Saturday, April 28, 2012
The Closing Bell-EPS expectations are too low
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):
Short Term Trading Range 12919-13302
Intermediate Up Trend 11515-16515
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):
Short Term Trading Range 1372-1422
Intermediate Term Up Trend 1209-1776
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 27%
High Yield Portfolio 33%
Aggressive Growth Portfolio 31%
The economy is a modest positive for Your Money. I would characterize this week’s economic data as dull and mixed with one notable exception--March durable goods orders which were awful. Importantly, since this particular datapoint carries a lot of weight with the economist community, it somewhat overshadows what would otherwise have been a very neutral set of stats. In addition, it provides further support to the argument that economic growth is not about to accelerate.
That said, this week’s quarterly earnings reports seem to be indicating just the opposite. For the second week in a row, the trend has been toward better than expected profits and guidance. In our Morning Calls, I have mentioned this as being something of a conundrum to me; that is, great earnings reports in what at best could be described as a ‘middling’ economy.
In trying to resolve this inconsistency, I have also raised the possibility that the better than expected profits could presage a more robust economy. This after having just dismissed the more optimistic case in last week’s Closing Bell.
However, after looking at the numbers, I believe this seeming divergence is best explained by the fact that earnings expectations for the first quarter were so low, that it was almost impossible not to have a high ‘beat’ rate. On the other hand, the actual magnitude of profit improvement is relatively low. So as the article below describes, the beat rate might be great, but the growth rate is for s**t.
Nevertheless, for the sake of remaining open minded, I am going to re-instate a better than expected economic growth rate as a possible risk to our own forecast--at least until no reasonable doubt remains that this quarter’s ‘beat’ rate is anything but a function of unnecessarily poor analyst expectations.
But 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,.... 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.’
This is a not very sanguine assessment of the economy (medium):
The other risks to our outlook haven’t changed:
(1) oil prices are still at elevated levels and as such continue to carry the potential of stifling consumer spending and shrinking corporate profit margins--which in turn will only exacerbate any other forces of economic lethargy.
I have expressed optimism regarding the long term potential of lower natural gas prices to offset the effect of high oil prices. However, that won’t help us over the next few months if energy prices cause a deceleration in economic growth.
This, of course, says nothing about the political volatility in the Middle East which has the potential to negatively impact more than just oil prices.
(2) the ECRI weekly index declined for the second week in a row. This shouldn’t be too concerning since it follows 13 weeks of consecutive increases. However, I have kept this on our list of risks because of [a] its track record for calling economic downturns and [b] the adamancy of its founder regarding this particular call. Bottom line: I am not overly concerned about this indicator at the moment primarily as a result of such limited support being provided by the current data flow. On the other hand, it has a long time horizon; so until the founder cries ‘uncle’, I leave it as a risk to our outlook.
(3) finally, the sovereign and bank debt problems in Europe remain center stage and nothing this week suggested that conditions are improving. On the economic front, news almost universally pointed to a slowing in growth through out the EU.
The politics aren’t getting any better either with the collapse of the Dutch government over austerity measures as well as the French elections where socialist candidate Hollande is campaigning against austerity and appears to be about to win.
These developments have led to a growing consensus among the eurocrats that austerity is not the answer to decades of fiscal irresponsibility. Forgetting for the moment the validity of such a notion, the only alternative brought forth so far is simply to print more money to alleviate the funding requirements of the member states and their financial institutions. That may work in the short term; but printing more money and issuing more debt is not a viable response to too much debt.
Nevertheless, one can’t dismiss the historical propensity of the European political class to avoid doing the right thing until it is too late.
So my big fear here is that our forecast [‘muddling through’] may end up being correct in the short term but simply set the EU up for a much worse fall subsequently.
Bottom line: the economy continued its mixed performance this week though admittedly those lousy durable goods orders are concerning. That said, the better than expected earnings season to date seems to be assuaging investor fears; but as I noted above they may be just kidding themselves. All in all, I would say that our Model continues to fit the economy nicely.
Our political class continued to do its usual fine job ignoring the critical issues in favor of irrelevant bulls**t. This week it was the secret service hookergate and WalMart bribing Mexican officials. But what the hell, they still have eight months to fix the fiscal tax and spending disaster that will occur 1/1/13 and there is nothing on their agenda to prevent them from giving their full attention to this problem.
‘Across the pond, the eurocrats are doing what they do best--smoking cigars, drinking wine, chasing skirts and laying on the beach; in other words, doing everything possible to ignore their problem. My obvious concern is that this strategy is not a formula for correcting an acute case insolvency. They may ultimately solve it but it appears that it will take an emergency to generate the necessary action; and given the progressive worsening of the situation, the risk is that conditions will simply deteriorate to the point where the problem is unfixable. In any case, it appears that a crisis is needed to prod action. We just don’t know when and the extent of the economic fallout’.
This is a great editorial on the current state of global monetary policy and why it is not working (medium/long and today’s must read):
This week’s data:
(1) housing: weekly mortgage applications fell but purchase applications rose; March new home sales were positive as were pending home sales [though the latter was a blow out number]; the Case Shiller home price index came in slightly higher than anticipated,
(2) consumer: weekly retail sales were mixed; weekly jobless claims were in line with expectations; the April Conference Board’s index of consumer confidence was below forecast while the University of Michigan’s consumer sentiment index came in above estimates,
(3) industry: March durable goods orders were atrocious; the Richmond Fed’s manufacturing index came in well above expectations while the Chicago Fed’s activity index was a disappointment,
(4) macroeconomic: first quarter GDP was less than anticipated as was the GDP deflator.
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 13228, S&P 1403) closed within both their short term trading ranges (12919-13302, 1372-1422) and their intermediate term up trends (11515-16515, 1209-1776).
Based primarily of our Valuation Model, I am skeptical that the short term trading range can remain as narrow and lofty as it is presently. So a decline incorporating a lower, lower boundary would not be a surprise. However, that is not a call for a bear market. As I have pointed out repeatedly, the Averages have several other support levels including (1) their 200 day moving averages [12150, 1273], (3) the neckline of the reverse head and shoulders pattern [12287, 1266] and (4) the old resistance/support level [11741, 1230].
It has been a while since I ran our internal indicator: as of the close Friday, in a 156 stock Universe, 65 stocks were over their comparable 12919, 1372 level, 69 were not and 22 were too close to call. That is a deterioration since the last reading when the indices were at a lower price level than present. In other words, the Averages have broken above 12919, 1372, re-set to a lofty trading range and the breadth of our Universe has worsened. Thus, while I don’t think that this suggests a Market plunge, I am saying that this indicator supports the notion that the indices are not likely to break to the upside.
Volume on Friday was down; breadth mixed. The VIX was up fractionally, closing within its short/intermediate term trading ranges.
GLD inched up again, remaining firmly within its short and intermediate term trading ranges. The reverse head and shoulders formation continues to develop (a positive).
(1) the DJIA and the S&P are in a new short term trading ranges (12919-13302, 1372-1422) and an intermediate term up trend (11515-16515, 1209-1776),
(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 (13228) finished this week about 20.9% above Fair Value (10940) while the S&P closed (1403) 3.8% over valued (1352). 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.
This week’s economic data supports the sluggish recovery forecasted by our Economic Model; although as I noted above, first quarter earnings results to date provide a bit of cognitive dissonance. However, for the moment I am leaving the inputs to our Economic Model unchanged which in turn means that the price estimations in our Valuation Model are also unchanged.
Our political class is doing absolutely nothing to help matters. Indeed the highlights of their actions this week include the senate’s violation of previously agreed upon deficit limits via an $11 billion bailout of the post office (unions), a top EPA official characterizing his approach to regulating oil companies as similar to the Romans terrorizing subjects to keep them under control and the Ber-nank keeping QEIII on the table. Apparently not up for discussion is the looming tax hikes coming 1/1/13. In other words, not a week designed to lift the confidence of investors/the electorate nor alter the growth inhibiting assumptions in our Models.
‘The solvency/liquidity of the European states and their financial institutions continue to pose the greatest risk to our Valuation Model. The problem is not that we don’t understand the size and scope of this crisis, the problem is that no one seemingly has the balls to do anything about it--which clearly threatens our ‘muddle through’ scenario. To be sure, the eurocrats have acted to pull back from the brink on prior occasions. However, the risk is that because Spain and Italy are so much larger than Greece, the momentum towards default may be impossible to stop once it gathers speed. That raises the probability that either a misstep will lead to a very severe recession and/or a counterparty default in the CDS market snowballs out of control throughout the global financial system.’
I am leaving the ‘muddle through’ assumptions on Europe unchanged for the moment. However, the odds of a disaster scenario blossoming are rising.
The problem with being positive about Europe (medium):
‘In sum, the US economy continues to make slow progress in its recovery in spite of the best efforts of our ruling class and their even less effective European counterparts. With this fundamental background, at current prices, investors appear to be a bit generous in their valuation of US equities; so a drift to lower prices would not be a surprise. The kink in armor is eurocratic intransigence that could ultimately negatively impact US economic growth and/or the stability of our financial institutions. That is not factored into our Models and remains the biggest risk. As a result, I think that the proper strategy is to stay hedged with plenty of cash and gold and focus on individual stocks, mindful of our trading stops and our Buy Lists on any weakness and our Sell Half Discipline on any strength.’
Our Portfolios Added to their GLD position this week.
(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 4/30/12 10940 1352
Close this week 13228 1403
Over Valuation vs. 4/30 Close
5% overvalued 11487 1419
10% overvalued 12034 1487
15% overvalued 12581 1554
20% overvalued 13128 1622
Under Valuation vs. 4/30 Close
5% undervalued 10393 1284
10%undervalued 9846 1216 15%undervalued 9299 1149
* 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.