10/21/17
Statistical
Summary
Current Economic Forecast
2016 actual
Real
Growth in Gross Domestic Product 1.6%
Inflation
(revised) 1.6%
Corporate Profits (revised) 4.2%
2017 estimates
(revised)
Real
Growth in Gross Domestic Product -1.25-+0.5%
Inflation +.0.5-1.5%
Corporate
Profits -15-0%
Current Market Forecast
Dow
Jones Industrial Average
Current Trend (revised):
Short
Term Uptrend 21494-24200
Intermediate Term Uptrend 19094-26425
Long Term Uptrend 5751-24198
2016 Year End Fair Value
12600-12800
2017 Year End Fair Value
13100-13300
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend (?) 2511-2786
Intermediate
Term Uptrend 2276-3050
Long Term Uptrend 905-2763
2016 Year End Fair Value
1560-1580
2017
Year End Fair Value 1620-1640
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 marginally higher upward bias to equity valuations. The
data flow this week was positive: above estimates: weekly mortgage and purchase
applications, the October housing market index, September existing home sales, month
to date retail chain store sales, weekly jobless claims, the October
Philadelphia Fed business outlook index, September industrial production, the
October NY Fed manufacturing index; below estimates: September housing starts, September
import/export prices, the September leading economic indicators; in line with
estimates: none.
On the other
hand, the primary indicators were mixed:
September industrial production (+), September existing home sales (+), September
housing starts (-) and September leading economic indicators (-). Given the majority of the stats were positive,
the call is a plus. Score: in the last 105
weeks, thirty-one were positive, fifty-six negative and eighteen neutral.
The Fed released its latest Beige Book this
week which showed growth in all regions along with relatively mild inflation
pressures. What struck me about this
survey was that the numbers from those Fed regions that were impacted by
Harvey, Irma and Maria were up along with the rest of the country. That seemed so absurd that I had to read it
twice just to be sure.
To be clear, this has nothing to do with
the accounting for a major disaster (i.e. not recognizing the loss of lives, assets,
etc. but reflecting the economic activity of replacement). My problem is that somehow all the lost wages,
production and sales were somehow offset by growth in other areas. Of course, it could be that the real data
simply hasn’t shown up in the reported data---though that is not the way it was
characterized in the Beige Book narrative.
The point being that I believe that this report is worse than worthless.
Overseas, the numbers
were mixed, with China reporting the best data.
I wonder if that has anything to do with the convening of the Communist
Party Congress. Net, net, I continue to
believe that Europe has begun growing again while China and Japan are still
mired in the same struggle as the US to improve growth.
On the fiscal front, with
the senate’s passage of a FY 2018 budget, congress took a concrete step towards
tax reform. Not that we are there
yet. Plus, in their current form, if
enacted, I believe that both the budget and the tax reform measures would be
more a negative than a positive because they would continue to push the deficit
and debt to higher levels.
Bottom line: this
week’s US economic stats were positive; though that is tempered somewhat by
mixed primary indicators. I remain open
to the notion that the data could be signaling the long awaited improvement in
economic growth. However, this week’s
numbers were hardly strong evidence of such.
The international data was mixed, leaving our forecast with Europe no
longer ‘muddling through’ but the rest of the world still stuck in that rut.
Longer term, with
the national debt now larger than GDP, I am less confident in my upgrading our
long term secular growth rate assumption by 25 to 50 basis points based on
Trump’s deregulation efforts. The latest
senate version of the FY2018 budget proposal simply adds to that concern as
does the tax reform measure in its current form. Thus, any further increase in
that long term secular economic growth rate assumption stemming from enactment of
the Trump/GOP fiscal policy is up to question.
Our (new and
improved) forecast:
A now
questionable pick up in the long term secular economic growth rate based on
less government regulation. This hoped
for increase in growth could be further augmented by pro-growth fiscal policies
including repeal of Obamacare and enactment of tax reform and infrastructure
spending; though the odds of that are uncertain. Unfortunately, any expected increase in the
secular rate of economic growth could be rendered moot if tax reform (assuming
its passes) increases the national debt and the deficit.
Short term, the
economy is struggling and will likely continue to do so; though the improving
global economy may at some point have an impact.
The
negatives:
(1)
a vulnerable global banking system. This week, I linked to several articles
expressing concern about the derivative holdings on bank balance sheets. As you know, this has been a worry of mine
since the financial crisis. To be sure,
US regulatory authorities have forced banks to fortify their balance sheets via
capital increases. However, [a] the same
can’t be said for the EU banks and [b] because during the financial crisis, the
US banks were allowed to carry derivative contracts at book value, we have no
idea the magnitude of the risk they now pose to bank solvency.
(2)
fiscal/regulatory policy.
The
major development this week was the senate’s passage of its version of the
FY2018 budget. The house still needs to
pass its version and the two have to be reconciled. But if successful, it would pave the way for
tax reform. Unfortunately, as it relates
to anything remotely associated with reality, the senate measure could just as
easily been written by my three year old granddaughter. I linked to the math involved in Friday’s
Morning Call; net effect being our senators are in dream land and we should
expect ever higher budget deficits and national debt if it is enacted in its
current form.
Just as
unfortunate, the tax reform measure, in its current form, will just do more of
the same. In these pages, I have dwelled
on the impact on economic growth of a country’s national debt once it has
reached a certain level---which the US has already attained. The point being that a tax reform bill,
however simpler or fairer it makes the tax code, ceases to be stimulative if it
pushes the deficit/debt to the point where all the benefits of any reforms are
consumed servicing that increased deficit/debt they cause.
In
trade, the third round of NAFTA negotiations ended. The fact that there was agreement for another
round was a better result than many had expected. On the other hand, Mexico and Canada
expressed displeasure with the results so far.
Frankly, I take that as a positive---the US is pressing for more
favorable terms but not hard enough to make Mexico and Canada walk away. That doesn’t mean that they won’t. But so far, so good.
What happens if the negotiations fail (medium):
Further, the Treasury declined to name any country a
currency manipulator. As you know, for
years this has been a major bone of contention between the US and China. So its absence has to be a plus. Of course, it could be more related to North Korea
than to trade. Even if it is, it is a
sign that the two parties are working on their issues.
(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 or is creating asset
bubbles in the stock market as well as in the auto, student and mortgage loan
markets.
The news, what
there was of it, included:
[a] continued
speculation over who will be the next Fed chair. Rumors now have Powell as the leading
candidate. This guy is a dove, so should
he get the nod, I wouldn’t expect monetary policy to change dramatically. Meaning an agonizingly slow retreat from QE.
[b] release of
the latest Fed Beige Book which I found less than helpful {see above},
You know my
bottom line: when QE starts to unwind, so does the mispricing and misallocation
of assets. That thesis is about to be
tested.
(4) geopolitical
risks: Domestic issues held the
headlines this week, but tensions between the US and North Korea, Iran and
Russia remain high. Add to that the
secession movement in Catalonia that is causing heartburn in Spain at the
moment.
***overnight,
Spain suspends Catalan government (medium):
None of these
issues has been resolved; and there remains a decent probability of an
unpleasant outcome in any one of them.
The one bit of
good news was the resolution of a boundary dispute between the Iraqi government
and the country’s Kurdish minority. Any
outbreak in hostilities could have driven oil prices higher. That risk has apparently been eliminated.
(5)
economic difficulties around the globe. This week:
[a] the
September UK inflation rate hit a five year high while its jobless rate fell to
a 42 year low; September UK retail sales were well below estimates; October
German investor sentiment improved slightly; September EU car sales declined,
[b] the
September Chinese CPI was in line but PPI was well above expectations; third
quarter GDP was also in line although retail sales, industrial output and fixed
asset investment were slightly above forecasts. Finally, the Communist Congress
convened and will pass a new five year economic/social agenda; that should
produce some news,
[c] the August
Japanese all activity index was below forecasts.
So mixed
overall; but I am not sure of the credibility of the upbeat Chinese data. In short, Europe appears out of the woods;
but the Japanese and Chinese stats continue to be far too erratic to draw any
conclusions.
Bottom
line: our near term forecast is that the
US economy is stagnate though there is a possibility that the improved
regulatory outlook and a now growing EU economy may be stimulative. If Trump/GOP were to pull off a (near) revenue
neutral healthcare reform, tax reform and infrastructure spending on a
reasonably timely basis, I would suspect that sentiment driven increases in
business and consumer spending would return.
However, the senate version of the FY2018 budget as well as tax reform in
its current form suggest more of the same fiscal irresponsibility we have come
to know and love from our ruling class.
To be sure,
Trump’s drive for deregulation and improved bureaucratic efficiency is and will
remain a plus. As you know, I inched up
my estimate of the long term secular growth rate of the economy because of it. But I fear that this positive could be
reversed if the congress passes a FY2018 budget and/or tax reform that raise
the deficit/debt---however, simpler and fairer the tax reform may be.
The
Market-Disciplined Investing
Technical
The indices (DJIA
23328, S&P 2575) turned in another stellar day. Volume was up (but largely impacted by option
expiration) and breadth continued strong (indeed, it is now well into
overbought territory). Both remain above
their 100 and 200 day moving averages and are in uptrends across all time
frames.
The VIX (10.0) was
down slightly, despite having declined substantially intraday. It remained below the upper boundary of its short
term downtrend and below its 100 and 200 day moving averages. However, it is above the lower boundary of
its long term trading range and continues to develop a very short term uptrend. At the moment, it appears that the July low
was the bottom.
The long
Treasury plunged 1%, finishing below its 100 day moving average (if it remains
there through the close on Tuesday, it will revert to resistance) and the lower
boundary of a developing very short term uptrend. However, it continued to trade above its 200 day
moving averages (support) and the lower boundaries of its short term trading
range and its long term uptrend.
The dollar rose,
but ended in its short term downtrend and below its 100 and 200 day moving
averages. However, it closed above the lower boundary of a developing very
short term downtrend. If it remains
there through the close on Monday, it will void that trend.
GLD was down, but
finished above its 100 and 200 day moving averages (support) and the lower
boundary of a short term uptrend. However,
it moved below the lower boundary of its very short term uptrend.
Bottom line: long term, the indices remain
strong viz a viz their moving averages and uptrends across all timeframes.
Short term, they are above the resistance level marked by their August highs,
meaning that there is no resistance between current price levels and the upper
boundaries of the Averages long term uptrends.
Their advance has been relentless and will stay that way until it does
not. ‘When’ is the question to which I have
no answer.
Friday’s trading
in UUP, GLD and TLT reversed what had appeared to be another reversal. In other words, their short term price
movements have lost all informative directional value.
I remain uncomfortable
with the overall technical picture.
Institutions
continue to sell to the public (medium):
Fundamental-A
Dividend Growth Investment Strategy
The DJIA and the
S&P are well above ‘Fair Value’ (as calculated by our Valuation Model). However, ‘Fair Value’ could be rising based
on a new set of regulatory policies which could lead to improvement in the
historically low long term secular growth rate of the economy (depending on the
validity of Reinhart/Rogoff); but it still reflects the elements of a botched
Fed transition from easy to tight money and a ‘muddle through’ scenario in Japan
and China.
The US economic stats
continue to reflect sluggish to little growth---although there have been signs
of late of some improvement; just not enough for me to consider changing our
forecast. Overseas, the story is the same---anemic
growth with the exception being Europe.
Nevertheless, stock
prices are rising as investors are seemly willing to make, or at least begin to
make, the bet that the economic growth rate will soon pick up. I think that if equities were more reasonably
priced that would make sense. However,
with stocks at all-time high valuations, it seems that nirvana is being
discounted. So the current meteoric rise
seems to be double counting, even if the economic growth rate increases.
On the fiscal
front, congress is toiling in the trenches to pass a budget bill which is a
precursor to tax reform. While the
former seems likely out of pure necessity, the latter remains in question. Unfortunately in their current forms, both
will add to the deficit/debt---and I believe that is a negative for growth. To be sure, a simpler, fairer (?) tax code is
a plus and may add marginally to the secular growth rate. However, I remain convinced that, given the
magnitude of the current national debt, the present proposal will not provide
the impetus to economic growth many hope for.
As a result,
even if passage is achieved, I believe that Street estimates for economic and
corporate profit growth are too optimistic based on the improving economy,
fiscal reform narrative. And when it
wakes up from this fairy tale that could, in turn, lead to declining growth expectations
as well as valuations.
That said,
fiscal policy is a distant second where it comes to Market impact. The 800 pound gorilla for equity valuations
is central bank monetary policy based on the thesis that (1) QE did little to
help the economy but led to extreme distortions in asset pricing and allocation
and (2) hence, its unwinding will do little to hurt the economy but much to
equities as the severe perversion of security valuations is undone.
That thesis is
about to get tested with the Fed announcing the unwind of its balance sheet and
other central banks are making noises like they could follow suit. That said, the appointment of a new Fed chair
could impact this process, perhaps either accelerating the unwind or slowing it
down depending on which candidate is selected.
Bottom line: the
assumptions on long term secular growth in our Economic Model may be beginning
to improve as we learn about the new regulatory policies and their
magnitude. Plus, there is a ray of hope
that fiscal policy could further increase that growth assumption though its
timing and magnitude are unknown. On the
other hand, if it raises the deficit/debt, I believe that it would negate any
potential positive. In any case, I continue to believe that the current Street
narrative is overly optimistic---which means Street models will ultimately will
have to lower their consensus of Fair Value for equities.
Our Valuation
Model assumptions may be changing depending on the aforementioned economic
tradeoffs impacting our Economic Model.
However, even if tax reform proves to be a positive, the math in our
Valuation Model still shows that equities are way overpriced.
As a long term investor, with
equity valuations at historical highs, I would want to own cash in my Portfolio
and would use the current price strength to sell a portion of your winners and
all of your losers.
Kyle Bass makes a great
point: with all the money flowing into ETF’s all the Market risk is being
assumed by those who don’t know how to take risk (medium):
DJIA S&P
Current 2017 Year End Fair Value*
13200 1630
Fair Value as of 10/31/17 13116
1620
Close this week 23328
2575
Over Valuation vs. 10/31
55%overvalued 20329 2511
60%overvalued 20985 2592
65%overvalued 21641
2673
70%overvalued 22297 2754
* 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.
Steve Cook received his education
in investments from Harvard, where he earned an MBA, New York University, where
he did post graduate work in economics and financial analysis and the CFA
Institute, where he earned the Chartered Financial Analysts designation in
1973. His 47 years of investment
experience includes institutional portfolio management at Scudder. Stevens and
Clark and Bear Stearns, managing a risk arbitrage hedge fund and an investment
banking boutique specializing in funding second stage private companies. Through his involvement with Strategic Stock
Investments, Steve hopes that his experience can help other investors build
their wealth while avoiding tough lessons that he learned the hard way.
