Saturday, January 26, 2019

The Closing Bell

The Closing Bell


I am off to the beach.  Back on 2/11.

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%


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                     13994-30206
Long Term Uptrend                                  6585-29947
2018     Year End Fair Value                                   13800-14000

                        2019     Year End Fair Value                                   14500-14700

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Trading Range                          2349-2942
                                    Intermediate Term Uptrend                         1338-3148                                                          Long Term Uptrend                                     913-3073
2018 Year End Fair Value                                       1700-1720         
                        2019 Year End Fair Value                                     1790-1810

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                           56%
            High Yield Portfolio                                     55%
            Aggressive Growth Portfolio                        56%

The Trump economy is a neutral for equity valuations.   The data flow this week was positive: above estimates: month to date retail chain store sales, weekly jobless claims, the January flash composite and manufacturing PMI’s, January Richmond and Kansas City manufacturing indices; below estimates: December existing home sales, weekly mortgage and purchase applications; in line with estimates: December leading economic indicators, the January flash services PMI.
There were two primary indicators reported this week: December existing home sales (-) and December leading economic indicator (0).  And there were two not reported: December durable goods orders and December new home sales.  I am going to give this week’s data a tentative plus rating even though: (1) the trend in the secondary indicators suggest that the durable goods number would miss its mark (2) the housing stats have been almost universally poor of late, not the least of which was this week’s existing home sales.   Score: in the last 172 weeks, fifty-six positive, seventy-six negative and forty neutral.

There was plenty of data from overseas this week and most of it was negative.  Certainly, some portion of those poor results stem from the effects of the US/China trade dispute and economic/political turmoil in the UK, France and Italy.  However, at the risk of stating the obvious, if those problems can’t be resolved, then they are going to keep impacting the global economy.

My forecast:

Less government regulation, Trump mandated spending cuts, (hopefully) getting out of the Middle East quagmire and possible help from a fairer trade regime are pluses 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 is slowing as the effects of the tax cut wear off, the global economy decelerates and credit expansion slows with the unwind of the Fed’s balance sheet (now in question).  There appears to be an increasing risk that the economy may not be as strong as even my forecast has portrayed it.

       The negatives:

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

This problem just won’t go away.

(2) fiscal/regulatory policy. 

The two most important near-term issues are:

[a] the shutdown.  There was, at least, a temporary resolution to wall/shutdown political standoff.  I have said repeatedly in these notes that the ruling class watches the polls closely and that when it became obvious which side was losing, a solution would be forthcoming.  Trump was losing, so he cut his losses---which in my opinion, was a great decision.  You don’t play out a losing hand if you want to stay in the game.

[b] the US/China trade talks.  It looks like progress is being made.  The head of China’s negotiating team will be in the US for meetings next week.  The statements out of the administration remain contradictory {Ross (-) versus Kudlow (+)} though Kudlow has always been a positive spinmeister even when he wasn’t in the White House.  

That said, Trump is likely looking for a win, after shutdown resolution.  So, my concern is that he folds on, what I consider to be the most important aspect of establishing a new political/trade regime with China, the Chinese theft of US intellectual property.  Still sitting down and talking is better than doing nothing.

I will spare you my usual rant about the weakening effects of an outsized federal debt/deficit on the economy, except to say that those effects may be becoming more pronounced [and visible].

(2)   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.  

This week, China made changes in bank reserve accounting which has the effect of providing more liquidity to its financial system. 

That left the US as the sole central bank pursuing QT---maybe.  Because on Friday, the Fed announced that it is considering ceasing the runoff of its balance sheet.  I could write a treatise on how f**ked up a decision like that would be---if it happens. But the two most important are: in conjunction with global QE [a] it would allow the financial system to get even more leveraged up and have an even smaller equity cushion when things go wrong---which inevitably they will and [b] it will continue to exacerbate the social tensions in this country as the rich get richer {asset prices rise} and the less advantaged don’t---because stopping QT will do almost nothing for the economy and those who benefit from one that grows. 

You know my bottom line on this issue: QE does little to support the economy but feeds liquidity into the financial system resulting in the mispricing and misallocation of assets.  QT has the opposite effect.  All other things being equal, if the central banks are indeed back to expanding their balance sheet, then I expect little impact on the economy but higher asset prices. 

(3)   geopolitical risks: 

Europe is a mess with Brexit, riots in France and fiscal policy discord in Italy; and it continues to be reflected in a negative way in the economic stats.

Trump is now backtracking on his promise to get out of the Middle East which will likely push the threat meter higher as the rest of the players just try to figure out what US policy is.

Plus, you never know how the situation in Venezuela plays out.

(4)   economic difficulties around the globe.  The stats this week were again negative, continuing to point to a global economic slowdown:  

[a] the January EU flash composite, manufacturing and services PMIs were all below estimates; the January EU consumer confidence index was lower than anticipated,

[b] fourth quarter Chinese GDP was less than expected, December fixed asset investments and industrial production were in line and retail sales were ahead of forecasts,

[c] the Bank of Japan lowered its estimate for 2018 GDP growth; while it raised the numbers for 2019 and 2020, it also lowered its inflation outlook which is something of an offset; the January flash manufacturing index was below December’s reading.

            Bottom line:  on a secular basis, the US economy is growing at an historically below average rate.  Although some recent policy changes are plus for secular growth, they 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 the US’s 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 is once again slowing as evidenced by the data from both here and abroad. As a result, my initial US 2019 economic growth rate assumption is at risk of being too optimistic.

          Finally, any move to a more dovish stance by the Fed is not likely to have an impact, cyclical or secular, on the economy.  QE II, III, and Operation Twist didn’t, and QE IV probably won’t either.   Meaning that if the Fed thinks backing off QT will help support economic growth, in my opinion, it will be disappointed.

The Market-Disciplined Investing

The Averages (DJIA 24737, S&P 2664) had a great day.  Both Averages remain below both MA’s, are in short term trading ranges and seem to have launched themselves off the support that they had been building at the former 61.8% Fibonacci retracement level. 

Volume was up; breadth improved and moved further into overbought territory.

The VIX fell again, finishing below its 100 DMA for a second day (now support, if it remains there through the close on Monday, it will revert to resistance).  Still it ended above its 200 DMA and in a short term uptrend.

The long bond was down, but remained above both MA’s, in short and intermediate-term trading ranges, in a very short-term uptrend and above its last prior higher low.  
The dollar also declined.  Nevertheless, it closed above both MA’s, in a short-term uptrend and within that mid-November to present consolidation phase. 

GLD spiked on volume, ending well above both MA’s, within a very short-term uptrend and within a short-term trading range---a healthy chart.

 Bottom line: the Averages appear to be headed for another leg higher. Though they are so overbought right now, it may be a short one before some backing and filling occurs.   On the other hand, supporting the notion of another leg higher, the VIX is about to a successful challenge its 100 DMA.

            The pin action continues to suggest that the December 24 low was a bottom. If so, then I would feel more confident putting money to work in any dip---assuming a stock moves into its Buy Range.   The flip side of this is that stocks as measured by the Averages remain way overvalued.  So, I will also be looking to take money off the table if a stock moves into its Self-Half Range.

          The dollar and gold traded in line with an easier money scenario; but the long bond didn’t---a little confusing.
Friday in the charts

Fundamental-A Dividend Growth Investment Strategy

The DJIA and the S&P are still 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.  We are still missing a lot of primary indicator data, but with the evidence at hand, it would seem that US economic activity is slowing. There is almost no question that the global economy is slowing; and that is not going to help our own cause.  Still, it is certainly possible that the US can continue to grow as the rest of the world slows.  But declining global growth is likely going to the rate of US growth as well as any improvement in earnings. 

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.  The current trade talks with China clearly hold promise.  Unfortunately, thus far, we have gotten little more than platitudes and rumors regarding what has been discussed.  Though the fact that another round of negotiations is occurring next week which involve higher level trade officials must be looked at as a plus.
(3)   the rate at which the global central banks unwind QE.  The most significant development is the recent data on global central banks’ balance sheets showing that a huge injection of liquidity began in the past month.  I noted that at least a part of this expansion is due to seasonal factors in China.  However, this week, the Bank of China instituted measures with positive longer term member bank liquidity implications.  
And then, there is the Fed which this week said that it was studying the possibility of delaying/ceasing QT.  I don’t know if this is a reaction to December’s Market decline or a rising concern about the health of the economy [or both]---though the proximity to the former may be indicative.   Whatever the reason, if the Fed ceases QT, it will be a short term plus for the Markets.  Over the last decade, we have seen all the evidence we need concerning the impact on asset pricing and allocation of easy monetary policy in an economy whose growth is constrained by secular forces.  The bad news [for the Market] is that, at least for the moment, QT policy is just being studied.

(4)   current valuations. the Averages have recouped roughly one half of their October to December loss and appear on their way to recouping even more.  Since they were grossly overvalued [as determined by my Valuation Model] in October, they are now just slightly less grossly overvalued.  That said, if the latest central bank liquidity surge continues valuations will remain irrelevant.

On the other hand, there were buying opportunities created in late December which I took advantage of.  Unfortunately, they are no longer there.  To be sure, many stocks are still well off their highs; but my measure is not how far they have fallen but have they fallen enough to trade into their Buy Range.  So I am back on the sidelines being patient. If there is another correction that sends some stocks back into they Buy Range, I will again step in.

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.  In addition, a global central bank ‘put’ has returned that is also likely to be a plus for stock prices.  On the other hand, I believe that overall fiscal policy (growing deficits/debt) will hamper economic and profit growth, restraining the E in P/E.

The recent 10-11% rally brought most stocks off their lows and some out of their Buy Ranges (at least as determined by our Valuation Model).   Hence, I am back sitting on my hands

            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 2019 Year End Fair Value*              14600             1800
Fair Value as of 1/31/19                                 13958            1717
Close this week                                               24737            2664

* 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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