Saturday, January 07, 2012

The Closing Bell-Beneath this week's calm is a lot of turmoil



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 25%
High Yield Portfolio 26%
Aggressive Growth Portfolio 27%

Economics

The economy is a modest positive for Your Money. The data was mostly upbeat this week. The only negative stats was weekly mortgage/purchase applications and those were impacted heavily by seasonal factors. The standout numbers were all employment related--weekly jobless claims, the ADP private payroll report and December nonfarm payrolls; all coming in better than expected. I view this data quite positively; and if future reports continue this strong, I may have to raise my 2012 forecast. In the meantime, they clearly support our current outlook: 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.

Domestically, the principal downside threat to this outlook is the ECRI weekly leading index which is still calling for a recession. Unfortunately, this week’s employment data does nothing to contradict the ECRI since it is very forward looking and employment is a lagging indicator. In other words, the US economy could be at the tail end of a mini recovery but is about to roll over again. That said, I am not changing our forecast at this time and indeed believe the risk of being wrong could be shifting from being not pessimistic enough to not being optimistic enough.

The latest ECRI reading showed a marked down turn:
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php

The ECRI versus leading economic indicators as the best predictor of recession (medium):
http://advisorperspectives.com/dshort/commentaries/Conference-Board-ECRI-Leading-Indicator-Smackdown.php

Of course, the 900 pound gorilla in the room is the EU and the risks associated with the eurocrats mishandling the resolution of their sovereign debt problems; those risks being:

(1) a recession born out of lack of policy clarity that does sufficient damage to the global demand that it will impact the rate of US economic recovery. As you know, our Economic Model now assumes a Greek default with the rest of the PIIGS ‘muddling through’. However, the current maddenly slow pace of reform I fear will lead to ‘[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.’

This in turn may ultimately lead to a downward revision in the growth assumptions in our Economic Model depending on severity of [a] and [b] above.

However, that aside, our Valuation Model may already be getting impacted to the extent that the persistent uncertainty surrounding either endless eurocrat procrastination or a sudden collapse of the Markets as they get fed up with endless eurocrat procrastination is acting as a governor on equity multiples.

(2) multiple bank and country defaults that lead to a collapse in the EU credit default swaps market which in turn results in an abrogation of counterparty obligations that negatively impacts US bank balance sheets as much as or more than Lehman Bros. While there is plenty of data around measuring both our financial system’s gross and net CDS commitments, it is very uncertain [a] what the probabilities are of a party being unable to meet its CDS commitments, [b] if that were to occur, what the ‘snowball’ effects would be and [c] what, if any, steps would or could be taken by government to mitigate the losses.

The ultimate bad news scenario here is that US financial institutions’ gross exposure becomes their net exposure--which would wipe out the capital of our entire banking system and then some. Because there are so many unknowns associated with such an occurrence, it makes it a bit scary.

Bottom line: our Economic Model remains unchanged though I may have to adjust it upwards if we continue to get better than expected US economic data. On the other hand, there are two scenarios that could cause a downward revision: (1) the eurocrats continue to follow policies that will result in a severe case of Japan 2.0 that lasts decade or two or (2) another round of US bank capital destruction stemming from the exposure to counterparty risk in the EU financial derivatives market.

In addition, I may have to negatively alter our Valuation Model based on what I think could be a continuing global hesitancy to invest and spend because of uncertainty over the apparent unwillingness of the EU political class to face and develop a workable remedy to their sovereign debt problem.

One final note on our ruling class. This week’s actions by Obama: multiple ‘recess appointments’ and reducing defense spending without comparable cuts in nondefense and entitlement spending indicates that (1) absolutely nothing will get done in Washington till January 2013 and (2) this election is going to be highly partisan even by our own standards. That is not necessarily a negative in that (1) doing nothing is better than doing something harmful and (2) our Model has an inept political class priced in.

This week’s data:

(1) housing: weekly mortgage and purchase applications fell but those numbers were heavily influenced by seasonal factors,

(2) consumer: weekly retail sales were mixed, while December sales were positive following a weak showing last month; December auto sales improved; weekly jobless claims fell more than anticipated, the ADP private payrolls report was strong and December nonfarm payrolls rose more than expected,

(3) industry: the December Institute for Supply Management manufacturing index was up more than estimates while the nonmanufacturing was up less than forecasts; November construction spending was up more than double expected; November factory orders were up slightly less than anticipated,

(4) macroeconomic: none.


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 last two weeks may have been the least volatile weeks in the Markets in months. It was almost boring. On the other hand, it is a lot easier to invest in this environment than what we have been going through.

In any case, the indices (DJIA 12359, S&P 1277) finished the week well within their intermediate term trading ranges (10725-12919, 1101-1372); and on Friday, they confirmed the break above the neckline of the reverse head and shoulders about which I have frequently spoken. As fate would have it, the upside target from this break would be roughly S&P 1360-1370 which dovetails nicely with the upper boundary of the current trading range (1372). Resistance exists at the 200 day moving averages (11955, 1259) and the neckline of the reverse head and shoulders (12287, 1266).

Technically speaking, I think that the Market is set to go higher. However, this is most likely, in my opinion, a short term trading opportunity at best (too many stocks hitting their Sell Half Price, Fair Value = 1336 and Europe) and, if I am correct, therefore, for only the nimble of foot. I am tempted to make a trading buy of the VIG in the Aggressive Growth Portfolio; but given my last three trades, I am feeling a little snake bit.

Volume was lower on Friday; breadth weakened again. The VIX continued to sell off--a plus for stocks.

GLD (157) sold off yesterday, thus remaining below its 200 day moving average. However, as you know, it has bounced off its 300 day moving average, broken above the 153 support, turned resistance level and made a new short term high. As you also know, our Portfolios recently re-established a small position in GLD. No further purchases will be made until that 200 day moving average barrier is successfully challenged.

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 (12359) finished this week about 14.3% above Fair Value (10805) while the S&P closed (1277) 4.4% undervalued (1336). 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.

Unfortunately, I know that some of the assumptions behind that ‘Fair Value‘ judgment are going to change and probably sooner rather than later. However, the factors, especially those relating to a resolution of the EU debt crisis, that will influence those assumptions are multiple, disparate and of sufficient magnitude and uncertainty that any alteration of our Model at this point would be meaningless and potentially misleading. So I am settling with a coward’s way out: recognize that changes are coming, discuss the potential sources of those changes but plead ignorance/incompetence in assessing their potential likelihood. With that:

As I suggested in the Economics section, this week’s employment data was quite impressive; and were it to continue, I would likely need to raise the growth assumption is in our Economic Model. All other things being equal that would be a positive for corporate earnings and would in turn necessitate a similar upward revision of our Valuation Model. Unfortunately, this weekly ECRI reading once again turned negative; and this makes me very circumspect about making any immediate changes to either our Economic or our Valuation Models.

Further, as disappointing as it may be, our political class appears incapable of doing anything to positively affect Valuations. Of course, the good news is that they are also unlikely to foist any more obnoxious regulation and legislation on us that would cause a downward revision in our Model.

Europe, on the other hand, continues to keep the risks to both our Models very high. The eurocrats have to do something to deal with their unsustainable budget deficits. So far their propensity has been to do only as much as is absolutely necessary to keep their house of cards from collapsing.

Now, there are scenarios whose outcome and impact on our Models would not be terribly bearish, at least in the intermediate term (Germany allows the issuance of joint and severally backed ‘eurobond’ or the ECB to print money); but neither I nor anyone else I can find has a clue as to the likelihood of their occurrence.

On the other hand, a Japan 2.0 scenario in which eurocratic intransigence keeps fears of global investment and consumption constipation at elevated levels suggests that the assumed multiples in our 2012 Fair Values may be too high. That said, the range of potential outcomes to this scenario is so wide that making a forecast ahead of further clarity seems symbolic at best and a waste of time at worst.

Of course, in my opinion, the biggest risk to both our Models is the true net exposure of our banking system to EU credit default swaps market. The problem is that we simply don’t know what will happen 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’.

Finally, I expect the dollar to maintain its recently acquired status of being the least of all evils. If that occurs, then sooner or later it will likely have a negative affect on the earnings of multinational companies (Economic Model) though that may be offset by a positive impact on US asset prices (Valuation Model). As an aside, it could also act as a restraint on GLD; but this last week the recent dollar/gold inverse relationship seems to be decoupling.

All said, I have little concrete reason to believe that stocks will move up or down enough to break their current trading ranges. But to be sure, there are plenty of factors that can drive prices to either of their trading range limits. That said, given current equities’ valuation and their relative position within their trading ranges, the downside risks appear to out weigh the upside opportunities; so caution seems the better part of valor.

This week our Portfolios Bought back one third of their GLD positions and Sold several stocks that traded into their Sell Half Range.

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 2012 Year End Fair Value* 11300 1400
Fair Value as of 1/31/12 10805 1336
Close this week 11886 1219

Over Valuation vs. 1/31 Close
5% overvalued 11345 1402
10% overvalued 11885 1469
15% overvalued 12425 1536


Under Valuation vs. 1/31 Close
5% undervalued 10264 1269
10%undervalued 9724 1202 15%undervalued 9184 1135

* 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.