Saturday, June 09, 2012
The Closing Bell-Long term looking brighter; short term looking darker
Current Economic Forecast
Real Growth in Gross Domestic Product (revised): +1.0- +2.0%
Inflation (revised): 2.5-3.5 %
Growth in Corporate Profits (revised): 5-10%
Real Growth in Gross Domestic Product +1.0-+2.0
Corporate Profits 0-7%
Current Market Forecast
Dow Jones Industrial Average
Current Trend (revised):
Short Term Trading Range (?)-13302
Intermediate Up Trend 11773-16773
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 1236-1803
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. There wasn’t much data this week; and what there was, was mixed: positives---mortgage applications, weekly retail sales, the ISM nonmanufacturing index, unit labor costs, wholesale sales and inventories and the most recent Fed Beige Book report; negatives---mortgage purchase applications, factory orders, first quarter productivity and the April trade balance; neutral---weekly jobless claims. This follows a rotten set of numbers last week; but as I have often said, one week’s worth of stats doesn’t make a trend. So in getting back to a more mixed flow, it should lessen concerns that the economy is suddenly taking a turn for the worse. So 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.’
Note that I have added a 2013 forecast in the above stats. It basically depicts the continuation of the current sluggish recovery with the rate of both inflation and corporate profits falling. The inflation number may raise some questions given my continual trashing of the Fed for too much easing. The answer is that basically for the long term nothing has changed; but as long as the US together with most of the globe continues to limp along, the day when the Fed will have to start tightening keeps getting pushed back. In addition, this outlook ignores any potential improvement derived from more sound governance---something that could occur if voter sentiment in Wisconsin reflects that of the electorate in general (more on that below).
As for the risks facing this forecast:
(1) a vulnerable banking system. Not much news on this front this week. JP Morgan’s difficulties have faded if only temporarily. However, that in no way mitigates the risk to our financial system that JPM’s original problem exposed. Indeed, this week we got more news on just how mismanaged MF Global was. Not that I am comparing Dimon to Corzine; but they both still experienced the same results from poor risk management---the only difference was that of degree. So the risks have not gone away: [a] nobody had a handle on the magnitude of 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,
(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 was negative again 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. Furthermore, it has a long time horizon; so until the founder cries ‘uncle’, I leave it as a risk to our outlook.
This video from Charles Biderman supports the ECRI data (6 minutes):
(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 be 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, 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 chattered endlessly but decided nothing, [b] Spain discovered it had more debt than it originally thought and was rewarded with a downgrade from Fitch, [c] the French made their usual constructive contribution by lowering their retirement age and [d] most concerning of all, the Greek, Spanish, Portuguese and Italian banks continue to lose deposits [to the Germans]. This money flow is completely unsustainable and will at some point precipitate a banking crisis that has the potential of turning into something much worse.
‘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......... 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.’
On the other hand, there were two events this week that could potentially impact our forecast positively:
(1) the voters in Wisconsin stood up and said yes to fiscal responsibility. My assumption is that if this sentiment runs that deep in an otherwise very liberal state, it is likely pervasive throughout America. The positive aspects to this are hopefully that [a] it is a prelude to the November elections which could return the management of this country towards a more centrist orientation, and [b] it is a clarion call to the political class that a quiet revolution is brewing at the grassroots, that their jobs are on the line and that their current routine of putting their re-election ahead of their responsibility to properly manage this country is no longer the working model.
To be clear, [and assuming that I am correct] nothing is going to happen tomorrow to improve the economy, cut spending, cut taxes, reduce regulation, remove the ‘fiscal cliff’ as a risk or sop up all the money sloshing around the banking system. However, if the attitude of Wisconsins begins to manifest itself nationwide and impacts the priorities of the political class, then policies will begin to change, the government will be pointed in the direction of fiscal/monetary responsibility, business and consumer optimism will return and with it, investing, hiring and spending. Hence, America may have a chance for the gradual return of conditions that foster normal secular economic growth.
(2) China cut interest rates. As you know, this country has been the engine of global economic growth over the past five to ten years but recently suffered a bout of the same malaise as most of the rest of the world economies. Any new steps to improve China’s growth prospects will likely positively impact the economies of both the US and Europe---helping the US to remain on its growth path and lessening the severity of the impending European recession. All that said, I repeat my caveat that this assumes that the Chinese economy isn’t in much worse shape than we think.
Bottom line: the economy continues to perform pretty much as we have expected and may get something of a boost from recent Chinese easing in monetary policy. So our forecast remains unchanged.
Our political class continues its inept and inexcusable behavior. However, they got a wake up call from Wisconsin this week. It is too soon to know how well they have listened; but hopefully this election was the first step back towards less but more responsible governance. (Apparently Obama didn’t get the message because in a just completed press conference on the economy, He had the audacity/ignorance/cluelessness to say the ‘the private sector is doing just fine’ and what the economy needs is more spending in the public sector. Say good night Barack.)
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.
This week’s data:
(1) housing: weekly mortgage applications rose, but purchase applications fell---again,
(2) consumer: weekly retail sales were up; weekly jobless claims were down slightly more than anticipated,
(3) industry: April factory orders fell more than expected; the ISM nonmanufacturing index came in better than estimates; wholesale inventories were up as anticipated with wholesale sales very much stronger,
(4) macroeconomic: first quarter productivity was down more that forecasts while unit labor costs rose less than anticipated; the most recent Fed Beige Book report was upbeat about both growth and inflation; the April trade balance was a bit worse than estimated.
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 12554, S&P 1325) closed solidly within their intermediate term uptrends (11773-16773, 1236-1803). In addition as of the close Friday, they are in the midst of a challenge of the short term downtrend (12354, 1302) off the May highs. If these boundaries can be taken out to the upside, that would also contribute strength to a support zone (12037-12269, 1266-1285) for the short term trading range. If they can’t successfully challenge the downtrend, that probably means that stocks are headed lower and those support zones won’t hold.
However, even if the 12037, 1266 levels were to fail, there are other visible support levels including the lower boundaries of the Averages intermediate term up trends [11773, 1236] and 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 [12807, 1356] and (4) the 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 have been 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 down; though breadth was up. The VIX fell, but closed above the lower boundaries of its intermediate term trading as well as its short term uptrend.
GLD was up modestly, finishing above the lower boundary of its intermediate term trading range. However, it continues to toy with me over whether or not it successfully challenged the short term downtrend. For the moment, I am leaving the question open.
(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 (11773-16773, 1236-1803],
(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 (12554) finished this week about 13.8% above Fair Value (11030) while the S&P (1325) closed 2.8% 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.
The economic data continue to support our forecast. As noted above, the economy potentially received some additional help this week, near term from the Chinese dropping interest rates and quite possibly longer term from the ramifications of the Wisconsin vote. If the full potential of the latter could be realized, it would do much to alter the economic/political assumptions that are built into our Models. It is too soon to do so; but not too soon to hold out hope.
In the meantime, domestically, our economy must still deal with the potential impact of (1) energy prices making a sudden move one way or the other and (2) the JPM fiasco turning uglier than most expect. However at the moment, neither seems to developing in a way that poses significant risks to the economy.
For now, the US economic/political inputs to our Valuation Model are unchanged; however, for the first time in a long time, there are positive developments that could alter our Model instead of a list of solely negative factors.
Unfortunately, the same cannot be said for Europe as 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. Surprisingly enough (at least to me), ‘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: the positive news this week notwithstanding, the global economy and, hence, the US economy must still deal with a potential meltdown in Europe. While stocks are likely pricing in some variation of a ‘muddle through’ scenario, the risk of something much worse occurring is in no way reflected; and regrettably, the probability of that happening is sufficiently high that our investment strategy has to take it into account. Hence, our Portfolios’ large cash and GLD positions.
The silver lining to this somewhat dismal assessment is that our Portfolios have plenty of fire power to take advantage of our growing Buy Lists.
This week, our Portfolios took no action.
(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 6/30/12 11030 1364
Close this week 12459 1317
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.