The Closing Bell-6/26/10
Steve Cook on Disciplined Investing

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Statistical Summary

   Current Economic Forecast
   
2009
    Real Growth in Gross Domestic Product:        -1.0 - -2.0%
    Inflation:                                                                      1-2 %
   Growth in Corporate Profits:                                      0- -5%

2010 (revised)

   Real Growth in Gross Domestic Product:          +3.0- +4.0%
    Inflation:                                                                    1.5-2.5 %
   Growth in Corporate Profits:                                     10-20%

Current Market Forecast
   
    Dow Jones Industrial Average

       Current Trend (revised):
          Short Term Trading Range                             9830-11257
          Long Term Trading Range                              6432-14180
                    
        2009    Year End Fair Value                                9440-9460

        2010    Year End Fair Value (revised)               10120-10140
 
    Standard & Poor’s 500

       Current Trend (revised):
            Short Term Trading Range                             1042-1220
            Long Term Trading Range                              666-1575
               
       2009    Year End Fair Value                                1165-1185

      2010    Year End Fair Value                                  1250-1270   

  Percentage Cash in Our Portfolios

     Dividend Growth Portfolio                  20%
    High Yield Portfolio                              20%
    Aggressive Growth Portfolio               21%

Economics
   
The condition of the recovery has become increasingly uncertain, making the economy,  for the moment, a neutral  for Your Money
.  The data this week confirmed that May was lousy month, economically speaking.  The most notable numbers being those on the housing market.  To be sure, the Market was prepared for a weak showing based on the expiration of the home buyers tax credit; however the magnitude of the decline in activity was unexpected.  Further dimming optimism on the economy was the increased temerity of the Fed policy statement following the FOMC meeting.  Adding to the uncertainty regarding the rebound was (1) the lack of progress in stopping the BP spill and hence any clarity as to the ultimate damage this disaster will have on the lives and the economy of the Gulf coast and (2) an as yet incomplete picture as to how the EU sovereign debt problem will get resolved.  The good news here is that this issue will be at the top of the agenda of the G20 meeting this weekend which hopefully means less ambiguity by Monday. 

Bottom line: our forecast hasn’t changed though my conviction regarding its correctness has.  To be sure, the May economic data has not been good; and the doomsayers are out in force, making standing firm that much more difficult.  That said, there have been plenty of times in the past that the economy has slowed for a breather in the midst of period of economic growth; so I am not going to abandon our short term outlook just yet.  Clearly though the odds of that happening have increased.  Nevertheless, it is important to note that the issue for me is not whether there will be a double dip but rather the pace at which the economy is growing.  June’s data will hopefully allow us to better define the shape of the rebound.
 
On the other hand, I feel much more confident in our long term outlook which is that the economy is burdened by the accumulation of too much irresponsible monetary/fiscal/regulatory policy to return to its historical secular rate of growth. 

This week’s data:

(1)    housing: weekly mortgage applications fell 1.2%; and both the May existing and new home sales were horrendous,
 
(2)    consumer: weekly retail sales were again mixed; weekly jobless claims were better than expected; the University of Michigan’s final June index of consumer confidence came in at 76.0 versus estimates of 75.5,

(3)    industry: May durable goods orders fell but less than anticipated; the Richmond Fed June index of general business conditions weakened a bit,

(4)    macro:  first quarter gross domestic product was revised down, inflation was revised up and corporate profits were revised up; the statement from the latest FOMC meeting was more guarded than those from the recent past.

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 negative for Your Money.
   
    Spend less, borrow less (long):
    http://money.cnn.com/2010/06/25/news/economy/stimulus_spending_cuts.fortune/index.htm

    Saturday morning humor (5 minute video):
    http://www.clubforgrowth.org/perm/?postID=13586

    Obama’s disrespect for the law (long):
    http://article.nationalreview.com/437133/the-law-how-quaint/victor-davis-hanson

The Market-Disciplined Investing
    
  Technical

The Averages (DJIA 10143, S&P 1076) ended the week inside their current trading ranges (9830-11257, 1042-1220) though they have traded below the 10210, 1084 support level for two day.  As you know, I had expected a bounce at this level.  If it doesn’t materialize by Tuesday, 9830, 1042 become the next visible candidates for support.  Unfortunately, if equity prices fall to that area, we have to worry about the likelihood (or lack thereof) of a triple bottom--which are rare occurrences, i.e. the third time is usually the charm and support collapses.  Adding to my concern is the VIX which closed Friday for the second time above both its initial resistance level as well the recent down trend off its May high.

To feel comfortable putting cash to work, I would really like to see a bounce from point higher than 9830, 1042.  If that doesn’t happen, then as I noted above, we have to worry about the high probability of a break below that level.

Bottom line:

(1) short term, the indices are in a trading range defined by 9830-11257, 1042-1220; however, the lower boundaries could easily be challenged this week,

(2)    long term, stocks are in a trading range defined by the 2002/2009 lows [S&P 666-766] and the 2000/2007 highs [1545-1575].  Importantly, I think that equity prices will continue to recover within that range but it will be a slow and volatile process.

   Fundamental-A Dividend Growth Investment Strategy

    The DJIA (10143) finished this week about 3.6% above Fair Value (9795) while the S&P closed (1076) around 11.6% undervalued (1218).
 
The good news this week is that we received some clarity on a number of unknowns:

(1)    we now know the shape of the financial regulation.  This will remove investor uncertainty about its final form--a plus.  It also is a lot more benign than many feared--a potential positive depending on your point of view.  Unfortunately, it does little to address the problems of the last meltdown and hence will do little to prevent the next one.  Further, it is 2,000 pages long, senator Dodd says that he has no idea what impact it will have on financial institutions--and that suggests lots of unintended consequences.

Dylan Radigan on the financial regulation bill (medium):
http://www.ritholtz.com/blog/2010/06/wall-street-reform-politicians-lie-media-applauds-america-suffers/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+TheBigPicture+%28The+Big+Picture%29&utm_content=Yahoo!+Mail

And Barry Ridholtz (medium):
http://www.ritholtz.com/blog/2010/06/grading-financial-regulatory-reform/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+TheBigPicture+%28The+Big+Picture%29&utm_content=Yahoo!+Mail

(2)    we will likely know more about how the world will deal with the sovereign debt risk following the G20 meeting this weekend--though Obama is likely to get an unsympathetic ear to His plea for more fiscal stimulus,

(3)    speaking of which, this week the senate DK’d  Obama’s latest stimulus plan; plus England and Germany both announced reductions in government spending--the first hints of fiscal responsibility in a decade,

(4)    and finally, if the second quarter corporate profit number in the GDP report [see Friday’s Morning Call] is any kind of signal for the upcoming earnings season, we should be getting some positive profit figures over the next couple of weeks. 

More analysis of the first quarter corporate profits number (short):
http://scottgrannis.blogspot.com/2010/06/corporate-profits-look-very-strong.html

The bad news is that we had another week of mixed to lousy US economic numbers, the economic outlook as defined by the FOMC statement is weakening,  the BP spill continues and there is now the risk of a hurricane in the area by next week and we still need clarity on how the Europeans are going to handle their sovereign debt problem.  Of course, with stock prices down 3%+ this week and 11% below Fair Value (as defined by the S&P), at least some of these potential risks/problems are price in. 

I noted in the Closing Bell last week that it was premature to get jiggy as a result of the additional information we received on the sovereign debt problem in Europe and the BP oil spill.  I would caution this week not to get beared up because of the poor housing data and the Casper Milquetoast tone of the FOMC statement. 

Having said all of that, the bottom line is that stock prices are at a juncture that demands caution.  I have both a Buy List and a Sell List and await developments next week.

This week, the Dividend Growth and Aggressive Growth Portfolios lightened up on stocks that experienced a technical breakdown.

           Bottom line:

(1)      our Portfolios will carry a higher cash balance than pre-financial crisis but it will be more a function of individual stock valuations and less on macro Market technical trends,
 
(2)    we continue to include gold and foreign ETF’s in our asset mix because we continue to believe that inflation is the major long term risk.  An investment in gold is an inflation hedge and holdings in other countries provide Angel a hedge against a weak dollar and Beer exposure to better growth opportunities,

(3)    defense is still important.

                                                                     DJIA                    S&P

Current 2010 Year End Fair Value*        10130                    1260
Fair Value as of 6/30/10                           9795                    1218
Close this week                                         10143                   1076

Over Valuation vs. 6/30 Close
      5% overvalued                                   10284                    1278
    10% overvalued                                    10774                   1339 
    15% overvalued                                    11264                   1400

Under Valuation vs. 6/30 Close
    5% undervalued                                    9305                   1157
    10%undervalued                                 8815                      1096
    15%undervalued                                  8325                    1035   

* 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 06-26-2010 11:53 AM by Steve Cook