The Closing Bell
2/10/18
Statistical
Summary
Current Economic Forecast
2018 estimates
(revised)
Real
Growth in Gross Domestic Product 1.5-2.5%
Inflation +1.5-2%
Corporate
Profits 5-10%
Current Market Forecast
Dow
Jones Industrial Average
Current Trend (revised):
Short
Term Uptrend 23729-26205
Intermediate Term Uptrend 12986-29192
Long Term Uptrend 6222-29669
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2390-3161
Intermediate
Term Uptrend 1248-3062
Long Term Uptrend 905-2963
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 providing an upward bias to equity valuations. The
data flow this week was meager but slightly positive: above estimates: weekly
jobless claims, January retail chain store sales, December wholesale
inventories and sales, the January ISM nonmanufacturing index; below estimates:
month to date retail chain store sales, the December trade balance; in line
with estimates: weekly mortgage/purchase applications, December/November
consumer credit, the January Markit services PMI.
There were no
primary indicators reported. The call this
week is positive, but a weak positive. Score:
in the last 122 weeks, forty-two were positive, fifty-seven negative and
twenty-three neutral.
This dearth of
stats means that there is nothing to add to the narrative of the prior weeks;
which is, that the trend in the last six weeks has been very much akin to 2017
as a whole---below average growth. That,
in turn, raises two questions: (1) how much of the November/early December
surge was a function of recovery activity from the hurricanes and wild fires? and
(2) while there has been a definite improvement in psychology resulting from
the increase in wage and cap spending by corporations, it is not yet showing up
in the numbers. So when is that going to
happen?
As to the
latter, there has been a marked slowdown in the last two weeks in the pace of
announcements from companies increasing wages and cap ex. That is not to say that the trend is over;
but if what we got is all that we are going to get, then any growth impulse from
the prior activity will probably be less than many hoped for.
Overseas, the data
remains upbeat---growth and improving business confidence around the globe. All
of this fits the developing theme of strength in the EU and improvement among
the other major economies. In short, the trend in global growth
remains positive.
The big item
this week in economic news was the congressional passage of legislation that
will up government spending (deficit) and eliminate the debt ceiling. I have beat this rented mule already in my
Morning Calls and will do more of it below.
The bottom line is that this action risks introducing an inflationary impulse
that may force the Fed to tighten much quicker and much further than it wants.
Our (new and
improved) forecast:
A pick up in the
long term secular economic growth rate based on less government
regulation. As a result, I have raised
our 2018 growth forecast. This increase in secular growth could be further
augmented by pro-growth fiscal policies including repeal of Obamacare and
enactment of tax reform and infrastructure spending. While the tax bill was not perfect, much to
my surprise, we initially received a much more pro-growth response to it from
corporate America than I had expected.
The latter is not yet in the forecast because (1) it is too soon to
project a change of trend and (2) what trend there was seems to have fizzled. And even when, as and if it does, the
question remains the degree to which the tax bill’s lack of revenue neutrality will
act as a governor on potential growth.
The
negatives:
(1)
a vulnerable global banking system. The Fed slammed Wells Fargo this week for its
continuing egregious treatment of its customers. I linked to the article on Monday, so I won’t
repeat any commentary. I just point out
that the banksters haven’t changed their policies of growing profitability by
hook or by crook---emphasis on the latter----and probably won’t until somebody
goes to jail.
(2)
fiscal/regulatory policy.
In the
center ring this week was the multifaceted deliberations on the continuing
resolution, the budget, the debt ceiling and immigration. All wrapped up in a partisan stew of
political ineptness and irresponsibility.
And true
to form, our ruling class took the easy way out by raising spending and
removing the debt ceiling. Combined with
the loss of revenues from the tax cut, they have now added $2 trillion to the
federal deficit/debt. In a recession,
that might not be so bad. But with the
economy seemingly firing on all cylinders, the government should be reducing
debt.
I have
harped too many times on the effect too much debt has on economic growth; so I
won’t be repetitious. However, I will
add that the risk is rising that all this new deficit spending will trigger
inflationary forces and keep pushing the dollar lower.
You know
my bottom line, too much debt stymies economic growth even if it partly comes
from a tax cut. And a rapidly expanding
deficit and a tumbling dollar are not just bad for the country, they may push
the Fed to be more aggressive in its tightening policy. Not that I would object; but the Market
would.
(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 Fed crown
was passed to Powell this week; so there is a new sheriff in town. Whether he is as big a pussy [no pun
intended] as the former chief is yet to be determined.
That said, I
linked to an article this week detailing the unwinding of QE thus far and it
appears that the Fed has been more aggressive in rolling off its debt than
outlined in its schedule. There could be
technical reasons for this to have occurred; but it clearly needs
watching.
This article
suggests answer: the velocity of money has started to increase (medium and a
must read):
In addition,
the Bank of England adopted a more hawkish tone to its narrative. While it has done nothing to date, it has
indicated that a reversal in QE [rates going up higher and faster than
originally projected] is in the offing.
If this trend
toward unwinding QE [if indeed it is a trend] continues then we should be
getting a preview to the answer to the question, if stocks went up due to QE,
will they go down in its absence? [see
the S&P chart last week]
Of course, the
aforementioned would be a problem under benign economic conditions. Unfortunately, our ruling class has enacted
highly stimulative spending and tax measures at a time of near full
employment---which historically has been a recipe for inflation. If it materializes, that will likely force
the Fed’s hand in unwinding QE; that is, Yellen et al had dreamed of raising
rates and running off its balance sheet at a slow enough pace to hopefully not
disturb the Markets [‘dreamed’ being the operative word]. If that option is being removed, then it
seems reasonable to expect a much more aggressive increase in rates and unwind
of the $4 trillion in assets that it currently owns.
The bottom line
is that if growth/inflation picks up and/or the dollar continues to fall, the
Fed has no good alternatives. It has
left itself in the same place as every other Fed in the history of Fed; that
is, it has waited too long to begin normalizing monetary policy and now it must
either hold to its dovish ways and risk a big spike in inflation or begin to
tighten policy more aggressively and risk cutting off a potential increase in
the long term secular growth rate in the economy just as it is starting.
You know my
bottom line: when QE starts to unwind, so does the mispricing and misallocation
of assets.
(4) geopolitical
risks: Unicorns in South Korea.
(5)
economic difficulties around the globe. Which there seems to be less and less of. I know that I have said this before; but much
more of this, I am going to remove it as a risk.
[a] the January German factory orders and the
construction PMI were better than anticipated,
[b] the January Chinese trade surplus narrowed
substantially {if you believe it; remember the Chinese have a vested interest
in not getting into a trade war with the US over the Chinese trade surplus}.
The bottom line
remains the same: Europe gaining strength, Japan may be improving as is China,
if we assume the data that it is reporting is reasonably accurate.
Bottom
line: the US economy growth rate appears
to be faltering once again despite the positive impact on its secular growth
rate brought on by increasing deregulation, the better performance of the EU
economy and rising business and consumer sentiment.
However, the big
issue right now is how will the tax cut and increased deficit spending impact
economic growth and inflation. And that
is not factoring in a big infrastructure bill and/or the potential fallout from
a more aggressive trade policy. As you
know, I have an opinion (bigger deficit/debt=slower growth; higher deficit
spending=inflation) but given the unexpected positive corporate actions
following the tax cut, I am hesitant to push the point too hard.
It is important
to note that the real negative here is not the impact that tax cuts and
increasing spending have on economic growth; it is how they might affect
inflation and as a result Fed policy. The
central banks have created a Hobson’s choice for themselves: remain
accommodative and risk higher inflation or tighten and risk unwinding the
mispricing of global assets. Whatever
the outcome, it will only confirm what I have said repeatedly in these
pages---the Fed has never in its history managed the transition from easy to
normal monetary policy correctly and it won’t this time either.
The
Market-Disciplined Investing
Technical
The indices
(DJIA 24190, S&P 2619) managed a rally on Friday. The S&P bounced off its 200 day moving
average and both closed above their 100 day moving averages and the lower
boundaries of their short term uptrends.
However, both are also in very short term downtrends. To get jiggy about the very short term, the
indices have to negate that downtrend.
Volume rose and breadth improved. It is too soon to alter the technical
assumption that stocks are going higher.
The VIX fell
13%, but remained at elevated levels---continuing to exert a negative impact on
the Market.
The long
Treasury declined ½ %, finishing within a point of the lower boundary of its
long term uptrend. If that level is
successfully challenged, it will break a 16 year plus uptrend and point clearly
at the bond markets concern about rising interest rates/inflation
The dollar was up
two cents. It continues to develop a
very short term uptrend but on shrinking volume at a time that the long bond is
getting hit hard.
GLD was down slightly,
which it should be doing in a high interest rate, rising dollar scenario.
Bottom line: very
short term, stocks are in a downtrend; long term, the trend is up. Last week’s stomach churning volatility may
raise some questions about whether the Market has hit a high; but so far the
answer is no.
The price action
in the TLT, UUP and GLD continues to baffle me both as they relate to the
equity market and to each other.
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’ has risen based on a
new set of regulatory policies which will lead to improvement in the
historically low long term secular growth rate of the economy. Further, there is the chance that the
economic growth rate could be even higher if the recent trend continues in
enhanced corporate spending stemming from the tax bill.
With respect to
the latter, any further changes in our Economic Model are dependent on (1) more
follow through from corporate America increased spending on wage hikes and
increased capital spending [as opposed to higher dividends, stock buybacks and
executive compensation] and (2) the impact of the spiraling deficit. Until I have a better handle on this, I am holding
off on any increase in my 2018 growth outlook---which is putting me at odds
with a generally more optimistic view from the Street.
That said, even
if I am being too conservative, I don’t believe that a more rapidly improving
economy justifies current valuations and may even exacerbate the real problem (in
my opinion) facing the Markets---which is Fed policy/QE and the effect an
inflationary impulse would have on its current ‘tighten as long as the Markets
remain calm’ policy. In other words, the
need to control inflation may trump the best laid plans. That is not my forecast, at least, at the
present. But if it occurs, it will be a carbon
copy of every other time the Fed was forced to move aggressively against
inflation because it waited too long to normalize monetary policy in the first
place.
I want to
reiterate the point that I don’t believe that a tighter Fed will cause a
recession because QE did very little to help the economy. Although it may act as a governor on the rate
of economic progress. However, it will
have a significant negative impact on equity valuations because that was where
QE had its positive effect. I don’t know
how the Market can go up on the presence of an easy Fed and also go up in its
absence; especially when it has led to the gross mispricing and misallocation
of assets.
The pin action
this week may be indicating that investors are coming to that realization as
(1) long term interest rates increase, (2) the latest monetary data out of the
Fed indicates that it has been shrinking its balance sheet faster than its
narrative suggests and (3) other central banks [save the BOJ] are sounding much
more hawkish of late. It is too soon to
assume that investors are now worried about the consequences of unwinding QE;
but at least we have a sign that it could be touching the periphery of their
consciousness.
Bottom line: the
assumptions on long term secular growth in our Economic Model have improved as a
result of a new regulatory regime. Plus,
there is the chance that the effects of the tax bill could further increase
that growth assumption though its timing and magnitude are unknown. On the other hand, (1) if Trump follows
through with his trade threats, and/or (2) the deficit/debt continues to rise,
I believe that it/they would negate or, at least, partially 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 some cash in my Portfolio
and, if I didn’t have any, I would use the current price strength to sell a
portion of my winners and all of my losers.
When things break
(short):
DJIA S&P
Current 2018 Year End Fair Value*
13860 1711
Fair Value as of 2/28/18 13315
1643
Close this week 24190
2219
* 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 50 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.
