The Closing Bell-10/16/2010
Steve Cook on Disciplined Investing

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Statistical Summary

   Current Economic Forecast

    2010 (revised)

      Real Growth in Gross Domestic Product:        +2.5- +3.5%
      Inflation:                                                                        1-2 %
      Growth in Corporate Profits:                                     10-20%

   2011

       Real Growth in Gross Domestic Product:          +1.5- +2.5%
       Inflation:                                                                         2-3 %
       Growth in Corporate Profits:                                        7-12%


  Current Market Forecast
   
    Dow Jones Industrial Average

     Current Trend (revised): 
         Short Term Up Trend (?)                       10345-13584
          Short Term Trading Range                     9645-11257
         Long Term Trading Range                      6432-14180
                    
     2009    Year End Fair Value                        9440-9460

    2010    Year End Fair Value (revised)        10095-10115
 
  Standard & Poor’s 500

     Current Trend (revised):
        Short Term Up Trend (?)                          1078-1482
        Short Term Trading Range                       1042-1220
         Long Term Trading Range                        666-1575
               
    2009    Year End Fair Value                           1165-1185

   2010    Year End Fair Value                         1240-1260   

Percentage Cash in Our Portfolios*

     Dividend Growth Portfolio                  20%
    High Yield Portfolio                              19%
    Aggressive Growth Portfolio               18%

*keep in mind that 3% of the absolute increase was due to the sale of one third of our Portfolios’ gold position

Economics
   
The economy is a neutral for Your Money.
  There was a dearth of economic data this week.  What was reported was again mixed.  So there was nothing in the data to alter our forecast: an economy growing at a below average secular rate.  On the other hand, there were developments that could ultimately impact our outlook:
 
(1)    Bernanke and his cohorts are driving to the hoop on QE2.  I have opined on this subject ad nauseum; so I will do nothing more than repeat my conclusion: it will do nothing but inflame inflationary expectations.  The best thing that could happen to QE2 is an early grave.

I finally found a positive opinion of QE2.  Here it is (medium):
http://www.ritholtz.com/blog/2010/10/today-bernanke-and-qe2/

On the other hand, here is the Chinese opinion (medium):
http://www.zerohedge.com/article/empire-strikes-back-china-daily-warns-about-currency-war-blames-dollar

(2)    the foreclosure crisis is a wild card that has the potential of pushing the economy into the ‘double dip’ that I thought that we had avoided.  To be clear, I have no idea how really bad this problem is.  The links that I have provided in the Morning Calls predict a wide range of outcomes--everything from’ it is only a technical snafu in the paper work that will be corrected in week’ to ‘the Fed owns $1 trillion of now worthless paper’.  With time, we will get clarity on just how serious the problem is.  In the meantime, I think that we have to mark this as a negative that could disrupt the slow plodding recovery that is our forecast.

Another depressing analysis of this situation (medium):
http://www.nakedcapitalism.com/2010/10/foreclosure-fraud-we-need-to-fix-the-banks-again.html

(3)    on Friday the Treasury decided to postpone the decision on whether or not to declare China a currency manipulator until after the up coming G20 meeting.  It is a typical Tiny Tim wimp move; but it is better than starting a trade war with China.  If the administration goes through with its threat to declare China a currency manipulator, this drama will not end well,

(4)    speaking of China, the Thursday US Treasury note auction went very poorly, meaning there was a shortage of buyers.  Who is the biggest buyer?  Yep. China.  I don’t think this poor auction was just a coincidence in front of the Treasury’s circle jerk over the yuan.  If China [and any other country that might follow in its wake] decides to stop buying US paper, say good bye to the bond rally, any recovery in housing and hello to an inflationary impulse and probably lower stock prices.

(5)    how can I address the future course of the economy and not mention the elections?  They remain, in my opinion, the key to the intermediate and longer term economic outlook.  However, there is nothing to add to what I have already said.

    Bottom line: the economy is in a slow, painful recovery; and (1) QE2, assuming it happens, (2) the potential problems that could arise out of the foreclosure crisis and (3) the ominous implications of the poor Treasury auction all support the thesis that the recovery will remain slow and painful for a long time to come.  The one factor that could alter that scenario is a major change in the political/economic/social agenda that would arise out of the November elections. 

This week’s data:

(1)    housing: weekly mortgage applications rose 14.6% although new purchase applications fell 8.5%,
 
(2)    consumer: weekly retail sales were positive and September retail sales came in better than anticipated; weekly jobless claims increased more than expected;  the preliminary October University of Michigan index of consumer sentiment was reported at 67.9 versus estimates of 68.8 and September’s reading of 68.2,

(3)    industry: August business inventories rose more than forecast,

(4)    macroeconomic: September producer prices jumped, while consumer prices rose less than anticipated; the August trade deficit was larger than expected as was the September budget deficit; the New York Fed business index exploded coming in three times higher than estimates; finally, in a speech Friday morning, Bernanke re-emphasized the need for QE2.

    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

The domestic political environment potentially could move from negative to neutral for Your Money while the international political environment remains a negative for Your Money.
       
    A letter to Obama from Ken Langone (medium):
    http://online.wsj.com/article/SB10001424052748704361504575552080488297188.html?mod=WSJ_Opinion_LEADTop

    How to turn a recession into a depression (long):
    http://www.nationalreview.com/articles/249783/how-turn-recession-depression-victor-davis-hanson

The Market-Disciplined Investing
    
  Technical

The Averages (11062, 1176) are trading within the boundaries of a trading range (9645-11257, 1042-1220).  In addition, I have speculated that for a number of technical factors (Angel manner in which the S&P blew through the 1149 resistance level, Beer the historic behavior of stocks after they negate a head and shoulders formation, Coffee  the historic behavior of stocks when they successfully complete a reverse head and shoulders and Drinks the historic behavior of the third year of the presidential cycle--the strongest of the four year cycle), the indices may also be re-setting to an up trend (10345-13584, 1078-1482).

Three other technical factors occurred this week that suggest more positive pin action: (1) a pick up in volume, (2) stocks’ refusal to go down in the face of bad news, (3) a break down in the technical pattern of the VIX--a positive for stocks. 

My conclusion from Friday’s Morning Call: ‘the question in my mind now is, are stocks in a trading range or re-setting to an up trend?  Key points to watch are (1) the upper boundaries of the indices trading ranges [11257-1220] to see if they hold, (2) the former upper boundaries of the current range which were resistance now turned support levels [10725, 1149] and (3) the rising lower boundary of the hypothetical new up trend [10345, 1078].’ 

‘Clearly from yesterday’s closing prices, there is considerable room in both directions for stocks to trade before challenging any meaningful resistance/support.  So technically speaking, there is nothing to put us on high alert.  We watch.’

Bottom line:

(1) short term, the indices are in a trading range probably defined by 9645-11257, 1042-1220; but could be in the process of re-setting to an up trend (10345-13584, 1078-1482),

(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.

   Fundamental-A Dividend Growth Investment Strategy

    The DJIA (11062) finished this week about 10.6% above Fair Value (9994) while the S&P closed (1176) around 5.1% undervalued (1239).  The key assumptions on Fair Value are that;

(1)    the economy is and will continue to grow at a historically sub par secular rate.  There were plenty of developments this week that could weigh on the economy and consequently keep this scenario in place irrespective of my second assumption.  They include [without further discussion] the rising consensus that QE2 will do more harm than good, the chance that the foreclosure crisis could turn into another banking system nightmare, the possibility that the administration will misplay its game of chicken with the Chinese,

(2)    November 2 will bring gridlock to Washington--but nothing more.  The polls measuring the likelihood of the GOP taking the senate keep inching up; but the last one that I saw still has the dems in control.  But that aside, I neither read nor saw anything this week to suggest that the republican establishment is any more inclined to reversing the current agenda; and if that doesn’t happen, then our forecast won’t change.

    Given the above comments, that puts stock prices in general near Fair Value which means that my neutral fundamental opinion is somewhat at odds with my much more positive technical opinion.  I continue to note the cognitive dissonance this generates for me.

    My near term solution to this problem is to (1) not argue with the Market and (2) if some action is required to the upside, to hedge it as much as possible, but (3) at the same time not ignore our Sell Half discipline. 

Longer term, I have to (1) model the economic/political changes that would bring an improved fundamental outlook in line with the technicals and have a Buy List reflecting those changes and (2) determine the stocks for which I need to exercise more price sensitivity if the technicals weaken and began supporting the fundamentals.

    http://www.minyanville.com/businessmarkets/articles/quantitative-easing-recession-economic-recession-qe2/10/15/2010/id/30582?camp=featuredslide&medium=home&from=minyanville

          This week, our Portfolios took their gold position down by 3% and the Dividend Growth Portfolio reduced the size of its UGI holding as a result of it having traded into its Sell Half Range.
 
           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*                    10105 (revised)  1250 (revised)
Fair Value as of 10/31/10                                     9994                    1239
Close this week                                                     11062                   1176

Over Valuation vs. 10/31 Close
      5% overvalued                                                10493                    1300
    10% overvalued                                                10993                    1362 
    15% overvalued                                                11493                     1424

Under Valuation vs. 10/31 Close
    5% undervalued                                                 9494                      1177
  10%undervalued                                                  8994                      1115
    15%undervalued                                                8494                    1053   

* 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 10-16-2010 9:31 AM by Steve Cook