Edson Gould’s SRL: Chipotle Mexican Grill Downside Target Update

Posted on October 6, 2012 by | Leave a comment

In a series of articles examining Edson Gould’s Speed Resistance Lines (SRL), we put some big name stocks to the test.  The test was to see if Gould’s SRL had any reasonable predictive ability to determine the downside targets for the stocks in question.  The results have been astounding and are well worth your careful consideration.

First, we will review the SRLs for Netflix (NFLX) and Green Mountain Coffee Roasters (GMCR) and the outcome of the analysis related to Gould’s indicator.  Next, we will review the updated Chipotle Mexican Grill (CMG) downside target.

The first stock that we applied the SRLs to was Netflix (NFLX) on December 3, 2010.  At that time, NFLX was trading at $205.90.  When the stock rose to the eventual peak of $298.73, we thought that maybe the SRL was a waste of effort.

However, almost one year to the day after we ran the SRL on Netflix, the stock had broke through our conservative downside target of $117.76.  Even more amazing, NFLX later declined below the extreme downside target that we set at $68.63.  Today Netflix trades at $66.56.  Because we’re not short-sellers, we did not take any position on the decline of the stock.  However, we were able to buy the stock at $62 and sell the stock at $100 in the subsequent rebound from the initial low.

The next stock that we applied the SRL to was Green Mountain Coffee Roasters (GMCR) in our October 25, 2011 review of Edson Gould’s formula.  At the time, GMCR was trading at $64.75 after declining –42% from the peak in the stock price on September 19, 2011.  There were some who said that the stock was a bargain and should be bought.  However, Gould’s SRL indicated that at minimum, GMCR was to decline to $59.93 and possibly decline to the $37.21 level.

In a May 2, 2012 revision of Gould’s SRL for Green Mountain Coffee Roasters (GMCR), when the stock was trading at $28.50, we suggested that the stock could trade down to $22.53 with and additional downside target of $8.30.  Today GMCR trades at $22.13 (see chart above).

In the same October 25, 2011 review of Green Mountain Coffee Roasters, we covered Chipotle Mexican Grill (CMG).  At that time, Gould’s indicator suggested that CMG had a conservative downside target of $200.59 and an extreme downside target of $114.16.  As we’ve indicated in the past, SRLs are based based on the highest price the stock attains. In this case, CMG rose as much as +45.70% since our October 25, 2011 article.  Below is the revised SRL for CMG.

image

Based on the high of $440.40, Chipotle Mexican Grill has a conservative downside target of $233.23 and an extreme downside target of $146.80.  We’re cautious about anyone who suggests that CMG is a “good buy” or “undervalued” at the current price. Already, we’re within striking distance of the $233.23 conservative downside target as CMG trades at $280.93 after hedge fund manager David Einhorn recently recommended selling the stock short (article found here).  If past use of SRL is any indication, when CMG declines below the upward trending conservative downside line, you can be assured that the stock will hit $233.

Again, our purpose of using SRLs to determine the downside risk of a stock that we’d like to buy but don’t want to chase.  We’re willing to wait for the eventual decline or admit that we missed the boat on a great investment opportunity.  Again, we don’t sell stocks short because we’re interested in acquiring great companies at the best price possible.

Disclaimer: This piece is a continuation of the examination of Edson Gould's speed resistance line as explained in prior articles. This is not an endorsement to sell short at the current levels nor buy these stocks once falling below the extreme downside targets since the stocks have been randomly selected, at best.

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U.S. Dividend Watch List: October 5, 2012

Posted on October 6, 2012 by | Leave a comment

Below are the 27 companies on our U.S. Dividend Watch List that are within 11% of their respective 52-week lows. Stocks that appear on our watch lists are not recommendations to buy. Instead, they are the starting point for doing your research and determining the best company to buy. Ideally, a stock that is purchased from this list is done after a considerable decline in the price and rigorous due diligence.

Symbol Name Price % Yr Low P/E EPS (ttm) Dividend Yield Payout Ratio
INTC Intel Corp.  22.68 1.84% 9.61 2.36 0.90 3.97% 38%
CLC Clarcor Inc. 44.24 1.89% 18.21 2.43 0.54 1.22% 22%
EXPD Expeditors International 35.55 2.07% 21.16 1.68 0.56 1.58% 33%
IBKC IBERIABANK Corp.  45.73 2.86% 20.60 2.22 1.36 2.97% 61%
CRR Carbo Ceramics, Inc. 63.17 2.98% 11.06 5.71 1.08 1.71% 19%
ABM ABM Industries, Inc. 18.49 3.59% 19.06 0.97 0.58 3.14% 60%
FRS Frisch's Restaurants, Inc 19.39 5.15% 45.09 0.43 0.64 3.30% 149%
WGL WGL Holdings, Inc. 39.70 5.44% 20.15 1.97 1.60 4.03% 81%
MATW Matthews International Corp.  29.47 5.70% 13.27 2.22 0.36 1.22% 16%
MCD McDonald's Corp.  91.00 5.91% 17.11 5.32 3.08 3.38% 58%
ERIE Erie Indemnity Company  64.77 5.95% 23.05 2.81 2.21 3.41% 79%
JW-A John Wiley & Sons Inc. 45.89 6.13% 14.12 3.25 0.80 1.74% 25%
ETP Energy Transfer Partners 43.59 6.97% 9.25 4.71 3.58 8.21% 76%
ED Consolidated Edison, Inc.  60.22 7.40% 16.64 3.62 2.42 4.02% 67%
VVC Vectren Corp. 29.10 7.74% 15.00 1.94 1.40 4.81% 72%
HRL Hormel Foods Corp. 29.45 7.95% 16.36 1.8 0.60 2.04% 33%
CWT California Water Service 18.59 8.46% 21.13 0.88 0.63 3.39% 72%
BUSE First Busey Corp.  4.80 8.60% 19.20 0.25 0.16 3.33% 64%
ANAT American National Insurance 72.39 8.73% 10.71 6.76 3.08 4.25% 46%
LM Legg Mason, Inc.  24.35 8.90% 22.55 1.08 0.44 1.81% 41%
PPL PP&L Corporation 29.12 9.15% 9.90 2.94 1.44 4.95% 49%
PBI Pitney Bowes Inc  13.81 9.26% 4.04 3.42 1.50 10.86% 44%
UNM Unum Group 19.98 9.30% 27.00 0.74 0.52 2.60% 70%
CAH Cardinal Health, Inc.  40.52 9.78% 12.99 3.12 0.95 2.34% 30%
OMI Owens & Minor, Inc. 30.17 10.23% 16.40 1.84 0.88 2.92% 48%
APD Air Products & Chemicals 83.90 10.24% 13.30 6.31 2.56 3.05% 41%
MCY Mercury General Corp. 39.91 10.83% 15.23 2.62 2.44 6.11% 93%
27 Companies

Watch List Review

Topping out list this week is Intel (INTC).  We’ve been watching and waiting for the number one chip maker to appear on our list and it did so at the top.  Pressure from the slowing PC market and little presence in the tablet market pushed the stock down below $23.  Earning estimates has been coming down and analysts now expect the company to earn $2.19 next year, a forward P/E of 9.6.  Current dividend yield is 4% and payout ratio of 38%.  We were excited to see this stock trade down to the current level that added Intel to our holdings (refer to our transaction alert here).

Clarcor (CLC), maker of filtration products, came into our top five for the first time.  The company raised its dividend by 12.5% at the end of September.  Although dividend yield is only 1.22%, it is higher than its 5-yr average yield of 0.9%.  The stock has been under pressure because profit in the third-quarter fell 5% and missed analysts’ consensus by $0.09.  We don’t know much about this company but should have more information on it soon.

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Market Cycles Revisited

Posted on October 5, 2012 by | Leave a comment

Below is a revised piece that was originally published on December 15, 2008 at our former blog at Dividend Inc. (original posting found here.)  This posting is necessary for all visitors to our site.  It covers the market cycles based on what we believe are the best sources of data.  These cycles are subject to revision if more consistent data can be located and verified.

Article Summary:

  • Stock market cycles are 33 years with the mid-point being 17-19 years.
      • as an example, if the peak in the bull market was 2007 then the next peak is expected near 2040.
  • Real estate cycles are 18 years with the mid-point being 8-10 years.
      • as an example, if the bottom was in 2010 the next bottom will be near 2028 (our latest RE article based on this cycle can be found here).
  • Inflation cycles are 50 years with the mid-point being 25-29 years.
      • as an example, the last peak in inflation was 1980, the next peak is expected near 2030.

December 15, 2008 Article:

In the right hand column I have added the cycles for three different markets. The cycles that I have added are for the stock market, real estate market and inflation. These three are necessary for anyone who is interested in investing, saving or spending their money in the "long-term." As far as I'm concerned the long-term is only as long as you're willing to wait for the next cycle top. If a person doesn't have the time to wait until the next cycle top then they should be in the most conservative "guaranteed money" vehicles that are available. I have a section on the lower right hand column that quotes the most current money market and certificate of deposit rates that can be obtained.

First is the stock market which has, in general, a full cycle of 33 years from peak to peak or trough to trough. In the most recent period, the stock market had a run from the bottom in 1974 to 2007 (33 years). The period when the Dow went from 100 to 1000 took 32 years. When the Dow went from 1000 in 1983 until 10,000 which was accomplished in 17-19 years or half the 33 year cycle range.

Another perspective on the stock market cycle could be viewed from the length of prior bull and bear markets. In the preceding bear market when the Dow stayed at or below 1000 from 1966 to 1982 lasted for 16 years. The bull market in the Dow from 100 in 1942 until the high of 1000 in 1966 lasted for 24 years. When the Dow was at 100 in 1906 and didn't cross over 100 until 1925 lasted 18 years. Obviously there are many ways to view the stock market cycles. I have chosen to use 33 year cycles until better or more convincing information comes along.

Next, we have the real estate cycle. There is only one source that I rely upon for real estate and that is Roy Wenzlick. Mr. Wenzlick's insights and statistical analysis of St. Louis and national real estate is unparalleled. The way that I found Roy Wenzlick was while thumbing through the 1987 book, "The Wall Street Waltz," by Kenneth Fisher. In the last paragraph referencing Mr. Wenzlick's real estate cycle chart we have this quote from Mr. Fisher, "The next long cycle trough isn't until 1990, which means that real estate has some bad years still coming- perhaps until 1992." When you add 18 years to 1990 or 1992 you get the next real estate cycle bottom in 2008 to 2010. As we are already in 2008 the bottom might be in however I'll opt for 2009 or 2010 just to play it safe. How prescient is that? What's more fascinating is that Mr. Wenzlick passed away in 1989 but his research on real estate is still useful. Mr. Wenzlick called almost all real estate cycle peaks and troughs since the initiation of his Real Estate Analyst newsletter in 1932.

Finally, we have the inflation cycle which has an inverse relationship to the interest rate cycle. The inflation cycle is much longer than the prior two cycles and lasts 50 years from peak to peak or trough to trough. As some readers will remember, our last peak in inflation was around 1980. From 1980 we have seen inflation slowly fall from double digit figures to our current level of nearly zero. Presently we are on track towards 25 to 27 years of a reversal in inflation. The only thing left before we're on that path is to get past the next couple years of disinflation/deflation.

A good book to refresh yourself on where we have come from and where we are going to, in terms of inflation, is titled, "Is inflation Ending? Are You Ready?" This book, written by Forbes columnist A. Gary Schilling, was published in 1983 and predicted everything that has happened since. The chapter titled "Apocalypse Now? The Risk of a Financial Collapse" is interesting since the subsection headings have titles that are eerily relevant to today. Some sample titles are:

  • Thrift institutions: Why Merging the Strong and the Weak May Be Throwing Good Money after Bad (WaMu, IndyMac and Citigroup)
  • Municipalities: Will Defaults Throw the Market into Turmoil? (California, anyone?)
  • Financial Markets: Speculative Excesses Could Cause a Panic (Fannie Mae, Freddie Mac, Bear Stearns, Lehman, Merrill Lynch)
  • Money Market Funds: The threat of a Redemption Stampede (recent breaking of the buck)

If you could have read this book back in 1983 then you probably wouldn't be surprised by any of the headlines that we see today.

The cycle information that I have provided on the right hand column is intended to be for reference purposes. I expect that as time passes these cycle periods will be reviewed and changed according to the quality research and data that I come across. I feel that as investors we should put all of our investments in perspective especially relative to the "big picture." Investing, saving or hoarding any other way would be spitting into the wind.

Sources:

  • Fisher, Kenneth. Wall Street Waltz. Contemporary Books. 1987. page 132.
  • Shilling, A. Gary and Sokoloff, Kiril. Is Inflation Ending? Are You Ready?. McGraw-Hill. 1983. page 151

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Transaction Alert: Bought Intel (INTC) at $22.84

Posted on October 5, 2012 by | Leave a comment
  • We have taken a 15% position in Intel (INTC) at the average price of $22.84.  We expect to add to this position as the price declines to the $16 level.

Intel (INTC) is being purchased for the following reasons:

  • Trading at 9x earnings
  • At $22.47, the stock is within 3% of the one year low
  • The stock has a 4% dividend yield, the ex-dividend date is approximately November 2, 2012
  • INTC has increased the dividend steadily since 1992, the annual rate of increase has averaged 31% since 2003
  • Trading at 5.7x cash flow; Value Line indicates that fair value is at 10x cash flow, nearly double the current price

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Dow Theory: Not Broken, Just Misunderstood

Posted on October 1, 2012 by | Comments Off on Dow Theory: Not Broken, Just Misunderstood

Barron’s attempts at Dow Theory has failed miserably…again. In the September 29, 2012 article by Jacqueline Doherty titled “Broken Dow Theory,” it is suggested that “A lagging transportation sector historically has been considered a bad omen…” and then recites the standard, sub-standard nomenclature “…less shipping means fewer goods are being produced and purchased, which means the economy is slowing and the stock market could be headed for a fall.” Doherty goes on to cite data from Bespoke Investment Group asserting that even though the Transportation index has fallen behind the market in general, it may not mean that the stock market, as represented by the S&P 500, necessarily needs to follow the same script.

Fortunately, Dow Theory is very specific about how to interpret the Dow Jones Industrial and Transportation Averages since the publication of Robert Rhea’s book The Dow Theory. Nowhere in the rules of Dow Theory is there any indication that the vacillations of the S&P 500 are remotely part of the interpretation of the theory. Especially since the S&P 500 came onto the scene over 60 years after the creation of the Dow Industrials.

Despite the fact that there are some Dow Theorists who frequently use the S&P 500 as a substitute for indications of a rising or falling market (this isn’t Dow Theory), there is little evidence that using the additional index is necessary. Alternate indexes are only necessary when and if the Dow Jones Industrial and Transportation Averages no longer exist.

While the prevailing opinion is that the Dow Industrials isn’t a relevant index reflective of the market as a whole, a distinction should be made between a “lagging” index and a “divergent” index. A lagging index is one which is going in the same direction as the other but is not increasing/decreasing at the same rate. A divergence is when one index goes up while the other index is going down. The chart below shows two failures and one divergence between the Industrials and Transports.

image_thumb[8]

When one index cannot make new highs in accordance with the other index, it should be considered a significant failure and a warning sign. A perfect example is when the Transportation Index made a new high in 2008 and the Industrial Index could not follow through. The subsequent decline in both indexes was staggering.

In situations where there has been a divergence between the Dow Industrials and Transports, it is the Transports that typically leads the divergence to the upside or downside, meaning that the Transports will provide a clue as to the potential market direction in spite of the action of the Dow Industrials. Although historically this has been the case, Barron’s has unwittingly legitimized the view that the spread between the Dow Industrials and Dow Transports is some form of Dow Theory. In no way is this the case. In fact, in the period from 1896 to 1984, the Transports have exceeded the Industrials, on a percentage basis, 15 out of 25 Dow Theory bull and bear market moves.

Year DJI beat by DJT beat by Year DJI lost by DJT lost by
1896 33.50%   1899 -13.30%  
1900   51.00% 1902 -6.40%  
1903 88.60%   1906 -7.30%  
1907 24.50%   1909 -5.30%  
1910 10.10%   1912 -13.80%  
1914 78.70%   1916 -3.10%  
1917 64.80%   1919 -26.00%  
1921 18.40%   1922   -2.30%
1923 192.30%   1929   -3.80%
1932   15.60% 1937   -21.40%
1938   20.60% 1938   -6.40%
1939   20.30% 1939 -5.30%  
1942   64.40% 1946   -16.50%
1947   39.40% 1948   -20.50%
1949   92.50% 1953   -6.50%
1953 3.80%   1956   -27.80%
1957   819.90% 1959   -12.40%
1960 5.80%   1961 -2.90%  
1962   48.80% 1966   -7.00%
1966   19.20% 1968   -22.30%
1970   82.40% 1972   -14.50%
1974   10.00% 1976 -13.10%  
1978   86.50% 1981   -10.60%
1982   44.00% 1983   -9.70%
1984   177.80% 1984   -31.00%
           
  DJI DJT   DJI DJT
Total 520.50% 1592.40% Average: -9.65% -14.18%

The table above reflects the percentage by which the respective indexes exceeded the other from either the bull market low or the bear market top. In the timeframe indicated above, the Transports have routinely exceeded the Industrials to the upside by nearly three times. The same is true for Dow Theory bear market moves where the Transports have excessive downside moves as compared to the Dow Jones Industrial average by nearly 50%.

The pattern of excessive gains and losses in the Transports versus the Industrials has remained the case since 1984. As an example, at the peak in 2007, the Dow Industrials declined –54% while the Transports declined –60%. On the rise from the 2009 bottom, the Industrials and Transports registered gains of +110% and +162% based on their respective peaks. Excessive gains and losses, by the Transports above that of the Industrials, demonstrates that the Transports usually act as a leading indicator of market direction.

It should be noted that before the work of Wall Street Journal editor William Peter Hamilton and author Robert Rhea on the topic of Dow Theory, Charles H. Dow (co-founder of the Wall Street Journal) created and analyzed the Rail Index (now Transports) without the existence of the Dow Industrials for 12 years, from 1884 to 1896, for indications of market direction. Those 12 years are the basis of what Dow was able to formulate his observations on the market.

Unfortunately, the Barron’s article goes on to quote a CIO who states that the “…Nasdaq 100 and S&P 500 are better leading indicators than the transports.” Based on the available data, the Nasdaq 100 has not been able to exceed the all-time high set in January 2000. Additionally, the S&P 500 has not managed to exceed the all-time high set in October 2007. In the bull market run since the 2009 low, the Transportation Average has managed to exceed its all-time high unlike the Nasdaq 100 and S&P 500.

Finally, Barron’s quotes data from Bespoke which reviews, “…periods when the S&P 500 exceeded the transport index by 10 percentage points over a 50-day trading period. Going back to 1928, the S&P 500 gained 1% in the subsequent six months, not awful although below the average six-month gain of 3.5%.” Using a “50-day trading period” to arrive a conclusion about the next six months is inadequate in making even a cyclical determination of a bull or bear market based on Dow Theory, let alone a secular indication. Dow Theory is about the primary trend of the market which tends to last from 3-4 1/2 years at a time.

In order to make a “complete” secular and cyclical analysis based on Dow Theory, interpretation should begin at the prior dual Industrial and Transport peaks in 2007/2008, at minimum. Until there is a dual Industrial and Transport new high, cyclical new highs in one index or the other would be a bear market reaction as indicated in our August 9, 2011 note titled “Bear Market Rally Targets.” Our indication that a bear market rally was about to take place was with 2% of the October 3, 2011 low, giving full opportunity to seek out new investment opportunities before the bear market rally to the current peak in the Industrials. The current divergence of the two indexes is confirmation of the fact that we’re still in a bear market rally until the prior 2009-2011/2012 highs are exceeded for a cyclical bull market and all-time highs for a new secular bull market.

Until 1956, Barron’swould include Dow Theory analysis in the Market Laboratory section every week. Since 1956, Dow Theory would show up only in feature articles from experts on the topic. Now, it seems that anyone making mention of either the Dow Industrials or Dow Transports can suffice as knowledgeable on the topic of Dow Theory.

Naturally, there are many critics who adamantly speak out against Dow Theory, which is surprising since Charles H. Dow’s work of creating the Wall Street Journalalong with his theories of the stock market are the foundation of both fundamental and technical analysis in the United States. However, the critics, even without knowing the nuances of Dow Theory, are justified in their claims especially when the “analysis” is so incomplete and inaccurate.

If the goal is to do away with Dow Theory and eliminate the indexes then that is fine. However, if the goal is to actually interpret the theory in some mediocre fashion then it should be done by someone who has actually studied the topic extensively. Barron’s, a place where William Peter Hamilton and many other great Dow Theorists were prominently featured, is doing a disservice by connecting unrelated and disparate themes and suggesting that somehow the theory is “broken.”

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U.S. Dividend Watch List: September 28, 2012

Posted on September 29, 2012 by | Leave a comment

Below are the 20 companies on our U.S. Dividend Watch List that are within 11% of their respective 52-week lows. Stocks that appear on our watch lists are not recommendations to buy. Instead, they are the starting point for doing your research and determining the best company to buy. Ideally, a stock that is purchased from this list is done after a considerable decline in the price and rigorous due diligence.

Symbol Name Price % Yr Low P/E EPS (ttm) Dividend Yield Payout Ratio
CRR Carbo Ceramics, Inc. 62.92 1.80% 11.02 5.71 1.08 1.72% 19%
IBKC IBERIABANK Corp.  45.80 3.01% 20.63 2.22 1.36 2.97% 61%
EXPD Expeditors International  36.35 4.36% 21.64 1.68 0.56 1.54% 33%
ERIE Erie Indemnity Company  64.27 5.14% 22.55 2.85 2.21 3.44% 78%
UNM Unum Group 19.22 5.14% 25.97 0.74 0.52 2.71% 70%
CAH Cardinal Health, Inc.  38.97 5.58% 12.49 3.12 0.95 2.44% 30%
MATW Matthews International Corp.  29.82 6.96% 13.43 2.22 0.36 1.21% 16%
MCY Mercury General Corp. 38.65 7.33% 14.75 2.62 2.44 6.31% 93%
FRS Frisch's Restaurants, Inc 19.85 7.65% 46.16 0.43 0.64 3.22% 149%
ABM ABM Industries, Inc. 18.93 8.11% 19.52 0.97 0.58 3.06% 60%
ANAT American National Insurance 71.83 8.65% 10.63 6.76 3.08 4.29% 46%
PPL PP&L Corporation 29.05 8.88% 9.88 2.94 1.44 4.96% 49%
WGL WGL Holdings, Inc. 40.25 9.26% 20.43 1.97 1.60 3.98% 81%
RLI RLI Corp. 66.66 9.28% 12.97 5.14 1.28 1.92% 25%
ED Consolidated Edison, Inc.  59.89 9.45% 16.54 3.62 2.42 4.04% 67%
MCD McDonald's Corp.  91.75 9.57% 17.25 5.32 3.08 3.36% 58%
JW-A John Wiley & Sons Inc. 45.95 9.69% 14.14 3.25 0.80 1.74% 25%
VLY Valley National BanCorp.  10.02 10.11% 14.74 0.68 0.65 6.49% 96%
LM Legg Mason, Inc.  24.68 10.38% 22.85 1.08 0.44 1.78% 41%
CWT California Water Service 18.65 10.95% 21.19 0.88 0.63 3.38% 72%
20 Companies              

Watch List Review

Carbo Ceramics (CRR) came back to top our watch list this week.  August 3 was the last time the company topped our list, traded at $64.69.  After falling 2.7%, the stock has a yield of 1.8%, the second highest yield this company has seen.  We saw the stock traded at the highest yield at 2.32% at the market low in 2008.  Our valuation model suggests a fair value of $88 but with possible downside to $45.  While risk/reward of 28/40 is somewhat attractive, we are not comfortable taking position while the Transport is weakening.

IberiaBank (IBKC) reached the top five for the first time on our list.  We know little about this Southeast Regional bank thus we won’t elaborate much about its fundamental.  Technical level shows that $45 is the next support level while a break below that will lead a stock to see $42 support level.  Over the past three years, the stock has been compressing and a break above or below its trend line will determine the major move of the stock.

Top Five Performance Review

In our ongoing review of the NLO Dividend Watch List, we have taken the top five stocks on our list from September 30,  2011 and have check their performance one year later. The top five companies on that list can be seen in the table below.

Symbol Name 2011 Price 2012 Price % change
FNFG First Niagara Financial Group 9.15 8.07 -11.80%
EMR Emerson Electric Co. 41.31 48.27 16.85%
GTY Getty Realty Corp. 14.42 17.95 24.48%
NFG National Fuel Gas Co. 48.68 54.04 11.01%
MMM 3M Co 71.79 92.42 28.74%
      Average 13.85%
         
DJI Dow Jones Industrial 10,913.38 13,437.13 23.13%
SPX S&P 500 1,131.42 1,440.67 27.33%

NLO_20120928

Our top five  under underperformed the market by nearly 10% partly due to the loss from First Niagara (FNFG).  Despite that, other four stocks managed to reach 10% mark within one year time frame.

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Gold Stock Indicator: Performance Review

Posted on September 28, 2012 by | Leave a comment

Article Summary

  • Our Gold Stock Indicator is currently in a rising trend.
  • The XAU Index could rise another +25%, IF prior indications are correct.
  • Gold stocks have registered solid gains since our “blanket” recommendation to buy on July 31, 2012.
  • Our preference for NEM, ABX and GG exceeded returns of FCX, BVN and GFI.
  • NUGT increased +88.19%

Our Take

Gold stocks have registered solid gains since our recommendation on July 31, 2012 (found here).  This recommendation was based on the fact that our Gold Stock Indicator was clearly in the long-term buy range as indicated by the red circle in the chart below:

image

We have a few observations that are worth considering regarding our Gold Stock Indicator.

The current parabolic rise at point (C) is matched by the rise the took place at point (A) and point (B).  Point (A) took place from January 12, 1987 to April 9, 1987.  The rise in the Philadelphia Gold and Silver Stock Index (XAU) at that time was +55.98%.  To put this into perspective, during the same four months, Barrick Gold (ABX) rose +77.36% Newmont Mining (NEM) rose +60.86% and Agnico-Eagle (AEM) rose +33.87%.

At point (B), from February 5, 1993 to June 25, 1993, the Philadelphia Gold and Silver Stock Index rose +54.14%.  Barrick Gold rose +43.29%, Newmont Mining rose +20% and Agnico-Eagle rose +98.34%.

So, what is the message in all this data? In theory, based on the two prior moves at point A and B, The XAU Philadelphia Gold and Silver Index could rise another 25%. If you believe in a further rise in gold stocks, then Barrick Gold is the one to own. You now have the date ranges so you can now compare any other gold stocks that are out there and see if there is a consistent performer out there other than Barrick.

Another observation is that there were three similar powerful parabolic moves that failed at points 1, 2 and 3. Because we really don’t know how much further this rise will go, we always advise that investors take the gains and rotate into whichever gold stocks are currently trading near a new low.

One thing you must remember, gold itself did not perform well in comparison to gold stocks.  In 1987 and 1993 periods mentioned above, gold rose only +2.43% and +14%, respectively.  This is why we call it the Gold Stock Indicator, it reflects the relative outperformance to the upside and downside, as compared to the actual precious metal.

For those willing to accept the risks, two alternatives to owning individual gold and silver stocks could consider Exchange Traded Funds (ETFs) in the form of Global X Silver Miners ETF (SIL) or Market Vectors Junior Gold Miners ETF (GDXJ).  In the period from July 31st to September 28th, SIL increased +36.34% while GDXJ increased +28.46%.  It is important to note that when you eliminate the individual stock risk with these ETFs, you inherit and assume brand new risks that may have not been fully revealed due to the relatively short history  of ETFs.

The performance of all the gold stocks since the July 31, 2012 recommendation are as follows (our picks in yellow):

Symbol
 Name 7/30/2012 9/28/2012 % change
PAAS Pan American Silver Corp. $15.18 $21.44 41.24%
SLW Silver Wheaton Corp. $28.27 $39.71 40.47%
GOLD Randgold Resources Ltd. $91.18 $123.00 34.90%
RGLD Royal Gold, Inc. $76.63 $99.83 30.28%
AUY Yamana Gold, Inc. $15.17 $19.11 25.97%
ABX Barrick Gold Corporation $33.17 $41.76 25.90%
GG Goldcorp Inc. $36.70 $45.85 24.93%
NEM Newmont Mining Corp. $45.06 $56.01 24.30%
SSRI Silver Standard Resources Inc. $13.07 $16.03 22.65%
KGC Kinross Gold Corporation $8.59 $10.21 18.86%
AEM Agnico-Eagle Mines Ltd. $44.16 $51.88 17.48%
FCX Freeport-McMoRan $34.01 $39.58 16.38%
BVN Buenaventura SA $36.89 $38.96 5.61%
AU AngloGold Ashanti Ltd. $34.55 $35.05 1.45%
GFI Gold Fields Ltd. $13.09 $12.85 -1.83%
HMY Harmony Gold Mining Co. Ltd. $10.07 $8.41 -16.48%

As a follow-up, the Direxion Daily Gold Miners Bull 3X Shrs (NUGT) increased by the staggering amount of +88.19%.

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What a Time to Issue a Sell Rating

Posted on September 27, 2012 by | Comments Off on What a Time to Issue a Sell Rating

In honor of the latest “sell” rating on Hewlett-Packard (HPQ), this time coming from Jefferies and Co. (article found here), we’d like to give the “Stock Quote of the Day” to UBS for their sell recommendation of HPQ at the worst possible time (sell recommendation here).  On January 11, 2011, UBS gave a “buy” recommendation of HPQ when the stock was trading at $44.86 (buy recommendation here).  On August 7, 2012, over a year later and after a -58% decline, UBS finally gave a “sell” rating on HPQ.

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A “sell” rating on HPQ after the stock has decline so much in the last two years does not do justice to the use of a buy or sell rating.  We’re not suggesting that HPQ is a “buy” at this point in time.  However, this is traditionally when values are confirm through additional due diligence.  If a person had already held shares of HPQ, the only reason to sell at this point is if you believe the company is going out of business within the next twelve months.

Is it any wonder that investors tend to buy high and sell low?

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Agnico-Eagle Is Now A Sell

Posted on September 25, 2012 by | Comments Off on Agnico-Eagle Is Now A Sell

On April 8, 2012 (article found here), we recommended Agnico-Eagle Mines (AEM).  At the time, we were basing our first individual recommendation of gold stocks on our Gold Stock Indicator.  Our Gold Stock Indicator had been in a declining trend since November 2010 suggesting that no purchase of gold stocks should take place. However, once our Gold Stock Indicator declined below the long-term buy indication in early April 2012, it was a clear signal to start acquiring gold stocks.

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The reversal of the declining trend has been reflected in gains in the gold stock sector across the board.  In our initial analysis of Agnico-Eagle Mines (AEM) we projected that, based on Edson Gould’s Altimeter, the stock price was likely to increase from +100% to +175% over a two year period.  Since our recommendation on April 8th, Agnico-Eagle has gained just over +45%.  Our experience indicates that there will be many opportunities to re-acquire Agnico-Eagle at better relative prices.

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According to Value Line Investment Survey, Agnico-Eagle trades at a fair value of $39.  The current price of Agnico-Eagle, at $49.76, is 27% above the fair value price.  Stocks that are selling above fair value and that have had above market returns should be sold.  Yahoo!Finance and Morningstar.com indicate that Agnico-Eagle is operating at a loss for the trailing 12-months.  We will re-consider Agnico-Eagle when the stock approaches an undervalued range based Edson Gould’s Altimeter.

Those not interested in following through with our sell recommendation can feel comfortable knowing that Agnico-Eagle (AEM) is a reasonable holding until our Gold Stock Indicator crosses above the long-term sell level.  So far, AEM has a 45% downside cushion since our investment observation. It should be noted that the stock faces significant upside resistance at $52 and $60.

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“Apple-Less Dow” is a Good Thing

Posted on September 23, 2012 by | Comments Off on “Apple-Less Dow” is a Good Thing

An article titled “Apple-less Dow faces changes to make-up,” found in the Financial Times, suggests that the current owners responsible for the composition of the Dow Industrials are considering ways to make it possible to add Apple (AAPL) to the 116-year old index. The myopic view of changing the Dow Industrials simply for the purpose of adding AAPL will haunt the index managers and investors alike.

In the past, the changes in the composition of the Dow have been ill-timed to begin with.  In our article titled "Dow Jones' Decline Largely Impacted by Index Changes," we highlight the fact that composition changes routinely negatively impacted the Dow Industrials. Additionally, we have demonstrated that the changes to the Dow Industrials from 1929 to 1932 was the sole contributor to the decline of the index by -89%, when compared to the Barron's 50 Index in the same time frame.

In a follow-up article titled “After the Crash, Recovery was Faster Than Most People Think” we show how the irresponsible changes to the Dow Industrials from 1929 to 1932 was the reason for the index to take 25 years to get back to the 1929 high.

We’ve shown that many high quality stocks (the purpose of the Dow Industrials is to represent “high quality” stocks) were able to reach their 1929 high in 8-9 years instead of 25 years like with the Dow Industrials (as reflected in the Monsanto Chart below).  The extended delay in getting back to the prior high was due solely to a losing trader's mentality of buying high and selling low applied to addition and subtractions to the Dow Industrials.

The recent addition of Unitedhealth Group (UNH) to the Dow Industrial Average, replacing Kraft Foods (KFT) exemplifies the "buy" high mentality of those who manage the index. United Health is being added after nearly 215% gains in the stock since the March 2009 low. This compares to "only" a 100% gain in Kraft Foods since the same starting point, see chart below.

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To emphasize our point, since the March 9, 2009 low, the following are the major index returns:

  • NYSE Composite: +98.22%
  • Dow Industrials: +107.41%
  • S&P 500: +115.98%
  • Dow Tranports: +128.74% (does not contain AAPL)
  • Russell 2000: +149.23% (does not contain AAPL)
  • Nasdaq Composite: +150.66%

As the theory goes, the performance of a well diversified index should achieve moderate gains and moderate declines.  The Dow Industrials have performed as though it was a well diversified index, rather than one composed of only 30 companies.  On the flip side of the diversification theory, a highly concentrated portfolio should have higher volatility both up and down.  For a sense of perspective, the Russell 2000 does not contain Apple while the Nasdaq Composite does.  The absence of Apple in the Russell index did not inhibit its ability to effectively match the performance of the Nasdaq Composite.

As we’ve pointed out in our article titled “Broader Market And Dow Theory Suggest Proceeding With Caution,” if the Value Line Geometric Index is any indication, broad participation of the rise from 2009 is faltering (see chart below).

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This is a warning that the narrow focus on a few companies at the top (based strictly on market cap) is going to collapse upon itself or more focus on values not related to the largest cap stocks is necessary.  Market history suggests that broad based equal-weighted indexes that don't make new highs is the canary in the coal mine.  Anyone seeking Apple’s (AAPL) inclusion to the Dow Industrials are fated to repeat the mistakes of the past with unsurprising outcomes to follow.

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Posted in AAPL, Apple Computer, Dow, Dow Industrials, Dow Transports

Canadian Dividend Watch List: September 21, 2012

Posted on September 22, 2012 by | Leave a comment

This is a list of Canadian dividend stocks that currently, or in the past, had a history of consecutive dividend increases. For those wishing to find the most complete fundamental information on these companies, we recommend visiting one of Canada’s leading financial websites, the Financial Post (found here). However, Yahoo!Finance probably has the better long-term charts and historical dividend data.

Symbol Name Price P/E EPS P/B % from low Downside risk*
FFH.TO Fairfax Financial Holdings 359.99 35.54 - - 0.99% -28.01%
FTS.TO Fortis Inc. 33.05 18.78 1.73 1.6 5.52% -15.10%
IGM.TO IGM Financial Inc. 39.05 11.83 3.3 2.29 6.09% -33.42%
SJR-B.TO Shaw Communications, Inc. 20.1 13.4 1.52 2.61 6.18% -12.94%
RBA.TO Ritchie Bros. Auctioneers Incorporated 19.02 24.7 0.77 3.12 6.61% -36.91%
CCA.TO Cogeco Cable Inc. 37.25 7.3 5.06 1.55 8.13% -28.46%
TCL-A.TO Transcontinental Inc. 8.66 - -1.77 0.7 8.66% -7.97%
PWF.TO Power Financial Corporation 25.75 10.55 2.43 1.58 9.02% -8.27%
GS.TO Gluskin Sheff + Associates, Inc. 14.42 10.6 0.6 5.58 9.49% -58.32%
IFC.TO Intact Financial Corporation 58.59 15.71 3.82 1.95 9.78% -20.91%
  1. stocks are in Canadian dollars.
  2. *based on Dow Theory 50% Principle

Watch List Summary

This month’s list has one important feature that is an added benefit for those wondering about our take on the downside risk for these stocks.  We’ve added a downside risk column to suggest what an investor might reasonably be able to expect for the listed companies in the coming year.  Our estimate for the downside risk is based on the Dow Theory 50% Principle.

The Dow Theory 50% Principle is based on the midpoint between the low, after a significant decline in price, and the most recent peak in the price.  According to Charles H. Dow, the 50% Principle, also known as the law of action and reaction, works in the following fashion:

“The market is always responsive to the great law of action and reaction. The longer the swing one way the longer it will be the other. One of the best general rules in speculation is the theory that the reaction in an advance or a decline will be at least one-half of the primary movement.” (Dow, Charles H. “Review & Outlook.” Wall Street Journal. October 19, 1900.)

In the chart below, we have circled the low and high for Fairfax Financial (FFH.TO).  The mid-point between the high and the low is $259.15 or –28.01% below the current trading price.

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We believe that the downside targets are a necessary consideration before the purchase of any stock. This become even more of an issue when we believe that the stock market appears to be topping and Dow Theory currently indicates that we are in a bear market.

For good measure we have applied the 50% Principle for the Toronto Stock Exchange Composite Index.  Our expectation is that if the TSX manages to stay above 10,922.12 then the market will go back to the 2012 high.  However, if the TSX cannot stay above the mid-point, then we expect it to decline to the 9,747 level.  Anything below the 9,747 level will result in a decline to the 2009 low.

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Dow Industrials Altimeter

Posted on September 21, 2012 by | Leave a comment

Below is a chart of the Dow Jones Industrial Average Altimeter.  Our best interpretation of the current altimeter pattern is that the Dow Industrials need to exceed the previous high set in April of 2011 in order for us to feel that a new bull market has emerged.

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As we’ve described before, the Altimeter reflects the relative value of a stock or index compared to the dividend that is paid.  Those interested in knowing what the dividend for the Dow Industrials is can find that information in Barron’s Market Laboratory section under Indexes’ P/Es & Yields (found here).

Surprisingly, the formation of the Dow Industrials Altimeter is exactly the same formation as the Value Line Geometric Index, as seen in the chart below:

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In a previous article (found here), we talked about how the Value Line Geometric Index (VLIC) is an equal weighted index that reflects how all stocks are doing since the bull market began in the first quarter of 2009.  The fact that the Value Line Geometric Index has not achieve a new high suggests that there is limited participation by all stocks in the market. Therefore, confidence in new highs by large cap stocks, as reflected in the Dow Industrials and S&P 500, should not be trusted.

We believe that there is limited upside potential based on the Dow Theory non-confirmation (article found here) and the broader market as reflected in the VLIC Index.

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Gold Stock Investors: To Beat Inflation Look to Food Processors, Producers and Distributors

Posted on September 20, 2012 by | Leave a comment

We’ve long maintained the view that in order for long-term investors to beat inflation, the conventional wisdom of investing in gold and silver stocks is not the most advantageous way to benefit from what almost everyone believes is coming as a consequence of QE4ever.  While we favor the physical metals (especially silver) and their paper derivatives like (GLD) and (SLV), we’ve also claimed that a specific strategy is needed in order to get the most mileage out of gold and silver stock investing.  However, in order to really beat inflation, forget gold and silver stocks and instead consider companies involved in food processing, producing and distribution industries.

Before we can tackle our food processors, producers and distributors, we need to examine the well documented wealth destruction that has occurred in the gold stock sector in the last year despite the relatively slight decline in the price of gold. Below is a table reflecting the percentage range that many gold and silver stocks have experienced between their one year high and low.

Symbol Name 1-yr % range
NG NovaGold Resources Inc. -69.33%
MUX McEwen Mining Inc. -68.23%
SSRI Silver Standard Resources Inc. -57.35%
PAAS Pan American Silver Corp. -56.19%
KGC Kinross Gold Corporation -55.98%
BAA Banro Corporation -53.55%
AUQ AuRico Gold Inc. -53.13%
AEM Agnico-Eagle Mines Ltd. -51.78%
HMY Harmony Gold Mining Co. Ltd. -44.81%
ABX Barrick Gold Corporation -41.79%
GG Goldcorp Inc. -41.74%
NEM Newmont Mining Corp. -40.69%
AU AngloGold Ashanti Ltd. -37.81%
GFI Gold Fields Ltd. -36.32%
BVN Compania de Minas Buenaventura SA -34.03%
SLV iShares Silver Trust -30.46%
GLD SPDR Gold Shares -15.50%

In all instances, those who had invested in these stocks did not expect that they’d face the prospect of –30% declines in value before they’d realize a gain. In fact, many of these stocks are not at a break-even point if purchased a year ago. Naturally, this should lead inflationistas and gold bugs to feeling a high level of frustration with the belief that gold stocks are a true inflation hedge.

Some perpetual gold bull analysts/marketers argue that gold junior and exploration companies provide better investment opportunities as compared to the many large cap gold stocks like Barrick Gold (ABX), Agnico-Eagle (AEM), and Newmont Mining (NEM). However, the last year has been unforgiving to the larger junior and exploration companies as represented by the Market Vectors Junior Gold Miners (GDXJ) in the chart below:

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As early as 2008, in an article titled “Why Gold Will Decline More than the Markets,” we’ve cautioned gold stock investors to be prepared for gold stocks to decline by a greater percentage whenever the general stock market, as represented by the Dow Jones Industrial Average (DIA) or S&P 500 Index (SPY), declines -10% or more.

Within the last year, the closest the Dow Industrials and S&P 500 came to a -10% decline was from April 2nd to June 1st when the indexes fell –8.63% and –9.93%, respectively.  Unfortunately, the Philadelphia Gold and Silver Stock Index (XAU) was already in a declining trend after having lost -22.85% from the April 8, 2011 high until April 2, 2012.  Despite this fact, the XAU Index managed to lose an additional –20.87% from April 2, 2012 to the May 15, 2012 low.

As an alternative to the “mines” of precious metal stock investing, we’ve recommended investing in food processors, producers and distributors that have a history prudent of dividend increasing policies to take advantage of the expectations of high inflation down the road.  Among the many companies that we’re currently following closely  in this sector are Hershey (HSY), ConAgra (CAG), and Sysco Foods (SYY).

With all the unexplained pain in the precious metal sector in the last year, companies like ConAgra (CAG), Hershey (HSY) and Sysco Foods (SYY) have continued to increase shareholder value, dividend payments and see steady gains in their stock price.  Although the last two years hasn’t been as favorable for Sysco Foods, HSY and CAG have managed to keep pace with the overall market.

Our belief in the processors, producers and distributors is rooted in the performance of these stocks during the last precious metal bull market from 1970 to 1980 and beyond. In a piece titled “ConAgra: A History of Beating Precious Metals During a Commodity Bull Market,” we compared the performance of ConAgra to Newmont Mining (NEM) and Hecla Mining (HL) at the peak in the market in 1972, before the –42% decline in the Dow Industrials, and the subsequent peak in the commodity bull market in 1980.

What we found was that CAG matched the performance of NEM and HL by the end of the gold bull market in 1980 and went on to out-distance both stocks after the commodity bull market ended, by nearly seven time in 1983.  As a follow-up to our initial ConAgra observation in November 21, 2010, we can see the performance of the same three stock in the chart below:

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The performance of ConAgra over the last 2 years has been exceptional in comparison to Newmont Mining and Hecla Mining. Today, ConAgra reported that first quarter net doubled and raised their full year expected earnings. CAG’s stock was up +6.20% on the news.  The news out of ConAgra suggests that processors, producers and distributors have much to gain from the coming inflation.

Precious metal enthusiasts will likely argue that the less than redeeming attributes of the companies selected (Newmont Mining and Hecla Mining) such as bad management, unprofitable properties, etc. contributed to the poor performance.  Another common refrain is, “look how my gold stocks have done in the last 3 or 4 months.” We believe such arguments are the equivalent of whistling past the graveyard.

Consider the following data points, since June 30, 1972 CAG, HL and NEM have generated the following returns, according to Morningstar.com:

  • CAG: +9,021.62%
  • HL:  -42.76%
  • NEM: +392.29%

When viewed from the perspective of trying to beat inflation, during the only proven gold bull market in recent history, gold and silver stocks don’t have the durability to truly beat inflation. For those that are ardent long-term value investors, you don’t really need to wade into the dark pools of precious metal stock investing where a mine can flood, a strike will break out, management can be slightly off with their estimates or the cost of production increases causing a stock to collapse in the middle of widely recognized gold bull market.  Instead, focus your research and due diligence in the food processors, producers and distributors that are trading near their respective new lows. You will be rewarded far beyond the high inflation period to come.

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Posted in CAG, ConAgra, gold, gold bugs, HL, inflation, NEM

Sell Abbott Laboratories (ABT) at the Market

Posted on September 19, 2012 by | 2 comments

There comes a time when great companies reach a sell range.  In our view, Abbott Laboratories (ABT) just approached that mark for us.

After highlighting the fundamental and technical aspects of Abbott back at $47 on September 24, 2009, (article here) and actively accumulating the stock near the January 31, 2011 low (article here), the stock has risen 47% since 2009 and 53% since 2011 (excluding dividends). The annualized return is equivalent to +13.89% since 2009 and +28% since 2011. The stock outpaced the S&P 500 by roughly 13% from our 2009 review and by 37% since our early 2011 article.

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Let’s revisit our original assessment of Abbott in 2009. The stock was trading at 14x earnings, 10x cash flow, and sporting a 3.4% dividend yield. Today, Abbott is currently trading at 22x earnings, 12x cash flow, and 3.0% dividend yield. The table below shows the relative change that has occurred since 2009.

2009 2012 % Chg
P/E 14 22 57%
P/CF 10 12.4 24%
Yield 3.4% 3.0% -12%
Price $47.00 $68.90 47%

While our valuation model shows that Abbott is undervalued at a 3% dividend yield, 13x earnings, and 10x cash flow, we’d rather recommend selling the stock only if purchased near the $45-$47 price range as indicated in our prior articles.

Those not interested in following through with our sell recommendation can feel comfortable knowing that ABT is a great long-term holding with a minimum 40% downside cushion since our 2009 posting.  It’s no doubt that income investors can hold shares of Abbott knowing that dividend will be safe and will continue to grow.  Anyone who bought Abbott at $47 would be sitting on yield on cost of 4.3%. Not too bad when 10 Year T-Bill is close to zero.

In any event, we believe it may be a good time to off load shares of Abbott by either selling the entire position or selling the principle while letting the profit runs.

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Posted in Abbott Labs, ABT, Sell Recommendations

QE3: A Blunt Object with Dull Impact

Posted on September 16, 2012 by | Leave a comment

On September 13, 2012, the Federal Reserve issued a statement (found here) that an additional round of quantitative easing (QE3) was going to be the preferred method for monetary policy going forward.  The  QE3  would be in the form of $40 billion of monthly purchases of agency backed mortgage securities.  The rationale for this policy implementation was explained to be put in place to ensure maximum employment and price stability.  We wonder whether a natural state of maximum employment has already been achieved.  After all,  isn’t it always at the maximum level?

It is necessary to put the implementation of QE3 into perspective.  The first official pronouncement of QE took place on November 24, 2008.  At that time, the stock market, as reflected by the Dow Jones Industrial Average, had already declined –37.66% from the October 2007 high.  The deployment of QE1 at the time resulted in a temporary bounce and then the stock market proceeded to complete the decline to the March 2009 low, an additional decline of –26%. A -26% decline as if there was no effort on the part of the Federal Reserve to stabilize the situation, speaks volumes of the relative ineffectiveness of such a policy.

The second iteration of QE took place in early November 2010.  At the time, the Dow Jones Industrial Average was already in an established rising trend (+75% above the March 2009 low) and tacked on an additional +11.94%, to the April 2011 peak.  After the April 2011 peak, the Dow Jones Industrial Average declined –15.91%.  The implementation of QE2 in 2010 was nearly 5% above the October 3, 2011 low.  Does billions of dollars of money thrown at the economy suggest that it was worth the stagnant or mild gains in the economy?

As we’ve said in our January 2011 article titled “Federal Reserve Isn’t to Blame for the Current Market Run,” and as demonstrated by the relatively mild gains and/or declining returns as represented by the Dow Jones Industrial Average, whenever monetary policy has been put in place, quantitative easing has little impact on the expected outcome for where the stock market and economy will go.  Additionally, we've shown how in periods when the Federal Reserve didn't exist (1864-1913), the stock market would routinely rebound 50% to 100% of prior losses.

Why do we make comparisons between the stock market and Federal Reserve policy when actions taken by the Fed are intended to affect economic activity and not the stock market?  The answer lies in a 2004 paper, co-authored by Ben Bernanke before he became Fed chairman, titled “Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment” which is THE basis for quantitative easing in the United States.  On page 8 of the 113 page document, step one for effective QE (out of three) is stated as follows:

“..using communications policies to shape public expectations about the future course of interest rates…[1]”

This is significant because the stock market is the court of public opinion on all matters relating to current and future economic expectations.  Dow Theory, a 110-year old approach to interpreting the stock market, has the following to say on this matter:

“The Averages Discount Everything — The fluctuations of the daily closing prices of the Dow-Jones rail and industrial averages afford a composite of all the hopes, disappointments, and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events (excluding acts of God) are always properly anticipated in their movements.[2]”

All initial communications by the Federal Reserve are meant to sway the public and is voted on by the stock market either rising or falling in acceptance or rejection of the Federal Reserve’s communiqué. The book by Benjamin Graham titled Security Analysis highlights the point that the market is an arena where votes are cast in the following quote:

“The stock market is a voting machine…[3]”

We believe that the Federal Reserve decides exactly how much they have to follow through with their “communication policies” based on the magnitude of the reaction from the financial markets.

For us to believe that quantitative easing is an effective tool in the court of public opinion and ultimately for the economy, we'd like to see both the Dow Jones Industrial Average and Dow Jones Transportation Average to exceed previous all-time highs on the news.  Unfortunately, the latest announcement has not catapulted both indexes to new highs which, according to Dow Theory, puts the latest policy initiative in question.

Although there is little to demonstrate that monetary tools being put in place, like quantitative easing, are actually effective, what we are seeing is an emerging trend in when the Federal Reserve decides to take action.  In the chart below we see that when the percentage change from a year ago of real gross domestic product (GDP) has peaked, the Federal Reserve will attempt to take steps to stop the declining trend of GDP.

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Keep in mind that since QE2, real GDP growth has still managed to trend lower than the period before, on a percentage basis.  This is not the ideal outcome of massive amounts of “liquidity” being “created.”  As can be seen in the chart above, the overall trend in year-over-year (y-o-y) percentage growth in real GDP has reflected a pronounced declining trend in alignment with the peaks of 2000 and 2004.  However, in the entire history of collected y-o-y percentage growth in real GDP, since 1947, the declining trend has been well established and should not be considered a new phenomena.

The fact that QE2 could not demonstrate y-o-y growth greater than the 2010 peak before QE3 was implemented suggests that the stock market and economy are easily susceptible to a major “shock” in spite of the Federal Reserve’s best efforts.  An additional takeaway from our interpretation is that, unless under “emergency conditions,” the Federal Reserve Bank will implement massive amounts of renewed quantitative easing if real GDP appears to have peaked as was the case shortly before the QE3 announcement on September 13, 2012.

[1] Ben S. Bernanke, Vincent R. Reinhart, and Brian P. Sack. “Monetary Policy Alternatives at the Zero Bound:
An Empirical Assessment.” Federal Reserve Bank, Washington D.C. 2004. PDF found here.

[2] Rhea, Robert. The Dow Theory. 1932. Barron’s Publishing, page 19.

[3] Graham, Benjamin. Security Analysis. 1934. page 452. found here.

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Posted in Federal Reserve Bank, GDP, Quantative Easing

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