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.    

  

Dividend Watch: Increases Still Outnumber Decreases

• Dividend Cuts by S&P 500 companies during the coronavirus have been far less than what was predicted just a month ago.
• From March 1 through April 17, only 27 companies in the S&P 500 announced dividend suspensions or cuts.
• Dividends remain an important linchpin connecting major corporations and income-hungry investors. 
• We forecast total S&P 500 dividend payments will fall in the range of 10-15%, far less than Wall Street expectations. 

Dividend announcements were slow last week.  They will speed up in late April through May.  Here are the most recent overall dividend data. 

Dividend Actions by S&P 500 Companies 
March-April 17, 2020

Dividend Paid	Dividend Increased	Dividend Decreased
192	96	27

The number of companies increasing their dividends since March 1 grew to 96,  with two important companies, Johnson and Johnson (JNJ) and Procter and Gamble (PG), hiking payouts approximately 6%.  The star of the week was Skyworks Solutions (SWKS), who raised its dividend an eye-popping 57%. While 27 S&P 500 companies have announced dividend cuts, most of these were smaller companies with modest dividends.  So far, the 96 companies that have raised their dividends, have pushed total dividends paid for the period modestly ahead of the same period last quarter.  

        We believe more cuts are inevitable as companies are forced to take government bailouts in the months ahead.  However, we believe total dividend cuts by S&P 500 companies will be far less than the 25%-30% levels predicted just a month ago, perhaps less than half that number.

        Next time we'll list companies that have announced dividend cuts, and list a group of companies that our research suggests are in danger of lowering or eliminating their dividends.

Greg Donaldson, Founder

Donaldson Capital Management

 

Dividend Watch: Dividends Aren't Dead

        In 2009, shortly after the government required all banks to cut their dividends, we created what we named the Dividend Watch to track dividend announcements and actions of all companies in the S&P 500.  It was our opinion that the overall stock market was overreacting to the financial problems that appeared to be narrowly focused in the banking sector.  We held this view because a look at the long-term dividend payment records of the S&P 500 revealed that companies are very reluctant to cut dividends.  Indeed, in the 50 years from 1958 to 2008, dividends had been cut by over 1% in just 5 years.  During this same period, stock prices had fallen in 16 years and earnings had fallen 13 times.  Annual changes in prices and earnings on a percentage basis were about 2.5 times that of changes in dividends.  We were hopeful that the Dividend Watch Report could act as a barometer for not only the stock market but also for the overall economy.  If few companies in the S&P 500 Index, other than banks, cut their dividends, it would signal that most companies believed they could navigate the crisis with minimal ill effects and continue to pay their dividends.  
        Our Dividend Watch Report soon revealed that few companies, beyond the banks, would cut their dividends in 2009.  In fact, many companies were actually increasing their dividends.  The surprising number of companies hiking dividends allowed us to become more bullish early in 2009 about the near-term prospects of the overall stock market and, to some extent, the U.S. economy.    
        We are again firing up the old Dividend Watch Report in the current coronavirus pandemic.  The current pandemic will affect many more companies than did the 2008-09 banking crisis, but we again believe that corporate America will surprise us with dividend actions that are more positive than is now being priced into the stock market.  As we release this 2020 Dividend Watch blog, Wall Street analysts predict that S&P dividends will be cut approximately in the range of 33%.  
        Our analysis runs from March 1 to the present.  Early March was when the full impact of coronavirus exploded into our collective consciousness.  We'll track the dividend announcements on a weekly basis. 
      

Dividend Actions by S&P 500 Companies In March 2020.

Dividend Paid	Dividend Increased	Dividend Decreased
43	10	18

From March 1 through today, approximately 30% of S&P 500 companies announcing dividend actions have cut or suspended their payments. (18 of 63).  We suspect that some companies that have announced suspensions may reinstate their dividends later in the year after the full effects of the Covid 19 economic damage has been assessed.  We'll track reinstatements if and when they occur.  Companies cutting their dividends have been centered in three industries: Travel and Leisure, Oil and Gas, and Retail.  Among the big names that have announced cuts or suspensions are Ford Motors, Delta Airlines, Marriott, Carnival Cruise Lines, GAP, Occidental Petroleum, and Boeing.
        As you will note in the table above, 10 companies have raised their dividends during this time.  The biggest hikes so far have come from Dollar General at 12.5% and General Dynamics at 7.84%.
        We have long believed that dividends are the linchpin tying individual investors and corporations together.  With stocks careening all over the place, it would appear that traders and speculators are betting that companies will break this bond.  We believe the bond will hold and provide an undergirding to the overall stock market.  

Greg Donaldson, Founder
Donaldson Capital Management   

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

Headwinds and Tailwinds: Which Way Will the Markets Blow?

There are several major headwinds and tailwinds in today’s markets.  Here we examine each and its potential impact on the market:

Tailwind: The “Fed Put”

“Don’t Fight the Fed” has been the operative word for a long time.  That looks like it will continue.  Widespread expectations were that the Federal Reserve would taper Quantitative Easing (QE).  On Thursday, the Federal Open Market Committee (FOMC) voted to keep asset purchases unchanged at $45 billion in Treasury securities and $40 billion in mortgage-backed securities.

Pent Up Demand: A Future Driver of Economic Growth

Pent Up Demand Pushing Cyclical Stocks

We are coming out of a lengthy period of decreased spending in the wake of 2008-09, which has built pent up demand for automobiles, housing and capital expenditures.  The average age of vehicles on the road has reached a record high of 11.4 years.  Demand for new houses fell off dramatically since the Great Recession.  The average U.S. home was built in 1974 and continues to age. 

As people have chosen to fix rather than replace their vehicles and homes, we’ve seen the replacement-type industries do very well.  Auto Retail’s 2^nd quarter sales and earnings per share were up 14.7% and 18.6%, respectively.  Home improvement retail grew sales nearly 10% with earnings up 20% from 2^nd quarter 2012.

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.

Are Dividend-Paying Stocks Becoming Better Than Bonds?

Speculators are throwing stocks around like dead fish, but even a simple analysis of companies in the S&P 500 shows that they are very much alive.  There are now 214 companies in the S&P 500 that have a dividend yield higher than the 2.10% yield of a 10-year US Treasury bond. 

These 214 companies have an average current dividend yield of 3.70%.  Importantly, as an indicator of their vitality, these companies have increased their dividends by an average of 8.20% over the last 12 months. This level of dividend hikes is eye-popping when considering that the US economy grew at only 1.60% during this time.

For the S&P 500 as a whole, the current dividend yield is 2.25%, also higher than the 10-year Treasury bond.  But when including the additional 286 companies whose yield is lower than the 10-year Treasury bond yield, or pay no dividend at all, the average 12-month dividend growth has been just over 14.0%.  During the same time, earnings for the S&P 500 grew by close to 12%.  That means that companies actually grew their dividends modestly faster than their earnings were growing.  Would dead fish companies do that?  Absolutely not.  A company would only hike its dividend at a faster rate than its earnings if it was completely confident that it would not need the money later.

So we have another one of those conundrums here.  The average company in the US is reasonably optimistic about its future.  We would add that the Wall Street analysts agree.  Last Friday, the analysts raised 2012 earnings to new all-time highs.  Thus, at the very time when the speculators were beginning to sling dead fish like there was no tomorrow, the analysts were pushing up 2011 and 2012 earnings. The actions of the analysts are vitally important in solving the conundrum:  It was almost exactly a year ago when the analysts also went against  the fish tossers by continuing to hike earnings for 2010 and 2011 even though stocks were selling off.  We all know now that they were right.  Earnings and dividend increases kept on rolling in and stock prices exploded.

We are not completely discounting the action of the fish tossers.  There certainly is a foul smelling odor coming from Washington these days, and the puny growth of the US economy stinks; but we believe speculators are missing the bigger picture.  World-wide economic growth is projected to be near 3.5% for 2011.  That rather spritely figure includes the smelly slow grow rates in the US and Europe.  The truth is the developing world is still showing solid growth, and, of equal importance, the developing world is a lot bigger than most investors understand.

In previous blogs we have extolled the concept of bond-like stocks.  Our view is for many companies the current dividend payments are very safe; indeed, we believe they will grow at solid rates over the next few years.  Mathematically, a stock yielding 3.7%, with its dividend growing at 7%-8% should clobber the current 2.10% return on a 10-year US Treasury bond.  It is not a guarantee, . . . but perhaps in light of recent events, we might say that questions have been raised about the credit quality of US Treasury bonds, as well.

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.

Sell in May And Go Away . . . . At Your Own Risk

Because stocks have had solid double-digit gains over the last 12 months, we hear many people predicting that they are ready for a fall.  In addition, the "Sell in May and Go Away" crowd is giving us all the statistics of how stocks have fared between May and November historically.

The reasons given for a stock sell off are full of language about momentum, price gains, and too much-too soon. We want to add very quickly that few of the "stocks are too high" crowd today were among the "stocks are too low" crowd  at the market bottom in March of 2009.  Indeed, if you go back to their blogs and read what they were saying around the bottom of the market, you will find many of them were saying "stocks are too high," even then.

In the blizzard of words we see written about the stock market, we seldom see the word valuation.  Valuation, it would seem, has no meaning in a high-octane traders' market, where computers are trading with computers for about 70% of the daily volume.  Individual investors seem to have decided that long-term value investing has gone the way of the Oldsmobile.

Ah, but we beg to differ!   In the long-run, valuation will rule just like it always has.The reason is over the last 80 years, S&P stock prices are highly correlated to both After Tax Profits and Dividends.  The computers and traders will wage their daily battles of betting on zig or zag, but in the long-run, zigs and zags will ultimately be seen as vanity, a chasing after the wind.

From a valuation perspective, stocks are still cheap and could only become expensive if the economy were to fall off a cliff and drag earnings and dividends with it.  The chart below shows index of the S&P 500 (red line) compared to Total U.S. After Tax Profits Index (blue line).  Please note that After Tax Profits reached an all time high in December of 2010 and, based on S&P estimates, will rise by nearly 13% in the second quarter of 2011 versus the same quarter a year ago. Tracking the After Tax Profits Index is our favorite way of measuring earnings, because it measures only earnings that companies actually paid taxes on.  

The graph below vividly shows that while After Tax Profits have reached an all time high, the S&P 500 has not. In fact, the chart suggests that the S&P has a long way to go to reach fair value.

Corroborating the view that stocks are still undervalued is the graph of the S&P 500 Index (red line) compared to Total Corporate Dividends Index (blue line).  Total Corporate Dividends paid is an important indicator of the health of the current turn-around in the stock market, because dividends are paid in cash and not promises.  As the chart shows, dividends took a hit during the sub prime crisis.  Importantly the chart also shows that they have turned higher.  S&P is predicting that dividends will grow nearly 10% on a year over year basis for the first quarter of 2011.  Dividends have not reached a new high, but we believe the old record will be eclipsed over the next 12 months.  This would be good news for continued stock price gains.

These two simple, yet important measures of stock market valuations are still flashing green.  That does not mean that stocks will go straight up from here.  In our judgment, it does mean, however, that saying stocks are too high is nonsense, and "Sell in May and Go Away" is worse.

Investment Policy Committee -- Weekly Outlook

Summary:

1. Q2 company earnings and revenues continue to surprise on the upside.
2. The stock market is responding positively to more certainty around full-year 2010 earnings.
3. Many investors are relying too much on popular media for their economic news. The media stories are superficial, shaded toward pessimism, and miss many key facts. This quarter’s client letter addresses that problem.
4. Preferred stocks gained in value as the European bank stress test results made people feel better about the health of European banks and the global credit market.

Discussion :

The market reacted favorably last week to the positive results announced by the roughly 1/3 of S&P 500 companies that reported their 2nd quarter earnings. This holds with our view that a good earnings season would help reduce some of the uncertainty and anxiety that had been holding valuations below historical levels. (By valuation, we mean the price/earnings ratio, or P/E, which is calculated by dividing a company’s stock price by its earnings per share.)

The market continued to move higher yesterday in response to more positive earnings news and June new home sales that were higher than expected. This also continues to support our view that strong corporate earnings will eventually result in higher stock prices, and that despite the pessimistic economic news often heard in the popular media, companies could not have turned in 5 consecutive quarters of better-than-expected earnings unless the economy was strengthening.

More data have come in indicating that individual investors continue to keep their money either in cash or bonds, staying away from stocks.  Institutional, or professional, investors however are increasing their holdings of common stocks.  Clearly, one group is much more uncertain than the other.  We wonder how much of this anxiety among individual investors (also called “retail investors”) is due to excessive influence from popular media.

This quarter’s DCM client letter tries to reduce that influence a bit by pointing out that partly out of necessity and partly by choice, the popular media can only tell a superficial story about something as huge and complex as a $14 trillion economy.  Also, in order to gain viewers and sell advertising, whatever story they do tell is often written to be “newsworthy”, and unfortunately, bad news is often considered more newsworthy than good.  As old newspapermen say: “If it bleeds, it leads”.

What retail investors may be missing is that they are not investing in the economy.  They are investing in companies. And, some - even many - companies can do quite well even during weak economies.  We do study the economies of the major countries here at DCM, but more to get a broad feel for general direction and to identify which economic sectors might have more or less favorable conditions for companies in those sectors.  Choosing which companies to actually invest in, however, is about 95% the company’s individual potential for growth and 5% overall economic conditions.

On the fixed income side of the ledger, specific increasing or decreasing uncertainties are being felt lately.  The uncertainty relates to future tax rates.  The yields of 30-year, tax-exempt bonds have been steadily dropping over the past month.  They are now about 0.4% lower than they were in May (~ 4.125% vs. 4.505%).  This drop we believe is almost entirely due to concerns in the bond market that tax rates will move up in 2011.  Higher income tax rates mean that tax-exempt municipal bonds become more valuable to high income individuals and corporations because they can achieve a better after-tax return than investing in taxable bonds.  We hope this “bet” by the bond market is wrong. But, of course, no one will know until Congress takes action – or doesn’t - on the expiring Bush tax cuts.

For preferred stocks, less uncertainty about the health of European banks and the good earnings from US banks, has moved prices of preferred stocks higher.  The European bank stress tests themselves and their results released last Friday were far from perfect.  They did, however, make some additional data public and did reduce concerns about bank stability.  This benefited European banks the most, but also U.S. and other banks since all would suffer from a major shock to European credit stability.

This increased confidence reduced the credit risk discounts that had been applied to the prices of many financial industry preferred stocks, pushing their prices higher and yields lower.  This is a good sign and a development we can use to our clients’ advantage.

We remain optimistic about corporate earnings and, as a result, about stock prices over the remainder of the year.  We continue to believe that inflation will remain muted, and that interest rates will trade in a narrow range.  Stocks remain the most undervalued assets we can see and, we believe the path of least resistance for stocks is now up.

Randy Alsman, Editor
Mike Hull
Rick Roop
Greg Donaldson  

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

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

The Riots in Greece Reach the US Security Markets

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Fed Got it Wrong!

My prediction that the Federal Reserve would lower their target rate by 50 basis points was wrong, but in my judgment, they will see the error of their ways and continue to cut rates very soon. I do believe, however, that they missed the opportunity to stay out ahead of the unfolding worries in the subprime market. Today's downgrade of Citigroup by Wall Street analysts is proof of the pudding, so to speak. Citigroup is down nearly 7% on rumors of more write offs and the possibility that they may have to cut their dividend. Citigroup's bad news has spilled over into the general market, pushing the Dow down nearly 1.5%. If you recall in the blog where I predicted the 50 basis point rate cut, my central theme was that the yield spread between Fed Funds and T-Bills was signalling continuing worries about the banks, especially the big investment banks. When the Fed Funds Target Rate is significantly above the rate on T-Bills, it is a clear message that sophisticated buyers are opting for government-backed paper over bank-backed paper. When I first started talking about this phenomenon in early September, the difference was over 1.25%, as high as it had been in nearly 20 years. As a result of the mid-September rate cut, yesterday that difference had fallen to near 1%. Yesterday, after the Fed announced only a 25 basis point cut and indirectly expressed the notion that future cuts may be unnecessary the yields on T-Bills began to fall. For those of you worrying about inflation, a fall in T-bill yields is a very big bet by very big investors that you are wrong. Indeed, a fall in T-bill yields says two things:

1. The odds are increasing for a recession.
2. The Fed got it wrong.

I do not believe there is a high probability of a recession, but I do believe that the Fed got it wrong. The good thing is, they can still get it right and well before the next meeting in December. Fed governors give speeches everyday. All they have to do is to take away the implication that the rates cuts are done.

They have now lost the lead in taming the ongoing banking worries, and they will have to do some heavy lifting to regain that position, but if they speak with one voice, they can regain their rightful leadership position by December.

As it now stands, the Fed Funds Target Rate is 4.5%. After yesterday's and today's rallies in T-Bills, they now yield about 3.7%, yield spread of about .8%. That is still high by historical standards and implies the credit and liquidity crunch is far from over.

The Fed is the banker of last resort, and I'm confident that they will ultimately get it right. Having said this, I think they made a mistake in reading the markets that Alan Greenspan would not have made.

The Flip Side of Maximum Pessimissm

Last time, I discussed John Templeton's investment strategy of investing in the world and stocks where there was the most pessimism. He practiced this strategy because he believed that as an economy, industry sector, or individual stock becomes completely tarred and feathered deeper pockets and steadier hands often step in to buy the stock that the momentum players are dumping. I have noticed that in periods of maximum pessimism there is an equal and opposite force that I will call maximum optimism. In this regard, investing is a zero sum game. If the momentum crowd bails out of bank stocks, as they have, the money has to go somewhere. If it goes to cash, it drives down short-term interest rates. If it moves to bonds, it drives down longer-term interest rates. Finally, if it goes into stocks in different industry sectors or even different countries, it will tend to drive the stocks in those new areas higher. In the recent sell off, some money has gone into short-term, high quality bonds, but it is clear that little has gone into longer term bonds because bond yields have not moved much. To my eye, it is clear that the money that has left the bank and financial stocks has moved to energy, consumer staples, and commodity related stocks. Now guess what? Stocks in those sectors are now reaching fair value and, indeed, energy has pushed into overvalued territory. So, does that mean that under John Templeton's investment strategy we should be selling the energy stocks? Good grief, that is nuts, isn't it? Doesn't everyone know that oil prices are going to continue to go higher through the end of the 21st century? The new middle class of China, India, Eastern Europe, and South America are going to drive Lexi, aren't they? Aren't they going to end up consuming about the same per capital amount of energy as, for instance, the middle class of Europe? My answer is -- not by a long shot. Motorola had incredible success in China in the 1990s selling pagers. There were few telephone land lines in most areas of the country, so the early form of communication in China was by pager. Gradually pagers gave way to cell phones. Land lines are still in short supply in the country, but second and third generation wireless telecommunications are filling the needs of many of the new middle class in the nation. The same thing is going to happen in transportation. Second and third generation modes of transportation are and will continue to explode. Intra-city public transportation is growing at a high rate, and high speed bullet trains are in the works. You can bet that these "centralized" forms of transportation will be the rule in the country because that is the one area where the old Communist mindset makes sense. The same goes for India and South America. They know they cannot rely on the suburban American model of 2.2 cars for every household and ribbons of high-speed asphalt highways connecting every city in the country. Public transportation is how the Communist leaders can maintain a modicum of relevance. Communications in most of these countries will continue to be like the wild west, but transportation will be more controlled, more out of those famous Communist five-year plans. As the world comes to understand the "new world" model, it will become more clear that natural resource consumption will not grow at geometric trends, as is now feared. In short, oil prices are not going up as far as the eye can see, or the mind can think. Energy stocks are overvalued, but we are not selling yet. Indeed, we would be foolhardy to announce in advance that we think oil stocks have reached their peaks. Just say that oil stocks are fully prices, and we will be keeping a keen eye out for prices that factor in oil prices rising "forever." We think that is what Mr. Templeton would have done. He knew that the "crowd" often gets it wrong. But, why take your profits too early when the crowd will always push prices beyond reason, both in sectors where the news is bad as well as where the news is good.

It's a Subprime Crisis, Not a Banking Crisis.

After Countrywide Financial warned in July that they were experiencing delinquencies across all credit quality classes of mortgages, the stock market went into a tailspin, assuming that all banks were either deep into subprimes or that prime mortgages were beginning to default.

We were watching the chart at the right, which shows the % of delinquencies of subprime (blue line) and prime (orange line). It has been clear that subprimes have been in big trouble for the last two years, with delinquencies now running at over 15% of subprime loans oustanding. So if the big banks are deep into subprimes, they will, indeed, be taking big write offs. However, if they have managed to sell off or avoid their low quality loans, the prime sector of mortgaes would appear to be in very good shape, with only 2.7% of prime loans currently delinquent.

Our analysis of Bank of America, Wells Fargo, and Wachovia, tells us that these three major US banks have only modest amounts of subprime loans and that they are well secured and manageable.

Wachovia said in their July earnings meeting that they did not have any subprime loans. Since then they have announced that they are going to commit $15 million to the lower quality market. We think this is a smart move, since almost everybody else is exiting the sector. There are probably some great bargains.


The evidence is growing steadily that the big banks in the country sold off their high risk mortgages to the big pools of money that Wall Street was throwing their way.

The market is on pins and needles awaiting the big banks to announce their earnings, or lack of them. We are firmly in the camp that believes the news will be better than Wall Street now believes, and for this reason, we believe the aforementioned banks represent very good values.

Stocks Twelve Months After a Rate Cut

If history is a guide, the Fed will cut rates today and will continue to cut for at least the next four months.

The top part of the chart at the right shows the graphs of the Fed Funds Target Rate and the yields on 90-day T-bills. The bottom of the chart shows the difference between the two in red. I discussed the significance of the recent divergence between the two short-term rates in our Sept. 4th post.

There have been four previous divergences that have approached one percent over the past 20 years: the crash of 1987, the S&L troubles of 1989, the Asian Financial crisis in 1998, and the popping of the tech bubble in 2000. In each case, as the divergence between Fed Funds and T-bills approached one percent (.9% more precisely) the Fed cut rates and the differential and, ultimately, the crisis went way.

I have done some additional studying of these divergences and I see two additional areas of interest:

1. On average, after rates were cut, Fed Funds were lower by .75%, within four months . Thus, if history is to be our guide, today's cut is just the beginning.
2. Twelve months after the first Fed rate cut during three of the credit crunches (1987,1989,1998), stocks were higher, including dividends, by nearly 20%. In the year following the tech bubble, stocks were down nearly 15%, including dividends. The average for the four periods was about 12%.

After what we have waded through 2007, the hopes of a 12% total return over the next year sounds very acceptable. However, I think it may well be better than that because of the unusual circumstances surrounding the poor performance of stocks in the year after the popping of the tech bubble. That pushed us into the time of Enron and then the 9-11. It would have been hard to imagine that stocks could have risen during that time, no matter what the Fed was doing.

Thus, I think it is best to call the period after the tech bubble a special case and drop it from our analysis. If we do that, as I said earlier, the average total return after the Fed started cutting rates in the other three occurrences of a credit crisis, was near 20%.

As they say, the future is not the past, but sometimes it is the best guide we have.

The Fed Rate Cut: How Much?

By Greg Donaldson and Mike Hull

As we returned from the Labor Day weekend, there are still some in the financial media that are saying that the current state of the economy does not warrant a cut in the Fed Funds Rate.

We don't agree and history shows that the Fed has cut rates in the past, even when the economy was not in or near recession.

The chart at the right shows the yields on 90-day T-Bills (blue line), which are backed by the full faith and credit of the US Government; the Fed Funds Target Rate(green line), the rate paid and guaranteed by banks; and the difference between the two at the bottom (red line).

The top part of the chart shows that for most of time over the last 20 years the interest rates on 90-day T-Bills and fed funds have stayed very close together. This would make sense. One strong bank borrowing from another would not expect to pay a rate of interest much higher than the government would have to pay for a short-term loan.

However, when fears of recession or the strength of the banking system is called into question, the spread between fed funds and T-Bills widens. Why, because big investors decide they feel safer in government backed T-Bills than they do in the banks and they bid T-Bill yields lower.

To see this, let's focus on the red line at the bottom of the chart, which shows the difference between the Fed's Funds Target Rate and the yield on a 90-day T-Bill.

Each time the yield differential has been at least one percent, the Fed has cut rates within a short time. In addition, you will note that T-bills have always led fed funds lower.

There have only been 5 times in the last 20 years when the yield differential between T-bills and fed funds have been approximately one percent: immediately after the stock market crash of 1987, during the Saving and Loan Crisis in 1989, during the Asian Flu of 1998, in mid 2000, when it was clear that the Tech bubble was popping, and today.

The chart is a month-end chart so it does not show every day for the last 20 years, but it is remarkable that on a month-end basis that the events of September 2001, did not produce a one percent spread.

These one percent spikes have occurred coincident with an extreme crisis of confidence in the financial markets, not necessarily in the economy. The US economy was fine in 1987, 1998, and 2000 at the times of the spikes.

Thus, the arguments today that the Fed won't cut the fed funds rate because the US economy is not close to recession is beside the point. The point is the Fed has a financial crisis to deal with and history shows that the way they deal with these types of events is to cut rates. They can always raise rates later if the crisis passes without a sharp fall off in the economy.

The arrow at the far right of the chart shows that the recent spike is higher than at any time going back to 1989. In our minds, the question is not if the Fed will cut rates, but how much? One of us thinks .25%, the other .50%.

Energy: The New Y2K -- Boeing, Toyota, and United Technologies

While we are grappling to understand the height, width, and breadth of the mortgage crisis, another crisis that we have detailing has fallen off the front pages: the energy crisis. Here's why we have been describing energy as the next Y2K:

1. 9-11 was a harsh lesson in the Islamists' visceral hatred of our Western way of life, and the fiendish extremes to which they would go to harm us.
2. The internecine fighting in Iraq, if anything, should be a constant reminder that the terrorists seek to destroy anyone who stands in their way, even their own people.
3. Katrina showed how fragile our refining and energy distribution systems were.
4. Too much of the American, yes the Western, way of life is held hostage to energy; and too much of the world's energy supply is in countries who hate not just Americans, but any country that follows an open society of free markets and democracy.

The recent sell off has hit almost all stocks and sectors. During this sell off, we have been nibbling on the three stocks that we believe currently possess the best technology and products to dramatically reduce energy consumption, without abandoning out our way of life-- Boeing, Toyota, and United Technologies. These three companies currently have products on the market that can reduce energy consumption by up to 50%(compared to older technologies) in planes, automobiles, and heating and air conditioning systems, respectively.

Here's our bottom line, and we are borrowing from a press release by the World Business Counsel for Sustainable Development (WBCSD): There is a talk about "green" this and "green" that, but, thus far, most individuals, companies, and governments have done very little to diminish energy consumption.

Energy conservation may seem like an oxymoron, but we believe that a true cost-benefit inflection point is near, when people will realize that the technology is available and affordable here and now to dramatically reduce energy consumption.

The reason we call this an Energy Y2k is because when that day comes, there will be a mad rush to get aboard the new technology. We don't know what will cause it, and we have no special skills at seeing the future, but no individual, corporation, or government can live beyond its means indefinitely.

In saying this, we are not talking about doomsday or end-times. We are just saying that there are technologies available that offer people some insurance against rising energy prices, resulting from uncertain energy supplies, and the wisest course of action may be to own both the new technologies and the companies who own them.