3 Headwinds for Dividend Stocks: Will They Continue?

This blog was written prior to today's news about Greece. Based upon everything we see thus far, the Greece situation has short-term implications, but not long-term. Investors and financial institutions have had seven years to get used to the prospects of a Greek default. Furthermore, Greece represents only 2% of the European Union, which is a fraction of the global economy. We will have more to say on this over the next few months.

Dividend investors have had a difficult time so far this year.  While the S&P 500 Index has risen 3.0% on a total return basis, the Dow Jones Dividend Index is down 2.2% and the Vanguard Dividend Achievers Index is down 0.4%.  As usual, the nay-sayers are neighing that dividend investing is dead. But whoa Nellie, there have been three disparate forces that have pulled in the reins on stocks with higher than average dividend yields:

1.       Rising long-term interest rates

2.       Sharply appreciating U.S. Dollar versus most world currencies

3.       Collapsing energy prices

In many ways, the confluence of these three forces is unusual and not likely to last.  Over the last 20 years, long-term interest rates have been negatively correlated with oil prices and oil prices have been negatively correlated with the dollar.  One or two of these economic measures would be rising in a "normal" environment, but not all three at the same time.  It would be highly unusual if these three price trends continue in the same direction for much longer.

As strange as this time has been, the result has been clear. The current trend of these three economic measures has had a negative impact on many of the most important stock market sectors for dividend investors:

• The rise in interest rates has hit the prices of the utilities, REITs, and telecoms sectors in much the same way as it has bonds.  
• The rise in the dollar has significantly lowered multinational companies’ earnings and dividend growth, along with their stock prices.  
• The collapse in oil prices has sent big oil and pipeline stocks down by as much as 30%.

The only sector with higher than average dividend yields to escape the adverse prevailing forces has been the financials, whose net interest margins and profits normally improve with rising interest rates.

As dividend investors, we have been facing all three headwinds for the last six months.  The question most of us are asking is, “How much longer can the headwinds last?”

Here is our view of these trends over the short and intermediate-term trends:

Interest rates:  With Greece teetering on the edge of default, we expect money will be in a flight-to-safety over the near-term.  This will push U.S. Treasury yields lower and allow for a modest rally in interest-sensitive stocks such as utilities and REITs.  How long the rally prevails will depend on how long it takes for the markets to digest the final outcome of Greece.  Regardless, we expect long-term interest rates will slowly move higher once the crisis is over. 

Oil prices:  The supply and demand of oil is nearing equilibrium. If that is the case, oil prices may have seen their lows.  Despite their rally in recent months, they are still 40% lower than a year ago. We have difficulty believing that a rally in oil stocks is near.  The Greek tragedy is a deflationary event. If it lasts very long, we would expect oil prices to trend lower. Furthermore, we will likely see some negative surprises from those oil and pipeline companies with high debt loads.  The companies in our portfolio are of the highest quality in the industry, which means they are in better shape to handle sustained low oil prices than their peers.

U.S. Dollar:  The flight-to-safety we spoke of would benefit U.S Treasury bonds and should also push the U.S. dollar higher.  The Greece concerns may not be a long-term occurrence, but will continue to produce near-term headwinds to most big multinational companies’ earnings and dividend growth.

Our analysis of the headwinds that have held back the performances of many great dividend stocks in the first six months of the year suggests that the second half will be modestly better than the first. However, we don’t see big moves in interest rates, oil prices, or the value of the dollar.

Companies that can produce double digit earnings and dividend growth in this environment will be highly prized.  We will continue to favor higher dividend growth versus higher dividend yield in the coming months.  We particularly like companies that derive more than 60% of their earnings in the United States. These kinds of companies are not as sensitive to the movements of the dollar as are the multinational stocks.  In addition, their higher growth can trump changes in interest rates.

In addition, most of them are benefactors of lower oil prices.  As long as these companies can produce above average earnings and dividend growth, we believe investors will continue to push their stock prices higher. We'll talk about some of our favorites in future blogs.

Finally, a near-term modest fall in interest rates would seem to be a negative for the financials.  In addition, they have all experienced strong price growth year to date.  With the trouble in Greece filling the headlines, we would not be surprised to see the financials tread water for a few weeks to months.

The Greek tragedy seems to be a never ending story that will lead surely to a catastrophic ending, but investors have had five years to get out of the way of a doomsday scenario for Greece.  We doubt the effects will be long lasting.

The Great P/E Debate: Are Stocks Overvalued?

Janet Yellen made headlines last week with her comment that stock market valuations “generally are quite high.”  The market took note, driving down prices.

Is she right?  Are stocks overvalued?

It certainly feels that way to most investors.  Stocks are trading at all time highs and are in the midst of a bull market that has seen the S&P 500 move up more than 200% since mid-2009 lows.

However, investing based upon feelings isn’t usually a very good idea.  That’s why we rely so much on statistical models to help us be objective about where market valuations stand at any given point in time.  Let’s see what we can uncover.

The Average P/E Says… Stocks Overvalued

It is most likely that Yellen was referring to the price-to-earnings (P/E) ratio in her speech.  Stock market pessimists have been promoting doom-and-gloom for years now.  The #1 argument they make is that the P/E ratio is higher than its long-term average.

Below is a chart showing the S&P 500’s P/E ratio going back to 1962, as represented by the red line.  The blue line is the S&P 500’s long-term average P/E of 15.  

The current P/E of 18.5 is higher than the long-term average. Taken at face value, this would indicate that stocks are frothy.  However, this argument has several critical flaws.

1. Stocks seldom trade at average P/Es.
  
Since 1962, the S&P 500 spent virtually no time at its long-term average of 15. In many years, it traded at a P/E far from its long-term average.

2. A “fair” P/E ratio is impossible to determine in isolation.
What is a “fair” P/E ratio?  Is 15 fair?  If so, what makes it fair?  The point is that P/E ratios mean little in isolation. There are other factors that we must consider to get the entire picture.
   

The Missing Link: Inflation

What is the most important factor in determining fair P/E ratios?  We have looked at correlations between P/E ratios and all kinds of variables.  We do not find strong relationships between any of the widely followed indicators such as interest rates, GDP growth or earnings growth.  We have found that inflation is the best predictor of P/E ratios at any given point in time.

To make this more intuitive, we’ve converted the P/E ratio into E/P, which is known as the “earnings yield”.  In other words, if the S&P 500 paid out 100% of its earnings as a dividend, what would the yield be?

The chart below compares the S&P 500 earnings yield and the personal consumption deflator, which is what the Fed uses as its inflation measure.

As you can see, there is a clear visual relationship between the two.  To measure the relationship mathematically, we created the scattergram shown below.  On the left axis is earnings yield and the bottom axis is inflation. Drawn through the middle is a linear regression line.

The correlation between inflation and earnings yield is not perfect, but it is there.  Using this regression, we arrive at the formula shown in the bottom right corner.  That formula is:

y = 0.9048x + 0.0366

In the above formula, “y” represents the estimated earnings yield and “x” represents the current inflation level.  If we plug in today’s level of inflation, the formula will predict where today’s earnings yield should be based on the historical relationship between inflation and earnings yield over the past 212 quarters.

In the chart below, we’ve applied this formula to each quarter going back to 1962.  The blue line represents the “predicted” earnings yield and the red line represents what the actual earnings yield was.

Most people aren’t used to looking at charts of earnings yield, so we converted the earnings yield (E/P) back into P/E.  That chart is shown below.

The chart above clearly has more predictive power than the “average” P/E.  If you were simply following this chart, you would have predicted that stocks were about fairly valued in most periods except the following:

• Overvalued from 1968 to 1973
• Undervalued in 1985
• Overvalued in 1987 (right before the market crashed by 25%)
• Significantly overvalued from 1992 through 1994
• Significantly overvalued from 1998 through 2001
• Undervalued from 2009 through today

What does this mean for today’s market?

This model tells us a few things:

1. Stocks are not overvalued.

Far from it.  According to this model, the appropriate earnings yield is roughly 4.7%, which translates to a P/E just over 21. If the personal consumption deflator were to hold around 1.1%, the market would likely continue P/E expansion.

2. The stock market can handle some inflation.

The Fed has stated that their target inflation level is 2% vs. today’s 1.1%.  If inflation does rise to 2%, our formula estimates that the fair P/E would be about 18.5, which is exactly where we are now.  The stock market appears to be pricing in the expectation that inflation will rise.

3. The Fed isn’t going to wreck the stock market.

Investors across the globe are concerned that stocks will be hurt when the Fed starts to raise rates.  According to our research, however, this just isn’t the case.  Inflation is twice as correlated with P/Es as interest rates.  In our judgement, a gradually rising Fed funds rate won’t bring down the market. As long as the Fed does not aggressively raise rates, signalling that they see a significant risk to higher inflation, stocks can handle a period of rising interest rates.

The Great P/E debate will surely rage on for decades to come, but we believe many investors - including our own Fed chairwoman - have completely missed the point.  Average P/Es have no predictive ability for future P/Es without taking inflation into consideration.   

Unless inflation rises above 2%, the S&P 500 will be driven primarily by the future growth of earnings and dividends.  In this regard, there is plenty of good news.  Wall Street analysts are currently projecting double-digit growth in both earnings and dividends over the next 12 months. 

If Fed chair Janet Yellen jawbones inflation worries higher, that could derail stocks.  If she focuses her attention on containing inflation rather than forecasting stock market valuations, we would all be better served.

What About Bonds?, Part II: Inflation and Interest Rates

This is the second installment in a series of blogs aimed at providing answers to our most frequently asked questions regarding bonds, interest rates, and inflation.  The format is Q&A. Nathan Winklepleck, co-editor of the Blog, is moderating the discussion by sharing these inquiries with Joe Zabratanski, Senior Fixed Income Manager, and Greg Donaldson, Chief Investment Officer.  

Nathan: There is a lot of jargon in the fixed income world. I think it would be beneficial to our readers if we began by defining "inflation" and "interest rates" and explaining what each one means in this context.

Joe: Great idea.  I’ve found over the years that the term “interest rate” can mean many different things to many different people, so before we get started, let’s make sure everyone is on the same page. An “interest rate” is simply the rate charged by a lender to a borrower for the use of money or an asset. The term applies to many investments including the interest rate on U.S. savings bonds, bank certificates of deposit, savings accounts, home mortgages, and car loans.  From an investor standpoint, interest rates are the rate of return we are paid in exchange for lending money to a business or government. The interest rate in this context can vary significantly depending on the maturity date (length of time until we get our money back) and the risk of default (the possibility that the borrower will be unable to repay our money). Today’s discussion will focus on  interest rates as they relate to U.S. Treasury bonds.

We can define “inflation” as the rising price level for goods and services. If the groceries in your shopping cart cost $100 in Year #1 and inflation for that year is 2%, those same items will cost $102 the next year. Over time, your original $100 will purchase fewer and fewer groceries. You can think of inflation as the general decline in the real purchasing power of money.

Nathan: In the last installment we discussed the inverse relationship between bond prices and interest rates. You described it as a teeter-totter effect: as interest rates fluctuate up and down, bond prices move in the opposite direction.  What is the relationship between interest rates and the level of inflation?

Fixed Income, Part I: Relationship Between Interest Rates & Bond Prices

With interest rates at historic lows, and the Fed saying they will keep short rates low for an “extended time,” there is much confusion among financial pundits as to where interest rates and bond prices are headed in the coming years. With so much disagreement among the experts, many of our clients have asked that we provide an in-depth discussion of our views on inflation and interest rates, and the path these rates may follow in the coming years.

Although we regularly answer these questions in our client meetings, using our blog allows us to quickly explain our current views and strategies to a larger audience.

This particular series of blogs focuses primarily on the bond market; beginning with the basics before tackling the more complicated issues.

The format is Q&A. The first installment is a brief analysis of the fundamentals of bond investing, which we hope will build a solid foundation of understanding as we move forward. Nathan Winklepleck, co-editor of the blog, has assembled a list of our most frequently asked questions. He will serve as the moderator for the Q and A and will ask Joe Zabratanski our Senior Fixed Income Manager and Greg Donaldson our Chief Investment Officer to provide answers and commentary.

Q: Nathan: We have received several questions from clients about the impact of changing rates on bond prices.  Could you explain the relationship between interest rate fluctuations and fixed income prices?  How and why does one influence the other? 

Economic Indicators Point to Slow, Steady Growth in Economy & Stocks

We have several economic metrics that we follow very closely at DCM.  These indicators give us a peek into the health of the economy and indicate where we may be headed.  We want to share three of those indicators with you and provide an overall outlook on current U.S. economic conditions and what they might mean for the stock market for the remainder of 2014.

1. After-tax Profits

  
The price of the S&P 500 index (blue line/right axis) plotted against after tax profits for the entire U.S. market (red line/left axis), which is measured in trillions of dollars.

Of all the indicators we watch, this one might be the most compelling argument for the strength of U.S. corporations.  After-tax profits reached a high around $1.4 trillion in late 2006 before their sharp decline during the Great Recession of 2008-09.  Today’s levels are well above where they were pre-2008 and show no signs of slowing down.  Companies are operating with incredible efficiency.  Many of the companies we follow can produce as much or more than they did prior to the Great Recession with significantly fewer employees. While this hasn’t been good news for employment (more on that in a minute), it is very positive for corporate earnings.

ABCs of Dividend Investing: How to Navigate the Current Sell-off

Since the beginning of the year, stocks have fallen by about 5%.  The modest pullback has many investors wondering whether a full out “correction” (drop in prices by 10% or more) is on its way.  

When the inevitable fluctuations in stock prices come, investors are all left with the same question: What should I do with my portfolio?

At Donaldson Capital Management, we have a particular strategy for handling market upswings and downswings.

What Is An ABC Portfolio?

As many of you are familiar, we invest only in dividend-paying stocks but we break down our portfolios into three types of dividend-paying stocks.  For those of you who are not familiar, we structure our portfolio into A, B and C stocks.  

Below is a summary of each sub-portfolio and it’s specific characteristics.  You can read about each sub-portfolio in more detail here.

Our primary investment model (“Rising Dividend-Cornerstone”) is comprised of all three types of dividend stocks.  

Regardless of what type of market we are in, a portfolio of A, B and C dividend stocks will have at least one group that performs better-than-expected.  This type of portfolio significantly outperforms

Dividends: A Guiding Compass in Choppy Stock Market Waters

At the close of the market on January 27th, the S&P 500 was down 3.1% from its record high on January 15th.  This modest pullback has caused nervousness amongst many investors.

Is this pullback something long-term investors should be concerned about?  We don't think so.  Here's why:

1. Stock Market Volatility is Normal

The market's unbroken march upward in 2013 caused many investors to forget what market turbulence looks like.

With so many forces at work in the stock market, it is difficult for one particular trend to last for a sustained period of time.  The market is positive 7 out of 10 years, but the standard deviation of 20% around the long-term average of 10% would make anything between 0% and 30% normal.  Rarely does the market advance higher without

Dow Jones 18,000: Here's How We Get There

2013 was a banner year for the stock market.  On December 31st, the Dow Jones closed at an all-time high for the 56th time of the year, ending with a total return of over 27%.  

While stocks had their best year since 1997, the economic news did not seem to support such a dramatic increase in stock prices. 

• At the beginning of 2013, Wall Street estimated 8% earnings and dividend growth for the year. Dividends met expectations, but earnings growth was a disappointing 4.5%.

• Sub 2% GDP growth continued for most of the year, and while the unemployment rate fell, much of the improvement was a result of frustrated workers giving up their job searches and thus no longer being counted in the official unemployment rate. 

• Sequestration hit in 2013, reducing Government spending and dragging down already slow U.S. GDP growth by about 0.5% for the year.

• Interest rates, which are typically inversely correlated with stock prices, increased significantly.  The yield on 10-year U.S. Treasury bonds began the year trading below 1.85%. After the Fed began talking about tapering Quantitative Easing (QE), the 10-year started its upward climb to end 2013 just above 3.0%.

• The Government shutdown in mid-October threatened to derail economic recovery and highlighted growing dysfunction in Washington. 

Why Was the Market Up 25%+?

With so much lukewarm economic data, how could the markets have gone up over 25% in 2013?

So Goes the Dividend, So Goes the Stock

The Government shutdown and looming default deadline are consuming the majority of headlines.  Our stance remains unchanged: we believe U.S. politicians will eventually reach a deal.  For more details, you can read last week’s article here.

Rather than join the ongoing government shutdown discussion, we want to take a step out of the short-term gloom-and-doom to look at what impacts long-term stock market growth or decline: earnings and dividends.

Our statistical models show dividends to be a highly significant predictor of long-term stock prices.  The chart below shows the basic correlation between nominal dividends paid and the S&P 500 index price over the past 20 years.

Barnyard Forecast is Bull-ish on Stocks

The Barnyard Forecast is a basic model we use to determine whether the current monetary policy environment is accommodative, neutral or restrictive towards stock market growth.  Since 1990, the Barnyard model has correctly predicted the general direction of the market over the next 6 to 18 months approximately 80% of the time.  Our last published Barnyard analysis appeared in 2012.

The Forecast gets its name from the acronym of its components: economy, inflation, earnings, and interest rates = opportunity for stock market appreciation (E+I+E+I=O).  Each factor is rated as positive (2 points), neutral (1 point), or negative (0 points) for stocks based upon historical relationships between that component's economic data and its likely effect on the Federal Reserve's monetary policy.  The total points are added up to arrive at a score between 0 and 8.  A score above 4 indicates a positive environment for stocks.  

Uncorrelated Correlations: Market Correlation Changes Create Opportunities

Falling Correlations in the Stock Market

In 2008-09, the sell-off in stocks was deep.  Nearly every company in every industry was hit hard – regardless of credit quality or fundamentals.  Coming out of 2009, stocks continued to trade very much in lockstep with one another.  Companies with very different fundamental values were trading up or down by very similar amounts.  In other words – the market was not rewarding strong companies more than weaker ones. 

Over the past 5 years, that trend has steadily been reversing.  The CBOE Implied Correlation Index measures the average correlation of stocks that comprise the S&P 500 against the S&P 500 Index itself.  The Implied Correlation Index has been on a year-over-year decline since 2008-09.  The trend has continued this year, as correlations have trended downward from year-end 2012 highs above 70 to current levels in the low 50’s (see chart below).

S&P 500 Implied Correlation Index Historical Data (CBOE.com)

Stocks are no longer moving together quite as tightly as they have over the last 5 years.

Nowhere Else to Go: Rising Rates Won't Be Enough to Curb Stocks

Fed Taper Talks Drive Rates Higher

Since Fed taper talks began in early May, 10-year U.S. Treasury yields have risen from a 1.6% to 2.9%, an increase of nearly 100%.  At their current pace, rates will be near 4% by year-end.  Worries that the Federal Reserve might taper their Quantitative Easing program have speculating futures traders betting on higher rates in the near-term.  We don’t believe it.

The question is not as much where rates are headed, but how quickly they will get there.  We agree that
rates will eventually normalize.  However, we do not believe rates will continue to rise towards 4% in the same linear path they have held over the past few months.  Even the most aggressive analyst’s interest rate projections don’t have interest rates reaching 4% until 2015.  In the short term, we believe the 10-year U.S. Treasury yield will likely stabilize within a trading range of around 2.5% to 3.0%.

Bond-Like Stocks Are Still Winning

We regularly slice and dice the S&P 500 to determine what general categories of stocks are doing well.  Periodically, we do what we call a strategy check.  Simply put a strategy check is an analysis of the three or four investment criteria that we believe are at the core of our Rising Dividend investment strategy.  The following is a brief discussion of the criteria we follow most closely and how companies with those characteristics have fared over the past twelve months.

Quality:  As we have detailed many times in these blogs, our investment selection process begins with the quality door.  Except on rare occasions, we invest only in companies whose bonds achieve at least an investment grade rating by one of the major rating agencies.  The reason for this is obvious:  sooner or later, tough times come, and when they do winnings stocks are almost always found among companies with good credit histories and ratings.

The following are the 12-month median total returns of the S&P 500 companies broken down by ratings.                  

Rating	Median Total Return
AA-AAA	12.8%
A	4.8%
BBB	4.0%
B-BB	-10.5%
NR	-1.8%
Standard and Poors 500 Index	3.72%

The last twelve months have been a roller coaster ride for stocks of monumental proportions.  In this kind of environment, it is not surprising that the higher quality stocks have performed well versus lower rated stocks.  It is a bit surprising that the total returns by bond rating are so symmetrical.  As we have noted before, the stocks in our Cornerstone investment strategy have an average bond rating of A+.  

Dividend Yield:  After a stock makes it through the quality door, the first thing we look at is its dividend yield.  Dividends are cash money.  Dividend payments place a premium on a management team that focuses on the proper balance between the cash flows necessary to pay the dividends and the capital expenditures necessary to keep the cash flows growing.  In short, dividends require a disciplined management team.  We think this means that most companies who pay a regular dividend are less likely to be taking wild-eyed fliers with our money. 

Dividend Yield Quintiles	Median Total Returns
Top 100 Dividend Yielders	8.2%
2nd 100 Stocks	4.7%
3rd 100 Stocks	2.4%
4th 100 Stocks	3.8%
5th 100 Stocks	-1.6%

It is not surprising that the median returns of high yielding stocks are showing good results.   Bond yields are historically low, and people have been moving to higher yielding stocks in a steady stream.  What is surprising to us, again, is that the results are nearly symmetrical.  We believe this might be a cautionary signal.  Many high yielding stocks we see on the list of top performers have very little dividend growth and are presently borrowing money to pay the dividend.  That is not a good sign and could signal some dividend disappointments in the year ahead.  That is the reason we focus so intently on dividend growth. It is the best way we know that a company can offer tangible signals about it future prospects. Talk is cheap, but dividend hikes mean a company's money is where its mouth is.

Dividend Growth:  We learned a long time ago that dividend yield alone is not enough; dividend growth also plays an important role in the long-term performance of a stock.  The following tables show the median total return over the past 12 months of stocks in the S&P 500 sorted by dividend growth quintiles. 

Dividend Growth Quintiles	Median Total Returns
Top 100 Dividend Growers Last 12 Months	4.8%
2nd 100	5.9%
3rd 100	7.6%
4th 100	2.5%
5th 100	-8.1%

The table shows that investors have not rewarded the top dividend growth companies that are located in quintiles 1 and 2.  Investors have been buyers of the lower dividend growers in quintile 3.  A closer look at that group is very revealing.  The average dividend yield for the stocks in quintile 3 is 3.4% and the average annual dividend growth is 5.9%.  This compares to the S&P 500 where the dividend yield is approximately 2%, with dividend growth last year of near 10%.  

It is important to note, that while quintile 3’s slower dividend growth was the top performer, quintiles 1 and 2 also outperformed the S&P 500 total return of 3.7%.  That is also the the case in our Cornerstone investment strategy.  The 30 stocks in that portfolio have a current yield of 3.5% and dividends grew last year at just under near 10%.        

Our bottom line summation of what this strategy check is telling us is that, indeed, in this low interest-rate, slow growth environment our concept of “bond-like” stocks is still a winning strategy.  The markets are rewarding higher quality over lower quality.  Investors are buying dividend yields that are higher than bond yields and are favoring current yield over dividend growth, although companies with high dividend growth are outperforming the average stock.  We have spoken about these bond-like stocks in several previous blogs.  Please access these links,1. Bond-Like Stock Audio, 2. Bond-Like Stocks, to see and hear a more expansive discussion of why we believe this concept is working and will continue to work.

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

The Dollar's Slide: Terminal or Temporary?

We’ve had a number of clients write or call us lately concerned about the continuing weakness of the U.S. dollar. (It’s down about 10% since December against a basket of currencies.)  Here’s a representative example of their concerns:

“I feel the weak dollar (and growing weaker) is causing us problems and will cause greater problems if the world loses confidence in the US dollar as the world's monetary standard.  Oil is priced in $'s and the dollar's weakened position is costing US and world consumers.  When will the world say enough is enough and then what happens to the US economy?”

There is and old saying among economists that goes: “The solution to high prices is high prices.”  By this they mean that because of the law of supply and demand, higher prices tend to lead to lower demand.  Eventually, this lower demand will cause the sellers of the products to cut prices in order to regain the lost demand.  In this way, higher prices are self-correcting.

The dynamics of currency exchange rates are similar.  To a great extent, the problems tend to correct themselves over time.  As a quick primer, there are five major dynamics that have the most influence over the value of a country’s currency:

Interest Rates:  Holding everything else constant, higher interest rates for a given country relative to its trading partners would cause its currency to strengthen because the high rates would attract buyers.

Inflation:  Higher inflation in a country relative to its trading partners normally weakens its currency.

Balance of Trade: Shifts in a country’s balance of trade exert pressure on its currency.  Growing exports relative to imports strengthen its currency; weakening exports do just the opposite.

Budget Deficits:  Higher budget deficits as a percent of GDP weaken a country’s currency, while lower budget deficits strengthen its currency.

GDP: So long as a country’s inflation rate is muted, the higher the country’s GDP, the stronger will be its currency.

As with most aspects of investing, the expectations of how each of the above factors will behave in the future have as much impact on the value of the currency as their current levels.

This analysis, unfortunately, may produce as many questions as it answers, but such is the nature of discussing currencies.  Someone once said, “When it comes to currencies, everything affects everything.” Having said this, currency fluctuations are a daily concern for us because we own so many foreign based stocks.  Thus, based on our current holdings, we are keeping an eye on the Canadian dollar, the British pound, the Chinese yuan, the Swiss Franc, the Danish krone, and the euro.

Using the above five factors, let us offer a brief analysis of the most likely trend of the U.S. dollar over the next few years. 

• Short-term interest rates in the U.S. are among the lowest in the world.   However, when the current round of quantitative easing (QE2) ends in June, those rates should rise, at least a little.  Further, the Fed is expected to begin raising the Federal Funds Rate (FFR) – now at 0.0% - 0.25% by year end.  So, both ending QE2 and raising the FFR should lift the US$.
•  Core inflation in the U.S. is hovering around 1%, very low compared to our trading partners.  Thus, this is favorable for the dollar.  However, if inflation gets too high, the Fed will raise interest rates to fight it.  (Higher interest rates = stronger currency, part of that self-limiting mentioned above.)
• A cheap dollar makes U.S.-manufactured goods more competitive overseas, helping to boost U.S. exports.  Higher exports improve our balance of trade and GDP and should give a lift to the dollar.  This is a prime example of the self-correcting qualities of a weak dollar.  Ironically, however, a weak dollar means that the cost of imports rise, especially oil.  This puts upward pressure on inflation.  Are you getting the picture of the concept of “everything affects everything?"
• Budget deficits and high U.S. debt relative to GDP are the big killers right now for the value of the dollar.  Standard and Poors’ (S&P), in its recent change of outlook for US debt from stable to negative, said one of the reasons for the action was their belief that prospects for meaningful deficit reduction in the current political climate were low.  As you remember, the Dow Jones fell over 200 points for the day on that news, and S&P’s action jumped from the financial pages to the dinner table.  In doing so, S&P may have done us all a favor by turning up the heat on Washington to make progress on budget cutting.  S&P’s message was clear: clean up your financial house or face a downgrade of your bonds.  Downgrade or no, deficits will continue to play a role in the direction of the dollar.
• The United States GDP is the largest in the world, so that helps.   But it is not growing as fast as GDP in the developing countries of China, India, Brazil and other Asian countries.  Indeed, U.S. GDP is growing more slowly than the global average right now, which has somewhat of a weakening influence on the dollar. 

So there you have it. Combining all these factors and comparing them with similar data from our major trading partner nations is producing a negative demand for the US dollar against most other major currencies.

We believe the two primary drivers of the weak dollar are the negative attitudes by some about QE2 and the size and growth rate of the US budget deficit.  As you know, we have been in favor of QE2 because we believe it has provided needed stimulus for the economy and consumer confidence.  We also believe the Federal Reserve has the will and the power to terminate it without disrupting the markets.  Our view has been validated by the rising stock prices over the last six months; unfortunately our optimism has not been shared by the currency traders.  With QE2 coming to an end, it would seem some pressure on the dollar should abate.  

The problem with the budget deficit is too big to solve in the near term.  Indeed, it is exacerbated by the political divide in Washington.  Yet, the problem is too big to ignore any longer.

As we have evaluated the issues surrounding the weakness in the U.S. dollar, in many cases, we believe they are self-limiting or self-correcting.  However, as we said earlier, the biggest problem facing the dollar is the lack of confidence in Washington’s willingness to make the tough decisions to limit the growth of the U.S. debt.  In light of this, pressure on the dollar may continue.

This discussion of the dollar is not simply an answer to a client question.  We deal with currency decisions everyday.  Four years ago we concluded that the dollar was likely to trend lower.  That was even before, the huge increase in government debt.  We redirected our portfolios to benefit from a falling dollar.  At present, more than 60% of the revenues of the companies we own comes from outside the US. Not only are our companies more competitive as a result of the lower dollar, but when their foreign profits are converted back into dollars, they are higher than if they had been produced in the U.S.  Additionally, nearly 20% of our portfolio companies are domiciled outside the US.  With these companies we are benefiting not only from their growing earnings and dividends, but also from the currency translations.  As an example, one of our biggest holdings is Nestle (NSRGY).  A few years ago Nestle’s stock price in Switzerland ended the year flat.  Taking into consideration the currency translations from the falling dollar versus the Swiss franc, NSRGY made a total return of nearly 11%.

Next time we’ll take a swing at the U.S. dollar’s declining importance as the reserve currency of choice.

Written by:  Randy Alsman and Greg Donaldson

Principals and Clients of Donaldson Capital Management own Nestle.

Donaldson Barnyard Forecast is Positive for Stocks

Randy Alsman, VP and Senior Portfolio Manager, describes the most recent reading from our proprietary Barnyard forecast and explains how we arrive at the scoring.



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Rising Dividend Investing
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Southern Company Looks Undervalued

We believe many high quality, dividend-paying companies are very attractive compared to US Treasury bonds.  We have previously described the concept we call "bond-like" stocks.  Bond-like stocks to us mean companies that

1. Have strong balance sheets 
2. Have a history of paying dividends
3. Display a history of raising its dividends,and
4. Possess dividend yields that are close to the yield on a 10-year US Treasury bond.  

 We have previously written about two such companies, Procter and Gamble (PG) and Royal Bank of Canada (RY).  The third stock in this series to meet the bond-like stock criteria is Southern Company(SO).  SO is one of the nation's largest electric utilities, and we believe it has a lot going for it that is being ignored by investors.

Our Dividend Valuation Model above (click to enlarge), which is based on the relationship between SO's price versus its dividend growth and the level of interest rates on long US Treasuries, suggests that the stock may be undervalued.  Indeed, the model is projecting that the total return of SO over the next 12 months may approach 17%.  As we always say, our model is based on historical relationships and thus is certainly not a guarantee of the future, but we are inclined to believe that SO is positioned to do well over the next year.  Here's why:

1. SO's bonds are A rated by both rating agencies, among the highest rated utilities in the US.  
2. It is the second largest utility in the US and the largest in the Sunbelt, where the population is still growing.
3. SO has a near monopoly in its service areas and produces power through a diverse array of power sources from coal to nuclear power.
4. SO has generated a 14% annualized return over the last 10 years, far outpacing the S+P.
5. The company has paid a dividend since 1948, and its current dividend yield is just under 5%.
6. SO has raised its dividend for 9 consecutive years at an annual rate just over 4%.

Our conclusion:

SO sells a product necessary for our daily lives and is as well run as any utility in the US.  It has a current dividend yield of nearly double that of the 10-year Treasury bond.  SO's implied return of 9% (5% dividend yield plus 4% dividend growth) compares favorably to the 10-year Treasury yield of 2.75%.

We believe the recent aversion to risk that has gripped the markets can not last forever. As investors realize that they cannot live very well on CDs paying .3%, they will begin looking for quality alternatives, and the first place they will look will be the electric and natural gas utilities.  When they start looking at the utilities, it will be hard to beat what they find in Southern Company.

Clients and principals of Donaldson Capital own SO.  Please see Term and Conditions of this blogsite on the right sidebar.