The Closing
Note: August is going to be a family-active month for us. Next Wednesday, SSI wife and I are taking my 88 year old father to his favorite vacation destination--
The Bottom line
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:
Medium Term Uptrend 12783-14246
Long Term Uptrend 11400-23400
Year End Fair Value: 13000
2008 Year End Fair Value: 14000
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: 1500
2008 Year End Fair Value: 1625
Percentage Cash in Our Portfolios
Dividend Growth Portfolio 13%
High Yield Portfolio 37%
Aggressive Growth Portfolio 11%
Economics
The economy is a positive for Your Money; though the recurring poor news from the housing market is increasing the likelihood that we will lower our 2007 economic growth forecast. As you know our intent is to wait until the July statistics on home construction and sales are in before making the revision; but absence a major turnaround in the next month, some downward adjustment appears inevitable. However, it is important to re-emphasize that this action will not qualitatively alter our outlook--that the economy is undergoing a ‘soft’ landing and inflation is moderating.
(1) on housing, June existing home sales fell 3.8% versus expectations of a decline of 1.4%, putting this number at its lowest level in five years; June new home sales dropped 6.6% versus expectations of a decrease of 1.6%; and
weekly mortgage applications dropped 3.6%--the lowest in five months.
Increasing the dismal outlook for this market are the delinquency problems that have spread from the sub prime sector into the higher quality brackets,
(2) the consumer spending data was once again mixed: the International Council of Shopping Centers reported that weekly sales of major retailers fell .2% but rose 3.0% year over year while Redbook Research reported month to date retail chain store sales rose .5% versus the comparable period in June and up 2.8% versus the similar period in 2006.
In related news, the
(3) industrial activity continues to rebound as June durable goods orders were up 1.4% versus a decline of 2.4% in May; the June number was slightly disappointing in that expectations were for an increase of 1.5%,
(4) employment remains strong: weekly jobless claims fell 2,000 versus expectations of a rise of 11,000--the second week in a row where claims have dropped when estimates were for an increase,
(5) on macro economic data points, the Fed released its periodic beige book report [an every six weeks anecdotal look at the economy] which showed moderate economic growth [2-2 ½%], consumer spending restraint, an upswing in industrial activity, continuing weakness in residential construction and moderate price pressures. Two points [a] it fits our reading of the economic tea leaves--which we consider a positive and [b] it is the Fed’s last internally generated look at the economy before its next FMOC meeting {where Fed policy is set}.
Second quarter gross domestic product was reported up 3.4% versus expectations of a rise of 3.2% and a significant rebound from the first quarter’s .7% increase. Also in that report, the personal consumption expenditure [PCE] index posted a 4.3% increase versus estimates of 2.8%; however, the core PCE was up 1.4% versus expectations of rise of 2%.
Bottom line: Save housing which we opined on above, most of the economic statistics reported this week were generally positive. Of particular note is the continued strength in employment and corporate profits. It is unfathomable to us that the economy could be in trouble in the face of such vigorous activity.
That said, the most important economic development this week had nothing to do with the reported data points; rather it was the spill over of the default problems in the sub prime market into quality mortgage instruments (Countrywide’s acknowledgement that delinquencies were spreading into higher quality home equity loans) and private equity financing (Cerberus’ difficulties financing the Chrysler transaction). While these developments are clear signs of trouble, at the moment we have no clue about the extent of damage that is being or has been done to either these funding segment or to the economy in general; and until we do, it is pointless to speculate on whether or not revisions to our economic forecast will be necessary. We will concede that there are possible consequences that could result in an economic growth rate lower than expected (via corporations being unable to finance growth or consumers inability to borrow to buy cars, appliances, etc); but like the erratic behavior in the industrial sector earlier this year and the current sloppiness of consumer spending, we need more information before making that judgment and any additional adjustments to our 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
The domestic/international political environment is a negative for Your Money. Art Laffer, who is one of our heroes, was on Larry Kudlow’s (another hero) show this week and in response to a question, basically said that risks unquestionably exist of increased protectionism, rising taxes, spending and regulation but it is too soon for the Market to begin discounting them. He may be right; but we are not smart enough or confident enough in our ability to read investors’ pulse, i.e. knowing when they are starting to discount a risk, to make Art’s distinction. So our conclusion remains that the risks are there, their probability of occurrence increases with time, at some point investors will decide (if they haven’t already) to begin pricing those risks into equity values and that pricing mechanism will be a negative for stock prices.
The Market
Technical
The DJIA is in an up trend defined by the approximate boundaries of 12743 and 14246. The S&P once more traded below the 1527 level which in our mind again raises the issue as to whether those three breakouts above 1527 which failed to hold truly mark the start of an uptrend. We are going to leave it to time to answer that question. Meanwhile, any confidence that the S&P is trading in an uptrend has to be questioned. (if it is in an up trend, its boundaries are defined by 1449-1585; if it is in a trading range, the boundaries are 750-1527.)
Fundamental
The Market significance of the Countrywide announcement and the sudden loss of liquidity in the private equity financing market is (1) the elimination of one source of liquidity [private equity buy outs] that has been driving stock prices higher [the others being corporate buy outs--we saw three companies in our Portfolios announce acquisitions on Friday morning--and stock buy backs--26 companies announced buy backs this week] and (2) that the private equity market’s inability to find a clearing price for the newly perceived higher risk [i.e. junk] debt may ultimately result in a possible new impediment [too expensive or completely unavailable credit] to earnings growth [and hence, a rise in the stock price] of companies that (a) serve the financial and homebuilding markets, (b) require new financing near term to conduct business or (c) have a substantial majority of their earnings in the US.
The question of course is how well the Market responds to this change in credit conditions. Certainly, this week’s market performance, particularly on Thursday and Friday, suggests that the investors are not processing that this adjustment to a less euphoric credit market very rationally. And the truth be told, there is probably little chance for any meaningful improvement in Market psychology until the participants in the credit market can agree on the clearing price of newly perceived higher risk debt--meaning that we shouldn’t expect stocks to resume any sustained upward trend until the junk debt market stabilizes (which it will).
That said, we think it important to remember that (1) corporate profits continue to climb--as an example, as of the close of business Friday, 60% of the S&P 500 companies have reported second quarter earnings with the market capitalization weighted profits up 15% and (2) there is absolutely no evidence, none, zip, nada that there has been even the slightest diminution in global economic strength. So there are some strong economic positives to support equity values.
Our bottom line is that our Price Disciplines suggest that stocks are still mildly over valued and that they are clearly returning to Fair Value via a rapid emotionally charged sell off that it is creating buying opportunities.
Our investment strategy has shifted somewhat:
(1) pay close attention to our Price Disciplines in particular our
(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) insure that our Portfolios can ride out any further turmoil brought on by trouble in the credit markets
On final note: when we began developing our dividend based investment strategy, one of our primary goals was to remove as much emotion from the investment process as possible. One way of doing that was through owning a portfolio of stocks which produced a growing income stream every year regardless of Market conditions/psychology. By creating the luxury of improving cash flow, it relieves the investor’s anxiety of having to sell stocks when they are down in order to meet bills. The other of course is through our Price Disciplines that push us to raise cash reserves by selling stocks when it seems the most ridiculous (like the recent partial sale of ConocoPhillips--who woulda thunk?). We provide this little unsolicited pep talk not just because it has been a tough week, but also because we think that there is more of the same to come. So hang in there, we own cash for buying opportunities which are being created daily. We own the stocks of great companies. And we have our Stop Loss Discipline which will keep losses to a minimum.
DJIA S&P
Current 2007 Year End Fair Value 13000 1500
Fair Value as of
Close this week 13265 1459
Over Valuation vs. 7/31 Close
5% overvalued 13431 1548
10% overvalued 14102 1626
15% overvalued 14807 1707
20% overvalued 15543 1792
The Portfolios and Buy Lists are up to date.
Company Highlight:
Altria (Philip Morris) is a leading tobacco products company (Marlboro, Benson & Hedges, Merit,
EPS: 2006 $5.70*, 2007 $4.25, 2008 $4.50; DVD: $2.75, YLD 4.9%
http://finance.yahoo.com/q?s=MO
*includes earnings from Kraft
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.
