Saturday, July 28, 2012

The Closing Bell--What will the Germans do?


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 12059-17059
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 1269-1849
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. Not much data this week, with the general flow basically mixed. Positives: weekly retail sales, weekly jobless claims, June durable goods orders and the July index of consumer sentiment. Negatives: purchase applications, June new home sales, durable goods orders ex transportation orders, the June Richmond Fed manufacturing index. Neutral: mortgage applications, second quarter GDP.

While it was a slow week for data, nonetheless, the general tenor was something of a rebound from last week’s more negative tilt and reinforces my conviction that the economy will avoid a recession. That, of course, doesn’t mean that I am not keeping that possibility foremost in my mind. But, at this moment, the numbers don’t warrant a change in our forecast:

‘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.’

My confidence is being aided somewhat by a `few reassuring positives:

(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) with the exception of retail sales, the ‘big four’ measures of the economy show little sign of recession,

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

The negatives:

(1) a vulnerable banking system. There were no new revelations of misconduct amongst the banking class this week, though [a] it is becoming increasingly apparent that both Geithner and the Fed knew what was occurring in the Libor price fixing scandal and did nothing of substance to stop it and [b] the call from Sandy Weill to break up the banks is the first serious assault on this den of thieves. We can only hope that it has legs. Meanwhile, in another blow the justice, the COO of Barclays (Libor scandal) resigned and received a ‘golden parachute’ versus a set of handcuffs. Not exactly awe inspiring to plebeians.
http://www.zerohedge.com/news/barofsky-geithner-we-should-see-people-handcuffs

The risks here are two fold: [a] investors lose confidence in our financial institutions and refuse to invest in America and [b] these scandals are simply signs that our banks are not as sound as we have been led to believe and, hence, are highly vulnerable to future shocks, particularly a collapse of the EU financial system.

(2) a blow up in the Middle East. Nothing new this week except the ongoing civil war in Syria and more importantly, a further rise in oil prices. Leaving aside the geopolitical risk, rising energy and food prices are not going to positively influence either consumer and business confidence or our forecast,
http://www.minyanville.com/business-news/markets/articles/energy-stocks-xle-oil-crude-oil/7/26/2012/id/42750

(3) the drought persists in the Midwest. Prices across the entire food complex [grains and meats] rose again this week. To the extent that these are passed on to consumers, higher food [and energy] prices act as a tax on income and hence restrain economic growth. Combine this with the fear of the ‘fiscal cliff’ and you have a formula for a serious slowdown in consumption and investment.

(4) continuing its saw tooth pattern, the ECRI weekly index was up last week. As you know, this erratic behavior sustains my skepticism regarding the validity of its recession 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

(5) another week and nothing done on the ‘fiscal cliff’ except for a couple of political posturing votes. As you know, 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. In the meantime, the inability of our political class to address this potentially devastating threat to the economy contributes to the fear and uncertainty among businesses and consumers and by extension their willingness to spend, invest and hire.

(6) finally, the sovereign and bank debt crisis in Europe remains the biggest risk to our forecast. The big news this week was ECB head Draghi’s statement that the eurocrats would do everything necessary to save the euro. I provided my opinion in Friday’s Morning Call, so I won’t bore you with repetition, except to repeat the bottom line: the only tool he has is the printing press; without the German balance sheet, he has zilch; so until we hear from the Germans, it appears that his statement is just another eurocrat attempt to jawbone a solution instead actually doing something meaningful.

Nevertheless, as I have repeatedly noted, as long as investors act like lemmings and maintain their confidence in the marshmallows running the EU, the ‘muddle through’ scenario will continue to work. Unfortunately, there is a large enough probability that the Market will tire of the endless bulls**t and take matters in its own hands---the result of which will likely be an unpleasant ending.
http://economistsview.typepad.com/timduy/2012/07/draghi-blinks-maybe.html

And:
http://www.zerohedge.com/news/mutiny-ecb

And:
http://www.zerohedge.com/news/guest-post-bernanke-and-draghi-are-dangerous

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 were up fractionally but purchase applications declined; June new home sales plunged,

(2) consumer: weekly retail sales were up; weekly jobless claims spiked but they continue to be heavily influenced by seasonal adjustments; the final University of Michigan’s index of consumer sentiment came in slightly above forecasts,

(3) industry: June durable goods orders rose, though ex transportation orders, they dropped; the June Richmond Fed manufacturing index fell off a cliff,

(4) macroeconomic: the initial second quarter GDP reading was down from the first quarter number but better than expected; while the GDP deflator was in line.


The Market-Disciplined Investing

Technical


The indices (DJIA 13075, S&P 1385) were on a moon shot Thursday and Friday, blasting through the 12904, 1264 interim resistance levels. Nonetheless, they closed within the boundaries of their primary trends: (1) short term trading ranges [12022-13302, 1266-1422] and (2) intermediate term uptrends [12059-17059, 1269-1849].

Our time and distance discipline is now operative on the interim resistance levels; however (1) the time element will be shorter and (2) given the magnitude of the Thursday/Friday advance, the distance element is very close to being satisfied. Basically, that means that unless we get a major reversal on Monday, the 12904, 1364 interim resistance will be negated and our attention will turn to the 13302, 1422 level as the next area of resistance.

Friday’s close 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 improved. The VIX fell but remains above the lower boundary of its intermediate term trading range (and the neckline of a developing head and shoulders formation).

GLD was up, finishing above the lower boundary of its intermediate term trading range and is on the verge of breaking the long string of lower highs.

Bottom line:

(1) the indices are in short term trading ranges [12022-13302, 1266-1422] and remain well within their intermediate term up trends (12059-17059, 1269-1849],

(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 (13075) finished this week about 18.0% above Fair Value (11075) while the S&P (1385) closed 1.0% overvalued (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. On the other hand, we have to be mindful that its capacity to absorb additional shocks and not slip into recession is limited.

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. In my mind, no better example exists than this week’s developments. On Thursday, Draghi announced that the ECB will do everything necessary to save the euro when in actuality, the only thing it can really do is print more money. In response, investors bit heavily and stock prices soared.

The fly in the ointment of Draghi’s puffery is that without German approval (balance sheet and cash flow), the money printing would be a useless if not damaging exercise. So on Friday, Draghi announces that he is going to meet with the head of the Bundesbank implying that somehow Germany was on board; and stocks kicked in the after burner. However, as of this writing, no one knows the German reaction.

All that said, I recognize full well that as of the close Friday, my skepticism has me on the wrong side of this trade. Here is why I am sticking to my guns until we hear from the Germans:

(1) Draghi, like Bernanke, can print money and lend it [it can’t just give euros away with no recourse] to the banks and sovereigns to pay their debts and no matter what grandiose or organizationally complex terms are used to describe that money flow, in basic terms, it starts at a printing press and ends on the bank/sovereign balance sheet.

But the banks and sovereigns already have too much debt---that is their problem. So the only thing more loans to the banks/sovereigns accomplish is to create more creditors for the banks/sovereigns.

That is turn makes it tougher for the banks/sovereigns to ever pay any of these debts off. And therein lies the problem because some entity ultimately has to be responsible for those debts if the banks/sovereigns
default.

The only entity with the balance sheet and income statement even close to being able to do that is Germany [taxpayers] and I am not sure even it can backstop all the new debt Draghi envisions ‘lending’. And at this moment, we have no idea if Germany will even go along with this plan; if it doesn’t, all the rhetoric of the last two days is just empty bulls**t.

The point here is that it is questionable whether Mr. Draghi’s bold plan will work even with German complicity but nobody has a clue as to whether the Germans will go along---so why is everyone tip toeing through the tulips?

(2) but let’s assume the best of all possible worlds, i.e. the Germans buy in, lock stock and barrel. Europe is still in a recession that is only going to get deeper based on the policies that would have to be implemented in order for Draghi’s plan to have a snowball’s chance in hell of succeeding---that more or less is our ‘muddle through’ assumption in our Valuation Model; and given that assumption, our Valuation Model prices the S&P at circa 1370 currently---which means that if everything positive that investors are assuming actually occurs and does so on a timely basis, then the S&P at Friday’s close is slightly overvalued.

Lost in the shuffle is the possibility that (1) this latest move by Draghi is just another ill fated eurocrat attempt to kick the can down the road and avoid the really tough decisions that have to be made and (2) its chief consequence may be to hasten the point at which 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.

My investment conclusion: I acknowledge that in waiting for a definitive statement from the Germans, I may be proven wrong for not having already put our Portfolios’ cash reserves to work in the stocks on our Buy Lists. On the other hand, if I am wrong in my skepticism about the success of Draghi’s new plan, then I will ironically be proven correct in my ‘muddle through’ scenario.

Remember that the decision to not invest our Portfolios’ cash was a function of (1) my worry that the probability of our ‘muddle through’ was only slightly better than 50/50 and (2) the downside risks associated with not ‘muddling through’ were so large that I wanted a valuation ‘cushion’ before committing funds. Hence, if the Germans go along with the Draghi plan, then the likelihood of the ‘muddle through’ scenario increases substantially; and that would go a long way to removing my need for a ‘cushion’ before buying the stocks on our Buy Lists at current prices.

But first things first. The eurocrats have to deliver a jointly and severally agreed upon workable plan. Then, we look at the prices of the stocks on our Buy Lists and consider spending some cash.

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 13075 1385

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.