Lots of Headwinds, But Stocks Will Continue to Climb in 2013

Hurricane Sandy’s Potential Economic Impact

Our thoughts and prayers reach out to the people of the Northeast and everyone who is affected by Hurricane Sandy. 

At this time, the estimated economic damage of this storm is $30-50 billion.  In the short term, we believe this will have a negative impact on economic activity in the region and a modest effect on overall U.S. GDP.  Sandy’s timing is particularly unfortunate because roughly 33% of annual retail sales occur in the last 25% of the year.  Additionally, the storm will provide plenty of “noise” to distort economic data as the effects of Sandy and the cleanup are felt for many months to come.  Cataclysmic storms are destructive and cause much human and material loss.  However, history shows us that the post-storm cleanup and rebuilding efforts stimulate economic growth by infusing capital and increasing employment into the affected area.

The Barnyard Forecast

The Forecast is our proprietary model for predicting stock appreciation over the next 6-18 months. Since 1990, it has correctly predicted the direction of the market about 75% of the time. It receives its name from the acronym used to “score” the prospects for stocks: Economy + Inflation + Earnings + Interest Rates = Opportunity.  Each component receives a score between 0 and 2, depending upon whether or not it is deemed to be negative, neutral, or positive for stocks.  The Forecast currently scores 5 out of a possible 8 points, which is a favorable score for rising stock prices.  The current stimulative policies of the Federal Reserve are the primary drivers of the model’s positive forecast.  Whereas, the most recent flat corporate earnings pulled down the model’s score.

Positive Analysts’ Earnings Estimates for 2013

Looking forward to 2013, Wall Street analysts’ current estimates for earnings growth are nearly 10% higher than 2012.  Earnings growth above 7% would move the Barnyard Forecast to a perfect score of 8 points.  Historically, stocks have produced double digit returns when the model reaches that level.     

Stocks on Sale!

The price-to-earnings (P/E) ratio reveals how much investors are willing to pay for $1 of earnings.  The most recent reading from our proprietary “P/E Finder” model indicates that the price to earnings ratio of stocks should be near 17.  The P/E ratio is currently selling at 14.3 times earnings.  Multiplying the model’s predicted P/E of 17 times the analysts’ 2012 earnings estimates of $105 suggests a year-end value for the S&P 500 of over 1700.  That is nearly 20% higher than the current level of about 1400.  In addition, our “Dividend Valuation Model” currently estimates that stocks are 15-20% undervalued based on the historical relationship between dividends and price.  We feel this confirmation of two separate models measuring two different indicators both arriving at the same conclusion is convincing evidence that stocks are, indeed, undervalued. 

Why are stocks trading so cheap?  The answer in two words is “risk premium.”  Our “P/E Finder” model is based on the relationship between P/E and inflation.  Historically P/E ratio has moved inversely with inflation.  Investors are worried that the Fed’s aggressive monetary policies will push inflation significantly higher.  We believe inflation may move modestly higher, but will not exceed 3% for an extended period of time.  In our judgment, inflation would have to stay above 3% for more than a year for P/Es to meaningfully fall.  With this in mind, in the absence of unforeseen shocks to the economy, we remain optimistic about 2013 stock performance.    

Fiscal Cliff

The media are full of worrisome stories about the repercussions of a continued stalemate between the Republicans and Democrats on a wide range of fiscal issues.  The so-called “Fiscal Cliff” is a combination of the expiration of the Bush-era tax cuts along with across-the-board cuts in defense spending and entitlements.  The consensus of the Wall Street experts we follow is that the ramifications of not solving these issues are unacceptable to both sides and that an agreement will be reached either before the deadline or shortly after the new Congress takes office on January 3rd.  The stakes are just too high for Republicans and Democrats to do nothing.  

The Elections

On balance, we believe the stock market would do better under Mitt Romney than under President Obama, who’s anti-business, anti-rich rhetoric has not endeared him to the business community.  Having said this, investors will be relieved just to have the uncertainties surrounding tax laws and the state of the U.S. budget cleared up one way or the other.  The only thing that would derail our positive view for the stocks would be if President Obama makes further attempts to expand the role of government at the expense of the business community or if earnings disappoint.  

As will be familiar to many readers, we rely on our models more than we rely on the hot news of the day.  Eventually stock prices follow value.  We believe stocks are already undervalued and will become more so in the year to come.  In this environment the path of least resistance for stocks is up.

Houston, We Have Convergence

Please see the article with the above title that we wrote for Seeking Alpha about the recent action of the major stock market indices. We also discuss briefly what Quantitative Easing will mean for the economy.  Please follow this link.

The Good News and Bad News in The Bond Market

The bond market has reached the surreal stage.  The flight to safety and the various machinations of central banks around the world have combined to push interest rates down to levels never seen before. Currently, a 5-year U.S. Treasury bond yields.70%, a 10 year bond yields1.65%, and a 30-year bond yields a robust 2.70%.   Indeed, a few weeks ago, high quality German bonds were  sold at a negative yield.  Think of it; for safety’s sake, investors were actually willing to accept less principal back than they invested.  

Our clients have largely been shielded from this collapse in interest rates for two reasons: 1)  For many years, we have emphasized the purchase of bonds with long maturities and calls, thus, we have had to deal only sparingly with re-investing large sums of money in this low interest rate environment. 2) We aggressively bought municipal bonds as recently as early 2010, when prices collapsed and yields soared, after a Wall Street analyst pronounced a dire warning about municipal defaults on the “60 Minutes” television show.  In short, these strategic moves have saved our clients from the full force of the collapse in interest rates and will continue to do so for years to come.    

That being said, we have spent more time in our recent investment policy meetings talking about bonds and bond strategies than at any time in our history.  The reason is a case of bond good news-bad news.  

Even though the projected average life of the bonds in our portfolios currently stands at about 4.5 years, when we bought the bonds the projected average life was nearly 15 years. This shortening of the portfolio’s average life is being caused by the collapse in interest rates.  Almost all of the bonds we own in our clients’ portfolios have interest rates that are higher than the underlying municipality or company would have to pay in today’s market.  The good news is 99% of all the bonds we own have “call” protection, meaning the bonds cannot be redeemed until some time in the future.  Because of this call protection, as interest rates have fallen, investors have pushed up the prices of our bonds.  

This call protection, along with our purchase of long-term bonds, has meant that our overall bond portfolio has averaged nearly a 10% annual return over the last three years.  At first, that would seem impossible.  How can you make 10% per year in bonds when bond yields never came close to that level during the last few years?  

To help clarify what has been going on in the bond market, let’s look at a simple example.  Let’s say we bought $100,000 of a Munster Indiana taxable school bond on August 10th 2009.  The bond had a 6% interest rate and a maturity date of August of 2023.  Importantly, however, the bond could not be redeemed or called prior to August of 2017.  Because a 6% yield is so much higher than the going rate for this kind of bond in today’s market, investors have pushed the price of the Munster Bond up to 112.  That means the $100,000 in bonds we bought three years ago are now worth $112,000.  Over the last three years, we have made 12% extra in price appreciation above the 6% interest rate of the bonds.  If we amortize the 12% over the three year holding period, we arrive at an average annual appreciation of 4.0% (12%/3 = 4.0%).  Then adding the interest rate of 6% to the average annual price appreciation means that our clients who bought this bond in 2009 have made a 10.0 % average annual return.  That is great and far better than we would have ever expected when we bought the bonds.

The total annual return in the example above is very close to actual returns we have made on the nearly $40 million of taxable municipal bonds that we bought in 2009 and 2010.  So what’s the fuss?  Why have we been spending so much time discussing what to do about our bonds when the news seems to be so good?

First, we must sell the bonds to achieve the 12% gain, which doesn’t seem like a very smart thing to do, when interest rates are so low.  But there is just as big a problem if we decide to keep the bond, and this is a problem that few investors ever think about: “What is my rate of return if I hold the bond until it is called?”

A bond calculator is needed to make the actual calculation, but in the spirit of keeping things simple, let’s work through what is going to happen to our Munster Indiana Bond in the years to come.  Remember the bonds are callable in August of 2017.  With rates so low, the odds are very high that the bonds will be called on that date.  In this case, the call price is 100.  Thus between now and 2017 the price of the bond will fall from its current price of 112 to its call price of 100.  To compute the average annual effect of this fall in price, we divide the 12% we will lose by continuing to hold the bond by the number of years (5) until it is called (12%/5= 2.4%).  We then subtract this amortized loss from the 6% interest rate of the bond, and we find that we will earn approximately a 3.6% annual rate of return from this point until the call date.    

In the case of the Munster School Bond, we believe it is still underpriced, and we have decided to hold it for a while longer.  In other cases, the annualized yield to the call date is as low as 1%.  In many of these cases we have begun to take profits and move to higher yielding bonds or preferred stocks. The good news is these bonds have treated us very well. The bad news is, they offer a very poor return between now and the time they can be called. While its tough giving up a bond with high interest rates, if in doing so we can protect a sizable gain, its the right thing to do. 

This is the first of a series of blogs about the current bond market.  In the coming weeks we will discuss our views on corporate bonds, high-yield bonds, and preferred stocks. The bond market has been very good to us over the last 20 years, but the current low rates are requiring deep analysis and new strategies. We will be talking about our thinking on the bond market more and more through the rest of this year.

Take-Aways 6-25-12

In this edition of the weekly Take-Aways, Randy Alsman reviews the Investment Policy Committee's concerns about Europe's ability to find a solution to its economic crisis and how its effect on the markets call for a more defensive investment strategy and what we have found the defensive stock indicators to be.

We hope you find this helpful. As always, please feel free to give us feedback that you think might help improve our communication with you.



The audio blog is also available at the link below:

http://www.youtube.com/watch?v=9IfKB2_aJLU

Bond-Like Stocks Are Still Winning

We regularly slice and dice the S&P 500 to determine what general categories of stocks are doing well.  Periodically, we do what we call a strategy check.  Simply put a strategy check is an analysis of the three or four investment criteria that we believe are at the core of our Rising Dividend investment strategy.  The following is a brief discussion of the criteria we follow most closely and how companies with those characteristics have fared over the past twelve months.

Quality:  As we have detailed many times in these blogs, our investment selection process begins with the quality door.  Except on rare occasions, we invest only in companies whose bonds achieve at least an investment grade rating by one of the major rating agencies.  The reason for this is obvious:  sooner or later, tough times come, and when they do winnings stocks are almost always found among companies with good credit histories and ratings.

The following are the 12-month median total returns of the S&P 500 companies broken down by ratings.                  

Rating	Median Total Return
AA-AAA	12.8%
A	4.8%
BBB	4.0%
B-BB	-10.5%
NR	-1.8%
Standard and Poors 500 Index	3.72%

The last twelve months have been a roller coaster ride for stocks of monumental proportions.  In this kind of environment, it is not surprising that the higher quality stocks have performed well versus lower rated stocks.  It is a bit surprising that the total returns by bond rating are so symmetrical.  As we have noted before, the stocks in our Cornerstone investment strategy have an average bond rating of A+.  

Dividend Yield:  After a stock makes it through the quality door, the first thing we look at is its dividend yield.  Dividends are cash money.  Dividend payments place a premium on a management team that focuses on the proper balance between the cash flows necessary to pay the dividends and the capital expenditures necessary to keep the cash flows growing.  In short, dividends require a disciplined management team.  We think this means that most companies who pay a regular dividend are less likely to be taking wild-eyed fliers with our money. 

Dividend Yield Quintiles	Median Total Returns
Top 100 Dividend Yielders	8.2%
2nd 100 Stocks	4.7%
3rd 100 Stocks	2.4%
4th 100 Stocks	3.8%
5th 100 Stocks	-1.6%

It is not surprising that the median returns of high yielding stocks are showing good results.   Bond yields are historically low, and people have been moving to higher yielding stocks in a steady stream.  What is surprising to us, again, is that the results are nearly symmetrical.  We believe this might be a cautionary signal.  Many high yielding stocks we see on the list of top performers have very little dividend growth and are presently borrowing money to pay the dividend.  That is not a good sign and could signal some dividend disappointments in the year ahead.  That is the reason we focus so intently on dividend growth. It is the best way we know that a company can offer tangible signals about it future prospects. Talk is cheap, but dividend hikes mean a company's money is where its mouth is.

Dividend Growth:  We learned a long time ago that dividend yield alone is not enough; dividend growth also plays an important role in the long-term performance of a stock.  The following tables show the median total return over the past 12 months of stocks in the S&P 500 sorted by dividend growth quintiles. 

Dividend Growth Quintiles	Median Total Returns
Top 100 Dividend Growers Last 12 Months	4.8%
2nd 100	5.9%
3rd 100	7.6%
4th 100	2.5%
5th 100	-8.1%

The table shows that investors have not rewarded the top dividend growth companies that are located in quintiles 1 and 2.  Investors have been buyers of the lower dividend growers in quintile 3.  A closer look at that group is very revealing.  The average dividend yield for the stocks in quintile 3 is 3.4% and the average annual dividend growth is 5.9%.  This compares to the S&P 500 where the dividend yield is approximately 2%, with dividend growth last year of near 10%.  

It is important to note, that while quintile 3’s slower dividend growth was the top performer, quintiles 1 and 2 also outperformed the S&P 500 total return of 3.7%.  That is also the the case in our Cornerstone investment strategy.  The 30 stocks in that portfolio have a current yield of 3.5% and dividends grew last year at just under near 10%.        

Our bottom line summation of what this strategy check is telling us is that, indeed, in this low interest-rate, slow growth environment our concept of “bond-like” stocks is still a winning strategy.  The markets are rewarding higher quality over lower quality.  Investors are buying dividend yields that are higher than bond yields and are favoring current yield over dividend growth, although companies with high dividend growth are outperforming the average stock.  We have spoken about these bond-like stocks in several previous blogs.  Please access these links,1. Bond-Like Stock Audio, 2. Bond-Like Stocks, to see and hear a more expansive discussion of why we believe this concept is working and will continue to work.

Take-Aways 6-11-12

In this addition of the weekly Take-Aways, Randy Alsman discusses recent developments in the Spanish banking crisis and why the U.S. stock market is likely to continue to be volatile over the next several months. He will also highlight the good news in U.S. corporate earnings.


We hope you find this helpful. As always, please feel free to give us feedback that you think might help improve our communication with you.



The audio blog is also available at the link below:

http://www.youtube.com/watch?v=tEw7Z-aIhFM

June 4, 2012 Takeaways

We hope you find this helpful. As always, please feel free to give us feedback that you think might help improve our communication with you.