The Closing Bell-2/13/10
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

Current Trend (revised):
    Short Term Trading Range                                  ???-10725
    Long Term Trading Range                                  6432-14180
                    
 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                               ???-1151
       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                  25%
    High Yield Portfolio                             26%
    Aggressive Growth Portfolio             25%

Economics
   
The economy is a neutral for Your Money. 
This week the economic data was again mixed--which sounds like a broken record.  However, the good news is that it signals that the economy remains on track for a slow struggling recovery.  Longer term, our forecast calls an economy growing at an historically below average rate, though as I have noted previously, I think that prospects for a slightly better long term secular growth rate have improved as the probability of gridlock in Washington increased.

Nevertheless, the US economy is burdened with structural difficulties that make a return to historical growth rates seem unlikely. The reasons, I have harped on ad nauseum: (1) a crippled banking system incapable of financing a ‘normal’ recovery, (2) ten years of fiscal profligacy that has burdened our economic system with levels of debt and spending that usurp capital for investment and employment, and (3) a Fed balance sheet so bloated and crammed with securities of questionable value that an ‘exit’ strategy that avoids either an economic relapse or debilitating high inflation seems unlikely. 

This week investors were being reminded daily that the above problems are not going away soon.  The sovereign debt difficulties of Greece dominated the headlines, the most important aspect of which in my opinion was to maintain awareness that financial irresponsibility is not peculiar to Greece alone but a systemic global problem that will restrain economic expansion for a long time to come.  In addition, while less noticed but even more important to the US, China is busy giving US government officials a lesson in monetary/fiscal accountability--specifically raising bank reserve requirements and increasing central bank lending rates.  These steps will serve to slow economic growth in China, slow US exports to China and, hence, contribute to a slower rate of US economic growth.

To be clear, I am not saying that sovereign debt issues and a restrictive Chinese monetary policy are huge new woes that will lessen US economic growth and whack equity values.  I am saying that they are simply both a part of the macroeconomic picture that argues for an extended period of below average long term economic growth.

This week’s data:

(1)    housing: weekly mortgage applications fell 7.0%,

(2)    consumer: weekly retail sales were up and January retail sales came in better than expected; weekly jobless claims dropped much more than anticipated; the University of Michigan’s preliminary February index of consumer sentiment came in below estimates,
http://mjperry.blogspot.com/2010/02/rise-in-retail-sales-brightens-recovery.html

(3)    industry: both December wholesale and business inventories fell, but sales declined even more, driving down their inventory to sales ratios [again],
 
(4)    macro:  the December US trade deficit was larger than forecast.

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 environment for Your Money maybe improving although the War on Radical Islam is becoming more negative.

The Market-Disciplined Investing
    
  Technical

    The Averages (DJIA 10099, S&P 1075) remain in a trading range with the upper boundary defined as 10725, 1150; and, as you know, I am tentatively putting the lower boundary at 9645, 1009. 

Another trend that I have been watching is the very short term down trend off the January 2010 high.  On Thursday both indices broke above that trend line and stayed above it at the close Friday (the intersection points are now 10025 and 1072).  However, since stock prices declined Friday, the Averages remained above the down trend line only by virtue of having fallen less than the trend line.  I certainly wouldn’t characterize that as a strong performance; so I want more time/distance before assuming the down trend line is broken.  I spend all this time and space on this point because it gives me important information regarding the longer term trend, i.e. if the break occurs, it would halt the January to present down trend and more firmly set stocks in a trading range. 

Bottom line:

(1) short term, the indices are most likely in a trading range defined by 9645-10725, 1009-1150,

(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 (10099) finished this week about 6.5% above Fair Value (9482) while the S&P closed (1075) around 8.8% undervalued (1179). 

    The sovereign debt problems of Greece took center stage this week and will likely remain there until it is clear how this situation gets resolved.  As you know, I am not especially optimistic about a truly workable solution; though, as you also know, that is more a function of the opinions of guys who know a lot more than me about sovereign debt issues than any extensive analysis that I have done.  At the moment, it seems like the optimistic scenario is that Greece and its ultimate guarantors will sort of ‘muddle through’, which doesn’t give me a particularly warm and fuzzy feeling.  Nevertheless, under that scenario, the euro would strengthen, the dollar weaken (as happened this past week) and if the inverse dollar/stock relationship holds (which it has been), stocks would go up.

    The less sanguine crew, which include most of the guys to whom I talk, believe that the only solutions that will suffice involve monetary/fiscal policy measures that no one in Greece or the EU has the will/courage/cojones to implement. While the fixes currently being bandied about may offer some temporary reprieve, ultimately they won’t work.  Under this more pessimistic view, the dollar becomes the least bad refuge for investors who want to exit the financial assets of weak countries (meaning that it appreciates in value).  Again, if the inverse dollar/stock relationship holds, stocks go down.

    Two other items bouncing around in the background:

(1) China efforts to tighten monetary policy in order to cool off its robust economy.  It is so embarrassing to have to admit that a country that only recently emerged from third world status manages its government policy more responsibly than the US.  But it is; and it is doing so with a relentlessness that suggests that there will be no reversal anytime soon.  The consequences are that it puts pressure on our government officials to follow suit, i.e. tighten monetary policy.  And as you know, a tightening monetary policy is generally accompanied by higher interest rates which, in turn, tends to attract global investors to dollar denominated assets. And that means a stronger dollar (see above for the impact on stocks).

(2)    the so-called ‘dollar carry trade’ is likely getting long in the tooth.  You recall that because the Fed has kept interest rates near zero, hedge funds and certain other financial institutions have been borrowing dollars cheaply, selling them [the reason dollar was weak for most of 2009] and investing in higher yielding assets as well as volatile commodities.  When, as and if, US interest rates start to rise, that jacks up the cost of money and lowers the rate of return on this investment.  Sooner or later, those trades get unwound, i.e. the high yielding assets and commodities are sold and dollars bought.  That means even more buying pressure on the value of the dollar (see above for the impact on stocks).

Clearly, there is a lot going on that can impact stock prices but have nothing to do with those factors we normally attribute to influencing equity values (earnings, dividends, new products, etc).  If I am correct in the above analysis, then most of these outside issues will impact the value of the dollar positively, which at the risk of being repetitious, suggests lower stock prices.  Now as you know, I am a big proponent of a strong dollar; and long term, I think a strong dollar equals higher stock prices.  But as long as this inverse dollar/stock relationship holds, I am going to be wrong.

Finally, both the sovereign debt problem and China leading the way to monetary responsibility play directly to one of our central themes--that long term secular outlook for economy growth will be restrained by deleveraging that has to take place at all levels of society and by the necessity of governments to manage their affairs more prudently than has been the case for the past decade.

In sum, while the technical picture may be improving, the fundamentals are not.  Patience rules.

This week, several stocks were Added to our Buy Lists but no transactions were affected.
 
           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 [now under review]

(3)    defense is still important.
 
                                                                     DJIA                    S&P

Current 2010 Year End Fair Value*         9640                    1200
Fair Value as of 2/28//10                          9482                    1179
Close this week                                        10099                   1075

Over Valuation vs. 2/28 Close
      5% overvalued                                     9956                    1237
    10% overvalued                                   10430                     1297 
    15% overvalued                                   10904                   1356

Under Valuation vs. 2/28 Close
    5% undervalued                                     9008                    1120
   10%undervalued                                   8534                      1061
    15%undervalued                                    8060                    1002   

* 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 02-13-2010 9:33 AM by Steve Cook