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.

Katrina and the Economy - I

I have held up publicly commenting on Hurricane Katrina for the last two days because it did not seem right to me to be talking money when so many lives have been lost or dislocated. However, I have spoken to many of you, and I think it is appropriate that I pass on to everyone my thoughts of the short and long-term implications of Katrina. The history of natural disasters has followed a fairly regular course. There is a short-term dip in economic activity followed by a strong uptick 3 months to 12 months later. It may seem impossible that anything good can come out of such a destructive storm, but from a pure economic perspective, once the rebuilding begins there is a significant economic stimulus. I think the best way to understand this is to think of the economic implications of one family. For our purposes here, let's call them Mr. and Mrs. America. The Americans lived in a 30-year old home on a side street in a pleasant middle-class neighborhood. Their children are gone, and they both work outside the home. The storm's winds have completely wrecked their home, and they are living with friends in another part of town. We will assume that they will continue to receive their salaries from their places of employment. They have been in contact with their insurance broker and they have been told that they will be receiving a full settlement of $240,000 for their house and $50,000 for contents. They will also be receiving some bridge type support for living expenses while they rebuild. They have already talked with a contractor friend, and he has agreed to rebuild a home with approximately the same square footage and improvement as their old home. Some additional improvement they would like will add another $25,000. The biggest problem they have is that their street is still covered with water, and it will take weeks to clear the damaged trees and houses in their neighborhood. They could begin work much sooner if they rebuilt in a more suburban area farther from the center of the city. Thus even though they have a check waiting for them at their insurance office and a contractor ready to go, they must wait. The only thing they can do to get their lives back to some semblance of normalcy is to begin the process of shopping for the essentials that they know they will need, such as sheets, towels, and everyday clothes. They have leased a storage unit, and they plan to go shopping at a nearby Walmart that is powering its facility with a generator. To get at the implications of the storm's effect on the economy of the area, we have to make two estimates of the American's annual spending. The first is the amount they spend annually on the contents of their home. and the second is the annual maintenance cost on their home. Because they will still be eating and brushing their teeth at about the same rate as before the storm, the biggest change in their family expenditures is the money they would ordinarily be spending on their total living expenses that is now in suspension. Let's assume that the $50,000 they received from the insurance company for the contents of their home has an average life of 5 years. That means that the American's spend an average of about $10,000 per year on clothes, furniture, decorating, electronics, and appliances. That is an average of about $800 per month. To keep things simple, let's assume they have no mortgage on their house. The $240,000 they received for their home would have had an average life of 40 years, meaning maintenance and improvement on their home would have been about $6,000 per year, or about $500 per month. Finally, they spend about $700 per month on utilities, telecommunications, cable, and insurance. The items total about $2000 per month. This represents about 50% of the American's take-home pay. With some possible exceptions, the remainder of the American's expenditures will continue as before. If this 50% hit to spending were wide spread across the area, the economic implications for the New Orleans area would be devastating. Economically speaking, Mr. And Mrs. America would be fine: they have the insurance proceeds to replace their home and belonging, and they still have jobs. But the storm has essentially cut their spending by half for as long as the damage takes to clean up, and thus, the economy in the area will suffer. The ironic thing about the American's situation, however, is their current shortfall in spending will be more than made up over the next 12-18 months. At some point over the next 18 months, they will be spending the insurance proceeds of $240,000 plus the additional $25,000 for the improvements on their new home. In addition they will be spending the greater part of the $50,000 they received for the contents of their home. Looking at it from another perspective had the storm not occurred, they would have spent about $24,000 on items related to their home. Now, because the storm has destroyed their home, they will be spending $315,000. Multiply this times thousands of people and the Delta region will resemble a boomtown. In essence, it is hard to believe, but these natural disasters can actually spur economic activity on a delayed basis. For this reason, I do not believe the economic impact of the situation will be anywhere near as bad as some are now warning. The real risk to Katrina is the damage she did to the oil infrastructure in the area. I will not cite statistics that you can easily find elsewhere, but there is heavy damage to the offshore oil rigs as well as the refineries. I can not speculate on how much damage there is, or how long it will take to repair it, but I do know that the refineries in this country were already running near capacity. Thus, even if one refinery is severely damaged, the supply of oil will be cut and prices will rise. But even here, in my judgment, the situation is not catastrophic; repairs will eventually be made, and the supply will be back on line in time. In the meantime, the higher oil prices (they may go as high as $4 a gallon) and the awe that all of us feel at the incredible destruction that Katrina has wrought will act to dampen our animal spirits a bit and cause a general slowing of the economy. I cannot emphasize enough, however, that the slowdown will be temporary. The rebuilding will give a big lift in the coming months. The hypothetical situation above is neither a best case or a worst case scenario. The issues are far more complex for those people without insurance or are not able to maintain their jobs. In these cases, the burden falls to the state and federal governments. The costs will be terrific, but I believe all parties realize the magnitude of the problems and the consequences if any of them shirks their responsibilities. I am heartened that the state of Texas has not only offered the use of the Astro-Dome for the 25,000 refugees who were trapped in the Super-Dome, but has also opened their schools for the fall term to the school-age children who will living in the Dome. I will report more on the rebuilding in time. The key thing for the economy is how long it takes to pump out the water and how long it takes to clean up the damage. From that point on, the economic benefits of the rebuilding will be substantial. Rebuilding the Delta region will take years, but the economy will be stronger than many commentators now believe. The stock market is a discounting machine. It knows everything I have said here and more. I believe it will be able to look through Katrina's devastation and see that, in effect, she has slugged us, but our nation has proved over and over that we are resilient. Addendum: Many are now saying that Katrina is the worst natural disaster in US history. The "Big Easy" has fallen, and she needs our help. I would encourage anyone reading this to contribute whatever you can to help those who have lost everything. Check with your local Red Cross. It is my understanding that they can take your contribution and get it to the Katrina relief effort.

Summer Stroll #18 - Retirement Respite

You have just retired. You have a million dollars to live on the rest of your life. Who do you trust to guide you? What do you put the money in? Where do you start? The old Who, What, Where questions bombard you with a weight that is surprising and unrelenting. You may be good at sales, or a whiz at accounting, fly a plane like nothing, or sing like a bird, but you are leaving your active career, and you are now faced with a job just as big and potentially more important that the job that produced this wealth. You are about to enter the world of Retirement Roulette. I keep using the term Roulette because unless you are very wise, you will do what most "financial planners" are recommending, and the moment you start down that road you are sowing the seeds of depleting your assets, if not literally, then figuratively. The reasons are two fold: 1. The annual fees of the financial planning crowd, which can run between 2% and 3%, are too high to permit investing in much fixed income securities. 2. This means that advisors who use only mutual funds must rely heavily on stock funds, whose volatility we believe many people in retirement find psychologically difficult to live with. There is a way out of this game of chicken that is practical, doable, and livable. Let me go back to my idea of the buckets. In this case, I want to use the concept of what I will call the three buckets of retirement. The first bucket will be invested in fixed income securities. Today it is possible to buy investment grade fixed income securities that yield near 6%. Let's say we have put half of our money in the fixed income bucket. At 6% it will produce annual income of about $30,000. This bucket will not grow, but its contents are safe and its principal and income will be very steady. In bucket number two, we will invest in selected rising dividend stocks. The stocks we want in this bucket are stocks with as much dividend yield and dividend growth as we can find. Currently our Rising Dividend Model Portfolio yields 3.5%. That means if we invest the other half of our million dollars in bucket number two, we can expect to produce $17,500 in dividend income. Almost all of the companies in bucket number two have raised their dividends for years and possess strong finances so statistically we believe the odds are in the 90% range that this income will grow. At this point, our portfolio will produce $47,500 in annual income. The first question you should ask is, "Why don't we put more money in bucket one? If we put it all in that bucket, we would have $60,000 in safe annual income." Yes, you would but you would miss the rewards of bucket three. This bucket contains the price appreciation of the stocks in bucket two. Our Rising Dividend Portfolio has enjoyed annual dividend growth over many years of just over 7%. Indeed, over the past two years its dividend growth has been near 10%. But let's stick with 7% for the illustration. If dividend growth averages 7% over the next few years, we would expect the price appreciation of the portfolio to also grow by at least 7%. In addition, in most of the stocks in which we invest there is a high correlation (80%-90%) between dividend growth and price growth. Thus if we have the right stocks in bucket two, it is statistically a near certainty that we will achieve price growth in bucket three. Bottom line we expect bucket three will produce near $35,000 in average annual appreciation. Our best guess is that the three bucket approach would produce $82,500 in average annual benefits. That's good news, but the best news is that only about 40% is in price appreciation. The other 60% would come from the income out of the other two buckets. Another good thing about the three bucket approach is that it is only approximately one-third to one-half as volatile as the standard asset allocation being recommended by many investment people today. Or said another way, it is an order of magnitude more predictable, thus livable. We believe the secret to the three bucket approach is to keep expenses down by investing in individual stocks and bonds. In this way, we save the whole layer of fees that the mutual funds charge. We are money managers, and we charge a fee to manage accounts, but because we do not use mutual funds our total fees are a fraction of those that are routinely charged by the planning crowd. The money we save by cutting out the funds goes into our clients pockets. And because of our lower fees, we can invest in more income producing securities than can the typical recommended mutual fund asset allocation. Additionally, by investing in more income producing securities we can dramatically lower the volatility and risk. There are of course all the usual disclaimers about trying to project the future by looking into the past, and there are questions that I have raised and not answered, but at the end of the day, your retirement years should not be a time when you are timing the market or supporting a financial planner's lifestyle, needlessly. Ninty-nine percent of those of you who are reading this blog are probably clients or prospects of Donaldson Capital Management. If you are not, you owe it to yourself to see if an individually crafted three-bucket-investment plan would work for you. My email is gdonaldson@dcmol.com. My phone number is 800-321-7442. Email me or call me. I'll get you in touch with one of our portfolio managers. It does not make any difference where you are. We have clients in 28 states. In the past week we have been in Arkansas, Alabama, Kentucky, Illinois, Tennessee, and Indiana. We are harping on this not because we think we have the only answer, but judging from the new accounts that our firm is adding every day, the name brand investment firms in the Midwest do not have a clue about how to construct a portfolio that will stand the test of time and provide "Retirement Respite," instead of a Retirement Roulette.

The Barnyard Forecast

Every day we get a new dose of economic data and depending upon the source(and political persuasion), of your news, you might conclude on some days that the the sky is falling, or on others that the sky's the limit. This is not a new phenomenon. We think it goes with the territory, so it is important to be able to zero in on just those few indicators that drive the markets. To provide a means of taking the pulse of the stock market's near-term prospects, many years ago we devised a very simple acronym, EIEIO, which helps us to focus our attention on the fewest and most important data points. Over time the acronym has become known as the Barnyard Forecast because EIEIO sounds like the chorus from the children's song, Old McDonald's Farm . EIEIO is taken from the first letter of Economy, Inflation, Earnings, Interest Rates and Opportunity. Each of the indicators is scored on a three point scale for its positive or negative implications for stocks in the coming 6-12 months. We give each indicator 2 points if we believe the trend of the indicator is positive for the stock market, 1 point if it is neutral, and 0 points if it is negative. Economy: The 80-year average of GDP is just over 3%, and we believe the ouch point for the Federal Reserve is 3.5% real growth. On a year over year basis, the GDP has grown at 3.6%. That is very good news for the economy, but not great news for the stock market because it means the Fed may well continue to raise short-term interest rates until the economy slows toward the 3-3.5% range. We rank the economy neutral for stocks, not because if its weakness, but because its strength will keep the Fed on the alert. 1 point. Inflation: We believe the Fed's inflation ouch point is 2.5% on the core CPI. On a year over year basis, the core CPI has risen 2.6%. That's close enough to the acceptable level of 2.5% that we will give it a neutral score. 1 point. Earnings: Earnings are nothing short of outstanding. Economy wide after-tax corporate earnings have risen nearly 20% in the last 12 months. That's good news anyway you look at it. 2 points. Interest Rates: While the Fed has consistently pushed short rates higher, our model looks at 10-year bond yields and long-term mortgage rates. Both of these long-term interest rates are almost exactly where they were a year ago. We rate them neutral for stocks. 1 point. Opportunity: Totaling the scores gives us a kind of short-hand view of the prospects for stocks in the next 6-12 months. At a total of 5 points (1+1+2+1) out of a total of 8 points, our model is suggesting a modestly positive rating for stocks. We believe the Barnyard Forecast is suggesting the sideways motion of the major indices may continue at least until the Fed sees economic growth slow a bit. However, we continue to believe that companies with above average dividend yields and growth can escape this sideways motion. A stock with a 3% dividend yield and expected dividend growth of 7% offers an implied rate of return of 10%. With 10-year rates at 4.25%, these solid dividend payers are too cheap, and investors are increasingly recognizing it. We will take a more in depth view of some the companies we like in the coming weeks.