It's a Subprime Crisis, Not a Banking Crisis.

After Countrywide Financial warned in July that they were experiencing delinquencies across all credit quality classes of mortgages, the stock market went into a tailspin, assuming that all banks were either deep into subprimes or that prime mortgages were beginning to default.

We were watching the chart at the right, which shows the % of delinquencies of subprime (blue line) and prime (orange line). It has been clear that subprimes have been in big trouble for the last two years, with delinquencies now running at over 15% of subprime loans oustanding. So if the big banks are deep into subprimes, they will, indeed, be taking big write offs. However, if they have managed to sell off or avoid their low quality loans, the prime sector of mortgaes would appear to be in very good shape, with only 2.7% of prime loans currently delinquent.

Our analysis of Bank of America, Wells Fargo, and Wachovia, tells us that these three major US banks have only modest amounts of subprime loans and that they are well secured and manageable.

Wachovia said in their July earnings meeting that they did not have any subprime loans. Since then they have announced that they are going to commit $15 million to the lower quality market. We think this is a smart move, since almost everybody else is exiting the sector. There are probably some great bargains.


The evidence is growing steadily that the big banks in the country sold off their high risk mortgages to the big pools of money that Wall Street was throwing their way.

The market is on pins and needles awaiting the big banks to announce their earnings, or lack of them. We are firmly in the camp that believes the news will be better than Wall Street now believes, and for this reason, we believe the aforementioned banks represent very good values.

From Sea to Shining Sea

Americans are provincial. Whether you live in New York or New Harmony you believe that your world revolves around the good ole US of A. You are wrong. As much as we are proud of our country and what it has given to the world, we live in a global marketplace. The unions will try to deny and fight it, the Democrats and Republicans will try to politicize it and prevent it, but at the end of the day, unless we want to turn back the clock of progress, you will realize that we are just a big part of a bigger world. Mamma's let your children grow up to be cowboys, because a cowboy might be a better profession than an autoworker, steelworker, or software engineer, perhaps even attorney and stockbroker. The times they are a changin', and the times for the us US of Aers will change the most. We have won the battle and lost the war. We have proved to the world that freedom and free markets are the instruments of progress and the touchstones of life, liberty, and the pursuit of happiness. Only a handful of countries in the world now believe that central planning can bring prosperity to its citizens. In the early 1980s Ronald Reagan said that only 2o% of the world believed and practiced freedom and free markets, and that was the reason that the world was so stuck in a rut. He railed against a taxation system that rewarded those who road on the wagon without ever taking their turn at pulling it. He condemned the politicians worldwide who were so blind to think that taxing the efforts of the few could provide life, liberty, and the pursuit of happiness for the many. Quite frankly, he changed the world, and caused freedom to ring around the globe. But as the scriptures say, the dog returns to its vomit, and Russia, which collapsed under the weight of its own corruption, is returning to it effluence. Europe, which always speaks the poetry of wisdom, but practices the witchcraft of feudalism is raising up the lords and ladies of royalty as bequeathed by the power elite. Even the home country of Mr. Reagan, the USA, has decided that the rich must pay more than their fair share to be citizens of this county. Democrats and Republicans in this country have completely forsaken the simple wisdom of President Reagan, and they now grovel in front of a demanding electorate that has decided that the strong will carry not only the weak, but also the able. No politician in this country has the courage to name the charade for what it is: from him who has, to him who has not; not by choice, but by law. The problem is him or her who has, knows how he or she got it and how much it cost, and he or she is not going to give it away just because the politicians say so. Money moves at the speed of light from sea to shining sea. The time is fast approaching when the flags of the pullers of the wagon may well move to a country with different stripes. Companies are moving their headquartes out of this country for lower taxes, citizens will be next. Canada has just lowered it tax rate for corporations to near 25% less than that of the US. How long do you think it will be before they get real smart and lower their individual tax rates below that of the US. They are a long way from from that today, but they can see the it is near an inevitability that taxes are going up in the US. Don't you think the same Canadian lawmakers who cut corporate tax rates are going to figure out that if they cut individual tax rates they might attract the cream of American entrepreneurs, and the jobs that will accompany them. You think I am talking nonsense? You have your head in the sand. I cannot count on two hands the number of Canadians I know who left Canada because of the taxes, and I cannot count on two hands the number of Americans who would gladly move to Canada if the price were right.

New Estimate of the "Fair Value" of the Dow Jones Industrials

Periodically, we plug in new estimates for dividend growth and changes in interest rates for the coming year and make a prediction for the "fair value" of the Dow Jones over the next 12 months.

As a reminder, in our January 2007 Barnyard Forecast with the DJ 30 near 12400, we said that our Dividend Valuation Model was signally that the "fair value" for the Dow in the year ahead was near 14,000. Indeed, that is about where the market stands today.

We have updated the model from time to time over the last 9 months to reflect actual dividend growth and changes in interest rates, and except for a brief period in early summer when rising interest rates drove it lower, the model has stayed near 14,000.

In our judgment, the solid performance of the Dow has been spurred by the near 12% dividend growth for 30 companies in the Average .

The chart above shows our estimate for the "fair value" of the DJ 30 in the year ahead, again using our estimates of dividend growth and interest rates. The predicted level turns out to be near 15,500. That would be a price increase of near 10%. Adding in dividends, our best guess for the total return of the Dow Jones over the next 12 months would be near 12%.

That may seem a bit optimistic in the face of all of the uncertainties in the markets and the economy, but we would not be surprised to see a return of that magnitude. We believe the US economy will be stronger than most people are predicting, and US multi-national firms will continue to benefit from the expanding global economy.

In addition, you will notice that the model has done a good job of identifying the "fair value" of the DJIA. It did not go along with the "tech head fake" of the late 1990s and correctly signaled how undervalued the Dow became in 2003, 2004, and 2005. Until it proves otherwise, we don't think it would be wise to ignore the voice of the model.

We'll keep you posted on how this estimate turns out as the year progresses.

Target is on Target

We believe one of the best signals for investing in the retail sector is right after the retailers bemoan the fact that for whatever reason, "This year Christmas will not come." This week Target warned about potentially soft sales and earnings through year end. Since Target (TGT) is a leader in mass retailing, we would expect many more retailers to be making similar declarations in the weeks and months
ahead.


Real estate news is gripping the headlines, but it is interesting to note that only 2.7% of "prime" mortgage loans are in default and that is where 90% of all mortgage loans are located. The subprime mess is a small part of the mortgage pie, and even though it is causing lots of pain, it does not drive the economy of the United States. Jobs drive the US economy and America is at work and that is the reason that delinquencies on prime mortgages are so low.

Indeed, as it relates to the retailers, we have also found that "he who hollers first" is often the ultimate winner. In this regard, Target is a company we like a lot. They have the right strategy, the right product mix, and we believe they will have a solid Holiday selling season and continue to gain on Walmart.

Our Dividend Valuation Model above shows that TGT is as good a value as it has been since 1996.

Target may not seem like an obvious pick for these times, but who doesn't know that? The "Christmas isn't coming" crowd got out of retail a long time ago. When they see that they are wrong, they will be back pushing Target and the other top flight retailers higher.

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.

Soaking the Rich Will Backfire on the Politicians

Ask the proverbial man or woman on the street if rich people should pay more taxes and the answer is a resounding yes. Ask almost any of the Democratic contenders for the presidency what this country needs most and you are likely to hear tax fairness, in the form of higher taxes for the wealthy. There seems to be almost universal agreement that one of the great ills of the United States is that wealthy people do not pay enough taxes. The facts, however, suggest that higher income people in the US are anything but under taxed. According to an Op/Ed piece in the April 2007 Wall Street Journal, the Congressional Budget Office (CBO) reports that in 2004, people making more than $43,000 (the upper 40%) pay 99.1% of all taxes. That, of course, means that the lower 60% of the American population pay under 1% of federal taxes. But there is more. The top 10% earners in the United States, those families making more than $87,300, pay almost 71% of all federal taxes. What makes this so remarkable is that in 1979 the top 10% paid only 48%. Heaven forbid that a person be in the top one percent of earners in this country; according to the same CBO report, their part of the total federal tax bill was 37%. Many will make the point that the rich make all the money, why shouldn't they pay all the taxes? The problem with that kind of attitude is that rich people become rich by knowing the score and putting their money where it is treated the best. One of the reasons Francois Sarkozy won the French presidency was the shocking revelation to the citizens of France that many of their wealthiest and most prominent families were moving to Belgium to avoid the high taxes in France. Soaking the rich can not go on indefinitely. It has its costs. The wealthy can vote with their feet. Corporate Taxes are another huge problems in the US. The motto of many in this country is "Let's squeeze the big corporations." They make their money here, they should pay their fair share. Well, my friends, it may surprise you to learn that at 38% the US has the highest corporate income tax in the developed world. Canada just lowered their corporate tax rate this week to approximately 31%. Germany, Britain, Spain and France (yes France) have all cut corporate income taxes in recent years and none of these countries now taxes corporations at a rate of greater than 30%. The author of the Op/Ed piece, Ari Fleischer, makes the following statement: Our tax system comes up short in a lot of ways: It doesn't foster economic growth. It isn't simple. And it certainly isn't fair. The one place it does excel is at redistributing income. Soaking the rich is not solely a strategy of the Democrats. The present system has been largely brought to us by Republicans. The current tax systems is a recipe for disaster. Too many people in this country are paying virtually no federal income tax, thereby pushing their rightful burden off on to the fat cat down the street. The problem is if the economy in this country were to slow quickly, the income for the top 1% would also slow sharply and the current budget deficit would become a budget chasm. The country needs to simplify taxes and make sure that everybody pays to keep the country's light on. Most importantly, we need to regain our historical position as the low-tax country in the world. Low taxes encourage people to take chances, because when they win they get to keep most of the winnings. Ronald Reagan knew that and his tax cuts in the early 80s put our country on a growth path that is the envy of the world. But Ronald Reagan spoke incessantly of requiring everyone to climb down off the wagon and help pull it. Former President Reagan is surely turning in his grave at today's situation, when only 40% of Americans are on the ground pulling the wagon, while the other 60% get a free ride.

Stocks Twelve Months After a Rate Cut

If history is a guide, the Fed will cut rates today and will continue to cut for at least the next four months.

The top part of the chart at the right shows the graphs of the Fed Funds Target Rate and the yields on 90-day T-bills. The bottom of the chart shows the difference between the two in red. I discussed the significance of the recent divergence between the two short-term rates in our Sept. 4th post.

There have been four previous divergences that have approached one percent over the past 20 years: the crash of 1987, the S&L troubles of 1989, the Asian Financial crisis in 1998, and the popping of the tech bubble in 2000. In each case, as the divergence between Fed Funds and T-bills approached one percent (.9% more precisely) the Fed cut rates and the differential and, ultimately, the crisis went way.

I have done some additional studying of these divergences and I see two additional areas of interest:

1. On average, after rates were cut, Fed Funds were lower by .75%, within four months . Thus, if history is to be our guide, today's cut is just the beginning.
2. Twelve months after the first Fed rate cut during three of the credit crunches (1987,1989,1998), stocks were higher, including dividends, by nearly 20%. In the year following the tech bubble, stocks were down nearly 15%, including dividends. The average for the four periods was about 12%.

After what we have waded through 2007, the hopes of a 12% total return over the next year sounds very acceptable. However, I think it may well be better than that because of the unusual circumstances surrounding the poor performance of stocks in the year after the popping of the tech bubble. That pushed us into the time of Enron and then the 9-11. It would have been hard to imagine that stocks could have risen during that time, no matter what the Fed was doing.

Thus, I think it is best to call the period after the tech bubble a special case and drop it from our analysis. If we do that, as I said earlier, the average total return after the Fed started cutting rates in the other three occurrences of a credit crisis, was near 20%.

As they say, the future is not the past, but sometimes it is the best guide we have.