Watch the Utilities for Clues About the Future Direction of the Market

Standard and Poors 500

The question on everyone's mind is "Does the current uptick in stocks have the muscle to push into new territory, or is it just another sucker's rally destined to flip sand in our faces once again?"  It's a great question because the stock market has been trapped in a trading range for the last year.  The chart at the right shows just how many attempts the S+P 500 has made to push to new intermediate highs only to be thwarted by the sellers. 

In our blogs, we have spoken about the forces propelling and impeding the markets over the past few months.  In many respects the negatives outnumber the positives.  However the major force propelling stocks to the upside might be able to trump most of the negatives all by itself.  That powerful positive force is rising earnings.  If S+P 500 earnings meet their current estimates, they will have risen by nearly 33% over 2009, well above the estimates at the beginning of 2010. 

We are just entering another earnings reporting period.  We think earnings will again surprise to the upside, which will be the 7th quarter in a row that that has happened.  But the big news is that analysts are now predicting that S+P 500 earnings for 2011 will rise over 15% above 2010.  If this earnings growth does come to pass, in our minds, stocks will rise, even if the US economy continues in its funk.



Utilities IShares XLU

Having said this, our key indicator of the potential for the market to smash through the sellers and move back toward the highs of 2007, is not earnings.  They are important, but we believe there is another indicator that measures the combination of rising earnings and better "animal spirits" for investors.  That indicator is the price chart of Utilities.

At the right is a chart of XLU, the Utilities exchange traded fund.  We use XLU as a proxy for the average utility stock.  You will notice that its recent price is attempting to break above its December 2009 high.  If it is successful, we believe the whole stock market will make an assault on old intermediate highs.

Here's the reason.  Utilities are a prime example of "bond-like" stocks that we have been extolling in numerous blogs.  Most Utilities have solid balance sheets,  a dividend yield higher than the yield on a 10-year US Treasury bond, and a long history of paying and increasing their dividends.  Utilities also possess an additional feature that makes them potentially safer than the average stock: most have a monopoly or near monopoly over their product offering in a geographical area.

We have seen an incredible rally in Treasury bonds that has spread progressively to corporate bonds, municipals bonds, and junk bonds.  When I saw junk bonds rallying, I  knew to start watching Utilities.  The Utility sector has led us out of almost every major sell off in stocks since the 1970s.  I think they will do it again.

Moreover, as it becomes clear that the Utilities are breaking out, I believe you will see many other bond-like stocks also lead the way higher.

Talk of the positive qualities of dividend stocks is literally so thick you can cut it with a knife.  Since we have been praising dividend stocks for 20 years, we are gratified that they are getting so much attention in the media, but we would add a caveat.  Do no play dividend stocks just for the bounce.  Do yourself a favor, invest in high quality dividend-paying companies for the rest of your life.  Dividend investing is a way of life, not a trading strategy.

We'll keep an eye on the Utilities in the days and weeks ahead.


We own lots of Utilities.  See the term of use of this site on the right sidebar.

Donaldson Barnyard Forecast is Positive for Stocks

Randy Alsman, VP and Senior Portfolio Manager, describes the most recent reading from our proprietary Barnyard forecast and explains how we arrive at the scoring.



This is a video/audio webcast. If you are unable to view this post, click here.

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Reprising Jimmy Chitwood

Job growth is still stalled long after the Administration promised it would be rising again.  It is now clear that the Administration's stimulus plan was doomed to failure from the beginning because it was aimed in the wrong direction.  As a result, the President is reshuffling his economic advisers, Lawrence Summers is the latest to go.  Why am I not more confident that the next band of expert economists will serve the country any better than the last?  The reason is simple:  American small businessmen and woman are completely exasperated with what they have seen coming out of Washington. They are in no mood to hire new employees on the bet that the economy is going to get dramatically better under the current policies.  In my judgment, they will remain in a siege mentality until President Obama and the Democratic leadership show some understanding and appreciation of sound business practices.

This is not a new story.  Indeed, it is remarkable how consistently off the mark the crowd in Washington has been toward business.  The following is a blog I wrote July 14, 2009.  In it I explain why the government's attempt to stimulate the economy will fail and what it will take to create job growth.  I am presenting the blog just as I wrote it 14 months ago, but with just a few brackets [ ] to add additional insight. 

I am also reprising the blog to persuade you to contact your Congressional representatives to advocate that the Bush Tax cuts be extended for at least two years for all income levels, not just those below $250,000.  In addition that the taxes on dividends remain at the same rate as capital gains.  In my judgment, these actions on taxes would go a long way toward the President building a bridge to the business community.  It would signal that the President would be backing off of his "soak the rich" mantra and realizing that this country needs its brightest and best business minds to take the risks necessary to create the jobs that the country and our citizens so desperately need.  It does absolutely no good for our country to take money from the rich and create government jobs.  Surely Greece, Spain, Ireland, and Portugal have clearly shown us that a country dependent on government jobs is a country headed for the rocks.

Here's the blog from last year.

Tuesday, July 14, 2009


Capitalism Means Giving the Ball to Jimmy Chitwood


Whatever your political persuasion, the truth is, capitalistic principles that have served humanity well are currently under attack in the halls of Congress. Yesterday's Wall Street Journal sounded the alarm that the highest tax bracket may soon rise 11%, from 35% to 46% [as high as 58% with state taxes], by the time the Democrats in Congress are done.


"Soak the rich! Soak the rich!" can be heard in stereophonic surround sound if you drive by the Capitol these days. Indeed, the most important allocators of capital are no longer found on Wall Street, they now reside on Capitol Hill.


The Administration and the Democratic leadership have declared war on the business class. In doing so, they are dooming the country's hopes for a strong economic turnaround. Here's why. The very people who know best how to create jobs, the business class, are being tied up in a never ending barrage of new taxes, regulations, and anti-business rhetoric and legislation.


But just as the Law of Gravity still holds, so do the laws of economic growth, even if House Ways and Means Chairman, Charles Rangel, says they don't [Mr. Rangel has other problems understanding laws and is no longer Chairman]. I have no doubts that he will find a return to normal economic growth increasingly difficult to accomplish should his tax hikes become law.


Let me take a different tack to explain the problem, [Professional] basketball, for example. Isn't the objective to win, not just allow every player on the team equal playing time, regardless of their ability? Further, say we're down to the wire with only 10 seconds left on the clock. The object is to win, not to make heroes, not to please parents, or sponsors, or girlfriends. The object is to win. If you are the coach, would you call the team trainer off the bench and set up a play for him to take the last shot because it's his turn to shoot? Or would you get the ball into the hands of the best SCORER on your team? The answer is so simple children can figure this out. Get the ball to the guy or girl on the team who has a demonstrated gift for putting the ball in the basket. Do that and you will have a long career as a coach. Give it to a player with less ability and wins become losses, and you will be out of coaching.


This concept is graphically shown in the movie "Hoosiers." With just a few seconds left, Gene Hackman, who plays Hickory's coach, calls a time out. He wants to run the "picket fence" and that Jimmy Chitwood, the teams prolific scorer, will act as a decoy. The team is stunned and turn away from the fiery coach, but no one says anything. Every guy on the team knows the coach is wrong, but no one speaks. Finally, Jimmy, who has been almost stoic throughout the whole movie, says, "I'll make it." Hackman immediately agrees and says get the ball to Jimmy and give him room. You know what happens. See it here on this link.


http://www.youtube.com/watch?v=A0QTBAWc3tM


Coaches don't win games, trainers don't win games, equipment managers don't win games, and bench warmers don't win games. All these people are important contributors to success, but ultimately it is great players who win games.


As it relates to business, businessmen and women produce economic growth, not politicians, regulators, or tax collectors. Until the Obama Administration grasps this basic truth, the economy will trudge along in low gear.


Over the weekend, Vice President Joe Biden and President Obama were both apologizing for still skyrocketing unemployment, even though they said it wouldn't happen if the Congress passed their $750 billion stimulus plan. After Congress finally passed the measure, I said it was actually 30% a stimulus plan and 70% a welfare plan. The money went to the wrong places and until it gets to the right places, the Administration is going to be apologizing, a lot, about unemployment.


A wide gulf has formed between business people and politicians. All business people are being painted with the ugly brush of the big banks and their subprime destruction. Ninety-five percent of business people had nothing to do with the subprime fiasco and don't deserve to be treated as villains. However, every business person in this country now knows that he or she will be picking up the tab for the health-care plans of the Obama Administration. We know that we will be paying for the Administration's ill-conceived "Cap and Trade" environmental programs. Finally, we know that we will be paying for the huge deficits that the Congress has saddled our country with as far as the eye can see.


Business people, particularly small business people, where most of the jobs have been created over the last decade, know that they are in the gun sights of Congress and the Administration. That will keep a lid on employment gains for the foreseeable future. The main reason for this is that all these new taxes and regulations require that a businessman or woman's first order of business is to cut costs to defend profitability. The truth about costs is that the biggest one is labor. In the back of most entrepreneurs' minds is the fact that, in the stroke of a pen, the government could at some future date make it very costly if not impossible to reduce employment.


The Soviet Union was full of big talk and government-created, five-year economic plans for growth. As the years wore on, the bigger the talk grew the more failures the five-year plans produced.


I would have thought that the complete collapse of the illusory workers' paradise that was the Soviet Union would have been proof enough for almost any politician of what does not work. But, what is going on in Washington [and Europe] today would make Karl Marx smile for the first time in a long time.


If you consider yourself a businessperson, I recommend that you start communicating regularly with your politicians. As the employment news gets worse, they might actually start to listen.


This is what I said a 14 months ago.  If it sounds like the current situation in the country, get used to it, because unless the Obama Administration has an epiphany soon, this is a blog I can repeat each year at about this time and it will sound just as fresh.  Like it or not, Washington is violating economic laws and our citizens will pay for it in a lower standard of living and higher unemployment for years to come.

This is not to say that I am bearish on the US stock market.  US companies realize that the opportunities for sustainable growth are outside our borders.  Company after company in the S+P 500 now produce over 50% of their earnings outside the United States.  Stocks will do fine.  It is Mr. and Mrs. America that I am worried about if the current anti-business environment continues. 

Southern Company Looks Undervalued

We believe many high quality, dividend-paying companies are very attractive compared to US Treasury bonds.  We have previously described the concept we call "bond-like" stocks.  Bond-like stocks to us mean companies that

1. Have strong balance sheets 
2. Have a history of paying dividends
3. Display a history of raising its dividends,and
4. Possess dividend yields that are close to the yield on a 10-year US Treasury bond.  

 We have previously written about two such companies, Procter and Gamble (PG) and Royal Bank of Canada (RY).  The third stock in this series to meet the bond-like stock criteria is Southern Company(SO).  SO is one of the nation's largest electric utilities, and we believe it has a lot going for it that is being ignored by investors.

Our Dividend Valuation Model above (click to enlarge), which is based on the relationship between SO's price versus its dividend growth and the level of interest rates on long US Treasuries, suggests that the stock may be undervalued.  Indeed, the model is projecting that the total return of SO over the next 12 months may approach 17%.  As we always say, our model is based on historical relationships and thus is certainly not a guarantee of the future, but we are inclined to believe that SO is positioned to do well over the next year.  Here's why:

1. SO's bonds are A rated by both rating agencies, among the highest rated utilities in the US.  
2. It is the second largest utility in the US and the largest in the Sunbelt, where the population is still growing.
3. SO has a near monopoly in its service areas and produces power through a diverse array of power sources from coal to nuclear power.
4. SO has generated a 14% annualized return over the last 10 years, far outpacing the S+P.
5. The company has paid a dividend since 1948, and its current dividend yield is just under 5%.
6. SO has raised its dividend for 9 consecutive years at an annual rate just over 4%.

Our conclusion:

SO sells a product necessary for our daily lives and is as well run as any utility in the US.  It has a current dividend yield of nearly double that of the 10-year Treasury bond.  SO's implied return of 9% (5% dividend yield plus 4% dividend growth) compares favorably to the 10-year Treasury yield of 2.75%.

We believe the recent aversion to risk that has gripped the markets can not last forever. As investors realize that they cannot live very well on CDs paying .3%, they will begin looking for quality alternatives, and the first place they will look will be the electric and natural gas utilities.  When they start looking at the utilities, it will be hard to beat what they find in Southern Company.

Clients and principals of Donaldson Capital own SO.  Please see Term and Conditions of this blogsite on the right sidebar.
                                

More Answers to Your Questions: Bank Dividend Growth

Greg Donaldson talks about potential dividend growth for the big banks in light of the new banking regulations.

Posted Question: When will banks begin paying dividends again?



Rising Dividend Investing

More Answers to Your Questions: Why There Are so Many Widely Divergent Views of the Economy

Randy Alsman, Senior Portfolio Manager and Strategist, discusses the wide variance of economic viewpoints in the current market place and some reasons why they exist.

Posted Question: How can the opinions of so many bright people be so far apart? Where is reality? Who do you listen to other than yourself?



People/Groups we listen to:

Ed Yardeni - http://www.yardeni.com/
Bank Credit Analyst - http://www.bcaresearch.com/
Standard and Poors - http://www.standardandpoors.com/
Value-Line - http://www.valueline.com/
Morningstar - http://www.morningstar.com/
Briefing.com - http://www.briefing.com/
Bloomberg Professional - various strategists and economists
Wall Street Professional
Argus Research - http://www.argusresearch.com/
We also have access to many investment research resources through our relationship with TD Ameritrade.

See all the DCM portfolio managers' bios on our website http://www.donaldsoncapitalmanagement.com/content/our-staff