Wednesday, May 28, 2008

Barnyard Forecast: Year End 2008 Looks Good

It's a dark night, the dog ate my speech. Actually I left the speech on the desk in the hotel in Indianapolis. I am to give that speech in 30 minutes to a crowd of maybe 100 people. I am not worried too much because the speech is about the economy and prospects for stocks. I can wing that with an overhead slide or two. Then I see flashing yellow lights ahead and an illuminated sign that says: Return to Marked Detour. Now I am worried, because I did not see any detour signs for the last 20 miles. There will be no backtracking and still make the speech on time. Then in the cornfield on my left I see the unmistakable signs of a solution to my problem: the moonlit dust of a fellow traveler. There is a back road around this detour and it follows the contour of this cornfield. Fifteen minutes later I am in the room where I will give the speech. I am greatly relieved to have arrived on time, but now I am faced with the task of saying something intelligent to the gathering crowd from a speech I do not possess. I do as I always do. I mentally work through the acronym E+I+E+I = O. Economy plus Inflation plus Earnings plus Interest Rates equals Opportunity. As many of you know, this is what has come to be known as the Barnyard Forecast. The Barnyard Forecast is a rule of thumb method to ascertain the "on balance" forces driving the stock market at any particular time. The story of the Barnyard Forecast began 20 years ago as I sat in front of that detour sign, but I still use it today, even when I have lots of time. The reason is simple: it is a quick way to wade through the underbrush of conflicting economic data and see the current status of the Fed's efforts to stimulate economic growth while containing inflation. Each component of the forecast is rated as positive for stocks (2 points), negative for stocks (0 points), or neutral for stocks (1 point). Economy: The economy is growing at a rate less than its optimal rate of 2.5%-3%. 2 points. This is counter-intuitive. Why should a poor economy be good for stocks? The reason is simple. The Fed will be making money cheaper in a weak economy. Lower rates will ultimately spur economic growth. In this case, the weak economy, for purposes of the model, is counted as a positive. Inflation: I have always scored inflation both on a headline rate and on a core rate. The headline rate is above the optimal rate of 2%, thus it gets 0 points. The core rate is near 2%, resulting in a score of 1point. The average of the two is .5 of a point. Earnings: Earnings are positive if the expected earnings growth is above the 80 year average of 7% and negative if they are projected to be below that level. Year-ahead earnings growth for the S&P 500 is currently projected to be 8.3%. That merits a positive score of 2 points. Interest Rates: To score interest rates, I also use two measures: the current rate on Fed Funds verses it rate of a year ago, and the same measurement for the rates on 10-year Treasury bonds. Both Fed Funds and 10-year Treasury bond yields are lower than they were a year ago. 2 points. Opportunity: Since there are 2 points for each component of the Barnyard Forecast, anything above 4 points would be a positive reading for stocks over the coming year. A score under 4 would be considered negative. Economy: 2.0 points. Inflation: 0.5 points Earnings: 2.0 points Int. Rates 2.0 points ........Total 6.5 points Wow, 6.5 points is about as high a score as is possible for the model to produce. That would mean it is signalling that stocks should have a very strong performance over the remainder of 2008. Earnings, however, are a wild card in the forecast. While earnings are expected to grow 8.3% for the year, most of that growth is expected to come in the fourth quarter, when comparisons against 2007 are easy. Thus, while I am optimistic that stocks will end the year much higher than they are now, I think they are in for the summer blahs, while we work our way toward easier comparisons in the fourth quarter. The single biggest exception to this forecast would be better-than-expected bank earnings in the second and third quarters of the year. If bank write-offs end, stocks will rally, no matter when it comes.

Wednesday, May 14, 2008

A Visit to the Investment Committee

By Greg Donaldson, Mike Hull, Rick Roop, and Randy Alsman In our Investment Policy Meeting of two weeks ago we discussed a short list of important concepts to watch: The market appeared to be juggling three questions marks: 1) The Credit Crisis and its effect on US consumers; 2) The Strong Global Economy – could it last?; and 3) The Emerging Markets' ability to “decouple” from its dependence upon the US for their exports. Additionally, the spread between the 90 day T-Bills and the Fed Fund Target Rate carried important implications that banks still didn't trust each other. With all of the perceived risk present in banks, big money had parked their money in T-Bills for their safety, instead of in the banks, which had caused a pretty steady 1% premium of Fed Funds over T-bills, far greater than their average .20% spread. In mid April, 90 day T-Bill rates stood at 1.35% and Fed Funds were at 2.25%, still nearly 1% difference between the two, even after all the rate cuts and all the cheap money the Fed had offered the banks. It was very hard to believe that the 1% spread had not shrunk for going on 8 months. It was our thinking, as we have chronicled here, that closing this risk premium spread to a more normal level of near .20%, would signal that money was flowing back to the banks, and most importantly, that the banks were loaning money more readily to each other. That would also mean some normalcy was reemerging in the banks. In addition, such a narrowing of the spread between Fed Funds and T-bill yields would be a clear signal that the coast was clearing not only for the banks, but also for the economy, as well. Two weeks later, we see some change in these market movers: We think the market now believes that it can see the full extent of the damage from the Credit Crisis. The damage has yet to be totally absorbed, but the market acts as if it has an idea of the damage that is yet to come. And it is growing more comfortable that it is manageable. The market also knows these things: 1. The Fed rescuing Bear Stearns’ said to anyone who wanted to listen, “We will not let this economy (or markets) go down the tubes.” 2. Q4 2007 write-offs by most major banks were massive, and Q1 2008 write-offs probably went beyond what will ultimately be lost. 3. The banks have very easily replaced the lost capital resulting from the write-offs. Issuing new capital has been expensive, but with all the woes in banking, there was no shortage of investors both big and small who were willing to pony up more money. (We have seen issues of many of the new-issue bank preferred stocks rise in price since they came to the market.) 4. The first release of GDP data showed the US economy grew (albeit modestly) in Q1. And, we expect that small growth number, 0.6%, to be revised higher when the just-reported increase in Net Exports get factored in. 5. The unemployment data simply has not been as bad as most would have expected this far into an economic slowdown. 6. Inflation has remained under control. 7. Finally, the market has moved away from the Consumer Staples stocks, implying it is ready to leave the safety, consistency, and predictability the staples offer and move more toward growth.

8. Corporate earnings ex-financials rose by nearly 10%, a very welcomed surprise. While a slowing US economy will impact the rest of the world’s economies, the strong global economy seems to remain on track. Additionally, there is evidence that the emerging markets are continuing to decouple from their dependence upon the US. As we said earlier, historically, 90-day T Bills have traded at a 0.20% spread below the Fed Funds Target Rate. During the last two weeks, the 90-day T Bill has moved from 1.35% to 1.81%, almost exactly 0.20% below the Fed Funds Target Rate of 2%. This would indicate that the big investors believe that a level of peace has returned to the valley, thanks to the quick and creative work of the Fed. Given everything spelled out above, very low interest rates (long and short), and an economic stimulus package just now being mailed to taxpayers, it looks as though the coast is becoming clear for stocks to move higher, perhaps significantly higher. The one big bugaboo in the economy right now appears to be rising petroleum prices. Our discussion seemed to have arrived at the point that consumers are already finding ways to adapt to high gas prices and they will continue to pursue others. We will all be on the watch-out for continuing evidence of this theory.

We believe it is time to nibble on a short list of beaten down stocks that generate a large percentage of their earnings overseas. Since we have not bought them all yet, we will not name them, but the Industrial Sector still looks very strong to us.

Monday, May 12, 2008

WW Grainger: Old Fashion is in Style

WW Grainger - GWW is the quintessential industrial company. They produce few products that most investors have ever heard of, yet they provide nearly 180,000 products that other companies use to produce end-user products. GWW's products include electric motors, compressors, HVAC components, lighting, signs, and hand tools.
While most of their business is in North America(they do have a small operation in China), their primary customers are major multinational US and Canadian companies that export products to companies and consumers throughout the world. Thus, in our way of thinking, GWW is a beneficiary of the weak dollar and the growth of US exports.
They have increased their dividend for 36 years consecutively. Over the last five years, GWW earnings and dividends have grown by almost 16% per annum. They recently reported earnings that were about 5% better than expectations, which has propelled the stock higher, even in the face of the backing and filling of the major indices.
Monday GWW reported that April sales were up nearly 13% over the same period a year ago. Investors liked the news and pushed the stock higher.
One of the things I really like about GWW is that they report sales growth on a monthly basis. What a wonderful old fashion idea: to keep their investors apprised of how they are doing, they report much more frequently than most companies.
Grainger is a regular on the lists of "Most Admired Companies."
This is a "crown jewel" company selling at bargain basement prices. Our Dividend Valuation Model above shows that GWW is 15%-20% undervalued. You and I know that such a gain in the coming year is not a sure thing, but at least you'll be hearing about how they are doing monthly. That is a comfort in a world where the question I find myself asking frequently about many financials is: Who are you? For you are certainly not the company I have known for these many years, or for that matter, last summer, or even last quarter.
WW Grainger has spent nearly 80 years building a reputation for straight talk and solid results. Perhaps one of the best things it has going for it is that the "money gunners" on Wall Street probably don't know much about it because it is an old fashioned industrial company. That my friends is a solid reason to look into it.
We own the stock are buying more.

Friday, May 02, 2008

About an Economy: A Welcomed Week

This was the week that was as it related to the true strengths and weaknesses of the US economy. As we said in our earlier edition, our belief was that the data would show that economic conditions were slightly better than most people believed. If you are willing to let the data speak for itself and not twist it to meet the headlines in the media and in blogland, we believe that is what we have seen. Economy: Economic growth in the first quarter was estimated to be .5%, adjusted for inflation. The actual number came in at .6%, indeed, slightly better than the consensus estimates, but dramatically better than the gloom and doomers were predicting, who began calling for a recession in the first quarter of 2008 as far back as August of 2007. Finally, today it was reported that fewer jobs were lost in March, which resulted in the the unemployment rate falling to 5.0%. Inflation: The GDP Price Deflator grew at an annual rate of 2.6%, lower than the consensus rate of 3.0%. The Core GDP Price Deflator, which excludes food and energy, grew for the quarter at .2%, a tick above the expectations of .1%. The Core GDP Price Deflator, which is the Fed's favorite indicator of inflation, grew over the past twelve months at a rate of 2.2%, within range of the Fed's comfort zone of 2%. The runaway inflation that everyone seems to be in such a tizzy over just was not present in the data. Even in the GDP Price Deflator, which includes food and energy, evidence of runaway inflation was not present. Energy and food prices were offset by much lower prices for housing, clothing, appliances, and motor vehicles. People seem to forget that collapsing home prices are included in the inflation data. Housing is the single largest component of inflation in either the GDP deflator series or the Consumer Price Index, and it is down and will continue to stay down for a while. It is hard to make the math show inflation, when the biggest component is deflating. Earnings: Corporate Earnings were surprisingly strong if we exclude the Financials. It may not seem fair to look at it this way, but the single biggest worry in the minds of most analysts is that the crash in housing will spill over into the rest of the economy. For at least this week the worries should subside. Two out of three corporate earning reports met or beat estimates, which is about normal. Importantly, according to economist Ed Yardeni, if we exclude the financials, first quarter earnings grew by about 10%. Here's the important thing about this data: Dr. Ed reports that in December 2007, estimates for first quarter earnings, ex-financials were 8%. Earnings were, of course, helped by global sales, which have remained robust, but there is no doubt in our minds that the first quarter earnings, so far, have been a big surprise to even the crusty old analysts. Conclusion: This was not a great week. We still have lots of trouble to wade through in real estate and financial land before we can start talking about "good" weeks. Having said this, it was a welcomed week. Of even greater importance to us, is that it was about what we expected judging from the string of data leading up to the reports. In addition, one reason we were optimistic at the beginning of the week was the stock market's action in recent weeks: it has been moving higher, even in the face of bad news. That means to us that the market believes that at least the boundaries of the subprime situation are coming into view, and our economy and capital markets can afford the ultimate costs without landing in the ditch. That is our belief.