Saturday, March 17, 2012

The Closing Bell - A good week, but was it that good?

Statistical Summary
Current Economic Forecast


Real Growth in Gross Domestic Product: +1.5- +2.5%
Inflation: 2-3 %
Growth in Corporate Profits: 7-12%


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 13049-14769
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 30%
High Yield Portfolio 36%
Aggressive Growth Portfolio 33%


The economy is a modest positive for Your Money. The data continues to come in mixed to positive. This week, mortgage purchase applications, weekly retail sales, employment stats and two regional Fed surveys were up beat while business inventories and the University of Michigan consumer sentiment numbers were negatives and February retail sales and industrial production were mixed.

Two other positive events took place this week:

(1) the Fed ran another stress test and most banks passed with flying colors. That clearly implies that the balance sheet of the US banking system has improved; and I am not going to argue with that conclusion. To be sure, the Fed’s policy of lending massive amounts of money to banks at 0% so that they can buy Treasuries at 1-2% and earn a risk free spread, has allowed the banks to use the profits earned to write down bad loans. So I am confident in the general thesis that our banking system’s balance sheets have grown stronger. On the other hand, [a] we have no clue {i} how much crap (defaulted mortgages) and {ii} potential crap (derivatives on EU bank and sovereign debt) are sitting at book value on bank balance sheets, and [b] don’t forget that the Fed allowed the banks to swap their worst assets at book value for US Treasuries. Those assets are still on the Fed’s balance sheet and someday must be dealt with. So while our banking system maybe in better shape, our financial system is likely not nearly as improved.

(2) long term interest rates began moving up. Unfortunately, it is still too early to determine whether this a change in trend or just a big wiggle in bond prices [interest rates]; however, it is important which alternative it is. The reason: a change in trend suggests one of two things or both: [a] an improving economy {if the real interest rate is what is increasing}, [b] higher inflation {if the inflation premium is what is increasing}. Of course, since we don’t even know if a change of trend has taken place, we clearly don’t know what could be driving investors to bid up rates. Nevertheless, we need to be paying close attention to the bond market right now as well as bond investor motivation because a change in trend will provide more evidence on either the underlying strength of the economy or on inflation fears.

This analyst doesn’t think that higher rates are a problem (medium):

The argument against higher inflation (short):

The exuberant reception of the above notwithstanding, there is not enough there, in my opinion, to provide sufficient reason for altering our forecast. On the other hand, as you know, one of the risks to our forecast that I list every week is that I may be too pessimistic; and stronger bank balance sheets and rising interest rates (if driven by demand) only increase that risk.

At the same time, while a healthier banking system (depending on how much healthier) and rising interest rates (driven by robust economic activity versus inflation fears) may presage a stronger recovery than incorporated in our outlook, they may not because it is a matter of degree. That is, will they be enough to alter our main thesis or to make a significant enough impact on our Economic Model. At the moment, my answer is no. So as much as this puts me at odds with current consensus, our forecast remains roughly the same--I am removing the phrase ‘a financial system with an impaired balance sheet’:

‘a below average secular rate of recovery resulting from too much government spending, too much government debt to service, too much government regulation,.... 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.’

Has weather played a role in the better economic data (long):

Aside from the impact that the encouraging results of the bank stress test and the potentially constructive reason for higher interest rates have on my ‘too pessimistic’ risk, the remaining list of risks to our Economic Model is unchanged:

(1) oil prices continue at an elevated level. I am not going to repeat the argument for why high energy prices are a governor on economic activity. I will observe that the arrival of a third US naval carrier group in Middle East is not a sign that prices are going to retreat anytime soon,

Latest vote by Israeli cabinet (short and must read):

(2) I continue to include the recession call by the ECRI because of [a] its track record for calling economic downturns and [b] the founder remains adamant in his forecast, having reaffirmed it this week {see below}. Nonetheless, this week’s reading was once again [ninth time in a row] less negative than the prior week.

This week’s summary (medium):

Here is an editorial by the founder published Thursday defending the ECRI’s current call (medium):

(3) while Europe managed to stay out of the headlines this week, its ultimate solvency/insolvency is still the biggest challenge facing the US and global economy [save a Middle East conflagration]. We still don’t know [a] if the agreement between the Greeks/eurocrats will take place on the terms agreed upon and [b] how the market on the CDS’ written against Greek debt will clear. But we do know that this week both Germany and Spain announced that they had failed to meet their own agreed upon austerity goals. This situation remains a giant clusterf**k; and no one in Europe seems to realize it.

Plus, trouble in Hungary (medium):

My biggest worry, as you know, is that a single country default will precipitate 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.

Bottom line: the US economy continues to perform as expected though clearly this week the news in aggregate was more positive than it has been in some time.

Our political class maintains its destructive behavior toward the economy and the electorate.

The Europeans remain hunkered down in their foxholes, praying no one notices them.

Finally, oil prices haven’t budged from their historically damaging heights; and the reason for their current elevation is no closer to being resolved, unless you think that one more US carrier group in the Middle East is a cause for celebration. Sooner or later, these high oil prices are either going to decline or collide with all the investor euphoria over a better than expected improvement in the economy. Absent a decline, history suggests a nonoptimal resolution for both the economy and investors.

This week’s data:

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

(2) consumer: weekly retail sales were positive; February retail sales fell a little short of estimates; weekly jobless claims were down more than anticipated; the preliminary March University of Michigan index of consumer sentiment was a disappointment,

(3) industry: February industrial production was unchanged versus forecasts of an increase; capacity utilization was in line with expectations; January business inventories rose more than estimates, but sales increased less; both the New York and Philadelphia Fed manufacturing indices were stronger than anticipated,

(4) macroeconomic: both February PPI and CPI came in lower than estimates; the February US trade deficit was considerably larger than forecasts.

The Economic Risks:

(1) the economy is weaker [stronger] 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.)


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


The indices (DJIA 13232, S&P 1404) had another great week: (1) the Dow re-gained its intermediate term up trend and closed Friday well within its boundaries (13054-14774) and (2) the S&P is seemingly in the process of breaking out of its intermediate term trading range (1101-1372). A close Monday above 1372 which appears highly likely will re-set it to an intermediate term up trend and end the period of divergence with the DJIA.

A check of our internal indicator produced the following results: as of the close Friday in a Universe of 160 stocks, 77 had exceeded their comparable 12919/1372 level, 58 had not and 25 were too close to call--that is an improvement from last week. I would continue to characterize it as slightly positive--however, notice that with both indices over their 12919/1372 levels, less than one half of our stocks are over their comparable levels. That hardly signifies a broad based rally.

Nevertheless 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 [13054, 1351], (2) their 200 day moving averages [12030, 1260], (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 enormous but that was related to option expiration; breadth was down. The VIX finished below the lower boundary of its intermediate term trading range, re-starting the clock on our time and distance discipline for a potential break and re-set to a down trend--something that would be quite positive for stocks.

After a long agonizing battle around the upper boundaries of the intermediate term trading ranges, the bulls can declare victory at the close Monday--at least as judged by our time and distance discipline. That will make my call that those upper boundaries would hold a wrong one.

So now, I adjust; and how I do that depends on where the Market is. By that I mean that setting aside (1) whether or not our Valuation Model is currently too pessimistic and (2) whether or not our internal indicator is valid measure of market strength, the fact is that currently stocks are up over 100% off their March 2009 bottom but only 11% from their all time highs. That does not make a great risk/reward construct no matter how fast one thinks the economy and corporate profits will grow, how deft one thinks the Fed will be in withdrawing a trillion dollars in excess reserves from the financial system, how likely one thinks that the eurocrats are to avoid catastrophe and how small the probably one might place on a Middle East conflict.

Assuming Monday isn’t a major down day, then my strategy at that point will be four fold: (1) as I mentioned in a previous post, I intend to use this gift to eliminate the lower quality holdings from our Portfolios [even though they satisfy the minimum criteria for inclusion in our Universe], (2) our Portfolios will put sufficient cash to work to take Cash to 25% [now around 30%], (3) buy shares of any stock on our Buy Lists in which our Portfolios don’t have a full position [TCP and BCPC] and (4) to use a highly liquid Market ETF as a substitute for the remainder of the cash being put to work [for ease of exit when the time comes].

This week, GLD confirmed the break of its initial support level and re-set to a short term down trend. It remains in an intermediate term trading range. If it breaks the lower boundary of that range, our Portfolios will liquidate the remainder of their GLD holding. On the other hand, if it holds that level, our Portfolios will start to re-build their positions.

Bottom line:

(1) the DJIA is in a short term up trend (13054-14774) 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 (13232) finished this week about 21.4% above Fair Value (10895) while the S&P closed (1404) 4.3% 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. Admittedly, it has improved over the last two weeks; plus the results of the bank stress test can’t be ignored. However, (1) two weeks don’t make a trend, (2) even this better data is not that much better and (3) aside from providing down side protection in the case of a debacle in Europe, the principle benefit derived from an improved banking system balance sheet is more lending and businesses aren’t borrowing at a rate sufficient for investors to be getting jiggy. Now it may change; but until it does, no cigar.

Our political class continues to disappoint. The latest example: the price of oil, the risk of supply disruptions from the Middle East and our leadership’s response. One word--pathetic.

As discussed in the Economics section, a good week of headlines and ebullient sentiment notwithstanding, there are other issues which I am concerned can negatively impact our Valuation Model: (1) the high price of oil [negative for corporate profits], (2) the potential lack of availability of oil [negative for industrial production and consumption], (3) rising interest rates IF they are a sign of increasing inflation fears [downward pressure on stock multiples] and (4) the European sovereign debt crisis spinning out of control [a potentially deep recession in Europe that would in turn impact US companies earnings and/or a financial crisis that could spill over into the US/global banking system].

Of course, none of the above negatives may come to fruition and even if they do, the Market may already be factoring them into valuations. Certainly, that is what current prices are telling us. While I continue to strongly believe in (and challenge) the assumptions made and the result provided by our Valuation Model, price is truth and truth says I am about to be wrong. As noted on prior occasions, I have never confused being right with making money, so all I can do at this moment is adapt. That means raising our Portfolios equity exposure but providing for a quick exit when, as and if investor euphoria plays out. I believe that the strategy described in the Technical section accomplishes that goal.

This week the our Portfolios Sold one half of the remainder of their GLD position (now at 2.5%).

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.


Current 2012 Year End Fair Value* 11300 1400
Fair Value as of 3/31/12 10895 1346
Close this week 13232 1404

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.