Saturday, December 1, 2012

The Closing Bell--Ain't euphoria great?

  
The Closing Bell

12/1/12

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 Trading Range (?)                 12460-13302
Intermediate Up Trend                            12857-17857
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 Trading Range (?)                         1343-1424
                                    Intermediate Term Up Trend                     1357-1952 
                                    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.  There was quite a bit of data this week; and I would characterize it as mixed/neutral: positives---weekly mortgage purchase applications, the latest Case Shiller home price index, November consumer confidence, October durable goods orders (ex transportation), the Richmond Fed’s manufacturing index, November Chicago PMI and revised third quarter GDP; negatives---weekly mortgage applications, October personal income and spending, the Chicago Fed’s national activity index, the Dallas Fed’s manufacturing index and revised September new home sales; neutral---weekly retail sales, October durable goods orders, weekly jobless claims and the latest Fed Beige Book.

Some of these numbers contain Sandy related information; some did not.  So in aggregate, (1) they don’t provide an exact picture of the economy, (2) but  they are not distorted enough to prevent us from concluding that they continue to reflect a struggling economy.  In other words, they fit nicely with our current outlook:

‘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.’

Update on the big four economic indicators (medium):

The pluses:

(1) an improving economy.  This factor is, of course, dependent on how the ‘fiscal cliff’ gets resolved and whether or not Europe implodes.  That said, American business is doing the best it can to overcome a far too intrusive government that over taxes, over spends and over regulates. That doesn’t mean that the economy will return to its historical secular growth rate; but it does mean that industry will continue to innovate to at least partially compensate for the  burden that is the US government. 

(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.

The latest problem to appear on the horizon is the impending student loan crisis---yet another example of the government encouraging poor lending practices with the implied prospect of bailing out the financial system should things go wrong.  Well, things are starting to go wrong; witness the skyrocketing delinquency rates among this class of loans.  Sooner or later this is going to cause massive heartburn for someone; and if history repeats itself, it will be the US taxpayer.

‘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.’
    
(2) the ‘fiscal cliff’

This issue is, of course, center stage at the moment.  As you know, there are basically three alternative outcomes: (1) the right one, i.e. a grand bargain that reforms the tax code as well as the entitlement system, (2) the wrong one, i.e. we go off the cliff, and (3) the half assed one, i.e. an agreement but no real reform and not before investors soil their trousers.  You also know my opinion as to which alternative we will get---door number 3. 

The good news is that this solution defines our long term forecast in the same terms as our 12-18 month outlook---so it saves me a lot of work.      

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.

                 The myth of austerity (medium and must read):

(2)   rising inflation:

[a] the potential negative impact of central bank money printing.  As you know, the Fed along with the central banks of the major global economic powers are now ‘all in’ for monetary easing.  This week some declared themselves more than ‘all in’: {i} the Bank of Japan proposed its version of QEXII and {ii} with Uncle Ben’s job now safe, he let the markets know that he would likely up his commitment to the paper and ink industries and inject even more money into the system---what the hell, you only live once, right?

‘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 {four 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.

                       
[b]       a blow up in the Middle East.  Well, we had a blowup but it had a limited impact on oil prices---though gasoline prices are higher.  Of course, the Palestinian/Israeli skirmish is a sideshow to the main event.  So while I am encouraged that the short Gaza war didn’t lead to anything more substantive, that doesn’t mean this risk has gone away.  Indeed, one expert argues that Israel went after Hamas and its rockets so that it wouldn’t have to worry about a two front war if {when?} hostilities break out with Iran.

The risk here is that war brings impairment to either the production and/or the transportation of crude oil out of the Middle East long enough to begin hindering US {and global} economic growth and ultimately pushes the economy into recession and/or adds fuel to inflationary impulses 

(4)   finally, the sovereign and bank debt crisis in Europe remains the biggest risk to our forecast.  This week in Greece, the eurocrats threw more spaghetti on the wall to see if anything would stick.  So far the answer is nein. In Spain, there was [a] another regional vote for secession and [b] a new plan to help shore up the banks---which had it good points but also some bad.  Net, net, economic and political conditions continue to deteriorate throughout Europe---which brings them and us ever closer to a disruptive event.

While the question on investors’ minds at the moment seems to be ‘how likely is it that the US runs off the fiscal cliff?’, in  my opinion, they would be well advised to be more concerned about how likely it is that Europe implodes. First because the fiscal cliff is not likely to occur and secondly because we know exactly how much the US economy will be affected, if it does happen.  On the other hand, in my opinion, an unraveling of the eurozone has higher odds and I don’t have a clue how to quantify that scenario.

                    
Bottom line:  the US economy continues to plod along and will likely do so in 2013 unless the political class allows us to run off the fiscal cliff---which I doubt.  A corollary of that is that I see little likelihood of the burdens of too much government spending, too high taxes, too much regulation; and the risk of inflation growing, being lifted. 

The risk of multiple European sovereign/bank insolvencies continues to weigh heavily on our forecast.  For one, the probability of its occurrence rises daily as the eurocrats insist on avoiding a real solution.  And secondly as I note repeatedly, I am not smart enough to quantify the downside which I intuitively believe to be rather large.  We may get lucky and Europe muddles through; but I fear something far worse.

This week’s data:

(1)                                  housing: weekly mortgage applications fell but purchase applications rose nicely; October new home sales fell slightly but the September number was revised down big; the September Case Shiller home price index was up,

(2)                                  consumer: weekly retail sales continued their rebound helped by the timing of Thanksgiving and Black Friday; November retail sales were a meager advance over October but they were impacted by Sandy; both October personal income and spending were disappointing but also reflected the influence of Sandy; November consumer confidence was above expectations; weekly jobless claims dropped though less than anticipated,   

(3)                                  industry:  the Chicago October national activity index and the Dallas Fed manufacturing index were sub par while the November Richmond Fed manufacturing index was well above estimates;  the November Chicago PMI was ahead of forecasts; October durable goods orders were so so, but ex transportation, the number was good,      
                
(4)                                  macroeconomic: the latest Fed Beige Book was generally up beat; revised third quarter GDP was up but that was anticipated.

           
Revisions to economic data (short and must read):
                       
The Market-Disciplined Investing
           
  Technical

Friday, the indices (DJIA 13025, S&P 1416) drifted higher.  As a result, they finished for the third day above the upper boundaries of their short term downtrends, thereby confirming the break of those trends.  They will now re-set to short term trading ranges, the lower boundaries of which are 12460/1343.  The initial candidates for the upper boundaries are the 50 day moving averages (13178/1419) and/or the 13302/1422 former support now resistance levels. 

They remain well within the boundaries of their intermediate term uptrends (12857-17857, 1357-1952).  Having successfully tested the lower boundaries of those intermediate term uptrends, our portfolios will likely put money to work on a second challenge.

Volume on Friday was up; breadth was mixed.  The VIX rallied but remains below its 50 day moving average and the upper boundary of its short term downtrend.  It trades above the lower boundary of its intermediate term trading range. (neutral)

GLD sold off fractionally; and remains below its 50 day moving average.  It is near a support level (164) and above a very short term uptrend.  However, if it trades below the 164 level, our Portfolios will Sell the remaining shares of Tuesday’s trading Buy.  GLD is still above the lower boundaries of its short term uptrend and intermediate term trading range.

            Bottom line:

(1)   the DJIA and S&P [a] are re-setting to short term trading ranges and [b] continue to trade within their intermediate term uptrends {12857-17857, 1357-1952},

(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 (13025) finished this week about 15.2% above Fair Value (11300) while the S&P (1416) closed 1.1% overvalued (1400).  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 ‘lowering of the long term secular growth rate of the economy’ follows from the assessment that the fiscal cliff agreement will be non-optimal, that is, we do not get the ‘grand bargain’ of tax and entitlement reform on the fiscal cliff---to which I give a very high probability.  On that score, I appear to be at odds at the moment with investor consensus, i.e. a higher chance of an economically meaningful compromise.  However, until there are more encouraging signs to the contrary, my best guess is an agreement that does little other than keep the economy from running off the cliff.

There is one other variant to this scenario and that is that the negotiations go  down to the eleventh hour, 59th minute and 59th second.  While the current positive  investor mood seems to indicate a lack of concern about this prospect, it could induce some heartburn when they actually have to witness our politicians endlessly quibble and posture for the cameras until they have one foot off the cliff (which as you know I would consider a potential buying opportunity).

         More concerning to me is the diminishing likelihood that Europe will ‘muddle through’.  This week’s Greek bail out is already in question with the Greek banks refusing to go along.  More broadly, the economic news for the whole of Europe keeps getting worse---unemployment has reached a high and retail sales are declining. 

For whatever reason,  investors appear to care less; and as long as they do, the eurocrats skate and ‘muddle through’ remains the operative scenario.  And as you know, that is the current assumption in our Models. 

‘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:  with stocks (as defined by the S&P) slightly above Fair Value, I am not jumping up and down to put our Portfolios’ cash to work.  This judgment is made all the more so by the undetermined risks associated with the EU crisis.  However, if those risks begin to be reflected in stock prices, our Portfolios will become Buyers.

            Last week, our Portfolios made a bad trade, buying GLD on Tuesday, then selling half of those shares at a loss on Thursday.

       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 12/31/12                                 11300                                                  1400
Close this week                                                13025                                                  1416

Over Valuation vs. 12/31 Close
              5% overvalued                                 11865                                                    1470
            10% overvalued                                 12430                                                   1540 
            15% overvalued                             12995                                             1610
            20% overvalued                                 13560                                                    1680   
                       
Under Valuation vs.12/31 Close
            5% undervalued                             10735                                                      1330
10%undervalued                                  10170                                                  1260    15%undervalued                             9605                                                    1190

* 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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