The Closing
The Bottom line
Statistical Summary
Current Economic Forecast
2007
Real Growth in Gross Domestic Product (revised): 2.0- 2.5%
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 13105-14676
Long Term Uptrend 11757-23751
Year End Fair Value (revised): 13250
2008 Year End Fair Value (revised): 14250
Standard & Poor’s 500
2007
Current Trend:
Medium Term Uptrend (?) 1452-1585
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
2008 Year End Fair Value: 1625
Percentage Cash in Our Portfolios
Dividend Growth Portfolio 9%
High Yield Portfolio 30%
Aggressive Growth Portfolio 5%
Economics
The economy is a positive for Your Money. The recent Fed action was a major positive as is the revised second quarter gross domestic product data (see below). Yet the economic numbers reported in August and September have been agonizingly mixed--the primary problem being weaker than expected statistics from both the consumer and industrial sectors. That has thus far prompted me to lower my estimates for 2007 economic growth though this revision was to a ‘softer’ ‘soft’ landing not a recession. The good news is that this week’s economic numbers offer encouraging support for that forecast.
(1) in housing, more abysmal news: weekly mortgage applications fell 2.8% while August existing home sales declined 4.3% versus July [though they were in line with expectations] and August new home sales dropped 8.3% versus July and expectations of a 6.1% decrease;
(2) consumer spending data was pretty good though the outlook was tainted by the confidence numbers:
(a) the International Council of Shopping Centers reported weekly sales of major retailers down 1% but up 2.4% year over year. Redbook Research reported that month to date retail chain store sales rose .5% versus the comparable period in July and increased 2.2% versus the similar 2006 period,
(b) August consumer spending was up .6% versus expectations of up .4% while August consumer income rose .3%, in line with expectations--both positive,
(c) more good news: weekly jobless claims decreased 15,000 versus expectations of a rise of 9,000. Things can’t be too bad if everyone has a job,
(d) now the disappointing news: the Conference Board’s September consumer confidence index came in at 99.8 versus expectations of 104.5 while the
(3) statistics in the industrial sector were mixed to positive:
(a) August durable goods orders declined 4.9% versus expectations of a drop of 3%; ex transportation orders, they were down 1.8%. Not good but recall that July’s stats were much better than had been expected; and if the two are averaged, the trend is not as bad as first appears,
(b) August construction spending rose .2% versus expectations of a decline of .2% while nonresidential construction jumped a solid 2.3%,
(c) the September Chicago purchasing managers’ index was reported at 54.2 versus expectations of 53.0.
(4) the macro economic data pointed to a strong second quarter:
(a) second quarter gross domestic product [GDP] growth was revised from the original estimate of up 4% to up 3.8%, in line with expectations,
(b) the revised second quarter GDP deflator came in at up 1.4% versus the initial report of up 1.3% and up 2.4% in the first quarter; in addition, in August, the core personal consumption expenditure index rose .1%, bringing its twelve month increase to 1.8%--inflation continues to not be a problem,
(c) second quarter corporate profits rose by a revised 5.2% versus the original estimate of up 5.4%.
(5) the Fed: while credit markets have loosened up since the easing of last week, problems still exist in the commercial paper sector. In the last two weeks, corporations have been unable to roll over between $10-20 billion in short term debt per week. Certainly that is an improvement, but more work needs to be done. To that end, the growth in the monetary base has accelerated dramatically; that may be enough but further rate cuts could also be necessary.
Bottom line: while one week does not a trend make, the improvement in the consumer and industrial data this week sounded a promising note that my revised ‘softer’ landing scenario could prove correct. Of course, we can’t ignore the possibility that these numbers were aberrations. To be sure, there are plenty of pundits (not the least of which is Alan Greenspan) out there that read the tea leaves differently and are predicting recession. However, I am just not ready to do that yet because (1) I think we need more information before making that call and (2) if a recession is in the offing, then I am totally confused by the current Market action.
Historically, equity prices decline in anticipation of a recession especially before investors have a handle on its potential magnitude and depth, then they recover when investors recognize that the worst is over. Furthermore, the times that stocks deviate from this pattern is not when investors fail to anticipate a recession but rather when they discount recessions that ultimately don’t even happen (hence the old saw, ‘the Market has discounted 10 out of the last 5 recessions’).
So if we are going to have a recession as so many are predicting, when are investors going to start discounting it? There is certainly enough doom and gloom in the media to provide the basis for it. Or did it already happen? Was it the 12% drop in the DJIA last month (which didn’t even break that index’s intermediate term uptrend)? If so, that would not suggest much concern over the magnitude or depth of an oncoming economic set back.
Our point here is that if we look at today’s Market as a discounting mechanism for the future, then either (a) the ‘soft landing’/no recession scenario is likely correct, (b) the Market has anticipated a minor recession [the 12% August decline] and is now looking at the recovery, (c) investors have somehow ignored the doom and gloom, will ultimately have to come to grips with the recession and so we are faced with a rough period in the Market, or (d) the historical pattern is no longer relevant. My conclusion is that:
(1) option (b) is irrelevant since the decline would have already been discounted,
(2) there is sufficient pessimism on the airwaves and in print that it seems inconceivable that investors would be bidding stocks to near all time highs if they thought a recession was imminent. Even if they are struggling with whether or not it will occur, it still would make sense to assume that they wouldn’t be paying peak prices for stocks in an increasingly uncertain economic environment. That makes option (c) seem unlikely.
(3) that leaves option (d) with which I have no clue as to how to deal and
(4) option (a) which brings me back to my ‘soft’ landing forecast.
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
(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. If you have been reading the links in this week’s Daily Blogs, you know that not only are the Dems eagerly going about taxing and spending Your Money, they are getting plenty of help from the GOP (Dream Act-education [citizenship for illegal immigrant students]; S-CHIP-health care for children [defined as anyone up to age 25 in families with incomes up to $82,000 a year], the transportation act [earmarks], the water resources act [more earmarks] and the proposed legislation to eliminate the home interest tax deduction). Taxpayers/investors only help seems to be coming from threatened W vetoes (note to W: it’s about time).
http://www.clubforgrowth.org/2007/09/mcconnell_where_art_thou.php
By the way, if you watched the Democratic presidential candidates’ debate Wednesday night, they left no doubt in my mind that taxes, especially those related to capital formation, are going up if any one of them wins the White House. You may not object to that based on social/political rationale; but, in my opinion, it won’t be good for Your Money.
http://www.ocnus.net/artman2/publish/Analyses_12/Silence_in_Syria_Panic_in_Iran.shtml
The Market
Technical
The DJIA is in an up trend defined by the approximate boundaries of 13105 and 14676. The S&P remains in its seven year trading range with boundaries of 750-1527. Nothing better illustrates the bifurcated Market which I addressed in Wednesday’s blog than the performance of these two indices--the DJIA (which has fewer financials and more industrials and materials) is smoking and the S&P (which has a significant weighting in the financials) can’t rise above its 2000 high. In the aforementioned blog, I paraphrased conclusions of a couple of technical gurus to the effect that generally these kind of split personality Markets tend to resolve themselves by the high flying industry groups (currently industrials and materials) declining versus the lagging sectors catching up (financials, retail and healthcare).
Given the current Market action, stocks would seem to be thumbing their nose at those esteemed technicians. However, SSI’s own internal technical indicator (the ratio of Sell Half stocks to Buy stocks) has shifted dramatically in the last two weeks in the direction of supporting their thesis. To be clear, it has not entered the red zone yet; but it is getting close with most of those stocks that are at or near their
Fundamental
Of course, there is a somewhat tangential fundamental rationale for the ‘high-flying-stocks-decline’ technical thesis at least as it relates to the SSI indicator because its key variable is stock Valuation (i.e. it is the ratio of overvalued to undervalued stocks as measured by company fundamentals). I say ‘somewhat’ because a stock being overvalued based on fundamentals says as much about the stock price as it does about the fundamentals; so that in current circumstances, the US economy could avoid a recession, the global growth thesis could remain in tact and the industrial/materials companies’ earnings could continue to grow at a healthy pace, yet stocks of some companies could correct because they are discounting an even more optimistic economic scenario.
The bottom line here is (1) that given the differences in the composition of the DJIA and the S&P, it is not difficult to come up with a scenario in which the industrial/material stocks correct, pushing the DJIA down while the financial, retail and healthcare stocks stay flat or even rally which would keep the S&P unchanged or drive it higher [and it has the added benefit of fitting perfectly with my Valuation Model’s Fair Value calculation for both indices], but (2) by the SSI indicator, while the probability of that scenario occurring is increasing, the Market bifurcation could certainly continue a while longer.
As a final note, there are some major issues which I tried to address in the Closing Bell that will likely get resolved in the next 3-4 months: (1) will or won’t the
The DJIA (13895) finished this week more than 5% over valued (13751) while the S&P (1526) is right on Fair Value (1525).
Our investment strategy is:
(1) use our Price Disciplines to take advantage of the ongoing heightened volatility to upgrade the quality of our Portfolios by Selling our weakest holdings and to take profits in those stocks rising into their Sell Half Range when prices spike to the upside and buying the stocks of great companies when opportunities present themselves,
(2) insure that our Portfolios can ride out any further turmoil brought on by trouble in the credit markets
DJIA S&P
Current 2007 Year End Fair Value 13250 1525
Fair Value as of
Close this week 13895 1526
Over Valuation vs. 9/30 Close
5% overvalued 13715 1578
10% overvalued 14368 1653
Under Valuation vs. 9/30 Close
5% undervaluation 12409 1427
10%undervaluation 11755 1352
The Portfolios and Buy Lists are up to date.
Company Highlight:
Cedar Fair L.P. is a master limited partnership which operates theme parks (Cedar Point, Valleyfair, WorldsOceans of Fun, Knott’s Berry Farm,
FFO: 2006 $3.29, 2007 $3.30, 2008 $3.95; DVD: $1.90 YLD 6.8%
http://finance.yahoo.com/q?s=FUN
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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