9/16/08

Economics

Recent Data

August industrial production fell 1.1% versus expectations of a .3% decline and a .1% increase in July; capacity utilization for the same period came in at 78.7 versus estimates of 79.5 and 79.9 recorded in July.

The September Empire State Manufacturing survey index reading was -7.4 versus forecasts of +.5%; looking at the internals of this index, there was a bright spot in new orders which were 4.5 versus expectations of -2.2.

Clearly, these are disappointing data from what has been the strongest sector of the economy.

The August consumer price index was reported down .1% (yeah, it was oil); core CPI was up .2%. Both were in line with estimates.

Other

Some positive notes on what looks like a negative day:

http://mjperry.blogspot.com/2008/09/resilience-of-american-finance.html

http://mjperry.blogspot.com/2008/09/factual-evidence-shows-significant.html

http://mjperry.blogspot.com/2008/09/when-it-comes-to-economy-we-have-become.html

Politics

Domestic

International War Against Radical Islam

The problem with Pakistan:

http://www.slate.com/id/2200134/#

The Market

Technical/ Fundamental

Technical thoughts on the market:

http://traderfeed.blogspot.com/2008/09/few-thoughts-about-current-stock-market.html

Charts on the S&P and the financial sector:

http://bespokeinvest.typepad.com/bespoke/2008/09/sp-500-and-the.html

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Yesterday the DJIA (10917) closed above its July 2008 intraday low (10809) while the S&P (1192) finished below its similar level (1198). The next support level for the S&P lies in the lower boundaries of the October 2007 to present downtrend (1152) and the May to August downtrend (1115).

In yesterday’s Morning Call, I held out the hope that by the close we would have a clearer technical picture than we had at the start of the day. I don’t feel like we do. On the positive side, (1) the DJIA held above its July 2008 low, (2) the volatility index spiked to above 30 [which is usually a sign of a bottom], (3) volume was typical of a bottom, (4) historically [4 out of 5 times] when stocks experience a day like yesterday, it marked a bottom and (5) despite the problems of Lehman Bros, Merrill Lynch and AIG and a big drop in oil prices, only a couple of our financial and oil stocks performed poorly. The bad news is that (1) the S&P didn’t hold its July 2008 low, (2) there was no price reversal and (3) most disconcerting, the stock price of a number of our Portfolios’ holdings pushed through their pre-set Stop Loss Prices.

What to do? If it was clear that a bottom had been made, our Portfolios would be buying today. If was clear that the July lows had been broken and further downside appeared ahead, our Portfolios would be Selling all or a portion of those holdings mentioned above whose stock prices fell below their Stop Loss. Unfortunately (at least for me) it is not enough of either. Plus today we get (1) Goldman Sachs earnings report and of more interest the narrative about its financial condition that will accompany, (2) the Fed meeting and (3) hopefully additional clarity in AIG’s crisis.

My dilemma is that if yesterday was the ‘flush’ and today is the ‘bounce’, any sale would be stupid. Of course, if yesterday was just the beginning of the ‘flush’ any sale will look like genius. As always, I am erring on the side of preserving principal. So this morning at the Market open:

Subscriber Alert

The Dividend Growth Portfolio will Sell (1) sufficient shares in T Rowe Price (TROW-$54) to reduce this position to a three quarter size holding (2) sufficient shares of Chevron (CVX-$80) to reduce this position to a one half size holding (3) it entire position in McGraw Hill. On MHP, it seems to me that ultimately S&P (which McGraw Hill owns) and Moody’s are going to be held responsible for their role in this financial crisis. They will almost surely survive; but I have no idea how much pain the shareholders will have to endure. This is a potential problem we don’t need at this time.

The High Yield Portfolio will Sell sufficient shares in Realty Income Trust (O-$24) and Universal Corp (UVV-$50) to reduce these positions to one half size positions.

The Aggressive Growth Portfolio will Sell sufficient shares in Charles Schwab (SCHW-$23) and Staples (SPLS-$24) to reduce these positions to one half size holdings. It will sell sufficient shares of Medtronic (MDT-$53) to reduce this position to a three quarter position.

I made the statement last week and 600 points ago that I would rather sell today with the objective to preserve capital and look stupid if the Market rallies afterward than not sell and lose money. Ditto today.

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As a final comment with much longer term implications than anything said above, to ultimately correct the problems that led to this mess that we are in, something needs to be done about (1) the rules on short selling, particularly the naked short sell [selling a stock that can’t be delivered to the buyer], (2) the unbelievably, irresponsible high leverage ratios investment banks were/are able to assume and (3) the current application of the ‘mark to market’ accounting treatment of highly illiquid securities.

A look at the mark to market problem:

http://www.thestreet.com/p/_htmlrmd/rmoney/marketcommentary/10437271.html

A look at the risk management (high leverage) problem:

http://www.capitalspectator.com/archives/2008/09/nirvana_for_nib.html

Company Highlight

McDonald’s operates or licenses more than 31,000 fast food restaurants world wise. Over the past ten years, the company has grown profits at a 9% pace but dividends at 20% annualized while earning a 25%+ return on equity. Looking forward, the pace of advance of dividends should slow somewhat although earnings growth is expected to rise as a result of:

(1) despite the recent rise in commodity prices, the company’s purchasing power and menu diversity should fuel margin expansion,

(2) global growth not only in the number of restaurants but also in same store sales,

(3) introduction of new higher margin products [coffee, chicken],

(4) shorter term, the trade down from casual dining to less expensive fast food.

MCD is rated A++ by Value Line, carries a 42% debt to equity ratio, has an ongoing stock repurchase program and its stock yields 2.4%.

http://finance.yahoo.com/q?s=MCD

9/08

News on Stocks in Our Portfolios

A positive write up on McDonald’s (Dividend Growth Portfolio):

http://www.zacks.com/rank/zcommentary/?id=8586

More Cash in Investors’ Hands

9/15/08

Economics

Recent Data

A graphic look at the rebound in consumer confidence:

http://mjperry.blogspot.com/2008/09/consumer-confidence-rebounds.html

Other

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.). New estimates of the federal budget deficit are not positive:

http://www.heritage.org/Research/Economy/wm2057.cfm

This is a great analysis of how economic and stock market performance varies under Democrats versus Republicans:

http://www.poorandstupid.com/2008_09_07_chronArchive.asp#5994601770590690716

The Commodity Futures Trading Commission’s report to Congress on speculation in oil:

http://www.ibdeditorials.com/IBDArticles.aspx?id=306024468188608

A look inside the home foreclosure statistics:

http://mjperry.blogspot.com/2008/09/excluding-az-ca-fl-mi-and-nv.html

Some historical perspective on bank failures:

http://mjperry.blogspot.com/2008/09/were-still-long-way-from-real-banking.html

Are our Markets too de-regulated?

http://www.forbes.com/opinions/2008/09/12/lehman-greenspan-regulation-opinions-cx_br_0912ritholtz.html

Politics

Domestic

Palin and the Bush Doctrine, courtesy of ABC:

http://hughhewitt.townhall.com/blog/g/7656b78a-a090-4a56-9bf5-0e37bdaff80a

Palin and the bridge to nowhere:

http://article.nationalreview.com/?q=Y2FiMjBlNWE0ZTJhNDBjZWExYzA2M2M5MWZkYmFlN2I=

International War Against Radical Islam

The Market

Technical

Technical update from Traderfeed:

http://traderfeed.blogspot.com/2008/09/indicator-update-for-september-15th.html

Fundamental

As I am sure you know, today is going to be a wild ride. Lehman Bros is declaring bankruptcy, Bank of America is buying Merrill Lynch, American International Group is begging the Fed for a $40 billion bridge loan and oil prices are off $5 a barrel suggesting that the forced liquidation we witnessed last week is not over. Markets around the world are off 4-5% . Clearly my assertion in last week’s Closing Bell that the financial stocks in general appeared to have bottomed will get a stiff challenge. At the moment about the only good news is that our Portfolios have a 20-22% cash position.

The big question on my mind today will be, assuming the Market sells off big initially, will there be a rebound and if so, will that constitute the emotional sell off/test of the July lows that we have been looking for? I hope that we have an answer to that by tomorrow morning. In the meantime, remember our Portfolios own good quality, financially sound (even our holdings of financial stocks) companies that raise their dividends consistently, we have a cash position that provides stability of capital and a reserve to allow us to buy stocks of good companies inexpensively and a Sell Discipline that will help us continue to preserve capital.

News on Stocks in Our Portfolios

Walgreen (Aggressive Growth Portfolio) has made an offer to acquire Long’s Drug Stores for $3 billion in cash.

http://www.thestreet.com/story/10437222/1/walgreens-offers-to-buy-longs-drug-stores.html?puc=_htmlbtb

More Cash in Investors’ Hands

The Closing Bell

The Closing Bell

9/13/08

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-again)

Real Growth in Gross Domestic Product (GDP): -1.0 - +1.05%

Inflation: 2-3%

Growth in Corporate Profits: 0-5%

Current Market Forecast

Dow Jones Industrial Average

2008

Current Trend:

Short Term Downtrend 10090-11477

Medium Term Downtrend 10658-12605

Long Term Trading Range 7100-14203

Year End Fair Value (revised): 13450-13850

2009 Year End Fair Value (revised): 13850-14250

Standard & Poor’s 500

2008

Current Trend:

Short Term Downtrend 1122-1273

Medium Term Downtrend 1155-1374

Long Term Trading Range 750-1527

Long term Up Trend 1317-1797

Year End Fair Value (revised): 1533-1577

Percentage Cash in Our Portfolios

Dividend Growth Portfolio 22%

High Yield Portfolio 23%

Aggressive Growth Portfolio 24%

Economics

The economy is a neutral for Your Money. The economy continues to struggle. The data on the consumer this week was generally soft (decline in consumer credit, poor weekly and August retail sales, a smaller than expected decline in weekly jobless claims) though the University of Michigan’s preliminary September index of consumer sentiment surprised analysts on the upside (73.1 versus estimates of 64.0). There was no help from the industrial sector with both wholesale and business inventories up more than expected largely as a result of lousy wholesale and business sales. The big (pleasant) surprise came in the form of the August producer price index which declined .9% versus forecasts of .3% increase. In sum, there was nothing to ease concerns about a potential recession but there is growing evidence that the threat of inflation is lessening. Bottom line: the economy may or may not be in a recession; but if it is, I don’t expect any slowdown to be dramatic. My concern about inflation is subsiding.

Here’s the glass half full argument:

http://www.poorandstupid.com/2008_09_07_chronArchive.asp#2985918066237617746

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 US economic growth.).

(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

Both the domestic and international political environments are a negative for Your Money.

I haven’t commented on the political environment in some time; and this isn’t a long one. But it is amazing how a competitive political environment can drive rhetoric to the center. Note, Obama’s statement (1) on Iraq in the O’Reilly interview and (2) that he wouldn’t raise taxes in a difficult economic environment and Congress’ move toward allowing more offshore drilling. Much more of this and I may have to rate this factor as a neutral.

The Market-Disciplined Investing

Technical

The DJIA (11421) and S&P (1251) closed Friday in two clearly defined down trends: (1) a very short term trend marked by the May 2008/August 2008 highs whose boundaries are DJIA circa 10090-11477 and the S&P circa 1122-1273 and (2) a medium term down trend extending back to October 2007 whose boundaries are DJIA circa 10658-12605 and S&P circa 1155-1374. Fortunately, there are a couple of additional support levels for both indices above the lower boundaries of these two down trends; it is at their early July 2008 intraday lows: DJIA 10809, S&P 1198 and their late July intraday lows: DJIA 11132, S&P 1209. Bottom line: I remain hopeful that the July intraday lows will mark the bottom to this Market cycle; but that notwithstanding, no matter how you look at it, technically the risk remains high of additional downside at least for the Averages.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (11421) finished this week about 15.7% below Fair Value (13549) while the S&P closed (1251) around 19.1% undervalued (1547).

Last weekend, I thought that depending on the components of the Treasury’s plan for salvaging Fannie/Freddie, we would get a clearer picture of Market direction this week. Nope. Granted that the Treasury back stopping of Fannie/Freddie provides additional clarity in the resolution of the financial crisis; but it didn’t do much galvanize investor sentiment.

I opined in Friday’s Morning Call that there were signs that we are in some sort of rolling Market bottom--the early July low marking the bottom in the financial and consumer discretionary stocks and this week the oil/commodity stocks attempting to make a low. Some would argue with that of course. Especially today with investors focused on Lehman Bros, AIG, Washington Mutual and Merrill Lynch and what might happen if Lehman can’t meet its commitments. And to be sure, there are some stocks within the financial group (namely those mentioned above) that are getting hammered as this is written. However, when I review the pin action of the preponderance of bank, insurance, broker and money management stocks in our Universes, there was, in my opinion, a clear bottom in July among a big segment of the financial stocks.

Here’s a chart of the S&P financial sector to support this point:

http://bespokeinvest.typepad.com/bespoke/2008/09/sp-500-financia.html

So what to do if my hypothesis of a rolling bottom is correct? Well, the first step would be to bulk up our Portfolios’ commitments in financial and consumer stocks. That is largely done, although there is a little work to do in the Aggressive Growth Portfolio (we got stopped out of Mastercard last week, so those funds need to be reinvested; plus its holdings in Lowe’s and Walgreen are only partial positions and need to be added to).

The big issue right now is have the oil/commodity stocks hit bottom and should our Portfolios begin re-building their allocations to the oil/commodity/industrial sector. So far we haven’t (presently most of our holdings in these sectors are one quarter to one half of normal size) though we have attempted to grow positions in beneficiaries of lower oil prices (transportation, oil refiners); and a major reason that we haven’t is that I think that right now the fate of oil stock prices are in the hands of institutional investors (who have been massively liquidating their oil/commodity stock holdings) rather than a function of the fundamentals of their respective markets (remember I still believe that global industrialization is alive and well). As a result, the only way I know to deal with these stocks is technically.

To quote Thursday’s Morning Call: ‘...the answer is to look at a stock’s chart and measure the current price against (1) the upper boundary of the stock’s identifiable downtrend [in other words, did yesterday’s price increase move the stock out of an established downtrend?] and (2) whether or not the stock was able to regain the price level of the Stop Loss [that I had originally set at an identifiable support level] which pushed our Portfolios to Sell these holdings in the first place [in other words, following Tuesday’s decline, did Wednesday’s recovery push the stock price above the Stop Loss {support level} which in my judgment would suggest that a bottom has been made].

As of the close Friday, while none of stocks of our holdings have broken out of their short term downtrend several of the stocks in which our Portfolios have a position re-gained the price level of the prior Stop Loss (item #2 above). This may be a signal that the bottom may have been or is being made. However, until we have a more universal recovery, our Portfolios are on the side line.

Whether or not we are in a ‘rolling’ bottom scenario, the schizophrenic behavior among various sectors’ stock price performance is making our current investment strategy of managing our cash position between 15% and 20% difficult, e.g. when the Market was getting clocked last week and our strategy called for committing cash, there were stocks that had moved up into their Sell Half (take profits) Ranges forcing our Portfolios to Sell. I am not abandoning this strategy, just pointing out that implementing it in this Market is a lot tougher than advocating it.

On a slightly longer term basis, our investment strategy remains:

(a) defense is still important--protect profits and avoid losses,

(b) watch Market technicals for confirmation that a bottom has [is being] been made,

(c) on a longer term basis, recognize that there remain 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.

DJIA S&P

Current 2008 Year End Fair Value 13650 1555

Fair Value as of 9/30//08 13549 1547

Close this week 11421 1251

Over Valuation vs. 9/30 Close

5% overvalued 14226 1626

10% overvalued 14904 1701

Under Valuation vs. 9/30 Close

5% undervalued 12872 1469

10%undervalued 12194 1392

15%undervalued 11516 1315

20%undervalued 10839 1238

The Portfolios and Buy Lists are up to date.

Company Highlight:

Stryker Corp develops, manufactures and markets orthopedic implants for the hip, knee, spinal and craniomaxilofacial needs as well as power instruments, endoscopic systems and other operating room devices. The company has grown profits and dividends at a 20%+ annual rate for the past 10 years earning a 17-19% return on equity. SYK should maintain this record as a result of:

(1) strong demographic trends, i.e. the a rapidly growing older segment of the population,

(2) an extensive and well diversified product line,

(3) an active acquisition program.

SYK is rated A by Value Line, has no debt, is in the midst of a $750 million share buy back program and its stock yields .7%.

http://finance.yahoo.com/q?s=SYK

9/08

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.