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 12850-14175
Long Term Uptrend 11757-23751
Year End Fair Value: 13250
2008 Year End Fair Value (revised): 14050
Standard & Poor’s 500
2007
Current Trend:
Former Long Term Trading Range 750-1527
Long Term Uptrend 1225-2400
Year End Fair Value: 1525
2008 Year End Fair Value (revised): 1615
Percentage Cash in Our Portfolios
Dividend Growth Portfolio 9%
High Yield Portfolio 35%
Aggressive Growth Portfolio 15%
Economics
The economy is a positive for Your Money though getting less so. This week’s data was generally dismal: housing showed no signs of improving, the consumer stats were weak overall, data on industrial activity was disappointing, the credit markets are seizing up again and the only upbeat news was from the macro economic numbers. When this latest data is loaded on top of that which has been released over the last six to eight weeks, I think sufficient evidence has accumulated to warrant a revision in our forecast (I mentioned the likelihood of this four weeks ago). I am still not buying into the recession scenario; though it seems clear that the slowdown in the rate of economic growth will be larger than I initially anticipated. The good news is that inflation remains moderate. Before getting into the specifics of the revised forecast, a review of this week’s data points:
(1) housing statistics were abysmal, as usual:
(a) October existing home sales [remember this market is 5 times larger than new home sales-see below] fell 1.2% versus expectations of a decline of .8%; in addition, the average existing home price dropped again and existing home inventories continued to climb,
(b) October new home sales rose 1.7% versus expectations of a drop of 2.6%, though the mathematics of this increase was a result of a downward revised September number. It was also a function of big price cuts by builders to move inventory--a painful necessity,
http://bigpicture.typepad.com/comments/2007/11/new-home-sale-1.html
(c) finally, weekly mortgage applications [secondary indicator] dropped 4.3%.
(2) consumer data was basically sub par:
(a) October consumer income was reported up .2% versus expectations of an increase of .4%,
(b) October consumer spending was also reported up .2% versus expectations of up .3%,
(c) the International Council of Shopping Centers reported weekly sales of major retailers fell .1% [versus a .8% rise last week] and increased 2.5% on a year over year basis. Redbook Research reported month to date retail chain store sales up .4% [versus +.3% last week] versus the comparable week in October and up 2.4% versus the similar timeframe in 2006,
(d) weekly jobless claims were up 23,000 versus expectations that they would be flat; however, the Thanksgiving holiday impacted this statistic,
(e) last, the Conference Board reported its November consumer confidence index at 87.3 versus expectations of 91.0 and 95.6 recorded in October.
(3) the numbers on industrial activity were also disappointing:
(a) October durable goods orders decreased .4% versus expectations that they would be unchanged; ex the volatile transportation sector, orders fell .7% versus expectations of an increase of .3%,
(b) October construction spending fell .8% versus expectations of a decrease of .2%,
(c) and finally the first positive statistic, the November Chicago purchasing managers’ index [PMI], a secondary indicator, came in at 52.9 versus expectations of 50.5 and 49.7 recorded in October.
(4) the macro economic data was the bright spot this week:
(a) third quarter gross domestic product [GDP] was revised from up 3.9% to up 4.9%, in line with expectations,
(b) the third quarter personal consumption expenditure [PCE] index rose 1.7% versus an increase of 4.2% in the second quarter while core PCE [the Fed’s favorite] was up 1.8% versus being up 1.4% in the second quarter. Another inflation measure, the third quarter chain weighted GDP price index, came in at +1.9% versus expectations of +.8% and +2.6% in the second quarter,
(c) the Fed released its latest beige book report [an every six weeks anecdotal look at the
(5) the credit markets are freezing up again: virtually guaranteeing a Fed Funds rate cut is the re-freezing up of the commercial paper market. In the last three weeks, the volume of short term paper that corporations couldn’t refinance has risen back to the levels experienced in August. Remember this is normal short term borrowing that the business community uses to finance its everyday credit needs--so if it can’t do so, a drop in economic activity is almost sure to follow.
In August, the Fed demonstrated that it recognized the risks inherent in an illiquid short term credit market by lowering interest rates. It seems reasonable to expect the same this time. Indeed, the Fed made a huge injection in the monetary base last week; so much so that the growth rate of the monetary base for the three month, six month and 12 month periods were all positive for the first in almost a year. Nevertheless, further action on interest rates is also needed for the simple reason that at the moment the banking system’s cost of money [the Fed Funds and discount rates] is higher than the long term lending rate [10 year US Treasury bonds]--it is clearly uneconomic to borrow money at a higher rate than that at which it can be lent.
http://kudlowsmoneypolitics.blogspot.com/2007/11/kudlow-101-more-shock-and-awe.html
Bottom line: the economic statistics this week represent a return to the mixed data reports characteristic of most of this quarter and reverse the mildly positive trend of the prior couple of weeks. Even worse, unless the credit markets can resume the normal financing of short term business liquidity needs, they will surely cripple the economy’s ability sustain growth of any measure. As I said above, I believe that the Fed is responding correctly and that the economy will avoid a recession; however. the evidence increasing indicates that the ‘soft’ landing will be ‘harder’ than initially forecast.
It is too late for this greater than estimated slowdown to get reflected in the 2007 macro numbers, but I am revising my 2008 estimates for the growth of real GDP from +3-3.5% to +2-2.5% and corporate profits from up 7-9% to up 3-5%. Given the continuing good behavior in the inflation statistics, I am leaving the inflation forecast unchanged. (See Current Economic Forecast above)
I have said on numerous occasions that changes in the cyclical rate of economic growth and corporate profits don’t tend to impact our Valuation Model all that much; however, a 200%+ drop in the growth rate of corporate profits does have some influence even though it is disproportionately smaller. As a result, I have revised the 2008 Year End Fair Values of the DJIA (from 14250 to 14050) and S&P (from 1640 to 1615). (See Current Market Forecast above)
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
Domestic
I always hate stating the obvious but we are now less that a year from elections. On the premise that investors tend to look a year plus or minus into the future in discounting events, the time has come to start getting serious about assessing the likely outcome of the 2008 elections and its economic consequences--and, of course, you know what I am going to say next: if the current polls prove correct and the Democrats take control of the White House and retain control of Congress--and taking the Democrats at their word--the US economy (and electorate) post January 2009 is looking at higher taxes, a ramp up in government spending, a tilt toward a more protectionist approach to world trade and a more restrictive regulatory environment.
Usual disclaimer: you may agree with some or all of these policies; but they are not conducive to maximizing the potential growth of the economy and corporate profits and, therefore, act as a governor to rising equity values, i.e. Your Money.
It would be foolish at this point to assume a Democratic sweep of both branches, but each day, week and month that passes will give us a better feel for the outcome and should the ‘Democrats will rule’ scenario remain the most likely, in my opinion, investors will start discounting the economic consequences of their current platform. (To be clear, I am not giving up on the chance that the Democrats become less likely to rule in the November ’08 elections--it just doesn’t look that way at the moment.)
The point here is (1) Democratically controlled executive and legislative branches, in my opinion, will result in a slow down in the secular growth rate of the economy--and that number [the long term secular growth rate of the economy] carries much more weight in our Valuation Model than the cyclical growth rate of the economy [ the issue I dealt with above in discussing the revision to my 2008 economic forecast] (2) the slower secular economic growth, the lower the general level of Fair Value for equities as computed by the Valuation Model and (3) therefore, should the probability increase of a slower secular economic growth rate, so too will the likelihood of [a] a less robust advance of stock prices and [b] an increased relative value of cash and real assets, including gold.
In other words, this nagging little worry that I mention (some of you might use a stronger word) off and on in this section has gone from being a perhaps interesting but hypothetical thought to one that may soon start impacting equity values and portfolio strategy.
The Market
Technical
The DJIA is in a trading range defined by 12523 (the August intra day low) and 14203; the S&P 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 (13371) finished this week, about 1% over Fair Value (13250) while the S&P closed (1481) almost 3% undervalued (1525).
The $64,000 question is ‘have the negative concerns over potential corporate profit declines (losses) resulting from the sub prime credit problems and an economic recession run their course and, therefore, should investors be aggressively committing cash or has this week’s Market action been a head fake?’
(1) to repeat a point from a Morning Call: on a price basis, the Market’s performance this week looked like a ‘double bottom’ had been made; unfortunately, the volume statistics would suggest otherwise,
(2) to repeat another oft utilized phrase: the Market is in a trading range and will be until it is not--that means that in technical terms, there is nothing to prevent stock prices from revisiting the August/November lows,
(3) it is likely that there are still problems related to either/or/both the sub prime difficulties and a potential recession that are yet to surface--that means that in fundamental terms, there is nothing to prevent stock prices from revisiting the August/November lows or going lower,
(4) all that said, in the end the dominant factor in our buy/sell decisions is our Price Disciplines [Valuation Model]; and right now, there are a large number of stocks on our Buy Lists--many more in fact than the last time that the Averages were at current levels. Furthermore, our Buy Lists don’t even include the stocks of all those financial and housing companies that have been absolutely destroyed. [I am working feverishly to adjust the Valuation Model for this group of stocks; and while I can’t guarantee that any of them will ever appear or re-appear on our Buy Lists, history suggests that they will.[ Finally, as I noted above, there is nothing of a cyclical economic nature that would alter the assumptions or math of the Valuation Model--this all means that as values appear [which they currently have], our Portfolios will profit in the long term by following our Disciplines and Buying those values.
(5) the big caveat is the discussion above regarding the impact of the Democratic economic agenda on the equity values [our Valuation Model],
(6) bottom line: Our investment strategy is:
(a) continue to use our Buy Price Discipline and average into stocks of great companies,
(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 13371 1481
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:
Paychex Inc provides computerized payroll-accounting services, salary deposit services, automatic payroll tax payment and tax return filing services and human resource products and services to approximately 500,000 small and medium sized businesses. The company has earned a 25%+ return on equity over the last 10 years, has grown profits and dividends 13-15% in the same time period and has a debt free balance sheet. This record should continue as PAYX grows its client base, its clients grow (increased use of services), it adds new fee generating services and it aggressively pursues its stock buy back program.
EPS: 2006 $1.22, 2007 $1.35, 2008 $1.60; DVD: $.79 YLD 3.0%
http://finance.yahoo.com/q?s=PAYX
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.
