The Closing Bell-3/19/11
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 Trading Range                     11554-12405 (?)
          Intermediate Up Trend                           11624-15148
          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 Trading Range                   1247-1345 (?)
        Intermediate Up Trend                            1220-1649   
        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                  20%
    High Yield Portfolio                             22%
    Aggressive Growth Portfolio             22%

*Excludes 6% invested in a muni bond ETF

The economy is a modest positive for Your Money. 
This week’s data was mixed though I would weigh it to the negative side.  However, there was nothing to cause me to challenge our forecast: (1) a below average secular rate of recovery resulting from too much government spending, too much government debt to service, too much government regulation, a financial system with an impaired balance sheet and a business community unwilling to hire and invest because the aforementioned, (2) the likelihood a rising and potentially corrosive rate of inflation due to excessive money creation and the historical inability of the Fed to properly time the reversal of that monetary policy.

Obama just doesn’t get it (medium):

As an aside, I am sure you noted that I have left the phrase ‘financial system with an impaired balance sheet’ in the litany of problems suppressing the rate of economic recovery.  I also sure that you saw the announcement on Friday allowing some banks to resume paying dividends.  That seems inconsistent you say.  And you are correct, sir.  The reason relates to (1) the incestuous relationship between Washington and Wall Street and (2) the fact that there is still no accounting for all the crap on bank balance sheets that is being carried at book value. 

As evidence, I submit that (1) as long as the Fed lends unlimited amounts of money to the banks at virtually 0% so that they can buy short Treasuries at 2% and book the spread risk free, it means that there is still damage to the banks’ ‘real’ capital that needs to be repaired, and (2) if banks are healthy enough to pay dividends, they are healthy enough to be lending.  Take a look at the latest data on C&I loans.  Yes, they are up; but not nearly to the level that they should be.  Also note, that paying dividends allows paying bigger bonuses (paying dividends, lowers equity, which raised return on equity, which is the basis for bonuses)--to the exact same group of guys that came within a short hair of driving our economy off a cliff.  Investors got jiggy with the dividend announcement on Friday, I think it a travesty.

Of course, economics were not the focus this week; rather investor attention was dominated by the tragedy in Japan.  There is not much to add to the comments already made this week; but I will repeat the conclusions: (1) we don’t yet know what we don’t know; so all scenarios remain on the table, (2) excluding the doomsday alternative, the overall impact of this disaster on the global economy will likely be Angel a fractional decline in growth and Beer additional upward pressure on inflation.

    The chief takeaway, at least, from what we do know is that Angel and Beer above potentially exacerbate my main worry over our forecast, i.e. that it may be too optimistic.  As you know, I have speculated that the explosion in commodity prices could ultimately put a brake on an already sluggish recovery.  The massive injection of liquidity by the Japanese central bank runs the risk of adding fuel to the speculative fever that has been driving commodity prices (read costs of production) higher Beer.  Rising raw material costs then lead to margin pressure among corporations (see Nike) and reduced consumption by consumers which potentially reduce global economic growth Angel. Any decline in Japanese growth would only add to the slow down Angel, no matter how small it may be.  I know that rising prices and declining economic activity seem inconsistent. To which I reply, go back and look at what happened in the 1970’s.

Internationally, there are other areas of concern:

(1)    continuing turmoil in the Middle East and the threat that it poses to oil supplies and prices.  Violence in Libya escalated this week.  By Thursday night the UN decided to get involved but may have been too late to affect the outcome.  In fact, depending on how Gaddafi reacts to this event [Saturday morning news says the pro Gaddafi forces are still on the attack], things could get much better or much worse.  In addition, Saudi Arabia sent troops into Bahrain to help that government put down demonstrations.  The final outcome of this period of unrest seems very uncertain.

(2)    EU sovereign debt problem:  it was relatively quiet in the EU this week although Moody’s did downgrade Portugal’s debt.  However, just because there was no news doesn’t mean the storm is over.  In fact, it probably hasn’t even begun in earnest.
Bottom line:  the economy is recovering at a below average secular pace as a result of inept monetary/fiscal management and an improperly functioning financial system.  However, there are potential headwinds that could render even this modest forecast too positive; they include: rising energy and other commodity prices’ impact on production costs and consumer demand; a bankruptcy or two among the PIIGS; a potential nuclear disaster in Japan and/or severe dislocations in the oil market brought on by possible and/or attempted regime change in the Middle East.   

This week’s data:

(1)    housing: continuing the very erratic pattern of late, weekly mortgage applications declined as did purchase applications; February housing starts and building permits plunged well below estimates,
(2)    consumer: weekly retail sales were again ever so slightly positive; weekly jobless claims were much lower than anticipated,

(3)    industry: February industrial production and capacity utilization were weaker than forecasts; both the March New York Fed and Philadelphia Fed monthly index of business conditions were much stronger than expected,
(4)    macroeconomic: February leading economic indicators came in below estimates; both the February producer price index and consumer price index were up more than 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.)

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

This week the Averages (DJIA 11850, S&P 1279) took out their short term up trend as well as the initial support level following the break.  That means that short term, the indices are in a trading range tentatively defined by Wednesday’s lows and the highs in the March 2009 to present up trend (11554-12405, 1247-1345).  Intermediate term, the Averages remain within their up trend (11624-15148, 1220-1649),

On a very short term basis, I am watching (1) the down trend off the recent high [which at the close Friday intersects at 11788, 1278] as an indicator that the recent correction could be over.  Of course, the DJIA clearly finished Friday over that level while the S&P closed right on it.  So Monday’s pin action should confirm or negate this trend line, and (2) the lower boundary of the intermediate term up trends to mark either the end of the current consolidation [if those boundaries hold] or the signal that a top has been made [if the boundaries don’t hold].  I await clarity before taking any action.

Like stocks, GLD continues to struggle to either hold its intermediate term up trend or re-set to a trading range; and like stocks, I wait clarity before taking any action.

Bottom line:

(1) intermediate term, the DJIA and S&P are in an up trend defined by 11624-15148, 1220-1649; short term they are in a trading range tentatively marked by 11554-12405, 1247-1345,.

(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 (11850) finished this week about 15.4% above Fair Value (10268) while the S&P closed (1279) around 0.07% overvalued (1270).  The clear affect of this week’s pin action was to bring stocks back to Fair Value--at least as measured by the S&P.  That, in turn, makes me a lot more comfortable putting money to work if we can get a bit more clarity on the technical side. 

Of course, just because the S&P is at Fair Value that doesn’t mean that (1) it can’t get cheaper, (2) all stocks are at Fair Value, (3) our Portfolios should rush to get fully invested.  Meaning that we want to stick to our Price Disciplines.  I say that because despite being willing to spend cash for stocks on our Buy Lists, there are still a number of stocks that are near their Sell Half Price.

As contradictory as that may sound, there have plenty of times when the indices are in a trading range but internally there are a lot shifts in values among market sectors and stocks.  So it would not be inconsistent to let’s say be Buying Pepsico on the same day that Caterpillar hits its Sell Half Range.  I don’t know that we are entering a period like that; I am just saying our Universe looks that way at this moment. 

Conveniently, that would not be inconsistent with our Economic Model: an economy that has attained a max cyclical growth rate that is sub par on a historical secular basis and because of that produces not only more erratic data points but also more Market sector volatility as investors seek relative value in an anemic recovery.

Having said all that, I am still very concerned that our Valuation Model could be pegging valuations too high because (1) the Fed has reached the point of no return [for spiking inflation rates in the near future] on tightening monetary policy and/or (2) the already high energy, food and industrial commodity prices could lead to an even slower rate of economic growth than I am forecasting.  That adds to my hesitancy to spend a lot of cash in an apparent Fairly Valued Market.

This week, our Portfolios Sold the Emerging Market Local Currency Bond ETF to lock in a small profit on a risky cash substitute.

           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 2011 Year End Fair Value*                 10760                 1330
Fair Value as of 3/31/11                                   10268                    1270
Close this week                                                  11850                  1279

Over Valuation vs. 3/31 Close
      5% overvalued                                            10781                    1333
    10% overvalued                                             11294                     1397 
    15% overvalued                                            11808                    1460
    20% overvalued                                            12321                    1524

Under Valuation vs. 3/31 Close
    5% undervalued                                             9754                     1206
   10%undervalued                                             9241                     1143
    15%undervalued                                              8727                    1079   

* 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 03-19-2011 11:07 AM by Steve Cook