The Closing Bell-10/23/2010
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                      7148-14180
          Very LT Up Trend                                      4187-14789   
                    
      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                        766-1575
         Very LT Up Trend                                       644-2000
               
   2009    Year End Fair Value                            1165-1185

     2010    Year End Fair Value                           1240-1260   

Percentage Cash in Our Portfolios*

    Dividend Growth Portfolio                  19%
    High Yield Portfolio                             18%
    Aggressive Growth Portfolio              17%

Economics
   
The economy is a neutral for Your Money. 
Not much economic data this week; and in keeping with our forecast, it was generally mixed.  Thus the economy remains on track to continue growing at a below average secular rate (and I add with a lessening risk of a ‘double dip’).  However, as I noted last week, there are several developments on the near term horizon that could have a material impact on our outlook:

(1)    the G20 is meeting this weekend.  This week Geithner made a show of talking up a strong dollar,  However, Angel he can do very little without the cooperation of the Fed {did someone say QE2}, Beer a ‘strong dollar’ has been the punch line for every Treasury Secretary for the last couple of decades and they all lied, Coffee everyone at that meeting knows Angel and Beer, so I can’t see anything meaningful coming out of this gathering.  However, just in case we get a miracle, the good news scenario would be for the G20 to agree to a currency realignment and linkage to gold or a commodity index--anything that would introduce discipline and stability,

(2)    November 3 is the next scheduled Fed meeting.  From all appearances, Bernanke et al will lay out their plans for QE2.  If they go full bore, I believe that the implications for currency/trade [risk a global race to ‘beggar they neighbor’/’competitive devaluation’] and inflation [higher] are negative.  If this occurs, I will likely have to adjust both the secular economic growth rate [as world trade declines] and inflation numbers in our Economic Model.  I reiterate:  The best thing that could happen to QE2 is an early grave.

http://www.calculatedriskblog.com/2010/10/fomc-and-qe2.html

I found another article supporting on QE2:
http://www.capitalspectator.com/archives/2010/10/qe2_and_history.html#more


(3)    foreclosure-gate.  I still don’t have a clue about the magnitude, the degree of fraud and the solution to the foreclosure crisis.  The problem is that there are countless opinions and a huge spread in the possible outcomes.  However, to date I haven’t read or heard an analysis definitive enough on the actual facts in this situation to come to any kind of conclusion; and until there is one, foreclosure-gate is simply an unquantifiable dilemma that will overhang investor sentiment until its risk can be reckoned.  The bad news is that it could result in another massive assault on bank capital that further restricts management’s ability to fund economic growth.  The good news is that it is much ado about nothing.

(4)    the elections.  It won’t be long now.  So far I see nothing to alter my view that Angel either the republicans will win just big enough to cause gridlock, but nothing more, Beer or that even if they do stage a dramatic sweep of both houses that they have the stones to implement the necessary spending, taxing and regulating reforms that would alter our constrained, muddle through economic scenario.  Two things would change our forecast: Angel the dems do better than I think, in which case I will likely lower the prospects for growth and raise the inflation target, Beer  a revolution unfolds November 2 that results in more responsible fiscal, regulatory and trade policies but most importantly, dramatically turns around  business sentiment and stimulates investment and employment.

I am encouraged by British PM Cameron’s determination to slash his country’s budget and both surprised and encouraged that the French Parliament endorsed Sarkozy’s plan to alter the retirement age.  My God, how embarrassing would it be for the French to find the will to correct their fiscally irresponsible ways and Americans could not?  How does the US retain the mantle of global leadership under such circumstances?

    Bottom line: the economy is in a slow, painful recovery which can be thrown off track by QE2 and/or the potential problems that could arise out of the foreclosure crisis.  On the other hand, a major change in the political/economic/social agenda arising out of the November elections could result in a re-birth of optimism in business and the consumer. 

This week’s data:

(1)    housing: weekly mortgage applications fell 10%; while September housing starts were much better than expected, building permits were worse,
 
(2)    consumer: weekly retail sales were mixed; weekly jobless claims fell more than expected,

(3)    industry: September industrial production came in below forecast; the October Philadelphia Fed business index was slightly better than anticipated,

(4)    macroeconomic: September leading economic indicators were in line with estimates; the most recent Fed Beige Book report was more up beat than expected.

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.
       
The Market-Disciplined Investing
    
  Technical

The Averages (11132, 1183) are trading within the boundaries of a short term (10 months) trading range (9645-11257, 1042-1220) and my hypothetical re-set up trend (19 months) (10398-13666, 1086-1220). 

Supporting  the technical argument that stocks are in the process of re-establishing an up trend are several factors that I have mentioned frequently over the last month: (1) the manner in which the S&P blew through the 1149 resistance level, (2) the historic behavior of stocks after they negate a head and shoulders formation, (3)  the historic behavior of stocks when they successfully complete a reverse head and shoulders and (4) the historic behavior of the third year of the presidential cycle--the strongest of the four year cycle).

To those, I would add (5) a break down in the technical pattern of the VIX--a positive for stocks and (6) a golden cross in the S&P and NASDAQ [when the 50 day moving average breaks above the 200 day moving average--historically a sign of higher prices.
 http://stockcharts.com/h-sc/ui?s=$SPX&p=D&b=5&g=0&id=p56241293446&a=173595175

Of course, it doesn’t matter how many technical factors I list that argue for higher prices, if stock prices don’t go up, it is all mental masturbation.  So my hypothetical re-set up trend is just that--hypothetical; and this week’s churning pin action wasn’t exactly a ringing endorsement for higher prices.   Nevertheless, at the moment I will continue to  focus on (1) the upper boundaries of the indices trading ranges [11257-1220] to see if they provide strong enough resistance to prevent higher prices and (2) the former upper boundaries of the current range which were resistance now turned support levels [10725, 1149]--if they provide support I would interpret that as a signal that there is a rising bid under the Market and a promising sign that ultimately the up trend will be re-set.

Bottom line:

(1) short term, the indices are in a trading range 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, the Averages are in a very long term [78 years] up trend defined by the 4187-14789, 644-2000 and a shorter but still long term [13 years] trading range defined by 7148-14198, 766-1575. 

   Fundamental-A Dividend Growth Investment Strategy

    The DJIA (11132) finished this week about 11.3% above Fair Value (9994) while the S&P closed (1183) around 4.5% 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.   Unfortunately, there are a number of risks to this scenario that could result in having to lower some important assumptions.  To be clear, these are new forces that would [actively] push economic activity down and are in no way related to the now ‘old’ ‘double dip’ argument that postulated an economy [passively] rolling over as a result of running out of steam.  The risks include: Angel   QE2 which if fully implemented would fuel inflation and could quite likely exacerbate the trend toward ‘competitive devaluation’ and Beer foreclosure-gate which could turn into another banking system nightmare--although to be clear at this point in time, this is a much murkier issue than QE2,
 
(2)    November 2 will bring gridlock to Washington--but nothing more.  The biggest risk to this assumption is that the democrats do better in the elections than is now expected and the current spend, tax and regulate agenda continues. I believe that the long term secular economy growth rate would slow and inflation would get a boost. However, I don’t think that there is a high probability of this scenario occurring.  

Of course, at the top of most investors’ wish list is a republican sweep and the immediate reversal of the current economic/political/social program.  Unfortunately, the polls don’t suggest a democratic thumpin’ nor has there been indication that the republican establishment understands the need for a dramatic reversal or  is any more inclined to reversing the current administration’s policies.

    None of the above suggest any urgent need to build our Portfolios’ equity positions. However, ex this week’s churning action, the technical strength of the Market has been pointing to higher prices; and, as you know, I have been conflicted by this divergence in the technical and fundamental factors.  Of course,  this past week’s pin action can’t be ignored; and whether it was just a pause that refreshes or an early sign that the bulls are running out of steam, it is too early to tell.  So my internal struggle will continue until there is clarity on this point.  The good news is that prices presently are at a level that doesn’t argue for action in any case.  So for the moment, I will remain on the sidelines and wait for either the battle between the technicals and fundamentals to resolve itself or the price action forces me to resolve my own cognitive dissonance.
    http://www.ritholtz.com/blog/2010/10/forbes-interview/

          This week, our Portfolios bought back one half of the GLD positions that were Sold last week.
 
           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                                                      11132                   1183

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 10-23-2010 8:24 AM by Steve Cook