The Closing Bell
1/13/18
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 23424-25806
Intermediate Term Uptrend 12863-29069
Long Term Uptrend 6009-29456
2018
Year End Fair Value 13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2357-3128
Intermediate
Term Uptrend 1243-3057
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 mixed: above estimates: weekly mortgage and purchase
applications, November wholesale and business inventories/sales, December PPI, December
import and export prices, the December budget deficit; below estimates: November
consumer credit, weekly jobless claims, December retail sales, month to date
retail chain store sales, December small business optimism survey, December
CPI, ex food and energy; in line with estimates: none.
However, the lone
primary indicator was negative: December retail sales. The call this week is negative---but clearly
just barely. Score: in the last 118
weeks, forty were positive, fifty-seven negative and twenty-one neutral.
Given the
paucity of data, I am not going to read too much into this week’s numbers. I think they will matter only if we see a
further weakening in the stats. I will
reiterate a point I made on Friday: while the PPI reading was undeniably upbeat,
it nonetheless was a decline in a sustained two year uptrend. Like this week’s data, it is only meaningful
if it reverses that trend.
Overseas, the datapoints
were also scarce but the pattern remained the same: strength in Europe which is
likely contributing to a pick in growth here; not so much in the rest of the
globe---in China the stats were mixed
In short, the
trend in global growth remains upbeat. In
my mind, the issue remains the duration of this growth spurt. And as you know, I believe that it will be
short lived. Certainly, this week’s less
than stellar numbers suggests that as a possibility; though as I stated above,
it is far too soon to be making that call. My bottom line is that I don’t see
how the US/rest of the world can undergo a rise in its long term secular growth
rate at the same time that the magnitude of the levels of debt that have to be serviced are so
high---and rising.
Having said
that, I have already raised my long term secular economic growth rate
assumption based on an improved regulatory environment. 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.
Counterpoint:
https://www.project-syndicate.org/commentary/global-economy-growth-risks-2018-by-jim-o-neill-2018-01
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.
There
were kerfuffles in the area of trade this week [China, NAFTA], both of which I have
covered and the results of which is that it appears little will come of them. But I do want to repeat my bottom line on
this issue: free trade is good for
everyone. It expands economic growth for
both parties. Sometime trade agreements
need to be updated due to changing economic circumstances---which I hope is
what is occurring now. That is also
good, assuming each party can negotiate in good faith.
The US
trade deficit keeps getting bigger (medium):
The
other development that bears comment is
the Donald’s statement that congress ought to bring back earmarks. While he is correct is saying that it would
make the passage of legislation easier [essentially buying votes with your and
my money]. And it clearly reflects the
mentality of ‘deal maker’. However, with
the US debt/deficit at record highs, in my opinion, the US cannot afford this
kind vote buying scheme for the sake of passage of legislation that may not be
all that positive for the US electorate in the first place. Let’s hope this was just another the Donald’s
shoot first and aim later comments.
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.
There were rumblings
in two of the major foreign central banks:
[a] the Bank of
Japan reduced the size of its purchases of US Treasuries in a single transaction. The response was immediate as US long bonds
sold off. However, in a subsequent
transaction, the BOJ resumed its former level of purchases. At this point, we don’t know if there were
just technical reasons for the initial reduced size of purchases or the bank
was testing the waters for a policy change, i.e. the start of the unwinding of
Japanese QE [higher interest rates].
[b] in
addition, there were rumors that the Chinese were reducing the size of their US
Treasury holdings [supposedly as retaliation for Trump’s tough trade
talk]. That also got investors worrying
about higher interest rates. Subsequently, the Chinese said that they were
adjusting their reserves as a result of the decline in US Treasury prices. While that sounds less confrontational, the result
is still the same---they are selling US Treasuries.
Whatever the
reasons for these central bank actions, we know the Markets reactions---which
is, investors are very edgy about a concerted global unwinding of QE.
This, of
course, fits with my thesis that the Markets can’t go up on QE but not go down
in its absence. It also fits with the notion that the central banks have painted
themselves into a corner---which is, that they can continue QE and risk pushing
inflation over acceptable levels or not and fail in their unstated, unsanctioned
goal of stimulating wealth.
I have no clue
what the future holds. Although we have
a sign that the Markets will not react kindly to the unwinding of QE. 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.
The absurdity of the ECB QE
(medium and a must read):
(4) geopolitical
risks: The most significant development
this week relates to the reaction of the Pakistanis to the Donald’s negative
tweets and threats to cut foreign aid. I
covered Pakistan’s response which was basically to tell the US to stick it where
the sun doesn’t shine and open negotiations with China and Iran for aid and
joint projects.
This appears to
be the first instance where the ‘art of the deal’ rhetoric has seemingly backfired. The result in itself is not a plus as
Pakistan provides critical assistance in our [losing] fight in
Afghanistan. However, if it gives other
parties the courage to call Trump’s bluff, that would really spell trouble for
his administration.
In addition,
Trump made some nicey, nice comments on North Korea and Kim Jung Un, suggesting
that the recent move by the North to re-establish contact with the South may be
paying off in a lessening of tensions with the US. That is the good news.
(5)
economic difficulties around the globe. There were few stats this week but we got was in
line with recent trends.
[a] 2017 German GDP rose at the fastest rate in six
years,
[b] a Chinese official said the 2017 Chinese GDP grew
faster than forecast---remember these guys lie.
As witness to that, December Chinese exports and imports declined.
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.
In addition, the
end of QE appears to be drawing ever closer, leaving the central banks with a
Hobson’s choice: 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 25803, S&P 2786) continued their melt up on higher volume and
stronger breadth. Long term, they remain
robust 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 their long term uptrends. The technical assumption has to be that
stocks are going higher.
The VIX was again up on a solid up Market day. For the last week, it has almost entirely
divorced itself from any (inverse) correlation with stocks. I think that means one of two things and
perhaps both: (1) somebody in stock land is doing serious hedging [of their equity
positions] and (2) volatility will likely be much higher going forward than it
was in 2017.
The long
Treasury continued its recovery from the shellacking it took following the PPI
number---although it was not that impressive.
I believe that suggests that the bond boys are not convinced that the
Fed will stay as accommodative as the equity investors seem to think. That said, TLT is technically in something
of a no man’s land, not providing any clear directional information.
However, the
other indicators that I follow are providing strong indications of lower
rates. On Friday, GLD was up over 1%
while the dollar was down over 1%.
I remain
uncomfortable with the overall technical picture.
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 further improve the long term secular economic
growth rate. That said, I have to point
out that (1) at the moment, a six week improvement in the data suggests that I am
wrong and (2) 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.
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. That may be true if the Fed was the only
central bank that was tightening---which, in fact, it has been up until
recently. Now the central banks of Japan
and China are making noises that suggest less accommodative monetary policy is
in the near future. Plus the ECB is
scheduled to begin shifting towards unwinding its own version of QE later this
year. To be sure, all these guys have mewed about tightening monetary policy
before and done nothing. And that may
prove to be the case this time around.
But whether it
does or not, it won’t change the fact that the global 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, (1) if Trump follows
through with his trade threats, and/or (2) the deficit/debt continues to rise,
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.
DJIA S&P
Current 2018 Year End Fair Value*
13860 1711
Fair Value as of 1/31/18 13266
1637
Close this week 25806
2786
* 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.
