Saturday, August 24, 2013

The Closing Bell--8/24/13

The Closing Bell


Statistical Summary

   Current Economic Forecast


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


                        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 Trading Range                      14190-15550
Intermediate Uptrend                              14643-19643
Long Term Trading Range                       4918-17000
                        2012    Year End Fair Value                                     11290-11310

                  2013    Year End Fair Value                                     11590-11610                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                      1628-1783
                                    Intermediate Term Uptrend                       1554-2142 
                                    Long Term Trading Range                         715-1800
                        2012    Year End Fair Value                                      1390-1410

                        2013   Year End Fair Value                                       1430-1450         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                              43%
            High Yield Portfolio                                        46%
            Aggressive Growth Portfolio                           43%

The economy is a modest positive for Your Money.   It was a very slow week for economic data; and what we got was modestly upbeat: positives---weekly purchase applications, July existing home sales, the Markit flash PMI, July leading economic indicators and the Kansas City Fed’s August manufacturing index; negatives---weekly mortgage applications, July new home sales, weekly jobless claims; neutral---weekly retail sales, the Chicago Fed’s July national activity index.

The big news, of course, was the release of the minutes from the latest FOMC meeting.  They showed a Fed that was slightly more pessimistic on the economy and a bit more ambivalent on ‘tapering’. 

I am not particularly concerned about this less optimistic view of the economy.  The fact is that the general flow stats from the US economy continues to track our forecast.  Plus there has been a steady stream of upbeat numbers out of Europe---which one would think would be helpful to the US economy’s advance.

The issue of ‘tapering’ remains fraught with confusion; probably because the Fed seems just as confused as everyone else about what to do, when to do it and what the impact of ‘tapering’ will be.  As I noted in Thursday ‘s Morning Call, because QEInfinity has had so little positive influence on the economy, I am not at all convinced that ending it will have any negative effect. (more on that later).  However, given the probable proximity of the transition from easy to tight money, until we know for sure the impact ‘tapering’ will have on the economy, I am leaving the yellow light flashing.  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 historic inability of the Fed to properly time the reversal of a vastly over expansive  monetary policy.
            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. 
       The negatives:

(1) a vulnerable global banking system.  This week the news included the relentless pursuit of JP Morgan’s misdeeds by multiple Federal regulatory agencies, Moody’s putting Goldman, JPM, Morgan Stanley and Wells Fargo on review for downgrade and the increase in bad loans in Spanish banks.

‘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.  Obamacare held much of the spotlight this week as company after company along with nonprofit and even governmental agencies alter [read ‘lower’] their healthcare benefits because of the negative [read ‘costly] impact of this misbegotten piece of social engineering.  We knew early on that no one had a clue about what this piece of crap was going to cost Americans.  Now that employers are pushing the numbers, we know that it is expensive and unworkable.  But we don’t know how much of an additional burden it will ultimately prove to be on overall economic activity.

Meanwhile, the debates over the budget [the fiscal year ends 9/30] and the debt ceiling loom in September.  I have no clue how those issues will be resolved; although on Friday Boehner assured the electorate that there would be no government shutdown.  Which begs the question; does that also mean that he assured the electorate that there would be higher spending?  Whatever happens, September will likely be a fun filled month of political acrimony.

        I include in each Closing Bell a lament regarding the potential impact that higher interest rates will have on have on the budget deficit.  Now those risks are upon us:  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)   the potential negative impact of central bank money printing:  The key point here is that [a] the Fed has inflated bank reserves far beyond any comparable level in history and [b] while this hasn’t been an economic problem to date, {i} it still has to withdraw all those reserves from the system without creating any disruptions---a task that I regularly point out it has proven inept at in the past and {ii} it has created or is creating asset bubbles in the stock market as well as in the auto, student and mortgage loan markets. 

The debates continued this week about whether or not the Fed really intends to ‘taper’ and if so when; though I think that consensus is moving in the direction ‘yes’ and sooner rather than later---helped along, as it often is, by the price action in the fixed income market.  I have pursued this subject ad nauseum this week so I don’t want to be repetitious; but let me summarize:

[a] the transition from easy to tight money has to start some time and it appears to be drawing nigh,

[b] the Fed has a dismal record of success in prior transitions,

[c] unfortunately, this time around the Fed must start the transition from and unprecedented absurd level of monetary ease,

[d] the good news is that QEInfinity did little to improve the economy, so it is reasonable to assume that it will do little to hurt when the economy as it comes to an end.  The problem with ‘tapering’ is not if, when and by how much it will occur.  The problem is the uncertainty created by the Fed’s seeming confusion about it makes businesses and consumers less inclined to invest and spend.  If the Fed will just tell us already what it intends to do, we all can make our plans accordingly.

[e] the bad news is that QEInfinity has created bubbles in multiple asset classes largely through the so called ‘carry trade’ in which the trading desks of banks and hedge funds borrow cheap money provided by the Fed and speculate in other potentially higher return securities,

[f] bond investors appear to have had enough and are starting to drive rates up all along the yield curve, save for the very short term rates which the Fed controls,

[g] this has tightened sphincter muscles of all investors.  Whether this is the start of a great ‘unwind’ in all those asset bubble trades remains to be seen; but the risk certainly seems to be growing.

[h] the Fed can always come out tomorrow and promise QE to Infinity.  But until is does and investors believe it, this situation remains dicey at best and could really get ugly at worse.  

      QE is betrayal (medium):

Here is an interesting take: bonds rates are up because the bond guys believe that the Fed won’t ‘taper’; of course in the end, it doesn’t matter, higher rates are still crushing the ‘carry trade’:

(4)   a blow up in the Middle East.  The turmoil heightened this week in [a] Egypt where both the new military government and supporters of the Muslim Brotherhood escalated the killing and [b] Syria where supporters of the opposition were gassed---by whom is uncertain.

     How about that Arab Spring, sports fans? 

As usual, the US is on the wrong side of these conflicts to the extent that we are even involved---which in no way means that the rest of world, especially the major oil suppliers in that region, aren’t choosing up sides and placing their bets.

My sympathies here are with Henry Kissinger: it is a shame that they both can’t lose.  That said, there is a lot at stake in both countries in terms of oil transportation [Egypt---the Suez Canal; Syria---a natural gas pipeline supplying Europe].  Leaving aside our inept foreign policy, the world is still dependent on Middle East oil and an increasing number of players are becoming more deeply involved every day---which means probability of a misstep by any one party grows and with it the potential for disruptions in the supply or transportation of oil.

(5)   finally, the sovereign and bank debt crisis in Europe.  We have seen enough upbeat economic news out of the EU over the past month to assume that the odds have increased that Europe is finally lifting out of recession.  That is clearly good news for the US economy in the sense that a rise in EU demand  should help overall US economic growth as well as the earnings from companies with a large European exposure. 

In addition on the margin, this improvement will undoubtedly lessen the risk of a sovereign or bank default.  Rising economic activity should produce higher tax revenues for the governments and profits for the banks, thereby lowering the chances of a default.  However, offsetting that is the increase in interest rates which will require more funds to service the sovereign debt.  Furthermore, remember that the European banks are massively overleveraged---a condition that won’t be remedied easily.

In short, the EU’s economic improvement is a positive and lessens the probability of a sovereign or bank debt crisis.  So,  It would [a] increase the probability that our ‘muddle through’ scenario will work out and [b] it would lessen my concerns about a sovereign/bank default.  In other words, it would do nothing to alter our forecast; although it would temper the tail risk of this factor.’

Bottom line:  the US economic data remains encouraging.  Fiscal policy which has been mildly positive of late (sequestration and the tax hike) is about to move into the limelight as negotiations on the budget and the debt ceiling commence in September, a second round of sequestration kicks in with all the likely attendant doomsday forecasts and the wrangling over Obamacare exposes more costly flaws.  In short, the economy will likely get no help from fiscal policy.

Monetary policy is everyone’s focus at the moment primarily due to concerns about the potential impact of rising interests rates on economic activity.  While I have some sympathy with that notion, as I have said previously, easy money did very little for the economy even the interest sensitive sectors (housing); so I am more inclined to think that its absence will likely do little harm.  The more important aspect for the economy is the uncertainty about if, when and how much ‘tapering’ will occur.  It is that uncertainty that tends to keep businesses and consumers from investing and spending.

Europe seems to be coming out of its recession.  That is a positive in the sense that it increases the probability of our ‘muddling through’ scenario.  However, it remains a long road to unwind the enormous leverage of both sovereigns and banks.

This week’s data:

(1)                                  housing: weekly mortgage applications fell [again], though purchase applications were slightly up; July existing home sales were much better than anticipated while new home sales were very disappointing,

(2)                                  consumer: weekly retail sales were mixed; weekly jobless claims rose more than forecast,

(3)                                  industry: the Chicago Fed’s July national activity index  was weak but not as much as expected; the August Kansas City Fed’s manufacturing index was ahead of forecasts; the August Markit flash PMI was slightly better than estimates,

(4)                                  macroeconomic: July leading economic indicators were up, in line; the minutes from the latest FOMC meeting revealed a Fed that [a] was a bit more pessimistic about the economy and inflation, [b] split over ‘tapering’, [c] but comfortable with the ‘data dependent’ conditionality of ‘tapering’.

The Market-Disciplined Investing

The Averages (DJIA 15010, S&P 1663) experienced some sharp moves in both directions this week but ended on a positive note---helped enormously by spike up in Microsoft after Ballmer announced his retirement and the bad news is good news take on plunging new home sales.  The Dow ended in a short term trading range (14190-15550), while the S&P remained within its short term uptrend (1628-1783).

Both of the Averages are well within their intermediate term (14643-19643, 1554-2142) and long term uptrends (4918-17000, 715-1800).

This leaves the indices out of sync (S&P up, Dow flat); plus the DJIA is below its 50 day moving average while the S&P managed to close above its 50 day moving average on Friday.  In sum, this means that the Market direction is indecisive.

Volume on Friday declined; breadth was mixed.  The VIX closed down 5%.  But for all intents and purposes, this indicator has been flat since the first of the year (short term trading range).  Nevertheless, it is also firmly within its intermediate term downtrend.

GLD was strong this week and continues to build on a very short term uptrend.  However, it is still within its short term and intermediate term downtrend.
Bottom line: with the Averages out of sync and divergences occurring in several other technical indicators, this is the time to do nothing unless you are a very good trader.

            Margin debt at risky levels:

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (15010) finished this week about 30.5% above Fair Value (11500) while the S&P (1663) closed 16.6% overvalued (1426).  Incorporated in that ‘Fair Value’ judgment is some sort of half assed attempt at getting fiscal policy under control, a botched Fed transition from easy to tight money, a historically low long term secular growth rate of the economy and a ‘muddle through’ scenario in Europe.

The economy continues to grow sluggishly, in line with our forecast.  It is amazing how well it has hung in there considering the entire global political class seems intent on doing everything in its power to screw things up.  It speaks well of our business class and the tenacity of most Americans.

Speaking of political classes, ours is apparently having way too much fun engaging in ideological warfare to bother with such mundane, plebian matters as managing the ship of state.  The good news is that their forces are so evenly matched that the danger of them imposing even more burdens on the electorate than they already have is close to nil.  The bad news is that they have already done enough damage to keep the rest of us busy for a long time to come just trying to cope with it. 

So while fiscal policy may be improving by default (sequestration and the tax hike), the upcoming negotiations on the budget and debt ceiling will likely not make for upbeat headlines.  With the entire Washington community now looking to 2016 and with little indication that they will do anything for the greater good, I am not convinced that much will get done other than keeping the fiscal affairs on life support long enough to get to the 2016 elections.  That is not a necessarily bad thing for the economy if spending can be held in check; but it could cause heartburn for the Market.  Meanwhile, the costs of Obamacare keep rising and that is not good for anyone.

Monetary policy has reached the status of an Abbott and Costello routine.  No seems to know if ‘tapering’ is going to occur, when it is going to occur and how large it will be---including apparently most members of the FOMC.  Small wonder that many investors are confused. 

As I have made clear, in this transition, I think that the risks for the Markets are greater than those for the economy.  They are the only entities that have truly benefited from QEInfinity; hence, it would seem that they are ones apt to take it in the snoot when this extraordinary policy is unwound.  I end this part of the discussion as I always do: I cannot tell you how this story is going to end; but I don’t believe that it will end well. 

Finally, the economic news out of Europe has improved consistently enough over the last month that our ‘muddle through’ scenario may actually have a chance of being correct.  To be sure, major risks still exist in the form of overly indebted sovereigns and over leveraged banks; but economic growth can cure a lot of ills.  In the end, this still represents a significant risk, just not as significant as it was several months ago.

          Bottom line: our Valuation Model hasn’t changed sufficiently to alter the Fair Values of the stocks in our Portfolios---which as you know are considerably below current price levels.  Hence, there are very few bargains and a goodly number of stocks that are overvalued. 

          That suggests a continuation of our strategy of lightening up on any of our stocks that trade into their Sell Half Ranges and deferring purchases of even those stocks on our Buy Lists until the current excesses in the Markets are being wrung out.
        This week, our Portfolios did nothing.

DJIA                                                    S&P

Current 2013 Year End Fair Value*                11600                                                 1440
Fair Value as of 8/31/13                                   11500                                                  1426
Close this week                                                15010                                                  1663

Over Valuation vs. 8/31 Close
              5% overvalued                                 12075                                                    1497
            10% overvalued                                 12650                                                   1568 
            15% overvalued                             13225                                                      1639
            20% overvalued                                 13800                                                    1711   
            25% overvalued                                   14375                                                  1782   
            30% overvalued                                   14950                                                  1853
            35% overvalued                                   15525                                                  1925
            40% overvalued                                   16100                                                  1996
Under Valuation vs.8/31 Close
            5% undervalued                             10925                                                      1354
10%undervalued                               10350                                                  1283   
15% undervalued                             9775                                                    1212

* 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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