Saturday, May 05, 2012

The Closing Bell-More reasonable valuations ahead?

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 12919-13302
Intermediate Up Trend 11570-16570
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 1215-1782
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%


The economy is a modest positive for Your Money. This week’s economic data was basically mixed though with a somewhat negative bent. On the plus side: mortgage applications, auto sales, personal income, weekly jobless claims and the ISM manufacturing index. The negatives included: personal spending, April retail sales, the ISM nonmanufacturing index, March construction spending and factory orders, April nonfarm payrolls, first quarter productivity and both the April Chicago PMI and the Dallas Fed manufacturing survey. All in all, a portrait of an economy moving forward but at a sub par rate.

Corporate profits continued to advance and the ‘beat’ rate is holding strong. However, as I noted last week, the magnitude of earnings increases has been quite modest. This seeming contradiction appears to be best explained by prior downward revisions of earnings expectations by the Street---making a high ‘beat’ rate almost inevitable. So in the final analysis, I don’t see a great deal of significance in this quarter’s ‘beat’ rate. Nevertheless while I think it a meaningless exercise at this point, 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.

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.’

The other risks to our outlook haven’t changed:

(1) oil prices are still at elevated levels, though both crude oil and gasoline prices did soften this week and were down big on Friday---which is clearly good news; and if the trend continues, the risk will lessen that high energy prices could stifle consumer spending, shrink corporate profit margins and become another headwind to the economy.

This, of course, leaves aside the associated risk that political volatility in the Middle East could severely disrupt not only prices but also supplies.

(2) the ECRI weekly index declined for the third week in a row. I am still not too concerned with this indicator since the current data flow doesn’t really give it much credence. That said, I continue to keep 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. Furthermore, 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 the elephant in the room. This week the economic data [employment, production and nonmanufacturing] continued to deteriorate with the result that the consensus is accepting that a recession is under way. The only question is its magnitude.

Further, bond markets aren’t improving, keeping the cost of money rising and making debt service ever more difficult.

The politics aren’t getting any better either as politicians are piling on the anti austerity bandwagon but doing little to strengthen economic growth as an offset to mounting deficits. Barring a reversal of this nonsense, our ‘muddle through’ scenario will likely fade into the sunset which would raise the risk of a much deeper EU recession and/or a seize up in its financial system---outcomes that will most assuredly mean trouble for our own economic progress.

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

Our political class spent the week arguing about who would have done what to Osama, ignoring the rising national debt, the deluge of fiat currency, the looming tax increases on 1/1/13 and pandering to the rent seeking class. So barring a minor revolution in November, I continue to expect deficits into infinity, stifling regulation, un-free trade and an ineffective Fed. Regrettably, this is also all in our Model.

‘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; April retail sales were anemic; April auto sales were in line with expectations; March personal income was better than estimates while personal spending was less; weekly jobless claims fell much more than forecast while the April ADP private payroll and nonfarm payroll reports were disappointments,

(3) industry: The April ISM manufacturing index was better than anticipated while the nonmanufacturing index was worse; March construction spending was considerably less than expected; March factory orders fell; the April Chicago PMI fell well short of estimates and the Dallas Fed manufacturing survey was horrendous,

(4) macroeconomic: first quarter productivity declined more than forecast as did unit labor costs.

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.

If I wanted America to fail (4 minute video):

The Market-Disciplined Investing


The DJIA (13045) closed within both its short term trading range (12919-13302) and its intermediate term up trend (11570-16570); though it could not hold its 50 day moving average (13055).

However, the S&P (1369) penetrated the lower boundary of its short term trading range (1372-1422). That activates our time and distance discipline, so I now await either confirmation of this new challenge or a rebound back above 1372. Under normal circumstances, that should occur by the close of trading Wednesday. The S&P remains well within its intermediate term uptrend (1215-1782), but finished the day below its 50 day moving average.

In addition, to potentially taking out the lower boundary of its short term trading range, the S&P may also end up diverging from the Dow. This also will need to be worked out.

I have opined on occasion that based on (1) our Valuation Model, (2) our internal indicator and (3) the start of what appears to be a breakdown of major support levels among some of our stocks, I was skeptical that the indices short term trading ranges could remain at their defined elevated levels. Clearly, some investors seem to be agreeing; however, only time is going to determine if that judgment is correct.

All this said, based on our Valuation Model, I am only looking for a re-set to the lower boundaries of the current trading ranges, not some plunge to bear market lows. As I have pointed out repeatedly, the Averages have several other support levels including (1) the relatively weak support levels set earlier this year [12774, 1338], (2) their 200 day moving averages [12162, 1275], (3) the neckline of the reverse head and shoulders pattern [12287, 1266] and (4) the old resistance/support level [11741, 1230].

In the end, I will be encouraged if stocks can settle on a lower boundary to their short term trading range. In the process, our Buy Lists will likely grow and this will provide the opportunity to re-invest at least some of the funds that have been built over the last several months.

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

GLD was up again, remaining firmly within its short and intermediate term trading ranges. Indeed, it bounced off of the lower boundary of its short term trading range which (1) adds strength to this support level and (2) keeps the development of the reverse head and shoulders formation in tact.

Bottom line:

(1) the DJIA is in a new short term trading ranges (12919-13302) and an intermediate term up trend (11570-16570); the S&P is now challenging the lower boundary of its short term trading range (1372-1422) while remaining within its intermediate term uptrend (1215-1782),

(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 (13045) finished this week about 18.7% above Fair Value (10985) while the S&P closed (1369) 0.8% over 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 Economic Model and therefore its inputs to our Valuation Model.

Our political class is doing absolutely nothing to solve our fiscal problems. Instead this week Obama and Romney had a nonsensical argument over who would have killed Osama bin Laden the deadest and the state department completely botched giving asylum to a blind Chinese dissident. No mention much less action on spending, taxes, the deficit or the explosion in fiat money. Well done, gentlemen, well done. But a word of thanks for remaining true to the assumptions in our Models.

With respect to Europe, I wish that I could point to some change, however small since it is poses the most substantial risk to our forecast and Valuation Model. But alas ‘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 having to alter our outlook to the negative increases daily.

My investment conclusion: the economy is on track with our forecast, the US political class is doing nothing to improve that outlook, Europe is lurging toward another fiscal crisis which will likely be worse than the first and stocks are valuing this scenario too generously. As a result cash, gold and our Sell Discipline are the most important components of our strategy right now; however, a continuing sell off in the Market will price stocks, in general, at more reasonable valuations and some stocks into their Buy Value Ranges. I wait with bated breath.

This week, our Portfolios acted on trading stops, reducing the size of several holdings.

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 13045 1369

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.