The Closing Bell- Close but no cigar

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 12%
High Yield Portfolio 11%
Aggressive Growth Portfolio 16%

Economics

The economy is a modest positive for Your Money. It was a slow week for data. What we started off with some bad news (disappointing ISM nonmanufacturing index and factory sales) but ended on an upbeat note (jobless claims and consumer sentiment). So basically, it was a week of mixed data. Much like last week; and, I as noted in last week’s Closing Bell, the less robust numbers are not all that concerning because the stats had been so good for the last month, we had to get some poor data at some point--either that or I was going to have revise our forecast up. Hence, this shift in the data flow away from portraying a vigorous recovery to one less so keeps the economy on a track reflected by 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.

Of course, as the numbers again point to a weak rebound, the ECRI weekly leading index (which as you know has been calling for a recession) becomes more troublesome. This indicator continues to be the biggest source of cognitive dissonance for me with respect to the US economy.

That said, the ECRI index resumed its upward march (it is less negative) this week. However, the video embedded in this link is a must watch interview with the founder of ECRI who makes his case for the recession call:
http://advisorperspectives.com/commentaries/dshort_120911.php

And globally, conditions are not so hot either (short):
http://www.investmentpostcards.com/2011/12/10/global-pmi-scorecard-not-a-pretty-picture/

The other major risk to our outlook lies with whether the EU is able to resolve its sovereign debt problems without bringing its and the world’s economy to their knees. As you know this week was a big one for the euros with meetings galore and at the end some new policy initiatives.

To summarize them: (1) some power to determine fiscal policy was centralized, (2) sanctions were created for those countries who don’t comply with fiscal policy, (3) additional bailout funds will be available sooner than expected, (4) however, the ECB will not play a significant role in the bail out by ‘printing money’ [at least not yet], (5) there will be no haircuts on sovereign debt taken by the private sector and (6) the eurocrats hope to have the details worked out by March 2012.

My take is that this is a very weak version of the ‘muddle through’ scenario. By that I mean that to the extent that the ‘muddle through’ alternative postpones the pain that must be eventually endured, these measures, in my opinion, don’t postpone that pain for very long.

There are two basic reasons:

(1) short term, I don’t think that without the help of the ECB that the euros can manage the rollover of all the debt maturing in the next twelve month, provision (3) above notwithstanding. If not, then virtually every bond auction becomes an occasion for the bond vigilantes to wreak havoc and potentially force a default. That will not be good for those countries trying to re-finance themselves or the Markets.

(2) long term, I can’t make the math work, i.e. keep Europe solvent, if there is no write down of current debt. They collectively owe so much relative to their GDP that at the very least Europe will experience a Japan 2.0 decade or two of recession and at worst, one or more countries fail to re-finance their debt and that triggers a panic which the eurocrats can’t reverse.

Now that doesn’t mean that there won’t be additional steps that could prevent the disaster scenario; but the point here is that for those additional steps to come it appears that another crisis will be required. So the current policy steps may be incremental enough for the moment to keep investors from throwing in the towel; I just have serious issues with how long that ‘moment’ will last.

Thus, my bottom line has shifted to a bit more negative. While these latest measures keep Europe on track with the assumptions in our Economic Model, they do so just barely. And they raise the odds of both a prolonged European recession and/or the uncontrollable unfolding of a disaster scenario. Certainly, the EU can endure a series of mini-crises each of which spawns additional necessary measures that bring the European economy back from the brink. But that will do little to improve our own economic outlook and keeps the risk on the table of a disaster scenario which in turn will likely impact to some extent US investment and consumption psychology.

EU Council statement recap from the Pragmatic Capitalist (medium):
http://pragcap.com/eu-council-statement-no-bazooka

Thoughts on this plan from Felix Salmon (medium):
http://www.thedailybeast.com/articles/2011/12/09/half-baked-treaty-deal-could-lead-to-collapse-of-eurozone.html

And from Marc Faber (6 minute video):
http://www.investmentpostcards.com/2011/12/10/dissolve-the-eu-says-marc-faber/

Please read this carefully. This is a great discussion of my version of the disaster scenario, i.e. one default leads to a collapse of the CDS market because few will be able to meet their counterparty risk (so suddenly gross exposure becomes net exposure) including those owned by US banks:
http://www.zerohedge.com/news/evolution-warns-total-carnage-and-meltdown-european-bank-sales-cds-european-sovereign-debt-soar

This week’s data:

(1) housing: both weekly mortgage and purchase applications came back strong following the Thanksgiving holiday week,

(2) consumer: weekly retail sales were weak partially due to seasonal factors; weekly jobless claims declined more than expected; the University of Michigan’s preliminary December index of consumer sentiment came in at 67.5, much better than anticipated,

(3) industry: the November ISM nonmanufacturing index was reported below estimates; October factory orders were also disappointing; October wholesale inventories and sales were quite strong,

(4) macroeconomic: October consumer credit rose; the October US trade deficit was slightly less than forecast.


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.

We know what creates financial crisis (short):
http://www.ritholtz.com/blog/2011/12/the-financial-crisis-was-entirely-foreseeable/


The Market-Disciplined Investing

Technical

The Averages (DJIA 12184, S&P 1255) had another volatile week, challenging both resistance and support levels. At the close yesterday: (1) they remained solidly within their intermediate term trading ranges [10725-12919, 1101-1372], (2) having broken out of the down trend off the October high earlier in the week, then trading back into that trend on Thursday, they finished the week with a sharp rebound; coincidentally, the S&P also bounced off of its 1230 support level, (3) in the process, they continued to the formation of a reverse head and shoulders, (4) but the S&P has not been able to surmount its 200 day moving average.

Most of the above are a plus and suggest that Thursday’s pin action did not deal as big a blow to what has been a positive bias to Market as I originally thought. Nonetheless, the S&P has struggled repeatedly with its 200 day moving average (circa 1261) and has been unable to successfully challenge it. Since it looks like another assault is near, we should have a better read on the technical strength of the Market once that occurs.

Support currently exists at 11741, 1230.

Volume was low on Friday; breadth quite good. The VIX nosedived, finishing once again outside the upper zone of the current trading range--a positive for stocks.

GLD was up fractionally, closing out the week well within its intermediate term up trend, but unfortunately also within a well developed pennant formation.
http://www.investmentpostcards.com/2011/12/10/you-can%E2%80%99t-print-more-gold/

Short term the Market seems to be in decent shape technically speaking; although the volatility keeps my confidence in that statement uncomfortably low. It is a little easier to address the longer term trend which in this case is a trading range. I continue to believe that the boundaries of those ranges will hold possibly for as long as six to nine months barring a meltdown in Europe (the probability of which increased this week) or the clear sign of a massive turnover in our political class.

This indicator is not nearly as sanguine (medium):
http://advisorperspectives.com/dshort/guest/Lance-Roberts-111209-STA-Risk-Ratio-Update.php

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 (12184) finished this week about 13.2% above Fair Value (10760) while the S&P closed (1255) 5.6% undervalued (1330).

Equities (as defined by the S&P) are below Fair Value (as defined by our Model). 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. Most economic/political data/events on the home front supports this conclusion.

Europe, on the other hand, is more of a problem. Our ‘muddle through’ scenario assumes that enough would be done in the short term to stave off another crisis until at least the second half of 2012.

However, as a noted above, in my opinion, this week’s ‘agreement’ among the EU ministers is probably going to prove ineffective in holding their debt crisis at bay for any length of time, primarily because it provides insufficient liquidity, no proposals for improving economic growth and an inadequate means for the heavily indebted PIIGS to gain relief from their debt service obligations. So in the absence of additional measures the latest steps buy a month or two at the most.

Of course, the operative words in the above statement were ‘in the absence of additional measures’. Clearly, those ‘additional measures’ could be forthcoming. However, based on what we know now, the odds have increased of either a deeper recession in Europe and/or some event causing a financial stampede the eurocrats can’t contain.

That said, I am not altering either of our Models at this moment primarily because of the propensity of the eurocrats to lean as far out over the cliff as possible before pulling back and taking the next step toward correcting their problem. In other words, there is a decent likelihood of those ‘additional measures’ occurring. Nevertheless, the current crisis is acute enough that the amber light is flashing.

Having said all that, judging by Friday’s pin action, I am on the pessimistic side of Street consensus. Whether this is a function of me being wrong in my interpretation of this week’s events or the Santa Claus rally mentality simply overwhelming the facts, I haven’t a clue. However, I am less sanguine about the intermediate term which makes me more comfortable with gold and cash, less inclined to Buy and more inclined to honor short stop loss prices.

This week the Aggressive Growth Portfolio made another piss poor trade in the VIG market ETF.

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 12/31/11 10760 1330
Close this week 12184 1255

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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