The Barnyard Forecast: Has Europe Changed Things?

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

The Riots in Greece Reach the US Security Markets

A friend called today and asked the question that is on every one's mind: "How in the world can the financial troubles of a tiny nation like Greece cause the world's financial markets to screech to a halt? As I listened to him I saw the stock market fall off a cliff: down 60 points on the Dow Jones, down 100 points, down 200 points, down 300, 400, 500, 600 points. I did not see the print of down 900 points because I turned away from my screen for a moment.

Before I could begin trying to explain my thoughts about Greece, my friend asked another question: "Are we going to go back to the bottom of the market we saw in March of 2009?"

My answer was quick, but I have been thinking about it ever since I saw the first riots break out in Greece. "I don't think so," I said.

"I was looking for a more positive answer from you. You have been optimistic lately," he replied.

I told him that I was much more optimistic about the subprime crisis in the US because I could see that the various important players in the drama were all doing their parts. The Fed pushed every lever they had to keep money flowing in the banking system. Congress appropriated enough seed capital to head off a liquidity crisis in the economy. Businesses rightsized their costs relative to their revenues. Consumers reduced spending but did not freeze up. The US Treasury department orchestrated a step by step program to return confidence to the banking system. This enabled the banks to raise hundreds of billions of dollars in new capital to offset the mind-boggling losses they were taking in real estate. I told my friend that as ugly as the subprime crisis was that I remained reasonably confident throughout because I could see there was a unified effort to control the damage and the full power of the United States was being invested to execute the plan. There was a will and a way to get past the crisis.

I explained that taming the financial crisis in Europe was different than taming the subprime crisis in the US for these reasons: Europe is not a single unified entity. Even though they have a common currency with a framework for a kind of United States of Europe, that little of the framework has been codified into law. Thus, the idea of Europe as a single nation is a complete illusion. Europe is still a collection of independent countries. Thus, it is quite possible that nationalistic tensions could sabotage the best intentions and plans of the nominal leaders. In short, European leaders may see a way out of their mess, but there might not be the collective or individual will to do it. In addition, there is no one really in charge. It is like a big club.

The frugal citizens of Germany do not want to loan money to the bankrupt citizens of Greece, who in turn do not want to change any of their financially profligate ways. There does not appear to be a unity of purpose, even if the resources are available to solve the problem.

My friend asked, "So is there reason for optimism that the wealthy nations of Europe can rein in Greece and the other countries that are having trouble?"

I answered, "There is and it is based on the strongest of human emotions: survival. Sooner or later the citizens of Greece will realize they are doomed as a nation without the loans. They may be burning bank buildings today, but one day soon when the lights go out and water doesn't flow from the taps, they will realize that as a nation and as citizens they have been living beyond their means so long that they are no longer free to run their own affairs. The water has been turned off, so to speak. They will agree to the loan arrangements and begin the process of trying to live with them. There is really no alternative.

Portugal and Spain are also having debt issues. Watching Greece crash and burn will be a reminder to them of where any intransigence they may harbor will likely end."

The world wide economy is gaining traction. Almost every economic measure in the US has been better than expected in recent weeks. After a long period of weekly job losses, job gains have now occurred in the last three weeks. The developing world is still growing rapidly. Indeed, economist Ed Yardeni recently reported that 60% of US exports were going to the developing world. The economic fundamentals appear to be improving almost everywhere but in Europe. That is not likely to change with the internal squabble that has erupted.

The economic world did not just evaporate today. There are many rumors of so-called "black-box" automated trading systems that generated errant trades, causing precipitous falls in stocks ,which had no negative news of any kind.

So the eternal question hangs heavy in the air: Was the market efficient today? Did the economic underpinnings of companies really fall by as much as did the market prices?

I think what we are seeing is a pure trading frenzy that has little to do with the intrinsic valuation of underlying companies. Here is the best proof I can offer of this. Procter and Gamble, one of the largest, best managed companies in the world, a company that has paid a dividend since the late 1890s and who has raised their dividend for 53 consecutive years, was selling for around $60 late in the afternoon. In a matter of moments the stock fell to $39.37. It then climbed all the way back to close at $60.75. PG's stock movement today had nothing to do with its underlying value. It had everything to do with the noise and mayhem of a video game played by hedge fund tech-savy kids with real money.

Does it mean that we long-term investors have to acquire the latest programed trading machines, so we can beat the money gunners at the their own game. Heavens no. There is a secret that we know about Procter and Gamble that the money gunners could care less about. Over the last 20 years our model indicates P & G's annual price gain has been nearly 90% correlated to its annual dividend increase. At it current dividend rate, our model says Procter and Gamble is very undervalued. As for me, I would rather trust 20 years of mathematical probabilities that one day of video game idiocy.

The Buzz About Dividend Taxation

An article in Friday's "Wall Street Journal" bemoaned the fact that taxes on dividends could rise dramatically by the end of the year. Here is a quote from the article: "Last week the Senate Budget Committee passed a fiscal 2011 budget resolution that includes an increase in the top tax rate on dividends to 39.6% from the current 15%—a 164% increase. This blows past the 20% rate that President Obama proposed in his 2011 budget and which his economic advisers promised on these pages in 2008." A paragraph later the Journal heaps more pain onto their analysis of dividend taxation: "And that's only for starters. The recent health-care bill includes a 3.8% surcharge on all investment income, including dividends, beginning in 2013. This would nearly triple the top dividend rate to 43.4% in Mr. Obama's four years as President. We suppose the White House would call this another great victory for income equality." While these changes to dividend taxation are not yet the law of the land and the details may change by January 1, 2011, there is now ample evidence that the Bush dividend tax breaks enacted in 2003 will be allowed to die. That means that dividends in 2011 and beyond will be taxed at ordinary income rates. All of the talk about new taxes on dividends has prompted lots of questions about our dividend investment strategy after January 1. Here are a few important points to ponder: The first point is that dividends for most of my 35 years in the investment business have been taxed at ordinary income rates. So the the new taxes are not really new but merely a return to the old way dividends were taxed prior to 2003. The tax breaks of the past 7 years have been a blessing, but with the runaway government deficits this country is experiencing, it is too much to expect that President Obama would hold to his campaign promise of only hiking the tax on dividends to 20%. Because dividends have historically been taxed at ordinary income tax rates, many years ago we created two dividend investment styles. The first is called Cornerstone. Cornerstone currently consists of 30 stocks with an average dividend yield of just over 3% and 5-year average annual dividend growth of near 8.5%. The second is called Capital Builder. Capital Builder currently owns 31 stocks with an average current dividend yield of only 1.9% but the current portfolio has achieved a 5-year average annual dividend growth rate of over 12%. Capital Builder was created specifically for our clients in higher tax brackets. Its current dividend income is much lower than Cornerstone's but it makes up for it with higher dividend growth. Remarkably, however, the total annual rates of return for Cornerstone and Capital Builder have been within a quarter of one percent of each other over the last 15 years. Another important point to remember is that even though dividend taxes may rise, the 43.4% rate quoted in the "Wall Street Journal" only applies to families in the maximum tax bracket, which currently kicks in at about $374,000. There is talk that in the interest of squeezing more out of the "so-called" rich that the maximum tax bracket might be lowered to $250,000. Either way the new higher rates of taxation will only affect a small percentage of the population. Indeed, the current Federal Income Tax Guide shows that for families with taxable income up to about $68,000, the ordinary income tax rate is just under 15%. Taxable income between $68,000 and $137,000 is taxed at 25%. Thus, for many people the tax bite from higher dividend taxes will be very modest. To confuse matters more, the Bush income tax cuts of 2001 will also end on January 1, 2011. If Congress does not act, all income tax brackets will be rising by about 3%. Since President Obama ran on a pledge of no tax hikes for the middle class, we assume that Congress will pass legislation between now and year end that will freeze the Bush 2001 income tax brackets at their current levels, except for people making more than $250,000. Are you confused yet? Not any more than they are in Washington, and that is one of the reasons I have not ventured into the area of dividend taxation until now. It remains very much a moving target, and until the ink is dry I don't foresee that we will recommend many changes to our clients. There are many commentators saying that the reversion to the old form of taxation on dividends will cause American corporations to curtail dividend payments. I believe that line of thinking is completely false. Corporations know that the dividend is an important linchpin between themselves and their shareholders. In addition, dividends are cash money, and in a world of very low interest rates, there are millions of people who count on their dividend income to pay their bills. Corporations who cut dividends or try to sell the idea that they can do better with our money than we can won't get very far. The best examples of this are the major US banks. Almost all of them were forced to cut their dividends over the past 18 months. As their fortunes have improved, they are being besieged with questions about when they are going to reinstate their dividends. Keep an eye on interviews with bank CEOs. In almost every public conversation they are talking about their dividend policies. In summary taxes on dividends are probably going up, but we have been here before, and we have alternative investment styles that can minimize the effect of higher taxes. In addition as it relates to corporations' willingness to pay dividends, IBM just raised their dividend by 18%. IBM can read the headlines about dividend taxation just as well as we all can. If they were going to begin ratcheting down their dividend policy, why would they hike the dividend so sharply? They could have raised their dividend by a nominal amount and no one would have squawked. I believe they hiked the dividend by 18% because they are generating significant free cash flow and they wanted to reward their shareholders for sticking with them during the uncertain times of the last 18 months.

This Is a Classical Bull Market

For those of you who have hibernating in your bear caves, wake up, take a look at the chart at the right. This is no time for bears; this chart looks very much like a classical bull market -- higher highs, higher lows -- with significant tests along the way. The chart at the right is a 12-month chart of the Standard and Poors 500. It has climbed a proverbial wall of worry over the past 12 months and now sits at a new intermediate high. Yet as classical as is the bull market price chart, so too are the classical wailings of the bears who are left back at the abyss, staring into the dissipating darkness. The bull market in stocks is for real. It is not a reflex action, or an illusion. It has legs and it will continue to lay waste to any bears it encounters. The reason is simple: corporate earnings for the fourth quarter in a row are off the charts. These are not "less-bad" earnings, these are good earnings and good sales to boot, even dividends have started to tick higher. Indeed, it now appears that S&P 500 operating earnings for the first quarter will be up nearly 70% over the same quarter a year ago. Ah, but the bears cry out "Too far, too fast. The S&P 500 is up nearly 82% from its low of 670 on March 9, 2009. It cannot sustain this move; surely a correction of monumental proportions is near." (Please see comments section for a correction a loyal reader made) But I answer, "Too low, too fast." The market fell by nearly 50% from October 2008 to March 2009. It fell on fears that mankind was powerless to correct the calamity he had created in the subprime crisis. It fell on hope being tossed away as though it did not exist. It fell on every doom-filled tirade of the fear mongers. Finally it fell, well, because it fell yesterday." I have said many times that in understanding an upturn of the market, you must study the downturn. The chart at the right is a three-year chart of the S&P 500. It clearly shows how fast stocks fell from August and September of 2008 to the market bottom in March of 2009. Yes, indeed, stocks are moving higher, but they are moving higher in an orderly fashion with little signs, yet, that a capitulation by the bears has occured. And until the bears capitulate, the market's path of least resistance is up. Looking back at the first chart, it is clear that after the bottom was made in March of 2009, the S&P 500 has "saw toothed" it way higher, with buyers arriving every time the sellers started to take charge and sellers appearing each time the buyers appeared to be winning. This is what I mean by a classic bull market. It has been a tug of war trending higher. These kinds of classic "saw tooth" markets almost always occur after severe market corrections. Think of it this way: big sell offs in the market always come swiftly and sharply and are always accompanied by very bad news of some kind. Traders are slow to react to the encroaching bad news, but eventually capitulate by selling out, and excuse themselves for cutting bait at the bottom by saying that things can only get worse. They have no faith in history; they have no faith in the principles of economics. Evidence of this capitulation shows up in spikey price action such as that from November of 2008 through March of 2009. Here is a blog we wrote on March 20, 2009, just a little over a year ago. It is entitled "Is This the Bottom?" In it we briefly describe why we believed the market had collapsed and why we thought it was ready to turn higher. Here is a short quote from that blog: "Indeed, one could say that we are floating in a sea of value. All we need is for some sort of good news to propel stocks to much higher levels." In our judgment, we are still floating in a sea of value. Earnings are estimated to be up in 2010 by 25% and 20% in 2011. We are convinced the market has not priced in all the good news that is coming. Indeed, we will only start to worry about valuations when stock prices start getting spikey to the upside. That would mean that the bears have capitulated and become bulls. You know what comes after that!

Dividend Investing is Very Much Alive

We estimate that dividends for S&P 500 companies will rise by over 10% this year. If we are right, it will be the first year since 2007 that dividends for the S&P will have risen on a year over year basis. Indeed, dividends have taken a beating over the last two years, and there are those who say that dividend investing is dead. You won't be surprised if we don't see it that way. Our analysis of the dividend cuts for 2008 and 2009 reveals that the preponderance of the cuts were in the financial sector. Additionally, over the last three years, six of the nine major S&P industry sectors have raised their dividends (Consumer Cyclicals, Consumer Staples, Energy, Health-care,Tech, and Utilities), one sector kept dividends about the same (Industrials), and only two sectors cut dividends Financials and Materials). Here are five reasons that we believe dividends will rise in the coming year:

1. Corporate earnings are projected to grow by nearly 25%, with free cash flow growing even faster.
2. Loan loss reserves are peaking at many banks, and we are convinced that banks will begin hiking dividends as soon as the regulators allow it.
3. Corporations don't need to hoard cash since the capital markets have returned to near normal functioning.
4. Even among companies that don't want to commit to permanent dividend hikes, we believe many will choose to pay special one-time dividends as a reward to their shareholders.
5. In our judgment, corporate America is growing very weary of the run and gun stock trading crowd. Companies are becoming more and more anxious to attract shareholders who are interested in the long-term success of the company. The quarter-to-quarter trading crowd can never be successfully sold on the idea of investing in companies as opposed to stocks.

We'll report periodically in future blogs on how dividend growth is faring.

Wells Fargo: Is Wall Street Underestimating Their Future Earnings?

Wells Fargo's (WFC) stock appears to be trying to break to a new high. Could this possibly mean that Wall Street is underestimating their earnings over the next couple of years? Recently I wrote a blog offering my thoughts on when the big banks would begin hiking dividends. In doing research on that blog, I stumbled across a presentation that Wells Fargo made at the Credit Lyonnais Asia Conference. Wells Fargo's presentation at the conference was one of the most upbeat presentations of a bank that I have heard in a long time. It wasn't a pep rally, but it left a clear picture of the strategy that the company is employing to return to solid earnings growth. In two words that strategy is cross-sell and market share expansion. WFC's culture has been wedded to the concept of cross-selling multiple products to their customers going all the way back to the old Norwest days. In the recent meeting, they said their average cross sell was now up to 5.95 products per customer. What was most interesting was their discussion of their Wachovia acquisition and the roll out of the WFC cross-selling program within Wachovia. It seems Wachovia's cross-sell average is about 4.6 products per customer. CEO John Stumpf, spent a lot of time discussing the opportunities of moving Wachovia's cross-sell average up to WFC's average. He said it would increase revenues on the Wachovia business by nearly 30%. And he wasn't just talking about the opportunity, he described WFC's ongoing program to accomplish this growth. Not surprisingly the growth plan had many moving parts primarily related to training and incenting employees to the WFC way. What was surprising was the number of new employees that were being added to former Wachovia branches. This was surprising because WFC is noted as a low expense-ratio bank and adding lots of new people in branches would seem to be counter to expense control in these difficult times. Stumpf made it clear that WFC was using these bad times to take market share. Listening to Mr. Stumpf, it was clear that they were being selective about what new business they went after, but it was equally clear that they were aggressively competing to expand their business footprint in every market in which they served. The final chapter on how the financial debacle of 2008-2009 will turn out has not been written. It may be years before loan losses can return to historical trends. Certainly, WFC has plenty of problem loans, but Mr. Stumpf convinced me that WFC had sufficient capital and reserves to handle their problems. One day the banking crisis will fade from the front pages and lending will not be seen as such a treacherous undertaking. When that day comes, my guess is WFC will have been the big winner in gaining market share in the United States. From the looks of the price graph above, there are many investors who believe Wells Fargo is on the right track. With any kind of luck, it will break to a new intermediate high, joining GE and further signaling that investors are trying to put the subprime crisis behind them. We own WFC. Please see Conditions of Use on the right side-bar.

Is GE Signaling Stocks Are Going Higher?

Our Investment Policy Committee spent most of last week's meeting discussing whether or not the stock market may be at an inflection point that could lead to significantly higher prices. There were five key points running through our discussions.

1. 80% of S&P 500 companies beat their earnings estimates for the fourth quarter, much higher than expected.
2. Fourth quarter US GDP growth significantly exceeded expectations at 5.9%.
3. Economists surveyed by Bloomberg are now estimating 3.0% GDP growth for 2010, up from 2.5% at the beginning of the year.
4. Fed comments continue to paint a benign picture for inflation, meaning that rate hikes are not likely before the end of the year at the earliest. Economists are still forecasting that core inflation will be 1.3% by year-end 2010. This benign inflation data flies in the face of the gold bugs and those who believe that runaway inflation is a foregone conclusion.
5. The price action of General Electric (GE) is impressive.

Perhaps the most significant part of our discussion of the five points was related to the recent price action of GE. GE has recently broken above a several-month trading range on high volume. GE has many qualities that make it something of a microcosm of the US economy. Thus, it's price breakout suggests that worries about its loan losses and perhaps loan losses for financial companies in general might be peaking. These five points do not suggest that stocks will soar again in 2010 like they did in 2009. The reason is simple: we could just as easily assemble another list containing at least five powerful negative forces facing the market. Yet, investors are certainly aware of all of the negatives, and because of this we believe the price action of GE in recent days is an important signal.

GE has been in the middle of the financial crisis, and for it to power to a new post crash high (see chart above) is big news. We've watched price graphs long enough to know that some very big money has just made some very big bets that the news for GE is going to get better over the coming months.

Additionally, because GE's business is so multi-faceted, there is reason to believe that good news for GE is probably good news for the whole economy and stocks.

Interestingly, GE had a couple of big days right after their CFO announced that the company was considering a dividend hike in 2011. In this regard, their message is similar to the one we suggested in last week's post about the banks. That is, companies, even companies in the financial services sector, appear to feel comfortable with their current levels of capital reserves. When GE starts talking about dividend hikes, it sends a clear message: they don't have any dilutive equity capital underwritings in the works. That is good news, but even more importantly, if they are talking dividend hikes, it follows that they must see an end to their loan losses. That's even better news.

We own GE. Please see conditions for using this blog on the right sidebar.