Saturday, January 14, 2012

The Closing Bell-No improvement in Europe; but then no one cares

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


The economy is a modest positive for Your Money. There was little data this week and most of it was negative--though there were some bright spots: consumer sentiment and the Fed’s latest Beige Book. However, I don’t view the disappointing stats as concerning because we have had such a positive flow over the last couple of months. Indeed, if the numbers kept improving unabated for much longer, I would have to raise on estimates of 2012 US economic performance.

Not that I wouldn’t be delighted to do it. I am simply saying that a forecast of a below average secular recovery presupposes an erratic data flow and this week’s numbers fit that pattern. Hence 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.

Also increasing my confidence in our forecast was some additional developments this week: (1) a request by Obama to raise the debt ceiling another $1.2 trillion [too much debt to service] and (2) a less than successful attempt by the Fed to sell some of its non Treasury debt holdings [the inability of the Fed to properly time the reversal of that monetary policy].

That said, I am always worried about where I could be wrong. One reason, which I mentioned above, is a steady and extended string of up beat economic numbers depicting better growth than I am anticipating. That clearly is not bad; it would simply render our forecast is too pessimistic.

A second is the complete opposite concern: the recession call by ECRI weekly leading index which has an admirable record of predicting economic trends. While its forecast flies in the face of the recent positive flow of economic reports, given its past performance, it has to be respected.

The latest ECRI reading posts another decline:

In the end, however, the above two worries are warts on a goat’s ass. The elephant in the room is the EU and the risks associated with the eurocrats mishandling the resolution of their sovereign debt problems. While a relative calm has existed over this issue since the new year began, I don’t envision it lasting for no other reason than that little has been done to address the underlying causes of this crisis: too much sovereign debt to service and too much of that debt on the balance sheets of the EU financial institutions.

Our (and the globe’s) problem is that we simply don’t have any clarity as to the aforementioned resolution of these issues. Even worse, irrespective of whether the eurocrats finally decide on and implement a corrective path or the Markets do it for them, there is no painless solution; it will simply be a matter of degree. I have covered various alternatives at length in these pages, so I will only summarize the most likely:

(1) ‘muddling through’ whereby just enough is done to keep most nations and banks afloat but which requires a decade or more of the gradual trimming of spending and debt, leaving few resources to create growth, i.e. Japan 2.0. This will almost surely include periods of intermittent mini crises that will not only spawn recessions in Europe but will likely impact global growth as well,

(2) a much more severe recession or a depression brought on by investors either tiring of the endless eurocratic procrastination or panicking in the midst of one of the mini crisis mentioned above that results in the sudden collapse of the Markets and global economic activity,

(3) and/or, 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. 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.’

Bottom line: our Economic Model remains unchanged. The good news is that, this week’s data notwithstanding, economic conditions could be improving faster than I thought which could lead to an upward adjustment to our forecast. The bad news is that the EU debt crisis in not going away; and the most positive outcome--muddling through--acts to reinforce the restraining factors in our own economy, keeping a governor on our own growth.

On the other hand, the other two more depressing scenarios would result in a serious downward revision to our outlook: (1) a ‘muddling through’ gone bad version in which investors’ panic drives down securities markets that in turn severely restrain global investment and consumption or (2) another round of US bank capital destruction stemming from the exposure to counterparty risk in a collapsing EU financial derivatives market.

This week’s data:

(1) housing: weekly mortgage and purchase applications rose strongly,

(2) consumer: weekly retail sales were mixed to negative, while December chain store sales were well below estimates; weekly jobless claims were a bust; the preliminary January University of Michigan index of consumer sentiment came in at 74.0 versus forecast of 71.8 and a final December reading of 69.9,

(3) industry: both November wholesale and business inventories were below expectations, though sales did fine,

(4) macroeconomic: the Fed Beige Book had a surprising up beat narrative; November consumer credit skyrocketed; and the November US trade deficit was larger 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.)


The domestic political environment is a neutral but could be improving for Your Money while the international political environment remains a negative.

The latest from Europe (medium):

A primer on the latest ECB lending facility (medium):

The reality of our situation and it is not great (another must read):

Russia now getting involved in the Middle East turmoil (medium):

The Market-Disciplined Investing


The indices (DJIA 12422, S&P 1289) finished the week within 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: 11977, 1238).

Technically speaking, stocks seem likely to continue to rise for a whole host of reasons:

(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 {11995, 1257}, [c] the aforementioned lower boundary of their short term up trends {11977, 1238} and [d] the old resistance/support level {11741, 1230},

(4) finally, Europe was back in the news Friday [see below-S&P downgrades the rating of multiple countries and Greek bail out talks break down]: and while the Market was down, it closed well off its lows--raising the obvious question of how much bad news from Europe is already in the price of stocks. I am not convinced that the recent Market calm means that a bad news EU scenario is discounted; however, I was surprised by the nonchalance with which these latest developments were greeted and that gives credence to the notion that going forward, the EU debt crisis will have less impact on the Market than I have been assuming.

That said, I believe that the 12919, 1372 are about as far as stocks can go, making the risk/reward on technical grounds not that appealing. Add to that the number of stocks either in or near their Sell Half Ranges, the current Fair Value of the Market – S&P 1336 as computed by our Valuation Model and the overhang of unfinished business on the EU debt crisis and I am content to do nothing at present. However, if the Market remains impervious to negative events in Europe, I will have to reassess my more conservative assumptions in our Models. In the meantime, really aggressive traders might want to play this rally.

Volume was higher on Friday while breadth declined. The VIX rallied but is still trending down--a plus for stocks.

GLD sold off yesterday and closed right on its 200 day moving average. Under the rules of our time and distance discipline, four days above a resistance level normally constitutes the confirmation of a break. However, given the magnitude of yesterday’s retreat and the fact that it closed right on the trend line, I am waiting one more trading day to make that call in order to be sure GLD will bounce off of rather than penetrate this important support/resistance indicator.

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 (12422) finished this week about 14.9% above Fair Value (10805) while the S&P closed (1289) 3.5% 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.

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.

This is an excellent piece by Van Hoisington and Lacy Hunt explaining with more technical flourish and detail the basis for our forecast (a must read):

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.

Of course, if that was all I had to worry about, then I would be a happy dude. Unfortunately, even forgetting China, which may or may not be slipping into a recession or turmoil in the Middle East which may or may not occur, we know that mathematics of the EU debt crisis, we know that virtually nothing has been done to deal with the root causes of the problem and we know that there is no easy, painless solution.

On the other hand, we also know that the recently implemented ECB funding program has bought time for the eurocrats to craft a solution that deals with the causes. That, at least in the short term, is a positive and partially explains why I am sticking to our Models’ assumption of a ‘muddling through’ scenario.

That said, given the long history of eurocratic procrastination, there is clearly a reasonable probability of a worse outcome. The problem I have reflecting this more negative view in our Models is not that I don’t know what a depression in Europe or severe strains in the derivatives Markets would look like, it is that I have no clue when the last straw gets put on the camel’s back. Is the jig up tomorrow or three years from now?

The news out of Europe on Friday is a perfect example of this dilemma: the negotiations on the second Greek bailout broke down. Now I expect a Greek default; most of the world expects a Greek default. But the eurocrats simply can’t get their s**t together on the easiest problem with which they have to deal. It is this lack of will and every subsequent incident of bureaucratic calcification that has the potential of being the aforementioned proverbial straw--we just don’t know which one will cause the break and when.

The best I can do is take the values produced by our Models, acknowledge that there is a reasonable chance that they could at some time be way too optimistic and invest accordingly. That means that until we get some clarity to the EU sovereign debt problem, I am assuming that equities have little upside from current level, that I need to pay very close attention to our Sell Discipline and that while I not let myself get antsy about owning a lot of cash, to be vigilant for signs that the Market has discounted more of the European problem than I now believe.

As a final note, the S&P lowered the credit ratings of several EU countries. That wasn’t disastrous news because it was anticipated. However, its critique of EU policy forthrightly describes the problem of eurocratic inaction and as such is a must read.

This week our Portfolios took no action.

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 12422 1289

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.