Saturday, January 21, 2012

The Closing Bell--Can this rally last?

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):
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 22%
High Yield Portfolio 25%
Aggressive Growth Portfolio 25%


The economy is a modest positive for Your Money. The data this week was mixed, although there was a positive bias. The pluses included weekly mortgage and purchase applications, December existing home sales, weekly retail sales, the NY Fed business index and--the standout--declining weekly jobless claims; December new home starts was the major negative. Finally, I would term as mixed December industrial production, the Philly Fed index and the inflation numbers.

All in all, not bad and fairly reflective of 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.

Supporting the inept-yet-burdensome-government assumption in this thesis was Obama’s determination this week to ‘conditionally’ reject the Keystone Pipeline project. There is absolutely nothing beneficial to decision other than to pander to the environmental lobby; and it only illustrates that 2012 will be a lost year in the sense of any progress being made in correcting irresponsible government fiscal and regulatory policies.

Unfortunately, the republicans are doing everything possible to prolong this scenario:

Of course, I am always worried about where our forecast could go awry One way would be the resumption of the almost universally positive string of economic stats that we witnessed in December which would portend a stronger recovery than is in our outlook. That thesis was helped this week by the upbeat data in housing and employment, two indictors that have long been a drag on the economy. However, given the oft repeated headwinds that the US economy faces, I need a longer period of sustained improving data before revising upward our forecast. Nevertheless, it still remains a risk to outlook that I may be underestimating the natural recuperative power of the US economy.

On the other hand, I am equally concerned about the recession call by the very forward looking ECRI weekly leading index given (1) its track record and (2) the likelihood of a major revision in the computation of the leading economic indicator which may also show a weakening economy [see Thursday’s Morning Call for a more detailed discussion].

This week’s ECRI reading reversed again to the upside which helps keep its latest recession call from becoming a slam dunk.

It may seem confusing and contradictory to be simultaneously fretting over the economy being either stronger or weaker than our forecast. However to me, it actually serves to support it, in that multiple forces pulling the economy in opposite directions probably insures that it will progress much as I anticipate.

All that said, the major risk to our outlook comes not from within but from Europe, specifically the potential that the eurocrats will mishandle the resolution of their sovereign debt problems. To be sure, the recent implementation of the new ECB funding program has served to lessen liquidity strains and diminish the possibility of a disaster scenario. That clearly is a positive. Indeed, it raises substantially the probability that our ‘muddle through’ scenario will prove correct.

On the other hand, it only buys time for the eurocrats to do the heavy lifting on the more significant problem, i.e. reducing spending and reducing debt; and unfortunately, little has been accomplished on that score. So this play is nowhere near its last act; and to be clear, the last act is going to involve pain. The only question is, how severe will it be?

If the eurocrats elect to continue on the current course that they are on, that is, do only enough to prevent Europe from imploding, then our ‘muddling through’ forecast will likely best portray the EU economy for the next decade as it moves from mini crisis to mini crisis struggling to reduce debt and reduce expenditures and failing to produce growth. This may be the least painful scenario in the short term but it ultimately becomes a decade long Chinese water torture, stifling progress and growth in Europe and contributing nothing to global growth (Japan 2.0).

Regrettably, it also leaves open the possibility that investors will tire of the eurocrats lack of will and courage and either refuse to support them or panic. Whichever might occur, the result would be a much more severe economic contraction not only in Europe but in the global economy and would include the possibility of (my biggest fear):

‘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.’

This from Gary Shilling (medium):

Bottom line: virtually all the current data and political developments both here and abroad support our forecast; so our Economic Model remains unchanged; There are risks, of course, including but not limited to a roll over in the US economic growth and a change for the worse in either investor or the EU electorate’s patience with a bumbling European political class that leads to multiple bank and/or country defaults and severe recession.

However, just to be clear, our’s is a positive outlook. It is just tempered by the reality that much work has to done to return both our government and the EU to a sound fiscal basis; and that involves below average secular growth as the Western world deleverages.

This week’s data:

(1) housing: weekly mortgage and purchase applications rose strongly again, though seasonal factors influenced these numbers; December housing starts fell much more than an anticipated, while existing home sales [by far the larger market] rose in line with forecasts,

(2) consumer: weekly retail sales were up; weekly jobless claims plummeted,

(3) industry: December industrial production was slightly below expectations; there were somewhat conflicting signals from two January regional Fed business indices--the NY Fed’s came in up and better than estimates while the Philadelphia Fed’s was up but below forecasts,

(4) macroeconomic: December PPI headline number was very positive [down versus expectations of up] while the core PPI was exactly the opposite; December CPI headline and core figures were reported as estimated.

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.

The Market-Disciplined Investing


The indices (DJIA 12623, S&P 1314) had another great week, closing near the upper boundaries of their intermediate term trading ranges (10725-12919, 1101-1372) and well above the lower boundaries of the short term up trends off the October 2011 lows (current intersect: 12070, 1248).

Clearly, the very positive technical bias continues unabated, suggesting more of the same in upcoming weeks. The numerous factors contributing to this positive outlook include:

(1) there is almost no resistance between current price levels and 12919, 1372,

(2) the upside target for the recent break above the reverse head and shoulders formation is S&P 1360-1370,

(3) the Averages have a number of near-in support levels [a] the neckline of the reverse head and shoulders pattern {12287, 1266}, [b] their 200 day moving averages {11961, 1257}, [c] the aforementioned lower boundary of their short term up trends {12070, 1248} and [d] the old resistance/support level {11741, 1230},

(4) the S&P 50 day moving average [1248] continues to close on the 200 day moving average [1257]. The intersection and penetration of the 200 by the 50 day moving average, commonly referred to as a ‘golden cross’, is viewed very positively by technicians,

(5) the VIX fell another 8% Friday, busting to the downside of what looked like a developing base. Further declines would be a sign of improving stock prices.

As overwhelming as this assortment of up beat indicators is, there are persuasive counter arguments to the notion that stocks will shoot the moon; among them the number of stocks either in or near their Sell Half Ranges or significant resistance levels, the current Fair Value of the Market--S&P 1336 as computed by our Valuation Model, the fact that the upper boundaries of the current trading ranges offer resistance and the overhang of unfinished business on the EU debt crisis.

So at least in my analysis, equity prices are at or close to a critical juncture. On the one hand, stocks are nearing the upper boundary of a trading range with a momentum that seems unstoppable; on the other, our Valuation Model is giving multiple signals that stocks in general are fairly valued while a goodly number are expensive on an historical absolute and relative basis.

Situations like this when the technicals and fundamentals are dramatically at odds are confounding at best and can be gut wrenching affairs. But that is not an argument for doing nothing. My strategy has always been to listen to (my version of) the fundamentals until the Market tells me that I am wrong--and in this case, that won’t happen until the Averages confirm a break over 12919,1372. So for the moment, my focus is on the fundamentals specifically our Sell Discipline; if the Market ends up proving that judgment wrong, then I will take my lumps and adapt.

Volume was higher on Friday but that was related to option expiration activity; breadth was mixed though the flow of funds indicator was quite strong. Finally, as I noted above, the VIX sank another 8% leaving it firmly in a down trend.

Where’s the volume?

Stock price/bond yield disconnect (short):

GLD was up yesterday, closing above its 200 day moving average and the lower boundary of its short term up trend.

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 (12720) finished this week about 17.7% above Fair Value (10805) while the S&P closed (1314) 1.6% 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.

To quote from last week:

Two assumptions in the above statement seem to tracking as I had expected; that is, (1) the most recent data support the view that the secular growth rate of the economy is presently distinctly sub par and likely to remain so without some changes in policies governing spending, taxation, regulation, trade and money supply and (2) that is probably not going to happen until at least early 2013 and perhaps not then.

That leaves investors, entrepreneurs, business men and consumers to rely on their own ingenuity to overcome (1) above and then to attempt to create value. The good news is that seems to be happening in a limited way right now and for that we have to be thankful. But I believe that the headwinds are simply to powerful to enable the economy to recover at an historically normal pace without removing the obstacles presented by an over active, inefficient, economically ignorant and far too paternalistic government.

Furthermore, as I noted in the first paragraph of this section, much of the progress that either has been and is being made is decently reflected in current stock prices. Sure there remains a gap between current prices and Fair Value. But that gap is small and very general in nature. Meanwhile, there are plenty of stocks that have reached extraordinary valuations, at least as computed by our Model. To be sure, there is some chance that economic growth may improve more than I am forecasting; but it is not going to move the needle on valuations by much. Bottom line: none of the above makes me overly anxious to put money to work. (note: only the technicals do)

The point of all this is that (1) I am not negative on the prospects for growth in the US, I just think that they we will be sub par, (2) nor am I betting that Europe will implode, I just think it will not grow until it has solved its fiscal problem, (3) nor do I believe stocks prices are in for a fall. What I am saying is that to the extent that our forecast is a positive one, it is well reflected in current valuations in general and richly valued in some specific cases--and as a money manager, right now I have to address the latter. Reflecting that, this week our Portfolios Sold small portions of a number of either fundamentally or technically overextended stocks; and if prices continue to advance, additional sales can be expected. Our Portfolios also Added to their GLD holdings.

This from Morgan Stanley (medium):

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.


Current 2012 Year End Fair Value* 11300 1400
Fair Value as of 1/31/12 10805 1336
Close this week 12623 1314

Over Valuation vs. 1/31 Close
5% overvalued 11345 1402
10% overvalued 11885 1469
15% overvalued 12425 1536
20% overvalued 12966 1603

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.