The Closing Bell-12/18/2010
Steve Cook on Disciplined Investing

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Next week, we leave Wednesday morning to visit my father, then my wife’s family for Christmas.  We then go to Santa Fe to spend New Year’s with good friends.  So no Morning Call or Closing Bell from Thursday 12/23/10 to 1/2/11.  As always I will have my computer with me and will stay in touch with the Market.  If action is required, I will communicate via Subscriber Alerts.  I wish you all a very Happy Holiday.

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                                 10819-14350
         Long Term Trading Range                         7148-14180
         Very LT Up Trend                                         4187-14789   
               
     2010    Year End Fair Value (revised)            10095-10115
 
     2011    Year End Fair Value                            10750-10770

  Standard & Poor’s 500

      Current Trend (revised):
         Short Term Up Trend (?)                                 1132-1555
          Long Term Trading Range                             766-1575
          Very LT Up Trend                                             644-2000

      2010    Year End Fair Value                               1240-1260   

     2011    Year End Fair Value                                 1320-1340

Percentage Cash in Our Portfolios*

    Dividend Growth Portfolio                  17%
    High Yield Portfolio                              17%
    Aggressive Growth Portfolio              15%

Economics
   
The economy appears to be transitioning into a modest positive for Your Money.
  This week’s economic data delivered that message in spades.  To be clear, it provided more evidence that the economy is indeed recovering not slipping back into a ‘double dip’; it did nothing to lift my expectations that economic rebound will be anything other than at a below average secular rate.

There were two very positive political/economics stories of this week:

(1)    passage by both chambers of congress of the Obama/republican tax compromise.  I believe this to be a positive because Angel it is a hopeful sign that Obama is shifting to the center {admittedly something I had thought very unlikely} and Beer as a tax cut stimulus package, it should prove much more effective than the Stimulus I big-government-spending bill.

That said, there are caveats to both Angel and Beer above:  Angel ‘hopeful sign’ are the operative words.  Our economy needs a lot more bipartisan cooperation with tax cuts/reform, spending cuts, regulatory reform and free trade agreements if we are to have any hope that it returns to a normal secular rate of growth.  That means that there has to be constructive legislation that will occur only if Obama’s shift to the right becomes permanent; gridlock this time around simply won’t get the US economy out of its current hole.  Beer these tax cuts in the first instance will only blow another $1 trillion hole in the deficit.  They have to accompanied by {i} spending cuts and {ii} an improvement in consumer/business sentiment that leads to a more vigorous rate of economic growth which in turn results in increased tax receipts.

(2)    the senate voted down a horrendous [my opinion] $1.1 trillion earmark ladened omnibus [spending] budget  bill for FY 2011.  Aside from the obvious benefit of avoiding one more budget packed with irresponsible spending, there are two additional positives: Angel it will now fall to the new congress to construct the 2011 budget.  Rep. Paul Ryan will become the chairman of the house budget committee; and his stated intent is to move the base line spending back to the 2008 level.  The aforementioned budget bill had moved that base line spending up from the 2010 level.  The net effect should be lower government spending in FY 2011.  Beer the budget bill contained the initial funding installment for Obamacare which would have been nearly impossible to reverse since it would have had to overcome an Obama veto.  Now the republicans can choose not to fund it in the first place.

Not that everything is coming up roses.  There are still problems out there that can mitigate the positives that should come from lower taxes and, hopefully, lower spending.

(1)    QE2: the Federal Open Market Committee met this week and reiterated its concern about the economy.  It left interest rates unchanged and reiterated in unequivocal terms its intend to take QE2 to fruition.  Absent the tax compromise, I think that pumping another $600 billion into banking reserves will prove unnecessarily inflationary.  However, if the tax bill accomplishes its intended purpose, the added liquidity will be even more problematic.  This is not to say that the Fed won’t alter its policy if it sees the facts changing.  However, historically, the Fed has never [and never is a very long time] gotten its timing correct--the main problem always being saying too tight (loose) too long.
 
(2)    foreclosure-gate isn’t going away,

(3)    the EU sovereign debt problem:  It too is not going away and it is not going to end well.  The end game is likely a default, devaluation or withdrawal from the EU. This week we got rating cuts for Ireland, rioting in Spain and the continuing debate over who will be baring the risks of default, etc--the taxpayers or the debt holders. That is a rough choice in which the best alternative is still bad.  I haven’t a clue how this plays out; however, after seeing the extent of the exposure of US banks [I linked to the data in a Morning Call] to this problem, I am not nearly as sanguine about the outcome as I have been to date.

    Bottom line: not much change: ‘the economy is in a recovery characterized by below average secular growth.  In my opinion, the only thing that could change that forecast is government that is more fiscally responsible and more pro-capitalist.  We got a whiff of hope that this could happen this week with the Obama/republican tax compromise.  To be sure, ‘whiff’ is the operative word; much more is needed before there is a chance of an improved economic outlook (with the passage of the tax compromise and the lack of passage of the senate omnibus budget, I would upgrade ‘whiff’ to ‘the first concrete sign’). 

I have attempted to account for the other potential problems listed above (except foreclosure-gate) in our Models.  However, as I have noted repeatedly, any one of them could derail our recovery if I am wrong in my assumptions regarding them.’

This is a very thought provoking article on the potential relationship between income inequality and economic malaise (a must read):
http://www.nakedcapitalism.com/2010/12/guest-post-extreme-inequality-helped-cause-both-the-great-depression-and-the-current-economic-crisis.html

This week’s data:

(1)    housing: weekly mortgage applications fell 2.3%; however, November housing starts rose 3.9% which was better than expected,
 
(2)    consumer: weekly retail sales were mixed--again; though November retail sales were up almost twice what was anticipated; weekly jobless claims fell by more than forecasts,

(3)    industry: October business inventories rose and sales increased even more; November industrial production came in above estimates; both the New York and Philadelphia December indices of general business conditions were much better than expected,

(4)    macroeconomic: the November leading economic indicator increased in line with expectations; both the producer and consumer price November indices came in very tame--as anticipated.

    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 is a neutral but could be improving for Your Money while the international political environment remains a negative.
   
The Market-Disciplined Investing
    
  Technical

The Averages (11491, 1243) had another decent week, both closing within their up trends (10819-14350, 1132-1555).  Volume has been satisfactory; and on Friday, the VIX did an elevator move to finish so far outside its trading range that our ‘distance’ criterion is confirming a re-set to a down trend.  Since Friday was quadruple witching, I am going to hold off making that call till Monday just in case there was some funny business in the expirations trade.  However, assuming Friday’s pin action reflects investor bets, this indicator is now a big positive for stocks.   

And lest we forget, it rejoins the other the other powerful technical forces which I have previously brought to your attention that are fuel for rising stock prices.  They are: (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)., (5) the 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].

My big hang up, as you know, is breadth, which is at a level historically marked by consolidation/sell offs.  As you also know, my stated strategy is to commit additional cash if stocks resume their up trend.  That has happened but on declining breadth.  I still intend to put some cash to work but only after the current overbought/declining breadth condition corrects itself.
    http://www.marketwatch.com/story/sentiment-has-taken-turn-for-the-worse-2010-12-17

    Gold rebounded on Friday, finishing above the outside limit of the ‘distance’ element of our time and distance discipline.  However, it remains below the lower boundary of its short term up trend--which means that the ‘time’ element is still operative.  A close below that boundary on Monday would confirm the break and would prompt the sale of a third of our Portfolios’ positions.

    The bull case for gold (medium):
    http://www.minyanville.com/businessmarkets/articles/precious-metals-investing-in-precious-metals/12/17/2010/id/31760?camp=featuredslide&medium=home&from=minyanville

    A review of the January effect and the presidential cycle (medium):
    http://www.mebanefaber.com/2010/12/14/will-the-january-effect-and-the-presidential-cycle-combine-for-a-big-january-in-stocks/

Bottom line:

(1) short term, the S&P and DJIA are in an up trend defined by 1132-1555, 10819-14350.

(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 (11491) finished this week about 13.7% above Fair Value (10105) while the S&P closed (1243) around 0.6% undervalued (1250).  Clearly, on the assumptions in our Models, the valuations provide little reason to push to get fully invested. 

That said, the passage of the tax compromise bill with what in retrospect proved to be a minimum of democratic pissing and moaning plus the ease with which the senate- initiated omnibus budget bill went down in flames are promising signs that the economic/political environment is changing to the positive.  Indeed, if we could be sure that (1) the center of gravity of political/economic policy had shifted away from the left and (2) that consumers and business will respond favorably by increasing spending, investing and hiring and if we didn’t have (1) QE2 and (2) the EU sovereign debt crisis to worry with, I would be considering raising our growth estimate for 2011.

Unfortunately, those problems remain though over the intermediate term there is at least some probability of better news.  Certainly, Obama’s rightward move could be for real; and clearly we will know whether He has or not within the next three to six months. Likewise, any improvement in consumer and business sentiment will be making its way into the data in the same time frame. 

As far as Bernanke goes, I haven’t given up all hope.  If the above two conditions transpire, surely he will put an early end to QE2.  That said as I have observed on numerous occasions, the Fed has an absolutely atrocious habit of overstaying any tightening/loosening moves; so I think it absolutely essential that it NOT be given the benefit of the doubt. 

Finally and regrettably, I can see no good way out of the EU debt problem.  These guys have created such a mess and irresponsibly refused to deal with it for such a long period of time, that there just doesn’t seem to be even a semi-painless solution.  Making matters worse, this week I saw for the first time the extent of US banks’ exposure to this tragedy; and I am now tinkering some of the assumptions in our Economic Model to reflect this new information.  I haven’t completed the process yet, but common sense tells us that it won’t have a positive effect,

The bottom line: the economic data this week was quite positive though not so much so as warrant a change in our Economic Model.  The political developments were unquestionably a plus and if we see a continuation, then some mark up in the assumptions in our Models will be necessary (remember right now our key political assumption is gridlock).  As noted above, I am in the process of adjusting our Economic Model to reflect a higher exposure of US banks to EU debt than I previously assumed. 

If we get any improvement in breadth to go along with an already strong technical picture and given the increasingly likelihood that a better political/economic environment could motivate investors to stretch for 2011 Year End Values, our Portfolios will take their current cash position from 17% to 12-13%.  That said because there continue to be   a number of very visible factors that could have both positive and negative affects on stock values, our strategy more than ever must include the willingness to quickly recognize any flaws in our analysis and the flexibility to react promptly.
 
           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 12/31/10                                      10105                    1250
Close this week                                                       11491                  1243

Over Valuation vs. 12/31 Close
      5% overvalued                                                  10610                    1312
    10% overvalued                                                  11115                    1375 
    15% overvalued                                                  11620                   1437

Under Valuation vs. 12/31 Close
    5% undervalued                                                   9599                   1187
    10%undervalued                                                  9094                   1125
    15%undervalued                                                   8589                    1062   

* 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 12-18-2010 12:36 PM by Steve Cook