Friday, September 28, 2007
Real estate news is gripping the headlines, but it is interesting to note that only 2.7% of "prime" mortgage loans are in default and that is where 90% of all mortgage loans are located. The subprime mess is a small part of the mortgage pie, and even though it is causing lots of pain, it does not drive the economy of the United States. Jobs drive the US economy and America is at work and that is the reason that delinquencies on prime mortgages are so low.
Indeed, as it relates to the retailers, we have also found that "he who hollers first" is often the ultimate winner. In this regard, Target is a company we like a lot. They have the right strategy, the right product mix, and we believe they will have a solid Holiday selling season and continue to gain on Walmart.
Our Dividend Valuation Model above shows that TGT is as good a value as it has been since 1996.
Target may not seem like an obvious pick for these times, but who doesn't know that? The "Christmas isn't coming" crowd got out of retail a long time ago. When they see that they are wrong, they will be back pushing Target and the other top flight retailers higher.
Monday, September 24, 2007
Europe has already slowed, Japan is having one of its never-ending political upheavals, and China and India are attempting to slow their economies in the face of rising inflation.
Additionally, the recent cut in rates by the US Federal Reserve has spiked the US dollar lower against most of the other world currencies. This will give US companies a powerful competitive advantage in the global markets, and at the same time, make foreign exports to our nation more costly. Taken together, these forces will cause a string of interest rate cuts around the world, probably beginning with Canada.
In the picture I see forming, our Canadian neighbors may well come out looking very good for a period of time. They are a natural resource exporting nation, so their products will continue to be in demand, even if prices begin to stabilize.
Canada's banks are strong, with few of the subprime issues that will continue to nip at the heals of American banks, and finally, the country's Conservative government is finally beginning to deliver on some campaign promises. Importantly, as I said last time, Canada just cut corporate income taxes to near 30%, among the lowest in the developed world, and well under US corporate tax rates.
In running Canadian companies through our Dividend Valuation Model, I see many that are cheap. In the coming months, I will describe a few here.
The best valuation I see is Toronto Dominion Bank (see chart above). It is the second largest bank in Canada and has been making strategic acquisitions in the US. Its combination of a 2.8% dividend yield and low double-digit dividend increases over the past few years has made it a solid performer but has still left it significantly undervalued.
Our model says (I am showing TD in its local currency) that the stock may be as much as 15% undervalued, based on my estimate of next year's dividend growth.
Canada's natural resource oriented economy will insulate it from the economic slowdown that may hit most of the rest of the G-7 nations. Indeed, Canada and the US may be the only G-7 nations that will not experience any negative quarters of economic growth over the next six months to a year.
Sunday, September 23, 2007
Tuesday, September 18, 2007
If history is a guide, the Fed will cut rates today and will continue to cut for at least the next four months.
The top part of the chart at the right shows the graphs of the Fed Funds Target Rate and the yields on 90-day T-bills. The bottom of the chart shows the difference between the two in red. I discussed the significance of the recent divergence between the two short-term rates in our Sept. 4th post.
There have been four previous divergences that have approached one percent over the past 20 years: the crash of 1987, the S&L troubles of 1989, the Asian Financial crisis in 1998, and the popping of the tech bubble in 2000. In each case, as the divergence between Fed Funds and T-bills approached one percent (.9% more precisely) the Fed cut rates and the differential and, ultimately, the crisis went way.
I have done some additional studying of these divergences and I see two additional areas of interest:
- On average, after rates were cut, Fed Funds were lower by .75%, within four months . Thus, if history is to be our guide, today's cut is just the beginning.
- Twelve months after the first Fed rate cut during three of the credit crunches (1987,1989,1998), stocks were higher, including dividends, by nearly 20%. In the year following the tech bubble, stocks were down nearly 15%, including dividends. The average for the four periods was about 12%.
After what we have waded through 2007, the hopes of a 12% total return over the next year sounds very acceptable. However, I think it may well be better than that because of the unusual circumstances surrounding the poor performance of stocks in the year after the popping of the tech bubble. That pushed us into the time of Enron and then the 9-11. It would have been hard to imagine that stocks could have risen during that time, no matter what the Fed was doing.
Thus, I think it is best to call the period after the tech bubble a special case and drop it from our analysis. If we do that, as I said earlier, the average total return after the Fed started cutting rates in the other three occurrences of a credit crisis, was near 20%.
As they say, the future is not the past, but sometimes it is the best guide we have.
Wednesday, September 12, 2007
- 4.75%. . . . . . .74%
- 5.00%. . . . . . .26%
If you do the math, 100% of investors in Fed Funds believe at least a .25% rate cut is coming. Significantly, and perhaps surprisingly 74% of investors believe a .50% cut is at hand. I'm in this latter camp for reasons I have discussed earlier.
Here's where everyone is flying a bit blind. If Greenspan would have seen this Fed Fund action and he had no intentions of cutting rates by half a percent, he would have Greenspeaked it --talked it down.
We don't know if that is how Bernanke is going to operate. He may believe in more openness but less guidance and less Bernankespeak. If this is the case, my thinking is a quarter percent cut will be viewed as a disappointment by the stock market and it may well sell off. Heaven forbid if rates aren't cut at all.
The saving grace is the Fed's statement accompanying their decision. They can still signal there intentions in the statement which would have the effects of muting the actual move they might make. That may be where Mr. Bernanke has decided to speak.
I can't remember a Fed meeting in years where so many investors are so confused about the outcome. Should make for an interesting day.
Thursday, September 06, 2007
Each week our investment policy committee deals with the events and issues of the day, as well, as charting the course of our investments.
There are four of us: Mike Hull, our president, who has wide experience in consumer attitudes and consumer products; Vice President, Rick Roop, who has had many years of experience in energy production and organizational systems, Vice President, Randy Alsman, who has a background in finance and has been an executive in both the consumer products, as well, as the pharmaceutical industries; and Greg Donaldson, who has a long history in economic strategy, financial institutions, and valuation metrics.
This past week we had a wide-ranging discussion of the goings on under the sun, so to speak. The following in a general synopsis of our thinking: The points seem rather straight forward, however, we can tell you the getting-there was not so straight forward, but a flood of thoughts and ideas that sprang up and were either shot down or allowed to pass on. In the end, this is what WE believe, and I (GCD) am proud to say it is reasoned, reasonable, and, in my judgment, a good bet to come to reality
We saw the troubles in real estate coming. We were convinced they would be worse than what most people thought. We said as much here 15 months ago.
We are surprised that the subprime mortgage mess is as widespread as it is. Unknowns in the banking system are always unnerving, and we believe the damage is enough to warrant the Fed starting to cut the Fed Funds rate.
In the short-run, say the next six weeks, the market could be very volatile. But, if the Fed moves in a measured way, the economy and the corporations that produce most of our goods and services will perk up in the coming months and provide a very healthy stock market. Here's why:
1. The Fed has done an excellent job of gradually slowing economic growth so that inflation has not gotten out of hand. Their actions have been appropriate enough that we see a slower economy ahead but no recession -- a soft landing.
2. The Fed's second responsibility (after holding off inflation) is to stimulate economic growth to create jobs. So far, the unemployment numbers tell us the economy hasn't slowed enough. But, that is looking in the rear view mirror. Every Fed tightening in recent history has ended with a "financial accident." These accidents have become a signpost for the Fed that by raising rates, they have slowed some area of the economy enough to do some damage. This time it was housing and sub-prime lending (both of which needed some cooling off - greed had taken over the decision-making in that part of the economy).
3. Many investors, politicians, and corporate leaders are yelling about a pending recession and calling for the Fed to cut the Federal Funds Target Rate. This is the second signal that tells the Fed they can cut rates. If the CEOs of major corporations believe we are heading for a recession, what happens to their hiring practices? Right, they dry up. Their screams for rate cuts precede a rise in unemployment.
The credit crunch and the housing market could well get worse before they get better. It does appear, however, to be fairly contained. But, at this point, the Fed does not want to rescue the bad decisions made there. In fact, they see the losses and pain as healthy for the economy longer term. And, the stock market will see that, too.
We say all of this to reach these logical conclusions:
- The Fed has slowed the economy. Unemployment is going to rise.
- That will give the Fed the room it needs to revert to stimulating the economy by lowering interest rates.
- We think they will begin soon and continue doing so at a measured pace for several months.
- The stock market loves it when the Fed lowers rates -- it means the Fed does not fear inflation and is trying to stimulate economic growth.
- That will lead to an attitude that earnings growth will be stronger and more sustainable.
- As the market looks ahead to 2008, stock prices should start to rise and that could continue as long as the Fed continues lowering rates.
- We are bullish on prospects for stocks over the next 18 months.
Tuesday, September 04, 2007
As we returned from the Labor Day weekend, there are still some in the financial media that are saying that the current state of the economy does not warrant a cut in the Fed Funds Rate.
We don't agree and history shows that the Fed has cut rates in the past, even when the economy was not in or near recession.
The chart at the right shows the yields on 90-day T-Bills (blue line), which are backed by the full faith and credit of the US Government; the Fed Funds Target Rate(green line), the rate paid and guaranteed by banks; and the difference between the two at the bottom (red line).
The top part of the chart shows that for most of time over the last 20 years the interest rates on 90-day T-Bills and fed funds have stayed very close together. This would make sense. One strong bank borrowing from another would not expect to pay a rate of interest much higher than the government would have to pay for a short-term loan.
However, when fears of recession or the strength of the banking system is called into question, the spread between fed funds and T-Bills widens. Why, because big investors decide they feel safer in government backed T-Bills than they do in the banks and they bid T-Bill yields lower.
To see this, let's focus on the red line at the bottom of the chart, which shows the difference between the Fed's Funds Target Rate and the yield on a 90-day T-Bill.
Each time the yield differential has been at least one percent, the Fed has cut rates within a short time. In addition, you will note that T-bills have always led fed funds lower.
There have only been 5 times in the last 20 years when the yield differential between T-bills and fed funds have been approximately one percent: immediately after the stock market crash of 1987, during the Saving and Loan Crisis in 1989, during the Asian Flu of 1998, in mid 2000, when it was clear that the Tech bubble was popping, and today.
The chart is a month-end chart so it does not show every day for the last 20 years, but it is remarkable that on a month-end basis that the events of September 2001, did not produce a one percent spread.
These one percent spikes have occurred coincident with an extreme crisis of confidence in the financial markets, not necessarily in the economy. The US economy was fine in 1987, 1998, and 2000 at the times of the spikes.
Thus, the arguments today that the Fed won't cut the fed funds rate because the US economy is not close to recession is beside the point. The point is the Fed has a financial crisis to deal with and history shows that the way they deal with these types of events is to cut rates. They can always raise rates later if the crisis passes without a sharp fall off in the economy.
The arrow at the far right of the chart shows that the recent spike is higher than at any time going back to 1989. In our minds, the question is not if the Fed will cut rates, but how much? One of us thinks .25%, the other .50%.