Momentum is a wonderful thing, when momentum is in your favor. Only problem is momentum is like the wind -- nobody knows where or for how long it blows.
As the subprime crisis has extracted its toll from the banks and retail stocks, that toll has been invested in the so-called defensive stocks: consumer staples, oils, and utilities.
The chart at the right is our 20-year Dividend Valuation chart of McDonald's. If you wondered where the money went that they took out of your favorite bank stock recently, look no farther because a bunch of it went here. McDs has been moving straight up in 2007. Much of its rise has been warranted because the company has had a string of good earnings reports and a big dividend hike. However, some of the recent run up is probably due to momentum -- meaning its going up because its going up.
Our model is suggesting that the stock has a projected rate of return for the next twelve months of only 5%, give or take 5% (represented by the blue striped bar at right). In our way of thinking that means, judging from the last 20 years, the most probable year-ahead rate of return for MCD is between 0% and 10%. That does not give us much of a margin of safety if the US economy is a little stronger than many observers now believe. A stronger economy could well cause the momentum of MCD to reverse.
The Fed is meeting today, and to the extent that they keep cutting rates, the odds improve that economic growth may surprise on the upside in the year ahead. If that is the case, financials would be a better buy than staples. Almost all the financials we follow are nearly 25%-35% undervalued, again based on their long-term relationships to dividend growth.
A word of caution. We are only buying highly rated financials whose dividend is secure. I have no idea where Countrywide Financial or Washington Mutual will be a year from now. Additionally, while many consumer staples stocks are overvalued, many are not. I'll have more to say on some of the undervalued staples in future blogs. We will also have more to say on what financials we like.