The Closing
Just a reminder that SSI daughter, her husband and three children will be here next week. I will be rising early and producing the Daily Blog but won’t have time to write the Closing Bell. Clearly, I will be on top of stock prices and will notify you if action is warranted.
The Bottom line
Statistical Summary
Current Economic Forecast
2007
Real Growth in Gross Domestic Product (
Inflation: 2 - 2.5 %
Growth in Corporate Profits (revised): 6-8%
2008
Real Growth in Gross Domestic Product (GDP): 3-3.25%
Inflation: 1.75-2%
Growth in Corporate Profits: 7-9%
Current Market Forecast
Dow Jones Industrial Average
2007
Current Trend:
Medium Term Uptrend 12855-14293
Long Term Uptrend 11400-23400
Year End Fair Value (revised): 13250
2008 Year End Fair Value (revised): 14250
Standard & Poor’s 500
2007
Current Trend:
Medium Term Uptrend (?) 1449-1585
Long Term Uptrend 1225-2400
Former Long Term Trading Range (?) 750-1527
Year End Fair Value (revised): 1525
2008 Year End Fair Value (revised): 1640
Percentage Cash in Our Portfolios
Dividend Growth Portfolio 10%
High Yield Portfolio 34%
Aggressive Growth Portfolio 9%
Economics
The economy is a positive for Your Money--and there is nothing in this week’s economic data to suggest otherwise.
(1) in housing, the only data point was weekly mortgage applications which were up 8.1% after two weeks of decline; yes, this is a secondary indicator; yes, the credit market problems will continue to plague home construction and sales; and no, we aren’t arguing that this week’s mortgage application number is a sign that housing has bottomed.
(2) consumer spending continues its erratic advance. The International Council of Shopping Center reported weekly sales by major retailers dropped .3% [versus a 1.1% increase last week] but rose 3.1% on a year over year basis. Redbook Research reported month to date retail chain store sales increased .6% versus the similar period in July and 2.9% versus the comparable period in 2006.
Retail Metrics reported July retail sales up 2.9%; OK but well short of the 3.9% posted in July 2006,
On the other hand, June consumer credit rose 6.5% on an annualized basis and was up 5% from the comparable period in 2006.
Bottom line, consumer spending may not be waxing but neither is it waning.
Finally, weekly jobless claims rose 7,000 versus expectations of an increase of 4,000; while mildly disappointing, employment remains strong.
(3) in the industrial sector:
(a) second quarter non farm productivity rose 1.8% versus expectations of a rise of 2.1%; seemingly a disappointment but in fact, it is the highest rate of increase since the first quarter of 2006.
(b) second quarter unit labor costs up 2.1% versus expectations of up 1.8%; again doesn’t look good on the surface, but it has less inflationary implications than the 3% increase in the first quarter.
Repeating several points: [i] historically, corporate profits rise rapidly in the early stages of an economic cycle with increases in wages trailing; then later in the cycle, unit labor costs accelerate as they are doing now. The point being that these numbers are to be expected and not something about which to fret. [ii] labor has to participate in the fruits of the free market economy in order to assure economic, social and political stability. Wages increases are simply catching up to prior profit growth--and, in our opinion, that is a good thing.
(c) June wholesale inventories rose .5% versus expectations of an increase of .4%; however, as has been occurring for the last couple of months, June wholesale sales grew faster [.6%], keeping the wholesale inventory to sales ratio at 1.1 months--a record low and a positive sign for future production.
(4) in the government sector, the US Treasury announced that the FY2007 budget deficit at the end of July was $157 billion versus $239 billion for the comparable period in 2006. Thank you W.
Bottom line, our forecast remains that the economy is slowing gradually but won’t experience recession (the ‘soft’ landing) and that inflation is moderating. We noted a couple of weeks ago that (1) the short term risk to this forecast was a second down leg in housing, (2) if the July existing and new home sales numbers show no sign of improvement, there is a decent probability that we will lower our 2007 economic growth forecast, (3) but that adjustment would be minor unless consumer spending falters. At this point, we have little reason to believe that July’s housing data will show signs of a turnaround or that consumer spending will roll over; hence some minor adjustment to our 2007 economic growth rate is likely but it will not alter the general pattern: ‘soft’ landing and moderating inflation.
The wild card is the current well publicized credit problem, in that if additional bankruptcies among financial institutions not only inhibit the financing of anything other than the marginal mortgages and LBO’s (that led to the problem in the first place) but also lead to job losses that could reduce consumer spending, further downward revisions in economic growth would be necessary and turn the slow down from a ‘soft’ to a ‘hard’ landing. To be clear, at the moment, this is only a risk not something we expect.
Finally just to confuse you, we have raised modestly our forecast for corporate profit growth for 2007. The second quarter earnings season is basically behind us and profits were up an average of 11% (15% on a capitalization weighted basis). That is considerably better than many (including ourselves) expected and reflects the increasing influence that the global economy is having on US corporate profits. It therefore puts our forecast for a rise in 2007 earnings of 5-7% on the low side. So we are revising that 2007 outlook for profit growth up to 6-8%.
Before you scoff, (1) that is a 16% increase in the rate of change in growth and (2) our Economic Model is based on long term secular trends not shorter term cyclical factors. In making this revision, we are implicitly saying that (1) we think the probability is low of the credit market problems spreading outside the financial sector of the economy, (2) the problems in the housing market will be contained and (3) barring political stupidity, global war or some major negative exogenous event, the powerful secular growth of the global economy will be driving world economic and US corporate profit growth for years to come.
The Economic Risks:
(1) the economy is weaker than expected (brought on by further problems in the credit market).
(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
(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 environment are negatives for Your Money. If you read our blogs this week or watched the AFL-CIO sponsored debate among the Democratic candidates, you have a sense of our concern regarding a change in the direction of economic/social policy. Protectionism, higher taxes, more regulation, welfare programs for the middle class--they are all there in the Democratic agenda. Yes, it may be just primary political rhetoric. Yes, even if they are dead serious, conservative elements in the legislature (and perhaps the executive branch) may prevent the passage of the more radical elements. And yes, you may agree with this more liberal agenda. But strictly from the standpoint of equity valuation, these policies would not be a positive if enacted.
http://article.nationalreview.com/?q=MzVmMjZkMWM2ZGQ5MTk1N2ZlZDc2NjZmYWYzMWVhZjE=
If you haven’t been paying close attention to the news out of
The Market
Technical
The DJIA closed the week above the 13200 level. This is the fourth time 13200 has been challenged and held. Furthermore, the S&P held 1449 (the lower boundary of a short term up trend). This is all to the good; certainly the more times investors buy when DJIA trades at 13200 (S&P 1449), the more likely it is that they will buy again when prices reach that level.
The DJIA is in an up trend defined by the approximate boundaries of 12855 and 14293. The S&P for a third time failed to remain above the 2000 to present trading high of 1527 which, in our opinion, leaves that index in its seven year trading range with boundaries of 750-1527.
Fundamental
Two fundamental points to make:
First, our Valuation Model changed modestly following the revision our 2007 corporate profits forecast. Factoring this modification into our Valuation Model, our 2007/2008 Year End Fair Values have been revised up: 2007 DJIA from 13000 to 13250, 2008 DJIA from 14000 to 14250; 2007 S&P 500 from 1500 to 1525, 2008 S&P 500 from 1625 to 1640.
Second, stepping back from the current high level of anxiety, we want to stress that equities today are basically fairly valued (as defined by our Valuation Model). This correction is not some much needed adjustment after a wild Titan III shot that took stocks into dramatically over valued territory. Indeed, stock prices in general are barely about their 2000 level. Don’t forget that it has been less than a year since the DJIA broke above the high set back in 2000 and it is now barely 12% above that former high. Meanwhile, the S&P still hasn’t traded above its 2000 high in any convincing manner.
Granted stocks were over valued in 2000; but while equity prices are at virtually the same level seven years later, the health of the US economy and US corporations have dramatically improved and the global economy is even more robust. Even if the US economic growth slows more than we expect, it is still strong and again global economic demand for US goods and services will serve to limit the extent of any slowdown in economic or corporate profit growth (US equity valuations).
To be sure, stocks have been slightly over valued for the last couple of months (again as defined by our Valuation Model); that over valuation was likely going to be corrected sooner or later and now it has been. Ignoring the extreme volatility, to date that is all that has really happened.
As to the credit crisis, it is (1) the result of excessively speculative behavior by a small segment of the financial community, (2) moreover, the risks are much more widely dispersed [i.e. lower exposure per investor] than would have been the case a decade ago. So we think that there is a decent argument that it will remain contained. Granted the extent of the problem still isn’t known and may not be for some time to come; but in the scheme of things, the likelihood of some ‘financial collapse’ scenario is probably small.
What is making this situation seem so bad is that, similar to all past financial panics, those investors who are being hurt by their own inappropriate speculation are disproportionately impacting security prices at the margin, which is to say, (1) the speculators are be forced to sell securities to meet financial obligations [like redemptions] and often the only thing that they can sell is not the problem securities but higher quality, more liquid stocks and (2) since investors’, in general, are fearful of the consequences of the aforementioned unwise risk taking, they are afraid to buy stocks; therefore, there are no bids and, therefore, any selling by the speculators drives security prices down dramatically. In the final analysis, that creates value for people like us.
So hang in there; as this is being written, (1) the SEC has announced in will review the finances of major investment banking firms [which will start to provide investors with knowledge about the volume and pricing of sub prime loans on these financial institutions books--and that is a major positive] and (2) the Fed has stepped in three times to provide liquidity [this does nothing to quantify or identify sub prime problems although it does {a} help the banks continue to lend money to each other and {b} demonstrates that the Fed is in tune to the risks of the current situation]. We still don’t want to be buying the financial stocks yet, but the SEC and Fed actions do move us closer to that point.. In the meantime, values in other sectors of the Market are being created which we will want to take advantage of when order returns to the Market.
DJIA S&P
Current 2007 Year End Fair Value 13250 1525
Fair Value as of
Close this week 13238 1453
Over Valuation vs. 8/31 Close
5% overvalued 13650 1570
10% overvalued 14333 1649
Under Valuation vs. 8/31 Close
5% undervaluation 12380 1421
10%undervaluation 11761 1349
The Portfolios and Buy Lists are up to date.
Company Highlight:
Polaris Industries designs, engineers and manufactures snowmobiles, all terrain vehicles, personal water craft and motorcycles. In 2006 the company experienced a drop in revenues which precipitated a stock decline. However, PII management has been aggressively working to resolve its problems by releasing new products, improving operating efficiencies, reducing production and inventories in those product lines experiencing sales weakness. In addition, it is working to enhance shareholder value via a $450 million stock buy back and annual increases in its dividend. The company has historically grown profits and dividends 10-11% annually while earning a 30%+ return on equity. The company assumed debt as it began its stock buy back program taking its debt/equity ratio to levels that we find too high. However, PII has outstanding cash flow which it is using to aggressively lower that debt.
EPS: 2006 $2.76, 2007 $2.95, 2008 $3.50; DVD: $1.40 YLD 2.6%
http://finance.yahoo.com/q?s=PII
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 38 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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