Saturday, August 04, 2012

The Closing Bell-Good news is good news, bad news is no news

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 12103-17103
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 1273-1853
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. The economic data this week continued mixed. Positives: July nonfarm payrolls, the Case Shiller home price index, personal income, the ADP payroll report, consumer confidence, June construction spending, the ISM nonmanufacturing index and Chicago PMI. Negatives: purchase applications, weekly jobless claims, the ISM manufacturing index, June factory orders and the Dallas Fed manufacturing index. Neutral: mortgage applications, weekly retail sales, personal spending and June domestic vehicle sales.

The stand out number was, of course, better than anticipated nonfarm payrolls. This is a hot button stat to which everyone in the universe pays attention---as was obvious from Friday’s explosive pin action. This strength of the Market reaction suggests that the current economic consensus may once again start to shift. This time from being more pessimistic than our forecast to being in line.

Two other economic developments that bear mentioning are:

(1) the latest FOMC meeting in which there was no change in policy. As you know, I have expected QEIII in some form; not because I think it the correct policy [the Fed has already pumped too much money into the banking system] but because I think the Fed is under pressure from the Administration to do anything to goose the Markets. So while I may have expected QEIII and while others will quite likely be disappointed that it didn’t occur, I consider it a positive because [a] it will hopefully take some weight off the Fed to ease [b] which in turn will not add to the already enormous potential for ‘a corrosive rate of inflation’.


(2) the non-plan from Draghi. Like QEIII, investors had optimistically expected some sort of firm commitment or at least an outline of commitments to be developed that would deal with the underlying causes of EU bank/sovereign insolvencies. Didn’t happen. Not even close---which keeps alive the principal risk [Europe implodes] to our ‘muddle through’ forecast. That said, as long as investors continue to give the eurocrats a pass [which they clearly did this time], that risk is being held at bay.

In sum, after a very exciting week of data and events, our economic forecast continues to unfold:

‘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.’

Additional pluses:

(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 latest example being Ted Cruz [tea party] victory in the Texas republican senate runoff election.

The negatives:

(1) a vulnerable banking system. There were no new revelations of misconduct amongst the banking class this week, though the trading screw up at Knight Capital adds to the notion that our financial system is totally f**ked up.

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 civil war in Syria got more dangerous as Russia sends in the marines [see below]. In addition, Romney’s visit to Israel lit a fire under speculation about the timing of a potential preemptive Israeli strike against Iran. That in turn seemed to be the force behind a rebound in oil prices. My concern is a conflagration in which all bets will be off.

Russia ups the ante (short):

(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 lower confidence and a threat of a serious slowdown in consumption and investment.

(4) continuing its schizophrenic behavior, the ECRI weekly index was down last week. As you know, this indicator’s ongoing erratic performance 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.

(5) another week and nothing done on the ‘fiscal cliff’. To its credit, congress appears to be working on a measure to insure government funding through March 2013; although it is as much a matter of avoiding an election eve emergency as it is about attempting to do the right thing. To be clear, this compromise has nothing to do with the ‘fiscal cliff’.

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. As noted above, the big news this week was ECB head Draghi’s follow up to his statement last week that the eurocrats would do everything necessary to save the euro. Regrettably, his plan was to develop a plan. In other words, one giant dose of more bulls**t, one teeny weeny potential step forward. And so far, not one word from Merkel, who is basically the only one who counts.

Nevertheless, after investors pressed stock prices up 400 DJIA points last week, there was very little reaction to the milquetoast proposal from Draghi. That suggests to me that investors are relying on blind hope that somehow the eurocrats will solve their solvency problems. But that also means that there remains a high [though less than 50/50] probability that the Market will eventually tire of this ‘hope’ strategy and take matters in its own hands---the result of which will likely be an unpleasant ending.

Mohamed El Erian on the central bank problem (medium):

Where is the money (short):

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; the May Case Shiller home price index rose more than anticipated,

(2) consumer: weekly retail sales were mixed to negative; June personal income was stronger than expected, personal spending was flat---hence, savings are up and that is good; weekly jobless claims rose, the ADP private payroll report showed job growth, July nonfarm payrolls were much better than anticipated; July domestic vehicle sales were flat; the Conference Board’s July index of consumer confidence came in better than estimates,

(3) industry: the July ISM manufacturing index was weaker than forecasts, while the nonmanufacturing index was slightly better; June factory orders fell versus estimates of an increase; June construction spending rose; the July Dallas Fed manufacturing index plunged while the Chicago PMI came in ahead of expectations,

(4) macroeconomic: none.

The Market-Disciplined Investing


The indices (DJIA 13091, S&P 1390) had a roller coaster week, but still closed within the boundaries of their primary trends: (1) short term trading ranges [12022-13302, 1266-1422] and (2) intermediate term uptrends [12103-17103, 1273-1853].

I think that in the last two week’s of trading, this Market has shown a very positive bias. To review briefly, (1) last week, consensus was that this week [a] the Fed would implement some version of QEIII and [b] following the ECB meeting, Draghi would outline a substantive plan to deal with the EU bank/sovereign insolvencies. As a result, the Market rallied hard on those prospects, (2) this week, neither occurred; but stocks sold off modestly and (3) Friday, we got a better than expected nonfarm payrolls report and prices exploded again.

In other words, as I speculated in Friday’s Morning Call, it seems like we are in one of those Markets where good news is good news and bad news is ignored. If stocks were below Fair Value, I could understand. But they are not; they are, in fact, slightly overvalued at least as defined by the S&P and our Model. I could also understand if something material had occurred that would cause me to alter our Model; but all that happened this week was that our forecast for the US economy and our fears about the EU economy were both confirmed.

So with the Averages once again in the upper quadrant of their short term trading ranges, I see no compelling technical reason to initiate any buying. Indeed 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 fell dramatically; breadth improved but the flow of funds indicator remains weak. The VIX fell and finished the week very near the lower boundary of its intermediate term trading range (and the neckline of a developing head and shoulders formation). A confirmed break of this level would be positive for stocks.

GLD was up, finishing above the lower boundary of its intermediate term trading range but is still unable to break 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 (12103-17103, 1273-1853],

(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 (13091) finished this week about 17.7% above Fair Value (11120) while the S&P (1390) closed 1.0% 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 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, of course, is our forecast; but it has been somewhat optimistic viz a viz the consensus. The Friday payrolls report seems to have brightened the Street’s outlook; and that likely means that our take is once again moving from the ‘too optimistic’ camp to the ‘just right’. Nevertheless, from our Model’s point of view, nothing has changed; so its calculation of Fair Value remains the same.

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. No better example exists than this week’s developments in which Draghi failed to deliver on last week’s promises of a plan to deal with the EU debt crisis.

That really means that this part of our forecast is being sustained by what I would describe as investors drinking the Kool Aid. And that, of course, is why I am so concerned with my EU assumptions in the Model. To be sure, investors can continue their addiction to pixie dust into infinity---which would sustain the ‘muddle through’ outcome without actually meeting the economic preconditions for ‘muddling through’.

On the other hand, the risk is that at some point investors lose patience and realize that the eurocrats simply don’t have the cojones to enact/enforce the measures needed to solve the bank/sovereign insolvencies, crush the Eurobond market and force an EU banking crisis that spills over into our own financial system which is not nearly as clean and healthy as we thought a month ago.

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 8/31/12 11120 1376
Close this week 13107 1385

Over Valuation vs. 8/31 Close
5% overvalued 11676 1444
10% overvalued 12232 1513
15% overvalued 12788 1582

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.