Economy Watch: The One-Handed Economist

Someone once said that what the world really needs is a one-handed economist. The reason for this pithy statement is because economists are famous for making grand prognostication and then saying, on the other hand such and such could happen, which would give us a completely different outcome. Tomorrow's headlines in your local newspaper will make the case that economists keep their two-handed approach. The headline will read, "Inflation at 25 Year High." It will be true, but "on the other hand" it will not be meaningful. The 1.2% jump in the consumer price index was almost entirely caused by the surge in energy prices during and after the two storms. The core CPI rate, which excludes food and energy and is the measure of inflation that the Federal Reserve believes is most important, rose only .1%. So take your pick; either we have annual inflation of 14.4% (the 1.2% is a monthly figure) or 1.2%. My belief is that inflation is much closer to 1.2% than it is the former. I can assure you that the main stream media will get this so wrong that I will be countering their ignorance of this issue for many months to come. So now in addition to monitoring dividends hikes and economic growth, I will be commenting on the real rate of inflation on a regular basis for a while. This blog is supposed to be about dividends, but we will have to do battle with the forces of dis-information and confusion before the quiet voice of dividends can be heard at all. At .1% the core rate was actually less than the estimates. The core rate of inflation is so important because it shows the rate of inflation in the 85% of the economy apart from the very volatile food and energy sectors, and, thus, measures the spill over of high energy prices into the rest of the economy. The "one-handed" answer to how much spill over there has been is -- not much. Over the past year, the core CPI has grown by under 2%, while the CPI including food and energy, has grown at near 4%. If I am correct in my belief that oil prices will cool down as a result of sticker shock at the gasoline pumps, then the Consumer Price Index should begin trending lower in 2006. I realize this flies in the face of the headlines in your favorite news source, but to me it is almost baked in the cake.

A Dividend Star Does Some Talking

As I mentioned in the last edition, I am very interested in the dividend hikes of major companies during the fourth quarter. This is a time when many companies make dividend increases based, in part, on what kind of a year they have had, but also, influenced by their expectations for the year ahead. Paychex is a processor of payroll checks and human resources outsourcing for small and medium-sized companies. The company is a solid Dividend Star having raised its dividend for 16 years in a row and has the 4th highest dividend growth among companies that have raised their dividends for at least 10 years in a row. PAYX's dividend growth had slowed to the low double digits over the past 5 years, reflecting the after effects that 9/11 had on employment. However, their business has bounced back, solidly, over the past year in line with US employment growth. Here's the good news. PAYX just announced a 23% dividend hike. That was twice what Value-line was projecting, and 50% more than our own expectations. In our judgment, this larger-than-expected dividend hike is about as important an announcement as we could hope for in this environment. First, as it relates to PAYX, the dividend hike is at a higher rate than their earnings growth for the year and at a much higher growth rate than their hikes of recent years. The only conclusion that makes any sense to me is that they believe their business will continue to improve. Second, and even more importantly, since they are the second largest processor of payroll checks, and the largest processor for small to mid-sized companies, I believe there is a not-too-subtle message that they are bullish on employment in the coming year. This is exactly the kind of "signaling" that I believe companies do all the time with their dividends. In this case, the signal carries over to the the economy as a whole, which is vitally important because of the unknowns created by the hurricanes and the oil spikes. PAYX, it seems to me, is giving us a clear signal that they believe (as we do) that the economy will shake off the ill effects of the storms and grow at about the same rate in 2006 as it has in 2005. As I described earlier in the year, the signaling qualities of companies is a key in our overall analysis of the attractiveness of a company's prospects. Our dividend discount model values PAYX at about $40 per share. With the stock selling at just over $36 per share, it is a reasonable value. It's dividend is not high enough to qualify for our pure dividend style of management, but we do own it in our high growth portfolio. I'll report again when another major company speaks with their money.

Dividend Increases Talk

The fourth quarter is one of the heaviest times of the year for dividend increases. Many corporate boards will be announcing to shareholders what part of 2005 corporate profits they will be paying out in dividends. But it is important to remember that dividends are as much about the future as the past. No company wants to set a dividend rate that they will have to reduce should business turn soft. With Katrina and Rita having cut a whole in near term earnings and blurred prospects for 2006, I will be very curious to see what kind of dividend increases we get, particularly for the Dividend Stars. Dividend Stars, you will recall, are companies that have consistently raised dividends for many years, even when dividends were out of fashion. Also of interest will be the dividend hikes from the oil stocks. Earnings are way up, but dividend increases have not been anywhere close to earnings growth for Exxon and Chevron. Will they share the wealth, or will they keep buying back stock. Stock buybacks are fine, but did you ever ponder the fact that stock buy backs mostly favor people selling out. Gimme the cash, I'll reinvest it if its good enough. Finally, I will become concerned about forward earnings if we see a lot of the major dividend payers hike payments by 6%-7%. A hike of this magnitude is the long-term trend and is the same thing as a punt. Dividends talk, and I want some of the key dividend companies, like GE, United Technologies, MMM, Coke, and Pepsi to be hiking payments in the 10%-15% range. In my mind that would be signaling as much about the coming year as the one just past. I continue to believe that stocks are very cheap relative to bonds, maybe as much as 20% undervalued. With 2005 earnings now expected to rise 12%-13% versus expected growth of 7% at the beginning of the year, most companies have had a windfall year. Will they reward us with windfall dividend hikes or will they revert back to long-term trend hikes in the 6%-7% range? I will chronicle important dividend announcements on the site through the end of the year. I will provide a list of the lineup in a future blog.

The Barnyard Forecast Revisited

On August 18, prior to the Hurricanes Katrina and Rita, we took a look at the prospects for the stock market in the year ahead via our Barnyard Forecast. The forecast is a big picture analysis of the position of the major components of the economy and how they resolve themselves on-balance. You may want to review the previous post for a more expansive explanation of how we view each component. Economy: In the Barnyard model, economic growth above 3.5% is considered negative because its means the Federal Reserve will be applying the brakes by raising interest rates. Prior to the hurricanes, GDP had been growing at about 3.6%, which we ranked as neutral for stocks. The hurricanes are now expected to chop near 2% off GDP growth over the remainder of this year. That would seem to imply that the Fed's long string of rate hikes is nearing an end, which would be good for stocks. The only problem with this view is that the rebuilding of the Gulf Coast area will provide a huge stimulus to the economy and probably push economic growth in the early part of 2006 back above the caution level of 3.5%. I still rate the economy neutral for stocks, 1 point. Inflation: This is the wild card in the deck. The stop and go nature of the economy for the coming year assures volatile readings. I believe the core CPI will average near the caution level of 2.5%. This will be neutral for stocks, 1 point. Earnings: There will also be a stop and go quality to corporate earnings during the next twelve months. With business currently slowed or stopped in the Gulf Coast region, in the near term, earnings will be lower than expected; but the uptick in the rebuilding process will also lift earnings growth next year above 7%, which is the threshold required to achieve a positive score. Positive 2 points. Interest Rates: I still rate interest rates neutral. The 10-year T-bond is currently yielding 4.25%. That is about the same as it was at the beginning of the year, as well as a year ago. Interest rates could drift a little higher in the early part of 2006, but I do not see long-term bond yields or mortgage rates being much higher a year from now. Neutral 1 point. Opportunity: The model scores 5 points (1+1+2+1), which is the same as it did on August 18, before the hurricanes. It may be hard to believe, but the hurricanes have done little to the longer-term outlook for growth of the economy or corporate earnings. Certainly, there will be some rearranging, with a slowing followed by a return to stronger growth, but the net effect is a reading that is about the same as a month ago. I do believe, however, that the Fed will stop raising rates in 2006, and as it becomes clear that they will do so, stocks will likely have a strong advance. Stocks are very cheap now. Earnings are up nearly 13% over a year ago, yet prices are down. This divergence cannot hold, and I believe it will be resolved by stocks moving higher.

The Fed Interest Rate Hike

With the recent devastation of Hurricane Katrina and another storm on the way, there were many who believed that the Federal Reserve may interrupt there long string of rate increases, in favor of a wait and see attitude. Thus, the stock market has registered its displeasure with the Fed’s announcement of another .25% hike by selling off nearly 150 points. But we believe the stock market has it wrong because a close reading of the news release that accompanied the rate hike contains some good news about the long-term strength of the US economy. Before we analyze the Fed’s statement, it is important to remember that the Federal Reserve’s responsibility is to set interest rates consistent with maximizing economic growth and minimizing inflation in the long-term. The operative word here is long-term. The Fed’s accompanying statement stated the following regarding the impact of Hurricane Katrina: “While these unfortunate developments have increased uncertainty about near-term economic performance, it is the Committee's view that they do not pose a more persistent threat. Rather, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity.” We believe their statement is very straight forward and very good news. The Fed is the most sophisticated economic data gathering entity in the world. They have looked at this data and other instances of natural disasters, and they have concluded that in the short-term the hurricane’s damage to the overall economy will be readily contained, and the long-term prospects for the economy are still very good. The Fed is making its decision to hike rates based on its long-term view of things, not the current news of the day. In our judgment, it is this focus on the long-term that has allowed Alan Greenspan and Company to navigate through countless crises during his 18 year reign as Chairman of the Federal Reserve. There are many politicians and media-types, who are lambasting the Fed’s rate hike as being insensitive to the plight of the suffering. To the contrary, if the Fed believes there are untamed inflationary pressures building, they would be just one more body of governmental body shirking their responsibilities if they took a pass. The stock market and some politicians may not approve of the hike, but we are actually encouraged with the language of the press release and relieved that the Fed believes, as we do, that Katrina will not take the wind out of the US economy in the long run.

Katrina Changes Things

The Wall Street Journal reported that US gasoline consumption has fallen by 4.3% since Hurricane Katrina hit the Gulf Coast. The Journal went on to explain that few analysts are ready to project a continuation of this trend, but as I said last time, I am. I think the uncertainty of the oil supply is finally reaching the consciousness of Americans, and I believe they will embark on a mini conservation program that will result in a slowing of per capital energy consumption. For years we have been warned repeatedly that our mobile lifestyle was being made possible by such "rock solid" bastions of democracy as Indonesia, Russia, Iran, Saudi Arabia, Venezuela, and Nigeria. But since there have been few alternatives and oil has remained available and cheap, we have looked the other way. But, oddly enough, Hurricane Katrina has done what OPEC and terrorism could not do: it has shown us how fragile our supply of oil really is. One big storm knocked out 50% of the refining capacity of this country. Emergency oil supplies have been released and gasoline prices have fallen from near $3.40 gal. (Indiana) on the day of the storm to $2.90 gal. today, but I do not believe prices are destined to go significantly lower in the coming year. Indeed, gasoline prices now have three tail winds pushing them: A terrorism premium, a storm or natural disaster premium, and an emergency supply premium. The first two premia are obvious, but the third needs some explanation. If you are a major US organization with large energy needs, whether you are a government or commercial enterprise, you must now consider the merits of having an emergency fuel supply as a backup for your needs. This kind of emergency fuel storage build up occurred during the last energy crisis in the late 1970s in very large numbers, as governments, businesses, and individuals installed storage tanks to buy ahead of the perceived inevitable price increases in oil prices, but also to provide an emergency supply of energy. I believe, at some level, this better-safe-than-sorry type of hoarding will happen again. Indeed, the probability of this kind of hoarding would increase dramatically if gasoline prices were to rise above the recent hurricane-induced price spike of $70. The same motive forces that will compel institutions to add emergency energy storage capacity will also compel consumers to go on something of a energy diet. But more importantly, it will cause a dramatic increase in demand for for fuel efficient automobiles, appliances, and houses. This conservation and efficiency ramp up will not wait on solid cost-benefit solutions, but will spring first from a sense of buying "insurance," and then, as innovations become abundant, will evolve into a kind of Y2K stampede toward smart cars, houses, and cities. Again, the first step will be conservation, but the next step will be a huge increase in demand for high-mileage cars, especially, hybrid cars and diesels. With home prices in a persistent uptrend in most areas of the US and low unemployment, the average family in this country feels pretty well off right now, and buying a high-mileage hybrid car or a diesel powered car in response to the heightened awareness of the fragility of our energy supply, will trump the normal cost-benefit analysis. Americans have been awestruck by the devastation and human toll of Hurricane Katrina. But the subliminal message in every heart-rending picture from the storm's aftermath is that those who were able to take care of themselves fared much better than those who waited on the government. I am not slamming the government here. There are enough people doing that. I am just stating that we are a nation of doers. Most of us are in this country because we or someone among our forbearers decided to move on. We are a freedom loving people, and one of our most prized possessions is our lifestyle. Most of us are not willing to move back into the city and use public transportation. Someday smarter cities with a more people friendly attitude may pull that off, but until that happens, we will move heaven and earth to fight for our way of life. I believe that the cumulative effects of terrorism, unstable or hostile governments in control of the oil supply, and the shocking events of a natural disaster, will stick in the crawl of most people, and little by little, they will take steps to use less energy. It is not something that you will see start tomorrow morning, or next week, or next month. It may not show up in the economic statistics for a long time, but I am convinced a new attitude about energy consumption is underway. It will change the profitability of a lot of industries. We are already making some changes in your portfolios that we believe will take advantage of the new forces at work. When we are finished, I will discuss some of our views on individual companies in more detail. Next time, I'll take you through an update of the Barnyard Forecast. Not to fear, the forecast for the economy and stock prices is still good.

Katrina and the Economy - Oil Prices

There has been an odd dichotomy is the energy markets for the last couple of years. By all accounts, the available supply of crude oil has been consistently in excess of the demand, but the demand for gasoline has been nearly 100% of the supply. At first this seems to be a circular statement that makes no sense. That is until you realize that crude oil and gasoline are not the same commodity. The difference, of course, is that gasoline is refined. In essence, there has not so much been an oil shortage, as a refining shortage. Refineries are big and smelly and not welcomed in many areas of the country. The last refinery to be built in the US was the Garyville, Louisiana facility, which started up 29 years ago in the 1976. It was one of the eight refineries shut down by Hurricane Katrina, but reports say that it and three others will be back in operation by Monday. The huge Chevron refinery, which suffered a lot of damage, is said to be nearer to coming back on line than was originally thought. The release of oil from the Strategic Petroleum Reserve by the President was crucial in bringing some measure of stability to the oil markets. This is because many of he oil production platforms in the Gulf are adrift or damaged and may be months away from operation. Thus the crude released by the President gives vital feedstock to the refineries, which the experts say have been damaged but are mainly awaiting power to come back online. In addition, the International Energy Association is releasing 2 million barrels of crude oil per day to the US. These two sources of crude oil pushed crude oil prices down by nearly $2 on Friday to approximately $67.50. I am not as worried about the energy situation in the short run as are many analysts. My reason for modest optimism is something called the elasticity of demand. This is a very basic concept in economics that says as prices rise, demand slows. Many of the commentators that you hear spouting about oil prices going through the roof believe that oil consumption is inelastic. That is, oil consumption is not responsive to price. History would appear to be on their side because oil consumption has, indeed, risen over the years, even in the face of rising prices. Where I differ from these commentators is that it has been my observation that things change during crises. Crises make people stop and think. You might say tough times make people count the costs. With gasoline prices at $3.40 per gallon and the horrors of Katrina fresh in our minds, in my judgment, prices will bite and oil consumption will begin to moderate. I want to keep reminding you of what happened the last time we had an oil crisis that actually reached the consciousness of the American people. That was in 1979 during the Iranian revolution. The Shah of Iran had fled the country and the radical Islamic Ayatollah Khomeini and his followers seized power. They may have known something about revolution, but they knew nothing about oil production, and Iranian oil production collapsed, causing oil prices to skyrocket world wide. Because American's saw prices explode and realized supplies were likely to be uncertain for a long time, they began a conservation and substitution campaign that was utterly remarkable. In 1979 the US imported 32 million barrels/day of oil from OPEC. Three years later that figure had fallen to 19 million barrels/day. I don't foresee a pullback in consumption of that level, but I believe Americans will begin to become more conscious of their gasoline consumption and in doing so their consumption will slow. This sounds like a bold statement without much to back it up, but I have observed time and again that when events appear to be spiraling out of control, people will almost always insert their own attempt to control events. There is only one thing they can do: cut back on consumption, and I think that is what they will do. I still believe the economy will dip between now and the beginning of the year, but I completely disagree with those people who are calling for a recession. In my mind, that would be almost an impossibility. Prior to Katrina, most estimates had GDP growth above 4% for the third and fourth quarters. I do not believe it is possible to shut down an $11 trillion economy so fast as to push us into recession. I expect the economy will be accelerating by the early part of 2006. The rebuilding of the Delta region will be a massive stimulus to the economy for the foreseeable future. I admit that my view of the unfolding events is optimistic. I think you also know that my attitude is that most people overestimate the negative effects of natural disasters. My experience tells me as bad as things may seem, repairs will be made, the lights will come on, the water will leave New Orleans and a rebuilding process will begin. The only obstacle I can see that would slow the coming economic stimulus is if a debate breaks out about the wisdom of rebuilding a city that lies below sea level. I am hearing some rumblings of this. If it becomes widespread, the rebuilding may be delayed until next spring. If that were to happen, the economy will slow after the first of the year. I'll have more comments in the days ahead.