The Closing Bell-3/26/2011
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 Trading Range                               11554-12405
        Intermediate Up Trend                                      11722-15146
        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                                    1228-1657   
       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              21%

*Excludes 6% invested in a muni bond ETF

Economics
   
The economy is a modest positive for Your Money
though this week’s data will likely have some pundits questioning their optimistic forecasts.  The numbers were almost universally negative: housing and industry stats were awful; consumer data was mixed though some made a big deal out of weekly jobless claims being down 3,000 versus expectations of down 2,000; and the final fourth quarter GDP came in slightly better than estimates. 

These results certainly provide no reason to raise our GDP growth rate assumptions; indeed, if anything my concern is that I may need to lower them.  However, since I have been preaching that we can only expect erratic improvement in an anemic recovery, I need to heed my own advice and hold off getting too beared up about the outlook.  So for the moment it remains: (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 historic inability of the Fed to properly time the reversal of that monetary policy.

Of course, this week the domestic economic data took a back seat to international economic/political events--again:

(1)    Japan seems to be getting control of the problems surrounding the potential health and safety issues resulting from the damage to the nuclear reactors.  There are still things that we know that we don’t know; but that threat is shrinking.  My focus now is on how the earthquake/tsunami/nuclear disaster will impact Japanese [global] growth both short term and long term. I want to be sure that we don’t over emphasize what will almost surely be the initial, though transitory, negative blow to Japanese [global] GDP while ignoring the positive longer effects of rebuilding. 

Right now, I am most worried about how the Japanese central bank’s  massive short term liquidity injection influences global inflation.  Specifically, it runs the risk of adding fuel to the current speculative fever that has been driving commodity prices higher which in turn leads to margin pressure among corporations and reduced consumption by consumers. The end result is lower global economic growth.

(2)    the continuing turmoil in the Middle East threatens future oil supplies and prices.  I have made it clear what I think of US involvement in Libya; but the real problem is what happens to its oil production; and right now, I haven’t seen any projected end game that adequately addresses this issue.  Of course, we should all be so lucky that Libya was the only problem. Unfortunately Angel violence continues in Yemen and has spread to Syria and Israel/Gaza, Beer the media seems to have forgotten about Egypt, but it is not clear that all is well in that country, Coffee the Saudi and Bahraini monarchies continue to attempt to ‘buy off’ their protestors with uncertain results to date and finally Drinks and most importantly, reports of Iranian subterfuge throughout the Arab world  could lead to a Sunni/Shi’ite face off.  All in all, not a set of scenarios that instill confidence in  stable oil supplies and prices.

(3)    the EU sovereign debt problem hasn’t disappeared.  This week Portugal rejected austerity and its government resigned.  Meanwhile, it has to roll over about $6 billion in debt in the next thirty days and the EU is still fiddling with how to handle the conflicting sovereign demands of each country versus their need for financial assistance and the exposure that the major banks now have to any default.  The Euros may get this dilemma worked out; but it is not clear how and how much financial pain will be suffered and by whom as a result.  Until there is clarity, the potential exists for economic dislocations that will spill over into the global economy.
http://www.minyanville.com/businessmarkets/articles/portugal-portugal-economy-euro-sovereign-debt/3/25/2011/id/33567?camp=featuredslide&medium=home&from=minyanville

Bottom line:  the economy is recovering at a below average secular pace accompanied by an increasing rate of inflation.  However,  the risk is growing that I have underestimated the latter’s rise. If that is not concerning enough, there are potential headwinds that could render even our modest forecast for growth too positive; they include: rising energy and other commodity prices’ impact on production costs and consumer demand; a bankruptcy or two among the PIIGS; the liquidity impulse of the Japanese central bank exacerbating global inflation and 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: weekly mortgage applications rose as did purchase applications; February existing home sales dropped much more than anticipated while February new home sales fell off a cliff; January housing prices declined,
 
(2)    consumer: weekly retail sales were mildly negative; weekly jobless claims fell slightly more than forecasts; the final March University of Michigan index of consumer sentiment came in at 67.5 versus expectations of 68.2,

(3)    industry: February durable goods orders decreased versus estimates of a jump; two Fed bank indices of manufacturing activity were both below estimates,
 
(4)    macroeconomic: the final fourth quarter GDP number was slightly above forecasts while prices came in 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 (DJIA 12220, S&P 1313) finished the week well within both their intermediate term up trend (11722-15146, 1228-1657) and their short term trading range (11554-12405, 1247-1345).  Ultimately the difference in trend between these two must be resolved, i.e. with the short term trend turns up or the intermediate term trend goes flat;  although it appears right now that the powerful underlying momentum of this Market favors the former. As I have made clear, I do not understand or agree with the optimism driving that momentum; but I am obviously being out voted.  The dominant trend is up and will be until it is not; so I might as well enjoy it.

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

Bottom line:

(1) intermediate term, the DJIA and S&P are in an up trend defined by 11722-15146, 1228-1657; 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 (12220) finished this week about 19.0% above Fair Value (10268) while the S&P closed (1313) around 3.3% overvalued (1270).  I said in last week’s Closing Bell that I felt more comfortable with valuations with the S&P having retreated to near Fair Value.  As a result, our Portfolios Bought those stocks on our Buy Lists that they didn’t already own. 

However, I also noted that stocks being AT Fair Value didn’t mean that they couldn’t get cheaper; and, hence, I didn’t see it as a compelling reason to get fully invested, especially when considering the headwinds that the global economy and equity markets face.  That argument has even more meaning today with stocks having had a very strong week price wise in spite of lousy economic numbers and no improvement in either the Middle East turmoil or the EU sovereign debt problem. 

Furthermore, I am worried that our Valuation Model could already 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. 

Clearly, the fact that the current strong Market momentum conflicts with my perception of weak fundamentals that are being threatened from multiple sources frustrates me  to no end.  Of course, nobody promised me that this process wouldn’t be frustrating.  My solution is to not argue with the strength of this Market except where prices either enter their Sell Half Ranges or violate significant support.

This week, our Portfolios both (1) nibbled at stocks on our Portfolios’ Buy Lists, specifically Pepsico, Target and CF Industries and (2) Sold several stocks that broke major support levels (NKE, WAG) or hit their Sell Half Range (HD).

           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                                                 12220                  1313

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 03-26-2011 6:44 PM by Steve Cook