Saturday, July 21, 2012

The Closing Bell--Stocks are Fair Value but with lots of problems



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 12005-17005
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 1264-1844
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%

Economics

The economy is a modest positive for Your Money. Lots of data this week with the general flow ever so slightly tilted to the negative side. Positives: mortgage applications, housing starts, industrial production, business inventories, the NY Fed manufacturing index and June CPI. Negatives: purchase applications, existing home sales, weekly and monthly retail sales, jobless claims, business sales, the Philly Fed index and June leading economic indicators. Neutral: building permits and core CPI. The key numbers were industrial production (a plus) and June retail sales (a minus)---so again a very mixed picture..

I should add to this the congressional testimony of Bernanke as well as the latest Fed Beige Book report---the narratives of which were generally reflective of our forecast. In sum, a data flow with enough conflicting stats to suit any forecast if selectively interpreted but overall one that portrays an economy performing much as we expect:

‘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.’

Clearly not an outlook to give great comfort but also not one over which to agonize. Somewhat reassuring to me are:.

(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) three of the ‘big four’ measures of the economy show little sign of recession with the exception being retail sales [see Thursday’s Morning Call],

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

That said, there remains plenty about which to worry:

(1) a vulnerable banking system. There were no new revelations of mischief by our titans of finance this week. Frankly, I am not sure how much more thievery the electorate/investors can take before it loses complete confidence in the banking system and nitwits that are regulating it. Certainly, it doesn’t help that the instances of hubris, greed and dishonesty keep piling up and yet no one has been fined or gone to jail.

On a long term basis, I fear that faith in our financial institutions in general and the securities markets in particular will continue to decline and with it the confidence to invest in America.

Nearer term, the consequences may be extremely harsh if bank balance sheets are weaker than we have been led to believe and we learn that fact the hard way, i.e. a European banking crisis leads to the bankruptcy of major EU financial institutions with which US banks have CDS counterparty risk.
http://dealbook.nytimes.com/2012/07/18/behind-credit-default-swaps-market-a-cartel-left-open-to-collusion/?ref=business

http://in.reuters.com/article/2012/07/20/mortgages-repurchase-idINL2E8IK04O20120720


And now the NY Fed proposes suspending the redemption feature of money market funds: (this is long but you need only read the first paragraph):
http://www.zerohedge.com/news/government-your-legal-right-redeem-your-money-market-account-has-been-denied-sequel


The stink is spreading (medium):
http://www.zerohedge.com/news/scandal-imf-senior-economist-resigns-says-ashamed-have-had-any-association-fund-all


The Libor scandal widens (medium):
http://www.zerohedge.com/news/hedge-fund-trail-liborgate-gets-hotter-mega-fund-brevan-howard-next

(2) a blow up in the Middle East. Events this week brought this scenario perilously close to reality. Bombings of Israeli citizens in Bulgaria and the defense power structure in Syria has everyone on edge and oil prices rising for the first time in a long time. How the current crisis plays out is anybody’s guess but with a fourth US carrier group headed for the Middle East and the fact that Russian influence in this region could take a severe blow if the Assad regime in Syria bites the dust, the situation is clearly quite volatile and fraught with geopolitical as well as economic [oil prices] risk.

(3) the drought persists in the Midwest. The price of corn and the other grains are moving steadily higher. If this continues especially if accompanied by surging oil prices, it will not be good on either consumer sentiment or spending; nor will it be good for the bottom line of many of the consumer staple companies---which just happen to be one of the strongest Market sectors. Sooner or later rising food prices will have an impact on an already struggling economy; and while it may be due to a short term weather related problem, it could still be that catalyst that shoves the economy below stall speed.
http://pragcap.com/implications-of-the-summer-drought

(4) the ECRI weekly index reversed itself yet again this week and finished down. As you know, this see sawing back and forth is indicative of the exceptionally erratic behavior of this index of late; so I remain 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.
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php

And these thoughts on recession from Capital Spectator:
http://www.capitalspectator.com/archives/2012/07/seasonal_distor.html#more

(5) another week and nothing done on the ‘fiscal cliff’. My position on this issue is 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.

On the other hand, when Bernanke lists it as one of his two major concerns about the economy, I can’t be too Pollyannaish if for no other reason than the universe heard him express his worries and that is not exactly going to spur businesses and consumers to spend/invest/hire.
http://www.zerohedge.com/news/stunning-political-reality-fiscal-cliff-debate

(6) finally, the sovereign and bank debt crisis in Europe remains the biggest risk to our forecast [that concern is also shared by Bernanke]. There was not much news out of the EU this week except that from all the jawing going on amongst eurocrats, it is pretty clear that the much hailed Spanish bank bailout of two weeks ago was DOA. Nevertheless as I have repeatedly said, 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. How likely that is, I haven’t a clue; but the probability is high enough that we would be foolish not to have insurance against its occurrence.
http://blogs.telegraph.co.uk/finance/jeremywarner/100018786/the-euro-graph-of-doom/

http://www.zerohedge.com/news/europes-fundamental-flaw-resurfaces

And the latest from Spain (medium):
http://www.nakedcapitalism.com/2012/07/spain-slides.html

And this from the IMF---which one has to wonder about given the above link (medium):
http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100018882/imf-loses-all-faith-in-the-euro-project/

Bottom line is unchanged: ‘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 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 soared while purchase applications declined: June housing starts were above expectations and building permits were in line; but June existing home sales [10 times the size of new home sales] fell,

(2) consumer: weekly retail sales were weak; June retail sales were lousy; weekly jobless claims were terrible,

(3) industry: June industrial production was up, in line; May business inventories rose, but sales declined; the July NY Fed manufacturing index came in well ahead of forecast while the Philly Fed index was lower than anticipated,

(4) macroeconomic: June CPI was unchanged while core CPI was in line; the June leading economic indicators declined much more than expected; both Bernanke’s congressional testimony and the latest Beige Book portrayed an economy that was sluggish but not enough so to warrant QEIII, at least not yet; while the ‘fiscal cliff’ and Europe are listed as the principal concerns.

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 12822, S&P 1362) gave back much of this week’s gains on Friday, but nonetheless closed within their (1) short term trading ranges [12022-13302, 1266-1422] and (2) intermediate term uptrends (12005-17005, 1264-1844). Hence the primary trends remain in tact.

Looking at the shorter term trading pattern, on Friday (1) having broken the 12903, 1364 interim resistance levels on Wednesday, the Averages traded back below that level, negating the Wednesday break and leaving 12903, 1364 as resistance, at least for the moment and (2) having broken the upper boundary of a developing pennant formation on Wednesday, the S&P fell back to that boundary’s current intersect (1362). This doesn’t negate the break but it does extend the time element of our time and distance discipline. This pin action leaves open the question of whether stocks on a short term basis are in an interim trading range 12345-12903, 1292-1364 or they are about to lift and perhaps mount a challenge to the 13302/1422 level..

In either case, the close Friday leaves the Averages in the upper half of their short term trading ranges---not a zone that, technically speaking, I think attractive for buying; however, a further move to the upside may push some of our holdings into either their Sell Half Ranges or trading highs that could warrant selling.

Volume on Friday rose; breadth deteriorated. The VIX was up, leaving it above the lower boundary of its intermediate term trading range (and the neckline of a developing head and shoulders formation).

The technical case for being positive (medium):
http://www.marketwatch.com/story/no-one-believes-in-this-market-2012-07-19?link=home_carousel

GLD was up, 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 (12005-17005, 1264-1844],

(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 (12822) finished this week about 15.7% above Fair Value (11075) while the S&P (1362) closed 0.6% 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 despite the headwinds created by our worthless, do-nothing political class, a widening drought in the country’s bread basket and a corrupt financial system. That the economy can sustain itself in this kind of environment speaks to its strength; but at the same time warns us that it most likely can’t withstand additional shocks and not get pushed into a ‘double dip’.

Europe is still managing to ‘muddle through’---but only because the investment community maintains its faith in the eurocrats in face of overwhelming evidence to the contrary. The latest bail out of the Spanish banks is crumbling not only before our eyes but before the Spanish electorate which when I last checked had taken to the streets---again. That said, as long as the bond vigilantes give the eurocrats a pass (i.e. they keep buying euro garbage), ‘muddle through’ will be the operative scenario. The risk to both our 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. If so, then the key question is at what price levels is that euro disaster discounted? While I don’t have a clue, I do believe that 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.

DJIA S&P

Current 2012 Year End Fair Value* 11300 1400
Fair Value as of 7/31/12 11075 1370
Close this week 12822 1362

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.