Tuesday, October 30, 2007

Fed Rate Cut: 50 Basis Points or 25?

Trading in Fed Fund futures is signaling over a 90% probability that the Fed will cut rates on the 31st. Trading also suggests that the most probable cut is a quarter of one percent. That is also the best guess of our president, Mike Hull, who is now sporting a 0-1 win-loss record against me. Last time, I predicted that the Fed would cut rates by a half percent because I believed they recognized that a credit crisis was underway, and they needed to get out ahead of it and signal that they were more worried about an economic slowdown than an uptick in inflation. One of the indicators on which I based my prediction was the yield spread between Fed Funds, the overnight rates at which banks loan money to each other, and T-bills, the short-term rate at which the US government borrows money. That yield spread had spiked to more than 1.25%. I suggested then that such a wide yield spread was not only unusual (it had only occurred four times in the last 20 years) but a clear signal that loaning money to a bank was considered much more risky that loaning money to the government. This crisis of confidence regarding the creditworthiness of the banks jeopardized the economic health of the US economy and had -- and would continue to cause the banking system to freeze up, unless decisive action was taken. I advocated a 50 basis point cut as a preemptive move to "knock" the bankers on the head and remind them that the Fed was in charge not only of fighting inflation, but also ensuring liquidity in the banking system and economic growth. The Fed's subsequent 50 basis point cut was a bit of a surprise to the stock market and it responded by powering higher nearly 300 points. The Fed needs to cut rates by 50 basis points again because the yield spread between the Fed Funds rate today, 45 days after the last cut, is still nearly one percent: Fed Funds rate 4.75% and T-bills at 3.85%. In my mind this wide spread is still signaling the credit crisis is alive and well. I think the Fed should cut rates until the yield spread falls to no higher than .5%, and they need to do it swiftly. They currently have the liquidity crises corralled but not tamed. They need to tame it, and the best tool they have to do this is to continue cutting rates at a pace greater than the market predicts. The value of these continued sharp cuts will ultimately get the market's attention and allow equilibrium to return the banking system and the economy. If need be, the Fed can take back some of the rate cuts after normalcy has been restored. Even though I realize it is a long shot, put me down for a half percent cut. Shawn, Ken, David, Mike, Joe, Jay, et al, here's your chance to get your money back.

Monday, October 29, 2007

The Flip Side of Maximum Pessimissm

Last time, I discussed John Templeton's investment strategy of investing in the world and stocks where there was the most pessimism. He practiced this strategy because he believed that as an economy, industry sector, or individual stock becomes completely tarred and feathered deeper pockets and steadier hands often step in to buy the stock that the momentum players are dumping. I have noticed that in periods of maximum pessimism there is an equal and opposite force that I will call maximum optimism. In this regard, investing is a zero sum game. If the momentum crowd bails out of bank stocks, as they have, the money has to go somewhere. If it goes to cash, it drives down short-term interest rates. If it moves to bonds, it drives down longer-term interest rates. Finally, if it goes into stocks in different industry sectors or even different countries, it will tend to drive the stocks in those new areas higher. In the recent sell off, some money has gone into short-term, high quality bonds, but it is clear that little has gone into longer term bonds because bond yields have not moved much. To my eye, it is clear that the money that has left the bank and financial stocks has moved to energy, consumer staples, and commodity related stocks. Now guess what? Stocks in those sectors are now reaching fair value and, indeed, energy has pushed into overvalued territory. So, does that mean that under John Templeton's investment strategy we should be selling the energy stocks? Good grief, that is nuts, isn't it? Doesn't everyone know that oil prices are going to continue to go higher through the end of the 21st century? The new middle class of China, India, Eastern Europe, and South America are going to drive Lexi, aren't they? Aren't they going to end up consuming about the same per capital amount of energy as, for instance, the middle class of Europe? My answer is -- not by a long shot. Motorola had incredible success in China in the 1990s selling pagers. There were few telephone land lines in most areas of the country, so the early form of communication in China was by pager. Gradually pagers gave way to cell phones. Land lines are still in short supply in the country, but second and third generation wireless telecommunications are filling the needs of many of the new middle class in the nation. The same thing is going to happen in transportation. Second and third generation modes of transportation are and will continue to explode. Intra-city public transportation is growing at a high rate, and high speed bullet trains are in the works. You can bet that these "centralized" forms of transportation will be the rule in the country because that is the one area where the old Communist mindset makes sense. The same goes for India and South America. They know they cannot rely on the suburban American model of 2.2 cars for every household and ribbons of high-speed asphalt highways connecting every city in the country. Public transportation is how the Communist leaders can maintain a modicum of relevance. Communications in most of these countries will continue to be like the wild west, but transportation will be more controlled, more out of those famous Communist five-year plans. As the world comes to understand the "new world" model, it will become more clear that natural resource consumption will not grow at geometric trends, as is now feared. In short, oil prices are not going up as far as the eye can see, or the mind can think. Energy stocks are overvalued, but we are not selling yet. Indeed, we would be foolhardy to announce in advance that we think oil stocks have reached their peaks. Just say that oil stocks are fully prices, and we will be keeping a keen eye out for prices that factor in oil prices rising "forever." We think that is what Mr. Templeton would have done. He knew that the "crowd" often gets it wrong. But, why take your profits too early when the crowd will always push prices beyond reason, both in sectors where the news is bad as well as where the news is good.

Tuesday, October 23, 2007

Templeton's Theory of Maximum Pessimism

John Templeton, founder of the Templeton Funds (now part of Franklin Templeton), will leave a giant legacy when he passes on to his reward. He is widely recognized as the father of international investing. He was investing in foreign lands before most US citizens were even investing in the US. He was an early apostle, as he put it, for "turning Americans into investors instead of savers." When he was advocating this only about 20% of Americans had any money in the stock market; today that figure is over 50%. He was born in Tennessee and he kept the commonsense of the Volunteer state while amassing a fortune helping people invest their money though the value investing principle of "Maximum Pessimism." He was a rock-bottom value investor. He wanted to invest in countries and companies where there was not only blood in the street, from an investment perspective, but it had dried. He wanted to buy just after the last person at the local stock exchange had turned out the lights. "Maximum Pessimism" to him meant that in a country or company all the bad news was completely out and known by everyone from school teachers to captains of industry, from alderman to the President of the country. He wanted abject pessimism. He would then begin to buy. Templeton believed that once "Maximum Pessimism" was reached the odds swung in his favor. It was at this point that the citizens, capitalists, and politicians were fully cognizant of the problem and each in his or her own way was pressed to do the right thing -- stop the bleeding. Crises result from bad decisions gone bad. Crises call out for leadership to solve the problem -- stop the bleeding. This "stopping of the bleeding" is difficult and requires that very proud men and women (usually men) to admit that they have failed. Most business leaders do not have the courage to do that the right thing when it makes them look bad . It is only when the markets turn against them that they are actually rewarded for admitting their failures. Stopping the bleeding is facing the fact that something is wrong, identifying what is wrong, and cutting it out. Consumers, bankers, and the government have been riding the magic carpet of debt. The recent subprime crisis has shown the magic carpet for what it is -- a rug. The leadership of companies that are the first to acknowledge that the magic carpet is a rug and value it appropriately will survive. Those who hold any illusion that the carpet has any powers of flight will find themselves without a job very soon. Thus far, I believe one of the first bankers to call the magic carpet a rug is Kenneth Lewis of Bank of America. My guess is that John Templeton would approve of Mr. Lewis' confession that the had learned about all he wanted to know about investment banking. I'm betting that Mr. Lewis will stop the bleeding in BAC's investment banking division, and in doing so, persuade deep value investors who are followers of John Templeton that "Maximum Pessimism" has been reached.

Wednesday, October 17, 2007

Investing versus Speculating -- UTX

Just a few days ago, I was extolling the virtues of United Technologies and its high level of predictability. Today the company reported outstanding earnings but warned that 2008 earnings growth would be in the range of 10%-14%, at the low end of its heretofore projected average growth rate of 14%. Since UTX has had a good run this year, the traders headed for the door and UTX was down nearly 2.5 points.

If I thought UTX had significantly changes its stripes, I would be selling too, but I don't believe they have. They operate in 4 areas: Aerospace and defense, Otis elevator, Carrier HVAC, and their security division. Few companies in recent years have been as well positioned and running as smoothly as UTX.

Their announcement of slowing earnings growth is reasonable and proper. We believe the US economy will slow in the coming year. UTX derives 50% of their profits in the US, so it is predictable that the company would warn about a slowdown in earnings.

UTX's strength, however, is their inroads into the rest of the world. Think global economy: think Otis Elevators and Escalators. Think energy conservation: think the new line of Carrier Heating and Air Conditioning systems, which is reported to produce energy savings of up to 35%. Thinks Aerospace and Defense where UTX is a leader in jet engines and helicopters. Think terrorism: think UTC security and protection.

Our Dividend Valuation Model suggests UTX has a high probability of reaching nearly nearly $90 per share in the year ahead, even using the company's lower earnings growth targets.
Notice how tight the actual price (blue line) has been over the last 20 years to the model's predicted price (green bars). This very tight fit is suggesting that, even at a slower growth rate, UTX has a lot of room to run.
Good to great companies aren't on sale unless there is some vexation going on. UTX is a wonderful company undergoing a mild case of vexation. We think it will pass.
We own the stock and have owned it for a few years.
The old saying on Wall Street is that the momentum players cut bait and sell to the value players when the timing is poor but the price is right. All the value players have to do is wait Our model is giving us a clear message that UTX's price is right. Unless UTX's earning and dividends slow to single digits, if we are patient enough, time will provide us a nice profit. It certainly is not guaranteed, but the tight fit of the model suggests that it is as good a guess as we can make of what to expect in the year to come.

Monday, October 15, 2007

Using Dividends to Predict Stock Prices

The academics have been telling us for years that the stock market is efficient. That is, it is not possible to use technical or fundamental analysis to predict the winners and losers in the stock market because each stock's current price already factors in everything that can be known about its future. Warren Buffett has said that the academics are off their rockers because he could not have amassed his $50 billion fortune if their concept of the efficient market were true. Our approach to investing is a bit different from either the efficient market approach or Warren Buffett's approach. We call our investment approach the Predictable Market Approach, and of course, the driver of the PMA is the dividend. We have found that approximately 100 of the 500 stocks in the S&P 500 have some correlation between price growth and dividend growth. By adding in interest rates, we can increase the stocks that have some predictable qualities to about 150. In the Dow Jones Industrials, we have found that about 15 of the 30 stocks are significantly correlated to their dividend growth and/or changes in earnings and interest rates. On the contrary, we can find little correlation in the S&P 500 between prices and dividends, earnings, or economic growth. As academia would say, the S&P 500 is random. On the contrary, we believe the Dow Jones is not as random in its movements as the S&P 500, mainly because the companies that comprise it have consistently paid a higher percentage of their earnings in dividends, which makes them more predictable. Here's a brief look at the PMA.
  1. Predictable: first we look for companies where some combination of fundamental data reaches an acceptable threshold of correlation to changes in their stock prices.
  2. Undervalued: second we look for companies where the predictability equation suggests a stock is undervalued, based on a simple one year projection of fundamental changes.
  3. Momentum: third we look for companies that pass the first two screens and have some validation of their undervaluation manifested in the upward movement of their stock prices.
Here's the bottom line--predictability of the potential total return for a stock is a tremendously under appreciated concept. Think about it this way, the price of United Technology (UTX) in the Dow Jones Industrials is over 90% correlated to changes in its annual dividend growth and changes in interest rates. IBM's price, on the other hand, is not correlated at any significant level to any company or economic data; it's random. You might be the world's greatest expert in predicting the dividend or earnings growth for IBM, but history tells us that there has been little opportunity to profit from this knowledge. On the other hand, if you have been skilled at predicting dividends or earnings for UTX, you have had a very high probability of predicting when UTX was over or undervalued, and profiting from this knowledge. Currently, our work shows that among the 150 companies in the S&P 500, which have some predictive qualities, 27 meet the three criteria listed above. That may seem like a low number, but that is up from 17 a month ago.

Thursday, October 11, 2007

It's a Subprime Crisis, Not a Banking Crisis.

After Countrywide Financial warned in July that they were experiencing delinquencies across all credit quality classes of mortgages, the stock market went into a tailspin, assuming that all banks were either deep into subprimes or that prime mortgages were beginning to default.

We were watching the chart at the right, which shows the % of delinquencies of subprime (blue line) and prime (orange line). It has been clear that subprimes have been in big trouble for the last two years, with delinquencies now running at over 15% of subprime loans oustanding. So if the big banks are deep into subprimes, they will, indeed, be taking big write offs. However, if they have managed to sell off or avoid their low quality loans, the prime sector of mortgaes would appear to be in very good shape, with only 2.7% of prime loans currently delinquent.

Our analysis of Bank of America, Wells Fargo, and Wachovia, tells us that these three major US banks have only modest amounts of subprime loans and that they are well secured and manageable.

Wachovia said in their July earnings meeting that they did not have any subprime loans. Since then they have announced that they are going to commit $15 million to the lower quality market. We think this is a smart move, since almost everybody else is exiting the sector. There are probably some great bargains.

The evidence is growing steadily that the big banks in the country sold off their high risk mortgages to the big pools of money that Wall Street was throwing their way.

The market is on pins and needles awaiting the big banks to announce their earnings, or lack of them. We are firmly in the camp that believes the news will be better than Wall Street now believes, and for this reason, we believe the aforementioned banks represent very good values.

Saturday, October 06, 2007

From Sea to Shining Sea

Americans are provincial. Whether you live in New York or New Harmony you believe that your world revolves around the good ole US of A. You are wrong. As much as we are proud of our country and what it has given to the world, we live in a global marketplace. The unions will try to deny and fight it, the Democrats and Republicans will try to politicize it and prevent it, but at the end of the day, unless we want to turn back the clock of progress, you will realize that we are just a big part of a bigger world. Mamma's let your children grow up to be cowboys, because a cowboy might be a better profession than an autoworker, steelworker, or software engineer, perhaps even attorney and stockbroker. The times they are a changin', and the times for the us US of Aers will change the most. We have won the battle and lost the war. We have proved to the world that freedom and free markets are the instruments of progress and the touchstones of life, liberty, and the pursuit of happiness. Only a handful of countries in the world now believe that central planning can bring prosperity to its citizens. In the early 1980s Ronald Reagan said that only 2o% of the world believed and practiced freedom and free markets, and that was the reason that the world was so stuck in a rut. He railed against a taxation system that rewarded those who road on the wagon without ever taking their turn at pulling it. He condemned the politicians worldwide who were so blind to think that taxing the efforts of the few could provide life, liberty, and the pursuit of happiness for the many. Quite frankly, he changed the world, and caused freedom to ring around the globe. But as the scriptures say, the dog returns to its vomit, and Russia, which collapsed under the weight of its own corruption, is returning to it effluence. Europe, which always speaks the poetry of wisdom, but practices the witchcraft of feudalism is raising up the lords and ladies of royalty as bequeathed by the power elite. Even the home country of Mr. Reagan, the USA, has decided that the rich must pay more than their fair share to be citizens of this county. Democrats and Republicans in this country have completely forsaken the simple wisdom of President Reagan, and they now grovel in front of a demanding electorate that has decided that the strong will carry not only the weak, but also the able. No politician in this country has the courage to name the charade for what it is: from him who has, to him who has not; not by choice, but by law. The problem is him or her who has, knows how he or she got it and how much it cost, and he or she is not going to give it away just because the politicians say so. Money moves at the speed of light from sea to shining sea. The time is fast approaching when the flags of the pullers of the wagon may well move to a country with different stripes. Companies are moving their headquartes out of this country for lower taxes, citizens will be next. Canada has just lowered it tax rate for corporations to near 25% less than that of the US. How long do you think it will be before they get real smart and lower their individual tax rates below that of the US. They are a long way from from that today, but they can see the it is near an inevitability that taxes are going up in the US. Don't you think the same Canadian lawmakers who cut corporate tax rates are going to figure out that if they cut individual tax rates they might attract the cream of American entrepreneurs, and the jobs that will accompany them. You think I am talking nonsense? You have your head in the sand. I cannot count on two hands the number of Canadians I know who left Canada because of the taxes, and I cannot count on two hands the number of Americans who would gladly move to Canada if the price were right.

Wednesday, October 03, 2007

New Estimate of the "Fair Value" of the Dow Jones Industrials

Periodically, we plug in new estimates for dividend growth and changes in interest rates for the coming year and make a prediction for the "fair value" of the Dow Jones over the next 12 months.

As a reminder, in our January 2007 Barnyard Forecast with the DJ 30 near 12400, we said that our Dividend Valuation Model was signally that the "fair value" for the Dow in the year ahead was near 14,000. Indeed, that is about where the market stands today.

We have updated the model from time to time over the last 9 months to reflect actual dividend growth and changes in interest rates, and except for a brief period in early summer when rising interest rates drove it lower, the model has stayed near 14,000.

In our judgment, the solid performance of the Dow has been spurred by the near 12% dividend growth for 30 companies in the Average .

The chart above shows our estimate for the "fair value" of the DJ 30 in the year ahead, again using our estimates of dividend growth and interest rates. The predicted level turns out to be near 15,500. That would be a price increase of near 10%. Adding in dividends, our best guess for the total return of the Dow Jones over the next 12 months would be near 12%.

That may seem a bit optimistic in the face of all of the uncertainties in the markets and the economy, but we would not be surprised to see a return of that magnitude. We believe the US economy will be stronger than most people are predicting, and US multi-national firms will continue to benefit from the expanding global economy.

In addition, you will notice that the model has done a good job of identifying the "fair value" of the DJIA. It did not go along with the "tech head fake" of the late 1990s and correctly signaled how undervalued the Dow became in 2003, 2004, and 2005. Until it proves otherwise, we don't think it would be wise to ignore the voice of the model.

We'll keep you posted on how this estimate turns out as the year progresses.