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The Closing Bell

The Closing Bell


3/24/18


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 24290-26891

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 2452-3223

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 a slight upward bias to equity valuations. The data flow this week was mixed: above estimates: February existing home sales, month to date retail chain store sales, February durable goods orders, February leading economic indicators; below estimates: new home sales, weekly jobless claims, the March Market flash PMI’s, the fourth quarter trade deficit; in line with estimates: weekly mortgage/purchase applications, the March Kansas City manufacturing index.

The primary indicators were definitely a plus: February existing home sales (+), the February leading economic indicators (+), February durable goods orders (+) and new home sales (-). The call is positive. Score: in the last 128 weeks, forty-four were positive, sixty negative and twenty-four neutral.


Hard/soft data (short):

Animal Spirits Remain Spirited

While this week was only the third upbeat week in the last two months, it was by far the most positive of those three. And we can’t forget that blowout jobs report two weeks ago. That doesn’t mean that the trend toward slowing economic growth is changing. But there has been two solid data weeks in the last three, so I have to be open to the possibility. Still my current thinking remains 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, thus, (2) the tax bill will not be proven fairer, simpler or pro-growth.

Overseas, the data was mixed. Most of the stats out of Europe were less than upbeat; and the EU has been the bright spot in the global economy. But like the US, one week does not a trend make. So the forecast is unchanged but with the acknowledgement of some cognitive dissonance,

The big item in DC this week was the Donald ramping up the volume on trade---slapping $50 billion in tariffs on Chinese goods. 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.

Also Congress passed a FY2018 spending bill, saddling the electorate with even more national debt. Trump has announced that he/GOP were going to propose a second round of tax cuts, which would only make matters worse. Of course, this may just be part of election year tactics. 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 raised our economic 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 may have 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. Nothing new this week.

When finance becomes parasitic (medium):

When Finance Turns Parasitic

  1. fiscal/regulatory policy.

Our ruling class really did a number on the economy/electorate this week.

First, congress passed a $1.3 trillion spending bill for FY2018 which will up the deficit from FY2017 and, hence, further expand the national debt. On top of that the GOP is threatening to introduce another round of tax cuts---though my hope is that this is just election year engineering. I will save you my usual harangue; but you know my bottom line: with the national debt already at a stratospheric level, deficit spending and the resulting increase in national debt will not be stimulative to the economy. Indeed, the cost of servicing that debt it will have the opposite effect, slowing the rate of economic growth. (must read):

The Debtor's Prism

Second, on trade, there was some good news and bad news. Starting with the former, it appears the US and NAFTA are making decent progress in revising that agreement. Ditto that with our EU trading partners over the steel/aluminum tariffs. Then on Friday, the Donald exempted even more countries. In other words, the longer we go, the less vicious his bite.

Trump Suspends Tariffs On Multiple Nations (Not China Or Japan) Until May

The bad news is that the faceoff with China was reached the stage at which someone must blink. Trump has slapped $50 billion in tariffs. China countered with $3 billion in tariffs---not a very aggressive move. It implies that the Chinese may be ready to negotiate. That said, late Friday, a Chinese official said that there was more to come.

Here It Comes: China About To Launch "Tens Of Billions" More In Tariffs

Based on Trump’s prior ‘art of the deal’ tactics, my hope is that this confrontation will get resolved behind the scene which will allow China to save face. The confounding thing about this particular situation is that the Chinese theft of US intellectual property is by far the most egregious violation of free trade that the US faces. Meaning that if the Chinese don’t provide relief, then we may be about to have a gunfight with one of our largest trading partners; and that won’t be good the US economy.

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. A trade war is a lose/lose proposition.


  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.


Center stage was the FOMC meeting which included Powell’s first meeting as Fed chair. The results were pretty much as expected: it raised the Fed Funds rate by 25 basis points and said that the unwind of its balance sheet will continue as planned. However, the Fed did strike a more hawkish tone as it raised its estimates for the number of rate increases in 2019 and 2020.

It continued its annoyingly upbeat assessment of the economy [I repeat, what numbers are these guys looking at?]. Even if the economy is starting to improve some, the trend has still been negative for the last two months. I don’t know if the members really believe their narrative or they are just using it to move along the unwind of QE---hoping somehow to get it done without wrecking the Markets. Good luck with that.

Another concern along those lines is the recent rapid rise in LIBOR rates which roughly $350 trillion in global debt is tied to. I have linked to several articles on this issue. At the moment, those increases in rates aren’t having much of an impact on US rates; and maybe they never will or they will reverse themselves. But it is an important enough development that it needs to be monitored.

"Baked In The Cake" - Why LIBOR's Blowout Has Already Done Its Damage

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] if 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: Nothing new this week.

  1. economic difficulties around the globe. The international data this week was a mixed bag; but the concerning thing was the EU stats were largely negative. As you know, Europe has been the real bright spot in globe, economically speaking. So while it is way too soon to think that it is slowing, attention must be paid.

[a] February UK CPI was below consensus as was the unemployment rate, while retail sales advanced; the March Markit EU PMI’s were below estimates, March German business conditions were slightly better than anticipated, though expectations were quite low.

The bottom line remains the same: Europe gaining strength, though this week didn’t help that view. Japan may be improving as is China.

Bottom line: the US economy growth rate may 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---with the caveat that while this week’s numbers from both the US and EU don’t fit that forecast, a one week countertrend is no reason to alter it.

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 fiscal issue (for me) which we know with certainty; that is, how the original tax cut, a second proposed new improved tax cut, increased deficit spending and a potentially big infrastructure bill will impact economic growth and inflation. As you know, I have an opinion (at the current level of the national debt, 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, in 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. In fact, if LIBOR rates continue to blowout and begin to impact US rate, the Fed may not even have this option, [b] if does nothing and the economy stumbles, it has few policy measures available to combat any economic weakening, [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 23533, S&P 2588) were pounded again yesterday. Volume rose, and breadth was negative. Both of the Averages closed below their 100 day moving averages for the second day; if they remain there through the close next Monday, they will revert to resistance. In addition, the Dow finished below the lower boundary of its short term uptrend for the second day; if it remains there through the close next Monday, it will reset to a trading range. Finally, both are in very short term downtrends.

While equities may be on the cusp of an important trend change, the current challenges have yet to be successful; and there is still plenty of support lower down. In short, it is way too soon to be predicting that a high has been made or that momentum is reversing to the downside.

The VIX was up another 6 ½ %, ending above its 100 and 200 day moving averages and the lower boundary of its short term trading range. However, despite the moonshot over the last two trading days, it has not yet established a very short term uptrend.

VIX Curve Inverts Again As Futures Market Interest Collapses

The long Treasury was down fractionally---which seems a little off on a day in which investors are worried about a trade war, global interest rates are rising and the Fed just kicked the Fed Funds rate higher. So there wasn’t any safety trade or interest rate worries reflected in its pin action. That said, TLT is still below its 100 and 200 day moving averages and in an intermediate term downtrend---indicating higher rates in the offing.

The dollar was down, like bonds, not an indication that it was being sought out as a safety trade. While it is struggling to stabilize, the trend remains down.

GLD soared 1 ¼%, likely reflecting the concerns over a trade war. It remains above its 100 and 200 day moving averages and within a short term uptrend.

Bottom line: while the technicals of the equity market point higher for the long term, some cracks are starting to appear in that thesis. Granted these may only be short term issues; but clearly, investors have to be on alert, especially given the recent switch in psychology from ‘buy the dips’ to ‘sell the rips’---which happened again on Friday.

I am confused by yesterday’s aggregate pin action in TLT and UUP.

Friday in charts (medium):

Carnage... Everywhere

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 arriving at a resolution to this problem has so far been rocky and there remains a decent risk of adverse consequences---which clearly the Markets won’t (don’t) like.

The danger of subdued growth and higher inflation was exacerbated this week with the passage of the FY2018 $1.3 trillion spending bill. Further, Trump/GOP have announced their intent to pursue a second round of tax cuts; although that could just be election year fluff. I needn’t be repetitive here; but my bottom line is that the budget deficit and national debt are already too high to render either deficit spending or 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.

Finally, this week’s action by the FOMC (raise interest rates, continue the unwind of the Fed’s balance sheet) moves the Markets closer to the time at which the elimination of QE, whether gradual or not, will also start the undoing of the gross mispricing and misallocation of assets. And, indeed, the blowout in LIBOR rates could be the first sign; although it is still too soon to know.

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.

That said, even if I am wrong on all the above points, 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.

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 questionable, (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 23533 2588

* 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.