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The Morning Call

The Closing Bell

9/15/18

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 Trading Range 21691-26646

Intermediate Term Uptrend 13628-29833

Long Term Uptrend 6410-29847

2018 Year End Fair Value 13800-14000

Standard & Poor’s 500

Current Trend (revised):

Short Term Uptrend 2636-3407

Intermediate Term Uptrend 1308-3122 Long Term Uptrend 905-3065

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: weekly purchase applications, weekly jobless claims, September preliminary consumer confidence, the August small business confidence index; below estimates: weekly mortgage applications, month to date retail chain store sales, July wholesale inventories/sales, July business inventories/sales, August budget deficit; in line with estimates: August/revised July retail sales, August industrial production, August PPI and CPI, August import/export prices.

Primary indicator were also mixed: August/revised July retail sales (0), August industrial production (0) and August PPI/CPI (0). So I rate this week a neutral. Score: in the last 153 weeks, fifty-one were positive, seventy-one negative and thirty-one mixed.

Two comments:

  1. I rated the August PPI/CPI and import/export price reports neutral because they are a double edged sword. On the one hand, lower prices are great for us paeans, but they are also a sign of a weak economy. The $64,000 question is, what does the Fed do with this information?

  1. given the strength on the second quarter GDP [and revisions], I am increasing my forecast for real GDP growth in 2018 from 1.5%-2.5% to 2%-3%. But that is simply the recognition of a one-time pop in the economy brought on by the tax cuts. It in no way alters my outlook for the long term secular growth rate of the economy.

The numbers from overseas this week were mixed, continuing the trend of mixed to negative stats. That means our own economy is losing that as a tailwind.

Our (new and improved) forecast:

A pick up in the long term secular economic growth rate based on less government regulation. There is the potential that Trump’s trade negotiations could also lead to an improvement in our long term secular growth rate, The agreement with Mexico is clearly a step in that direction. Further, the Canadians made noises this week suggesting our trade issues with them could be resolved. However, that still leaves the EU, China and now Japan. So a lot is left to be done before raising my assumption of the US long term secular growth rate.

Moreover, the tax cut and spending bills, as they are now constituted, are negative for long term growth (you know my thesis: at the current high level of national debt, the cost of servicing the debt more than offsets any stimulative benefit); and we got news this week that the deficit is growing faster than anticipated.

On a cyclical basis, while the second quarter numbers were definitely better than the first, there is insufficient evidence at this moment to indicate a strong follow through. So my current assumption remains intact---an economy struggling to grow.

The negatives:

  1. a vulnerable global banking system.

‘The overseas dollar funding problems [the necessity to buy dollars to service/refinance current dollar denominated debt] continue to grow as more countries are having problems. This issue impacts the banks because they own a major portion of the debt that is being serviced/refinanced. If that debt goes into default, then the banks’ balance sheets/capital account takes a direct hit and that would in turn [a] impede lending and [b] weaken their solvency, making their own debt more difficult to service/refinance.

The global economy has had crises brought on by dollar funding problems twice in the last thirty years. The results were not pretty. To date, we are not in as extreme a circumstance; but we are clearly moving in that direction.’

  1. fiscal/regulatory policy.

Trade talks initially took a turn for the better this week with [a] Canadians seemingly willing to compromise on dairy imports and [b] the Chinese initiating a charm offense and the US responding in kind. Then on Friday, Trump spoiled the party, instructing aides to proceed with the $200 billion in tariffs against China.

Trump To Proceed With $200BN More In China Tariffs Despite Talks; Stocks, Yuan Tumble

While clearly a disappointment, I reiterate my thesis that resolving the outstanding issues with Canada, the EU and China will be a plus for the long term secular economic growth rate of the US.

On a more discouraging note, the CBO forecasted that the US budget deficit would hit $1 trillion in this fiscal year which was then pretty much confirmed when the Treasury reported a huge jump in August budget deficit . My bottom line here hasn’t changed: a rising budget deficit/national debt are deterrents to economic growth. The risk being that the positive accomplishments by Trump [deregulation, potentially fairer trade] will be offset by the country’s inability to service its debt and grow at the same time.

Goldman: What Is Going On In The US Is "Usually Reserved For Times Of War"

  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.

The misallocation of assets problem continues to reveal itself in the emerging market dollar funding problem. These difficulties will likely spread as the Fed continues to unwind QE [which its representatives insist it will and which the narrative in this week’s latest Beige Book supports] and the federal government continues to run ever higher deficits [which it is doing].

Fed's Brainard says an inverted yield curve won't get in way of rate hikes

This week, it clearly manifested itself in Turkish central bank’s move to raise interest rates by over 600 basis points [dramatically higher rates hopefully encourages inflows to the Turkish lira which in turn provides the funds to service the country’s dollar denominated debt]. While that may solve its dollar funding problem, it clearly won’t be a stimulus to the economy [higher borrowing rates]. Less dramatic but still notable, the Russian central bank also increased rates to stem the depreciation of its currency and the rise of inflation.

Don’t cry for me, Argentina.

Argentine Peso Closes At Record Low As IMF Withholds $3 Billion Bailout Tranche

In other central bank news, both the Bank of England and the ECB met and both left rates unchanged. In the ECB’s case, its accompanying narrative reiterated its intent of leaving rates unchanged through mid-2019 but will continue to unwind its QE by lessening bond purchases through the end of the year and suspending them thereafter. No mention was made of when sales might begin. Nevertheless, given the size of the ECB bond buying program, the cessation of liquidity injections is a big step toward ending QE.

As you know, my thesis is that ending QE will have little impact on the US economy but cause pain for the Markets whenever and however it unwinds.

The hubris of the Fed (medium):

Albert Edwards: Why We Are Destined To Repeat The Mistakes Of The Past

  1. geopolitical risks: not much news this week, though North Korea, Iran/Middle East, Brexit, Italy and Russia hang in the background as potential sources of economic/military disruptions.

  1. economic difficulties around the globe. Another week of mixed results:

[a] July EU industrial production declined more than expected,

[b] the August Chinese trade surplus with the US hit a record high; both August PPI and CPI came in above estimates, retail sales were ahead of forecasts, industrial production was in line and fixed asset investment was a disappointment,

[c] Q2 Japanese GDP growth was the strongest in three years.

Bottom line: on a secular basis, the US long term economic growth rate could improve based on decreasing regulation. In addition, if Trump is successful in revising the post WWII political/trade regime, it would almost certainly be an additional plus for the US long term secular economic growth rate. ‘If’ remains the operative word though clearly the US/Mexico agreement is a positive step.

At the same time, these long term positives are being offset by a totally irresponsible fiscal policy. The original tax cut, increased deficit spending, a potentially big infrastructure bill and funding the bureaucracy of a new arm of military (space force) will push the deficit/debt higher, negatively impacting economic growth and inflation, in my opinion. Until evidence proves otherwise, my thesis remains that cost of servicing the current level of the national debt and budget deficit is simply too high to allow any meaningful pick up in long term secular economic growth.

Cyclically, growth in the second quarter sped up, helped along by the tax cuts. At the moment, the Market seems to be expecting that acceleration to persist. I take issue with that assumption, based not only on the falloff in global activity but also the lack of consistency in our own data and the never ending expansion of debt.

The Market-Disciplined Investing

Technical

The Averages (DJIA 26154, S&P 2904) ended basically flat after a roller coaster day. Volume fell; breadth was mixed. They remain strong technically; and my assumption is that they will challenge the upper boundaries of their long term uptrends (29807, 3065).

The VIX was down again, ending below its 200 DMA (now resistance) and its 100 DMA (now resistance). It now appears poised to challenge the lower boundary of its short term trading range (which it has already done three times this year). That generally supports higher equity prices.

The long bond declined, finishing below its 200 DMA (now resistance), its 100 DMA (now resistance), and the lower boundary of its long term uptrend for a fourth day (if it remains there through the close next Monday, it will reset to a trading range). Clearly, TLT is at a potentially critical level. All I can do is wait for follow through. That said, it has challenged this boundary six times in the last year, so I will wait for a longer follow through than normal before concluding that TLT’s long term uptrend is over.

The dollar was up on good volume, remaining technically strong and making a second very short term higher low. Its pin action is not likely to change as long as dollar funding problems continue in the emerging markets.

Dollar Surges As 10Y Treasury Hits 3.00%

GLD was down (pitifully), making it the ugliest chart on the block.

Bottom line: the indices remain technically strong. I continue to believe that they will challenge the upper boundaries of their long term uptrends.

The dollar will likely remain strong until the dollar funding problems are resolved.

The pin action in TLT is my main focus because if the long term uptrend breaks, pointing to much higher rates, that will have implications in all the other Markets.

Friday in the charts.

US Stocks Rally, Shrug Off Treasury Curve Crumble, Macro Data Dump

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’ is being positively impacted based on a new set of regulatory policies which should lead to improvement in the historically low long term secular growth rate of the economy. A further increase could come if Trump’s drive for fairer trade is successful. On the other hand, a soaring national debt and budget deficit are negatives to long term growth and, hence, ‘Fair Value’.

At the moment, the important factors bearing on corporate profitability and equity valuations are:

  1. the extent to which the economy is growing. Clearly, the second quarter GDP number was a sign of improved growth. However, that is a single stat and in no way implies a trend. Indeed, most Street estimates for third quarter GDP growth are lower than that of Q2. Unless the tax cuts alter investing and consumption behavior on a more permanent basis, Q2 growth will likely prove to be an outlier. Furthermore, the effect that those tax cuts are, at least presently, having on the deficit/debt {see above} are just as meaningful, in my opinion, as any growth implications, to wit, the servicing of that debt will constrain growth.

My conclusion remains that while the economy is growing, it simply isn’t growing as rapidly as many think. On the other hand, as you know, I have never thought that the economy was going into a recession. And while there clearly is some probability of a meaningful pick up in the long term secular growth rate of the economy [deregulation, trade], I am not going to change a forecast, beyond what I have already done, based on the dataflow to date or the promise of some grand reorientation of trade.

Also, lest we forget, the growth rate in rest of the global economy is starting to slow and will not be helped by the decelerating effects of the dollar funding problems in the emerging market. That can’t be good for our own prospects. It is certainly possible, even probable, that the US can continue to growth if the rest of the world slows. But it is not likely that its growth rate will accelerate.

My thesis remains that the financing burden now posed by the massive [and growing] US deficit and debt has and will continue to constrain economic as well as profitability growth.

In short, the economy is not a negative but it not a positive at current valuation levels.

  1. the success of current trade negotiations. If Trump is able to create a fairer political/trade regime, it would almost certainly be a plus for secular earnings growth. Clearly, the US/Mexico agreement is a step in that direction. In addition, this week, Canada made some positive sounds with regard to resolving its trade issues with the US; but as of this moment, there has been no new developments.

As I noted above, China and the US were making nicey nice over the air waves early this week; then Trump dropped a turd in the punchbowl, issuing instruction to proceed with the imposition of $200 billion in tariffs on Chinese goods. This, of course, is just a repeat of what happened two weeks ago, when everyone got all atwitter over potential talks that promptly fell flat. In spite of all this, I, perhaps foolishly, remain hopeful that the Donald’s current negotiating strategy will pay off; however, the risks and rewards associated with failure and success are very high. Either outcome would almost surely have an impact on corporate earnings and, probably, on stock prices,

Can optimism make America great again?

  1. the rate at which the global central banks unwind QE. At present, it is happening. Given the recent comments from various Fed members, it seems likely to continue at least in the US. As I noted above, the ECB is on track to cease bond purchases by the end of this year. While not removing excess liquidity in the global money supply, it will not be contributing to it. And that is a start. In the meanwhile, the central banks of several emerging markets have been forced to raise interest rates as the dollar funding problem persists. I remain convinced that [a] QE has done and will continue to do harm to the global economy in terms of the mispricing and misallocation of assets, [b] sooner or later that mispricing/misallocation will be reversed---and the dollar funding problem is the first material sign that it is happening and [c] given the fact that the Markets were the prime beneficiaries of QE, they will be the ones that take the pain of its demise.

  1. finally, valuations themselves are at record highs based on the current generally accepted economic/corporate profit scenario which includes an acceleration of economic growth [which I consider wishful thinking]. Even if I am wrong, there is no room in those valuations for an adverse development which we will inevitably get.

Weekend Reading: A Permanent Shift To Valuations?

Bottom line: a new regulatory regime plus an improvement in our trade policies should have a positive impact on secular growth and, hence, equity valuations. On the other hand, I believe that fiscal policy will have an opposite effect on economic growth. Making matters worse, monetary policy, sooner or later, will have to correct the mispricing and misallocation of assets---and that will be a negative for the Market.

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 simple: 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 any price strength to sell a portion of my winners and all of my losers.

As a reminder, my Portfolio’s cash position didn’t reach its current level as a result of the Valuation Models estimate of Fair Value for the Averages. Rather I apply it to each stock in my Portfolio and when a stock reaches its Sell Half Range (overvalued), I reduce the size of that holding. That forces me to recognize a portion of the profit of a successful investment and, just as important, build a reserve to buy stocks cheaply when the inevitable decline occurs.

DJIA S&P

Current 2018 Year End Fair Value* 13860 1711

Fair Value as of 9/30/18 13764 1698

Close this week 26154 2904

* 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 Investing for Survival, Steve hopes that his experience can help other investors build their wealth while avoiding tough lessons that he learned the hard way.