Saturday, February 16, 2013

The Closing Bell-2/16/13

     
The Closing Bell

2/16/13

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 Uptrend                                13400-14048
Intermediate Uptrend                              13357-18357
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 Uptrend                                       1458-1527
                                    Intermediate Term Uptrend                       1413-2008 
                                    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                              38%
            High Yield Portfolio                                        38%
            Aggressive Growth Portfolio                           41%

Economics/Politics
           
The economy is a modest positive for Your Money.   Another slow week for data; though the good news is that it was weighted toward the plus side: positives---January retail sales, weekly jobless claims, the NY Fed manufacturing index, consumer sentiment and the January government budget surplus; negatives---January industrial production and weekly mortgage and purchase applications; neutral---weekly retail sales and December business sales and inventories.

Though meager, these stats nonetheless continue to support 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.’
           
The pluses:

(1) 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. 
                
(2) an improving Chinese economy.

       The negatives:

(1) a vulnerable global banking system.  JP Morgan just can’t stay out of the news.  This week witnessed another report on their trading operations in which the measure that traders used to control risk in their portfolios substantially understated that risk due to a programming error; in other words, JPM has been carrying more risk in its trading operations than it thought.  This simply illustrates [one more time] [a] the potential risk that exists on any one bank’s balance sheet and [b] because of the counterparty risk via derivatives becomes a potential risk on all banks’ balance sheets.

‘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 ‘debt ceiling/sequestration/continuing resolution cliff’.  In the ongoing sequestration debate, this week Obama, in His SOTU, again refused to take tax increases off the table and doubled down by offering a full menu of new programs that He wants to initiate.  He claimed that they won’t cost a dime, though the universe knows that is simply more of His bulls**t.

On the other hand, the GOP is hanging tough on allowing the sequester to go through.  As you know, I am all for that occurring, absent a compromise that would include an equal but more targeted spending reduction. 

However as I have pointed out, it would not immediately solve our debt and deficit problems---although it would be the first sign in over a decade that someone in Washington is actually prepared to take a fiscally responsible action.   

Nor would it, in the near term, improve the economic outlook:

“according to the Rogoff and Reinhart study, countries whose national debt is more than 90% of GDP grow at below average rates as a result of being encumbered by policies that are required in order to service that debt.  Today that debt to GDP ratio in the US is 105%.   So while the sequester may be a first step in the long term journey toward fiscal responsibility, the policy of reduce spending must be sustained long enough to drive that debt to GDP ratio back to the point where the economy is free to grow at its historic secular rate.  Hence, in the short term, the sequester and any other subsequent spending cuts will not have an immediate impact of economic/profit growth’

Of course, the sequester hasn’t occurred yet; and Obama is not going to let this happen unchallenged.  With only two weeks to go, He will undoubtedly turn up the heat; and given His acumen as a politician, gosh only knows what He will pull out of His bag of tricks.
    
 So while I am root, root, rooting for the home team [sequester advocates], until I see it happen, I will remain a nonbeliever. In addition, ‘I maintain my thesis that this is ‘a line in the sand’ moment---the ruling class either puts government finances on a fiscally responsible course or we will be firmly on a course to a European nanny state [many of whom are rapidly approaching bankruptcy].’ 


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 an 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.

(3)   rising inflation:

[a] the potential negative impact of central bank money printing.  My initial concern with rampant money printing [aside from deforestation] was either recession or price inflation.  To date neither has happened.  But the longer the expansion of bank reserves goes on and the larger they become, the more difficult it will be to return to normal without either pushing the economy into recession [if the tightening is too big too fast] or creating inflation [if too slow]. 

Since the Fed has never gotten this exit correct, more often erring on the side of too little too late, my primary worry is inflation.  Here are the problems:

First--  [a] Bernanke has already said {too many times to count} 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}.  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.
     
      ‘Second, the bond market may not even give the Fed the luxury of deciding when it wants to start tightening.  If bond investors get spooked enough and start imposing some serious whackage on bond prices, the Fed will be faced with a Hobson’s choice---hold on to the bonds, suffer the accompanying price depreciation and print more money to counter the loss on its balance sheet or sell the bonds faster than it planned, in effect tightening money policy faster than it would like and raising the risk of creating a recession.

‘Third, an overly easy monetary policy generally results in the depreciation of the currency of that bank’s country which in turn improves that country’s trade balance and strengthens its economy.  That is great unless its trading partners get pissed and commence their own ‘easy money/currency depreciation’ effort.  At that point, you got yourself a currency war; and that seems to be the direction that the major economic powers are headed in.’ 

This week, the G20 chose to completely ignore the recent moves by the Japanese to depreciate the yen just like they have largely closed their eyes to US money printing.  So far, it has been easy enough to ignore our Fed’s easy money policy because it has not shown up in the dollar exchange rates to date.  On the other hand, the yen has already depreciated 20%---a little tougher to overlook.  The potential problem arises if at some point, the Japanese yen  gets cheap enough and/or investors quit giving the Fed a free ride and everyone else in the world starts retaliating---at that point, we have a very serious problem.

[b] a blow up in the Middle East.  It was mostly quiet on this front this week.  However, it would likely be a mistake to assume that all is well.  My concern is that one or more of the current hot spots [Syria, Egypt, Algeria, Mali, Iran, Israel] will escalate in violence which in turn leads to a disruption in either the production or transportation of Middle East oil, pushing energy prices higher.

(4)   finally, the sovereign and bank debt crisis in Europe remains a major risk  to our forecast.  This week, the EU economic stats showed the continent in recession [which won’t help sovereign and bank balance sheets], the elections in Italy got iffier by the day [with an anti-austerity Berlusconi gaining in the polls] and the G20 in a state of denial regarding the impact of a weakening yen on EU production and trade.

Nevertheless, investors are back doing what they do best which is giving the eurocrats a free pass on any hair brained, destructive scheme they come up with---despite the fact that they have done nothing to either correct their countries’ sovereign/bank debt problems or to lessen the banking community’s exposure to the derivative markets.


Bottom line:  amazingly enough, the US economy continues to grow in spite of dysfunctional monetary and fiscal policies.  While not the ideal scenario, it does, of course,  fit our 12-18 month forecast.  Whether or not this remains our long term outlook depends on our ruling class changing their irresponsible ways. 

On fiscal policy, I have said repeatedly that I considered the sequestration debate a line in the sand. If it happens, then the economy has a chance of righting itself---assuming the fiscally responsible crowd can continue to hold the line until the debt to GDP and government spending to GDP return to historically normal levels.  However, even if they succeed, growth won’t return to its higher secular rate over night and hence will have no immediate impact on our Economic Model.

If it doesn’t happen, then I believe that the US will be locked into the European economic model---slow growth, intrusive taxes, profligate spending.

On monetary policy, I can’t see how the US escapes the consequences of the current Fed policy of infinite money creation.  For the moment, investors apparently are enjoying the liquidity buzz enough that tomorrow doesn’t matter.  Someday, it will; and when that occurs, our Economic Model will most probably change---and not for the better.

The biggest risk to our Models is multiple European sovereign/bank insolvencies.  The likelihood of those happening has probably increased as the EU economy slips further into recession, political stability is again being challenged [Italy, Spain, Greece] and the eurocrats adopt the ostrich strategy in dealing with the ‘all in’ currency deprecation policy of the Japanese.  That said, nothing will happen as long as investors maintain their current optimism.  Regrettably, this calm could have been used by the political class to actually do something constructive to solve the sovereign/bank balance sheet problems; but thus far, they have done nothing.  Which begs the question of whence judgment day?

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications were down big,

(2)                                  consumer: weekly retail sales were mixed while January retail sales rose in line with forecasts; weekly jobless claims fell much more than expected; the University of Michigan’s final February index of consumer sentiment came in above estimates,

(3)                                  industry:  December business inventories and sales were up less than anticipated; January industrial product was down versus forecasts of an increase; the New York Fed February manufacturing index was a blow out,      
                
(4)                                  macroeconomic: the budget was in surplus in January.

           
The Market-Disciplined Investing
           
  Technical

The indices (DJIA 13981, S&P 1519) finished within both their short term uptrends (13400-14048, 1458-1527) and intermediate term uptrends (13357-18357, 1413-2008).   They both continue to hug the upper boundary of their short term uptrends and certainly act like getting to 14140/1576 will not be a problem.

Volume on Friday was up while breadth was mixed---though the on balance volume indicator continues to not confirm the recent move up.  The VIX was off but still closed within its intermediate term downtrend---a positive for stocks.

GLD was off, remaining in its short term downtrend.  As you know, this week it  broke to the downside out of the developing pennant formation and then fell below a secondary support level.  Technically, this is not a plus for GLD.

            Bottom line:

(1)   the Averages are trading within their short term uptrends [13400-14048, 1458-1527] as well as their intermediate term uptrends [13357-18357, 1413-2008].

(2) 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. 

            Is the best behind us (short):

            Margin debt near all time highs (short):

            Never sell a dull Market short?? (short):

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (13981) finished this week about 23.2% above Fair Value (11350) while the S&P (1519) closed 8.0% overvalued (1406).  Incorporated in that ‘Fair Value’ judgment is some sort of half assed compromise on the fiscal (debt ceiling/sequestration/continuing resolution) cliff, continued money printing, a historically low long term secular growth rate of the economy and a ‘muddle through’ scenario in Europe.

The economy is tracking with our forecast; so as I noted above, no alterations are needed to our Economic Model.  Neither is it necessary to change the assumptions in our Valuation Model.  However, the outcome of the sequestration battle could impact both, but on a very long time horizon, i.e. if the spending cuts envision in the legislation are implemented, that could mark a turn toward fiscal responsibility.  But before getting too jiggy about the whole thing, there are a number of big ‘ifs’ that must be dealt with.

First and foremost is whether or not we even get the sequester.  Sure the GOP is hanging tough for now.  But Obama has yet to put on the inevitable full court press.  If republicans fold, nothing changes now or in the future.

Second, if sequestration takes place, it should not be looked as anything more than a symbolic first step.  As Rick Santelli noted, the total sequestration amount is 1/3 of 1% of the budget---hardly a reason to start popping champagne corks over some new  found austerity.  Further, it is not even a cut in spending, it is a cut in the rate of growth of spending.  The point being that (1) unless this action is followed by more such actions, sequestration will mean nothing and (2) it takes time before any cumulative reductions in spending impacts our Economic Model. 

On the other hand, if progress is made, then valuations will likely begin rising before any noticeable impacts on economic growth are visible.  So there is the possibility under the best case scenario of more optimistic assumptions in our Valuation Model even before those in our Economic Model.

As far as monetary policy goes, our Models assume a rising inflation rate resulting from the Fed’s current aggressive money printing.  I see almost no way of improving those assumptions.  Sooner or later, we will be faced with either a recession (if the Fed gets too tight too fast) or inflation (if the Fed does its usual slow on the draw shtick)---which as you know is my scenario of choice.  In the former case, our Models would probably change; in the later, not so much. 

Meanwhile, Euroland continues to slide toward recession and instability.  If there were ever a perfect example of the old saw of Nero fiddling while Rome burned, the eurocrats fit it to a tee.  They did nothing in the recent period of relative economic and Market calm to address the sovereign/bank solvency problem.  So I can only assume that when, as and if the world awakes from its euphoric slumber and takes Europe to task, the tail risks of EU sovereign/bank insolvencies potentially threatening the global financial system have not lessened.

       My investment conclusion:  nothing has happened that would warrant a change in the assumptions in our Valuation Model.  Hence, stocks remain overvalued.  There is the chance that somewhere out there in the future if sequestration occurs and if it is a precursor to further moves to fiscal responsibility that our growth rate assumptions in the Economic Model and our discount assumptions in the Valuation Model could improve.  But it is far, far too soon to make that bet.
  
       The thing that could impact our Models near term is a crisis in Europe.  Economic and social conditions are deteriorating, raising the odds that our ‘muddle through’ scenario will prove inaccurate.  My problem, as I have frequently noted, is quantifying the downside of not ‘muddling through’.

       The ‘tail risks’ of spiking interest rates and inflation in the US and a financial crisis in Europe keep our Portfolios over weighted in cash

       Finally, GLD has me completely baffled.  It has broken down technically in a big way.  While I believe our Portfolios will need the inflation protection offered by gold at some time in the future, clearly the Market doesn’t think that time is now.  As you know, I am not inclined to risk principle to prove a point, so our Portfolios have Sold out of their GLD, at least temporarily.

        This week, our Portfolios also continued to lighten up on either fundamentally or technically overextended stocks.

       The latest from Charles Biderman (4 minute video):

       And Mohamed El Erian (short):

       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 [which is now under review].  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 2013 Year End Fair Value*                11600                                            1440
Fair Value as of 2/28/13                                   11350                                                  1406
Close this week                                                13981                                                  1519

Over Valuation vs. 2/28 Close
              5% overvalued                                 11917                                                    1476
            10% overvalued                                 12485                                                   1546 
            15% overvalued                             13052                                             1616
            20% overvalued                                 13620                                                    1687   
            25% overvalued                                   14187                                                  1757               
Under Valuation vs.2/28 Close
            5% undervalued                             10782                                                      1335
10%undervalued                                  10215                                                  1265    15%undervalued                             9647                                                    1195

* 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.








No comments:

Post a Comment