Saturday, May 4, 2013

The Closing Bell-5/4/13

The Closing Bell

5/4/13

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 Uptrend                                14245-14962
Intermediate Uptrend                              13858-18858
Long Term Trading Range                       4783-17500
                                               
                        2012    Year End Fair Value                                     11290-11310

                        2013    Year End Fair Value                                     11590-11610                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                       1565-1642
                                    Intermediate Term Uptrend                       1469-2058 
                                    Long Term Trading Range                         688-1750
                                                           
                        2012    Year End Fair Value                                      1390-1410

                        2013   Year End Fair Value                                       1430-1450         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                              41%
            High Yield Portfolio                                        42%
            Aggressive Growth Portfolio                           43%

Economics/Politics
           
The economy is a modest positive for Your Money.   The economic data was mixed this week but once again tilted toward the negative: positives---weekly mortgage  applications, the Case Shiller home price index, March personal spending, weekly jobless claims, April nonfarm payrolls, consumer confidence and the March trade balance; negatives---weekly mortgage applications, April vehicle sales, the ADP private payroll report, the April ISM manufacturing and nonmanufacturing indices, the Chicago PMI, the Dallas April manufacturing index, April construction spending, March factory orders, first quarter productivity and unit labor costs; neutral---weekly retail sales.

 The US economic numbers continue to slowly deteriorate, though investors have chosen to focus on the employment data to the exclusion of other stats.  At the moment, that is okay because, in total, the numbers still have not reached the point to warrant a change in our forecast.  Nevertheless the risk that the economy could slip into recession remains. 

Exacerbating this concern are lousy reports out of both Europe and China, though admittedly, there were a few upbeat datapoints out of the EU this week.  In addition, Japan seems to have gotten a lift recently from the Bank of Japan’s new triple down, all in, balls to wall monetary policy. 

The latter notwithstanding, the amber light on recession is flashing; and as I noted in Thursday’s Morning Call if the economic weakness in Europe and China continue to complement our own, the transition from sluggish to no growth could happen much quicker than would otherwise have been the case.   

For the moment, our outlook remains unchanged:

‘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:

            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. 
                                         
(2) an improving Chinese economy. The data out of China continues to disappoint.  One more week of this and I will remove this as a positive factor.
           
       The negatives:

(1)   a vulnerable global banking system.  We almost managed a week without hearing  about more inexcusable behavior from the banksters.  Then, wouldn’t you know, Friday morning we learn that JP Morgan [our fortress bank] has perpetrated yet another scam---this time to defraud the state of California:

Why banks are still ‘too big to fail’ (medium) new

‘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) fiscal policy.  With congress on break, we didn’t get a lot of movement this week on the budget.  However, the central issue is unchanged: can our elected representatives reach some sort of ‘grand bargain’ that addresses exploding entitlements and rationalizes the tax code in a way that stimulates confidence and growth? 

My bottom line is, if they can, that could help our economy move back toward its long term secular growth rate---in which case, fiscal policy would become a positive. However, the Administration’s latest move to sacrifice the economy [its attempt to furlough air traffic controllers] to forward its political agenda [more spending and more taxes] may have lowered the odds of achieving meaningful fiscal reform.

I am also worried about...... the potential rise in interest rates and  its impact on the fiscal budget.  As I have noted previously, the US government’s debt has grown to such a size that its interest cost is now a major budget line item---and that is with rates at/near historic lows.  Moreover, government debt continues to increase and the lion’s share of this new debt is being bought by the Fed. 

So the risk here is two fold: [a] to the Fed---its balance sheet is levered to the point that Lehman Bros. looks like it was an AAA credit.  So if interest rates go up {and prices go down}, the very thin equity piece of the balance sheet would disappear.  The Fed would then be technically bankrupt. and [b] to the Treasury---it must pay the interest charges.  Hence, if rates go up, the interest costs to the government go up; and if they go up a lot, then this budget line item will explode and make all the more difficult any vow to reduce government spending as a percent of GDP.....
                  
(3)   rising inflation:

[a] the potential negative impact of central bank money printing.    Under our current forecast, the risk of a major mistake {i.e. inflation} in the transition from easy to tight monetary policy grows daily as the Fed relentlessly prints money and adds bank reserves.  However as I noted above, if the recent simultaneous weakening in the US, EU and Chinese economic data portends recession, that would likely render this point moot---at least for the short term.  That is, it would almost certainly reduce demand on labor, production and resources.  Hence, any risk of inflation would drop short term. 

On the other hand, the central banks would almost surely pour even more money into the global financial system ultimately increasing the difficulty of absorbing all those bank reserves without risking either a third recession or much higher inflation. 

Sooner or later, those bank reserves have to be withdrawn.  It may be in a day, a month, a year, two years or five years.  Whenever that happens, the Fed will have the same problem that it has had every time it has transitioned from easy to tight money; only if a recession were to postpone it, the magnitude of the transition will be exponentially larger than at any time in the past. 

Other problems, aside from the fact that this massive injection of liquidity has not accomplished the central bankers’ goal, are that:

{i} our banks have used this largess for speculative purposes, increasing trading activities and funding the growth of auto and student loan bubbles---and now perhaps a new mortgage bubble.  And what better way to pop a bubble than to slide into recession which would in turn make the recession that much worse,

{b} any  new infusion of global liquidity (Japan and the EU) will likely only exacerbate this problem.
     
In addition, one of the corollaries of too much money printing is the rise in the potential for a currency war.  ‘ an overly easy monetary policy generally results in the depreciation of the currency of that bank’s country which in turn improves that country’s trade balance and strengthens its economy.  That is great unless its trading partners get pissed and commence their own ‘easy money/currency depreciation’ effort.  At that point, you got yourself a currency war; and that seems to be the direction that the major economic powers are headed in.’ 
     
     So you can see how what might start out as a run of the mill economic slowdown could be made worse by the popping of various asset bubbles and/or an intensifying race of competitive devaluations.

[b] a blow up in the Middle EastSyria continued as the main  regional flashpoint this week.  My worry is that if violence erupts, it may in turn lead to a disruption in either the production or transportation of Middle East oil, pushing energy prices higher.
                       
(4)   finally, the sovereign and bank debt crisis in Europe remains a major risk  to our forecast.  This week, the data flow out of the EU actually turned mixed.  I don’t know if this means conditions are improving or it is simply a brief respite before further declines.  Nevertheless, the ECB joining the easy money crowd this week will undoubtedly provide sustenance to notion that the EU will be improving economically. 

However, we need more information before declaring Europe on the road to health.  After all, as positively as we might want to view the above, much of the southern European sovereigns still have a long way to go on fiscal reform, the banks remain overleveraged, the EU bureaucrats are as unpredictable as ever and if the ECB gets aggressive in the money printing department, it will only add to the problems associated with financial system deleveraging.

On the other hand, if the EU is healing, then our ‘muddle through’ scenario will have been the correct call at least in the short term.

    Deutsche bank raises capital (medium)

  Bottom line:  the US economy remains a positive for Your Money, though it appears to be entering a slower growth environment---hopefully only temporarily.  While this could be the precursor to a recession, it is far too early to tell. 

Fiscal policy remains uncertain as Obama appears to have not given up on an ideologically driven political agenda in which He seems prepared to forgo economic growth to achieve it.  On the other hand, if the employment data continues to improve and the Market stays in overdrive, He is going to have a tough time selling the notion that cuts in government spending are a negative for the economy.

The Fed went a bit further out on the limb this week declaring in its latest FOMC statement that it is prepared to increase monetary easing.  Further, the ECB seems to be joining the party.  Regrettably,  I am not smart enough to know when Markets will cease to tolerate this irresponsible behavior by the central banks or what the magnitude of the fall out will be when they do.  My guess is that it won’t be pretty and I will likely have to alter our Model.

This week’s data:

(1)                                  housing: weekly mortgage applications rose but purchase applications fell; the February Case Shiller home price index was very strong,

(2)                                  consumer: weekly retail sales were mixed; March personal income was below expectations while personal spending was slightly ahead; April vehicle sales were below estimates; April nonfarm payrolls rose more than anticipated; the April ADP private payroll report was up less that forecasts while weekly jobless claims were a positive; the April index of consumer confidence was well ahead of expectations,

(3)                                  industry: both the April ISM manufacturing and nonmanufacturing indices were lower than estimates; March factory orders, the April Chicago PMI, the Dallas Fed manufacturing index and March construction spending were very disappointing,      

(4)                                  macroeconomic: first quarter productivity rose less than anticipated while unit labor costs advanced smartly; the March trade balance was well below consensus expectations; the statement from this week’s FOMC meeting suggested that further easing was possible.

The Market-Disciplined Investing
           
  Technical

The indices (DJIA 14973, S&P 1614) smoked this week, closing  within all major uptrends: short term (14245-14962 [OK the Dow was slightly above this upper boundary], 1565-1642), intermediate term (13858-18858, 1469-2058) and long term  (4783-17500, 688-1750). 

On Monday, the S&P confirmed its break above its former all time high; then both Averages sprinted higher for the week.  Clearly, the bulls are in control and the question is now, how high can stocks go?  My bet is on the upper boundaries of the indices long term uptrend (1750/17500); but as I noted earlier this week, my bet has been for s**t lately.

Volume was up a bit on Friday; breadth was mixed.  The VIX fell slightly, finishing within its short and intermediate term downtrends.  It is still a positive for stocks; though as it approaches the lower boundary of its long term trading range, a trader might want to buy a position as a hedge.

GLD was up fractionally, finishing within its intermediate term downtrend.  Until we get a test of either the prior low or the lower boundary of its long term uptrend, I don’t think that there is any bet here.

            Bottom line:

(1)   the indices are trading within their short term uptrends [14245-14962, 1565-1642] and intermediate term uptrends [13858-18858, 1469-2058].

(2) long term, the Averages are in a very long term [80 years] uptrend defined by the 4873-17500, 688-1750. 
           
   Fundamental-A Dividend Growth Investment Strategy

The DJIA (14973) finished this week about 31% above Fair Value (11425) while the S&P (1614) closed 13.9% overvalued (1416).  Incorporated in that ‘Fair Value’ judgment is some sort of half assed attempt at getting fiscal policy under control, continued money printing, a historically low long term secular growth rate of the economy and a ‘muddle through’ scenario in Europe.

The economy along with the first quarter earnings season continues to track our forecast, though admittedly a bit more erratically in the last couple of weeks.  As you know, I am upbeat on the economy and I believe in American business’ ability to grow in adversity.  However, even with an improving US economy and Europe actually being able to ‘muddle through’, our Valuation Model just can’t get equity valuations to current levels.

I noted above, there is a good news aspect to the fact that (1) the media is focusing on the positive employment numbers, ignoring the more unpleasant stats (2) while investors are just jiggy with anything---and that is, it may make it much more difficult for Obama to continue to poor mouth sequestration and by extension other cuts in government spending.  If this helps push Him toward some sort of negotiated budget settlement that includes entitlement and tax reform that would in turn change this factor from a negative to a positive in both our Economic and Valuation Models.  ‘If’ being the operative word. 

Global monetary policy remains a negative and gets more so as other central banks [ECB] join the money printing extravaganza.  While their  purpose is, of course, to stimulate economic activity, the bottom line is that (1) if global economic conditions improve from here, then the day the Fed/central banks must began tightening is drawing nigh, but (2) if the global economy is deteriorating, then we will likely see an even greater infusion of liquidity into the financial system.  While that may postpone the drop dead date for monetary tightening, regrettably it won’t eliminate it. 

The point here is that if history repeats itself, (1) the transition from easy to tight [normal] monetary policy will be a negative for our Models; I just don’t know when, (2) more importantly, neither do I know the extent of the damage that will occur in the tightening process because we are in totally uncharted waters and (3) as a result, this risk is not properly reflected in our Models.

With respect to Europe specifically, whether or not its economy is or is not be getting worse, any new monetary easing from the ECB will likely produce some short term positive effects and would assure that our ‘muddle through’ scenario  remains alive and well.

         My investment conclusion:  most of the assumptions in our Models are unchanged.  The developments this week that may eventually have to be factored in are (1) continued softness in the US, the nonfarm payrolls number notwithstanding, (2) disappointing data out of China, (3) a new liquidity injection from the ECB and, (4) a potential bottoming in the economic deterioration in the EU.  However, none of these have risen to the level that warrants amending our Valuation Model.
     
            Neither is there anything that makes me want to chase stock prices further into overvalued territory.  I recognize that I am in the unenviable position of being wrong on the Market right now; and I hate that.  But our Valuation Model has served me well for over thirty years; so I am not going to chicken out in the heat of battle.  Indeed, one of the main reasons that the Valuation Model was constructed was to prevent emotional decisions at Market extremes.  So while I absolutely hate being wrong, I don’t hate it enough to risk principal by lowering our Portfolios’ above average cash positions.
             
         This week, the Dividend Growth Portfolio Sold a portion of its Nike position when the stock traded into its Sell Half Range

                Why own bonds (medium):


               The latest from Gary Shilling (medium and a must read):

       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 [which is now under review].  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 2013 Year End Fair Value*                11600                                                1440
Fair Value as of 5/31/13                                   11425                                                  1416
Close this week                                                14973                                                  1614

Over Valuation vs. 5/31 Close
              5% overvalued                                 11996                                                    1486
            10% overvalued                                 12567                                                   1557 
            15% overvalued                                13138                                                  1628
            20% overvalued                                 13710                                                    1699   
            25% overvalued                                   14281                                                  1770   
            30% overvalued                                   14852                                                  1840
            35% overvalued                                   15423                                                  1918

Under Valuation vs.5/31 Close
            5% undervalued                             10853                                                      1345
10%undervalued                                  10282                                                  1274   
15%undervalued                             9711                                                    1203

* 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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