Saturday, August 18, 2012
The Closing Bell--Wait just a bit longer before getting jiggy
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 12184-17194
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 1283-1863
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. We got some important readings on the economy this week in the form of better than expected July retail sales and July industrial production. These are two of the ‘big four’ indicators to which economists give the most weight in assessing the economy’s health. They were strengthened by a blowout July building permits number, a docile CPI and better than expected consumer sentiment and July leading economic indicators. So from a qualitative point of view, this week’s data was quite positive and signals a declining risk of recession.
However, there were negative stats: mortgage and purchase applications, housing starts, July business inventories and sales, PPI and both the New York and Philadelphia Fed August manufacturing indices---all just to remind us that this recovery is anything but robust. Nevertheless, let’s be thankful for a modestly positive week---which also happens to fit nicely into our current forecast.
In addition, the political economy got a potential boost with the selection of Paul Ryan as the republican VP candidate. As you know, Ryan has more knowledge of and done more work on the budget than probably anyone else in Washington. And while not as much of a fiscal, regulatory purist as I would like, his orientation is at least toward less spending, lower taxes and fewer government regulations than the current administration. Hence, if the republicans win the White House and take control of the senate, I see the opportunity for implementation of policies that would put the economy on a higher secular growth path than is now reflected in our Model. I am not wee weeing in pants over this, but at least I have for the moment stopped considering shooting myself.
That said, until we see a republican victory and get a feel for any changes in policy, our forecast remains;
‘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.’
(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 earlier weakness in the numbers,
(2) the ‘big four’ measures of the economy show little sign of recession. Indeed, as noted above, even retail sales, the weak sister of this group, is showing improvement,
(3) the seeming move of the electorate towards embracing fiscal responsibility. While clearly Romney/Ryan are not the electorate, they are giving voters a clear choice in policy direction. We can only hope that the ‘seeming move to fiscal responsibility’ gets manifested in the November election.
(1) a vulnerable banking system. This week there were no new instances of bankster malpractice, though the regulators made up for it by slapping Standard Chartered on the wrist with an embarrassingly low fine and giving Corzine a ‘get out of jail free’ card. So the public remains 0 for 5 in receiving justice from the banksters/political class.
And another win for the banksters (medium):
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. The Syrian civil war grinds on accompanied by a rise in the decibel level of sword rattling from Israel. My concern is less about who gets blown up and who doesn’t [with the marshmallow we have in the White House right now, our political risk is not becoming embroiled in another Middle East war but simply getting muscled around by the serious players---Russia, China, Iran] and more about the potential fallout of higher energy prices and their impact on our own economic growth and inflation rate.
On the other hand, I note that a republican victory could accelerate progress of the US’ path to energy independence. It certainly appears that we have the resources; we are just currently missing the will to develop them. Clearly, a more aggressively pursued policy of energy self sufficiency would go along way in neutralizing the political risk of an unstable Middle East and the economic risk of higher oil prices.
(3) the drought persists in the Midwest, though there was more rain relief this week. Nonetheless, the damage to the corn crop appears irreversible; and while the US soybean crop may be salvageable, worldwide weather problems will likely limit the global harvest. As a result, grain prices 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 lower confidence and a threat of a serious slowdown in consumption and investment.
(4) the ECRI weekly index was up for the second week in a row. As you know, this indicator’s ongoing erratic performance sustains my skepticism regarding the validity of its recession prediction. Indeed, if it doesn’t start getting worse pretty soon, I am going to remove this factor as an item of concern. But for the time being, 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 in his recession call by several economists for whom I have great respect.
(5) another week and nothing done on the ‘fiscal cliff’; and since congress will be campaigning full time for re-election until mid September, there is nothing to expect anytime soon.
However, this week there was a new development that could raise the magnitude of this risk. As you know, I have noted under the category of the risks related to Europe that there was a significant danger that investors would stop believing in the ability/will of the eurocrats to solve the continent’s bank/sovereign debt problem, crush the Eurobond market making it impossible for the banks/sovereigns to service their massive debts.
Well, that same risk exists in the good, ol’ US of A, to wit, if investors lose faith in the Fed/government to manage the economy, interest rates will soar placing a crushing added burden on the Treasury to service the massive US debt, thereby increasing the magnitude of the ‘fiscal cliff’.
This week, Treasury yields made a big move up. I am not suggesting that this move is the beginning of the collapse of the US bond market [it could simply reflect an improving economy]. I am suggesting that it could be; and if it is, we would likely be facing a ‘fiscal cliff’ whether or not the tax increases and spending cuts are reversed.
As you know, my position on the ‘fiscal cliff’ as it currently exists 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. With a substantial majority of the EU political class on vacation, there were no real developments this week. However, this quiet period will come to an abrupt halt in September.
And this just released study from UBS isn’t going to help. It is a bit long but you need to read it:
Nevertheless, investors maintained their willingness to believe the best about the eurocrats As you know, my concern is that their patience wears thin and they trash the eurobond/eurocurrency markets, creating a crisis that is beyond the eurocrats’ capability to resolve---a likely outcome of which is a freezing up of the entire financial system which infects our own [via counterparty risk in credit default swaps].
Finally, I linked to an article this week that argued that a good deal of the negative economic fallout [wealth exiting the eurozone, decline in cross border lending and trade, etc] that would occur if the EU broke apart is already happening. I think that this thesis has validity. Hence, I am much more sanguine about the downside on trade and sales/earnings impact on US companies doing business in Europe. However, because of the opacity of our/their financial institutions, I am still very worried about the consequences of an EU banking crisis on our own financial institutions.
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 and purchase applications were both down; July housing starts fell more than expected while building permits soared,
(2) consumer: weekly retail sales were mixed but July retail sales were a blowout; weekly jobless claims rose slightly; the University of Michigan’s preliminary August index of consumer sentiment was up more than estimates,
(3) industry: July industrial production came in ahead of forecasts; July business inventories and sales were weak; the August NY Fed manufacturing index was abysmal and the Philly Fed index wasn’t much better,
(4) macroeconomic: July PPI numbers were hotter than expected while CPI measures were lower than anticipated; July leading economic indicators rose more than estimates.
The Market-Disciplined Investing
This week, the indices (DJIA 13275, S&P 1418) closed near the upper boundaries of their short term trading ranges [12022-13302, 1266-1422]. They remained well within their intermediate term uptrends [12184-17184, 1283-1863].
The primary characteristics of the Market continue to be low volatility and low volume but with an upward bias; and given that we are at the height of the vacation season, I think it likely that these conditions will prevail through the end of the month.
That leaves the Averages in the upper quadrant of their short term trading ranges---a level at which I see no compelling technical reason to initiate any buying. Furthermore, as I noted in Friday’s Morning Call, our internal indicator is implying that the S&P 1422 resistance level will hold. So, my focus now is on the Sell side---monitoring those holdings that are near to either their Sell Half Ranges or trading highs.
Volume on Friday was up, primarily as a result of option expirations; breadth was mixed. The VIX was down sharply, closing for the eighth day below the lower boundary of its intermediate term trading range. As you know, there have been some confusing signs from this indicator that has kept me from making a confirmation call of the support line break. Friday’s pin action, however, pushes me to make that call; though I feel very uneasy about it, largely due to my fundamental position. Nevertheless, our technical rules stand on their own. Historically, a technical break like this points to higher stock prices.
GLD was up, finishing above the lower boundary of its intermediate term trading range but below the level of the last in a long series of lower highs.
(1) the indices are in short term trading ranges [12022-13302, 1266-1422] and remain well within their intermediate term up trends (12184-17184, 1283-1863],
(1) 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 (13275) finished this week about 19.4% above Fair Value (11120) while the S&P (1418) closed 3.0% overvalued (1376). 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; although we did get very positive news this week in the form of upbeat data in two of the ‘big four’ economic indicators. If anything that reduces the risk of recession and provides additional support to our ‘sluggish recovery’ forecast.
Another potential plus is raised by the prospect that ‘a change in personnel in Washington’ may be in the offing. It is certainly too early to tell if that will occur and even if it does, the magnitude of any directional change in fiscal policy. Thus, I am not changing any assumptions in our Models at this time; but it opens the door of ‘hope’ just a bit wider.
On the other hand, the spike in bond rates this week could portend further interest rate increases that would complicate the process of solving the ‘fiscal cliff’/our budget problems. Again, we can’t start altering our assumptions after only a week of bad bond performance; but we clearly must be mindful of this change in price direction and watch it closely.
All that said, for the moment, nothing in the economic/political environment warrants altering the assumptions in our Models.
Europe is still managing to ‘muddle through’; although (1) virtually nothing is happening at present since the entire continental political class, ex Merkel, is on vacation until September and (2) the investment community continues to maintain its faith in the eurocrats in face of overwhelming evidence to the contrary.
That leaves us in sort of a state of suspended animation. Meanwhile, the Market is pricing in a ‘muddle through’ scenario as a certainty and ignoring the financial/economic consequences of it not occurring. As you know, while ‘muddle through’ is our forecast, I consider it anything but inevitable.
On the other hand, I do buy the thesis that a portion of the damage that would take place if the euro broke up is already happening. That diminishes the potential economic risk associated with a break up of the EU. However, it does nothing to lessen the financial (balance sheet) risk our institutions have to the eurobanks. Of course, that risk could be zero; but due to the opacity of bank financial reporting, we simply have no idea regarding its magnitude.
As a result, while (1) ‘muddle through’ remains our base assumption and (2) the economic risk of it not happening is probably less than I thought a week ago, I can not be as sanguine as investors appear to be about Europe’s prospects for containing its bank/sovereign debt crisis and the potential damages if it doesn’t.
European equity valuation versus sovereign credit risk (short):
My investment conclusion: ‘stocks (as defined by the S&P) are above Fair Value (as defined by our Model). Under less stressful circumstances, that would dictate a cash position of around 15%. Our Portfolio’s are at double that level primarily because of the large risk of failure in the EU and the even larger downside to our economy and in particular our financial institutions if that occurs. That said, because I can’t quantify either, I believe that the best strategy is to ‘nibble’ through any Market declines which our Portfolios will do but starting at much lower levels.’
And in the meantime, as I noted in Friday’s Morning Call, I am willing to pay an opportunity cost (a heavy cash position) for more clarity.
The final report on second quarter earnings and revenue ‘beat’ rate:
This week, the High Yield Portfolio Sold Half of its holding of SNY. The Aggressive Growth Portfolio Sold its position in SPLS and Bought a small holding in COH..
(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 8/31/12 11120 1376
Close this week 13275 1418
Over Valuation vs. 8/31 Close
5% overvalued 11676 1444
10% overvalued 12232 1513
15% overvalued 12788 1582
20%overvalued 13344 1651
Under Valuation vs. 8/31 Close
5% undervalued 10564 1307
10%undervalued 10008 1238 15%undervalued 9452 1169
* 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.