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 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 24%
High Yield Portfolio 24%
Aggressive Growth Portfolio 29%
Economics
The economy is a modest positive for Your Money. The data was mixed again this week. The good news included a second consecutive outstanding jobless claims figure and great business survey stats from the New York and Philadelphia Feds. The bad news was poor mortgage purchase numbers as well as weak November retail sales and industrial production. So after spurt in solidly positive data in October/November, we are back to a statistical flow that more nearly matches our current 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.
Lurking behind this near perfect data picture supporting our (slow, sluggish growth) outlook is that pesky ECRI weekly leading index which is still calling for a recession. This historically accurate indicator remains my primary concern that the assumptions in our economic Model are too optimistic. I am not changing our forecast at this time because I think that, the ECRI aside, the consensus forecast is too pessimistic and I always feel more comfortable in a contrarian posture. That said, I recognize the risk of recession and remain very sensitive to it.
However, making it a bit easier to be sanguine, the ECRI index reading improved (again) this week:
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php
The other major risk to our outlook is that the eurocrats will bungle the resolution of their sovereign debt problems which in turn will result in sufficient damage to the global economy that it will impact the rate of US economic recovery. That said, as you may have gathered from my comments in the last week or so, I am coming around to a different and somewhat unconventional view of this situation:
(1) while a ‘muddling through’ scenario, i.e. the politicians and the ECB do just enough to allow the sovereigns to roll over their debt and the banks to avoid major haircuts on that debt, is what I have assumed in our Models, it has become somewhat more tenuous as a result of the rather pathetic ‘new’ plan put forth by the EU leadership last week for solving their crisis. If there was ever an example of doing the absolute minimum to avoid having to do what is necessary, this was it; and if this strategy continues, it is a prescription for [a] the EU flitting from one crisis to another in the short run, keeping the global economy off balance and inhibiting investment and consumption and [b] as a result, a zero or negative growth rate for the continent as far as the eye can see.
Although this has not yet led to any revisions in our Economic Model, it could if the above comes to fruition. However, it does impact our Valuation Model to the extent that the persistent uncertainty surrounding the possibility of either an endless stream of ‘new’ plans and/or one or more defaults will likely act as a governor on equity multiples.
http://www.nakedcapitalism.com/2011/12/ecb-success-and-folly.html
And the continued sophomoric behavior like this will do nothing for investor confidence (short):
http://www.zerohedge.com/news/diplomatic-war-between-france-and-uk-goes-defcon-2
(2) the multi country/bank default now being viewed as a worse case scenario, I have concluded may not be so bad: the PIIGS exit the euro, lots of unserviceable debts are wiped out as are financial risk takers and, if we are really lucky, long over due austerity is imposed. Certainly, the banks would have to be recapitalized, but they need to be anyway. Yes, there would be lots of defaults; but remember a default has both a winner [the sovereigns] and a loser [the bankers]; plus, it does not impact demand. Indeed, by freeing the governments of a lot of that unserviceable debt, demand may actually rise.
Furthermore, while I would undoubtedly have to lower the near-in growth assumptions in our Model, [a] aside from the derivative risks, I don’t believe that the impact on the US will be nearly as devastating as many of the current doom and gloom forecasters are suggesting and [b] it would improve the long term economic outlook as well as P/E ratios
Of course, the US banking system’s real exposure as a counterparty to the EU bank credit default swaps is the potential turd in this punch bowl to this more sanguine take on multiple country/bank defaults. While there is plenty of data around measuring both our financial system’s gross and net commitments, it is very uncertain what will happen if one or more counterparty can’t meet their obligations. As you know, this is one of my biggest worries.
(3) there is a new alternative disaster scenario; and that is if the PIIGS impose draconian austerity measures on themselves but receive no relief from debt write offs and/or an easier monetary policy. That is the model for the 1930’s like depression Ms Lagarde was warning against this week; and unfortunately, that is exactly what the eurocrats are doing at the moment. The only reason that I am not getting really beared up as a result is that I believe that when push comes to shove either the PIIGS politicians will opt to leave the euro [see scenario (2) above] rather than face a depression or the Germans will relent.
As an aside, whatever occurs in Europe and in however low esteem I hold our own ruling class, I can not see them making the same mistakes that led to the Depression in the US. As I noted Friday, [a] there is no way, the Fed will tighten money in the face of declining economic activity and [b] I can’t come up with a political scenario where the government would both cut spending and raise taxes.
Bottom line: our Economic Model remains unchanged though I may have to make a slight negative adjustment to our Valuation Model based on what I think will be a heightened and more prolonged concern over the EU economy based on the apparent unwillingness of the EU political class to face their sovereign debt problem.
The two EU outlier scenarios that could cause an alteration to our Economic Model are (1) some combination of sovereign defaults and financial institution bankruptcies that would result in [a] a downgrade in our growth outlook near term but an improvement longer term or [b] another round of US bank capital destruction stemming from the exposure to counterparty risk in the EU financial derivatives market, (2) the EU political elite blindly following a path of spending cuts, tax hikes and tight money that could push Europe into a severe recession or depression.
One final note on our ruling class. This week’s battle over the payroll tax extension demonstrates that very little that is sensible is going to get done in this country until after November 2012 and perhaps, not even then. The good news is that (1) the economy is demonstrating resilience in spite of these morons and (2) our Model has an inept political class price in.
This week’s data:
(1) housing: weekly mortgage applications rose but purchase applications fell,
(2) consumer: weekly retail sales were mixed following a weak showing last week; November sales were disappointing; weekly jobless claims declined more than expected for the second week in a row,
(3) industry: the November industrial production was very poor; on the other hand, the December readings of the New York and Philadelphia Fed business surveys were well above estimates; October business inventories and sales were strong,
(4) macroeconomic: October PPI was hotter than anticipated though core PPI was weaker; October CPI was unchanged while core CPI advanced more than estimates; the third quarter current account deficit was smaller than expected.
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.
Mohamed El Erian on the EU problems (long):
http://www.foreignpolicy.com/articles/2011/12/15/downward_spiral
The Market-Disciplined Investing
Technical
While the roller coaster ride continues, the indices (DJIA 11886, S&P 1219) still finished the week well within their intermediate term trading ranges [10725-12919, 1101-1372].
With the close last night, the S&P has now confirmed its break of the 1230 (resistance turned support turned resistance turned) support and is one more trading day away from confirming the break of its 50 day moving average. It has not yet nullified the developing reverse head and shoulders formation; but with any further weakness, it will. At the moment, resistance exists at 1230 and support at 1158.
The DJIA has yet to confirm the negative pin action of the S&P, holding above both its 50 day moving average and the comparable 1230 support level (11741). As you know, I think that the Averages need to be in sync to feel comfortable about trend and any trading moves. Hence, for the moment, I am sitting on my hands.
Volume soared on Friday due primarily to the quad option expiration; breadth improved. The VIX sold off finishing below that upper zone of its current trading range and within a developing short term down trend--a positive for stocks.
More on the VIX (medium):
http://www.zerohedge.com/news/guest-post-do-we-get-year-end-rally-or-not-santa-dukes-it-out-mr-vix
GLD (155) was up Friday after being hammered all week. That close put it above the 153 support level which it broke two days earlier as well as its 300 day moving average (149). At the moment, our Portfolios hold no GLD--which is not to say that won’t change if it appears GLD had found a bottom.
With the indices in conflicting short term trends, our Portfolios are on the side lines. Nevertheless, they both remain solidly within their intermediate term trading ranges; and I continue to believe the current boundaries of those trading ranges will hold over the next six months or so barring disaster in Europe and/or a change of leadership at home.
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 (11886) finished this week about 10.4% above Fair Value (10760) while the S&P closed (1219) 8.3% undervalued (1330). As you know, incorporated in that ‘Fair Value’ judgment is a ‘muddle through’ scenario in Europe and a sluggish recovery at home that isn’t likely to improve until we change the personnel in Washington.
This week’s economic data was well as the farce being acted out in Washington over the payroll tax extension and the continuing (government funding) resolution support both our Economic and Valuation Models.
Europe, on the other hand, is bit trickier. I have covered this problem in this week’s Morning Calls as well as in the Economics section above, so I’ll confine my comments to the investment implications.
First, I think that even though (1) the numbers in our Economics Model won’t change based on what I consider a very ‘weak’ version of the ‘muddle through’ scenario implicit in the ‘new’ EU plan announced last week and (2) there will likely be a new ‘new’ plan as it become obvious to the EU leadership that its ‘new’ plan isn’t enough, I am concerned about the impact on psychology (P/E’s) of investors that seem doomed to facing an endless stream of ‘summits’ that accomplish just enough at the margin to prevent an immediate collapse but guarantee another crisis in a month or two. In my opinion, as long as this Chinese water torture continues, multiples can go no way but down.
Second, I don’t think that multiple country/bank defaults will be as negative for stocks as the general narrative on the Street suggests. Certainly, at the outset prices could decline (depending on their valuation level), but given my less pessimistic view of the economic consequences of those defaults, they should snap back relatively quickly and perhaps be even higher in a short time. Further, as well publicized and discussed as this scenario has been and is, I have a difficult time believing that much if not most of ‘default’ scenario isn’t already discounted.
Third, investors must deal with the potential investment risks associated with two known unknowns:
(1) the true net exposure of our banking system to EU debt derivatives market. Of course, we do know both the nominal gross and net exposures of our financial system. We also know from MF Global that a counterparty can fail leaving very large losses behind and the system still handle a single such occurrence. What we don’t know is what happens if multiple counterparties fail. This may not be a high probability risk; but given that the global regulatory authorities still don’t have the accounting and risk management systems in place to properly oversee this market, we can’t even begin to quantify the true risk being carried in the derivative markets,
(2) the likelihood of current EU economic policies [austerity, no growth, tight money] birthing a depression. As I noted in the Economic section, if left unchanged that likelihood is significant. However, as I also noted, I think that these policies put the PIIGS in such an untenable position economically that either they will withdraw from the euro or the above policies will become more accommodative. Clearly, I could be wrong on this count and therein lies the risk.
Fourth, virtually all the above suggest that the dollar is likely to maintain its recently acquired status of being the lesser of all evils. That should (1) negatively impact the earnings of multinational companies, (2) keep downward pressure on the price of gold and foreign stocks and (3) positively impact, or at a minimum, act as floor for US asset prices.
My take on these factors is that strategy wise they leave me slightly more negative on stock valuations over the next year and with most of the risks being associated with being too fully invested versus not enough. However, at current price levels, much if not all of that additional negativity is being discounted. Finally, (1) and (3) in the above paragraph act as offsets to each other, while (2) suggests a more cautious approach to GLD and foreign ETF’s.
This week our Portfolios Sold their GLD positions.
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 a major long term risk. An investment in gold is an inflation hedge and holdings in other countries provide exposure to better growth opportunities. However, the likelihood of a continued strengthening in the dollar argues for less emphasis on these investment alternatives over the intermediate term.
(3) defense is still important.
DJIA S&P
Current 2011 Year End Fair Value* 10760 1330
Fair Value as of 12/31/11 10760 1330
Close this week 11886 1219
Over Valuation vs. 12/31 Close
5% overvalued 11298 1396
10% overvalued 11836 1463
15% overvalued 12374 1529
Under Valuation vs. 12/31 Close
5% undervalued 10222 1263
10%undervalued 9684 1197 15%undervalued 9146 1130
* 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.
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