A Lot of Bullet Points That Add Up to Stocks Being Higher by Year-End

Summary Points:

• Continuing to assess stock market outlook – balance still positive
• Recent pullback in stock prices has been moderate on low volume

Discussion

The Donaldson Capital Management Investment Policy Committee continued our review of economic data and forecasts for the year. While the economic headwinds are much in the news, it is our experience that positive events get less play in the media than negative ones. To try to identify an appropriate balance, while recognizing that items listed are not all equal in impact, we built our own list of significant headwinds and tailwinds.

 Headwinds

• QE 2 ends this month.
• The May new jobs number came in way below trend.
• The European Economic Community has not yet solved the Greece problem.
• Consensus 2011 global GDP growth expectations have dropped 0.5% or so.
• National average house prices are still dropping.
• The unemployment and “functionally unemployed” rates have ticked higher.
• State and local governments are still eliminating jobs.
• Savings rates are high, potentially reducing consumer spending.
• Gas prices are ~$1/gal. higher than a year ago.
• Congress has not passed a solution to the Deficit and Debt problems.
• Regulatory uncertainty exists in regards to: health care, taxes, and banking.
• 3/11 Tsunami had bigger effect on supply chains than was previously thought.

Tailwinds

• Reported corporate profits remain strong.
• Estimates for 2011 corporate profits have held, despite economic headwinds.
• GDP growth outside the U.S. and Europe remains robust.
• Capital asset purchases (e.g. trucks, cars) are recovering significantly.
• Banks are seeing a slowing of defaults on mortgages and credit card debt.
• The weaker U. S. dollar is boosting U. S. exports.
• A debt default by the U.S. is seen as very unlikely by most economists we follow.
• Stock values (price/earnings) are now lower than the 80-year average. No bubble
• About 50% of S&P 500 sales come from faster growing, non-US economies.
• Crude oil and gasoline prices are dropping from recent highs.

The Committee also reviewed a discussion by The Bank Credit Analyst of the US economic outlook. BCA is a Canadian firm (which we believe gives them objectivity about the U.S.) that we’ve followed for many years. Their analyses are well reasoned; they do not rant or get emotional; and, they use data to develop and explain their views. A synopsis of their June 8 presentation follows:

• US growth will accelerate later this year.
• Tsunami-related supply chain problems are easing.
• The savings rate is high, but slowly dropping, benefiting consumer purchases later.
• Housing is too low to sink much further, reducing its drag on the economy.
• US structural deficits are only about 5% of GDP, more manageable than many think.
• The US tax/GDP ratio is the lowest in G-20, encouraging economic growth.
• The US has added more than 1.3 million net new jobs over the past year.

The Committee was concerned about the Fed’s recent lobbying for the 35 largest banks to raise their Tier 1 capital levels from 7% to 10%. This will continue to put pressure on bank stocks in the near term because of the potential dilutive effects of big equity underwritings. So far, this is still in the talking stage, and the banking industry is pushing back very hard. It remains to be seen how this will play out, but for the moment it has already been priced into the stocks, so any softening of the Fed’s position should provide a quick lift to the banks.

Although industrial stocks have dropped more than the S&P 500 lately, most industrial companies continue to have very bullish outlooks for 2011. CEO Sandy Cutler of Eaton Corp (ETN), for instance, is very confident his firm will see 14% revenue growth with earnings growth much higher than that. Many of Eaton’s customers delayed purchases of expensive capital goods during the recession, but these customers are now back in the market because the average age of their equipment has reached multiyear highs, causing repair costs to jump. This same dynamic is playing out across the spectrum of a number of industries.

Unemployment remains stubborn. Historically, however, the correlation between increased corporate profits and increased employment is very tight. The two trends separated during the recession. However, the average work week, especially in the industrial sector, has extended to the point where more overtime just may not be possible. The longer corporate sales volumes and profits grow, the more pressure there will be for businesses to increase hiring.

While major new negative developments in the Middle East, a major economic slowdown in China, or a fiasco on the debt limit in Washington D.C. could turn the 2011 outlook decidedly negative, we don’t consider any of them as having a high probability at this time. Our views are echoed by the economists and strategists that we follow. The market pullback over the past six weeks – the first six-consecutive week pullback in 10 years – has been relatively modest, less than 5%. Finally, trading volumes have been relatively light, potentially indicating there is not a lot of urgency in the selling.

After considering all the above, the Committee is holding to its outlook for stocks to return 5% - 10% for all of 2011. Of course, we will continue to monitor the data and the economic and political environments.

Edited by Randy Alsman

Greg Donaldson Mike Hull Rick Roop Randy Alsman

We own many industrial stocks including Eaton.

If Analyst Estimates Are Correct, Stocks Are a Buy!

A year ago the stock market fell into a deep swoon buffeted by troubles in Greece, worries about a double-dip in the US economy, and the prognostications by many analysts that the Federal Reserve was powerless to stimulate growth.

The red line on the chart at the right shows that in 2010 the S&P 500 fell from about 1250 in April to under 1050 in June, nearly a 20% plunge.

Reading the headlines today and watching the recent activity in the stock market, one gets the feeling that we've seen this movie before. Greece is still in danger of default; economic growth in the US slowed to 1.8% in the first quarter; and the Fed has just announced that QE2 will end at the end of June.  So the obvious question is, "Are stocks headed for another 20% correction?"

We don't think so and we believe the above chart provides the best argument against a big sell off.  We explain ad nauseum that what stocks are doing in June has little correlation to what they will do for the full year.  The chart shows that stocks reversed their 2010 April-June tailspin and recovered to close over 15% higher on the year.  Those investors who sold out in the midst of all the negative blab in summer missed a terrific year for stocks.

Was there any signal last summer that told us that the stock market swoon was just noise?  Yes, analysts earnings estimates for year-end 2010 for the S&P 500, as shown by the black dashed line, never dipped.  Indeed, for most of the summer the analysts were hiking S&P 500 earnings in the face of falling stock prices.  Looking closer, the chart reveals that analysts started the year estimating that S&P 500 earnings (left scale) for the year would be about $77.  They actually ended the year at about $85.

Another clue that stocks, and for that matter the economy, were not headed for a double dip was the fact that actual reported earnings, as shown by the blue stair-step line, were moving sharply higher.

Obviously we could not have seen year-end earnings in mid 2010, but earnings in the first and second quarters were strongly and surprisingly higher.  It was clear by early July that a big earnings rebound was underway.

So where do we stand today, and what are the analysts forecasting for year-end 2011 S&P 500 earnings?  The chart at the right shows the 2011 data discussed in the first chart.

In short, the picture for mid-June 2011 is similar to mid-June 2010.  Stocks (red line) are selling off, while actual earnings (blue line), and analysts' year-end earnings estimates (black dashes) are continuing to rise.

In our judgment, the key component in this chart and in the ultimate direction of stocks is the trend of the analysts' earnings for year-end 2011.  They have risen throughout 2011 and are still trending higher.  The analysts are in close communications with the companies they cover, and if they were hearing bad news from the companies their earnings estimates would be already headed down.  We see little evidence of weakening earnings estimates among the companies we hold.

We will continue to report on the analysts' estimates for 2011 in future blogs.

This is a good time to remind our readers that we invest in global companies and not just the US economy.  Our companies produce over 60% of their earnings outside the US, with much of it coming from the fastest growing nations in the world.  We as Americans still have great difficulty conceptualizing that the US now represents only 25% of world GDP.  The global economy has become a very big place, and we no longer dominate the world's economic growth like we once did.  The good news is the world economy is growing much faster than that of the US.

If corporate earnings continue to be strong, as we believe they will, we envision that stock market activity in 2011 might turn out to be a movie that we have seen before -- down in the summer, up by year-end.