Saturday, June 1, 2013

The Closing Bell--6/1/13

The Closing Bell

6/1/13

Statistical Summary

   Current Economic Forecast

           
            2012

Real Growth in Gross Domestic Product:                           2.2%
                        Inflation (revised):                                                              1.8 %
Growth in Corporate Profits:                                            16.1%

            2013

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

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Uptrend                                14612-15320
Intermediate Uptrend                              14028-19028
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                                       1600-1677
                                    Intermediate Term Uptrend                       1488-2076 
                                    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                              42%
            High Yield Portfolio                                        44%
            Aggressive Growth Portfolio                           43%

Economics/Politics
           
The economy is a modest positive for Your Money.   This week’s economic data was basically mixed: positives---weekly purchase applications, May Chicago PMI, the March Case Shiller home price index and both May consumer confidence and consumer sentiment numbers; negatives---weekly mortgage applications, April pending home sales, weekly jobless claims, April personal income and spending, the May Dallas Fed manufacturing index; neutral---weekly retail sales, the May Richmond Fed manufacturing index and revised first quarter GDP, price deflator and corporate profits.  So the data continues to roughly reflect our forecast; however, I am  leaving the amber light flashing.

‘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. 

      And:
                                               
       The negatives:

(1) a vulnerable global banking system.  This week the Bank of International Settlements warned global central banks about bank lending practices [cough, leverage, cough, cough, derivatives].  I linked to a detailed explanation in Thursday’s Morning Call.

And (medium):

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

(2) fiscal policy.  While a scandal ridden administration makes for juicy headlines and fodder for the late night comics, it provides the ruling class an excuse to avoid doing the right thing---entitlement and tax reform. 

On the other hand, with the sequester and tax hikes doing their job [reducing the deficit], the Washington morality play takes the ruling class’ attention off the any effort to reverse them.  Furthermore, new administrative/regulatory  overreaches are surfacing almost every day---the cumulative impact of which may have Obama grasping for a life jacket in any from to save His government/legacy.  And nothing saves better than a ‘grand bargain’.  That, of course, may be wishful thinking in extreme; but, at the least, a wounded Obama will have a lot less leverage in negotiating entitlement, tax and healthcare reform. 

All that aside, US government debt continues to grow and that means that the risk is also increasing of 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.....

I remain open to the possibility that congress may address the twin long term budget problems of entitlement spending and tax reform which if successful would turn fiscal policy into a positive for the economy.  However, I am not betting any money on it.
                  
(3)   the potential negative impact of central bank money printing: as you may have noticed, I altered the title of this section from ‘inflation’ to the above.  The primary motivating factor is the current turmoil in the Japanese markets where its central bank’s expansive monetary policy may be starting to come unraveled.  [the operative words being ‘may be’] and inflation is nowhere is sight. 

As you know, I have long held that the transition of central bank monetary policy from ease to tightening would result in either recession or inflation; and my bet was on inflation.  However, if the birds are indeed coming home to roost in Japan, it is not immediately apparent that inflation is a foregone consequence.  In fact, economically speaking, I am not sure what is occurring; or perhaps better said, I am not sure what is going to occur if investors continue to drive interest rates up.

On the other hand, I have also said that we are in uncharted waters.  So perhaps that renders my prediction of inflation in a transition period more suspect than I would have thought a week ago.  My point is whether or not, the current collapse in Japanese bond prices turns out to be the first step in unwinding QEInfinity, it forces me to acknowledge that I am less certain that the end result will be inflation.  Indeed, I lowered our inflation forecast for 2013 from 2.5-3.5% to 1.5-2.5%.

That by no means should be interpreted as inferring that the transition from easing to tightening will be any less painful.  It simply means that I am not sure that the end result will be inflation.  It could be recession; and indeed it could be both.

Other potential problems flowing out of the current massive injection of liquidity are:

[a] 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.  The popping of any/all of these bubbles would likely drive the US economy back into recession,
               
[b] 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.

(4) a blow up in the Middle East.  The US, Russia and Israel continue to lay down markers in the Syrian civil war.  As each side gets less flexible in its position, I worry 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.

    And (medium):

(5)   finally, the sovereign and bank debt crisis in Europe.  This week, the data flow out of the EU stayed negative.    Unfortunately, given the level of sovereign indebtedness, the overleveraged European bank balance sheets and the [low] quality of the assets on those balance sheets, the EU economy is much more susceptible to minor changes in growth than in the US.

To date, the EU has held together  and the banking system remained nominally solvent [‘muddled through’] largely as a result of the ‘do anything necessary’ policies of the ECB; and clearly, there is some probability that the ‘muddle through’ scenario will continue to be operative.  However, if QEInfinity is coming to an end, this could cause economic problems for the sovereigns [less growth] and liquidity problems for the banks.  If that proves to be the case, then ‘muddle through’ would likely meet its end.
   
  Bottom line:  the US economy remains a positive for Your Money.  Fiscal policy is uncertain.  If we can get entitlement and tax reform, it would be a positive.  On the other hand, if the political class does nothing except pursue its internecine brawl, fiscal policy will remain a drag on the economy.

Central bank reserve creation continues in overdrive, though the current turmoil in the Japanese bond market could be signal that this is all coming to an end.  If so, I am uncertain about the magnitude of the fallout for the simple reason that the US and global economy has never experienced money creation on the current scale.  My guess is that this is not going to end pretty and some adjustment to our Model will be necessary.

Finally, Europe remains a problem.  Its economy is deteriorating.  Meanwhile, the eurocrats have done nothing to lower the level of sovereign debt or improve highly overleveraged bank balance sheets.  That is a combustible combination.  True, Europe is and may continue to ‘muddle through’; but not because any attempt has been made to fix the underlying problems.

This week’s data:

(1)                                  housing: weekly mortgage applications declined while purchase applications were up; April pending home sales increased less than forecast; the March Case Shiller home price index rose more than anticipated,

(2)                                  consumer: weekly retail sales were mixed; both the April consumer income and spending numbers were a disappointment; May consumer confidence was quite strong and the final May University of Michigan index of consumer sentiment was ahead of forecast; weekly jobless claims were higher than estimates,

(3)                                  industry: the May Chicago PMI came in much stronger than expected; the May Dallas Fed manufacturing index was weaker than forecast, while the Richmond’s index was down less than estimates,     

(4)                                  macroeconomic: revised first quarter GDP growth rate was slightly less than forecast and so was the deflator, while corporate profits showed an marked slowdown in growth.


The Market-Disciplined Investing
           
  Technical

The indices (DJIA 15118, S&P 1630) kept up their recent see saw behavior closing down big on Friday.  Nevertheless, they remain within all their major uptrends: short term (14612-15320, 1600-1677), intermediate term (14028-19028, 1488-2076) and long term  (4783-17500, 688-1750). 

Volume was up big time though much of that was attributed to index fund rebalancing; breadth declined.  The VIX surged.  It remained within its short and intermediate term downtrends; although it is nearing the upper boundary of its short term downtrend.

GLD dropped, reversing the upside break in Thursday’s pin action---which keeps our Portfolios on the sideline.  However, it finished above the recent double bottom and the lower boundary of its long term uptrend.

Bottom line: one bad day doesn’t make a change of trend.  So I am hesitant to make too much of Friday’s pin action.  That said, following last Wednesday’s ‘outside down day’, the Averages have been unable to regain any sustained upside momentum.  The ‘buy the dippers’ are certainly still out there.  However, they failed to drive prices to new highs for the first time in a long time.  Let’s see how well they do next week.  The critical level they most over come is 1675 in order to negate the impact of that ‘outside down day’.

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (15168) finished this week about 32.4% above Fair Value (11450) while the S&P (1630) closed 14.8% overvalued (1419).  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.

Monetary policy held the spot light this week in the form of turmoil in the Japanese bond market and an expanding debate regarding Fed ‘tapering’.  As you know, this is one of my chief concerns; specifically because (1) the massive global expansion of liquidity is unprecedented; and therefore, it is likely that the unwinding process will also be unprecedented and (2) Fed has never, ever, ever successfully transitioned from easing to tight money policy.  The point here is that transition process may be starting prompted by bond investors’ unwillingness to hold and buy endless amounts of Japanese bonds and the heightened anxiety in the US regarding Fed ‘tapering’.

Regarding the latter, yesterday the economic news was reasonably positive (strong Chicago PMI, upbeat consumer sentiment), yet the pin action was awful, seemingly suggesting that QE is a lot more important to investors than a good economy. Meaning that if the monetary party is ending, this up Market may be over.

So the $64,000 question is, is it indeed crunch time for the Fed?  Will it start a transition and if it does, will it be too much or too little?  Unfortunately, as noted above, policy is so far into the unknown, Bernanke has little historical precedent to rely on even if he thinks he knows how to bring about a successful end game. 

From the minutes of a Fed policy meeting (short but a must read):

Net, net, if history repeats itself with monetary policy now in uncharted waters, the transition from easy to tight [normal] monetary policy will likely be a bigger negative for our Models than is currently reflected; I just don’t know by how much.

         Bottom line:  most of the assumptions in our Models are unchanged; though that of monetary policy almost assuredly will, the alterations will most likely be to the negative and they may happen sooner than I would have thought a week ago. 

        Certainly nothing has occurred that improves equity valuations or persuades me to buy stocks are current price levels.
             
         In fact, this week, the Dividend Growth Portfolio Sold Half of its Tiffany holding and the High Yield Portfolio Sold the remainder of its Pioneer Southwest Energy Ptrs position.

DJIA                                                    S&P

Current 2013 Year End Fair Value*                11600                                                  1440
Fair Value as of 6/30/13                                   11450                                                  1419
Close this week                                                15118                                                  1630

Over Valuation vs. 6/30 Close
              5% overvalued                                 12022                                                    1489
            10% overvalued                                 12595                                                   1560 
            15% overvalued                                13167                                                     1631
            20% overvalued                                 13740                                                    1702   
            25% overvalued                                   14312                                                  1773   
            30% overvalued                                   14885                                                  1844
            35% overvalued                                   15457                                                  1916

Under Valuation vs.6/30 Close
            5% undervalued                             10877                                                      1348
10%undervalued                               10305                                                  1277   
15%undervalued                             9732                                                    1206

* 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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