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.

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. 

Germany's Tough Medicine Can Save Europe . . .And Others

"Americans can always be counted on to do the right thing...after they have exhausted all other possibilities." -- Winston Churchill If we’re lucky, we may be about to see the European corollary to this Churchill quote. The reverse corollary would be that European politicians can be counted on to do the right thing for their debt crisis. . . when they no longer have any other choice. (It’s probably generally true of all politicians, but for today, we’ll focus on Europe.) The sovereign debt crisis in Greece has spread to become a crisis of confidence in the European Economic Union (EEU) and has the potential to explode into a global credit crisis on the scale of last year’s subprime debt crisis. However, since Europeans – the Germans and the Greeks more specifically – are very close to having exhausted all other possibilities, there is a good chance that a positive solution could come out of the mess in the days and weeks ahead. The unfolding events in Europe prove that a monetary union without a fiscal (budgeting) union leads to chaos. Greece, which represents only 2% of European GDP, now threatens to break up the whole European Union, an area of the world with nearly 400 million people and GDP about the same as the United States. That would be like a looming bankruptcy in the state of Tennessee bringing down the whole United States. Doesn't seem possible, but it's playing out before our eyes. We are now at the point where Greece can no longer sell bonds to finance its profligate ways unless other European governments agree to back them up. And, other EEU countries – really, it’s Germany that’s in charge here – can’t afford to let Greece implode without potentially causing a collapse of the euro and their own banks. The potential positive outcome mentioned at the top would be that Germany is successful in persuading Greece and the other PIIGs countries (Portugal, Ireland, Italy, Greece) to adopt dramatic, lasting, and effective austerity measures. In addition it is critical that the EEU figures out how to put more teeth into its paper-tiger requirement that no member country have an annual budget deficit greater than 3% of GDP. If these two steps are accomplished, in our judgment, the crisis will be averted and stability will return to Europe and the world markets. Admittedly Germany's fiscal measures for Greece and the PIIGS will be painful in the short run. But from what we know of them, they are the kind of common sense budgeting that every household on the face of the earth must abide by. We are hopeful that something close to the German austerity plan prevails in the capitols of Europe. Then let's start a petition that would require that the United States send a delegation to Berlin to see what our country can learn from the Germans about fiscal sanity. This would ensure that our country will not end up one day begging the world for a hand out. Investment Policy Committee Greg Donaldson Mike Hull Rick Roop Randy Alsman, Editor

The Barnyard Forecast: Has Europe Changed Things?

Our regular readers, will remember that the Barnyard Forecast is our short-hand version of determining the prospects for US stocks over the next 6-12 months. The Forecast receives its name from the acronym we use to "score" the prospects for stocks: Economy+Inflation+Earnings+Interest Rates=Opportunity (EIEI=O). Economy: We believe that the huge bail out fund that Europe announced over the weekend will continue to support stocks around the world. If Europe would have continued to dither, then there would have been trouble plenty. The way it is, though, we still see 3.5% world wide GDP growth and 3% US GDP growth. We were only counting on Europe gaining 1% before the bailout, and with the new taxes and cuts in government spending, they'll be lucky to achieve even that low level. A 3%-3.5% level of economic growth is not likely to put the Fed or central banks around the world on the warpath. Thus we would rate the Economy as positive for stocks. -- 2 points. Inflation: We believe the events in Europe will actually keep inflation contained. We still expect about 1.5% core inflation for the US. That is at the lower end of Fed targets and not likely to cause Bernanke and crowd to start hiking rates before the end of the year. Inflation is positive for stocks. -- 2 points. Earnings: We started off the year predicting 20+% growth in corporate earnings. It looks like S&P 500 earnings may actually rise closer to 30% for the year. This is an outstanding underpinning for the stock market for the rest of the year. Earnings are positive for stocks. -- 2 points. Interest Rates: We still believe 10-year US Treasury bonds will likely end the year near 4.5%. That would be appreciably higher than December of 2009, and thus negative for stocks. Zero points. The Barnyard Forecast totals 6 points out of a possible of 8. That is a bullish score. In light of the bailout of the troubled countries in Europe, we believe that the path of least resistance for US stocks is up. Had the problems been left to fall where they may, a domino effect could have continued to pound world wide stock markets. However, since European leaders have put forth such a massive bailout package, we believe the markets are likely to return their focus to the fundamentals and the fundamentals, particularly in the US, are utterly outstanding. The Barnyard Forecast is only based on what it can see. It cannot see the potential for new crises developing in places that are not now apparent. But from what it can see, it still signals an environment that is positive for rising stock prices.

The Riots in Greece Reach the US Security Markets

A friend called today and asked the question that is on every one's mind: "How in the world can the financial troubles of a tiny nation like Greece cause the world's financial markets to screech to a halt? As I listened to him I saw the stock market fall off a cliff: down 60 points on the Dow Jones, down 100 points, down 200 points, down 300, 400, 500, 600 points. I did not see the print of down 900 points because I turned away from my screen for a moment.

Before I could begin trying to explain my thoughts about Greece, my friend asked another question: "Are we going to go back to the bottom of the market we saw in March of 2009?"

My answer was quick, but I have been thinking about it ever since I saw the first riots break out in Greece. "I don't think so," I said.

"I was looking for a more positive answer from you. You have been optimistic lately," he replied.

I told him that I was much more optimistic about the subprime crisis in the US because I could see that the various important players in the drama were all doing their parts. The Fed pushed every lever they had to keep money flowing in the banking system. Congress appropriated enough seed capital to head off a liquidity crisis in the economy. Businesses rightsized their costs relative to their revenues. Consumers reduced spending but did not freeze up. The US Treasury department orchestrated a step by step program to return confidence to the banking system. This enabled the banks to raise hundreds of billions of dollars in new capital to offset the mind-boggling losses they were taking in real estate. I told my friend that as ugly as the subprime crisis was that I remained reasonably confident throughout because I could see there was a unified effort to control the damage and the full power of the United States was being invested to execute the plan. There was a will and a way to get past the crisis.

I explained that taming the financial crisis in Europe was different than taming the subprime crisis in the US for these reasons: Europe is not a single unified entity. Even though they have a common currency with a framework for a kind of United States of Europe, that little of the framework has been codified into law. Thus, the idea of Europe as a single nation is a complete illusion. Europe is still a collection of independent countries. Thus, it is quite possible that nationalistic tensions could sabotage the best intentions and plans of the nominal leaders. In short, European leaders may see a way out of their mess, but there might not be the collective or individual will to do it. In addition, there is no one really in charge. It is like a big club.

The frugal citizens of Germany do not want to loan money to the bankrupt citizens of Greece, who in turn do not want to change any of their financially profligate ways. There does not appear to be a unity of purpose, even if the resources are available to solve the problem.

My friend asked, "So is there reason for optimism that the wealthy nations of Europe can rein in Greece and the other countries that are having trouble?"

I answered, "There is and it is based on the strongest of human emotions: survival. Sooner or later the citizens of Greece will realize they are doomed as a nation without the loans. They may be burning bank buildings today, but one day soon when the lights go out and water doesn't flow from the taps, they will realize that as a nation and as citizens they have been living beyond their means so long that they are no longer free to run their own affairs. The water has been turned off, so to speak. They will agree to the loan arrangements and begin the process of trying to live with them. There is really no alternative.

Portugal and Spain are also having debt issues. Watching Greece crash and burn will be a reminder to them of where any intransigence they may harbor will likely end."

The world wide economy is gaining traction. Almost every economic measure in the US has been better than expected in recent weeks. After a long period of weekly job losses, job gains have now occurred in the last three weeks. The developing world is still growing rapidly. Indeed, economist Ed Yardeni recently reported that 60% of US exports were going to the developing world. The economic fundamentals appear to be improving almost everywhere but in Europe. That is not likely to change with the internal squabble that has erupted.

The economic world did not just evaporate today. There are many rumors of so-called "black-box" automated trading systems that generated errant trades, causing precipitous falls in stocks ,which had no negative news of any kind.

So the eternal question hangs heavy in the air: Was the market efficient today? Did the economic underpinnings of companies really fall by as much as did the market prices?

I think what we are seeing is a pure trading frenzy that has little to do with the intrinsic valuation of underlying companies. Here is the best proof I can offer of this. Procter and Gamble, one of the largest, best managed companies in the world, a company that has paid a dividend since the late 1890s and who has raised their dividend for 53 consecutive years, was selling for around $60 late in the afternoon. In a matter of moments the stock fell to $39.37. It then climbed all the way back to close at $60.75. PG's stock movement today had nothing to do with its underlying value. It had everything to do with the noise and mayhem of a video game played by hedge fund tech-savy kids with real money.

Does it mean that we long-term investors have to acquire the latest programed trading machines, so we can beat the money gunners at the their own game. Heavens no. There is a secret that we know about Procter and Gamble that the money gunners could care less about. Over the last 20 years our model indicates P & G's annual price gain has been nearly 90% correlated to its annual dividend increase. At it current dividend rate, our model says Procter and Gamble is very undervalued. As for me, I would rather trust 20 years of mathematical probabilities that one day of video game idiocy.

The Madoff Crying Shame

The news that Bernard Madoff may have stolen $50 billion from his clients puts an exclamation point on a tragic year for the finance industry. It’s one thing to make stupid subprime investmentments, as much of Wall Street and some of the banks have done, but it's another ball game when an individual outright steals people’s money. That is bottom of the barrel stuff, especially when so much of the money belonged to foundations whose aim it is to help those less fortunate.

There are many parts of the Madoff story that just defy credulity. He seemed to operate in the cracks of all of the various regulatory bodies.

One part of his operating procedures that we faced some years ago is that of being both a money manager, and the custodian of the assets. As a custodial investment manager, Madoff not only managed his client’s assets, but he also had direct access to the assets. To us that seemed like a lot of added risk and expense. Thus we chose to be a non-custodial manager. As most of you know, TD Ameritrade is our custodian. They hold the assets and make the trades. Our clients sign what is known as a limited trading authority that allows us to manage their accounts and collect our fees.

While being a custodial investment manager has some advantages for clients, such as more flexibility in moving money, the added risks, regulations, and capital costs that we would have had to incur to become a custodian manager outweighed the conveniences.

The only real encumbrance that we have to deal with as a non-custodial manager is that, since we have no direct access to our clients’ funds, TD Ameritrade requires a little more paperwork to authorize moving money around.

As the years have gone by, however, with faxes and email, this has gotten a lot easier, and knowing that we have a very capable custodian partner like TD Ameritrade gives us confidence that no money ever leaves an account that does not have the consent of the client and corroborating paperwork. I can tell you that having TD Ameritrade on board is a comfort to me, and I hope after the Madoff scandal, it is a comfort to our hundreds of clients spread across 29 states.