Saturday, February 25, 2012

The Closing Bell-Greece and oil don't equal higher prices



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 Up Trend 12619-14694
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 29%
Aggressive Growth Portfolio 27%

Economics

The economy is a modest positive for Your Money. There were very few economic stats this week but what there was, was almost universally positive. The only negative was the weekly mortgage and purchase applications numbers. This keeps our forecast on track:

‘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.’

Are we entering the period in which the aforementioned inability of the Fed to time an easy money policy reversal comes into play?:
http://pragcap.com/inflation-update-7

On the political/economics front, Obama along with the GOP candidates are getting more specific on their tax plans. The good news is that virtually all of them include some version of ‘lower the marginal rates and broaden the base’ alternative--a scenario I wholeheartedly endorse. The bad news, of course, is that (1) we don’t know how much of these proposals are just political bulls**t and (2) even if we assume that each would be enacted in full, nothing is going to happen for over a year which does us (or our forecast) no good today. Nonetheless, I am encouraged that at least the concept of lower rates and a broader base is in everyone’s lexicon.

As far as the risks to our outlook goes:

(1) the odds of a ‘double dip’ are no longer falling. The original source of my concern stems from the historically reliable ECRI weekly index which has been predicting a recession. While the recent readings of this indicator have raised doubts about its latest call [indeed, the index improved again this week], in a recent interview the founder reiterated his forecast of downturn. That notwithstanding, the abundance of more positive data, lessens my concern.
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php

However, reinforcing the case for a ‘double dip’ is the recent rise in oil [and gasoline] prices. The cause is mounting Middle East tension, specifically, [a] the sanctions being imposed on Iran because of its continuing development of its nuclear capability as well as Iran’s reaction to those sanctions and [b] the worries of an Iranian/Israeli confrontation--either of which could lead to diminished oil exports from that region of the world and, as a result, higher prices. The danger, as it relates to the US economy, is that increased consumer expenditures on energy mean less to spend on other things and the result is a stalled recovery.

Clearly, there is a difference in the impact on oil prices between an extended period of saber rattling that would accompany a political standoff over Iran’s nuclear program and the consequences of an Israeli attempt to bomb that program out of existence. In the first case, global oil supplies aren’t impacted all that much; it is the oil market participants plus speculators that drive up prices in their hedging operations. In the latter, there is a potential for a significant reduction in oil supplies.

I am not a geopolitical strategist; so I am not qualified and therefore won’t attempt an analysis of the various potential scenarios and their probabilities. But I do think it safe to say that either alternative presents an additional headwind to our economic recovery, it is simply a matter of degree depending on what eventually transpires. I think that it is also safe to say that even assuming that the lesser of the two evils occurs, the longer the period of tension lasts and oil prices continue to climb, the greater the odds of high energy prices pushing the economy back into recession.

So forgetting whether or not the ECRI is correct, if oil prices remain high for another month or two, I will have to lower our forecast for growth and raise it for inflation.
http://www.ritholtz.com/blog/2012/02/rising-gasoline-prices-point-to-consumer-spending-risk/

And:
http://www.google.com/hostednews/ap/article/ALeqM5ii_0ArZcG65B8RYgpMgHIl2IaGLQ?docId=07530f688c6f4dcdbd4e985ee0ad63ad

(2) while not backed by the fact pattern [in my opinion], investors nonetheless remain overly optimistic about the current pace of recovery. It may be that I am missing something, though if so, I clearly haven’t found it yet. Nonetheless, with so many investors leaning towards a higher rate of economic growth, I have to consider it a risk that popular sentiment will be proven correct. So while I won’t alter our forecast until and unless the fact pattern changes, I remain vigilant to any signs of a stronger rebound,

All that said, with the exception of a Middle East war, the entirety of the above risks pale in comparison to that posed by the final resolution to the EU sovereign debt crisis. This week, the Greeks supposedly received their second bailout; however, (1) all parties have not agreed to the terms yet, and (2) even if they do, they will agreeing to an unachievable solution--because the math simply doesn’t work. I won’t regurgitate the litany of problems. If you need to be reminded, then they are available in every post that I have done this week.

The danger in this situation is that the eurocrats keep jerking themselves off thinking that they have prevented Greece’s bankruptcy, that it will remain within the EU and that we are all going to live happily ever after. They haven’t, it won’t and we’re not. As long as these guys keep their blinders on, social and fiscal pressures will continue to mount in Greece and other PIIGS. Unless they are relieved by real solutions other than the EU taxpayers having to eat all the past eurocratic mistakes, the risk is that investors/electorates take matters into their own hands and the result is 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.

Over the weekend (medium):
http://www.reuters.com/article/2012/02/23/greece-restructuring-idUSL2E8DN7TK20120223

Greece announces the terms of the exchange offer (must read):
http://www.zerohedge.com/news/greece-issues-exchange-offer-terms-raises-minimum-acceptance-threshold-75-66-%E2%82%AC10-billion-buys-p

A third bailout? (medium):
http://www.zerohedge.com/news/juncker-greece-may-need-third-bailout

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’t 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.’

Further, the price of oil has reached the point that, in historical terms, if it keeps rising, it will start negatively impacting inflation, consumer spending and business profits. That means slower economic growth and lower equity valuations (P/E’s). We may have a 30-60 day window for the price trend to reverse itself; if none occurs, our forecast will turn negative.

This week’s data:

(1) housing: weekly mortgage applications and purchase applications plunged; January existing home sales were flat while new home sales were better than expected,

(2) consumer: weekly retail sales were up; weekly jobless claims were better than anticipated; the February University of Michigan’s final index of consumer sentiment was better than estimates,

(3) industry: none,

(4) macroeconomic: none.

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.


Iran’s rationality (medium):
http://www.nationalreview.com/articles/291862/iran-s-terrible-rationality-rich-lowry

A must read piece on ‘rights’ (medium):
http://www.ocregister.com/opinion/rights-341786-government-free.html

The Market-Disciplined Investing

Technical


While there was a bit of volatility this week, the indices (DJIA 12982, S&P 1365) continued to work their way higher. The DJIA confirmed the upside break of the upper boundary of its intermediate term trading range per our time and distance discipline and has re-set to an intermediate term up trend (12619-14694). Meanwhile the S&P remains within its intermediate term trading range (1101-1372). This leaves the Averages out of sync and under our time and distance discipline, directionless. Until this divergence is remedied, it is impossible to make a Market trend call.

A check of our internal indicator produced the following results: as of the close Friday in a Universe of 157 stocks, 68 had exceeded their comparable 12919/1372 level, 63 had not and 26 were too close to call--an improvement from last week. I would characterize this reading as ‘on the negative side of neutral’--but certainly not a reason to get jiggy over a break out.

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 [12619, 1312], (2) their 200 day moving averages [12000, 1257], (3) the neckline of the reverse head and shoulders pattern [12287, 1266]and (4) the old resistance/support level [11741, 1230].

Volume on Friday was abysmal; breadth declined. The VIX rebounded modestly; and while it remains within its short term down trend, it also found support from the lower boundary of its intermediate term trading range for a second time..
http://advisorperspectives.com/dshort/commentaries/Trading-Volume-in-the-SPX-120224.php

Despite the confirmation of the Dow’s up side break, I remain skeptical that this rally has enough strength for the Market to re-set to an up trend. The reasons being (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 fractionally but stayed above the upper boundary of its recently re-set trading range. It has now re-set again into a short term up trend. Following this pin action, our Portfolios will Add their positions.

Bottom line:

(1) the DJIA has re-set to an up trend (12619-14694) while the S&P is in an intermediate term trading range (1101-1372), though is upper boundary is close to being 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 (12982) finished this week about 19.6% above Fair Value (10850) while the S&P closed (1365) 1.7% 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.

We did receive something of a positive from our political class this week in the new tax proposals from Obama and Romney both of which incorporated some form of ‘lowering the rate and broadening the base’. Unfortunately even if we assume the best case (i.e. that tax reform actually gets enacted), it won’t happen until 2013 and probably won’t kick in until 2014. That doesn’t help us, the economy or our Models today. Of course, there could be a psychological boost in early 2013 from just knowing better times are on the way.

As far as our assumption that Greece defaults and the rest of Europe ‘muddles through’, at the moment, it appears that Greece has avoided default but that Europe will successfully ‘muddle through’. That would suggest that this crisis has ended with an even more positive outcome than is built into our Economic and Valuation Models.

The problem, of course, is that I don’t believe that Greece has evaded bankruptcy. I believe (and have tried to document) that the eurocrats have their collective heads in the sand and are losing control of the situation. The risk is that investors revolt or panic causing multiple country/bank defaults and the possibility of a collapse in the derivative markets that would result in the implosion of the global banking system. The longer the current circle jerk goes on, the greater the odds that are Models are too optimistic.

A second area of concern is that history has shown us time and again that spiking energy prices equal economic slowdown. It was easy enough to ignore the Middle East saber rattling and bluffing when oil prices were lower. But now they are moving up on momentum and that is bad news for inflation, consumers, any business where energy is a major cost item and the economy in general. This can’t go on much longer (a month or two) before both our economic growth and Fair Value forecasts will have to change negatively.

This week the Dividend Growth and High Yield Portfolios began moving out of Federated Investors (FII) which failed its recent financial review.

How optimism is retained in the face of reality. Indeed. (short):
http://www.ritholtz.com/blog/2012/02/how-unrealistic-optimism-is-maintained-in-the-face-of-reality/

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 12942 1365

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.
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