Saturday, March 03, 2012

The Closing Bell-Close but no cigar



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 12739-14366
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 30%
Aggressive Growth Portfolio 26%

Economics

The economy is a modest positive for Your Money. We had a good solid week of data which I would characterize as basically mixed: on the positive side were weekly mortgage purchase applications, pending home sales, February retail and auto sales, the Conference Board’s consumer sentiment index, three regional Fed manufacturing surveys and fourth quarter GDP; negatives included the Case Shiller home price index, January personal income and spending, the February ISM manufacturing index and January construction spending; mixed were weekly retail sales and jobless claims as well as January durable goods orders.

Clearly, sufficient positive numbers to support our outlook for economic growth, but enough negative and mixed data to keep a governor on our enthusiasm. 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.’

As far as the risks to our outlook goes:

(1) high oil prices continued to cast a pale over the sustainability of our recovery. While they were quite volatile this week, the current levels along with a steady stream of disquieting rumors out of the Middle East [Israeli commandos attack an Iranian nuclear facility, a Saudi pipeline sabotaged] kept traders and investors nervous. As long as these conditions [i.e. high prices] exist, high oil prices act as a tax on the economy and, hence, an obstacle to growth. However, if something actually happens to disrupt oil supplies then clearly our energy dependent economy could easily slip into a recession.

Oil prices and recession (short and a must read):
http://www.zerohedge.com/news/guest-post-if-such-strong-economy-why-does-chart-look-recessionary

(2) hanging around in the back ground is the insistence by the ECRI founder that the index’s current prediction of a recession remains valid which he reiterated this week [see below]. To be sure, he isn’t getting much support from the incoming economic data or, for that matter, from his own index. Indeed, this week’s reading was yet another improvement [see below]. Nonetheless, given the historic accuracy of forecasts from the ECRI, I think it prudent, at a minimum, to not ignore it.
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php

Update from the founder (short):
http://www.zerohedge.com/news/art-cashin-why-economy-weaker-it-has-been-21-months

(3) as you know, Bernanke caused quite a stir this week by omitting any reference to QEIII in his Humphrey Hawkins testimony. To be clear, he didn’t say that it wasn’t coming; he just didn’t say that it was. I don’t want to be repetitious here because I covered this in Thursday and Friday’s Morning Calls but I will restate my conclusions: [a] if the lack of mention of QEIII is a signal that the Fed is starting to worry about the trillions of dollars of excess reserves sloshing around the global financial system, then I applaud, [b] however, what it probably means is that the Fed thinks that Operation Twist {keeping interest rates unnaturally low} is working just fine to keep financial markets unclogged, and [c] if the numbers start to show a slowing in the recovery, QEIII is a heartbeat away. In other words, fugetabotit, it was a tempest in a teapot.

(4) while there is nothing in the above that gets me jiggy, investor enthusiasm for a stronger recovery than I am forecasting continues. It is a major source of cognitive dissonance for me and keeps me looking for where I could be wrong. Unfortunately, I haven’t found it. Of course, that doesn’t mean that it is not there; so I remain cognizant that our forecast could be too conservative and vigilant to any signs of a stronger rebound.

(5) of course, the 900 pound gorilla in the room is how the EU resolves its sovereign debt crisis; and I would rate that still as ‘to be determined’. A lot happened this week including some minor developments: the G20 refusal to fund IMF aid to the EU, S&P dropping Greece’s rating to default status offset by the German parliament’s approval of the terms of the Greek bail out and the EU leaders signing a deficit control treaty.

However, the major items were [a] the implementation of the ECB’s second round of bank funding. You will recall that the intent of this policy was to allow {already troubled} banks to borrow cheap and invest the funds in the sovereign debt thereby allowing troubled countries to continue to finance the deficits. The only problem is that the banks elected to recycle a good deal of the money into ECB deposits instead of investing them. How this works out remains to be seen; but it is somewhat reminiscent of our own Fed pumping trillions into US banks only to have them hold on to those funds as reserves versus making loans. The difference is that several EU countries are on the edge of an abyss.

[b] the International Swaps and Derivatives Association determined that there was no Greek default in the terms of the latest bail out. While that avoids my nightmare scenario, it could ultimately wreck the sovereign CDS market making it at best more expensive for countries, especially the less fiscally sound, to borrow money but at worse near impossible to get any funding during periods of economic malaise.
http://www.ritholtz.com/blog/2012/03/credit-default-swaps-cds-are-insurance-products-not-tradeable-assets/

As you know, my worry in all this is that the eurocrats keep their heads firmly planted up their collective asses, Greece defaults {which I continue to believe is a virtual certainty}, insufficient preparations have been made for this default to be orderly with the result of 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.

Greece is already crawfishing on their bail out deal (medium and a must read):
http://www.zerohedge.com/news/greek-cds-hit-record-german-economy-minister-accuses-greece-reneging

As are the rest of the PIIGS (medium):
http://www.zerohedge.com/news/european-solidarity-everybody-knows-spanish-are-lying-about-figures%E2%80%9D

And a review of the problems of a monetary union without a fiscal union (medium):
http://advisorperspectives.com/commentaries/pimco_30312.php

My bottom line remains unchanged: ‘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 fell but purchase applications were quite strong; January pending home sales were slightly better than expected; while the Case Shiller home price index continued to decline,

(2) consumer: weekly retail sales were back to being mixed though both the February retail chain store sales and auto sales were robust; January personal income and spending were both below estimates; weekly jobless claims were fractionally better than anticipated; the February Conference Board’s index of consumer confidence was well above estimates,

(3) industry: the February ISM manufacturing index while positive nonetheless came in below forecasts: likewise January construction spending fell dramatically short of expectations; January durable goods orders were very disappointing though ex transportation they came as anticipated; three regional Fed’s [Dallas, Richmond, Chicago] February manufacturing indices were all above estimates,

(4) macroeconomic: fourth quarter GDP came in slightly better than forecast.

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


While there was a bit of volatility this week, the indices (DJIA 12977, S&P 1369) managed to close a little higher. The DJIA remained within its intermediate term up trend (12739-14366) though it has been struggling with the 13000 level.

Meanwhile, although the S&P finished Thursday above the upper boundary of its intermediate term trading range (1101-1372), it could not hold that level and closed Friday below it. Under our time and distance discipline, the clock has been re-set to 0; and, therefore, the S&P will have to close back above 1372 to re-start the confirmation process. This also 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.

Is the correction camp overcrowded (medium)?
http://www.ritholtz.com/blog/2012/03/is-the-correction-camp-too-crowded/

A check of our internal indicator produced the following results: as of the close Friday in a Universe of 160 stocks, 69 had exceeded their comparable 12919/1372 level, 64 had not and 27 were too close to call--that is virtually unchanged from last week; so my characterization of this reading remains the same: ‘on the negative side of neutral’. Not a reason to get jiggy over a break out.

However, 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 [12739, 1323], (2) their 200 day moving averages [12000, 1258], (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. While it remains within its short term down trend, it is also above the lower boundary of its intermediate term trading range.

While the pin action of the last couple of weeks has been nerve racking, at least for someone who believes that stocks are near an intermediate term top, 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 [1346], (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 had a terrible week suffering some extreme whackage on Wednesday following Bernanke’s nonstatement regarding QEIII. In the process, it decisively broke the lower boundary of its short term up trend. On Wednesday, it also closed below the initial support under the short term up trend; however, it managed to recover on Thursday and remained there on Friday.

I voiced my confusion repeatedly over the causes and rationale for this really negative price action and found nothing until I read Dennis Gartman’s Friday letter. According to a contact of his, on Wednesday a (unmentioned) central bank came to the Market with a firm offer to Sell 3 million ounces of gold immediately. If true, there was a clear intent to knock the price of gold down because that market simply isn’t large or liquid enough to handle a held Sell order of that size. The bank’s motivation is unknown; but this explanation does at least help me understand what transpired and makes me a bit more sanguine about the outlook for GLD.

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 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 (12977) finished this week about 19.1% above Fair Value (10895) while the S&P closed (1369) 1.7% over valued (1346). 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 continues to support both our Economic and Valuation Models. We received a little cognitive dissonance this week with the whole brouhaha over Bernanke’s nonstatement on QEIII; however, when the dust settled, I think that it was much ado about nothing. While I may wish that the Fed was on its way to a tighter rein on monetary policy that probably isn’t what is occurring. More likely, it feels that Operation Twist is providing all the assistance to banks that is needed; and I am sure that if the Fed thinks additional liquidity is required, QEIII will appear in a flash. My point here is that the inflation risk in our forecast is alive and well.

What isn’t in our Models is an extended period of high and rising oil prices. Putting aside the ‘war in the Middle East’ scenario, as long as tensions remain at elevated levels, a certain amount of oil supply hoarding and futures speculation is impossible to avoid. The longer this keeps oil prices high, the longer energy expenditures negatively impact the rest of the economy and the greater the risk that our forecast and equity valuations will prove too optimistic.

As far as our assumption that Greece defaults and the rest of Europe ‘muddles through’, if anything, things got worse this week. True Greece appears to have secured its bail out money. However, I continue to believe that neither the Greeks nor the eurocrats can ignore Greece’s fiscal math indefinitely. Indeed, it is almost impossible for me to think that the Greek electorate will tolerate the implementation of the measures necessary to maintain EU financial support.

How long the charade can go on, I haven’t a clue. But the longer it does, the greater the risk 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. No aspect of this risk is reflected in our Model.

In the final analysis, with the information we have at hand, our Valuation Model judges equities in general to be Fairly Values (as calculated by the S&P) though some stocks are richly so. Hence, there is little call for action other than responding to our Sell Half Discipline. However, the longer oil prices remain high and the longer the eurocrats fiddle while Greece burns, the greater the risk that our Economic Model is too optimistic and our Valuation Model is pricing stocks ahead of where they should be. That is the rationale for our Portfolios’ hefty cash and GLD positions.

This week the Dividend Growth and High Yield Portfolios completed their sale of Federated Investors (FII); the Aggressive Growth Portfolio sold one half of its holding in Fastenal as a result of it hitting its Sell Half Price; and all Portfolios Added to their GLD positions.

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 3/31/12 10895 1346
Close this week 12977 1369

Over Valuation vs. 3/31 Close
5% overvalued 11439 1413
10% overvalued 11984 1480
15% overvalued 12529 1547
20% overvalued 13074 1615

Under Valuation vs. 3/31 Close
5% undervalued 10350 1278
10%undervalued 9805 1211 15%undervalued 9260 1144

* 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.