Saturday, December 8, 2012

The Closing Bell--12/8/12

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The Closing Bell

12/8/12

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                     12460-13302
Intermediate Up Trend                            12907-17907
Long Term Trading Range                      7148-14180
Very LT Up Trend                                       4546-15148        
                                               
                        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                              1343-1424
                                    Intermediate Term Up Trend                     1363-1958 
                                    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 weighted on the plus side: positives---weekly mortgage purchase applications, November auto sales; weekly jobless claims, November nonfarm payrolls, November PMI, the November ISM nonmanufacturing index, October construction spending, October factory orders and the third quarter productivity and unit labor cost numbers; negatives---the November ISM manufacturing index and December consumer sentiment; neutral---weekly retail sales, weekly mortgage purchase applications and the ADP private payroll report.

Some of these numbers still contain Sandy related information; however, in total, they are a reasonably accurate look at the economy.  More important, they were solidly positive after a month of either slightly negative or Sandy masked data.  That suggests that the economy is tracking with 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 likelihood a rising and potentially corrosive rate of inflation due to excessive money creation and the historic inability of the Fed to properly time the reversal of that monetary policy.’

Update on the big four economic indicators (medium):

The pluses:

(1) slightly stronger data than currently in our outlook.  This factor has been clouded of late primarily by the Sandy impacted stats; but this week’s numbers seem to be supporting this notion.  Of course, that means nothing if the ‘fiscal cliff’ isn’t resolved satisfactorily or if Europe implodes.  Those issues aside [see below] I think that American business has done a marvelous job recovering from the financial crisis in the face of a far too intrusive government that over taxes, over spends and over regulates.

(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. 

       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.

Several things occurred this week that bear mentioning [a] Citigroup laid off 12,000-15,000 employees---not a sign that this institution has achieved financial health, [b] Deutsche Bank reported that it had not disclosed $12 billion in losses on its balance sheet during the financial crisis. While a German bank, it still reveals the mentality of global big bank management---they are all a bunch liars, thieves and rule breakers. 

‘My concern here is that: [a] investors ultimately lose confidence in our financial institutions and refuse to invest in America and [b] the recent scandals are simply signs that our banks are not as sound and well managed as we have been led to believe and, hence, are highly vulnerable to future shocks, particularly a collapse of the EU financial system.’
    
(2) the ‘fiscal cliff’

This issue is, of course, center stage at the moment.  As you know, there are basically three alternative outcomes: (1) the right one, i.e. a grand bargain that reforms the tax code as well as the entitlement system, (2) the wrong one, i.e. we go off the cliff, and (3) the half assed one, i.e. an agreement but no real reform and not before investors soil their trousers.  You also know my opinion as to which alternative we will get---door number 3. 

The good news is that this solution defines our long term forecast in the same terms as our 12-18 month outlook---so it saves me a lot of work.      

It is important to note that the deadline for coming up with a fix is not 12/31 as the talking heads keep reminding us---it is 12/17-18.  Obama leaves for Hawaii on 12/17.  The last day legislation can be submitted for consideration prior to year end is 12/18. 

So for all intents and purposes, a compromise has to be reached by the time that next week’s Closing Bell is published.  The odds of this happening seem a bit long to me; especially since Congress awarded itself a long weekend, this weekend.

Certainly, miracles do occur; but at the moment, it seems to me that door #3 is a lock.  To be clear, I believe that an agreement will be reached; it just won’t happen the easy way.

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. 

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.  As you know, the Fed along with the central banks of the major global economic powers are now ‘all in’ for monetary easing.  Nothing occurred this week to suggest that any of these guys are backing off their full Monte policies.  Indeed, it was rumored that the Fed would announce QEIV after the FOMC meeting next week.

‘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 {four 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}.  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.
                        http://www.zerohedge.com/news/2012-12-07/guest-post-where-here
                       
[b]       a blow up in the Middle East.  Well, we had one blowup {Gaza} and now we are working on another {chemical weapons in Syria}.  Neither have had much impact on oil prices---though gasoline prices are higher. 

While the relative stability of oil prices in the face of the above is encouraging, I don’t think that it mitigates the risk that a larger scale conflict {US invades Syria, Israel bombs Iran} brings impairment to either the production and/or the transportation of crude oil out of the Middle East long enough to begin hindering US {and global} economic growth and ultimately pushes the economy into recession and/or adds fuel to inflationary impulses 

(4)   finally, the sovereign and bank debt crisis in Europe remains the biggest risk to our forecast.  This week in Greece, the eurocrats continued their inept struggle to affect the new ‘bail out’ agreement.  Meanwhile, Greek unemployment rose [again] and S&P downgraded Greek credit to ‘selective default’. 

In addition, Italian PM Monti’s economic [austerity] policies suffered through but defeated a ‘no confidence’ vote.  Analysts believe that this won’t be the last such challenge; and were Monti to lose, he could be replaced by someone far less market friendly.

Finally, the economic data out of Europe reflected further deterioration; and on Friday, Draghi presented a far from optimistic assessment of EU economic activity over the next 12 months.

Net, net, economic and political conditions continue to worsen throughout Europe---which brings them and us ever closer to a disruptive event.

Counterpoint (medium):

As I noted last week: ‘While the question on investors’ minds at the moment seems to be ‘how likely is it that the US runs off the fiscal cliff?’, in  my opinion, they would be well advised to be more concerned about how likely it is that Europe implodes. First because the fiscal cliff is not likely to occur and secondly because we know exactly how much the US economy will be affected, if it does happen.  On the other hand, in my opinion, an unraveling of the eurozone has higher odds and I don’t have a clue how to quantify that scenario.’

                    
Bottom line:  the US economy continues to make slow progress though it is neither stable nor at the level of historical trends.  There is a risk that our distinguished and selfless political class will allow the fiscal cliff to occur---but I doubt it.  However,  I have little doubt that they will wait to the last millisecond to come up with a compromise and scare the hell out of investors.  I also think it highly unlikely that any agreement will lift the burdens of too much government spending, too high taxes, too much regulation; and the risk of inflation growing. 

The risk of multiple European sovereign/bank insolvencies is the turd in the punchbowl of our forecast primarily because (1) the probability of its occurrence rises daily as the eurocrats insist on avoiding a real solution and (2) as I note repeatedly, I am not smart enough to quantify the downside which I intuitively believe to be rather large.  We may get lucky and Europe muddles through; but I fear something far worse.

A review of the global economy (medium/long):

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications rose though  purchase applications’ increase was anemic,

(2)                                  consumer: weekly retail sales reflected seasonal factors on their weekly comparisons but were positive on a  year over year basis; November auto sales were strong;  weekly jobless claims fell while the ADP private employment report showed weak growth; the November nonfarm payrolls report was very positive [though there was some problems with the make up of this number---see below]; and December consumer sentiment plunged to 74.5 versus estimates of 83.0,   

(3)                                  industry:  November purchasing managers index came in above expectations;  while the November ISM nonmanufacturing index improved, the manufacturing index was a big disappointment;                  October construction spending was a blowout number as were October factory orders,      
                
(4)                                  macroeconomic: both third quarter nonfarm productivity and unit labor costs were better than estimates.

                       
The Market-Disciplined Investing
           
  Technical

Friday, the indices (DJIA 13155, S&P 1418) finished on an up note and within their (1) short term trading ranges [12460-13302, 1343-1424] and (2) their intermediate term uptrends [12907-17907, 1363-1958]. 

For the second week, the S&P also closed within a very tight trading range (1395-1424).  As fate would have it, its 50 day moving average is also within that range (1416)---so there is a lot technical congestion at current levels. 

Looking for signs of how this bottleneck might be resolved, I offer three indications:

(1)                            on Friday, the S&P [and the Dow] closed above that 50 day moving average.  Our time and distance discipline is now operative for this trend line to confirm this break.  The time element is two to three days,

(2)                            I performed two studies on our own internal indicator with the following results:

[a] of 157 stocks in our Universe, 104 are above their 50 day moving average, 46 are not and 7 are too close to call,

[b] of 157 stocks in our Universe, 82 are above  the comparable S&P 1424 level, 60 are not and 15 are too close to call.

            All three of these signals suggest an upside resolution out of the 1395-1424 trading range.  Were that to occur, the next resistance level for the S&P is 1474.

Volume on Friday was flat; breadth was up.  The VIX fell below its 50 day moving average (a plus for stocks) and closed in the narrowing zone between the upper boundary of its short term downtrend and the lower boundary of its intermediate term trading range.

GLD was up fractionally and remains below its 50 day moving average but above the lower boundaries of its short term uptrend and intermediate term trading range. A confirmed break below the former will likely prompt sale of a portion of our Portfolios’ investment position.

            Bottom line:

(1)   the DJIA and S&P are in [a] short term trading ranges {12460-13302, 1343-1424} and [b] intermediate term uptrends {12907-17907, 1363-1958},

(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 (13155) finished this week about 16.4% above Fair Value (11300) while the S&P (1418) closed 1.3% overvalued (1400).  Incorporated in that ‘Fair Value’ judgment is some sort of compromise on the fiscal cliff, a ‘muddle through’ scenario in Europe and a lowering of the long term secular growth rate of the economy.

As you  know, our assumption on the fiscal cliff is that (1) there is no ‘grand bargain’, (2) a compromise will be reached; and if not by year end then by early 2013 and provisions will be retroactive and (3) the agreement itself will do nothing to help the economy.  That is, taxes will be raised and spending will be barely cut, if at all.  This is exactly the scenario built into our Models; so nothing will change in terms of equity valuation unless we get a grand bargain or our political class allows the cliff to happen.

Pursuant to item (2) above, it appears that a resolution will not be reached before year end which I had thought would produce some heartburn among investors.  At the moment, they seem to be happy as clams with the thought that the exact timing of any agreement is not that important and that any drama in the negotiating process will just be part of the show. 

That may prove to be the correct scenario; and if it is, then I will clearly have been wrong.  That said, I am still unconvinced.  Indeed, I believe that there is a strong argument to be made that a compromise will be reached only if there is panic in the Markets that in turn forces the politicians hands.  In the end, the only relevance to this difference in perspective is whether any  hard sell off on fears of no compromise creates a buying opportunity.

         More concerning to me with respect to both our Economic and Valuation Models is whether or not Europe can manage to ‘muddle through’.  This week, the economic news showed continuing deterioration across most of the continent but especially in the southern half. Ominously, Germany appears to be sliding in the direction of recession.  In addition, Italy is back on the front burner as political descent in parliament over austerity measures may force Monti to call new elections. 

For whatever reason,  investors also appear no more concerned about economic turmoil in Europe than they are about it here.  As long as they do and Markets stay calm, the eurocrats will be able to kick the can down the road and ‘muddle through’ will remain the operative scenario.  And as you know, that is the current assumption in our Models. 

‘I recognize the flimsiness of such an assertion.  However, while I may believe that the odds of ‘muddling through’ are shrinking by the day and may currently be no better than 50/50, I don’t know how to quantify not ‘muddling through’.  I do believe that the consequences will be severe: depressing economic activity (which I can quantify) and another financial crisis (which I can’t; simply because we have no idea how much of the notional value of current CDS’s held in the banks will become exposed when those banks start going under).  Witness the Deutsche bank story this week in which it admitted that it had hidden $12 billion in derivative losses during the 2008/2009 financial crisis.

My solution to this dilemma, as you know, is to carry an above average cash position as insurance and to insist on lower stock prices to reflect the risk.’ 

       My investment conclusion:  with stocks (as defined by the S&P) slightly above Fair Value, I am not jumping up and down to put our Portfolios’ cash to work.  This judgment is made all the more so by the undetermined risks associated with the EU crisis.  However, if those risks begin to be reflected in stock prices, our Portfolios will become Buyers.

       The pricing of uncertainty (medium):

            Last week, our Portfolios unwound the last of poor trading purchase of  GLD the prior week, selling the remaining shares of that trading position.

       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. 

(3)                                defense is still important.

DJIA                                                    S&P

Current 2012 Year End Fair Value*                11300                                           1400
Fair Value as of 12/31/12                                 11300                                                  1400
Close this week                                                13155                                                  1418

Over Valuation vs. 12/31 Close
              5% overvalued                                 11865                                                    1470
            10% overvalued                                 12430                                                   1540 
            15% overvalued                             12995                                             1610
            20% overvalued                                 13560                                                    1680   
                       
Under Valuation vs.12/31 Close
            5% undervalued                             10735                                                      1330
10%undervalued                                  10170                                                  1260    15%undervalued                             9605                                                    1190

* 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.











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. Steve's goal at Strategic Stock Investments is to help other investors build wealth and benefit from the investing lessons he learned the hard way.

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