Saturday, March 16, 2013

The Closing Bell---JP Morgan, the fortress bank


The Closing Bell

3/16/13
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                                13685-14366
Intermediate Uptrend                              13498-18498
Long Term Trading Range                       4783-17500
                                               
                        2012    Year End Fair Value                                     11290-11310

                        2013    Year End Fair Value                                     11590-11610                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                       1492-1567
                                    Intermediate Term Uptrend                       1433-2027 
                                    Long Term Trading Range                        688-1750
                                                           
                        2012    Year End Fair Value                                      1390-1410

                        2013   Year End Fair Value                                       1430-1450         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                              39%
            High Yield Portfolio                                        42%
            Aggressive Growth Portfolio                           40%

Economics/Politics
           
The economy is a modest positive for Your Money.   It was an average week for economic data flow; all in all, I would judge it as mixed with both really bright spots (February retail sales and February industrial production) and some not so good news (March consumer sentiment): positives---weekly retail sales, February retail sales, weekly jobless claims, small business sentiment, February industrial production, the fourth quarter current account deficit and the February budget deficit; negatives---weekly mortgage and purchase applications, February PPI and CPI, March consumer sentiment and the NY Fed manufacturing index; neutral---February core PPI and CPI.

 As I have said before, mixed data is not particularly concerning especially when the good news part includes better retail sales and higher industrial production.  Hence the outlook remains:

‘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 big four economic indicators (medium):

            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. Lousy economic data continues to come out of China.  Another week of this and I will remove it from the pluses.
           
            This just hit Friday afternoon (short):

      However, here is some good news (medium):


       The negatives:

(1)   a vulnerable global banking system.  This week low light was the Senate Finance Committee’s review of JP Morgan [our ‘fortress’ bank to quote a talking head] in which this august institution was accused of lying, mismanagement and the inappropriate assumption of risk [i.e. an uncontrolled and excessive exposure to derivatives]. 

All of these are must reads:

    And:


   And:

  Joining in the fun, British regulators estimated losses on UK bank balance         sheets could reach $90 billion (medium):

    For the hat trick, don’t forget the Kyle Bass piece on Japan, I linked to on       Tuesday

All this emphasizes the points that [a] a potential risk exists on any one bank’s balance sheet and [b] because of the counterparty risk via derivatives, it 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’.  Two positives to note:

[a] the economic data flow continues relatively upbeat as the time period that captures the impact of the January tax increase is being released---a sign of the underlying strength in the economy.  We don’t know yet if the sequestration alone or in conjunction with the tax increase will start to impede growth; but so far it hasn’t.  And as you know, I don’t believe that it will be.

[b] Obama continues his charm offensive, telling republicans Thursday night that He favored tax and entitlement reform.  While I am a cynic when it comes to Obama’s motivations, I can’t deny that the above sounds very hopeful.   But we must await more information before assuming that this transformation in attitude is real. 

As I noted last week, if Obama has truly changed character, if He is willing to negotiate in good faith toward some sort of more fiscally sound budget outcome and if it actually occurs, this would be a major positive.  It would move fiscal policy from a negative to a positive in our economic outlook. Of course, that is a lot of ‘ifs’; so for the moment, government spending and taxes remain a negative.

A problem ...... 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.....
                
(3)   rising inflation:

[a] the potential negative impact of central bank money printing.    Easing continues at full throttle.  This week the Chinese expanded their criticism of too much money printing to the global central banks after banging on the Japanese last week.  As I noted, if they get pissed and decide to take the Japanese or the Fed to task, they can cause some heartburn.  Nevertheless, the banksters appear to be ignoring the warnings and continuing the race for the title of ‘most bloated balance sheet in the universe’. 

As you know, I don’t believe that the current massive injection of liquidity is going to end well; and the longer it goes on, the worse that outcome will be..

Of the twin evils {recession, inflation} that come with the irresponsible expansion of monetary policy, my bet is that tightening won’t happen soon enough; so the US economy will sooner or later face soaring inflation  [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.
     
      A corollary concern is that all this money printing increases the potential for a currency war {i.e. this week’s Chinese reaction}.  ‘ 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.’ 
     
[b] a blow up in the Middle East.  The concern remains that violence could erupt in any of the many flash points in the region and that would in turn lead 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, economic conditions continued to deteriorate with employment and industrial production weakening across the continent, spiced up by a UK report on a worsening in domestic bank balance sheets and heartburn in the Italian and Spanish debt markets.

Nonetheless, investor insist on trying to make a silk purse out of a sow’s ear; and the eurocrats are only too happy to use these moments of euphoria to do nothing to correct the sovereign/bank insolvency problems.   As a result, the risks mount that a sick EU will, at a minimum, be a drag on global growth and could potentially precipitate a sovereign or financial institution bankruptcy that would expose the world banking community to another round of counterparty defaults.
     
Bottom line:  the US economy remains a plus for Your Money.  Fiscal policy is now on hold; but there is some probability (however small I think it may be) that our elected reps will do the right thing, put the budget on a more sustainable path and turn an economic negative into a positive. 

Meanwhile, the rocket scientists over at the Fed are doing their damnest to insure that we experience something worse that 2000 or 2007.  I am not smart enough to know when conditions will start to unravel or the magnitude of the fall out when they do.  When it does, I will likely have to alter our Model.

Finally, the eurocrats are no closer to resolving the multiple European sovereign/bank insolvencies than they were a year ago.  Meanwhile, the EU economy is faltering which will likely only exacerbate the funding and servicing of overly indebted countries and overly leveraged banks.  That said, investors continue to give the eurocrats a pass; so the current slow walk to disaster can go on until either one or more electorates or the Markets hold the ruling class to account.

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications fell,

(2)                                  consumer: weekly retail sales improved again and February retail sales soared; weekly jobless claims fell versus expectations of an increase; March consumer sentiment plunged,

(3)                                  industry: February industrial production came in higher than anticipated; January business inventories rose more than estimates though sales couldn’t keep up; February small business sentiment improved; the March NY Fed manufacturing index were shy of forecast,      
                
(4)                                  macroeconomic: the February PPI and CPI headline numbers came in a bit hotter than expected; however, ex food and energy, they were in line; the fourth quarter current account deficit was below anticipated; and the February budget deficit was slightly less than estimates.


The Market-Disciplined Investing
           
  Technical

The DJIA (14514) remains above its previous all time high (14190) and the upper boundary of its short term uptrend (13685-14366).  It closed within its intermediate term uptrend (13498-18498) and its long term uptrend (4783-17500). 

However, the S&P (1560) remains below its previous all time high (1576) and the upper boundary of its short term uptrend (1492-1567).  So for one more day, the break out of the Dow is not confirmed.  The S&P is within its intermediate term uptrend (1433-2027) and its long term uptrend (688-1750).

For the second week, we are left with the question as to whether we are witnessing a topping process or a consolidation in preparation for a launch higher.  I have noted that (1) our internal indicator suggests at least an S&P assault on 1576 will occur but (2) even if it is successful, there is only about circa 10%  to the upside left before it encounters the upper boundary of an eighty year uptrend---which I don’t believe it will surmount. 
  
Volume was up big; but that was due to quadruple witching.  Breadth deteriorated.  The VIX was unchanged and so it remains in both a short term and intermediate term downtrend---a positive for stocks.

GLD rose but remained in its short term downtrend.  It continues to hold above a developing support level.
                        http://www.zerohedge.com/news/2013-03-15/two-gold-charts

            Bottom line:

(1)   the S&P is trading within its short term uptrend [1492-1567] while the Dow finished above the upper boundary of its short term uptrend [13685-14366].  They both closed within their intermediate term uptrends [13498-18498, 1433-2027].

(2) long term, the Averages are in a very long term [80 years] uptrend defined by the 4873-17500, 688-1750. 
           
   Fundamental-A Dividend Growth Investment Strategy

The DJIA (14514) finished this week about 27.8% above Fair Value (11350) while the S&P (1560) closed 10.9% overvalued (1406).  Incorporated in that ‘Fair Value’ judgment is some sort of half assed attempt at getting fiscal policy under control, 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.  However, we at least have a chance that the political class will come up with a meaningful compromise on setting the budget on a sustainable path.  It is much too early to build such an assumption into our Valuation Model; but were it to occur, it would certainly have a positive impact on our long term corporate profit growth rate and on the discount factor (P/E’s).

On the other hand, every week that goes by adds another $20 billion to the Fed balance sheet.  While we don’t know where this will end, we do know how two similar monetary expansions ended (2000, 2007); and as you know, they weren’t pretty.  Regrettably this time around, Bernanke’s money printing puts those previous examples to shame.

As you know, I believe that the outcome this time around (i.e. inflation) will simply be a worse version of the prior occasions.  In attempting to reflect its potential outcome in our Models, I have built a  rising rate of inflation into our Economic Model and adjusted the future discount factor in our Valuation Model.  However, I feel reasonably sure that these current assumptions inadequately deal with this situation because we have never been in these uncharted waters of monetary expansion before.  So my best shot in coping with this unknown has been to push our Portfolios’ cash positions to an above average level in compensation for my inability to quantify the risk.

That goes double for Europe.  Economic, social and political conditions continue to degenerate while sovereign debt ratios rise and banks become even more leveraged.  The amazing thing is that investors have provided a window of opportunity to the eurocrats to fashion measures to deal with this problem; and those eurocrats have elected to do nothing---except smoke cigars, drink whiskey, chase skirts and slap each other on the back praising their collective wisdom.   This too I fear is going to end badly.

       My investment conclusion:  the economic assumptions in our Valuation Model are unchanged.  The fiscal policy assumptions are also unchanged but there is some hope of an improvement---it is simply too soon to tell.  The monetary policy assumptions are also unaltered.  However, it seems certain that they will change and not for the better.

       Further, the risks of a European recession/financial debt crisis are rising.  These could affect our profit assumptions in both Models and our P/E assumption in our Valuation Model.  The problem is that I still can’t quantify those dangers associated with a severely wounded financial system except that they will have a negative impact.
     
      Our Portfolios’ extraordinarily high cash is compensation for not being able to adequately model the risks of a promiscuous Fed and a continent led by a bunch of unrealistic, self serving nogoodniks.

       This week, the High Yield Portfolio sold its position in TC Pipeline (TCP) after the company failed to pass its most recent financial quality check up.

       Message to myself: don’t chase (short):

      The latest from Howard Marks (medium and a must read):


       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 3/31/13                                   11375                                                  1409
Close this week                                                14514                                                  1560

Over Valuation vs. 3/31 Close
              5% overvalued                                 11943                                                    1479
            10% overvalued                                 12512                                                   1549 
            15% overvalued                             13081                                             1620
            20% overvalued                                 13650                                                    1690   
            25% overvalued                                   14218                                                  1761   
            30% overvalued                                   14787                                                  1831
           
Under Valuation vs.3/31 Close
            5% undervalued                             10806                                                      1338
10%undervalued                                  10237                                            1268    
15%undervalued                             9668                                                    1197

* 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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