Saturday, February 23, 2013

The Closing Bell-2/23/13


The Closing Bell

2/23/13
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 Uptrend                                13462-14116
Intermediate Uptrend                              13398-18398
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                                       1465-1535
                                    Intermediate Term Uptrend                       1418-2013 
                                    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                              39%
            High Yield Portfolio                                        40%
            Aggressive Growth Portfolio                           40%

Economics/Politics
           
The economy is a modest positive for Your Money.   This week’s data was tilted to the negative side: positives---January building permits and weekly retail sales; negatives---weekly mortgage and purchase applications, January housing starts, weekly jobless claims and the February Philly Fed index; neutral---January PPI and CPI, January existing home sales and the January leading economic indicators.

 However, the real economic news this week included continued deterioration in the EU economy, the slight change in tone in the FOMC meeting and the approaching sequester (March 1).  I will cover all of these issues in Pluses and Negatives portion of this narrative.  But in summary: (1) the economic data though mildly negative is typical of the current recovery and taken by itself is not of concern to me, (2) a decline in European economic activity can’t be good for our own growth prospects, though I am not making any changes in our forecast to reflect it---at least for now, (3) while the reading of the latest FOMC minutes spiked investor blood pressure Wednesday and Thursday, on Friday Fed officials were all over the print and TV media reassuring all that the presses will be at full throttle into the foreseeable future and finally (4) I believe that the sequester will be a positive for the economy---assuming it occurs,  Bottom line: while I am not changing our outlook, this week’s developments have raised my anxiety level:

‘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.’
           
            Update of big four economic 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.

            Counterpoint:

       The negatives:

(1)    a vulnerable global banking system.  The big news items this week were the bankruptcy of the second largest Spanish bank, loan problems in Italy, Elizabeth Warren taking the too big to fail banks to task and a study on the unknowable size of the global financial systems exposure to derivatives.  I add one more straw on this camel’s back via the link below: 

The latest math on the vulnerability of the too big to fail banks (medium):

In sum, these all illuminate [a] the potential risk that exists on any one bank’s balance sheet and [b] because of the counterparty risk via derivatives becomes a potential risk on all banks’ balance sheets.

‘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 ‘debt ceiling/sequestration/continuing resolution cliff’.  Double, bubble, toil and trouble.  March 1 draws nigh and it is getting hot in the kitchen.  The airwaves are buzzing with a multitude of horrendous, recession inducing consequences if sequestration is allowed to take effect.  Bulls**t.  The reductions in the rate of spending from the sequester are a wart on elephant’s ass in comparison to the total spending that will occur even with the sequester.  Nevertheless, this dishonest, hyper-rhetoric will get even worse next week.

The only question is will the GOP fold or hold firm?  At the moment, it appears that there is  no fallacy, no illusion, no mendacity that Obama will not stoop to in order to pressure the republicans into folding.  Regrettably, I don’t have a great deal of confidence in the steel in the GOP’s backbone.  So I remain a skeptic. 

As you know, this is my line in the sand.  If republicans cave; hello European nanny state.  Even if they don’t, it will still be only a baby step in the direction of fiscal responsibility.  It will not solve our debt and deficit problems; nor will it improve the economic outlook near term.  Only if it is the first of many steps can we hope to get the debt to GDP ratio down from 105% to under 90%---which is the threshold postulated by Rogoff and Reinhart below which a country’s growth is unimpeded by the burdens associated with too much government debt. 

       And:

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 an 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.  The big news this week was the discussion in the FOMC minutes regarding an end to monetary easing and then two day later {after a Market hiccup} the very public multiple denials that the Fed will tighten in our lifetimes.

I had originally opined that while I didn’t believe the Fed was close to tightening, the mere mention of it in the FOMC minutes could prompt investors to start worrying about when it might take place and start hedging their bets in the bond markets.  That could still occur; but with Friday’s Mission Impossible-like disavowal of any knowledge of monetary restraint, I suspect this is now a moot point----leaving investors to return to their prior state of ignorant bliss. 

And leaving the rest of us with the problem that {i} the Fed has never managed a successful transition from easy to tight money without causing either a recession or high inflation and {ii} the longer the Fed pumps, the more difficult that transition is likely to be. 

As you know, my bet is that tightening won’t happen soon enough; so we get what is behind door number two: inflation  [a] Bernanke has already said {too many times to count} 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.

     Saturday morning humor (two minute video and a must watch):

      Update on inflation (medium):

      A corollary concern is that all this money printing increases the potential for a currency war.  an overly easy monetary policy generally results in the depreciation of the currency of that bank’s country which in turn improves that country’s trade balance and strengthens its economy.  That is great unless its trading partners get pissed and commence their own ‘easy money/currency depreciation’ effort.  At that point, you got yourself a currency war; and that seems to be the direction that the major economic powers are headed in.’ 

[b] a blow up in the Middle East.  It was mostly quiet on this front this week---although the experts are starting to worry that the expansion of the conflict in Mali will spill over into Nigeria {a major source of light, sweet crude}.  Hence, it would likely be a mistake to get lulled into a false sense of security.  There are plenty  of flash points any one of which could escalate into violence that would in turn lead to a disruption in either the production or transportation of Middle East oil, pushing energy prices higher.

(4)   finally, the sovereign and bank debt crisis in Europe remains a major risk  to our forecast.  This week, we were barraged with a steady stream of lousy headlines out of the EU: [a] poor PMI numbers across the continent, [b] a revised European Commission economic forecast that calls for recession in the eurozone lasting into 2014, [c] a rapidly expanding Spanish budget deficit [d] a disappointing second round of LTRO bank repayments and [e] a Moody’s downgrade of the UK credit rating. 

Looking ahead only slightly, the Italian elections occur Sunday and Monday with Berlusconi’s anti austerity party running in second place.  Any outcome that would lead to a reversal of current fiscal policy could threaten Italy’s ability to borrow from the ECB.

Still, investors refuse to hold the eurocrats to account for their inaction in dealing with the current sovereign/bank insolvency problems; and hence, they  continue to do nothing.  As a result, the worsening economic climate will at the very least impact global activity and at the worse precipitate another state or financial institution bankruptcy that potentially exposes the global banking community to another round of counterparty defaults.

      And:

Bottom line:  the US economy continues to grow in its erratic, subpar manner.  I see little domestically that would alter that scenario.  Sequestration will almost certainly not be the disaster that Obama and the MSM are portraying it to be.  Indeed, I think that it could be a positive, if it occurs.  Fed policy is unlikely to change in the next six to nine months, as affirmed by Friday’s Fed media blitz. 

The biggest risk to our Models is multiple European sovereign/bank insolvencies.  The likelihood of those happening has probably increased as the EU economy slips further into recession (lousy PMI’s, Spanish budget deficit, EC forecasts recession into 2014) and political instability (Italian elections).  Of course, nothing will happen as long as investors maintain their current optimism---which will not likely go on forever.

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications were down; January housing starts declined but building permits were up while existing home sales fell fractionally,

(2)                                  consumer: weekly retail sales improved; weekly jobless claims rose more than anticipated,

(3)                                  industry: the Philly Fed February manufacturing index plunged,      
                
(4)                                  macroeconomic: January PPI and CPI were basically in line with forecasts; January leading economic indicators were up slightly less than expected.
           
The Market-Disciplined Investing
           
  Technical

The indices (DJIA 14000, S&P 1515) finished within both their short term uptrends (13462-14116, 1465-1535) and intermediate term uptrends (13398-18398, 1418-2013).   With Friday’s nice rebound, the Wednesday/Thursday air pocket appears to have had no lasting impact.  I still think it reasonable that the Averages will challenge 14140/1576.

Volume on Friday was up and breadth was particularly strong.  The VIX was off but still closed within its intermediate term downtrend---a positive for stocks.

GLD rose for the second day, but still could not recover above the lower boundary of its short term downtrend---not good.


            Bottom line:

(1)   the Averages are trading within their short term uptrends [13462-14116, 1465-1535] as well as their intermediate term uptrends [13398-18398, 1418-2013].

(2) 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 (14000) finished this week about 23.5% above Fair Value (11350) while the S&P (1515) closed 7.8% overvalued (1406).  Incorporated in that ‘Fair Value’ judgment is some sort of half assed compromise on the fiscal (debt ceiling/sequestration/continuing resolution) cliff, continued money printing, a historically low long term secular growth rate of the economy and a ‘muddle through’ scenario in Europe.

The economy is tracking with our forecast; and as I noted above, (1) any Fed tightening is still a ways off and (2) any spending cuts from sequestration will have minimal impact on the economy.  Hence, there are no domestic economic reasons to alter the assumptions in our Valuation Model.

That said, there could be one potential psychological impact:  if our ruling class actually does the right thing, makes substantial reductions in government spending which would in turn portend a higher future economic and corporate profit growth rate.  I  categorize this as unlikely; so I am not even considering factoring it into our Valuation Model.  I will, however, be watching. 

On the other hand, Europe continues to deteriorate both economically and politically.  If these trends aren’t reversed, then my guess is that sooner or later our Valuation Model gets changed as a result of  (1) declining US corporate profits due to the poor performance of European subsidiaries and/or (2) damage done to the global financial system by sovereign/bank insolvencies. Unfortunately,  the odds of one or both of the above are something more than unlikely. 

As you know, our forecast is for Europe to ‘muddle through’’ and so far, that is exactly what it has done.  Regrettably, this scenario is more a function of investors being willing to believe that the eurocrats can successfully stem any crisis than actual proof that they can or even know how do so.  To be fair, to date they have held off disaster.  However, they have done nothing to fix its systemic causes---which in point of fact have gotten worse.  So the question is, can they do it again when conditions have further deteriorated?  I don’t know; but I am suggesting that (1) the odds of averting a crisis the next time are lower than they were on the previous occasion and (2) the tail risks have grown in magnitude.

       My investment conclusion:  nothing has happened (data, FOMC minutes, sequestration) that would warrant a change in the assumptions in our Valuation Model.  Hence, stocks remain overvalued. 

       However, the risks of a deeper European recession/financial debt crisis are rising.  These could effect our profit assumptions in both Models and our P/E assumptions in our Valuation Model.  The problem is that I still can’t quantify those dangers associated with a severely wounded financial system.
     
       This week, our Portfolios continued to lighten up on either fundamentally or technically overextended stocks.

       The latest from JP Morgan (medium):

       Final readings on this season’s revenue and earnings ‘beat’ rate (short):

       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 2013 Year End Fair Value*                11600                                            1440
Fair Value as of 2/28/13                                   11350                                                  1406
Close this week                                                14000                                                  1515

Over Valuation vs. 2/28 Close
              5% overvalued                                 11917                                                    1476
            10% overvalued                                 12485                                                   1546 
            15% overvalued                             13052                                             1616
            20% overvalued                                 13620                                                    1687   
            25% overvalued                                   14187                                                  1757               
Under Valuation vs.2/28 Close
            5% undervalued                             10782                                                      1335
10%undervalued                             10215                                                1265   
 15%undervalued                             9647                                                    1195

* 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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