Saturday, May 05, 2007

Slowing Economy, Rising Stock Prices, Part 2

Greg Donaldson and Mike Hull write:

In our October 27, 2006, blog we wrote that while the economy would likely continue to slow, US and international blue chip stocks would likely continue to rally. The following is a quote from that piece:

"Markets seldom feel right because we human beings have a habit of projecting today's headlines onto tomorrows stock performance. Remember, the stock market is not a democracy. Prices move in the direction that big money pushes it. Fortunately, big money is normally rational and understands economic cycles and the power of the Fed to slow and speed up the economy.

Big money has a problem. The places where it has been treated well over the past few years are all rolling over. Treasury bonds yield are under 5% in most of the major industrialized nations of the world. Bonds simply are not competition to stocks. Real Estate and commodities are no longer competing effectively for investors against stocks because they are now in downtrends.

Blue Chip stocks, alone, stand out as a value now that bonds, real estate, and commodities have become over owned and over valued. Finally, blue chip stocks are in an uptrend. This positive momentum is a rarity in today's world's financial markets. As long as earnings growth holds near 10%, stocks will continue their strong advance."

Since we wrote that piece, stocks, as measured by the Dow Jones Industrials, have risen nearly 12%, including dividends, (an annualized return of over 20%) while the US economy has slowed to under 2% real growth.

And here's the answer to the question we are asked most often: Yes, stocks have room to go higher and the path of least resistance is up for the same reasons we explained in our October 2006 piece -- stocks are still cheap and they have no competition from other forms of investment. In addition, with economic growth having slowed and inflation cooling, the Fed is poised to begin lowering rates sometime in 2007.

The chart below shows our most recent update of our proprietary Dow Jones 30 Dividend Valuation Model.

As you recall, the Dividend Valuation Model is a single formula that is constructed from the associations between dividends, interest rates and prices. You might think of the green bars as the values predicted by the normalized relationship among the data points. The actual prices are shown as a blue line.

It is important to keep in mind that every green bar on the chart, which goes back 25 years, is produced by the same formula. By comparing the green bars, which we call "value steps," and the actual prices, it is clear to see that the fit is very tight.

The key areas to note on the chart are the late 1990s, when the value steps clearly showed that prices were overvalued, and the DJ 30's turn in 2002, which occurred almost precisely on the predicted "value step."

Since 2002, the chart shows that, even though actual stock prices have risen sharply, they have remained consistently in undervalued territory. The model currently predicts that fair value is near 14,100. That would be our best guess of where the market runs out of value, and where we would become less bullish about blue chip stocks.

Finally, the recent run up in stocks has been met with fear and not greed, as is the usual case in run ups. Everyone is now talking about pullbacks and the old adage of,"sell in May and go away." We have found that when USA Today or your local newspaper starts telling you to "sell in May and go away," that it might not be a bad idea to "buy in May have a nice payday by Labor Day." Granted its not as catchy as the original adage, but we suspect it will be more profitable approach this year.