The Closing Bell-11/7/09
Steve Cook on Disciplined Investing


Have You Seen This?


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Have You Seen This?

  Statistical Summary

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


       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

        2009    Year End Fair Value (revised):                 9440-9460

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

            Current Trend (revised):
            Short Term Trading Range                        ???-1101
             Long Term Trading Range                        666-1575
      2009    Year End Fair Value                            1165-1185

      2010    Year End Fair Value                           1190-1210   

  Percentage Cash in Our Portfolios

    Dividend Growth Portfolio                  17.5%
    High Yield Portfolio                             17.5%
    Aggressive Growth Portfolio              17.5%


    The economy is a neutral for Your Money and may soon become a negative.
  That is not to say that the economy isn’t recovering.  Despite the disappointing payrolls report on Friday, the rest of this week’s data was generally up beat--supporting the forecast of a rebound.  The issue with respect to Your Money is, how adequately is the current up turn reflected in stock prices?
    I noted last week that I was working on our Valuation Model considering yet another revision of our long term assumptions on growth and inflation.  One of the toughest issues I had to come to grips with in deciding whether or not to alter our model was my ingrained optimism regarding the US economy. Not that I didn’t recognize the dilemma faced by the Fed in properly executing its exit strategy; nor that the current rate of unrestrained spending by the government isn’t a problem.  But rather it was accepting that these are not cyclical issues that can get resolved by the natural workings of free markets.  They are serious systemic problems.

Since the Greenspan era began, the mind set of the Fed has been to throw money at any problem as a solution.  The result is we have skipped from one asset bubble to the next.  And this time is no different.  Furthermore, profligate spending is not a recent (Democratic) phenomena.  I bitched and moaned through the entire Bush administration about his irresponsible spending.  The bottom line is that the current situation is just too reminiscent of the Nixon/Carter years in the mismanagement of both monetary and fiscal policy.  Result: I had to recognize that barring a sudden Clinton-like shift to the right by Obama (which I think highly unlikely), we are probably in for a much longer period of below average secular growth accompanied by a higher structural rate of inflation than was reflected in our Model’s assumptions.

So I formalized those misgivings in a new set of assumptions; and net, net Year Fair Values have changed again.  For 2009, the Year End Fair Value of the DJIA is 9440-9460, for the S&P, 1165-1185.  That puts the DJIA in slightly overvalued territory while the S&P remains undervalued, but just not as much as it was under my former assumptions.  The good news is that I have been intuitively anticipating such a change by moving our Portfolios into the foreign ETFs’ and a much larger gold position.  So there isn’t any significant immediate impact on portfolio structure, although it clearly influenced the decision to up the gold/foreign ETF allocation from 15% to 20%; and it means that I am not wee-weeing in my pants to get our cash to work.
    This weeks’ data:

(1)    housing: weekly mortgage applications rose for the first time in a month; September pending home sales surged,

(2)    consumer: weekly retail sales rose again; auto sales were down but that was expected following the termination of the ‘cash of clunkers’ program; weekly jobless claims fell more than forecast; but unfortunately October nonfarm payrolls dropped more than estimates and unemployment rose to 10.2%

(3)    industry: September construction spending was up versus forecasts of a decline; September factory orders climbed in line with estimates; September wholesale inventories fell less than expected, but wholesale sales continued to rise, driving down the inventory to sales ratio; the two October Institute for Supply Management indices came in mixed--the manufacturing index was much better than expected while the nonmanufacturing index was a bit disappointing,

(4)    macroeconomic: third quarter productivity and unit labor costs came in much better than anticipated; the FOMC left interest rates unchanged.

 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.)


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

    Our government at work.  The taxes hidden the House healthcare bill:

The Market-Disciplined Investing

    The indices (DJIA 10023, S&P 1069) appear to have transitioned into a trading range.  At the close Friday, the S&P remains well below the lower boundary of the March to present up trend; the DJIA is touching it for a second day (the rise in the Dow was matched by the rise in the trend line) but can’t get back above it.  The VIX did fall again and is noticeably below the upper boundary of the former October to present down trend; however, it is well above its prior low, so no sign of re-setting the down trend. 

If stocks are in a trading range, we know the upper boundary of that range (circa 10110, 1100).  The first bounce following the break of the up trend was at circa 9645, 1028--making it a contender for the lower boundary; however, that seems unlikely to me.  I am also watching the following levels in the S&P: 1020, 990, 978, 870 as potential candidates. 

‘appear to’ are the operative words in the above statement.  As I have chronicled in the week’s Morning Call, the Market is in one of those schizophrenic phases that we encounter from time to time; and I am not sure there is much difference in the likelihood of re-establishing an up trend as there is of remaining in a trading range.  In other words, I have no overpowering conviction that I am right in my trading range call; and until I get some conviction, I am staying close to the side lines.

However, my prejudice makes me point out that the ongoing pattern of trading appears to be building a ‘right shoulder’ in a head and shoulders formation.

Finally, Friday we got some additional evidence that the strong inverse relationship between the dollar and stocks/gold/commodities may to be coming unraveled: the dollar was up a little (implying slightly down stocks, gold and commodities).  But stocks were also up.  Gold was very strong; while oil got whacked.

The point in focusing so intently on this relationship is that I am trying to discern what factors investors are keying on to drive prices. An economy improving much as anticipated doesn’t work anymore (does not going down on a lousy payrolls number count?), the hoped for improvement in fourth quarter revenues didn’t work and the tight dollar/stock/gold/commodities nexus now seems in question. 

So what are investors focused on?  At the moment, I can’t figure it out--and perhaps neither can anyone else.  That may explain current Market behavior--investors have lost the reason to push valuations up; but they are OK with current prices.  So the churn.

Bottom line:

(1) short term, both indices appear to be moving into a trading range.  In that environment, 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

    As noted above, this week I completed the revision of the assumptions in our Valuation Model.  The DJIA (10023) finished this week about 5.8% above Fair Value (9438) while the S&P closed (1069) around 8.8% undervalued (1173). 

Last week, I listed three issues that I believe will likely impact stock prices in the near future.  One of them was valuations which I addressed above.  The other two are still with us:
(1)    the economy: specifically, 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)    ‘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.’

Note: as I suggested above, we may be at that time though it is not entirely clear; and whether or not is it is does not change my conclusion:

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 brief, it is a time for caution.  That doesn’t mean disaster looms. After all, the S&P is still undervalued by 8-9% even under our revised valuation.  It does mean that it is likely that much of the easy money has been made at least for a while.

This week our Portfolios took no action but we did raise their maximum exposure to gold and foreign ETFs from 15% to 20%.
           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                                         10023                   1069

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  below average secular growth for the next 3 to 5 years with 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 11-07-2009 10:07 AM by Steve Cook