Saturday, December 15, 2018

The Closing Bell


The Closing Bell

12/15/18


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%

            2019

Real Growth in Gross Domestic Product                          1.5-2.5%
                        Inflation                                                                          +1.5-2.5%
                        Corporate Profits                                                                5-6%


   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                      21691-26646
Intermediate Term Uptrend                     13880-30087
Long Term Uptrend                                  6585-29947
                                               
2018     Year End Fair Value                                   13800-14000

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Trading Range                          2536-2942
                                    Intermediate Term Uptrend                         1323-3138                                                          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 slightly negative: above estimates: weekly mortgage and purchase applications, weekly jobless claims, November retail sales, November industrial production, November import/export prices; below estimates: month to date retail chains store sales, the December Markit flash manufacturing, services and composite PMI’s, October wholesale inventories/sales, November small business optimism index, November PPI; in line with estimates:  November CPI.

However, the primary indicators were positive: November retail sales (+) and November industrial production (+).  I am giving this week a plus rating.  Score: in the last 166 weeks, fifty-four were positive, seventy-four negative and thirty-eight neutral.

Update on big four economic indicators.

The data from overseas was not good.  Not helping is the ongoing turmoil over Brexit, the civil unrest in France/Macron’s response, the Chinese/US trade relations and Italy’s budget dispute with the EU.

My forecast:

Less government regulation, Trump mandated spending cuts and possible help from a fairer trade regime are plus for the long term US secular economic 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, the economic growth rate will slow as the effects of the tax cut wear off, the global economy decelerates and the unwind of the Fed’s balance sheet limits credit expansion.

       The negatives:

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

Wall Street turns skittish on leveraged loans.

And:

And:

(2)   fiscal/regulatory policy. 

Trade remains the most immediate issue; and we got some good news of that front this week.  In Thursday’s Morning Call, I covered the decision of the Chinese to provide concessions in their trade dispute with the US and what it might mean.  So I won’t be repetitive except for the bottom line:

[a] short term the Chinese increasing purchases of US soybeans and oil and lowering tariffs on US auto imports is a plus for the economy.  On Friday, we got some clarity on exactly what this means---the auto tariffs will be lowered for three months---the grace period for making a permanent deal,

[b] longer term, the announced willingness to change in their China 2025 industrial policy {including theft of IP}and what it would imply for future trade relations with the US would also be a big positive if they mean it.  But that is such a huge compromise, I think it needs to be verified before getting too jiggy with it.

As you know, last week I expressed growing doubts that Trump is really willing to do what is right regarding China’s egregious policies [theft of intellectual property] because to do so will cause pain; and given the Donald’s Market based personal rating system, he has yet to show that he willing to take that pain for a greater good.  I may have been premature in that judgment; but I await clarity before coming to any conclusion.

The other issue is the funding of the border wall which Trump has tied to a partial government funding measure that needs to be enacted shortly.  He has threatened to shut the government down is he doesn’t get his way---‘threatened’ being the operative word. Trump/Pelosi/Schumer had a shouting contest early in the week, suggesting no give from either party.  So we wait to see who blinks.  Generally, a government shutdown is not a plus short term for the economy or the Markets, though the longer term impacts have been marginal.

My bottom line, short term, the Chinese concessions are a plus.  Longer term they may also be; but clarity is needed before making that judgment. 

I will spare you my usual rant about the weakening effects of an outsized federal debt/deficit on the economy.

(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.  

Nothing really new on this front this week.  The ECB did confirm that it will cease its bond buying program but with the caveat that it won’t hesitate to renew it if economic conditions dictate.  Note to Draghi: the economic conditions already dictate it: the EU economy is deteriorating, not being helped by the political turmoil in the UK, France, Italy and Germany. 

I think that the ECB, like the Fed, knows that QE did major damage to the pricing of risk (assets) and that it needs to be reversed---and that is what is happening.

(4)   geopolitical risks: 

Brexit, civil unrest in France, the EU/Italy standoff; and now Russia and Ukraine are threatening each other.  They all could be much to do about nothing; or any one could cause serious negative financial consequences. I have no clue on any potential outcome; but they can’t be ignored.

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

[a] the December EU flash composite PMI came in below forecasts; October/revised September EU industrial production was poor as was October UK industrial production; the October UK GDP was in line,

[b] November Chinese PPI and CPI were below estimates, November exports/imports were weak, retail sales and factory production were disappointing and auto sales declined dramatically,

[c] Japanese Q3 GDP declined but as anticipated; the December flash manufacturing PMI was better than expected.

            Potentially, the OPEC production cut agreement could have an impact on the global economy [i.e. higher oil prices].  The ‘everything is awesome’ crowd will piss and moan about it; but history suggests that a stable and gradually rising oil price is good for the world economy.

            Bottom line:  on a secular basis, the US economy is growing at an historically below average 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.  The long term positive potential from an altered Chinese industrial policy would have a meaningful effect on the US long term secular growth rate.

            However, these possible long term positives are being offset by a totally irresponsible fiscal policy.  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 even with improvement from deregulation or the current trade regime (a caveat being if China does change its industrial policy).

Cyclically, the US economy to once again slowing.  (1) Removing the uncertainty of no NAFTA treaty should help return economic conditions within the three countries to what they were before, (2) increase in Chinese purchases of soybeans and oil and the lower tariffs on autos and (3) a slowdown in the rise of short term interest rates will help keep in slowdown under control.  On the other hand, a weakening global economy points to slower growth.  As a result of these factors, my guess is that my initial US 2019 economic growth rate assumption will likely change as their impact becomes more apparent.

The Market-Disciplined Investing
           
  Technical

The Averages (DJIA 24100, S&P 2599) had another rough day.  They both finished below both moving averages, have set a second set of lower highs and lower lows and are now sitting on their October lows.  Both have challenged this level previously and were unsuccessful.  So another bounce wouldn’t be surprising, especially given the indices’ oversold condition.  Still the odds of a Santa Claus rally declines daily.

Volume was up; breadth was poor.  The VIX was up 4 ¾ %, though once again, surprisingly, it continues to be quite stable given the indices’ erratic pin action.  Its chart remains positive.

The long bond was up, finishing above its 100 DMA (now support), above its 200 DMA (now support) and right on the upper boundary of its short term downtrend.  It has challenged this boundary twice earlier this year and failed.  So I repeat, it needs to take out this downtrend before the latest pin action is anything more than a rally in a bear market.

The dollar rose, ending back above the rising lower boundary of its very short term up trend.  It remains above both MA’s and in a short term uptrend. So the chart continues to be technically strong.

GLD fell, but still closed above its 100 DMA and continued to build strength. 

 Bottom line: the Averages still act poorly despite their oversold condition.  They ended right on their late October lows---a support level that they unsuccessfully challenged earlier this year.  Plus historically powerful seasonal forces are at work.  So a decent bounce here would not be surprising---although I am starting to sound like a broken record on that point.  On the other hand, if they blow through their October support level, the next stop is 23352/2536.
           
            The long bond continues to attempt a challenge of the upper boundary of its short term downtrend---something that it has done unsuccessfully twice before this year.  While it remains above both MA, it needs to successfully challenge this level before the current move up is more than just a rally in a bear market.
           
            The dollar’s chart remains quite strong and will likely continue to do so as long as dollar funding (liquidity) problems grow. 

                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 is slowing; and what appears to be a temporary reprieve in the US/China standoff should help keep the slowdown within my forecast.

On the other hand, the rest of the globe is slowing even faster than I expected.
 It is certainly possible, even probable, that the US can continue to grow as the rest of the world slows.  But this will act as a drag on any improvement.

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.  Having whiffed on NAFTA 2.0, the prospect of a meaningful change in the trade regime with China would be a big plus to the US long term secular economic growth rate. 

As I noted above, China’s move to buy more soybeans and oil along with lowering auto tariffs will help over the very near term.  Longer term, I think it reasonable to be hopeful but nothing more.

(3)   the rate at which the global central banks unwind QE.  The Fed appears to be pulling back from its move to hike the Fed Funds rate.  However, that is less important to QT than the run off of its balance sheet---and, at the moment, it appears that it will continue unabated. In addition, this week Draghi said that the ECB is on schedule to halt its bond purchase program.

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.

However, I remain convinced that [a] QE has done and will continue to do harm 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, despite the recent sell off, 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, investors seem to be balking at raising valuations any further. That doesn’t mean that a crash is imminent but it does suggest that, at a minimum, further upward progress may be limited.

I hear lots of woe over the recent decline; but it is important to remember that the Averages haven’t even challenged their October 2018 lows much less February 2018 lows.  So while the current decline might be uncomfortable, if stocks begin to mean revert keep my Model’s 2018 Year End Fair Value in mind---S&P 1700-1720.

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 12/31/18                                13860            1711
Close this week                                               24100            2599

* 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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