Monday, July 28, 2014

This B-U-L-L Market Is Getting L-O-U-D

Throughout the history of the U.S. stock market, there have been many bull and bear markets. Studying these market cycles can teach investors a great deal about how the market behaves and the underlying reasons behind it.  If you can identify the driving forces of a bull or bear market, you can make more intelligent decisions to either protect yourself against a looming bear market or take advantage of a bull market.

In the 20-year history of our firm, we’ve seen several of these market cycles and have studied countless others.  While no bull or bear market looks exactly the same, the past provides us with useful insights about the future.  In the words of Mark Twain, “History doesn’t repeat itself, but it does rhyme.”

Today, we are going to see how the current bull market “rhymes” with years prior and what information we can gather from its historical patterns.

Anatomy of a Bull Market

The anatomy of almost all bull markets can be broadly defined by four primary characteristics that make up the acronym B-U-L-L, which you can read more about here.

1. Breadth
2. Unrelenting
3. Leadership Rotation
4. Loud

The “Loud” part of the equation is of particular interest in today’s market.    Bull markets attract a lot of attention from media and Wall Street.  Everywhere you turn, it seems like you hear about the stock market.  The local newspaper, CNBC, Wall Street, and even outings with family and friends can turn into investment discussions.

That’s typical of bull markets.  They grab you and force you to pay attention.  For all of those investors who have been out of the market since 2009, the run-up in stocks over the past five years has shown them just how wrong they have been.

Bull markets attract their fair share of commentators on both sides of the fence.  Some say the bull market will keep going, while others continually predict it’s demise.  The longer the bull market goes, the louder the shouting on both sides become.  Amongst all of the noise, it’s difficult to discern between what is truly relevant information and what is just that - noise.  

A lot of the chatter lately has been speculation about when the current bull market will end.  If you look back on nearly every bull market we have ever had in the United States, you will find that the vast majority of them don’t die of old age, they are killed.  There are two primary killers of bull markets:

(1) Recessions

Pullbacks and corrections can occur at any time, but it is really difficult to have a real bear market unless there is an economic recession that negatively impacts company fundamentals.  Remember, prices will always follow valuation in the long-term.  So if long-term values are increasing, the long-term trajectory of the stock market should also be increasing.

The majority of the data we see coming out of the economy have been very positive.  We thought the Q1 economic data were mostly weather-related, which turned out to be correct.  Employment numbers have improved significantly.  The economy has now added at least 200,000 jobs for the past five consecutive months.

As the economy starts to heat up, we should see increased activity from consumers and better sales growth for U.S. corporations.  Unless there is an unforeseen major geopolitical issue or natural disaster that disturbs the global economy, neither our Macroeconomic Team or the economists we follow foresee any recessions on the horizon.

That leads us to the second major killer of bull markets...    

(2) The Federal Reserve  

In the absence of any major economic shocks, the Fed is the primary suspect in the death of most Bull Markets.  

When interest rates are low, investors look outside the safety of U.S. Treasuries and into more traditionally risky assets such as stocks.  As the stock market increases from the inflow of funds, people begin to experience the “wealth effect” from watch their account values go up.  As consumers feel more wealthy, they increase their spending, which puts upward pressure on capacity.  To meet the rising demand, businesses hire more people and invest in new factories and technology to push up supply. When the Fed raises interest rates, the opposite tends to occur.

Even when the Fed raises rates, however, the stock market has historically been very slow to respond. Looking back to previous bull markets, it has taken several months of interest rate increases before the stock market has had any meaningful reaction.  This is not to say that this time will be the same - but it does contradict the widely held belief that the stock market will be hurt by the Fed raising short-term rates in the coming year or two.  Using history as our guide, that just doesn’t seem to be the case.

Furthermore, the small body of evidence we have about Federal Reserve Chair Janet Yellen suggests that she isn’t going to be quick to raise interest rates. Yellen believes wholeheartedly in the Fed’s dual mandate of both maintaining price level control (inflation) and in promoting employment.  As long as the economy continues to have above average unemployment, it is very likely that Yellen will push the Fed to keep rates low.  And as long as rates stay low, there is nowhere for investors to go but stocks.

When Is The End?

While we would consider ourselves to continue to be optimistic about the future of stocks, we certainly are not raging bulls.  We know that all bull markets must come to an end at some point, we just don’t believe that will happen in the near-term.  

While no one can know for sure when the bull market will end, there are often signs that start show up ahead of time.  One of the things we look for are the “one percent days.”  If stocks start moving up rapidly with a series of these large increases, that is likely a sign that Mr. and Mrs. America are starting to get tired of sitting in cash.  As they pour into the market, the buyers dry up and leave nothing but sellers.  On the flip side, a long string of negative one percent days typically indicates that the market is going through more than just a batch of profit taking.

We get a lot of questions about what we would do if we sense weakness in the market.  When we see potential trouble on the horizon, we don’t just immediately move to cash or try to time the market. We find it in our clients’ long-term interests to “take air out of the ball.”  

If things were to get rowdy, we would strategically reduce more volatile positions (“A” stocks) and look to add more “Royal Blue (RB)” stocks to stabilize our portfolio.  This does two things: (1) it reduces the volatility of our portfolio and (2) provides solid earnings growth and dividends to get our clients through the worst of the storm.  In bad markets, the RB stocks become defensive strongholds.  They are so big and strong that they can absorb huge amounts of shock without damaging the intrinsic value of their businesses.

Current Outlook

At this moment, we don’t see much sign of weakness. Despite the geo-political issues in Russia, the market has continued to move higher.  If shooting planes out of the sky doesn’t spark even a small pullback, that’s a pretty strong indicator that the market can continue to drive north.

Valuations for some companies are getting frothy, but the overall market is about fairly valued and well within its normal statistical range.  With interest rates so low, even higher valuation multiples than we are currently seeing would not be out of the question. While that’s a possibility, we don’t anticipate getting any additional return from valuation multiple expansion.  

In our opinion, stocks are likely to return what they generate in net earnings and dividend growth over the next 6-12 months.  If Q2 earnings are any indication, growth is starting to accelerate along with the economy.  As long as the companies continue to be the stars that they have been, this bull market still has strength to keep charging on.

Wednesday, July 09, 2014

What About Bonds?, Part II: Inflation and Interest Rates

This is the second installment in a series of blogs aimed at providing answers to our most frequently asked questions regarding bonds, interest rates, and inflation.  The format is Q&A. Nathan Winklepleck, co-editor of the Blog, is moderating the discussion by sharing these inquiries with Joe Zabratanski, Senior Fixed Income Manager, and Greg Donaldson, Chief Investment Officer.  

Nathan: There is a lot of jargon in the fixed income world. I think it would be beneficial to our readers if we began by defining "inflation" and "interest rates" and explaining what each one means in this context.

Joe: Great idea.  I’ve found over the years that the term “interest rate” can mean many different things to many different people, so before we get started, let’s make sure everyone is on the same page. An “interest rate” is simply the rate charged by a lender to a borrower for the use of money or an asset. The term applies to many investments including the interest rate on U.S. savings bonds, bank certificates of deposit, savings accounts, home mortgages, and car loans.  From an investor standpoint, interest rates are the rate of return we are paid in exchange for lending money to a business or government. The interest rate in this context can vary significantly depending on the maturity date (length of time until we get our money back) and the risk of default (the possibility that the borrower will be unable to repay our money). Today’s discussion will focus on  interest rates as they relate to U.S. Treasury bonds.

We can define “inflation” as the rising price level for goods and services. If the groceries in your shopping cart cost $100 in Year #1 and inflation for that year is 2%, those same items will cost $102 the next year. Over time, your original $100 will purchase fewer and fewer groceries. You can think of inflation as the general decline in the real purchasing power of money.

Nathan: In the last installment we discussed the inverse relationship between bond prices and interest rates. You described it as a teeter-totter effect: as interest rates fluctuate up and down, bond prices move in the opposite direction.  What is the relationship between interest rates and the level of inflation?

Thursday, June 19, 2014

Fixed Income, Part I: Relationship Between Interest Rates & Bond Prices

With interest rates at historic lows, and the Fed saying they will keep short rates low for an “extended time,” there is much confusion among financial pundits as to where interest rates and bond prices are headed in the coming years. With so much disagreement among the experts, many of our clients have asked that we provide an in-depth discussion of our views on inflation and interest rates, and the path these rates may follow in the coming years.

Although we regularly answer these questions in our client meetings, using our blog allows us to quickly explain our current views and strategies to a larger audience.

This particular series of blogs focuses primarily on the bond market; beginning with the basics before tackling the more complicated issues.

The format is Q&A. The first installment is a brief analysis of the fundamentals of bond investing, which we hope will build a solid foundation of understanding as we move forward. Nathan Winklepleck, co-editor of the blog, has assembled a list of our most frequently asked questions. He will serve as the moderator for the Q and A and will ask Joe Zabratanski our Senior Fixed Income Manager and Greg Donaldson our Chief Investment Officer to provide answers and commentary.

Q: Nathan: We have received several questions from clients about the impact of changing rates on bond prices.  Could you explain the relationship between interest rate fluctuations and fixed income prices?  How and why does one influence the other? 

Thursday, May 22, 2014

Economic Indicators Point to Slow, Steady Growth in Economy & Stocks

We have several economic metrics that we follow very closely at DCM.  These indicators give us a peek into the health of the economy and indicate where we may be headed.  We want to share three of those indicators with you and provide an overall outlook on current U.S. economic conditions and what they might mean for the stock market for the remainder of 2014.

1. After-tax Profits

The price of the S&P 500 index (blue line/right axis) plotted against after tax profits for the entire U.S. market (red line/left axis), which is measured in trillions of dollars.

Of all the indicators we watch, this one might be the most compelling argument for the strength of U.S. corporations.  After-tax profits reached a high around $1.4 trillion in late 2006 before their sharp decline during the Great Recession of 2008-09.  Today’s levels are well above where they were pre-2008 and show no signs of slowing down.  Companies are operating with incredible efficiency.  Many of the companies we follow can produce as much or more than they did prior to the Great Recession with significantly fewer employees. While this hasn’t been good news for employment (more on that in a minute), it is very positive for corporate earnings.

Tuesday, May 13, 2014

John Burr Williams and Chickens For Their Eggs

This is the third blog in a series exploring the theories of John Burr Williams. You can read the first post here and second post here.

In Part I of this series, we quoted Arnold Bernhard, founder of the Value-Line Investment Survey, as being an early advocate of the theories of John Burr Williams.  He agreed entirely with Mr. Williams’ belief that investors needed a generally accepted valuation criteria. He also joined Williams in warning that the effects of not having such a methodology had resulted in excess stock market and economic volatility over the years that had damaged investor confidence not only in the stock market but also in the free markets.
Bernhard boldly stated,
“In our own experience, during periods of inflation as well as at other times, in this country and abroad, it has been found that dividend-paying ability is the final determinant of the price of a common stock.  Whenever, over a period of years, the dividend or the ability to pay dividends, went up; so too did the price of the stock.  When the dividend-paying ability went down, so did the price of the stock, inflation or no inflation.”  
In applauding John Burr Williams’ theory; however, Bernhard inserted a subtle twist to Mr. Williams’ basic premise by adding the words, “ . . . or the ability to pay dividends.”  By adding just these few words, he reentered the world of earnings and left behind the “dividends only” world that Williams had described as so important in determining long-term intrinsic value.

Thursday, April 24, 2014

The Dividend Theories of John Burr Williams, Part II: Investing versus Speculating

This is the second blog in a series exploring the theories of John Burr Williams. You can read the first post here.

John Burr Williams’ book, The Theory of Investment Value, was not about beating the market or getting rich in the market.  It was really a wake-up call to the investment elite to offer them a theory of investment value that would encourage more long-term investing and less speculation.  Williams postulated that investors’ inability to properly value stocks increasingly led them to become speculators. Most people would not admit that they were speculators, but it was clear by their decisions that they were not appraising the intrinsic value of companies but betting that they knew something that the market did not.

Wednesday, April 02, 2014

ABCs of Dividend Investing: John Burr Williams, The Father of Dividend Investing Still Speaks

Because we have long espoused John Burr Williams' theories of dividend investing, we are often asked why he focused on dividends and not on earnings in determining a stock's value.  This prioritizing of dividends ahead of earnings was controversial in 1937 when he published his book, The Theory of Investment Value, and it remains so today.

This is Part I of a series of three blogs in which we will describe who John Burr Williams was, why he believed dividends trumped earnings in determining the intrinsic value of a company, and finally, why his theories on economic growth matter so much today.

In 1937 near the end of the worst bear market in US history, Williams, a thirty-five year old Harvard doctoral student in economics, made the following statement in his thesis: 
“The investment value of a stock is the present worth of all future dividends to be paid upon it . . . discounted at the pure [risk less] interest rate demanded by the investor.”
Mr. Williams’ dissertation did not immediately earn him his doctorate.  That would not be forthcoming until 1940.  Prior to his final oral exam, he sold the rights to his thesis to Harvard University Press, who published his dissertation as a book, but only with Mr. Williams subsidizing a portion of the costs. 

It would seem that only a fool would sell his doctoral thesis before he had been granted the degree. Williams, however, who was already a successful Wall Street investor when he went back to Harvard, explained that he had returned to college to learn what had caused the 1930s stock market crash (and the subsequent economic depression) from the best minds possible.  Since he had come for the knowledge and not the degree, and since his work was complete, he wanted to share his findings with the public as quickly as possible. 

What he did not say at the time, but would later admit, was that because of some of the views he had expressed in his thesis, he had become persona non-grata with key Harvard professors and was unlikely to have been awarded the degree anyway. 

Blaming the Bureaucrats 

His troubles with the dons of the school of economics were many but were centered in two areas: (1) Williams claimed that the correct method for determining the intrinsic value of a company was by calculating the present value of its future dividend payments, not earnings as was the universal belief at the time, and (2) he voiced great skepticism of the theories of John Maynard Keynes and the New Deal programs of President Franklin Roosevelt.  Williams devoted an entire chapter in the book entitled "Taxes and Socialism" to debunking the notion that the redistribution of wealth could lead a country to prosperity.

Finally, in 1940, with the book drawing praise from important financial commentators, and his success as an investor gaining accolades, John Burr Williams went before the Harvard dons to seek his doctorate. 

As expected, he was soundly criticized for publishing the thesis before he had obtained his doctorate, and his professors were upset that he did not embrace Keynes’ teachings. Oddly enough, however, they did not dispute his dividend-centric theory of investment value but questioned if a thesis studying the valuation of stocks had enough significance to justify a doctorate in economics from Harvard.  After a heated debate, he was granted his doctorate. 

The truth is often born of travail, matures under constant testing, and once acknowledged, is subject to twisting.  That has certainly been the case with John Burr Williams’ theory.  What had angered his Harvard professors, at first, caused Wall Street brokers to scoff.  The majority of the wizards of Wall Street believed then, as they still do today, that earnings are the driver of stock prices and that dividends are only a by-product.  Furthermore, intrinsic value has never commanded a big following on Wall Street, where trading and short-term speculation have long been the accepted modus operandi

Blaming Wall Street 

A closer reading of the book, however, turned Wall Street’s ridicule to scorn.  The ways of Wall Street were being blamed, at least partly, for the stock market crash.  Williams' thesis stated the following: 

“The wide changes in stock prices during the last eight years, when prices fell by 80% to 90% from their 1929 peaks only to recover much of their decline later, are a serious indictment of past practices in Investment Analysis [Wall Street]. Had there been any general agreement among analysts themselves concerning the proper criteria of value, such enormous fluctuations should not have occurred, because the long-run prospects for dividends have not, in fact, changed as much as prices have. Prices have been based too much on current earning power, too little on long-run dividend-paying power. Is not one cause of the past volatility of stocks a lack of a sound Theory of Investment Value? Since this volatility of stocks helps in turn to make the business cycle itself more severe, may not advances in Investment Analysis prove a real help in reducing the damage done by the cycle?” 

Gradually, particularly among seasoned investment analysts and some academicians, Williams’ valuation theories gained credence. Arnold Bernhard, the founder of “The Value-Line Investment Survey,” perhaps the most famous of all independent, investment research firms, quoted Williams in his book, The Evaluation of Common Stocks, and echoed his concerns, 
“Williams postulates that the value of a stock is the sum of all its future dividends discounted by the present interest rates. . . . Because there is no generally accepted standard of value, the market prices of stocks fluctuate far more widely than their true values. The wide fluctuations have in the past imposed a heavy burden on the general economy and undermined the faith of many people in the free market economy. The need, therefore, exists for rational and disciplined standards of value that cannot lead to the wildness of 1929 or 1949 or the present." 

Myron Gordon in his 1959 book, Dividends, Earnings, and Stocks Prices, pays tribute to Mr. Williams for his pioneering work in discovering methods of calculating the intrinsic value using the dividend.  Mr. Gordon would later win a Nobel Prize for his expansion of John Burr Williams' ground breaking work.  There are many academics, as well as, investment professionals who believe that Mr. Williams' work also deserved a Nobel prize.

John Burr Williams is called the "father of dividend investing," but he was much more than that.  Williams recognized that the erratic behavior of stock prices was caused by a lack of connection to the true, fundamental value.  He was one of the first people to quantify the intrinsic value of a company.    

John Burr Williams' theories are the foundation upon which we have built our Rising Dividend Investing strategy.  Over the last 20 years of employing his ideas, we have seen time and again that prices for individual stocks and the market as a whole are often disconnected from what is later shown to be their true intrinsic value.  

Next time, we will discuss Williams' views on investing versus speculating.