Saturday, August 3, 2013

The Closing Bell

The Closing Bell


Next week starts a lot of absentee time for me.  Number one grandson arrives today and we will visit several colleges in the area.  The following week, number two granddaughter and number three grandson arrive and we go to the beach.  A week later is Labor Day and we are taking an extended holiday.  The following two weekends, we have a housewarming in Savannah, then a wedding of a close friend.  At this point, I am not sure which days I will be blogging.  So things will be erratic for the next month or so.  As always, I will be watching the Market, will have my computer and will be in touch if action is required.

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                              14498-19498
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                                      1606-1762
                                    Intermediate Term Uptrend                       1538-2126 
                                    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.   This week’s economic data  was basically mixed: positives---the Case Shiller home price index, the ADP private payroll report, weekly jobless claims, the July Markit PMI, the July ISM manufacturing index, June personal spending; negatives---weekly mortgage and purchase applications, consumer confidence, the July Chicago PMI, Dallas Fed manufacturing index, July nonfarm payrolls, and June personal income; neutral---June pending home sales, weekly retail sales, second quarter and revised first quarter GDP and June/revised May factory orders.

There were some highlights within both the positive (ISM manufacturing index) and negative (July nonfarm payrolls) numbers; but all in all the data flow confirms our outlook.  Also in this mix was the statement from the latest FOMC meeting which (1) pointed to a slightly weaker economy and (2) completely ignored the ‘tapering’ issue. 

Whether the latter was an unconscious decision or reflected the fear that if anything was said, it would introduce more volatility into the Markets, I would argue that it demonstrates the Fed’s continuing confusion over what to do with QEInfinity.  While that may not directly impact the data tomorrow, it does create enough uncertainty to leave businesses and consumers hesitant to invest and spend---and that keeps a lid on economic growth.

If Bernanke wanted to be clear about Fed policy, he would have reiterated his policy statement made during his recent congressional testimony.  Indeed, given the Market’s sensitivity to this issue, Bernanke should repeat that policy statement every morning as he eats his Post Toasties. 

For that reason, I am leaving the yellow light flashing on our forecast which otherwise looks to be right on track:

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 more problems of cheating from JP Morgan and unexpectedly large deleveraging of the Deutsche bank balance sheet.

JP Morgan fines over the last two years (medium):

One more example of the banksters defrauding investors (medium)

And for the true cynics (medium);

Deutsche Bank deleveraging at record pace (medium):

Bad loan problems at Italian banks (medium):

Of course, less than stellar behavior from our ‘fortress’ bank has gotten to be old news.  However, Deutsche Bank massive unwinding of its derivatives portfolio may be saying a great deal about the risk being carried on EU/US bank balance sheets in general---which as you know, is one of the primary worries I have with respect to the health of the global financial system.

‘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.  Obama continued His new economic campaign, this week offering up His version of a ‘grand bargain’ which [a] said nothing about entitlement reform and [b] instead of lowering the tax rate and extending the base for all taxpayers, it {1} ignored individuals completely, {ii} also left out small business---which as you know, generate most of the job growth, {iii} eliminated the tax breaks on corporate overseas earnings and {iv} hiked spending on social programs---programs on which, I remind you, that the government has already spent hundreds of billions with little or no impact on growth in the economy or jobs.

This just adds one more irreconcilable issue to full plate of economic problems [budget, debt limit, Obamacare] that must be dealt with in the fall. All that said, the shrinking budget deficit and the serial delays in the implementation of Obamacare remain short term bright spots in an otherwise cloudy long term outlook.

        The Detroit template:

I also continue to worry 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)   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 over whether or not Bernanke really intends to ‘taper’, whether ‘tapering’ is ‘tightening’, whether or not investors have discounted ‘tapering’ and whether or not investors have diminished faith in the Fed.  It was not helped by the absence of any reference to ‘tapering’ in the press release from the latest FIMC meeting.  It seems to me that if Bernanke meant what he said during his latest congressional testimony and he wanted to be sure that Markets remained calm, there would have been a reiteration of that stance in the Fed statement.  No such luck.

Given what I see as continuing confusion regarding the aforementioned issues, I have been simply focusing on interest rates as an indication of the net consensus among bond investors on Fed policy.  It is too soon to tell if that is a workable strategy; but it is one that I am testing at the moment.

Bottom line: my thesis has been that Fed will repeat its past mistakes and botch the transition from easy to tight money.  The lack of any mention of ‘tapering’ in the statement following this week’s FOMC meeting reinforces that notion.  My concern is that the longer the Fed continues on its current QEInfinity path, the more painful the transition process will be.

The Fed’s dual mandate (medium):

The Fed and trust (medium)

 (4) a blow up in the Middle East.  The big news this week was the closing of US embassies across the Middle East over concerns about a terrorist attack.  Ignoring for the moment the endless policy mistakes that have occurred because ‘al Qaeda has been decimated’, this, nonetheless, reminds us that we are at war, our enemy inhabits the Middle East and that means the potential for disruptions in the supply or transportation of oil continue to be a threat to prices---which can in turn influence economic growth of heavy energy consuming economies.

(4)   finally, the sovereign and bank debt crisis in Europe.  This week witnessed more upbeat economic news out of Europe though the picture of the banking system remains quite weak. 

As I noted last week: ‘If we do assume for the sake of argument that Europe is improving, what would that mean to our forecast?  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.’

But that is getting a bit ahead of ourselves.  For the moment, I am encouraged by the European economic news over the last three weeks, but it is too soon to get jiggy.

The state of the Greek banks (short)

                And the state of the Greek state (medium):

     And the state of unemployment in Spain (medium):

Bottom line:  the US economic data remains encouraging.  Fiscal policy may be creating less of a drag (sequestration and the tax hike) than it was a year ago, but the tone out of Obama and congress suggests that entitlement and tax reform are little more than a wet dream.  Furthermore, on a short term basis, September maybe a tough month on this front with 2014 appropriations bills due, a likely vote on the debt limit and the kick in of the next round of sequestration.

Monetary policy is the stick of dynamite stuck up our ass.  Confusion abounds and the lack of any comment in the FOMC press release simply adds to the problem.  In my opinion, the Fed knows that the magnitude of QEInfinity has put its policy in a precarious position, but is scared sh**less to let the Market know.  Until that uncertainty is removed, it is likely that businesses and consumers will remain cautious.

Europe seems to be making progress; but the good news scenario is ‘muddling through’.  So if in fact that occurs, it does nothing to improve the outlook for either of our Models.

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications fell [again]; the Case Shiller home price index continued strong on a year over year basis; June pending home sales were off less than anticipated,

(2)                                  consumer: weekly retail sales were mixed; the ADP private payroll survey was better than forecasts as were weekly jobless claims; but July nonfarm payroll increased less than expected; June personal income was less than estimates while spending was more; the index of consumer confidence was slightly below anticipated results,

(3)                                  industry: the July ISM manufacturing index was better than forecast; the July Chicago PMI was below expectations as was June construction spending; June factory orders were up less than estimated, though May’s number was revised upward; the July Markit PMI was a tad better than anticipated; the July Dallas Fed manufacturing index was below expectations,

(4)                                  macroeconomic: second quarter GDP was much better than forecasts; but first quarter GDP was revised down; the release from the latest FOMC meeting turned a bit more dovish and failed to mention ‘tapering’.
The Market-Disciplined Investing

The Averages (DJIA 15628, S&P 1706) were quite volatile this week.  The Dow round tripped the upper boundary of its short term trading range (14190-15550) again, but finished the week above that level.  A close Monday over 15550 will re-set the DJIA’s short term trend to up (14994-16000).

The S&P remained within its short term uptrend (1606-1762) all week, but did trade below the May high (1687) twice.  Nevertheless, it ended the week on a very strong note.

Both of the Averages are well within their intermediate term (14498-19498, 1538-2126) and long term uptrends (4918-17000, 715-1800).

Volume on Friday was flat; breadth was negative.  The VIX closed right on the lower boundary of its short term trading range and well within its intermediate term downtrend.  A break below the trading range lower boundary would be positive for stocks.

GLD reversed the prior week’s strong performance, breaking its very short term uptrend.  That leaves it within its short and intermediate term downtrends.  Nothing to do here.
Bottom line: the challenge of the 15550/1687 level appears to be coming to an end.  Of course, that was my conclusion last week; so not that much has changed.  On the other hand, the move to the upside this week was much more pronounced than the week before.  So it seems more likely that it will, in fact, happen this time around.  If the Dow does close above 15550 on Monday, it will re-set to an uptrend.  At that point, the Market’s short term trend will also be re-set to up. 

And if that occurs, there will be no overhead resistance save the upper boundaries of the three major trends (S&P short term---1762, intermediate term---2126, long term ---1800). 

If 1762/1800 (short and long term upper boundaries) represent the technical upside in stocks, that is only about up 3-5% from current levels versus 6% downside if stocks return to the short term lower boundary, 9% if they slide to the intermediate term lower boundary, 18% if they return to Fair Value and 57% if they make it all the way to the long term lower boundary

            How are the Markets in the rest of the world doing? (short):

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (15658) finished this week about 36.1% above Fair Value (11500) while the S&P (1709) closed 19.8% 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 perform in a very encouraging way and, therefore, remains a positive input to our Valuation Model.

While fiscal policy is improving by default (sequestration and the tax hike), I was again disappointed by the rhetoric and tone of Obama’s introduction of His ‘grand bargain’.  Like His new economic plan which was simply more of the same old income distribution routine, His ‘grand bargain’ was neither grand nor a bargain.  Meanwhile, the GOP was not about to be left out of this budget clusterf**k---Boehner announced that the republican controlled house would not have an appropriations bill by its due date (9/30). 

In other words, ideology and institutional sclerosis continue to rule fiscal policy.  While there is no doubt that the economy is benefiting from weaker headwinds, there is still too much spending, too high taxes and too much regulation to prompt the kind of confidence and behavior in businesses and consumers that would lead to a return to historical levels of growth. 

So while businesses will continue to do what they to best, i.e. figure out how to raise revenues and earnings despite inept fiscal leadership, it appears that they will have to spend more time than needed dealing with fiscal restraints and less time than necessary to close the current gap between production and capacity and move economic growth to a higher level.  Hence, fiscal policy will remain a headwind to growth in the economy and, more important, to corporate profits and valuations.

Monetary policy continues to push into uncharted territory.  Despite the Fed’s inability to stimulate economic activity, it persists in pumping money into bank reserves which serve only to (1) allow the government to finance its irresponsible fiscal policy and (2) encourage speculation within the banking class via promoting the ‘carry trade’ which is driving asset prices into ‘bubble’ territory. 

Despite the Fed’s pontificating about its policies for unwinding the massive expansion of its balance sheet and how they are ‘data driven’, history says that it doesn’t have a f**king clue.  Remember, it was only a few years ago that Bernanke said that there were no problems in the housing industry.  All the on again, off again nonsense on ‘tapering’ is an even more recent example of the limited understanding that the Fed has of its power to forecast and control outcomes. 

I end with what has become my weekly refrain: I cannot tell you how this story is going to end; but I don’t believe that it will end well.  Because we are in uncharted waters, trying to judge the impact on our Economic and Valuation Models would be nothing but a wild assed guess.

Finally, the economic news out of Europe improved again this week.  This is starting to look like a trend; and if that turns out to be the case, then the Markets will have dodged a major bullet.  Of course, it is not over yet.  The financial system is overleveraged with too much junk debt.  Plus only God knows the extent of the banks’ exposure in the derivatives markets.  For the moment, let’s hope for a continuation of this nascent trend---which if it occurs will simply fortify our ‘muddle through’ scenario.

          My bottom line hasn’t changed from last week:  ‘our main issue today is, are there any changes warranted in our investment strategy should Fed induced euphoria return and stocks shoot the moon?   Or less dramatically put, what happens if stocks break out to the upside, driven as it were by more punch? 

(1)     our Valuation Model hasn’t changed, so neither have the Fair Values of the stocks in our Portfolios.  To be sure, we have a few names on our Buy Lists.  But our Portfolios already own full positions in most.  I am going to leave the remainder at less than full positions because of the simple risk/reward equation that I cited above.  But for an investor that just has to put money to work, use our Buy Lists,

(2)     if any of our stocks trade into their Sell Half Ranges, our Portfolios will act accordingly,

(3)     for anyone wanting to push out on the risk curve: [a] if 15550/1687 hold and prices roll over, simply buying the VIX (VXX) is a good alternative as well as the Ranger Short ETF (HDGE) and [b] if stocks rocket upwards and you have to play, a good multi asset class ETF (IYLD) would be a less risky way to participate; the Russell 2000 ETF (IWO) would be the more risky alternative.  A purchase of any of these alternatives should be accompanied by very tight stops.’
        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                                                15658                                                  1709

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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