The Closing Bell-7/3/10
Steve Cook on Disciplined Investing

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Statistical Summary

   Current Economic Forecast
   
2009
   Real Growth in Gross Domestic Product:        -1.0 - -2.0%
    Inflation:                                                                      1-2 %
    Growth in Corporate Profits:                                      0- -5%

2010 (revised)

   Real Growth in Gross Domestic Product:          +3.0- +4.0%
   Inflation:                                                                      1.5-2.5 %
   Growth in Corporate Profits:                                       10-20%

 Current Market Forecast
   
    Dow Jones Industrial Average

       Current Trend (revised):
         Short Term Down Trend                                     9241-10457
          Long Term Trading Range                                 6432-14180
                    
        2009    Year End Fair Value                                9440-9460

        2010    Year End Fair Value (revised)                 10120-10140
 
    Standard & Poor’s 500

        Current Trend (revised):
           Short Term Down Trend                                     988-1111
           Long Term Trading Range                                  666-1575
               
        2009    Year End Fair Value                                1165-1185

        2010    Year End Fair Value                     1250-1270   

  Percentage Cash in Our Portfolios

     Dividend Growth Portfolio                  21%
    High Yield Portfolio                              20%
    Aggressive Growth Portfolio               22%

Economics
   
The condition of the recovery remains  uncertain, making the economy,  for the moment, a neutral  for Your Money. 
The data this week confirmed that not only was May a lousy month, economically speaking but also June is starting out much the same.  Indeed, this week investor attention seemed to shift from the many headwinds (China, EU sovereign debt, BP oil spill) to what is going on inside the US economy--the concern being that it is heading for a ‘double dip’ irrespective of what may be occurring elsewhere.  While that is certainly a risk, as you know, I think that it is not the most likely scenario.  I concede that if June’s economic stats are not any better than May’s, I am going to have to recant my latest change in our forecast (that the economic growth rate was accelerating) and I might even have to lower second half growth.  But that is not to suggest that the economy will return to recession. 

To me the biggest problem right now is not the data, it is the politics.  The administration is driving to hoop on increased spending, higher taxes and more regulation.  How they can possibly believe that these policies will improve our lot mystifies me.  Hence, in my opinion, the single biggest risk to our forecast is that somehow Obama continues to have success in implementing His agenda and/or there is not a revolution at the polls in November.

Of course, just because focus temporarily moved off of China, the EU and BP doesn’t mean that they have gone away.  China announced disappointing manufacturing data this week.  However, as I said in Friday’s Morning Call, the debate on the Chinese economy is not whether it is going grow or go into a recession, it is an argument about how fast it is going to grow.  Moreover, the pace we can only dream of--accordingly to Goldman, it will expand at a double digit rate.  That is not exactly a major bullet point for the bears.

There were developments in the EU sovereign debt problem--most positive: a successful debt offering by Spain, less credit support needed by the EU financial system, expansion of the number of banks subject to the ‘stress test’ and increased willingness to implement austerity measures by the larger EU members.  That said, I am not at all convinced that this crisis is over.  There is still much we don’t know about the solvency of their banking system.  In addition and, perhaps more important, the aforementioned austerity measures include both spending cuts and tax increases.  While the European politicians’ resolve is admirable, if those measures are enacted, I believe that it raises the probability of a slowdown, even a recession, in Europe which will ultimately have some impact on the US.

Here is a more optimistic view of Europe (medium):
http://www.ritholtz.com/blog/2010/07/eu-economy-to-survive-outperform-us/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+TheBigPicture+%28The+Big+Picture%29&utm_content=Yahoo!+Mail

The BP situation is a conundrum.  There are so many potential negatives that can occur (offset well doesn’t work, a hurricane).  We know that there is a piggy bank out there (BP) that will absorb much of the costs now being incurred.  But until that well gets capped, there is no way to estimate the final cost of the destruction.  That is a big unknown and there is no way to price it into stocks.

Bottom line: the economy clearly hiccupped in May; if it was more than a hiccup then our short term outlook may be a tad high.  But any alterations that I might make would not be sufficient to change the forecast to a double dip.  In reality, it would simply make our long term outlook (an economy burdened by too much irresponsible monetary/fiscal/regulatory policy and a crippled banking system to return to its historical secular rate of growth) the short term forecast.  The two caveats that could create a more negative outcome are the BP spill and what happens in Washington.

This week’s data:

(1)    housing: weekly mortgage applications fell 3.3%; while May pending home sales plunged 30%,
 
(2)    consumer: weekly retail sales were again mixed though more positive than they have been of late; June auto sales were slightly below forecast; May personal income and spending both rose in line with estimates; weekly jobless claims increased versus expectations of a decline and the June nonfarm payroll number was a disappointment; finally, the Conference Board June index of consumer confidence fell out of bed,

(3)    industry: the June ISM manufacturing index came in below expectations; May construction spending was better than forecast; May factory orders fell 1.4% versus an anticipated decline of 0.5%; the June Chicago PMI was slightly better than expected,

(4)    macro:  no data this week.

    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 negative for Your Money.
   
    This is probably the best domestic political scenario that we can hope for; but it is better than what we have now (medium):
    http://cafehayek.com/2010/07/failure.html
   
The Market-Disciplined Investing
    
  Technical

The Averages (DJIA 9868, S&P 1022) have broken out and down of the trading range that they had been in (9830-11257, 1042-1220).  Under our technical discipline, they are now in a down trend whose boundaries as of the close Friday were 9241-10457, 988-1111.  As I noted earlier in the week, support does exist close in at 9646, 1009; though I am not hopeful that this level will offer much.  The next visible support level is much lower at 8088, 870.  There are a couple contrary indicators that may be presaging a less gruesome end to this decline: the VIX traded lower on Friday, breaking its up trend and our internal indicator, while weakening, is still suggesting more internal strength than we see in the Averages (out of a Universe of 157 stocks, 70 are above their 9830, 1042 comparable level, 64 are below and 23 are too close to call).

As I noted Friday, I have my Sell List that I made in case of just such a break as we have had.  (See Subscriber Alert below).

Bottom line:

(1) short term, the indices are in a down trend defined by 9241-10457, 988-1111,

(2)    long term, stocks are in a trading range defined by the 2002/2009 lows [S&P 666-766] and the 2000/2007 highs [1545-1575].  Importantly, I think that equity prices will continue to recover within that range but it will be a slow and volatile process.

This is not good news (chart):
http://www.ritholtz.com/blog/2010/07/sp500-head-shoulder-formations/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+TheBigPicture+%28The+Big+Picture%29&utm_content=Yahoo!+Mail

  
   Fundamental-A Dividend Growth Investment Strategy

    The DJIA (9686) finished this week about 1.6% below Fair Value (9850) while the S&P closed (1022) around 16.5% undervalued (1225).
 
The bad news for equities is that (1) the economic news continues to portray a wobbling recovery, (2) our elected representative prove everyday that they are clueless on economic matters.  While that is not exactly unknown, it is critical under current circumstances when the economy is struggling to rebound from the worse recession since the Great Depression, (3) while the EU is attempting to deal with its economic problems, the initial effects of the cure will likely be worse than the disease and (4) both the government and business have failed society miserably in their handling of the BP oil spill.  Regrettably, the saga continues virtually unabated, increasing daily the wreckage to lives and the environment of the Gulf coast.  We have no idea what the eventual cost will be.

The good news is that (1) corporate balance are flush with cash, (2) second quarter earnings are apt to be good, (3) the ‘bad’ news out of China simply isn’t that bad, (4) at 16% below Fair Value [at least by our Model’s valuation of the S&P] stock prices are reflecting at least a portion of the bad news and (5)  as lousy as the current political approach to solving our economic problems is, if the polls are anywhere near correct, regime change is going to occur in four months; and sooner or later, stocks are going to start to discount that.

Having said all of that, the bottom line is that stock prices have broken down technically; and that can’t be ignored.  Task number one right now is to protect principal and that means building cash.

This week, the Dividend Growth and Aggressive Growth Portfolios took additional steps to lightened up on stocks that experienced a technical breakdown.

           Bottom line:

(1)      our Portfolios will carry a higher cash balance than pre-financial crisis but it will be more a function of individual stock valuations and less on macro Market technical trends,
 
(2)    we continue to include gold and foreign ETF’s in our asset mix because we continue to believe that inflation is the major long term risk.  An investment in gold is an inflation hedge and holdings in other countries provide Angel a hedge against a weak dollar and Beer exposure to better growth opportunities,

(3)    defense is still important.

                                                                    DJIA                    S&P

Current 2010 Year End Fair Value*        10130                    1260
Fair Value as of 7/31/10                            9850                    1225
Close this week                                          9686                   1022

Over Valuation vs. 7/31 Close
      5% overvalued                                    10342                    1286
    10% overvalued                                    10835                    1347 
    15% overvalued                                    11327                   1408

Under Valuation vs. 7/31 Close
    5% undervalued                                    9357                   1163
   10%undervalued                                   8865                   1102
    15%undervalued                                  8372                    1041   

* 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.









Posted 07-03-2010 1:14 PM by Steve Cook