The Closing Bell-4/16/2011
Steve Cook on Disciplined Investing

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Note: the next month or so is going to be a tough one for me.  My father has gone into the hospital with kidney failure.   That will likely require numerous trips back and forth from his home which is about two hours away.  In addition, we just sold our house and bought a new one.  Gosh only knows the amount of down time the move will require.  I will always be in touch with the Market and communicating however briefly on any action taken in the Portfolios.  However, the daily comments may be less than consistent.

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                            11890-15312
        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                          1250-1679   
         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                  21%
    High Yield Portfolio                             21%
    Aggressive Growth Portfolio             22%

*includes the 3% VXX position

Economics
   
The economy is a modest positive for Your Money. 
The economic data this week was mixed. Positives included industrial production, the NY Fed’s latest manufacturing survey and the preliminary April University of Michigan survey of consumer sentiment; negatives: mortgage applications and weekly jobless claims.  This lack of uniformity fits our Economic Model perfectly; so that keeps our current forecast in tact: (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. 

Higher inflation than even I am forecasting remains the largest near term risk to our outlook. This problem will almost surely be aggravated by the aggressive expansion of liquidity by the Japanese central bank.   To be sure, there are many that would argue that neither the PPI nor CPI, which were reported this week, are in the red zone.  Nevertheless, there are signs of rising inflationary pressures in particular a study that shows inflation calculated as it was in the 1970’s stagflation period is approaching a 10% annualized rate.  In addition, the monetary substitutes of gold and silver for fiat currency are clearly pointing to higher prices.

Further supporting this notion is the fact that fiscal policy remains basically out of control which keeps pressure on the Fed to monetize the government’s massive increase in debt. While we did get a compromise in spending cuts to the 2011 fiscal budget this week and while it did have some symbolic value, in the scheme of things, it will do little to solve our budget problem.  Moreover, a careful read of Obama’s counter to the Ryan budget was mostly fluff; plus His rhetoric suggests that the likelihood of achieving significant cuts in spending before the 2012 elections are very small.  So this source of demand on the Fed to be accommodative isn’t going to lessen for at least 18 months.

I am also becoming increasingly concerned that our outlook for economic growth may be too high.  At the moment, we are still below consensus though in the last week or so, Market forecasts seem to be coming down.  Where everyone is in agreement is the worry that high and rising commodity costs will dampen consumer demand and negatively impact corporate profit margins.  In my opinion, there is insufficient data as yet to warrant changing our forecast; but this is a mounting concern.

On the international scene:
 
(1)    the Japanese situation remains uncertain.  We still don’t have a clear idea of how they are going to neutralize the nuclear disaster, the geographic extent of the fallout damage or the shape of their recovery plan.  In the meantime, as noted previously, the printing presses are going 24/7 and that is not helpful in any attempt to quell inflationary pressures.

(2)    the continuing turmoil in the Middle East threatens future oil supplies and prices.  This week’s edition featured Qaddafi riding through the streets of Tripoli in an open car [embarrassing], the MSM running  clips of Gates saying the US was no longer involved in combat in Libya followed by one of US planes bombing Libya [pathetic] and new and larger riots in Syria.  Outside of Libya, nothing has happened yet that would seriously threaten oil supplies; but with the current unrest and the likelihood of Iranian mischief, the risks to oil supplies and prices remain.

(3)    the EU sovereign debt problem just gets messier.  Greece regained center stage this week suggesting that it will need further bailout assistance in 2012, illustrating once again that every ‘fix’ is just a wish and a prayer and only serves to kick the can down the road.  This strategy will come to an end at some point and it probably wouldn’t be of the fairy tale variety.  The included link analyzes Germany’ s latest response to the Greeks..
http://www.nakedcapitalism.com/2011/04/will-german-push-for-greece-restructuring-tank-greek-banking-system.html
 
Bottom line:  the economy is recovering at a below average secular pace accompanied by an increasing rate of inflation.  My principal concerns at the moment are (1) rising commodity price inflation and (2) that this is/will ultimately wreak havoc with consumer confidence and corporate profit margins rendering even our below consensus forecast too optimistic.  Not helping consumer confidence is the failure of our political class to address their lack of fiscal responsibility.  That condition is not apt to be remedied till after the 2012 elections, if then.  For the moment, I am leaving our Economic Model unchanged; but the risk is increasing that I may have to lower some assumptions on growth and/or raise them on inflation. 

This week’s data:

(1)    housing: weekly mortgage applications declined as did purchase applications,
 
(2)    consumer: weekly retail sales were mildly positive, while March retail sales were slightly weaker than expected; weekly jobless claims were up much more than forecasts; the April preliminary University of Michigan survey of consumer sentiment came in at 69.6 versus estimates of 68.0 and March’s final reading of 67.5,

(3)    industry: March industrial production was almost double estimates; February business inventories increased less than anticipated; the April New York Fed’s manufacturing survey was very strong; small business sentiment was down in March,
 
(4)    macroeconomic: March CPI came in a bit above expectations though core CPI was slightly less; on the other hand, March PPI was below estimates while core PPI was above forecasts; the March budget deficit was larger than expected as was the March trade deficit.

     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 12341, S&P 1319) finished the week well within their intermediate term up trend (11890-15312, 1250-1679) and their short term trading range (11554-12405, 1247-1345). 

The S&P continues to develop into a reverse head and shoulders formation.  The significance of this being that in technical land a break of the neckline (1345) would point to much higher prices.  If this occurs, it would clearly put the pin action at even greater odds with our Valuation Model than it already is. 

The obvious issue then becomes, how would our Portfolios respond to this even greater divergence in technical/fundamental factors?  I could, of course, elect to continue to resist Adding to stocks--which has been relatively easy to do of late because stocks have gone nowhere since mid February.  However, a break out to the upside would alter the terms of the game; and as I have said many times, this game is not about being right, it is about making money.  But, even if I decide not to argue with the Market, my investment choices are limited primarily because our Portfolios have already Bought all the stocks on our Buy Lists.  Nevertheless, some alternatives do exist including Adding selectively to our foreign ETF’s, in particular Canada, our gold (GLD) holding and, if I can bring myself to it, establishing a trading position in the S&P ETF. 

That said, my focus will not be diverted from our Sell Discipline.

Following GLD’s break out of that extended pennant formation/sextuple top last week, it has performed in text book fashion, i.e. a strong move up.  So far I am enjoying the ride.

Bottom line:

(1) intermediate term, the DJIA and S&P are in an up trend defined by 11890-15312, 1250-1679; 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 (12341) finished this week about 19.6% above Fair Value (10322) while the S&P closed (1319) around 3.4% overvalued (1276).  I have dwelled on the disparity in current prices and our Valuations ad nauseum, so it seems pointless to rehash the same old arguments except to say that nothing has changed to alter them.  Indeed as I stated above, if anything this divergence could increase because our Economic Model and by extension our Valuation Model  may be too optimistic.

And in fact a deteriorating economic environment may only lead to a widening in the price/valuation gap.  I have speculated that since I could find no economic or valuation reasons to explain the current price/valuation discrepancy, the most likely cause was the very generous liquidity policy of the Fed.  If that is so, then a slowing economy, with little or no improvement in the employment or housing numbers may only serve to make the Fed even more accommodative.  Furthermore, as became apparent this week, our fiscal problems are not likely to be resolved in a responsible way until at least 2012; and as long as the government is running massive deficits, the pressure will be on the Fed to print the money to pay for them. 

When this merry-go-round (higher commodity prices slow growth which prompts more easing [and higher stock prices] which prompts even higher commodity prices which........you get the picture) stops, I have no clue.  But I think foreign ETF’s and gold will probably do well in that environment; hence, that is my focus on the Buy side.  How it stops, however, will not likely be pretty.  Either the political class including Bernanke steps up and administers the painful remedy or the Markets will do so.  In either case, stock prices will likely trade lower. So I continue to focus on our Sell Discipline.

Of course tomorrow, the Fed could begin tightening monetary policy and our elected representatives could spring as full grown adults from the head of Zeus; and nothing would make me happier.  I eagerly await that or signs that the economy is improving in a manner that would prompt a change in our Models.  But until one or the other happens, caution is a virtue.  

This week, our Portfolios made no changes.

           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 4/30/11                                 10322                  1276
Close this week                                                12341                  1319

Over Valuation vs. 4/30 Close
      5% overvalued                                           10838                    1339
    10% overvalued                                           11354                      1403 
    15% overvalued                                           11870                     1467
    20% overvalued                                           12386                    1531

Under Valuation vs. 4/30 Close
    5% undervalued                                            9805                    1212
   10%undervalued                                            9289                    1148
    15%undervalued                                          8773                    1084

* 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 04-16-2011 12:42 PM by Steve Cook