The Non-Consensus View of Things to Come

For many years, I have begun each year with a back-of-the-envelope analysis of the prospects for stocks, bonds, and the economy in the coming year. In this first look, I am only interested in how my views compare to the published consensus estimates. The reason is simple--many studies have shown that the consensus view is almost always wrong. So, in effect, the one place investors can be sure that the financial and economic markets are NOT going is where the current consensus is now pointing. It may sound almost sacrilegious, if not foolish, to use the consensus estimates of the smartest, most respected strategists and economists in the world in this way. My own experience and the aforementioned studies have convinced me, however, that to get the coming year right, so to speak, it is necessary to be sure I am not following the most widely accepted view of things. I'll have more to say about this in coming letters, but here's how we at Donaldson Capital Management view the financial prospects for the coming year in comparison to the consensus view of the Bloomberg Survey. Our view was constructed this past Monday in our Investment Policy Committee meeting in discussion among all four of our portfolio managers.

• Economy: The consensus is for 2.6% GDP growth in 2010. We believe economic growth will be closer to 3%. Thus we are more optimistic about the year-ahead economy than the consensus.
• Inflation: Consensus for core CPI is 1.3%. We believe the core rate will be closer to 1.5%. That's close enough, however, to say we agree with the consensus that inflation will remain tame.
• Earnings: The current estimates by analysts is that S&P 500 company earnings will grow by over 20%. Our estimate is similar to the consensus.
• Interest Rates: Bloomberg economists predict that the 10 year T-bond will yield right at 4.0% by year-end 2010. We believe interest rates on T-bonds will be more in the range of 4.5%.

In summary, we agreed with the consensus on core inflation and corporate earnings, and diverge on the strength of the economy and interest rates. In trying to move away even farther from the consensus, we would lean toward higher earnings growth than investors are now forecasting and higher core inflation. If our non-consensus financial view of the coming year were to prove correct, we believe it would have big implications for stocks.

We believe our non-consensus view would result in stocks moving strongly higher during the first six months of the year, on the back of better-than-expected earnings and economic growth. Stocks would then flatten out or retreat modestly as this better-than-expected growth would prompt the Fed to start raising interest rates sooner than Wall Street is now predicting.

In our estimation, if the economy unfolds the way we currently see things, stocks will likely end the year with a low double digit total rate of return. On the heels of the big turnaround for stocks in 2009, we would be very pleased to see another good year for stocks.

Blessings to you all and may you have a happy, safe, and prosperous New Year.

Greg Donaldson

Our Valuation Model Signals Stocks Are Still Undervalued

Stocks have moved a long way since March and there are many analysts that are calling for a correction of these gains. We are not in that camp. In an August blog, with the Dow at near 9,200, we showed that our valuation model was indicating that the fair value of the Dow was near 10,900. With the Dow now approaching 10,500, we thought it would be interesting to recalculate the model. The graph shows the valuation model going back to 1960. The red line is the actual annual price of the Dow Jones. The blue bars are the model's output of the predicted values. The ouput is derived from a multiple regression of the DJIA's dividend, earnings, and the yield on 20 year bonds against the price of the DJIA. The way the model works is to mathematically produce what we might call a "normal" price of the Dow based on the historical relationship among the various inputs. Today the model calculates a "normal or fair value" of 11,400 for the DJIA. In addition, remember this is what we call a "coincident" indication of value. Since the model is positively correlated to rising dividends and earnings, a rise in both of these inputs will push the fair value of the DJIA higher. Knowing how the model works, we would not be surprised if the fair value of the DJIA rose to near 12,000 sometime in 2010. We'll revist what the model is saying after 4th quarter earnings are released. Please read the Terms and Conditions at the right.

Nike Is Poised for a Christmas Season Run

Optimism is in short supply among many analysts regarding the Christmas selling season this year. Indeed, economists are predicting that Christmas sales will fall for the second year in a row.

Since we have been saying for many months that corporate earnings would continue to surprise to the up side, we see no reason to get cautious now.

We believe the the odds are very good that analysts' earnings for many important retail stocks will prove to be too low for the holiday season of 2009-2010. Notice that we say the Christmas selling season of 2009-2010. Indeed, research shows that the old fashion Thanksgiving to Christmas Eve selling season has morphed into a much longer season. Our best guess is that the Christmas season now begins well before Thanksgiving and ends after the first of the year. We know in our own office of many extended-family Christmas celebrations that occur after the first of the year.

We also believe in the maxim, "Christmas always comes." Almost every year we hear retailers and analysts fretting that this is the year that people will stay at home and give up the gift giving habit. Without a doubt this has been a very tough year. Consumers will not be spending money foolishly, however, Christmas is such a deeply held part of our culture that we find it difficult to believe that people will give up the joy of giving. The joy of giving, after all, is one of the things that makes Christmas such a wonderful time of the year.

One retail stock that we like is Nike (NKE). NKE's Dividend Valuation Chart is shown above. The model is indicating that NKE's current share price is at a discount to its 2010 valuation, which is based on its normal relationship with its dividend growth and changes in interest rates. Additionally, from a contrarian point of view, NKE is always the subject of lots of nay saying about their ability to sell "pricey" athletic shoes and apparel in a tough economy. We believe for many young people the "one" gift they want, to the exclusion of others, is something with the swoosh on it.

In short, we think NKE's earnings will surprise to the up side.

We own the stock. Please click the Terms and Conditions link at the right.