Saturday, October 22, 2011

The Closing Bell Will Europe get it right?



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. The data this week was a bit more ‘mixed’ than in the recent past, providing both good news and bad news (housing starts strong versus existing home sales weak; the Philly Fed index a blow out versus the NY Fed index a disappointment; September industrial production was up but so was PPI). However, this doesn’t diminish the overall more positive tone to the economy of the last month or so. Accordingly, our forecast 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.

Nevertheless, as I noted several weeks ago, I am concerned about the deterioration in the ECRI weekly leading index--which is continuing (see link below). In an article I linked to this week, the author noted that (1) historically, it has not been unusual for the ECRI to be flashing red while current economic data showed no sign of recession and (2) the reason being that the ECRI anticipates much further into the future than current data.

The latest ECRI update:
http://advisorperspectives.com/commentaries/dshort_102111.php

So recession remains a real risk to me. This all means that on a relative basis that since investors have become more up beat of late, my bias has moved from being on the optimistic side of consensus a couple of months ago to now being on the pessimistic side of consensus.

All that said, what is occurring in the US is much less important than events in Europe; more specifically, how the eurocrats manage the EU through what will almost certainly be a Greek default, a possible ‘haircut’ to the sovereign debt of other countries, and the stability of EU financial institutions when all this is taking place.

I opined in last week’s Closing Bell that there were three possible scenarios: (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 and the Med countries get their fiscal houses in order, (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.

Frankly, I don’t think that the eurocrats have the collective balls to implement the necessary but painful long term solution to this problem (a return to fiscal responsibility), thereby nixing scenario (1). On the other hand, because European officials seem to have at long, last realized that no action is a nonoptimal solution, I believe that something will be done to resolve the Greek issue and provide protection to the EU bank balance sheets at least for another year or so, ruling out scenario (3).
http://www.zerohedge.com/news/truth-behind-europes-%E2%82%AC17-trillion-triangle-terror

Because EU officials do appear to be struggling toward a solution that will treat at least the symptoms of the crisis, Europe will likely avoid disaster in the short term. Longer term though, the can is simply being kicked down the road; and that virtually guarantees that Europe will settle into an economic malaise similar to what Japan has been enduring for a decade.

That said, if they were to do everything that I wanted (the wet dream scenario), it still wouldn’t improve our outlook, at least in the short term (18-24 months). If they do something really stupid, the impact would likely be immediate and quite negative (the every man for himself scenario). If they manage to muddle through (Japan 2.0 scenario), I will probably lower the growth rate for our economy.

Which of these alternatives occur is nothing more than a guess, though as suggested above, I think the ‘muddle through’ the most likely. However, because of the significance and uncertainty of the outcome, I am leaving our Economic Model as is until we know.

As an aside, I think that our only way of fighting off the negative implications of the above scenarios 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: weekly mortgage and purchase applications were down, but were distorted by the Columbus Day holiday; housing starts soared but most of that was accounted for by multifamily construction; building permits fell; existing home sales were down more than expected,

(2) consumer: weekly retail sales were mixed; weekly jobless claims declined as anticipated,

(3) industry: September industrial production rose as estimated; capacity was in line with forecasts; the NY Fed’s manufacturing index was disappointing while the Philadelphia Fed’s index was a blow out,

(4) macroeconomic: September producer prices were much ‘hotter’ than expected, though consumer prices were basically in line; September leading economic indicators rose slightly less than anticipated.

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 11808, S&P 1238) had another great week, closing within their intermediate term trading ranges (10725-12929, 1101-1372). However, of potentially more significance, both index blew through both the 11548, 1219 and 11719/1230 resistance levels.

While our time and distance discipline becomes operative with the break to the upside, both index fulfilled much the distance (circa 1%) element of our discipline. So it won’t take much of an additional move up (in distance) to obviate the time element of our discipline. As I have previously noted, if that occurs, stocks appear to have a straight shot to the 12919, 1372 level with almost no resistance in between.

Volume picked up on Friday, but much of that was attributable to option expiration. Unfortunately, while the VIX fell, it was not by much and thus remains in that upper zone of its current trading range--a factor that I consider negative for stocks.

Finally, a review of our internal indicator shows that in our 165 stock Universe, 71 have clearly broken above the comparable 11719, 1230 level, 62 have not and 33 are too close to call. I see no informational value in this; in other words, there is nothing in those numbers to suggest anything other than reflecting Market movement.

GLD recovered above the lower boundary of its intermediate term up trend, negating the start of our time and distance discipline on Thursday.

Here is a good discussion from a bond market expert on monetary policy and where it is leading us (hard assets):
http://www.zerohedge.com/news/paul-brodsky-seeds-our-destruction-were-and-still-are-sown-bond-markets

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 (11808) finished this week about 10.9% above Fair Value (10645) while the S&P closed (1238) 5.8% undervalued (1315).

Equities as measured by the S&P (which I consider superior to the DJIA) are modestly undervalued, at least as measured by our Valuation Model--which incorporates both a sluggish below average secular economic growth rate, a very disappointing political environment (fiscal and regulatory irresponsibility) and modest fallout from the EU sovereign debt crisis.

Supporting our Model’s valuations are corporate earnings. Once again quarterly profit reports are coming in above estimates; more important, guidance continues to be positive. Indeed, for the last year, both earnings and guidance have tracked a pace higher than my earnings capacity assumption (remember the earnings metric in our Valuation Model is not current earnings but rather current earnings capacity) in our Model, clearly suggesting that I am underestimating it and further that our Valuation Model is too conservative.

This quarter’s revenue and earnings ‘beat rate’ so far:
http://www.bespokeinvest.com/thinkbig/2011/10/21/bottom-and-top-line-q3-beat-rates.html

However, before getting too jiggy, let’s look at my biggest immediate concern: the EU debt crisis. Despite the Market’s recent rally off the October lows on the improving headlines out of Europe, the only really new thing that we know since those lows is that the eurocrats have finally grasped that there is no easy way out of their dilemma and that something has to be done.

Regrettably that ‘something’ has been such a rapidly moving and sometimes ephemeral target, that it is impossible to make any adjustments to the assumptions in our Models to account for the impact that the ultimate outcome will have on the US economy/stock valuations.

Nevertheless, as I noted in the Economic section, that ‘something’ will likely involve enough agony to assuage Markets at least in the short term. This may make investors feel all warm and fuzzy, but longer term it means that the EU struggles with a massive, unsustainable debt load that limits its ability to grow. That in turn impacts the US’s already stunted growth rate--offsetting at least partially my overly conservative earnings capacity assumptions discussed above.

I should also include in this discussion the influence of a ‘double dip’ on our Model. As you know, I put some stock in the ECRI forecast which is now projecting a second recession. If it occurs, then when investors realize it, stock prices will almost surely be impacted negatively. However, since our Valuation Model is based on earnings capacity verses stated earnings, it won’t have that much effect on our valuations. So my worries about a second economic decline is one of being sure our Portfolios have sufficient cash to take advantage of values being created by lower prices

In summary, I am going to have to make some adjustments to our Valuation Model. One such alteration is clearly positive--a higher earnings capacity than currently assumed. The second is a negative: the strong likelihood that whatever the outcome of the current EU debt crisis, it will impose a lower bias to our earnings capacity assumption. Unfortunately, I have no idea how this latter factor plays out, so I am making no changes to our Model till I do.

A third and final factor that could impact the earnings growth capacity is the potential alteration of the political landscape in this country. If the American electorate can find the will to toss out enough of the current ruling class in 2012 and elect a regime that understands and appreciates fiscal responsibility and the myriad of functions that the government is NOT supposed perform, then our own economic renaissance could more than offset any stagnant demand from the EU. It is simply a hope and a prayer at the moment; but as November 2012 approaches, it can gain purchase.

This week our Portfolios made no changes.

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 11808 1238

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.