Rising Dividend Investing

DeepSeek Is Good News For The AI Gold Rush

noreply@blogger.com (Greg Donaldson) — Sun, 02 Feb 2025 22:02:00 +0000

In July and August of the past year, I explained the world had entered an AI and tech gold rush. Enormous amounts of money were pouring into building computer models that could extract and interpret golden data.

Since that time, the number of AI miners and camp followers has exploded, making AI or Nvdia names that even your grandmother knows.

In those articles, I cautioned that I believed the AI miners would find golden data, but how much of it they would find and how much investors would be willing to pay for it were big question marks.

The other reality that I saw was that, with AI, we are in the mining phase, not the golden-products phase. No single product or service stands out at present as the game-changing prototype of things to come.

This past week, a more ecnomical Chinese DeepSeek model caused lots of wild gyrations of most tech stocks. Net, net the tech market ended down only 3-4%. On the surface, DeepSeek, which costs a fraction of that of an NVDA, chip would seem to be a category crushing piece of software.

That many big techs rose sharply, such as GOOGL, AMZN, and Meta reminds us of what stage we are traversing in the gold rush. In short, those stocks rising clearly suggest that we are in the mining stage of the gold rush and not in the ingot stage.

AMZN may be the biggest benefactor of the AI gold rush of any stock in America. They have millions of employees, millions of products, thousands of warehouses, millions of delivery miles worldwide, and billions of customers. If a better, more efficient, and less costly means of doing business is not in AMZN's future, AI will be the biggest bust since Beany Babies.

Other giant benefactors of AI will be WMT, COST, the banking and insurance industries, and the industrial sector. If industrial sector companies like Raytheon, Caterpillar, Honeywell, 3M, and GE are to 'reshore', jobs from overseas, they must extract enormous costs from domestic manufacturing. My guess is they can do it, but it will take years, maybe decades, to get it done.

I believe DeepSeek will ultimately be viewed as a boon to the AI industry. It reduces the cost of participating in the AI gold rush and broadens the number of institutions and people who can afford to play.

Greg Donaldson has founded or co-founded four investment advisory firms and two families of mutual funds. He has authored two books, one on investing and a book of poetry published soon after he was out of college.

This article is not intended as investment advice. You should seek an investment professional's views before making any investment.

These views I have shared here are my own and not any company I am associated with.

Caution: We Are Entering A "Prove It" Market

noreply@blogger.com (Greg Donaldson) — Tue, 07 Jan 2025 21:49:00 +0000

In my recently released book, The HIdden Power of Rising Dividends,(available at Amazon) I make the case that dividend growth is highly correlated with price growth for many stocks and indices.

In the book, I suggest that dividend growth alone is highly correlated with price growth for 25-35% of S&P 500 stocks. For an additional 50% of stocks, dividend growth is the most important indicator of value, but the correlation scores rise when we add some portion of sales and earnings growth, along with changes in interest rates.

The consensus view of many stock market prognosticators today is that stocks, now trading at 27 time operating earnings, are extremely overpriced and are due for a big correction.

My S&P 500 valuation model is telling a much more balanced story:

The above chart is what I call a Value Bar chart. The green bars show my model's annual predicted price of the S&P 500 going back to 2005. A quick look at the bar farthest to the right on the chart shows the model's current predicted price of the S&P 500. That figure is approximately 5,400. With the current price of the S&P 500 at around 6,000, the model is saying stocks are overvalued by about 10%. That, however, is before we factor in 2024 year end earnings and 2025 forward earnings.

Before we take a deeper look at the current predicted price, let's look back over the years to see how the model has fared.

Simply speaking, if the red line (actual price) is above its corresponding Value Bar, we would say stocks are overvalued. If the the red line is lower that the Value Bar for the same year, we would say stocks are undervalued. For the last 20 years, the red line has stayed very close to the top of the Value Bars. A significant divergence is evident in only 2007, 2008,and 2022. In almost all other years, the Value Bars and actual prices of the S&P 500 are very close.

Stocks continued to climb heading into the beginning of the Great Recession in 2007. At some point during the year, the model would have issued an overvalued signal. The model clearly signaled the market was overvalued in 2008.

After the bear market of 2008 and 2009, the Value Bars stayed in fairly-valued or undervalued territory until the end of 2021, when they gave an overvalued reading. That signal correctly foresaw the selloff in 2022.

That brings us to the current modest overvaluation. Plugging in Wall Street's current estimates of sales, earnings, dividends, and interest rates give us a figure of 6,500.

We are now entering what I call a "Prove It" market. This means, tech stocks, where the majority of the growth is coming from, must "Prove It" that they can continue with mid 20% sales and earnings growth. If they do, we should have another pretty good year. If not . . . .

If any of you would like to discuss this article privately, please email me at info@gregdonaldson.com.

AAPL AIN'T CHEAP . . . MSFT IS

noreply@blogger.com (Greg Donaldson) — Tue, 03 Dec 2024 21:22:00 +0000

1. In my recent book, The Hidden Power of Rising Dividends (available at Amazon), I argue that very few individuals or professional investors are confident in how to calculate the intrinsic value of a stock.

2. The typical stock investor today has largely become a trend follower. Put another way, they are really momentum investors.

3. I have been in the investment business for nearly 50 years, and I have learned many people who admit to being momentum investors, find that they cannot pull the trigger to buy or sell when the momentum trend changes. In failing to sell at the right time, most of them become "stuckholders."

4. In my many years of exploring every classical and "wild hair" investment strategy I could find, I have found that many slow-growing stocks can be valued very precisely. Most companies; however, require a deep dive into their fundamentals, looking for "tell" signals. Finally, valuing very fast-growing companies is always an educated guess at best.

Last time, I showed valuation guesstimates on PepsiCo (PEP) and Coke (KO). These are both slow growing, high dividend-paying companies with powerful brands. My models predict that Coke (KO) is modestly overpriced and PepsiCo (PEP) is significantly underpriced when using year-ahead estimates.

This time I am comparing Microsoft (MSFT) and Apple (AAPL). The valuation correlation metrics for these two tech stocks are much more difficult to find because dividend growth alone does not offer high correlations for either stock. For Apple, earnings growth offer a 90%+ correlation with stock prices over the last decade, and gives us a decent guesstimate of the company's current valuation.

For Microsoft, it is necessary to use a proprietary valuation model that includes some portion of dividends, earnings, and interest rates. The chart below shows the remarkable tightness between MSFT's actual stock price (red line) and the model's annual predicted price, shown in green. Currently, the model says MSFT should trade at approximately $422 per share. It is currently trading for near $430. At least in this first step, MSFT would appear to be about fairly priced.

The picture for Apple indicates a bit more risk.

Apple's correlation model shows that its actual price of $239 per share, shown in red, is clearly higher than its predicted price, in green, of $206.

Based on historical data over the last 13 years, my models are saying MSFT is selling about where it should be, and AAPL is selling nearly 15% higher than its fair value. But as I said last time, "the future is in the future" for all stocks, so we must plug in next year's estimates for both companies to determine if that makes any difference.

Using the mean forecasts from Wall Street analysts, my model predicts a year-end 2025 price of $483 for MSFT and $228 for AAPL. That would offer an approximately 12% gain for MSFT and a relatively flat rate of return for AAPL in the coming year. Indeed, selling at $239, AAPL is already trading above my modeled $228 predicted year-end 2025 price.

I own both stocks and do not have plans at this time to sell either. However, seeing Apple's valuation does cause me some concerns that I had not thought through before I began this exercise. MSFT, on the other hand, looks even better than I would have guessed. As I said last time, this is not Wall Street research. I am using simple correlation models to arrive at the price estimates I am showing. Thus, this article should not be viewed as investment advice, but just a simple analysis of fundamental data within each company that is highly correlated with changes in its annual stock price.

Simple Dividend Model Says PepsiCo Is Better Value Than Coke

noreply@blogger.com (Greg Donaldson) — Tue, 12 Nov 2024 23:56:00 +0000

1. In my recently released book, The Hidden Power of Rising Dividends, I described my 40-year journey into finding methods of valuing stocks.

2. In a recent post, I showed mathematical valuations of Coke and PepsiCo based on their last 15 years of price and fundamental data. As it turned out for both companies, dividends alone had the highest correlation with their prices over this period.

3. I chose Coke (KO) and PepsiCo (PEP) for my first valuation calculation because both are powerful brands that have won over our taste buds, grocery shelves, and portfolios. Since they are so dominant and so similar in their products and marketing, most people assume they are both always about fairly valued because they are so large and their products are a staple of everyday life for many people.

4. Last time I showed a chart for each company as shown below. The green line on each chart is the actual annual price over the last 15 years. The red line is the predicted price my model calculates. A closer look at the two charts shows that PepsiCo's current price is about 9% lower that its predicted price, based on the correlation between its dividend and price growth over the last 15 years. Coke, on the other hand, appears to be selling about 9.5% above its predicted price using he same metrics.

Studying the two dividend correlation charts suggests PepsiCo is clearly the better value. But, as I said last time, my dividend correlation model is looking only at historical data. The future is in the future for all stocks. So, let's take a swing at estimating the future growth of both companies. Remember, dividend growth alone trumps all other indicators for these two stocks, and in both cases the correlation between the companies' dividends and stock prices is over 90%.

In valuing Coke and Pepsi, I am using a simple linear regression model that measures the average changes of prices versus dividends for each company over the last 15 years, and then performs annual standard deviations to determine how tight the fit is. This model generates what is known as a correlation coefficient, or R2. Both Coke and Pepsi have R2s between annual price and dividend growth above .90. Put another way, annual changes in dividends for both companies has been able to explain over 90% of the annual changes in their stock prices. It's not perfect, but few investment professionals will be willing to bet you that this .90 correlation between prices and dividends is going to change very much in the coming year or years.

A linear regression calculation, as the name implies, assumes that the movement of prices v. dividends will form a line. The important things about lines is they all have a slope and slopes have formulas. Thus, here in November 2024, if we have a good prediction or guess about how much each company will increase its dividends in 2025, (both have unbroken strings of increasing dividends for over 50 years) we can plug that figure into the formula and have a predicted stock price for the coming year.

PepsiCo's linear regression formula is .52+35x, where x is next year's dividend. PepsiCo's current indicated dividend is $5.42. For this analysis let's just increase PepsiCo's dividend by 7%, which is its average increase of the last five years. Here are the results of the formula:

.52+35 x 5.80 = $203.52

This simple regression model is projecting that PepsiCo's price will reach $203.52 by the end of 2025. That would be a rise in the price of over 20%. Remember, this is a model, not an analytical projection of what I think the price will be. But, with a correlation so high, one might think of it as a ballpark figure of the upside potential of PepsiCo.

Coke's dividend growth over the last five years has averaged only 3.5%. Plugging dividend growth of that level into the regression model for Coke gives us a 2025 best guess price of $67.25, only slightly above today's selling price.

As always, this is not a Wall Street type deep dive type valuation analysis of either company, and it should not be taken as investment advice. This is just a mathematical look at financial data for both companies that has had a very high correlation over the last few years. Using this simple analysis, PepsiCo is our clear winner.

Someone might want to break the news to Warren Buffett. He holds a tremendous amount of Coke.

Next time I will compare two other name-brand blue chip stocks in the tech industry sector. That will be a tougher challenge because dividends probably won't work as well in these companies, and I will have to dig deeper to determine is any of the companies' fundamental data have a tight correlation with prices. If there is a fit, it should also give us an idea of how fairly valued some of the techs are after their huge run over the last two years.

Until next time.

If you would like to offer companies for me to value using this correlation process, please send me a note at info@gregdonaldson@gmail.com.

Thanks to several of you who informed me that my colors were wrong on the charts last time.

I own Pepsico.

Using Simple Mathematical Calculations to Value Coke vs. PepsiCo

noreply@blogger.com (Greg Donaldson) — Wed, 23 Oct 2024 21:14:00 +0000

1. In my recently released book, The Hidden Power of Rising Dividends, I described my 40-year journey into finding methods of valuing stocks.

2. My journey of valuation discovery was always about finding methods that worked, not just focusing on dividend investing, although for many companies, dividends are the best indicator.

3. Over the next few months, I am going to do a series of valuation comparisons of great companies of our country and the world. These comparisons will describe the various methods I have found to be helpful. The first two are Coke and Pepsi.

4. Coke and Pepsi are powerful brands that have won over our taste buds, grocery shelves, and portfolios. Most people are in one camp or the other, but these two companies are very similar in many ways. My blindfolded taste test can't tell them apart.

5. Since they are so dominant and so similar in their products and marketing, I have found that most people assume they are almost always efficiently priced and valued at about the same level. In this first look at the tools I have learned to use, a surprise may be in store for you.

In valuing Coke and Pepsi, I am using a multi-stage correlation model. This model computes a correlation score, called R2, for eight different fundamental indicators for each company, such as earnings, dividends, sales, profit margin, GDP, etc., compared to changes in the company's annual stock prices. With both companies, the correlation, R2, between their annual dividends and stock prices is above 90%, and overrides the need to include any of the other fundamentals. Very simply, this means that over the last 15 years, the annual changes in the dividends for each company were able to explain 90% of the annual changes in its price.

Next, look at each chart and note that stock prices are on the vertical axis and dividends per share are on the horizontal axis. The red line is the actual annual price over the last 15 years and the green line is the predicted price using the correlation formula. Here is where the model begins to talk. While these two companies are very similar in what they do, they are not similar in prospective valuation. PepsiCo's chart shows its current selling price of over $175.00 is well under its predicted price of $190.44. Coke's story is just the reverse. It is currently selling for over $68 per share, but its predicted price says it should sell for $63.74.

Remember, this analysis is pure math. It is not a deep analysis of each company's intrinsic value. This is just a statistically significant computation comparing the changes in each company's annual dividends with changes in their annual stock prices. Yet, with 90+% correlations for both companies, to ignore what the dividends are saying would be unwise. Indeed, these computations are saying Coke is over 15% more expensive than PepsiCo. A spread that wide would seem to favor PepsiCo at present. Next, however, we all know that the market always looks ahead. Next time I will share with you howe we can adjust the current valuations for a look into the future. In the meantime, let's just see how the the two stocks perform over the next few months.

Don't Fret, It's Picks and Shovels Time in the AI Gold Rush

noreply@blogger.com (Greg Donaldson) — Thu, 08 Aug 2024 18:13:00 +0000

Fears of a sharp economic slowdown, and worldwide heavy selling of stocks have hit U.S. stocks in recent weeks.

Recent economic releases have shown that unemployment is rising, home sales are slowing, manufacturing production is softening, and wage gains are flattening out. These weaker economic data points have caused fears of a recession and a move out of stocks and into bonds.

This flight to safety has seen 10-year U.S. Treasuries to fall from near 4.75% a few months ago to 3.75% on Tuesday. The slowing economy fears have caused the S&P 500 to fall by nearly 10%.

The sell off in stocks and specifically in the tech stocks is hard to reconcile in the face of the solid second quarter earnings growth reports across almost all industry sectors, from AI leaders to banks and industrial companies.

Does this big sell off mean the AI gold rush is already over? Moreover, does it mean the bull market in non-tech stocks, which was signaled in recent weeks, is also only a head fake?

It is important to remember that gold rushes are driven by forces other than “there’s gold in them thar hills.” At times, reality sneaks in to play a role in the pricing. The reality in this case is investors have become worried that the tech stocks have come too far too fast, and they no longer offer value at their inflated prices. There is nothing new about that worry. It’s very realistic and has been around as long as the tech stocks have been. The techs are trading at about 30-35 times earnings and projected to have earnings growth of 15-25% over the next 3-5 years. In an earlier post, I stated that if the current earnings projections for the techs and the S&P 500 prove correct for year-end 2024 and 2025, the market will go higher. My valuation model still says 5800 is the best guess of the current fair value of the S&P 500.

It is necessary to square the recent week economic news and sharp sell offs in worldwide stocksand interest rates with corporate earnings that are being reported every day. All these data

are being collected in the same time frame, and history tells us that earnings and dividend growth

have more predictive power in the long run than do changes in GDP and interest rates.

In my judgment, the billions of dollars that corporate America is investing in AI have not had nearly

enough time to find gold. We are in the “picks and shovels,” or early stages of the gold rush where

the miners are assembling the people and tools, and identifying where to mine. In short, nowthe big winners are the chip companies that manufacture the AI chips. The products

and services that will be forthcoming in the years ahead are still concepts. Yet, when giant sums

of capital are being placed in the hands and minds of the smartest tech people in the world,

life-changing products and services are assured.

I believe an AI gold rush is underway. AI gold will be found and lead to huge stock gains in many existing, as well as start-up companies. My calling it a gold rush is not a total disparagement. The operative questions are: How much gold is there to be found, and who will find it? Almost certainly, too much money will ultimately join the gold rush, but it is far too early to declare AI dead. That being the case, the huge selloff in tech stocks is way overdone and offers a buying opportunity in the coming weeks and months.

Warren Buffett selling a huge chunk of Apple is probably the best news I have seen to assure us that AI has real merit. I am a great fan of Mr. Buffett, but he is anything but a gold rush player. He is strictly a “picks and shovels” guy. He did not sell out entirely. He just took some profits.

In an earlier post, I said we are traversing a gold rush in AI, and almost all gold rushes end poorly for the average investor. However, for the recent sell off in AI and the stock market to be anywhere near correct, AI would have to be a complete bust. My bottom line is all gold rushes are driven by periods of reality and illusion. AI has been called the driver of a new industrial revolution. That is big talk, but to say that AI is a bust is just as big an exaggeration.

Stay tuned.

It's Official: The AI Goldrush Is Underway

noreply@blogger.com (Greg Donaldson) — Tue, 18 Jun 2024 21:18:00 +0000

Near the end of the dot-com bubble in 2000, my business partner and I stumbled onto the notion that the techs were acting much like a gold rush. Gold was being found in the dot-com world and creating riches, but its passion was producing ever more gold miners with golden dreams.
Our company had traversed the dot-com craze during the late 1990s, chasing the gold like everyone else. But in early 2000, our valuation models simply could not justify the tech prices . . . not by a mile.
A simple truth spoke to us: Never in the history of the US stock markets had an industry grown fast enough, long enough, to justify the prices of most tech and big consumer stocks.
We decided to cut back on the hottest of the highflyers. It changed our company and our lives forever.

This seemingly bold move was not based on something we were convinced we knew, but just the opposite. It was because we knew we did not know how to value the techs, and that being the case, we decided to stand aside. Even then, there was nothing bold about our decision to start cutting back on techs. In fact, we visited every client we had and admitted to them we believed the techs had reached the gold-rush state, but they might just keep going higher like they had over the last decade. The only thing we could say for sure was that our valuation models showed that many slower-growing companies were great values. We advised them we recommended placing sell orders 15% below the current prices on the six most overvalued tech stocks. Should any of these sell orders be triggered, we would invest the proceeds in undervalued dividend-paying stocks with dominant positions in their industries.

During the year 2000, all six of the stocks' sell orders were triggered, and we bought financials, consumer staples, and industrial companies whose prices had gone flat in recent years because their sales and earnings were growing in the high single digits, much less than the 25-50% annual earnings growth of the techs. Interestingly, these undervalued dividend-paying stocks actually rose in 2000 when the overall market fell by over 10% and the dot-com gold rush ended.

Why am I sharing this old tale? Am I predicting the AI gold rush is near its end? Indeed, are there other stocks that offer much better value with good prospects for future growth? No I’m not. I am announcing; however, that the gold rush in AI is now a reality and there are two truisms about gold rushes of the past. 1) When everyone, everywhere knows that an industry or a particular stock is the center of the investing universe, there is a good chance that everyone owns the stocks and the new money needed to push the stock higher will soon be tapped out. 2) The analysis at the end of gold rushes has always revealed that the companies that sold the picks and shovels for the miners were the best place to put your money, not in the gold miners themselves.

As one who is old enough to remember the dot-com collapse, my reason for writing this blog is to just give everyone a heads up that in my judgment, the AI phenomenon has officially reached the gold rush state. I said last time, my valuation models are showing that an S&P 500 level of 5700 is reasonable. If the AI world can produce overall sales and earning growth for corporate America of 11-12% over the next five years, the market is fairly priced. If earnings growth is higher than that, stocks still have a good run ahead of them. However, if the earnings growth falls back to a 7% or 8% handle, stocks will fall. Additionally, I do not see a long list of undervalued non-AI companies. Thus, I conclude the gold rush has room to run. I’ll keep you posted on what my models are saying as we go.

If you would like to communicate with me directly, email me at info@gregdonaldson.com

Dividends and Earnings Say, The S&P's Current Price is About Right

noreply@blogger.com (Greg Donaldson) — Mon, 27 May 2024 19:00:00 +0000

The question I have been asked most in recent months is, "Is the current bull market in tech stocks signaling another dot-com massacre, or is it justified in light of the promise of AI?"

1. Most of my questioners lived through the dot-com bubble of the 1990s and its subsequent crash in early 2000. In the late 1990s, the notion that computer and internet stocks could only go higher took hold, which proved dead wrong and devastating to many investors when some tech stocks fell by 90%.

2. Nvidia and its artificial intelligence computer chips are skyrocketing in much the same way that Cisco and Intel did in the late 1990s, before crashing back to earth in 2000.

3. The Fed gives the impression that their rate hikes are finished, but inflation is still running near 3.5% and shows little signs of slowing on a month over month basis.

3. If the Fed does not have inflation under control, a spike in long-term interest rates could cause another sell off in tech stocks just as it did in 2022.

One of the most disappointing aspects of modern day investing is we seem to have all become momentum investors. Find a winning stock, jump on board, and hope to sell out before it turns lower. Ben Graham's famous quote about how stocks operate is in full bloom today. He said, "In the short run, the market is a voting machine, but in the long run it is a weighing machine." The point being, stock prices can be driven to ridiculous levels by short-term projections of how high is the sky, but ultimately, stock prices find their correct value.

Over the years, I have developed two stock market valuation tools. One looks back and is primarly earnings driven. The other looks forward and is dividend and interest rate driven. Dividends would seem to be a very pedestrian way to value a gold rush, but over the years, I have found the growth of S&P 500 dividends in combination with changes in long-term interest rates have been the best risk-adjusted predictor of S&P 500 prices. At present, my dividend discount model predicts that the fair value of the S&P 500 is approximately 5800. At 5300, that would mean stocks are modestly undervalued. However, one has to realize that the forward dividends and earnings estimates are heavily influenced by Wall Street's 3-5 year forward estimates for tech stocks.

My answer to the questions I have been receiving about the risks in the markets is a familiar one: "It depends." It depends on whether the AI and other high-flying tech stocks can deliver the dividends and earning growth Wall Street is now projecting. If the overall S&P 500 can deliver numbers reasonably close to the current estimates, the market is modestly undervalued and vice versa. I'll keep you posted in the weeks and months ahead how the estimates are holding up and measuring up, as well report on how interest rates are impacting my model.

Paul Volcker Taught Us How to Tame Inflation

noreply@blogger.com (Greg Donaldson) — Wed, 15 Jun 2022 15:33:00 +0000

I started writing a monthly investment update for the investment firm I was with in 1975. I didn't know what I was doing at first, so the older people in the firm would feed me what to say, and I would write the update. This was just a few years after the OPEC oil embargo and inflation had shot higher. As the months rolled on and inflation continued to rise, I found fewer and fewer of the old-timers were stepping up to tell me what to say, so I became a student of the Federal Reserve in order to have something halfway intelligent to say. That was no help for several years. Inflation remained persistently high. At times, prices changed on grocery shelves and gas pumps while I was standing in front of them, ready to make a purchase. Interest rates kept going higher and higher, and none of the Federal Reserve's rate hikes seemed to make any difference.

An inflation mentality set in on Wall Street, Main Street, and Ivy Street. Inflation became a way of life. We had silly government programs such as Whip Inflation Now (WIN) and a lot of other kinds of cute sloganeering that was not rooted in any economic truth because very few people really understood inflation and how it worked.

We all became followers of the money supply. M1, M2, and M3 discussions went on at social gatherings like somebody somewhere knew what it all meant. "Too many dollars chasing too few goods" became the wink and a nod answer to all things inflation.

There was one man who did understand what drove inflation and how to control it. His name was Paul Volcker. Volcker was promoted to chair of the Federal Reserve in 1979. He immediately began a series of rate hikes that would drive the Fed Funds rate up from around 11% in September 1979 to 20% in March 1981. The 6’7”, cigar-chopping man taught us all that in dealing with inflation, the right course of action was to use a leading interest rate strategy instead of a lagging strategy. In effect, Volcker made it clear verbally and by his actions that wherever inflation went, he would push interest rates even higher. His leading strategy was truly remarkable, and it broke the back of the inflation panic that had been raging through the economy for years. Inflation peaked at 14.8% in March of 1980 and by 1983 had fallen below to near 3 %.

Today, we face another inflation crisis and the same 'we got this thing under control' illusion that I watched play out for years in the late 1970s. Modern Monetary Theorists, who spoke so boldly of 'we got this economic thing' and advocated dumping huge quantities of dollars onto anyone who could breathe, have become silent. They should have done so much sooner.

Inflation is as much of a psychological phenomenon as it is a monetary phenomenon. The present Fed has been saying 'we got this thing' for too long. They are losing both the psychological battle as well as the monetary battle. They must come out of today's meeting with two huge changes in what they say and what they do. First, they must say "Paul Volcker taught how to tame inflation, and we are now following his playbook." Second, they must raise Fed Funds by at least 1% and promise even more 1% hikes in the future. Jerome Powell must ignore the politicians, jump straddle inflation, and fight it with tools history shows us have worked. If he continues to bow down to the politicians and make small interest rate hikes, we may be fighting inflation four years from now.

I believe the stock market understands what needs to be done and will soon find a bottom if the Fed takes a tougher stance. If the Fed keeps nickleing and diming us along, stocks will likely keep falling because big investors know that the longer we allow the current lagging interest rate strategy to prevail, the worse will be the ultimate recession.

The illusion of 'we got this thing" should end today."

Dividend Watch: Divi-Do Land

noreply@blogger.com (Greg Donaldson) — Sat, 06 Jun 2020 17:04:00 +0000

Media headlines have growled that dividends were dying or dead for most of the last three months

Yet, few in the crowd of 'Divi-Don'ters' have bothered to chronicle the 'Divi-Doers.'

That's a shame because there is a splendid story in Divi-Do land.

On April 7, we made the following statement:

"We have long believed that dividends are the linchpin tying individual investors
and corporations together. With stocks careening all over the place, it would appear
that traders and speculators are betting that companies will break this bond.
We believe the bond will hold and provide an undergirding to the overall stock market."

Early on, over 20 S&P 500 companies announced dividend cuts, mostly in retail, energy, and travel and entertainment. In late March, estimates of dividend cuts by some observers for S&P 500 companies were as high as 35%. But soon company after company began announcing that they intended to pay their dividends. But that wasn't all; a surprising number of companies announced dividend hikes. The table below shows the dividend actions of S&P 500 companies made from January through June 6, 2020.

S&P 500 Company Dividend Actions

Through June 6, 2020

Companies Paying Dividends Paid	Companies Cutting Dividendsd	Companies Raising Dividends
363	47	146

So far 47 companies have cut, suspended, or omitted their dividends. That represents about 10% of the Index, but only about 3% of total dividend payments. Wall Street now estimates that total S&P dividends for calendar year 2020 will fall approximately 2.5%.
The reason the percentage total dividend cuts for the Index will be small is the 146 offsetting companies that are hiking dividends. In addition, some of the dividend cutters, such as TJ Maxx, have announced they will reinstate payouts once they have assessed the damage from the quarantine. The dividend hikes have a median growth rate of almost 8%.
In analyzing the cash flows of hundreds of dividend-paying companies, it is clear many will be borrowing to pay their dividends. That would have seemed like folly in a time of such great uncertainty. We believe this commitment to paying a dividend is not well understood by many investors. Companies know that many of their shareholders count on dividend payments to pay their bills. They also know that millions of individual investors and thousands of dividend etfs and mutual funds will sell any stock that cuts their dividends. Finally, these companies have experts advising them on the effects of the coronavirus and its impact on the economy both in the short run and in the long run. These companies would not borrow to pay dividends if such an action would imperil their firm. They are taking such actions because they have concluded that the doomsday scenarios spun by many politicians, media, financial analysts, and so-called scientists are far too pessimistic. Life will go on, and as people return to the streets, business will come alive again.
Think of it--almost 90% of S&P 500 companies that were paying a dividend before the coronavirus struck are still doing so in the face of the most horrific headlines since the 1930s. Of this number, over 40% raised their dividends. That's actual money going out the door. Either these Divi-Do companies are daft or prescient. We vote prescient.

Sources: Bloomberg, Marketbeat, Seeking Alpha

Dividend Watch: A Bar Bet You Will Win

noreply@blogger.com (Greg Donaldson) — Wed, 20 May 2020 13:41:00 +0000

Here's a bar bet you can win: What is the ratio of S&P 500 company dividend hikes to cuts year to date?
Oops, I forgot the coronavirus has made bars and bar betting taboo for most of us. Save this one until they open.
While the dividend news has been much better than almost any of your bar buddies would guess, there is some not-so-good news creeping in.

First the good news: Through last Friday, 369 companies have paid a dividend in 2020. Of these dividend payers, 124 increased their dividends at a median rate of 8%.

Now, the bad news: 39 S&P 500 companies have suspended, cut, or eliminated their dividends since the first of the year. More on this later.

Back to the good news: Dividend hikes have outnumbered cuts by over three to one. That tidbit of dividend news will win you the drink of your choice at a time and place when you once again can have social distance with friends and colleagues. The financial media has been so full of bad dividend news that most people will bet just the opposite of what has actually happened.

Back to the bit of bad news: Bloomberg now estimates that cumulative S&P 500 second quarter dividends will fall by approximately 2% from last year. Bloomberg also is now forecasting that total dividends for the S&P 500 in 2020 will be slightly less than 2019. I'll keep you posted on changes in the estimates as we traverse the rest of the year.

We look for dividend news to calm down for a few weeks. Dividend news is often announced at regular quarterly earnings reporting intervals. These meetings will not return to full throttle until July.

As the country opens and people begin to move toward some level of normalcy, the economic picture will either become clearer or even more opaque than it has been for the last three months. We said early on that the dividend actions of major American corporations would tell us a lot about how destructive the coronavirus would likely be to the economy for the long-term. We believe the dividend actions year to date by major American companies are telling a much more positive story than the "things will never be the same again" crowd who know very little about economics and even less about the truth.

Sources: Marketbeat, Simply Safe Dividends, Seeking Alpha, Bloomberg, Value-Line

Dividend Watch: New Data Show S&P 500 Dividend Payments Still Rising

noreply@blogger.com (Greg Donaldson) — Mon, 04 May 2020 23:12:00 +0000

The percentage of S&P 500 companies paying dividends continues to be much better than was predicted two months ago.
Dividend increases are running almost 3 times that of dividend cuts.
Many companies are specifically committing themselves to honoring their dividends.

The news on dividend payments by S&P 500 companies continues to be better than many experts predicted in the early days of the coronavirus outbreak. The table below shows the dividend actions of companies that either made a dividend announcement from March 1 through today, or paid a dividend during this time.

Dividend Actions by S&P 500 Companies
March-May 4, 2020

Dividend Paid	Dividend Increased	Dividend Decreased
361	98	35

We are approaching the end of the initial round of dividend actions by S&P 500 companies since the onset of the virus, and so far the news is good for the overall stock market and income investors. We are awaiting only nine companies that pay irregular dividends, usually annual or semi-annual payers, and 16 companies that did not make dividend payments or declarations in March or April. We should be able to log the remaining companies over the next six weeks. Remember, seventy-nine companies do not pay a dividend.

Even though the number of companies cutting dividends are the most in many years, we are not even close to the number of cuts in the 2008-2009 Great Recession. This has surprised many observers because the economic impact of the massive country-wide shutdown is having a more negative effect on the overall U.S. economy than did the Great Recession. Of even more interest, many companies are taking the unusual step of promising their shareholders that they are committed to paying their dividends and will cut them only as a last resort. The following are statements from some of the largest companies making these types of public statements:

United Parcel (UPS): Our dividend remains a high priority and is a hallmark of our financial strength. We are confident our actions will continue to enable us to fund the business and support shareowner interest.

Coke (KO): We will of course continue to focus on protecting the progress we made on working capital and free cash flow in 2019. And in this context, our capital allocation priorities remain very much focused on investing wisely to support our business operations and continuing to prioritize our dividend. Specifically, with regard to the dividend, we currently have no intentions to change our approach.

IBM (IBM): The key here for investors I think are two questions. One, in any of these scenarios, do you still have the strength of your cash, your liquidity position to ensure that you can, one, invest in your business to make sure as you come out of this—that you can emerge stronger. And two, can you maintain your capital allocation and your commitment to our investors with regards to the dividend, and both of these [we answer] emphatically, yes.

Starbucks (SBUX): To further enhance our financial flexibility, we have also temporarily suspended our share repurchase program and are taking steps to defer capital expenditures and reduce discretionary spending. We do not expect to reduce our quarterly dividend.

Caterpillar (CAT): "We continue to expect our strong financial position to support the dividend. As a reminder, Caterpillar has paid a quarterly dividend every year since 1933 through a variety of challenging business conditions. We remain committed to returning substantially all our free cash flow to shareholders through the cycles." – CEO Jim Umpleby

Exxon Mobil (XOM): After all, Exxon and its predecessors have paid uninterrupted dividends since 1882, and management continues to emphasize that "a reliable growing dividend"

remains a priority.

Chevron (CVX): “Chevron’s financial priorities remain unchanged. Our focus is on protecting the dividend, prioritizing capital that drives long-term value, and supporting the balance sheet.” – Chevron CFO Pierre Breber

Some of these companies, such as the oil companies, would almost certainly have to borrow to pay their dividends. That might seem risky, but Exxon recently reaffirmed their continued dividend payments, indicating that nearly 70% of their shareholders were either individuals who count on the dividend income or long-term investors who seek stable growing income.

The dividend story of 2020 is still in the early stages, and the recent positive trends could change if the country's economy takes too big a hit from the shutdown and the virus, but the story thus far has been much brighter than observers were predicting. We believe this is an indication that stocks have seen their lows and will continue to push higher.
The other bit of good news is that total dividends paid by S&P 500 companies is still higher than it was a year ago. With few exceptions, the companies cutting dividends have not been big dividend payers compared to the average S&P 500 company. Thus the cumulative dividend increases from companies hiking their dividends has more than offset the dividends lost resulting from the cuts, even though the cuts on a percentage basis have been higher.

Dividend Watch: The Financial Media Are Barking Up The Wrong Tree

noreply@blogger.com (Greg Donaldson) — Sat, 25 Apr 2020 21:26:00 +0000

The financial media are howling about all the companies cutting, suspending, or omitting dividends; but among S&P 500 companies, they are barking up the wrong tree.
Since March 1, only 28 of the S&P 500 have officially cut or omitted their dividends.
That number of cuts pales compared to the 212 companies that have paid dividends and is blown away by the 103 companies that have raised their dividends.
The financial media might be guilty of looking so hard for the bad news that they are ignoring the good news.
Since March 1, nearly 50% of the 212 companies announcing or paying dividends have hiked them compared with just 13% that have cut them. We expect more good news in the weeks ahead.

The media are missing the powerful message that most major U.S. corporations are broadcasting: "The coronavirus is devastating and creates much uncertainty, but we believe it will pass sooner than most headlines are stating"
As I mentioned in a previous Dividend Watch, in 2008-2009 we noticed that apart from the banks, few U.S. companies were cutting their dividends in the face of the recession. Indeed, much as today, many companies were hiking dividends. That was one reason we became more optimistic that the credit crisis would be shorter and more shallow than was the consensus of the day. The coronavirus pandemic is unlike anything we have ever seen, but the greatest corporations in the world are telling us, at least for the present, that tomorrow is coming and it will be much brighter than most of us now believe.
You may argue with the point I'm making, but I believe the stock market has zeroed in on the net positive dividend actions of major corporations, and that is one of the reasons stocks are nearly 20% above their recent lows.

The following are the 28 S&P 500 companies that have cut or omitted their dividends. We will have a list early next week of companies whose dividend may be in jeopardy.

S&P 500 Companies Cutting Their Dividends

From March 1-April 24

Alaska Air ALK	Darden Inc. DRI	Invesco Corp IVZ	MGM Corp MGM
Apache Energy APA	Estee Lauder Co EL	Nordstrom JWN	Noble Energy NBL
Aptiv PLC APTV	Ford Motors F	Kohl's Corp. KSS	Occidental Pete OXY
Boeing Corp BA	Freeport-McMoRan FCX	L Brands Inc. LB	PVH Corp PVH
Carnival Cruise CCL	Gap Inc. GPS	Las Vegas Sands LVS	Schlumberger Int'l SLB
CenterPoint Energy CNP	Hilton Worldwide HLT	Macy's Inc. M	TJ Maxx TJX
Delta Air DAL	Helmerich &Payne HP	Marriott Int'l MAR	Tapestry Inc. TPR

Dividend Watch: Increases Still Outnumber Decreases

noreply@blogger.com (Greg Donaldson) — Sun, 19 Apr 2020 23:44:00 +0000

Dividend Cuts by S&P 500 companies during the coronavirus have been far less than what was predicted just a month ago.
From March 1 through April 17, only 27 companies in the S&P 500 announced dividend suspensions or cuts.
Dividends remain an important linchpin connecting major corporations and income-hungry investors.
We forecast total S&P 500 dividend payments will fall in the range of 10-15%, far less than Wall Street expectations.

Dividend announcements were slow last week. They will speed up in late April through May. Here are the most recent overall dividend data.

Dividend Actions by S&P 500 Companies
March-April 17, 2020

Dividend Paid	Dividend Increased	Dividend Decreased
192	96	27

The number of companies increasing their dividends since March 1 grew to 96, with two important companies, Johnson and Johnson (JNJ) and Procter and Gamble (PG), hiking payouts approximately 6%. The star of the week was Skyworks Solutions (SWKS), who raised its dividend an eye-popping 57%. While 27 S&P 500 companies have announced dividend cuts, most of these were smaller companies with modest dividends. So far, the 96 companies that have raised their dividends, have pushed total dividends paid for the period modestly ahead of the same period last quarter.

We believe more cuts are inevitable as companies are forced to take government bailouts in the months ahead. However, we believe total dividend cuts by S&P 500 companies will be far less than the 25%-30% levels predicted just a month ago, perhaps less than half that number.

Next time we'll list companies that have announced dividend cuts, and list a group of companies that our research suggests are in danger of lowering or eliminating their dividends.

Greg Donaldson, Founder

Donaldson Capital Management

Dividends Are Not Dead--They're Still Growing

noreply@blogger.com (Greg Donaldson) — Mon, 13 Apr 2020 22:50:00 +0000

Since 1958, cumulative annual dividend cuts in S&P 500 companies have been rare with only 5 annual cuts over 1%.
In the early days of the current coronavirus scare, investors were betting that dividends would be slashed across the board.
Dividend cuts in March and early April have been remarkably tame and outdistanced by dividend hikes.
Upcoming earnings season announcements may provide more clarity about companies' dividend payment intentions.

In order to see a broader picture of the dividend actions of the S&P 500, I tabulated all companies in the S&P 500 that either announced a dividend action or paid a dividend from March 1 through today. The results are far different from what the headlines might suggest.

Dividend Actions by S&P 500 Companies In March-April 2020

Dividend Paid	Dividend Increased	Dividend Decreased
187	87	21

One hundred eight-seven companies paid a dividend in March or early April, and of those, 87 have hiked their dividends. Only 21 companies have announced dividend cuts. The dividend increases had a median growth rate of 7.85%, about the same percentage hikes as in 2019. A Barron's article this weekend says S&P 500 futures are pricing in dividend cuts of approximately 30% for the next twelve months. Barrons also mentions that many Wall Street analysts are reducing their dividend-cut predictions.
The dividend actions thus far suggest that the big worries that ripped through the markets about dividend cuts in the early days of the sell-off are diminishing. Importantly, for the economy and the stock market, if corporations continue to pay and hike dividends like they have in the last month and a half, it would signal that many top managers are optimistic that the economy can recover faster than is now being touted by the financial media.
Wishful thinking is not always a good business or investment strategy, and the recent good trends could reverse, but if the dividend data continues to surprise to the upside, it might be the ray of sunshine we all need.

Blessing
Greg Donaldson, Founder
Donaldson Capital Management

Dividend Watch: Recent Corporate Dividend Announcements

noreply@blogger.com (Greg Donaldson) — Thu, 09 Apr 2020 16:05:00 +0000

Beyond the Great Depression, S&P 500 annual dividend cuts have been few and small, with the largest cut being 21% in 2009.
Analysts are now predicting dividend cuts in the range of 33% for S&P 500 companies in 2020.
Dividend cuts of that magnitude would signal that companies believe that the damaging effects of the coronavirus will continue to disrupt business well beyond 2020.

It is our hope and belief that dividend cuts will not reach the 33% level now predicted by many analysts. Even though dividend payments are a voluntary corporate decision, in the United States dividend cuts have a more negative connotation than in any other country in the world. There are many reasons for this, but the single biggest is that in the U.S. dividends are paid quarterly, while in many other countries they are paid semiannually or annually. In addition, in many other countries dividend payments have tax consequences to the corporations. Thus, in the UK for instance, dividend payments are pegged more closely to the annual performance of the company, while in the U.S. payments are seen more as a measure of the longer-term prospects of the company. For these reasons and others, U.S. corporations that announce dividend cuts usually see a corresponding cut in their stock prices.

I'll provide another Dividend Watch scoreboard of dividend actions since the beginning of March on Friday, but I wanted to share some recent dividend announcements by major corporations. Fed Chair Powell made the biggest announcement this morning when he said that he believes major banks are in good shape to pay dividends. Bank stocks exploded after the announcement. Many analysts were predicting a 50% chance of bank stock dividend cuts. Here are other recent dividend announcements. We believe announcements like these are one reason that stock prices have rebounded this week.

Major Banks

Fed's Powell sees banks in good shape to pay dividends

Starbucks

The company says it does not plan to cut its dividend but will temporarily suspend its share buyback program, while taking steps to delay expenditures and reduce costs.

AT&T

At&T reiterates confidence in its dividend despite economic uncertainty.

Exxon-Mobil
“Our capital allocation priorities also remain unchanged,” noted Woods. “Our objective is to continue investing in industry-advantaged projects to create value, preserve cash flow for the dividend and make appropriate and prudent use of our balance sheet.”

JP Morgan

Barring an Extremely Adverse Scenario, JP Morgan Hopes to Maintain Dividend

Walgreens

Walgreens Expects to Continue Dividend For Now

Genuine Parts

"Through these actions and our on-going working capital initiatives, the Company has the liquidity to operate through these uncertain times as well as continue to pay the dividend." – Chairman and CEO Paul Donahue

Chevron

Chevron says its focus is on protecting the dividend.

AT&T

AT&T reiterates confidence in its dividend despite economic uncertainty.

Greg Donaldson, Founder

Donaldson Capital Management

Dividend Watch: Dividends Aren't Dead

noreply@blogger.com (Greg Donaldson) — Tue, 07 Apr 2020 17:21:00 +0000

In 2009, shortly after the government required all banks to cut their dividends, we created what we named the Dividend Watch to track dividend announcements and actions of all companies in the S&P 500. It was our opinion that the overall stock market was overreacting to the financial problems that appeared to be narrowly focused in the banking sector. We held this view because a look at the long-term dividend payment records of the S&P 500 revealed that companies are very reluctant to cut dividends. Indeed, in the 50 years from 1958 to 2008, dividends had been cut by over 1% in just 5 years. During this same period, stock prices had fallen in 16 years and earnings had fallen 13 times. Annual changes in prices and earnings on a percentage basis were about 2.5 times that of changes in dividends. We were hopeful that the Dividend Watch Report could act as a barometer for not only the stock market but also for the overall economy. If few companies in the S&P 500 Index, other than banks, cut their dividends, it would signal that most companies believed they could navigate the crisis with minimal ill effects and continue to pay their dividends.
Our Dividend Watch Report soon revealed that few companies, beyond the banks, would cut their dividends in 2009. In fact, many companies were actually increasing their dividends. The surprising number of companies hiking dividends allowed us to become more bullish early in 2009 about the near-term prospects of the overall stock market and, to some extent, the U.S. economy.
We are again firing up the old Dividend Watch Report in the current coronavirus pandemic. The current pandemic will affect many more companies than did the 2008-09 banking crisis, but we again believe that corporate America will surprise us with dividend actions that are more positive than is now being priced into the stock market. As we release this 2020 Dividend Watch blog, Wall Street analysts predict that S&P dividends will be cut approximately in the range of 33%.
Our analysis runs from March 1 to the present. Early March was when the full impact of coronavirus exploded into our collective consciousness. We'll track the dividend announcements on a weekly basis.

Dividend Actions by S&P 500 Companies In March 2020.

Dividend Paid	Dividend Increased	Dividend Decreased
43	10	18

From March 1 through today, approximately 30% of S&P 500 companies announcing dividend actions have cut or suspended their payments. (18 of 63). We suspect that some companies that have announced suspensions may reinstate their dividends later in the year after the full effects of the Covid 19 economic damage has been assessed. We'll track reinstatements if and when they occur. Companies cutting their dividends have been centered in three industries: Travel and Leisure, Oil and Gas, and Retail. Among the big names that have announced cuts or suspensions are Ford Motors, Delta Airlines, Marriott, Carnival Cruise Lines, GAP, Occidental Petroleum, and Boeing.
As you will note in the table above, 10 companies have raised their dividends during this time. The biggest hikes so far have come from Dollar General at 12.5% and General Dynamics at 7.84%.
We have long believed that dividends are the linchpin tying individual investors and corporations together. With stocks careening all over the place, it would appear that traders and speculators are betting that companies will break this bond. We believe the bond will hold and provide an undergirding to the overall stock market.

Greg Donaldson, Founder
Donaldson Capital Management

Volatility Will Continue, But Stocks Are Going Higher

noreply@blogger.com (Greg Donaldson) — Sun, 10 Feb 2019 21:38:00 +0000

After an historic January run, the S&P finished the first full week of February in what looks to be a consolidation phase. As we thought might be the case, the S&P 500's 200-day moving average has proven to be a level of resistance for the market with a sharp pullback off the moving average in the middle of the week. Still, an impressive intraday rally took hold on Friday to see the market close well off its morning lows. Late Friday rallies have been a good sign during the last couple of years and continue to suggest that buyers abound at these levels. So while stocks may face a battle as they try to work through the 200-day moving average, the outlook is constructive for the longer-term and there are decent levels of technical support close by. This is born out by the surge in the percentage of stocks above their 50-day moving averages, which typically results in strong returns over the next 6 to 12 month time frame. Importantly, strong stock gains in January's tend to beget strong full-year performance.

Economy and Bonds

From a macro standpoint, the economic data continue to be more mixed, but that is probably the best case scenario for stocks grinding higher. US economic data softened significantly at the tail end of 2018, but a small rebound in the Mfg. PMI and last week’s stellar jobs report have tempered the recession talk. Still, consumer confidence has taken a hit, and business investment is rolling over a bit. With the recent mix of data and little inflation in sight, the Fed is probably on hold, and the cacophony of economic naysayers has been quieted. On that note, credit spreads have stabilized and more of a risk-on attitude has been evident. What is perhaps most striking in the recent upleg in stocks has been the behavior of US 10-year bond yields. One might think that a more lax Fed would allow inflation and growth expectations to creep higher, taking interest rates with them; but global economic woes are keeping inflation expectations and bond yields in the US well anchored. The US's expected GDP growth in the 2%-3% range for the year ahead looks downright rosy compared to much of the rest of the developed world. We believe this realization has not been lost on foreign investors.

Trade

Trade remains an issue as gamesmanship has once again emerged between the US and China as tariff deadlines draw near. Of great concern is the February 17^th deadline with the Eurozone that could lead to the imposition of tariffs on European autos. These tariffs have the potential to wipe out a good deal of the incremental tax cuts in 2019. This is an area to watch as well.

Earnings

Here's a quick update on fourth quarter earnings: With 66% of companies reporting, earnings have surprised by an average of around 3%. Revenue growth of 6.5% has contributed to earnings growth of 14% year over year. Fourth quarter earnings continues to look better than expected; however, expectations for Q1 earnings growth have softened. This is likely a symptom of the slower global growth. Still, there are pockets of strength that are relatively immune to the global slowdown. In our next blog we will discuss a few of the superior operators.

Finally, our overall valuation model says stocks are still in a sweet spot and should end the year higher than they closed on Friday.

Preston May, Certified Business Economist

Research Analyst

Donaldson Capital Management, LLC.

Editor Greg Donaldson

The Great P/E Debate: A Stopped Clock and Other Wild Eyed Guesses

noreply@blogger.com (Greg Donaldson) — Fri, 11 May 2018 23:18:00 +0000

We have shown in previous blogs that much of what academia and Wall Street tell us about how to calculate the most foolproof price-to-earnings ratio for the S&P 500 at any point in time is . . .well, foolish.

1. Professor Robert Shiller, the creator of the CAPE method of valuing stocks, which has many academic adherents, says that stocks are wildly overvalued. The only problem is he has been saying that for nearly six years, and in interviews, he cautions that CAPE is not a good metric for timing. But, professor, what good is a valuation metric if it is correct only once every decade, or so? That sounds a bit like the accuracy of a dead clock: it's correct twice a day but fails at telling time during the other 23 hours 59 minutes and 58 seconds of the day. CAPE currently suggests that the S&P 500 P/E is approximately 80% above it fair value.

2. There is another crowd of soothsayers who hold to the idea that the long-term average P/E of the S&P 500 is the correct metric to determine its fair value. These folks argue that a P/E of 16x is the right multiplier, and, that being the case, at 21.3x, stocks are currently about 33% overvalued. History shows us that if you would have bought every year when the S&P 500 was below a 16x P/E and sold or shorted every year above that level you would have crashed and burned a long time ago.

3. Many on Wall Street believe that the best way to calculate the normal P/E for the S&P 500 is to subtract the rate of inflation from 20. In our judgement, this crowd has had a better track record over the last 50 years than Dr. Shiller or the 16x crowd, but we have previously shown, there is a more statistically significant way to determine the right P/E at any point in time. That methodology is what we call the earnings yield to inflation' ratio.

Our work shows that since the 1960s, earnings yield (the inverse of P/E) minus core inflation has averaged 3.35% with a correlation coefficient of .70. For our calculations, we use earnings before extraordinary additions or subtractions and the core personal consumption deflator inflation (PCD, the data most favored by the Fed.) The current reading for these two data points are as follows. PCD is 1.6% and the trailing 12 month earnings yield is 4.70%, or a P/E of 21.3.

To determine where the model says the current earnings yield, (P/E) ought to be, we add the current PCD rate of 1.6% to the long-term constant of 3.35%, or 4.95%. Converting this back to P/E, we find the model predicts the correct P/E is now 20.2x. With the S&P 500 now trading at 21.3 times earnings, that would suggest that stocks might be about five percent overvalued. But there's more. The stock market is a discounting mechanism. That is, it is always looking ahead and pricing in where it believes current financial and economic data will be in the future. Currently the consensus view of analysts and economists is that the PCD inflation rate will climb to 2% by year end and S&P 500 earnings will grow to approximately 160. If these estimates come to pass, that would put the fair value of the S&P 500 at about 3200 by year end.

With the S&P 500 currently sitting at 2727, that would mean it is about 17% undervalued. That's my best guess and I'm sticking with it no matter how much volatility we see over the next few months. I'll update the model in the coming months.

Earlier, I said the correlation coefficient on our P/E model is approximately .70. Being less than 1.00 means that it has not perfectly predicted annual stock market moves (surprise, surprise). I offer it here because the model is simple and has done a reasonably good job of predicting stock market action over the last few years. We have another model that has more complexity and with an even higher correlation coefficient that also predicts stocks are undervalued by double digits. I'll show it in a future blog.

The Great P/E Debate: The End Is Not Near, Stocks Are Going Higher

noreply@blogger.com (Greg Donaldson) — Mon, 30 Oct 2017 13:53:00 +0000

The cacophony of “the end is near” cries from the doom and gloomers is much with us as stocks have marched unrelentingly higher over the last few years. The doom and gloomers do a lot of talking and shouting, but they don’t seem to do much actual research. For if they did, they would have discovered a relationship between earnings yields (the inverse of P/E) and inflation that suggests that at a P/E of 21.7x stocks are selling just about where they should be.

The picture below is a screenshot from my Bloomberg terminal showing the historical spreads of the S&P 500’s earnings yield and the personal consumption deflator, the measure of inflation that the Federal Reserve says is most accurate. Earnings yield, which I define as S&P 500 operating earnings divided by price, or the inverse of P/E, is quoted as a percentage, as is inflation. This produces a visual representation between the two data series that is easy to analyze.

I have written about this relationship as the most important driver of the S&P 500 and Dow Jones 30 price-to-earnings ratios for many years. I first discovered the relationship between earnings yield and inflation in the 1990s via some data that Value-Line provided their subscribers. I was surprised that of all the data that I studied, inflation was the most highly correlated with earnings yield. I would have bet almost anything that interest rates would have proven to have had the best correlation. (I will show the current picture of earnings yield and interest rates later.).

In the upper left-hand side of the picture, you can see the movements of inflation versus earnings yield charted on a quarterly basis going back to 1973. The difference between the two data series is shown in green. During this time, you will note that the two lines have moved almost on a tit for tat basis and now stand at about 4.6% for earnings yield and 1.4% for inflation. The data box at the top right of the picture shows that the average difference between earnings yield and inflation during this 43- year period has been about 3.4%. Right above that data-point is the current difference of about 3.3%. There is a lot of other data on this picture, but let me direct your attention to two other important indicators. I have drawn a red arrow (lower right) pointing at R^2 (Correlation). You can see that the R^2 between the two data series is very high at .705. R^2 is a statistical measure of fit between two or more data series and calculates that quarterly movements in inflation have been able to predict just over 70% of the movements of earnings yield and thus P/E. At our firm, we have more complex models using a wide range of other data series that can raise the R^2 up as high as 95%.

The second important indicator to consider is contained in the red circle I have drawn around a faint red asterisk on the lower left-hand side of the picture. The red asterisk shows the current differential between earnings yield and inflation, and it is sitting just about where we would hope it would be -- on the fair value line.

In summary, trading at 21.7 times operating earnings, stocks are not wildly overvalued, using inflation as the measure of value, and there is no other single data series that I know of that is able to pinpoint P/E with such statistical accuracy. I think the doom and gloomers are howling in the wind and their doom and gloom will continue to build as stocks go higher. In my judgement, if the current earnings growth continues, inflation would have to rise nearly one percent to roughly 2.5% before stocks would begin to feel headwinds.

Below I have copied a picture of the relationship between earnings yield and interest rates. You will note the fit between the two data series is much less convincing than that of earnings yield and inflation. Indeed, the two data series flip flopped positions in the late 1970s and thus have an R^2 of only about .42.

Black Monday: The Worst Day of My Professional Life, The Best Thing That Ever Happened To Me

noreply@blogger.com (Greg Donaldson) — Fri, 20 Oct 2017 17:32:00 +0000

I have not written a blog in awhile. I have been working on a book about the history of my firm's Rising Dividend Strategy. As I was doing a final front-to-back proof this morning, I realized that the Rising Dividend Story had it's beginning on Black Monday. Here is a sneak preview of the first four chapters of the book, which should be out in 2018.

Greg Donaldson

gdonaldson@dcmol.com

812-480-7256

Chapter 1

Black Monday

The stock market crash of 1987, or “Black Monday,” was both the worst day of my professional life and the best thing that ever happened to me. The largest one-day market crash in history happened on October 19 when the Dow Jones Industrial Average lost nearly 23 percent of its value, or over $500 billion in the United States alone. In the midst of the devastation, most of my illusions about investing were destroyed, sending me on a quest to find what ultimately became a life-changing investment strategy.

Before Black Monday, if you asked me what stocks to buy, my answer would have been quick and confident and best summed up as B.I.G. Trend investing -- Big companies that were Industry leaders and Growing. Trend meant I invested only in B.I.G. stocks whose prices were trending higher. By sticking with big companies that were widely covered in the media, I believed I could know as much about them as the Wall Street analysts. Industry-leading companies were typically very large and often had the highest profit margins. Yet surprisingly few of them had faster sales and earnings growth than the average company. Thus, the basis of my investment strategy was that earnings growth was the dynamo that propelled price growth. In addition, since the markets were driven by very bright people with lots of tools for uncovering successful investments, the final component of my strategy was to wait until those investors started buying and pushing stock prices higher, confirming that they believed the earnings growth was sustainable. Once this convergence of the trend of earnings growth was confirmed by the trend of price growth, I bought the stock and owned it until its price and earnings growth trends diverged.

A key to my strategy was Trend investing. My theory was that the millions of investors making buy and sell decisions would create a so-called “mind-of-the-market” where everyone was looking at the same price and earnings trends. This would pull more investors into the zone and push particular stocks and industries higher. My approach had been successful for many years. I was confident that if I watched the markets closely enough, I could see which trends held the most promise. I believed that my best chance of success depended on watching which way the trends were flowing, so I paid little attention to company fundamentals, such as price-to-earnings (P/E) ratios or growth in sales and dividends.

On Black Monday, the price of every stock suddenly collapsed. It was especially confusing because there was little negative economic or political news during the day to fuel the crash. The companies my clients owned were still big, industry leaders and growing, but all were headed straight down along with all the other stocks. The Trend investing strategy I had used for years was screaming to sell everything, but I found myself recoiling from that idea. It made absolutely no sense to throw good stocks at collapsing prices. Something seemed very wrong with the markets, not the companies. Yet, at the moment I decided not to sell everything, I cut myself adrift from any experiential confidence I possessed. If I ignored today’s sell signals, then when would I sell? And if I was not willing to sell, should I be taking advantage of the collapse and start buying? A strange sense of unknowing swept over me. The crash had revealed that my B.I.G. Trend strategy was really a fair weather investment tool, and now the weather was anything but fair. With the help of other portfolio managers at our firm, I decided I would hold all the remaining stocks that were in my clients’ portfolios.

Although there was no way to escape the crash, I knew I needed to minimize my emotional responses to the carnage as best as I could. Short of another Great Depression, the companies we owned would make it through these times, and when things calmed down, they would be the first to rebound.

Black Monday wore on and the telephone calls from frightened clients kept coming. I had few answers for them. Even if they insisted on selling, I had no idea where most stocks were trading. The electronic market on my quotation terminal was running as much as an hour behind the actual trading. It was anybody's guess what clients would receive for the sale of a stock.

At that time, a big day for the Dow Jones Industrial Average was a positive or negative change of 20 points. The market opened on Black Monday down 200 points before rallying back to 80 points down by mid-morning. When it again fell by over 200 points a few hours later, I knew the market was going a lot lower before the day ended.

As stocks continued to fall, it became clear that the crash would do as much psychological harm as financial. It also posed a serious threat to the existence of the small investment firm I had helped start the previous year. This would be a battle not only to protect my investors’ assets but also to save my company.

The crushing of my B.I.G. Trend strategy threw me into slow motion. I was anxious and worried, but since I had decided not to sell, I wasn’t chasing around trying to decide what to do next. If any companies were going to weather Black Monday, the companies we owned would do so, although by the end of the day most of them would be nearly 25% percent cheaper. Their rising price trends were gone, but they were not going to just dry up and blow away.

The phone calls poured in the entire day. I spoke with nearly every client I served, one after another. Sometimes, up to four calls awaited my attention. I ended my last call of the day around midnight. Considering the circumstances, people remained relatively calm, and they agreed with my decision not to sell into the crash.

As I spoke with each person, “Black Monday Talking Points” began to take shape. I was convinced from watching the action of the market that the collapse was, at least in some way, a structural problem. The normal interaction between buyers and sellers was corrupted because of the wild swings in stock prices. As an example, General Electric opened 15 percent lower than its previous close. It then retraced the entire loss before falling again by 25 percent, a swing of over 50 percent for the day. GE was a 100-year-old company that manufactured a wide range of products used all over the world. There was no way the fortunes of this company could change that much in a day even though GE’s price swings for the day were wider than would normally happen in an entire year.

My talking points about not joining the selling frenzy were that most of our portfolios were full of “essential services” companies in industries such as banks, food and beverage, health-care, energy, transportation, and utilities. No one knew what these companies would sell for in the coming days and months, but their existence was not in danger. Since they had strong balance sheets and were already the leaders in their industries, there was good reason to believe their businesses would improve at the expense of weaker competition. At a time like this, it was important to remember that we owned companies and not stocks. The U.S. economy had been strong going into Black Monday, and it was inconceivable that it could fall apart in such a short time. It was becoming clear that the violent action of the market was only marginally connected to the underlying values of most companies.

I realized that while the “Trend” part of B.I.G. Trend investing was dead, the B.I.G. part was going to save the day because big companies that were industry leaders and growing were holding up much better than small and highly leveraged companies. While this was good news, I was careful not to offer false hope to my clients, choosing to say that the crash was going to take a long time to fix.

As Black Monday wore on, I began to formulate a new investment strategy, the name and concept of which I would have scoffed at just hours earlier. On that day, The Rising Dividend strategy, as it would later be called, was set in motion by three phone calls I received. Each one was surprising and went against the grain of the day’s events. In the end, each one helped me see a way out of the wreckage of that bleak day by presenting an opportunity and asking me to consider it from a new perspective.

Chapter 2

The Three Calls

“When you pass through the waters, I will be with you; when you pass through the rivers, they will not sweep over you. When you walk through the fire, you will not be burned; the flames will not set you ablaze.” Isaiah 43:2

A friend of mine gave me a daily prayer journal just days before Black Monday. On that morning, I opened it to October 19. The above verse from Isaiah was written across the top of the page. I realized how much I needed to hear that passage. Before trading opened in the U.S. on that date, the financial storm had demolished the Japanese and European stock markets and would soon slam ashore in the U.S. I tried to pause and meditate on the scripture, but phones began to ring. So I just bowed my head and uttered, “Lord, give me your strength and your wisdom this day.”

Among the scores of calls I received that day, three in particular changed my perspective of investing forever and set me on a quest that I still follow to this day.

The First Call - A Self-Made Woman

Mildred Hagedorn was a remarkable woman, aside from giving birth to 12 children, she and her husband built a very large farming operation in southern Indiana and western Kentucky. After her husband died, she added coal and oil to her business interests. I had the privilege of working with her for many years, primarily on her municipal bond portfolio.

Because she owned few stocks, I was surprised when I recognized her voice around mid-morning. Her bond holdings were relatively unaffected by the carnage in the stock market. But I was surprised even more by what she wanted to discuss. Fully aware of what was happening in the stock market she came right to the point and asked me how much money she could borrow from her bond account to buy stocks. I tried to dissuade her by saying that buying into the crash was not a good idea and that it might take weeks, even months, before the market could put in a solid bottom. She then explained that she and her husband, Erwin, had accumulated thousands of acres of prime farm ground by buying when everyone else was selling. She had continued that strategy after he died, and it had always eventually resulted in large gains. Her tone with me was direct and confident. “Greg, I know what I am doing, and I am a big girl. If I am wrong and it doesn’t work out, I won’t blame you. And while I have no intentions of losing this money, if I do, my life will not change.”

I was awed by this self-made woman’s strength and resolve at a time when uncertainty prevailed. When I asked her what she wanted me to do, she requested that I compile a list of what I considered to be the best companies -- companies that would come out of this bad market perhaps stronger than they went in. I asked her whether she was thinking of buying these stocks to take a short-term profit if the market bounced back or to hold them for a while. “I want to buy companies that I can own for the rest of my life,” she said unequivocally. “That’s the way I buy farm ground; that’s the way I buy bonds; and that’s the way I’m thinking about these companies.”

In between calls that day, I thought about what it meant to own the best stocks. Before the crash my definition of the best stock was one that made the most money in the shortest time. But I quickly realized that this way of thinking about “best” was only possible by looking back. In this case, Mrs. Hagedorn wanted to know the best companies on a present and forward-looking basis. She was not asking me to pick companies with the best value or those defined as winners. Rather, she wanted me to pick a small group of the best companies.

There was no clear answer to her request. There were companies that were great values and those with the best risk/reward ratios, but “best” was just too relative a term to apply to companies. For awhile I was confused about what kinds of companies to recommend to her. Then I thought about what she was asking me to do according to her perspective in the world of farming. I grew up in a farming town. I had friends and relatives who were farmers. If I were to ask them what the best farm ground in their county was, they would use terms like lay of the land, richness of the soil, length of the rows, and yield per acre. They would take into consideration location, access points, creeks, drainage, and out buildings. But this line of thinking was not completely helpful either because farm ground is tangible and stocks are not.

Is anything tangible about a company? Stocks possess a book value, but that is not what truly gives most companies their value. Book value is just an accounting term -- a measurement of the depreciated value of the firm’s investments in its plant and equipment. In the stock market, what gives a company its value is how much its products and services are prized by consumers, the company’s ability to successfully extend its products, new and old, to new markets and, finally, the company’s ability to convert sales into profits.

Then it hit me. At the county fair, the best animal wins the blue ribbon, and the most attractive girl in the beauty contest wins the crown. A man gives his best girl a diamond. A great athlete becomes a star. In all societies, the best are given the prize and are prized. So what companies in the U.S. were most prized? Immediately Coca-Cola came to mind, then Disney (it was a much different company then than it is now), General Electric, Wrigley, and Johnson & Johnson. They were not just blue chips but icons that had stood the test of time, defeated all comers, were very profitable, and had star quality. They were what some people called their “brand.” The strength of a brand was as close as a company could get to being tangible.

I called Mrs. Hagedorn and gave her my line of thinking and the shortlist of names. I asked her to wait a few days. The market was coming apart, and I had no idea where these stocks were trading. She agreed. We did start to buy some of the “best” companies by the end of the week. It did not feel right to me at the time, but it was what she wanted. Regardless of how it made me feel, I realized that she had shared with me a priceless bit of investment wisdom. It was an axiom on Wall Street that buying low and selling high was the secret to success. But here in the teeth of the biggest sell-off in U.S. stock market history it took guts to buy stocks as Mrs. Hagedorn was doing. But she hadn't just called me on a whim. She wanted to be a buyer of stocks because she had learned to buy low through scores of farm ground purchases that turned out to be big winners. She had learned that big sell-offs were tremendous buying opportunities for top quality investments. That kind of thinking went against the grain of ninety percent of the people, including me.

Chapter 3

The Second Call -- Valuing bonds blindfolded

Shortly after finishing my call with Mrs. Hagedorn, I received a call from a friend and fellow employee of the Indianapolis-based investment firm I was with at the time. He was a broker, and I was in the money management department. He explained that he needed to sell some Indiana University bonds for a customer who was in a panic about the crash. When I asked him why he called me and not the bond desk, he said it was shut down. Actually, what was happening was that the stock market crash overloaded the quotation systems, and no one knew if the prices of stocks or bonds we were seeing on our Quotrons were current or hours old.

The collapse in stocks had caused a flight to the perceived safety of Treasury bonds, which caused them to soar in price. Under normal circumstances, municipal bonds trade with a spread to U.S. Treasury bonds. Thus, prices of municipal bonds like the Indiana University bonds should have been rallying along with Treasury bonds. But correctly valuing municipal bonds in the middle of a stock market crash was next to impossible. Additionally, no one knew if the normal spread between Treasuries and municipals was holding steady. As a result, many bond desks at firms across the country suspended operations.

When I heard the news that our bond desk was not bidding on bonds, my heart sank. It further opened my eyes to how big the crash was. It was starting to shut down the whole system. Shutting down the bond desk was like the power company shutting down one of its generating plants; the only reason they would do that was to salvage the system.

Stocks were collapsing and bond desks nationwide were suspending trading. Momentarily, I was seized with the notion that maybe this was another 1929-type crash, and everyone would lose everything. I quickly shook off that thought and steadied myself. The fact was that the economy was strong. And, since only about 25 percent of Americans owned stocks at that time, most people would wake up the next day, shower, brush their teeth, get dressed, get in their car, and stop for an Egg McMuffin on their way to work. Life would go on as usual. I paused right then to add Colgate, Procter and Gamble, and McDonald’s to Mrs. Hagedorn’s “best company” list.

My friend said that the seller of the bonds was a long-time client who was convinced a 1929-type depression was imminent and he wanted to raise his level of cash. He stressed that he really needed the favor. I told him I could not do favors with other people’s money. “All I want is a bid to show my client, not necessarily a favorable one,” he said.

I asked him how I was supposed to know where the market was trading if the bond desk didn’t even know. He responded that he thought maybe one of my firm’s money management clients might be interested in his client’s bonds. In fact, several of my clients had told me during the day to keep an eye out for bargains on bonds. I agreed to think about it and asked him to call back within the hour.

By law, the State of Indiana cannot have direct debt. The law was the result of the Wabash and Erie Canal debacle of the 1840s, which forced the state into bankruptcy and produced an 1851 statute prohibiting any future issuance of debt by the state. The prohibition meant that Indiana had one of the strongest financial conditions of any state in the nation.

As I thought about the bonds, I realized that Indiana University was as close to state debt as you could get. The good citizens of the Hoosier state would sell off their family jewels before they would let Indiana University go under. In addition, Bobby Knight and his Hoosiers basketball team had won the NCAA basketball championship the preceding March, and the state would likely have sold off the Capitol rotunda rather than give up the basketball arena. The bonds were safe. But what were they worth?

In valuing the bonds, the toughest hurdle to get over was that they were 20 years from maturity. Life and taxes would go on no matter what happened in the crash, and the tax-exempt interest the bonds paid would always be prized by investors in high income tax brackets. U.S. Treasury bonds had started the day yielding about 10.25 percent, and bond prices were rallying, so the yields were probably near 10 percent. If I could buy the IU bonds to yield the same amount as U.S. Treasury bonds, I would have a real bargain because in normal times tax-free bonds yielded approximately 80 percent of Treasury bonds.

When the broker called back, I told him I would buy the bonds to yield 10 percent, then told him to call the bond desk and get their approval before he told his client about my bid. The head of the bond desk called me immediately and began to explain what was happening with the bond market and his inability to bid. I stopped him and said I was aware of what was going on and was willing to buy the bonds if he approved it. He said he thought 9 percent might be a better level for the bonds, but I held firm at 10 percent and said my bid was good until the close of business. The broker called back in minutes to say the bond desk would not approve the 10 percent level but would allow it at 9.40* percent. I agreed to buy the bonds at that level, then called the bond desk to say I would offer a bid for any other bonds people wanted to sell.

I had budged on the yield I was willing to take on the bonds but reasoned that getting 94 percent of Treasury yields was still a good deal. I was also confident that buying Indiana University bonds when no one else would make a bid was sure to be a good buy, ultimately. In addition, the destruction of hundreds of billions of dollars by the stock market crash was a deflationary event that I was convinced would cause interest rates to fall.

As I returned to my blinking phone, I paused for a moment. I had just done something that I had never done before -- value a bond in the absence of a trading market. I had just committed my clients to up to 20 years of ownership of this bond, and I had done it in the middle of a panic unlike anything I had ever witnessed. What surprised me was that I was almost intuitively able to clear away all of the clutter and zero in on just the few details I needed to make the decision. But that wasn’t all. Without realizing it, I was following the investment strategy Mrs. Hagedorn said she and her husband had used for many years: Buy the best when nobody else wants it.

Chapter 4

The Third Call -- A Good Argument

The third call I received on Black Monday that set me on a different path came just as I was going to bed. It was from a client whom I had not spoken to during the day. He was very troubled. After trying to calm him with rational arguments, I realized that he could not hear me over the sound of his extreme fear and agitation. The more I tried to reason with him the further apart we drifted, like two people receding into a dense fog.
Billy Behr was, in his own words, “large and loud.” He had one of the keenest minds of anyone I had ever known and was a voracious reader, student of history, and the owner of a very successful information technology consulting firm. He often reminded me that he did not need a money manager, but I continued to manage a seven figure portfolio for him for more than 20 years.
Billy was a mystery. He was my best friend one day and my interrogator the next. He delighted in telling me that the portfolios he managed were outperforming the one I managed for him. When asked why he kept doing business with me, he would only say that he needed me to manage his conservative money.
On Black Monday, I missed calls from Billy all day. These were the days before cell phones, and he was on a business trip around the Midwest, hop-scotching across the countryside from pay phone to pay phone. He knew I was not selling into the crash. My assistant had informed him of this decision when he had called the first time. He agreed with that strategy but needed to speak with me as soon as possible. So, just before I left the office, I called his home and left a message saying that he could call me at home any time up until midnight.
When my phone rang at 11 p.m., I did not recognize the voice on the other end. It was very faint and strangely childlike. “Gregor,” the voice said. “Glad I caught you. I just got in and I’m shell-shocked at my losses. How far down is my account with you?” I told Billy somewhere between 20 and 25 percent. He said he was down much more than that in his other accounts, which were fully margined. He was sure he would have margin calls in the morning, and he wanted to know what I thought was going to happen in the next few weeks. I told him my best guess was that the market would continue its volatility, and that I would be surprised if it did not go at least 10 percent lower before finding its footing. I added that big sell-offs are usually followed by a rally, then a retesting of the bottom.
Billy said he was stunned by the day’s events and feared he had probably lost a million dollars. He asked me to remind him why I had decided not to sell into the crash. I repeated the talking points that I had been using all day -- we owned many of the greatest companies in America, and it was not prudent to throw good companies at bad prices, particularly when there seemed to be no economic reason for the selloff. Furthermore, it was becoming increasingly clear that Black Monday’s crash had been caused by a structural malfunction in the market that had been set in motion by computerized trading. The financial media were full of stories of how this programmed trading had careened out of control. And there was talk that the New York Stock Exchange was going to suspend such trading before the market opened in the morning.
Billy said one of the gurus whose telephone hot line he subscribed to was calling for a bottom of 400 points for the Dow Jones 30. That was more than 1,300 points lower than Black Monday’s close of 1,738 for the Dow. I asked who was making the prediction. When he told me who the advisor was, I said the guy had never seen a sunny day in his life and had been predicting the sky would fall for 20 years. Billy said that the advisor had been predicting a crash for a long time, and he should have listened to him earlier. It was clear that Billy was not listening to me.
“If the Dow Jones 30 falls to 400,” Billy sputtered, “I will be wiped out, and I just can’t take the chance of staying in the market.” Talking about the advisor’s doomsday prediction had sent him into a downward spiral. The fear in Billy’s voice caught me by surprise. Finally, after more disjointed chatter, he told me to sell everything at the opening of trading on Tuesday.
It was now 11:30 p.m. After a hard day of dealing with everyone’s emotions, including my own, and speaking with clients for nearly 17 hours, my voice and energy were spent. Billy’s irrational and morbid mood had begun to have a negative effect on the clarity and confidence I had felt all day. I knew that Black Monday would be the first of many long days and nights for me. In order to maintain enough mental and physical energy to make it through this dark time, I could not exhaust myself on one person. I muttered, “If that’s what you want, Billy, I’ll do my best…” but I immediately realized that I was doing him no favor. As the captain of one of his financial ships, I knew better than he did how to navigate this storm. I knew in the current market that there was a complete disconnect between prices and values. I did not know what the correct price for the Dow Jones 30 was, but I was sure that bailing out now was wrong. I also knew that trying to have an intelligent discussion with Billy in his present state was useless. So I decided to try another tactic.
“Billy, you realize in giving me these instructions to sell everything, you are firing me. We will never work together again.” He tried to protest, but I interrupted him. “If I am being fired I want you to understand that I think what you are doing is dead wrong, and you will soon be sorry.” He did not respond, so I continued. “As we have been talking, something keeps coming into my head. I’m not sure you will agree with it, but I cannot let our relationship end without telling you what I’m thinking.” He said that he was so worn out that he could barely stay awake but would listen as long as he could.
“Billy, you know there is a drought in this part of the country. Corn and bean crops are in bad shape and some farmers have plowed under whole fields. Have you seen that field at the corner of Highway 57 and Kansas Road?” “It’s burned up,” he replied. “Yeah, I know the farmer, and he said he’s going to plow it under. There is nothing to harvest. The sun has just roasted the beans. What do you think the odds are of anything ever growing in that field again?” I asked. “Better yet, are you willing to bet me that that field is somehow broken and will never produce crops again?”
Billy wouldn’t take the bet because he knew that the field would grow crops next year. I asked him on what basis he believed that. “It’s only natural,” he said, “Billy, think of everything that has to go right for that field to produce crops -- the right amount of rain all year, not too much or too little; the absence of a blight and destructive insects; the right seed; the right fertilizer; and the skill of the farmer.”
I asked Billy if he thought the value of the field had fallen because of the poor crop this year. He said he did not think so because in nine out of ten years the field would produce a crop, and some big crops would make up for the shortfall this year. “So from what you’ve just said, Billy, you have faith that the forces that have produced good harvests ninety percent of the time will re-establish themselves, and this year’s losses will be made up in the years to come?”
“Gregor, I know where you are going, but I’m just too tired to play logic games with you. Just do what I told you and sell all my stocks at the open tomorrow.”
“Billy, you hired me to manage a big portion of your assets, and I am going to do that until you tell me I am fired. I need to convince you that your cut and run action is not the right one.”
Billy’s temper flared. “Hey, man, don’t make things worse with cut and run talk. I’m not cutting and running. If this market keeps falling, I’ll be wiped out. I’ve worked a lot of years to build the assets I have. I don’t want to start at zero again.”
I then asked him why he was predicting a different ending for the stock market than he was for the farm ground. Fully awake now, Billy blurted out, “Because they are completely different animals. Farm ground did not fall by 23% today, and farm ground is a necessity to our way of life; stocks are not!”
“Billy, you are wrong when you say that farm ground and stocks are completely different animals. All farm ground is valued as a means of production for food, a basic necessity. How is that different from Southern Indiana Gas and Electricity? (SIGECO was the local electric and gas utility at the time. It is now Vectren.) SIGECO is a means of production of electricity, a basic necessity. Our society can no more live without electricity than it can without food. And how about Johnson and Johnson? It is one of the world’s largest pharmaceutical companies. If JNJ were to dry up and blow away, millions of people’s quality of life would go down hill in a hurry. Some might die. And how about Proctor & Gamble, Exxon, and General Electric? The fact that farm ground is tangible and stocks are not has nothing to do with how either one is valued or what they are ultimately worth. I recently saw where the total rate of return for farm ground in the United States over the last 50 years has been just modestly higher than inflation, whereas the rate of return for stocks during this same period has been five percent higher than inflation on an annual basis.”
“Farm ground and stocks are not the same thing,” Billy shouted. “Stocks fell today by 23%; farm ground probably did not move a penny.”
I shot back that “probably” was the operative word in his argument. “In the stock market, we live in a real-time quoted world. You can find out what any stock is selling for just by hitting a couple of buttons on a computer or reading it in the newspaper, and you can buy or sell millions of dollars worth of almost any stock on almost any day you choose. Write the check and you own it, or sell it and a check arrives in your mailbox in a week. It’s a real-time quoted live market; there is little or no ‘probably; about it. Farm ground is all about ‘probably.’ There is no real-time place where you can get a true selling price for that farm ground at Highway 57 and Kansas Road. There is no billboard on the corner showing the land’s moment-by-moment selling price, and there is no difference between tangible farm ground and intangible stocks.
“The moment-by-moment quoted market works for stocks 90% of the time, but because we humans are hardwired to fear loss, a sort of reverse alchemy occurs every time stocks go into a tailspin. Cascading markets transform our heretofore golden portfolios into junk. Almost magically vibrant and growing companies become nothing more than prices on a ticker tape, heading south. They are sold indiscriminately of their recent results or their prospects.
“Billy, you didn’t build a business as big as the one you own by cutting and running when the times got tough or someone threatened to sue you or run you out of business. Why are . . .
Billy interrupted me. “If you don’t stop this cut and run talk, I’m going to hang up this phone,” he growled. “You are preaching to the choir here, man. You know that my company is as big as it is because in recent years every time the IT market took a dive I stepped up and made acquisitions. I know how fear and greed can turn you into an idiot. That is why I keep an ongoing valuation metric for all of my important competitors in the Midwest. If any of them want to sell, I know exactly how much I will pay without stepping foot on the premises. If I get my price, I can clean up any problem they have.”
“Now we are talking,” I said with renewed fervor. “Would you mind sharing your valuation methodology with me?”
“Good grief, Greg, it’s midnight. You win, at least for tonight. Forget that I said sell everything. I’ll sleep on it and call you in the morning if I change my mind. But here is something that is non-negotiable. I’ve got enough risk in my trading accounts and in my businesses. I want you to reshape my portfolio to be entirely comprised of basic necessity companies. That is the only thing you have said tonight that has made sense to me.”
With that, Billy hung up. I lay in bed with questions running through my mind. I could not drive the race in front of me and read the roadmap at the same time. My purchase of the Indiana University bonds provided a yield above 9 percent, completely free of all taxes and backed by one of the most conservative states in the union. If that wasn’t a good buy, then what was? The next morning, I was going to tell the firm’s brokers to buy municipal bonds. Everyone would want to know what stocks to buy or sell, but it did not feel right to be jumping into the stock market until the bottoming process was further along, and it was too late to sell.
Then I began to think about the people I had spoken with that day. Among the scores of calls, the conversations with Mrs. Hagedorn, my friend with the IU bonds, and Billy Behr stood out. I knew they were seminal and would ultimately reshape my understanding of investing. Eventually, I would dig deeper into the impact of each call, but the one from my friend who wanted to sell the IU bonds took center stage. As I replayed the events surrounding the purchase of the bonds, I was struck by the fact that I’d been in the investment business for 12 years without knowing how to value a stock apart from its selling price on the exchange. Prior to Black Monday, I believed the market price dictated what a stock was worth. That is what I had been hearing for nearly a decade. On the night of Black Monday, I realized that the prevailing wisdom was nonsense. The average stock had fallen 23 percent. It was clear that investors were not trying to make informed decisions about the value of companies; they were just running from the storm. I was convinced of that, but I had no way to value a stock. Yet, today, I had priced a bond in the absence of a trading market.

Just before I dozed off, the only question on my mind was, “Is it possible to turn stocks into bonds?”

C’mon, Man: There Is No Such Thing as a “Normal” P/E

noreply@blogger.com (Greg Donaldson) — Wed, 27 Apr 2016 16:20:00 +0000

And now for the most exaggerated, overblown, annoying, and ignorant claim in the financial media today: “The stock market is dramatically overvalued and headed for a fall.”

The financial media from the Wall Street Journal to CNBC and everyone in between would have us believe that the S&P 500 is dangerously overpriced. Stocks are currently trading at a P/E ratio of nearly 19, which is 15% higher than the long-term “average” P/E ratio of 16.5.

[Cue the financial media freakout]

C’mon man (woman). You don’t know what you’re talking about. Using the average P/E to determine whether or not the market is fairly priced is like using a thermometer to determine how fast the wind is blowing. A thermometer is a useful device for measuring body temperature, but useless for measuring wind speed. As we will soon show, using the average P/E alone to value the market is also useless.

The chart below alone is enough to prove that average P/Es don’t tell you a thing. The blue line shows the actual P/E ratio vs. the long-term average P/E shown by the orange line.

Can any useful information be derived from this chart? Does the orange line tell you anything about the blue line?

There are; however, a few things we can glean from the chart.

1. Stocks Almost Never Trade at “Average P/E” Levels

With the frequency that “average P/E” is thrown out at us, you would think stocks often trade at the average P/E. But they don’t. In fact, stocks have traded at or near their long-term average in just 9 out of 676 months going back to 1960. That’s 1.3% of the time. The other 98.7% of the time, stocks did not trade at their long-term average P/E.

Can we just get the message through to the financial media: stocks almost never trade at their average P/Es. In effect, there is no such thing as a “normal” P/E. Please stop referencing it. It doesn’t exist.

2. Today’s P/E Ratio Isn’t Particularly High

Look at the far right of the chart showing where P/Es stand today vs. the historical average. Does it look all that high to you? It’s not.

The S&P 500 has traded at a P/E of 19 or higher nearly 30% of the time. Are P/E ratios higher than they have historically been? Yes. But it’s not like 19 is uncharted territory. It is still well within what we have seen before.

3. Stocks Can Still Go Up from “Elevated” P/Es

Even when the media are proclaiming that P/Es are “elevated” compared to historical averages, stocks have produced good results. Since 1960, when stocks have traded at a P/E of 19 or more, they have produced positive price returns more than 66% of the time over the next 12 months.

Do P/E Ratios Make Any Sense?

Historical P/Es look completely random, don’t they? Why did stocks trade at 7 times earnings in 1980 and then 30+ times earnings in 1999? Let’s see if we can find anything that would suggest why P/Es traded where they did over the last 50 odd years. If we can, we would have an honest to goodness valuation tool.

What is the “Right” P/E?

We’ve seen that stocks almost never trade at their average P/E. So that’s obviously not the “right” P/E. But if not the average, then what? To determine that, we need to flip our thinking upside down. We’re going to look at what is called the “earnings yield,” which is simply the P/E ratio flipped into an E/P ratio. If you buy a stock for $100 that generates $8 per year in earnings, you have paid 12.5 times earnings (P/E = 12.5). Flip that upside down and you would see that your “earnings yield” is $8 divided by $100 = 8%.

The “earnings yield” is more useful when comparing stocks (and businesses) to alternative investments that are quoted in percentages. When earnings yields on stocks are higher than bond yields - stocks are a better bargain. When bonds are yielding more than stocks - you might be in favor of buying bonds, instead.

Our research shows there is a high correlation between earnings yield (P/E upside down) and inflation. The chart below shows earnings yield as the blue line and inflation as the orange line.

There is a clear relationship between earnings yield and inflation. When inflation goes up, the earnings yield also increases (meaning the P/E ratio goes down). The statistical correlation between the two data series is more than 70%.

In the 1970s and 1980s, inflation was higher than we’ve ever seen it. At one point, inflation reached nearly 15%. At that time, the earnings yield for stocks reached nearly 15%. If you flip a 15% earnings yield back into P/Es - we calculate 1 / 15% = 6.7. So high inflation means high earnings yield (low P/E ratio).

The reverse is also true. When inflation is low, earnings yields should also be low (P/E ratios high). And that is what we have seen. In periods where inflation has been less than 3%, earnings yields have averaged approximately 5.2%. Flipped upside down, that means the P/E in those low inflation periods was 1 / 5.2% = 19.

So that brings us to one last chart. This shows the “real” earnings yield for stocks, which is simply the earnings yield (E/P) minus inflation. According to our research, this metric is a much better indicator than the simple P/E for determining the relative value of stocks at any given point in time.

When the real earnings yield (blue line) has been below the long-term average (orange line), that has meant that stocks were overpriced relative to the then current inflation levels. When the real earnings yield have been higher than the orange line, stocks have been a good buy.

You can see that this model correctly predicted that stocks were way overvalued in the mid-1970s, early 1980s, in 1987, during the “tech bubble” in the early 2000s, and during the Great Recession of 2008.

It also correctly indicated that stocks were a great value in the early 1980s and again in 2009.

So… Are Stocks Overpriced Today?

Today’s real earnings yield spread is 4.4%, which is significantly higher than its long-term average. If the earnings yield were to trade at it historical relationship to inflation, the appropriate real earnings yield today would be 2.8%. When you add back current inflation of 1%, we see that the appropriate earnings yield for the S&P 500 is about 3.8%. When you flip that upside down into P/Es, we get 1 / 3.8% = 26.3.

Are we suggesting that P/E ratios should go to 26.3? Not necessarily. But we are saying that the current low-inflationary environment should result in stocks trading at higher P/E ratios than the “average P/E.” If we were to see inflation remain at 1% for the next decade, it is entirely possible (and reasonable) that stocks could head towards a P/E of 25+. The CNBC broadcasters are starting to sweat at the thought of it.

For those of you that are still skeptical that stocks can go higher from here, just think about this. The current real earnings yield for the S&P 500 is 4.4%. There have been 123 months since 1960 when stocks have traded for a higher yield than that. With those months as a starting point, the average return over the next year was 21.5%.

So can P/E ratios expand from here? History tells us overwhelmingly that they can. Not only that, but the current inflationary environment says that they should.

Conclusion

Are we saying stocks are going to go up 21.5% over the next 12 months? Maybe yes, maybe no. There is reason to believe that the current slow economic growth will likely reduce future earnings growth and, thus, impact future stock returns. However, it should be clear that stocks are not trading at significant premiums to where they should be. Unless earnings collapse or inflation explodes, stocks could (and probably will) continue to move higher on the back of rising P/Es.

So next time you’re out with your friends or watching some talking head on CNBC and the topic of P/E ratios being high – remember that average P/Es are meaningless as a valuation tool. Anyone who says they should trade at 16.5x just because that has been the average doesn’t know what they are talking about. There is no such thing as a normal P/E.

Mad Markets: Why This Correction Is Just Noise

noreply@blogger.com (Greg Donaldson) — Mon, 15 Feb 2016 20:47:00 +0000

Stocks can decrease in value for any number of reasons -- many of which don’t make a whole lot of sense. Hillary Clinton tweets about drug pricing and all Healthcare stocks decline in value. The Fed raises rates and stocks go... up? Wait, and then the Fed raised rates too soon -- so now stocks go... down? Then oil prices collapse, which means the largest part of the U.S. economy (consumers) is now doing better. Sell, sell, sell!

The manic depressive behavior of the stock market is maddening. That’s why you can drive yourself nuts checking your account five times a day. It’s going to be up and down -- sometimes for no apparent reason.

But let’s take a step back here and get back to the basics. What is a stock? It is ownership shares in a real, tangible business. If stocks represent companies, the real question is not what the stock market says they are worth. The real issue is: What are the underlying companies worth?

If you own your own business, its value to you is represented by one thing: How much cash that business produces for you each year. Let’s say your company produces $10,000 per year in cash profits. The year after that, it generates $12,000. Then $15,000. Then $20,000.

What is happening to the value of the business? It’s going up, of course.

On the other hand, if your $10,000 profits fall to $8,000 then $6,000 then $0 -- what is the business worth? Well, not much. You’d be better off in a checking account.

The stock market is down by 12% to start the year. Traders have decided that U.S. businesses are now worth 12% less than they were just 42 days ago. Does that make any sense to you? Is it possible that companies have lost more than a tenth of their earnings power in just 1.5 months?

Probably not.

So if we can’t rely on the stock market to value businesses, on what do we rely?

Where Real Company Value Comes From

Going back to 1960, our valuation models indicate that dividends and earnings can explain more than 90% of the annual movements of stock prices. That means 10% of the market’s movements is just “noise” -- shouting broadcasters on Fox news, tweets from political leaders, and the latest news flash.

The 10% is what we see every time we check our account statements. It’s either + or - some number. But that’s not reality. The reality is in the 90%: the dividends and earnings. Over an extended period, these two forces will drive stock prices either higher or lower.

So what has happened to the real value of U.S. businesses over the past 1.5 months? Let's look at what drives value: dividends and earnings.

Dividends

Since the beginning of 2016, the dividend announcements for S&P 500 companies has been impressive.

Companies in the S&P 500 have increased their dividends by 0.7% so far in 2016. That’s on pace for 6.2% annual growth. That rate of increases isn’t impressive, but remember that many Energy companies are cutting their dividends. So the rest of the sectors are doing quite well.

Perhaps more importantly, the dividend estimates have been coming in about in line with expectations. Unless we start to see disappointing announcements, dividend growth appears stronger than the long-term average of 5.5%.

Earnings

If dividends aren’t declining, falling stock prices must be mirroring earnings. Dividends come from earnings, so a sharp drop in earnings will impact a company’s ability to pay and grow dividends in the future.

By our calculations, the market is pricing in a 24% decline in earnings for 2016. If other investors expect a reduction of that magnitude, where will it come from?

The most obvious place is Energy and Materials. These sectors’ earnings declined 57% and 15%, respectively, in 2015. If they repeated that performance in 2016, that would drag down the overall S&P 500’s earnings by less than 4%.

OK, so a 24% decline in earnings isn't solely from Energy and Materials. Where else will it come from? For another 20% decline in earnings, we need widespread earnings recession across all sectors.

But we’re not seeing that.

The Consumer Discretionary earnings continue to be strong (+15% year-over-year). Excluding the dollar’s impact, Consumer Staples companies are reporting impressive numbers. Healthcare continues to be a bright spot despite political issues (+12%). Utilities (+4%), Technology (+7%), and Telecom (+16%) are also showing strong earnings growth.

Patches of the Industrial sector have seen earnings expectations decline, but overall -- the industry still reported positive year-over-year growth in the most recent quarter. The lower expectation for Fed rate hikes has hurt the Financial sector, but not enough to drag down the S&P 500’s earnings by 20%.

When you add it up, the overall expectations for earnings are diminished, but not by anywhere close to what the market has priced in. As of February 15th, earnings expectations had declined by 3% in 2016. That’s not enough to warrant what we’ve seen from stocks.

Conclusion

If dividend and earnings are still largely intact, we can conclude that the fundamental value of U.S. businesses is relatively unchanged. If that’s the case, then the market’s 12% drop for 2016 has been mostly driven by “headline risk” rather than real decay in fundamentals.

As an investor in stocks, you can’t focus on the market prices on a daily basis. That’s maddening.

Ask yourself two questions:

1) Do I believe that U.S. corporations are going to be earning more money in 10 years?

2) Do I believe that those companies will be paying out more cash dividends in 10 years?

If the answer to both of those questions is “Yes” -- you will be rewarded for owning dividend paying stocks. Over the long term, higher earnings lead to higher dividends, which leads to higher value of the companies that pay them. The stock market prices will have no choice but to follow.

We can’t know what tomorrow holds. The stock market could be in a good mood, or it could be in a bad mood. What we can know is that dividend payments will continue to be paid. And those checks will continue to grow each and every year. As long as this continues, these market gyrations don’t make a difference for disciplined investors.

The Dividend Investor's View of Market Volatility

noreply@blogger.com (Greg Donaldson) — Fri, 28 Aug 2015 20:59:00 +0000

Today marks the close of one of the wildest weeks we’ve seen in the U.S. stock markets in a long time. At DCM, we have developed several valuation models that help us gauge where the fair value of the major indices are at any given time. These models help us separate the emotional roller coaster of the stock market against the reality of what the fundamentals are telling us.

We know these models are never going to be 100% accurate, but they have been particularly good over the long-term. We have used them for many years to help us navigate uncertain times. With the markets getting choppy this week, we thought it would be helpful to show you what those models are currently saying.

Model #1: Long-Term Divearn Model (going back to 1962)

This model uses dividends amongst a couple other variables to predict the fair value of the S&P 500 index. This model has predicted roughly 91% of the movement of stock prices going back to 1962. For brevity’s sake, we’ve shown only the years from 1990 through 2016 in the chart below.

The grey bars represent DCM’s predicted fair value. The “blue shadow” represents the model’s error range. And the red line is the S&P 500’s actual price.

As you can see, the red line (price) always tends to move towards fundamental value (grey bars). In most years, the S&P 500’s price stayed within our model’s fair value range (blue shadow).

Over the years, this model has been very effective. The market was grossly undervalued in the early 1990s before becoming grossly overvalued in the late 1990s. In 2002, the market came right back down to fair value. The financial crisis of 2008-09 again presented a great value. Since then, the market has moved up towards fair value and stayed right with our predicted fair value.

At this moment, the model is predicting the current fair value of the S&P 500 is 2,148 (+8% from here). There is an error on either side of that number. The market’s low this past week was 1,867 – just modestly below the lower range of our model’s estimates.

Model #2: Forward Divearn Model (going back to 2009)

The second model uses the same inputs as the first, but with two differences: (1) It uses forward earnings/dividends and (2) it uses the most recent 6 years (2009-2015). It has predicted roughly 93% of the movement of stock prices going back to 2009.

Again, you can see that the price (red line) follows closely to the fundamental value (blue bars). The market got outside of the error range (blue shadow) in just 5 out of 23 quarters.

You will note that the market got too high in the 1st quarter of 2015. Since that brief overshoot, we’ve seen stock prices go flat and now down. The primary culprit was the decrease in the energy sector’s forward earnings. Once those were past us, we’ve started to see fundamental value increase as we move towards the end of 2015.

You’ll notice that the S&P 500’s price has reached the lower end of the model’s range. This would suggest that stocks are trading at a discount to their current fundamental value. According to this short-term model, the fair value of the S&P 500 over the next 12 months is 2,153 - a roughly 9% discount from the market’s price as of today (Friday).

What Does It Mean For You?

Both of our models are saying the same thing. As long as there is not a recession on the horizon, these models give us confidence that stocks present a good buying opportunity at this point. As we talked about in a previous blog post, the “dog” (stock prices) can’t get too far away from their “master” (dividends) over a long period of time.

While this market volatility can shake your confidence, it presents an opportunity for the long-term investor. Looking at the fundamentals (dividends and earnings), it appears that we are trading lower than we should be.

F.A.N.G.: The 4 Companies Driving the Stock Market

noreply@blogger.com (Greg Donaldson) — Tue, 11 Aug 2015 17:17:00 +0000

2015 has been a challenging year for investors in individual stocks. So far this year, we’ve seen the price performance of individual stocks vary much more than it had been previously. If you haven’t been invested in the right sector or had a decent amount of your portfolio in just a few high growth stocks, it is unlikely that your portfolio has kept up with the S&P 500.

Nothing illustrates this more than the acronym FANG, which stands for the darlings of 2015: Facebook, Amazon, Netflix, and Google. As a whole, these stocks have accounted for more than 75% of the S&P 500’s returns year-to-date.

Amazon is up 68% so far this year. Facebook and Google are both up by 21%. Netflix is up a staggering 153%. These four stocks comprise just 3.5% of the S&P 500, yet have contributed 75% of its performance. Together, they have driven the S&P 500’s total return up by 1.6%. The S&P 500 is up by just 2.1% so far this year.

If you own individual stocks and you don’t own these four companies, your portfolio is going to have a very hard time getting close to the market’s performance.

The question that must be asked is this: If just four stocks in the S&P 500 have been doing so well, why not own these four stocks? Why not buy shares in Amazon, Facebook, Google, and Netflix?

None of them pay a dividend.

An investor who puts money into a stock that doesn’t pay a dividend can only profit in one way: If someone else is willing to pay them more for their shares in the future.

We invest in companies for which their market price growth closely follows dividend growth. A company that pays a dividend has shown that it can create cash from its business operations and is willing to share that cash with shareholders.

A company that doesn’t pay a dividend either (1) doesn’t make money consistently enough to afford to pay a dividend (2) is growing rapidly or (3) is not shareholder friendly.

Without a dividend, a company’s stock price is based far more on speculation about future earnings. We’ve seen over time that earnings can be volatile. In 2008-09, earnings for the companies in the S&P 500 plunged by more than 50% with price going right along with it.

They all trade for extremely high multiples.

The price-to-earnings (P/E) ratio is a quick way to see how optimistic other investors are about a stock’s future. It tells us how much investors are willing to pay for $1 of that company’s earnings. The current P/E for the S&P 500 is right around 18. That means the average stock delivers $1 in earnings for every $18 the investor pays to own it. That represents an annual return on investment of 5.6% ($1 divided by $18).

All four of these stocks are trading at extreme premiums to the rest of the market. Facebook’s P/E is currently just under 100. Netflix trades for a staggering 277 times earnings. And Amazon doesn’t even have a P/E because it doesn’t have positive earnings over the past 12 months. Google appears to be the “value” of the group trading at a price-to-earnings (P/E) ratio of 33.

The higher a P/E investors pay, the more hope they are putting in the future. If the next few years don’t pan out like investors currently expect, a company trading at a sky high P/E can see its stock price fall dramatically. Buying these stocks means signing up for a return on investment of:

$1 divided by $33 = 3% (GOOG)

$1 divided by $100 = 1% (FB)

$1 divided by $277 = 0.36% (NFLX)

$1 divided by negative profits = ? (AMZN)

If these companies don't have dramatically higher earnings in the future than they have today, their returns will be unattractive, to say the least. The only way you can profit from these shares is if you can find someone to pay even more at some point in the future.

Who knows what these stocks are worth?

Are these P/E ratios too high? Maybe. They might also be too low. No one has any idea what Facebook, Netflix, Google, or Amazon will be worth 10 years from now.

It’s quite possible that one or more of these companies will be trading far higher than they are today. It’s also quite possible that at least half of these companies will have been replaced by the latest and greatest technology of the day.

What’s clear is that earnings are not the major factor underlying the current market price per share. Instead, it’s what each investor is willing to imagine about the company’s future.

Trying to predict the future of these companies is nearly impossible. Predicting what people will pay for them is even more impossible. We believe most investors would be better off not to try, especially not with money they need to live on in retirement.

Conclusion

Wall Street is obsessed with trying to find the next “home run”. Who is the next Netflix or Facebook? Who is going to triple in price over the next few years? Betting on these types of stocks is not much different than going out to the casino and plopping down money on the roulette wheel. Your payout is big when you win, but the odds are against you over the long-term.

We find it much easier to hit “singles and doubles” investing in high-quality dividend growth stocks. Our multiple regression tool helps us identify stocks that are 10% to 25% undervalued. We know these companies aren’t going to blow the doors off of the market, but we do know this: The price of nearly every company in our portfolio is highly predictable based upon its future dividend payments.

For virtually all of the companies we invest in, the dividend has predicted 80-90% of the movement of its stock price over a multi-year period. That gives us confidence that our portfolios will continue to grow in value over the long-term. Investors in FB, NFLX, AMZN, and GOOG can’t say the same.

NOTE: Data as of 8/7/2015

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Companies Paying Dividends Paid

Companies Cutting Dividendsd

Companies Raising Dividends

363

47

146

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Dividend Paid

Dividend Increased

Dividend Decreased

361

98

35

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Dividend Watch: Increases Still Outnumber Decreases

Dividend Paid

Dividend Increased

Dividend Decreased

192

96

27

We believe more cuts are inevitable as companies are forced to take government bailouts in the months ahead. However, we believe total dividend cuts by S&P 500 companies will be far less than the 25%-30% levels predicted just a month ago, perhaps less than half that number.

Dividends Are Not Dead--They're Still Growing

Dividend Paid

Dividend Increased

Dividend Decreased

187

87

21

Dividend Watch: Recent Corporate Dividend Announcements

At&T reiterates confidence in its dividend despite economic uncertainty.

Barring an Extremely Adverse Scenario, JP Morgan Hopes to Maintain Dividend

Walgreens Expects to Continue Dividend For Now

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Dividend Paid

Dividend Increased

Dividend Decreased

43

10

18

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