Caution: We Are Entering A "Prove It" Market

 

• In my recently released book, The HIdden Power of Rising Dividends,(available at Amazon) I make the case that dividend growth is highly correlated with price growth for many stocks and indices.

• In the book, I suggest that dividend growth alone is highly correlated with price growth for 25-35% of S&P 500 stocks. For an additional 50% of stocks, dividend growth is the most important indicator of value, but the correlation scores rise when we add some portion of sales and earnings growth, along with changes in interest rates.

• The consensus view of many stock market prognosticators today is that stocks, now trading at 27 time operating earnings, are extremely overpriced and are due for a big correction.

• My S&P 500 valuation model is telling a much more balanced story:

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• The above chart is what I call a Value Bar chart. The green bars show my model's annual predicted price of the S&P 500 going back to 2005. A quick look at the bar farthest to the right on the chart shows the model's current predicted price of the S&P 500. That figure is approximately 5,400. With the current price of the S&P 500 at around 6,000, the model is saying stocks are overvalued by about 10%. That, however, is before we factor in 2024 year end earnings and 2025 forward earnings.

•  Before we take a deeper look at the current predicted price, let's look back over the years to see how the model has fared.

• Simply speaking, if the red line (actual price) is above its corresponding Value Bar, we would say stocks are overvalued. If the the red line is lower that the Value Bar for the same year, we would say stocks are undervalued. For the last 20 years, the red line has stayed very close to the top of the Value Bars. A significant divergence is evident in only 2007, 2008,and 2022. In almost all other years, the Value Bars and actual prices of the S&P 500 are very close.

• Stocks continued to climb heading into the beginning of the Great Recession in 2007. At some point during the year, the model would have issued an overvalued signal. The model clearly signaled the market was overvalued in 2008.

• After the bear market of 2008 and 2009, the Value Bars stayed in fairly-valued or undervalued territory until the end of 2021, when they gave an overvalued reading. That signal correctly foresaw the selloff in 2022.

• That brings us to the current modest overvaluation. Plugging in Wall Street's current estimates of sales, earnings, dividends, and interest rates give us a figure of 6,500. 

• We are now entering what I call a "Prove It" market. This means, tech stocks, where the majority of the growth is coming from, must "Prove It" that they can continue with mid 20% sales and earnings growth. If they do, we should have another pretty good year. If not . . . .
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If any of you would like to discuss this article privately, please email me at info@gregdonaldson.com.

Don't Fret, It's Picks and Shovels Time in the AI Gold Rush

• Fears of a sharp economic slowdown, and worldwide heavy selling of stocks have hit U.S. stocks in recent weeks.

• Recent economic releases have shown that unemployment is rising, home sales are slowing, manufacturing production is softening, and wage gains are flattening out. These weaker economic data points have caused fears of a recession and a move out of stocks and into bonds. 

• This flight to safety has seen 10-year U.S. Treasuries to fall from near 4.75% a few months ago to 3.75% on Tuesday. The slowing economy fears have caused the S&P 500 to fall by nearly 10%. 

• The sell off in stocks and specifically in the tech stocks is hard to reconcile in the face of the solid second quarter earnings growth reports across almost all industry sectors, from AI leaders to banks and industrial companies.

• Does this big sell off mean the AI gold rush is already over? Moreover, does it mean the bull market in non-tech stocks, which was signaled in recent weeks, is also only a head fake?  

It is important to remember that gold rushes are driven by forces other than “there’s gold in them thar hills.”  At times, reality sneaks in to play a role in the pricing. The reality in this case is investors have become worried that the tech stocks have come too far too fast, and they no longer offer value at their inflated prices. There is nothing new about that worry. It’s very realistic and has been around as long as the tech stocks have been. The techs are trading at about 30-35 times earnings and projected to have earnings growth of 15-25% over the next 3-5 years. In an earlier post, I stated that if the current earnings projections for the techs and the S&P 500 prove correct for year-end 2024 and 2025, the market will go higher. My valuation model still says 5800 is the best guess of the current fair value of the S&P 500.

It is necessary to square the recent week economic news and sharp sell offs in worldwide stocksand interest rates with corporate earnings that are being reported every day. All these data

are being collected in the same time frame, and history tells us that earnings and dividend growth

have more predictive power in the long run than do changes in GDP and interest rates.

In my judgment, the billions of dollars that corporate America is investing in AI have not had nearly

enough time to find gold. We are in the “picks and shovels,” or early stages of the gold rush where

the miners are assembling the people and tools, and identifying where to mine. In short, nowthe big winners are the chip companies that manufacture the AI chips. The products

and services that will be forthcoming in the years ahead are still concepts. Yet, when giant sums

of capital are being placed in the hands and minds of the smartest tech people in the world,

life-changing products and services are assured.    

I believe an AI gold rush is underway. AI gold will be found and lead to huge stock gains in many existing, as well as start-up companies. My calling it a gold rush is not a total disparagement. The operative questions are: How much gold is there to be found, and who will find it? Almost certainly, too much money will ultimately join the gold rush, but it is far too early to declare AI dead. That being the case, the huge selloff in tech stocks is way overdone and offers a buying opportunity in the coming weeks and months.

Warren Buffett selling a huge chunk of Apple is probably the best news I have seen to assure us that AI has real merit. I am a great fan of Mr. Buffett, but he is anything but a gold rush player. He is strictly a “picks and shovels” guy. He did not sell out entirely. He just took some profits.   

In an earlier post, I said we are traversing a gold rush in AI, and almost all gold rushes end poorly for the average investor. However, for the recent sell off in AI and the stock market to be anywhere near correct, AI would have to be a complete bust. My bottom line is all gold rushes  are driven by periods of reality and illusion. AI has been called the driver of a new industrial revolution. That is big talk, but to say that AI is a bust is just as big an exaggeration.

Stay tuned.

It's Official: The AI Goldrush Is Underway

 

1. Near the end of the dot-com bubble in 2000, my business partner and I stumbled onto the notion that the techs were acting much like a gold rush. Gold was being found in the dot-com world and creating riches, but its passion was producing ever more gold miners with golden dreams.

2. Our company had traversed the dot-com craze during the late 1990s, chasing the gold like everyone else. But in early 2000, our valuation models simply could not justify the tech prices . .  . not by a mile.

3. A simple truth spoke to us: Never in the history of the US stock markets had an industry grown fast enough, long enough, to justify the prices of most tech and big consumer stocks.

4. We decided to cut back on the hottest of the highflyers. It changed our company and our lives forever.

This seemingly bold move was not based on something we were convinced we knew, but just the opposite. It was because we knew we did not know how to value the techs, and that being the case, we decided to stand aside. Even then, there was nothing bold about our decision to start cutting back on techs. In fact, we visited every client we had and admitted to them we believed the techs had reached the gold-rush state, but they might just keep going higher like they had over the last decade. The only thing we could say for sure was that our valuation models showed that many slower-growing companies were great values. We advised them we recommended placing sell orders 15% below the current prices on the six most overvalued tech stocks. Should any of these sell orders be triggered, we would invest the proceeds in undervalued dividend-paying stocks with dominant positions in their industries. 

During the year 2000, all six of the stocks' sell orders were triggered, and we bought financials, consumer staples, and industrial companies whose prices had gone flat in recent years because their sales and earnings were growing in the high single digits, much less than the 25-50% annual earnings growth of the techs. Interestingly, these undervalued dividend-paying stocks actually rose in 2000 when the overall market fell by over 10% and the dot-com gold rush ended. 

Why am I sharing this old tale? Am I predicting the AI gold rush is near its end? Indeed, are there other stocks that offer much better value with good prospects for future growth? No I’m not. I am announcing; however, that the gold rush in AI is now a reality and there are two truisms about gold rushes of the past. 1) When everyone, everywhere knows that an industry or a particular stock is the center of the investing universe, there is a good chance that everyone owns the stocks and the new money needed to push the stock higher will soon be tapped out. 2) The analysis at the end of gold rushes has always revealed that the companies that sold the picks and shovels for the miners were the best place to put your money, not in the gold miners themselves.

As one who is old enough to remember the dot-com collapse, my reason for writing this blog is to just give everyone a heads up that in my judgment, the AI phenomenon has officially reached the gold rush state. I said last time, my valuation models are showing that an S&P 500 level of 5700 is reasonable. If the AI world can produce overall sales and earning growth for corporate America of 11-12% over the next five years, the market is fairly priced. If earnings growth is higher than that, stocks still have a good run ahead of them. However, if the earnings growth falls back to a 7% or 8% handle, stocks will fall. Additionally, I do not see a long list of undervalued non-AI companies. Thus, I conclude the gold rush has room to run. I’ll keep you posted on what my models are saying as we go.

If you would like to communicate with me directly, email me at info@gregdonaldson.com  

Dividends and Earnings Say, The S&P's Current Price is About Right

The question I have been asked most in recent months is, "Is the current bull market in tech stocks signaling another dot-com massacre, or is it justified in light of the promise of AI?" 

1. Most of my questioners lived through the dot-com bubble of the 1990s and its subsequent crash in early 2000. In the late 1990s, the notion that computer and internet stocks could only go higher took hold, which proved dead wrong and devastating to many investors when some tech stocks fell by 90%. 

2. Nvidia and its artificial intelligence computer chips are skyrocketing in much the same way that Cisco and Intel did in the late 1990s, before crashing back to earth in 2000.

3. The Fed gives the impression that their rate hikes are finished, but inflation is still running near 3.5% and shows little signs of slowing on a month over month basis. 

3. If the Fed does not have inflation under control, a spike in long-term interest rates could cause another sell off in tech stocks just as it did in 2022. 

    One of the most disappointing aspects of modern day investing is we seem to have all become momentum investors. Find a winning stock, jump on board, and hope to sell out before it turns lower. Ben Graham's famous quote about how stocks operate is in full bloom today. He said, "In the short run, the market is a voting machine, but in the long run it is a weighing machine." The point being, stock prices can be driven to ridiculous levels by short-term projections of how high is the sky, but ultimately, stock prices find their correct value. 

    Over the years, I have developed two stock market valuation tools. One looks back and is primarly earnings driven. The other looks forward and is dividend and interest rate driven. Dividends would seem to be a very pedestrian way to value a gold rush, but over the years, I have found the growth of S&P 500 dividends in combination with changes in long-term interest rates have been the best risk-adjusted predictor of S&P 500 prices. At present, my dividend discount model predicts that the fair value of the S&P 500 is approximately 5800. At 5300, that would mean stocks are modestly undervalued. However, one has to realize that the forward dividends and earnings estimates are heavily influenced by Wall Street's 3-5 year forward estimates for tech stocks. 

    My answer to the questions I have been receiving about the risks in the markets is a familiar one: "It depends." It depends on whether the AI and other high-flying tech stocks can deliver the dividends and earning growth Wall Street is now projecting. If the overall S&P 500 can deliver numbers reasonably close to the current estimates, the market is modestly undervalued and vice versa. I'll keep you posted in the weeks and months ahead how the estimates are holding up and measuring up, as well report on how interest rates are impacting my model.    

  

Paul Volcker Taught Us How to Tame Inflation

I started writing a monthly investment update for the investment firm I was with in 1975. I didn't know what I was doing at first, so the older people in the firm would feed me what to say, and I would write the update.  This was just a few years after the OPEC oil embargo and inflation had shot higher. As the months rolled on and inflation continued to rise, I found fewer and fewer of the old-timers were stepping up to tell me what to say, so I became a student of the Federal Reserve in order to have something halfway intelligent to say. That was no help for several years.  Inflation remained persistently high. At times, prices changed on grocery shelves and gas pumps while I was standing in front of them, ready to make a purchase.  Interest rates kept going higher and higher, and none of the Federal Reserve's rate hikes seemed to make any difference.  

An inflation mentality set in on Wall Street, Main Street, and Ivy Street. Inflation became a way of life. We had silly government programs such as Whip Inflation Now (WIN) and a lot of other kinds of cute sloganeering that was not rooted in any economic truth because very few people really understood inflation and how it worked. 

We all became followers of the money supply.  M1, M2, and M3 discussions went on at social gatherings like somebody somewhere knew what it all meant.  "Too many dollars chasing too few goods" became the wink and a nod answer to all things inflation.

There was one man who did understand what drove inflation and how to control it. His name was Paul Volcker. Volcker was promoted to chair of the Federal Reserve in 1979. He immediately began a series of rate hikes that would drive the Fed Funds rate up from around 11% in September 1979 to 20% in March 1981. The 6’7”, cigar-chopping man taught us all that in dealing with inflation, the right course of action was to use a leading interest rate strategy instead of a lagging strategy.  In effect, Volcker made it clear verbally and by his actions that wherever inflation went, he would push interest rates even higher. His leading strategy was truly remarkable, and it broke the back of the inflation panic that had been raging through the economy for years. Inflation peaked at 14.8% in March of 1980 and by 1983 had fallen below to near 3 %. 

Today, we face another inflation crisis and the same 'we got this thing under control' illusion that I watched play out for years in the late 1970s.  Modern Monetary Theorists, who spoke so boldly of 'we got this economic thing' and advocated dumping huge quantities of dollars onto anyone who could breathe, have become silent. They should have done so much sooner.

Inflation is as much of a psychological phenomenon as it is a monetary phenomenon. The present Fed has been saying 'we got this thing' for too long.  They are losing both the psychological battle as well as the monetary battle. They must come out of today's meeting with two huge changes in what they say and what they do.  First,  they must say "Paul Volcker taught how to tame inflation, and we are now following his playbook." Second, they must raise Fed Funds by at least 1% and promise even more 1% hikes in the future. Jerome Powell must ignore the politicians, jump straddle inflation, and fight it with tools history shows us have worked.  If he continues to bow down to the politicians and make small interest rate hikes, we may be fighting inflation four years from now.

I believe the stock market understands what needs to be done and will soon find a bottom if the Fed takes a tougher stance. If the Fed keeps nickleing and diming us along, stocks will likely keep falling because big investors know that the longer we allow the current lagging interest rate strategy to prevail, the worse will be the ultimate recession.

The illusion of 'we got this thing" should end today."         

Dividends Are Not Dead--They're Still Growing

• Since 1958, cumulative annual dividend cuts in S&P 500 companies have been rare with only 5 annual cuts over 1%.
• In the early days of the current coronavirus scare, investors were betting that dividends would be slashed across the board.
• Dividend cuts in March and early April have been remarkably tame and outdistanced by dividend hikes.
• Upcoming earnings season announcements may provide more clarity about companies' dividend payment intentions.

In order to see a broader picture of the dividend actions of the S&P 500, I tabulated all companies in the S&P 500 that either announced a dividend action or paid a dividend from March 1 through today.  The results are far different from what the headlines might suggest.

Dividend Actions by S&P 500 Companies In March-April 2020

Dividend Paid	Dividend Increased	Dividend Decreased
187	87	21

One hundred eight-seven companies paid a dividend in March or early April, and of those, 87 have hiked their dividends.  Only 21 companies have announced dividend cuts.  The dividend increases had a median growth rate of 7.85%, about the same percentage hikes as in 2019.  A Barron's article this weekend says S&P 500 futures are pricing in dividend cuts of approximately 30% for the next twelve months.  Barrons also mentions that many Wall Street analysts are reducing their dividend-cut predictions.  
        The dividend actions thus far suggest that the big worries that ripped through the markets about dividend cuts in the early days of the sell-off are diminishing.  Importantly, for the economy and the stock market, if corporations continue to pay and hike dividends like they have in the last month and a half, it would signal that many top managers are optimistic that the economy can recover faster than is now being touted by the financial media. 
        Wishful thinking is not always a good business or investment strategy, and the recent good trends could reverse, but if the dividend data continues to surprise to the upside, it might be the ray of sunshine we all need.

Blessing 
Greg Donaldson, Founder
Donaldson Capital Management

Dividend Watch: Recent Corporate Dividend Announcements

• Beyond the Great Depression, S&P 500 annual dividend cuts have been few and small, with the largest cut being 21% in 2009.
• Analysts are now predicting dividend cuts in the range of 33% for S&P 500 companies in 2020.
• Dividend cuts of that magnitude would signal that companies believe that the damaging effects of the coronavirus will continue to disrupt business well beyond 2020.

It is our hope and belief that dividend cuts will not reach the 33% level now predicted by many analysts.  Even though dividend payments are a voluntary corporate decision, in the United States dividend cuts have a more negative connotation than in any other country in the world.  There are many reasons for this, but the single biggest is that in the U.S. dividends are paid quarterly, while in many other countries they are paid semiannually or annually.  In addition, in many other countries dividend payments have tax consequences to the corporations.  Thus, in the UK for instance, dividend payments are pegged more closely to the annual performance of the company, while in the U.S. payments are seen more as a measure of the longer-term prospects of the company.  For these reasons and others, U.S. corporations that announce dividend cuts usually see a corresponding cut in their stock prices. 

I'll provide another Dividend Watch scoreboard of dividend actions since the beginning of March on Friday, but I wanted to share some recent dividend announcements by major corporations.  Fed Chair Powell made the biggest announcement this morning when he said that he believes major banks are in good shape to pay dividends.  Bank stocks exploded after the announcement.  Many analysts were predicting a 50% chance of bank stock dividend cuts.  Here are other recent dividend announcements.  We believe announcements like these are one reason that stock prices have rebounded this week.    

Major Banks

Fed's Powell sees banks in good shape to pay dividends

Starbucks

The company says it does not plan to cut its dividend but will temporarily suspend its share buyback program, while taking steps to delay expenditures and reduce costs.

AT&T

At&T reiterates confidence in its dividend despite economic uncertainty.

Exxon-Mobil
“Our capital allocation priorities also remain unchanged,” noted Woods. “Our objective is to continue investing in industry-advantaged projects to create value, preserve cash flow for the dividend and make appropriate and prudent use of our balance sheet.”

JP Morgan

Barring an Extremely Adverse Scenario, JP Morgan Hopes to Maintain Dividend

Walgreens

Walgreens Expects to Continue Dividend For Now

Genuine Parts

"Through these actions and our on-going working capital initiatives, the Company has the liquidity to operate through these uncertain times as well as continue to pay the dividend." – Chairman and CEO Paul Donahue

Chevron

Chevron says its focus is on protecting the dividend.

AT&T

AT&T reiterates confidence in its dividend despite economic uncertainty.

Greg Donaldson, Founder

Donaldson Capital Management

Volatility Will Continue, But Stocks Are Going Higher

After an historic January run, the S&P finished the first full week of February in what looks to be a consolidation phase.  As we thought might be the case, the S&P 500's 200-day moving average has proven to be a level of resistance for the market with a sharp pullback off the moving average in the middle of the week.  Still, an impressive intraday rally took hold on Friday to see the market close well off its morning lows.  Late Friday rallies have been a good sign during the last couple of years and continue to suggest that buyers abound at these levels.  So while stocks may face a battle as they try to work through the 200-day moving average, the outlook is constructive for the longer-term and there are decent levels of technical support close by.  This is born out by the surge in the percentage of stocks above their 50-day moving averages, which typically results in strong returns over the next 6 to 12 month time frame.  Importantly, strong  stock gains in January's tend to beget strong full-year performance. 

Economy and Bonds

From a macro standpoint, the economic data continue to be more mixed, but that is probably the best case scenario for stocks grinding higher.  US economic data softened significantly at the tail end of 2018, but a small rebound in the Mfg. PMI and last week’s stellar jobs report have tempered the recession talk.  Still, consumer confidence has taken a hit, and business investment is rolling over a bit.  With the recent mix of data and little inflation in sight, the Fed is probably on hold, and the cacophony of economic naysayers has been quieted.  On that note, credit spreads have stabilized and more of a risk-on attitude has been evident.  What is perhaps most striking in the recent upleg in stocks has been the behavior of US 10-year bond yields.  One might think that a more lax Fed would allow inflation and growth expectations to creep higher, taking interest rates with them; but global economic woes are keeping inflation expectations and bond yields in the US well anchored.  The US's expected GDP growth in the 2%-3% range for the year ahead looks downright rosy compared to much of the rest of the developed world.  We believe this realization has not been lost on foreign investors.

Trade

Trade remains an issue as gamesmanship has once again emerged between the US and China as tariff deadlines draw near.  Of great concern is the February 17^th deadline with the Eurozone that could lead to the imposition of tariffs on European autos.  These tariffs have the potential to wipe out a good deal of the incremental tax cuts in 2019.  This is an area to watch as well.   

Earnings

Here's a quick update on fourth quarter earnings: With 66% of companies reporting, earnings have surprised by an average of around 3%.  Revenue growth of 6.5% has contributed to earnings growth of 14% year over year.  Fourth quarter earnings continues to look better than expected; however, expectations for Q1 earnings growth have softened.  This is likely a symptom of the slower global growth.  Still, there are pockets of strength that are relatively immune to the global slowdown. In our next blog we will discuss a few of the superior operators.  

Finally, our overall valuation model says stocks are still in a sweet spot and should end the year higher than they closed on Friday.

Preston May, Certified Business Economist

Research Analyst

Donaldson Capital Management, LLC.

Editor Greg Donaldson

The Great P/E Debate: A Stopped Clock and Other Wild Eyed Guesses

We have shown in previous blogs that much of what academia and Wall Street tell us about how to calculate the most foolproof price-to-earnings ratio for the S&P 500 at any point in time is . . .well, foolish.

1. Professor Robert Shiller, the creator of the CAPE method of valuing stocks, which has many academic adherents, says that stocks are wildly overvalued.  The only problem is he has been saying that for nearly six years, and in interviews, he cautions that CAPE is not a good metric for timing.  But, professor, what good is a valuation metric if it is correct only once every decade, or so?  That sounds a bit like the accuracy of a dead clock: it's correct twice a day but fails at telling time during the other 23 hours 59 minutes and 58 seconds of the day.  CAPE currently suggests that the S&P 500 P/E is approximately 80% above it fair value.  

2. There is another crowd of soothsayers who hold to the idea that the long-term average P/E of the S&P 500 is the correct metric to determine its fair value.  These folks argue that a P/E of 16x is the right multiplier, and, that being the case, at 21.3x, stocks are currently about 33% overvalued.  History shows us that if you would have bought every year when the S&P 500 was below a 16x P/E and sold or shorted every year above that level you would have crashed and burned a long time ago.

3. Many on Wall Street believe that the best way to calculate the normal P/E for the S&P 500 is to subtract the rate of inflation from 20.  In our judgement, this crowd has had a better track record over the last 50 years than Dr. Shiller or the 16x crowd, but we have previously shown, there is a more statistically significant way to determine the right P/E at any point in time.  That methodology is what we call the earnings yield to inflation' ratio.  

Our work shows that since the 1960s, earnings yield (the inverse of P/E) minus core inflation has averaged 3.35% with a correlation coefficient of .70.  For our calculations, we use earnings before extraordinary additions or subtractions and the core personal consumption deflator inflation (PCD, the data most favored by the Fed.)  The current reading for these two data points are as follows.  PCD is 1.6% and the trailing 12 month earnings yield is 4.70%, or a P/E of 21.3.  

To determine where the model says the current earnings yield, (P/E) ought to be, we add the current PCD rate of 1.6% to the long-term constant of 3.35%, or 4.95%. Converting this back to P/E, we find the model predicts the correct P/E is now 20.2x.  With the S&P 500 now trading at 21.3 times earnings, that would suggest that stocks might be about five percent overvalued.  But there's more.  The stock market is a discounting mechanism.  That is, it is always looking ahead and pricing in where it believes current financial and economic data will be in the future.  Currently the consensus view of analysts and economists is that the PCD inflation rate will climb to 2% by year end and S&P 500 earnings will grow to approximately 160.  If these estimates come to pass, that would put the fair value of the S&P 500 at about 3200 by year end.  

With the S&P 500 currently sitting at 2727, that would mean it is about 17% undervalued.  That's my best guess and I'm sticking with it no matter how much volatility we see over the next few months. I'll update the model in the coming months. 

Earlier, I said the correlation coefficient on our P/E model is approximately .70.  Being less than 1.00 means that it has not perfectly predicted annual stock market moves (surprise, surprise).  I offer it here because the model is simple and has done a reasonably good job of predicting stock market action over the last few years.  We have another model that has more complexity and with an even higher correlation coefficient that also predicts stocks are undervalued by double digits.  I'll show it in a future blog.
  

Upcoming Dividend Hikes May Reveal What Corporate America Really Thinks

Europe’s economy is in a funk and may be heading for recession.  Terrorists in the Middle East have burst onto the scene straight out of some B movie horror show.  The Ebola crisis threatens to reap vengeance near and far.  In the midst of these threats and the unfathomable questions they pose, smart-guy politicians in the U.S. and Europe seem to have a strong resemblance to the Wizard of Oz after the curtain was pulled away.   

As an investor, where do we look for a glimpse of how these questions and issues will be resolved?  I have been in the investment business for nearly 40 years, and I have endured at least a dozen of these episodes when the vultures hanging in the sky were so numerous they left me stumbling around in the dark trying to find a light -- any light.  Indeed, the Rising Dividend Strategy that we use today was born during the crash of 1987, when the stock market fell by nearly 23% in a single day.  I went into that day believing that the daily stock price movements were the best indicator of where the stock was going in the near term.  I ended that day exhausted and humbled, but with a strange sense of hope.  Black Monday was such an egregious assault on my sense of how the markets worked that I realized such a selloff could not be driven by the fundamental soundness of the economy or of corporate America.  When all stocks go down, it is a signal that emotions have replaced reason in the driver’s seat because the prospects for all companies do not rise or fall in unison on a single day, week, or month.  

Our Investment Policy Committee has been studying and discussing the current sell off for several weeks.  What does it mean?  Is it for real?  How far will it go?  How will it end?  This past Monday we realized these were not questions that could be answered until after the selloff has ended.  We turned our attention to variables that our research has proved over the years to be the best predictors of stocks prices:  earnings, dividends, inflation, and interest rates.  We came away from that exercise very hopeful.  If the U.S. economy is headed for recession like Europe, corporate earnings should be soft.  The are not.  In fact, so far in this earnings reporting season they look better than last quarter. Inflation is anchored near 1.5%, and the ten-year Treasury bond yield has fallen to a multi-year low at near 2 percent.  Dividends are the real stars of the show.  They have already risen by over 10 percent for the year with nearly three months to go.  

None of these important variables of the U.S. economy and corporate America is signaling imminent bad news.  In fact, all of the data are headed in the right direction.  We concluded the current selloff must be looking over the hill at the aforementioned vultures and projecting that one or more of them will come home to roost, and the current good news will turn bad.    

After the crash of 1987, we gradually became dividend investors because we found that dividends were the best predictors of the true trend of stock market performance.  Dividends tell four powerful stories about the future trend of the stock market.:

1. Dividends are cash money.  They represent a real transfer of wealth from a corporation to the shareholder, unlike earnings which can be engineered and may be here today and gone tomorrow.

2. Dividends have represented over 40% of total stock returns over the last 80 years. Thus, not only are they real money, but they are also really important to total return for shareholders.

3. Dividend cuts by corporations in the U.S. are almost always punished by the market. Corporate executives know this. Because of this, S&P 500 dividends have fallen, on an annual basis, only about half as often as have earnings. In addition, the annual volatility of dividends is only about one-third that of earnings.    

4. The S&P 500’s long-term dividend growth of 5.5% is very close to long-term stock market price growth of 5.9%.  Dividend growth and stock market growth are not identical twins that move in lockstep, but they do shadow each other closely.    

In looking again at this list, we realized we had a tool that could give us a glimpse of what was going on in the economy over the hill beyond our sight.  That tool was the daily dividend announcements of corporate America.  In the long-run, the growth of stocks prices will look a lot like dividend growth.  Since corporate America is world renowned for its ability to rightsize costs with revenues, if top management sees trouble coming they will not only cut costs, but they will also cut back on dividend hikes.  We have many resources, including Bloomberg Professional Markets, that make dividend estimates.  By watching dividend actions versus Bloomberg’s estimates for all stocks, we should be able to see if companies are downshifting their internal growth estimates.

Why are dividend actions so important to our way of thinking?  American CEO’s live and die by their cash flow projections.  They do not want to spend an extra dollar on a project that is going nowhere or losing money.  Thus, they recommend dividend hikes to their boards of directors that reflect the company’s free cash flows that are not needed somewhere else. 


At present, Bloomberg and Wall Street analysts are predicting that dividends will grow at about 9 percent in 2015.  If that comes to pass, the recent selloff is a mistake and a great buying opportunity just like all the big sell offs in history have been.  If dividends remain flat or fall over the remainder of the year, then there may be more trouble coming than we are now projecting. Dividends only have to reach 5.5 percent growth to be in the normal range.  

So far in our study of dividend hikes the news is good.  Over the past month, dividends have grown 1.8 percent more on average than they were projected.  We will report our findings regarding dividend hikes on a regular basis throughout the end of the year.          

The ABCs of Dividend Investing: Divi-do or Divi-don't?

Low interest rates have propelled dividend income investing to greater popularity in recent years than at any time in the past six decades.

Despite dividend-investing's recent popularity, many investors still only look at one facet of the power of dividend investing: dividend yield.  These investors point to the fact that dividends have represented 40% of the total return of stocks since 1960 and that many dividend stocks yield more than short-term Treasury bonds.  But that is where they stop, and in doing so, they miss an important quality of dividend investing: dividends are more than income, much more. 

The most important element of dividend investing is the statistically significant long-term relationship between dividend growth and price growth.  Understanding this relationship is the key to unlocking the true power of dividend investing.

United Technologies: The Hidden Dividend Star

United Technology (UTX) is the Dividend Star most of the simple dividend-growth filters miss.  This is because they do not raise their dividend every year. UTX takes action on its dividend every six quarters, not every four quarters, as do many dividend stars.

I have even tried to explain to the company's investor relations department that while their every-six-quarters dividend hikes has been quite predictable, that such a policy means that about every three years their annual dividends flat line. Thus, the company is not included on many lists of companies with long-term histories of consecutive dividend hikes.  No matter says the company. They like to do it the their way.

In this case who am I to push against such a winning record, just to make it simple.  UTX has one of the most consistent dividend growth records of any company I follow.  The following are their 20, 5, and one year annual dividend growth rates.

1. 20-year growth rate  11.3%
2. 5-year growth rate    12.5%    
3. 1-year growth rate    12.9%

To top it off, the estimate of UTX's three to five year dividend growth rate is just under 12%.  At that rate of growth its dividend will triple over the next ten years.  Not bad for a company that has a current yield of 2.6%.

Despite UTX's consistent dividend hikes and earnings growth over the last twenty years, the Dividend Valuation chart at the top of this page suggests that the company is significantly undervalued based on the historical relationships among its price growth, dividend growth, and interest rates.  UTX's current price (red line) is much lower than its current valuation (blue bar) and even lower yet, than our estimate for next year (checkered blue bar).

The so-called Correlation Index, which measures how tightly the average stock is tracking the major indices, has risen to as high as 85% in recent weeks.  Its normal reading is near 15%.  This means that the constant on again off again European bail out proposals have turned what is normally a market of stocks into a stock market.  What I mean by this is that almost all stocks have been caught in the maelstrom of big up and down days, which would indicate that all companies have about the same future profit and dividend potentials.  If you take a few minutes to think about this, the truth almost smacks you in the face.  The one thing we know for sure is that the future prospects are not the same for all stocks, thus, it is just a matter of time before stocks start to trade on the bases of their own unique fundamentals, not the generalized fears of the European situation, no matter how things turn out.

In this regard, we believe UTX has quite a pedigree and will ultimately break away from the pack and show it star quality..   

I own UTX.

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

Have Multinational, Dividend-Paying Companies Become the World's Safest Investment?

Investment Policy Committee Notes

Summary Points:

•  Debt ceiling saga continues to keep markets in flux
•  Debt Rating agencies forewarn of credit downgrades for the world’s few AAA rated countries
•  The European Union scrambles to reschedule Greek debt
• The Municipal bond market somewhat stagnant as investors await Congress’ decision on the debt ceiling
•  2^nd Quarter company earnings continue to outperform

Discussion

Needless to say, there is a barrage of perceived and real worries in the world today.  Most pressing in our view, however, is the topic of the United States debt ceiling, and the anticipated outcome of Congress’ decision to either raise the limit or let the U.S. default.  The Donaldson Capital Management Investment Policy Committee (“IPC”) discussed at great length what truly constitutes a default. We have read many publications, and watched several news conferences in order to learn of the possible outcomes.

Timothy Geithner, the U.S. Secretary of the Treasury, seemed to dance around an interview question on the plausibility of the U.S. defaulting on its obligations.  Although he did not confirm that the U.S. would default, he did say that by definition the U.S. could be in a ‘technical default’.   Essentially we understood this to mean that without the debt ceiling being raised, with the current level of Government outlays exceeding tax revenues, certain obligations would not be paid.

This is where it gets a bit fuzzy.  There will be a natural order to things, or rather, a priority of who will get paid first in the hierarchy, but how that order is defined is the real question.  While difficult to determine who would get paid and who wouldn’t, the Government realizes that its creditors are made up of countries and large institutions with a strong investing prowess. Therefore it is very important the U.S. make good on its debt obligations to these creditors because we will have to go back to them for future borrowing needs.

However, should the U.S. fix its deficit issues off the backs of those dependent upon their monthly paychecks such as retirees or the disabled by taking away or reducing these benefits?  Either way you look at this issue, it’s very difficult to determine the best way to solve the problem at hand. 

The markets have responded to the expanding uncertainties with mixed emotions.  They have become more volatile in the past few weeks but have traded in a reasonably narrow range.  What seems to be the issue with the uncertainty is uncertainty itself. 

Another correlating variable to the volatility of the markets is the debt rating agencies’ warnings of decreasing credit ratings for some of the strongest countries in the world.  Standard & Poor’s rating agency, along with Moody’s and Fitch’s have all stated they will remove the U.S's AAA rating should either no deal, or a perceived insignificant deal, be passed.  This trend has extended, however, to other countries such as Germany.  This is rather surprising considering the positive attention the Germans have received for their strong fiscal budget and spending discipline.

This may be an unprecedented time in history to have the world’s ‘riskless’ investment (i.e. U.S. Treasury bonds) take on the risk by being downgraded.  What, then, should the world use as a benchmark for risk premiums, capital cost configurations, and the like?  It is the belief of the IPC that no matter the outcome, the U.S. policymakers will do what they can to prevent default and perhaps safeguard the status quo.

Not only so, but as it pertains to investors, differing investment options are graded on a curve. When surveying the world and all the differing investment securities available (from stocks, to bonds, to cash, to foreign currencies or securities, etc) investors perform a mental accounting to rank various investment options against each another.  While there is the real possibility the U.S. debt rating could be downgraded, generally speaking the U.S. is still one of the safest places in the world to invest one’s money. 

A comparison to the bailout plan offered by the European Union to support Greece shows the situation in the U.S. could be much worse.  Private holders of Greek debt are taking a 21% haircut on their investments, which is causing grumbling among investors.  As we have seen, a rippling effect can occur across the European Union should one country default on its obligations.  We are optimistic, however, to see that a new Greek debt restructuring plan should whittle down the country's debt-to-GDP ratio closer to 100% (a more manageable level). 

The IPC then turned its attention to the municipal bond market and noted that the issuance of new bonds has slowed dramatically.  It would take several more paragraphs to explain why, but Congress’s decision to limit new Treasury bond issuance as we near the federal debt ceiling has had the effect of reducing the number of new municipal bonds coming to market.  Therefore, the municipal bond market has now been, at least temporarily, impacted, by the debt-limit standoff.

That is not good news, but there is some good news about credit quality in the municipal bond market.  A recent analysis of our bond holdings showed significantly more upgrades than downgrades.  In fact, the municipal bond market as a whole has fared very well this year, especially in retrospect to analyst Meredith Whitney's dire prediction.  If you remember, she proclaimed there would be hundreds of billions of dollars worth of defaults in 2011.  So far in 2011, only $750 million have defaulted; a far cry from her forecast.  This compares to the amount defaulted in 2010 and 2009 of $2.5 billion and $4 billion, respectively.

Lastly, the IPC discussed corporate earnings for the 2nd Quarter.  So far in this earnings reporting season, a little over 200 companies within the S&P 500 have reported.  Earnings have continued to outperform in both year-over-year growth,18%, as well as earnings surprises,7.5%. (defined as the difference between actual earnings and analysts’ estimated earnings.)  These big earnings gains have also resulted in sizable dividend hikes.  In our two main dividend investment styles, dividend increases over the last year have averaged nearly 14%, the highest growth rate in many years. 

In the spite of all the news that is causing volatility in the stock market, U.S. companies are still expanding and growing at an impressive rate.

Many questions remain regarding the final outcome of the debt-limit stalemate in Congress.  Because this stalemate involves the heretofore safest investment on earth, U.S. debt securities, the options for a perfectly safe hiding place are very few.  Furthermore, we remain convinced that this stalemate will be broken and when it is the few investments that are doing well right now like gold and Swiss,Canadian, and Australian currencies will fall in price.  In essence to invest in these securities at this time is to bet that the U.S. will not only default but remain in a defaulted condition for an undetermined time.

As we have said on many occasions, it is becoming clear that high-quality, multinational corporations may now be the safest investments in the world.  They have piles of cash, significant free cash flows, modest debt loads, compete in every corner of the world and charge a price for their services dictated by the market and not decree, pay taxes in every country in which they operate, and return a significant portion of their annual earnings to their shareholders in the form of dividends.  Go back through this list of attributes and you will find few similarities with most sovereign debt in the world.

We'll report again next week on how the fiasco in Washington DC is playing out.

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.