Saturday, July 27, 2013

The Closing Bell--7/27/13

The Closing Bell

7/27/13

Statistical Summary

   Current Economic Forecast

           
            2012

Real Growth in Gross Domestic Product:                           2.2%
                        Inflation (revised):                                                              1.8 %
Growth in Corporate Profits:                                  16.1%

            2013

                        Real Growth in Gross Domestic Product                       +1.0-+2.0
                        Inflation (revised)                                                             1.5-2.5
                        Corporate Profits                                                              0-7%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                      14190-15550 (?)
Intermediate Uptrend                              14449-19449
Long Term Trading Range                       4918-17000
                                               
                        2012    Year End Fair Value                                     11290-11310

                        2013    Year End Fair Value                                     11590-11610                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                      1600-1756
                                    Intermediate Term Uptrend                       1535-2123 
                                    Long Term Trading Range                         715-1800
                                                           
                        2012    Year End Fair Value                                      1390-1410

                        2013   Year End Fair Value                                       1430-1450         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                              43%
            High Yield Portfolio                                        46%
            Aggressive Growth Portfolio                           43%

Economics/Politics
           
The economy is a modest positive for Your Money.   This week’s economic data  reversed the very positive flow last week and came in weighed to the negative: positives---weekly retail sales, the July Market flash PMI, June new home sales, the Kansas City Fed manufacturing index and the index of consumer sentiment; negatives---weekly mortgage and purchase applications, the May Chicago National Activity Index, June existing home sales, the July Richmond Fed manufacturing index, June durable goods, ex transportation; neutral---weekly jobless claims.

While this week’s numbers were a bit disappointing, they follow several weeks of upbeat data.  So I am not that concerned about one week’s worth of stats.   The key as always is whether this week is an outlier or marks the beginning of a trend, which by definition we won’t know for sometime. 

I continue to leave the yellow light flashing because of the confusion generated over ‘tapering’ which may be manifesting itself in this week’s spurt in interest rates.  Longer term if this move up in rates continues, I suspect that it will have an impact on investment and spending plan.  However, at the moment, it is confusion and not higher interest rates that prompts me to keep the caution flag up.  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 historic inability of the Fed to properly time the reversal of a vastly over expansive  monetary policy.
           
            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. 
               
       The negatives:

(1) a vulnerable global banking system.  This week the news came from the US where [a] UBS paid a $900 million fine for mortgage fraud and [b] the CFTC  began an investigation in metals market manipulation by Goldman Sachs and our ‘fortress’ bank, JP Morgan---the latter being a perfect example of what the banks are doing with all the money that the Fed is giving them for free.

Saturday morning humor (5 minute video):


‘My concern here.....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)   fiscal policy.  Unfortunately, Obama just couldn’t let a good thing continue.  This week He started a new economic campaign which sounded strangely like His old economic campaign that didn’t work---heavy on promoting income equality, light on promoting growth. 

So it sounds like this year’s budget wrangle will be another ideological battle.  The good news is that it will probably end like all the rest---in a stalemate that keeps spending under reasonable control.  ‘Reasonable’ being the operative word in light of the horrendous Farm Bill passed by the GOP controlled house.  The bad news is that entitlement and tax reform remain a wet dream.

        Why we have to have entitlement reform (medium):

      All that said, the shrinking budget deficit and the serial delays in the implementation of Obamacare remain short term bright spots in an otherwise cloudy long term outlook.

I also continue to worry about .....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.....
                  
(3)   the potential negative impact of central bank money printing:  The key point here is that [a] the Fed has inflated bank reserves far beyond any comparable level in history and [b] while this hasn’t been an economic problem to date, {i} it still has to withdraw all those reserves from the system without creating any disruptions---a task that I regularly point out it has proven inept at in the past and {ii} it has created or is creating asset bubbles in the stock market as well as in the auto, student and mortgage loan markets. 

The multiple debates continued this week over whether or not Bernanke really intends to ‘taper’, whether ‘tapering’ is ‘tightening’, whether or not investors have discounted ‘tapering’ and whether or not investors have diminished faith in the Fed. 

However, as I noted in Friday’s Morning Call, I think that investors, including me, have been missing the point.  The Market has made clear over the last month that it doesn’t like higher interest rates---whatever the cause.  The reasons they go up or down will manifest themselves in time.  The point here is to not get too heavily invested in why interest rates are going up or down because I will waste a lot more time and effort than I have already wasted trying to justify some thesis about Fed actions when the Fed isn’t even clear on what it is doing and why.  The point is, are interest rates are going up or down?

Bottom line: my thesis has been that Fed will repeat its past mistakes and botch the transition from easy to tight money.  It reinforced that notion with its bungling of the ‘tapering’ affair and attempting to wordsmith its way out of it by differentiating ‘tapering’ from ‘tightening’.  The only difference between the latest half assed effort at transitioning and the next will be that  the  Fed’s massively bloated balance sheet will be even more bloated.

Quotes from the chairman (medium):

The Markets have spoken and they said that they don’t like higher interest rates, whatever the reason.  In the fullness of time, they will likely tell us all we need to know about ‘tapering’ and ‘tightening’.

 (4) a blow up in the Middle East.  Little new this week.  Nevertheless, the region remains volatile, so potential disruptions in supply or transportation continue to be a threat to prices---which can in turn influence economic growth of heavy energy consuming economies.

(4)   finally, the sovereign and bank debt crisis in Europe.  This week witnessed more upbeat economic news out of Europe.  It is still too early to conclude that the EU economy has turned; but at least there is something upon which to hang ‘hope’. 

If we do assume for the sake of argument that Europe is improving, what would that mean to our forecast?  It would [a] increase the probability that our ‘muddle through’ scenario will work out and [b] it would lessen my concerns about a sovereign/bank default.  In other words, it would do nothing to alter our forecast; although it would temper the tail risk of this factor.

But that is getting a bit ahead of ourselves.  For the moment, I am encouraged by the European economic news over the last two week, but it is too soon to get jiggy.

To keep things in perspective:

The situation in Spain continues to worsen (medium): 

      Counterpoint:

      Europe extends and pretends (medium):

Bottom line:  the US economy continues to track with our forecast, this week’s lousy numbers notwithstanding.  Fiscal policy is creating less of a drag than it was a year ago, though my hopes of additional improvement have been tempered somewhat by the tone and message of Obama’s new economics campaign.  Entitlement and tax reform seem as far away as ever.

Monetary policy is unclear despite the best efforts of Bernanke and his colleagues to clarify ‘tapering’.  Confusion abounds on whether or not ‘tapering’ comes sooner or later, whether ‘tapering’ is ‘tightening’ and whether the Market has discounted ‘tapering’ assuming it comes.   Until that uncertainty is removed, it is likely that businesses and consumers will remain cautious.

In Europe there is a light at the end of the tunnel, perhaps.  Economic data over the last two weeks have improved but it is far too soon to know if that light is the end of the tunnel or an oncoming freight train.

Another piece from the optimist.  Note the number of ‘coulds’ and ‘shoulds’ versus  ‘is’s’. (medium):

This week’s data:

(1)                                  housing: June existing home sales were well below expectations, while new home sales were strong; weekly mortgage and purchase applications fell,

(2)                                  consumer: weekly retail sales were positive; weekly jobless claims rose, in line; the University of Michigan’s July index of consumer sentiment came in ahead of forecasts,

(3)                                  industry: June durable goods orders were up, but ex the very volatile transportation sector, they were off more than forecasts; May Chicago National Activity Index was very disappointing; the June Markit flash PMI was better than anticipated; the July Richmond Fed manufacturing index was negative versus positive estimates, while the Kansas City Fed index was above expectations,

(4)                                  macroeconomic: none.
           

The Market-Disciplined Investing
           
  Technical

The Averages (DJIA 15558, S&P 1690) were quite volatile this week.  The Dow broke above the upper boundary of its short term trading range (14190-15550), negated the break, then broke above that upper boundary for a second time.  If it closes above 15550 Monday, the trading range will be invalidated, the Dow will be back in sync with the S&P and the Market will re-set to a short term uptrend. 

While the S&P remained within its short term uptrend (1600-1756) all week, it did close below the May high (1687) which should have acted as support.  Nevertheless, it rebounded the next day, tried to challenge that level again on Friday but was unsuccessful.

With a strong bid under the Market, the bulls are still in control.  That suggests that the Dow will re-set to an uptrend Monday night and we will then shift our attention to the upper boundaries all uptrends: short term (14880-16000, 1600-1756), intermediate term (14449-19449, 1535-2123) and long term uptrends (4918-17000, 715-1800).

Volume on Friday was down; breadth was mixed.  The VIX closed near the lower boundary of its short term trading range and well within its intermediate term downtrend.

GLD had a good week and, in fact, is building a very short term uptrend.  It, however, remains solidly within both a short term and intermediate term downtrends.
           
Bottom line: the challenge of the 15550/1687 level appears to be coming to an end.  If the Dow closes above 15550 on Monday, it will re-set to an uptrend.  At that point, the Market’s short term trend will also be re-set to up. 

And if that occurs, there will be no overhead resistance save the upper boundaries of the three major trends (S&P short term---1756, intermediate term---2123, long term ---1800). 

If 1756/1800 (short and long term upper boundaries) represent the technical upside in stocks, that is only about up 3-6% from current levels versus 6% downside if stocks return to the short term lower boundary, 9% if they slide to the intermediate term lower boundary, 18% if they return to Fair Value and 57% if they make it all the way to the long term lower boundary

            A technical review of the Market (medium):

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (15558) finished this week about 35.6% above Fair Value (11475) while the S&P (1690) closed 18.8% overvalued (1422).  Incorporated in that ‘Fair Value’ judgment is some sort of half assed attempt at getting fiscal policy under control, a botched Fed transition from easy to tight money, a historically low long term secular growth rate of the economy and a ‘muddle through’ scenario in Europe.

The economy continues to perform in a very encouraging way and, therefore, remains a positive input to our Valuation Model.

While fiscal policy is improving by default (sequestration and the tax hike), I was disappointed by the rhetoric and tone of Obama’s introduction of His new economic plan this week.  Unfortunately, His focus is still on income inequality (i.e. redistribution) and not on growth.  The good news is that nothing will likely come of it; the bad news is that nothing will likely come of entitlement and tax reform.   Hence, fiscal policy will remain a headwind to growth in the economy and, more important, to corporate profits and valuations.

To be sure, the performance of American business had been nothing short of spectacular in the last four years.  But I  believe that businesses have squeezed their operations about as tightly as they are able and earnings growth via productivity gains are near an end.     For profit growth to return to historic levels, I believe that less regulation, a more rational tax structure and less government usurpation of capital are necessary; and that remains a hope and a prayer.

Monetary policy is not only lousy but it is, at the moment, confusing.  It has done little to improve the economy while simultaneously injecting risk in the form of bloated bank reserves, encouraging speculation via promoting the ‘carry trade’, buying up virtually 100% of the US government’s net new financing and being far too confident that it can manage the transition from easy to tight money---something for which it has absolutely no historical basis.  I cannot tell you how this story is going to end; but I don’t believe that it will end well; and because we are in uncharted waters, trying to judge the impact on our Economic and Valuation Models would be nothing but a wild assed guess.

Finally, bad news out of Europe has subsided, at least for the moment.  Because southern Europe is such a mess, it will take an extended period of improving economic results to remove the EU from the critical list.  Let’s hope for is a continuation of this nascent trend---which if it occurs will simply fortify our ‘muddle through’ scenario.

          My bottom line hasn’t changed from last week:  ‘our main issue today is, is there any changes warranted in our investment strategy should Fed induced euphoria return and stocks shoot the moon?   Or less dramatically put, what happens if stocks break out to the upside, driven as it were by more punch? 

(1)     our Valuation Model hasn’t changed, so neither have the Fair Values of the stocks in our Portfolios.  To be sure, we have a few names on our Buy Lists.  But our Portfolios already own full positions in most.  I am going to leave the remainder at less than full positions because of the simple risk/reward equation that I cited above.  But for an investor that just has to put money to work, use our Buy Lists,

(2)     if any of our stocks trade into their Sell Half Ranges, our Portfolios will act accordingly,

(3)     for anyone wanting to push out on the risk curve: [a] if 15550/1687 hold and prices roll over, simply buying the VIX (VXX) is a good alternative as well as the Ranger Short ETF (HDGE) and [b] if stocks rocket upwards and you have to play, a good multi asset class ETF (IYLD) would be a less risky way to participate; the Russell 2000 ETF (IWO) would be the more risky alternative.  A purchase of any of these alternatives should be accompanied by very tight stops.’
        
        This week, the High Yield Portfolio Sold its position in Sanofi.

        Three signs of a Market top (medium):


DJIA                                                    S&P

Current 2013 Year End Fair Value*                11600                                                  1440
Fair Value as of 7/31/13                                   11475                                                  1422
Close this week                                                15558                                                  1690

Over Valuation vs. 7/31 Close
              5% overvalued                                 12048                                                    1493
            10% overvalued                                 12622                                                   1564 
            15% overvalued                             13196                                                       1635
            20% overvalued                                 13770                                                    1706   
            25% overvalued                                   14343                                                  1777   
            30% overvalued                                   14917                                                  1848
            35% overvalued                                   15491                                                  1919
            40% overvalued                                   16065                                                  1991
           
Under Valuation vs.7/31 Close
            5% undervalued                             10901                                                      1350
10%undervalued                                  10327                                                  1279   
15%undervalued                             9753                                                    1208

* 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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