Saturday, September 08, 2012

The Closing Bell--the 'full Draghi'

Next week I am taking a belated Labor Day week vacation. So no Morning Calls or Closing Bell. I will be back on line Monday 9/17. In the meantime, I will have my computer and if action is needed will be in touch via Subscriber Alerts.

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 12316-17316
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 1298-1878
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 26%
High Yield Portfolio 26%
Aggressive Growth Portfolio 29%


The economy is a modest positive for Your Money. Not much data this week; what we got was basically mixed: Positives: weekly jobless claims, the ADP private payroll report, the ISM nonmanufacturing index and second quarter productivity. Negatives: mortgage and purchase applications, the ISM manufacturing index, July construction spending, unit labor costs and August nonfarm payrolls. Neutral: weekly retail sales.

The employment numbers were the big attention getters, aided and abetted by lots of political rhetoric. Taken as a whole, this week’s these stats were mildly negative with the importance of the monthly nonfarm payroll data carrying a bit more weight than the weekly reports.

Here is the silver lining (short):

That said, nothing in the numbers in aggregate persuades me to alter 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.’

Of course, the most watched event this week was the ECB meeting. No rate cuts but the good news is that Draghi’s new plan bought more time to correct the fiscal mismanagement-sovereign/bank debt problems. The bad news is that (1) nothing was done to actually address the aforementioned problems and (2) despite Mr. Draghi’s comments to the contrary, I don’t think that the ‘tail risk’ from Europe has been removed. Though to be fair, I acknowledge that it is still too soon to tell.

The pluses:

(1) the ‘big four’ measures of the economy show little sign of recession.

(2) the seeming move of the electorate towards embracing fiscal responsibility. I would argue that means a Romney/Ryan November victory which should be more conducive to fixing the monetary/fiscal problems that plague this economy than an Obama win. However, the polls, including intrade, continue to predict an Obama triumph.

The negatives:

(1) a vulnerable banking system. Nothing new this week; but doesn’t mean the risks are any less: [a] investors lose confidence in our financial institutions and refuse to invest in America and [b] the recent scandals are simply signs that our banks are not as sound and well managed 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 incessant saber rattling from Israel and a build up of US military forces in the Persian Gulf. The economic risk here is that hostilities bring higher oil prices which in turn hamper our economic growth and spur inflation.

Helping to keep energy prices high, at least in the short term, is the impact of Hurricane Isaac. This is largely related to the affects on supplies as oil companies had closed much of the production and refining assets pre-hurricane. Certainly, this will likely prove a temporary problem as companies rush to re-open those facilities and, therefore, have only a transient influence on consumers’ pocket books.

(3) the drought persists in the Midwest, though one of the positives from Hurricane Isaac is that a portion of the Midwest received some much needed rain. Indeed, much of the grain complex this week witnessed lower prices. Nevertheless, at least a portion of the already high prices will likely be passed on to consumers; and to the extent that they are, they 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) oh no, another up week for the ECRI weekly index. This has to be getting embarrassing for the keepers of the index and boring for you reading that this indicator of potential trouble isn’t in fact indicating any such thing. So I am removing this from the list of negatives but reserving the right to re-list if conditions change.

(5) another week, nothing done on the ‘fiscal cliff’ and no prospects anytime soon.

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.

That said, the risk here is that the above assessment is dead wrong; that is, we once again end up with a split government, both parties decide to play chicken and push the US over the cliff waiting for the other party to blink.

The other problem which I introduced last week is potential rise in interest rates and their impact on the fiscal budget. As I noted, the US government’s debt has grown to such a size that its interest cost is now a major budget line item---and that is with rates at/near historic lows. If investors tire of endless deficits and start to lose faith in our political class’ commitment to fiscal responsibility, rates could rise significantly. This budget line item will then explode and make all the more difficult any vow to reduce government spending as a percent of GDP.

In the meantime, the inability of our political class to focus on anything but its own re-election 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 I noted above, one of the most significant news events of the week was the revelation of the ‘full Draghi’ plan. To be fair, it does have some merits but only to the extent that it buys time for the really tough part, i.e. real reforms, to take place; and it is much too soon to assume that the eurocrats have the stomach for such measures.

On the other hand, it does buy time and, hence, [a] the ‘muddle through’ scenario continues to be operative, [b] especially since it is clear from Thursday and Friday’s pin action that investors continue to be willing to give the eurocrats the benefit of the doubt. I speculated in Wednesday’s Morning Call that investor patience could be running out; but that clearly has not proven to be the case.

However, until we know whether there is any policy follow through that will began correcting the current flawed model, the European ‘tail risk’ remains: investor 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 will be a freezing up of the entire financial system which infects our own [via counterparty risk in credit default swaps].

Bottom line: the US economy continues to limp along; though there appears to be less risk of recession than there was a month ago. Little can be expected from our elected representatives, at least until after November; and even then uncertainty will remain until we know the true agenda of the incoming regime. Further, it seems the Fed and ECB will continue to do what they do best---print money. For better or worse, this is all reflected in our Models.

But the Fed’s options may be limited (medium):

There is, to be sure, some probability that this time, the eurocrats will manage to implement some adult fiscal policies. But in the absence of those policies, it remains just a probability. Further, notwithstanding Draghi’s ebullient claim that his plan had eliminated the EU ‘tail risk’, it is not at all clear that this is anything more than an empty boast. Until the eurocrats deliver, the risk of multiple sovereign/bank bankruptcies and/or multiple exits from the EU with all the associated economic/financial problems remains the 800 pound gorilla in our forecast.

In the meantime, our outlook is unchanged.

This week’s data:

(1) housing: both the weekly mortgage and purchase applications declined,

(2) consumer: weekly retail sales were mixed; both the weekly jobless claims and the ADP private payroll numbers were better than forecast; unfortunately, August nonfarm payrolls rose less than estimates and June and July stats were revised down,

(3) industry: the August ISM manufacturing fell short of expectations while the nonmanufacturing index was better than anticipated; July construction spending declined versus estimates of an increase,

(4) macroeconomic: second quarter productivity was better than estimates while unit labor costs were higher than forecast.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (13306) finished this week about 19.2% above Fair Value (11165) while the S&P (1437) closed 4.0% overvalued (1382). 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 its slow. plodding progress---although the overall flow of economic news has improved in the last couple of weeks including more upbeat data in the ‘big four’ economic indicators. On the other hand, this week’s nonfarm payroll number was reason for some concern; but it was simply not negative enough to offset the positives in the totality of all recent economic data. Indeed that totality of news argues that the risk of recession is declining; although to be clear, in my opinion, it provides no reason to think that this recovery will be anything better than ‘sluggish’.

In fact, the only thing I see that could potentially lead me to upgrade our forecast is ‘a change in personnel in Washington’ which in turn would be a precursor to less government spending, taxing, regulation and intrusion into monetary affairs. I am biased toward the GOP to deliver those policies; but frankly, I could care less who does it, as long as it gets done. On the other hand, while biased, I am not at all convinced that the republicans can put enough strict fiscal/monetary conservatives in place to truly change the direction of government sufficiently to return this economy to its long term secular growth rate. My worry is that this election only further divides the country and leaves plenty of central planners in place to wreak havoc---and insure that our long term growth outlook will remain unchanged..

In the interest of balance, some thoughts on what government does build (medium):

All that said, the probability of severe economic dislocations in Europe remains the biggest risk in our forecast. To be sure, the plan Draghi set forth this week buys time to make the necessary corrections to avoid the disaster scenario; but that should not be confused with making those necessary corrections---which it most assuredly does not. On the other hand, it (1) keeps our ‘muddle through’ scenario operative and (2) seems for the time being to have bolstered the investment community’s faith in the eurocrats. Unfortunately, it does nothing for my confidence.

Of course, none of my fretting means a hill of beans with stocks smoking to the upside. Clearly, either the assumptions in or the credibility of our Valuation Model appear to be in question. So what could be wrong?

It may be that I am underestimating economic and corporate profit growth over the next one to two years; although there is nothing in the current data flow to suggest that the economy is about to ramp up a notch. It can’t be that I am too pessimistic about Europe because our Models assume the good news scenario. However, it could be that investors are ahead of me getting jiggy about a republican victory---though the polls and intrade suggest otherwise.

In the end, I think that investors are keying on central bank monetary policies on the assumption that more money equals higher stock prices. Clearly, gold is saying as much. My problem is that this is just a legalized Ponzi scheme, to wit, to date the benefits of massive global money printing haven’t had much of an impact on anything other than the securities markets. To be sure, that is good for our Portfolios in the short term. But all that has really been accomplished is a huge built up in the inflationary potential of bank balance sheets and huge distortions in fixed income markets. Nothing has been done to improve the economic factors that drive corporate profits and asset values.

I also recognize that this has created a bizarro world where bad news (lousy employment, Spain on the edge of default) is good news (more money printing). But sooner or later, reality imposes itself on prices, just as it did in the tech crash and the housing crash. When that happens, I have no clue. So in the meantime, I must choose to either dance till the music stops and hope that I am smart and quick enough to know when to sell or stick with our Valuation Model and Price Disciplines, grit my teeth and endure what I believe to be unwarranted investor euphoria. Since I am neither smart nor quick, I choose the latter.

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.’

This week our Portfolios Added to their GLD position.

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 9/30/12 11165 1382
Close this week 13306 1437

Over Valuation vs. 9/30 Close
5% overvalued 11723 1451
10% overvalued 12281 1520
15% overvalued 12839 1589
20%overvalued 13398 1658

Under Valuation vs. 9/30 Close
5% undervalued 10606 1312
10%undervalued 10048 1243 15%undervalued 9490 1174

* 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.