Saturday, November 17, 2012

The Closing Bell---11/17/12

 
The Closing Bell

11/17/12

As you know, next week is Thanksgiving. As usual I will be doing most of the cooking. Plus I have to do a quick turnaround to San Francisco to pick my grandkids.  So no Morning Calls or Closing Bell next week.  As always, I will be keeping close tabs on the Market and if action is needed, I will send a Subscriber Alert.  Hope all have a very Happy Thanksgiving.

Statistical Summary

   Current Economic Forecast

           
            2012

Real Growth in Gross Domestic Product:                      +1.0- +2.0%
                        Inflation (revised):                                                             2.5-3.5 %
Growth in Corporate Profits:                                 5-10%

            2013

                        Real Growth in Gross Domestic Product                       +1.0-+2.0
                        Inflation (revised)                                                             2.5-3.5
                        Corporate Profits                                                              0-7%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Down Trend   (?)                  12625-13109
Intermediate Up Trend                            12765-17765
Long Term Trading Range                      7148-14180
Very LT Up Trend                                       4546-15148        
                                               
                        2012    Year End Fair Value                                     11290-11310

                        2013    Year End Fair Value                                     11590-11610                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Down Trend  (?)                          1365-1415
                                    Intermediate Term Up Trend                     1347-1943 
                                    Long Term Trading Range                        766-1575
                                    Very LT Up Trend                                         651-2007
                       
                        2012    Year End Fair Value                                      1390-1410

                        2013   Year End Fair Value                                       1430-1450         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                              29%
            High Yield Portfolio                                        30%
            Aggressive Growth Portfolio                           31%

Economics/Politics
           
The economy is a modest positive for Your Money.  Virtually all of this week’s  economic data were impacted by Sandy; so they basically carried little information value.  That leaves our forecast unchanged:

‘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.’

As you know, this outlook comes with one caveat; and it centers on the how the impending fiscal cliff is resolved.  To be sure, I think that options (1) and (2) below are low probabilities; but they exist and have to be accounted for: 

(1)    the grand bargain:  The post election happy talk [Friday’s love fest notwithstanding] is now fading as both sides have started laying down markers.  What disturbs me is that all the verbiage is about the size, if any, of tax cuts.  Nobody is talking about reductions in spending---which are far more important to reducing the deficit than tax increases.  Hopefully, we will get there but I fear that Obama’s current strategy of wearing down the republicans defending the ‘taxes on the rich’ is working all to well.  That tells me that the odds of a grand bargain are rapidly slipping from slim to none. 

(2)    we run off the cliff: while Obama has yet to say it, many of His minions have: ‘there was an election and elections have consequences’. That, of course, was  His post 2008 attitude and we know how much compromise there was then.  The more often this argument is thrown at the republicans, the more likely they will become intransigent in their own willingness to compromise---suggesting that the probabilities of this scenario occurring are rising.  Were this to happen ‘our 2013 outlook [1-2% real GDP growth] would fly out the window and would likely move forward the ultimate day of reckoning [which I define as the day the world refuses to accept any more US debt without a significantly higher price tag---fiscal and monetary austerity are thus imposed from the outside and the US gets a nasty and extended recession---see Europe],’

(3)    a not-so-grand compromise:  as I have previously opined, if our political class sticks to its recent modus operandi, they will come up with some half assed solution that doesn’t fix our broken tax system but does raise taxes on the rich [we just don’t know how that will be defined], that keeps much of the purposeless social spending in place to feed the growing new class of dependents,  that does little to solve our deficit/debt problem and to the extent that it does anything, does in the out years [7 or 8 years from now] and last but certainly not least, this solution will likely only be reached at the eleventh hour after the politicians have scared the holy hell out of the electorate/investors.

I rate this as the most likely scenario primarily because it is the most typical.  The good news is that aside from paralyzing the nation for a week or two, it would not change our sluggish but still positive growth outlook.  On the other hand, it leaves us to face our day of reckoning somewhere out there in the future.

I want to be sure that I am being absolutely clear about something.  Most of the ongoing public debate is about whether or not the US is going to go off the cliff.  That is a bulls**t argument.  As I point out above, there is a strong likelihood that we won’t.  In my opinion, the important economic issue isn’t do we go off fiscal cliff or not; the issue is the solution; that is, what does the economy look like after an agreement is reached. My point is and the assumptions in our Models reflect no grand bargain, no falling off a cliff, but a business as usual, tax and spend, jack boot on the neck of US businesses compromise that insures ongoing sub par growth and ultimately a day of reckoning.  [there is another important point that is Market related, but I will deal with that below].

      It is more than just the fiscal cliff (medium and a must read):

Update on  big four economic indicators as well as a study on how they performed after Katrina (medium and very enlightening):

The pluses:

(1) an improving economy.  The ability of American business to improve its operations and grow is truly a wondrous thing.  It has demonstrated this unique capacity in the last decade in spite of a far too intrusive government that over taxes, over spends and over regulates.  Undoubtedly, it could continue to do so, if status quo could be sustained. 

(2) our improving energy picture.  The US is awash in cheap, clean burning natural gas.... In addition to making home heating more affordable, low cost, abundant energy serves to draw those manufacturers back to the US who are facing rising foreign labor costs and relying on energy resources that carry negative political risks. 

       The negatives:

(1)   a vulnerable banking system.  With a friendly White House and Fed, our banking class is now able to continue their free wheeling management style with the sure knowledge that they will be bailed out of any missteps and not be held to account for those actions.

This week the powers that be made a great show out of condemning Jon Corzine for his mismanagement of MF Global; but the last I checked, he was still walking around a free man and with his bank account intact.  Sticks and stones....................

‘My concern here is that: [a] investors ultimately 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.’
     
      The banks are still too big to fail (medium):

(2) the ‘fiscal cliff’.  [see above].

A problem related to the ‘fiscal cliff’ is the potential rise in interest rates and its impact on the fiscal budget.  As I have noted previously, 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.  Moreover, government debt continues to increase and the lion’s share of this new debt is being bought by the Fed. 

So the risk here is two fold: [a] to the Fed---its balance sheet is levered to the point that Lehman Bros. looks like it was a AAA credit.  So if interest rates go up {and prices go down}, the very thin equity piece of the balance sheet would disappear.  The Fed would then be technically bankrupt. and [b] to the Treasury---it must pay the interest charges.  Hence, if rates go up, the interest costs to the government go up; and if they go up a lot, then this budget line item will explode and make all the more difficult any vow to reduce government spending as a percent of GDP and/or manage the fiscal cliff.

(2)   rising inflation:

[a] the potential negative impact of central bank money printing.  The central banks of the major global economic powers are now ‘all in’  for monetary easing; meaning that the world is awash in liquidity.  Furthermore, with an Obama win, Ben’s job is safe; so he is under no pressure to stop the presses.

Indeed, this week in the released minutes of the most recent FOMC meeting, it was clear that [a] QEIII will probably go on for some time and [b] the Board can’t even agree on the trigger that would persuade it to halt monetary easing and/or begin shrinking the money supply.

‘The risk of a massive global liquidity infusion is, of course, inflation.  The bulls argue that thus far, all this money has gone into bank reserves [meaning it has not been spent or lent], that as long as banks are too scared to lend and businesses to borrow, it will remain unspent and unlent and therefore will have no inflationary impact.  And they are absolutely correct.  But the whole point of the Fed’s exercise, i.e. QEIII, is to encourage banks to lend and businesses to invest.  So on the off chance that the plan works, inflationary pressures will grow unless the Fed withdraws the aforementioned reserves before inflation kicks in.

And therein lies the rub.  [a] Bernanke has already said {three times} that when it comes to balancing the twin mandates of inflation versus employment, he would err on the side of unemployment {that is, he won’t stop pumping until he is sure unemployment is headed down (the latest rumored guideline is 7.25% }.  That can only mean that the fires of inflation will already be well stoked before the Fed starts tightening and [b] history clearly shows that the Fed has proven inept at slowing money growth to dampen inflationary impulses---on every occasion that it tried.  [see above FOMC comment]

                       
[b]       a blow up in the Middle East.  This week this area of the world went from powder keg to explosion; and this was just the opening scene.  Who knows to what level the violence will reach?  However, irrespective of the extent of hostilities, oil prices are rising and will likely continue to do so till calmer heads prevail.

The risk here is that these higher oil prices could last long enough to begin hindering US economic growth and ultimately push the economy into recession and/or add fuel to inflationary impulses 

                        Interview with Israeli ambassador (short/medium):


                        Petraeus’ congressional testimony (short):


[c]        food inflation.  Both PPI and CPI were reported this week and the results were quite tame.  Further, the winter wheat crop appears to be a good shape.  I am removing food inflation as a risk.

(3)   finally, the sovereign and bank debt crisis in Europe remains the biggest risk to our forecast.  Economic and political conditions continue to deteriorate throughout Europe---this week, the eurocrats couldn’t even agree on a Greek solution while speaking at the same news conference.  That is not a good sign that a fix is near.

The question is with our fiscal cliff duking it out with increasing violence in the Middle East for the lead headline, to what extent are stocks starting to price in something other than a ‘muddle through’ scenario in Europe? Given the increasingly apparent dysfunctionality of EU bureaucrats, I am going to assume some of the downside risk of an unraveling of the EU is being discounted, though I am convinced that it is not sufficiently so. 

                       And this bit of wisdom from Kyle Bass (short):


Bottom line:  the US economy continues to grow however slowly.  In light of this week’s rhetoric (again, yesterday’s political love fest notwithstanding), I think that my original assessment of Obama’s second term is right on: partisan politics as usual and an economy burdened by too much government spending, too high taxes, too much regulation; and the risk of inflation growing as the Fed prints money at a Mach 10 rate). 

This assumes some clumsy, derisory solution to the fiscal cliff which won’t solve much but will keep the economy from plunging off the cliff.  So the risk of a new recession should fade when and if some budget compromise is agreed upon; unless, of course, Europe or the Middle East blows up. 

Unfortunately neither Europe nor the Middle East are risks that could happen--- like the fiscal cliff---they are happening.  The only question is how much worse will they get?  I am less worried about the magnitude of the likely consequences in the Middle East.  Europe, though, is an economic basket case that could turn into an outright disaster if the eurocrats can’t figure out a solution other than to hope and pray. The risk is that inertia and ineptness win out, Spain defaults, Italy goes on the blocks, the recession turns to depression and the financial system implodes sending shock waves though the global banking system.

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications bounced back from the rough Sandy impacted numbers of the last week,

(2)                                  consumer: weekly retail sales rebounded from the Sandy induced decline of the prior week while October retail sales were down as Sandy’s influence moves from weekly to monthly data;               weekly jobless claims soared but it too reflected Sandy,   

(3)                                  industry: September business inventories and sales were very strong; both the New York and Philadelphia Feds’ manufacturing indices came in below estimates as did October industrial production---all due primarily to Sandy,      
                
(4)                                  macroeconomic: both October PPI deadline and core numbers were down versus expectations of an increase, while both October CPI stats were in line with forecasts.

                                   
The Market-Disciplined Investing
           
  Technical

Friday, the indices (DJIA 12580, S&P 1359) rebounded but still closed below the lower boundaries of their newly re-set short term downtrends (12625-13107, 1365-1415).  In fact, because the Averages have been so far below those lower boundaries for a number of days, they have developed new very short term downtrends (12333-12735, 1317-1359). 

Notice a couple of things: (1) the S&P is right on the upper boundary of its new very short term downtrend. A failure to trade above this weak resistance level would be a negative for stocks.  (2) it would take another up day or two like Friday just to get the Averages back to the lower boundaries of the short term downtrends. In other words, a couple more days of positive performance will do nothing to alter the Market’s negative short term bias.

The only bright spot in this picture is that the S&P managed to rally back above the lower boundary of its intermediate term uptrend (1347-1943); although the Dow remains below its comparable level (12765-17765) for the third day in a row.  That leaves the Averages out of sync.  It offers the hope that the DJIA will follow the S&P back to the upside; although at this point, I wouldn’t count on it.

Volume on Friday was up---not unusual for an options expiration day.  Breadth improved considerably more than I would have expected.  The VIX plunged, closing once again below the lower boundary of its very short term uptrend but remaining below the upper boundary of its short term downtrend and above the lower boundary of its intermediate term trading range.

GLD sold off fractionally, finishing below its 50 day moving average but above the lower boundaries of its short term uptrend and its intermediate term trading range.

            Bottom line:

(1)   the DJIA and S&P [a] have developed new very short term downtrends {12333-12725, 1317-1359} and [b] are below the lower boundaries of their short term downtrends {12625-13107, 1365-1415}.  The Dow closed below the lower boundary of its intermediate term uptrend [12765-17765] for the third day; while the S&P finished above its comparable level  [1347-1943],

(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 (12580) finished this week about 11.7% above Fair Value (11255) while the S&P (1359) closed 2.5% undervalued (1394).  Incorporated in that ‘Fair Value’ judgment is some sort of compromise on the fiscal cliff, a ‘muddle through’ scenario in Europe and a lowering of the long term secular growth rate of the economy.

The above assumes that the economy continues to progress, although it was impossible to tell in a week of data heavily impacted by Sandy.  That doesn’t mean that it is returning to its historic long term secular growth rate because I see little prospect that it can be relieved of its burdens of too much government spending, taxes and regulations.

 As to the compromise on the fiscal cliff, I have made it clear that I think that it will be the bare minimum needed to get a bill signed.  No grand bargain nor anything that will alter the ‘too much government spending, taxes and regulations’ scenario---just enough to keep the economy from dropping off the cliff.  

I say this with full knowledge of the happy talk that filled the airwaves Friday afternoon as congressional leaders made nicey-nice in front of the cameras after their meeting with Obama.  Regrettably, nobody said anything about a changed position; they all simply said that they recognized the problem---which again nobody bothered to define but presumably they meant too much spending and not enough revenue. 

Nevertheless, suddenly investors got all hyped up that these guys have some new understanding of the problem.  Please.  There is absolutely nothing special about these clowns recognizing the problem.  For gosh sakes, they recognized it fifteen months ago when they came up with this whole fiscal cliff idea in the first place.  They just didn’t want to deal with it then because they were all angling for the elections in hopes that the balance of power in Washington would shift.  Well, it didn’t.  In fact, if there was any change, the dems have slightly more chips today than then.

So nothing has changed---not the problem and not the problem solvers.  The only thing to get jiggy about is that our elected representatives aren’t so stupid as to run us off the cliff.  Unfortunately, that doesn’t mean that they are smart enough to come up with a  compromise that will do the economy any good.  So to repeat myself, it is highly likely, in my opinion, that a compromise is reached.  It just won’t change anything---not the economic outlook, not any assumptions in our Valuation Model.  The optimists on a grand bargain may be proven correct.  Color me skeptical.

In addition, it doesn’t mean that negotiations won’t come down to the eleventh hour, 59th minute and 59th second.  This is likely what will give investors heartburn---the prospect of watching these morons endlessly quibble and posture for the cameras until they have one foot off the cliff and then save the economy with some numb nut agreement that my six year old grandson could have done three months ago.

         Moving on to something important, I have to hold my nose when I suggest that Europe will ‘muddle through’; because there is no evidence to date that the EU political class is any better at dealing with difficult problems than our own.  Indeed, the only reason for making such a forecast is that so far it has worked.  In other words, the assumption is that despite one bone headed move after another, the eurocrats will somehow snatch victory from the jaws of defeat at the eleventh hour.

I recognize the flimsiness of such an assertion.  However, while I may believe that the odds of ‘muddling through’ are shrinking by the day and may currently be no better than 50/50, I don’t know how to quantify not ‘muddling through’.  I do believe that the consequences will be severe: depressing economic activity (which I can quantify) and another financial crisis (which I can’t; simply because we have no idea how much of the notional value of current CDS’s held in the banks will become exposed when those banks start going under).

My solution to this dilemma, as you know, is to carry an above average cash position as insurance and to insist on lower stock prices to reflect the risk. 

       My investment conclusion:  if there is any good news in the above discussion, it is that risks listed above are starting to be reflected in stock prices.  That means that at some point our Portfolios need to begin taking advantage of the opportunities on their Buy Lists.  That point is upon us; and it is generally when I increase my dependence on technical analysis.  So the first thing, I want to see is how the Averages resolve their current challenge of the lower boundaries of their intermediate term uptrends.  If prices hold, our Portfolios will likely put some money to work.  If not, then they will do nothing at least until the indices re-set to an intermediate term trading range.

Current revenue ‘beat’ rates (short):

          Third quarter earnings were not any better (short):

            Last 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. 

(3)                                defense is still important.

DJIA                                                    S&P

Current 2012 Year End Fair Value*                11300                                           1400
Fair Value as of 11/30/12                                 11255                                                  1394
Close this week                                                12580                                                  1359

Over Valuation vs. 11/30 Close
              5% overvalued                                 11817                                                    1463
            10% overvalued                                 12380                                                   1533 
            15% overvalued                             12943                                             1603
                                   
Under Valuation vs.11/30 Close
            5% undervalued                             10692                                                      1324
10%undervalued                                  10129                                                  1254    15%undervalued                             9566                                                    1184

* 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.








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