Saturday, November 19, 2011

The Closing Bell Whence Germany?

Next week, family starts arriving for the Holiday. As usual, I will be running to and from the airport as well as preparing the bulk of Thanksgiving Dinner. So I am again taking the week off. Of course, given the emotional roller coaster this Market has had us all on, I will be watching the markets and our Portfolios closely. If action is needed, I will be in touch via Subscriber Alerts.

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 (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):
Short Term Up Trend 11600-12564
Intermediate 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 14%
High Yield Portfolio 13%
Aggressive Growth Portfolio 9%*

*includes a 5% position in a market ETF as a trading position.


The economy is a modest positive for Your Money. The trend towards more encouraging US economic data continued this week. Most measures save the housing stats were positive, belying fears of a recession. Although to be sure, there are reasons to question our forecast:

(1) the ECRI weekly index--which has a great record of forecasting recessions; and it is doing so now. However, the ECRI has now improved three weeks in a row and keeps me unwilling to increase the likelihood of a recession.

The latest reading of the ECRI weekly leading index improved again, i.e. it is less negative; but the founder is sticking with his guns (includes a CNBC interview):

(2) a potential economic collapse in Europe if one or more of the PIIGS is allowed to default/withdraw from the EU--which hinges principally on the Germans’ decision on whether or not to allow the ECB to print money. Unfortunately, no one seems to have a clue how this end, perhaps not even the Germans; and as such, it is one of those known unknowns. Nevertheless, it can’t be ignored for no other reason than the bond vigilantes no longer care about the strides being made toward fiscal responsibility by the individual countries and are driving hard to hoop [demanding ever escalating interest rates on sovereign debt financings] for a German commitment. In doing so, they are making it near impossible for EU sovereigns to rollover their debt. Once one of those nations fails to self fund, it will be in default and the rest will likely come tumbling after.

So it appears that we will probably know the endgame sooner rather that later. Unfortunately, that outcome is binary, i.e. either the ECB prints, in which Europe muddles through, at least in the short term, or it doesn’t where upon there are multiple country and bank defaults. That makes it extremely difficult to come up with a single forecast from our Economic Model.

And this from Goldman (medium):

And this from Ireland (medium):

Hence, for the moment our outlook remains unchanged but with the caveat that if it is wrong, it will be wrong big time: 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.

There is one other factor weighing on investors’ minds that I have yakked about ad nauseum; so I only summarize:

The outcome of the negotiations in the super committee over a $1.2 trillion in deficit reduction remains in doubt. Maybe I have my head in the sand [or somewhere else], but I see this as much ado about nothing. Given the philosophical divide that now exists between the parties along with the complete lack of leadership, the most likely resolution has always been, in my opinion, a deadlock with nothing substantive from the committee.

Of course that also means $1.2 trillion in mandatory deficit reduction measures; and that sounds like good news to me. Why is it good news? Because (1) $1.2 trillion in deficit reductions are more than we have today and (2) the inability of our political class to come to agreement for the betterment of the country will hopefully so antagonize the electorate that they throw out most of these worthless turds in November 2012 and we will get a group that can act fiscally responsible.

In the meantime, every politician in the country is now running for re-election, so gridlock seems likely to prevail for the next 12 months; and as noted the deficit reduction measures don’t occur until January 2013. Therefore, there will be no new outside influence on economic factors from the government. This perfectly fits our forecast and is therefore priced into our Economic and Valuation Models.

The bottom line is that our Model discounts a sluggish US economy, a do nothing American political class and a Greek default with the rest of Europe muddling through. Clearly, that latter assumption is now in question. However, I still think the eurocrats will find a way to avoid the disaster scenario. Even if they don’t, I am unsure as to how to adjust our Model until we see the breadth and depth of any subsequent slowdown. But clearly it will be to our detriment. Once we gain some visibility, I can make the necessary adjustments.

The latest from Mohamed El Erian:

This week’s data:

(1) housing: both weekly mortgage and purchase applications were off considerably; October housing starts fell, but building permits rose strongly,

(2) consumer: weekly retail sales were universally up for the second week in a row; October retail sales soared; weekly jobless claims declined versus an expected increase,

(3) industry: September business inventories were unchanged but sales were quite strong; October industrial production climbed at almost twice the anticipated rate; the NY Fed index of business conditions came in above forecasts,

(4) macroeconomic: both October PPI and CPI came in hotter than estimates; October leading economic indicators rose 0.9% versus expectations of up 0.6%.

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.

From Charles Krauthammer:

A letter from Sen. Tom Coburn:

The Market-Disciplined Investing


The Averages (DJIA 11796, S&P 1215) did not have a good week. Even though they remain safely within their intermediate term trading ranges (10725-12919, 1101-1372), considerable technical damage was done:

(1) the S&P tried early in the week to push though its 200 day moving average to the upside [circa 1270], failed, and finished the week not far above its 50 day moving average [circa 1205]; a confirmed break of that moving average to the downside would be a negative for stocks,

(2) both the DJIA and the S&P fell below the lower boundary of a pennant formation decisively enough that the distance element of our time and distance discipline confirmed the violation. Generally, a break out above or below such a pattern determines the direction of prices over the short to intermediate term,

(3) the S&P also broke the lower boundary of its short term up trend again with enough authority that the distance component of our time and distance discipline confirms the break,

(4) the S&P dropped below the 1230 resistance turned support level, making 1230 again a resistance point.

Volume rose on Friday; breadth improved. The VIX was down but much more than I would have expected on a flat to slightly up day.

GLD was up, finishing the week well within its intermediate term up trend.

Net, net:

(1) the indices are diverging with respect to their short term up trend. Typically this is a time for inaction.

(2) the magnitude of the S&P’s fall below three trend lines mentioned above was enough to cut short the time element of our time and distance discipline. Given the extreme volatility of late, I began thinking that it might make sense to widen our distance element to account for that. After reflecting on it, I believe that it is a good idea; so I am holding off for at least another trading day [more time] before confirming the break and taking any trading action.

As long as I am on the subject of volatility, I noted that on Thursday the VIX was up much less than I would have thought on such a big down day; and yesterday, it was down a lot more than I would have thought on what was basically a flat day. I have no idea what this means; but it does make me wonder if there is some force at work on both the VIX and stock prices that is not immediately obvious to me.

(3) I mentioned in yesterday’s Morning Call that our internal indicator was not confirming the S&P break. While I think that volatility may have been playing a role in distorting the recent readings given by this normally reliable indicator, I still consider its current results a reason to question the S&P break to the downside.

My conclusion is that we have to respect the magnitude of the S&P break and the conditions surrounding it, i.e. it broke three levels of support on the same day and of a scale sufficient to cause concern. However, the divergence of the DJIA along with the issues I raised above, keep me on the sideline until the DJIA and the S&P are once again in sync.

A move to the downside would prompt a few sales that I have already marked. If S&P recovers, no action is warranted in as much as our cash is as low as I want at this time.

Bottom line:

(1) the DJIA and S&P are in an intermediate term trading range (10725-12919, 1101-1372); the DJIA is in a short term up trend (11600-12564), the S&P is not.

(5) 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 (11796) finished this week about 10.2% above Fair Value (10702) while the S&P (1215)closed 8.1% undervalued (1322).

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

The good news this week was the continued improvement in the economic data including that of the ECRI weekly leading index. This means our ‘sluggish recovery at home’ forecast is looking spot on.

The bad news is that the bond vigilantes and events are forcing Germany’s hand, demanding that it go ‘all in’ in order to deal with the near term sovereign debt problems of the PIIGS; and it is balking. Our Model assumes that Germany would do what was necessary to hold the EU together. That is clearly being challenged. If Germany refuses to help accommodate the refunding needs of the PIIGS, then the growth rate assumptions produced by our Economic Model are too high and that will directly (and negatively) impact our Valuation Model. That I am wrong on this assumption is the major risk to our forecast/equity valuations.

Somewhere in between the good and bad news is the ongoing saga of our corrupt, inept and self involved political class and its seeming inability to take even the smallest step towards fiscal responsibility/sanity. Here too our Models are potentially at odds with the prevailing sentiment. In this case, I assume failure but that is reflected in our Models. The Market appears to either not have this circumstance priced in yet or it is assuming graver consequences than I. I am a lot more comfortable being at odds with the consensus on this issue and don’t view it as a significant risk.

In summary, I am leaving both our Economic and Valuation Models unchanged. My biggest concern is a German refusal to allow the ECB to expand its money creation powers. On that score, it appears that forces are pushing the endgame forward; so we are likely to see a conclusion in the not to distant future. German support of the ECB would leave out Models in tact; a refusal would lead to a lowering of US growth expectations and even less credit availability with the obvious negative consequences for US equity valuations.

I should note that if everything goes swimmingly, S&P 1330 will still remain our Year End Fair Value. Since our Portfolios are presently about as fully invested as I would like, then a price move to that level will likely prompt some selling.

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.


Current 2011 Year End Fair Value* 10760 1330
Fair Value as of 11/30/11 10702 1322
Close this week 11796 1215

Over Valuation vs. 11/30 Close
5% overvalued 11237 1388
10% overvalued 11772 1454
15% overvalued 12307 1520

Under Valuation vs. 11/30 Close
5% undervalued 10167 1255
10%undervalued 9631 1189 15%undervalued 9096 1123

* 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.