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The Closing Bell

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.

3 Months After 'Harvey' - Boom Narrative Goes Bust

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.

How Well Does Financial Regulation Work? | naked capitalism must read

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?

  1. 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.

The Real Reason for Trump's Steel and Aluminum Tariffs by Martin Feldstein

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.

LEAKED: Trump Threatens to Launch Trade War v. Rattled China Over IP Theft | naked capitalism

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.

US National Debt Hits $21 Trillion

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.

Is The U.S. Economy Really Growing? (Spoiler Alert: No!)

  1. 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):

"They Killed The Market" - Not A Single Japanese Bond Traded On 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.

  1. 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.

  1. 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 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.