Saturday, February 04, 2012

The Closing Bell-By our work, the Market is at Fair Value

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. Lots of datapoints this week. They were basically mixed but tilted to the positive side primarily because the January nonfarm payrolls number was a blow out. This is the kind of stat that provides real weight to those who are arguing for no recession--which, as you know, I am. On the other hand, there is nothing in data to suggest that the current recovery will be anything close to ‘normal’. Thus, our forecast 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.’

Further supporting our outlook were:

(1) Obama’s new attempt to give more of Your Money away [too much government spending], this time to under water mortgage holders. The good news is that this measure has a zero chance of getting through congress,

(2) recent data that shows that the Fed has been the buyer of over 90% of net new US government debt issued since the debt ceiling was raised [excessive money creation].

Why rising inflation is inevitable (medium):

On the other hand, the gangbusters nonfarm payroll number:

(1) will almost surely provide sustenance to those that hope that the economy is rebounding at a more normal rate; and that clearly is what fueled Friday’s strong stock performance. However, before getting too jiggy, consider that this stat can’t be looked at in isolation. [a] just this week, we received poor housing figures and mixed industrial data. So everything is not coming up roses. [b] the payroll stat is seasonally adjusted. The unadjusted figure was actually a huge negative. I am not arguing that the reported number is bogus; I am suggesting that a few more datapoints are needed before tip toeing through the tulips. [c] employment is a lagging indicator. The leading indicators are not suggesting anything other than a sluggish recovery, [d] even if I concede that this increase in employment could be a signal that the economy may grow faster than I am assuming, there isn’t a lot of supporting data right now.

Bottom line: the payroll number suggests that there is a possibility that I could be underestimating the strength of the current recovery; however at the moment, the preponderance of evidence provided by other economic indicators argues against a change in our forecast or valuations.

(2) does diminish the probability of a double dip. As you know, what has kept me focused on the risk of a second recession is the latest call by the founder of the ECRI weekly leading index because of its forecasting record. That said, the readings from this leading indicator have been anything but conclusive of late; and when coupled with this strong lagging indicator, it reinforces my hesitancy to get too worried that a down turn was in our immediate future.

And speaking of an inconclusive ECRI, it improved again this week:

More detail on the NFP number (short):

Of course, the real risk to our forecast remains an inept European political class that bungles their sovereign debt problem. Greece continues to be the primary focus of their ineptness. They simply can’t agree on the terms of a bankruptcy even though it is clear that Greece is hopelessly insolvent. Worse, the eurocrats will probably continue to dick around for another month since Greece doesn’t run out of money until late March.

Aiding and abetting this lack of will is the recent implementation of a new EU funding policy. While it may buy some time, the risk is that the longer the eurocrats avoid acting, the greater the risk that bond holders will tire of their procrastination or panic as Portugal/Italy slide toward bankruptcy. The result would not be pretty as multiple bank/countries default and Europe plunges into a deep recession that includes the possibility of an implosion of the financial system.

Here is another inside look at the derivatives market and the risk that exists there (medium):

The good news is that the aforementioned credit facility along with further easing of our Fed does buy time, does potentially lessen the damage from Greek default/restructuring and, if supplemented with meaningful fiscal reforms throughout the EU, could ring fence the Greek problem and cement our ‘muddling through’ scenario. However, I would emphasize that even this ‘positive’ outlook implies flat to little growth long term (Japan 2.0); and, therefore, it will do nothing to improve the outlook for the US economy.

Bottom line hasn’t changed much from last week: the current US economic data and political environment support our forecast. Europe, at least in the short term, continues to ‘muddle through’. ‘For the moment that leaves our Economic Model unchanged, though with the recent action of the ECB and the Fed (and I would add Friday’s payroll report), 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 fell; the November Case Shiller home price index continued to decline,

(2) consumer: weekly retail sales were mixed; January auto sales were strong; December personal income rose slightly more than anticipated while personal spending was less than expected; weekly jobless claims dropped more than projected; the January ADP private payrolls report was a little below estimates while January nonfarm payrolls soared far beyond forecasts; the Conference Board’s January index of consumer confidence was well below expectations,

(3) industry: the January ISM manufacturing index was a bit light of estimates but the nonmanufacturing index was well above forecasts; December factory orders were less than anticipated; December construction spending came well above expectations; the Chicago purchasing managers index was less than estimates,

(4) macroeconomic: fourth quarter nonfarm productivity was better than anticipated, but unit labor costs soared.

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 12862, S&P 1344) reclaimed their upward momentum this week helped along by a ‘golden cross’ and that positive payroll number. They remain 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: 12326, 1273).

The upside objective, in my opinion, continues to be the upper boundaries of the current trading ranges since (1) there is almost no resistance between current prices and those levels and (2) the target set by the recent S&P break out above the reverse head and shoulders pattern is in the 1360/1370 vicinity.

In addition, I checked with our internal indicator with the following results: as of the close Friday in a Universe of 162 stocks, 56 had exceeded their comparable 12919/1372 level, 71 had not and 35 were too close to call. Historically speaking, that is not a sign that stocks are about to break to the upside. That is not to say that they ultimately won’t; it is simply to say that there has to be a lot more improvement in breadth to get a confirmed break above 12919, 1372.

If I am correct and the 12919, 1372 level holds, support exists at: (1) the neckline of the reverse head and shoulders pattern [12287, 1266], (2) their 200 day moving averages [11985, 1257], (3) the aforementioned lower boundary of their short term up trends [12326, 1273] and (4) the old resistance/support level [11741, 1230].

If I am wrong and a break above 12919, 1372 is confirmed, there is very little resistance until the October 2007 highs (14190, 1561) are reached.

As you know, I am skeptical that this rally has enough legs to carry it above the 12919, 1372 level based primarily on fundamentals (1) Fair Value for the S&P [1341], (2) the proximity of a number of our holdings to their Sell Half Ranges and (3) I will add the most recent reading of our internal indicator. So for the moment, I remain fixed on our Sell Discipline and will continue to chip away at stocks that are either fundamentally or technically overextended.

Volume was higher on Friday but not as much as the price action would suggest; breadth improved. The VIX fell, remaining in a well defined down trend.

GLD got whacked hard but remains above 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 (12862) finished this week about 18.5% above Fair Value (10850) while the S&P closed (1344) fractionally overvalued (1341). 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. Developments this week only lend further support: (1) the very positive nonfarm payroll report is another step in taking a ‘double dip’ off the table, (2) the eurocrats continued to do what they do best--which is basically nothing. The Greek problem seems are irresolvable as ever,

It may seem that my recent focus on our Sell Discipline and the shift of our economic forecast relative to consensus makes me a bear on the Market and the economy. However, as I have tried to emphasize, nothing could be further from the truth. My economic forecast is for growth; it is just that investor consensus is shifting from expectations of a recession to one of growth. That has taken me from being optimistic relative to others to neutral,

As for stocks, the issue is what an investor pays for sluggish growth. My answer is S&P 1341; and that is exactly where this index is trading as this is being written. That doesn’t mean that I am arguing for lower prices. What I am arguing is that in this Fairly Valued Market, there are few stocks that are undervalued and a whole host of those that have become richly valued; and we must manage our Portfolios accordingly.

That means not chasing prices for the sake of getting the last couple of percentage points of performance and exercising a little prudence by capturing some of the profit earned in the richly valued stocks and then awaiting the opportunity to Buy shares back at a lower price.

Pursuing such a strategy in the absence of omniscience and/or enormous luck means that there is almost a 100% probability being at least partially wrong. By that I mean that somewhere ahead of us is a top. Any selling done to date would be labeled selling too soon. And because our Portfolios are averaging out of holdings and because they only sell a maximum of one half, when the Market rolls over, there will still be money (profit) on the table. That would be labeled waiting too late.

However, what makes this a workable long term strategy (at least for me) is that (1) no matter how early I may be in the sale of a stock, ultimately, I almost always have the opportunity to Buy it back at a lower price and (2) if I don’t get shares sold, I still own a stock that is raising its dividend every year.

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.


Current 2012 Year End Fair Value* 11300 1400
Fair Value as of 1/31/12 10850 1341
Close this week 12660 1316

Over Valuation vs. 1/31 Close
5% overvalued 11392 1408
10% overvalued 11935 1475
15% overvalued 12477 1542
20% overvalued 13020 1609

Under Valuation vs. 1/31 Close
5% undervalued 10307 1273
10%undervalued 9765 1207 15%undervalued 9222 1139

* 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.