The Closing Bell-11/14/09
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                                   9851-11824
                 Long Term Trading Range                         6432-14180
                  Year End Fair Value (revised):                13450-13850
        
        2009    Year End Fair Value (revised):                 9440-9460

        2010    Year End Fair Value                               9630-9650
 
    Standard & Poor’s 500

      2008
            Current Trend (revised):
            Short Term Trading Range                        ???-1102
             Long Term Trading Range                        666-1575
            Year End Fair Value (revised):                  1533-1577
   
      2009    Year End Fair Value                             1165-1185

     2010    Year End Fair Value                              1190-1210   

  Percentage Cash in Our Portfolios

    Dividend Growth Portfolio                  18.5%
    High Yield Portfolio                             18.5%
    Aggressive Growth Portfolio              18.5%

Economics

    The economy is a neutral for Your Money. 
As I pointed out last week that is not a judgment that the economy is not recovering.  Even though we got little data this week, the recent evidence  supports the notion that a rebound is occurring albeit considerably below average.  I don’t see that changing.  Furthermore, longer term our forecast argues that this below average secular growth will continue (a crippled financial system incapable of financing normal growth and a federal government usurping private investment capital) accompanied by above average inflation (the inability of the Fed to ‘time’ correctly its ‘exit’ strategy from a massively expansive monetary policy and an unconstrained fiscal policy which will force the Fed to monetize the resulting debt).  As a result, it seems to me (courtesy of our Valuation Model) that while the economy will gradually labor its way higher, stocks are fairly close to adequately discounting the next six to twelve months.  Hence, I see nothing in the economic outlook that argues for materially higher stock prices in the near term.
    http://www.capitalspectator.com/archives/2009/11/the_recession_f.html#more

Of course, I could be wrong.  The economy could be weaker than expected or experience a ‘double dip’.  If so, then we will start to see it in the numbers and, hopefully, I will have time to adapt.  Or we could get lucky with some sort of combination of stronger than anticipated economic growth and/or lower inflation.  I think that the lower inflation part is highly unlikely but the natural optimist in me wants to believe the higher growth.  But once again, it has to show up in the stats; and when, as and if it does, I will adjust.  The point here is that I have a framework against which to make valuation judgments; but I am not so wedded to it that evidence to contrary will be ignored.

Bottom line: I think that our economic forecast is a ‘fair’ news scenario and that at current price levels under that scenario, stocks are close to being reasonably valued.  

    This week’s limited data:

(1)    housing: weekly mortgage applications fell hard,

(2)    consumer: weekly retail sales were mixed; weekly jobless claims declined more than expected; the University of Michigan’s preliminary November index of consumer sentiment was a disappointment,

(3)    industry: none,

(4)    macroeconomic: the federal deficits [budget and trade] just keep getting worse.

 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.

    Our government at work.  The taxes hidden the House healthcare bill:
    http://online.wsj.com/article/SB10001424052748703932904574511794170939688.html

    And how we got to the Ft. Hood massacre:
    http://article.nationalreview.com/?q=ZjNjZTljN2MxMGI4MTJkNTMxODA4YjA5MGNiMmRlYWM=

The Market-Disciplined Investing
    
  Technical

    The indices (DJIA 10269, S&P 1093) are in some sort of transitional phase.  I am just not sure into what they are transitioning.  The DJIA broke its up trend off the March low two weeks ago only to re-establish that up trend a week later (9851-11824).  The S&P (which I consider a much better indicator of general stock price movement), however, broke its March to present up trend, made a couple of half hearted attempts to surmount its prior high (1102) (thereby re-setting the up trend) and rolled over.  So at the moment, I can’t say with any clarity whether the Market’s primary direction is up or sideways although the lack of volume and breadth, our own internal indicator and the VIX’s behavior suggest that it more likely that stocks are in a trading range. 

If that is the case, then we know the upper boundary of the S&P range (circa  1102) while the lower boundary has multiple candidates: the first bounce following the break of the up trend was circa 1028 with other nominees being 1020, 990, 978, 870. 

Bottom line:

(1) short term, The DJIA is in an up trend, the S&P is in a trading range.  I await the resolution of this inconsistency.  In the meantime, it bolsters my focus on our strategy of sensitivity to our trading stops as they apply to stocks’ short term up trend off the March lows . 

(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 (10269) finished this week about 8% above Fair Value (9438) while the S&P closed (1093) around 6.8% undervalued (1173). 

As I have lamented in these pages, I am struggling to get a handle on what is driving stock prices.   The two issues that make the most sense to me are:

(1)    the economy--though as I stated above, I think that future economic growth is being adequately reflected in stock prices.  However, there are issues that demand our attention and they are, are we far enough along in the recovery that the Fed’s ‘exit’ strategy now moves front and center? and how much deeper in debt and more centralized will our government become before the electorate has had enough?  I don’t know those answers.  I do believe that they are sufficiently close that their resolution will start getting reflected in stock prices sooner rather than later.

(2)    the dollar/stock reflation trade.  Sure, as I have pointed out, that relationship has gotten a bit tenuous of late; but it still keeps re-asserting itself.  So we can’t ignore it.  That said, I repeat: ‘I am having an increasingly tough time believing that the dollar/stock inverse relationship can go on ad infinitum.  I believe that loose monetary policy and out of control spending have significant inflationary implications.  I believe that this implies a weakening dollar. I believe that a weak dollar likely means higher gold and commodity prices.  But I don’t believe that a declining dollar is good for stocks in the long run.  I have no clue when that relationship breaks apart, although I had my self convinced it was starting earlier in the week. But may be not; may be there is another leg to go.’

I would add that stocks seem to be in a place where good news is bad news (i.e. if the Fed gets its exit right, then rates will likely increase, the dollar increases and stock prices fall at least initially) and bad news is bad news (i.e. the Fed waits too long, the dollar continues to get whacked and if I am correct sooner or later investors panic in the face of rising inflation and sell stocks).

In sum, I have no good feel for what moves stock prices from here and that means the caution flag is out.  That doesn’t mean disaster looms. After all, the S&P is still undervalued by 6-7% even under our revised valuation.  It does suggest that much of the easy money has been made at least for a while.

Accordingly, this week our Portfolios raised cash by selling stocks.  Part of the funds were moved into their foreign ETF positions; the remainder took their cash position to 18.5%
 
           Bottom line:

(1)      our Portfolios will manage their cash between 12.5% and 22.5%.

(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*         9450                    1175
Fair Value as of 11/30//09                        9438                    1173
Close this week                                        10269                   1093

Over Valuation vs. 11/30 Close
      5% overvalued                                       9909                   1231
    10% overvalued                                     10282                    1290 
   
Under Valuation vs. 11/30 Close
    5% undervalued                                     8966                   1114
    10%undervalued                                     8494                  1055
    15%undervalued                                    8022                     997   

* 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 11-14-2009 11:09 AM by Steve Cook