Saturday, November 3, 2012

The Closing Bell---Waiting on Tuesday

                        
The Closing Bell

11/3/12

Statistical Summary

   Current Economic Forecast

           
            2012

Real Growth in Gross Domestic Product (revised):        +1.0- +2.0%
                        Inflation (revised):                                                             2.5-3.5 %
Growth in Corporate Profits (revised):                   5-10%

            2013

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

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range   (?)               12973-13661
Intermediate Up Trend                            12593-17593
Long Term Trading Range                      7148-14180
Very LT Up Trend                                       4546-15148        
                                               
                        2011    Year End Fair Value                               10750-10770

                        2012    Year End Fair Value                                     11290-11310

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Trading Range  (?)                        1395-1474
                                    Intermediate Term Up Trend                     1327-1925 
                                    Long Term Trading Range                        766-1575
                                    Very LT Up Trend                                         651-2007

                        2011    Year End Fair Value                                      1320-1340         

                        2012    Year End Fair Value                                      1390-1410

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 basically neutral to positive.  It had its pluses (October personal income and spending, weekly jobless claims, the October ISM manufacturing index, unit labor costs and October nonfarm payrolls) and negatives (mortgage and purchase applications, the Dallas Fed manufacturing index, the Chicago PMI, factory orders and third quarter productivity); but it also had lots neutrals (the Case Shiller home price index, weekly retail sales, consumer confidence and September construction spending).

The important numbers were October personal income and spending, October ISM manufacturing index and October nonfarm payroll, all of which were positive---that is what gives the positive bias to a week in which the numbers were all over the lot. I continue to be encouraged by this more healthy data flow; but more for what it doesn’t mean (recession) than what it could mean (a higher rate of economic growth).

As a result of these encouraging stats, I am going to add ‘an improving economy’ to the Closing Bell’s weekly list of pluses---subject to one enormous caveat:  the election is upon us; and I don’t have to tell you how radically different the economy will be managed depending on who wins (and assuming Romney fulfills his campaign promises). Consequently, our entire present forecast (not just ‘an improving economy’) is very iffy and could be subject to change in the next couple of months depending on who wins and how seriously they pursue their campaign pledges.

At the risk of repeating myself, my opinion is that a Romney victory, assuming that he fulfills his campaign promises, would likely lead to a recession by the second half of 2013 (avoid the fiscal cliff, but endure tighter monetary, fiscal policy pain initially). 

An Obama win would raise the risk of running off the fiscal cliff; but assuming that it was avoided, then the present accommodative monetary, fiscal policies would continue (and by definition the slow, sluggish recovery), until higher inflation and higher interest rates shut the whole process down---we get our pain later.

All that said, for the time being, our forecast 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 of big four economic indicators (medium):

The pluses:

(1) an improving economy

(2) our improving energy picture.  The US is awash in cheap, clean burning natural gas; and the entire energy picture will likely get better if the GOP regains the White House. 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 hopeful that this more conservative mood will prevail and that voters have become disillusioned enough with their prior selection that they choose not to give Him another four years.  I would love to see Romney/Ryan prevail and then follow through with their campaign pledges.  Unfortunately, that is a two step process; and if one or the other doesn’t happen, then we {collectively} will be stuck in the current economic purgatory that we find ourselves.  Equally regrettable, at this late date, the airwaves are full of contradictory predictions on who is going to win this election; so it is not even clear that the electorate has indeed embraced fiscal responsibility. 

           The negatives:

(1) a vulnerable banking system.  State’s Attorneys’ General continue to file suit against the banks [this week it was Barclay’s] for various and sundry offenses [see below].  My belief is that the big banks remain too big to fail, that their willingness to assume risk in their investment banking/trading operations appears undiminished and that their balance sheets remain as opaque as ever.

And they are criminals:

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)   another week, nothing done on the ‘fiscal cliff’.  The good news is that the elections are near; and after it is over, we will get a better picture as to how the political class plans on addressing this problem.  Right now, I think that we are more likely to get a compromise with Romney than with Obama---but that could be my own political prejudice.  That said, whoever wins, logic says that the victor would be a fool to allow us to run off the cliff; so I have nothing in our forecast that accounts such an occurrence.  But the risk exists and its consequences would have a material impact on our forecast.

A primer on the fiscal cliff (7 minute video):

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. 

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.

‘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?

                        The problem with low interest rates (medium):


[b]       a blow up in the Middle East.  This area of the world remains a powder keg---the civil war in Syria rages on and is spilling into Lebanon, the US has more ships in the Persian Gulf than in the San Diego naval base and Israel and Iran seem to be awaiting the US elections before escalating their confrontation. 

The risk here is that any further heightening in tensions or additional conflict could lead to higher oil prices which, at the least, will act as a hindrance to US expansion and, at the worse, could well push the economy into recession and add fuel to inflationary impulses 

[c]        food inflation.  With the harvest season almost over, grain prices remain elevated versus six months ago; although it appears that when all is said and done, the final crop yields are higher than originally feared.  As a result, I am unsure if or how soon higher prices work their way up the food chain and get reflected in consumer prices.  I will leave this as a risk for another week or two; but absent a fresh pop in the next price indices reports, I will likely remove this from our list of risks.

(4)   finally, the sovereign and bank debt crisis in Europe remains the biggest risk to our forecast.  Economic and political conditions in Greece and Spain continue to deteriorate.  Yet the financial press has largely taken its eye off of this problem.  I don’t know if they know something that I don’t know or if they are being way too Pollyannaish about it.  The data and the math [at least what I have seen] point to the latter; so my fear is that sooner or later the consequences of this massive fiscal/solvency problem will bite everyone on the ass---hard.

Merrill Lynch: Greek risk is back (did it ever go away?) (medium):

I have opined frequently that as long as voters, investors and the financial press go along with this charade, a ‘muddle through’ scenario will remain operative.  But that doesn’t mean that  the European ‘tail risk’ has gone away.  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 occur are very large.

                
Bottom line:  the US economy continues to show strength particularly in the primary indicators of economic health and growth.  This keeps talk of recession at bay at least for the time being.  But to be clear, all things remaining equal (no fiscal cliff, EU muddles through) , the growth that we are seeing in the current data is not at a sufficiently high rate to move the needle much on our forecast expansion rate.  As I have repeated ad nauseum, our deficit is still too big; our debt is still too large; the Fed remains out of control; and our tax and regulatory environment still too oppressive.  Correcting those problems will take time and involve some pain.

That said, all things are never equal; and right now we are facing an event that has a 100% probability of occurring but with potentially diametrically opposed results.  That, of course, is the election; and right now the potential economic outcomes of either candidate winning are so wide ranging that it is nearly impossible to come up with a forecast for 2013-2014.   

I don’t know who is going to win on Tuesday; and if Romney wins, I don’t know how firmly he will stick to his campaign promises.  That means that our current forecast for 2013 is nothing but a wild ass guess.  Until we know the victor; until we know his true agenda, there won’t be a forecast that is worth the paper it is written on. 

So for me, all that I can do is acknowledge what I don’t know (which is a lot), be objective about any forthcoming changes in fiscal, monetary and regulatory policy and its impact on the economy, then make adjustments to our forecast

Finally, the EU is doing what it does best which is lie to its citizens for the sake of preserving a bureaucratic wet dream.  I am not smart enough to know what happens next; but I do believe that unless the eurocrats get real with their citizens and their policies---and soon, the end will be uglier than I am now assuming. 

For the moment, this is all reflected in our Models; but as I noted, the level of uncertainty surrounding our assumptions is well above average.

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications were abysmal; the August Case Shiller home price index rose slightly less than forecast,

(2)                                  consumer: weekly retail sales were OK; personal income was up as anticipated while personal spending was better than expected; weekly jobless claims dropped more than estimates and October nonfarm payrolls were well ahead of forecasts; October consumer confidence came in below expectations but ahead of September’s report,   

(3)                                  industry: the October Dallas Fed manufacturing index came in slightly worse than forecast as did the October Chicago PMI; the October ISM manufacturing index was reported slightly ahead of estimates; September construction was up as anticipated: September factory orders were down versus both expectations and August’s reading,      
                
(4)                                  macroeconomic:   third quarter nonfarm productivity was a bit less than forecast and down from the second quarter reading; unit labor costs plunged.

The Market-Disciplined Investing
           
  Technical

This week the indices (DJIA 13093, S&P 1414) re-set their short term trend from up to a trading range (12973-13661, 1395-1474) but remained within their intermediate term uptrends (12679-17679, 1338-1934). 

Additional support is provided by the 200 day moving averages (12985.1370); while the 50 day moving averages (13334.1433) will act as an interim resistance point as well as the 13392,1422 former resistance, turned support, now resistance level.

I wondered out loud in Friday’s Morning Call whether Thursday’s strong pin action was a dead cat bounce or the start of something new---we got our answer; and surprisingly, the retreat occurred on a day that started with a positive nonfarm payroll number.  I don’t think a bad stock day on a good economic day bodes well for the Market.  So I am sticking to my opinion that the Averages will challenge and break though the lower boundaries of their new short term trading ranges---but as I said, that is just my opinion. 

Volume on Friday fell while breadth (advance/decline, flow of funds, up/down volume, and our internal indicator) was negative.  The VIX spiked off of the lower boundary of a newly formed very short term uptrend.   That is mildly negative and  leaves the VIX in the (1) ever narrowing zone between the upper boundary of its short term downtrend and the lower boundary of its intermediate term trading range, (2) as well as a much more constricted developing pennant formation.

GLD fell big time, pushing down off the upper boundary of a newly formed very short term downtrend to finish below the interim support level and only slightly above its 50 day moving average.  It remains above its 200 day moving average, the lower boundary of a short term uptrend and the lower boundary of its intermediate term trading range.  However, I think that it will almost surely test the short term uptrend; and if that is successful, our Portfolios will likely start re-Buying their trading position.

            Bottom line:

(1) the DJIA and S&P are in  short term  trading ranges [12973-13661, 1395-1474] and intermediate term uptrends [12593-17593, 1327-1925],

(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 (13093) finished this week about 16.3% above Fair Value (11255) while the S&P (1414) closed 1.4% overvalued (1394).  Incorporated in that ‘Fair Value’ judgment is a ‘muddle through’ scenario in Europe and a sluggish recovery at home that isn’t likely to improve until we change the personnel in Washington.

The economy continues to progress at a rate perhaps a little north of our current forecast.  To be clear, this is not ‘lift off’ speed but it is enough to move the immediate threat of recession to the back burner. As I noted above, we have too many institutionalized problems that need fixing before a return to a historical secular growth path is possible.

As far as a ‘change in personnel in Washington’ is concerned, we either will or won’t have it by the time I write the next Closing Bell.  The election being so close, it is pointless to speculate on the outcome---better to wait and see.  Besides I have already laid out my thoughts on the probable direction of the economy if Obama or Romney wins and if Romney wins, whether or not he follows through with his campaign pledges.

         Whatever happens in Washington, I remain fixated on the potential for severe economic dislocations in Europe as the principal near term threat to our forecast.  Not that the EU will fall apart in the next two months; but if it doesn’t, it won’t be because the eurocrats did anything meaningful to prevent it. 

            Indeed, both Greece and Spain continue to slide toward oblivion, the eurocrats are AWOL and the rest of the world doesn’t seem to give a s**t.  Of course, as long as they don’t, Europe will be allowed to continue to ‘muddle through’. 

Not that I have been betting heavily on an EU implosion.  As you know, I have maintained ‘muddle through’ as our default position all along even as it has seemingly becomes less likely.  My only excuse for not altering our forecast/strategy, and to be sure, it is not a good one, is that I get nervous when the market acts like it knows something that I don’t know (like everything will work out fine for the euros). In my defense, our Portfolios do have a roughly 30% cash position at this moment and that should help preserve principal if the feces hit the windmills in Spain. 

       My investment conclusion:  stocks (as defined by the S&P) are overvalued (as defined by our Model). However, making this slightly overvalued situation much more hazardous is that (1) enormous ‘tail risk’ exists if the EU sovereign/debt crisis is not properly addressed and (2) stock prices seem to be driven largely by [a] the fear of  fighting a far too easy, money printing Fed and [b] the sort of hopeless resignation that stocks are at this moment the least worse investment---not the two best reasons that I can think of for an up Market.  I have no clue how long this will go on; but it is a Market that is too risky for me to want to add to equity positions at these prices.
  
            Since our last Closing Bell, our Portfolios Sold their trading position in GLD.

       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                                                13343                                                  1433

Over Valuation vs. 11/30 Close
              5% overvalued                                 11817                                                    1463
            10% overvalued                                 12380                                                   1533 
            15% overvalued                             12943                                             1603
            20%overvalued                                  13506                                                   1672
                       
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.








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