Wednesday, July 28, 2010
Donaldson Capital Management Clients and Principals own Procter and Gamble.
Tuesday, July 27, 2010
- Q2 company earnings and revenues continue to surprise on the upside.
- The stock market is responding positively to more certainty around full-year 2010 earnings.
- Many investors are relying too much on popular media for their economic news. The media stories are superficial, shaded toward pessimism, and miss many key facts. This quarter’s client letter addresses that problem.
- Preferred stocks gained in value as the European bank stress test results made people feel better about the health of European banks and the global credit market.
The market reacted favorably last week to the positive results announced by the roughly 1/3 of S&P 500 companies that reported their 2nd quarter earnings. This holds with our view that a good earnings season would help reduce some of the uncertainty and anxiety that had been holding valuations below historical levels. (By valuation, we mean the price/earnings ratio, or P/E, which is calculated by dividing a company’s stock price by its earnings per share.)
The market continued to move higher yesterday in response to more positive earnings news and June new home sales that were higher than expected. This also continues to support our view that strong corporate earnings will eventually result in higher stock prices, and that despite the pessimistic economic news often heard in the popular media, companies could not have turned in 5 consecutive quarters of better-than-expected earnings unless the economy was strengthening.
More data have come in indicating that individual investors continue to keep their money either in cash or bonds, staying away from stocks. Institutional, or professional, investors however are increasing their holdings of common stocks. Clearly, one group is much more uncertain than the other. We wonder how much of this anxiety among individual investors (also called “retail investors”) is due to excessive influence from popular media.
This quarter’s DCM client letter tries to reduce that influence a bit by pointing out that partly out of necessity and partly by choice, the popular media can only tell a superficial story about something as huge and complex as a $14 trillion economy. Also, in order to gain viewers and sell advertising, whatever story they do tell is often written to be “newsworthy”, and unfortunately, bad news is often considered more newsworthy than good. As old newspapermen say: “If it bleeds, it leads”.
What retail investors may be missing is that they are not investing in the economy. They are investing in companies. And, some - even many - companies can do quite well even during weak economies. We do study the economies of the major countries here at DCM, but more to get a broad feel for general direction and to identify which economic sectors might have more or less favorable conditions for companies in those sectors. Choosing which companies to actually invest in, however, is about 95% the company’s individual potential for growth and 5% overall economic conditions.
On the fixed income side of the ledger, specific increasing or decreasing uncertainties are being felt lately. The uncertainty relates to future tax rates. The yields of 30-year, tax-exempt bonds have been steadily dropping over the past month. They are now about 0.4% lower than they were in May (~ 4.125% vs. 4.505%). This drop we believe is almost entirely due to concerns in the bond market that tax rates will move up in 2011. Higher income tax rates mean that tax-exempt municipal bonds become more valuable to high income individuals and corporations because they can achieve a better after-tax return than investing in taxable bonds. We hope this “bet” by the bond market is wrong. But, of course, no one will know until Congress takes action – or doesn’t - on the expiring Bush tax cuts.
For preferred stocks, less uncertainty about the health of European banks and the good earnings from US banks, has moved prices of preferred stocks higher. The European bank stress tests themselves and their results released last Friday were far from perfect. They did, however, make some additional data public and did reduce concerns about bank stability. This benefited European banks the most, but also U.S. and other banks since all would suffer from a major shock to European credit stability.
This increased confidence reduced the credit risk discounts that had been applied to the prices of many financial industry preferred stocks, pushing their prices higher and yields lower. This is a good sign and a development we can use to our clients’ advantage.
We remain optimistic about corporate earnings and, as a result, about stock prices over the remainder of the year. We continue to believe that inflation will remain muted, and that interest rates will trade in a narrow range. Stocks remain the most undervalued assets we can see and, we believe the path of least resistance for stocks is now up.
Randy Alsman, Editor
Friday, July 23, 2010
Friday, July 16, 2010
Wednesday, July 07, 2010
DCM's Investment Policy Committee continued to examine the data in our meeting this week to try to determine whether we are experiencing a normal stock market correction, or a market that is signalling that something has gone wrong with the consensus view of the economy and corporate earnings.
(Note: Our discussion, summarized below, ended in a consensus view by the Committee that if the upcoming corporate earnings season confirms the current forecast of $82 for annual 2010 S&P 500 earnings, then the current market pullback will reverse itself, possibly dramatically, sometime over the next few months.)
The Committee reviewed economic data and outlooks around the world, corporate earnings guidance from S&P 500 companies, and many other data points.
This week, we looked at a multiple regression analysis that assessed the correlation of core CPI rates with earnings yield of the S&P 500 Index. Earnings Yield is just the flip of P/E. That is, it is E/P instead of P/E. We used this inverted P/E in order to better see the "fit" when charted on a line graph. (See below) Click the chart to enlarge.
That analysis shows a tight correlation between core CPI and E/P, with an R2 of .71. The formula derived from the multiple regression indicates that the trailing P/E of the market with core CPI standing at .9% should be about 20X, not the current 14.8X.
If the market “should be” at a 20.2 P/E based on the historical statistical best fit between earnings yield and core CPI, then it is over 30% undervalued, excluding any contribution of earnings over the remainder of the year.
The economic recovery is definitely slowing. Our research, however, brings us to the belief that the economy is still expanding. It is not contracting. Further, during last year’s fourth quarter we, and many other forecasters, predicted that GDP growth in 2010 would slow down in the second half of the year. Everything we see, other than the stock market, is consistent with that forecast. The sharp sell off in stocks over the past three months is reflecting a more pessimistic view of the economy than we can envision at this time.
For the current P/E, and thus current S&P 500 stock price to be correct, earnings for the rest of this year would have to drop by 50% - 75%. A fall in earnings by that magnitude seems highly unlikely to us. Indeed, we believe earnings will continue to surprise to the upside.
We believe that the market sell off in recent weeks is the result of many factors, including: worries about the Administration's attitude toward business, low volume, bearish bets by short-term traders, emotion having greater influence on stock trades than facts, and some vague feelings of skepticism toward 2010 profits by some invesors.
As the earnings reports actually start coming out next week, we believe the market can regain its footing and take back some of the sell off that has so unnerved so many investors.
Having said this, the Committee will be watching and listening very closely to these announcements for any sign of significant earnings outlook deterioration.
Absent a pessimistic turn in earnings, it is hard for us to accept that overall market prices won’t begin turning up – possibly significantly up - before year end.
Randy Alsman, Editor