Surprise!  This weekend is my annual college pledge class reunion.  I am leaving on the Bell today.  So this week’s Closing Bell is short, but the stats are all updated.   My review of it is just a bit abbreviated versus normal.  I am starting the editing and publishing process a 2 PM; so if something doesn’t seem quite right because of an extraordinary move in the last hour, cut me some slack.


  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

      Real Growth in Gross Domestic Product:        +1.0- +2.0%
      Inflation:                                                                    1.5-2.5 %
      Growth in Corporate Profits:                                      7-15%

   Current Market Forecast
   
    Dow Jones Industrial Average

        2008
          Current Trend (revised):
                Short Term Trading Range                      ????-10110
               Long Term Trading Range                      6432-14180
               Year End Fair Value (revised):                13450-13850
        
        2009    Year End Fair Value (revised):                12030-12070

        2010    Year End Fair Value                                12400-12600
 
    Standard & Poor’s 500

      2008
            Current Trend (revised):
                Short Term Trading Range                       ????-1100
                Long Term Trading Range                        666-1575
                Year End Fair Value (revised):                 1533-1577
   
2009    Year End Fair Value                                1370-1410

        2010    Year End Fair Value                     1430-1450   

  Percentage Cash in Our Portfolios

    Dividend Growth Portfolio                  17.5%
    High Yield Portfolio                             17.5%
    Aggressive Growth Portfolio              17.5%

Economics

    The economy is a short term positive for Your Money, although  it may (1) either already be in the price of eggs or (2) as I noted last week, it may not be a positive for long.  Not that I don’t expect growth, I do--just not much of it.  Thursday’s better than expected third quarter GDP number notwithstanding, I continue to believe that the US is faced with a slow, sluggish, below normal recovery, the consequence of a severely constrained financial system and a federal government that thinks it knows more about how to spend Your Money than you do.

    Of course even that scenario would still be a positive for Your Money.  However, my concern today is that investors may already have a year or so’s growth discounted in stock prices.  Hence that growth isn’t going to do anything for valuations in the next six to nine months. 

To be fair, there are two potential problems with this argument. 

First, economic growth could be higher than called for in our forecast.  As evidence, some would point to the aforementioned GDP report which appeared to a show a recovery much stronger than I am projecting.  And that may well prove to be right.  But after reviewing subsequent analysis of the make up of that 3.5% increase, if the effects of the cash of clunkers and first time home buyers credit are removed, GDP grew 1.5%; in other words pretty much in line with our forecast.  So Thursday’s dramatic Market rebound on that GDP number does nothing to alter my stance.  We may still get additional data pointing to a much steeper rebound; and if we do, I would clearly have to reconsider.
    http://www.ritholtz.com/blog/2009/10/big-gdp-number-3-5/

    Second is the issue of valuation; that is, it could be that even the very slow recovery that I envision is still not adequately reflected in prices.  Supporting this notion is opening statement of the Fundamental section of each Closing Bell in which I note the degree of undervaluation of the indices. 

However, as I have stated previously I have been getting uneasy with the valuations coming out of our Model.  Specifically I am concerned that I may still be over estimating the longer term secular growth rate of the economy and/or under estimating the rate of inflation being built into the system.  As a result, I have spent a good part of this week playing around with different assumptions in our Model; and I will likely alter some of them and that will pull down Fair Value.  How far, I am not sure yet; but they will probably be sufficient enough that stocks in general will not appear nearly as undervalued as they do now, if at all. 

Of course, there is nothing to prevent investors from seeing more value than is either currently reflected in stock prices or might be reflected in any revisions in our Model. But if that is the case, as they bid stocks up, it will drive our Portfolios to higher cash positions.

    Longer term, I am not at all hopeful that the economy will be a positive for Your Money because of the strong likelihood that the Fed will be unable to time correctly its exit from an historically huge expansion of the money supply and the central government’s agenda of taking more of our money and spending it as well as massive borrowings on programs antithetical to free market capitalism [socialized medicine, an over regulated energy market, protectionism, etc].  Indeed, I am not sure that these potential problems are even long term.  The more apparent the recovery, the closer we are to the ‘timing’ issue of the Fed’s exit; and anyone watching the news knows that the healthcare issue is likely to be resolved soon.

    This week’s data:

(1)    housing: weekly mortgage applications slipped again; September new home sales were a disaster; but the August Case Shiller home price index increased,

(2)    consumer: weekly retail sales were a positive for the fifth week in a row; weekly jobless claims declined but not as much as anticipated; September personal income was unchanged, as was expected, while September personal spending fell 0.5%, also as expected; the two October measures of consumer confidence were mixed with the University of Michigan’s consumer sentiment index advancing above estimates while the Conference Board’s  index of consumer confidence was well below forecasts,

(3)    industry: September durable goods orders rose but less than estimates; the October Chicago purchase managers index came in well ahead of expectations,

(4)    macroeconomic: third quarter gross domestic product came in better than anticipated while the associated inflation index was less than forecasts.

 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.

The Market-Disciplined Investing
    
  Technical

    As of 2PM the indices (DJIA 9729, S&P 1035) appear to have broken their up trends off the March lows and are transitioning into a trading range.  We know the upper boundary of that range (circa 10110, 1100).  The task now is to define the lower boundary.  I am watching the following levels in the S&P: 1020, 990, 978, 870 as potential candidates. 

The VIX exploded to the upside, once again trading above that trend line off its October 2008 high, reinforcing the notion that stocks are breaking down.

Finally, I quote Thursday’s Morning Call: ‘...., our internal indicator also deteriorated further--of 161 stocks in our universe, only 88 remain in an up trend (versus 111 at last count).  The good news is that 106 remain above their November 2008 trading high (versus 108 at last count) and 122 remain above the down trend off their 2008 highs (versus 133 at last count)--which I choose to interpret as suggesting that while stocks may be in for a period of sideways action, we are not currently in any danger of retesting the March lows.’ 

Bottom line:

(1) short term, both indices appear to be moving into a trading range.  In that environment, it bolsters my focus on our strategy of sensitivity to our trading stops as they apply to stocks’ short term up trend off the March lows . 

(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 (9729) finished this week about 19.0% below Fair Value (12019) while the S&P closed (1035) around 25.3% undervalued (1386).  (now subject to change) 

The fundamental issues with which I am now grappling are:

(1)    the economy: specifically, are we far enough along in the recovery that the Fed’s ‘exit’ strategy now moves front and center? and how much deeper in debt and more centralized will our government become before the electorate has had enough?  I don’t know those answers.  I do believe that they are sufficiently close that their resolution will start getting reflected in stock prices sooner rather than later. 

(2)    the dollar/gold/commodities/stock price interconnect: I covered this point in Friday’s Morning Call, so there is not much more to say:

‘I am having an increasingly tough time believing that the dollar/stock inverse relationship can go on ad infinitum.  I believe that loose monetary policy and out of control spending have significant inflationary implications.  I believe that this implies a weakening dollar. I believe that a weak dollar likely means higher gold and commodity prices.  But I don’t believe that a declining dollar is good for stocks in the long run.  I have no clue when that relationship breaks apart, although I had my self convinced it was starting earlier in the week. But may be not; may be there is another leg to go.’

I would add that stocks seem to be a place where good news is bad news (i.e. if the Fed gets its exit right, then rates will likely increase, the dollar increases and stock prices fall at least initially) and bad news is bad news (i.e. the Fed waits too long, the dollar continues to get whacked and if I am correct sooner or later investors panic in the face of rising inflation and sell stocks).

(3)    valuations: I covered this above in the Economics section.
 

This week our Portfolios moved from 12.5% cash to 17.5% cash.
 
           Bottom line:

(1)      if stocks have moved into a trading range, our Portfolios will manage their cash between 12.5% and 22.5%.

(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 a hedge against a weak dollar and exposure to better growth opportunities,

(3)    I intend to maintain the use of trading stop losses at least until the economic, technical and fundamental factors impacting valuation become clearer.  These are much tighter stops [i.e. they follow the stock price up] than those determined by our Valuation Model. 

(4)    defense is important.
 
                                                                     DJIA                    S&P

Current 2009 Year End Fair Value*        12050                    1390
Fair Value as of 10/31//09                       12019                    1386
Close this week                                          9729                   1035

Over Valuation vs. 10/31 Close
      5% overvalued                                   12619                    1455
    10% overvalued                                   13221                      1524 
   
Under Valuation vs. 10/31 Close
    5% undervalued                                   11418                     1316
   10%undervalued                                   10817                    1247
    15%undervalued                                 10216                    1178   
    20%undervalued                                   9615                    1109
    25% undervalued                                  9014                    1039
    30% undervalued                                  8413                     970


* 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.