Saturday, February 8, 2014

The Closing Bell

The Closing Bell

2/8/14

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                        1705-2385
                                    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.   This week’s economic data turned a bit more mixed than in the recent past: positives---mortgage applications, weekly jobless claims, the January ADP private payroll report, the January ISM nonmanufacturing index, December construction spending and fourth quarter productivity and unit labor costs; negatives---weekly purchase applications, January light vehicle sales, January retail chain store sales, January nonfarm payrolls, December Markit PMI, January ISM manufacturing index and the December trade deficit; neutral---weekly retail sales, and December factory orders. 

The important numbers this week were (1) the ISM manufacturing index because in adds a poor number from the business sector to the already uncertain data on retail sales and employment and (2) the employment reports because they were again confusing.  All in all, the dataflow, particularly the primary stats of major GDP sectors, is getting more worrisome. 

And:

In this whole mix of uncertainty, economists and investors are also attempting to factor in two somewhat contradictory factors:

(1) on the negative side, economic and political turmoil in the emerging market have been exacerbating fears on a weak US economy---the concern being that a slowdown in growth there would raise the risk of recession here.  To be sure, they pose a risk.  However, the problems in the emerging markets have been around for eight or nine months and until lately were largely ignored as irrelevant.  So there is really no new news there. Nonetheless, psychology being what it is, the EM difficulties have now taken on more importance in investors’ minds.  Whether or not their difficulties ultimately impact the US economy remains to be seen. 

(2) weather.  No doubt, it has been a rough winter so far.  The optimists are insisting that sales, employment and ISM data are tainted by this factor and, hence, there is no reason to question the underlying strength of the economy.  I must say that I have some sympathy with this argument.  The real question though, is the weather aggravating an already slowing economy.  Clearly, we won’t know that for a while.

So we clearly are in a period in which the economic outlook has become a bit more opaque.  That said, it should be remembered that we have experienced several brief soft patches in economic stats during the current recovery with no lasting effects.  Hence, I remain of the opinion that it is too soon to be altering our forecast; but with Friday’s disappointing nonfarm payrolls report, I am turning on the yellow warning light.  For the moment, 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.  What is a week without another negative headline on JP Morgan [our fortress bank] misdeeds?

In addition, the regulators are now closing in on currency manipulation charges (short):

‘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.  It was business as usual for our ruling class this week: [a] Obama is raising the minimum wage for all federal contractors by executive order, [b] congress is in the final stages of passing an outrageously expensive Farm Bill that lines the pockets of corporate farmers, [c] the anecdotal evidence of Obamacare failures keeps growing, while [d] the CBO put a fine point on the macroeconomic consequences, forecasting higher unemployment and increased deficits as a result.

None of this suggests that Washington [and by that I mean both parties] is any closer to understanding the burden that its rules, regulations and taxes are placing on the economy.  Until it does, fiscal policy will remain a risk and a headwind to economic growth.

And:

As a post script, late yesterday afternoon, Treasury Secretary Lew announced that the debt ceiling will be hit in late February.  In an election year and with the GOP now having the dems on the run over Obamacare, I can’t fathom that extending the debt ceiling will be the same brouhaha that it has been the last couple of times.  While I would love to see the republicans continue to make an issue of it, which is not likely to happen for obvious political reasons.  But with this group of yahoos, you never know.

(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. 

Tapering for pussies is policy but the question is how much impact the recent confusing retail sales, employment and manufacturing data along with the continuing turmoil in the emerging markets will have on that policy.  Clearly, there is enough uncertain data out there to provide an excuse for the Fed to ease back on tapering.  If it does, then we are back on the same old treadmill, only the subsequent renewed tapering will start from even loftier levels.

If not, then the key 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. 
           
        A must read article from Barry Ritholtz on misguided Fed policy (medium):

(4)   a blow up in the Middle East.  No one has blown anyone else up this week.  So things are quiet.  That said, rumors are flying about potential terrorists attacks on the participants or spectators to the Sochi Olympics. This could be a wild card next week.


(5)   finally, the sovereign and bank debt crisis in Europe.  I suppose I could expand this risk to include the emerging markets; but as noted above, their problems have been well documented over the last eight to nine months---with little visible impact on the developed economies. 

Not to dismiss this issue out of hand, one instance where problems could arise is in the developed markets financial systems if, for example, Argentina or Venezuela goes toes up and one of the EU banks [Spain] has too much of that country’s debt.   It could potentially tip a bank with an already overleveraged balance sheet containing too much sovereign junk over the edge.

That said, the ECB’s decision this week to leave interest rates unchanged suggests that there is institutional confidence that the EU’s constituent economies and financial system are in reasonable shape.  I recognize that it could be dangerous to accept this assumption at face value [see link below].  But until there is some change in the dataflow, I am sticking with the ‘muddle through’ scenario.

Bottom line:  the economy continues to grow sluggishly though the data has become a bit more ambivalent.  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, as I noted above, I have turned on the flashing yellow light.          

Washington returned to its old fiscally irresponsible, overly enthralled with regulation self (Farm Bill, minimum wage) this week.  These guys remain one of the major obstacles to long term economic growth.

The outcome of tapering for pussies is and will remain an unknown for some time.  Whether or not it is successful depends on (1) if the Fed really proves effective in unwinding QE without causing economic disruptions---an immediate test coming from any Fed reaction to the increase uncertainty in the economic data, and (2) how the Markets handle tapering for pussies under conditions of extreme valuation?

There was little out of Europe this week to alter our outlook which remains that it will ‘muddle through’.

This week’s data:

(1)                                  housing: weekly mortgage applications rose while purchase applications fell,

(2)                                  consumer:  weekly retail sales were mixed while January chain store sales fell; January light vehicle sales were disappointing; weekly jobless claims dropped more than consensus; the January ADP private payrolls were up but below recent levels; and January nonfarm payrolls were lower than anticipated,

(3)                                  industry: the December Markit PMI was slightly below expectations; the January ISM manufacturing index was well below estimates while the nonmanufacturing index came in as anticipated; December construction spending was a tad over forecast; December factory orders were down but less than consensus,

(4)                                  macroeconomic: the December trade deficit was larger than expected; fourth quarter nonfarm productivity and unit labor costs were better than forecast.

The Market-Disciplined Investing
           
  Technical

The indices (DJIA 15794, S&P 1797) had a roller coaster week.  After a pounding on Monday, they recovered later in the week.  Both closed within short term trading ranges (15330-16601, 1786-1858).  They are out of sync on their intermediate term trends---the Dow in a trading range (14696-16601 and the S&P in an uptrend (1705-2485).  Long term, they are in uptrends (5050-17400, 728-1900).

Volume was flat on Friday and has been low for the entire rally this week; breadth was mixed.  The VIX was down, ending within its short term trading range and intermediate term downtrend.

The long Treasury was up fractionally, finishing within a now wider short term trading range and an intermediate term downtrend.

GLD was rose, but remains within both short and intermediate term downtrends.  It is trying to break the upper boundary of another very short term downtrend.  However of late, it has had such a lousy record of follow through after penetrating resistance levels, I am not sure how jiggy to be if that occurs.

Bottom line:  the bulls clearly still have mojo, recovering as they did from a drubbing on Monday and then rallying and even spiking on Friday following a lousy nonfarm payroll number.  However, volume on the rally was low and breadth mixed---not particularly reassuring for the optimists.  In addition, the short term uptrends of both Averages have been taken out as has the intermediate term uptrend of the Dow.  So just as clearly, some technical damage has been done. 

I have no idea whether or not the current correction is just some consolidation or is part of a topping process (remember Market tops are processes, not just a suddenly reversal that characterizes bottoms).  I continue to think that a potential deciding signal, if it were to occur, would be a breakdown of the S&P through the lower boundary of its intermediate term uptrend.   If it can hold above, then that likely means that the long term momentum is still to the upside and the old highs will probably be challenged at the very least; if not, then it could mark an end to a topping process.

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 trades into its Sell Half Range to act accordingly.

            Technical thoughts from Citi (medium):

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (15794) finished this week about 35.5% above Fair Value (11650) while the S&P (1797) closed 24.2% 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 recent confusing dataflow, particularly in the primary sectors of the economy, has raised questions regarding the sustainability of the current recovery.  Weather is being argued as a major mitigating factor; and I tend to agree with this analysis.  Nevertheless, the lousy numbers can’t be summarily dismissed.  So the caution flag is out.

Our ruling class continues to act as if its only responsibility is to itself and its own re-election---the Farm Bill, Obamacare and the hike in the minimum wage being just the latest examples.  As such they and their fiscal policy (too much government spending, too high taxes, and too much regulation) remain an anchor tied around the throat of the economy.

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 unwinding its massive balance sheet: (1) can the Fed manage a successful transition to tighter money? , and whether or not it does (2) what will be the impact on the economy? (3) what will be the impact on the Markets? and (4) will the Markets be patient enough to allow the Fed to execute its plan?

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 scenario (improved economic growth, responsible fiscal policy, successful monetary policy transition) that gets valuations to current price levels.  Said another way, we could get nothing but good news from here and that wouldn’t prevent losses in equities when, as and if they finally return to mean historical values.

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.
       
          This week the Dividend Growth Portfolio Sold is position in Target (TGT).

        This seasons earnings and revenue ‘beat’ rates (short):
       
DJIA                                                   S&P

Current 2014 Year End Fair Value*              11900                                                  1480
Fair Value as of 2/28/14                                  11650                                                  1446
Close this week                                               15794                                                  1797

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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