So Goes the Dividend, So Goes the Stock

The Government shutdown and looming default deadline are consuming the majority of headlines.  Our stance remains unchanged: we believe U.S. politicians will eventually reach a deal.  For more details, you can read last week’s article here.

Rather than join the ongoing government shutdown discussion, we want to take a step out of the short-term gloom-and-doom to look at what impacts long-term stock market growth or decline: earnings and dividends.

Our statistical models show dividends to be a highly significant predictor of long-term stock prices.  The chart below shows the basic correlation between nominal dividends paid and the S&P 500 index price over the past 20 years.

Government Shutdown & Default Fears Could Create Opportunity

Portfolio Changes

The strong bull market over the past 5 years has driven a handful of our companies’ valuations to fair or even over-valued in our statistical models. These stocks have done very well for our clients, however, there is a time to take profits and we believe that time is now for some of these companies. As a result, we are in the process of selling a few positions in favor of stocks with better long-term outlooks.

Government Shutdown: This Too Shall Pass

As we have been describing in weekly blog posts, the tailwinds are - in our mind - good for stocks.  Those are:

1. When the dust clears - interest rates are going to stay low.  We projected they would stay around 2.5% to 3.0% and that has held true.  The 10-year Treasury is now trading close to 2.6%.  Low interest rates will continue to push investors into stocks.
2. The economy continues to muddle along, which is a modestly good thing for stocks - as it prevents bubbles from forming and also keeps the Fed engaged in stimulative monetary policy.
3. Year-end earnings and dividend growth projections continue to hold in solidly positive territory.  According to Yardeni Research, 2014 earnings growth is now projected at 11.3% and 10.2% in 2015.

The most obvious headwind of today’s market is the Government shutdown and looming debt ceiling debate.  We spent the majority of our time in the Monday meeting going through the different scenarios that may play out.

Headwinds and Tailwinds: Which Way Will the Markets Blow?

There are several major headwinds and tailwinds in today’s markets.  Here we examine each and its potential impact on the market:

Tailwind: The “Fed Put”

“Don’t Fight the Fed” has been the operative word for a long time.  That looks like it will continue.  Widespread expectations were that the Federal Reserve would taper Quantitative Easing (QE).  On Thursday, the Federal Open Market Committee (FOMC) voted to keep asset purchases unchanged at $45 billion in Treasury securities and $40 billion in mortgage-backed securities.

The (Smart) Trend is Your Friend: Stocks Moving Higher

In the world of investing, you have to see things a little bit differently than everyone else.  You don’t win by following the “big dumb trends”.  These are the things that everyone already knows about.  These trends are - at best - fully reflected in the stock price.  At their worst - they create the types of bubbles we have seen balloon out of control and then pop. 

The danger in the stock market comes when everyone starts to see things the same way.  When investors start all herding together towards the same industry (see Technology in the late 1990s and early 2000s) or stock (Apple’s recent tumble from $700) or idea (homes will never decrease in value) - that is when things are most dangerous. 

Investors who buy or sell based upon what that they read about in the Wall Street Journal or see on CNBC don’t find out about the party until after it has happened.  They miss out on the biggest returns before the trends start or get scared out of good opportunities. 

A key to long-term stock market performance is

Pent Up Demand: A Future Driver of Economic Growth

Pent Up Demand Pushing Cyclical Stocks

We are coming out of a lengthy period of decreased spending in the wake of 2008-09, which has built pent up demand for automobiles, housing and capital expenditures.  The average age of vehicles on the road has reached a record high of 11.4 years.  Demand for new houses fell off dramatically since the Great Recession.  The average U.S. home was built in 1974 and continues to age. 

As people have chosen to fix rather than replace their vehicles and homes, we’ve seen the replacement-type industries do very well.  Auto Retail’s 2^nd quarter sales and earnings per share were up 14.7% and 18.6%, respectively.  Home improvement retail grew sales nearly 10% with earnings up 20% from 2^nd quarter 2012.

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.