Statistical Summary
Current Economic Forecast
2007
Real Growth in Gross Domestic Product (
Inflation: 2 - 2.5 %
Growth in Corporate Profits: 5-7%
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 (revised):
Medium Term Uptrend 12743-14246
Long Term Uptrend 11400-23400
Year End Fair Value: 13000
2008 Year End Fair Value: 14000
Standard & Poor’s 500
2007
Current Trend (revised):
Medium Term Uptrend 1448-1578
Long Term Uptrend 1225-2400
Former Long Term Trading Range 750-1527
Year End Fair Value: 1500
2008 Year End Fair Value: 1625
Percentage Cash in Our Portfolios
Dividend Growth Portfolio 10%
High Yield Portfolio 37%
Aggressive Growth Portfolio 11%
Economics
The economy is a positive for Your Money. As you know, our forecast is for economic growth in 2007 to slow (the ‘soft’ landing scenario) but not come to a halt and for inflation to moderate. The short term risks to this outlook right now are (1) that the housing market has started a second leg down and (2) weakness in the consumer sector. The economic statistics this week provided not only some good news with regard to these two worries but also positive data on other sectors of the economy.
(1) in the housing sector, June housing starts rose 2.3%--a very positive number versus expectations of a decline of 1.6%; in addition, weekly mortgage applications, while volatile and a secondary indicator, nonetheless were up .9%, the second increase in a row. On the other hand, June building permits fell 7.5% versus estimates of a decline of 2.6%.
(2) consumer spending showed some life, with the International Council of Shopping Centers reporting weekly sales by major retailers up .3% and up 3.4% year over year and Redbook Research reporting month to date retail chain store sales up .5% versus the comparable June period and up 2.7% versus the similar timeframe in 2006.
(3) the industrial sector continues to be the bright spot: June industrial production rose .5% versus expectations of up .4% and June capacity utilization came in at 81.7 versus expectations of 81.6. Finally, two secondary indicators: [a] the July New York Fed’s Manufacturing Index was reported at 26.4 [0 equals no growth] versus expectations of 17.5 and 25.7 recorded in June and [b] the Philadelphia Fed’s Manufacturing Index was reported at 9.2 [again, anything over 0 indicates growth] versus expectations of 10.0--mildly disappointing.
(4) employment remains strong. Weekly jobless claims fell by 8,000 versus expectations of rise of 4,000. We haven’t said this in some time: at full employment, we aren’t likely to have a recession nor will consumer spending stay stagnant for long.
(5) the above statement certainly seems in conflict with the June report on the index of leading economic indicators which fell .3% versus expectations of a decline of .1%, making it the fourth decrease in last six months. We would simply point out that (a) even in a ‘soft’ landing, it is reasonable to expect some weakness in the leading economic indicators and (b) in this ‘soft’ landing, with the exception of housing, the adjustments among the various economic sectors have been taking place on a consecutive versus a simultaneous basis [industrial activity slowed in the first quarter and is now recovering while consumer spending has only recently demonstrated weakness]. This is having the effect of drawing out the bottom in economic activity and would explain the more prolonged period of sub par performance by the leading indicators.
(6) on the inflation front, the June Producer Price Index [PPI] fell .1% versus expectations of a rise of .1%--lower food and fuel prices were the main cause; core PPI rose .3% versus expectations of an increase of .2%--higher car and truck prices, the primary reason. The June Consumer Price Index [CPI] rose .2% versus expectations of an increase of .1%--oil being the culprit [the seeming contradiction with PPI is explained by the time lag between PPI and CPI of the impact of a rise or fall in raw material prices]; the all important core CPI [ex food and energy] also climbed .2% in line with expectations, bringing the year over year rise in the core CPI to 1.8% [within the Fed guideline of 1-2%].
In Bernanke’s testimony before Congress this week, he lowered the Fed’s forecast for both 2007 and 2008 economic growth (now 2.25-2.5% and 2.5-2.75% respectively). The principal reason was the ongoing weakness in the housing market. Two points:
(1) we said last week that if the latest softness in housing statistics proves a precursor to another major down leg and/or if the recent weakness in consumer spending continued, that we would likely have to lower our estimates of future economic growth. So the Fed’s move doesn’t come as a surprise. However, we are going to stick to our original game plan (waiting for another month’s worth of data) before deciding if conditions warrant a downward revision of economic growth.
(2) one reason that we can be somewhat circumspect in not immediately following suit is (a) assuming the Fed is right quantitatively, it wouldn’t change the qualitative aspect of our forecast; that is, the economy would still be progressing through a ‘soft’ landing; it would just be a little ‘softer’ than our original forecast, and (b) more important, the impact on our equity Valuation Model would be minimal and in fact could be offset by our under estimation of corporate profit growth [a subject we covered last week].
The Economic Risks:
(1) the economy is weaker than expected.
(2) Fed policy (reading the data correctly). We haven’t commented on the Fed’s performance of late. One reason is that there has been nothing about which to complain. In our opinion, after a very rough start, Mr. Bernanke has been doing a great job learning his way into the chairmanship of the Fed. Accordingly, this risk is an ever shrinking one. However, before removing it altogether, we:
(a) want to see how the Fed manages the next transition in policy, i.e. to either a lower or higher Fed Funds rate.
(b) would like to see a change in the Fed’s affinity for the Phillips Curve [high employment = high inflation] analysis, which judging by Mr. Bernanke’s comments on Thursday, is still being followed. As you know, we take strong exception to the notion that everyone having a job is bad [inflationary].
(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
It is our belief that the domestic/international political environment is a negative for Your Money, though investors continue to ignore the risks--and nothing illustrates this risk better than Washington politics this week: Example one: Democrats reneging on their agreement with the Administration on free trade. We linked to a thorough discussion of this point in our Thursday post. For those of you who didn’t read it, here it is again (http://www.american.com/archive/2007/july-0707/2018fast-track2019-to-nowhere). One more perspective on Congress:
http://article.nationalreview.com/?q=MTdkMDkxZjMzNWNiNTgwYzZhNWUxNjZlY2NiZTY1OTY=
Example two: the politicizing of national security as exemplified by Tuesday night’s Senate slumber party. We don’t care which side of this issue you are on, the current tone of the debate is polarizing; it has to be demoralizing to those who daily have their lives on the line; and is surely aiding and abetting radical Islam--and that is a negative for Your Money.
The Market
Technical
The DJIA is in an up trend defined by the approximate boundaries of 12743 and 14246. If the S&P can remain above the 1527 level (which it looks like it will this time), its up trend is defined by boundaries of roughly 1449 and 1585. They will remain in those up trends until they are not.
*****
The continuing rise in short interest:
http://bigpicture.typepad.com/comments/2007/07/nyse-short-inte.html
*****
As of the Market close on Friday, approximately 25% of the S&P companies have reported last quarter’s earnings with the average increase in profit between 9% and 10%. Of those reporting, 59% have beaten Street estimates, 20% have fallen short and 20% have been in line with expectations.
Fundamental
A couple of bothersome developments this week:
First, Caterpillar, which is the poster child for global economic strength, reported disappointing earnings on Friday. The international business was robust, but the company attributed the shortfall to the poor HOUSING market. One of the most notable aspects of the current ‘soft’ landing has been the heretofore relative insulation of other sectors of the economy from the lousy housing market. So if Cat’s earnings are a precursor to an impending spillover effect, the ‘soft’ landing scenario could be in big trouble as well as the current upward momentum of the Market. At the moment, we are discounting this risk because what didn’t come out in the chattering class’ discussion of Cat’s earnings was that while the company’s second quarter revenues were just fine, thank you very much, management appears to have gotten a little sloppy on the expense side--and that may have been as much to blame for the profit shortfall as anything to do with housing. Bottom line, we need to be very vigilant to the upcoming earnings reports of other companies with exposure to the housing market which have to date been immune to any elated earnings disappointments; but at the moment, we are not overly alarmed.
Second, twice this week, the sub prime problem was the center of investor attention (although Caterpillar certainly contributed to the Friday sell off); and neither occasion was particularly pleasant. We are not sure that this problem has reached the status in which the lack of clarity on potential damages can put a cap on the Market advance. After all, nothing else has. But barring a complete collapse of the entire sub prime market, this problem may end up being like a Chinese water torture, i.e. further disclosures are dependent on the internal judgments by sub prime lenders on their own asset values and, if history (and Bear Stearns) is any guide, there won’t be any disclosures until bankruptcy is their only option. So information will probably remain sketchy and erratic; and that means that we are stuck with the kind of increased volatility in equity prices witnessed this week.
To be clear, we are not suggesting an end to this bull market or the powerful global growth that is driving it. But it does appear that there are some headwinds; so the rise in stock prices may become a bit more labored. Fortunately, this is all factored into our current investment strategy which remains to:
(1) pay close attention to our Price Disciplines in particular our Sell Half Prices
(2) as a corollary, use the present heightened volatility to our advantage by taking profits when prices spike to the upside and buying the stocks of great companies when opportunities present themselves,
(3) continue to focus on improving the quality of our Portfolios by Selling the stocks either of companies that fallen below the minimum standards of our Quality Discipline or that have performed poorly over an extended period.
(4) insure that our Portfolios can ride out any turmoil brought on by trouble in the sub prime market
DJIA S&P
Current 2007 Year End Fair Value 13000 1500
Fair Value as of
Close this week 13851 1534
Over Valuation vs. 5/31 Close
5% overvalued 13387 1544
10% overvalued 14025 1617
15% overvalued 14662 1690
20% overvalued 15300 1764
The Portfolios and Buy Lists are up to date.
Company Highlight:
Abbott Laboratories is a manufacturer of drugs, diagnostic tests, intravenous solutions, laboratory and hospital instruments, prepared infant formulas and nutritional products. The company has several new drugs in its pipeline as well as its recently approved Humira (rheumatoid arthritis, psoriatic arthritis and Cronin’s disease) which should allow it to continue its historical 10-11% annual earnings and dividend growth. Abbott earns 25% return on equity and has a debt to equity ratio of 31%.
EPS: 2006 $2.62, 2007 $2.82, 2008 $3.20; DVD: $1.30, YLD 2.3%
http://finance.yahoo.com/q?s=ABT
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.
