Saturday, December 22, 2012

The Closing Bell--Happy Holidays

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The Closing Bell

12/22/12

The Christmas holiday is here and I am once again going to take a break.  I will be back on 1/2/13 but the notes that week will be abbreviated.  Oklahoma plays Texas A&M in the Cotton Bowl the evening of 1/4/13 which will involve incoming friends from out of town as well as pre and post game festivities.  I will be back full time of 1/7/13.  In the meantime, I, as usual, will be keeping abreast of the Market; and if action is needed in our Portfolios, I will be in touch via Subscriber Alerts.  Have a very happy holiday season.

Statistical Summary

   Current Economic Forecast

           
            2012

Real Growth in Gross Domestic Product:                      +1.0- +2.0%
                        Inflation (revised):                                                             2.5-3.5 %
Growth in Corporate Profits:                                 5-10%

            2013

                        Real Growth in Gross Domestic Product                       +1.0-+2.0
                        Inflation (revised)                                                             2.5-3.5
                        Corporate Profits                                                              0-7%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                     12460-13302
Intermediate Up Trend                            13009-18009
Long Term Trading Range                      7148-14180
Very LT Up Trend                                       4546-15148        
                                               
                        2012    Year End Fair Value                                     11290-11310

                        2013    Year End Fair Value                                     11590-11610                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                       1426-1476
                                    Intermediate Term Up Trend                     1373-1968 
                                    Long Term Trading Range                        766-1575
                                    Very LT Up Trend                                         651-2007
                       
                        2012    Year End Fair Value                                      1390-1410

                        2013   Year End Fair Value                                       1430-1450         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                              33%
            High Yield Portfolio                                        34%
            Aggressive Growth Portfolio                           35%

Economics/Politics
           
The economy is a modest positive for Your Money.  This week’s economic data was basically mixed: positives---existing home sales, personal income, durable goods orders, and the Philly Fed manufacturing and Chicago National Activity indices; negatives---mortgage and purchase applications, housing starts, jobless claims, consumer sentiment and the New York Fed manufacturing index; neutral---weekly retail sales, personal spending, third quarter GDP and the November leading economic indicators.

These stats are nicely supportive of our forecast:

‘a below average secular rate of recovery resulting from too much government spending, too much government debt to service, too much government regulation, a financial system with an impaired balance sheet. and a business community unwilling to hire and invest because the aforementioned along with the likelihood a rising and potentially corrosive rate of inflation due to excessive money creation and the historic inability of the Fed to properly time the reversal of that monetary policy.’

And (short):

Update on the big four indicators:

            The pluses:

(1) our improving energy picture.  The US is awash in cheap, clean burning natural gas.... In addition to making home heating more affordable, low cost, abundant energy serves to draw those manufacturers back to the US who are facing rising foreign labor costs and relying on energy resources that carry negative political risks. 
     
(2) an improving Chinese economy.  As you know, I added this factor last week but with the caveat that there is disagreement among the experts about the extent of the progress. All things considered, I think that there is sufficient evidence to support the notion, even though we got no statistical collaboration this week.

       The negatives:

(1) a vulnerable banking system.  The Libor price fixing scandal continues to widen with UBS getting tagged with a $1.5 billion fine.  Once again this didn’t involve a US institution; but it is still illustrative of several points that I have been making: [a] the continuing lack of financial controls at major global institutions and [b] the negative consequences of an easy money, zero interest rate policy spawning the chase for performance by investors in particular those who are gambling with someone else’s money.

And (short):

‘My concern here is that: [a] investors ultimately lose confidence in our financial institutions and refuse to invest in America and [b] the recent scandals are simply signs that our banks are not as sound and well managed as we have been led to believe and, hence, are highly vulnerable to future shocks, particularly a collapse of the EU financial system.’
    
(2) the ‘fiscal cliff’. This week, the republicans abandoned the talks on a compromise, tried to pass Boehner’s Plan B, failed and went home for Christmas. This most likely means no compromise before 1/1/13.

On the other hand, we already know what Obama wants and He clearly holds all the cards right now.  The Tea Party republicans now appear to have two choices: (1) play hard ball, refuse to compromise, push the economy over the cliff and suffer the consequences, i.e. lose control of the House in 2014 or (2) take Ann Coulter’s advice, vote present on the Obama plan and make sure the electorate knows that He owns this plan. 

#2 above is roughly the alternative built into our Model [some tax increases, few spending cuts, and nothing to alter the longer term sub par growth rate of the economy].  However, the odds of #1 above occurring have gone up; and were it to happen, the economic outlook for 2013 would turn decidedly negative.

A problem related to the ‘fiscal cliff’ is the potential rise in interest rates and its impact on the fiscal budget.  As I have noted previously, the US government’s debt has grown to such a size that its interest cost is now a major budget line item---and that is with rates at/near historic lows.  Moreover, government debt continues to increase and the lion’s share of this new debt is being bought by the Fed. 

So the risk here is two fold: [a] to the Fed---its balance sheet is levered to the point that Lehman Bros. looks like it was a AAA credit.  So if interest rates go up {and prices go down}, the very thin equity piece of the balance sheet would disappear.  The Fed would then be technically bankrupt. and [b] to the Treasury---it must pay the interest charges.  Hence, if rates go up, the interest costs to the government go up; and if they go up a lot, then this budget line item will explode and make all the more difficult any vow to reduce government spending as a percent of GDP and/or manage the fiscal cliff.

(3)   rising inflation:

[a] the potential negative impact of central bank money printing.  In last week’s Closing Bell, I posed the question of how soon would the rest of global central bankers follow the Fed’s attempt to break the intergalactic speed record for money printing.  This week, Japan was the first to join. 

‘The risk of a massive global liquidity infusion is, of course, inflation.  The bulls argue that thus far, all this money has gone into bank reserves [meaning it has not been spent or lent], that as long as banks are too scared to lend and businesses to borrow, it will remain unspent and unlent and therefore will have no inflationary impact.  And they are absolutely correct.  But the whole point of the Fed’s exercise, i.e. QEIII {QEIV}, is to encourage banks to lend and businesses to invest.  So on the off chance that the plan works, inflationary pressures will grow unless the Fed withdraws the aforementioned reserves before inflation kicks in.

And therein lies the rub.  [a] Bernanke has already said {four times} that when it comes to balancing the twin mandates of inflation versus employment, he would err on the side of unemployment {that is, he won’t stop pumping until he is sure unemployment is headed down}.  That can only mean that the fires of inflation will already be well stoked before the Fed starts tightening and [b] history clearly shows that the Fed has proven inept at slowing money growth to dampen inflationary impulses---on every occasion that it tried.


[b] a blow up in the Middle East.  There was not much news out of the Middle East this week, save that Russia was sending two naval squadrons to the area.  However, I don’t think that this lack of news mitigates the risk that a larger scale conflict {US invades Syria, Israel bombs Iran} brings impairment to either the production and/or the transportation of crude oil out of the Middle East long enough to begin hindering US {and global} economic growth and ultimately pushes the economy into recession and/or adds fuel to inflationary impulses 

(4) finally, the sovereign and bank debt crisis in Europe remains the biggest risk to our forecast.  This week was generally quiet though there was some improvement in the economic data suggesting that conditions may have stopped getting worse (‘may’ being the operative word).  On the other hand, the political situation in Italy is deteriorating with former PM Berlusconi threatening that Italy may leave the EU if his party regains power in the upcoming elections.

All in all, this news does little to alter my opinion or assuage my concerns; although the longer investors are willing to believe that the EU can ‘muddle through’, the better chance there is that the eurozone economy can improve and allow the eurocrats to sustain their pipe dream.  It may happen; but if it doesn’t (and I still think that the odds are that it won’t), I can’t quantify the downside and that’s a problem. 

Bottom line:  amazing as it is, the US economy continues to growth though admittedly at a historically below average rate.  Unfortunately, our political class is doing nothing to correct that problem; and this week’s events only confirm that the obstacles created by irresponsible fiscal, monetary and regulatory policies will be with us indefinitely.  Indeed, the odds of running off the fiscal cliff appear to have risen.  In other words, not only are our politicians not trying to improve the economic environment, they seem unconcerned that they are getting close to making it worse. 

Uncle Ben isn’t helping matters either.  In my opinion sooner or later, QEIV will almost certainly lead to higher inflation.  That said, the fall in the price of gold this week at the very least raises doubts as to the timing of any surge in price levels.  For the moment, I am sticking with my forecast that the longer the Fed pumps money into the system and the more bloated its balance sheet becomes, the harder it will be to get the timing and magnitude of monetary tightening correct.  However, as I noted in Friday’s Morning Call that assumption is now under review.

The biggest risk to our Models is multiple European sovereign/bank insolvencies, though, as I said above, recent data suggest Europe may be through the worst of its current slowdown.  Coupled with investors’ current overly faithful confidence that the eurocrats will somehow hold the EU together, it would seem that our ‘muddle through’ scenario has a bit of a better chance of succeeding than I have been reckoning of late.  That doesn’t mean that the EU will ‘muddle through’; and if it doesn’t, I still have no clue how to assess the consequences of a crisis though I believe them to be significant.

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications fell sharply; November housing starts declined more than anticipated while existing home sales came in above forecasts,

(2)                                  consumer: weekly retail sales were mixed; weekly jobless rose more than expected; November personal income was above estimates while personal spending was in line; December consumer sentiment came in lower than anticipated,   

(3)                                  industry:  November durable goods orders were strong; the December NY Fed manufacturing index was very disappointing while both the Philly Fed manufacturing and the Chicago National Activity indices were above expectations,      
                
(4)                                  macroeconomic: third quarter GDP was revised upward; however most of the change was due to inventory build; the November leading economic indicators fell but in line forecasts.

                           
The Market-Disciplined Investing
           
  Technical

Friday, the indices (DJIA 13190, S&P 1430) had a rough day.  While the Dow closed back below the upper boundary of its short term trading range (12460-13392), the S&P did not return to a comparable level (1424) and remained within its newly re-set short term uptrend (1426-1476).  Both continue to trade within their intermediate term uptrends (13009-18009, 1372-1968).

Thursday’s DJIA break above the upper boundary of its short term trading range has once again been rejected.  So any move back above that boundary will simply re-start the clock on the time element of our discipline. 

The Dow is also now back out of sync with the S&P which has broken out of its short term trading range and re-set to an uptrend.  This pin action suggests that stocks are in a battleground zone between the bulls and bears---which means that our job is to stay patient until the Market works itself out directionally.

Volume on Friday soared (but it was option expiration); breadth was down.  The VIX was up a little; however, it couldn’t close above the upper boundary of its short term downtrend which I think a positive for equities.

GLD was up fractionally, but remains in a newly re-set short term downtrend.  However, it continues to trade above the lower boundary of its intermediate term trading range.

            Bottom line:

(1)   the DJIA is in a short term trading ranges [12460-13302], while the S&P has re-set to a short term uptrend [1426-1476].  Both remain within their intermediate term uptrends {12948-17948, 1368-1963},

(1)   long term, the Averages are in a very long term [78 years] up trend defined by the 4546-15148, 651-2007 and a shorter but still long term [13 years] trading range defined by 7148-14198, 766-1575. 

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (13190) finished this week about 16.7% above Fair Value (11300) while the S&P (1430) closed 2.1% overvalued (1400).  Incorporated in that ‘Fair Value’ judgment is some sort of compromise on the fiscal cliff, a ‘muddle through’ scenario in Europe and a lowering of the long term secular growth rate of the economy.

‘As you  know, our assumption on the fiscal cliff is that (1) there is no ‘grand bargain’, (2) a compromise will be reached; and if not by year end then by early 2013 and provisions will be retroactive and (3) the agreement itself will do nothing to help the economy.  That is, taxes will be raised and spending will be barely cut, if at all.  This is exactly the scenario built into our Models; so nothing will change in terms of equity valuation unless we get a grand bargain or our political class allows the cliff to happen.’

This week our political elite took two steps backward on the fiscal cliff---Boehner tried Plan B and failed.  There was nothing left to do but go home for the Holidays.  As you know, I still think that we will get some half assed excuse for a compromise.  It may come later than many wished; but probably not so late that more damage is inflicted on the economy.

The immediate Market question is, will investors retain their Pollyanna attitude toward the cliff following the demise of Plan B?  Friday’s pin action would appear to at least partially answer that question in the negative.  However, stocks (as defined by the S&P) are still overvalued (at least as defined by our Valuation Model).  So I don’t think that Friday’s decline necessarily presages investors giving up hope and panicking.  That is not to say that they won’t; just that they haven’t yet. 

I am still of the opinion that there is a reasonable argument to be made that until investors do panic and thump the Market, the politicians will continue to dick around and avoid having to make any firm decisions on taxes and spending.

Gold’s performance this week has given me reason to question the inflation assumptions in our Economic Model and the size of the GLD holding in our Portfolios.  Indeed, as you know, having Sold all of our trading position as couple of weeks ago, our Portfolios Sold one half of their investment position Thursday.  That doesn’t mean that I am changing our outlook.  It does mean that I am reviewing it and in the meantime want to preserve our profit in this holding.

          Europe continues to ‘muddle through’ helped by some slightly better economic data as well as an investor class that seems to have unbridled faith in their political leaders’ ability to solve the continent’s sovereign/bank debt problem.  I don’t believe that the economic risk of recession or the financial risk of serial derivative defaults by EU banks have diminished.  But as long as the Markets give the eurocrats a free ride, the danger of some imminent crisis is held at bay and time is bought for the eurocrats to do something meaningful.

The bad news is that I still don’t know how to quantify not ‘muddling through’.  I do believe that the consequences will be severe: depressing economic activity (which I can quantify) and creating another financial crisis (which I can’t; simply because we have no idea how much of the notional value of current CDS’s held in the banks will become exposed when those banks start going under).

       My investment conclusion:  while no economic good will likely come from a resolution of the fiscal cliff, the Market impact could be significant if these morons continue to fiddle. 

       No economic good will likely come from QEIV.  Rather as I have noted, it will simply continue to distort the math of investment returns, add to future inflationary pressures, rob savers and line the bankers’ pockets.  Sooner or later, I believe this will negatively affect the rate at which future earnings are discounted.

       Europe remains a problem.  A recession will clearly not help our recovery nor the earnings prospects for US companies; but (1) as I have said, American business has been spectacular in overcoming the serial burdens of the last five years and (2) China could more than offset in EU slowdown. 

       The more significant issue is the fragility of both the EU and the US banking systems caused by the nondisclosure of impaired assets on their balance sheets, the lack of financial controls and the continued atmosphere encouraging inappropriate risk taking by proprietary trading operations.  When, as and if the Markets ever decide to challenge banking policies and valuations, global market could be in for a rough ride.  My solution to this dilemma is to carry an above average cash position as insurance and to insist on lower stock prices to reflect the risk.’  

          The latest from David Rosenberg (medium):

            Last week, our Portfolios Sold one half of their investment position in GLD.

       Bottom line:

(1)                             our Portfolios will carry a high cash balance,

(2)                                we continue to include gold and foreign ETF’s in our asset mix because we continue to believe that inflation is a major long term risk [which is now under review].  An investment in gold is an inflation hedge and holdings in other countries provide exposure to better growth opportunities. 

(3)                                defense is still important.

DJIA                                                    S&P

Current 2012 Year End Fair Value*                11300                                           1400
Fair Value as of 12/31/12                                 11300                                                  1400
Close this week                                                13190                                                  1430

Over Valuation vs. 12/31 Close
              5% overvalued                                 11865                                                    1470
            10% overvalued                                 12430                                                   1540 
            15% overvalued                             12995                                             1610
            20% overvalued                                 13560                                                    1680   
                       
Under Valuation vs.12/31 Close
            5% undervalued                             10735                                                      1330
10%undervalued                                  10170                                                  1260    15%undervalued                             9605                                                    1190

* 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.








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