The Closing Bell-The longer these clowns take, the greater the risk of a disorderly default

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. Very few stats this week; what there was came in on the positive side of mixed. The consumer data continued strong with encouraging weekly retail sales, another good jobs report and a University of Michigan consumer sentiment index that, while below expectations, was still solid. Add to that better than expected December wholesale inventories and sales. The only really disappointing number was weekly mortgage purchase applications.

So the stats continue to support our economic forecast as well as the keeping the risk to that outlook moving toward underestimating the pace of recovery. However, that risk is still small and much more affirmative data will be needed before I start worrying about being too pessimistic.

On the other hand, I can’t ignore my oft repeated concern about a double dip--as you know, the primary basis for that worry was the ECRI founder’s call for a recession. As you also know, the ECRI weekly index has not been cooperating with that founder’s call of late; and this week was no different. It once again recorded a less negative reading. It would seem that something has to give here, i.e. the founder retracts the call or this index rolls over, because this dichotomy can’t go on forever. In any event, the case for recession continues to recede.
http://advisorperspectives.com/commentaries/dshort_021012.php

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.’

Turning to the real risk to both our Economic and Valuation Models (an inept European political class that bungles their sovereign debt problem), it was business as usual this week. Almost everyday, there was news that that an agreement was just hours away on a second Greek bailout, only to turn out to be another false alarm. In the meantime, the social fabric of the country was coming unglued in front of us on six o’clock nightly news.

Whether we get a final solution over the weekend or a month from now, it clearly has to happen because conditions in Greece are such a mess that there is no way that they stay the same. The risk is that the eurocrats can’t reach an agreement that allows for an orderly resolution to this crisis and investors/the Greek population precipitate a disorderly one.

If that occurs, then a lot of revising to forecasts (including our own) will follow in pretty short order with the magnitude of those changes dependent on just how disorderly the process becomes. In the end though, we would probably be looking at multiple bank/country defaults that would undoubtedly push Europe into a significant recession and raise the probability of my nightmare scenario--serial defaults in the credit derivative market that substantially impair the global financial system.

Just to repeat, that is not my forecast (which is flat to little growth long term, Japan 2.0) . I raise it because the longer the eurocrats f**k around, the greater the chance of its happening.

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.

Bottom line: while our outlook hasn’t changed (1) the recent US economic data flow is gradually taking the risk of a recession off the table, (2) but the ineptness of the European political class in coming to grips with a Greek bankruptcy is raising the risk of a disorderly default which would in turn result in a severe European recession at the best.

This week’s data:

(1) housing: weekly mortgage were up but purchase applications were basically flat,

(2) consumer: weekly retail sales were up across the board for the first time in several weeks; weekly jobless claims dropped versus expectations of an increase; the University of Michigan’s preliminary February index of consumer sentiment came in at 72.5 versus forecasts of 74.3 and the January reading of 75.0,

(3) industry: December wholesale inventories advanced at more the double the rate expected; more important, sales rose at an even faster pace,

(4) macroeconomic: the US December trade deficit came in almost exactly as 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

Friday’s rough ride notwithstanding, it is difficult to argue that the indices (DJIA 12801, S&P 1342) have lost any upward momentum. Nevertheless, there are some early warning signs (insider trading, the VIX, no volume) that the upper boundaries of their trading ranges (10725-12919, 1101-1372) are going to constitute a formidable barrier, at least on this current challenge.

A check of our internal indicator produced the following results: as of the close Friday in a Universe of 162 stocks, 56 had exceeded their comparable 12919/1372 level, 69 had not and 37 were too close to call--virtually unchanged from last week. Hence the same conclusion: ‘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.’

Should stocks experience some consolidation, 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 [12422, 1288], (2) their 200 day moving averages [11990, 1257], (3) the neckline of the reverse head and shoulders pattern [12287, 1266]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.

Volume declined; breadth deteriorated. The VIX spiked. While it is still in a short term down trend, it may begun building a base in 17-18 area--in other words, the worst for the VIX (best for stocks) may be behind us.

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) 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 got whacked hard, breaking down through the lower boundary of its short term up trend. It did manage to hold above a minor support level. However, further downside will prompt a reassessment of our position.

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 (12801) finished this week about 17.9% above Fair Value (10850) while the S&P closed (1342) virtually on Fair Value (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.

Everything on the home front (the economic data, a dysfunctional political class) supports both our Economic and Valuation Models. To be sure, the stats of late could be interpreted in a way that would suggest that our forecast is too pessimistic. To that I would simply respond that numbers are supposed to be positive in a growing economy growing, even if the rate of advance is less than historical norms. Nonetheless as I have noted repeatedly, there is still an upbeat takeaway from this good news and that is that the risk of recession appears to be receding.

On the other hand, the ruling class continues to enrich itself at the taxpayers expense (see the foreclosure abuse settlement), to promulgate ever more intrusive measures on the personal freedoms of the electorate (we can’t throw a Frisbee on the beach or eat an Oreo at school anymore) and operate as though the country isn’t facing a serious fiscal crisis (see broad outline of Obama’s new budget proposal below).

All four below are must reads.
http://scottgrannis.blogspot.com/2012/02/obama-americas-peron.html
http://www.washingtonpost.com/opinions/the-gospel-according-to-obama/2012/02/09/gIQAngvW2Q_story.html
http://www.nakedcapitalism.com/2012/02/the-top-twelve-reasons-why-you-should-hate-the-mortgage-settlement.html
http://www.zerohedge.com/news/obama-revises-cbo-deficit-forecast-predicts-110-debt-gdp-end-2013

Perhaps most disappointing (to a conservative like me) is the sorry choice the republicans are presenting us as an alternative to Obama. If any of these guys, save Ron Paul, gets the nomination, I am not sure how much more positive I can make the assumptions in our Models. That said, cynic that I am, I won’t have to. But none of us want this.

Finally as I have repeatedly noted, Europe is the potential turd in the punch bowl. I don’t want to be repetitive; but the eurocrats are now playing a high stakes of chicken in the Greek bailout. One wrong move and the entire EU edifice could come tumbling down on their heads. I have been making a blind faith assumption that they will be able to fashion an orderly Greek default and manage a long and painful return to fiscal health of the remaining PIIGS; but the odds seem to be mounting that I will be proven wrong.

All this considered, our Valuation Model prices the Market as Fairly Valued but with some components of the Market richly valued. That is what our Sell Discipline is for--to push our Portfolios out of at least a portion of those overpriced equity holdings. That is what our Portfolios have been doing and will continue to do as prices move higher.

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 10850 1341
Close this week 12801 1342

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.