Saturday, March 10, 2012

The Closing Bell-Greece defaults but EU crisis is still in the first quarter


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 28%
High Yield Portfolio 35%
Aggressive Growth Portfolio 32%

Economics

The economy is a modest positive for Your Money. The data continues to come in mixed to positive. This week, mortgage purchase applications, retail sales and employment stats were up beat, while numbers from the manufacturing sector were mixed and the government data was lousy. This supports our forecast:

‘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.’

The risks haven’t changed much either:

(1) oil prices remain high. History has shown that a prolonged period of elevated energy prices act as a drag on economic activity; and I see no reason to believe that this time will be any different. If we don’t get some relief by early to mid April, I think it likely that it will start to show up in the numbers. If that isn’t bad enough, if hostilities break out in the Middle East that will almost surely have an impact of oil supplies; if that were to occur, it is likely that we will have to kiss the current recovery good bye. And that would be the good news scenario. If the US gets involved militarily, things could get even uglier.

(2) for the three months, I have been linking to the weekly reading of the ECRI index as well as numerous articles debating the merits of its call for a recession. That analysts are paying this indicator as much as attention as they have speaks to the strength and accuracy of its record. That said, the facts on the ground continue to support the doubters--which is not necessarily to say that a recession won’t occur. But it does mean that unless we start to get some collaborating evidence, this risk will likely continue to fade. And once again, this week’s reading is an improvement over last week’s (eighth in a row).
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php

(3) on the other hand, for me, no risk is more perplexing than the apparent enthusiasm investors are displaying for a stronger recovery than I am forecasting. It is not in the reported numbers. Nor is there anything obvious that would cause the economy to suddenly accelerate to a more normal rate of recovery--energy prices, a deteriorating fiscal budget and slowing economic activity around the globe certainly make such an assumption questionable. So either there is a lot dope smoking going on or I am missing something. I remain puzzled but vigilant to any signs of a stronger rebound.

(4) European solvency/insolvency is still the biggest challenge facing the US and global economy [save a Middle East conflagration]. To be sure, this week the eurocrats once again managed to kick the resolution of their fiscal problems down the road again. While this is a short term positive in that a disorderly Greek default has been avoided and additional time has been bought, it is unlikely that the policies in place today will prevent a recurrence of a potential bankruptcy either in Greece or any of the other PIIGS. I have dwelled on the this point ad nauseum, so I am not going to repeat myself. I will, however, continue to point out in our narrative the potential risks of such an occurrence.
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/9132216/Legal-skull-duggery-in-Greece-may-doom-Portugal.html

My biggest worry, as you know, is that a single country default will precipitate of multiple bank/country bankruptcies 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.

And speaking of CDS’, the Greek bond exchange has been ruled a default; so we will get our first peek inside the sovereign CDS market (medium):
http://www.zerohedge.com/news/first-greek-cds-anstalt-appears-question-emerges-did-banks-not-square-margins

What happens next (medium):
http://www.zerohedge.com/news/greece-round-iii-which-we-learn-greek-debt-actually-increased-post-default

And:
http://www.zerohedge.com/news/greece-has-defaulted-here-where-we-stand

And:
http://www.zerohedge.com/news/germany-wants-new-european-constitution-there-are-new-centers-power-world

Bottom line: the US economy continues to perform as expected. Greece has defaulted and the eurocrats managed to make it an orderly one. So far so good. However, the shape of the solution (defrauding bond holders by government fiat, replacing the defaulted debt with yet even more debt) is hardly encouraging and most surely isn’t being lost on bond market investors. I said last week that I thought that the EU political class was being too clever by a half and that they were potentially sowing the seeds of their own destruction. Reading the links that I have been including from guys who know far more about this matter than I, it is clear that we may still be in the first of this game and that there is a lot more excitement to come. In other words, while the Greek problem played out in the short term as we had forecast, our longer term Japan 2.0 assumption for Europe remains the good news scenario. The potential is for much worse.

Meanwhile, I had never assumed high and rising oil prices in our forecast. As I have noted previously, historically high energy prices have not been good for growth. So I don’t think that the economy will be able to continue to track even a slow, sluggish growth path with no relief on this count. If none occurs in the next 30-45 days, I will likely have to revise our growth forecast down and our inflation outlook up.

This week’s data:

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

(2) consumer: weekly retail sales were positive; weekly jobless claims were up more than anticipated; however, the February ADP private payroll as well as nonfarm payroll reports were better than expected,

(3) industry: the February ISM manufacturing index came in better than forecast: although February factory orders fell versus estimates of an increase; and January wholesale inventories rose less than expected; worse still January wholesale sales fell 0.1%,

(4) macroeconomic: fourth quarter productivity was up as anticipated; but unit labor costs were double expectations; both the February budget and trade deficits were larger than anticipated; January consumer credit rose at twice the forecast rate.

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.


A different view of the Iranian problem (medium):
http://www.zerohedge.com/news/guest-post-backing-world-war-iii

The Market-Disciplined Investing

Technical


The technical picture of the indices (DJIA 12922, S&P 1370) remains muddled. The Dow finished Friday (1) slightly below the lower boundary of its intermediate term up trend [12931-14648]. This is the fourth day below that boundary. However making this break of trend weaker than normal is the fact that the Average has been up the last three days; it is just not rising quite as rapidly as the up trend’s lower boundary. As a result, I may give another day or two to make a more solid confirmation of the potential break. (2) modestly above the 12919 resistance, turned support, now resistance level. This is a contributing factor to the extension of the confirmation period for this particular trend violation.

The S&P continues to trade within its intermediate term trading range, though clearly it is in the process of a second challenge of the 1372 level. For the moment, this leaves the indices out of sync and us on the sidelines.

A check of our internal indicator produced the following results: as of the close Friday in a Universe of 161 stocks, 75 had exceeded their comparable 12919/1372 level, 67 had not and 19 were too close to call--that is somewhat improved from last week. I would characterize it as slightly positive--so it could be that this second challenge to the intermediate term trading range will be successful.

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 [12931, 1337], (2) their 200 day moving averages [12012, 1259], (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 flat; breadth was mixed. The VIX continued its decline. That leaves it solidly within its short term down trend, but above the lower boundary of its intermediate term trading range. A break of that support level would be a positive for stocks.

This week’s gyrations of the DJIA around the lower boundary of its intermediate term up trend and the S&P around the upper boundary of its intermediate term trading range have kept me on pins and needles. I continue to believe that over the short term, the barrier created by Fair Value (1346 for the S&P) supported by the proximity of so many stocks to their respective Sell Half Range will keep the current trading range in tact.

However, that call is clearly a short hair away from being wrong. As you know, when the Market says that I am wrong, I listen. So while I will hold to my position until our time and distance discipline confirm an up side break out, when, as and if that occurs, our Portfolios will put some cash to work.

GLD rebounded this week but remained below the initial support level long enough for that violation to be confirmed. However, on the last day (Friday, the fifth day), it closed right on the aforementioned support line. That makes me a little uneasy declaring a re-set to a short term down trend; so I am holding off till the close Monday to make that call.

Bottom line:

(1) the DJIA is in the process of challenging its short term up trend (12931-14648) while the S&P is challenging the upper boundary of its intermediate term trading range (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 (12922) finished this week about 18.6% above Fair Value (10895) while the S&P closed (1370) 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. Meanwhile our Glorious Leader continues to dwell in His ivory tower to the determent of labor and taxpayers. This week Obama actively lobbied the senate to reject a bill that would have advanced the development of the Keystone pipeline, despite His supposed devotion to job creation and the fact that the oil and gas industry has been a major source of job growth recently. In other ‘green’ announcements, (1) the government proudly paid a $10 million reward to Phillips Electronics for the development of...........(drum roll) a low wattage $50 [retail] light bulb, (2) an experimental car in to which the government has poured $500 million quit after 180 miles on the road and no one can explain why. If the US economy continues to improve, it will be in spite of our leadership; I am almost embarrassed to say that this too is in our Model

As discussed in the Economics section, the two factors that could potentially wreak havoc with not only our Economic Model but also our Valuation Model are (1a) a sustained level of high energy prices that would curtail consumer demand and squeeze corporate profit margins, (1b) an interruption in the supply of oil that would result in the loss of a critical component of production, and (2) the European sovereign debt crisis spinning out of control. My specific concerns here are [a] a potentially deeper recession in Europe than currently forecast that would in turn impact US companies earnings in the EU and [b] a financial crisis that could spill over into the US banking system and do further damage its ability to finance this country’s capital needs.

For the moment, 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.

Of course, I could be wrong about most if not all of the above. I say that because the Market pin action of late implies it. As strongly as I may believe in our Models and the assumptions made to achieve their results, I am not going to buck a major trend change. As a result, I continue to challenge the assumptions in our Models but I will stand my ground until the Market unequivocally tells me that I am wrong. At that point, I cease arguing and adjust our strategy.

This week the our Portfolios Sold one half of 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 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.