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.
