The Closing Bell-5/28/11
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                            ?-12919
           Intermediate Up Trend                           12266-15684
           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                             ?-1372
          Intermediate Up Trend                              1289-1718   
          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                             23%
    Aggressive Growth Portfolio             19%

The economy is a modest positive for Your Money. 
This week’s economic data was mixed.  The housing numbers were mostly positive as were the consumer stats; the industrial data showed a continuation of a softening trend in this sector; finally, first quarter GDP was revised down for a second time.  This pattern is virtually a mirror image of early in the year when the housing and consumer sectors showed little sign of life but the industrial stats were roaring.  All in all when coupled with the downward revisions of GDP, this fact pattern fits our forecast to a tee: (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. 

That said since I am always worried about where our forecast could be wrong, we do need to see the industrial sector stabilize in order to keep our forecast from going from below consensus to too optimistic.  Presently, there is insufficient data to raise this concern into the red zone; but a continuation for another month of lousy business data would start the amber light flashing.

The other side of this argument is that as the consensus’ growth rate assumptions have declined so have inflationary expectations.  Part of the reasoning is that a slowing economy accompanied by the end of QE2 will take upward pressure off prices--the operative words being ‘the end of QE2’.  I think that there is no better than an even chance this will occur; not necessarily because a sluggish economy will concern Bernanke but rather the mathematical (and political) necessity of the Fed having to finance the mounting US deficit.  Of course, it likely won’t be called QE3, but it will continue and it will still have an inflationary bias.

One other domestic economic item worth mentioning is the slowdown in the growth rate of corporate profits that was reflected in the GDP numbers as well as the S&P earnings as monitored by Bespoke.  As you know, I have been skeptical that corporate profits could continue their extraordinary roll.  To be sure, I underestimated the rapidity and magnitude of their recovery--a tribute to the extraordinary management of US corporate enterprises as well as my too low assumption regarding the strength of the foreign contribution to profits.  Nevertheless, my thesis that a sluggish economic rebound ultimately gets reflected in the rate of progress in business earnings I think was and is a correct one.  So I don’t see rising industrial earnings as a reason to assume a continuation of the extraordinary pace of the recent advance in stock prices.

On the international front:
(1)    data out of Japan reveal that its central bank is being much less aggressive in supplying liquidity to Japanese financial system in the wake of the nuclear disaster than I originally assumed.  That should mean less upward pressure on global prices than what otherwise might have been, 

(2)    while fighting continues in Libya, Yemen and Syria accompanied by turmoil in Pakistan, the issue of disruptions to future oil supplies and prices seems to be in the back seat for the moment.  Nevertheless, the threat remains,

(3)    the EU sovereign debt problem is back in the headlines.  Greece needs yet another bail out after having yet another budget lie to the ECB exposed.  The push back this time is harder than before but with the Chinese announcement this week [see Friday’s Morning Call] this can could very well get kicked down the road one more time.  My take is unchanged: this problem is not going away; you simply can’t resolve the difficulties of too much debt by issuing still more debt.  The more you try, the more painful the ultimate reckoning.

Bottom line:  the economy is recovering at a below average secular pace accompanied by an increasing rate of inflation.  That forecast has been below consensus until recently.  Now the growth assumptions for the industrial sector are slowing; and we have moved near the middle of the pack. At the same time though the Street is also lowering its inflation forecast.  So our outlook has now shifted from being below average on growth to being above average on inflation.  However, nothing in the data suggests a reason to alter either of our Models.

Why I think that our forecast is right on (short):

And (short):

This week’s data:

(1)    housing: weekly mortgage applications rose as did purchase applications; April new home sales were quite strong; April pending home sales fell 11.6%,
(2)    consumer: weekly retail sales were mildly positive; April personal income and spending were both up nicely; weekly jobless claims rose versus estimates of a decline; the final University of Michigan index of consumer sentiment came in better than anticipated,

(3)    industry: the April durable goods orders fell more than anticipated; while the Richmond Fed’s business conditions index turned negative,
(4)    macroeconomic: first quarter GDP was revised down [again]; the chain weighted price index went unrevised; the growth in corporate profits was cut in half.

     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

The Averages (DJIA 12441, S&P 1331) finished the week well within their intermediate term up trend (12290-15708, 1291-1720).  However, having broken their short term up trend, they are now in search of boundaries of their new short term trading range.  We know the upper boundaries (12919, 1372) which are the recent highs.  The lower boundaries are a bit more difficult.  At the close on Friday for the DJIA, it looks like the former 12405 resistance level could prove the best candidate; for the S&P it would be the former 1311 resistance level.  However, there is also support to be found at the lower boundary of intermediate term up trend (12290, 1291) and the shoulder line of the recent inverse head and shoulders (11995, 1293). 

Finally, we must also watch the descending trend line off the recent highs.  The indices have now touched it twice and retreated both times.  If this resistance  trend line holds, the short term trading range could quickly morph into a short term down trend.

As I have been suggesting all last week, I think the faltering of the short term up trend is indicative of a loss of up side momentum.  Whether that means some consolidation and then another quick advance or a more prolonged period of digesting recent gains, we will know soon enough.  Clearly, given the Valuations as calculated by our Models, I am partial to the latter scenario.

GLD was up again this week, remaining well within its intermediate term up trend while recovering and holding above the recently broken short term up trend. 

Bottom line:

(1) the DJIA and S&P are in an intermediate term up trend (12290-15708, 1291-1720) and are in the process of re-setting to a short term up trading range defined tentatively as 12405-12919, 1311-1372,

(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 (12441) finished this week about 19.9% above Fair Value (10376) while the S&P closed (1331) around 3.7% overvalued (1283). 

The retreat in prices over the last couple of weeks has brought the indices, in particular, the S&P back closer to Fair Value.  Part of this is a function of weaker than expected US economic data which raised again the possibility of a ‘double dip’; and part of it was the re-emergence of the EU sovereign debt problem which resulted in a strong dollar/weak Market (see our Wednesday and Thursday Morning Calls).

Since our Models have had values pegged lower than recent prices, this decline was welcome in the sense  (1) it at least suggests that our Model is reasonably accurate in defining Value and (2) it hopefully brings stock prices back toward their Buy Value Range.  Unfortunately, the latter isn’t happening in that we are seeing no real build in our Buy List--which our Portfolios would use as the primary purchase candidates.  On the contrary, there was actually one stock that hit its Sell Half Range this week and shares were Sold. 

This does not make me a happy dude; after pining for a decline to offer an additional Buying opportunity, we are getting it but no new Buy candidates.  Sort of like wishing for a shower and then putting on a wet suit.  As long as we hold to our Discipline, we are stuck with the unhappy scenario of stock prices in general declining just not the ones we want.  Making matters worse, while I am inclined to fudge on our Discipline if the Market is telling me that our Model is wrong, I am loathe to do so when its telling me that our Model is right. 

That leaves me and our Portfolios in a very conflicted position; but unless the Market experiences a real air pocket and our Buy Lists expand, our Portfolios will probably do nothing.

This week, the Aggressive Growth Portfolio Sold a portion of its Balchem holding after the stock hit its Sell Half Range.

           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 5/31/11                                 10376                    1283
Close this week                                                 12441                  1331

Over Valuation vs. 5/31 Close
      5% overvalued                                              10894                    1347
    10% overvalued                                             11413                      1411 
    15% overvalued                                             11932                      1475
    20% overvalued                                              12451                    1539
    25% overvalued                                               12970                    1603

Under Valuation vs. 5/31 Close
    5% undervalued                                               9857                      1218

 10%undervalued                                                  9338                      1154   

15%undervalued                                                    8819                    1090

* 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 05-28-2011 10:24 AM by Steve Cook