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."         

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

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

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

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

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

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

The Dividend Theories of John Burr Williams, Part II: Investing versus Speculating

This is the second blog in a series exploring the theories of John Burr Williams. You can read the first post here.

John Burr Williams’ book, The Theory of Investment Value, was not about beating the market or getting rich in the market.  It was really a wake-up call to the investment elite to offer them a theory of investment value that would encourage more long-term investing and less speculation.  Williams postulated that investors’ inability to properly value stocks increasingly led them to become speculators. Most people would not admit that they were speculators, but it was clear by their decisions that they were not appraising the intrinsic value of companies but betting that they knew something that the market did not.

Hot News Comes and Goes, But Dividends Are Forever . . .

Investors are constantly inundated with the latest regional conflict, political debate, economic data and interest rate predictions. All of this information represents the collective viewpoint or “consensus” of investors at any given point in time.

Over the many years we have spent studying the markets, the truest thing we know is that the consensus is already priced into the market... and the consensus is almost always wrong. If an investor believes the economy and earnings will be better in the future, they will “vote” with their money. In aggregate, all of those votes create the price level for a particular stock. If the consensus comes true, you won’t see much of a change in the markets and prices will generally drift sideways.

What changes the price of stocks are the things that the consensus doesn’t already expect. Therefore, the only way to make excess risk-adjusted returns is either:

1) Find where the consensus is wrong.

2) Look outside the box.

The ABCs of Dividend Investing: Part II, Dividend Growth Is Vital

In our previous blog on dividend investing, we offered some of our dividend research and a general theory on how to think about the importance of both dividend yield and dividend growth.  In this edition, we will share some of our insights into how different combinations of dividend yield and growth act in various kinds of stock markets.

When most people think of dividend-paying stocks, often they incorrectly think that such companies are unusual.  The truth is among the 500 stocks in the S&P Index, nearly 400 of them pay a dividend.  What makes a company valuable, according to our research, is that it has raised its dividend persistently and consistently over a long time.  We do not place hard limits on these descriptors because we do not want to eliminate companies that have persistently and consistently raised their dividends but not on a calendar basis. United Technologies (UTX), for instance, increases its dividend every six quarters; thereby, having years where it does not increase its dividend on a calendar basis.  The every-six-quarters approach is consistent and persistent, but UTX does not make the lists of dividend stars because of the occasional calendar miss. 

Our research in the dividend world began with the utility sector in the late 1980s.  That early research revealed some surprising results. 

Bond-Like Stocks Are Still Winning

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

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

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

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

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

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

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

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

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

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

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

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

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

The Dollar's Slide: Terminal or Temporary?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Written by:  Randy Alsman and Greg Donaldson

Principals and Clients of Donaldson Capital Management own Nestle.

Toyota: One Year Later -- It May Be Stronger Than Ever

We have an old saying at DCM that goes back a long way.  "Buy Coke when they are accused of poisoning someone."  This is not some morbid silly aphorism, it is truly how we think about investing.  Bad news that is widely known is probably fully discounted in the current stock price, and thus, financially strong, dominant companies that hit bumps in the road are probably a buy.  This is not the case with smaller, less financially strong firms.  With smaller firms there is always the risk that the banks will take over and ruin the company.

But with big, strong companies, particularly those with a powerful brands, bad news to us is often good news.  It does not mean that we buy every big company with trouble, but we do look at them.

A year or so ago, Toyota (TM) was embroiled in the sticking accelerator issue.  Lawsuits were piling up. Congress had hauled in newly-elected president Toyoda, grandson of the founder, for his obligatory tongue lashing. Local TV news teams were hounding Toyota dealers and customers like the paparazzi for candid shots of the fall of one of the most powerful brands on earth.  It turns out, the death of Toyota may have been announced prematurely.

During those times, Mike Hull, our consumer strategist wrote a piece that was upbeat and suggested that we were nibbling on the stock.  The bottom line of what he said was that Toyota was a powerful brand with customer loyalty that ran much deeper than most people thought.  Additionally TM was one of the strongest companies in the world and had the financial resources to deal successfully with all the issues that it faced. 

The chart at the right is of TM over the last twelve months.  It shows the violent collapse in February, followed by a long bottoming out phase that ended with a sharp upturn in the price of the stock in November of 2010 that reached as high as $86 per share.  The stock has risen nearly 14% since Mike wrote his blog.  That does not make it a hall-of-fame type stock pick, but it does, at least for now, give us further reasons to continue to look closely at great companies who stumble.

By the way, Mike thinks TM has begun a long strategic battle with the other auto companies in the US that may have domestic car companies crying "uncle" again one day.  For all the issues, real and imagined, that came from the sticking accelerator debacle, TM has survived. Mike believes the company is even more dedicated to quality today than they were before the problems, and they are still financially one of the strongest companies in the world. 

If GM, Ford, and the other car companies think they have turned the corner and can now compete effectively with TM across broad product lines, our guess is that time will put everything back in its rightful place.  In our judgment, even though TM may have had some glitches in recent years, they are committed to being in the high-quality personal transportation business.  We believe most other auto companies are in the, well, car business.  Think about it.  There is a difference.   

GE's Second Dividend Hike: Good News or Bad News?

GE's announcement of a 17% dividend hike on top of their 20% hike earlier this year was the topic of lively discussion at our investment policy meeting on Monday.

We all agreed that on the surface the news was good for GE and stocks in general, but several committee members voiced a surprising concern.

First let me share the positive implications we believe GE's dividend actions signal.

1. Their loan loss ratios in GE Capital (35% of the company) must be improving faster than previously expected.  This would be good news for both GE and the US economy.
2. An up-tick in their long-cycle industrial sector (jet engines, healthcare electronics, and power generation) may be underway.  Better news in these industries would be very good news for US trade balances with developing nations.
3. Short-cycle businesses (appliances and electrical system equipment) may have bottomed.  This would be modestly good news about US consumer spending.

We were surprised and delighted by GE's second dividend hike, and because GE is so large and so broadly diversified across the US economy, we believe many other companies may also be experiencing better-than-expected results. This would portend more higher-than-expected dividend hikes. And since our theory is that dividend hikes are the best sign that a business is growing, a spate of better-than-expected dividend hikes should also lead to higher stock prices.

The surprising concern that arose in our discussions was the possible negative implications of the dividend news. Two of us voiced the concern that because Jeffrey Immelt, GE CEO, has become so unpopular among many investors and analysts, the dividend hikes may only be his attempt to win favor with his constituents. This line of thinking didn't go far because one of the committee members reminded us that CEOs don't dictate dividend policy. That authority belongs to the board of directors.

The chart at the top of the page shows that GE is stair-stepping its way higher. The recent new, intermediate high signals the stock may attempt to move higher over the near term. If our notion that GE's business is improving starts showing up in their earnings, we could soon see GE take a run at a new 12-month high.

We own the stock. Do not make investment decisions based on this information. Please consult your personal financial advisor.  

  

Becton Dickinson : A Dividend Star with a Lagging Price

Last time we showed research that revealed that dividend-paying stocks have outperformed non dividend-paying stocks over the last three years.  Importantly, the research also showed that the higher the dividend growth of a stock, the higher its total rate of return, up to a point.  That point of diminishing returns occurred in the quintile that included companies with the highest dividend growth rates.  These companies did not perform as well, pricewise during the period, as did companies in the second quintile of dividend growth.

We have previously offered research showing that among dividend paying stocks that dividend growth is the best indicator of long-term price growth.  Thus, companies that are producing high dividend growth and not being rewarded with high price appreciation are of particular interest to us.  Our experience has taught us that these kinds of companies will at some point have a price growth spurt that will close the performance gap. 

Let us give you an example of what we mean by this:.

Becton Dickinson (BDX) is a global medical technology company that is focused on improving drug therapies, enhancing the quality and speed of diagnosing infectious diseases, and advancing research and discovery of new drugs and vaccines.

Over the past three years, BDX has hiked its dividend by an average of nearly 15% per year. During this time, its stock price has risen by only about 5% per annum.  Of course this has been a time when almost all health-care stocks have underperformed the market.  However, the difference between BDX and it brethren in the sector are stark.  BDX has not only produced dividends and earnings growth  much higher than the average stock in the health-care sector, but it has also enjoyed higher dividend and earnings growth than the average stock in the S&P 500.  Yet this strong fundamental performance has produced sub-par price gains.

The sub-par price performance of BDX, in the face of its outstanding dividend and earnings growth, has left the stock undervalued in our dividend model by about 17%, as shown on the chart above.  The dividend model also reveals that BDX has been undervalued for the last three years. 

As we have said many times before, a stock can stay undervalued or overvalued for a long time, but eventually price will seek to close the valuation gap. We often find that three years is about the limit of valuation gaps.

BDX recently announced a dividend increase for the coming year of 11%, the 38th consecutive year the company has raised its dividend.  This again is a bigger dividend hike than that of the average stock during the last twelve months.  In our minds, BDX's wide valuation gap cannot withstand many more above average dividend hikes.  The time for the the market to play some catch up may be near. 

We will show you more of these stocks with valuation gaps in the weeks ahead.

We own BDX in our Capital Builder investment style.  Do not use this blog for investment advice.  Please seek the advice of your own professional investment manager.

Donaldson Barnyard Forecast is Positive for Stocks

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



This is a video/audio webcast. If you are unable to view this post, click here.

Rising Dividend Investing
http://www.blogcatalog.com/directory/business/investing/stocks/

More Answers to Your Questions: Why There Are so Many Widely Divergent Views of the Economy

Randy Alsman, Senior Portfolio Manager and Strategist, discusses the wide variance of economic viewpoints in the current market place and some reasons why they exist.

Posted Question: How can the opinions of so many bright people be so far apart? Where is reality? Who do you listen to other than yourself?



People/Groups we listen to:

Ed Yardeni - http://www.yardeni.com/
Bank Credit Analyst - http://www.bcaresearch.com/
Standard and Poors - http://www.standardandpoors.com/
Value-Line - http://www.valueline.com/
Morningstar - http://www.morningstar.com/
Briefing.com - http://www.briefing.com/
Bloomberg Professional - various strategists and economists
Wall Street Professional
Argus Research - http://www.argusresearch.com/
We also have access to many investment research resources through our relationship with TD Ameritrade.

See all the DCM portfolio managers' bios on our website http://www.donaldsoncapitalmanagement.com/content/our-staff

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 Hidden Value of Dedicated Hearts And Minds

By Randy Alsman, VP and Portfolio Manager The bear market of the last year coupled with the seemingly spasmodic daily jumps and falls in price have shaken the confidence of many investors. Many days it seems that logic has left the building, with apologies to Elvis fans for borrowing the phrase. Also, people caught up in the visible market’s gyrations can lose sight of what the market really represents. A brief refresher might help restore faith in long-term investing for at least some of you. The stock market is nothing more than a place for centralizing and organizing the exchange of value. One part of that exchange is most often money…cash. That’s the visible part if you will. The other part of that exchange is equally, if not more, important. That other part, sometimes lost in the drama, is ownership. In the case of the stocks that we focus on, it’s ownership of some very high-quality companies. More specifically, shareholders own parts of tangible, and even more importantly, intangible assets. Obviously, buildings, equipment, inventory, etc. are some of those assets. And they have real and often significant value. But down yet another layer, shareholders own the most powerful and valuable of assets – ideas. Those ideas can be comprehensive and formal, such as patents, copyrights, and brand equities. A powerful new drug, a more energy efficient jet engine, a brand name that evokes high quality, are all intangible assets that can generate billions in revenue and profit. Equally or even more powerful are the smaller, daily ideas of thousands of employees trying to figure out how to better serve customers, outsmart competitors, or do their job more efficiently. In the best companies, job candidates are screened for their ability and tendency to think that way. Once they’re hired, millions of dollars are invested in training them to get even better at those thought processes and how to act on them more effectively. None of those intangible assets are much affected by short term stock market moves. Think about yourself, you go to work every day with some part of your brain trying to figure out how to do something better, earn a promotion through superior results, stretch your department’s budget to accomplish more with less, etc. Often, a setback on a project or a market downturn actually can cause you to work even harder for great new ideas. Those intangibles are the most powerful assets owned by an investor in a high quality company…the hearts and minds of thousands of talented, motivated people working every day to create more value. They can be defeated, and some of them are each day. But far more are finding new and better ways to win. When they do, they add to their small part to the larger total value that their shareholders own. When the market and the economy go through their down times, don’t lose sight of what a long-term investor in great companies actually owns. He owns a powerful force that does not accept permanent defeat. In total, across a portfolio of top companies, those hearts and minds have always found a way, and I think they always will. Hearts and minds may be the most powerful argument for taking the long view when investing. Temporary defeats may grab the headlines. The best employees of the best companies, however, never stop trying…and then they succeed. Those successes are often not directly reflected in stock prices over a few days, weeks, even over many months. But, for those who take the longer view, those accumulated victories have been rewarded handsomely.