Tuesday, October 21, 2014

Is The Economy Slowing Down? Not According to Dividends...

In our most recent blog, we indicated that corporate America’s dividend actions during this time of uncertain global growth will be among the best indicators of the true U.S. and global economic outlook.

Most investors don’t pay too much attention to a company’s dividend policy.  To Wall Street, dividends are just a product of earnings. They don’t mind the dividend payments they get each quarter, but they aren’t really focused on dividends.  Wall Street spends more time chasing earnings predictions and short-term price appreciation.

Despite the recent increase in popularity of dividend investing for income, most people still miss the most important point of all: the dividend is directly linked to the true health of the underlying business and the management’s expectations for the next 12 months and beyond.

Why is this?  For two main reasons:

  1. If you are the CEO of a company and you see a slowdown in future sales and earnings growth, you’re probably not too excited about more cash leaving the company.  Rather than increasing your cash dividend by 10% again this year, you might opt to hold some cash back in reserves and raise the dividend by, say, 5% instead.

  2. Dividends can’t be faked.  Not even the most creative accountant in the world can generate real cash.  Earnings numbers can be misleading, especially at significant turns in the market. Dividends, on the other hand, cannot be faked.  If a company falls into real trouble, it won’t be long before they have to conserve cash and cut their dividend (or at least stop growing it).

We believe that by focusing on dividend history and dividend growth, we can learn a great deal more about a company’s true future prospects.  We’ve seen it time and time again - the companies that slow or cut their dividends have dramatically underperformed the rest of the stock market over the next 12-24 months.

In addition to our numerous valuation models, we have a new model that we’ve built that uses data that is unavailable to the vast majority of investors.  In fact, we might be one of the only investment firms in the U.S. that (a) has this data available and (b) pays any attention to it.

In our view, this tool will be a powerful predictor of when a company starts to take a turn for the worse (or become optimistic about their future).  With this tool, we will be one of the first to be flagged about a company’s dividend behavior and be able to quickly make a decision based upon what we see - well in advance of the rest of the market.

We now have the ability to track not only the dividend announcements on a day-by-day basis, but what Wall Street and Bloomberg were estimating that the most recent dividend action would be.  Based upon statistical backtesting, these dividend estimates have an 88% accuracy rating.  Below is a summary of what the dividend tracker is currently telling us:


Using this tool, we will be able to see:

  1. What the companies believe economic growth will look like.  Are companies starting to slow their dividends as a whole?  Or accelerate them?  The median dividend increase for companies who have announced a dividend increase over the past 3 months is 12.5%.  That is even higher than the year-to-date number of 11%.  Based upon this number, companies are actually accelerating their dividends at a faster pace than they were earlier in the year.

    Perhaps the most encouraging news of all is that over the past 2 weeks, when the stock market was concerned about global growth, dividend announcements were actually a positive surprise of 2.1%.

  2. Are companies expecting to perform better or worse than expected?  By comparing actual dividend announcements vs. dividend growth expectations, we will be able to see red flags on the day they arise.  Of the companies who made announcements, 35 beat expectations while 9 missed.  If any of our companies were among the misses, we would probably give them a call to see what was going on.

  3. Have there been any companies that were supposed to raise their dividend that did not?  In our mind, this is the worst sin a company can commit.  Unless there is a good reason for it (like better investment in projects or a special dividend upcoming), a dividend cut is a bad sign for the future.  Over the last 3 months, there were 67 companies expected to raise their dividends. Every single one of them raised the dividend.  No cuts.  No flat lines.  On average, those companies beat expectations by 1.7% overall. That’s a very good sign.

So far, there is absolutely no evidence that U.S. or multinational companies are pulling back on their dividend increases.  That is very good news in the face of bad headlines across the world.  Companies are still very confident in their futures.  Despite the near “correction” (10% down) from top to bottom, dividends and dividend growth is still intact.  Until that changes, we believe the outlook for the companies in our portfolios is still very good.

Thursday, October 16, 2014

Upcoming Dividend Hikes May Reveal What Corporate America Really Thinks

Europe’s economy is in a funk and may be heading for recession.  Terrorists in the Middle East have burst onto the scene straight out of some B movie horror show.  The Ebola crisis threatens to reap vengeance near and far.  In the midst of these threats and the unfathomable questions they pose, smart-guy politicians in the U.S. and Europe seem to have a strong resemblance to the Wizard of Oz after the curtain was pulled away.   


As an investor, where do we look for a glimpse of how these questions and issues will be resolved?  I have been in the investment business for nearly 40 years, and I have endured at least a dozen of these episodes when the vultures hanging in the sky were so numerous they left me stumbling around in the dark trying to find a light -- any light.  Indeed, the Rising Dividend Strategy that we use today was born during the crash of 1987, when the stock market fell by nearly 23% in a single day.  I went into that day believing that the daily stock price movements were the best indicator of where the stock was going in the near term.  I ended that day exhausted and humbled, but with a strange sense of hope.  Black Monday was such an egregious assault on my sense of how the markets worked that I realized such a selloff could not be driven by the fundamental soundness of the economy or of corporate America.  When all stocks go down, it is a signal that emotions have replaced reason in the driver’s seat because the prospects for all companies do not rise or fall in unison on a single day, week, or month.  


Our Investment Policy Committee has been studying and discussing the current sell off for several weeks.  What does it mean?  Is it for real?  How far will it go?  How will it end?  This past Monday we realized these were not questions that could be answered until after the selloff has ended.  We turned our attention to variables that our research has proved over the years to be the best predictors of stocks prices:  earnings, dividends, inflation, and interest rates.  We came away from that exercise very hopeful.  If the U.S. economy is headed for recession like Europe, corporate earnings should be soft.  The are not.  In fact, so far in this earnings reporting season they look better than last quarter. Inflation is anchored near 1.5%, and the ten-year Treasury bond yield has fallen to a multi-year low at near 2 percent.  Dividends are the real stars of the show.  They have already risen by over 10 percent for the year with nearly three months to go.  


None of these important variables of the U.S. economy and corporate America is signaling imminent bad news.  In fact, all of the data are headed in the right direction.  We concluded the current selloff must be looking over the hill at the aforementioned vultures and projecting that one or more of them will come home to roost, and the current good news will turn bad.    


After the crash of 1987, we gradually became dividend investors because we found that dividends were the best predictors of the true trend of stock market performance.  Dividends tell four powerful stories about the future trend of the stock market.:


  1. Dividends are cash money.  They represent a real transfer of wealth from a corporation to the shareholder, unlike earnings which can be engineered and may be here today and gone tomorrow.


  1. Dividends have represented over 40% of total stock returns over the last 80 years. Thus, not only are they real money, but they are also really important to total return for shareholders.


  1. Dividend cuts by corporations in the U.S. are almost always punished by the market. Corporate executives know this. Because of this, S&P 500 dividends have fallen, on an annual basis, only about half as often as have earnings. In addition, the annual volatility of dividends is only about one-third that of earnings.    


  1. The S&P 500’s long-term dividend growth of 5.5% is very close to long-term stock market price growth of 5.9%.  Dividend growth and stock market growth are not identical twins that move in lockstep, but they do shadow each other closely.    


In looking again at this list, we realized we had a tool that could give us a glimpse of what was going on in the economy over the hill beyond our sight.  That tool was the daily dividend announcements of corporate America.  In the long-run, the growth of stocks prices will look a lot like dividend growth.  Since corporate America is world renowned for its ability to rightsize costs with revenues, if top management sees trouble coming they will not only cut costs, but they will also cut back on dividend hikes.  We have many resources, including Bloomberg Professional Markets, that make dividend estimates.  By watching dividend actions versus Bloomberg’s estimates for all stocks, we should be able to see if companies are downshifting their internal growth estimates.


Why are dividend actions so important to our way of thinking?  American CEO’s live and die by their cash flow projections.  They do not want to spend an extra dollar on a project that is going nowhere or losing money.  Thus, they recommend dividend hikes to their boards of directors that reflect the company’s free cash flows that are not needed somewhere else. 

At present, Bloomberg and Wall Street analysts are predicting that dividends will grow at about 9 percent in 2015.  If that comes to pass, the recent selloff is a mistake and a great buying opportunity just like all the big sell offs in history have been.  If dividends remain flat or fall over the remainder of the year, then there may be more trouble coming than we are now projecting. Dividends only have to reach 5.5 percent growth to be in the normal range.  


So far in our study of dividend hikes the news is good.  Over the past month, dividends have grown 1.8 percent more on average than they were projected.  We will report our findings regarding dividend hikes on a regular basis throughout the end of the year.          

Tuesday, October 07, 2014

The 4 Drivers of Stock Market Prices

We have found that very few investors understand what really drives the stock market.  In our view, the four primary drivers of market valuations are earnings, dividends, interest rates and inflation.  If you can quantify what is going on with those four variables, our models indicate that you can predict about 90% of the annual movement of stock prices.
Last time, we talked about the Barnyard Forecast which is a model that signals the probable direction of the market.  While the Barnyard Forecast does correctly predict the market’s direction 6 to 18 months from now with about 80% accuracy, it is not a short-term predictor nor does it have any valuation component.  Therefore, we use select valuation models to ascertain the relative attractiveness of stocks.

Almost all of these models use some component of the above mentioned variables.  Within those four variables, there are two that stand out above the others as being the most important drivers.  We’ll take a look at each factor and then conclude with what it means for stocks.

Earnings

Most investors look to earnings as the primary guide of what a company is worth.  In theory, that makes sense.  If Company A is earning $500 and Company B is earning $1,000 - wouldn’t you rather own Company B?
The problem with earnings is that they can be engineered by creative corporate executives.  In times of recession, earnings are particularly volatile. Earnings can be calculated in a variety of different ways, which adds additional complexity.  We don’t think earnings should be completely discounted in valuing companies or the stock market as a whole.  However, the unpredictable nature of earnings often gives very bad signals at turning points in the market.
Dividends

We have found dividends to work much better than earnings.  Over the past 50+ years, dividends have had approximately three times more predictive power than earnings.
Let’s say you own two rental properties.  One rents for $100 per month and the other rents for $200.  If both rents are increasing at 3% per year and both will continue to rent for the next 20 years, which rental property would be worth more to you?  The one that will pay you the most in rental income over its useful life… right?  
John Burr Williams was the first to apply this theory to stocks.  He said the value of a stock today is the sum of all future dividend payments discounted back at some required rate of return.  In other words, the more a company pays out to its owners in the future, the more valuable that company is to its owners today.  
Not only does that theory make “real world” sense, but it also holds up statistically.  In our models, we’ve found that dividends are the most important driver of stock prices by a wide margin.
Interest Rates
Interest rates are a primary concern for most stock investors.  The general level of interest rates essentially represents the “opportunity cost” of investing in stocks.
If your bank account were to start offering 10% per year on your savings account, you would probably prefer to “invest” in your savings account rather than in the stock market.  If your bank account is only paying 0.1%, however, the attractiveness of investing in stocks increases.
Many investors would be surprised, however, that interest rates are not the most important factor in determining long-term stock prices.  
Inflation
Inflation is actually a much more significant predictor.  How can that be? There are several reasons for this.
Interest rates can be artificially set by the Federal Reserve.  Inflation can be influenced by Fed policy, however, it is primarily a result of real world economic activity.

Inflation is also one of the primary drivers of interest rates.  If inflation is rising, it has the effect of diminishing the real rate of return for a bond investor.  In that environment, a bond buyer will demand a higher rate of interest to compensate for the loss of purchasing power.

In addition, inflation is impacted to a large degree by economic growth. When the economy is growing at a faster rate, the Federal Reserve will generally tighten monetary policy, which raises interest rates.
The importance of inflation is also reflected in several of our models.  We have a price-to-earnings (or “P/E”) Finder model that we use to determine the appropriate P/E ratio for stocks.  In that model, inflation has been a much better predictor of P/E than interest rates, GDP growth or earnings growth expectations.
Outlook for Stocks
If you can understand these four variables, you can get a fairly accurate gauge of the valuation of the market.  At this moment, all of these variables are very positive for stocks.
  • Dividend growth for the S&P 500 has been over 10% year-to-date.  We believe this will continue to be strong in 2015.  Companies are beginning to understand how valuable their dividend checks are to shareholders and have begun to emphasize dividend growth as a priority.

  • Earnings are expected to grow by over 10% in 2015.  Time will tell whether that will come true or not.  If it does, we anticipate the market will reward the companies for their continued strong performance.
  • Inflation remains very low.  With little capacity pressure from either employment or plant and equipment, we don’t see much of a chance that inflation gets higher than the Fed’s target of 2.5%.  The economy is simply not growing fast enough.
  • With inflation low and the Fed continuing their stimulative monetary policy, interest rates are likely to remain low.  The 10-year Treasury continues to trade at the low end of our 2013 prediction of between 2.5% and 3.0%.  We don’t anticipate that rates will get much higher than that over the near term.
As we talked about last week in our Barnyard Forecast, monetary policy conditions are very favorable.  Aside from a major geopolitical shock, stocks don’t face any major red flags going into 2015.

The most current reading from our S&P 500 valuation model indicates that the fair value of the market is about 1,950.  As this is being written, the S&P 500 is trading at about 1,952.  From both a directional perspective and a valuation perspective, our models are saying that stocks are still the place to be.

Wednesday, September 24, 2014

Barnyard Forecast: More Bull to Come or Is the Bear Growling?

Our last published Barnyard analysis appeared approximately 1 year ago in September of 2013.  At that time, the Barnyard Forecast resulted in 6 out of 8 points, indicating that the market would be favorable over the next 6-18 months.  That has come true, with the S&P 500 up nearly 20% since then.  We expect many will be surprised by the latest Barnyard Forecast.

During this week’s Investment Policy Committee meeting, we updated our “Barnyard Forecast” model.  The Barnyard Forecast is a basic model we use to determine whether the current environment is accommodative, neutral or restrictive towards stock market growth. Since 1990, the Barnyard model has correctly predicted the general direction of the market over the next 6 to 18 months with approximately 80% accuracy.

The Forecast gets its name from the acronym of its components: economy, inflation, earnings, and interest rates = opportunity for stock market appreciation (E+I+E+I=O).  Each factor is rated as positive (2 points), neutral (1 point), or negative (0 points) for stocks based upon historical relationships between that component's economic data and its likely effect on the Federal Reserve's monetary policy and market reactions.  The total points are then added up to arrive at a score between 0 and 8.  A score above 4 indicates a positive environment for stocks.  

Economy - 2 Points

When the economy is growing slowly, the Federal Reserve's projected actions over the next 12 months should favor stocks.  The Forecast score is positive when economic growth is less than the optimal, non-inflationary rate of economic growth of 3%.
Economic growth has improved significantly since the 1Q 2014 numbers.  However, year-over-year GDP growth remains below the 3.0% mark.  At this moment, we’re at about 2.5% with the 3-5 year range between 1.5% and 3.0%.  Economic growth would need to be at least 3.0% before the Federal Reserve would start taking any action to raise rates.  In our view, even 3.0% might be too low in light of the other data coming from the economy.  The bottom line: the economy is still not growing fast enough to warrant monetary policy tightening.  Positive for stocks – 2 points. 

Interest Rates - 2 points

Historically, the yield curve spread (difference between long-term and short-term interest rates) has been a predictor of economic performance.  As long as the spread remains positive, stock markets tend to rise.  When it turns negative, that is a danger signal for stocks.  
Spreads between long-term and short-term rates are currently very positive.  The 2-year U.S. Treasury is yielding around 0.5% versus nearly approximately 2.5% on the U.S. Treasury, a positive spread of 2.0%.  Since we are nowhere near a negative yield curve, this component of the model strongly suggests a favorable environment for stocks.  2 points.

Earnings - 2 points

Earnings growth is a statistically significant driver of stock market prices.  Over the long-term, earnings growth for U.S. corporations has been 7%.  The Forecast scores growth greater than 7% as being positive for stocks.  

In September 2013, the 2nd quarter earnings were only 3% - well under the 7% level.  This time around, earnings growth is markedly improved.  Last quarter’s earnings growth was close to 9%.  Earnings growth projections are for even better grow over the next 12 months.  Companies have continued to grow despite the lackluster economy.  Positive for stocks - 2 points.

Inflation - 2 points

The Federal Reserve's optimal level for core inflation is approximately 2% to 2.5% year-over-year.  Core inflation under 2% allows the Fed to stimulate the economy without creating inflationary problems and is positive for stocks.  Inflation greater than 2% is negative for stocks.

Mr. and Mrs. America tend to watch the Consumer Price Index (CPI) and core CPI (excludes energy and food).  However, the Federal Reserve pays more attention to the Personal Consumption Deflator, which tends to run about 0.5% less than CPI.  At the moment, CPI is about 2.0% and the Personal Consumption Deflator is around 1.5%.  Unless inflation ticks up at least another 0.5%, we don’t anticipate the Fed is going to raise rates.  Positive for stocks - 2 points.

= Opportunity for Stocks - 8 out of 8 (Positive)

Adding each of the 4 factors totals a perfect score of 8, which indicates conditions are very favorable for stocks.  Our Barnyard Forecast has historically done a good job of indicating the general trend of the market.  While there are many unknowns surrounding the Federal Reserve's next moves, our Investment Policy Committee agrees with the Forecast's projection of continued positive returns for the market over the next 6 to 18 months.

Wednesday, August 20, 2014

The ABC’s and XYZ’s of Dividend Investing

Let’s face it dividends are no longer a novelty.  They were very much so when we began writing this blog in December of 2004.  Thus, over the last ten years, a time when stocks have experienced both ecstasy and agony, many investors have come to understand the value of dividends as central to their investing strategies.  We have written a number of articles on the ABC’s of dividend investing, so some of this blog will be repetitive, but hang in there, when we get to the XYZ’s you’ll hear some new thoughts and tactics.
ABC’s

The two data points we discovered in the late 1980’s that really got our attention and set us on the road to becoming pure dividend investors were the following:    
  1. Since 1960, dividends have produced nearly 40% of the total return of the Dow Jones Industrial Average (DJIA)
  2. DJIA dividend growth during that time has averaged about 5.7%, and price growth has averaged near 5.9%.
When we first saw these two data points, it created a kind of eureka experience for us.  The fact that dividends represented such a high percentage of DJIA total return said that if we paid attention to dividends they gave us a 40% head start on achieving an attractive long-term return.  In addition, the remarkable similarity between the long-term average DJIA price and dividend growth had all kinds of implications.  When we first saw it, we realized in an instant how important dividend growth was to total return. 

Yet, with the numbers being so similar, there was a humongous thought that seemed almost too good to be true:  if the average annual rates of growth of DJIA dividends and prices were so similar, were they also highly correlated.  If they were, that would help to explain the other 60% of the DJIA’s total return because if the statistical significance of the correlation between dividend growth and price growth were high enough it would give us a tool to predict price growth.  To be more specific, if what is known as the coefficient of determination (R^2) were high enough, then so goes the dividend, so goes the stock.

Minutes after this thought went careening though our minds the answer was appearing on our Excel spreadsheet.  The coefficient of determination, or R^2 was nearly .90 (one is a perfect correlation). Over the last 54 years, dividend growth had been able to predict nearly 90 percent of the annual price growth of the DJIA. This is a fact that few people who consider themselves dividend investors are aware of.

The chart for this statistical study of dividend growth and price growth is shown below.
Dow Jones Industrial Average Price vs. Dividend
Since 1960
But, just as fast as this eureka occurred, another finding diminished our grand hopes.  Even though the cumulative prices of the 30 stocks in the DJIA were highly correlated with their cumulative dividends paid over the years, there were few of the individual members of the Index that had as high a correlation as did the DJIA itself.  In fact, only about eight of the companies had statistically significant correlations between their prices and their dividends.  

With such a short list, we turned to the S&P 500.  The S&P 500 prices and dividends were not nearly as highly correlated as was the case with the DJIA.  Nevertheless, when we ran correlation analyses of the 500 stocks in the Index, we found nearly 125 that had very solid correlations between prices and dividends, and many of these stocks were giving us buy signals on the basis of this simple correlation analysis.

For many years, we puttered around with our price-dividend models with some success.  Then came the mid-1990s and all the correlations fell apart.  Stocks price were growing at a much faster rates than were dividends.  Modern Portfolio Theory was in full swing by then and the wizards of academia were saying that share-buybacks were a more efficient way to reward shareholders than cash dividends because the former would be taxed at the then lower capital gains rate, while the latter would be taxed as ordinary income.

For almost the next six years, our correlation models gathered dust.  They were saying that stocks were significantly over valued as early as 1997, well before the Tech bubble was in full view.  During this time, we relied on our dividend discount models to ascertain buy and sell signals and used predominatly stocks with above average dividend yields and solid dividend growth in our portfolios.   

This first part of the story is what we call the ABC’s of dividend investment.  It identificed the importance of dividends in total return and lead us to stocks with higher than average dividend yields and solid dividend growth. We used these tools successfully for many years; then things changed, and we went looking for another valuation model to pinpoint over and undervalued companies. Between 2000 and the end of 2002, we learned a very hard lesson: estimates of future growth aren't guaranteed, indeed, sometimes projected dividend growth become actual dividend cuts.  
XYZ's
In early 2002, with stocks down from their highs of 2000 nearly 40%, almost by accident, we stumbled again onto our old correlation models.  As we ran correlation analyses of the S&P 500, we found company after company was significantly undervalued, many by as much as 25%.  The big sell off had pushed stocks too low relative to their dividend growth during this time.  As the year wore on, our confidence that our old correlation model was telling us the truth about the market steadily increased.  The main reason was that companies in a wide range of industries, from banking to capital goods to energy, were hiking dividends at an impressive pace.  The market was ignoring the hikes, but these companies were signaling with their dividends that their business was good and improving. In addition, there was a lot of talk about President Bush’s tax break for dividends.

Since we had not used the correlation model in several years, we called in consultants and statistical experts to look at our models and tell us how much we ought to trust the data we were seeing.  All the consultants were quick to warn us that correlation does not equal causation.  In essence, something other than dividend growth might be the real driver of the very high correlations that we were seeing. Interest rates had been falling, so we added interest rates to the formula.  In fact, we added just about everything we could think of to the formulas to ascertain what else might be driving the high correlations which revealed that stocks were undervalued.
In the end, only dividend growth and interest rates remained in the formulas for most stocks, and the story they told was clear: stocks were cheap.  As a witness to how convincing the data were, both consultants became clients and remain so to this day.
The real XYZ story, however, did not become apparent until late 2003.  Gradually our weekly correlation run, which took four and half hours to complete, showed that the companies with the highest correlations between their dividend growth and price growth were not the high-yielding stocks that we had traditionally used, but the companies with lower yields and faster dividend growth.
That trend has continued through the present.  In most cases, even during the 2008-2009 banking crisis, many of these faster growing companies had continued to hike their dividends at double digit rates and their prices have responded in kind. 

The following charts show the price-dividend correlations for four stocks: Praxair, Union Pacific, ONEOK, and Nike. All of these companies with the exception of ONEOK are XYZ stocks. They have yields as low as 1.2% for Nike but have generated double digit dividend growth over the last ten years.  

The first stock is Praxair (PX). PX is an industrial gas company with a remarkable 20 year record of rising dividends and prices. The chart is a scatter plot which shows dividends along the horizontal axis and stock price on the vertical axis. Importantly, look at the mathematical formula at the top of the chart. On the second line is the R^2 of the fit between PX's dividend growth and its price growth. That right! PX's dividend growth has been able to predict 98% of its price growth over the last twenty years. At present, the graph is showing that PX is at about fair value. However, if we use estimated dividend growth for 2015, the stock is a bargain.

Praxair (PX)
      
The next stock is Union Pacific (UNP). UNP is one of the largest railroads in the U.S. It has about a 2% current dividend yield. It has not had quite the twenty-year performance as has PX, but again it has a very high R^2 at .94 and the stock is about fairly valued. As with PX, using next year's numbers makes it a bargain.

Union Pacific (UNP)
Next, for those of you who insist on higher yielding stocks, ONEOK (OKE) may be your choice. It has a 3.4% current dividend yield and has increased its dividend over the last five years at a high double digit rate. OKE is one of the largest pipeline companies in the U.S. Their management team has taken bold steps to solidify their position as an important player in the oil and gas fields. Their R^2 is .98. OKE appears to be about fairly valued, as well.

ONEOK (OKE)
The last stock is Nike (NKE). You may wonder how in the world NKE can be counted at a dividend stocks. Well it may not be an old fashion ABC dividend stock, but it definitely is an XYZ dividend stock. Its current yield is only 1.2% but its dividend has grown at near 14% per year over the last fiver years. Nike has a .95 R^2, but with the price nearly $10 above fair value is not a bargain. Neither does it become a bargain when we add next year's projected dividend hike. However, it then becomes about fairly valued and thus, we continue to hold the stock.

Nike (NKE)

So there you have it. The ABC's and the XYZ's as we describe them in our dividend world. The ABC's might be considered the more traditional higher than average dividend yielders with long histories of hiking their dividends at modest rates. The XYZ stocks are those with average or below average dividend yield but with much higher than average dividend growth. In addition, these stocks are highly correlated to their dividend growth, usually over the long term.

In general, we believe most traditional ABC type stocks are fairly valued, or even a bit overvalued. On the other hand, we are find many bargains in the XYZ stocks. We'll talk more about them in coming blogs. Happy hunting.

Clients and employees of DCM own all of the above listed stocks. Please do not use this information for stock selection purposes. Please consult your financial professional.

Monday, July 28, 2014

This B-U-L-L Market Is Getting L-O-U-D

Throughout the history of the U.S. stock market, there have been many bull and bear markets. Studying these market cycles can teach investors a great deal about how the market behaves and the underlying reasons behind it.  If you can identify the driving forces of a bull or bear market, you can make more intelligent decisions to either protect yourself against a looming bear market or take advantage of a bull market.

In the 20-year history of our firm, we’ve seen several of these market cycles and have studied countless others.  While no bull or bear market looks exactly the same, the past provides us with useful insights about the future.  In the words of Mark Twain, “History doesn’t repeat itself, but it does rhyme.”

Today, we are going to see how the current bull market “rhymes” with years prior and what information we can gather from its historical patterns.

Anatomy of a Bull Market

The anatomy of almost all bull markets can be broadly defined by four primary characteristics that make up the acronym B-U-L-L, which you can read more about here.

1. Breadth
2. Unrelenting
3. Leadership Rotation
4. Loud

The “Loud” part of the equation is of particular interest in today’s market.    Bull markets attract a lot of attention from media and Wall Street.  Everywhere you turn, it seems like you hear about the stock market.  The local newspaper, CNBC, Wall Street, and even outings with family and friends can turn into investment discussions.

That’s typical of bull markets.  They grab you and force you to pay attention.  For all of those investors who have been out of the market since 2009, the run-up in stocks over the past five years has shown them just how wrong they have been.

Bull markets attract their fair share of commentators on both sides of the fence.  Some say the bull market will keep going, while others continually predict it’s demise.  The longer the bull market goes, the louder the shouting on both sides become.  Amongst all of the noise, it’s difficult to discern between what is truly relevant information and what is just that - noise.  

A lot of the chatter lately has been speculation about when the current bull market will end.  If you look back on nearly every bull market we have ever had in the United States, you will find that the vast majority of them don’t die of old age, they are killed.  There are two primary killers of bull markets:

(1) Recessions

Pullbacks and corrections can occur at any time, but it is really difficult to have a real bear market unless there is an economic recession that negatively impacts company fundamentals.  Remember, prices will always follow valuation in the long-term.  So if long-term values are increasing, the long-term trajectory of the stock market should also be increasing.

The majority of the data we see coming out of the economy have been very positive.  We thought the Q1 economic data were mostly weather-related, which turned out to be correct.  Employment numbers have improved significantly.  The economy has now added at least 200,000 jobs for the past five consecutive months.

As the economy starts to heat up, we should see increased activity from consumers and better sales growth for U.S. corporations.  Unless there is an unforeseen major geopolitical issue or natural disaster that disturbs the global economy, neither our Macroeconomic Team or the economists we follow foresee any recessions on the horizon.

That leads us to the second major killer of bull markets...    

(2) The Federal Reserve  

In the absence of any major economic shocks, the Fed is the primary suspect in the death of most Bull Markets.  

When interest rates are low, investors look outside the safety of U.S. Treasuries and into more traditionally risky assets such as stocks.  As the stock market increases from the inflow of funds, people begin to experience the “wealth effect” from watch their account values go up.  As consumers feel more wealthy, they increase their spending, which puts upward pressure on capacity.  To meet the rising demand, businesses hire more people and invest in new factories and technology to push up supply. When the Fed raises interest rates, the opposite tends to occur.

Even when the Fed raises rates, however, the stock market has historically been very slow to respond. Looking back to previous bull markets, it has taken several months of interest rate increases before the stock market has had any meaningful reaction.  This is not to say that this time will be the same - but it does contradict the widely held belief that the stock market will be hurt by the Fed raising short-term rates in the coming year or two.  Using history as our guide, that just doesn’t seem to be the case.

Furthermore, the small body of evidence we have about Federal Reserve Chair Janet Yellen suggests that she isn’t going to be quick to raise interest rates. Yellen believes wholeheartedly in the Fed’s dual mandate of both maintaining price level control (inflation) and in promoting employment.  As long as the economy continues to have above average unemployment, it is very likely that Yellen will push the Fed to keep rates low.  And as long as rates stay low, there is nowhere for investors to go but stocks.

When Is The End?

While we would consider ourselves to continue to be optimistic about the future of stocks, we certainly are not raging bulls.  We know that all bull markets must come to an end at some point, we just don’t believe that will happen in the near-term.  

While no one can know for sure when the bull market will end, there are often signs that start show up ahead of time.  One of the things we look for are the “one percent days.”  If stocks start moving up rapidly with a series of these large increases, that is likely a sign that Mr. and Mrs. America are starting to get tired of sitting in cash.  As they pour into the market, the buyers dry up and leave nothing but sellers.  On the flip side, a long string of negative one percent days typically indicates that the market is going through more than just a batch of profit taking.

We get a lot of questions about what we would do if we sense weakness in the market.  When we see potential trouble on the horizon, we don’t just immediately move to cash or try to time the market. We find it in our clients’ long-term interests to “take air out of the ball.”  

If things were to get rowdy, we would strategically reduce more volatile positions (“A” stocks) and look to add more “Royal Blue (RB)” stocks to stabilize our portfolio.  This does two things: (1) it reduces the volatility of our portfolio and (2) provides solid earnings growth and dividends to get our clients through the worst of the storm.  In bad markets, the RB stocks become defensive strongholds.  They are so big and strong that they can absorb huge amounts of shock without damaging the intrinsic value of their businesses.

Current Outlook

At this moment, we don’t see much sign of weakness. Despite the geo-political issues in Russia, the market has continued to move higher.  If shooting planes out of the sky doesn’t spark even a small pullback, that’s a pretty strong indicator that the market can continue to drive north.

Valuations for some companies are getting frothy, but the overall market is about fairly valued and well within its normal statistical range.  With interest rates so low, even higher valuation multiples than we are currently seeing would not be out of the question. While that’s a possibility, we don’t anticipate getting any additional return from valuation multiple expansion.  


In our opinion, stocks are likely to return what they generate in net earnings and dividend growth over the next 6-12 months.  If Q2 earnings are any indication, growth is starting to accelerate along with the economy.  As long as the companies continue to be the stars that they have been, this bull market still has strength to keep charging on.

Wednesday, July 09, 2014

What About Bonds?, Part II: Inflation and Interest Rates

This is the second installment in a series of blogs aimed at providing answers to our most frequently asked questions regarding bonds, interest rates, and inflation.  The format is Q&A. Nathan Winklepleck, co-editor of the Blog, is moderating the discussion by sharing these inquiries with Joe Zabratanski, Senior Fixed Income Manager, and Greg Donaldson, Chief Investment Officer.  

Nathan: There is a lot of jargon in the fixed income world. I think it would be beneficial to our readers if we began by defining "inflation" and "interest rates" and explaining what each one means in this context.

Joe: Great idea.  I’ve found over the years that the term “interest rate” can mean many different things to many different people, so before we get started, let’s make sure everyone is on the same page. An “interest rate” is simply the rate charged by a lender to a borrower for the use of money or an asset. The term applies to many investments including the interest rate on U.S. savings bonds, bank certificates of deposit, savings accounts, home mortgages, and car loans.  From an investor standpoint, interest rates are the rate of return we are paid in exchange for lending money to a business or government. The interest rate in this context can vary significantly depending on the maturity date (length of time until we get our money back) and the risk of default (the possibility that the borrower will be unable to repay our money). Today’s discussion will focus on  interest rates as they relate to U.S. Treasury bonds.

We can define “inflation” as the rising price level for goods and services. If the groceries in your shopping cart cost $100 in Year #1 and inflation for that year is 2%, those same items will cost $102 the next year. Over time, your original $100 will purchase fewer and fewer groceries. You can think of inflation as the general decline in the real purchasing power of money.

Nathan: In the last installment we discussed the inverse relationship between bond prices and interest rates. You described it as a teeter-totter effect: as interest rates fluctuate up and down, bond prices move in the opposite direction.  What is the relationship between interest rates and the level of inflation?