Friday, October 22, 2010

Channeling Ben Bernanke

Somewhere in Washington DC Ben Bernanke is surely smiling, if only slightly.  In recent weeks, stocks have been rising and last week the Utility Index (XLU) broke to a new 12-month high, signaling that investors may be willing to take on more risk.

Amid all the worries Ben carries on his shoulders about the viability of the US economy, he has to constantly be aware of the shifting moods of the players, consumers, and business people, in the current unfolding economic drama.  Ben knows what he needs most right now is a catalyst to lift the "animal spirits" of the players so they will return to more normal consumption and investing patterns.

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There has been precious little "feel good" news in the economic data for most of 2010.  Home prices are still wallowing at low levels; unemployment is still sky high; and until recently, stock prices have flat-lined.

There has, however, been lots of good news in the earnings reports of major corporations.  But with all of the ill winds in the economic news, many investors have concluded that these earnings increases are the result of expense reductions and layoffs and will only make the US economy worse.

Ben is smiling because he knows the earnings are real, and that rising earnings will ultimately lead to job growth.  He also knows that rising stock prices in the face of poor economic news are a good sign because it means that investors are beginning to look through the current malaise to better times.

The utility index breaking to a new 12-month high is important because, as we have said before, utilities are generally considered to be bond substitutes.  Their dividend yields are more than double that of the average stock; they usually operate with some kind of monopoly power, and their financial ratings are higher than the average stock.

History shows us that almost all major turn-arounds in stocks have been led by the utilities.  As investors become more confident and begin to move out of bonds, their first landing place is usually in the stock sector they consider to be the safest.  For most people that is the utilities.  Thus, it is not surprising that in the recent uptick in stocks, utilities have broken above their 12-month highs, while the S&P 500 Index is still nearly 3% under its 12-month high.  We would expect that the S&P 500 will follow the utilities lead and break to a new intermediate high by the end of the year.

This move will be driven by the recognition that stocks are cheap compared to bonds and that Ben will see to it that bond yields won't be rising anytime soon.

Saturday, October 16, 2010

Railroads May Soon Lose Some Steam

During the last two years, the rail stocks have acted more like rockets of the 21st century than lumbering piles of steel left over from the 19th century.

Since 2009 when Warren Buffett announced he was buying Burlington Northern, investors have been steaming back into the rail stocks, hoping another big hitter would follow Mr. Buffett's lead and take out another of the big rail companies.

The rail stocks today are certainly not your grandfather's bloated, broken-down companies.  Today railroads are key players in the inter-modal freight handling business.  Importantly, they are widely seen as the most economical and environmentally friendly mode of hauling goods over long distances..  But there is little question that Mr. Buffett's purchase of Burlington Northern has added a shine to the appeal of railroad stocks that wasn't there before.

That shine may be in the process of dulling a bit.  Our Dividend Valuation model for Union Pacific  (UNP) shows an interesting feature that we have seldom seen for any stock since the beginning subprime crisis: overvaluation.

The chart shows that UNP's current price (red line) is just over $85 per share, more than 15% above our model's current predicted value, and nearly 8% above next year's predicted price. (The other major rail stocks show similar overvaluations)  

As we have said before, overvaluation and undervaluation are not precise fall-off-the-cliff events.  Stocks can stay overvalued or undervalued for a long time.  But a look at UNP's valuation model shows that it has rarely been significantly overvalued: only 4 times in 20 years.  Each time it became overvalued its price ultimately fell back to its valuation bar. 

We doubt if the current momentum in the rail stocks gives a hoot about our valuation models, but we don't have to remind anyone that stocks get undervalued and overvalued and eventually they return to their value tracks.

A relative of the author owns UNP.  Please do not use this blog for investment decisions.  Please consult a licensed investment professional.

Thursday, October 07, 2010

Utility Watch: Still Waiting For The Breakout

As I said last time, we are watching the utility sector for clues about the future course of stocks overall.  The good news is that last week the Utility Sector (XLU) made a new 2010 high.  The not-so-good news is that its price did not exceed the December 2009 high. 

Utilities are a key indicator because they possess two important qualities.
  1. History shows us that they usually lead stocks out of bear markets and corrections.
  2. They are in the category of bond-like stocks that has been doing very well in recent months.
The bond-like qualities of utilities may be the most important indicator in the current market.  Bond prices continue to surge, with the 10-year T-bond now yielding under 2.5%.  By contrast, the current dividend yield of the utility sector (XLU)  is approximately 4% and, according to Bloomberg, has produced dividend growth of over 5% per annum over the past five years. 

I was modestly disappointed that XLU did not pop north of the December 2009 high in last Friday's big up move.  However, hot markets do not usually draw lots of investors to the slow-moving utilities; thus perhaps Friday's action should have been expected.

Another reason I am so interested in the utilities is that they are widely owned by individual investors.  A continuing uptrend in XLU would suggest that individuals may be accumulating their old faithful sector.  The other old-faithful dividend sector, banks, has completely betrayed the individual investor with dividend cuts and continued turmoil. 

If the utilities keep moving higher and break above their old high, it would not stretch the imagination to think that they might continue to move higher than most people now believe.  The reason is simple:  There are not many sectors of the stock market that have treated long-term investors very well in recent years.  The old favorites, health care and banks, have both let investors down over the last decade.  Only the utilties have provided a solid return during this time.

Our Dividend Valuation models are suggesting that utilities are as much as 25% undervalued.  Maybe just maybe, this industry has it affairs enough in order that they will pierce their 2009 highs and break into new territory.  That is what we are counting on.