Saturday, October 15, 2011

The Closing Bell 10/15/11


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 18%
High Yield Portfolio 18%
Aggressive Growth Portfolio 22%

Economics

The economy is a modest positive for Your Money. This was a very light week for economic data; however, what we got was generally up beat (mortgage applications, retail sales [extremely positive], business inventories) with the notable exception of the University of Michigan’s index of consumer sentiment. Albeit sparse, these stats continue the trend of modest improvement. So there is nothing to persuade me to alter 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.
http://www.capitalspectator.com/archives/2011/10/no_sign_of_rece.html#more

That said, as I noted in the last Closing Bell, I am mindful and concerned about the deterioration in the ECRI weekly leading index and the recession call made by its founder several weeks ago. This indicator has an excellent track record in anticipating economic down turns; so I leave the probability of a double dip high, just less than 50/50.

Here is the latest ECRI reading and there is no improvement (medium):
http://advisorperspectives.com/commentaries/dshort_101411.php

I also believe that given the recent positive bias in US economic data, if a recession comes, it will be the result of a slowdown in Europe brought on by eurocrats lack of success in managing its sovereign debt crisis. To be clear, economic activity in Europe is likely to decline even if the politicians get everything right--but our Model accounts for a mild slowdown. The problem comes if the financial system either refuses or isn’t offered sufficient back stop to allow it to write down the value of the sovereign debt on its books and replenish its capital. Therein lies the major risk to our forecast and to the Markets; and it will remain so until we know how this situation is resolved.

As I also outlined in the last Closing Bell, there are roughly three EU endgames: (1) the eurocrats succeed in ring fencing a Greek default/restructuring and providing a backstop to the financial system while it strengthens its balance sheet, (2) the eurocrats are ‘sort of’ successful in that they hold the system together with chewing gum and bailing wire but inadequately address the severely damaged balance sheet of the EU financial system, leaving the bulk of Europe in a Japan-like state of animated suspension [i.e. zero or near zero economic growth] or (3) failure that ultimately leads to an ‘every man for himself’ scramble that ends in multi country, multi bank defaults.
http://www.bloomberg.com/news/2011-10-13/greece-s-bondholders-brace-for-bigger-losses-to-solve-crisis-euro-credit.html

‘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 even further below the average long term secular growth rate.’

More over night news out of Europe (medium):
http://www.zerohedge.com/news/us-pours-cold-water-imf-expansion-plans-leaves-european-bailout-europeans

Bottom line: the economy continues to plod with each week’s data casting doubt on the recession thesis. Meanwhile, our political class is doing what it does best--run for re-election; though to be fair, the house’s dual actions this week in passing the three free trade bills and nixing Obama’s latest foray into fiscal irresponsibility were a welcome respite from the normal dose of scata we get out of those clowns. The good news is that this is all reflected in our Economic Model. Furthermore, it also accounts for a Greek default and some disruptions in the EU financial markets.

Unfortunately, neither the ‘every man for himself’ scenario which ends in financial chaos nor the ‘Japan 2.0’ alternative in which European economic growth remains stagnant for a decade are represented in our Model. They comprise the ‘known unknowns’ which may potentially impact our economy and our Market quite negatively. I have no probabilities on any of the three scenarios; though qualitatively, I think that the ‘every man for himself’ alternative decreases as time passes while the Japan 2.0 scenario increases faster than that of the ‘wet dream’.

This week’s data:

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

(2) consumer: weekly retail sales were mixed, while September sales were almost double expectations; weekly jobless claims rose slightly but still less than anticipated; the University of Michigan’s index of consumer sentiment was well below [57.5 vs. 60.3] what was anticipated,

(3) industry: August business inventories rose 0.5%, in line with forecasts; importantly, business sales were up 0.7%,

(4) macroeconomic: the August trade deficit came in a tad below estimates while the September budget deficit was right in line with expectations.

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 problem with being reasonable (medium)
http://www.nationalreview.com/author/56454/latest

I always find it instructive to read a counterpoint to current wisdom. This one on the Iranian bomb plot (medium):
http://politics.salon.com/2011/10/12/the_very_scary_iranian_terror_plot/singleton/

The Market-Disciplined Investing

Technical


The Averages (DJIA 11644, S&P 1224) had a second great week and closed within their intermediate term trading ranges (10725-12929, 1101-1372). On Friday, they also took out the first ‘lower high’ (11548, 1219). Now the last major barriers are the August intraday highs (11719, 1230).

Also notable, the VIX finally traded down and out side the upper zone of its current trading range. This is potentially quite positive for stocks. I also checked our internal indicator--at the close Friday, out of a Universe of 165 stocks, 58 have already traded through the comparable levels to 11719, 1230, 83 had not and 24 were too close to call. That is a pretty good sign that at least a major challenge of the August highs are about to occur; however, after the false signal we got at the October 3 low, I hesitate to assume a break will occur.

If stocks do break to the upside, there is almost no resistance visible between 1230 and 1372; so our Portfolios would likely Add to holdings. A bounce off the 1230 trading high would suggest some exhaustion to the current rally and I will probably wait until the subsequent decline ends before committing cash.

GLD tracked slowly higher during the week, staying comfortably within its intermediate term up trend. It is worth noting that much of the volatility has been drained out of this ETF.

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 (11644) finished this week about 9.3% above Fair Value (10645) while the S&P closed (1224) 6.9% undervalued (1315).

This week’s economic data brought some new, pleasant surprises and appear to have the experts starting to doubt their recent more bearish forecasts that now include recession. They also made me feel a bit more comfortable with our outlook. That said, the net effect was simply to confirm our Model’s estimates.

Further. our political class did little this week to either bolster or weaken the assumptions in the Economic Model. To be sure, the passage of the three free trade agreements is a plus. However, the key political assumption in the Model that impacts government policy on the economy is the Obama would stick to His ideological roots and do virtually nothing material to improve the fiscal, regulatory climate. He has done exactly as I expected; fortunately, that is also reflected in our Models

What is not in our Models is either the ‘every man for himself’ or the ‘Japan 2.0’ scenarios outlined above. Of course, at prices 7% below Fair Value, I assume that at least some of the risks of these alternatives are accounted for. However, I am not kidding myself that a failure by the eurocrats to ring fence Greece and their banks will lead to a simple hiccup. It won’t; and the resulting pain will not be pleasant. That is why our Portfolios have 18-22% in cash, 10% in gold and a (Sell) Price Discipline that allows me to sleep at night.

Bob Parker of Credit Suisse on the EU credit crisis (6 minute video):
http://www.investmentpostcards.com/2011/10/15/50-greek-debt-writeoff-best-for-economy-says-credit-suisse/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+wordpress%2FVYxj+%28Investment+Postcards+from+Cape+Town%29

This week our Portfolios made small additions to several holdings.

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 11644 1224

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.