The Closing Bell
Steve Cook on Disciplined Investing

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The Closing Bell

10/25/08

  Statistical Summary

   Current Economic Forecast

    2007
        Real Growth in Gross Domestic Product:        2.0- 2.5%
                 Inflation:                               2 - 2.5 %
Growth in Corporate Profits:                                      6-8%

2008 (revised-again)
        Real Growth in Gross Domestic Product (GDP):   -1.0 - +1.0%
        Inflation:                                2-3%   
        Growth in Corporate Profits:                         0-5%

   Current Market Forecast
   
Dow Jones Industrial Average

        2008
            Current Trend:
Short Term Trading Range                      7853--?
Long Term Trading Range                      7100-14203
            Year End Fair Value (revised):                13450-13850
        
        2009    Year End Fair Value (revised):                13850-14250
 
    Standard & Poor’s 500

2008
            Current Trend:
            Short Term Trading Range                         839--?
                                    Long Term Trading Range                      750-1527
            Long term Up Trend                    1317-1797   
            Year End Fair Value (revised):                 1533-1577
   
2009    Year End Fair Value                               1595-1635
   
  Percentage Cash in Our Portfolios

Dividend Growth Portfolio                  24%
    High Yield Portfolio                      21%
    Aggressive Growth Portfolio                  24%

Economics

    The economy is a neutral for Your Money.  There wasn’t enough  data reported this week to alter anyone’s opinion of economy or its direction.  We did get some positive news in housing--although weekly mortgage applications were down, existing home sales in September were up a solid 5.5% versus expectations of being unchanged.  Inventories were down which is good, as were home prices.  The latter may not sound all that great but it is a brutal necessity in healing the housing market. Another  bright spot was the leading economic indicators which were up .3% in September.  The bad news: retail sales were down and jobless claims were up. 

    A review of the existing home sales data:
    http://calculatedrisk.blogspot.com/2008/10/existing-home-sales-nsa.html
    http://calculatedrisk.blogspot.com/2008/10/existing-home-sales-increase-in.html

    While we still haven’t reached the point where the economy can be statistically defined as in recession, it seems clear from the weekly figures that we have been receiving that likely a matter of when not if the recession begins.  While I have built in the possibility of an economic downturn into our forecast, perhaps the more important issue is the magnitude of any decline; and given that 2008 is almost over, that measure will show up in the 2009 numbers.  To be honest, I can’t get a grip on a 2009 forecast because I am still not sure whether it is poor investor psychology that is having an undue negative influence on professional observers’ forecasts or the strong likelihood of a severe recession that is making investors so pessimistic.  This week’s lack of data gives me another chance to procrastinate.

    For the moment, our forecast remains (1) a stagnant economy--conceding that conditions may require a more pessimistic assessment (2) with inflation subsiding as a near term problem though the recent massive injection of liquidity into the financial system poses a major risk of future price pressures.

Inflation and real yields:
    http://www.capitalspectator.com/archives/2008/10/inflation_worri.html

 The Economic Risks:

(1)    the economy is weaker than expected.

(2) Fed policy (reading the data correctly). 

(3) a disruption in global oil supplies (It is not the price of oil but its availability that will cause severe economic dislocation.).

(4) protectionism (Free trade is a major positive for world and US economic growth.).

(5) fiscal profligacy (Government spending as a percent of GDP is too high and the looming explosion in entitlement expenditures will make it worse.  There is no good solution save spending discipline.).
       
(6) a rising tax and regulatory burden (Government has never proven that it could solve economic problems efficiently or satisfactorily.)

Politics

Both the domestic and international political environments are a negative for Your Money.

    Recent comments from Iran:
    http://www.haaretz.com/hasen/spages/1030279.html

The Market-Disciplined Investing
    
    Technical

Despite more violent volatility and the inability of the indices to hold the very tentative support lent by the October 10 to present short term up trend, both indices (DJIA 8378; S&P 876) still closed in what I am still hypothesizing is a new trading range (DJIA 7853--9707; S&P 839--1062).  The big question remains, will those October 10 intraday lows prove to be the bottom?  I was wrong about the July lows; the risk is that I am wrong again.

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (8378) finished this week about 38.3% below Fair Value (13583) while the S&P closed (876) around 43.5% undervalued (1550). 

           Last week I concluded:

‘Bottom line: I believe that the problems of the supply/demand imbalance in equities created by margin calls and/or redemptions and the fear and loathing spawned by the complete freeze up in the global financial system are past their peak.  However, the repercussions of both will likely be felt in the pace of economic activity; we just don’t know the extent.  As a result, stock prices will probably remain quite volatile and trendless until we gain some visibility as to the magnitude and length of any downturn.’ 
 
Less fear and loathing over a freeze up of the financial system--Si.  And the process continued this week, the rampant pessimism notwithstanding.

Fewer problems with margin calls and redemptions--No.  Much of the damage done this week was simply more of the indiscriminate forced selling resulting from margin calls and redemptions that we witnessed before.  In the end, that trumps everything including fundamentals.  Our Valuation Model and everyone else’s are and will continue to be almost meaningless in this environment.  Having said that, I do think that Friday’s pin action held a small (this being the operative word) kernel of hope:  as you know, stock futures were lock limit down going into the Market opening, but stocks while opening down didn’t dip nearly as far as the futures had implied.  That does suggest that the supply/demand balance between buyers and sellers shifted somewhat, at least for that day, i.e. sellers didn’t totally overwhelm buyers.

That notwithstanding, it does seem as though stocks are going to test their October 10 lows (DJIA 7853, S&P 839) and perhaps soon.  When that happens, as gut wrenching as it will be, our Portfolios will be Buying stock.  At Market extremes, I just don’t think that we should do nothing.  Indeed, as stocks traded from the upper end my hypothesized trading range to the lower end, our Portfolios sold shares of some of their stocks that had traded below their October 10 low and they bought shares of some of the stocks that appeared to be building a support level.  Granted all of these transactions were small; but they hopefully accomplished our goals of gradually adding stability of principal and positioning our Portfolios for the move up whenever that comes.

As long as stock prices in general hold their October lows that will continue to be our strategy.  

Our investment strategy includes:

(a)    manage our cash assets between 15% and 25%; but remain aware that defense is still critically important and will be become more so if I am wrong about the October 10 lows,

(b)    use price weakness as an opportunity to buy the stocks of attractive companies at attractive prices; use price strength to take profits when a stock’s price moves into its Sell Half Range or to move out of those stocks that traded below October 10 lows and can not recover,

(c)    on a longer term basis, recognize that there remain fundamental factors that argue for caution and therefore to proceed carefully with our Buying, keeping a larger than normal cash position in anticipation of valuation and strategy changes that could result from a potentially new domestic economic agenda.

                                                                DJIA                    S&P

Current 2008 Year End Fair Value*        13650                    1555
Fair Value as of 10/31//08            13583                    1550
Close this week                 8376                    876

Over Valuation vs. 10/31 Close
      5% overvalued            14262                    1628
    10% overvalued            14941                    1705
   
Under Valuation vs. 10/31 Close
    5% undervalued                             12903                    1473   
          10%undervalued            12224                    1395
    15%undervalued                             11545                    1318    
    20%undervalued            10866                                            1240
    25% undervalued            10187                    1162
    30% undervalued             9508                    1085
    35% undervalued                             8829                                             1007
    40% undervalued                          8150                                              930
    45% undervalued                            7471                                              852

* 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  the 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.
   Company Highlight:

    Sigma-Aldrich Corp develops, manufactures and distributes a wide assortment (130,000 products) of biochemicals, chromatography products and diagnostic reagents in over 150 countries.  The company has grown earnings and dividends at a 15%+ annual rate over the last 10 years while earning approximately 20% on its capital.  SIAL should be able to continue this performance because:

(1)    its business is immune from economic slowdown,

(2)    its program to procure raw materials and services more efficiently and better manage inventories,

(3)    the acquisition of faster growing add on companies in the rapidly growing pharmaceutical and biotech industries,

(4)    its ability to raise prices with little risk of the loss of business.

SIAL is rated A by Value Line, has only an 11% debt to equity ratio and its stock yields 1%.
http://finance.yahoo.com/q?s=SIAL
10/08


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 38 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.









Posted 10-25-2008 12:22 PM by Steve Cook
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