Saturday, February 15, 2014

The Closing Bell---2/15/14

The Closing Bell

2/15/14

Statistical Summary

   Current Economic Forecast

           
            2013

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

            2014 estimates

                        Real Growth in Gross Domestic Product                   +1.5-+2.5
                        Inflation (revised)                                                          1.5-2.5
                        Corporate Profits                                                            5-10%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                     15330-16601
Intermediate Uptrend                              14696-16601
Long Term Uptrend                                 5050-17400
                                               
                        2013    Year End Fair Value                                   11590-11610

                   2014    Year End Fair Value                                   11800-12000                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Trading Range                          1746-1858
                                    Intermediate Term Uptrend                        1711-2391
                                    Long Term Uptrend                                    728-1900
                                                           
                        2013    Year End Fair Value                                    1430-1450

                        2014   Year End Fair Value                                     1470-1490         

Percentage Cash in Our Portfolios

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

Economics/Politics
           
The economy is a modest positive for Your Money.   It was a slow week for  economic data and what we got was basically mixed---though the more important stats were negative: positives---small business confidence, consumer confidence, wholesale inventories and sales and the January budget deficit; negatives---weekly mortgage and purchase applications, December industrial production and capacity utilization, January retail sales and weekly jobless claims; neutral---weekly retail sales 

As I noted above, while the data flow was uneven, the numbers everyone is worried about were disappointing---mortgage applications, retail sales, industrial production and employment.  This clearly keeps the yellow light flashing.  That said, the weather remains a complicating/mitigating factor.   As I noted last week, while I accept that it is having an impact, I am not sure if it is otherwise hiding/exacerbating a slowdown already in progress.  Until we get a better feel for whether or not these weak figures are weather induced, our outlook will remain:

‘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.’
               
                Update on the big four economic indicators (medium):

        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.


Obama’s energy moment (medium):

       The negatives:

(1) a vulnerable global banking system.  JP Morgan does it again:

As did another bailed out bank (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.  This week’s notable events were:

[a] Obama raising the minimum wage for all federal contractors by executive order,

[b] congress raising the debt ceiling. While this will avoid the prior Market disrupting wrangling over government spending, it clearly does nothing to address the issue long term.  Fiscally irresponsible spending, exemplified recently by the Farm Bill and new estimates of the impact of Obamacare, along with over regulation [minimum wage] and over taxation remain a burden to this economy.  Any hope of economic growth returning to its former secular rate is largely dependent on lightening these millstones,

[c] in a surprising, little discussed and potentially very positive development, the CBO has altered its method of analyzing the national budget---switching to what is called ‘dynamic scoring’  which attempts to account for likely taxpayer responses to fiscal measures.  The easiest example is a tax increase/decrease.  Before the assumption was that the increased/decreased rate would simply be applied to the current level of earned income yielding an increase/decrease in taxes collected.  The new dynamic accounts for potential taxpayer response: working less/more, altering accounting treatments to decrease/increase declared income, etc.   The importance being that now any proposed tax cut will not reduce assumed tax receipts to the extent they did under the old methodology.   Hopefully this will make reforming the tax code a bit easier.


(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. 

Yellen held center stage this week as she made her first appearance before congress as Fed chief---and she didn’t disappoint the doves.  Her comments clearly pointed to tapering for pussies remaining policy and suggested that it could become even less of a threat to the Markets if the economic data continue to be troublesome. 

It is certainly too early to start characterizing the policies that will flow from her regime. But the initial take is that the Yellen Fed will remain every bit as easy as the Bernanke Fed.  That clearly does nothing to lessen the risk of an overly accommodative monetary policy.

The issues remain: [a] can the Fed successfully transition from easy to tight money without bungling the process---which it has done at every other such juncture in its history?  [b] from an economic standpoint, since QEInfinity had little effect on economic activity during its tenure, will it have an impact being unwound?  [c] from a Market standpoint, since asset prices are where the impact of QE has been felt the most, isn’t reasonable to assume that it is the Markets that will have to pay the price for the Fed’s monetary experiment. 
           
(4)   a blow up in the Middle East.  Quiet.


(5)   finally, the sovereign and bank debt crisis in Europe.  Draghi’s remarks notwithstanding, the data out of Europe this week was not that positive.  Of course as I often note, one week doesn’t a trend make.  Those numbers could just be statistical noise or perhaps the weaker US performance along with the continued sluggishness in the emerging markets are taking their toll.

In any case, this risk is less about EU economic growth and more about the leveraged state of the EU banking system, the [low] quality of those leveraged assets and the risk that some exogenous event could push one or more banks into insolvency.

****I apologize for all the must reads below; but they are.


Those potential exogenous events would include a currency crisis in an emerging market, the continued importation of deflation from Japan, a credit crisis in China or something closer to home. 

And (must read):

And (must read):

On the latter point, a debate within the EU this week centered on the implications of the German high court’s ruling on ECB’s ability to back stop the liquidity of the banks.  I have no idea how this issue resolves itself; but I do know that guys far more knowledgeable than me are not in agreement---that spells ‘risk’ to me.

                       

Bottom line:  the economy continues to grow sluggishly though the data is becoming increasingly worrisome.  I do believe that some of the shortfall in expectations can be attributed to weather; I am just not sure how much.  For the moment, I leave our forecast unchanged; though the warning light is flashing.          

The ruling class remains on script which is to say promise responsible fiscal policy and deliver something else.  Part of the reason that the Fed has gotten its dick in the wringer is trying to carry the economy in the absence of adult behavior from the politicians.  Unfortunately, nothing happening that would suggest a change in congress or the white house.

The outcome of tapering for pussies became a bit more cloudy this week with Yellen’s testimony, i.e. the Fed’s intent to follow through is a bit more suspect.  To be fair to her, part of this was more a function of how the Market interpreted what she said than what she actually said---that is, while she sounded dovish, investors assumed more dovish implications than were actually stated. 

We will know soon enough just how dovish she is.  Meanwhile, Yellen is stuck with a Herculean task of unwinding QE without causing economic disruptions. If she is more dovish than Bernanke and tapers or reverses the taper as a result of the poor economic stats, then she will just dig a bigger hole for the Fed to climb out of.  If not, history is still not on her side, i.e. the Fed has never successfully transitioned to tight money.  And that ignores the possibility that the Markets will get sick and tired of tapering for pussies and take matters into their own hands.

The economic news out of Europe was a bit more mixed this week.  The situation wasn’t helped by the generally punk news from around the globe (Chinese investment trusts defaulting, Italian government falls, German court decision raises questions about EU QE, Japanese deflation, political unrest in Venezuela, Turkey and Kazakhstan, etc.). I am leaving the ‘muddle through’ scenario in place.  But the international economic/political risks are growing.

This week’s data:

(1)                                  housing: weekly mortgage applications and purchase applications fell,

(2)                                  consumer:  weekly retail sales were mixed while January retail sales were disappointing; weekly jobless claims rose more than estimates; the initial February University of Michigan consumer sentiment index was better than forecast,

(3)                                  industry: December industrial production and capacity utilization were below expectations; the January small business confidence index rose; December wholesale inventories were up less than expected but more than sales,

(4)                                  macroeconomic: the January budget deficit was less than anticipated.

The Market-Disciplined Investing
           
  Technical

`           The indices (DJIA 16150, S&P 1838) tip toed through the tulips this week, spurred by Janet Yellen’s first testimony before congress and helped by some short covering on Friday.  However, they remained within their short term trading ranges (15330-16601, 1746-1858).  The Dow closed within its intermediate term trading range (14696-16601) but broke above its 50 day moving average, while the S&P is in an intermediate term uptrend (1711-2491) and above its 50 day moving average.  Both are in long term uptrends (5050-17400, 728-1900).

Volume was low, as it has been all week; breadth was mixed---a bit surprising for such a strong upward price day.  The VIX was down, ending within its short term trading range and intermediate term downtrend and closing below its 50 day moving average.

I checked again on our internal indicator---judging our stocks versus the S&P in terms of proximity to their former all time highs.  In a 153 stock Universe, 41 are approaching or have surpassed their former highs while 112 remain 3% or more away from their highs.

The long Treasury was up fractionally, finishing within a short term trading range and an intermediate term downtrend.  It continues to build a head and shoulders formation.

GLD put on another great performance (+1.3%).  It is now well above the lower boundary of that very short term uptrend; in fact, it is getting a bit ahead of itself.  It remains with both a short and intermediate term downtrend.  I am waiting to see where GLD will encounter support on its next sell off.

Bottom line:  the bulls controlled the board this week.  However, volume on the rally was low, breadth was mixed, the price action of the Averages is not being supported by our internal indicator, plus they are facing the resistance of a double top and there was a good deal of short covering on Friday.

That said, price is truth and right now prices are sizzling.  Clearly, the next important technical juncture will be at the 16601, 1858 level.  I wait with bated breath.

Meanwhile, we have a Market in a trading range; so there is really not much to do save using any price strength that pushes one of our stocks into its Sell Half Range and to act accordingly.

                For the bulls (medium):

            Technical thoughts from Citi (medium):

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (16150) finished this week about 38.6% above Fair Value (11650) while the S&P (1838) closed 27.1% overvalued (1446).  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 dataflow, especially in the primary sectors of the economy, remains weak.  Weather is being argued as a major mitigating factor; and I tend to agree with this analysis.  However, the lousy numbers can’t be summarily dismissed.  Nor can we assume that the Fed will make everything alright if the economy does deteriorate.  Indeed, if recent history is any guide, suspending or even reversing tapering will do little to stimulate economic activity.

The debt ceiling was raised this week which should allow us to avoid the gutting wrenching Market adjustments that the past fights have caused.  Don’t take that as particularly positive assessment.  It is probably good for the Markets short term but does nothing to alter irresponsible spending, taxing and regulatory policies.  As such, Washington will remain a drag on economic growth.

Having said that, the bureaucrats actually did us all a favor this week---the CBO moving to a dynamic scoring process on the budget.  By itself it does nothing because the politicians have to propose responsible budget measures to be scored in the first place.  However, it does take away the arguments of the more progressive members of congress that want more and more taxes.  We can only hope.

The recent signs of economic weakness raise an interesting question with respect to monetary policy: will a dovish Fed use these numbers as an excuse to taper the tapering and amplify the already extreme policy measures that it has taken since 2007 to stimulate the economy? 

To do so in my opinion would be a major negative and would only magnify the risks associated with managing a successful transition to tighter money.  Furthermore, the evidence of QE’s impact on economic growth is questionable.  That might not stop it from tapering or reversing the tapering; but that policy would be unlikely to help many save investors.  Perhaps the real question is, will the Markets be patient enough to allow the Fed to tinker with its previously stated policy?

Overriding all of these considerations is the cold hard fact that stocks are considerably overvalued not just in our Model but with numerous other historical measures which I have documented at length.  This overvaluation is of such a magnitude that it almost doesn’t matter what occurs fundamentally, because there is virtually no improvement in the current scenario (improved economic growth, responsible fiscal policy, successful monetary policy transition) that gets valuations to Friday’s closing price levels.  Indeed, the problem is that any revision in the economic outlook from here is more likely to be negative than positive.

Bottom line: the assumptions in our Economic Model haven’t changed, though the risks are rising that they might.

The assumptions in our Valuation Model have not changed either.  I remain confident in the Fair Values calculated---meaning that stocks are overvalued.  So our Portfolios maintain their above average cash position.  Any move to higher levels would encourage more trimming of their equity positions.
   
That said, I can’t emphasize strongly enough that I believe that the key investment strategy today is to take advantage of the current high prices to sell any stock that has been a disappointment or no longer fits your investment criteria and to trim the holding of any stock that has doubled or more in price.
       
     
       
DJIA                                                   S&P

Current 2014 Year End Fair Value*              11900                                                  1480
Fair Value as of 2/28/14                                  11650                                                  1446
Close this week                                               16150                                                  1838

Over Valuation vs. 2/28 Close
              5% overvalued                                12232                                                    1518
            10% overvalued                                12815                                                   1590 
            15% overvalued                                13397                                                    1662
            20% overvalued                                13980                                                    1734   
            25% overvalued                                  14562                                                  1806   
            30% overvalued                                  15145                                                  1878
            35% overvalued                                  15727                                                  1951
            40% overvalued                                  16310                                                  2023
            45%overvalued                                   16892                                                  2095

Under Valuation vs. 2/28 Close
            5% undervalued                             11067                                                    1373
10%undervalued                            10485                                                       1301   
15%undervalued                             9902                                                    1229

* 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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