Our son and his wife are heading for Paris this weekend, so we are headed to San Francisco to baby sit.  They, and hence we, will be gone for two weeks.  So there will be no Morning Calls or Closing Bells for the next two weeks.  However, both grandkids are in school; so I will be staying in very close touch with the Markets and if comments or actions are needed, I’ll communicate via Subscriber Alerts.

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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%

    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
   
        2008
            Current Trend (revised):
            Short Term Up Trend                                8977-10709
             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 Up Trend                                      988-1210
             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%
      High Yield Portfolio                             18%
     Aggressive Growth Portfolio               19%

Economics

    The economy is a short term positive for Your Money.  On balance the data this week supported the view that the economy is either bottoming or has already bottomed.  The debate among most observers is now about the ‘shape’ of the recovery.  I am in the camp of those who believe that it will be something like or between a ‘U’ and an ‘L’ (i.e. a slow, struggling up turn); the majority of those that disagree are forecasting a double dip (‘W’). 

I understand the arguments for both cases and the merit in the numbers supporting them; and I frankly I see no magic statistical bullet or series of statistical bullets that provide overwhelming evidence that the ‘U’/’L’ case is any better than the ‘W’.  Indeed, it is tough not to acknowledge that a ‘double dip’ has about as much likelihood of occurring as a ‘U’/’L’ recovery because (1) the economic premise for both cases [too much deficit spending, too much easy money] is so similar and (2) the outcomes are just variants of how successful the economy will be handling the excessive deficits and money growth, i.e. proponents agree that any recovery will be weak, their issue is how weak and they agree the Fed faces a monstrous task reigning in profligate money growth, their issue is its success in doing so.

What tilts me to the more optimistic (less pessimistic?) scenario is purely my experience: in every recession/bear market that I have lived through, it was always easier for investors to stay bearish around the economic turning point because (1) being bearish doesn’t involve change [and change is difficult for most] and (2) there are more negative coincident and lagging economic indicators in the news than positive leading indicators which helps the rationalization process.
 
    This week’s data:

(1)    housing: weekly mortgage applications fell, the first decline in five weeks,

(2)    consumer: weekly retail sales were once again anemic, while August sales were modestly better than anticipated; auto sales improved as they should have given the ‘cash of clunkers’ program; weekly jobless claims were down less than expected while the August nonfarm payrolls report was slightly worse than estimates [though the employment picture continues to get less bad],

(3)    industry: the two August Institute for Supply Management indices were both better than forecasts with the manufacturing index moving into positive territory--a very good signal that business conditions have bottomed; July factory orders rose though less than anticipated; July construction spending declined versus forecasts of an increase; finally, the August Chicago purchasing managers index was reported at 50.0, a sign that the worst is over for businesses in that region,

(4)    macroeconomic: revised second quarter productivity was up more than estimates, while revised second quarter unit labor costs declined in line with expectations.

 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.

    A history lesson from Victor Davis Hanson (long):
    http://article.nationalreview.com/?q=ZTA1MDg3NmI2ZWMwMTBiMTNhNjhmYzRmYjNmYmIwZDY=

    A look at the rationale for the war in Afghanistan (this is really long, but it is so well written that you won’t notice.  Plus, it is a must read for anyone with an opinion on the war against radical Islam):
    http://article.nationalreview.com/?q=MzFiZDY4MzlmMmU0MDdiNDViN2QxYzcxMDI5ZWI3MTQ=

The Market-Disciplined Investing
    
  Technical

    This week the Averages (DJIA 9441, S&P 1016) finished within their up trends off their March lows (8877-10709, 999-1210).

    The technical assumption that I have been working on since stock prices stalled at the S&P circa 1040 level even as the economic news continued to be very positive was that (1) the worst of the financial crisis and the accompanying recession was over and (2) the realization that an unimpeded Obama political/social/economic agenda would not be enacted, were fully discounted; and hence barring some new positive exogenous event, there wasn’t a lot of up side potential in the Market, at least in the short term. 

In itself that doesn’t argue that stock prices must go down.  However, (1) it is September and (2) our internal technical indicator has deteriorated of late; and those factors point to some price weakness.  So while I am not anticipating a crash, but it may be that short term a flat Market is the good news scenario.
 
Therefore under my current assumption, whether stocks test much lower levels (in Thursday’s Morning Call, I pointed at S&P levels 978 and 875 as possible candidates) or simply stays directionless (till third quarter profit reports start rolling in?) is the issue; and the first indications as to the future course of the Market should come next week when all the players will be back at their desks (Tuesday) and Obama delivers His address on healthcare (Wednesday).

Of course, the preceding may be nothing but a lot of mental masturbation on my part.  The indices closed Friday right on their early August resistance level (though they did so on very low volume, with the VIX still trading in negative territory and only the slightest improvement in our internal indicator). If stocks trade higher on Tuesday, then they are set to challenge the recently established 1040 resistance high.  If successful, we could be looking at a good September and my overly cautious stance of late will have been proven ill founded.

So going into next week,

Bottom line:
 
(1) short term, I think the correct focus should be on the current up trend in   stocks, not a trading range.  Stocks prices may have topped temporarily; so I am sticking with our strategy of extra-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, the recovery in equity prices will be slow and volatile, but a recovery nonetheless.

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (9441) finished this week about 21.3% below Fair Value (12004) while the S&P closed (1016) around 26.6% undervalued (1385). 

‘Our current economic forecast--a slow, plodding recovery accompanied by higher inflation--is not a lot about which to get excited.  True enough; but that doesn’t mean that the securities markets can’t improve--I think that they will.  It will just take longer to return to former highs than might otherwise have been the case.  As you know I have adjusted our Valuation model several times in attempt to reflect these factors; and I may have to do so again.  But at the moment even under our less than optimistic forecast, stocks are still undervalued.’

‘I believe stocks are now reflecting (1) the US economy is not imploding [that accounts for the 666 to 876 move] and (2) gridlock in Washington [that accounts for the 876 to 1004 {?}].  What is left to discount?  Earnings returning to a more normal albeit below average secular growth rate.  That ought to provide the propellant for a continued advance in stock price; although the ascent is likely to be a bumpy one.  The cognitive dissonance along the way will be driven by the realization that the economy will grow at a below average rate as well as what I am assuming to be a political donnybrook over Obama’s agenda.’

This week our Portfolios sold stocks whose prices had either (1) risen to within 5% of the upper boundary of their up trend off the March lows or (2) traded below the lower boundary of that same up trend.
 
           Bottom line:

(1)     our focus is on the process of getting fully invested. This won’t happen over night because our Buy Discipline simply won’t allow it. But the bottom line is that our objective is to buy stocks when they are rendered cheap by the Market.

(2)    we continue to include gold and foreign ETF’s in our asset mix because, as noted above, inflation isn’t going away as a problem and an investment in other countries provides a hedge against a weak dollar and exposure to better growth opportunities,

(3)    recognizing [and hedging] that our recent change in emphasis in investment strategy could be wrong, I intend to maintain the use of trading stop losses at least until it is clear whether or not this call is a correct one.  These are much tighter stops [i.e. they follow the stock price up] than those determined by our Valuation Model. 

(4)    while our strategy is now less defensive, defense remains important.

 
                                                                       DJIA                    S&P

Current 2009 Year End Fair Value*        12050                    1390
Fair Value as of 9/30//09                         12004                    1385
Close this week                                           9441                   1016

Over Valuation vs. 9/30 Close
      5% overvalued                                    12604                    1454
    10% overvalued                                    13204                    1523 

       
Under Valuation vs. 9/30 Close
    5% undervalued                                    11403                   1315
   10%undervalued                                   10803                    1246
    15%undervalued                                  10203                    1177   
    20%undervalued                                    9603                    1108
    25% undervalued                                   9003                    1038
    30% undervalued                                    8402                     969
   
* 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.