Saturday, April 14, 2012

The Closing Bell -- Investors realize Europe is still a problem


TStatistical 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):
Short Term Trading Range ???-13302
Intermediate Up Trend 11429-16429
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 ???-1422
Intermediate/Short Term Up Trend 1200-1767
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 34%
Aggressive Growth Portfolio 32%

Economics

The economy is a modest positive for Your Money. Not much data this week and what little we had was mixed to positive: weekly retail sales, February wholesale inventories and sales, March PPI and CPI, the February trade deficit and the latest Fed Beige Book were generally upbeat. Those were offset by more negative readings in weekly mortgage applications, weekly jobless claims, the March budget deficit and the latest University of Michigan’s consumer sentiment survey.

This pattern of slow, erratic economic progress reflects our forecast; so I see little need for any adjustments to our Economic Model. As you know as of our last Closing Bell two weeks ago, investors were getting jiggy about a faster recovery than envisioned in our outlook; and I rated the potential of our Model being too pessimistic as a major risk. However, since that time, investors have apparently sobered a bit and consensus about the economy appears to be moving back to something more akin to our sluggish growth forecast. Accordingly, I think the risk that I may be underestimating the US 2012 economic growth rate is fading rapidly and will soon cease to be a consideration.

So 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.’

A couple of the remaining risks to the economy have also shifted a bit in the last two weeks, while the principal risk remains as potentially lethal as ever.

(1) as I noted in Thursday’s Morning Call, I believe that the magnitude of recent natural gas discoveries coupled with natural gas’ much lower price per BTU will work to offset the stifling impact of high oil [gasoline prices], at least in the long term. In spite of the obstacles thrown up by our political class, the oil and gas industry has done a fantastic job discovering and building production of natural gas. Now the fracking technology that led to the expansion of shale gas reserves is being applied to oil shale. That should begin to raise our domestic oil production.

At the same time, industry and utilities are converting their energy usage from expensive and dirty oil and coal to cheaper and cleaner gas which should ultimately ease demand pressure on oil and its price. So barring [a] another moronic move by a heavily environmentalist administration to curb natural gas production and/or usage and/or [2] a conflagration in the Middle East, I am becoming much less concerned about the stagnating impact of high oil prices.
http://www.realclearmarkets.com/articles/2012/04/12/europe_cant_kick_the_can_much_farther_99613.html

(2) conversely, with the data flow no longer universally positive, that pesky ECRI recession call gains some added credence. Although once again the index improved--now for the thirteenth week in a row. Nonetheless, I leave it in our list of risks because of [a] its track record for calling economic downturns and [b] the founder remains adamant in his forecast.
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php

(3) the sovereign and bank debt problems in Europe have started to re-surface as the earlier generous ECB lending facility winds down--this week Spain and Italy held the spotlight. I had hoped that the Greek bankruptcy would spur more constructive action in terms of fiscal responsibility; but the EU political class seems more intent on rearranging the deck chairs on the Titanic than embarking on any substantive action. The risk here remains that either a major recession in the EU occurs and/or another country follows Greece in to bankruptcy but with much graver consequences [dislocations in the global financial derivatives market].
http://www.project-syndicate.org/commentary/europe-s-short-vacation

Bottom line: the US economy remains on track for a real growth rate in 2012 of 1.5-2% (i.e. our forecast). Meanwhile, our political class is now on permanent break until November (but who is complaining?). The only problem with the latter is that January 1, 2013 looms ever closer. That means big tax increases if nothing is done and a likely 2013 economic growth rate weaker than 2012.

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 have deteriorated 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.
http://www.realclearmarkets.com/articles/2012/04/12/europe_cant_kick_the_can_much_farther_99613.html

This week’s data:

(1) housing: weekly mortgage applications and purchase applications fell,

(2) consumer: weekly retail sales were again positive; weekly jobless claims were a disappointment; the preliminary April University of Michigan index of consumer sentiment came in at 75.7 versus expectations of 76.2 and the final March reading of 76.2,

(3) industry: February wholesale inventories and sales were strong; the Chicago Fed’s manufacturing index advanced,

(4) macroeconomic: March PPI was unchanged though the core rate rose more than anticipated; conversely, March CPI was a bit hotter than forecast, while the core rate was in line; the March budget deficit came in higher than expected; the February US trade deficit fell considerably more than estimated; the latest Fed Beige Book survey showed broad based economic improvement.

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.)

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


The indices (DJIA 12849, S&P 1370) confirmed the break of their short term uptrends this week but remain well within their intermediate term uptrends (11429-16429, 1200-1767). The question now before technicians is defining the boundaries of the newly re-set short term trading range. We, of course, know the upper boundary--the recent highs (13302, 1422).

The issue is the lower boundaries. At the moment, there are two likely candidates:

(1) the former 12919, 1372 resistance turned support. Early this week, the Averages cut below these levels like a hot knife through butter, spent two days below them, rallied one day back above, then finished the week once again below. Clearly, this is the current battleground between the bulls and the bears. I have no idea if these levels will hold; but this week’s pin action is not a positive sign. Adding credence to this notion is the S&P 50 day moving average [1374] which is clearly in very close proximity to 1372 and should have provided extra support--but hasn’t. All that said, I still lean on our time and distance discipline as the arbiter of the strength of 12919, 1372 and that will take a couple more days to make a determination.

(2) a very weak support zone at 12724, 1338. This week the Dow actually traded down, touched this level and then bounced. So it is worth keeping an eye on.

To be clear, the break down of the short term uptrend and the re-set to a trading range should not be viewed as a technically cataclysmic event nor should the penetration of either or both of the aforementioned candidates for the lower boundary of the new trading range. As I have noted many times, there is a surfeit of support levels that could hold any decline within reasonable bounds. In addition to the lower boundaries of the intermediate term up trends, these support levels include (1) their 200 day moving averages [12124, 1271], (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 up; breadth deteriorated. The VIX shot up again finishing above the upper boundary of its short term downtrend for the fifth day. That confirms the break and re-sets this indicator to a short term trading range. Here we know the lower boundary but must let it find an upper boundary. Wherever and whenever that occurs, this violation of the downtrend is not a good signal for stocks.

GLD seems to have found a base to its short term trading range and is now working to penetrate the upper boundary of a very short term down trend. While off on Friday, GLD nonetheless managed to remain above that upper boundary for the second day. I want to see it open Monday; but our Portfolios will likely Add to this position.

Bottom line:

(1) the DJIA and the S&P are in a short term trading ranges (???-13302, ???-1422) and intermediate term up trends (11429-16429, 1200-1767),

(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 (12849) finished this week about 17.4% above Fair Value (10940) while the S&P closed (1370) 1.3% 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.

The economic data has returned to being mixed to positive which supports both our Economic and Valuation Models. The period of universally upbeat stats appears well behind us and with it the risk that our Valuation Model is too pessimistic.

Our political class continues to disappoint. This week: Obama’s focus on higher taxes on the rich which if enacted would have an almost imperceptible impact on the deficit is nothing but a political ploy and fails to address the real reforms (spending cuts) that are needed to regain control of fiscal policy. This is unlikely to change before November and then there will be less than two months until the Bush tax cuts expire. Not confidence inspiring, but built into our Model.
http://www.washingtonpost.com/opinions/free-lunch-egalitarianism/2012/04/12/gIQAu3wnDT_story.html

Europe is back in the headlines and not for positive reasons. Despite recent optimism, conditions haven’t changed which is to say that the eurocrats continue to dick around, apparently afraid to make the necessary reforms to keep the continent solvent. This doesn’t mean that they won’t ultimately do the right thing. But the longer they wait, the greater the probability of a misstep that leads to a very severe recession and the chance that a counterparty default in the CDS market snowballs out of control throughout the global financial system. Just to be clear, even if politicians do manage to construct a viable ‘muddle through’ set of policies, Europe would still be faced with years of zero to very low growth. That will weigh on the international profits of many US companies--the good news is that this is in our Models.
http://www.washingtonpost.com/opinions/europes-financial-crisis-never-really-went-away/2012/04/12/gIQAsZrwCT_story.html

In sum, it is tough environment out there although the natural resilience of what is left of our capitalist society is pushing the economy forward despite the best efforts of both our own and the European political class. Our Valuation Model suggests that this scenario (save a European catastrophe) is reasonably well reflected in equity prices at current levels. And I think that the recent inability of stocks to hold their short term uptrend for any appreciable time provides additional support to our Model. Hence, I have no strong feelings about a big Market move in either direction. As a result, I think that the proper strategy is to focus on individual stocks, mindful of our stops and our Buy Lists on any weakness and our Sell Half Discipline on any strength.

I don’t have to tell you that the short term uptrend didn’t last all that long; and, therefore, the value of our Portfolios’ upside hedge in the VIG was also short lived. Our Portfolios Sold all of this position this week.

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 4/30/12 10940 1352
Close this week 12849 1370

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.