The Closing Bell
11/17/18
I am taking next week off. Back
on the 26th.
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 13803-30008
Long Term Uptrend
6410-29847
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2705-3476
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 a neutral for equity valuations. The
data flow this week was mixed: above estimates: October retail sales, the
October small business optimism index, September business inventories/sales, the
November NY and Kansas City Feds’ manufacturing indices; below estimates: weekly
mortgage and purchase applications, weekly jobless claims, October industrial
production, the November Philly Fed manufacturing index, October export/import
prices; in line with estimates: month to date retail chain store sales, October
CPI.
In addition, the
primary indicators were mixed: October retail sales (+) and October industrial
production (-). I am giving this week a neutral
rating. Score: in the last 162 weeks,
fifty-three were positive, seventy-two negative and thirty-seven neutral.
Overseas, the
economic data was poor. So the US economy is not being helped by any global
growth.
There
was were several other economic/political developments that could impact my
forecast.
(1)
the price of oil is getting hammered. However, this time around the ‘unmitigated
positive’ crowd is nowhere to be seen.
To be sure, technology continues to bring down the lifting cost of
oil. So the damage this time around could
be less, depending on how low prices go.
On the other hand, a large percentage of high risk bank loans are to the
oil companies. Meaning insolvencies in
this industry still have the potential to cause heartburn in the credit markets,
(2)
Brexit and the
Italy/EU standoff are taking their toll on the EU economy. The hope here is that both of these difficult
situations get resolved in a positive way and Europe just experiences some
temporary economic indigestion. The
downside, of course, they lead to major economic disruptions---and all that
implies for the global economy,
My forecast
(which has changed):
A number of
Trump policy changes should have a positive impact on what is now a below
average long term secular economic growth rate.
These include 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, the
explosion in deficit spending, especially at a time when the government should
be running a surplus, is a secular negative.
My thesis on this issue is that at the current high level of national
debt, the cost of servicing the debt more than offsets (1) any stimulative
benefit of tax cuts and (2) the secular positives of less government regulation
and fairer trade [at least on the agreements that have been renegotiated].
On a cyclical
basis, while the second quarter numbers were definitely better than the first,
third quarter stats showed slower growth and current expectations for the
fourth quarter are even lower. Perhaps
more concerning is the forward sales/earnings guidance from leaders in major
sectors of the economy suggesting a further slowdown in growth that is more
pronounced than current consensus.
So my current assumption
remains intact---an economy growing slowly---but with an increasing risk of
recession. The odds are not high enough
at this point to change my forecast but they are increasing.
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.
IMF sounds alarm on leveraged lending (must read):
While investors didn’t appreciate Maxine Waters’
comments regarding bank deregulation [or the ceasing/reversal there of], I
applaud, at least, the notion of not allowing banks to regain their former freedom
to take irresponsible risks and have a taxpayer put to bail them out if things
go awry. On the other hand, if anyone is
capable of proposing something stupid…………….
(2)
fiscal/regulatory policy.
Trade remains
a matter of concern, especially as it applies to China. Signs are everywhere that even the prospect
of a tariff war is causing economic indigestion. The dilemma, at least as I see it, is that
Trump, rightfully so, is attempting to correct a number of post WWII themes
[protecting Europe so that it could recover; allowing China to get away with
egregious policies {theft of intellectual property} so that it could move into
the twentieth century]. Those policies
were [a] the right thing to do and [b] very successful. But the more that they succeeded, the more
disadvantageous the US economic position became. So now the US is faced with enduring some short
term pain to correct these inequities or take the long term pain of being the
rest of the world’s patsy. My vote is
the former, but, as I noted, it can’t be achieved without consequences.
Fiscal gridlock
is now the favored scenario for the next two years. To which I say ‘amen’. The GOP has saddled the government/economy/taxpayer
with enough irresponsible deficit/debt creation to last for a long time. My hope is that the economy doesn’t sink into
a recession which will make matters worse.
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)
Compare
the cost of post 9/11 wars with the total debt computation from the prior link.
(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 latest data
on household debt.
The only
central bank/monetary policy headline this week was a speech by Powell in which
in which he reiterated the Fed’s positive outlook for the economy and its
intent to continue QT.
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.
Another ear
burner from Jeffery Snider (must read):
The Fed’s panic
trigger.
(4) geopolitical
risks:
Brexit appears
to have reached a boiling point. An
agreement has been made between the May government and the EU, but chaos reigns
inside the UK political class. I have no
clue how this turns out; but the potential is there for major economic disruptions,
To make matters
a bit more interesting, the Italian government stuck its finger in the EU’s
eye, refusing to amend its budget that includes a deficit that is well outside
EU guidelines. Again, I have no idea how
this situation resolves itself; but I do think that there is no positive
alternatives save the EU folding. If
Greece is a guide, that is not going to happen.
(5)
economic difficulties around the globe. The stats this week were negative:
[a], Q3 EU
flash GDP was in line; German flash GDP was below estimates; October EU
industrial production slightly better than anticipated but auto sales were
terrible; October UK retail sales were awful.
[b] October
Chinese fixed asset investment were above forecasts; industrial production in
line; retail sales below projections; credit growth slowed dramatically,
[c]
Q3 Japanese GDP was well below expectations.
As I noted earlier, this is not a picture
of economic health/growth.
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.
However,
these potential 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.
Further, political gridlock could shut
down any new tax cut/spending increase measures. For that, we should all be thankful. But until evidence proves otherwise, my
thesis is 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 derived from deregulation or the current somewhat improved
trade regime.
Cyclically,
growth in the second quarter sped up, helped along by the tax cuts. And removing the uncertainty of no NAFTA
treaty should help return economic conditions to what they were before. On the other hand, trade fears (China) and a
weakening global economy point to slower growth if not outright recession. As I noted above, that is not my forecast at
the moment; but the risk of such an outcome is increasing.
The Market-Disciplined
Investing
Technical
The Averages
(DJIA 25413, S&P 2736) posted a second day of positive follow through after
filling the late October gap open. The
Dow ended below its 100 DMA (now resistance) and above its 200 DMA (now support). The S&P finished below its 100 DMA (now
resistance), below its 200 DMA, (now resistance) but above the lower boundary of
its short term uptrend.
Both the indices
continued to develop a reverse head and shoulders formation---the technical
maxim being that this pattern is a sign of higher prices. However, as I noted Friday, (1) on the one
hand, a good deal more upside is needed to complete that formation, but (2) on
the other, the pin action seems to be setting up for the seasonal Santa Claus
rally.
Volume fell,
breadth was mixed---neither a plus on an up day.
The VIX fell another
8 ½ %, but remains technically strong.
However, with the latest sell off, it has now made two consecutive lower
highs and lower lows---a potential plus for stocks.
The long bond was
rose. While it is still below both
moving averages and in a short term downtrend, it continues to build a base very
short term (suggesting no further downside).
The dollar was
down ¾ %, but remains technically strong.
I continue to believe that UUP will move higher as long as the dollar
funding problem persists.
GLD was up ¾ %, finishing
above its 100 DMA (now resistance; if it remains there through the close on
Tuesday, it will revert to support).
Bottom line: the Averages continued to
build a positive reverse head and shoulders pattern. As long as this persists, the odds of a year-end
Santa Claus rally increase.
TLT
and UUP maintained their strong patterns (bonds down, the dollar up). GLD is
again toying with its 100 DMA; but a lot more is needed before this chart is
anything but ugly.
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. Economic activity in the third quarter slowed
and everyone pretty much agrees that it will do so again in the fourth quarter.
Also,
lest we forget, the growth rate in rest of the global economy has slowed and appears
to be slowing even further as fears of a prolonged US/China trade war impact
corporate investment/spending plans. 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 the rate of growth will likely be declining
nonetheless.
My
thesis is that, a trade war aside, the financing burden now posed by the
massive [and growing] US deficit and debt is offsetting the positive effects of
deregulation and fairer trade and will continue to constrain economic as well
as profitability growth.
In
short, the economy is not a negative [yet] but it is 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.
(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. In addition, the latest out of the mouth of Draghi was that [the
data notwithstanding] the EU economy is doing fine, suggesting that the ECB is
on track to begin its version of QT next year.
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 negative
effects of the trade dispute with the US.
I have no clue how this dance of conflicting monetary policy will play.
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.
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.
Whether
or not I am right about overall valuation levels, the investors seem to be losing
confidence in the earnings progress of what have to date been the Market
leaders [the FANG/technology stocks who have benefitted from very generous
valuations]. Typically, when investors
start marking down the multiples of the Market darlings, the rest of the stocks
are not too far behind. That doesn’t
mean that a crash is imminent but it does suggest that, at a minimum, further
upward progress may be limited.
This
from a bull.
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. 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 25413
2736
* 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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