Saturday, February 16, 2019

The Closing Bell


The Closing Bell

2/16/19

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                     14088-30287
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%

Economics/Politics
           
The Trump economy is a neutral for equity valuations.   The data flow this week was overwhelmingly negative: above estimates: December job openings, preliminary February consumer sentiment, the February NY Fed manufacturing index; below estimates: weekly mortgage and purchase applications, weekly jobless claims, December retail sales, month to date retail chain store sales, January industrial production, November inventories/sales, the January small business optimism index, the December budget deficit, January import/export prices; in line with estimates: January CPI/ex food and energy and PPI/ex food and energy.
           
There were two primary indicators reported this week: December retail sales (-) and January industrial production (-). So, this week’s call is easy: negative.  Score: in the last 175 weeks, fifty-seven positive, seventy-eight negative and forty neutral.

One note.  Some analysts might argue that lower import/export prices are a plus in that they would have a positive impact on prices---and that would be true.  However, I judge them to be negative because they support the notion of a weakening economy.

The data from overseas this week was mostly negative (again).  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 and the global economy decelerates.  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.

I covered the latest move by Banco Santander screwing bond holders in favor of stockholders, the continuing problems at Deutschebank and the defaults by two large Chinese companies.

China’s mountain of debt.

(2) fiscal/regulatory policy. 

Three important near-term issues are:

[a] the shutdown.  Not going to happen.  However, with Trump’s next move to declare a national emergency to obtain additional funds for the wall, the political rancor isn’t going away.  That said, I have never thought a government shutdown nor the seemingly perpetual political food fight as negatives for the economy.  Indeed, to the extent that they prevent additional fiscal irresponsibility, they are a plus,

[b] the US/China trade talks.  It looks like progress is being made.  US trade officials were in China this week.  All the press releases were rosy in their outlook.  Plus, Xi attended one session on Friday as a sign of goodwill; and Trump has made it clear that he wants a deal.  On the other hand, comments out of Xi regarding IP theft were anything but encouraging.

As you know, I have been supportive of Trump’s effort to negotiate fairer trade deals, correcting the disparities that grew up in the post WWII world.  If he is successful, I believe that it will be a plus for US secular economic growth.  My concern is that in this latest round, the Chinese beat him at his ‘art of the deal’ game leaving them free to continue their theft of US intellectual property. 

[c] the December budget deficit was reported larger than anticipated.  This is, of course, illustrative of my major concern about fiscal policy.               

Bottom line: whatever the positive impact that might to come from a US/China trade deal, irresponsible deficit spending will restrain US economic growth.

(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.  

The two headlines this week:
[a] the statement from a Fed governor that reshaping the QT unwind will be on the agenda at the next FOMC meeting.  If true and if the Fed does curtail QT, that would, in my opinion, be a major negative.   First of all, it would do little for the economy, just as QEII, QEII and Operation Twist did little. 

Second and more important, by kowtowing to the Markets [which it has no, zero, nada, nyet mandate to do], it would prolong the mispricing of risk.  To date, that hasn’t been a problem; in fact, it has been a plus in that it kept economically inefficient companies and bankrupt sovereigns afloat.   

However, in recent weeks that game seems to be playing itself out as defaults have increased in the banking and industrial sectors---the result of investor unwillingness to refinance economically unproductive or marginally unproductive enterprises. 

Of course, a return to QE may assuage this problem, at least near term.  But sooner or later asset misallocation and mispricing will likely be driven to their logical extreme---financing a project with no or a negative return.  At that point, a central bank ‘put’ would probably be meaningless and the repricing of risk would begin.

[b] the figures from the Bank of China show a huge injection of liquidity into its banking system.  So, it appears to have joined the Fed in ending QT and, perhaps, initiating some new phase of monetary easing---we may again have not a Powell ‘put’ but a central bank ‘put’.

More.

(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.

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] December EU industrial production declined more than expected; its Q4 flash GDP was in line, though Germany’s was a disappointment; December UK industrial production and Q4 GDP were below estimates,

[b] January Chinese exports were very positive while imports declined---which is not likely to help their negotiating position in the current trade talks; January CPI ran hotter than anticipated while PPI saw a big decline; January Chinese all-system aggregate financings hit a new high.

            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.

Wisdom from Charlie Munger (must read):

The Market-Disciplined Investing
           
  Technical

The Averages (DJIA 25883, S&P 2775) staged another Titan III move yesterday.  The Dow ended above its 100 DMA (now support), above its 200 DMA (now support) and back above the lower boundary of its newly reset very short term uptrend, voiding Thursday’s break.  The S&P remained in a very short term uptrend, above its 100 DMA (now support), above its 200 DMA (now resistance), re-starting the clock on this challenge (if it remains there through the close on Thursday, it will revert to support).   Both remain below their previous lower highs (~25977, 2800).

Volume rose (this is option expiration week; so, an increase in volume and volatility is to be expected) and breadth improved.

The VIX fell 7 ¾ %, ending below the lower boundary of its short term uptrend (if it remains there through the close on Wednesday, it will reset to a trading range).  And it remains below both MA’s (now resistance).

The long bond was up, finishing above both MA’s, in very short term uptrend and within short and intermediate-term trading ranges. 

The dollar was down pennies again but closed above both MA’s and within a short-term uptrend.  However, it finished fractionally below the upper boundary of its mid-November to present consolidation phase---not enough to concern me. 

GLD rose ½% on good volume, ending above both MA’s (the 100 DMA is crossing above its 200 DMA---a positive technical signal) and within very short-term and short-term uptrends.  

 Bottom line: the Averages are about to challenge their prior lower highs.  If successful, it would set the stage for a move to their all time highs.  If not, it will strengthen that resistance level.

          The dollar, bonds and gold seem to be attracting ‘safety trade’ investors even though their daily activity is not always consistent.
         
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---which the trend in the dataflow suggests is meager.  Yes, the employment numbers have been good; but employment is a lagging indicator.  As a result, I think that it is being given too much emphasis in light of other stats.

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 inhibit the rate of US growth as well as any improvement in earnings.  Speaking of which, the results from the Q4 earnings season as well as the forward guidance provided by companies suggest that the next couple of quarters could be disappointing.

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.  However, thus far, all we have gotten is positive verbiage; though the fact that another round of negotiations is occurring must be looked at as a plus.  Trump almost surely wants a win here.  But I think his choice is between no deal [because it doesn’t include changes in Chinese industrial policy and IP theft] or a deal [the doesn’t include them].  The latter might be a positive short term but [a] clearly won’t address the inequities in the US/Chinese trading regime and [b] will expose ‘the art of the deal’ as so much fluff.
(3)   the rate at which the global central banks unwind QE---or begin to rewind it.  The most significant development this week was the apparent complete reversal of the Chinese and our Fed’s QT.  We will have to wait for the Fed statement following the next FOMC meeting to be sure that this is the case.  However, the new Chinese policy can be seen in the numbers---so we know that is occurring.
That said, as I have constantly reminded, neither will likely be a plus of their respective economies. However, if QEII, QEIII and Operation Twist are any guide, they should be a big plus for the Markets, at least in the short term.

The central bank put (must read):
(4)   current valuations. the Averages have recouped much of their October to December loss and appear on their way to regaining 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.

As prices continue to rise, I will again be focusing on those stocks that trade into their Sell Half Range and act accordingly.

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.  More important, a global central bank ‘put’ appears to be returning and, if history is any guide, will almost assuredly 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.

            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 2/28/19                                 14016            1724
Close this week                                               25883            2775

* 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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