Why Weak Economic News Might Be Good for Stocks

As we mentioned in last week's article, we are providing our most current outlook on global economic growth.  We will update our projections periodically to reflect our latest views.

Economic indicators have been very confusing for investors.  “Good news” about economic growth has been perceived by the markets as “bad news”, as it could lead to reduced monetary stimulus from the Federal Reserve.  In this article, we will identify some key economic information and separate each point into good news and bad news, then come to a final consensus as to our specific views about the economy and how it will impact stock market growth moving into 2014. 

1. Slow Economic Growth

Economic growth in the United States has been mostly flat coming out of the recession in 2008-09.  In the 2^nd quarter of 2013, real GDP growth was a mere 2.5%.  The economy has been “muddling along” for quite some time.  We anticipate slow economic growth will continue into 2014. 

12 Random Ramblings

Every working day of our lives we get questions.  Questions about the stock and bond markets.  Questions about how natural disasters, politics, or economic and business crises will play out in the market place.

In this weekly blog we try to keep our comments narrowly focused on our dividend investment strategy.  As we were composing our most recent quarterly letter we admitted to our readers that at times we sound like a one trick pony:  our solution for every challenge and every opportunity is always -- buy and hold quality rising dividend stocks.  In the long run we know that will work.

Yet the matters we discuss and decide at our weekly investment policy meetings cover the waterfront of issues.  In this regard, heaven help us, we are like politicians because we have to have a basic understanding and a few talking points on just about everything that is going on in the world.  

We thought our readers would appreciate our short takes on a long list of issues facing our nation and the world.  Normally, when we write these blogs or our client letters, we try to offer solid proofs for our positions.  In this piece, we are not going to do that.  We are just going to give our views, without supporting arguments.  This way we can cover a wide range of issues that you may have questions about.  It is our plan to periodically offer an update to what we are calling 12 Random Ramblings from the Investment Policy Committee.

1. Stocks are undervalued by about 25%.  Energy, Industrial, and Consumer Cyclical stocks are very cheap.
2. US Government bond yields are at historic lows, but will not rise much over the next year.
3. Inflation will fall.
4. US Corporate profits will continue to surprise to the upside, driven by business in developing nations.
5. Greece is already bankrupt, but the European Union will keep the country on life support for an extended time.
6. The market has already priced in a Greek default.
7. The US economy will not fall into recession and may surprise to the upside in the fourth quarter of this year.
8. The worldwide economy will grow by at least 3%, after inflation, this year.
9. Dr. Doom, Nouriel Roubini, has signaled better times may be on the horizon for the US and the world by putting his investment advisory firm up for sale. 
10. The average dividend payout ratio for the S&P 500, which is now, under 40%, will move back toward its 80-year average of 50% over the next five years.
11. There is still a chance that Hillary Clinton will run against President Obama if his polling numbers don't improve by December.  She would likely beat any Republican, and the stock markets would rally, not because her views are so much different than Obama's, but because the economy and the markets did so well under Bill Clinton.
12. If  Roubini is selling his company, the price of gold may have already seen its highs.

Greg Donaldson, Chairman of the Investment Policy Committee

Donaldson Capital Management, LLC

Randy's Comment to a Client

This is a response to a client by Randy Alsman. Randy is our newest portfolio manager. Randy joined us from a major pharmaceutical company where he held numerous positions from finance to senior executive for managed care, where he dealt with the government and the insurance companies. You don't need to ask, why he's so happy to be back in his hometown. I consider Randy and expert in corporate strategy. He's a brilliant guy and has taken responsibility for our investment strategy in health care, insurance, and technology. His joining our firm will be good for all of us. Jim, here's my view of the current state of the market and economy: Oil traders continue to push oil prices higher because of fears that there are no new visible oil discoveries coming on board large enough to meet the increases in demand from the burgeoning economic expansions in China and India. In the face of these rising oil prices, US consumers are cutting back their use of gasoline for the first time in 20 years; however, both China and India still provide cheap oil to their citizens and thus, demand continues to grow at a high rate in these countries. Stock traders, seeing the runaway oil prices combined with their growing belief that more bad loan write-offs are coming in second quarter earnings releases beginning next week, have sent stock prices in the opposite direction of oil prices, with stocks falling to new 2008 lows. All of this flies in the face of the US economy which continues to confound the pessimists with a steady stream of better-than-expected reports, the most recent showing GDP growth in the first quarter of 1%. Indeed, many economists, who were formerly calling for a recession in 2008 have now come over to our view that the economy will just muddle along for the rest of the year. The media and many political candidates seem to be going in the opposite direction of the economists. From their perspectives, a "Hooverville" will be coming to a city near you soon. In fact, Arthur Lafley, chairman of Procter and Gamble, lashed out at the presidential candidates yesterday for crying, "woe is me" on the economy, which Mr. Lafley said was making people feel the economy is it much worse than it really is. The oil spike is lifting inflation fears and the credit crunch is increasing recession fears. We're a long way from stagflation (double digit inflation and unemployment at 6.5 - 7.0%), but it still feels like stagflation to a lot of people. The fixes for recession or inflation are pretty straightforward. However, facing both at the same time is much trickier. That uncertainty is causing traders to be more cautious, which translates into lower stock prices. Forced to put a stake in the ground, I'd guess near term trading will continue to be very volatile. If I am right and second quarter earnings come in much better than expected, the markets will be just as volatile on the upside as they have been on the down. Right now, we're pretty close to where we were at the January and March lows, which were just a few points shy of the mythical 20% down bear-market definition. Absent any big new news, we will most likely bounce up and down between here and 1,000 points higher for a while. Our investment strategy for 2008 is based on that scenario. Risking sounding like a broken record, we're buying and holding quality companies that have successfully weathered similar bad times, and worse, and that are increasing their dividends. So far, the average company in our portfolio has increased its dividend more than 11% over the last 12 months. We see that partly as a sign that they are expecting to come out the other side of this down market in decent shape. That’s all for now, I’ll have more to say when the earnings start rolling in. Randy Alsman, Vice President Portfolio Manager

A Discussion about the Economy with an Old Friend

Every year near Christmas time, a good friend and client comes visiting with Christmas presents for our staff. After the hub bub of the diet-killer delights he brings, he and I settle into a casual discussion of prospects for the coming year. I listen as much as I speak because I have found him to be a keen observer and a very good student of the markets, particularly human nature.

This will be the first of two or three items that we discussed.

Friend: Everyone seems to be bracing for a recession. I'm having trouble believing that a recession is imminent when most of the economic sectors are doing well with the exception of financial and retail. What do think the odds are of a recession?

GCD: I think they are less that 50/50, and I believe the consensus of our investment committe is that growth will slow, but recession is not the best bet. I have one chart I'd like to show you that I believe is not well understood and most people forget to take into consideration when they project recession.

The chart at the right is of US Net Exports of Goods and Services since 1970. The chart clearly shows that exports have not only been falling relative to imports since 1980, but that their rate of descent has accelerated dramatically since the early 1990s. That trend has been firmly in place until just in recent months when exports have turned higher relative to imports. Indeed, in the most recent quarter, exports represented nearly 20% of total real GDP.

Friend: So you are saying that exports alone may keep us out of recession?

GCD: No, I personally think the economy overall will be stronger than most people think. The housing issue is a tough hurdle to overcome, but I just don't believe that housing in most parts of the country got as overheated as in did in California and Florida, for instance; consequently, I don't think the unwinding of the excess housing stock in the country will linger as long as most people seem to believe. Export growth will almost certainly continue, so any good news in housing will produce more overall growth than Wall Street now predicts.

Friend: Exports are rising because of the fall in the dollar, correct?

GCD: I have said many times that oftentimes the seeds of destruction and the seeds of regeneration are in the same pod. The US's consumer mentality and heavy use of imported petroleum have caused a trade imbalance with almost every country in the world. In essence, we were trading dollars for goods. As those dollars were translated back into the home country's currency, dollars are sold and the home currency bought, ie., a weak dollar.

Friend: But for net exports to have turned higher, the dollar must have fallen sufficiently that our goods and services are now very competitive in the global economy? That still seems hard to believe. Most people think the dollar is destined to fall a far as the eye can see.

GCD: My best explanation for the power of a weaker dollar is the following: In the case of a citizen in Windsor Canada, a year ago a Cadillac at the local dealer and the one across the river in Detroit cost about the same. As a result of the collapse of the US dollar vs the Canadian dollar, the same Cadillac in Detroit is now nearly 20% cheaper than the one in Windsor. Thus, it pays the Canadian to drive across the bridge and "buy American."

Friend: I just saw where the big European consortium, Airbus -- Boeing's biggest competitor -- is saying that as a result of the collapse in the dollar, they will move $2 billion dollars of research on their new planes to a dollar denominated country. That would seem to mean that some, if not all of that work may come to the US.

GCD: I know we are speaking anecdotally, but this is happening all over the world. The fall in the dollar has made us more competitive and companies the world over have to deal with it.

Friend: Then I guess we are saying that the great bugaboo of a falling dollar is not all bad.

GCD: Yes, it eventually brings itself into an equilibrium level and begins to stabilize. That appears to be happening now, and I don't see it turning around anytime soon. I believe those people who are calling for a recession are missing the contribution of imports to the US economy .

Friend: That is what I have been thinking, as well.

Next time: Are US stocks overvalued?

Could Oil Prices be Topping?

Oil prices recently flirted with $100 per bl and the consensus of most analysts is that it is only a matter of time before that level is taken out, and we move ahead to ever higher prices. The argument is that with the developing economies of China, India, and Russia growing rapidly and representing nearly half of the world's population, it is inevitable that the price of oil can only rise as far as the eye can see.

When I hear the term "as far as the eye can see," I recall how often it turns out that the eye can't see very far. Indeed, it is almost a certainty that the equilibrium price for oil is far less that the current selling price. Anytime the as-far-as-the-eye-can-see crowd is at work, you can bet that they have laid up lots of bets on oil and, thus, there is a speculative premium in the current price.

I said in a September 2006 blog that what always kills real estate is the gap between market prices and rents. When rents begin to lag way behind prices, it means that the supply of housing is greater than the demand, and the cost of carry will soon become a factor for speculators in the decision to hold or sell the property, even if prices appear to be moving higher.

As it relates to oil, I believe that the best measure of "true demand" is the price of gasoline at the pump. Gasoline prices are thought by many to be inelastic. After all, we have our lives to live and; well, we have to drive to live, etc., regardless of price.

I have been thinking for the last couple of years that to assume that gasoline prices are inelastic is probably not justified. The fact that demand for gasoline has not fluctuated much with higher prices in the past may be because total fuel costs for the average household budget has been a relatively small percent, in the range of 4%-5%.

The chart above is a scattergram (you may want to click to enlarge) that shows, as you would suppose, there is a very high correlation between crude oil and gasoline prices -- R2 of .94. Note the three arrows I have drawn on the chart at the far right. These points, which are the last three months, suggest that prices at the pump are much lower than we would expect them to be based on their historical relationship to crude oil. For instance, last week when oil surged to near $100 per bl, gasoline prices at the pump (Midwest) should have been near $3.50 a gallon. Oil prices in my region never got above $3.15. Currently with crude prices near $90 per bl, the chart indicates that prices at the pump should be near $3.20. Bloomberg shows that the prevailing price in the Midwest in currently $2.95 a gallon.

The lag in prices can be the result of only three reasons. 1. Oil refiners and marketers are holding down the price of gasoline, 2. Consumers are balking at paying much above $3.00 a gallon, or 3. A combination of both.

If consumers are balking at higher gasoline prices, crude oil prices would at the least flatten out, if not fall. The reason oil prices may fall more than you might expect is because of the rampant speculation in crude oil futures.

I'll keep you posted on this trend in future blogs. Could it be that some elasticity of demand is appearing? We'll soon see.