The Closing Bell-3/14/09
Steve Cook on Disciplined Investing

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It is Spring, so it must be beach time.  Next week I will be soaking up the rays.  I will be in a place that allows constant contact with the Market.  So no Morning Calls or Closing Bell next week; but if action is required I will be in touch via Subscriber Alerts.

  Statistical Summary

   Current Economic Forecast
  
 
2008
        Real Growth in Gross Domestic Product (GDP):   -1.0 - +1.0%
        Inflation:                                                                     2-3%   
        Growth in Corporate Profits:                                     0-5%
         
2009
        Real Growth in Gross Domestic Product:        -1.0 - -2.0%
        Inflation:                                                                1-2 %
        Growth in Corporate Profits:                                   0- -5%

   Current Market Forecast
   
Dow Jones Industrial Average

        2008
            Current Trend:
                 Short Term Down Trend                         5461-7627
                  Long Term Up Trend                             3874-13539
                 Year End Fair Value (revised):                13450-13850
        
        2009    Year End Fair Value (revised):                12030-12070
 
    Standard & Poor’s 500

2008
            Current Trend:
            Short Term Down Trend                          346-772
            Long Term Up Trend                              592-1733
            Year End Fair Value (revised):                 1533-1577
   
2009    Year End Fair Value                                1370-1410

  Percentage Cash in Our Portfolios

     Dividend Growth Portfolio                  38%
    High Yield Portfolio                             38%
    Aggressive Growth Portfolio               32%

Economics

    The economy is a neutral for Your Money.  This week witnessed little in the way of economic data points though those that were reported largely pointed at a bottoming process.

    Weekly mortgage applications (secondary indicator) were once again the only indication of housing activity; they rose 7.1%.

    Measures of consumer health were generally good: weekly retail sales rose; and while February retail sales were off (though less than expected), ex auto, those sales were relatively strong; the University of Michigan’s preliminary March index of consumer sentiment came in at 56.6 versus estimates of 56.0 and the final February reading of 56.3.  The only sour note was the jobless claim number which rose more than forecast (but remember employment is a lagging indicator)
 
    Both the January wholesale and business inventory figures were reported down.  The bad news is that wholesale sales dropped at a faster rate than inventories; the good news is that business sales declined at a slower rate.  So we have just a tiny ray of light that inventories could be coming under control.


    Finally, on the macro economic front, February’s budget deficit reached $192.8 billion.  (And it is going to get much worse.)
   
    Once again, it was the nonstatistical economic news that was important.  I covered most of it in the Morning Calls; but just to list them (1) numerous signs that the banking industry is healing from within, (2) a hopeful indication that the auto companies are also making progress toward financial health, and (3) what we all have to hope is a move towards finally dealing with the toxic assets on bank balance sheets--what appears to be a mounting effort to revise the mark to market rule. 

    Bottom line: the economy may be in the process of proving that it is a lot more resilient than many believed.  Even if it is--and I think it too early to tell--in my opinion, any recovery will be weighed down by increasing usurpation of the productive capacity of this country by the government in the form of increasing regulation, huge budget deficits, rising tax rates and a more protectionist trade policy.  Furthermore, those monstrous budget shortfalls will be exacerbated by a more liberal social/political agenda and the inevitable day of fiscal reckoning coming in the entitlement programs.  Finally, money supply has been expanding at a rate similar to those of third world countries and seems likely to lead to a period of rapidly rising inflation.
 
 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.
http://article.nationalreview.com/?q=M2QzYTFlZTNhZDBlNzBjZGI2ZmExNzI2YTlmNDgyZTg=
http://legalinsurrection.blogspot.com/2009/03/russian-military-expert-warns-of.html

The Market-Disciplined Investing
    
    Technical

         The indices (DJIA 7223, S&P 756) closed this week in a downtrend whose boundaries are defined by approximately DJIA 5657-7793, S&P 556-799.  The nearest support level is the long term up trend line of both Averages which now sit at roughly the DJIA 3942, S&P 594 levels. 

           On a more positive note, both Averages smoked the short term resistance levels (DJIA 7146, S&P 741); and as you know, it generated an increase in the chorus of pundits predicting that a bottom has been made. While there are positive fundamentals to justify such as position (extremely undervalued stocks and early signs of some resilience in the economy), it is too early to start betting a lot of money on it.  I will be a lot more inclined to that line of thinking if equities can penetrate and hold above the  upper boundary of the August 2008 to present downtrend (DJIA 7793, S&P 799).
 
          Apropos of that, as I looked through the charts Friday after the close, it was apparent that many if not most of the financial stocks in our Universes closed right their own August 2008 to present downtrend line.  My take on this is that since the financials  have been the price leaders in this recent rally. this group could give us a good advance indicator of Market direction.  By that I mean, if they break through their respective downtrend lines, it would suggest that stocks in general may do the same.  If they roll over, ditto the Market. 
   
  Fundamental-A Dividend Growth Investment Strategy

         The DJIA (7223) finished this week about 39.3% below Fair Value (11914) while the S&P closed (756) around 44.9% undervalued (1374).
 
          It may be a potential positive that the animal spirits came alive this week; and certainly as the preceding paragraph makes clear, equities are undervalued at least based on my assumptions about corporate earnings and their pricing.  However, they have been undervalued for the last year and the only thing that has happened is that they just kept getting more so.  Plus, as I note above, one week’s positive pin action does not a trend make.  As a result, my conclusion last week remains unchanged:

         ‘..........our task in this emotion charged Market is to be sure that we survive and have the chips to be at the table when conditions improve.  Hence, till there is some indication (a big flush or prolonged trading at these or lower levels [to which I add ‘following a penetration of the upper boundary of the current August 2008 to present downtrend’]), our strategy focuses on liquidity (cash 30-50%) and a hedged position (gold 0-10% and the S&P short ETF 0-10%).  Within our equity holdings, the focus is on those stocks that at a minimum hold their October/November 2008 lows.’            

          As to our Portfolios’ actions this week, on two separate occasions, they Sold shares in technically weak holdings, using the funds received to Buy additional shares in those stocks that have held above their October/November 2008 lows.  The S&P short ETF was Sold following the S&P break above its 741 level. And cash was lowered slightly (1-2%). 

         Just to tie up a loose end from Friday’s Morning Call, the Aggressive Growth Portfolio did not buy the S&P long ETF (SPY), though it still may if the financials break through the aforementioned August 2008 to present downtrend.

         Finally, I have been doing some work on closed end bond funds because of the interest rate spreads between corporate bonds and Treasuries and the high rates available on corporate bonds.  A couple of gotten my attention.  The most relevant at the moment is the ING Prime Rate Trust (PPR) which owns over 300 first lien loans from companies in 37 different industries.  The shares of this fund are reasonably liquid and yield around 9%.  The High Yield Portfolio will Buy a 5% position at the Market open on Monday.  I am also watching the Nuveen Senior Income Fund (NSL).  Its portfolio is of slightly lower quality but yields over 12%.  I would like to feel better about the general direction of the economy before dipping in quality.
 
           For the moment, our investment strategy includes:

(a)    manage our cash assets between 30% and 50%; and remain aware that defense is critically important,

(b)    insulate our Portfolios from the impact of future inflation by increasing the position in gold and adjusting the weightings of various industry sectors to favor inflation beneficiaries [see the 2/14/09 Closing Bell],

(c)    use price weakness as an opportunity to buy the stocks of attractive companies at attractive prices; use price strength to take profits when a stock’s price appears to have gotten ahead of its underlying company’s fundamentals or to move out of those stocks with weak relative price performance,

(d)    on a longer term basis, recognize that there are a growing number of fundamental factors that argue for increased caution and therefore to proceed carefully in anticipation of valuation and strategy changes that could result from the current extraordinary domestic economic agenda.
 
                                                                 DJIA                    S&P

Current 2009 Year End Fair Value*        12050                    1390
Fair Value as of 3/31//09                        11914                    1374
Close this week                                        7223                    756

Over Valuation vs. 3/31 Close
      5% overvalued                                  12510                    1443
    10% overvalued                                 13105                    1511
   
Under Valuation vs. 3/31 Close
    5% undervalued                             11318                    1305   
    10%undervalued                              10722                    1237
    15%undervalued                             10127                    1168   
    20%undervalued                            9531                        1099
    25% undervalued                              8935                    1031
    30% undervalued                             8340                     962
    35%undervalued                               7744                     893
    40%undervalued                               7148                     824
    45%undervalued                               6553                     756
    50%undervalued                              5957                      687
    55%undervalued                                  5361                     618

* 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.

   Company Highlight:

    Caterpillar is the world’s largest producer of earth moving equipment serving the road building, mining, logging, agriculture, petroleum and general construction industries.  The company has earned in excess of a 20% return on equity on average over the past ten years growing earnings and dividends at a 10%+ annual rate.  While current economic conditions certainly cloud the near term earnings outlook for CAT, those difficulties appear well reflected in its stock price while longer term the company should continue to prosper as a result of:

(1)    continuing rapid growth in developing countries [particularly China and India] which have huge needs for  infrastructure build out, e.g.  China recently announced $500 billion+ in spending fro infrastructure and social projects to 2009-10,

(2)    the company is in the midst of a manufacturing transformation which will improve flexibility, reduce lead times (inventories) and improve margins,

(3)    in response to the current economic environment, CAT is also aggressively cutting costs via work force reductions, decline in over time work, shortened work weeks and delays in R&D expenditures.

CAT is rated A by Value Line, has larger than desirable debt to equity ratio of 67% and its stock yields over 4%.  
http://finance.yahoo.com/q?s=CAT
3/09


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 03-14-2009 2:52 PM by Steve Cook