Saturday, May 12, 2012

The Closing Bell-Is the 'best in breed' less than best?



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):
Short Term Trading Range (?)-13302
Intermediate Up Trend 11604-16604
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 Term Up Trend 1218-1785
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 33%
Aggressive Growth Portfolio 34%

Economics

The economy is a modest positive for Your Money. It was a very slow week for economic data. Most of it was mixed (retail sales, jobless claims and March wholesale inventories/sales) to positive (mortgage and purchase applications, the April PPI headline number and the University of Michigan’s preliminary May index of consumer sentiment) with one negative stat (the March trade deficit). While limited, there is nothing in these figures to warrant questioning our forecast.

However, what does cause me to question our outlook is the latest doozy from JP Morgan; that is, its prop trading desk took too much risk in the derivatives market, didn’t understand (or care about) the extent of the risk and lost a boat load of money. As I noted in yesterday’s Morning Call, coming out of the 2007/2008 financial crisis, one of my primary concerns was the soundness of the US banking system’s balance sheet. My reasoning was that in addition to the losses that they had to write off (that weakened their balance sheet), there likely remained plenty risk (losses) that they either didn’t know existed or they knew and were lying about it. As a result, in the summary of our economic forecast was the phrase ‘and a financial system with an impaired balance sheet’.

I was later duped by all the bright and rosy bulls**t from the Fed, the Treasury and the banks that they (the banks) had worked hard to get rid of or wrote off the poor assets and had strengthened their financial condition with the result that I mistakenly edited that aforementioned phrase out. Clearly, the huge loses from derivatives trading by the supposedly ‘best in breed’ bank suggest that I was premature in that judgment. That is bad enough; however, given that many European banks are on the precipice of bankruptcy, the question arises, how much exposure do our banks have to their EU counterparts and, like Morgan, have no clue (or are lying) about? Certainly, I don’t know; but this risk prompts me to re-add the statement regarding our financial system to our forecast summary---which also means my confidence in that forecast has been downgraded.

‘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.’

Another in depth but not so technical look at JP Morgan prop trading fiasco (medium):
http://www.nakedcapitalism.com/2012/05/jp-morgan-loss-bomb-confirms-that-its-time-to-kill-var.html

And the bottom line on the whole system of prop trading (medium):
http://www.ritholtz.com/blog/2012/05/imperfect-bankers/

As for the risks facing this outlook:

(1) as you know, I had previously re-established ‘a stronger than expected recovery’ on this list given the better than anticipated profit ‘beat’ rate in the initial weeks of first quarter earnings season. I stated that ‘while I think it a meaningless exercise....., I am going to leave ‘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 low analyst expectations.’

However, last week, the ‘beat’ rate stat reversed itself dramatically falling from 73% to 60%, the latter being below the average of recent quarters [62%]. I think that in light of this latest tally, we have reached the aforementioned threshold. Accordingly, I am removing ‘a stronger than expected recovery’ as a risk to our forecast.

(2) while oil prices are still too high, they continue to decline [Mr. President, aren’t you going to give speculators credit for that? Just asking.]. Clearly, the more they fall, the less the risk that that high energy prices could stifle consumer spending and shrink corporate profit margins. Indeed at some point, energy prices will transition from being a negative for the economy to a positive as consumer disposable income rises and the cost of a key production component falls. We are not there yet; but the trend is certainly going our way.
http://www.zerohedge.com/news/crudes-crash-conundrum-explained

That said, a blow up in the Middle East could change that in an instant.

(3) the ECRI weekly index was basically flat this week. I continue to not take this indicator too seriously. However, I am keeping it 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---which he reiterated again this week [see below]. Furthermore, it has a long time horizon; so until the founder cries ‘uncle’, I leave it as a risk to our outlook.
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php

(4) finally, the sovereign and bank debt problems in Europe remain the biggest risk to our forecast; and as you know, following last weekend’s French and Greek elections, it returned to center stage as the newly elected politicians promise that austerity is a thing of the past [as if]. Meanwhile, the economic data were grim, Greece is completely unraveling and the Spanish banks are a whisker away from the trash bin.

At the moment, the problem with all of this is the seeming inability of the political class to properly deal with a single critical issue. As a result, the euro is increasingly at risk of becoming a failed concept. What is so frustrating is that the evidence of its demise is right in front of the eurocrats’ eyes and it is never ending. This week, for example, in the face of the fallout from last weekend’s elections [and the excoriation of austerity] there was absolutely nothing [at least to date] in the way of a possible solution forthcoming from the EU establishment---not even the usual ‘everything is fine; there are no problems we can’t fix’ bulls**t they normally give out.

Once again, I am not saying that they won’t pull another rabbit out of the hat this time around. But their current ‘deer in the headlights’ response is not comforting. Hence, our ‘muddle through’ scenario probably has no better than an even chance of occurring. If it does not then, our forecast will have to deal with the increased likelihood of a severe recession if not a depression in Europe over the short term with the chance that the EU banking system seizes up and spreading to the global markets.

Not to end this on too dreary a note, the worse case [dissolve the euro or redefine the euro by kicking southern European countries out or something comparable] for the EU short term is actually the most positive case, in my opinion, longer term. Better to admit failure, cease compounding the error with more harmful fiscal/monetary policies and remove the drag from the economically responsible countries than bet the whole enchilada on what is fast becoming a bankrupt ideal.

A more sanguine look at Europe (medium):
http://pragcap.com/10-points-on-the-comity-of-europe

And a not so sanguine one (medium):
http://www.ritholtz.com/blog/2012/05/imperfect-bankers/


Bottom line: the economy continues to stumble along making slow but steady progress---just as depicted by our Model.

Our political class spent this week arguing over gay marriage while both our trade and budget deficit grow and 1/1/13 is a week closer. Discouraging as this all is, it too is in our Model.

As far as the major risk to our forecast, things have only gotten worse. To emphasize my conclusion, I considered putting the following in all caps or in bold italics or just repeating a couple more times. But since you have already read several times, I will leave it as it is:

‘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 week’s data:

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

(2) consumer: weekly retail sales were mixed; weekly jobless claims were basically flat with the prior week; the preliminary May University of Michigan index of consumer sentiment came in at 77.8 versus expectations of 76.2,

(3) industry: March wholesale inventories fell but sales rose; small business sentiment rose in April,

(4) macroeconomic: the March trade deficit was larger than anticipated; the April producer price index headline number fell while the core rose as expected.

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 12820, S&P 1353) closed solidly within their intermediate term up trends (11604-16604, 1218-1785); however, they are struggling with the reset of the lower boundary to their short term trading ranges (?-13302, ?-1422).

While the 12744, 1338 levels look to be decent candidates for the new lower boundary, there are plenty of others including (1) their 200 day moving averages [12183, 1276], (2) the neckline of the reverse head and shoulders pattern [12287, 1266] and (3) the old resistance/support level [11741, 1230].

As for resistance, we are now looking at (1) the 12919, 1372 former support level, (2) the 50 day moving averages [13062, 1386] and (3) upper boundaries of their short term trading ranges [13302, 1422]

Just to reiterate, I don’t believe the current Market weakness is a precursor to a bear market; it is simply probing for a lower boundary that will establish a wider trading range incorporating a more reasonable spread around Fair Value. The worse case would be a challenge of the lower boundaries of their intermediate term up trends

Volume on Friday was flat; breadth was down. The VIX was up, closing within its short/intermediate term trading ranges and continuing to build a reverse head and shoulders formation.

GLD closed down and below the secondary support level of 154.10. Our time and distance discipline kicks in here; but since there is a trading component to this holding, our Portfolios will Sell a portion of their GLD holdings Monday morning, barring an over night/early morning snap back above the 154.10 level. The lower boundary of the intermediate term trading range is 148.20.

Bottom line:

(1) the indices are probing for new lower boundaries to the short term trading ranges [?-13302, ?-1422] but remain well within their intermediate term up trends (11604-16604, 1218-1785],

(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 (12820) finished this week about 16.7% above Fair Value (10985) while the S&P (1353) closed 0.4% under valued (1358). 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 anemic recovery forecasted by our Model. The good news is that it may soon be getting additional help from declining oil prices. The bad news is that even the best CEO in our financial system can’t manage his ‘too big to fail’ bank, which adds an extra element of risk to our outlook. All that said, I haven’t altered the economic inputs to our Valuation Model.

Our political class continues to do absolutely nothing to solve our fiscal problems. This week they wasted their time debating gay marriage and whether an Arizona sheriff is a racist----you know, critically important s**t. Once again no mention much less action on spending, taxes, the deficit or the explosion in fiat money---just like we assumed in our Models.

With respect to Europe, I keep hoping that somebody will put on their big boy pants and take the steps needed to start the EU down the road to fiscal responsibility. But that is not happening; indeed I am reminded of Munich 1938 when the eurocrats ignored the risks and prayed their latest action would prevent catastrophe. We know how that worked out.

‘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.’

The risk to the financial system, I might add, is all the greater now that we know our own banks are not as financially sound as we had thought; and if they aren’t, how bad do think the eurosystem is?

My investment conclusion: if it weren’t for Europe, I would be resting easy, unconcerned about the economic outlook and equity values portrayed by our Models. Unfortunately, the EU political class seems incapable of seriously addressing the problems facing both their countries and their financial systems. Their only solution seems to be doing more of the same which (aside from being very little) only brings us to the classic definition of insanity (i.e. doing the same thing and expecting a different outcome).
http://www.telegraph.co.uk/news/worldnews/europe/greece/9257302/Its-too-late-for-Germany-to-save-the-euro.html

The good news is that stocks are at least starting to recognize that all is not well in Denmark. The bad news is that we don’t know how awful things can get; and unfortunately that has been made worse by the recent disclosure that our own banking system isn’t quite as swell as we thought.

That continues to argue for a big cash position and strict attention to our Price and trading Disciplines. I leave GLD as an asterisk to this strategy. Not because I don’t believe that it will ultimately prove to be a great hedge; but because right now the price action seems to be suggesting that I am in the minority on that judgment. In this Market, I am not going to stand in front of an oncoming train.

This week, our Portfolios did nothing.

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 5/31/12 10985 1358
Close this week 12820 1353

Over Valuation vs. 5/31 Close
5% overvalued 11534 1425
10% overvalued 12083 1493
15% overvalued 12632 1561
20% overvalued 13182 1629

Under Valuation vs. 5/31 Close
5% undervalued 10435 1290
10%undervalued 9886 1222 15%undervalued 9337 1154

* 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.