Saturday, January 28, 2012

The Closing Bell--Less downside, but no more upside



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 26%
Aggressive Growth Portfolio 27%

Economics

The economy is a modest positive for Your Money. This week was slow with regards to the release of economic data; and most of that reported was negative: three poor housing numbers, higher jobless claims, lackluster retail sales and a lower than expected fourth quarter GDP figure--though in fairness, it was an improvement over third quarter GDP. However, it wasn’t all bad news, as consumer sentiment and December durable goods orders came in above estimates.

Given our sluggish growth forecast, a mixed to negative week like this shouldn’t raise any particular concerns but that is especially so when (1) there is not that much data in first place and (2) it follows a period of solidly positive numbers. So our outlook remains: ‘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.’

In addition to the economic stats, our forecast got a boost this week from two other sources:

(1) an inept political class that will do nothing to improve the chances of a more robust recovery: Obama’s state of the union address served as pretty conclusive evidence that He hasn’t a clue about what ails our economy or how to fix it. The only goods news is that entire political class is so at odds with itself that Washington will be in vapor lock until at least January 2013; so at least we will be spared any more costly, inefficient, moronic policy initiatives. First do no harm.

(2) a rising rate of inflation: the Fed’s extension of its accommodative monetary policy to the middle of 2014. This will simply provide more time and opportunity for investors/businesses/the economy to begin aggressively drawing down all that liquidity [excessive bank reserves] on bank balance sheets and ignite an inflationary impulse. It will also likely mean that the Fed will add even more assets of questionable quality to its own balance sheet making it harder for the Fed to unwind its massive injection of money into the banking system [remember two weeks ago, it tried to sell some of these assets with very disappointing results; what a surprise, no bank wants that crap back on its own balance sheet].
http://www.ritholtz.com/blog/2012/01/living-in-a-qe-world/#more-75249
http://www.ritholtz.com/blog/2012/01/zero-rates-through-late-2014-puhlease/

On the other hand, having that extra liquidity on bank balance sheets should help avoid a Lehman like crisis if the European solvency problem ultimately ends in multiple bank/country defaults/restructurings that lead to counterparty failures in the credit default swap market.

The good news I suppose is that both of these outcomes [i.e. higher inflation, but a lesser risk of another Lehman Bros] support the assumptions in our Models.

That said, there are enough conflicting data to raise the possibility that the economy could be either:

(1) stronger than our forecast. The largely unbroken string of positive stats in December suggested that the rate of recovery could be rising sufficiently to render our growth assumptions too pessimistic. More recent data belie that scenario; but it will take a couple more weeks of ‘mixed’ numbers for me to dismiss it.

(2) or weaker than expected. As you know, the chief source of this bit of cognitive dissonance is the ECRI weekly leading index which has made a very firm call for a recession; and given its track record, one has to respect this prediction.

The good news is that the last four or five weekly readings have been trendless at best; and this week the ECRI index improved again. As strong as the narrative is from the developer of this index, the readings, at least as of this week, are not negative enough to alter the probability of recession in our Model. Nevertheless, I am watching this indicator warily.
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php

The bad news is that the just released revisions to the index of leading economic indicators do not make happy reading; and, as had been predicted by Doug Short last week, lend major support to the ECRI call.
http://advisorperspectives.com/dshort/commentaries/Conference-Board-Leading-Economic-Index-Revisions.php

To which I add one more bit of distressing analysis [today’s must read]:
http://advisorperspectives.com/dshort/guest/Lance-Roberts-120127-Q4-GDP-Prognosis-Still-Negative.php

All that said, the major threat to our forecast remains the risk that the eurocrats will mishandle the resolution of their sovereign debt problems. The latest example of their ineptitude is the inability to structure a Greek default. The universe knows this country can’t be salvaged in its current state and it knows that there is no painless solutions.

If the euros would just pick a course of action and go with it (1) the Markets would probably respond positively and (2) it would provide some comfort and support to those investors who believe that Europe can ‘muddle through’. Unfortunately, they are not going to be really pressured to make that choice until March when Greece runs out of money. So in the short term, the operative scenario is to ‘muddle through’ [i.e. the eurocrats do only enough to prevent Europe from falling off a cliff is still operative].

That is, unless it proves ‘the straw that breaks the camel’s back’ and unleashes the major long term risk in this crisis--the political class can’t/won’t make a decision, investors tire of their lack of will and courage and either refuse to support them or panic. That then leads to multiple bank/country defaults/restructurings that result in a severe economic contraction not only in Europe but in the global economy and could include the possibility of sufficient dislocations in the EU debt derivatives market that counterparty obligations are abrogated and the financial system implodes.

Having said that, the recent implementation of the new ECB funding program has served to lessen liquidity strains, push out the time frame and potentially lessen the severity of the above disaster scenario. In addition, our own Fed’s move this week to enhance liquidity in the US may also likely serve a preventive function. While all this increases the odds of our ‘muddle through’ scenario in the short run, in reality, it only provides breathing room during which the eurocrats must do the heavy lifting on their more significant problem, i.e. reducing spending and debt. Regrettably to date, virtually nothing on this score has been done. ‘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?’

Bottom line: the current US economic data and political environment support our forecast. Likewise Europe is following its ‘muddle through, Japan 2.0’ script to a tee. For the moment that leaves our Economic Model unchanged, though with the recent action of the ECB and the Fed, the magnitude of the downside risk has been mitigated somewhat. Unfortunately, nothing has been done to improve the upside. This all leaves me sanguine but cautious about 2012.

This week’s data:

(1) housing: weekly mortgage and purchase applications dropped big time; both the December new home sales and pending sales fell more than expected,

(2) consumer: weekly retail sales were mixed; weekly jobless claims rose more than anticipated; the University of Michigan’s final January index of consumer sentiment came in at 75.0 versus forecasts of 74.5 and January’s preliminary reading of 74.0,

(3) industry: December durable goods orders were better than estimates,

(4) macroeconomic: December’s leading economic indicator rose less than expected; the initial fourth GDP report was less than anticipated.

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 indices (DJIA 12660, S&P 1316) lost some of its upward momentum this week but still closed in the upper reaches 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: 12207, 1261).

This temporary rest break notwithstanding, the bias remains to the upside. Helping sustain the up trend are a plethora of near in support levels: (1) the neckline of the reverse head and shoulders pattern [12287, 1266], (2) their 200 day moving averages [11967, 1256], (3) the aforementioned lower boundary of their short term up trends [12207, 1261] and (4) the old resistance/support level [11741, 1230].

In addition, (1) neither index is hampered by resistance between current levels and 12919, 1372, (2) the upside objective of recent break above the reverse head and shoulders is S&P 1360-1370, (3) the S&P 50 day moving average [1255] is a short hair away from the 200 day moving average [1256]; a ‘cross’ would be bullish for stocks and (4) finally, the VIX [18.5] remains in a solid down trend; also positive for equities--although, I would note that major support exists at 15.5.

The one lone technical negative is the major resistance offered by the 12919, 1372 level.

Unfortunately, this hugely positive technical picture is at odds with the fundamentals which center around valuation (1) Fair Value for the S&P [1336] and (2) the proximity of a number of our holdings to their Sell Half Ranges. Ultimately, one of these two conflicting factors has to overwhelm the other--either stock prices flatten or roll over or my perception of the fundamentals change for the positive.

Historically, I have been the most comfortable paying the closest attention to the fundamentals, following the lead of our Price Disciplines and forcing the Market to prove me wrong. As you know that is the strategy I now pursue. If I am wrong, it won’t be first time. I’ll adjust.

Volume was higher on Friday; breadth was mixed. As noted above, the VIX fell, remaining in a well defined down trend.

GLD was up again and appears to be re-gaining its former luster.

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 (12660) finished this week about 17.2% above Fair Value (10805) while the S&P closed (1316) 1.5% 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.

Virtually all the fundamental factors (the strength of the US economic recovery, the Washington stalemate, the agonizingly slow pace of resolving the EU sovereign debt crisis) most likely to impact our forecast are tracking the assumptions in our Models. The things that have changed of late have been (1) a more erratic flow of data in the US, (2) the new ECB funding facility and (3) this week’s Fed extension of accommodative monetary policy. But these new developments only make the case for our forecast stronger.

Of course, the latter two do reduce the magnitude of our worse case scenario; and that is a plus. Regrettably, they do nothing to improve the upside. So while the potential volatility of results is less, the base case for our forecast and current valuations is unchanged.

The point of all this is that while I am not negative and indeed feel less concerned about global events going off track, by my analysis, stocks are, in general, fairly valued and, in some cases, richly so. I developed our Price Disciplines specifically to force action when the latter circumstance occurs; and it is a strategy that has served me well. That is why I have been acting on the Sell Discipline the last two weeks and will continue to do as long as valuations (as defined by our Model) are dramatically out of line.

This week our Portfolios continued to reduce the size of their holdings in both fundamentally and technically overextended stocks. In addition, they Added to their GLD position.

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 12660 1316

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.


1 comment:

  1. This comment has been removed by a blog administrator.

    ReplyDelete