The Closing Bell
12/16/17
I am leaving you again. Our
daughter and her family arrive today for Christmas. And the day after Christmas, we leave for the
beach. I will be back 1/2/18; but if
anything unusual occurs, I will be in touch.
Have a happy holiday season.
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%
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 22143-24879
Intermediate Term Uptrend 19516-26847
Long Term Uptrend 5751-24198
2016 Year End Fair Value
12600-12800
2017 Year End Fair Value
13100-13300
2018
Year End Fair Value 13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2586-2860
Intermediate
Term Uptrend 2339-3101
Long Term Uptrend 905-2763
2016 Year End Fair Value
1560-1580
2017
Year End Fair Value 1620-1640
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 mixed: above estimates: weekly jobless claims, November
retail sales, month to date retail chains store sales, the November small
business optimism index, October business inventories/sales; below estimates: weekly
mortgage and purchase applications, the December composite PMI, November PPI,
the November budget deficit; in line with estimates: October/November
industrial production and capacity utilization, the December NY Fed
manufacturing index, November CPI and November export/import prices.
The primary
indicators were slightly upbeat: November retail sales (+) and October/November
industrial production (0). The call is positive
(though just barely): Score: in the last 114 weeks, thirty-eight were positive,
fifty-six negative and twenty neutral.
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 and (2) in my
opinion, this latest spurt in activity is more related to improving investor
psychology as a result of the anticipated tax reform and the confidence that
the Fed will pursue its tightening process only so long as it is not disruptive
to the Markets. So I can envision a very
short term cyclical period of growth, However, I think it more related to the period
immediately after the Trump election when psychology turned upbeat and the
economic data suddenly improved only to fizzle out after a couple of
months. Therefore, I don’t believe it a
reason to assume that the economy is returning to its long term secular growth rate.
On the other
hand, this recovery has been below average; so perhaps there remains sufficient
underutilized capacity to extend the expansion for another couple of years. This is a key point on which my forecast will
be proven correct or not; and we will likely know the answer by mid first
quarter 2018.
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, the Chinese
data has shown a marked deterioration 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.
In fiscal
policy, tax reform appears to be a short hair a way from passage; and indeed, I
think that it will be enacted. That
said, my opinion is that it is not simpler (adds 20,000 new pages to the tax
code), fairer (most of the cuts to corporations and the wealthy) and will not
stimulate growth ($1.5 trillion in new debt will impede not promote economic
growth).
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. However, any expected increase in the secular
rate of economic growth would likely be rendered moot if tax reform (assuming
its passes) increases the national debt and the deficit.
Finally, 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.
The GOP
continues to drive to the hoop on its tax reform measure. I understand the political necessity of
getting this done. But as you know, I see
little economic rationale. As I have
tried to document, the measure as it is currently configured is not simpler,
fairer or economically stimulative. The
only possible positive outcome would be a boost to business and consumer
sentiment that would itself create some added growth. Along that line, remember that immediately
following Trump’s election, the economy experienced a boost in sentiment driven
activity only to have it fade after a couple of months.
Here is
last night’s release of the final compromise bill:
Welfare
for the wealthy (short):
This
from an optimist (medium):
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.
This week,
everybody got into the act:
[a] the Fed
raised the Fed Funds rate a quarter of a point {as expected}, projected three
more hikes in 2018 {as expected} and provided a very upbeat outlook for the
economy. That does raise the question,
if things are so good, why would the Fed drag its feet in normalizing monetary
policy? The answer is, of course, that
it is scared sh*tless that the Markets would look on such a move with
displeasure.
Which begs the
other question, why is the Fed effecting policy that accounts for a mandate
{Market stability} which it doesn’t have?
The answer is, because it has created a monster that it hopes and prays
it can finesse out back into a cage and, not coincidentally, be held
accountable for. Along those lines, in
Yellen’s subsequent news conference, she said that she saw no ‘red’ or even ‘orange’
flags on the horizon with respect to Market risk.
I may be wrong;
but I believe that this will go down as another of the stupidest remarks ever
uttered by a Fed head,
[b] the ECB and
the Bank of England also met this week and both left their respective monetary
policies unchanged, which is to say, no increase in rates and no cutback in
QE. This despite the clear improvement
in the EU economy. About the only thing
I can say is that these guys are making the Fed look like a bunch of tight
money advocates. But it is all relative.
[c] meanwhile,
having gotten through the Communist Party Congress meeting without an economic
mishap {at least none reported}, the Bank of China raised rates slightly this
week---a sign that government may be tightening the monetary/fiscal screws in
an attempt to flush out the weak companies and financial institutions that have
grown up over the past ten years in an easy money environment. Whether or not this leads to repercussions
outside of China remains to be seen.
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: little to add.
Apropos of
nothing, a bit of a history lesson (medium):
(5)
economic difficulties around the globe. The stats this week were in line with recent
trends.
[a] October EU industrial output plus its
manufacturing and services PMI’s were above expectations; November UK
unemployment fell, retail sales improved while CPI and PPI were in line,
[b] November Chinese industrial output and retail
sales were below estimates
The bottom line
remains the same: Europe gaining strength, Japan may be improving, China a big
question.
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 likely 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 well-being of this country.
The
Market-Disciplined Investing
Technical
The indices
(DJIA 24651, S&P 2675) smoked yesterday as tax reform appeared closer than
ever. Volume spiked (but it was option expiration); breadth was firm but not as
strong as I would have expected. 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.
The VIX (9.4) plunged
10 ½ %, closing below its 100 and 200 day moving averages (both resistance) and
back below the lower boundary of its long term trading range.
The long
Treasury was up, ending above its 100 and 200 day moving averages and the lower
boundaries of a very short term uptrend, its short term trading range and long
term uptrend. So bond investors are not
worried about higher rates or they are looking for a safety trade.
The dollar was
up slightly, finishing below its 200 day moving average (now resistance) but
above its 100 day moving average (now support) and back above the upper
boundary of its short term downtrend (if it remains there through the close
next Tuesday, it will reset to a trading range.
Gold
was up slightly, remaining below its 100 and 200 day moving averages, in a
developing very short term downtrend and within a short term trading
range.
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. If you own enough cash to sleep at night, lay
back and enjoy it.
Trading in UUP,
GLD and TLT continued to reflect an economy that is either less strong and/or
has less upward pressure on interest rates. Stocks and the VIX reflect economic
growth forever. I remain confused and
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’ could be rising based
on a new set of regulatory policies which would lead to improvement in the
historically low long term secular growth rate of the economy.
In addition,
that growth could be further augmented if the current tax bill delivers on its
promises. As you know, I have serious
doubts about that occurring; but I have to be open to the possibility. The more likely scenario is a brief pickup in
growth brought on by better business and consumer sentiment over the pending tax
bill followed by a return to more sluggish growth/stagnation when the
realization sets in that the tax bill is a GOP puff piece designed for talking
points in the 2018 elections.
To be clear, the
US long term secular growth rate appears to have picked up a little steam as a result
of an improved regulatory environment. Consequently,
I raised my 2018 GDP and corporate growth 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 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 it wakes 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 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 at some point those distortions will be corrected irrespective
of how or even whether the Fed pursues monetary normalization. To be sure, I have no clue what the trigger
event will be; but I didn’t know what would affect the Market collapses in 2000
and 2008 either---yet they still occurred. Finally, those distortions are so extreme that
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.
Counterpoint:
From an optimist:
As a long term investor, with
equity valuations at historical highs, I would want to own some cash in my
Portfolio and would use the current price strength to sell a portion of my winners
and all of my losers.
DJIA S&P
Current 2017 Year End Fair Value*
13200 1630
Fair Value as of 11/30/17 13200
1630
Close this week 23358
2578
Over Valuation vs. 11/30
55%overvalued 20460 2526
60%overvalued 21120 2608
65%overvalued 21780
2680
70%overvalued 22440 2771
* 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.
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