Saturday, October 01, 2011

The Closing Bell 10/1/11


The Closing Bell

10/1/11


Statistical Summary

Current Economic Forecast

2011

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

2012

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 19%
High Yield Portfolio 18%
Aggressive Growth Portfolio 20%

Economics

The economy is a modest positive for Your Money, though this is rapidly becoming a minority opinion; and as I have indicated, I am even becoming less convinced. What is weighing especially heavy on my mind is this week’s call by the creator of the ECRI weekly leading index that the US economy is tipping into recession. This indicator has an excellent record anticipating recession; so when its developer predicts a recession, I have to pay attention.

On the other hand:
http://scottgrannis.blogspot.com/2011/09/swap-spread-update_30.html
http://scottgrannis.blogspot.com/2011/09/money-supply-update_30.html
http://scottgrannis.blogspot.com/2011/09/swap-spread-update.html
http://scottgrannis.blogspot.com/2011/09/still-no-sign-of-double-dip.html

That said, as I interpret the current data flow, there nothing to persuade me to alter our forecast. And this week’s stats are no different. There was much with which to be pleased (housing, jobs or durable goods) and the little about which to be concerned (the rest were mixed). In the end, while I recognize that there is a growing probability of recession, it is still not great enough to become our forecast. So it remains: 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.

Unfortunately, whether I am right or wrong is not dependent on how businesses and consumers perform but rather rests in the hands of the ruling class in particular the eurocrats.

(1) the EU sovereign debt crisis is and will be the biggest risk to our forecast until it gets resolved. As you know, I have been encouraged by the recent steps taken to create a back stop for the financial system so that a more orderly process of restructuring can be affected; and there additional measures enacted this week as the German parliament approved the expansion of the EFSF [bail out] fund. If the eurocrats can act in time to ring fence Greece, allowing it an orderly default while delaying the implosion of the EU financial system long enough to obtain capital injections, then I think that the worst is behind us.

However, the steps taken so far are by no means sufficient to gain control of or get ahead of a potential disaster. Indeed, the markets are increasing the pressure for a resolution at a faster pace than the politicians are acting; if this continues, the endgame will not be a orderly restructuring of Greece [and perhaps other PIIGS] and an injection of equity into the banking system but rather an ‘every man for himself’ scramble into multi-country and multi-bank defaults and bankruptcies.

There is a third potential outcome; as sort of muddling through in which eurocrats manage to keep enough fingers in the dikes to hold the system together but fail to expunge the mountain of bad debt embedded in the system. That, unfortunately, would set the EU on a path to a Japanese-like decade or two of zero economic growth.

Neither the ‘every man for himself’ or the ‘Japan 2.0’ are properly reflected in our Model because we simply don’t know how this is going to turn out. Nor are there historical precedents for even making an educated guess. So until we know if the eurocrats succeed or fail to properly solve their sovereign debt crisis and, if they fail, how so, changing our economic Model is a waste of time. I simply note that in the ‘every man for himself’ alternative, our near term growth estimates will prove too high; while in the ‘Japanese 2.0’ scenario, our longer term economic growth estimates will fall to an even further below average secular rate.

Too little, too late? (medium):
http://www.telegraph.co.uk/finance/financialcrisis/8797958/German-bailout-vote-is-too-little-too-late.html

And (medium):
http://www.counterpunch.org/2011/09/29/europe-blinking-red/

And Europe is apparently not our only worry (medium):
http://pragcap.com/falling-like-a-bric

(2) on the other hand, our political class is performing exactly as anticipated by our Model. This week, Bernanke hinted that QEIII was waiting in the closet and could be implemented at a moment’s notice. Refutations notwithstanding, data represented in these pages clearly point to an upward drift in inflation [which is and always will be a monetary phenomena, to quote a sage] brought on by QEII. QEIII, if employed, will do nothing to abate that trend. So the inflation portion of our forecast is in tact.

And how could I fail to mention our elected representatives who took just enough time out of campaign mode this week to [a] accuse China of being a currency manipulator and propose punishing legislation? {Oh wait, that is part of pandering to the base so necessary to the dems campaign, isn’t it?} and [b] throw even more {of our} money at the current solar energy fraud. But for these yahoos, it is all in a good day’s work; so we are likely to get more of same. And regrettably, that too is part of our Model.

Bottom line: the economy continues to plod sluggishly along with this week’s data being better than most. Nevertheless, other indicators to which I pay attention are suggesting that recession is up on us. While I still don’t see it that way, I have to honor their record--the odds of a double dip continue to increase.

Worse though, however responsible the eurocrats are attempting to be, the Markets appear to be way out in front of them. To be sure, there is some probability that their recent actions are a precursor to more forceful policies that will lead to an orderly resolution of their sovereign debt problem (the ‘wet dream’ scenario). Unfortunately, there is also a decent likelihood of an ‘every man for himself’ scenario which ends in financial chaos or a ‘Japan 2.0’ alternative in which European economic growth remains stagnant for a decade. The consequences of each of these vary widely; so projecting a single forecast now is almost impossible. However, as I noted above, the ‘every man for himself’ scenario impacts the US economic growth rate negatively over the short term while the ‘Japan 2.0’ alternative slows even more our ability to return to former rates of secular growth.

This week’s data:

(1) housing: weekly mortgage and purchase applications were up strong; August new home sales were off less than expected; the Case Shiller July home price index improved modestly,

(2) consumer: weekly retail sales were mixed; weekly jobless claims fell dramatically; August personal income was disappointing, while personal spending was in line with forecasts; the two measures of consumer sentiment registered very different results--the Conference Board’s index of consumer confidence came in below estimates while the University of Michigan’s index of consumer sentiment was much better than anticipated,

(3) industry: August durable goods orders fell less than expected; the September Chicago PMI was very strong,

(4) macroeconomic: the second revision of second quarter GDP was in line with forecasts; inflation was slightly hotter than estimates.

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.)

Politics

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

Technical


The Averages (DJIA 10913, S&P 1131) had another rough week, but still managed to close within their intermediate term trading ranges (10725-12929, 1101-1372).

In last week’s Closing Bell, I noted that our internal indicator was not signaling any kind of technical breakdown. Then on Wednesday, I pointed out that a couple of our stocks had reached trading stop loss levels. However, none had broken down. I didn’t view that as particularly alarming given the schizophrenic Market we are in. Indeed, our Portfolios did some nibbling in the midst of the weakness.

Well on Friday, things got much worse. Almost 10% of the stocks in our Universe either broke below their trading stops or on the verge of doing so. True, that means that 90% are not breaking down; and it is certainly possible to get a bounce in prices that would stop this flashing red light. Unfortunately more often than not, when our internal indicator starts breaking down, it is time to get very worried. So until we get an improvement in our internal indicator, our Portfolios will suspend their Buying and focus on preserving principal (our trading stops).

GLD stabilized this week. It challenged the lower boundary of its intermediate term up trend several times and held. I thought that significant and our Portfolios made a small addition to their holding.

Bottom line:

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

(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 (10913) finished this week about 2.5% above Fair Value (10645) while the S&P closed (1136) 13.6% undervalued (1315).

While this week’s economic data in the US suggested anything but a double dip, weakness in EU data as well as tumbling stock markets globally increased investor concern about recession; and as I noted in the Economics section, yours truly also sees the probability of such increasing.

That said, with stocks circa 14% below Fair Value, some sort of global/US economic recession that will impact corporate profits is being discounted. The immediate problem is that the magnitude on any decline likely hinges on how well the euros manage their way through their sovereign debt crisis; and unfortunately, what they eventually do, its success (or lack thereof) and the consequences thereof fall in the category of ‘known unknowns’. So until we know the outcome, it is impossible to even attempt to measure it.

This, of course, intensifies investor uncertainty; and as we all know, uncertainty is not good for stock prices. All things considered, I thought developments this week would have relieved concerns somewhat, i.e. the German parliament approved the expansion of the EFSF. The fact that it didn’t suggests that unless and until the EU ‘every man for himself’ disaster scenario is taken off the table, we are likely in for more pain..

This week our Portfolios made small additions their GLD position and other holdings. The impact on cash was less than 1%.

Bottom line:

(1) our Portfolios will carry a high cash balance,

(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.

DJIA S&P

Current 2011 Year End Fair Value* 10760 1330
Fair Value as of 10/31/11 10645 1315
Close this week 10913 1131

Over Valuation vs. 10/31 Close
5% overvalued 11177 1380
10% overvalued 11709 1446
15% overvalued 12241 1512


Under Valuation vs. 10/31 Close
5% undervalued 10112 1249
10%undervalued 9580 1183
15%undervalued 9048 1117

* 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.