Saturday, September 17, 2011

This Week in Review 9/17/11

Statistical Summary

Current Economic Forecast


Real Growth in Gross Domestic Product: +1.5- +2.5%
Inflation: 2-3 %
Growth in Corporate Profits: 7-12%


Real Growth in Gross Domestic Product: +1.5- +2.5%
Inflation: 2-3 %
Growth in Corporate Profits: 0-10%

Current Market Forecast

Dow Jones Industrial Average

Current Trend (revised):
Intermediate/Short Term Trading Range 10725-12919
Long Term Trading Range 7148-14180
Very LT Up Trend 4187-14789

2011 Year End Fair Value 10750-10770

2012 Year End Fair Value 11290-11310

Standard & Poor’s 500

Current Trend (revised):
Intermediate/Short Term Trading Range 1101-1372
Long Term Trading Range 766-1575
Very LT Up Trend 644-2000

2011 Year End Fair Value 1320-1340

2012 Year End Fair Value 1390-1410

Percentage Cash in Our Portfolios

Dividend Growth Portfolio 18%
High Yield Portfolio 16%
Aggressive Growth Portfolio 19%


The economy is a modest positive for Your Money.
The data this week was basically mixed--some good news (mortgage applications, industrial production, consumer sentiment), some bad news (employment, inflation). As you know, this has been the general pattern for the last couple of months. That in itself is not a matter of particular concern to me because it is reflective of our forecast: a below average secular rate of recovery resulting from too much government spending, too much government debt to service, too much government regulation, a financial system with an impaired balance sheet and a business community unwilling to hire and invest because the aforementioned along with the likelihood a rising and potentially corrosive rate of inflation due to excessive money creation and the historic inability of the Fed to properly time the reversal of that monetary policy.

As you also know, this is not just our forecast for the next 12 to 24 months but is a scenario that I fear will prevail for at least another five to seven years. Given such a dismal outlook, the risks in this scenario are more heavily weighted to the down side (recession). A primary cause of the prolonged period of sluggish growth and the higher risk of recession is the economic ineptitude of the western world’s political class.

This, of course, is not a new theme for me. Hence, both an extended period of below average secular growth and a second rate political class are reflected in our Economic and Valuation Models. What is not discounted is (1) a ‘double dip’ which I think more probable today than I did a month ago and (2) the EU sovereign debt crisis spreading beyond Greece and inflicting additional damage to US financial institutions’ balance sheets and to the international earnings of US corporations.

The latest ECRI weekly leading index data (short):

(1) I hammer away every week that the administration is completely clueless on economics which is only made worse by its focus on ideology versus results. The GOP isn’t much better. While their rhetoric is more to my liking, their actions in general are as self serving as the dems. Until the voting public stops electing career politicians whose sole objective is to get re-elected and starts to focus on leaders with experience solving problems, I see no way out of the current malaise.

Manifesting all this is the fact that the economy is as lousy as it is, [a] and yet Obama’s jobs plan is a political not an economic document that has zero chance of enactment while [b] the congress is so dominated by two camps of such ideological purity that no help is likely to come out of this group. Charles Krauthammer argues that this is the workings of democracy at its finest in that each day two theories of how government should be managed are becoming more clearly defined however negative the short term consequences; and this circumstance sets up November 2012 as a pivotal moment in our political history. As a citizen, I may hope that his proposition is true; but as a Market participant, I wonder how much more pain businesses, consumers and investors can endure before throwing in the towel [a recession occurs].

(2) on a somewhat brighter note, we did get some signs of hope out of the EU this week. On Wednesday, France and Germany basically pledged to back stop the Greek economy for a couple more months IF that country continued to enact austerity measures. Then on Thursday, the ECB along other central banks created a facility to assist EU banks that were having dollar funding problems.

Both of these measures are very short term fixes and in no way address the real issue in the EU--the solvency of several countries and the entire EU banking system. However, there were hints that they were established to get the EU through the autumn vote by the EU member countries to expand the EFSF stability fund and, Angela Merkel’s current resistance notwithstanding, create some form of a Eurobond. These measures would act as a back stop of liquidity, improve the quality of bank liabilities [the TARP like purchase of bad loans] and give the banks a chance to raise equity capital.

In the first paragraph of this section, I referred to ‘some signs of hope’ and at the moment, that is all that the above are [the wet dream scenario]. I would never underestimate the ability of the political class to f*** things up; but at the moment, at least they appear to be headed in the right direction.

Here is another opinion (medium):

Euro TALF rumors (short):

Bottom line: the Three Stooges aren’t going to change until the electorate does it for them. Hence, in my opinion, we are stuck with another 12-18 months of a sluggish economy overseen by a second rate political class. The good news is that this is well reflected in our Models. What is not in our Models is a recession. As I have noted, while I believe the odds of such an occurrence are increasing, at present, I think them below 50/50 and hence have made no changes to our forecast.

The other problem that is not properly built into our Models is a multiple country default/restructuring in Europe accompanied by an implosion of their financial system. Until this week, the probability of such a scenario seemed to climb with every passing day. But we did get some positive developments addressing Greek and the EU banking systems liquidity. They by no means will solve the problem; but they were steps and we have to be thankful for that. So to be clear, this risk is not off the table and remains the biggest threat to our forecast. But at the moment, it just isn’t increasing.

This week’s data:

(1) housing: both weekly mortgage and purchase applications were strong,

(2) consumer: weekly retail sales were up, while August sales were soft; weekly jobless claims increased versus expectations of a decline [again]; the University of Michigan preliminary September consumer sentiment index was reported at 57.8 versus estimates of 56.5 and August’s final reading of 55.7,

(3) industry: August industrial production came in above expectations; July business inventories and sales were positive; two regional Fed [New York and Philadelphia] bank September business indices were disappointing,

(4) macroeconomic: August producer prices were up less than estimates while consumer prices were ‘hotter’ than anticipated; the second quarter budget deficit was less than forecast and the trade deficit improved.

The Economic Risks:

(1) the economy is weaker than expected.

(2) Fed policy (reading the data correctly).

(3) a disruption in global oil supplies (It is not the price of oil but its availability that will cause severe economic dislocation.).

(4) protectionism (Free trade is a major positive for world and US economic growth.).

(5) fiscal profligacy (Government spending as a percent of GDP is too high and the looming explosion in entitlement expenditures will make it worse. There is no good solution save spending discipline.).

(6) a rising tax and regulatory burden (Government has never proven that it could solve economic problems efficiently or satisfactorily.)


The domestic political environment is a neutral but could be improving for Your Money while the international political environment remains a negative.

The Market-Disciplined Investing


The Averages (DJIA 11509, S&P 1216) had their best week since mid summer and closed within their intermediate term trading ranges (10725-12929, 1101-1372). You will recall that the indices were out of sync coming into the week with the DJIA having broken the lower boundary of its short term up trend while the S&P had not. That nonconfirmation was corrected and both of the Averages are now trading above the lower boundaries of their short term up trends (11289, 1155). As you know, our Portfolios nibbled a bit on Friday and will continue to so in the absence of any meaningful break in trend.

Volume soared on Friday--not unusual for a quadruple witching. Breadth declined a bit, though the flow of funds indicator has started to turn up. The VIX was down again but remains at elevated levels.

GLD had another wild week, closing below the lower boundary of its short term up trend. If it doesn’t recover that level on Monday, our time and distance discipline will confirm it as a break. Nevertheless, GLD following its penetration of the short term up trend lower boundary found support almost immediately and on Friday bounced off of that level. That, of course, is encouraging; but if it doesn’t re-gain its short term up trend and breaks the initial support level, our Portfolios will likely lighten up.

Bottom line:

(1) the DJIA and S&P are in both an intermediate term trading range (10725-12919, 1101-1372) and a short term up trend,

(2) long term, the Averages are in a very long term [78 years] up trend defined by the 4187-14789, 644-2000 and a shorter but still long term [13 years] trading range defined by 7148-14198, 766-1575.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (11509) finished this week about 8.6% above Fair Value (10588) while the S&P closed (1216) 7.0% undervalued (1308).

Stocks as measured by the S&P are undervalued as calculated by our Valuation Model which, as you know, assumes that the economy will only stumble along and that our political class will do nothing but campaign for their re-election from now till November 2012. Not figured into our Model is a ‘double dip’. However, at 7% undervalued, certainly some of the risk of recession is reflected in current prices. Furthermore, were the S&P to return to its August low (and hence remain in the current intermediate term trading range) that would put it circa 15% undervalued; surely that would discount any kind of down turn currently envisioned by Street bears.

Also not included in our Models is a multi country default/restructuring in Europe accompanied by an implosion of its financial system. As you know, I consider this the biggest risk to our forecast. That is the reason that our Portfolios own a 10% position in gold and 15-18% in cash. Clearly, it could be argued that this is insufficient insurance against the worse case scenario; but my judgment is that when augmented by our trading sell discipline, it is adequate.

However, that judgment only has validity if there is some reason to assume that the Three Blind Mice will somehow muddle through the EU sovereign debt crisis. And to be sure, events in the last six months suggested that the eurocrats have been so inept in dealing with their liquidity/insolvency problems that it seemed that they weren’t even capable of muddling through. The trip wire for me has been if they fail to adopt a reasonable endgame for Greece [which could include an orderly default]; my thinking being that if they can’t handle the problems of a dip sh** country like Greece, how in the world could they manage the default of a Spain or Italy?

Not that a solution for Greece has been found. But as I detailed in the Economics section above, for the first time, this week there was an ever so slight hint that some kind of plan could be formulating. France and Germany are going to bridge Greece for a couple of months ASSUMING its austerity measures continue to make progress. In addition, the ECB with the help of other central banks (read, the Fed) created a facility to assist liquidity strapped banks. These measures appear designed to hold the system together until the member countries individually approve an increase in the size of and the use of the EFSF (bail out) fund to bail out Greece. Implicit in this is that it (along with a controversial Eurobond) would also be used to improve bank asset quality and allow the banks to raise capital.

Let me repeat, a solution to Greece’s financial problems has not been found much less those of larger, not quite so insolvent countries. So I am certainly not getting jiggy with these latest steps. However, the odds that Europe will at least muddle through have gone up; so I am also not going to get more beared up in our investment strategy until the eurocrats prove themselves incapable of managing a reasonable outcome to Greece’s financial dilemma.

This week our Portfolios (1) Sold a portion of their foreign ETF’s and (2) Added to several individual stock positions.

Bottom line:

(1) our Portfolios will carry a higher cash balance than pre-financial crisis but it will be more a function of individual stock valuations and less on macro Market technical trends,

(2) we continue to include gold and foreign ETF’s in our asset mix because we continue to believe that inflation is the major long term risk. An investment in gold is an inflation hedge and holdings in other countries provide [a] a hedge against a weak dollar--although this is becoming problematic as investors flock to the dollar to avoid the EU solvency issue and [b] exposure to better growth opportunities,

(3) defense is still important.


Current 2011 Year End Fair Value* 10760 1330
Fair Value as of 9/30/11 10588 1308
Close this week 11509 1216

Over Valuation vs.9/30 Close
5% overvalued 11117 1373
10% overvalued 11646 1438
15% overvalued 12176 1504

Under Valuation vs. 9/30 Close
5% undervalued 10058 1243
10%undervalued 9529 1177
15%undervalued 8999 1112

* 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 with somewhat higher inflation.

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 40 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.