The Closing Bell-10/24/09
Steve Cook on Disciplined Investing

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  Statistical Summary

   Current Economic Forecast
  
         
2009
       Real Growth in Gross Domestic Product:               -1.0 - -2.0%
       Inflation:                                                                             1-2 %
      Growth in Corporate Profits:                                            0- -5%

    2010

      Real Growth in Gross Domestic Product:              +1.0- +2.0%
      Inflation:                                                                         1.5-2.5 %
      Growth in Corporate Profits:                                         7-15%

   Current Market Forecast
   
    Dow Jones Industrial Average

         2008
            Current Trend (revised):
            Short Term Up Trend                                     9795-11716
            Long Term Trading Range                            6432-14180
            Year End Fair Value (revised):                    13450-13850
        
        2009    Year End Fair Value (revised):           12030-12070

        2010    Year End Fair Value                            12400-12600
 
    Standard & Poor’s 500

2008
            Current Trend (revised):
            Short Term Up Trend                               1065-1304
           Long Term Trading Range                        666-1575
            Year End Fair Value (revised):                 1533-1577
   
2009    Year End Fair Value                                1370-1410

2010    Year End Fair Value                               1430-1450   

  Percentage Cash in Our Portfolios

    Dividend Growth Portfolio                  12.5%
    High Yield Portfolio                            12.5%
    Aggressive Growth Portfolio              12.5%

Economics

    The economy is a short term positive for Your Money
--but that may not last much longer. To be sure, what little data we got this week continued to support the notion that the economy has bottomed and is in the early stages of recovery--housing stats were good, retail sales were up again and the leading indicators were stronger than expected.  We have now had a couple of weeks where the data has been generally positive and, as I said, that suggests a rebound is in progress; but I would stress that we will still likely have additional periods when the economic indicators will be disappointing.  That is to be expected in a ‘slow, sluggish’ up turn.  Unfortunately it would also be expected if the economy were to experience a double dip--and the slow recovery versus double dip is now an ongoing debate among investors.  My bottom line on that issue is that it is a side show--we only get a second down turn if the Fed is too early exiting from its current easy money strategy and that is a low probability occurrence. 

That’s not the real issue for me. My problem is that the time is rapidly approaching when the conditions will begin to appear that will determine the validity of the second part of our forecast--that we are faced with a period of rapidly rising inflationary pressures brought on by too much liquidity and too much government spending. 

In other words, we may now be approaching the juncture when the timing of the Fed’s exit strategy and the necessity of fiscal discipline become critical to the economy as well as Your Money.  There are, of course, multiple possible outcomes--some good, some bad.  On the positive side, there is some chance that the Fed will get its ‘exit’ strategy right and that Washington gridlock can last long enough for cooler heads (and a chastened electorate) to halt the head long plunge into fiscal ignominy. Negatively, the Fed could start its exit too soon resulting in the double dip noted above.  Or it can be too late with the consequence of dramatically rising inflation.

Only time will give us the answer.  My point is that the time is likely nigh and for the moment, in my opinion, it is unlikely that the Fed will be either too early or right on target and that restraint will suddenly appear in the halls of congress or at the white house.  Hence, my concern that the economy will not be a positive much longer.

    In the meantime, here’s this week’s good news:
 
(1)    housing: weekly mortgage applications fell; on the other hand, September housing starts rose more than expected and September existing home sales soared  by 9.4% versus estimates of a 5.8% increase,
http://mjperry.blogspot.com/2009/10/home-sales-inventory-highest-lowest-in.html

(2)    consumer: weekly retail sales turned in another up number while weekly jobless claims rose considerably more than anticipated,

(3)    industry: no data,

(4)    macroeconomic: September leading economic indicators were up more than expected while September producer prices declined more than forecasts.
   
 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

Both the domestic and international political environments are a negative for Your Money.

The Market-Disciplined Investing
    
  Technical

    The indices (DJIA 9972, S&P 1079) finished within their up trend off the March lows (9795-11716, 1065-1304), although they clearly struggled this week despite good news on both the macroeconomic front (see Economics above) and with regard to this earnings (revenue) season. 

The VIX also remains well below the upper boundary of the down trend off its October 2008 high (which is good), although it too seems to be struggling and gives the appearance that it may be making a bottom (which makes sense, if stock prices are making a high). 

Finally, our internal indicator (in a 161 stock universe, 111 are in up trends off their March lows, 133 have traded above the down trend line off their 2008 highs and 98 are above their November 2008 high) is not as positive as the last reading.  So it is also losing upward momentum.  The one really positive stat is that most stocks have successfully challenged the down trend off their 2008 high and continue to trade above it, suggesting that even if this Market reverts to a trading range, there appears little risk at this moment that it will roll over and test the old lows

In sum, there are some signs that this up trend is getting tired.  However, our Discipline is to force the Market to prove that it no longer wants to go up; so for the moment there is nothing to do but exercise our patience.  The good news is that there is little opportunity cost in waiting in that only 14 points separate the S&P level on Friday’s close (1079) and the lower boundary of its up trend (1065).

 (1) short term, both indices are in an up trend, though acting sluggish.  I am sticking with our strategy of sensitivity to our trading stops as they apply to stocks’ short term up trend off the March lows [keeping in mind the last time around I was too sensitive]. 

(2)    long term, stocks are in a trading range defined by the 2002/2009 lows [S&P 666-766] and the 2000/2007 highs [1545-1575].  Importantly, I think that equity prices will continue to recover within that range but it will be a slow and volatile process.

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (9972) finished this week about 17.0% below Fair Value (12019) while the S&P closed (1079) around 22.1% undervalued (1386). 

For the past month or so, these comments have begun with the observations that (1) despite a sluggish economic recovery, stock prices still appear inexpensive, (2) the rebound in stocks seem to have discounted (a) that the end of the world is not upon us and (b) gridlock in Washington that will allow us to avoid the more costly items in the Democratic agenda and that (3) that improving corporate revenues will fuel a slowing but upward momentum in stock prices.

As you know, this narrative, which originally embraced the revenues-are-key thesis, has gone from being skeptical after the initial patch of financial reports to being hopeful and now is back to being unconvinced.  Certainly another good day of reports on Friday accompanied by more stock price whackage reinforces the doubt (As of the close Friday 40% of S&P companies have reported; 81% have beaten earnings estimates, 62% have outpaced revenue forecasts). 

So where does that leave us on Market Valuation?  As I noted in Friday’s Morning Call: ‘(1) if the economic fundamentals are improving as we thought,  i.e. revenues are beginning to grow, but stock prices can’t move up, then the only conclusion that I can draw is that the Market has already discounted that development and my revenues-are-key thesis will be proven wrong [right that revenues improved, but wrong that they had any impact on stock prices].  If this is case, it probably means that I still haven’t adjusted the discount factor in our Valuation Model up enough, (2) if the economic fundamentals are not improving, i.e. the better than currently perceived revenue growth is more a function of expectation management than of reality, then the revenues-are-key thesis is irrelevant, and it likely means that I am still overestimating the growth rate assumption in our Valuation Model.”

 Either alternative calls into question current Valuations; and that is something about which to be worried (though I am not going to alter the Valuation Model just yet).

Also of concern is the weakening dollar and what has been a pretty tight inverse correlation between dollar and stock prices which I also noted on Friday has the disadvantage that it can’t work forever.

‘Sooner or later, the dollar has to stop declining because if it doesn’t, then we face a Zimbabwe economy--which is not going to be good for stocks.  On the other hand, for the dollar to stop falling short of the hyperinflation scenario, Fed has to start removing the excess liquidity from the financial system and the Federal government has to get a grip on its profligate spending.  That brings us to our current economic forecast: unless the Fed gets it exactly right, it will either take the punch bowl away too soon which could push the economy back into recession or too late which will ratchet the inflation rate up to uncomfortable levels--and if the late Nixon/Carter years are a guide to how the stock market reacts to uncomfortably high rates of inflation, that will not be good for stocks.’

Wrapping this all up in as neat a package as I can: (1) from the point of view of the economy, we seem to be nearing the point where very stimulative Fed and fiscal policies must either be curtailed or their consequences will start to kick in, (2) the Market technically seems to be losing steam and (3) all the potential positive fundamental developments, ex the long term impact of Fed and fiscal policies, may be in the current price of stocks.

That sounds fairly ominous but that was not my intent.  It was to point out that change in economic and fundamental Market factors seem to be occurring or about to occur and that will shift investors’ focus.  How that happens is a matter of debate but it will undoubtedly have an impact on stock prices.  Hence complacency at this point is not an option.  It may be a bit too early to alter our strategy but as I pointed out Friday ‘it is not too early to be aware of the risk and to start making plans for an adjustment in investment strategy if that proves to be the case.’

In the broadest of terms that means that any technical break in the Market, our Portfolios will start to re-build cash.  How that cash ultimately gets spent depends how the economic variables work out, i.e. if the Fed discovers restraint, we would lighten up on gold and foreign ETF’s and increase positions in US stocks; if no restraint is forthcoming, then more gold and foreign ETF’s would be appropriate.

This week our Portfolios took no actions.
 
           Bottom line:

(1)      our Portfolios have reached their near term objective of 12.5% cash position.  It is time for a pause.

(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)    I intend to maintain the use of trading stop losses at least until the economic, technical and fundamental factors impacting valuation become clearer.  These are much tighter stops [i.e. they follow the stock price up] than those determined by our Valuation Model. 

(4)    defense is important.
 
                                                                    DJIA                    S&P

Current 2009 Year End Fair Value*        12050                    1390
Fair Value as of 10/31//09                       12019                    1386
Close this week                                          9972                   1079

Over Valuation vs. 10/31 Close
      5% overvalued                                     12619                    1455
    10% overvalued                                     13221                      1524 
   
Under Valuation vs. 10/31 Close
    5% undervalued                                     11418                    1316
   10%undervalued                                    10817                    1247
    15%undervalued                                   10216                    1178   
    20%undervalued                                    9615                     1109
    25% undervalued                                     9014                    1039
   
* 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 10-24-2009 12:29 PM by Steve Cook