AAPL AIN'T CHEAP . . . MSFT IS

• 1. In my recent book, The Hidden Power of Rising Dividends (available at Amazon), I argue that very few individuals or professional investors are confident in how to calculate the intrinsic value of a stock.

• 2. The typical stock investor today has largely become a trend follower. Put another way, they are really momentum investors.  

• 3. I have been in the investment business for nearly 50 years, and I have learned many people who admit to being momentum investors, find that they cannot pull the trigger to buy or sell when the momentum trend changes. In failing to sell at the right time, most of them become "stuckholders."

• 4. In my many years of exploring every classical and "wild hair" investment strategy I could find, I have found that many slow-growing stocks can be valued very precisely. Most companies; however, require a deep dive into their fundamentals, looking for "tell" signals. Finally, valuing very fast-growing companies is always an educated guess at best.

• Last time, I showed valuation guesstimates on PepsiCo (PEP) and Coke (KO). These are both slow growing, high dividend-paying companies with powerful brands. My models predict that Coke (KO) is modestly overpriced and PepsiCo (PEP) is significantly underpriced when using year-ahead estimates.   

• This time I am comparing Microsoft (MSFT) and Apple (AAPL). The valuation correlation metrics for these two tech stocks are much more difficult to find because dividend growth alone does not offer high correlations for either stock. For Apple, earnings growth offer a 90%+ correlation with stock prices over the last decade, and gives us a decent guesstimate of the company's current valuation. 

• For Microsoft, it is necessary to use a proprietary valuation model that includes some portion of dividends, earnings, and interest rates. The chart below shows the remarkable tightness between MSFT's actual stock price (red line) and the model's annual predicted price, shown in green. Currently, the model says MSFT should trade at approximately $422 per share. It is currently trading for near $430. At least in this first step, MSFT would appear to be about fairly priced.

The picture for Apple indicates a bit more risk.

Apple's correlation model shows that its actual price of $239 per share, shown in red, is clearly higher than its predicted price, in green, of $206. 

Based on historical data over the last 13 years, my models are saying MSFT is selling about where it should be, and AAPL is selling nearly 15% higher than its fair value. But as I said last time, "the future is in the future" for all stocks, so we must plug in next year's estimates for both companies to determine if that makes any difference.

Using the mean forecasts from Wall Street analysts, my model predicts a year-end 2025 price of $483 for MSFT and $228 for AAPL. That would offer an approximately 12% gain for MSFT and a relatively flat rate of return for AAPL in the coming year. Indeed, selling at $239, AAPL is already trading above my modeled $228 predicted year-end 2025 price. 

I own both stocks and do not have plans at this time to sell either. However, seeing Apple's valuation does cause me some concerns that I had not thought through before I began this exercise. MSFT, on the other hand, looks even better than I would have guessed. As I said last time, this is not Wall Street research. I am using simple correlation models to arrive at the price estimates I am showing. Thus, this article should not be viewed as investment advice, but just a simple analysis of fundamental data within each company that is highly correlated with changes in its annual stock price. 

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

life-changing products and services are assured.    

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

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

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

Stay tuned.

It's Official: The AI Goldrush Is Underway

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

  

Volatility Will Continue, But Stocks Are Going Higher

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

Economy and Bonds

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

Trade

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

Earnings

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

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

Preston May, Certified Business Economist

Research Analyst

Donaldson Capital Management, LLC.

Editor Greg Donaldson

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

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

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

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

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

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

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

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

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

The 4 Drivers of Stock Market Prices

We have found that very few investors understand what really drives the stock market.  In our view, the four primary drivers of market valuations are earnings, dividends, interest rates and inflation.  If you can quantify what is going on with those four variables, our models indicate that you can predict about 90% of the annual movement of stock prices.

Last time, we talked about the Barnyard Forecast which is a model that signals the probable direction of the market.  While the Barnyard Forecast does correctly predict the market’s direction 6 to 18 months from now with about 80% accuracy, it is not a short-term predictor nor does it have any valuation component.  Therefore, we use select valuation models to ascertain the relative attractiveness of stocks.

Almost all of these models use some component of the above mentioned variables.  Within those four variables, there are two that stand out above the others as being the most important drivers.  We’ll take a look at each factor and then conclude with what it means for stocks.

Earnings

Most investors look to earnings as the primary guide of what a company is worth.  In theory, that makes sense.  If Company A is earning $500 and Company B is earning $1,000 - wouldn’t you rather own Company B?

The problem with earnings is that they can be engineered by creative corporate executives.  In times of recession, earnings are particularly volatile. Earnings can be calculated in a variety of different ways, which adds additional complexity.  We don’t think earnings should be completely discounted in valuing companies or the stock market as a whole.  However, the unpredictable nature of earnings often gives very bad signals at turning points in the market.

Dividends

We have found dividends to work much better than earnings.  Over the past 50+ years, dividends have had approximately three times more predictive power than earnings.

Let’s say you own two rental properties.  One rents for $100 per month and the other rents for $200.  If both rents are increasing at 3% per year and both will continue to rent for the next 20 years, which rental property would be worth more to you?  The one that will pay you the most in rental income over its useful life… right?  

John Burr Williams was the first to apply this theory to stocks.  He said the value of a stock today is the sum of all future dividend payments discounted back at some required rate of return.  In other words, the more a company pays out to its owners in the future, the more valuable that company is to its owners today.  

Not only does that theory make “real world” sense, but it also holds up statistically.  In our models, we’ve found that dividends are the most important driver of stock prices by a wide margin.

Interest Rates

Interest rates are a primary concern for most stock investors.  The general level of interest rates essentially represents the “opportunity cost” of investing in stocks.

If your bank account were to start offering 10% per year on your savings account, you would probably prefer to “invest” in your savings account rather than in the stock market.  If your bank account is only paying 0.1%, however, the attractiveness of investing in stocks increases.

Many investors would be surprised, however, that interest rates are not the most important factor in determining long-term stock prices.  

Inflation

Inflation is actually a much more significant predictor.  How can that be? There are several reasons for this.

Interest rates can be artificially set by the Federal Reserve.  Inflation can be influenced by Fed policy, however, it is primarily a result of real world economic activity.

Inflation is also one of the primary drivers of interest rates.  If inflation is rising, it has the effect of diminishing the real rate of return for a bond investor.  In that environment, a bond buyer will demand a higher rate of interest to compensate for the loss of purchasing power.

In addition, inflation is impacted to a large degree by economic growth. When the economy is growing at a faster rate, the Federal Reserve will generally tighten monetary policy, which raises interest rates.

The importance of inflation is also reflected in several of our models.  We have a price-to-earnings (or “P/E”) Finder model that we use to determine the appropriate P/E ratio for stocks.  In that model, inflation has been a much better predictor of P/E than interest rates, GDP growth or earnings growth expectations.

Outlook for Stocks

If you can understand these four variables, you can get a fairly accurate gauge of the valuation of the market.  At this moment, all of these variables are very positive for stocks.

• Dividend growth for the S&P 500 has been over 10% year-to-date.  We believe this will continue to be strong in 2015.  Companies are beginning to understand how valuable their dividend checks are to shareholders and have begun to emphasize dividend growth as a priority.

• Earnings are expected to grow by over 10% in 2015.  Time will tell whether that will come true or not.  If it does, we anticipate the market will reward the companies for their continued strong performance.
• Inflation remains very low.  With little capacity pressure from either employment or plant and equipment, we don’t see much of a chance that inflation gets higher than the Fed’s target of 2.5%.  The economy is simply not growing fast enough.
• With inflation low and the Fed continuing their stimulative monetary policy, interest rates are likely to remain low.  The 10-year Treasury continues to trade at the low end of our 2013 prediction of between 2.5% and 3.0%.  We don’t anticipate that rates will get much higher than that over the near term.

As we talked about last week in our Barnyard Forecast, monetary policy conditions are very favorable.  Aside from a major geopolitical shock, stocks don’t face any major red flags going into 2015.

The most current reading from our S&P 500 valuation model indicates that the fair value of the market is about 1,950.  As this is being written, the S&P 500 is trading at about 1,952.  From both a directional perspective and a valuation perspective, our models are saying that stocks are still the place to be.

Barnyard Forecast: More Bull to Come or Is the Bear Growling?

Our last published Barnyard analysis appeared approximately 1 year ago in September of 2013.  At that time, the Barnyard Forecast resulted in 6 out of 8 points, indicating that the market would be favorable over the next 6-18 months.  That has come true, with the S&P 500 up nearly 20% since then.  We expect many will be surprised by the latest Barnyard Forecast.

During this week’s Investment Policy Committee meeting, we updated our “Barnyard Forecast” model.  The Barnyard Forecast is a basic model we use to determine whether the current environment is accommodative, neutral or restrictive towards stock market growth. Since 1990, the Barnyard model has correctly predicted the general direction of the market over the next 6 to 18 months with approximately 80% accuracy.

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

Economy - 2 Points

When the economy is growing slowly, the Federal Reserve's projected actions over the next 12 months should favor stocks.  The Forecast score is positive when economic growth is less than the optimal, non-inflationary rate of economic growth of 3%.

Economic growth has improved significantly since the 1Q 2014 numbers.  However, year-over-year GDP growth remains below the 3.0% mark.  At this moment, we’re at about 2.5% with the 3-5 year range between 1.5% and 3.0%.  Economic growth would need to be at least 3.0% before the Federal Reserve would start taking any action to raise rates.  In our view, even 3.0% might be too low in light of the other data coming from the economy.  The bottom line: the economy is still not growing fast enough to warrant monetary policy tightening.  Positive for stocks – 2 points. 

Interest Rates - 2 points

Historically, the yield curve spread (difference between long-term and short-term interest rates) has been a predictor of economic performance.  As long as the spread remains positive, stock markets tend to rise.  When it turns negative, that is a danger signal for stocks.  

Spreads between long-term and short-term rates are currently very positive.  The 2-year U.S. Treasury is yielding around 0.5% versus nearly approximately 2.5% on the U.S. Treasury, a positive spread of 2.0%.  Since we are nowhere near a negative yield curve, this component of the model strongly suggests a favorable environment for stocks.  2 points.

Earnings - 2 points

Earnings growth is a statistically significant driver of stock market prices.  Over the long-term, earnings growth for U.S. corporations has been 7%.  The Forecast scores growth greater than 7% as being positive for stocks.  

In September 2013, the 2^nd quarter earnings were only 3% - well under the 7% level.  This time around, earnings growth is markedly improved.  Last quarter’s earnings growth was close to 9%.  Earnings growth projections are for even better grow over the next 12 months.  Companies have continued to grow despite the lackluster economy.  Positive for stocks - 2 points.

Inflation - 2 points

The Federal Reserve's optimal level for core inflation is approximately 2% to 2.5% year-over-year.  Core inflation under 2% allows the Fed to stimulate the economy without creating inflationary problems and is positive for stocks.  Inflation greater than 2% is negative for stocks.

Mr. and Mrs. America tend to watch the Consumer Price Index (CPI) and core CPI (excludes energy and food).  However, the Federal Reserve pays more attention to the Personal Consumption Deflator, which tends to run about 0.5% less than CPI.  At the moment, CPI is about 2.0% and the Personal Consumption Deflator is around 1.5%.  Unless inflation ticks up at least another 0.5%, we don’t anticipate the Fed is going to raise rates.  Positive for stocks - 2 points.

= Opportunity for Stocks - 8 out of 8 (Positive)

Adding each of the 4 factors totals a perfect score of 8, which indicates conditions are very favorable for stocks.  Our Barnyard Forecast has historically done a good job of indicating the general trend of the market.  While there are many unknowns surrounding the Federal Reserve's next moves, our Investment Policy Committee agrees with the Forecast's projection of continued positive returns for the market over the next 6 to 18 months.

Consolidating, Validating and Recalibrating

A number of different worries have rattled the market to start 2014.  Let’s take a closer look at what they are and what each of them means for the global economy and markets.

1. Housing Slowdown

Housing represents a very large part of the U.S. economy (about 20%), which is why economists and investors alike pay close attention to housing data.

 

After a strong 2013, the housing market data has weakened.  New home construction surged in November 2013, but fell in December 2013 and January 2014.  Rising interest rates are likely to blame.  Mortgage rates have risen to 4.5% from their lows around 3.5% in early 2013.  The threat of rising interest rates in 2014 and 2015 has investors concerned that the weakness in housing may continue.

The lull we are seeing in the data could be a result of last year’s low rates, which likely pulled forward some purchases that may not have ordinarily occurred until six months to a full year later.  The abnormally cold winter may also be

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

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

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

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

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

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

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

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

Why Was the Market Up 25%+?

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

Driving the Bull: Dividend Growth Pushing the Market Higher

Now that the government shutdown is past us and the debt ceiling has been pushed out for the near term, we thought it would be an interesting exercise to share with our readers some recent research that we have done in attempting to identify which types of stocks are doing the best in the current bull market.  

S&P 500 Total Return Analysis

The stock market has had a strong run since 2009.  Over the last 12 months, the S&P 500 is up approximately 25%.  We broke the S&P 500 companies down into quintiles of 100 stocks each and ordered them according to largest to smallest in 4 different fundamental categories including sales growth, earnings growth, dividend yield and dividend growth.  We then calculated the total return (dividends and capital appreciation) for each quintile over the last 12 months.

Barnyard Forecast is Bull-ish on Stocks

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

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

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.