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 12978-14520
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
Percentage Cash in Our Portfolios
Dividend Growth Portfolio 10%
High Yield Portfolio 33%
Aggressive Growth Portfolio 7%
Economics
The economy is a positive for Your Money. As you know, our forecast calls for the economy to slow but not slip into a recession and for inflation to moderate. As you also know, the economic data over the last two months have not exactly been confirming that outlook which has in turn led us to lower the probability of this ‘soft’ landing scenario occurring.
To briefly summarize the components of our forecast: we expect housing to be weak, but we are depending on consumer spending and industrial activity to pick up some of the slack, preventing the economy from slipping into recession. However, in the last couple of months,
(1) consumer spending has shown some signs of faltering--not collapsing mind you, but worrisome nonetheless, and
(2) while the macro economic statistics on business activity have been good, the revelation last week that second quarter domestic non financial profits [as reported in the GDP accounts] fell was disconcerting.
[How many times have we said that you can’t have a recession when corporate profits are beating expectations {and everyone has a job--see statistics measuring consumer spending were largely positive below}? Granted there are extenuating factors {these are the profits that are reported to the IRS; and they exclude international earnings}. Nevertheless, it is not a stretch to assume that falling domestic profits are likely to influence domestic capital spending and employment decisions; and it won’t be to the positive.]
In the economic data reported this week, there was bad news--housing (which everyone expects to be lousy) and Friday’s payroll number (a surprise)--and good news--everything else:
(1) the housing market remains a mess: July pending existing home sales fell 12.2% returning them to 2002 levels; on a mildly positive note, weekly mortgage applications rose 1.3%,
(2) statistics measuring consumer spending were largely positive: the International Council of Shopping Centers [ICSC] reported weekly sales of major retailers up .2% and up 2.3% on a year over year basis. Redbook Research reported month to date retail chain store sales fell .5% versus the similar period in July and but rose 2.7% versus the comparable period in 2006. In addition, while final figures are not yet in, ICSC is suggesting that August retail sales were likely up 2.9%--ahead of the 2.3% increase logged for the year to date and much better than had been expected..
August auto sales [which investors have been watching for fall out from the turmoil in the credit markets] dropped .6%--but this was also much better than had been expected,
Finally, weekly jobless claims fell 19,000 versus expectations of a 4,000 decline, suggesting that employment remains strong. However, August non farm payrolls fell 4,000 versus expectations of an increase of 115,000, the worst report in four years. Two points:
(a) given the problems in housing, the slowdown in business activity in the first quarter and the sluggishness in consumer spending in the second quarter, plus the recent change in US immigration policy that has in effect been forcing illegals out of the labor force, it is a miracle that it has taken this long to see any weakness in employment;
(b) that said, if this is a good number, it is worrisome; after all it is a huge variance from the expected. ‘If’, however, is the operative word in the preceding statement because this latest number doesn’t fit with virtually any of the other available employment data reported to date [incidentally, the unemployment rate at the end of August remained at 4.6%]. That doesn’t mean that it isn’t a valid statistic and, therefore, a precursor of things to come; nor does it mean that even if revised, it won’t show a decline in jobs.
But at this point, we have to bear in mind that even a ‘soft’ landing was going to have an impact on employment plus this is a single data point, the order of magnitude of the decline in jobs is completely unsupported by other employment data, it will almost assuredly be revised [not because we doubt it, but because almost every jobs report is revised]; and, therefore, we think it wise to await further data before assuming the worst.
Nevertheless, if the data over the next couple weeks shows the kind of weakness in employment that was reflected in the jobs report, it would be yet another blow to our ‘soft’ landing forecast.
(3) the industrial sector looks healthy: the August Institute for Supply Management’s [ISM] manufacturing index was reported at 52.9 versus expectations of 53.0--very slightly disappointing; but remember anything over 50 denotes growth. Meanwhile, the August ISM non-manufacturing index came in at 55.8, slightly better than the expected reading of 55.0.
July construction spending fell .4% versus expectations of a rise of .1%; however, most of the disappointment is attributable to residential construction [down .7%], while nonresidential construction was up .4%,
July wholesale inventories rose .2% versus expectations of up .4%, while wholesale sales increased .1%; this left the inventory to sales ratio at 1.11, near an historic low--and importantly, a sign that businesses continue to exercise tight financial controls.
Lastly, second quarter non-farm productivity rose 2.6% versus expectations of an increase of 2.4%
(4) the Fed’s beige book report was generally positive. At the risk of being repetitious, our conclusions on this report in our Thursday blog were:
(a) positive economic data is all fine and good but we don’t think that economic activity over the last six weeks is particularly relevant to resolving our most pressing current problem--the freeze up in the credit markets,
(b) this report is somewhat in conflict with the more negative monthly and weekly statistics reported over the last six weeks, so we are hesitant to view this beige book report as an offset to those data points.
Bottom line: For the moment we are sticking with our forecast--the data simply aren’t negative enough to warrant altering it--but the probability that the economy is weaker than expected continues to edge higher.
The Economic Risks:
(1) the economy is weaker than expected.
(2) Fed policy (reading the data correctly). Perhaps the most important number reported this week was the decline of another $50 billion in commercial paper outstanding [this brings the total to $300 billion]--in other words, corporations were unable to refinance another $50 billion in credit. This is our current biggest worry: as a result of credit fears, the economy temporarily needs more liquidity to affect normal business transactions and if it doesn’t get it, the probability of a recession rises significantly.
To repeat: in our opinion, the most critical problem facing the US economy at this moment is not a housing decline or lower domestic non financial corporate profits or the level of employment; it is whether or not there is sufficient liquidity in the financial system to prevent any or all of them from getting worse. Once we can be sure that normal business transactions can take place whatever the level of economic activity, we can then worry about what that actual level of activity is.
It seems unfathomable to us that the Fed doesn’t grasp this, so we are not making a doomsday forecast. But more action is required and soon.
(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 and international political environment is a negative for Your Money. You know our concerns as we move into an election year: virtually every Democrat presidential candidate has his/her proposals calling for more regulation, higher government spending, higher taxes and more protectionist measures. None are good for corporate profits; all will have a negative impact on inflation; and lower corporate profits and higher inflation are not good for Your Money. With Congress back this week and the fall presidential campaign season kicking off, expect more headlines addressing all these issues.
Developments in
http://www.powerlineblog.com/archives/2007/09/018383.php
The Market
Technical
The DJIA is in an up trend defined by the approximate boundaries of 12978 and 14520. The S&P is in its seven year trading range with boundaries of 750-1527.
Friday’s Market action indicates another test of the DJIA uptrend is under way--indeed, with the DJIA only 135 points off the uptrend, it may be largely done. However, if investors want to test the close of the last sell off, that would be DJIA 12859 and the S&P 1425.
Fundamental
Stock prices closed near Fair Value this week--the important point being that we see little fundamental reason for a further sell off from here. The DJIA (13133) finished near Fair Value (13062) while the S&P (1458) is slightly undervalued (1503).
Of course, many investors might argue that this observation somewhat blindly ignores the erratic, inconsistent economic data released of late as well as the nauseating stock price volatility resulting from investors’ schizophrenic reaction to those statistics. Two points:
(1) we have said before: the short term course of the economy doesn’t have any significant impact on our Valuation Model; so barring some truly terrible exogenous event, whatever data we get, our Fair Values won’t change much,
(2) more important, we think, at this moment, that the regularly reported economic data are of secondary importance. In our opinion, the two issues that will determine the Market’s near term course are: (a) whether or not the Fed pumps high powered money into the banking system to satisfy the rapidly expanding demand for money. If that doesn’t happen, no matter what the economic data tell us in the short term, the economy will come to a grinding halt. (b) until the major financial institutions come clean on how much sub prime debt they own and how they are pricing it [and, hence, the economic impact on their balance sheets and income statements], {i} the data being plugged into our or anyone else’s Valuation Model for that segment of the economy is questionable and {ii} investors aren’t going to be confident that this problem will be confined to the financial sector.
This isn’t an argument for selling all our stocks because (1) as we said above, we think it inconceivable that the Fed won’t respond to the freeze up in the credit markets and (2) what information we do have suggests that the sub prime problem is limited in scope. However, it is an argument for being cautious which is the reason we are (1) using price strength to eliminate weak holdings, (2) not rushing to use the cash generated from those sales to Buy new stocks on our Buy Lists and (3) glad we own gold (USERX).
Our investment strategy remains:
(1) continue to average into the Buy List stocks in which 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 13133 1458
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:
Merrill Lynch is a leading financial services firm providing underwriting, investment advisory, securities brokerage and trading and investment management. The company has grown profits and dividends 18-20% over the last five years, earning a return on equity in the 14-15% range. Recent results have benefited from increasing stock prices, rising IPO’s and healthy merger/acquisition activity. While the credit problems may curtail some parts of MER’s business, the likelihood of a ‘soft’ economic landing in the US, the global economic strength and the current reasonable valuation of US equities should insure that any shortfall will be modest and short lived; and the recent decline in Merrill’s stock more than reflects any near term slow down in earnings growth. Furthermore, the company’s $6 billion stock back program provides evidence of management’s confidence in the future growth.
EPS: 2006 $6.64, 2007 $8.75, 2008 $8.70; DVD: $1.40 YLD 1.9%
http://finance.yahoo.com/q?s=MER
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.
