Saturday, July 20, 2013

The Closing Bell--7/20/13

The Closing Bell

7/20/13

Statistical Summary

   Current Economic Forecast

           
            2012

Real Growth in Gross Domestic Product:                           2.2%
                        Inflation (revised):                                                              1.8 %
Growth in Corporate Profits:                                  16.1%

            2013

                        Real Growth in Gross Domestic Product                       +1.0-+2.0
                        Inflation (revised)                                                             1.5-2.5
                        Corporate Profits                                                              0-7%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                      14190-15550
Intermediate Uptrend                              14364-19364
Long Term Trading Range                       4918-17000
                                               
                        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                             1576-1687 (?)
                                    Intermediate Term Uptrend                       1527-2115 
                                    Long Term Trading Range                         715-1800
                                                           
                        2012    Year End Fair Value                                      1390-1410

                        2013   Year End Fair Value                                       1430-1450         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                              43%
            High Yield Portfolio                                        45%
            Aggressive Growth Portfolio                           43%

Economics/Politics
           
The economy is a modest positive for Your Money.   This week’s economic data was definitely upbeat: positives---weekly purchase applications, the NAHB home builders index, weekly jobless claims, June industrial production, the June NY and Philadelphia Fed manufacturing indices, June CPI and the Fed Beige Book; negatives---weekly mortgage applications, June housing starts and June retail sales; neutral---weekly retail sales and June leading economic indicators.

The numbers continue to track with our outlook.  However, I again leave the yellow light flashing because of the confusion generated over ‘tapering’.  Granted Bernanke is in full retreat; and whether or not investors face the facts, businesses and consumers saw the surge in interest rates following Bernanke’s initial comments.  That could keep them very guarded and perhaps even hesitant to proceed with any investment or spending plans already on the books.  So until we get a better sense of their reactions to this melodrama, the caution flag is up.  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 historic inability of the Fed to properly time the reversal of a vastly over expansive  monetary policy.
           
            Update on big four economic indicators:

            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. 
               
       The negatives:

(1)   a vulnerable global banking system.  The political situations in Portugal and Spain continue to deteriorate.  Italy’s budget deficit is growing relentlessly. While the Greek parliament agreed to the latest austerity demands of the ECB in order to get its next liquidity injection, the electorate is once again in the streets.  And on this side of the pond, it looks like JP Morgan will eat a $500 million fine for fraud in its trading unit---similar to the HSBC’s sentence last week. 

On the other hand, US banks are reporting improved earnings aided by a decline in reserves for bad loans which were set up back in 2008.  I won’t argue with the notion that bank balance sheets are healing. 

My problem is that we still don’t know [a] just how bad the loans losses are that remain on the balance sheets, [b] how much new risk has been assumed in the major banks prop trading desks, [c] anything about the condition of the EU bank balance sheets except that they are lousy with sovereign debt and [d] what US banks’ counterparty risk exposure is to those EU banks.  

That lack of visibility keeps the stability of the global banking system high on our list of risks

‘My concern here.....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)   fiscal policy.  Keeping the positive trends in this area in tact, the house voted this week to delay the implementation of the individual and employee mandates in Obamacare.   

That said, ‘delaying the implementation’ of Obamacare doesn’t make it go away and turn the long term into a rosy scenario; nor do the benefits of an improving economy [declining safety net costs and rising tax receipts] negate the headwinds posed by an entitlement system that is completely out of control and a tax system that is corrupt and inefficient. 

Unfortunately, entitlement and tax reform remain as elusive as ever which leaves the economy struggling to overcome a fiscal policy headwind and the Fed assuming that it alone must bear the responsibility of keeping the economy from falling back into recession---an assumption that has led to policy moves more harmful than helpful. 

I also continue to worry about .....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)   the potential negative impact of central bank money printing:  The key point here is that [a] the Fed has inflated bank reserves far beyond any comparable level in history and [b] while this hasn’t been an economic problem to date, {i} it still has to withdraw all those reserves from the system without creating any disruptions---a task that I regularly point out it has proven inept at in the past and {ii} it has created or is creating asset bubbles in the stock market as well as in the auto, student and mortgage loan markets. 

This week Bernanke continued his peace offense with the Markets, ‘clarifying’ in testimony before congress that ‘tapering’ was not on a fixed schedule but rather was ‘data dependent’ and that ‘tapering’ most assuredly wasn’t ‘tightening’.   As you know, I have viewed this full retreat from ‘tapering’ with a jaundice eye because:

[a] first and perhaps foremost, save for QE1, which I will stipulate greatly aided in preventing a melt down of the global financial system, there is hardly a scintilla of evidence that the subsequent QE’s have done anything to improve the economy.  Indeed, it seems that the only noticeable impact has been to push stock prices higher.  The Fed’s mandate is to focus on employment and inflation, not stock prices.  Hence, the Fed should be crawfishing on ‘tapering’ only if it believes that ‘tapering’ will negatively impact employment or inflation,  

[b] given the Market’s reaction to the initial ‘tapering’ comments, we know that investors will react negatively when it happens. If investors don’t like it now, how much more will they dislike it three, six or twelve months from now? More importantly, investors now know how stocks and bonds will react to ‘tapering’; so it stands to reason that they have to be adjusting their risk/reward models accordingly,

[c] given this whole ‘tapering’ episode, we/investors also know that the Fed has already made its first mistake in its transition from easy to tight monetary policy---proving my point that these guys, despite their best efforts, are not omniscient; that is why the Fed has always been inept at the transition process.  Unfortunately, this time around QEInfinity is in uncharted waters, raising the risk that the move to tight money will be even more disruptive than in the past; and the longer the Fed is cowered by the Markets and keeps adding reserves, the worse the end game is likely to be.

[d] Fed claims notwithstanding, ‘tapering’ {slowing bond purchases} is ‘tightening’ {raising the Fed Funds rate}.  When the Fed starts ‘tapering’ whether it is outright sales or allowing the bonds in its portfolio to mature and not reinvest the funds, the result is still the same.  New Market participants must now either buy the bonds sold or refinance the debt being ‘rolled over’.  {unless you believe that the government will cease borrowing any new money, in which case I have a bridge in Brooklyn I’d like to sell you}.  Since those new buyers will likely have a far different risk/reward model than the Fed, it is highly likely they will demand higher rates to finance that debt.  In other words, interest rates will increase---a very close cousin to the Fed definition of ‘tightening’ {a higher Fed Funds rate}. In the end, it won’t matter what the Fed Funds rate is, if investors demand higher rates on everything else.

Bottom line: my thesis has been that Fed will repeat its past mistakes and botch the transition from easy to tight money.  It reinforced that notion with its bungling of the ‘tapering’ affair and attempting to wordsmith its way out of it by differentiating ‘tapering’ from ‘tightening’.  The only difference between the latest half assed effort at transitioning and the next will be that  the  Fed’s massively bloated balance sheet will be even more bloated.

More from Lance Roberts on the Fed and the liquidity trap it has created (medium and a must read):

QE, growth, cause and effect (medium and also a must read):

 (4) a blow up in the Middle EastEgypt seems to have settled down for the moment and Syria is quiet, though there was a press release this week that Obama is considering addition measures against the Assad regime.   Nevertheless, the region remains volatile, so potential disruptions in supply or transportation continue to be a threat to prices---which can in turn influence economic growth of heavy energy consuming economies.

 (5) finally, the sovereign and bank debt crisis in EuropeSouthern Europe continues its slide: the Greek parliament voted for new austerity measures in order to get the next round of its bail out which prompted more rioting, while Portugal and Spain remain burdened by political turmoil that hampers the addressing of their troubled economies.

Yet despite the steady stream of bad news, southern EU countries have all managed to limp along aided only by a few half assed fiscal measures and a lot blustery rhetoric.  That is the very definition of ‘muddling through’.  One could argue that this can go on forever, except for one point---the economies of these countries continue to deteriorate.   That means that the risks rise that one or more, sooner or later will not be able to meet its sovereign obligations---which is bad enough.  But given that the indigenous banks are heavily levered with their parent country’s debt, the financial systems are also at risk. 

Unfortunately, we still have no clue how much our own banks are exposed as  counterparties to the EU debt fest.

  Bottom line:  the US economy continues to track with our forecast.  The good news is that fiscal policy is creating less of a drag than it was a year ago, though much must be still done to remove this factor as negative to growth.

The bad news is that (1) Bernanke wouldn’t stand up to the Markets and began exiting QEInfinity despite the lack of evidence that it is economically beneficial.  This will likely make any future ‘tapering/tightening’ more painful than it otherwise might have been and (2) Europe has still taken no measures to deal with its sovereign and bank debt problems even as economic and political conditions in the southern EU countries grow worse.

Global business confidence declines (medium):

This week’s data:

(1)                                  housing: weekly mortgage applications declined, while purchase applications rose; June housing starts plunged but many pundits questioned the numbers; The NAHB Home Builders Index was very positive,

(2)                                  consumer: weekly retail sales were mixed while June sales of major retailers were very disappointing; jobless claims fell more than forecast,

(3)                                  industry: June industrial production was above estimates; the NY and Philly Fed manufacturing indices were much stronger than anticipated,

(4)                                  macroeconomic: June leading economic indicators were flat; June CPI was slightly hotter than expected; the most recent Fed Beige Book was generally upbeat.
           
           
The Market-Disciplined Investing
           
  Technical

The Averages (DJIA 15543, S&P 1692) had another great week.  The S&P busted through the upper boundary of its short term trading range (1576-1687).  This challenge will be successful if the S&P can remain above 1687 though the close on Monday.  However, the DJIA has not penetrated its comparable upper boundary (14190-15550).  That puts the Averages out of sync.  For the Market to be deemed to re-set to an uptrend both of the indices must have broken to the upside.

However, they closed well within their intermediate term (14364-19364, 1527-2116) and long term (4918-17000, 715-1800) uptrends.   

Volume on Friday was up; breadth was down.  The VIX closed 13% lower; it has negated the very short term uptrend and is approaching the lower boundary of its short term trading range.

GLD gained; but its chart looks as sick as ever.
           
Bottom line: the challenge of the 15550/1687 is in process, with the S&P having traded above its short term trading range’s upper boundary for two days and the Dow still struggling to successfully assault its comparable level.  As you know, under our time and distance discipline, breaking a trend is a process not an event..  In this case, the S&P must continue to trade above 1687 though Monday’s close to confirm the break via the time element and the DJIA must complete a similar exercise to confirm an overall change in the short term Market direction. 

If successful, because the Averages would then be at all time highs, there exists no overhead resistance save the upper boundaries of the three major trends (S&P short term---1750, intermediate term---2116, long term ---1800). 

Assuming the 1750/1800 (short and long term upper boundaries) area represents the zone of maximum upside, that is about 3-6% versus 6% downside if stocks return to the short term lower boundary, 9% if they slide to the intermediate term lower boundary, 18% if they return to Fair Value and 57% if they make it all the way to the long term lower boundary

If the 15550/1687 levels hold, the risk exists that a double, even a triple top will have been put in.

 There is nothing to do but watch the process.

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (15543) finished this week about 35.4% above Fair Value (11475) while the S&P (1692) closed 18.9% overvalued (1422).  Incorporated in that ‘Fair Value’ judgment is some sort of half assed attempt at getting fiscal policy under control, a botched Fed transition from easy to tight money, a historically low long term secular growth rate of the economy and a ‘muddle through’ scenario in Europe.

The economy continues to perform in a very encouraging way.  The little bit of weakness that we witnessed eight to twelve weeks ago is long gone.  So that assumption carries good confidence. 

Fiscal policy is improving in a half assed sort of way; that is, the deficit is shrinking as a result of economic growth, the sequester and the tax hikes; and Obamacare is on life support.  On the other hand, there seems to be little hope of entitlement or tax reform before November 2014.  So I rate this assumption as less negative on a short term basis but little changed long term.

Monetary policy is poor and getting worse.  First the Fed backed off of the proposed move toward ‘tapering’ for no reason other than the Markets whined a lot.  As I have noted previously, I don’t think that QE II and beyond have done much if anything to improve the economy.  Although clearly they helped push stock prices higher.  While investors have been euphoric about that move up, I question whether it is a plus for the Market’s health to have stock prices determined by the amount of money that can be borrowed cheap and invested in stocks versus more fundamental factors.

Second, the mere fact that the Fed announced ‘tapering’ and quickly retreated supports my oft stated notion that the Fed is considerably less wise than investors want to believe and, therefore, it has and likely always will fail at the transition from easy to tight money.  The bigger the Fed’s balance sheet is when it starts that process, the more painful the outcome is likely to be. 

Third, I think the whole bulls**t routine the Fed went through trying to differentiate ‘tapering’ from ‘tightening’ only confuses the transition process further and was a disservice to investors.

My take is that (1) short term, the ‘tapering’ affair has chastened investors and that will make equities progress further into overvalued territory more difficult and (2)  the Market is still faced with the ever strengthening headwinds of either spiking inflation (if the Fed tightens too slowly) or another recession (if it tightens too fast) plus the uncertainty of how the stock, student loan, auto loan bubbles dissipate.

However, with respect to (1) above, it appears that I will be proven wrong.  Investor behavior over the last two weeks suggests that they are eager to take advantage of the Fed’s largess and willing to continue to use that money to ‘chase yield’.  

I am less worried about that than I am about the potential that I am doing something wrong in our Valuation Model.  So far events have unfolded pretty much on script: as the Market rises, our Valuation Model starts identifying stocks that have reached their historical absolute and relative high valuations, our Portfolios Sell Half, their cash position builds, the Market keeps stretching valuations, our Portfolios keep Selling Half and then the dam breaks and the Market adjusts stock valuations back to more normal levels.  That hasn’t happened yet; and the longer it doesn’t happen, the more I have to question both the assumptions and mechanics of our Model---which I do daily. 

Maybe it truly is different this time.

The technical argument on why things are fine (must read):

The fundamental argument for why you should be concerned (must read):

Finally, bad news continues to emanate out of Europe; so the risks of a sovereign and/or banking debt crisis remain a threat to our ‘muddle through’ scenario.

          My bottom line hasn’t changed from last week:  ‘our main issue today is, is there any changes warranted in our investment strategy should Fed induced euphoria return and stocks shoot the moon?   Or less dramatically put, what happens if stocks break out to the upside, driven as it were by more punch? 

(1)     our Valuation Model hasn’t changed, so neither have the Fair Values of the stocks in our Portfolios.  To be sure, we have a few names on our Buy Lists.  But our Portfolios already own full positions in most.  I am going to leave the remainder at less than full positions because of the simple risk/reward equation that I cited above.  But for an investor that just has to put money to work, use our Buy Lists,

(2)     if any of our stocks trade into their Sell Half Ranges, our Portfolios will act accordingly,

(3)     for anyone wanting to push out on the risk curve: [a] if 15550/1687 hold and prices roll over, simply buying the VIX (VXX) is a good alternative as well as the Ranger Short ETF (HDGE) and [b] if stocks rocket upwards and you have to play, a good multi asset class ETF (IYLD) would be a less risky way to participate; the Russell 2000 ETF (IWO) would be the more risky alternative.  A purchase of any of these alternatives should be accompanied by very tight stops.’
        
        This week, the Dividend Growth and High Yield Portfolios Sold Half of their ConocoPhillips positions.


DJIA                                                    S&P

Current 2013 Year End Fair Value*                11600                                                 1440
Fair Value as of 7/31/13                                   11475                                                  1422
Close this week                                                15550                                                  1692

Over Valuation vs. 7/31 Close
              5% overvalued                                 12048                                                    1493
            10% overvalued                                 12622                                                   1564 
            15% overvalued                                 13196                                                   1635
            20% overvalued                                 13770                                                    1706   
            25% overvalued                                   14343                                                  1777   
            30% overvalued                                   14917                                                  1848
            35% overvalued                                   15491                                                  1919
            40% overvalued                                   16065                                                  1991
           
Under Valuation vs.7/31 Close
            5% undervalued                             10901                                                      1350
10%undervalued                                  10327                                                  1279   
15%undervalued                             9753                                                    1208

* 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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