Volatility Will Continue, But Stocks Are Going Higher

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

Economy and Bonds

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

Trade

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

Earnings

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

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

Preston May, Certified Business Economist

Research Analyst

Donaldson Capital Management, LLC.

Editor Greg Donaldson

The Great P/E Debate: Are Stocks Overvalued?

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

Is she right?  Are stocks overvalued?

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

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

The Average P/E Says… Stocks Overvalued

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

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

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

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

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

The Missing Link: Inflation

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

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

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

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

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

y = 0.9048x + 0.0366

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

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

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

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

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

What does this mean for today’s market?

This model tells us a few things:

1. Stocks are not overvalued.

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

2. The stock market can handle some inflation.

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

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

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

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

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

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

This B-U-L-L Market Is Getting L-O-U-D

Throughout the history of the U.S. stock market, there have been many bull and bear markets. Studying these market cycles can teach investors a great deal about how the market behaves and the underlying reasons behind it.  If you can identify the driving forces of a bull or bear market, you can make more intelligent decisions to either protect yourself against a looming bear market or take advantage of a bull market.

In the 20-year history of our firm, we’ve seen several of these market cycles and have studied countless others.  While no bull or bear market looks exactly the same, the past provides us with useful insights about the future.  In the words of Mark Twain, “History doesn’t repeat itself, but it does rhyme.”

Today, we are going to see how the current bull market “rhymes” with years prior and what information we can gather from its historical patterns.

Anatomy of a Bull Market

The anatomy of almost all bull markets can be broadly defined by four primary characteristics that make up the acronym B-U-L-L, which you can read more about here.

1. Breadth

2. Unrelenting

3. Leadership Rotation

4. Loud

The “Loud” part of the equation is of particular interest in today’s market.    Bull markets attract a lot of attention from media and Wall Street.  Everywhere you turn, it seems like you hear about the stock market.  The local newspaper, CNBC, Wall Street, and even outings with family and friends can turn into investment discussions.

That’s typical of bull markets.  They grab you and force you to pay attention.  For all of those investors who have been out of the market since 2009, the run-up in stocks over the past five years has shown them just how wrong they have been.

Bull markets attract their fair share of commentators on both sides of the fence.  Some say the bull market will keep going, while others continually predict it’s demise.  The longer the bull market goes, the louder the shouting on both sides become.  Amongst all of the noise, it’s difficult to discern between what is truly relevant information and what is just that - noise.  

A lot of the chatter lately has been speculation about when the current bull market will end.  If you look back on nearly every bull market we have ever had in the United States, you will find that the vast majority of them don’t die of old age, they are killed.  There are two primary killers of bull markets:

(1) Recessions

Pullbacks and corrections can occur at any time, but it is really difficult to have a real bear market unless there is an economic recession that negatively impacts company fundamentals.  Remember, prices will always follow valuation in the long-term.  So if long-term values are increasing, the long-term trajectory of the stock market should also be increasing.

The majority of the data we see coming out of the economy have been very positive.  We thought the Q1 economic data were mostly weather-related, which turned out to be correct.  Employment numbers have improved significantly.  The economy has now added at least 200,000 jobs for the past five consecutive months.

As the economy starts to heat up, we should see increased activity from consumers and better sales growth for U.S. corporations.  Unless there is an unforeseen major geopolitical issue or natural disaster that disturbs the global economy, neither our Macroeconomic Team or the economists we follow foresee any recessions on the horizon.

That leads us to the second major killer of bull markets...    

(2) The Federal Reserve  

In the absence of any major economic shocks, the Fed is the primary suspect in the death of most Bull Markets.  

When interest rates are low, investors look outside the safety of U.S. Treasuries and into more traditionally risky assets such as stocks.  As the stock market increases from the inflow of funds, people begin to experience the “wealth effect” from watch their account values go up.  As consumers feel more wealthy, they increase their spending, which puts upward pressure on capacity.  To meet the rising demand, businesses hire more people and invest in new factories and technology to push up supply. When the Fed raises interest rates, the opposite tends to occur.

Even when the Fed raises rates, however, the stock market has historically been very slow to respond. Looking back to previous bull markets, it has taken several months of interest rate increases before the stock market has had any meaningful reaction.  This is not to say that this time will be the same - but it does contradict the widely held belief that the stock market will be hurt by the Fed raising short-term rates in the coming year or two.  Using history as our guide, that just doesn’t seem to be the case.

Furthermore, the small body of evidence we have about Federal Reserve Chair Janet Yellen suggests that she isn’t going to be quick to raise interest rates. Yellen believes wholeheartedly in the Fed’s dual mandate of both maintaining price level control (inflation) and in promoting employment.  As long as the economy continues to have above average unemployment, it is very likely that Yellen will push the Fed to keep rates low.  And as long as rates stay low, there is nowhere for investors to go but stocks.

When Is The End?

While we would consider ourselves to continue to be optimistic about the future of stocks, we certainly are not raging bulls.  We know that all bull markets must come to an end at some point, we just don’t believe that will happen in the near-term.  

While no one can know for sure when the bull market will end, there are often signs that start show up ahead of time.  One of the things we look for are the “one percent days.”  If stocks start moving up rapidly with a series of these large increases, that is likely a sign that Mr. and Mrs. America are starting to get tired of sitting in cash.  As they pour into the market, the buyers dry up and leave nothing but sellers.  On the flip side, a long string of negative one percent days typically indicates that the market is going through more than just a batch of profit taking.

We get a lot of questions about what we would do if we sense weakness in the market.  When we see potential trouble on the horizon, we don’t just immediately move to cash or try to time the market. We find it in our clients’ long-term interests to “take air out of the ball.”  

If things were to get rowdy, we would strategically reduce more volatile positions (“A” stocks) and look to add more “Royal Blue (RB)” stocks to stabilize our portfolio.  This does two things: (1) it reduces the volatility of our portfolio and (2) provides solid earnings growth and dividends to get our clients through the worst of the storm.  In bad markets, the RB stocks become defensive strongholds.  They are so big and strong that they can absorb huge amounts of shock without damaging the intrinsic value of their businesses.

Current Outlook

At this moment, we don’t see much sign of weakness. Despite the geo-political issues in Russia, the market has continued to move higher.  If shooting planes out of the sky doesn’t spark even a small pullback, that’s a pretty strong indicator that the market can continue to drive north.

Valuations for some companies are getting frothy, but the overall market is about fairly valued and well within its normal statistical range.  With interest rates so low, even higher valuation multiples than we are currently seeing would not be out of the question. While that’s a possibility, we don’t anticipate getting any additional return from valuation multiple expansion.  

In our opinion, stocks are likely to return what they generate in net earnings and dividend growth over the next 6-12 months.  If Q2 earnings are any indication, growth is starting to accelerate along with the economy.  As long as the companies continue to be the stars that they have been, this bull market still has strength to keep charging on.

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

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

1. After-tax Profits

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

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

Cross Currents Aplenty, Improving Fundamentals Will Prevail

Earnings Growth: Modest Growth, but Better-Than-Expected

Company earnings and revenue growth for the S&P 500 during the 2^nd quarter have both surprised to the upside. Earnings growth, as reported so far, has been about 3% higher than the 2^nd Quarter in 2012 – led by Financials up nearly 9%. Revenue growth so far has been just under 1.5% – despite the Energy sector reporting 9% lower sales than a year ago.

Prior to the release of 2^nd quarter earnings, the expectations were very low. While these revenue and earnings growth appear to be modest, they were better than expected – which gave the market a lift. Nearly 70% of companies beat expectations.

Companies are Not Cutting Back

There is little evidence that businesses have achieved earnings growth from cost-cutting. According to JPMorgan research, only 9 of the 228 companies that have reported thus far have boosted earnings based on higher sales and lower expenses. Companies have grown earnings by increasing revenue, investing in new technology, research and advertising – not by reducing expenses as many analysts had feared.

12 Random Ramblings

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

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

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

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

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

Greg Donaldson, Chairman of the Investment Policy Committee

Donaldson Capital Management, LLC

The Dollar's Slide: Terminal or Temporary?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Written by:  Randy Alsman and Greg Donaldson

Principals and Clients of Donaldson Capital Management own Nestle.

Donaldson Barnyard Forecast is Positive for Stocks

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



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Rising Dividend Investing
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The Barnyard Forecast: Has Europe Changed Things?

Our regular readers, will remember that the Barnyard Forecast is our short-hand version of determining the prospects for US stocks over the next 6-12 months. The Forecast receives its name from the acronym we use to "score" the prospects for stocks: Economy+Inflation+Earnings+Interest Rates=Opportunity (EIEI=O). Economy: We believe that the huge bail out fund that Europe announced over the weekend will continue to support stocks around the world. If Europe would have continued to dither, then there would have been trouble plenty. The way it is, though, we still see 3.5% world wide GDP growth and 3% US GDP growth. We were only counting on Europe gaining 1% before the bailout, and with the new taxes and cuts in government spending, they'll be lucky to achieve even that low level. A 3%-3.5% level of economic growth is not likely to put the Fed or central banks around the world on the warpath. Thus we would rate the Economy as positive for stocks. -- 2 points. Inflation: We believe the events in Europe will actually keep inflation contained. We still expect about 1.5% core inflation for the US. That is at the lower end of Fed targets and not likely to cause Bernanke and crowd to start hiking rates before the end of the year. Inflation is positive for stocks. -- 2 points. Earnings: We started off the year predicting 20+% growth in corporate earnings. It looks like S&P 500 earnings may actually rise closer to 30% for the year. This is an outstanding underpinning for the stock market for the rest of the year. Earnings are positive for stocks. -- 2 points. Interest Rates: We still believe 10-year US Treasury bonds will likely end the year near 4.5%. That would be appreciably higher than December of 2009, and thus negative for stocks. Zero points. The Barnyard Forecast totals 6 points out of a possible of 8. That is a bullish score. In light of the bailout of the troubled countries in Europe, we believe that the path of least resistance for US stocks is up. Had the problems been left to fall where they may, a domino effect could have continued to pound world wide stock markets. However, since European leaders have put forth such a massive bailout package, we believe the markets are likely to return their focus to the fundamentals and the fundamentals, particularly in the US, are utterly outstanding. The Barnyard Forecast is only based on what it can see. It cannot see the potential for new crises developing in places that are not now apparent. But from what it can see, it still signals an environment that is positive for rising stock prices.

Ben and Hank's Plan Was Inevitable, And It Will Work

"The Fed and the US Government will ultimately put together some sort of bail out plan for the $300 billion in subprime bad debt. The amount is smaller than the S&L bailout in the late 1980s, and it is the only way to keep the real estate market from being a drag on the economy for years to come." Rising Dividend Blog March 25, 2008. This is a quote from my March 25, 2008 blog entitled Tough Questions, Controversial Answers. I was wrong by 60%, but right in principle that the US Government would eventually be forced to buy the bad mortgage debts from the banks to end the mortgage crisis. I heard many negative comments about that blog. I heard about free markets, moral hazards, and a host of other issues that didn’t mean a twiddle. I heard them, and I listened patiently, but I knew where this subprime debacle was heading. Now we are here at a figure of $700 billion instead of my $300 billion. Could the number have been smaller had Ben Bernanke and Henry Paulson moved faster? No, they have moved as fast as they could. Politicos cannot move much faster than the populace, and the people were not ready for a government bailout until recently. The following is a paraphrase of the last question of the March 24 blog. Question: What about the precedent of bailing out people and institutions who made unwise investments? Answer: It is not the Fed's job to impose moral judgment on society. It is their job to maximize sustainable economic growth and minimize inflation. One could just as easily use the argument about the moral hazard of people in the US who live directly in hurricane alley, or tornado alley, or wildfire alley, or earthquake alley, or any other dangerous alley in the country. Why should the rest of us have to pay when Katrina rips away New Orleans or Houston, or a tornado tears through a city in Kansas. These people all built homes or bought homes in harms' way. Shouldn't we just leave it to them to clean up their own piles of trash? No, that is not the way our country works. There is no hiding place from the storms of life -- physical or financial. Our country has stepped forth time and again to calm the storms and solve the problems in one economic sector or region of our country so that the troubles of that area do not spread to other areas and take us all down. Of course, there were egregious lapses of judgment on Wall Street, but they are paying for it in the hundreds of billions of dollars in write offs they have taken, bankruptcies they have filed, and in the tens of thousands of jobs that they have lost since the beginning of the subprime debacle. I don't like bailouts any better than most of our readers, but some bailouts are necessary when the foolishness of one group imperils the general populace. I believe the subprime-real estate crisis rises to that level. Had the government not bailed out the S&Ls in the late 1980s, the S&L problems would have lasted a decade, cost hundreds of billions of dollars, and slowed overall economic growth to a crawl. As it was, the Resolution Trust Corp. cleaned up the majority of the mess in only a few years at a fraction of the $500 billion at stake. In almost all economic crises, the death knell is the freezing up of valuable assets behind fear and risk aversion. In essence, when the government steps in, they act as an icebreaker by breaking apart the frozen assets and keeping them flowing, then putting the assets up for sale in an orderly basis. That is what happened in the S&L crisis. That is what I predict will happen in the subprime crisis. So, now we long-term investors wait and watch the politicians as they wrangle their political advantage out of the bail out package. While they spout and speak of things they know and care very little about, the markets will dangle in a cloud of unknowing, and as a result, will swing with the wind. When the package is delivered to the President for his signature, if it is along the lines of Secretary Paulson’s proposal, the markets will calm and the seeds of trust and confidence will sprout. If it includes tag-ons like more “bridges to nowhere,” the market will see through it like a cheap suit, and we will have more weeks of rough weather until the politicians get it right. I am not worried about the future because in a crisis US politicians usually get it right. Politicians are pawns of political pressure. Political pressure is beholden to the will of the public. The will of the public is not as far from the truth as many in the media elite would have us believe. The public are figuratively in the streets chanting for a stop to the financial carnage. They know that much of New Orleans is under sea level, but they reach out to New Orleanians as the storm surges over their seawalls anyway. That’s what’s so great about America. We are a nation that forgives and forgets and moves on. You say things have changed and it won’t happen this time. History says you’re wrong.

Hank Paulson Got It Right on Fannie and Freddie

On Friday as I saw the 6.1% unemployment data released, I began writing a blog. Even though GDP was revised up, the meat and potato issues of lost jobs and homes were sure to cause the media to go on a "sky is falling, duck and cover" campaign that would leave most Americans wondering how we were ever going to get beyond this housing debacle, and in the process, freeze spending and weaken the economy in an even broader way. So I wrote that government must do more; that government must do what it could to stabilize all mortgage markets. To accomplish this, they must become direct participants in buying mortgages to push mortgage rates down, which would stimulate demand for housing and refinancing opportunities for those that qualified. Please read my Friday blog. It was not broadcast because I did not finish it until after 5:00 PM CDT. Late in the day, the Wall Street Journal carried a story that Hank Paulson, Treasury Secretary, was readying a takeover of Fannie Mae and Freddie Mac. In essence the US government was getting into the mortgage business. Hallelujah. This is something that I have been calling for since March, and this was the direct approach that I was advocating in the Friday blog and in previous ones. I repeat that I am a free market advocate to my bones, but the housing bubble threatens to set our economy on a decade-long bubble unwinding, which would produce sub par growth and economic malaise. The housing debacle has become a threat to our national security and that is a job for government to solve. Our friends on Wall Street and in the banking business have finally bitten off enough risk that they had choked the whole economy. The actions of Secretary Paulson will be debated and second-guessed, but I am convinced that they were necessary and that they will soon begin to bear fruit. Here's why. The weak link in the US economy is housing. If a floor is put under the housing market, the rest of the economy is still humming along reasonably well and will continue to do so. Oil prices and commodity prices are falling, which will have a positive psychological and economic effect on Americans consumption. High oil and commodity prices have not been overly worrisome to me from an inflationary standpoint because they have acted more like a tax on consumption. If these prices continue to fall, or even stay near current levels, inflationary pressure will diminish dramatically, and consumers can breathe a little easier and plan a little more long range. I believe Secretary Paulson's actions will be seen by worldwide investors as necessary and responsible and will cause money to begin flowing back into the US from foreign investors. The actions were bold, they were decisive, and even though I wish they would have happened a month ago, they will be rewarded with positive reactions in the US stock market. The government has more work to do to unfreeze the economy, but today's actions with Fannie Mae and Freddie Mac are a powerful message that Paulson and Bernanke are on the same page and will use every tool they have to produce an under girding to our economy. I also like the fact that the takeover of Fannie and Freddie has sunset provisions that will require the next administration and congress to act, or these changes will be gradually unwound.

The Bailout of Fannie and Freddie: The Beginning of the Beginning

Please forgive any punctuation or spelling errors you may find here. I continue to have trouble with the edit function of my blogger account. I will have things back to normal shortly.

Fannie Mae and Freddie Mac appear to be headed toward a rendezvous with something that John Maynard Keynes would advocate -- a bailout. Within days they are likely to be getting a helping and "visible hand" from Uncle Sam in the form of government loan guarantees and capital infusions to strengthen their capital bases. At issue is their net capital -- they don't appear to have enough of it to carry the trillions of dollars of mortgage loans that the two hold between them, especially when housing prices are falling and defaults are rising. As big and as powerful as Fannie and Freddie are, they could not stand as the savior of the housing industry. Only the US government can do that, but Fannie and Freddie will play an important role in the bailout of housing. They will be the conduits and the facilitators of the government's largess in cleaning up the housing debacle. Private and public financial types were in the news over the weekend discussing the Treasury Department's deeper intercession into the housing quagmire. Treasury Secretary Henry Paulson has announced that he will ask Congress to approve a wide-ranging package of loans and equity commitments to the Fannie Mae and Freddie Mac. I have had a growing worry that if the government did not step in to assist Fannie and Freddie that the negative momentum that has ensnared nearly all financial institutions may have propelled both government sponsored enterprises into a technical state of default, whether or not the financial statements would deem it fair or equitable. The banking system largely remains frozen, as banks shore up their own capital ratios with the spreads they can earn from borrowing short-term Fed Funds and investing in longer-term higher yielding debt. Almost all lenders surveys are now indicating a significant tightening of lending standards. Thus, Fannie and Freddie have been left as the home mortgage makers of last resort, and the only windows truly open to all comers. The possible demise of Fannie and Freddie was simply too big a risk for the government to take. They had to act. They had to give up on Adam Smith's invisible hand, for Keynes' visible hand. This intrusion into the fine points of capitalism will be debated ad nauseum, but though I am the staunchest of believers in free markets, I called for this move weeks ago, when I said that before the housing ordeal was over, the United States Government would be investing in mortgages. That was the only way I could see then, or now to stop the cascading real estate snowball from plowing through every bank in the country. Now the government is on the inside. Through an equity role with Fannie and Freddie they will be able to see the real numbers, not play peek a boo with enterprises that are trying to hide their true financial conditions. I want to speak to the different asset classes that Fannie and Freddie have in the market and their relative degree of risk associated with these changes. The list is not exhaustive. It is just the main body of securities that trade everyday. 1. So-called Sovereign Agencies, or Debentures: These are a staple in the investment world and a product that we use broadly. They have been rated AAA for years and continue to be. These Agencies have what is called an implicit backing by the government that just became explicit. This is good news.

2. Collateralized Mortgage Obligations guaranteed by Fannie or Freddie: These, too, just got a lot safer, though they were already had a high degree of safety even before this move because of their high quality collateral.

3. Preferred Stocks: The devil might be in the details here, but as I read Mr. Paulson's plan, Fannie and Freddie's preferred stocks should get and immediate boost. They just got a lot safer because there is now little likelihood that Fannie and Freddie will fail.

4. The wild card is the common stock: I think that was the reason these two stocks were so weak on Friday. If the government is going to take an equity position, it will be very dilutive to current shareholders if it looks like the private equity deals. Having said this, the stocks might pop a little higher if it looks like the deal will be approved quickly.

To me it was inevitable that the government would have to get into the mortgage business to turn around housing. I am very hopeful that in doing so, they have truly begun the beginning of a turn around in real estate.

Randy's Comment to a Client

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

Barnyard Forecast: Year End 2008 Looks Good

It's a dark night, the dog ate my speech. Actually I left the speech on the desk in the hotel in Indianapolis. I am to give that speech in 30 minutes to a crowd of maybe 100 people. I am not worried too much because the speech is about the economy and prospects for stocks. I can wing that with an overhead slide or two. Then I see flashing yellow lights ahead and an illuminated sign that says: Return to Marked Detour. Now I am worried, because I did not see any detour signs for the last 20 miles. There will be no backtracking and still make the speech on time. Then in the cornfield on my left I see the unmistakable signs of a solution to my problem: the moonlit dust of a fellow traveler. There is a back road around this detour and it follows the contour of this cornfield. Fifteen minutes later I am in the room where I will give the speech. I am greatly relieved to have arrived on time, but now I am faced with the task of saying something intelligent to the gathering crowd from a speech I do not possess. I do as I always do. I mentally work through the acronym E+I+E+I = O. Economy plus Inflation plus Earnings plus Interest Rates equals Opportunity. As many of you know, this is what has come to be known as the Barnyard Forecast. The Barnyard Forecast is a rule of thumb method to ascertain the "on balance" forces driving the stock market at any particular time. The story of the Barnyard Forecast began 20 years ago as I sat in front of that detour sign, but I still use it today, even when I have lots of time. The reason is simple: it is a quick way to wade through the underbrush of conflicting economic data and see the current status of the Fed's efforts to stimulate economic growth while containing inflation. Each component of the forecast is rated as positive for stocks (2 points), negative for stocks (0 points), or neutral for stocks (1 point). Economy: The economy is growing at a rate less than its optimal rate of 2.5%-3%. 2 points. This is counter-intuitive. Why should a poor economy be good for stocks? The reason is simple. The Fed will be making money cheaper in a weak economy. Lower rates will ultimately spur economic growth. In this case, the weak economy, for purposes of the model, is counted as a positive. Inflation: I have always scored inflation both on a headline rate and on a core rate. The headline rate is above the optimal rate of 2%, thus it gets 0 points. The core rate is near 2%, resulting in a score of 1point. The average of the two is .5 of a point. Earnings: Earnings are positive if the expected earnings growth is above the 80 year average of 7% and negative if they are projected to be below that level. Year-ahead earnings growth for the S&P 500 is currently projected to be 8.3%. That merits a positive score of 2 points. Interest Rates: To score interest rates, I also use two measures: the current rate on Fed Funds verses it rate of a year ago, and the same measurement for the rates on 10-year Treasury bonds. Both Fed Funds and 10-year Treasury bond yields are lower than they were a year ago. 2 points. Opportunity: Since there are 2 points for each component of the Barnyard Forecast, anything above 4 points would be a positive reading for stocks over the coming year. A score under 4 would be considered negative. Economy: 2.0 points. Inflation: 0.5 points Earnings: 2.0 points Int. Rates 2.0 points ........Total 6.5 points Wow, 6.5 points is about as high a score as is possible for the model to produce. That would mean it is signalling that stocks should have a very strong performance over the remainder of 2008. Earnings, however, are a wild card in the forecast. While earnings are expected to grow 8.3% for the year, most of that growth is expected to come in the fourth quarter, when comparisons against 2007 are easy. Thus, while I am optimistic that stocks will end the year much higher than they are now, I think they are in for the summer blahs, while we work our way toward easier comparisons in the fourth quarter. The single biggest exception to this forecast would be better-than-expected bank earnings in the second and third quarters of the year. If bank write-offs end, stocks will rally, no matter when it comes.

McD's May Be Going Up, Because It's Going Up

Momentum is a wonderful thing, when momentum is in your favor. Only problem is momentum is like the wind -- nobody knows where or for how long it blows.

As the subprime crisis has extracted its toll from the banks and retail stocks, that toll has been invested in the so-called defensive stocks: consumer staples, oils, and utilities.

The chart at the right is our 20-year Dividend Valuation chart of McDonald's. If you wondered where the money went that they took out of your favorite bank stock recently, look no farther because a bunch of it went here. McDs has been moving straight up in 2007. Much of its rise has been warranted because the company has had a string of good earnings reports and a big dividend hike. However, some of the recent run up is probably due to momentum -- meaning its going up because its going up.

Our model is suggesting that the stock has a projected rate of return for the next twelve months of only 5%, give or take 5% (represented by the blue striped bar at right). In our way of thinking that means, judging from the last 20 years, the most probable year-ahead rate of return for MCD is between 0% and 10%. That does not give us much of a margin of safety if the US economy is a little stronger than many observers now believe. A stronger economy could well cause the momentum of MCD to reverse.

The Fed is meeting today, and to the extent that they keep cutting rates, the odds improve that economic growth may surprise on the upside in the year ahead. If that is the case, financials would be a better buy than staples. Almost all the financials we follow are nearly 25%-35% undervalued, again based on their long-term relationships to dividend growth.

A word of caution. We are only buying highly rated financials whose dividend is secure. I have no idea where Countrywide Financial or Washington Mutual will be a year from now. Additionally, while many consumer staples stocks are overvalued, many are not. I'll have more to say on some of the undervalued staples in future blogs. We will also have more to say on what financials we like.

Bank of America: Dividend Growth Will Continue and the Price Looks Right

Many readers have asked that I show the Dividend Valuation Model for Bank of America. The company recently announced disappointing earnings and has seen it price fall off with the other big banks.

Having said this, I believe the bank is dealing with its issues in investment banking and will be one of the first big banks to get its writedowns behind it.
The current dividend yield is 5.5%. BAC has raised it dividend in each of the last 20 years. Dividend growth, during that time, has averaged nearly 13%, and nearly 15% over the last 5 years.

The past is no guarantee of the future, but I believe the company will continue to increase dividends, albeit at a slower pace.

Wall Street analysts are now estimating that BAC's earning over the next 3-5 years will average near 8%. The chart above uses 8% dividend growth in 2008.

The green candy cane at the far right of the chart is the implied value of BAC at this 8% dividend growth rate. That price is $56 per share.

No one knows the magnitude of the subprime loan problems that lurk in bowels of banks today, but we can make some simple observations. Unless the US economy falls off a cliff, the banks have enough capital to withstand a lot more trouble that the subprime problems appear to present. BAC's management has a reputation for being straight talkers. They did not sugar coat their writeoffs, and CEO Lewis said the performance was unacceptable and that changes were coming in the investment banking group.

By the swiftness of the subsequent actions, the plans must have already been underway on the day of the earnings announcement, because three weeks later they have already replaced many of the top managers of investment banking, and announced the elimination of 3,000 jobs.

Including dividends, if BAC reaches $56 per share over the next 12 months, that will represent nearly a 29% total return.

I admit that it doesn't seem possible in light of the news of the day, but, as I said earlier, if Fed does its job and the economy has even modest growth, the subprime fiasco will gradually fade from the headlines, which will allow the banks to move higher.

I own BAC and have for many years. At 5.5% dividend yield, it doesn't take much price appreciation to make a double digit return. That might look pretty good a year from now.

If you are not a client of DCM, please do not act on my discussion here alone. Consult your own financial advisor.

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.

Fed Rate Cut: 50 Basis Points or 25?

Trading in Fed Fund futures is signaling over a 90% probability that the Fed will cut rates on the 31st. Trading also suggests that the most probable cut is a quarter of one percent. That is also the best guess of our president, Mike Hull, who is now sporting a 0-1 win-loss record against me. Last time, I predicted that the Fed would cut rates by a half percent because I believed they recognized that a credit crisis was underway, and they needed to get out ahead of it and signal that they were more worried about an economic slowdown than an uptick in inflation. One of the indicators on which I based my prediction was the yield spread between Fed Funds, the overnight rates at which banks loan money to each other, and T-bills, the short-term rate at which the US government borrows money. That yield spread had spiked to more than 1.25%. I suggested then that such a wide yield spread was not only unusual (it had only occurred four times in the last 20 years) but a clear signal that loaning money to a bank was considered much more risky that loaning money to the government. This crisis of confidence regarding the creditworthiness of the banks jeopardized the economic health of the US economy and had -- and would continue to cause the banking system to freeze up, unless decisive action was taken. I advocated a 50 basis point cut as a preemptive move to "knock" the bankers on the head and remind them that the Fed was in charge not only of fighting inflation, but also ensuring liquidity in the banking system and economic growth. The Fed's subsequent 50 basis point cut was a bit of a surprise to the stock market and it responded by powering higher nearly 300 points. The Fed needs to cut rates by 50 basis points again because the yield spread between the Fed Funds rate today, 45 days after the last cut, is still nearly one percent: Fed Funds rate 4.75% and T-bills at 3.85%. In my mind this wide spread is still signaling the credit crisis is alive and well. I think the Fed should cut rates until the yield spread falls to no higher than .5%, and they need to do it swiftly. They currently have the liquidity crises corralled but not tamed. They need to tame it, and the best tool they have to do this is to continue cutting rates at a pace greater than the market predicts. The value of these continued sharp cuts will ultimately get the market's attention and allow equilibrium to return the banking system and the economy. If need be, the Fed can take back some of the rate cuts after normalcy has been restored. Even though I realize it is a long shot, put me down for a half percent cut. Shawn, Ken, David, Mike, Joe, Jay, et al, here's your chance to get your money back.

Oh Canada !

Whether or not the central banks of many of the world's developed nations acknowledge it or not, they will soon begin cutting interest rates. The reasons are plentiful but two stand out: the US economy will soon begin to trend lower and with it most of the rest of the G-7 nations.

Europe has already slowed, Japan is having one of its never-ending political upheavals, and China and India are attempting to slow their economies in the face of rising inflation.


Additionally, the recent cut in rates by the US Federal Reserve has spiked the US dollar lower against most of the other world currencies. This will give US companies a powerful competitive advantage in the global markets, and at the same time, make foreign exports to our nation more costly. Taken together, these forces will cause a string of interest rate cuts around the world, probably beginning with Canada.



In the picture I see forming, our Canadian neighbors may well come out looking very good for a period of time. They are a natural resource exporting nation, so their products will continue to be in demand, even if prices begin to stabilize.



Canada's banks are strong, with few of the subprime issues that will continue to nip at the heals of American banks, and finally, the country's Conservative government is finally beginning to deliver on some campaign promises. Importantly, as I said last time, Canada just cut corporate income taxes to near 30%, among the lowest in the developed world, and well under US corporate tax rates.

In running Canadian companies through our Dividend Valuation Model, I see many that are cheap. In the coming months, I will describe a few here.



The best valuation I see is Toronto Dominion Bank (see chart above). It is the second largest bank in Canada and has been making strategic acquisitions in the US. Its combination of a 2.8% dividend yield and low double-digit dividend increases over the past few years has made it a solid performer but has still left it significantly undervalued.

Our model says (I am showing TD in its local currency) that the stock may be as much as 15% undervalued, based on my estimate of next year's dividend growth.

Canada's natural resource oriented economy will insulate it from the economic slowdown that may hit most of the rest of the G-7 nations. Indeed, Canada and the US may be the only G-7 nations that will not experience any negative quarters of economic growth over the next six months to a year.