The Closing Bell--11/10/12

The Closing Bell 11/10/12 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 (?) 12973-13661 Intermediate Up Trend 12714-17714 Long Term Trading Range 7148-14180 Very LT Up Trend 4546-15148 2012 Year End Fair Value 11290-11310 2013 Year End Fair Value 11400-11610 Standard & Poor’s 500 Current Trend (revised): Short Term Trading Range (?) 1395-1474 Intermediate Term Up Trend 1343-1939 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. The economic data this week was sparse and some of that was meaningless due to the impact of Sandy (weekly retail sales and weekly mortgage and purchase applications). The remainder was either positive (weekly jobless claims, the September trade deficit, November consumer sentiment, September wholesale inventories and sales) or neutral (October ISM nonmanufacturing index). Of course, the key event this week was political; and with the election behind us, we do have better idea of the shape of our outlook---basically more of the same. I see little reason to assume that Obama or the dems in general will change their stripes, i.e. be any less inclined to spend, tax and regulate. So what has been our forecast will likely continue to be our forecast for some years to come: ‘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.’ That said, this outlook comes with one caveat; and it centers on the how the impending fiscal cliff is resolved: (1) the grand bargain: If all the post election high rhetoric of compromise actually takes place and the fiscal cliff is eliminated via a grand bargain [tax reform accompanied by spending cuts], then there is the possibility of having something of a repeat of Clinton’s second term. That would clearly not only eliminate the fears centered on the consequences of running off the fiscal cliff but also alter our longer term economic forecast toward a more hopeful, growth oriented scenario. Not that I think that this is going to happen; but there is some probability of it occurring---and if you have been watching the news, some pundits are absolutely giddy about the new spirit of compromise. I, on the other hand, give it low odds; but however low they may be, they still exist and we must account for them as we look ahead. (2) we run off the cliff: if Obama adopts His post 2008 attitude---I won, so I get my way---then certainly that will harden the republicans’ stance and, thus, the chance of any compromise falls significantly. In this case, our 2013 outlook [1-2% real GDP growth] would fly out the window and would likely move forward the ultimate day of reckoning [which I define as the day the world refuses to accept any more US debt without a significantly higher price tag---fiscal and monetary austerity are thus imposed from the outside and the US gets a nasty and extended recession---see Europe], (3) a not-so-grand compromise: as in noted in Thursday’s Morning Call, if our political class sticks to its recent modus operandi, they will come up with some half assed solution that doesn’t fix our broken tax system but does raise taxes on the rich [we just don’t know how that will be defined], that keeps much of the purposeless social spending in place to feed the growing new class of dependents, that does little to solve our deficit/debt problem and to the extent that it does anything, does in the out years [7 or 8 years from now] and last but certainly not least, this solution will likely only be reached at the eleventh hour after the politicians have scared the holy hell out of the electorate/investors. I rate this as the most likely scenario primarily because it is the most typical. The good news is that aside from paralyzing the nation for a week or two, it would not change our sluggish but still positive growth outlook. On the other hand, it leaves us to face our day of reckoning somewhere out there in the future. Update on the ECRI and big four economic indicators (medium): http://advisorperspectives.com/commentaries/dshort_110912.php The pluses: (1) an improving economy. The risk of recession appears to be fading. On the other hand, the hope I had for a more sound fiscal policy if Romney won is no more---which also means less risk that a more austere budget over the short term that would slow economic growth. The fly in the ointment is that the risk of running off the fiscal cliff has increased [see below]. (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. (3) the seeming move of the electorate towards embracing fiscal responsibility. I am not going to belabor the points that I have already made in this week’s Morning Calls; but for obvious reasons, I am removing this from the list of pluses. 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. 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) it’s go time on the ‘fiscal cliff’. The players all know who won which elections and what they stand for. Knowing Obama to be an ideologue and listening to Boehner Tuesday night, it seems reasonable to assume that the risk of no compromise is high. On the other hand, Obama could change His stripes as His more recent bipartisan rhetoric would suggest [some pundits proclaim that His concern will now become His legacy and that means leading the country away from the fiscal cliff] and Boehner sounded a bit more conciliatory in his comments on Wednesday. That said, I see no grand bargain in the works. I am not saying a compromise won’t be reached; I am saying that the odds are that it will do more to kick the fiscal can down the road than it will to solve our budget problem. This from Paul Krugman (medium): http://www.nytimes.com/2012/11/09/opinion/krugman-lets-not-make-a-deal.html?hp&_r=0 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. And we now know that neither is likely to change anytime soon. Making matters even worse, under QEIII the Fed is adding another $40 billion a month in mortgages to its balance sheet. 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. (3) rising inflation: [a] the potential negative impact of central bank money printing. The central banks of the major global economic powers are now ‘all in’ for monetary easing; meaning that the world is awash in liquidity. Furthermore, with an Obama win, Ben’s job is safe; so he is under no pressure to stop the presses. ‘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 {three 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. Why will this time be any different? [b] a blow up in the Middle East. This area of the world remains a powder keg; and if Obama’s limpwristed response to the Benghazi massacre is a sign of future US policy in this region, then the odds of a negative event occurring just went up. The risk here is that any further heightening in tensions or an additional conflict could lead to higher oil prices which, at the least, will act as a hindrance to US economic growth and, at the worse, could well push the economy into recession and add fuel to inflationary impulses [c] food inflation. Right now this is the least of our worries. We know that grain prices are higher than six months ago and meat prices will likely follow suit, We have also seen some impact on consumer prices; but we don’t know how much more there is to come. I am leaving this as a risk until we get another PPI/CPI report. If it then appears that higher raw costs are continuing to be reflected in CPI, I will leave it. (4) finally, the sovereign and bank debt crisis in Europe remains the biggest risk to our forecast. Economic and political conditions continue to deteriorate throughout Europe---as we saw recessionary forces spread into Germany and major riots in Greece this week. Unfortunately, the financial press recently took its eye off of this problem, perhaps to focus on the US elections. I have opined frequently that as long as voters, investors and the media go along with this charade, a ‘muddle through’ scenario will remain operative. However, ignoring a crisis does not make it go away or lessen its potential severity. So while our forecast remains that the EU will somehow ‘muddle through’, the risk of that not occurring is still substantial and growing and the consequences to the US economy should that happen are very large. Is the end game in sight for Greece (medium): http://www.zerohedge.com/news/2012-11-09/reading-between-lines Bottom line: the US economy continues to grow however slowly. The Obama re-election pretty much assures that nothing will change (ex some new found desire to compromise) domestically (sluggish growth due to too much government spending, too high taxes, too much regulation; and the risk of inflation grows as the Fed prints money at a Mach 10 rate) in the next 12-18 months. Recession is fading, ex the fiscal cliff and the euro disaster; and in the end, I don’t think that we will run off the cliff. To be sure, I used a lot of ‘ex’s’ in my above description for the economy. So there are clearly events that can throw our outlook off track. The good news is that we are going to know fairly quickly whether or not our political class has discovered a willingness to compromise and if it can construct a ‘grand bargain’ as part of the fiscal cliff solution. My best guess is that neither will happen, but I leave open the chance that they could occur. Europe, however, is another story. The eurocrats main strategy in dealing with their acute bank and sovereign debt problem is to hope and pray. That may work; certainly the majority of investors seem to think that it will. And as I point out repeatedly, as long as everyone participates in this orgy of denial, the EU will hang on and muddle through. My fear is that before any true remedies to deal this crisis are implemented, someone will finally point out that the emperor has no clothes and the subsequent panic will drag not just the EU economy but the global financial system into the toilet. For the moment, our Models reflect no ‘grand compromise’ but a half assed resolution to the ‘fiscal cliff’ and a ‘muddle through’ scenario in Europe. As you know, I believe the biggest risk is in the latter assumption in which the tail risk is unquantifiable. The divergence between Goldman Sachs’ micro and macro indicators (medium): http://www.zerohedge.com/news/2012-11-09/micro-weakness-smelling-macro-collapse This week’s data: (1) housing: weekly mortgage and purchase applications were not good, but they were impacted by Sandy, (2) consumer: weekly retail sales were lousy but they too were influenced by Sandy: weekly jobless claims dropped versus estimates of a rise; the University of Michigan’s preliminary November consumer sentiment index came in at 84.9 versus forecasts of 83.3 and the final October reading of 82.6, (3) industry: the October ISM nonmanufacturing index was reported slightly below of estimates; September wholesale inventories rose 1.1%; even more impressive, wholesale sales were up 2.0%, (4) macroeconomic: the September US trade deficit was not as large as anticipated. The Market-Disciplined Investing Technical Friday, the indices (DJIA 12815, S&P 1379) closed three quarters of the way through a challenge of the lower boundaries of their short term trading ranges (12973-13661, 1395-1474). If they close below those levels Monday, the break will be confirmed under our trading discipline and the Averages will then have to re-set to a short term downtrend. In addition, the indices also closed below their 200 day moving averages (12991/1381), the Dow for the third day, the S&P for the second. There is nothing in this pin action to be heartened by. Nevertheless, both of the Averages remain above the lower boundaries of their intermediate term uptrends (12714-17714, 1343-1939). Unless stock bounce hard on Monday, it would appear that they are destined to challenge those boundaries. Biggest head and shoulders top in 100 years? (short): http://www.thereformedbroker.com/2012/11/09/the-largest-head-and-shoulders-top-in-100-years/ The S&P and the International Economic Surprise Index (short): http://www.zerohedge.com/news/2012-11-09/most-important-chart-consider-weekend-or-tom-lees-nightmare Volume was down slightly; breadth (advance/decline, flow of funds, up/down volume, and our internal indicator) improved. The VIX rose slightly and remains within two narrowing zones. Both are bordered on their tops by the upper boundary of its short term downtrend. The shorter term zone is marked on the downside by the lower boundary of a very short term uptrend; the longer by the lower boundary of its intermediate term trading range. GLD sold off fractionally, finishing above the interim resistance level for the second day. Normally that is enough to confirm a break of a very short term trend; however, GLD is still hovering just below its 50 day moving average. So as I have done before, I am treating both resistance levels in tandem---they both need to break to confirm an upside bias. If that happens, our Portfolios will begin re-building their trading position in GLD. http://www.zerohedge.com/news/2012-11-09/gold-and-potential-dollar-endgame Bottom line: (1) the DJIA and S&P are challenging the lower boundaries of their short term trading ranges [12973-13661, 1395-1474] but continue to trade within their intermediate term uptrends [12714-17714, 1343-1939], (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 (12815) finished this week about 13.8% above Fair Value (11255) while the S&P (1379) closed 1.1% undervalued (1394). Incorporated in that ‘Fair Value’ judgment is a ‘muddle through’ scenario in Europe and a lowering of the long term secular growth rate of the economy. The economy continues to progress at a rate perhaps a little north of our current forecast. To be clear, this is not a return to the historic long term secular growth rate of the US economy but it is enough to remove the immediate threat of recession. As I have noted repeatedly, we have too many institutionalized problems that need fixing before we can return to an average growth path. As I am sure you noted, I have altered the above phrase from ‘a sluggish recovery at home that isn’t likely to improve until we change the personnel in Washington’ to ‘a lowering of the long term secular growth rate of the economy’. Regrettably, Tuesday may well have been the electorate’s last chance to accomplish the ‘change of personnel in Washington’ goal and it failed. There is some lingering hope that while the personnel haven’t changed, their attitudes still can. That could happen; but I suspect that it carries a low probability. More likely, it means: (1) economically, nothing changes. That is, this country’s growth outlook both short and long term will continue to be held down by irresponsible spending paid for partially by higher taxes, partially by more printed money. There are, of course, two caveats to this scenario. The short term will be dependent on how the fiscal cliff gets resolved. Will Obama decide to remain an ideologue or to start building His legacy as a leader? Will the GOP remains stuck on no tax increases? The good news scenario is a grand bargain; and we would all love for that to happen. While I am open to accepting that as a possible alternative, at the moment, I give it low odds. The really bad news scenario is that both parties play a game of chicken and we do in fact go off the cliff. I give that somewhat higher odds but in the end I think reason will prevail. The most likely chain of events, I think, is that we get a cross between falling off the cliff and the ‘grand bargain’ and we may not get that until the very last minute; meaning that: if our political class repeats its historic behavior pattern (1) it will scare the living s**t out of taxpayers/investors before any deal is done, and (2) it will be such lame ass excuse for a solution [more spending just not as much, tax increases just not as much] that the economy is will still likely experience some of the negative effects of the fiscal cliff anyway, to wit, a slowdown in an already paltry rate of economic growth. The other caveat is that the economic policies that are causing this sub par growth can’t keep going ad infinitum. Sooner or later we start taking on the characteristics of Europe which means the best case is the US becomes France 2.0 or in the worse case, Greece/Spain 2.0. To be sure, this is a long way away. What has been built, won’t be compromised overnight. But this country is now firmly headed in that direction. (2) politically---and at the risk of sounding overly dramatic---it means that a founding principal of this country, to wit, that the job of the government is to insure liberty not a livelihood, is going if not gone. There now appears to be a majority of voters that [a] expect goodies from the government rather than to be left alone and [b] don’t mind being told what to do and how to live their lives. That represents a profound change in psyche of this nation and will lead to the Europeanization of this country. You may agree with it, I don’t. As important, it will likely lead to a decline in the relative power of the US as a nation state. The Russians, Chinese and Iranian have to be laughing their collective asses off, smoking cigars, slapping each other on the back and planning their next adventure. As discouraging as the above is for the long run, near term my major concern is the ongoing circus in Europe. The entire continent is slipping into recession while southern Europe is battling social unrest---at times quite extreme. The eurocrats are no closer to solving the bank and sovereign debt problems of Greece and Spain than they were a month ago despite the fact that conditions in those countries continue to worsen. The only positive news is that the world seems to have suddenly re-awakened to the crisis; and hopefully that will jack up the eurocrats to get off their collective asses and develop a viable solution. As you know, our Model assumes a ‘muddle through’ scenario even though the aforementioned eurocratic inaction is making it less likely. Hence, sticking with it is becoming increasingly difficult. My problem is that even if I assumed Europe was going to implode, I don’t know how to quantify that. My solution has been and remains to keep an above average cash position in our Portfolios and demand lower equity prices to compensate for those risks. Draghi runs out of options (medium): http://www.macrobusiness.com.au/2012/11/draghi-runs-out-of-options/ My investment conclusion: stocks (as defined by the S&P) are now slightly undervalued (as defined by our Model). While this circumstance would normally lead me to a modestly favorable disposition toward equities, the enormous ‘tail risk’ of the EU sovereign/debt crisis necessitates extraordinary caution. That doesn’t mean that I think that stocks are headed dramatically lower; it does mean prices need to decline by at least 5-7% to begin to account for the euro tail risk. Last week, our Portfolios took no action. 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. However, the likelihood of a continued strengthening in the dollar argues for less emphasis on these investment alternatives over the intermediate term. (3) defense is still important. DJIA S&P Current 2012 Year End Fair Value* 11300 1400 Fair Value as of 11/30/12 11255 1394 Close this week 12815 1379 Over Valuation vs. 11/30 Close 5% overvalued 11817 1463 10% overvalued 12380 1533 15% overvalued 12943 1603 Under Valuation vs.11/30 Close 5% undervalued 10692 1324 10%undervalued 10129 1254 15%undervalued 9566 1184 * 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.