Second Quarter Earnings Could Be Catalyst For Next Leg Up

The stock markets and many other markets, as well, appear to be waiting for new news to give them direction. Most investors are now looking for a very gradual uptick in the economy in the third quarter, as well as modestly better housing news, and fewer nerve wrenching headlines from the banking sector. Yet, even though things are "less bad" now, few strategists are able to find many of the green shoots that Chairman Bernanke speaks of sprouting leaves. In our investment meeting this morning, we went over the news of the day and the most recent economic data, and we find that our views are essentially those of the consensus except in one area -- earnings. We believe corporate earnings in the second quarter will be better than expected. To you old pros that is like saying nothing because quarterly reported earnings are almost always better than expected. That is the game that corporate America plays: beat the consensus earnings estimates by a penny or so. However, we think this quarter may show more corporations beating earnings estimates more than usual. Three of our four portfolio managers have run large organizations in their previous careers. They all agree that the revolution in corporate management tools of the last 25 years has given top management a much wider field of vision in terms of input needs and utilization. Enterprise Resource Planning (ERP) software, Just-in-time inventory management processes, and new more flexible labor arrangements have all come together to enable the top management of most companies to "right size" employment and inventory. In our view, this right sizing translates into a much higher probability that companies can price right, and by extension price profitably. We believe these smarter and more flexible management tools will begin to reveal themselves in the upcoming second quarter earnings results. Having said this, strap yourselves in; even good earnings news will send stocks gyrating.

The Pause

About two weeks ago, I wrote a blog entitled "The Bottom Is For Real, But a Pause is Due." My reason for that blog and this one is to help my readers understand the push and shove of markets. You may wonder why a number of my recent blogs have discussed elements of technical analysis, such as moving averages, levels of support and resistance, etc. Chart reading coming from a guy whose motto is, "so goes the dividend, so goes the stock," would seem to be a contradiction in terms. Technical analysis is for traders, isn't it. Technicians are people who couldn't care a twit about the fundamentals of a company or the products they make. The truth is I grew up reading charts. I managed money in my early years using almost exclusively charts combined with a bit of macro-economics. That all changed in the crash of Black Monday in 1987. Something in me gave way that day. Something said that I should be buying, even though all my charts were saying to sell. Since that day, I have become predominantly a fundamental investor. After searching for a number of years for a fundamental metric that best predicted stock prices, by the early 1990s, I was convinced that the metric I was in search of was dividend growth. Having said that, at Donaldson Capital Management, we use any indicators we can find that work. Thus in our firm at present, we use three markers or predictors to determine what to buy and sell: 1.) dividends to select individual stocks and determine market valuations; and, 2.) macroeconomics to grasp the lay of the economic landscape; and, 3.) technical analysis to validate the first two predictors, as well as to provide clues about the economic landscape that the fundamentals do not explain. Here is what our assorted markers are saying about the current situation. 1.) Using data from our Dividend Valuation Models, we believe that stocks are at least 25% undervalued based on the long-term relationship of prices, dividends, and interest rates. Thus, from a valuation perspective, the path of least resistance for stocks is up. 2.) Our macroeconomic view is that things are "less bad" than they were just a few months ago. A number of economic data points such as the sales of existing homes are trying to bottom but few, if any, economic data are showing genuine growth. This suggests that there is little fuel in sight to push stocks significantly higher. This would argue for stocks to pause at this level. 3.) This is where technical analysis comes in very handy. The chart above shows that in recent months stocks have made a solid turn, pierced the 50 day moving average, and are now trying to move through the 200 day moving average. Our experience in technical analysis tells us that a move through the 200 day moving average without a fundamental catalyst will be difficult. Thus, technically speaking, stocks are a bit overbought and in need of some consolidation, or sideways motion. This sideways trading is likely to be of a sawtooth pattern because the economic news is "less bad" and not yet good. We believe that increases in corporate earnings expectations will ultimately be the catalyst that will push stocks through their 200 day moving average. Earnings have fallen like a stone for the past two years. But corporations have been slashing costs and earnings expectations for the S&P 500 recently ticked higher for the first time in a long time. Cobbling together the three markers, we believe argues that stocks are likely to trade in a sideways range for at least another month or so. Coincidentally that is about the amount of time until the next earnings season. If corporate earnings come in better than expected for the second quarter, we believe stocks will pierce the 200 day moving average and push to higher levels. If earnings fail to surprise to the upside, stocks will likely continue to trade between 8000 and 9000 on the Dow Jones 30, awaiting better economic and earnings news. We do believe that the March 9th bottom in stocks will hold under almost any circumstances. In March, stocks were pricing in the worst case scenario. The stabilization of the banks and the better news coming from the real estate market argue that the worst is over. We are now awaiting some of the green shoots that Fed Chairman, Ben Bernanke, described to blossom.

The Shotgun Weddings That the US Performed on Chrysler and GM

Many observers charge that the US government, in its attempts to clean up the auto industry mess, has used strong-arm tactics to force speedy bankruptcies for Chrysler and General Motors. In doing so, the rule of law and our country's reputation as a safe place to do business may have taken a very bad hit that will resound for years.

The State of Indiana, representing its state retirement plans which hold secured Chrysler bonds, has filed suit in the Chrysler bankruptcy case. Indiana claims laws were broken when the US Government gave the United Auto Workers (UAW) 55% of the ownership of the post bankruptcy company, far in excess of the UAW's secured interests. Indeed, the deal the government struck with the Chrysler assets appears to go against all existing legal precedents and statutes. The secured bondholders were thrown from the train in favor of the mostly unsecured union claims.

The fact that President Obama was widely supported by the UAW brings some clarity to the situation. Political spoils, however, should not extend to rewriting the bankruptcy laws on the run.

I have spoken with many legal authorities in recent weeks. Not one of them could explain how the UAW could have ended up with such big pieces of the post-bankruptcy auto industry. "Politics" was the only consistent answer I received.

Here's the problem. Who will ever loan GM or Chrysler money again? Indentures are no good, precedents are no good, and laws are no good. The answer is no one will loan these dinosaurs money again, except perhaps in some form of equipment trust certificate arrangement. That means the United States government will be in the auto business for a very long time. And that means US taxpayers will be asked again and again to ante up to support the UAW.

Here's hoping that Indiana can get their case to the Supreme Court. If the case gets there, things might get very interesting. If it doesn't the shotgun wedding that was performed by the United States Government will stand and fairness and the rule of law will fall.

I do not own any GM or Chrysler securities. This blog is for information purposes only.

The Bottom is For Real, But A Pause is Due

The stock market has rallied sharply since the middle of March leaving a lot of bears wandering and wondering in the woods. The chart at the right shows that the Dow has rallied close to 2000 points, or nearly 30%, since the bottom on March 9. The chart also shows that the Dow has now reached the 200 day moving average (blue line). We think the market may pause here. One reason for this belief is the long sideways trading action from July 2008 through the middle of October 2008. This trading range left a lot of traders with significant losses as stocks collapsed in February. Human nature says those traders will become sellers as the market moves closer to Dow 9,000. We believe this pause in the market's recent upward march will be temporary. Stocks will continue higher later in the summer as Wall Street earnings estimates begin to turn higher in recognition of an improving economy. As you may remember, we said on March 20, that we believed forces were in place to produce a turn in stocks. We have reiterated that call three additional times since then. The bottom line on these calls was and is the undergirding and strengthening of the banks. We believe the collapse in the market in February was caused by Treasury Secretary Timothy Geithner's February 10th speech that was supposed to answer all of our questions about how the government was going to rescue the banks. Mr. Geithner did not distinguish himself in that speech and questions began to fly about the possibility of "nationalizing" the banks. Bank nationalization fears were unleashed when Mr. Geithner announced that the banks would be subjected to rigorous stress tests. Nationalization of the banks combined with the realization that the US auto industry was bankrupt caused investors to "think the worst" and abandon stocks. Stocks finally found a bottom as the Administration repeatedly promised that they had no intentions of nationalizing the banks. Indeed, the Administration continued to champion the idea that the banks were in reasonably good shape but needed more capital, which they were willing to provide. By late April the results of the stress tests were announced and showed that only about half of the banks tested needed additional capital and none of them appeared to be close to a government takeover. Stocks gained upward momentum as those banks who were cited as needing more capital were able to sell additional stock in the open market. This would have been impossible before the results of the stress tests. Adding power to the run-up in stocks has been a string of economic news that can best be described as "less bad" than before. Few data show truly good numbers, but it is clear that the economy is starting to respond to the Fed's very low interest rates and numerous programs to aid homeowners. The news will not show positive data for many months yet, but we believe the worst is behind us.