Monday, February 01, 2010

The CRUD Will Pass

Donaldson Capital Investment Policy Committee Meeting 2/01/10 For the past two weeks or so the market has reacted to very positive earnings and GDP news in a very unexpected and negative way. Q4 2009 earnings and revenue news is better than expected – much better. Q4 2009 GDP change came in at +5.7%, more than a full point higher than consensus. Further, it wasn’t just inventory rebuilding. In fact, inventories actually continued to decrease in Q4, although at a significantly reduced rate. The consumer spending element of Q4 GDP was better than expected. In our view, the market’s negative action over the past two weeks was a result of news beyond solid earnings and GDP reports that caused greater uncertainty on several major fronts. And, the market almost always reacts negatively to greater uncertainty. In our meeting today we coined the acronym CRUD to explain the issues we believe were most responsible for this increase in uncertainty: C = China tightening their money supply to slow their double-digit growth R = Real estate and housing data that suggest the uptick may have stalled. U = Unemployment claims moving higher than recent trends. D = The Democrats’ loss in Massachusetts, causing chaos in the political scene. The above new developments caused investors to be less certain about the strength of the economic recovery as well as about how the shift in the balance of power in the Senate might affect pending and future legislation. In the case of the latter, it was sort of “The devil you know is better than the devil you don’t know.” Business generally wasn’t crazy about health care reform, cap and trade, tax hikes, etc. But at least they had some idea of what the future ground rules would be. With the upset in MA being so recent, no one has any idea of what to expect out of Washington over the next several years . . . therefore increased uncertainty. All of this has been aggravated by a tendency for the market in the short-term to have a “boom or bust” psychology. That is, it tends to operate as though there are only two possible outcomes; things will be terrific, or things will be terrible. The actual economic data, however, is playing out fairly consistently with what the Investment Committee has been expecting:
  • Q4 earnings are surprising to the upside, in large part because of aggressive cost cutting.
  • Quarterly year over year earnings are higher for the first time in almost 2 years.
  • Revenues are no longer declining, they are starting to grow modestly.
  • GDP was very strong in Q4.
  • Unemployment remains stubbornly high, around 10%
  • The Fed is keeping the Fed Funds Rate low at 0% - 0.25%
  • Dividend stocks have outperformed non-dividend stocks over the past 1, 3, & 6 months, reversing the “Survivors’ Bounce” effect of March-September.
  • Dividend paying stocks have lower P/Es than the market average.
  • Emerging market economies are strong; Europe is weak; US is recovering In our view, the CRUD uncertainties are a temporary issue. The fundamentals of business and the economy are headed in the right direction, and in general, valuations still favor our dividend-paying stocks. The primary remaining uncertainty with Rising Dividend stocks is just how much they will increase their dividends for 2010. We have no idea yet, but two of the earlier announcements were good omens. Praxair (PX) and CVS (CVS) Drugs each increased their 2010 dividends per share by about 13%. EPS estimates for the coming year for the S&P 500 are at $77.95, a near 25% increase over 2009. The 2011 earnings forecast is $94.56, a 21% increase. If the estimated P/E ratio for the market were to be at its long-term average of 15 at the end of this year, and expected 2011 EPS were still $94.56, the S&P 500 would be at 1418, or nearly 30% higher than today’s market close. The Committee is not predicting a 30% gain in the market. But, with fundamentals improving for the economy and businesses, we continue to believe that total returns for 2010 will be quite good. A newly added variable to the market psychology equation is President Obama’s proposed fiscal 2011 budget. His official budget proposal was made public this morning. Over the next several weeks, the Investment Policy Committee will be studying the budget’s major elements, as well as their interpretation by investors.


Randy Alsman, Editor

Mike Hull

Rick Roop

Greg Donaldson