Is This The Bottom? Part ll

Last week with the stock market having turned modestly higher, I asked if this turn could hold when so many other recent upturns have failed. I concluded that my answer was yes; not because the chart of the Dow Jones Industrial Average looked good, but because of the massive under girding of the economy by the various government programs that would shore up the banking industry, unfreeze consumer lending, and stimulate spending. I should have added something that I have been saying for months: the law of supply and demand. Sometimes I think the US media are the most economically illiterate people in the world. They simply have no idea of the power of the free market and the law of supply and demand. The free market (of course with proper regulation) is simply a marvel at setting price where the merchandise will sell. As we are all too familiar, the US has been in an incredible housing recession over the last two years, which has caused prices to fall by 25% and more in certain areas. Countless news media reports I have read have been saying that there was no end in sight. Prices and housing unit sales could only go lower. They were partly right. Prices are going lower, at least for a little while, but housing on a unit sales basis has had some very good news in recent days, and I believe it is one of the big reasons that the stock market has risen nearly 600 points since last Friday. Last week new building permits and housing starts were surprisingly strong, and this week new and existing home sales were much higher than expected. Home prices, indeed, have fallen and will continue to do so until excess inventory is worked off, but unit sales of homes appears to be turning up in many parts of the country. Importantly, if unit home sales have bottomed and are turning up, they will ultimately take home prices . . . and stock prices with them. I do not want to discount the good durable goods orders data this week, or the new program announced by Treasury Secretary Geithner to rid the banks of toxic loans. The latter particularly is vital to the health of the banks. Having said this, housing on a unit basis appears to be bottoming, and housing is the key to a sustained rally in stocks. The simple reason is this: housing got us into this mess, and I believe housing will have to get us out. As I write this, the market is pushing 8000 on the Dow. I would be a very surprised person if the recent upturn races right through 8000 and keeps going. If you look at the chart above, you will see that 8000 was an important level of support from October through November. There are plenty of sellers waiting at the 8000 level to sell out and get their money back. Thus, I would predict some back and forth sideways motion for a few weeks as we digest recent data and evaluate new housing statistics for a corroboration of the recent good news. If this is the bottom in housing unit sales, it has come the old fashion way: by prices falling to a point where the buyers were waiting, and the same goes for stocks. A bottom in housing unit sales would be welcomed news, but for a full turn around to begin in the economy, we need home prices to at least flatten out. That has not happened yet, so the stock market will remain on edge. But this was a very good week for stocks and lends credence to the notion that we have seen the bottom.

Is This The Bottom?

We spend most of our time looking at our various valuation models in search of stocks that are cheap. We do, however, watch the price trends of stocks and the major indices, especially in times like these when we believe prices have become so disconnected from valuations.

The chart at the right (click to enlarge) shows the Dow Jones Industrial Average (DJIA) for the last twelve months. You will note that we are also showing two moving averages: a 200 day (dark line) and a 50 day (light line).

The 50-day moving average, in our minds, is the key technical indicator that most traders are watching. With the benefit of hindsight, the reason is simple: the 50-day moving average has been a key level of resistance for the overall market since last June.

Look at price movement of the DJIA during May of last year. It was at this point that the DJIA fell through its 50-day moving average. The chart also shows the market's feeble attempt to climb back above the 50-day moving average in late May and again in early June.

The market then fell sharply before attempting to make a bottom in mid-July. At that time, it turned higher and made a valiant attempt to pierce the 50-day moving average during August and September. Unfortunately, the DJIA failed in its attempt to get through the 50-day and once again it sold off sharply in October.

After the sharp sell off, the market appeared to find a bottom in November and December at around the 8000 level on the DJIA. But again its attempt to meaningfully pierce the 50-day moving average in December and January ran into sellers, who once again drove stock prices into a free fall that finally reached the 6600 level on the DJIA.

The DJIA is now attempting at least its fourth try in the last year at getting out from under the selling pressure that has come each time the market has tried to get through the 50-day moving average. The chart shows that the recent rally has once again brought us very close to the 50-day moving average. The actual level is near 7500.

We think the odds have dramatically improved that a bottom is near for these reasons. Chart reading is not an exercise in quantifying valuation. It is an exercise in measuring emotions, particularly at its extremes. In our judgment, the DJIA has kept breaking below its 50-day moving average at critical levels because of negative momentum, but also because the majority of investors did not believe the Fed and the US Government were doing enough to deal with the credit crisis. There are now at least three major programs that either are now or soon will be in place to deal with the capital of the banks, the freezing up of consumer and corporate loans, and the real estate fiasco. The latest plan was the announcement this week by the Federal Reserve. Fed chief Ben Bernanke announced that the Fed will buy up to a trillion dollars of US government bonds, mortgage agency notes, and mortgage backed securities. These purchases should push not only mortgage rates lower, but also interest costs for corporation. Combine all this with the bailout of the Auto industry and the stimulus plan and the US government has now gone a long way toward putting a floor under the economy and we believe under the stock market, as well. In light of this massive undergirding of the economy, we believe that the probabilities for upticks in both economic growth and corporate profits have grown for the latter part of 2009. If this is the case, the odds that a decisive bottom in the Dow Jones is near have increased. This argument is augmented by the fact that stocks are down over 50% from their highs. Indeed, one could say that we are floating in a sea of value. All we need is some sort of good news to propel stocks to much higher levels. If the market is able to fight its way through the 50-day moving average many of the persistent sellers of the last year will become buyers and add staying power to the beginnings of a new bull market.

More on Rising Dividend Research

A few weeks ago I discussed a column from Gene Marcial of "BusinessWeek" extolling the virtues of rising dividend investing. Mr. Marcial cited a research report from the Ned Davis Company, a well respected investment research firm, that showed that rising dividend stocks had outperformed other general investment styles from 1972 through 2008. I wanted to add a bit to that earlier piece because a friend of mine sent me a copy of the summary of the whole report. The following are the annual rates of returns for various types of dividend-oriented investment styles over the last 36 years.

1. 8.6% Dividend Growers & Initiators -- Companies that have raised their dividends for at least five consecutive years.
2. 7.6% All Dividend-Paying Stocks
3. 6.0% Dividend Payers with No Change in Dividends
4. -0.3% Dividend Cutters or Eliminators
5. 0.2% Non-Dividend Paying Stocks
6. 5.9% S&P Geometric Equal-Weighted Total Return Index

The table makes some powerful statements about stock performance over the last 36 years:

1. In general dividends matter
2. Consistently rising dividends matter most of all
3. Non-Dividend Payers, which would include a lot of tech stocks, have had a lot of ups and downs, but after 36 years are about where they started.
4. Dividend Cutters or Eliminators are to be avoided

The above returns were based on a monthly equal-weighted geometric average of total returns of S&P 500 component stocks, with components reconstituted monthly.

With all the news of companies that are cutting their dividends, you might think that a rising dividend strategy might have become obsolete. That is far from the truth. There are many high quality companies that are increasing their dividends year after year and, yet, still possess a low dividend payout ratio.

I'll have more to say about additional rising dividend companies in the weeks and months ahead.