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 12926-14462
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 (?) 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
2008 Year End Fair Value: 1625
Percentage Cash in Our Portfolios
Dividend Growth Portfolio 7%
High Yield Portfolio 30%
Aggressive Growth Portfolio 7%
Economics
The economy is a positive for Your Money. The data points this week generally support our revised ‘soft’ landing forecast: the economy is slowing a bit more than originally forecast but remains strong enough to avoid a recession; meanwhile, the risk of inflation may be morphing into a risk of deflation. That said, we believe that the key to the success of our forecast (and economic growth) lies with how the Fed handles the seize up in the credit markets. The economy can not grow if businesses can’t arrange for the normal financing of their operations (see The Fed below) and that is becoming a problem. For the moment, we are assuming that the Fed will do what is necessary to insure that liquidity problems don’t impair non sub prime business/consumer transactions; but it does not have the luxury of time.
(1) in housing, more bad news: weekly mortgage applications fell 4%; and July existing home sales fell .2% versus expectations of a rise of .5%; further existing home inventories jumped 2.2% to the highest level in 16 years. Remember that the [negative] existing home sales is a much more important number than the [positive] new home sales reported last week because that market is 7x bigger.
(2) the consumer remains sluggish:
The International Council of Shopping Centers reported weekly sales of major retailers up .3% and up 2.5% year over year; Redbook Research reported month to date retail chain store sales fell .7% versus the similar period in July but up 2.3% versus the comparable period in 2006.
On a more positive note, July consumer income was reported up .5% versus expectations of up .3% and July consumer spending was reported up .4% versus expectations of up .3%.
Looking for signs of future spending, the Conference Board reported its August index of consumer confidence at 105, in line with expectations but down from 112.6 reading in July. On the other hand, the
Finally, weekly jobless claims rose 9,000 versus expectations of an increase of 2,000. We always hate to see a rise in jobless claims, but remember that there have been floods across the
Net, net, the consumer appears to be muddling through but not collapsing--in line with our revised softer ‘soft’ landing economic forecast.
(3) only one data point on the industrial sector but it was positive: factory orders rose 3.7% in July versus expectations of an increase of 2.5%
(4) in the macro economic data, second quarter gross domestic product [GDP] came in up 4%, in line with expectations and versus the initial estimate of up 3.4%. The current housing/sub prime problems notwithstanding, this number has to be viewed positively. Certainly it is less positive than it would have been if the economy wasn’t in the midst of dislocations in the housing/credit markets; on the other hand, [a] the housing statistics were lousy in the second quarter and yet the headline number showed good strength despite their incorporation in those GDP calculations and [b] it denotes an economy regaining momentum which should enable it to better absorb the current credit market difficulties.
In that same report, the second quarter core personal consumption expenditure index [PCE] rose 1.3% on an annualized basis [this number is the calculated by multiplying the quarterly increase by 4] versus expectations of an increase of 2.7%.
Subsequently, the July core PCE rose .1% versus expectations of an increase of .2%; by this gauge the year over year increase in PCE is 1.9% [this measure is the sum of the last 12 month’s PCE reports].
The two inflation numbers are definitely positive in that [a] they are both within Fed guidelines {1-2%}, and [b] they should lower Fed concerns about inflationary pressures {or better yet doesn’t it mean the inflation fight is over?} making it less difficult to ease monetary policy to better manage current liquidity problems.
The Fed
The Fed and speculation about what its policy is or is not regarding liquidity in the financial system was in and out of news every day this week. We covered both the release of the minutes of the Fed’s August FOMC meeting and Mr. Bernanke’s letter to Senator Schumer in our daily blogs, so we won’t do a rehash.
Friday, Bernanke spoke at a Fed sponsored conference, the highlights of which were:
(1) the Fed recognizes the precarious condition of the financial markets,
(2) further, it is concerned about the impact of a freeze up in liquidity on the economy,
(3) it will act to alleviate any credit market problems,
(4) but Bernanke made no commitment to any action and stated specifically that the Fed would not bail out lenders and borrowers that entered into inappropriate transactions.
These comments basically reiterate the position outlined in prior Fed statements; so we see little new information value to them although Bernanke reiterating the Fed’s concern and its willingness to act was undoubtedly reassuring to investors.
Our bottom line is that if Bernanke means (1), (2) and (3) above, then the Fed has to address the exploding demand for money immediately. We don’t want to get too academic but it is important to understand--right now, investors/financial institutions are avoiding risk; that means that they are putting their funds in US Treasury bills or cash and not making other investments, even high quality investments like asset backed commercial paper. In other words, instead of employing their investable funds as they normally would to finance business (by buying commercial paper), banks/money market funds/hedge funds/individuals are sticking their money in the mattress (US Treasury bills).
To illustrate this problem, in the last three weeks companies have been unable to ‘roll over’ (refinance) over $240 billion in commercial paper (used to finance inventories, accounts receivables, etc), $185 billion of which is asset based (backed by collateral). This clearly hampers economic growth and if not corrected soon will likely push the economy into recession.
The solution to this problem is to temporarily inject more inexpensive (lower the Fed Funds rate) money (increase the money supply) into the economy to meet the ‘demands’ of businesses to finance normal transactions. Lowering interest rates and increasing money would have another benefit--interest rates on adjustable rate mortgages (ARM) are tied to the Fed Funds rate; hence if the Fed Funds rate drops, the plethora of upcoming ARM mortgage resets would make the new mortgage payments more affordable (easier not to default on).
W
W also got into the act Friday, making his own speech and proposing:
(1) modernizing the FHA, allowing them to insure mortgages with lower down payments and larger mortgages,
(2) provide assistance to homeowners with good credit histories but who can’t afford their mortgage payments when their current ARM resets,
(3) changing the tax code so that the amount of any debt forgiveness on a renegotiated mortgage is not taxed as income,
(4) improving the disclosure of the terms of mortgage loans,
(5) making the requirements to qualify for a mortgage more stringent.
Our view is that this was largely a political move to (1) avoid a Katrina-like appearance of inaction in the face of catastrophe and (2) stymie more intrusive measures being proposed by the Dems.
Bottom line, we believe that the economy is sufficiently vigorous to insure a ‘soft’ landing; however, there are liquidity issues that could short circuit that strength. We further believe that the Fed has the necessary tools to address the aforementioned liquidity issues and that it will in fact address them. However, the risk that the economy is weaker than expected has never been higher.
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 political environment both domestic and international is a negative for Your Money. The economic agenda (more regulation, more government spending, more taxes, more restrictive trade policy) of the Democratic Party which at the moment appears likely to make further gains in the 2008 elections is not a positive for Your Money whatever your opinions regarding its social/political benefits.
The Market
Technical
The DJIA is in an up trend defined by the approximate boundaries of 12926 and 14462. The S&P is in its seven year trading range with boundaries of 750-1527.
Tuesday and Wednesday felt like a test of the August 16th low. However, given that we still have only limited knowledge of the extent of ownership of sub prime paper, there are probably more bad headlines to come and, as a result, further retests of the 12900 level.
Fundamental
Stock prices closed near Fair Value this week. The DJIA (13357) finished near Fair Value (13000) while the S&P (1473) is slightly undervalued (1496)--the deviation between the two being the result of the much higher representation of financial stocks [which have been underperforming] in the S&P than the DJIA.
In light of the rising chances of a ‘hard’ landing, we wanted to re-emphasize a point that we have made before: even though a weaker economy might lead to lower corporate earnings than we now estimate, our Fair Value calculations for the indices and individual stocks will likely not change because our Model focuses on long term trends related to capacity, productivity, pricing power, market share and financial strength. That generally means (1) much less volatility in our Fair Values than in corporate earnings and (2) that our Fair Values tend to be high relative to current prices when the Market is at a cyclical low and visa versa--and that is as we planned it. We designed our Valuation Model in such a way that our Price Disciplines force us to take profits when everyone is tip toeing through the tulips and to put money to work when the world as we know it is coming to an end.
Our investment strategy remains:
(1) continue to average into the Buy List stocks in which are our Portfolios have established either a partial position or none at all,
(2) use our Price Disciplines to take advantage of the ongoing heightened volatility to upgrade the quality of our Portfolios by taking profits in our weakest holdings 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
DJIA S&P
Current 2007 Year End Fair Value 13250 1525
Fair Value as of
Close this week 13367 1473
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:
McGraw Hill Co. is a global information provider serving the financial, education and business markets via Standard & Poor’s, McGraw Hill Education, Business Week, Aviation Week and Platts. MHP earns an amazing 25-35% return on equity, with virtually no debt and has grown profits and dividends 8-14% annually over the last 10 years. The company should continue to grow as a result of rising demand for security information services (S&P) and the strong adoption cycle for new textbooks. McGraw Hill’s stock price has declined recently due to concerns about declining revenues from S&P’s rating of mortgage backed securities. However, (1) demand from this sector remains robust and (2) it is, in any case, a small part of S&P’s overall business.
EPS: 2006 $2.58, 2007 $3.05, 2008 $3.45; DVD: $.82 YLD 1.6%
http://finance.yahoo.com/q?s=MHP
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.
