Hank Paulson Got It Right on Fannie and Freddie

On Friday as I saw the 6.1% unemployment data released, I began writing a blog. Even though GDP was revised up, the meat and potato issues of lost jobs and homes were sure to cause the media to go on a "sky is falling, duck and cover" campaign that would leave most Americans wondering how we were ever going to get beyond this housing debacle, and in the process, freeze spending and weaken the economy in an even broader way. So I wrote that government must do more; that government must do what it could to stabilize all mortgage markets. To accomplish this, they must become direct participants in buying mortgages to push mortgage rates down, which would stimulate demand for housing and refinancing opportunities for those that qualified. Please read my Friday blog. It was not broadcast because I did not finish it until after 5:00 PM CDT. Late in the day, the Wall Street Journal carried a story that Hank Paulson, Treasury Secretary, was readying a takeover of Fannie Mae and Freddie Mac. In essence the US government was getting into the mortgage business. Hallelujah. This is something that I have been calling for since March, and this was the direct approach that I was advocating in the Friday blog and in previous ones. I repeat that I am a free market advocate to my bones, but the housing bubble threatens to set our economy on a decade-long bubble unwinding, which would produce sub par growth and economic malaise. The housing debacle has become a threat to our national security and that is a job for government to solve. Our friends on Wall Street and in the banking business have finally bitten off enough risk that they had choked the whole economy. The actions of Secretary Paulson will be debated and second-guessed, but I am convinced that they were necessary and that they will soon begin to bear fruit. Here's why. The weak link in the US economy is housing. If a floor is put under the housing market, the rest of the economy is still humming along reasonably well and will continue to do so. Oil prices and commodity prices are falling, which will have a positive psychological and economic effect on Americans consumption. High oil and commodity prices have not been overly worrisome to me from an inflationary standpoint because they have acted more like a tax on consumption. If these prices continue to fall, or even stay near current levels, inflationary pressure will diminish dramatically, and consumers can breathe a little easier and plan a little more long range. I believe Secretary Paulson's actions will be seen by worldwide investors as necessary and responsible and will cause money to begin flowing back into the US from foreign investors. The actions were bold, they were decisive, and even though I wish they would have happened a month ago, they will be rewarded with positive reactions in the US stock market. The government has more work to do to unfreeze the economy, but today's actions with Fannie Mae and Freddie Mac are a powerful message that Paulson and Bernanke are on the same page and will use every tool they have to produce an under girding to our economy. I also like the fact that the takeover of Fannie and Freddie has sunset provisions that will require the next administration and congress to act, or these changes will be gradually unwound.

The Fed and Treasury Must Become More Aggressive

Back at Purdue, when I used to play a lot of contract bridge, there was a saying that unfortunately I found to be too true: One peek is worth two finesses. It simply meant that if a player could catch sight of an opponent's hand he could see for sure what the opponent held as opposed to using laborious finessing techniques to find the truth of who held what. Yesterday the stock market was down 344 points without economic data that would justify such a sharp fall in prices. Late in the day, my assistant, Carol Stumpf, asked me why the market had fallen so much. It was actually a question that I had been thinking about and just before I answered her, the thought rang through my mind: One peek is worth two finesses. I answered her that bad news on employment during the day had caused some weakness, but that tomorrow (Friday) big numbers were coming out and my guess was that the data were going to be ugly. She asked me how I knew that, and I said that I didn't know for sure, but today's action (Thursday) of stocks told me that somebody knew something for sure. Tomorrow's employment data had leaked and the recipients of the leak had beaten the snot out of the market. So what does this leak have to do with the long-term view of the market? Nothing. It just shows that Wall Street is still up to their old tricks of peeking if they can and pounding us little people half to death with their trading in advance of our knowledge of the the facts. This may seem like a bit of a stretch, but consider this. The employment figures were, indeed, ugly today: unemployment jumped to 6.1%, the highest since 2003. And on the day of this seemingly ugly news, stocks are up nearly 35 points. Please don't try to tell me that the market is up today because there is good news. The market is up today because the short sellers yesterday are covering their shorts today. Many people who had no idea of what was going on were probably drug along in the sales frenzy from yesterday and will regret it in a few months. The bad employment news actually has a silver lining. It definitely puts the Fed on hold; they will not be raising rates anytime soon. Indeed, the rate cuts they have made thus far have not had time to do much to stimulate the economy. It is well known that Fed cuts take 6 months to a year to filter their way through the economy. Bill Gross of Pimco Investments, the largest bond fund in the US, also had a bit to do with yesterday's fall in stocks when he called on the government to start treating the current slow economy like a 1929 type situation. He said a tsunami of selling had caused the markets to freeze up because banks and other financial intermediaries were dumping anything of value to raise enough capital to stay viable. Bill Gross does a lot of lecturing to the government and the markets and I usually think he is full of himself, but in this case I don't think he is far from the truth. I believe, as I have said here previously, that the government needs to quit finessing the weak mortgage and real estate markets and get in these markets directly, especially the mortgage market. They need to be buyers of mortgages, which will drive down mortgage rates and entice people to buy the glut of unsold houses and also allow people with good enough credit to refinance to do so. The Fed has cut rates from 5.25% to 2.00%, yet mortgage rates have hardly budged because of the perceived risk of mortgages. The US government needs to get a lot more aggressive. If they would do this, the banks would also benefit because they could then sell some of the mortgages they have at good prices, freeing up funds that would enable them to make loans elsewhere. Consumers and businesses would benefit because the banks would be back in the banking business instead of in the risk aversion business. Ben Bernanke is considered to be one of the world's experts on reviving an economic collapse. In my judgment, we are a long way from an economy of the 1929 variety, but Mr. Bernanke can be sure that it never gets that bad if the Federal Reserve and the Treasury Department of the US government begin to take aggressive actions to bring stability back to the credit markets. The most expedient way to do that is for them to become direct buyers of a variety of asset classes from corporate bonds to mortgages --even the equity of certain important institutions. I remain convinced that this will ultimately happen, but I believe it would be far better to do this prior to any escalation in the crisis. The US Government is the lender of last resort. The ugly employment statistics today flickers like a 1950s neon sign: "Last Resort Ahead." If the Fed and Treasury do their jobs in a bold and creative way, the real estate market will turn sooner rather than later and with it the stock market, and in a year, today's employment statistics will seem like a aberration . If the Fed and Treasury do not take bolder actions, unemployment is probably going higher and the economy will soften by the fourth quarter. Here is the most important statement of this whole blog. The Fed has done a lot to provide liquidity and keep the economy chugging along; the problem is the banks. As a matter of survival, they have not passed on the rate cuts; they have kept the extra spread for themselves. Thus the Fed's actions have been muted. The US government needs to get directly into the "peeking" business. Not the dishonest kind like some bridge participants, but the kind that puts the Fed in the position of being a direct buyer and seller of a wide range of securities that will enable them to affect the markets in a more efficient way, instead of trying to finesse the economy through the banks.

Dow Jones Fair Valuation Model - 13,500

How cheap are stocks? You don't hear that question often these days, but we believe that is the appropriate question to ask as we pass through the one year anniversary of the subprime crisis. Bank write offs have been staggering and many analysts believe some of the write offs will later be recaptured as the markets unfreeze and normal business activity returns to banking and real estate. Even if earnings are not recaptured, losses at some point will cease and the banks will again begin reporting earnings, thus the earning we are seeing today for the major indices are understated significantly from what they are likely to be two to three years down the road. Having said this, we believe the Dow is undervalued even using 2008 projections for dividends and earnings. We have computed the "fair value" of the Dow Jones Industrials using current data from S&P on 2008 projected dividends, earnings, and AAA corporate bonds yields. Using these assumptions, we then ran the the data through our Valuation Model(click to expand), and we arrived at a fair value of 13,500, as shown on the chart above. The chart shows that the valuation bars, in blue, have followed closely the actual price (except during the mania of the late 90s) of the indices shown in red. With price now buried deep in the value bar for 2008, our model is signaling that stocks are undervalued. The standard error for the formula is about 900 points. That would mean that current "fair value" range for the index should be somewhere between 12,600 and 14,400 -- even the bottom range of the model is appreciably above the Dow's current level of 11,500. We believe the Dow is currently discounting a much slower overall earnings and dividend growth landscape than we are likely to experience, thus we continue to believe that stocks, even in these uncertain times, are undervalued. As we always say, our model is based on historical relationships and thus is not a guarantee of future results. It is, however, based on long-term relationships between growth, interest rates, and price. An important truth that most people miss is that the 30 companies in the Dow will likely raise dividends nearly an average of 10% for 2008, including Citigroup which cut its dividend 40%. That is a clear signal that these major multinational companies do not believe that the economy is going to fall off a cliff. We'll have a new reading of the valuation model on a regular basis.

Durable Goods Will Stay Strong

The durable goods sector continues to confound the gloom and doomers. July's growth for the sector was 2%, with year over year growth at nearly 7%. While the sector's string of good numbers seems to surprise investors every time new data are reported, it shouldn't, the major players are all companies that are benefiting from five powerful forces:

1. They are prime beneficiaries of globalization.
2. They are net exporters, thus, they have benefited from the fall in the dollar over the last several years.
3. As a result of many years of consolidation, they are a much more focused industry with far few players than just a few years ago.
4. They are getting a tail wind from companies in the US who are using these softer economic times to upgrade their operating efficiencies through the purchase of new capital equipment.
5. These companies are not the old metal bending companies that come to mind when many people first think of the group. The companies, in many cases, have converted themselves into technology companies that bend metal around some sort of a computer application.

Yet, while this group has continued to put up good numbers, many of the best companies in the group have languished, including United Technologies (UTX). Its price is down 11.8% over the last year, even though its earnings have risen in mid-double digits.

Indeed, looking at UTX from an historical perspective is very revealing: Over the last 20 years, UTX's earnings and dividends have grown at about 10% per annum. During this same time, its P/E has averaged about 20x. Based on projected earnings for 2008, with earnings growth projected to be up nearly 12.5%, UTX's P/E is running at about 13.5x earnings. This doesn't make much sense. Earnings growth will be up nearly 25% over UTX's long-term average, yet it's price to earnings multiple will be down nearly 30%. The same kinds of relationships hold for its 10 and 5 year ratios, as well.

UTX, along with many other durable goods companies, have gotten very cheap, and we don't believe the forces that have driven their successful operating results are going away anytime soon. Thus, we believe they are significantly undervalued.

This means we are not in the camp that believes that the dollar is starting a secular upward march, neither do we believe that the forces of globalization are at and end.

Our Dividend Valuation Model above shows that UTX has sunk deep into an undervalued condition. Our model is projecting that 2009's fair value for UTX is near $82. With the stock selling around $65, that leaves room for a nice potential gain in the coming year.

As we say often, our model is not foolproof, but we believe it has done a good job of uncovering relative value over the years. We think UTX is a great company and a good value. We own the stock and have been buying it. If you would like more information on the services Donaldson Capital Management offers, please see our website: www.dcmol.com.

My email address is gdonaldson@dcmol.com.

This site should not be used for investment decisions. It is for information purposes only.

lllinois Tool Works: Works

Illinois Tool Works (ITW) is the epitome of a capital goods or industrial company. They make products that manufacturers the world over use to make finished goods. Indeed, many investors watch ITW as a barometer of the whole economy because their product line is so diverse and their business so geographically broad.

The company recently posted 17% growth in earnings vs. a year ago and increased their dividend 11%, both slightly higher than market expectations.

ITW serves customers in 50 nations through 800 companies, all engaged in industrial products. About 50% of their earnings come from outside the US. Their presence in Asia and the Far East is growing rapidly.

The Dividend Valuation Model above shows that ITW's price is buried in its value bar. According to our models, that is a sign of undervaluation. Indeed, you have to go back to the early 1990s to find a time when the stock was as cheap as it is today on a relative basis.

Based on the current fiscal year's projected earnings, ITW is selling for under 14X. That is well under its 20-year average PE of nearly 20X. We can find no reason for this cheapening of the stock, and we believe as the market finds its footing and begins to move higher that ITW has a lot of catching up to do.

We own the stock and have for the last couple of years.

For more information on Donaldson Capital Management, please see our website http://www.dcmol.com/.

About Donaldson Capital Managent And Living Income

Donaldson Capital Management serves clients in 30 states and a few foreign countries representing nearly $360 in assets. How is is that a firm from a modest sized town in the Midwest serves so many people is such a wide geographic area? We believe there are two reasons. One of our New York clients said 20 years ago, "Remember I do business with you because you are from the Midwest and not from New York." I asked him what he meant by that statement. He said, "You know that old line in the song, 'if you can make it here, you can make it anywhere, New York, New York?' Everybody in New York is trying to make it. Make it big, make a name for himself or herself. I believe one could say I'm trying to do the same thing, but I don't want someone trying to make it on my money. I look into these money mangers eyes and I don't see me anywhere. I see them and their agendas. On the other hand, when I look into your eyes I see me. I'm important to you. I figure if I am important to you will will do your best. that's all I ask. But remember one thing. I don't need you to make me rich. I'll do that or not do that for myself. I want you to hang on to what I've got and make it grow. If you do that I will never leave. Now I am leaving my New York money manager because his game is clear to me -- I have become a part of him making it. I don't like the feeling and it is completely clear to me that is what is going on." We have served that man for nearly 20 years. Since he is still with us, I'm guessing that we still make him feel like we are more interested in "him" making it than us making it. One reason for our success in attracting clients from areas outside Indiana and the Midwest, is that we don't take a cavalier approach to client relations. In fact, that's what we are all about. We believe our clients are a blessing to us, and hopefully we to them. The second thing that Donaldson Capital Management has to offer, in my estimation, that makes us very rare among investment managers, is our ability to provide "living income" out of people's assets. People come to us with 35 mutual funds headed in umpteen different directions, trying to live off of the "capital gains" the darn things produce. We show them that retirement is a lot easier if you invest in dividend paying stocks and income producing securities that actually produce the income you need. Most people are shocked to learn that it is possible to produce 5%-6% in income from a portfolio of investment grade stocks and fixed income with a strong probability that the income and capital will increase in the future. You don't need to do Monte Carlo simulations or other tests if you only take the income the portfolio actually generates. If you do that you won't be tapping the principle, thus the tough markets we have been going through lately are much more tolerable. Indeed, almost all of our clients' portfolios will produce more income this year than last, even though the values of their portfolios may have fallen in value. We own what we think are the best companies on earth; why in the world would we want to sell these great companies for today's lousy prices. We'll just wait out this latest tizzy that the markets are going through. Our feeling is if the greatest companies on earth aren't worth anything, then what is? Is the US government, or China, or, France more important than Johnson and Johnson (JNJ) or Wells Fargo (WFC) or Proctor and Gamble (PG)? Most of these companies have been around for a hundred years. They have taken on all comers and every stripe of politician, and they have not only made it, they have prospered. Why would we want to bail out of them to go into T-bills yielding 1.8%, when all of these companies have probably produced an average annual return in excess of 10%. There are thousands of you who read this and I know most of you are interested in dividends in some way. As you know, we think they are the heart and soul of investing and the key to an abundant retirement. If you have grown weary of CNBC's crisis-a-day hype, wary of Wall Street and their programs that are supposed to be good at zigging and zagging at the right time, you might find our long-term income-oriented approach a blessing. Our particular strategy is dealing with people who are in or nearing retirement. Our minimum account is $500,000, with the average near $1.5. We are fee only, so their are no hidden charges. I am talking in this blog about Donaldson Capital because I see a crisis forming in investment management in this country. It seems the whole industry has gone to some form of Modern Portfolio Theory where you spread your money across the whole globe and then try to live off capital gains. We think in the years to come this kind of approach will be increasing discarded because there is no attention to income -- the thing you live on. Increasingly people are going to realize that 4 times in the last 8 years there were no capital gains, thus their living income came from principal. No one wants to live that way, if they can help it. If you have an interest in finding out more about Donaldson Capital Management, email me at gdonaldson@dcmol.com. I also encourage you to check out our website at http://www.dcmol.com/. I like to say that our company has a head and a heart, and both of them are very good. The stakes are high, we think there is a better way for most people to harvest their retirement assets.

Peak Oil: The Golden Geese Are Squawking

Americans have an addiction to cheap oil and it was engendered and nurtured by OPEC. This addiction could have gone on for many more years, except that OPEC, emboldened by the prospects of the global economic expansion and with the cover of the war in Iraq, got greedy and allowed oil prices to skyrocket way beyond oil's demand-supply equilibrium price. Since much of the oil consumed in the developing world is government subsidized, the end users in those countries do not pay a market driven price, but an artificially low price. Thus, the fastest growing parts of the world felt no pain from OPEC's price hikes. This has led to huge increases in energy demand in China and India and helped drive worldwide oil prices higher than almost anyone could have imagined just a few years ago. Having said this, we think OPEC forgot all about monopoly pricing theory, and in the process, unleashed a backlash among American consumers, who bristled with each new all-time high price for a gallon of gasoline. The laws of supply and demand and price elasticity have not been suspended for the oil market. Period. Every student who takes a course in economics knows that monopolies or near monopolies like OPEC must always be careful to price their goods on the demand curve; in this case,meaning pricing oil where consumers will pay the going price and keep consuming more. It’s no different than a drug cartel. Price the drug right, hook the users and keep them hooked on cheap drugs, then let price gradually rise to meet the gradually rising demand. Then do it all over again, being ever careful not to raise prices so much that the hikes reach the users’ consciousness and provoke a “push back” that results in their cutting back consumption. The reason is simple. The drug-pusher knows if you raise prices so much that it moves to the front of the users’ minds, his clientele may decide to go into rehab and get off the drugs. OPEC May Have Misjudged Us The shocking rise in oil prices has, however, led to an unexpected outcome in the United States, which is still the most important oil market in the world. As gasoline prices moved past $4.00 per gallon, Americans began to cut back their oil consumption, something that many believed would never happen. In early July, US oil consumption is down 3% year-over-year, on top of 2% and 1% cut backs in June and May, respectively. Three data points make a trend, and Saudi Arabia and the rest of OPEC know the routine. They must stop the upward spiral of oil prices at all costs and soon; indeed, they must get oil prices down so most Americans think the whole thing was just an aberration. Again, as we have said in previous blogs, the reason is simple: conservation, substitution, and innovation. Conservation, Substitution, and Innovation Americans may have been addicted to cheap oil for a long time; however, if oil is not going to be cheap anymore, then American consumers are going to make some changes. They are going to conserve, even if it is only at the margin. They are going to use alternate forms of energy and transportation to make their daily rounds; and they are going to encourage and buy new technologies that will allow them to live the kind of lives to which they have grown accustomed. Sales of high mileage automobiles are skyrocketing, while the sales of trucks and gas-guzzling SUVs have all but stopped. The use of mass transit is growing rapidly. High-efficiency heating and air conditioning equipment is flying off the warehouse floors. GE says it is having difficulty keeping its high efficiency “energy smart” light bulbs on the shelves. Because it is now cheaper to ship merchandise across the country on trains than on trucks, railroad stock prices are at 100-year highs, while trucking profits are poor. Shopping center associations tell us retail sales remain close to last year’s levels, but the numbers of visits shoppers are making to the malls are down. Wind farms have popped up in 20 states, including our own Indiana. Capital is being invested in more fuel-efficient automobiles, homes, and offices. Rapid Transit is sprouting up in many cities, Phoenix being the most recent. If you ask a Portlander from Oregon what they are most proud of about their city, you are likely to hear about the bike friendly byways, the beauty of the Willamette River, or the majesty of Mt. Hood, but soon you will hear about Max, the city’s rapid transit system. It’s clean, it goes where you want to go, and it’s cheap. Why should we be surprised with these manifestations of conservation, substitution, and innovation? We have grown addicted to cheap oil, but that does not mean that it has addled our brains completely. Once before when OPEC put the squeeze on us, we cut back and overall consumption went sideways for many years.

In 1978 the US consumed 19 billion barrels of oil per day, at the time of the Iran-Iraq War. As prices rose rapidly and calls for conservation became more common, US consumption fell to about 15 billion barrels per day by 1983. It was not until 1994 that our total consumption and imports reached the 1978 levels.

According to “The Economist” a virtual explosion of alternative energy plans is underway throughout this country and the world. Wind power, solar power, clean-burning coal, liquid coal, nuclear power, geothermal, tides, grain based, hydroelectric, electric cars, hybrid cars – you name it somebody with very deep pockets is investing heavily in it and putting the brain power behind it to make it commercially viable.

The American consumer, which is the golden goose of the oil cartel, is squawking and we think it's likely to continue. A limit seems to have been reached by many Americans: rich or poor, they seem to have decided that this mass export of our dollars to the sands of The Middle East has gone on too long with too little to show for it. We are changing our consumption and driving habits; we are challenging each other to use less energy.

We remember 9/11 and where most of those terrorists called home, and we know that in some way we have been dancing too long at the end of somebody else’s string.

The geese have finally begun to realize they are being fleeced. It ought to be interesting to see how OPEC backs out of this one.