Saturday, January 11, 2014

The Closing Bell

The Closing Bell

1/11/14

Statistical Summary

   Current Economic Forecast

           
            2013

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

            2014 estimates

                        Real Growth in Gross Domestic Product                   +1.5-+2.5
                        Inflation (revised)                                                          1.5-2.5
                        Corporate Profits                                                            5-10%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Uptrend                               15748-20748
Intermediate Uptrend                              15748-20748
Long Term Trading Range                       5050-17400
                                               
                        2013    Year End Fair Value                                   11590-11610

                    2014    Year End Fair Value                                   11800-12000                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     1783-1936
                                    Intermediate Term Uptrend                       1680-2361
           
                                    Long Term Trading Range                         728-1900
                                                           
                        2013    Year End Fair Value                                    1430-1450

                        2014   Year End Fair Value                                     1470-1490         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          43%
            High Yield Portfolio                                     46%
            Aggressive Growth Portfolio                        46%

Economics/Politics
           
The economy is a modest positive for Your Money.   This week’s meager economic data tilted to the plus side: positives---mortgage applications, weekly jobless claims, the ADP private payroll report, November factory orders and the November trade deficit; negatives---weekly purchase applications, December nonfarm payrolls and the December ISM nonmanufacturing index; neutral---weekly retail sales and the latest FOMC minutes. 

The big numbers this week were those that were employment related---mostly because they were totally confusing.  Strong private payrolls and jobless claims, weak nonfarm payrolls.  I do think that weather is a legitimate reason to view the latter as something of an outlier.  Nonetheless, the unemployment rate was down (6.7% versus 7% prior) with that lousy payrolls number; this being largely a function of additional dropouts from the labor force---which is definitely not a positive.  The bigger this datapoint becomes, the more it distorts the overall employment picture and the greater the potential to lead to inappropriate monetary and fiscal policy actions---which are already among the biggest risks to our economic forecast,

And:

Overall the rest of the data flow was positive and that keeps our forecast on track:

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.
                       

        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 just released upbeat November trade deficit basically reflected the improving energy picture in the US---declining imports and rising exports.  The benefits of this trend are (1) the geopolitical advantage of being less dependent on foreign oil and (2) an improving trade balance strengthens the dollar which historically has been good for the economy as well as stocks.


       The negatives:

(1) a vulnerable global banking system.  A new week, the same old song.  This time around [a] JP Morgan {who else?} settled a dispute over its role in the Madoff scandal, [b] the SEC continues to pursue fraud charges in the sale of mortgage backed securities and [c] China’s credit crisis deepened

The credit crisis grows in China (medium and must reads):

SEC investigating pricing fraud of mortgage backed securities (medium):

And JP Morgan enters into deferred prosecution agreement over its role in the Madoff debacle.  Please note that JPM strongly suspected Madoff was a fraud and pulled its own money out---any wonder why I hate bankers? (medium):

‘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.  In the last Closing Bell, the best thing I could say about the Ryan/Murray budget compromise was that the electorate wouldn’t have to face another threat of a government shutdown.  On the other hand, it scraped the spending limits set up by the sequester which I believe has much bigger long term negative consequences.

Just to prove that they really, really aren’t serious about fiscal responsibility, the senate this week held a procedural vote that opens the way for debate on extending unemployment benefits for the eleventh time.  I recognize that [a] there are a lot hurdles this legislation must go through before it becomes law and [b] there is always a chance that there could be spending offsets in other area.

But the fact that it even got to a procedural vote demonstrates the senate’s willingness to consider more fiscal profligacy.  [I know, I know.  This makes me Scrooge McDuck.  But this would be the eleventh extension, the prior ten having showed no macroeconomic benefit]. 

Adding insult to injury, we are getting daily updates on the ongoing disaster that is Obamacare.  

In other words, after a brief hiatus of fiscal responsibility [the sequester], it is back to business as usual---spend, spend, spend.

(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. 

Tapering for pussies has begun; and we have a new chairperson of the Fed [irony?].  That was the easy part.  The hard part is as it always has been: can the Fed successfully transition from easy to tight money without bungling the process---which it has done at every other such juncture in its history? 

The big question in my mind, at least for the economy, is this: since QEInfinity had little effect on economic activity during its tenure, why should it have an impact being unwound?  Clearly, ‘it shouldn’t’ is a reasonably probable answer---and I wouldn’t disagree with that.

However, it is not the economy that gives me the willies right now; it is the Markets. This is where QE was been felt the most---in the run up of asset prices everywhere.  So it seems reasonable to assume that at some point, the Markets will have to pay the price for the Fed’s monetary experiment. 

     The Fed’s logical fallacies (medium):

(4)   a blow up in the Middle East.  The latest news is coming out of:

[a] Iraq where al Qaeda now controls a big chunk of the country---a chunk I might add that a large number of our boys and girls died to ‘pacify’,

[b] Libya where rebel forces and the government are in a pissing contest over who controls [benefits economically] from oil exports---the risk being that both sides employ a scorched earth policy, i.e. destroying the oil production altogether rather than letting the opposition in on the vig. We know that the most of the important muslim players are ideological nut jobs, so such an outcome doesn’t seem all that unreasonable. 



That said, I am less worried about Libya in particular than I am about the general breakdown in society throughout that Middle East [Syria, Lebanon, Egypt, Libya, Iraq, Afghanistan] and where that could lead. 

My primary concern being that that Israel and most of the Gulf sunni muslim powers have to be sitting on pins and needles and have the military capacity to act if their survival is in question---injecting more not less instability into the region.

(5)   finally, the sovereign and bank debt crisis in Europe.  The economic news out of Europe remained mixed this week.  My hope is that Europe is recovering in the same fashion as the US---slowly, fitfully but on a sustained basis.  That would allow our ‘muddle through’ scenario to remain in tact. 

Counterpoint (medium):

Bottom line:  the economy continues to click along nicely despite this week’s confusing employment data.  Fiscal policy, on the other hand, has deteriorated in the sense that recent senate action is a sign of the continuing inability of our ruling class to come to grips with budget discipline.

Tapering is a first step in the transition to a more normal monetary policy.  While the fact that this transition has begun is a plus, it says nothing about how it will end.  And the end, of course, is what will distinguish success from failure.  So the two big questions remain (1) will the Fed really prove effective in unwinding QE without causing economic disruptions? and (2) how will the Markets handle tapering for pussies under conditions of extreme valuation?

There was little out of Europe this week to alter our outlook which remains that it will ‘muddle through’.

This week’s data:

(1)                                  housing: weekly mortgage applications were up though purchase applications were down,

(2)                                  consumer:  weekly retail sales were mixed; weekly jobless claims fell more than forecast; the ADP private payroll report was strong but December nonfarm payrolls were well below consensus,

(3)                                  industry: November factory orders were better than expected; the December ISM nonmanufacturing index was below consensus,

(4)                                  macroeconomic: the November US trade deficit was less than anticipated; the minutes from the last FOMC meeting provided little new information on Fed policy.

The Market-Disciplined Investing
           
  Technical

The indices (DJIA 16437, S&P 1842) had a trendless week, though they closed within uptrends along all timeframes: short term (15748-20748, 1783-1936), intermediate term (15748-20748, 1680-2261) and long term (5050-17400, 728-1900).

Volume on Friday rose slightly; breadth was mixed.  The VIX was down, ending right on the lower boundary of its short term trading range.  A break of this support level would be a big positive for stocks.  It is also in an intermediate term downtrend.   

The long Treasury was up strong, so much so that it will invalidate the developing head and shoulders if it remains at current levels or higher until Market close on Tuesday.

GLD was also up big, finishing over the upper boundary of the very short term downtrend.  While a positive for GLD, it is still too soon to get jiggy.  It remained within its short and intermediate term downtrends. 

Bottom line:  all trends of both indices are up.  Trading was a bit confusing on Friday following the release of nonfarm payrolls number,  Initially, it appeared the bad (economic) news was bad (Market) news---contrary to recent sentiment responses where bad news was good news because the assumed Fed response.  Nevertheless, later in the days, stocks recovered. 

However, the bond and gold markets were a bit more definitive.  Both rallied on what I assume was the conclusion that the lousy employment data meant that the Fed would ease up on its tapering strategy.

Whether or not we are entering another one of those schizophrenic phases in the equity markets will likely be clarified in next week’s trading---which I am sure will be influenced by follow through or the absence thereof in bond and gold markets.

Given the lack of any challenge to any of the major uptrends, I have to assume that the odds are for an assault on the upper boundaries of the Averages long term uptrends (17400/1900).

However, if one of our stocks trades into its Sell Half Range, our Portfolios will act accordingly.

               
   Fundamental-A Dividend Growth Investment Strategy

The DJIA (16437) finished this week about 41.4% above Fair Value (11625) while the S&P (1842) closed 27.6% overvalued (1443).  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 track our forecast, though this week’s confusing employment picture injects some unneeded uncertainty that has the potential of leading unwarranted fiscal and/or monetary policy actions.  We don’t know that will happen; we just need to be aware that it could occur.  Unfortunately, whether or not this leads to inappropriate fiscal actions, the economy is already burdened with too much government spending, too high taxes, too much regulation.

Speaking of inappropriate fiscal policy, the senate opened the door this week for yet another extension of unemployment benefits.  While much has to happen before this move would become law, it is still a sign that at least a part of our political class doesn’t understand.

Many will argue that the nonfarm payrolls number is a perfect example of why additional benefits need to be appropriated---and I appreciate their position.  So at the risk of sounding heartless, let me make two arguments (1) unemployment benefits have already been extended tem times with little result (2) the declining labor participation rate could very well be a direct function of never ending unemployment benefits.  I recognize that that is not a factual statement; but it is a hypothesis worth testing. In the end, the senate’s actions illustrate the knee jerk reaction of the political class to throw money at anything perceived as a problem on the false notion that the government can fix it---which is the reason our finances are in a shambles in the first place.

Monetary policy which is already a mess could become more so following Friday’s nonfarm payroll number.  Almost certainly, it will give the doves ammunition to prolong (reverse?) its current tapering for pussies policy.

Hence, all the old issues associated with an unwinding of QE remain: what happens when, as and if the transition gets serious, what happens if the Fed never gets serious, how long will the Markets accept ever more government paper without demanding a higher risk premium.

I don’t know the answer to those questions although history gives us a hint---and the consequences are not positive.

Bottom line: the assumptions in our Economic Model haven’t changed.  The nonfarm payrolls number was not good news, but it is only a single number and there were extraneous reasons for the shortfall.  So it is far too soon to start worrying about a slowdown.

The assumptions in our Valuation Model have not changed either.  I remain confident in the Fair Values calculated---meaning that stocks are overvalued.  So our Portfolios maintain their above average cash position.  Any move to higher levels would encourage more trimming of their equity positions.
   
That said, I can’t emphasize strongly enough that I believe that the key investment strategy today is to take advantage of the current high prices to sell any stock that has been a disappointment or no longer fits your investment criteria and to trim the holding of any stock that has doubled or more in price.

           The latest from Lance Roberts (medium):
            
          This week our Portfolios did nothing.
       
DJIA                                                   S&P

Current 2014 Year End Fair Value*             11900                                                  1480
Fair Value as of 1/31/14                                  11625                                                  1443
Close this week                                               16437                                                  1842

Over Valuation vs. 1/31 Close
              5% overvalued                                12206                                                    1515
            10% overvalued                                12787                                                   1587 
            15% overvalued                             13368                                                      1659
            20% overvalued                                13950                                                    1731   
            25% overvalued                                  14531                                                  1803   
            30% overvalued                                  15112                                                  1875
            35% overvalued                                  15693                                                  1948
            40% overvalued                                  16275                                                  2020
            45%overvalued                                   16856                                                  2092

Under Valuation vs.1/31 Close
            5% undervalued                             11043                                                    1370
10%undervalued                                10462                                                  1298   
15%undervalued                             9881                                                    1226

* 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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