VIX was up
fractionally, finishing above both MA’s and in a short term uptrend. However, the upper boundary of that trend
acted as resistance and the VIX bounced off of it.
The long bond
was hammered, re-establishing a very short term downtrend and finishing within
a short term downtrend and below both moving averages. Still a negative technical picture,
indicating higher interest rates.
The dollar was up,
closing back above its August high, within a short term and a very short term
uptrend and above both moving averages. I
continue to believe that UUP will move higher as long as the dollar funding
problem persists.
GLD lifted
fractionally, ending above its 100 DMA.
However, there is nothing remotely decisive about its pin action.
Bottom line: the Markets were really
the story last week. Equities sold off
hard and then rallied equally so. The
implication of the latter (which was aided by favorable news [bulls**t?] on
trade) is that the worse is over.
On the other
hand, TLT’s and UUP’s performances both continued to point to higher interest
rates (a tighter Fed) which is definitely not a plus for the Markets.
Right now, I am
focusing on the S&P which is trading between its 200 DMA (which has been a
significant level for the past two years) on the upside and the lower boundary of
its short term uptrend (which it challenged unsuccessfully last week) on the
downside. Whichever of those boundaries
gets successfully challenged should tell us a lot about (1) how much of the
Donald’s trade comments that investors are willing to bet money on and (2)
price direction.
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 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 potential sign of improved growth; and if this quarter’s
earnings season continues to come in better than expected, it would indicate
that, at least, some of the Q2 strength spilled over into the third quarter and
would suggest 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, the overall trend in
the dataflow does not support the notion that the economy continues to grow at
the second quarter rate.
Many will point
to the strong earnings third quarter reports as an indication of continued higher
economic growth. However [a] some of
this improvement is the result of {i} advanced buying ahead of the imposition of
Chinese tariffs and {ii} Wall Street’s inclination to focus on the generally
more positive non-GAAP profits and [b] forward {sales and earnings} guidance
from many companies has pointed to lower growth.
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. 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 surely be a plus for secular earnings growth. And while the US/Mexico/Canada and South
Korean agreements help short term cyclical growth in that they remove
uncertainty, 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.
A
potential deal with China would be a huge plus if its theft of US intellectual
property can be stopped; but any agreement that mimics the aforementioned NAFTA
2.0 agreement is not a template for success on that point. One can only hope that there is more to this
week’s announcement of progress in the US/China trade talks than just political
smoke. But a healthy dose of cynicism is
probably appropriate.
Who to
believe?
Or?
https://www.zerohedge.com/news/2018-11-02/idiot-algos-panic-buy-stocks-again-trump-talks-china-trade
(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. And this week’s positive primary indicator readings will likely
only serve to bolster the Fed’s conviction to continue its tightening strategy.
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.
The shrinking
Fed balance sheet.
As you
know, I applaud the end of QE because of its destructive impact on corporate
and individuals’ investment decision making, i.e. price discovery and the mispricing and
misallocation of assets. But it will
have negative consequences for [a] credit borrowers---we are starting to see in
the dollar funding problems in foreign economies and [b] financial markets, in
general, as price discovery returns.
On top
of that, the ECB will commence the unwinding of its own QE policy soon and that
will only add to the global liquidity problem.
On the other hand, the BOJ remains entrenched in its version of QE and
the Chinese are using every policy tool available, including monetary easing,
to stem the effect of the trade dispute with the US. As I noted above, I have no clue how this
dance of conflicting monetary policy will play.
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 [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 any 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 overall fiscal policy (growing deficits/debt) 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.
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 11/30/18 13828
1706
Close this week 25270
2723
* 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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