Saturday, October 29, 2011

The Closing Bell There is still a recession to worry about



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 (revised): +1.0- +2.0%
Inflation (revised): 2.5-3.5 %
Growth in Corporate Profits (revised): 5-10%


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 15%
High Yield Portfolio 18%
Aggressive Growth Portfolio 19%

Economics

The economy is a modest positive for Your Money. The data this week was mixed again, though it was weighted a bit to the positive side: the housing and business stats were generally good and the third quarter GDP number gave no hint of a recession; on the other hand, most of the consumer related measures were negative. So the US data continue to support 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.

In sticking with our forecast, I am not ignoring the oft mentioned ECRI weekly data that continues to point to a recession. I consider this a major risk to our economic scenario; indeed with the improvement this week in the EU outlook, it now ranks equally with Europe as ‘the biggest risk’ in our forecast. But at this time, given the current flow of data, I am just not willing to raise the probability of such to over 50%.

Here is the latest ECRI weekly index:
http://advisorperspectives.com/commentaries/dshort_102811.php

Speaking of Europe, the EU sovereign debt problem gained some clarity this week. I have covered the introduction of the new EU plan extensively in our Morning Calls, so I don’t want to get repetitive here. But to summarize:

(1) the plan calls for a ‘voluntary’ 50% haircut on Greek debt [a default by any other name is still a default], a mandatory increase in the equity capital by the eurobanks and a bailout fund (EFSF) to back stop the banks and the governments.

(2) the effect is to [a] take the disaster scenario off the table, at least in the short term, [b] however, by not dealing with the underlying causes of the problem {fiscal irresponsibility}, it also removes the good news scenario from consideration, [c] leaving Europe facing an extended period of painful deleveraging likely to result in very slow or negative growth and subject to another possible episode such as we have just lived through {Japan 2.0}.

Finally, there is this: Gee, why can’t I be Greece?:
http://www.zerohedge.com/news/global-moral-hazard-dawns-merkel-says-it-must-be-prevented-others-come-seeking-haircut-ireland-

And this: what do you mean, my CDS isn’t worth anything?
http://www.zerohedge.com/news/guest-post-greek-cds-shennanigans

What does this mean for the US economic prospects? Since Europe is a major trading partner of the US, any slowdown in its economic growth will almost certainly impact our own. As a result, it also contributes to the increased risk of a US recession--clearly, imposing lower export activity on an already struggling economy raises the probability of tipping it into an economic decline.

Finally, it is important to note that any changes to the numbers in our Economic Model represent changes in the growth of productive capacity (increases in capital goods and enhanced worker productivity) not growth in production (actual output). So any lowering of our forecast based on an economically weakened Europe, reflects (1) not an actual fall in production [although, in this case, it almost certainly will] but a decrease in productive capacity [willingness and wherewith all to invest in plant and equipment and the slowing growth and declining skill level of EU labor force] and (2) that any slowdown in Europe is not a short term cyclical phenomena; it is structural, just as the already below average growth assumptions for the US in our Model are based on structural factors [irresponsible fiscal, regulatory and monetary policies]. In addition, any euro slowdown will also act as a downward bias on US corporate profits for obvious reasons.

However, there are offsetting factors to Europe’s expected drag on the US economy. One is the expected increase in the anticipated growth in other areas of the world. A recently mentioned second reason is the continuing trend in much better corporate profits resulting from corporate management’s persistent drive for operating efficiencies.

The bottom line to all this for our Economic Model is that, I am going to assume that improving developing economies/Asia will at least partially offset the decline from Europe: I am lowering 2012 real GDP growth from 1.5-2.5% to 1.5-2%, thereby lowering the mean/expected result.

As for corporate profits, I am also narrowing the range of anticipated profit growth in 2012 from 0-10% to 5-10%, which (1) affirms the slowing rate of growth from 2011 [7-12%] but (2) has the effect of raising the mean/expected outcome. I am justifying (rationalizing?) the seeming contradiction of a lower economic growth rate with a slightly improved profit picture based on the aforementioned ability of US corporate management to continue to generate positive results in what has otherwise been a hostile economic as well as political environment.

When I ran these changes through our Valuation Model, along with the assumption that inflation (and hence, interest rates) is likely to rise as a result of the continuing need by US and EU monetary authorities to print money, the effect was almost negligible.

Net, net, economic growth is likely to slow a bit (but still no recession) while corporate profits will continue to surprise on the upside; but the continuing economic mess in both the US and EU will lead to more money printing which will in turn lead to higher inflation (a higher discount factor). The 2012 Year End Fair Value, however, remains unchanged.

As a final note, I reiterate last week’s hope for a more positive outcome: ‘I think that our only way of fighting off the negative implications of the above scenario(s) is to throw out enough of bums now inhabiting Washington, to start moving this country toward a fairer tax system, a more fiscally responsible budget, fewer regulations on all of our lives and enact election and lobbying reform to break the link between the political class and rent seeking special interests.’

This week’s data:

(1) housing: both the weekly mortgage and purchase applications were up; September new home sales were very strong, though pending home sales were unexpectedly down; and the Case Shiller home price index was unchanged,

(2) consumer: weekly retail sales were mixed; weekly jobless claims declined but not as much as anticipated; both the September personal income and spending numbers were weaker than estimated while the PCE deflator came in below forecasts; finally, the two measures of consumer sentiment painted distinctly different pictures: the Conference Board’s October reading was awful, while the University of Michigan’s final October number was up beat.

(3) industry: September durable goods orders fell but less than expected; the Chicago Fed business index was negative but less than half as much as anticipated,

(4) macroeconomic: initial third quarter GDP was reported up 2.5%, giving no sign of recession.
http://mjperry.blogspot.com/2011/10/real-gdp-recovers-to-above-pre.html

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.


Investing in the government put (short):
http://pragcap.com/the-global-government-put

The Market-Disciplined Investing

Technical


The Averages (DJIA 12231, S&P 1285) had a fantastic week, closing within their intermediate term trading ranges (10725-12929, 1101-1372) and well above the 11548/ 1219 and 11719/1230 resistance levels. In fact, they now appear to have set to a short term up trend (S&P 1207-1313). 12919, 1372 here we come.

Volume declined on Friday; breadth also faded a bit, but the flow of funds remains very strong. The VIX closed for a second day well outside the upper zone of its current trading range--a positive for stocks.

Finally, a review of our internal indicator shows that in our 165 stock Universe, 95 have clearly broken above the comparable 11719, 1230 level, 32 have not and 38 are too close to call. Clearly, this indicator is now confirming the indices move to the upside. What is a bit befuddling as well as concerning to me is that while this indicator has historically been a leading indicator in this latest break to the upside, it was lagging. Of course when it lags, it offers little informational value. So if this is a sign of things to come, I will have to give up my confidence in its value.

GLD was off fractionally on the day but has still made a great recovery from the lows last week.

All in all, the technical outlook is a bit brighter; however, I would caution that last week’s break above the 11719, 1230 level notwithstanding, stocks are still in an intermediate term trading range; and the higher they trade within that range, the lower the urgency to buy.

Bottom line:

(1) the DJIA and S&P are in 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 (12251) finished this week about 15.1% above Fair Value (10645) while the S&P closed (1285) 2.2% undervalued (1315).

Equities (defined by the S&P) are approaching Fair Value. Incorporated in that ‘Fair Value’ judgment is a zero economic growth rate in Europe, a Greek default and a sluggish recovery at home that isn’t going to improve until we change the personnel in Washington.

The good news is that (1) a collapse in the EU has been taken off the table, at least in the short term and (2) even though I have moved up the earnings growth capacity assumption in our Model, I may still be underestimating it. The bad news is that the odds of a ‘double dip’ is high enough to be worrisome and that is not helped by what is likely to be a slowing rate of growth in Europe.

In the end, I see little reason to assume that stocks won’t continue to trade around their Fair Value. When that happens, it means we have to be very price sensitive on the Buy side, if there is Buying to be done. Further, if the charts are correct, i.e. that equity prices could run to the 12919, 1372 level, then that will put them above Fair Value, so our focus will be shifting to the Sell side.

This week our Portfolios made small additions to their 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 12231 1285

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.