Saturday, May 19, 2012

The Closing Bell-It ain't over, till it's over

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):
Short Term Trading Range (?)-13302
Intermediate Up Trend 11641-16641
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 1223-1790
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 31%
High Yield Portfolio 34%
Aggressive Growth Portfolio 35%


The economy is a modest positive for Your Money. The data this week were weighted to the plus side: positives--mortgage applications, housing starts, homebuilders confidence, April retail sales, industrial production, business inventories, CPI and the NY Fed manufacturing index; negatives--purchase applications, the leading economic indicators and the Philly Fed manufacturing index; neutral--weekly retail sales and weekly jobless claims. Clearly, they support our economic outlook:

‘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.’

As for the risks facing this forecast:

(1) a vulnerable banking system. As you know, this concern surfaced last week with the JP Morgan loss. My worry is not the announced deficit; it can easily be absorbed by JPM. Rather it is [a] if the premier risk manager in the industry could sustain such a loss unknowingly, how much more damage lies on the balance sheets of lesser banks. Indeed, as a sign of this problem, the loss at JP Morgan grew this week from $2 billion to a rumored $5 billion---so the bank doesn’t even have a handle on its own problem, [b] as a corollary, it speaks to the lack of effective regulatory oversight. Even if this latest incident is a one off occurrence, what happens next time when mismanagement is systemic, and [c] how much additional risk exists in the form of counterparty risk to EU banks if the s**t hits the fan across the pond.

Until something is done by the legislative/regulatory powers to deal specifically with prop trading and the use of derivatives, I believe that our financial system will be hostage to the hubris and greed of the banking class.

(2) oil prices remain at elevated levels, though they continue to creep downward. The risk here is that high energy prices stifle consumer spending and shrink corporate profit margins. However, the longer the decline in energy prices is in place, the less negative this factor becomes to the economy; and as I noted last week, at some point it starts transitioning from being a negative to a positive. We are not there yet; but the trend is certainly going our way.

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

(3) the ECRI weekly index was up modestly this week. While it was down the prior three weeks, it had been up the preceding two and a half months. So it is small wonder that I remain somewhat skeptical of the validity of its latest recession call. Nevertheless, 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 last week. Furthermore, it has a long time horizon; so until the founder cries ‘uncle’, I leave it as a risk to our outlook.

(4) finally, the sovereign and bank debt crisis problems in Europe remain the biggest risk to our forecast. This week, [a] the Greek political parties were unable to form a working coalition; so there will be another round of elections mid June, if the country can hold on that long, [b] Moody’s downgraded the credit ratings of both the Spanish and Italian banks and [c] worse of all, bank runs appeared to be occurring in Greece and Spain.

***over night Spain announced that its budget deficit had grown from 8.5% of GDP to 8,9%

It is this latter that really has me worried. Bank runs in general end badly; but when accompanied by political paralysis [which I have been yelping about for the last couple of weeks], there is little to moderate the damage.

Not to pile it on, but don’t forget about Portugal and Ireland (medium):

As always I enter the caveat that the eurocrats could wake and devise a plan to [a] at least lessen the damage from a Greek exit of the euro which at the moment seems inevitable or [b] provide temporary support to the Greek/Spanish banking systems if a full fledged bank run begins. But their silent inaction speaks volumes. Moreover, when, as and if they do arise from their stupor, events may have already progressed to the point where any measure will prove inadequate.

The questions then are [a] how bad is it going to get? For that I have no answer. There are simply too many policy {and their consequences} unknowns and [b] how much of all this is the price of stocks? I do have an answer there; and it is ‘probably not nearly enough’. So while I can’t quantify any new assumptions that would reflect a scenario worse than our current ‘muddle through’, I can judge that our Portfolios need a substantial safety net until we know the extent of the impending carnage in Europe.

Bottom line: the economy continues to stumble along making slow but steady progress; and this week’s data support that notion.

Our political class had another marvelous week highlighted by the senate’s 0 to 100 vote against Obama’s 2012 budget and a sophomoric, whiney butt proposal from that same august body to penalize an American from renouncing his citizenship. Once again nothing on spending, taxes, the deficit. All in all, depressing as hell; but well reflected in our Models.

Of course, when it comes to the magnitude of risk, Europe remains the 800 pound gorilla in the room; and as noted above, this week, conditions only got worse. So my take on Europe is unchanged:

‘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 applications rose, but purchase applications fell; April housing starts were strong, but building permits were disappointing; the April homebuilders confidence index advanced modestly,

(2) consumer: weekly retail sales were mixed; April retail sales were up; weekly jobless claims were basically flat but ahead of expectations,

(3) industry: April industrial production was quite strong; March business inventories rose and at half the rate of sales; the May NY Fed manufacturing index was up much more than anticipated while the Philadelphia Fed index was terrible,

(4) macroeconomic: the April leading economic indicators were down; the April CPI was unchanged; the minutes of the latest FOMC meeting revealed nothing new policy wise.

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 12369, S&P 1295) closed solidly within their intermediate term up trends (11641-16641, 1223-1790). However, with the S&P’s close Friday, they both have now confirmed the break below the 12744, 1338 support level; and therefore continue to struggle to reset a lower boundary to their short term trading ranges (?-13302, ?-1422).

For a hint of where that may be, we turn to other visible support levels; and as you know in addition to the lower boundaries of the Averages intermediate term up trends, there are a number, including (1) their 200 day moving averages [12198, 1277], (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 former 12744, 1338 support level, (3) the 50 day moving averages [13032, 1380] and (4) upper boundaries of their short term trading ranges [13302, 1422]. Notice the growing list of resistance levels?---making any recovery potentially torturous.

I have repeatedly opined that I don’t believe the current Market weakness is a precursor to a bear market; and that it is simply probing for a lower boundary that will establish a wider trading range incorporating a more reasonable spread around Fair Value. That said, as the fundamentals in the EU continue to deteriorate and the eurocrats procrastinate, the greater the risk that prices will knife through all the above support levels and disprove my thesis.

Update on ‘the best stock market indicator ever’:

Volume on Friday was up big; breadth was mixed with the flow of funds indicator continuing to plunge. The VIX was up, closing above the upper boundary of its short term trading range for the third day. While the time element of our discipline generally encompasses four to five days depending on the price action, in the this case the distance element has completely overwhelmed the process. Accordingly, the break above the upper boundary of the short term trading range is confirmed---and that is not good for stocks.

GLD had another strong day Friday, recovering above the former lower boundary of its short term trading range.

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 (11641-16641, 1223-1790],

(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 (12369) finished this week about 12.5% above Fair Value (10985) while the S&P (1295) closed 4.6% 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 provided support to the ‘recovery’ part of the slow recovery forecasted by our Model. Lower oil prices are also helping. Not so positive is the continued uncertainty around the magnitude of the JPM loss as well as the extent to which bank management’s in general simply don’t know how much risk is being carried on their balance sheets. All things considered though, I believe that our economy is currently on track to come in as our Model projects. Thus, the US economic inputs to our Valuation Model are unchanged.

Our political class continues to be an embarrassment. This week the senate voted Obama’s 2012 budget down 0 to 100, but offered no alternative, leaving the US without a budget for the third year in a row. Adding insult to injury, they managed to whip up all the righteous indignation of a 12 year old school girl by proposing legislation to penalize individuals who otherwise are sick and tired of putting up with their incompetency and have the cojones to seek refuge elsewhere. Good job---just like we assumed in our Models.

With respect to Europe, conditions continue to deteriorate. This week’s actions were particularly disturbing as a bank run began in Greece and appeared to be spreading to Spain. And nothing from the political class to address those disruptions or to either hold Greece in the euro or moderate the pain of its exit.

‘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.’

My investment conclusion: stocks are starting to reflect the risks of some sort of European meltdown. The problem is that we won’t know the extent of that meltdown until either the eurocrats take some action to moderate it or it just ignites on its own. In either case, though, some portion of the outcome is getting priced in.

The good news is that our economy is growing even though not at a satisfactory rate. The even better news is that (1) our Sell Discipline has led to a build up in cash as some stocks have hit their Sell Half Range and (2) our trading discipline has also moved our Portfolios out of a portion of holdings where the stock prices have violated major support. All that cash brings stability in times of downward volatility and provides reserves for taking advantage of lower stock prices.

In addition, our Buy Lists are growing; and we even nibbled a bit Friday morning. We will continue that strategy if prices decline further. Once support is achieved, our Portfolios will get more aggressive on the Buy side.

I did not shine in my GLD transactions this week, having made a trading sale early in the week but Buying shares back on Friday morning. The redeeming news to this otherwise clumsy trade was that GLD was Bought back at a slightly lower price than the original sale.

This week, our Portfolios Sold then bought back GLD. In addition, several positions in stocks that were breaking down technically were Sold and proceeds used to Buy back shares in other positions that had previously been liquidated at higher prices.

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 5/31/12 10985 1358
Close this week 12369 1295

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

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.