Saturday, June 16, 2012
The Closing Bell-More liquidity does not solve a solvency problem
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 12022-13302
Intermediate Up Trend 11811-16811
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 1241-1808
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%
The economy is a modest positive for Your Money. The data flow was pretty slow again this week and was largely negative: positives---mortgage and purchase applications; negatives---May retail sales, weekly jobless claims, April business sales, the May budget deficit, industrial production, capacity utilization, the NY Fed manufacturing survey and the University of Michigan’s June consumer sentiment index; neutral---weekly retail sales and May PPI and CPI (although the headline numbers were down largely as a result of lower gasoline prices and residential energy costs, i.e. natural gas prices).
We now have a rotten data flow for two of the last three weeks. That, of course, doesn’t mean that the economy is potentially slipping back into recession. Indeed, the optimists argue that the strong weather related first quarter ‘stole’ growth from the second and third quarters; and therefore, the current more sloppy trend in the stats is to be expected. I think that this case has some validity to it.
Plus, if the electorate’s recent strong endorsement of fiscal responsibility continues to manifest itself, then as we move into the late third quarter and early fourth quarter, the polls will likely reflect a move to more sound governance. If that is the case, then consumer, business and investor psychology should improve and with it an increase in spending, hiring and investing. To be sure, there are a lot of ‘ifs’ in this latter point. But it presents the opportunity for the return of a positive force impacting economic growth.
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.’
As for the risks facing this forecast:
(1) a vulnerable banking system. As you know, I added this factor following the disclosure of JP Morgan’s large trading loss; my concern being that poor risk management by the major banks could contribute to another credit crisis in particular if Europe implodes. This week Jamie Dimon testified before congress on JPM’s problem; but it was much ado about nothing. Unfortunately, our elected representatives simply don’t know enough about hedging/trading derivatives to actually have an intelligent investigation or come to any conclusions about reform.
So 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, if the regulators have a clue or what impact a freeze up/collapse of the EU banking system will have on our own financial institutions,
(2) oil prices remain elevated, but continue to decline. Given the latest inflation data in the aforementioned PPI and CPI reports, I think that prices have declined enough that high energy costs are no longer impacting the economy negatively. So I am removing it as a risk.
The only caveat is that a blow up in the Middle East could change everything in an instant.
(3) the ECRI weekly index turned fractionally positive this week; but its recession call remains in place. 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 lousy 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.
(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, [a] our political class remains focused more on its own re-election than dealing with the problems our economy faces---witness Obama latest policy initiative granting immunity to underage illegal immigrants and [b] businesses and consumers also have no idea about what will happen and that fact will likely curb enthusiasm to 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] the EU extended bail out funds to Spain’s banks, though we still don’t know the terms, [b] meanwhile, Moody’s lowered Spain’s and the large Dutch banks’ credit ratings, [c] fears of Italy needing financial assistance surfaced and [d] most concerning of all, the Greek bank run has turned into a stampede.
This weekend, the Greek runoff elections hold center stage. So far global investors have gotten all jiggy at the prospect of the central banks doing their job, i.e. providing liquidity in case of political/economic instability following the elections. Why the burst of enthusiasm over a ‘given’, I have no idea; except that we now know that a fiscal/solvency issue won’t be exacerbated by liquidity problems.
On the other hand, Europe is a basket case; it threatens the global economy with recession if its fiscal/solvency difficulties can’t be resolved; and no amount of money printing will prevent it. To be sure, whatever the outcome of the Greek elections, I have no doubt that the eurocrats will throw enough bailing wire and chewing gum at the problem to push off the really tough decisions for yet another week or month.
But the chasm remains and only gets worse as more debt is piled on top of too much debt. The risk is that investors call ‘bulls**t’ on the continuation of these half baked ‘fixes’, rip the face off the securities markets and start a financial panic that the eurocrats can’t get in front of.
Here is the bull case on what is occurring (medium):
Bottom line: I continue to believe that the economy is on track to maintain its sluggish below average growth path. However, the recent trend of weaker data is concerning; and another couple of weeks of largely negative stats will get the warning light flashing. On the other hand, falling energy prices, global monetary easing and a hopefully improving voter psychology will likely keep the economy moving forward albeit at its current disappointing pace.
Meanwhile, our political class remains fixated on re-election versus solving this country’s fiscal problems despite the message from Wisconsin last week. While this may change long term, for the next several months business and consumer concerns over the ‘fiscal cliff’ will likely keep a lid on 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.’
This week’s data:
(1) housing: weekly mortgage applications and purchase applications soared but mainly as a result of seasonal factors,
(2) consumer: weekly retail sales were mixed, though May retail sales were down [for the second month in a row]; weekly jobless claims were up more than anticipated; the University of Michigan’s preliminary June consumer sentiment index came in lower than forecasts,
(3) industry: May industrial production declined versus expectations of an increase while capacity utilization was lower than estimates; the New York Fed manufacturing index fell well short of forecasts; April business inventories were up faster than anticipated with business sales much weaker,
(4) macroeconomic: the headline number of both the PPI and CPI were down while the core figures were up; the May budget deficit was $125 billion.
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 12767, S&P 1338) closed within their intermediate term uptrends (11811-16811, 1241-1808) and their short term trading ranges (12022-13302, 1266-1422).
At the moment, my focus is on the developing reverse head and shoulders of both Averages in particular the necklines (12731, 1338). As you can see, the Averages finished Friday at or above those levels. If there is no reversal early next week, that sets an upside objective of 13400/1440. Furthermore, any reversal that leaves the indices above the shoulder line of the same pattern (12344, 1292) keeps the formation in tact and leaves open a move to higher levels.
Volume on Friday soared but that was largely based on the quadruple option expiration. Breadth improved. The VIX fell, but closed above the lower boundaries of its intermediate term trading range as well as its short term uptrend. However, it is developing a head and shoulders formation which if completed would be a positive for stocks.
GLD was up modestly, finishing above the lower boundary of its intermediate term trading range and appears to be setting into a short term uptrend.
(1) the indices are probing for new lower boundaries to the short term trading ranges [12206-13302, 1266-1422] but remain well within their intermediate term up trends (11811-16811, 1241-1808],
(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 (12767) finished this week about 15.7% above Fair Value (11030) while the S&P (1338) closed 1.9% 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 recent economic data is starting to call our forecast into question. To be clear, there are no warning bells going off; but there will be if we get another two to three weeks of consistently lousy numbers. For now, it would be premature to begin obsessing about a change in outlook; although, it is never to soon to raise one’s awareness. Nonetheless, the economic inputs to our Valuation Model are unchanged.
The economic/political inputs to our Valuation Model are also unchanged---which is to say they represent a major constraint on economic growth both in short and long term. That said, for the first time in a long time, the political landscape could be shifting positively. If the Wisconsin message delivered last week becomes manifest in body politic then fiscal sanity (lower spending, lower taxes, less regulation) may return and with it a faster rate of secular growth brought on by a rise in spending, hiring and investment.
Unfortunately, the same cannot be said for Europe as conditions continue to deteriorate. Of course, this issue was confused by investor realization Thursday that the central banks might actually do their job and provide liquidity if the demand for money spikes following the Greek elections. I am not trying to pooh pooh this factor; having the assurance that the central banks are there if a crisis occurs is a positive.
But it does nothing to stem the crisis. The problem is the Greeks, the Portuguese, the Spanish and the Italians have lived beyond their means for decades, have accumulated too much debt and continue to address these issues by taking on even more debt. Until they deal with their own fiscal profligacy, conditions will only get worse; and all the liquidity in the world won’t matter---except that if left in the monetary system it can generate an inflationary impulse.
Net, net accommodative central banks and another set of half assed Band-Aids on the system may allow Europe to ‘muddle through’ a while longer; but it does not take the systematic risk posed by the PIIGS off the table. The assumptions in our Valuation Model call for a Greek bankruptcy and a slow, tedious and erratic move to more fiscal sanity extending for perhaps a decade. But at the moment, even that isn’t happening. The eurocrats are standing around with a glass of wine in one hand and their johnsons in the other, praying that something good will miraculously occur.
Hence, it looks to me like it will take some sort of extreme event to shock the political class out of its stupor and implement genuine reforms that can affect the turn to that slow, tedious, erratic progress. The risk in our assumptions is not that the extreme event will occur; it is that when it occurs, the problems are beyond salvation and no amount of reforms or liquidity will prevent Europe from driving over the cliff.
For valuation purposes, the question then 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 rallied hard last week based primarily on investor relief that the central banks were on the job should a panic occur following the Greek elections. That got them (the S&P) close to Fair Value. But since the central banks doing their job is implicit in our Model, I see no reason for further upside.
On the other hand, as I noted above, my concern is that the eurocrats continue to procrastinate taking the necessary steps to put Europe on a path to fiscal responsibility and events get out of control. That is not in our Model; and regrettably, the probability of that happening is sufficiently high that our investment strategy has to take it into account. Hence, (1) I see little reason for chasing prices from current levels and (2) I am very comfortable with our Portfolios’ large cash and GLD positions.
The silver lining to this otherwise dismal assessment is that our Portfolios have plenty of fire power to take advantage of our growing Buy Lists when prices decline.
This week, our Portfolios Added to their GLD position.
(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 12767 1338
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.