The Closing Bell
1/6/18
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 23217-25953
Intermediate Term Uptrend 12794-29000
Long Term Uptrend 6009-29456
2018
Year End Fair Value 13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2354-3125
Intermediate
Term Uptrend 1236-30501
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 a
higher upward bias to equity valuations. The
data flow this week was again upbeat: above estimates: weekly purchase
applications, December retail chain store sales, December light vehicle sales,
the December ADP private payroll report, November construction spending, November
factory orders, the December Markit manufacturing and services PMI’s, the
December ISM manufacturing index; below estimates: weekly mortgage applications,
month to date retail chain store sales, December nonfarm payrolls, weekly
jobless claims, the December ISM nonmanufacturing index, the November trade
deficit; in line with estimates: none.
The primary
indicators were also positive: November construction spending (+), November
factory orders (+) and December nonfarm payrolls (-). The call is positive. Score: in the last 117 weeks, forty were
positive, fifty-six negative and twenty-one neutral.
Overseas, the
pattern remains the same: strength in Europe which is likely contributing to a
pick in growth here; not so much in the rest of the globe. Indeed, despite the
media rhetoric to the contrary, the Chinese data has shown scant improvement
since the conclusion of the Chinese Communist Party Congress; and that will
likely be aggravated by the recent tightening in standards for the financial
industry which are being implemented to halt the excessive use of debt.
China admits economic
data miscalculation
In short, the
trend over the last two months has clearly been upbeat. Whether this spurt is the last hoorah of an
eight year below average expansion or the sudden liftoff to a new and glorious
growth phase in the economy is the big question.
My vote is the
former because (1) as noted, this expansion is already long in the tooth; and
while it has been below average in magnitude, it is still reaching historical
end of cycle markers, like unemployment and profit margins, (2) I don’t believe
that the tax reform package will provide an enduring increase in the US long
term secular growth rate, (3) we don’t
how much of the recent advance in economic activity is the result of the
inevitable short term pick up that occurs after disasters such as the three
hurricanes that we experienced last fall and (4) the debt level in all sectors
of the economy are so high, I don’t see how the US can undergo a rise in its
long term secular growth rate at the same time that those levels of debt have
to be serviced. Furthermore, if we see
long rates at 5%, not only will the Fed be technically bankrupt but the
majority of tax revenue will go to just pay the interest cost on the debt.
The budget
deficit
And
all the other debt (medium):
On the other
hand, (1) I have already raised my long term secular economic growth rate
assumption based on an improved regulatory environment; so some of the recent
increase reflects that, (2) certainly, the pickup in global economic activity
is a contributor to the better numbers.
But the question
is the same as I raised above, to wit, is this a last hoorah or the dawning of
a new age? My answer is the same---the
debt levels in the EU, China and Japan are so astronomical, that servicing that
debt will simply take too many resources that could otherwise be used for
growth. Plus, we have no idea what the
magnitude or quality of the debt is in China; though we do know that a decent
percentage of it is nonperforming.
Finally, remember
that I am not bear on the economy. My issue isn’t whether it will keep growing;
my issue is by how much.
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 (revenue
neutral) tax reform and infrastructure spending. We may be getting the former, but, unfortunately,
not the revenue neutral tax reform as it will expand the national debt by
another $1.5 trillion. As a result, I fear
the odds of an additional bump in the long term secular growth rate of the
economy are low.
To be sure, short
term growth is improving, propelled by improved psychology and a pickup in
international growth. However, I have
doubts that the former will lead to any permanent increase in the long term
secular growth rate.
The
negatives:
(1)
a vulnerable global banking system. Nothing new.
(2)
fiscal/regulatory policy.
With tax
reform out of the way, the next big issue is the passage of the FY 2018 budget
and how the inevitable rise in the deficit will be handled, given the current
restraint imposed by prior legislation.
This is another one of those dead horses that is a waste of time for me
to beat: given the current level of the deficit and debt, whatever our ruling
class comes up with, anything short of significant spending cuts across the
board will inhibit not stimulate growth.
You know
my bottom line, too much debt stymies economic growth even if it partly comes
from a tax cut.
(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 FOMC
released the minutes of its last meeting this week. Nothing really changed [a] because the same
dovish crew is making the decisions and [b] even if the Committee’s composition
had changed, nothing would have been done in lieu of the imminent arrival of a
new Fed chief. A lot of ink is going to
get spilled over the coming months interpreting his comments and any shifts,
however subtle, in policy. Regrettably,
all signs to date is that he will do little to extricate the Fed from its current
policy dreamland.
I include this
article because of its absurdity. The
author speculates that the Fed worrying about how to deal with the next
recession as opposed to dealing with its $4 trillion balance sheet. That may be the case but it demonstrates how
contorted the policy making inside the Fed is.
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: Two new developments, both
potentially positive: [a] North Korea reaching out to the South and [b] the
civil unrest in Iran. It is not clear
what the results will be but it seems that they are more likely to be a plus.
(5)
economic difficulties around the globe. The stats this week were in line with recent
trends. Much more of this and I will
remove this factor as a risk.
[a] December EU composite PMI and the UK services PMI
were above forecasts; December EU inflation declined; the December German
unemployment rate hit a record low,
[b] December Chinese Caixin services PMI was above
estimates.
The bottom line
remains the same [Europe gaining strength, Japan may be improving, China is a question
simply because the government lies] but the warning light is flashing
indicating the potential for a more upbeat outlook.
Bottom
line: the US economy growth rate appears
to be improving as a result of a combination of the positive impact on its
secular growth rate brought on by increasing deregulation, plus rising business
and consumer sentiment stemming from the passage of tax reform and the better
performance of the EU economy. The issue
is, will this pick in economic activity have any legs? I remain skeptical because (1) the current
recovery is already at record length and (2) the tax bill, in my opinion, will
do little to stimulate growth. There is
the possibility that the current acceleration in economic activity is largely
sentiment driven and that by itself could prove me wrong. However, I believe that the more likely
scenario is loss of business and consumer optimism when they realize the tax
bill will do little to improve the economic overall well-being of this country.
The
Market-Disciplined Investing
Technical
The indices
(DJIA 25295, S&P 2743) are in a Titan III formation, as the rate of
increase continues to increase. Volume
declined on Friday though it is still high; breadth was strong. The bottom line remains that both of the
Averages continue to trade above their 100 and 200 day moving averages and are
in uptrends across all time frames---with the assumption being that stock
prices are going higher.
While stock
investors are enthused about ‘global synchronized growth’, the investors in the
long Treasury, the dollar and gold are not supporting that view as bonds and
gold rally and the dollar continues to get whacked.
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. The technical assumption has to be that stocks are going higher. The pin action in TLT, UUP and GLD is causing
me a lot of cognitive dissonance. I
remain confused and uncomfortable with the overall technical picture.
Chinese
liquidity injections are helping to move global markets (medium):
Retail
investors aren’t (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’ 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.
Consequently, I
raised my 2018 GDP, corporate growth and Fair Value estimates. However, I have serious doubts that the tax
reform bill will do anything to improve the long term secular economic growth
rate. That said, I have to point out
that a number very smart analysts for whom I have great respect disagree with
this position. We will probably know who
is right sometime in early 2018.
In short, I
believe that Street estimates for economic and corporate profit growth based on
a stimulative tax reform are too optimistic.
As a result, if stocks continue to fly on this notion, they will
discount even more future growth that is either not there or so far in the
future as to not be really relevant to today’s valuations. And when investors wake up from this fairy
tale that could, in turn, lead to declining 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.
The Phillips
curve versus the Laffer curve (medium):
At this point, I
couldn’t be more at odds with Market extremely positive sentiment grounded on
the assumption that the Fed has the Market’s back and will pursue the unwinding
of QE only to the extent that it does not disrupt the Markets. To be sure, the thesis has proven correct to
date. However, I believe that the
monetary authorities have created huge asset price distortions just as they did
in 2000 and 2008; and given their abject failure to transition to normalize
monetary policy in the past, I doubt that they will do so this time. Unfortunately, this time around those
distortions are the most extreme in history; so I expect the subsequent price
adjustments will be very painful.
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 a ray of hope (though fading) 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 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.
And:
DJIA S&P
Current 2018 Year End Fair Value*
13860 1711
Fair Value as of 1/31/18 13266
1637
Close this week 25217
2743
* 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.
