The Rising Tide May Keep Rising in 2011

As of this morning, the S&P 500 is up over 13%, including dividends, for 2010.  This performance is significantly above long-term average returns, and remarkable when considering all of the headwinds that the markets faced in 2010.

These impressive results are largely due to the exceptional growth in corporate earnings, which will increase nearly 47% over 2009.  Of course, the above average growth in both stock prices and corporate earnings came after exceptionally low earnings and market prices in 2008 & 2009.  The S&P 500’s current Price/Earnings ratio (P/E) will be about 15.0 for 2010, modestly below the long-term average.  We see this as evidence that the market has not rebounded excessively from the low in March, 2009.   Rather, it is much more likely that the March 9, 2009 S&P 500 low of 676 was excessively low.

In our view, the overshooting of a “fair value,” be it a high or a low, has become the new normal of the stock performance.  For a number of reasons, we believe it is becoming increasingly possible that US stocks could overshoot on the upside over the next year or two.   Part of this is based on our view of how human emotions influence stock market movements.  At times, it seems there are only two emotions, at least when it comes to investing – fear and greed.   When a market trend, which may have begun for legitimate reasons, reaches a certain point, it often becomes self-sustaining and poised for an overshoot.

That is, the market often moves in a direction primarily because it has been moving in that direction, not because of underlying fundamentals justifying a continued rise or fall.  People tend to believe that what has been happening will continue to happen.  Their fear or greed amplifies that tendency, and the market overshoots or undershoots, as the case may be.  Also, with roughly 70% of all trades today being driven by electronic algorithms meant to capitalize on momentum and not fundamental values, volatility and overshoots are further amplified.

There are two catalysts we see forming that could send stock prices much higher in the coming year: 1) Many Wall Street economists have recently hiked GDP growth for the coming year as a result of the stimulus effect of the $858 billion Tax Relief Act of 2010.  The curious thing to us is that Wall Street has not increased 2011 earnings estimates materially in weeks.  We understand GDP growth does not fall directly to earnings, but we believe earnings are likely to grow faster in 2011 than investors now predict. 2) The other catalyst is the likely reversal of the 2008-2010 money flows out of stocks and into bonds and cash.  

The nearby chart shows a nearly $1 trillion cumulative difference in money flows out of stock mutual funds and into bond funds from December 2007 to today.  Adding to this the similar money flows out of individual stocks into individual bonds and short-term bank CDs, means there are trillions of dollars currently sitting in extremely low yielding investments that were formerly in stocks.

As fear continues to subside and economic growth continues to climb, we believe more and more investors will shift their assets back to stocks and out of bonds and cash.  Stocks will end 2010 nearly 90% higher than at the bottom in March of 2009.  There are certainly still doomsayers aplenty, but a recovery of the magnitude that we have witnessed is just too big to ignore.  In short, a 1% CD is starting to look pretty paltry compared to the performance of quality stocks over the last two years.

It is possible that this bond to stock shift will be gradual enough not to cause stocks to become over-priced.  We hope that will be the case.  However, as the chart below shows, over the last 15 years stocks have gone from overvalued to undervalued with regularity

This is where our dividend investing philosophy should serve us well.  As we have said before dividends fill two important roles for us. 1) They are real cash and have represented over 40% of the total returns of stocks since 1926; 2) Companies that pay a consistently rising dividend can be more accurately valued than non-dividend payers or irregular dividend payers.  Our dividend valuation models give us a ballpark idea of the “fair value” of a company at any point in time.  In our minds, as stocks continue to march higher, our models will be very helpful in assisting us in knowing when the fair value line has been crossed.


We will offer a few counterpoints to this bullish view for stocks in a coming blog.  As always, there are some clouds on the horizon.

The Rising Tide May Keep Rising

As of this morning, the S&P 500 is up over 13%, including dividends, for 2010.  This performance is significantly above long-term average returns, and remarkable when considering all of the headwinds that the markets faced in 2010.

These impressive results are largely due to the exceptional growth in corporate earnings, which will increase nearly 47% over 2009.  Of course, the above average growth in both stock prices and corporate earnings came after exceptionally low earnings and market prices in 2008 & 2009.  The S&P 500’s current Price/Earnings ratio (P/E) will be about 15.0 for 2010, modestly below the long-term average.  We see this as evidence that the market has not rebounded excessively from the low in March, 2009.   Rather, it is much more likely that the March 9, 2009 S&P 500 low of 676 was excessively low.

In our view, the overshooting of a “fair value,” be it a high or a low, has become the new normal of the stock performance.  For a number of reasons, we believe it is becoming increasingly possible that US stocks could overshoot on the upside over the next year or two.   Part of this is based on our view of how human emotions influence stock market movements.  At times, it seems there are only two emotions, at least when it comes to investing – fear and greed.   When a market trend, which may have begun for legitimate reasons, reaches a certain point, it often becomes self-sustaining and poised for an overshoot.

That is, the market often moves in a direction primarily because it has been moving in that direction, not because of underlying fundamentals justifying a continued rise or fall.  People tend to believe that what has been happening will continue to happen.  Their fear or greed amplifies that tendency, and the market overshoots or undershoots, as the case may be.  Also, with roughly 70% of all trades today being driven by electronic algorithms meant to capitalize on momentum and not fundamental values, volatility and overshoots are further amplified.

There are two catalysts we see forming that could send stock prices much higher in the coming year: 1) Many Wall Street economists have recently hiked GDP growth for the coming year as a result of the stimulus effect of the $858 billion Tax Relief Act of 2010.  The curious thing to us is that Wall Street has not increased 2011 earnings estimates materially in weeks.  We understand GDP growth does not fall directly to earnings, but we believe earnings are likely to grow faster in 2011 than investors now predict. 2) The other catalyst is the likely reversal of the 2008-2010 money flows out of stocks and into bonds and cash.  

The nearby chart shows a nearly $1 trillion cumulative difference in money flows out of stock mutual funds and into bond funds from December 2007 to today.  Adding to this the similar money flows out of individual stocks into individual bonds and short-term bank CDs, means there are trillions of dollars currently sitting in extremely low yielding investments that were formerly in stocks.

As fear continues to subside and economic growth continues to climb, we believe more and more investors will shift their assets back to stocks and out of bonds and cash.  Stocks will end 2010 nearly 90% higher than at the bottom in March of 2009.  There are certainly still doomsayers aplenty, but a recovery of the magnitude that we have witnessed is just too big to ignore.  In short, a 1% CD is starting to look pretty paltry compared to the performance of quality stocks over the last two years.

It is possible that this bond to stock shift will be gradual enough not to cause stocks to become over-priced.  We hope that will be the case.  However, as the chart below shows, over the last 15 years stocks have gone from overvalued to undervalued with regularity

This is where our dividend investing philosophy should serve us well.  As we have said before dividends fill two important roles for us. 1) They are real cash and have represented over 40% of the total returns of stocks since 1926; 2) Companies that pay a consistently rising dividend can be more accurately valued than non-dividend payers or irregular dividend payers.  Our dividend valuation models give us a ballpark idea of the “fair value” of a company at any point in time.  In our minds, as stocks continue to march higher, our models will be very helpful in assisting us in knowing when the fair value line has been crossed.


We will offer a few counterpoints to this bullish view for stocks in a coming blog.  As always, there are some clouds on the horizon.

Municipal Bonds: Apocalypse Now or Buying Opportunity?

The most recent drama brought to us by the news media has been the risk of municipal bond issuers defaulting on their debt obligations.

We and other professional investors in municipal bonds have been aware of and monitoring the heightened municipal bond default risk for nearly three years.  However, it took a segment on 60 Minutes featuring the photogenic, publicity-minded banking analyst, and newly-minted municipal bond expert Meredith Whitney to really light up the airwaves on this issue.

Whitney predicted: “Fifty to 100 sizeable defaults.  More.  This will amount to hundreds of billions of dollars’ worth of defaults.” 

The one-year record for municipal defaults (2008) was just over $8 billion.  So, Whitney’s prediction of “hundreds of billions” would be at minimum a 2,400% increase in the rate of municipal defaults.   If she is wrong even by a factor of ten; however, it would still be a very bad year for municipal defaults. 

We believe that there are serious deficit and debt problems in many cities, counties, and states across the country.   We also believe that the relative risk of municipal defaults is, indeed, as high as it’s been in a long time.  In this case, however, the word “relative” is critical.   Let’s set the context for that higher relative risk with some data:

·      Since 1930 Moody’s has recorded nearly 2,000 defaults by non-financial major corporations.

·      In stark contrast, since 1930 zero states have defaulted on their debts.

·      The largest municipal bankruptcy in history – Orange County, California in 1994 – was just $1.6 billion.  (More on that later.)  “Hundreds of billions” in defaults would mean over 125 Orange Counties declaring bankruptcy and defaulting.

·      Since, 1970, municipal defaults have averaged just over one per year.  Multiply that tenfold, and Whitney’s estimate is still nearly 1,000% larger.

·      A Moody’s study covering 1970 – 2000 counted just 18 municipal defaults, ten of which were not-for-profit hospitals.

·      During that same 30 years, zero general obligation (tax-backed) bonds defaulted

Even if a municipal bond issuer actually does default, however, all is likely not lost.  In fact, most is likely not lost.  The average recovery rate on defaulted municipal bonds has been 66%.  That infamous Orange County bankruptcy?  They did not default on their bonds at all.  The county cut services, raised taxes, and fully paid the $1.6 billion owed their bondholders.  In this case and many others, bankruptcy is not a direct route to loss.  It allows the municipality time to correct their mistakes and right size their revenues and expenses. 

But all that is history. A recession, housing value collapse (think property taxes), credit crisis, and persistent near-10% unemployment all combine to cause real trouble for many states and municipalities across the nation.  Also state Medicaid costs, unemployment compensation, and other social support costs all got bigger, not smaller, during this recession.  So, Ms. Whitney is accurate in saying that today’s municipal bond market is not the sleepy, low risk market that most of us have come to know and trust over the years.

Yet we come back to the word relative in rebuttal to Ms. Whitney.  Yes, there is more risk in today’s municipal bond market. But as we will show, it is a long way from more relative risk in municipal bonds to the long list of defaults Ms. Whitney is forecasting.

To better explain why we don’t see higher relative risk as meaning high absolute risk, review the following list of things states and municipalities can do that corporations cannot.  Each serves to lower the absolute risk of municipal default:

·      Municipalities have far more capacity to increase revenues than do companies.

·      The size of the problem relative to revenue capacity is small.  For example, in Illinois, possibly the sickest state, just a 2% increase in state income tax rate would totally eliminate the state’s budget deficit.

·      Municipalities can cut costs without reducing their revenues.  Labor costs are the largest expense for most municipalities.  They can, and many have, reduced headcount and instituted unpaid furloughs.

·      In many, maybe most cases, municipalities are legally required to give the highest priority to debt service payments.  The first tax dollar pays bondholders, not the last.

·      Municipal annual budget deficits are actually getting smaller, not larger, due to an improving economy and cost-cutting.

The list is much longer, but we’ll stop there.   Bottom line:  The risk of municipal default is higher than the norm of the past 70 years.  But, history and the factors just described show us that municipal bonds are far less risky than corporate bonds. That is the reason that the average credit rating of all municipal bonds is near AA, while the average rating for corporate debt is at least a letter grade lower.

There are still municipalities out there that are very bad credit risks. And, Ms. Whitney rightly says there is more risk in municipal bonds today than there has been over the last 70 years.

That being said, we do not agree with her forecast of imminent huge losses in municipal bonds.  Indeed, we believe that few high quality municipalities will file bankruptcy and even fewer will actually default on their bonds.

Ms. Whitney’s 60 Minutes appearance has had the effect of shouting fire in a crowed room.  Many people have panicked and sold bonds indiscriminately.  As most of you know, during the past few weeks we have been buyers of selected municipal bond issues by municipalities and states that our research has shown to be low credit risks.

Our optimism about the prospects for municipal bonds is shared by most of the investment research firms that we have counted on for many years.  Indeed, we note that the Pimco bond king, Bill Gross, is said to be buying municipal bonds for his personal account.

The judgment of a life-long professional bond investor putting his own money behind his opinion is to us the best evidence that the current drama is actually a buying opportunity.

Sources: Bloomberg BMO Capital, BCA Research, Moody's

GE's Second Dividend Hike: Good News or Bad News?

GE's announcement of a 17% dividend hike on top of their 20% hike earlier this year was the topic of lively discussion at our investment policy meeting on Monday.

We all agreed that on the surface the news was good for GE and stocks in general, but several committee members voiced a surprising concern.

First let me share the positive implications we believe GE's dividend actions signal.

1. Their loan loss ratios in GE Capital (35% of the company) must be improving faster than previously expected.  This would be good news for both GE and the US economy.
2. An up-tick in their long-cycle industrial sector (jet engines, healthcare electronics, and power generation) may be underway.  Better news in these industries would be very good news for US trade balances with developing nations.
3. Short-cycle businesses (appliances and electrical system equipment) may have bottomed.  This would be modestly good news about US consumer spending.

We were surprised and delighted by GE's second dividend hike, and because GE is so large and so broadly diversified across the US economy, we believe many other companies may also be experiencing better-than-expected results. This would portend more higher-than-expected dividend hikes. And since our theory is that dividend hikes are the best sign that a business is growing, a spate of better-than-expected dividend hikes should also lead to higher stock prices.

The surprising concern that arose in our discussions was the possible negative implications of the dividend news. Two of us voiced the concern that because Jeffrey Immelt, GE CEO, has become so unpopular among many investors and analysts, the dividend hikes may only be his attempt to win favor with his constituents. This line of thinking didn't go far because one of the committee members reminded us that CEOs don't dictate dividend policy. That authority belongs to the board of directors.

The chart at the top of the page shows that GE is stair-stepping its way higher. The recent new, intermediate high signals the stock may attempt to move higher over the near term. If our notion that GE's business is improving starts showing up in their earnings, we could soon see GE take a run at a new 12-month high.

We own the stock. Do not make investment decisions based on this information. Please consult your personal financial advisor.