Saturday, July 14, 2012

The Closing Bell-A Den of Thieves

Statistical Summary

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
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 11973-16973
Long Term Trading Range 7148-14180
Very LT Up Trend 4546-15148

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 1260-1840
Long Term Trading Range 766-1575
Very LT Up Trend 651-2007

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. It was a pretty slow week for data; what we got was generally positive—weekly mortgage purchase applications, weekly retail sales, weekly jobless claims, consumer credit, wholesales inventories, the May trade deficit, core PPI and the June budget deficit. Still there were a couple of negatives: weekly mortgage applications, wholesale sales, headline PPI and July consumer sentiment. In addition to the stats, the FOMC released the minutes from its latest meeting which were generally reflective the prior statement issued after that meeting (economy OK, no indication of the need for QEIII).

While I am not overwhelmed with this week’s positive numbers, they are better than a sharp stick in the eye; and they continue the move toward a more balanced portrait of the economy. That is not to say the risk of a recession has been eliminated---but this data suggest that it is somewhat less than it was a month ago.

So 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 anemic as this forecast is, it is still relatively positive. To be sure there are a bevy of potential negatives (which I attempt to cover in detail each week) that could render it too optimistic. On the other hand, there are some pluses that will hopefully keep the economy on track.

(1) the seasonal pattern of economic data for the prior two years was strong in the first and fourth quarters sandwiching weaker second and third quarters; given the positive impact of unseasonably warm weather in the first quarter, there is reason to think that a repeat of this model is accounting for the recent weakness in the numbers,

(2) the continuing decline in oil prices

(3) the seeming move of the electorate toward embracing fiscal responsibility.

As for the aforementioned risks:

(1) a vulnerable banking system. This week [a] JP Morgan admitted {i} to a $5 billion derivatives trading loss---up from $2 billion, but still short of the rumored $9 billion and {ii} that its traders had falsified CDS pricing, [b] another commodities firm {PFG} went belly up with at least $200 million in customer funds unaccounted for, [c] the Libor price fixing scandal came into full bloom and [d] HSBC was accused of laundering money for Iran, Cuba and other close allies,

Why Libor matters (first six minutes of this video---must watch):

How much did the banksters make (medium):

And something of a counterpoint (medium):

Rick Santelli explains the PFG debacle (3 minute video):

All this simply confirms that the banking system harbors a den of thieves and that the regulators are either complicit, clueless or both. That the guilty banksters are still walking around with either their money or their jobs or both is an affront to the voters and taxpayers. As long as the current conditions are allowed to continue, we all collectively will bear the ultimate financial responsibility for any of the as yet undiscovered losses resulting from the arrogance, hubris and carelessness that is clearly endemic in the financial system---and God help us if Europe runs off a cliff, severely impairing the massively overleveraged balance sheets of its banking system.

(2) a blow up in the Middle East could change everything in an instant. As a corollary to this fear that some geopolitical event could cause oil prices to spike, I want to add the concern about increasing grain [i.e. food] prices. If you have been watching your 10 o’clock news, you know that there is a drought in the Midwest that will negatively impact this year’s corn crop. If it continues another month, soybeans will be similarly affected. Nothing says poor consumer sentiment like high energy and food prices. Granted lower oil prices have helped of late; but this positive could be offset if the current drought continues,

(3) the ECRI weekly index was positive again this week. As you know, the recent trend in the readings of this indicator has been quite erratic; so I have been somewhat skeptical of the validity of its prediction. Nevertheless, it remains on our list of risks because of [a] its track record for calling economic downturns, [b] the adamancy of its founder regarding this particular call and [c] perhaps more importantly, he has been joined recently in his recession call by several economists for whom I have great respect. Despite the recent more positive trend in the weekly data flow, the added gravitas of these economists makes this factor a bit more worrisome.

The argument against recession (medium):

(4) we are one week closer to the 1/1/13 so-called ‘fiscal cliff’. This week, Obama did propose extending the Bush tax cuts for the ‘middle class’ knowing full well the GOP would ix-na it. So nothing has really changed. On the other hand, you know that 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, businesses and consumers remain fearful of what could happen and, therefore, unwilling spend/invest/hire at least in the very short term,

Exacerbating this problem is the knowledge that absent a major rollover in the composition of our elective institutions, Obamacare with all its tax increases and regulatory costs is now going to be loaded on top of the ‘fiscal cliff’ burden,

And lest we forget--the coming disaster in student loans (medium and a must read):

(5) finally, the sovereign and bank debt crisis in Europe remains the biggest risk to our forecast. The principal developments this week were [a] the German high court stating that it would take two to three months before it could render a decision on the constitutionality of the Spanish bank bail out and [b] the EU and the Spanish government attempting some half measures to shore up the banks---two of the major consequences of which were to screw Spanish taxpayers as well as many small shareholders that had previously been enticed to convert their savings accounts into bank equity. The result? Rioting in Madrid.

The latest on the pain in Spain (medium):

So this latest bail out appears to be just another half assed plan that represents but a teeny, tiny step toward resolving Europe’s massive insolvency problem; and even that could be negated by an adverse German high court ruling. In other words, after two weeks it appears that the EU may not even be a teeny, tiny step closer to a solution to the Spanish bank insolvency problem and we won’t know that for another 60-90 days.

Of course, as long as the Markets allow the European political class to do nothing more than smoke cigars, drink wine and go on vacation, then the disaster scenario will be avoided. Clearly, there is some probability that eurocrats will be able to evade accountability into infinity. On the other hand, the likelihood also exists that at some point investors will run out of patience, refuse to accept another half baked ‘management by crisis’ miniscule step toward a solution and precipitate a crisis that the eurocrats can’t get in front of. At that point, everyone’s forecast except those predicting the end of the world will be void.

Bottom line: the US economy remains on its sluggish growth track and unfortunately is getting no help from the political class, the financial system, the weather or the yahoos in charge of avoiding a financial catastrophe in Europe. Yet the inherent strength of what is left of our capitalist system has, at least to date, managed to move the economy forward in spite of these headwinds. So for the moment our forecast remains unchanged.

Nevertheless, I can’t overstate my concern about that the financial markets will tire of watching the exceptionally slow motion pace of the current ‘muddle through’ eurocrat strategy, start pricing European debt for a worse case scenario which in turn overwhelms the EU bureaucracy and creates enormous problems for our own less than perfect banking system.

This week’s data:

(1) housing: weekly mortgage applications fell, but purchase applications rose,

(2) consumer: weekly retail sales were up; weekly jobless claims declined but largely as the result of seasonal factors; consumer credit soared; the preliminary July index of consumer sentiment came in below estimates,

(3) industry: May wholesale inventories rose, but sales declined; small business sentiment tanked,

(4) macroeconomic: June PPI was much hotter than expected while core PPI was in line; the US May trade deficit fell due mostly to lower oil prices; the June budget deficit was less than anticipated.

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 12777, S&P 1356) spiked on Friday; for what reason I haven’t a clue---perhaps the smell of bank fraud really gets investors’ juices flowing; or maybe it’s disappointing China numbers; or maybe it’s the hotter PPI report; or maybe it’s lower consumer sentiment; or maybe............well, you get the point. In any case, the Averages closed within their intermediate term uptrends (11973-16973, 1260-1840) and their short term trading ranges (12022-13302, 1266-1422).

Looking at the shorter term trading pattern, on Friday the indices recovered above the Wednesday/Thursday penetration of both their 50 day moving averages and the uptrends off the June lows---negating those breaks. I think that the inability of the indices to confirm the penetration of their 50 day moving averages and the uptrends off the June lows suggests an upward bias short term.

The S&P is developing a pennant formation (a series of lower highs in conjunction with a series of higher lows)---the completion of which, in technical speak, should determine price direction in the immediate future (i.e. if the S&P breaks above the upper boundary of the pennant, the direction is up). The DJIA has not constructed a similar price pattern.

The close Friday puts the Averages about midway between the boundaries of their short term trading ranges---not a zone that, technically speaking, I think attractive for either buying or selling.

Volume on Friday was down---surprisingly for such a big price move up; breadth improved, but the flow of funds indicator remains weak. The VIX plunged, but remained above the lower boundary of its intermediate term trading range and continued to develop a head and shoulders formation. A break below the lower boundary of the intermediate term trading range (15.4) which is also the neck line of the head and shoulders pattern would portend more downside---a positive for stocks.

GLD popped, 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 remain well within their intermediate term up trends (11973-16973, 1260-1840],

(2) long term, the Averages are in a very long term [78 years] up trend defined by the 4546-15148, 651-2007 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 (12777) finished this week about 15.3% above Fair Value (11075) while the S&P (1356) closed 1.0% below Fair Value (1370). 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 economy continues to limp along with absolutely no help from our political class. Oh wait a minute, they did so something constructive this week---they ranted about the US Olympic uniforms being made in China; not that the US financial system is rife with thievery, or that the federal deficit continues to soar, or that the student loan program is set to blow up in our collective faces. Clowns to the left of me, jokers to the right. Regrettably, it is just as we have assumed in our Models. Helping to keep a lid on growth are the mounting likelihood of food inflation resulting from the current drought and a decline in the faith that our banking system had somehow righted itself.

Europe is still managing to continue to fulfill our ‘muddle through’ scenario---but just barely. The latest bail out of the Spanish banks is now hostage to the German high court; the EU and Spanish government are heaping a world of hurt on the Spanish electorate; and the Spanish electorate is taking the Greeks’ lead and rioting. That said, as long as investors don’t force the eurocrats’ hand, ‘muddle through’ will be the operative scenario. The risk to both Models is that those investors lose patience, crush the Eurobond market and force an EU banking crisis which spills over into our own financial system which is not nearly as clean and healthy as we thought a month ago.

From a valuation standpoint, this all fits the assumptions (except the euro disaster) in our Valuation Model. The nagging question 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---but it almost certainly lies at lower levels.

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.


Current 2012 Year End Fair Value* 11300 1400
Fair Value as of 7/31/12 11075 1370
Close this week 12880 1367

Over Valuation vs. 7/31 Close
5% overvalued 11628 1438
10% overvalued 12182 1507
15% overvalued 12736 1575

Under Valuation vs. 7/31 Close
5% undervalued 10521 1301
10%undervalued 9967 1233 15%undervalued 9413 1164

* 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.