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The Closing Bell

The Closing Bell

12/22/18

I am taking off for the holidays. Back 1/2/19. If I take any actions in this period, I will send out a Subscriber Alert.

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%

2019

Real Growth in Gross Domestic Product 1.5-2.5%

Inflation +1.5-2.5%

Corporate Profits 5-6%

Current Market Forecast

Dow Jones Industrial Average

Current Trend (revised):

Short Term Trading Range 21691-26646

Intermediate Term Uptrend 13952-30159

Long Term Uptrend 6585-29947

2018 Year End Fair Value 13800-14000

2019 Year End Fair Value 14500-14700

Standard & Poor’s 500

Current Trend (revised):

Short Term Trading Range 2536-2942

Intermediate Term Uptrend 1323-3138 Long Term Uptrend 905-3065

2018 Year End Fair Value 1700-1720

2019 Year End Fair Value 1790-1810

Percentage Cash in Our Portfolios

Dividend Growth Portfolio 59%

High Yield Portfolio 55%

Aggressive Growth Portfolio 55%

Economics/Politics

The Trump economy is a neutral for equity valuations. The data flow this week was slightly negative: above estimates: November housing starts, November existing home sales, month to date retail chain store sales, weekly jobless claims, December consumer sentiment, November personal spending, final Q3 corporate profits; below estimates: weekly mortgage and purchase applications, the December housing index, November personal income, November durable goods orders, December NY, Kansas City and Philly Fed manufacturing indices, the revised October/November leading economic indicators, final Q3 GDP ; in line with estimates: the Q3 trade deficit.

However, the primary indicators were mixed: November housing starts (+), November existing home sales (+), November personal spending (+), Q3 corporate profits (+), November personal income (-), November durable goods orders (-), October/November leading economic indicators (-), final Q3 GDP (-). I am giving this week a neutral rating. Score: in the last 167 weeks, fifty-four were positive, seventy-four negative and thirty-nine neutral.

The data from overseas was a bit thin but still not good. Not helping is the ongoing turmoil over Brexit, the civil unrest in France/Macron’s response and the Chinese/US trade relations.

My forecast:

Less government regulation, Trump mandated spending cuts and possible help from a fairer trade regime are pluses for the long-term US secular economic growth rate.

However, the explosion in deficit spending, especially at a time when the government should be running a surplus, is a secular negative. My thesis on this issue is that at the current high level of national debt, the cost of servicing the debt more than offsets (1) any stimulative benefit of tax cuts and (2) the secular positives of less government regulation and fairer trade [at least on the agreements that have been renegotiated].

On a cyclical basis, the economic growth rate is slowing as the effects of the tax cut wear off, the global economy decelerates and the unwind of the Fed’s balance sheet limits credit expansion.

The negatives:

  1. a vulnerable global banking [financial] system.

Credit rating downgrades in the corporate sector are rising.

Another A-Rating Goes Up In Smoke As "Fallen-As" Hit A Quarterly Record

Plus, a freeze up in the CLO and leveraged loan markets.

"This Is A Bid-Wanted Situation": Credit Hit By Liquidation Panic Amid Unprecedented Firesales

  1. fiscal/regulatory policy.

Trade remains the most important near-term issue. Developments this week included [a] in a speech, Xi said that China would not be bullied {yawn}, [b] Mnuchin made more of the ‘we are making great progress’ comments {ZZZZZ}, [c] the US indicted two Chinese hackers and [d] perhaps most important, some of our allies are apparently willing to stand by the US in its fight against Chinese unfair trade practices. If the Chinese see that most of their major trading partners are willing to follow the US lead in imposing sanctions, this could be the factor that brings them to heel. Now, if those trading partners will act.

Stocks Tumble After Navarro Says "Agreement With China Difficult" Unless Beijing Does Full Trade Overhaul

The other issue is the government shutdown over funding of the border. To be clear, it is not a total shutdown because much of the agency funding has already been done in other bills. So, its economic impact will not be as significant as it would be if the entire government were closed. In addition, not much gets done in DC this time of year anyway. So, the most immediate affect will be psychological; and the Market will be where it is mostly felt. In short, I don’t consider this a big deal, economically speaking; but it could be for the Market.

Shutdown Begins As Trump, Democrats Wrestle Over Border Wall

I will spare you my usual rant about the weakening effects of an outsized federal debt/deficit on the economy.

  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 asset bubbles in the stock market as well as in the auto, student and mortgage loan markets.

In Its Fight With the Fed, the Bond Market Wins Every Time | RealClearMarkets

The big news of the week was the Fed raising the Fed Funds rate and continuing to unwind its balance sheet. You know my bottom line on this issue: as long as the Fed continues a QT policy, liquidity shrinks creating credit funding problems and putting downward pressure on asset prices. However, I don’t expect it to have a major impact on the economy.

Dealers Are "Hoarding Collateral" At A Rate Not Seen "Since The Worst Days Of 2008"

Trump now considering firing Powell---which will only make matters worse.

Trump Is Considering Firing Fed Chair Powell

Meanwhile both the Bank of England and Bank of Japan left rates unchanged and the Chinese announced plans for more fiscal and monetary stimulus.

I have no idea what the ultimate net economic impact of conflicting monetary policies will have on global liquidity; though to date, US policy seems to be overwhelming the rest.

  1. geopolitical risks:

The EU/Italians seemed to have worked a solution to Italy’s budget issue. That takes one potential negative off the table. Still Brexit is causing heartburn in the UK. There were no headlines this week in the Russia/Ukraine dust up, but I don’t think that is going away. They all could be much to do about nothing; or any one could cause serious negative financial consequences. I have no clue on any potential outcome; but they can’t be ignored.

Update on Brexit.

May Prepares "Secret" Brexit Plan B To Avoid "No Deal" Armageddon

US withdrawal from Syria and Afghanistan will almost surely have some effects on Middle East politics and the fight against terror. As you know, I think that we should wall the whole region off and let them keep killing each other until no one’s left or they figure out that is not a good strategy. Getting our own troops out may be the next best thing: it will save the lives and money: [a] if the US had all the money that it has spent in the Middle East for meager if any long-term benefit, how much better offer would our fiscal situation be and how many young men would still be alive? [b] why are we involved in an internecine Arab food fight? We don’t need their oil. What else do they have to offer us or the rest of the world?

Dates?

The ‘supposed’ inside story about the withdrawal decision.

The Inside Story Behind Trump's "Shocking" Withdrawal From Syria

  1. economic difficulties around the globe. The stats this week were very negligible but negative:

[a] the October EU trade surplus was below estimates; November UK retail sales were above consensus; December German business sentiment was slightly below forecast,

[b] the November Japanese trade deficit was much larger than anticipated.

Bottom line: on a secular basis, the US economy is growing at an historically below average rate although I assume decreased regulation, the likely successful completion of the NAFTA 2.0 agreement and Trump’s spending cuts (assuming implementation) will improve that rate somewhat. The long term positive potential from an altered Chinese industrial policy would have a meaningful effect on the US long term secular growth rate.

However, these possible long term positives are being offset by a totally irresponsible fiscal policy. Until evidence proves otherwise, my thesis is 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 even with improvement from deregulation or the current trade regime (a caveat being if China does change its industrial policy).

Cyclically, the US economy to once again slowing. (1) Removing the uncertainty of no NAFTA treaty should help return economic conditions within the three countries to what they were before, (2) increase in Chinese purchases of soybeans and oil and the lower tariffs on autos and (3) a slowdown in the rise of short-term interest rates will help keep the slowdown under control. On the other hand, a weakening global economy points to slower growth. As a result of these factors, my guess is that my initial US 2019 economic growth rate assumption will likely change as their impact becomes more apparent.

The Market-Disciplined Investing

Technical

The Averages (DJIA 22445, S&P 2416) again started off the day on their front foot then faded through the day and closed down significantly. They both finished below both moving averages and are now in a pronounced very short-term downtrend. The Dow finished below its February low, while the S&P ended below the lower boundary of its short-term trading range (also its February low) for a third day, resetting to a downtrend.

Volume was up; breadth was terrible again and is getting even more extremely oversold.

The VIX was up 6%, ending above both moving averages and in a short-term uptrend. Its chart remains strong which is bad on stocks.

The long bond was down two cents, but still closed above its 100 DMA (now support), above its 200 DMA (now support) and in a short-term trading range. It appears that the rise in long term interest rates (decline in bond prices) is over.

This is the message the yield curve is sending about the economy

And.

HIGH-YIELD CREDIT SPREAD BLOWOUT

The dollar was up ½ %, ending below the lower boundary of its very short term up trend (just barely) for a second day, voiding that trend. It still finished above both MA’s and in a short-term uptrend. So, the chart continues to be technically strong.

GLD was down ½ % on big volume, closing above its 100 DMA but right on its 200 DMA, negating Thursday’s move above it (now resistance).

Bottom line: the Averages continued their plunge with the S&P resetting its short-term trend to down. To state the obvious, that is not good news. Further, there is no sign of any slowing in downward momentum. That said, the indices are becoming ever more oversold. So, rally seems inevitable.

Longer term, the next major support level for the S&P is ~1800, coincidentally roughly the same level as my Model’s 2019 Year End Fair Value. Also remember that the lower boundary of the S&P’s intermediate term uptrend is ~1300; so, there is plenty more downside before real technical damage is incurred.

Brace For "Seismic" Volatility: Pensions To Buy Record $60BN In Stocks In Coming Days

The long bond is in trading ranges across all timeframes, suggesting the end of the 2016-2018 rise in rates.

The dollar recovered Thursday’s loss, but not enough begin rebuilding a very short-term uptrend. Still its chart remains strong and will likely continue to do so as long as there are increasing dollar funding (liquidity) problems.

Friday in the charts.

"Panic In The Air" - Stunned Traders Speechless At The Carnage

Fundamental-A Dividend Growth Investment Strategy

The DJIA and the S&P are still well above ‘Fair Value’ (as calculated by our Valuation Model), the improved regulatory environment and the potential pluses from trade and spending cuts notwithstanding. At the moment, the important factors bearing on Fair Value (corporate profitability and the rate at which it is discounted) are:

  1. the extent to which the economy is growing. US economic activity is slowing; and the rest of the globe is slowing even faster than I expected.

It is certainly possible, even probable, that the US can continue to grow as the rest of the world slows. But declining global growth will still act as a drag on any improvement.

My thesis is that, a trade war aside, the financing burden now posed by the massive [and growing] US deficit and debt is offsetting the positive effects of deregulation and fairer trade and will continue to constrain economic as well as profitability growth.

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

US Financial Markets Stress Index Ticks Up To 2-1/2 Year High

  1. the success of current trade negotiations. If Trump is able to create a fairer political/trade regime, it would almost surely be a plus for secular earnings growth. Having whiffed on NAFTA 2.0, the prospect of a meaningful change in the trade regime with China seems questionable, but if it happens, would be a big plus to the US long term secular economic growth rate.

As I noted above, China’s move to buy more soybeans and oil along with lowering auto tariffs will help over the very near term. Longer term, if our allies stand with us against China’s unfair trade practices AND it has the desired effect, that would be a huge plus. I think it reasonable to be hopeful but nothing more.

  1. the rate at which the global central banks unwind QE. The Fed has reduced the rate at which it will hike the Fed Funds rate. However, that is less important to QT than the run off of its balance sheet---and, at the moment, it appears that it will continue unabated. In addition, this week Draghi said that the ECB is on schedule to halt its bond purchase program.

On the other hand, the BOJ remains entrenched in its version of QE and the Chinese are using every policy tool available, including monetary easing, to stem the negative effects of the trade dispute with the US. I have no clue how this dance of conflicting monetary policy will play.

However, I remain convinced that [a] QE has done and will continue to do harm in terms of the mispricing and misallocation of assets, [b] sooner or later that mispricing/misallocation will be reversed 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. the recent sell off has begun to rationalize valuations in some Market sectors, offering some buying opportunities. But large segments remain overvalued, though investors are clearly beginning to balk in general. If there is follow through, then investors that have built cash positions for the last three years will be rewarded.

I hear lots of woe over the recent decline; and the S&P resetting its short-term trend to down won’t help. But I repeat my comment above: the S&P can trade down to its next support level (~1800) which is also my Model’s 2019 Year End Fair Value and not even break the lower boundary of its intermediate term uptrend (~1300).

Bottom line: a new regulatory regime plus an improvement in our trade policies along with proposed spending cuts should have a positive impact on secular growth and, hence, equity valuations. On the other hand, I believe that overall fiscal policy (growing deficits/debt) will have an opposite effect. 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.

The math in our Valuation Model is getting more reasonable. The indices and some sectors of the Market remain overpriced. However, other sectors have been beaten like a rented mule. As you know, I am focusing on that set of companies as potential buy candidates. Quality companies whose stocks are down 50% or more should be bought.

That said, I believe that there is more pain to come; so, my purchases, for the moment, will be small. Still this situation is what I designed my Valuation for---to buy low after having sold high.

The latest from Doug Kass.

Kass: Nowhere To Run, Nowhere To Hide?

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 12/31/18 13860 1711

Close this week 24100 2599

* 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.