The Closing
Statistical Summary
Current Economic Forecast
2007
Real Growth in Gross Domestic Product: 2.0- 2.5%
Inflation: 2 - 2.5 %
Growth in Corporate Profits: 6-8%
2008 (revised)
Real Growth in Gross Domestic Product (GDP): 2.0-2.5%
Inflation: 1.75-2%
Growth in Corporate Profits: 3-5%
Current Market Forecast
Dow Jones Industrial Average
2007
Current Trend:
Medium Term Trading Range 12523-14203
Long Term Uptrend 11757-23751
Year End Fair Value: 13250
2008 Year End Fair Value: 14050
Standard & Poor’s 500
2007
Current Trend:
Long Term Trading Range 750-1527
Long Term Uptrend 1225-2400
Year End Fair Value (revised): 1525
2008 Year End Fair Value (revised): 1615
Percentage Cash in Our Portfolios
Dividend Growth Portfolio 8%
High Yield Portfolio 35%
Aggressive Growth Portfolio 15%
Economics
Despite the Fed’s poor management of the credit crisis, the economy, for the moment, remains a positive for Your Money. The good news is that this week’s data points from every sector of the economy showed strength; the bad news (excluding Fed policy for the moment) is that the inflation numbers were disappointing--though not entirely unexpected.
Once again, the only housing data came from weekly mortgage applications which rose 2.5% to the highest level since July 2005. As noted last week, the recent spike in this number is mainly the result of mortgage refinancing because of lower interest rates (question for Fed: do you think that the connection between lower interest rates and rising refinancings has any implications for the solving the sub prime loan problem? i.e. to what extent would a lower Fed Funds rate lead to lower mortgage rates which would in turn make it easier for those home owners with ARM’s about to reset to higher rates refinance into a new lower fixed rate mortgage? Just asking.)
The statistics measuring consumer health were almost universally positive: (1) the International Council of Shopping Centers reported that weekly sales of major retailers increased .2% and rose 2.3% year over year; Redbook Research reported month to date retail chain store sales fell .5% [though this decline is related to the timing of Hanukkah] versus the same period in November but was up 1.6% versus the comparable period in 2006, (2) November retail sales as reported by the Commerce Department was up a much stronger than expected 1.2% versus expectations of an increase of .6%; ex auto’s, sales were up 1.1% versus estimates +.7%, (3) finally, weekly jobless claims fell more than anticipated--down 8,000 versus expectations of a decline of 3,000,
The industrial sector continues to show strength: (1) October wholesale inventories were unchanged versus expectations of a rise of .5%; importantly, wholesale sales were up .7% driving down the inventory to sales ratio to 1.09, a record low, (2) October business inventories rose only .1% versus estimates of an increase of .3%; business sales were up a much stronger .7%, lowering the inventory to sales ratio, again--both of the above series of numbers provide more evidence that businesses are doing an outstanding job of managing their way through the ‘soft’ landing slowdown, (3) November industrial production was up .3% versus expectations of an increase of .2% and a .7% decline in October and (4) November capacity utilization came in at 81.5 versus expectations of 81.7 and 81.4 reported in October,
Finally, the macro economic statistics included some disappointing inflation numbers: (1) the US October trade deficit was reported at $57.8 billion, basically in line with expectations and up slightly from the September deficit [think higher oil prices], (2) the November producer price index [PPI] jumped 3.2%, far above expectations of 1.5% [think higher oil prices] while the core PPI rose .4% also higher than the +.2% estimate and (3) the November consumer price index [CPI] increased .8% versus expectations of + .6% [think higher gasoline prices]; core CPI rose .3% versus estimates of a .2% increase.
The generally positive data the last couple of weeks point to an economy rebounding in November from a fairly bleak October performance which I am going to choose to interpret as supporting our ‘soft’ landing scenario. Keep in mind that when an economy the size of the
The only troubling economic news this week was on inflation; but this is a single month’s measure and one that runs counter to other recently reported data. Furthermore, as a result of the spike in oil and gasoline prices, the world knew that the November inflation numbers would be bad and more important, it also knows those prices have since backed off. I am not trying to be Pollyannaish, but as I have said many times, one month does not a trend make. If we get another two months of poor inflation statistics, I will start to worry. That said, these inflation statistics will undoubtedly make the Fed’s job more complicated as it attempts to balance concerns of the inflation hawks against worries about the lack of liquidity in the financial markets.
Of course, the Fed doesn’t need any outside help making its job complicated; it is doing a pretty good job of that all on its own. I am clearly referring the really big news this week: the Fed interest rate cuts/liquidity moves. I covered these developments in Wednesday and Thursday’s Morning Call--so I will only repeat the bottom line: I think that the Fed stumbled in its effort to alleviate the freeze up in the commercial credit market. In the end, while those steps may indeed help, the way in which they were communicated to the Markets as well as them being a little too cute by half while ignoring the negative impact of current Fed policies (an inverted yield curve and the slow growth in the money supply--as of Friday, the 3, 6 and 12 month growth rates of the monetary base are all negative) will likely negatively impact the Fed’s credibility--the significance of which is to raise the risk premium (P/E) investors factor into security valuation decisions. Furthermore, if these new Fed policy measures don’t work, the risk of recession will rise.
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. But this is good news:
http://news.bbc.co.uk/2/hi/business/7144774.stm
The Market
Technical
The DJIA (13339) is in a trading range defined by 12523 (the August intra day low) and 14203; the S&P (1467) similarly is in a long term trading range of 750-1527 and a shorter term trading range (roughly comparable to the current DJIA trading range) of 1370-1573.
Fundamental
The DJIA (13339) finished this week less than 1% over Fair Value (13250) while the S&P closed (1467) almost 4% undervalued (1525).
The biggest thing on my mind at the end of this week is, what will the impact be of, what I believe to be, a major failure by the Fed in addressing the freeze up in the short term credit markets? I am troubled because before the Tuesday Fed meeting, I believed that the Market had seen its lows, at least one determined by any fall out from the financial crisis based on (1) the increasing transparency of the problem--we have been getting estimates of the size of the problem, financial institutions have been taking write downs, it has become apparent that a good deal of the sub prime paper is held by non-US entities and industry investors have been making capital infusions in troubled banks/brokers, presumably after doing their due diligence and (2) the assumption that the Fed understood the problem and would do what was necessary to insure that the credit crisis didn’t become unmanageable and lead to recession.
While item (1) is still an ongoing process--and that’s a positive--, I fear that I was very wrong about (2). That means (mea culpa) that if the Fed doesn’t move quickly to provide additional liquidity, I think that there is now more downside price risk in equities, in general and financial stocks in particular.
Indeed, this week the price of American International Group (AIG-$55) stock was down about 9% and that of Wells Fargo (WFC-$30) 10%; by the Market close Friday they were both trading below the lower boundary of their respective Buy Value Ranges. While they remain above their respective Stop Loss Prices, if the Fed hasn’t done something to rectify its poor management of the credit crisis before the Market open Monday, the Dividend Growth Portfolio will Sell one half of each of these positions.
Unfortunately, it looks like the events of this week are going to prove me wrong for a second time for having stepped in to buy the financial stocks.
That said, I could be dead wrong about all of the above: the Fed’s policy moves may prove prescient, the freeze up in liquidity could be thawing as I write this and stocks may be only a moment of clarity away from regaining their footing. Furthermore despite my pessimism, I have to keep in mind that (1) stocks in general are trading at or below Fair Value as measured by our Valuation Model, and (2) the Buy Lists hold a large number of names which historically is a sign that stocks are much closer to their lows than their highs.
As you know, my solution to dilemmas like this is to pay close attention to our Price Disciplines--which I am doing, However, until either the Fed takes additional steps to correct the inverted yield curve and slow monetary growth or it is obvious that I am wrong about the effectiveness (or lack thereof) of the Fed’s management of the current liquidity crisis, the lower boundary of Buy Value Ranges, the Stop Loss Discipline and the distance in between will have my undivided attention.
Our investment strategy remains:
(a) continue to use our Sell Price Discipline to take profits in those stocks moving into their
(b) recognize that there are both technical and fundamental factors that argue for caution and therefore to proceed carefully with our Buying, keeping a larger than normal cash position in anticipation of valuation and strategy changes that could result from a potentially new domestic economic agenda,
(c) continue to pay very close attention to the Stop Loss Discipline, occasionally moving the Stop Loss price above its historic level,
DJIA S&P
Current 2007 Year End Fair Value 13250 1525
Fair Value as of
Close this week 13339 1467
Over Valuation vs. 12/31 Close
5% overvalued 13912 1601
10% overvalued 14575 1678
Under Valuation vs. 12/31 Close
5% undervaluation 12588 1449
10%undervaluation 11925 1372
The Portfolios and Buy Lists are up to date.
Company Highlight:
Canadian National Railway operates
EPS: 2006 $2.92, 2007 $3.40, 2008 $3.75; DVD: $.84 YLD 1.8%
http://finance.yahoo.com/q?s=CNI
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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