Saturday, June 23, 2012

The Closing Bell-Europe still holds the key


Statistical Summary
Current Economic Forecast


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%

2013

Real Growth in Gross Domestic Product +1.0-+2.0
Inflation 2.0-2.5
Corporate Profits 0-7%


Current Market Forecast
Dow Jones Industrial Average


Current Trend (revised):
Short Term Trading Range 12022-13302
Intermediate Up Trend 11866-16866
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 1266-1422
Intermediate Term Up Trend 1243-1810
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 32%
Aggressive Growth Portfolio 33%

Economics

The economy is a modest positive for Your Money. The data flow was slow again this week but it moved back to more mixed in nature: positives---May building permits, weekly retail sales, May leading economic indicators; negatives---mortgage/purchase applications, the Philly Fed index and lower Fed expectations for US economic growth; neutral---May housing starts and weekly jobless claims.

The stats have now alternated between negative and mixed for two cycles. While that is better than a consistent stream of negative numbers, it nonetheless weighs the overall trend toward the downside. However, it is still too early to assume that the economy is slipping back into recession; and that notion is reinforced by (1) the seasonal pattern of economic data for the prior two years which was strong in the first and fourth quarters sandwiching weaker second and third quarters, (2) the continuing decline in oil prices and (3) the potential psychological benefit of the electorate seemingly embracing fiscal responsibility.

So there are both quantitative and qualitative arguments for holding fast to our forecast. Nonetheless, I would be a fool to ignore the more erratic data and its potential as a warning that the economy may fall short of our forecast. To be clear, it is too soon to alter the economic outlook; but not too soon to worry.

For the moment, our economic outlook remains unchanged:

‘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.’
http://www.zerohedge.com/news/guest-post-fed-and-goldilocks-economic-forecasting


As for the risks facing this forecast:

(1) a vulnerable banking system. Jamie Dimon testified before congress again this week; but overall this issue appears to be fading as an investor concern. However, that doesn’t mean that it should. We still don’t know the extent of JPM’s losses, whether or not JPM could have the problem again, if there are even greater problems on the balance sheets of less effectively run banks and the 800 pound gorilla---what impact a freeze up/collapse of the EU banking system will have on our own financial institutions,

(2) declining oil prices have shifted to a neutral/positive factor for our economy.
http://www.bespokeinvest.com/thinkbig/2012/6/22/impact-of-commodity-prices-on-the-consumer.html

However, a blow up in the Middle East could change everything in an instant.
http://www.zerohedge.com/news/escalation-syria-says-turkish-jet-shot-down-was-over-syrian-territorial-waters

(3) the ECRI weekly index turned negative [again] this week. As you know, the recent trend in the readings of this indicator has been erratic; so I remain somewhat skeptical of the validity of its prediction. On the other hand, the equally erratic economic stats of late lend support to the ECRI’s recession forecast. So it remains on our list of risks for that reason and because of [a] its track record for calling economic downturns and [b] the adamancy of its founder regarding this particular call.
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php

(4) every week that goes by, the closer we get to the 1/1/13 so-called ‘fiscal cliff’. As you know, I believe that in the end, the scheduled tax increases and spending cuts will not occur; or if they do, they will be quickly reversed. Whoever wins in November will do something in January to alter this outcome---we just don’t what that will be. In the meantime, however, our political class remains more focused on its own re-election than dealing with the problems our economy faces, leaving businesses and consumers fearful of what could happen and, therefore, unwilling spend/invest/hire at least in the very short term,

(5) finally, the sovereign and bank debt crisis in Europe remains the biggest risk to our forecast. This week [a] Greece had its run off election and the supposed ‘good guys’ won; however, while no government has been formed, the sole issue on which all the potential coalition members agree is that Greece must be given a three year pass before implementing the fiscal terms of the bail out---once again revealing the lack of will to deal with years of fiscal irresponsibility, [b] the only other news was the lack thereof, i.e. the eurocrats continue to blow a lot smoke while the economic data worsens, interest rates rise and money exits the weak country banking systems.

As dismal as this assessment is, I have no doubts that at the next squeeze point, the eurocrats will come up with another half assed scheme to hold things together for another week or month. Unfortunately, that is becoming an all too familiar pattern with nothing really being done to solve the solvency problems of both the countries and their banks. My fear is that at some point, global investors refuse to buy another token ‘fix’ to the system and precipitate a financial panic that no amount of reform can halt.
http://www.zerohedge.com/news/latest-european-bailout-plan-fizzles-record-time

Bottom line: I continue to believe that the economy is on track to maintain its sluggish below average growth path. That said, the recent trend of weekly stats swinging from negative to mixed and back again raises my level of discomfort. To be sure, there are plenty of arguments for being circumspect about data flow. However, I would be a fool to ignore them. For the moment though our forecast remains unchanged.
http://www.macrobusiness.com.au/2012/06/the-us-triple-dip-panic-arrives/

Meanwhile, our political class remains fixated on its re-election while businesses and consumers worry increasing about the ‘fiscal cliff’---a circumstance that is not likely to improve the outlook for growth.

‘European mismanagement of their sovereign and bank debt problems remains the greatest threat to our forecast. I have no idea how this situation resolves itself, but the odds of a bad news scenario are high enough and the consequences severe enough, that we have to leave open the possibility of another recession in the US. To be clear, that is not our forecast but there is a significant risk to it.’

The French continue to do their part (short):
http://www.zerohedge.com/news/hollande-goes-full-obama-second-great-october-socialist-revolution-takes-place-june

The pessimist’s scenario (medium):
http://www.zerohedge.com/news/eric-sprott-presents-ministry-untruth

This week’s data:

(1) housing: weekly mortgage applications and purchase applications fell; May housing starts were off, though April starts were revised up hugely; building permits were up; May existing home sales were down though this was expected,

(2) consumer: weekly retail sales were up; weekly jobless claims were basically flat,

(3) industry: the Philadelphia Fed’s June manufacturing index dropped considerably more than anticipated,

(4) macroeconomic: May leading economic indicators were better than estimates. In its latest FOMC meeting, the Fed lowered its expectations for economic growth.

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 12640, S&P 1335) closed within their intermediate term uptrends (11866-16866, 1243-1810) and their short term trading ranges (12022-13302, 1266-1422).

This week the reverse head and shoulders pattern and its follow through were negated---which means my focus reverts to the two above primary trends. Within the short term trading range, the former reverse h&s ‘necklines’ (12744, 1338) now offer initial resistance (indeed, in Friday’s pin action the S&P traded up to that level and then retreated) while the former ‘shoulder lines’ (12344, 1292) mark initial support.

Volume on Friday was up; breadth improved. The VIX fell, closing again below the lower boundary of its short term uptrend. As you know, it broke that uptrend for the first time this past week but under our time and distance discipline failed to confirm that break. Friday’s action re-starts that process. In the meantime, it remains above the lower boundary of its intermediate term trading range.

GLD was up modestly, finishing above the lower boundary of its intermediate term trading range,

Bottom line:

(1) the indices are in short term trading ranges [12022-13302, 1266-1422] and well within their intermediate term up trends (11866-16866, 1243-1810],

(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 (12640) finished this week about 14.5% above Fair Value (11030) while the S&P (1335) closed 2.1% under valued (1364). 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.

While the economic data continues to track our forecast, we have received some cognitive dissonance of late, i.e. a decline in magnitude of positive stats, weaker than expected growth in Germany and China and the Fed’s downgrade of its outlook. To be fair, there are some offsetting considerations: that 2012 could be a repeat of the seasonally weak pattern of growth in 2010/2011 and declining oil prices. In total, these factors raise the likelihood that the US may slip back into recession but not enough to alter our Model. Hence, the economic inputs to our Valuation Model are unchanged.

The political inputs to our Valuation Model are also unchanged. This week our political class spent their time arguing about immigration and the ‘fast and furious’ scandal. Not that these are unimportant issues; but they are way down the list after dealing with the ‘fiscal cliff’, cutting taxes, reducing regulations, etc. I know this is an election year and the ‘important’ issues are too sensitive to deal with---but that is my point: there is always some bulls**t reason for not addressing the problems that are preventing our economy from returning to its historically higher rate of secular growth.

I have observed that this could change if the recent message delivered by the Wisconsin voters is echoed through the entire electorate. Unfortunately at the moment, that is just a gleam in our eye.

All that said, the key factor that will determine the correctness of the economic assumptions in our Valuation Model is the effectiveness with which Europe deals with its sovereign and bank debt problems. As you know, those assumptions are that (1) Greece leaves the euro, but (2) the eurocrats will take sufficient steps to ring fence the remaining PIIGS and allow the eurozone to ‘muddle through’---which I define as a slow, painful process of correcting the fiscal imbalances with the most likely result being zero overall growth for approximately the next decade.

The operative words above are ‘sufficient steps’ which have been hard to come by of late. Regrettably, the eurocrats have yet to demonstrate the will or the balls to face their problems---their latest steps being perfect examples: all the focus is on supporting the current unsupportable level of debt by..............piling on more debt.

To be sure, when their collective backs are against the wall, the eurocrats could come up with a workable solution. They have done so in the past. However, the risk is that they fiddle until an extreme shock occurs but it will be too late to salvage the eurozone and a financial panic ensues.

That means that the key valuation issue is, at what price levels is a European disaster scenario discounted? ‘Unfortunately, as I have said several times, I have no idea what the answer is because we don’t have a model for the dismise/shrinking of a monetary union. So, in the absence of any worthwhile fundamental assumptions to the contrary, I have to look at technical support levels, the most dominant of which is the lower boundaries of the Averages intermediate term uptrends. The problem of course is that it is not that far away and common sense tells me that a ‘disaster’ scenario implies a much lower level.’

My investment conclusion: stocks (as defined by the S&P) are right on Fair Value (as defined by our Model). Under less stressful circumstances, that would leave room for our Portfolios to ‘nibble’ at stocks on our Buy Lists. However, this is not exactly a normal time with an unquantifiable risk on the immediate horizon that is impossible to reflect in our Model. Hence, our Portfolios’ large cash and GLD positions. That said, because I don’t know the magnitude or probability of any downside move, the best strategy is to ‘nibble’ through any Market declines which our Portfolios will do but starting at lower levels.

This week, our Portfolios took no action.

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 6/30/12 11030 1364
Close this week 12640 1335

Over Valuation vs. 6/30 Close
5% overvalued 11581 1432
10% overvalued 12133 1500
15% overvalued 12684 1568

Under Valuation vs. 6/30 Close
5% undervalued 10478 1295
10%undervalued 9927 1227 15%undervalued 9375 1159

* 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.