The Closing Bell--11/13/2010
Steve Cook on Disciplined Investing


Have You Seen This?


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Have You Seen This?

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%


      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 (?)                        10526-13875
           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 (?)                            1107-1525
            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                  17%
    High Yield Portfolio                             17%
    Aggressive Growth Portfolio              15%

The economy is a neutral for Your Money. 
This week was a slow one from the perspective of new economic data. Nevertheless, most of it was positive, further confirming our forecast of an economy growing at a below average secular rate and likely to continue to do so; plus there was nothing to suggest a ‘double dip’ will occur.  However, like last week, politics, macroeconomic issues and the Fed continued to dominate the information flow. 

(1)    in the political arena, the most significant development was the release of a draft of Obama’s deficit reduction commission recommendations. I have discussed the most  important of them in our Morning Calls as well a linking to additional analysis.  So I will only repeat my conclusion: this is potentially the most positive political/economic news that we have had in ten years.  If the commissions proposals were enacted as is, it would put the US government back on the path to fiscal responsibility, open the possibility of the US economy returning to its [higher] historical secular growth rate, would likely lift business sentiment leading to increased investment and hiring and increase investor confidence [higher valuations].  Of course, that is not going to happen anytime soon; but it finally starts an adult conversation about one of the two most significant economic problems this country has faced in my lifetime [the other was the bout with inflation in the Nixon/Carter era].

We also got a hopeful sign from Obama that He was willing to extend the Bush tax cuts.  Unfortunately, it was delivered with head fakes, obfuscations and contradictions, as He attempted to dance around His base supporters.  But most progressive and conservative political observers alike seem to agree that it is going to happen.  That is a positive.  On the other hand, Obama totally mucked up the South Korean free trade agreement that was supposed to be signed while He was in Seoul.  That is a negative.  Net, net that leaves me skeptical that any significant fiscal reform can occur during an Obama presidency.

However, as I observed last week there is a ‘possibility that Angel the democratic senators up for re-election in 2012 will be sufficiently concerned about the November 2 results that they will go along with republican efforts to make fiscal, regulatory and trade policy more responsible, Beer businessmen interpret the outcome of the elections more positively than I and begin investing and hiring at a level not anticipated in our forecast and Coffee Obama may surprise us all and actually be willing to compromise.  At this point, there is no way of handicapping the likelihood of any or all of these occurring, so all we can do is wait and see.’.....but any or all of them would be positive.
(2)    the Fed announced its first month’s action on QE2 and implemented it starting yesterday; so there appears to be no reprieve here.   I continue to believe that if the Fed pushes another $600 billion of liquidity in to the financial system over the next eight months, things will end badly ‘for currency/trade [risk a global race to ‘beggar they neighbor’/’competitive devaluation’] and inflation [higher]’.

Simultaneously, the Chinese reported an unexpectedly high inflation number and suggested that higher interest rates were coming.  Depending on how aggressively they pursue a tighter monetary policy, it could negatively impact [i.e. offset the potential ‘benefits’ of] QE2.  If that were to lead to the Fed abandoning this policy, it would be a positive; if it causes the Fed to redouble their efforts.........well, then we are really in deep kaka.
(3)    foreclosure-gate isn’t going away.  We keep getting more anecdotal evidence of malfeasance and incompetence on the part of the bankers, although it is still not possible to quantify the potential liability [hit to the banking systems capital base].  Until we can, this will continue to overhang the Market.

(4)    finally, like a bad case of herpes, the EU sovereign debt problem is back.  Irish, Greek and Spanish government bonds took it in the snoot this week; and concerns mounted about bank failures and a slowing in European economic activity.  While this all had a salutary effect on the dollar, longer term additional turmoil and the potential for large reductions in bank capital is not a positive for US economic outlook.

    Bottom line: the economy is in a slow, drawn out recovery.  Unfortunately, the Fed’s insistence on pursuing QE2 (pushing up inflation) and the potential of further damage to capital base of the banking system (inhibiting capital investment) from foreclosure-gate and/or the EU sovereign debt problem could potentially harm this rebound.  On the other hand, we got a second ray of sunshine on political economy this week with release of the draft of the deficit reduction commission.   So far, I have made no changes to our forecast as a result of any of the above; although clearly as developments occur, they all have the prospect of altering our outlook.

This week’s data:

(1)    housing: weekly mortgage applications rose 5.8%;
(2)    consumer: weekly retail sales were positive; weekly jobless claims were better than expected; the University of Michigan’s initial November index of consumer sentiment came in at 69.3 versus estimates of 68.5 and the final October reading of 67.7,

(3)    industry: September wholesale inventories rose more than forecast though sales did not keep pace,
(4)    macroeconomic: the October budget deficit was less than expected while the September trade deficit was in line with estimates.
    The Economic Risks:

(1)    the economy is weaker than expected.

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

This 9 minute video interview with Nassim Taleb (author of the Black Swan) is a must watch:

(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.)

The domestic political environment is a neutral for Your Money while the international political environment remains a negative.
The Market-Disciplined Investing

The Averages (11192, 1199) had a pretty rough week.  While the DJIA managed to re-set from a trading range to an up trend, the S&P couldn’t successfully challenge the  upper boundary of its trading range.  However, by week’s end, both were back below the  upper boundaries of their recent trading ranges (11257, 1220).  That raises the question as to which of the two divergent performances was the outlier?  Perhaps the answer lies with the how they manage the lower boundary (support) of their very short term up trends (11253-11900, 1203-1281); and you will note that each Average violated  their respective trend line.  Our time and distance discipline is operative; so I am not saying these tends lines are broken yet,  We will have a better feel by Tuesday.  If prices rally and sustain those short term up trends, then my money is still on the longer term up trend off the March 2009 low (10525-13875, 1107-1525) being the controlling trend.  If the short term trend is busted, then the old trading ranges (9645-11257, 1042-1220) will probably be the dominant trend.

So equities close the week battling with several support/resistance levels and with our time and distance discipline acting as a restraint on any action.  Until there is clarity, I remain on the sidelines.

    For the bears (medium):

Bottom line:

(1) short term, the indices closed the week amidst uncertainty over whether stocks are in a trading range defined by 9645-11257, 1042-1220 or an up trend marked by 10526-13875, 1107-1525,

(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 (11192) finished this week about 11.3% above Fair Value (10049) while the S&P closed (1199) around 3.6% undervalued (1244).  That proximity to Fair Value suggests little need for action.  However as you know, I have been fretting the last couple of weeks over a multitude of potential problems that could impact Valuations.

And yet investors have largely ignored them--that is until late this week.  First off, the EU sovereign debt crisis appears to have reached critical mass (again) and investors are worried about the potential impact on bank capital (the ability/willingness to lend and finance growth).  While I haven’t seen any recent estimates of the magnitude of any losses that might be incurred by the financial system, I have included assumptions regarding their effect on global economic growth in our Economic Model and by extension in our Valuation Model.  To be sure, those assumptions could prove to be wide of the mark.  Nevertheless, until we know more about the ultimate scope of this problem, our Models will be unchanged.  In other words, to the extent of our knowledge, this problem is priced into Valuations and hence there is no reason to believe that, on its own, it will push prices lower.

The other concern which surfaced Friday after the Chinese reported a ‘hot’ CPI number, was the fear of a tightening in their monetary policy (higher interest rates, slower economic growth).  As you may recall, this isn’t the first time that this worry has popped up; and the previous analysis that I studied (and linked you to) largely suggested that any moves by the government would be directed at real estate speculation not an overheating economy--and for a very good reason: the Chinese government has two huge problems: (1) it doesn’t rule with the consent of the governed and (2) there is a mass migration going on in that country from farms to the cities.  All those new workers have to either be given gainful employment or they become potential protesters/rioters/revolutionaries--which is a problem for any government but it is especially dangerous for one that is imposing its will on a billion or so people.  The point here is that I don’t think the Chinese government will institute any measure that will significantly impede the growth (job creation) of the country (or global economic growth).

However, as I noted above, there is the potential that a rise in Chinese interest rates could serve to at least partially thwart the Fed’s QE2 objectives; that is, the Fed is trying to stimulate the US economy with cheap money.  If global interest rates rise then so to will US rates and then money becomes ‘less cheap’.  That said, how many times have a lamented in these pages the potential negative outcome of QE2?  Therefore, any thing that might force Bernanke to cut/slow down/stop the printing of more money is a positive (in my opinion) for the economy.

Here is a less sanguine assessment (medium):

The bottom line to all this discussion is that nothing in this week’s events prompts me to alter the growth assumptions in either our Economic or Valuation Model; hence, I don’t see a lot of downside to stock prices--certainly not enough to push them below the lower boundary of the recent trading range.

On the other hand, they could have an impact on inflationary expectations and that would effect our GLD position.  Any further weakness in gold that is confirmed by our time and distance discipline will likely result in some lightening up of this position.

Update on last quarter’s earnings ‘beat’ rate (chart):

If you own or are thinking of owning bonds, you need to read this (medium):

Our Portfolios took no action this 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 11/30/10                                         10049                    1244
Close this week                                                          11192                   1199

Over Valuation vs. 11/30 Close
      5% overvalued                                                     10551                    1306
    10% overvalued                                                     11053                     1368 
    15% overvalued                                                     11556                    1430

Under Valuation vs. 11/30 Close
    5% undervalued                                                     9546                         1181
  10%undervalued                                                        9044                      1119
    15%undervalued                                                      8541                      1057   

* 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 11-13-2010 11:26 AM by Steve Cook