The Closing Bell-4/25/09
Steve Cook on Disciplined Investing

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  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 Trading Range                         6432-?
               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 Trading Range                                      666-?
            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                  27%
     High Yield Portfolio                             27%
    Aggressive Growth Portfolio              27%

Economics

    The economy is a neutral for Your Money; although on a short term basis, it is becoming a positive as investors’ perception focuses on the slowing rate of economic decline--which, of course, assumes that a recovery will follow.  I don’t take issue with that position.  Indeed, our forecast basically agrees it.......except for one major caveat:  that once the economy stops deteriorating, a whole new set of inflation related problems will begin to emerge driven by excessive monetary growth and a fiscally irresponsible budget.  In my opinion, that keeps the economy as a neutral at best on a longer term basis.

    There were few data point this week; but those that were reported were generally supportive of the notion that the economy is struggling through a bottoming process:
   
(1)    March existing home sales fell more than estimates as did the March new home sales--however, the latter was from a February new home sales number which was revised up dramatically; weekly mortgage applications [secondary indicator] fell 4.2%,

(2)    weekly retail sales were better than expected though they were positively impacted by the Easter/Passover holiday; weekly jobless claims rose 27,000 which was less than forecasts,

(3)    March leading economic indicators were down .3%--more than estimated-- while March durable goods orders declined one half of what was anticipated.

One comment on the biggest non statistical (and non political--wink,wink) economic news of the week which was the release Friday of the terms of the so called bank ‘stress test’.  Market participants, at least as described by the Market pundits, had been wary all week, concerned that (1) the ‘stress’ conditions of the test could be ball busters , (2) and as a result, the May 4 scheduled revelation date for how each bank faired under the test could potentially reveal grave weaknesses in some bank balance sheets (3)  which would in turn lead to another October ’08, November ’08 or March ’09 type sell off in stocks. 

Not to worry; as it turns out, the ‘stress test’ wasn’t all that stressful.  Plus both Geithner and the Fed in separate statements said that no bank is going to fail--so I doubt that there is much potentially ‘bad’ news coming from any particular bank.  And my guess is that by the time that the official results are made public, all or most of the information will already have been leaked anyway.  In other words, this all seems to have been much ado about nothing.

Which leads to the questions, why have a stress test in the first place? and now that we have had it, what do we do now?  Since each bank, the FDIC and the Fed already run stress tests as a matter of course,  a new test hardly seems necessary.  Of course, it could be that it was just a ruse to somehow make the public feel warm and fuzzy about the financial system.  If so, then come May 4, those banks that made A’s and B’s will be allowed to pay back the TARP money, those making C’s will be allowed to earn their way out of the TARP obligations and those making D’s (remember no one has failed) will be put into bankruptcy with the FDIC taking them over and doing what it does best.  On the other hand, if the test was to justify the government cramming more money into the banks and to assume even more control than it has already commandeered....well, then Houston, we have a problem.  Let’s hope that concern is ill founded,

Here is the complete text of the stress test, for those who care:
http://paul.kedrosky.com/archives/2009/04/lots_of_testing.html

Here is a distilled version:
http://www.ritholtz.com/blog/2009/04/stress-test-white-paper/

 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.

    I reprint my lament from Thursday’s Morning Call:

    ‘In the last week or so, garbage is starting to accumulate that will have, I believe, a negative impact on stock prices.  It includes: (1) the recent report from the Inspector General [which I linked to in an earlier Morning Call] that stated that the TARP program was riddled with fraud and other abuses [note; this was reinforced Friday by the report from the Government Accountability Office reporting that similar problems existed in the recently passed $700 billion Stimulus Act—see link below], (2) the vacillation of our Philosopher King on whether or not to prosecute those in the CIA that approved and executed the prisoner interrogation programs [if there are show trials of CIA agents or lawyers who worked to achieve a justifiable approach to terrorist interrogations that ultimately proved successful in stemming further attacks on the US, my bet is that investors will not react positively], (3) a new energy policy that will impose an enormous tax on consumers and (4) the proposal to tax the foreign unrepatriated earnings of US companies [wait till the first major US corporation moves its headquarters offshore; and tell me the Market goes up on that news].’
http://blogs.abcnews.com/politicalpunch/2009/04/government-watc.html
http://article.nationalreview.com/?q=OTcyNzBkNzg4YWI3MWM4YzY1MjIyMzY1MDIwNDE5Mjk=


The Market-Disciplined Investing
 
  Technical

The indices (DJIA 8076, S&P 866) closed this week in a very short term trading range defined roughly by DJIA 7800-8401, S&P 820-876.  As you can see, the S&P closed at the high end of this range.  The 8401, 876 level also functions as the upper boundary of a longer term, but still developing, trading range that has a lower boundary of the early March lows (6432, 666).

My bottom line on the technicals is that the last three weeks have been nothing but Market churn.   At the moment, it is pointless to try to speculate on whether stocks will break to new highs or begin a test of the March lows.  This is a time for patience; stocks will let us know which way they want to go in their own good time.  But just by way of anticipation--if they move up, the next resistance level is DJIA 9078, S&P 947; if down, support exists at the November 2008 lows (DJIA 7437, S&P 740).

Here is a very interesting look at the volume during this latest rally as compared to past bounces off bear market lows:
http://www.ritholtz.com/blog/2009/04/bear-market-rally-look-at-volume/
 
  Fundamental-A Dividend Growth Investment Strategy

The DJIA (8076) finished this week about 32.2% below Fair Value (11929) while the S&P closed (866) around 37.0% undervalued (1376).
 
           As I noted above, short term the economic data being released is being interpreted positively by investors (me included) and that seems to be driving stock prices higher helped along with the fact that the public is playing catch up from a woefully underinvested position. 

I have a tough time believing that the Market can go much higher as long as the political economy is evolving as it is (exemplified in part by the government policies delineated in the Politics section above).  Indeed, if we get much more of this, I will likely ratchet down (again) the long term secular economic growth rate assumptions and raise the inflation assumptions in our Valuation Model--which would have the affect of lowering the Valuation Ranges of stocks as well as the Averages. 

For the moment, my thinking remains the same:

“--it is tempting to believe that in light of the recent stock price increases a new bull market is under way.....In my simplistic way of looking at things, stocks aren’t in a bull market until they trade above their preceding highest high (DJIA 14190, S&P 1575).  Indeed, stocks aren’t even out of a bear market until they penetrate the downtrend line from that Market high (circa DJIA 11669, S&P 1250).

    That said, it doesn’t mean an investor stays at a maximum cash position until one or both of those levels are breached.  It just means that following a Market low, stocks are in a trading range and the degree to which the investor wants to hedge (cash, gold, etc) is a function of their price level. For instance, when I became convinced that the early March lows were the bottom, our cash position went from 30-50% to 20-30%; and our Portfolios discontinued trading the S&P short ETF. 

And for the moment, that is as far as I want to go.  Why?  Because right now, we don’t know the first price level that stock prices will meet meaningful resistance
(but as noted above, if stock prices can’t get through the 8401, 876 level, we will).  More important, we don’t even know if DJIA 6432, S&P 666 marked the bottom; and we won’t know for sure until there is a test to the downside.    So to me, this is a time for patience.  And when the test of the 6432--666 level comes (and assuming it is successful), it will in all likelihood be time to move our cash position to 15-25%.

In the meantime, I want to use
(additional) .. Market strength (a move to the S&P 900 level) to (1) sell lower quality securities, stocks of companies that continue to disappoint fundamentally and to trim positions in stocks that have gotten ahead of themselves fundamentally, (2) use part of the proceeds to buy the stocks of companies that are performing fundamentally and (3) the rest to gradually raise cash towards the 30% level.”

    If stocks drop to the S&P 740 level, our Portfolios will Buy stocks taking cash to the 24% level.
   
As to our Portfolios’ actions this week: none were taken.
 
 Our investment strategy includes:

(a)    manage our cash assets between 20% and 30%; and remain aware that defense remains 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 4/30//09                          11929                    1376
Close this week                                           8076                    866

Over Valuation vs. 4/30 Close
      5% overvalued                                    12525                    1445
    10% overvalued                                     13121                    1513
   
Under Valuation vs. 4/30 Close
    5% undervalued                                  11332                    1307   
          10%undervalued                          10736                    1238
    15%undervalued                                10139                    1170   
    20%undervalued                                  9543                      1101
    25% undervalued                                  8946                    1032
    30% undervalued                                  8350                     963
    35%undervalued                                    7753                     894
    40%undervalued                                   7157                     826
    45%undervalued                                     6560                     757
   
* 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 04-25-2009 2:35 PM by Steve Cook