Saturday, February 18, 2012

The Closing Bell -- Default is the good news senario


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 23%
High Yield Portfolio 27%
Aggressive Growth Portfolio 27%

Economics

The economy is a modest positive for Your Money. The economic data were generally mixed again this week. Here is how I would score it (1) positive: jobless claims fell again, business sales were strong, both the NY and Philly Fed business surveys were above expectations and PPI and CPI were less than expected, (2) negatives: mortgage purchase applications and building permits were weak and core PPI was stout, (3) mixed/mostly impacted by weather: housing starts, retail sales and industrial production.

All in all, the stats fit very well with our forecast and continued to shift the risk away from a ‘double dip’. While I am still paying heed to the ECRI weekly index’s call for a recession, the data flow of late has clearly been contrary to this call. Indeed, the index itself seems to be reflecting a less ominous outlook--this week’s reading improved again (this is the fifth up week in a row):
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php

On the other hand, investors, or at least the main stream media, are sounding unusually up beat of late suggesting that the pace of recovery may be accelerating well above our current forecast. That may happen; but as I observed in Friday’s Morning Call, given that this group was calling for a recession as little as a month ago, I am hard pressed to accept the argument that the numbers have improved so dramatically that the economy has gone from faltering into a recession to accelerating to a more normal historical pace of recovery.

On the political/economics front, Obama released His proposed 2013 fiscal budget this week. Ordinarily, this would warrant plenty of space especially if it posed potential threats to our forecast. To be sure, the budget is threat to the economic health of this country; but it is not much of a threat to our forecast because (1) higher spending, higher taxes, higher deficit, more regulation are already in our forecast though with somewhat less dire assumptions, (2) this monstrosity is a political rather than an economic document and, hence, has little chance of enactment and (3) even if this country is unfortunate enough to have Obama re-elected and the dems sweep the house and senate, the budget won’t be enacted until early 2013 and therefore its impact is 18-24 months. I leave it at that.

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.’
Of course, any disagreement over the pace of US economic recovery is almost irrelevant compared to the risks that exist in the resolution of the EU sovereign debt crisis. As you know the primary focus of this risk is now the Greek bailout/bankruptcy or perhaps better said, how the eurocrats will manage the Greek bailout/bankruptcy. And to date, I would say the clear conclusion would be, not very well. This whole fiasco is reminiscent of Ground Hog Day in the sense that everyday we are assured a solution is hours away only to find out that it isn’t.

I am convinced, as are many others, that an orderly default for Greece is not only the best solution for the EU, it is the best solution for Greece. Why the eurocrats don’t just do it and get it over with is a mystery to me. More important, in my opinion, the longer they fiddle around, the greater the probability of precipitating a much worse solution in which investors and/or the Greek electorate proceed towards a disorderly default which would include multiple bank/country defaults that would undoubtedly push Europe into a significant recession and raise the odds of my nightmare scenario--serial defaults in the credit derivative market that substantially impair the global financial system.

‘On the other hand, even if there is some sort of announced agreement, that doesn’t mean that the turmoil in Europe is over. The risk still exists that the Greeks will fail to live up to their end of the accord just like they have failed to live up to every other deal. That may extend a ‘muddle through’ period, but sooner or later, somebody is going to have to bite a bullet.

In addition, it is not like Greece is the only irresponsible, profligate country in the EU. In the past week, I have linked to articles that nominate Portugal, Spain and Italy as the next domino to fall. And almost assuredly, once any Greek bailout is enacted, they will get line for similar terms. To date, I have reasonably sanguine about the prospects that the eurocrats will be able to manage this process. However, their performance with Greece gives me pause. I am not altering our ‘Greek default, muddle through’ EU assumptions in our Models; but the political class has made such a mess of a fairly straight forward math problem, the risks are shifting toward a more economically, socially disruptive scenario.’
http://www.nakedcapitalism.com/2012/02/greece-is-out-of-time-again.html

Bottom line: the data flow continues to suggest that our forecast for the US economy is right on: no recession, just a slow sluggish recovery. On the other hand, our Japan 2.0 outlook for Europe (Greece defaults, but the rest ‘muddle through’) is becoming less likely. The eurocrats, I fear, are being too clever and too sophisticated by a half--no matter how sophisticated and clever you are, you can beat the math. And the math says that Greece is tits up.

The longer these guys live in denial, the greater the risk that the Markets will take matters into their own hands; and if that occurs, the likelihood of an orderly default drops and with it the odds of any kind of ‘muddle through’ scenario. I haven’t changed our forecast because (1) I am still hoping these clowns will wake up and do the right thing and (2) if we get a disorderly default, we are facing some major unknowns and I have no clue how to quantify them before they happen.
http://www.zerohedge.com/news/daniel-hannan-channels-upton-sinclair-warns-all-options-here-are-bad

This week’s data:

(1) housing: weekly mortgage applications declined but purchase applications plunged; January housing starts jumped dramatically, though they were influenced by weather and a heavy weighting to multi-family units built for rent; building permits fell versus expectations of an increase,

(2) consumer: weekly retail sales again turned mixed; January retail sales were well below estimates, though they were impacted by slow auto sales; weekly jobless claims dropped more than anticipated,

(3) industry: January industrial production was well below forecasts, though weather had an effect on this outcome; December business inventories advanced slightly less than expected, but sales were quite strong; both the New York and Philadelphia Fed business surveys came in well above estimates,

(4) macroeconomic: both the January PPI and CPI were below forecasts although the core PPI was almost double expectations; the January leading economic indicators advanced somewhat less than forecasts.

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


After a roller coaster start to the week, the indices (DJIA 12949, S&P 1361) regained momentum and powered their way toward the upper boundaries of their intermediate term trading ranges (10725-12919, 1101-1372). Indeed, the DJIA closed above the 12919 level; although the S&P remained below 1372.

As you know, I believe that the S&P is more indicative of the general Market; and, therefore, I view this break out of the DJIA as having much less import than if it were the S&P. That said, our time and distance discipline is now in play for the DJIA’s break above 12919. If the Dow is still above 12919 by the end of next week, it will re-set to an up trend.

However, another tenet of our discipline is that the Averages must be in sync to confirm a change in Market direction. In other words, even if the DJIA confirms its break above 12919, it will not constitute a change in Market trend until the S&P does the same. So we are still a ways away from re-setting the Market to an up trend.

A check of our internal indicator produced the following results: as of the close Friday in a Universe of 164 stocks, 61 had exceeded their comparable 12919/1372 level, 69 had not and 34 were too close to call--a very slight improvement from last week. But the conclusion is the same: ‘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 a break above 12919, 1372 is confirmed, there is very little resistance until the October 2007 highs (14190, 1561) are reached.

On the other hand, should stock prices back off, there are plenty of support levels that should keep it in the mild to moderate range. They include: (1) the lower boundary of their short term up trends [12579, 1300], (2) their 200 day moving averages [11995, 1257], (3) the neckline of the reverse head and shoulders pattern [12287, 1266]and (4) the old resistance/support level [11741, 1230].

Volume increased sharply; breadth was actually down, though the flow of funds indicator was up. The VIX fell and remains within its short term down trend.

Despite the indices nerve racking proximity to those intermediate term upper boundaries, I remain skeptical that this rally has enough strength to confirm a break 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) 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.

GLD fell again but only fractionally so, remaining within its short term trading range.

Bottom line:

(1) the DJIA and S&P are in an intermediate term trading range (10725-12919, 1101-1372), though the upper boundaries are under assault,

(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 (12949) finished this week about 19.3% above Fair Value (10850) while the S&P closed (1361) 1.5% over valued (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.

The economic data continue to support both our Economic and Valuation Models. While investor/media psychology seems to be getting a bit frisky in their economic assumptions, I think that premature at best. Yes, I may be underestimating growth; but it will take considerably more data before that gets confirmed. In the meantime, all evidence, in my opinion, points to sluggish US economic growth.

Further, none of our assumptions in either Model is going to get a boost from our political class. Cases in point: the new Obama budget, the GOP acquiescence to not funding the extension of the payroll tax credit, the narrowing of the field of republican presidential candidates to two big spenders.
http://www.washingtonpost.com/opinions/charles-krauthammer-overreach--obamacare-vs-the-constitution/2012/02/16/gIQAmupcIR_story.html
http://www.powerlineblog.com/archives/2012/02/geithners-gabble.php

Finally, I recognize that my assumptions on the likelihood and the shape of the resolution to the Greek financial crisis are at odds with consensus at least as it is expressed in the media. And since this potentially could have the largest impact on our as well as the consensus forecast, it is no small matter is setting Fair Value and investment strategy.

Clearly, I am aware of this divergence of opinion. Accordingly, I spend an inordinate number of hours pursuing every available information source attempting to either prove myself wrong or at least reconcile the differences. To date, I have been unsuccessful. I am not arguing that I am right in my judgments; I am just saying that I can’t find a convincing case to the contrary. So I stick with my assumption that Greece will default in an orderly manner--which, by the way, is the good news scenario.

To be sure, the euros could come up with some means of temporarily papering over a bankrupt Greece. But it would only be temporary; and it would raise the risk that the Markets will do the job for them with much messier consequences.

In the end, our Valuation Model has the Market (as defined by the S&P) as slightly over Fair Value but with some individual stocks richly valued. It is in times like these that our Price Disciplines prove their worth. At the moment, the focus is on the Sell side.

This week the Aggressive Growth Portfolio reduced its position in Polymedix.

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 2/29/12 10850 1341
Close this week 12949 1361

Over Valuation vs. 2/29 Close
5% overvalued 11392 1408
10% overvalued 11935 1475
15% overvalued 12477 1542
20% overvalued 13020 1609

Under Valuation vs. 2/29 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.