The Dawn of Bernankespeak or Not Speak

Alan Greenspan was the master of the overstated understatement. A group of investors could listen to his testimony and come away with diametrically opposed interpretations of what he had said. By contrast, Ben Bernanke has promised a new openness and clarity, but it has been slow going so far. It is my belief that he has a bit of a tin ear to the markets. He had not come to the realization that HE IS the news and billions of dollars of bets are spring-loaded in computerized trading systems hanging on his every word. Greenspan had a lot of faith in the markets. He listened to them, and he talked to them. If he saw the traders going off in the wrong direction he would say something simple and clear to get them back on the right track. If he thought they had it about right, it seemed to me that he became more obtuse. Next week we have the first real test of the Bernankespeak. The Fed meeting on September 18th, is now on the lips of everyone from cab drivers to cowboys. Will he, won't he? That is what we are all asking, and all of us have become closet economists arguing our points of view, no matter how silly or off the wall they may be. At the rate we are going, by next Tuesday, all of the markets will grind to a halt awaiting the Fed's decision on interest rates. In the midst of all the talkers are a group of investors who are making bets, so to speak, on the outcome via Fed Fund Futures. Bloomberg has a new analytical tool that extracts the implied probability of changes to Fed Funds by analyzing the trading data. Today's readings for Fed Funds Futures, are as follows:

• 4.75%. . . . . . .74%
• 5.00%. . . . . . .26%

If you do the math, 100% of investors in Fed Funds believe at least a .25% rate cut is coming. Significantly, and perhaps surprisingly 74% of investors believe a .50% cut is at hand. I'm in this latter camp for reasons I have discussed earlier.

Here's where everyone is flying a bit blind. If Greenspan would have seen this Fed Fund action and he had no intentions of cutting rates by half a percent, he would have Greenspeaked it --talked it down.

We don't know if that is how Bernanke is going to operate. He may believe in more openness but less guidance and less Bernankespeak. If this is the case, my thinking is a quarter percent cut will be viewed as a disappointment by the stock market and it may well sell off. Heaven forbid if rates aren't cut at all.

The saving grace is the Fed's statement accompanying their decision. They can still signal there intentions in the statement which would have the effects of muting the actual move they might make. That may be where Mr. Bernanke has decided to speak.

I can't remember a Fed meeting in years where so many investors are so confused about the outcome. Should make for an interesting day.

We are Bullish on Stocks

Each week our investment policy committee deals with the events and issues of the day, as well, as charting the course of our investments.

There are four of us: Mike Hull, our president, who has wide experience in consumer attitudes and consumer products; Vice President, Rick Roop, who has had many years of experience in energy production and organizational systems, Vice President, Randy Alsman, who has a background in finance and has been an executive in both the consumer products, as well, as the pharmaceutical industries; and Greg Donaldson, who has a long history in economic strategy, financial institutions, and valuation metrics.

This past week we had a wide-ranging discussion of the goings on under the sun, so to speak. The following in a general synopsis of our thinking: The points seem rather straight forward, however, we can tell you the getting-there was not so straight forward, but a flood of thoughts and ideas that sprang up and were either shot down or allowed to pass on. In the end, this is what WE believe, and I (GCD) am proud to say it is reasoned, reasonable, and, in my judgment, a good bet to come to reality

We saw the troubles in real estate coming. We were convinced they would be worse than what most people thought. We said as much here 15 months ago.

We are surprised that the subprime mortgage mess is as widespread as it is. Unknowns in the banking system are always unnerving, and we believe the damage is enough to warrant the Fed starting to cut the Fed Funds rate.

In the short-run, say the next six weeks, the market could be very volatile. But, if the Fed moves in a measured way, the economy and the corporations that produce most of our goods and services will perk up in the coming months and provide a very healthy stock market. Here's why:

1. The Fed has done an excellent job of gradually slowing economic growth so that inflation has not gotten out of hand. Their actions have been appropriate enough that we see a slower economy ahead but no recession -- a soft landing.

2. The Fed's second responsibility (after holding off inflation) is to stimulate economic growth to create jobs. So far, the unemployment numbers tell us the economy hasn't slowed enough. But, that is looking in the rear view mirror. Every Fed tightening in recent history has ended with a "financial accident." These accidents have become a signpost for the Fed that by raising rates, they have slowed some area of the economy enough to do some damage. This time it was housing and sub-prime lending (both of which needed some cooling off - greed had taken over the decision-making in that part of the economy).

3. Many investors, politicians, and corporate leaders are yelling about a pending recession and calling for the Fed to cut the Federal Funds Target Rate. This is the second signal that tells the Fed they can cut rates. If the CEOs of major corporations believe we are heading for a recession, what happens to their hiring practices? Right, they dry up. Their screams for rate cuts precede a rise in unemployment.

The credit crunch and the housing market could well get worse before they get better. It does appear, however, to be fairly contained. But, at this point, the Fed does not want to rescue the bad decisions made there. In fact, they see the losses and pain as healthy for the economy longer term. And, the stock market will see that, too.

We say all of this to reach these logical conclusions:

1. The Fed has slowed the economy. Unemployment is going to rise.
2. That will give the Fed the room it needs to revert to stimulating the economy by lowering interest rates.
3. We think they will begin soon and continue doing so at a measured pace for several months.
4. The stock market loves it when the Fed lowers rates -- it means the Fed does not fear inflation and is trying to stimulate economic growth.
5. That will lead to an attitude that earnings growth will be stronger and more sustainable.
6. As the market looks ahead to 2008, stock prices should start to rise and that could continue as long as the Fed continues lowering rates.
7. We are bullish on prospects for stocks over the next 18 months.

The Fed Rate Cut: How Much?

By Greg Donaldson and Mike Hull

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

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

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

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

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

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

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

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

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

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

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

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

The Fair Value of the Dow Jones Industrials --Too Cheap

By Greg Donaldson and Mike Hull

By our reckoning the stock market, as measured by the Dow Jones Industrials, is significantly undervalued, maybe as much as much as 13-15%. We make this call based on the readings of our Dividend Valuation Model using the most recent data available.

The chart at the right shows the model going back to 1975. The blue line is the average annual price of the Dow and the green bars are the model's predicted values. The model uses only the dividends paid by the 30 companies in the Dow and long-term high-quality bonds.

We have previously explained that we believe the model has done a good job of indicating when the market was cheap and when it was dear.

Until the early 1980s the model indicated that values remained flat. This was a period when interest rates were shooting higher, and their ascent overwhelmed the modest dividend growth during the period.

During the mid to late 1980s and early 1990s the model said the market was undervalued, which turned out to be correct. Prices and values came into equilibrium in 1994 and 95, before prices went off into their tech fit -- and the model refused to go along.

Since the end of 2002, the model has signaled that the market has been undervalued.

The model's exact reading as of today is 13,980. That is based on dividends paid thus far in 2007 by Dow companies and interest rates at their current level. But this coincident pricing is not the way that the stock market operates.

During normal times, the market discounts what it can see, which is normally a year or so ahead. If we add in our projections of dividends and interest rates for he next 12 months, we arrive at a total return for he Dow of just over 14%. This would include the catching up of the current undervaluation and then achieving a fair value on next year's growth.

We think this is very possible if the Fed begins to cut rates. Importantly, we believe that kind of rate of return will come sooner rather than later, once the Fed makes it first rate cut. Think of it as being front loaded.

Our best guess is that the current gyrations in the stock market and headlines of this doom or that will provide cover for a new leg of the bull market that began in 2003 to begin.

We cannot see the future better than anyone else, but we are students of the past and that is how markets usually react, once a crisis is beginning to wane.

Dividends Do it Again

The recent meltdown of the subprime mortgage business has caused stocks in the US, as measured by the S&P 500 Index, to fall by 1.9% over the last 30 days. That return, however, as poor as it is, is mild compared to the return of the average stock in S&P 500 Index, which has fallen 3.7%. This disparity between the rate of return of the Index itself and that of the average stock in the Index means that stocks with higher market capitalizations have performed better during the sell off than smaller members of the Index. In addition to the larger companies doing better than smaller companies in the index during the last 30 days, the rates of return by dividend yield is very telling. Indeed, breaking the 500 stocks into quintiles shows a remarkable inverse relationship between dividend yield and average loss.

1. Top 100 highest yielding stocks -1.4%
2. Next 100 highest yielding stocks -2.8%
3. Next 100 highest yielding stocks -3.6%
4. Next 100 highest yielding stocks -3.6%
5. Lowest 100 yielding stocks . . . . . -7.1%

The inverse relationship is very tight with stocks with the lowest dividend yields performing the worst and stocks with the highest dividend yields faring the best.

One might conclude that this is the way it ought to be because higher yielding stocks are more mature and usually more creditworthy, but that would miss the point that many REITs and Banks are included in the highest yielding quintiles, and these sectors, initially, took a solid thumping before recovering.

My conclusion is going to sound familiar: dividend paying stocks are easier to value because a good portion of their rate of return is produced by their dividend, thus, in a manner of speaking they are more transparent.

Speaking of transparent, that will be the key word to describe the recent subprime mess. Too many companies were more deeply involved in the subprime market of one variety or another than they disclosed in their quarterly and annual reports. When management is playing fast and loose with their shareholders' capital and not disclosing it, it is a breech of trust and they deserve to be fired without benefit of the usual golden severance package. I'll have more to say on this in the coming weeks.

Barclays is Cheap

After Wells Fargo and Bank of America raised their dividends in early August by 12% and 14%, respectively, we said it was a clear sign to us that they were not in the eye of the storm of the subprime problems, and their stocks were too cheap.


The chart at the right shows that both stocks have recovered smartly over the last two weeks, as it has become clear that, indeed, neither is likely to take big losses. As we write this, however, we believe both stocks may be still as much as 15% undervalued based on the long-term relationships between their dividend growth, interest rates, and their stock prices.



We want to add another stock to the list of banks that we believe has been unfairly punished by the recent liquidity crisis. Barclays Bank is a London-based bank with offices spanning the globe. They have three world-class divisions: banking, capital markets, and asset management (ishares Exchange Traded Funds).

The stock has fallen by nearly 20% over the last 60 days on fears of Barclay's involvement with sub-prime loans, private equity, and hedge funds. There is no way for us to know their precise exposure to these groups, but the company has repeatedly stated that they are not experiencing any large scale losses.


Barclays recently raised their dividend by nearly 18%. A dividend hike of that magnitude is real money since they now yield over 5%.



The chart at the right is Barclay's Dividend Valuation Model. The blue line is the actual annual price over the last 15 years, and the green bars are the model's predicted values. The chart shows a close association between the model and prices over the last 15 years and a predicted 2008 value of just over $55.

From today's price of approximately $49, including the dividend, our model is suggesting that Barclay's may be even more undervalued than BAC or WFC.

Barclays has been in business since 1736. With that kind of longevity, we believe they might know a thing or two about how to navigate financial storms. Their AA bond ratings ensures access to the capital markets and minimizes liquidity issues.

The bank has been in a pitched battle with the Royal Bank of Scotland to acquire ABN Amro, a Dutch banking giant. We believe that the market is worried that Barclays may be dragged into a bidding war. In our minds, Barclays had done a lot of things right over the past 270 years. We're inclined to follow with their judgment with ABN Amro.

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

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

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

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

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

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

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

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