Saturday, May 26, 2012

The Closing Bell-Will the eurocrats ever offer a solution; if so, how much is priced in?


The summer is upon us and that means beach time. I leave this Sunday and will return the following Saturday. That means no Morning Calls or a Closing Bell next week. As always, I will have my computer with me and will be in touch via Subscriber Alerts if action is required.

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 11692-16692
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 1227-1794
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%

Economics

The economy is a modest positive for Your Money. The data this week were minimal and basically mixed: positives--mortgage applications, new and existing home sales, consumer sentiment; negatives--purchase applications, durable goods orders and the Richmond Fed manufacturing index; neutral--weekly retail sales and weekly jobless claims. Note that over the last couple of weeks, we have started to see a design in the numbers: housing getting better, production getting worse and the consumer flat. That is not the most encouraging pattern; but then neither is our forecast. Nonetheless, progress is being made albeit slowly. Our economic outlook remains:

‘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. The news keeps getting worse here. Estimates of the JP Morgan loss are edging toward $5 billion and I have heard numbers as high as $8 billion. This only sustains my concerns that [a] nobody has a handle on Morgan’s losses and by extension, nobody had a handle on Morgan’s risk management process, [b] if JPM doesn’t/didn’t know it had problems, what lies on the balance sheets of much more poorly run banks like BofA and Citicorp, [c] our regulators are clueless; so what’s to keep this from happening over and over again and finally, the big Kahuna [d] how much additional risk exists in the form of counterparty risk to EU banks if all hell breaks loose over there,

‘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.’
http://www.minyanville.com/business-news/politics-and-regulation/articles/tbtf-too-big-to-fail-banks/5/24/2012/id/41227

(2) oil prices remain high, but once again are less high than they were this time last week. That means that the risks associated with elevated energy prices [dampened consumer spending and narrowing profit margins] are diminishing. However, they are still high enough to act as a governor on US economic growth.

Of course, a blow up in the Middle East could change everything in an instant.

(3) the ECRI weekly index is back in the negative this week. However, as you know, the recent trend has been somewhat erratic; 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.
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php

(4) with the release of the congressional budget office’s assessment of the so-called ‘fiscal cliff’ that will occur 1/1/13 [with the expiration of the Bush tax cuts and the implementation of the mandatory sequestration of spending], I am adding this to our list of worries. As I noted Thursday, it is not that I think that the tax increases and spending cuts will be implemented. Whoever wins in November will do something in January to alter the CBO’s outcome---we just don’t what that will be. In the meantime, however, businesses and consumers also have no idea about what will happen and that fact will likely curb enthusiasm to spend/invest/hire; and depending on the level of fear and loathing this issue spawns, it could negatively impact even our modest growth forecast.

(5) finally, the sovereign and bank debt crisis in Europe remains the biggest risk to our forecast. This week [a] the political class had several meetings and nothing was decided, [b] Spain discovered it had more debt than it originally thought, and [c] worse of all, the banks continue to lose deposits---and this in the globe’s highest loan to deposit banking system.
http://www.zerohedge.com/news/europe-its-all-about-bank-run

‘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.’


Bottom line: the economy continues to perform pretty much as we have expected. So our forecast remains unchanged. Our political class continues its inept and inexcusable behavior. While it could positively influence our outlook if it would only man-up, I doubt that will occur.

Obama’s record as a venture capitalist (short):
http://mjperry.blogspot.com/2012/05/obamas-public-equity-record-is-real.html

Europe is to our forecast what a stick of dynamite jammed up your ass is to a quiet weekend. One wrong move and fagitabotit. I have no idea what these morons in Europe are thinking; but whatever it is, it is not helping. 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---again; both the April new home and existing home sales were up more than anticipated,

(2) consumer: weekly retail sales were mixed; weekly jobless claims were basically flat; the final May University of Michigan consumer sentiment index came in at 79.3 versus expectations of 77.8,

(3) industry: April durable goods orders were terrible; the Richmond Fed manufacturing index was equally as bad,

(4) macroeconomic: none.


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.

http://fullcomment.nationalpost.com/2012/05/23/jesse-kline-the-case-for-universal-fiscal-austerity/#more-78994

The Market-Disciplined Investing

Technical


The indices (DJIA 12459, S&P 1317) closed solidly within their intermediate term up trends (11692-16692, 1227-1794). Throughout the week, they continued to seek the lower boundary of a short term trading range. Importantly, they bounced off of the 12344, 1292 level for the second time; and just as significant, they traded up through and remained above their very short term downtrend for the third day. The break will be confirmed at the close next Tuesday. So this pin action has all the appearances of re-setting that lower boundary of the Averages short term trading range to 12344, 1292.

However, even if the 12344, 1292 levels were to fail, there are other visible support levels in addition to the lower boundaries of the Averages intermediate term up trends. They include (1) their 200 day moving averages [12226, 1281], (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 [12949, 1374] and (4) upper boundaries of their short term trading ranges [13302, 1422].

I have repeatedly opined that I don’t believe the current Market weakness is a precursor to a bear market. Even if the eurocrats continue to stumble along in some torturous ‘muddle through’ scenario, the low would probably be no worse than the lower boundary of the Averages’ intermediate term up trends. Rather I think the indices are simply probing for a lower boundary that will establish a wider trading range incorporating a more reasonable spread around Fair Value. Of course, this all assumes that Europe doesn’t implode; if it does, all bets are off and I will be wrong.

Volume on Friday was up down; so was breadth. The VIX was up, closing above the lower boundary of its intermediate term trading but below the former (?) upper boundary of its short term trading range for the second day.

GLD had another strong day Friday, finishing above the lower boundary of its intermediate 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 (11692-16692, 1227-1794],

(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 (12459) finished this week about 13.4% above Fair Value (10985) while the S&P (1317) closed 3.0% 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.

The economic data continue to support our forecast. Domestically, this outlook could be impacted if (1) energy prices make a sudden move one way or the other, (2) the JPM fiasco turns uglier than most expect, (3) our political class actually do something meaningful to improve the economy’s growth prospects [like dealing with the ‘fiscal cliff’, cutting spending, reforming taxes, etc, etc, etc]. Unfortunately, they seem more inclined to jerk the electorate around [like Obama claiming government spending as grown slower during His administration than any since Eisenhower] than do anything constructive. So for now, the US economic inputs to our Valuation Model are unchanged.

With respect to Europe, conditions continue to deteriorate. This week the eurocrats met and met and nothing happened. Meanwhile, Spain’s debt is mounting faster than expected and the banks continue to lose deposits.

Despite all this, the Market performs as if the EU political class will come up with a solution that somehow minimizes the damage of a Greek withdrawal from the EU and ring fences the rest of the PIIGS. It clearly is not out of the question; though equally clear is that the eurocrats actions to date don’t inspire much confidence in it occurring. If history repeats itself, then the more likely route is another Band-Aid that allows Europe to ‘muddle through’ for another three to six months but simply delays the inevitable. However, the grenade in our underpants is that eurocrats dick around until events overwhelm them and real damage gets done to the global economy and banking 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
and (3) the recent decline has expanded our Buy List and brought many of the stocks whose holding size was cut as a result of our trading discipline down to identifiable support. In sum, our Portfolios are now positioned with lots of cash that brings stability in times of downward volatility and a growing list of attractively valued stocks.

This week, our Portfolios continued to nibble at stocks on our Buy Lists and stocks of current holdings that were Sold on a trading basis 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.

DJIA S&P

Current 2012 Year End Fair Value* 11300 1400
Fair Value as of 5/31/12 10985 1358
Close this week 12459 1317

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.