The Closing Bell
3/17/18
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%
Current Market Forecast
Dow
Jones Industrial Average
Current Trend (revised):
Short
Term Uptrend 24246-26847
Intermediate Term Uptrend 13057-29262
Long Term Uptrend 6410-29847
2018 Year End Fair Value
13800-14000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2426-3107
Intermediate
Term Uptrend 1254-3068
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 negative: above estimates: weekly mortgage and purchase
applications, weekly jobless claims, March consumer sentiment, the February
small business optimism index, the March NY Fed manufacturing index, February industrial
production and capacity utilization; below estimates: the March housing index,
February housing starts, month to date retail chain store sales, February
retail sales, January business inventories/sales, the March Philly Fed
manufacturing index, February import/export prices; in line with estimates: the
February US budget deficit, February CPI and PPI.
The primary
indicators were also negative: February retail
sales (-), February housing starts (-) and February industrial production (+). Making matters a bit gloomier, the Atlanta Fed
lowered its first quarter GDP growth estimate for the fourth time. The call is negative. Score: in the last 127 weeks, forty-three
were positive, sixty negative and twenty-four neutral.
So the recent two
month trend in dataflow remains negative. And it confirms my thinking that (1) the
initial surge in economic activity following the tax bill was more likely
attributable to post hurricane/wild fire recovery spending than the much touted
jump in wages/cap ex spending and (2) the tax bill will not prove fairer,
simpler or pro-growth.
Overseas, the data
was sparse. What we got was upbeat stats
from China; but its congress convened this week, so who knows how much fluff is
in these numbers.
The big item in
DC this week was the Donald ramping up the volume on trade---specifically going
after the Chinese over their theft of US intellectual property. I covered this in this week’s Morning Calls
as well as below. The bottom line being
that this action is, in my opinion, warranted, was way overdue but will raise
the risk of unintended consequences far more than the steel/aluminum tariffs
did.
Trump also
announced that he/GOP were going to propose a second round of tax cuts. I have also made myself clear on tax cuts at
a time of high deficits/debt on numerous occasions: increasing the deficit when
the debt service costs are already high inhibits not stimulates 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. Many had hoped that 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. However, it appears that the positive effects
of the tax bill have quickly dwindled. Indeed, my original assessment of it may
be spot on, i.e. the bill was not fairer, simpler or pro-growth. Further,
Trump’s approach to free/fair trade is stomach churning and while he appears
more circumspect than originally thought, we still don’t know whether or not it
will result in a trade war in the end.
At this point, our forecast remains economic growth at a slightly better
long tem secular rate but still below historical standards.
The
negatives:
(1)
a vulnerable global banking system. I noted last week that a move was afoot to
roll back some provisions of Dodd Frank.
This week the senate did just that.
While the house has yet to vote, its version is even more liberal than
the senate’s.
So, our ruling class now appears to be
reintroducing bank balance sheet risk in the US. As I observed last week, none of the players
responsible for the 2007 financial crisis have been punished in any way; so why
should we expect them to act any differently this time around?
(2)
fiscal/regulatory policy.
The main
focus this week was again on trade; this time Trump going after the Chinese
over their theft of US intellectual property.
This has been an ongoing problem, costing US companies as much as $60-90
billion a year in lost revenue. And it is acknowledged not just by the business
community but by politicians on both sides of the aisle. The issue has always
been one of the courage. to take corrective measures against a major global
power and a country whose economy is extensively intertwined with our own.
In my
opinion, it had to be done. The big
questions are
[a] in
his ‘art of the deal’ strategy, how far is the Donald willing to go to achieve
satisfactory results? His handling of
the steel and aluminum tariffs clearly indicate that his initial bark is a lot
worse than the ultimate bite. On the
other hand, the magnitude of the problem in that case is a wart on a goat’s ass
compared to the intellectual property issue; so he may prove less flexible,
[b] how
are the Chinese going to react? These
guys make a living out of playing hard ball. So we simply don’t know how far
they can be pushed. Whatever the
ultimate outcome, {i} there is a much greater risk of a misstep that could lead
to a more disastrous result than with the steel/aluminum tariffs and [{ii} even
if all ends well, the intervening process is apt to be stomach churning at
best.
Bottom
line, I thought that the steel/aluminum tariffs created too much theater for
what might be ultimately accomplished and I doubt anything really substantial
will come on this issue. On the other
hand, the Chinese theft of US intellectual property is one of the most
important trade issues the US will confront in our generation and its
resolution will likely set the tone not just for future US/Chinese trade
relations but for our diplomatic relations as well.
Unfortunately,
that wasn’t all that came out of Washington this week. The other news was that Trump/GOP was
preparing a second round of tax reform, the primary provision being to make the
individual tax rate reductions incorporated in the first bill permanent [they
are now scheduled to expire in 2025]. As
you might expect, I do not think this good news in that it will simply keep the
budget deficits higher, longer. Of
course, it could be just election year politics.
Again, you know my bottom line on this score. 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.
(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.
On the central
bank front, the only news this week was a statement from Draghi/ECB that it was
approaching the unwinding of QE cautiously---a slightly more dovish statement
than came out of the ECB meeting last week.
Not particularly surprising. It
is in line with most central bank policy statements over the last years---say
something hawkish and then back it up with a dovish statement. In short, do as little as possible. And it certainly comports with my thesis that
the central banks have waited too long to begin the normalization of monetary
policy.
And then there
is Japan (short and a must read):
https://www.zerohedge.com/news/2018-03-13/they-killed-market-not-single-japanese-bond-traded-tuesday
The bottom line
is that 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, [a] if there is an increase in inflation, it must either hold to its
dovish ways and risk a big spike in inflation or begin to tighten policy more
aggressively and risk trashing the Markets or [b] the US economy slips into
recession, it has few policy to tools to help alleviate its magnitude; and Markets
don’t like recessions.
(4) geopolitical
risks: it looks like the odds of a Trump
and Un meeting are going up, although there remains numerous preconditions that
have to be met. If this all works out,
then a lowering of tensions between the US and North Korea would clearly be a
plus.
Just remember that we have heard this tune from
North Korea before and look where it got us.
Furthermore, we have no idea how related this move is to the coming
trade confrontation between China [North Korea’s primary sponsor and defender]
and the US.
(5)
economic difficulties around the globe. A dearth of data this week and what there was
is politically suspect.
[a] the February Chinese industrial output, fixed asset
investment and retail sales were all strong and above estimates. The Chinese congress meets this week.
The bottom line
remains the same: Europe gaining strength, Japan may be improving as is China.
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.
This week’s
turmoil on the trade face off with China was needed and was long overdue,
though there is an enhanced risk of unintended consequences. While Trump’s rhetoric may again be part of
his ‘art of the deal’ strategy, this time he is taking on a heavy weight. So reaching a viable resolution may entail a
rough ride.
That leaves the larger
issue (for me) which we know with certainty; that is, how will the tax cut, the
new improved tax cut, increased deficit spending and a potentially big
infrastructure bill impact economic growth and inflation. As you know, I have an opinion (bigger
deficit/debt=slower growth; higher deficit spending=inflation).
It is important to
note that the biggest negative here is not the impact that tax cuts and
increasing spending have on economic growth---though, I my opinion, they are a
negative. It is Fed policy. The central bank has created a no win
situation for itself: [a] if it does nothing and economy accelerates, it risks
inflation, [b] if does nothing and the economy stumbles, it has few policy
measures available to combat it, [c] if it moves forward with the unwind of QE,
it will begin the unwinding of the mispricing and misallocation 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 24946, S&P 2752) were higher yesterday, which I had suggested might
be the case if history is any guide to the pin action around the first quarter
quadruple expiration. Clearly, there was
no ‘sell the rip’. But so many factors
influence a quad witching beyond investor sentiment or economic fundamentals, that
I don’t think that Friday’s performance was indicative of anything. Volume was up, as you would expect. Breadth was quite good.
The indices are
above both moving averages and within uptrends across all major timeframes. The
technical assumption is that long term stocks are going higher. However, they are now stuck in a narrowing
range defined by lower highs and higher lows.
In addition, they need to overcome their former all-time highs before we
have an all clear signal.
The VIX was down
another 4 ¾ %; and the recent pattern of wide intraday stock price volatility
concurrent with a falling VIX held---a plus for stocks.
The long
Treasury declined, ending in a very short term trading range. The momentum remains to the downside as it is
below both moving averages and is in a short term downtrend. Nonetheless, the recent strength may be an
indication of a shift in investors’ consensus from stronger to weaker economic growth. However, a lot more upside is needed to confirm
such a change in attitude.
The dollar was up
slightly again, which is not the usual price action when rates are
falling. UUP perhaps is being helped by
the new NEC chief Larry Kudlow who has extolled the virtues of ‘king dollar’
and urged investors to sell gold.
GLD was down
fractionally (see above). It broke below
the lower boundary of its short term uptrend; if it remains there through the
close next Tuesday, it will reset to a trading range. And like the dollar is not reflecting a weak
economy/lower interest rates. If it
successfully completes the challenge of its short term uptrend, it would
definitely slow the current upward momentum.
Bottom line: the
technicals of the equity market point higher for the long term; though very
short term the pin action suggests some more downside.
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. Unfortunately, the recent decline in the
strength of economic activity suggests that any benefit from enhanced corporate
spending stemming from the tax bill was short lived. Plus a second round of tax cuts, in my
opinion, will not improve the outlook for economic growth, given the current
stratospheric level of debt. Further,
if Trump’s move in raising tariffs proves too aggressive, this would likely
have an adverse impact on growth---although I am all in favor of taking on the
Chinese over the theft of intellectual property issue.
This week, trade
remained center stage though it took on a more ominous tone from the
perspective of the Markets. As I said
above, I support Trump’s effort to reign in the Chinese pirating of US
intellectual property; but I think that arriving at a resolution to this
problem will be a rocky road and has a decent risk of adverse
consequences---which clearly the Markets won’t like.
The danger of subdued growth and higher
inflation was exacerbated this week with the announcement that Trump/GOP will
pursue a second round of tax cuts. I
needn’t be repetitive here; but my bottom line is that the budget deficit and
national debt are already too high to render tax cuts an effective growth
stimulant. Making them bigger will only
make things worse. In short, in my
opinion, Street estimates for economic and profit growth are too optimistic and
valuations will have to adjust when that reality becomes manifest.
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 the need for the Fed to normalize monetary
policy. If improved growth led to a
continuing tightening of policy, ending QE, it, in my opinion, would not be
good for the Markets, since they are the only thing that benefitted from QE.
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 in the first place; 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.
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 still may be a chance that the effects of the tax bill could further
increase that growth assumption. Unfortunately,
(1) currently that effect appears to be dwindling, (2) if Trump follows through
with his trade threats, and/or the deficit/debt continues to rise driven by the
recently announced spending proposals, I believe that it/they would negate or,
at least, partially negate any potential positive. More debt will inhibit not
enhance growth and will likely create inflationary pressures which will have to
be dealt with by the Fed, sooner or later.
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. That math is simply: 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 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 3/31/18 13375
1650
Close this week 24946
2752
* 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
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.
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