The Closing Bell 8/20/11
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): 
        Intermediate/Short Term Trading Range    10725-12919
        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):
       Intermediate/Short Term Trading Range    1172(?)-1372   
       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                             20%
   Aggressive Growth Portfolio             20%

Economics
   
The economy is a modest positive for Your Money.
  No, this week’s data notwithstanding, I haven’t changed my forecast--at least not yet.  Actually, I didn’t think that the stats were not nearly as bad as the media, some experts and the pin action would have you believe.   To be sure, some numbers were especially lousy (mortgage applications, existing home sales, jobless claims, the NY and Philly Fed manufacturing indices); but there were also some positive measures (housing starts, industrial production, leading economic indicators).  So I don’t see getting overly negative on the US economy based on this week’s data. 

The real threat to the US economy, in my opinion, is not internal.  Rather it is the fallout if Europe implodes causing another round of damage to financial institutions’ balance sheets and the deterioration of the international earnings of US corporations; and clearly, there is some probability that this will occur.  However, it is a ‘when, as and if’ event; so until it happens, I am not going to alter our Model.

Thus, our forecast 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. 

After a week of poor data, here is some good news indicating that the economy is still moving forward:
http://scottgrannis.blogspot.com/2011/08/bank-lending-continues-to-increase.html

Update on the ECRI weekly leading index (short):
http://advisorperspectives.com/dshort/updates/ECRI-Weekly-Leading-Index.php

That said, as you know, I believe that US and EU economics are being driven by politics. 

(1)    the Three Stooges: the US economy is clearly struggling in no small part because of poor, ill conceived, mistimed decisions by our political class, Markets are turmoil at least partially as a result and yet ever last one of these a**holes are on vacation.  True Obama ‘says’ that He has a plan for dealing with jobs and the budget deficit; and He will get right back to us after schmoozing with the rich and famous for a couple of weeks on Martha’s Vineyard.  Thanks.  In the meantime, corporations and consumers are holding on to their wallets like a drowning swimmer to anything that floats. 

Of course, for all my complaining, this is the precise forecast that our Model reflects only with the emotion.  I fully expect Obama’s ‘new plan’ to be smoke and mirrors full of political ‘bulls**t’; and I think congress will do no better.  In other words, the political class will posture and then lie to us [themselves?] about what great, effective steps that they are taking to address our fiscal problems that will in reality just postpone the debate about the size and scope of government spending until the 2012 elections.  This will keep corporate and consumer uncertainty at elevated levels, the consequence of which is restraint in investing, hiring and consumption.  But then, as I said, that is our forecast.

(2)           the Three Blind Mice. As near as I can tell, the euros are simply standing around in a giant circle jerk and praying.  I have no clue how the EU sovereign debt problem resolves itself.  My guess is that neither does anyone else and hence the current Market panic.  The risk, of course, is that defaults spread beyond Greece, negatively impacting the economic growth in Europe, potentially scaling up the level of political unrest and re-damaging the balance sheets of US banks and reducing revenues and earnings of US companies doing business in Europe.   As I have said, this is the real risk to our forecast; and such a scenario would require me to adjust our Economic Model’s global growth rate down.
   
    These three articles give a thorough review of the current situation:
    http://www.nationalreview.com/articles/275014/euro-disaster-rich-lowry
    http://www.nakedcapitalism.com/2011/08/marshall-aureback-are-we-approaching-the-endgame-for-the-euro.html
    http://www.minyanville.com/businessmarkets/articles/european-debt-crisis-european-crisis-eurozone/8/18/2011/id/36411?page=2

And here is a much different perspective and today’s must read:
http://pragcap.com/the-price-of-liberty

When as and if I make those changes, the big question is how will US companies handle this bad news scenario?  Based on their performance over the last couple of years, I think that there is reason for more optimism than currently exists.  That said, investors attitudes now require absolute proof. 

Bottom line:  the economy continues to muddle through and, if my low expectations for a budget fix from the current crew in power is correct, it should continue to do so through early to mid 2013.  The good news is that both a sluggish economy and a second rate political class are reflected in our Valuation Model. 

The bad news is that the EU political class seems incapable of properly dealing with the growing likelihood of multiple country bankruptcies.  Until it does, the financial condition of the PIIGS will almost surely continue to deteriorate.  If left unaddressed, that will not good for the euros, it will not good for US companies doing business in Europe, it will not be good for the US financial institutions with exposure to EU sovereign debt and it will likely not be good for stocks.  Maybe we should all join the EU political class in their prayer.

This week’s data:

(1)    housing: weekly mortgage applications were up but purchase applications fell 9%+; July housing starts declined but less than anticipated while July existing homes sales dropped versus expectations of a rise,
 
(2)    consumer: weekly retail sales were mixed; weekly jobless claims increased more than estimates,

(3)    industry: July industrial production rose more than forecasts; while two of the August Fed bank local business conditions indices were both very bad,

(4)    macroeconomic: July leading economic indicators were better than expected; both the PPI and CPI were hotter 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.)
   
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 10817, S&P 1123) had another brutal week.  The DJIA remains within its intermediate term trading range (10725-12919); however, the S&P closed Friday in the midst of a challenge to the lower boundary of its intermediate term trading range (1172-1372).  Importantly, neither index has challenged their earlier intraday lows (10596, 1101).  Nonetheless, stock prices are clearly in the midst of either re-testing the prior lows or initiating a new leg down.  I thought that Friday would give us a hint as to which is occurring; but it was not to be.  So we wait for another day.  It’s nerve wracking but that is the game we play.  The only thing that we can be proactive at is having our buy list ready if a test is confirmed and a list of the technical weak sisters if we are headed lower.

This is a study of volatility in the Market.  If history is any guide then it suggests that there is more downside (short):
http://advisorperspectives.com/dshort/commentaries/Four-Percent-Dow-Declines-Since-1928.php

GLD continues to perform great; indeed a bit too great.  It keeps getting more overextended; but as I noted in Friday’s Morning Call, I don’t want to take anything more off the table until the problem with physical gold gets resolved.

Bottom line:

(1) the DJIA and S&P are in an intermediate/short term trading range (11863-12919, 1172-1372), though the S&P is in the midst of a severe challenge,

(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 (10817) finished this week about 2.5% above Fair Value (10546) while the S&P closed (1123) 13.7% undervalued (1302). 

In my opinion, equity prices are now struggling to properly discount (1) the uncertainties related to potential multiple bankruptcies among the EU countries/the dissolution of the EU and the resulting impact on US bank balance sheets and US corporate profits plus (2) the additional pessimism born of a complete lack of faith in the western political class’ ability/will to address and solve these problems. 

Of course, with the S&P priced 13.7% below Fair Value, at least some of this trauma is being reflected. With respect to Europe, until we know how bad the ultimate outcome is, it is tough to know what the correct stock valuations are.  That said, the worst outcome today is not likely to be nearly as bad as the worst outcome a year from now if the can gets kicked down the road.  The point being that another smoke and mirrors patch is the bad news scenario.  If either Germany or some combination of PIIGS withdrew from the euro Monday morning, there may be an initial negative reaction; but I think stock prices would be higher a week later.  It’s that week that poses the valuation problem.

As far as the lack of confidence in our elected representatives, I haven’t had any confidence in them for at least 12 years.  Yet others seem only now to be waking up to the fact that the electorate has saddled itself with a bunch of self interested, self important parasites.  For better or worse, I have no such delusions and have priced in the continuing reign of this group of morons through 2012.  However, until the rest of the Market gets that done, prices will likely stay under pressure--the operative word being ‘until’ because it could be happening now.
 
Through this all volatility and emotion, the constant that I hold on to is our Price Disciplines.  Our Model makes plain that stocks, in general, are undervalued and many of our stocks specifically are trading at historically low absolute and relative valuations.  That doesn’t mean that those candidates won’t get cheaper nor that there aren’t stocks that remain on the high side of Fair Value that have the potential of getting cracked really hard.  The good news is that our Disciplines provide us with an unemotional gauge with which to make those ‘cheap’ and ‘high side of Fair Value’ judgments.  Staying focused on our Disciplines has always gotten me and our Portfolios through rough times. 

This week our Portfolios Added to several holdings, taking their cash positions from 23-24% to 20%.
 
           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 8/31/11                                10546                    1302
Close this week                                               10817                  1123

Over Valuation vs. 8/31 Close
      5% overvalued                                           11073                    1367
    10% overvalued                                          11600                     1432 
    15% overvalued                                          12127                     1497
   
   
Under Valuation vs. 8/31 Close
    5% undervalued                                         10018                      1236
 10%undervalued                                            9491                      1171   
 15%undervalued                                           8961                        1106

* 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 08-20-2011 9:47 AM by Steve Cook