Archives for February 2009

Dow Discussion – Part 2 of 3

 

Per our last discussion, we discovered that the Dow is a price-weighted index. Another common way an index is built is capitalization-weighted (i.e. the S&P 500 Index). The impact of a capitalization-weighted index is that as a component’s price changes, it is in proportion to the issue’s overall market value, which is the share price times the number of shares outstanding. However, this is not how the Dow works; rather it is calculated by adding the price of 1 share of each of the 30 component company’s share prices together and dividing it by a divisor (which was discussed last time). Some may argue that a price-weighted index doesn’t make much sense. Let’s dig in.

First, you should know that the keeper of the Dow, Dow Jones, has an unwritten rule that any DJIA stock that falls and stays for an extended period of time below $10 gets tossed out. Currently, there are 4 stocks trading less than $10 (GE is flirting, but I won’t include that…yet).

Alcoa (AA) = $7.06

Bank of America (BAC) = $5.83

Citi (C) = $2.69

General Motors (GM) = $2.59

If all four of these stocks went to zero on today’s open, the Dow would lose only 144 points!

The financials in the Dow are:

Amex (AXP) = $13.71

Bank of America (BAC) = $5.83

Citi (C) = $2.69

JPMorgan (JPM) = $18.09

If every financial stock in the Dow went to zero on today’s open, it would only loose 368 points! This number used to be huge, but nowadays, a 300 point swing is commonplace.

It gets crazier. If all sub-$10 stocks listed above, all the financials listed, AND GE opened at zero (AA, BAC, C, GM, AXP, JPM and GE), the Dow loses 522 points. Now, say just one company, IBM, opens at zero, the Dow loses 706 points! So, the Dow says that IBM has more influence on the index than all the financials, autos, GE, and Alcoa combined. To look at it another way, a 10% positive move for IBM would move the Dow up by over 70 points. A 10% move by Citigroup would increase the Dow by barely over 2 points.

The component companies are decided upon by the Index Committee at Dow Jones. This Committee will remove and replace companies as it sees fit, whether it be the sub-$10 unwritten rule, or if they feel a different company would represent the American economy better than a current component (i.e. in 1999 Microsoft replaced Goodyear Tire & Rubber to make way for the technology revolution). Some argue that the Dow Jones Index Committee isn’t doing their job because they aren’t removing the sub-$10 stocks during this crisis, possibly because of the political fallout of booting out Citi or GM. As a result, this index is now severely distorted as it has tiny weightings to stocks that don’t move the charts much. While these 30 companies could be debated if they represent the American economy well, I’m sure we’d all agree that now that we know how a price-weighted index works, we’ll be a lot wiser when we hear how the Dow did on any particular day.

Sources:    www.2000wave.com

www.wikipedia.com

www.djindexes.com

Disclaimer:    For all you anal ones out there double checking my numbers, I used the intra-day prices of the Dow 30 stocks on the morning of February 26, 2009 and the divisor from my previous post.

Contact Your Rep in Congress to Get Relief from Mark-To-Market Accounting

On Tuesday I attended an economic forecast by Brian Wesbury.  You can read my notes from his speech here.

During his presentation Brian talked about what a mess the mark-to-market accounting rules has created.  These rules force every bank to take losses before they even happen.  These accounting rules are having disastrous effects on our economy.  Brian believes the market would rally if  we suspended or terminated mark-to-market accounting.
Learn more about mark-to-market accounting and why it should be suspended by:
Brian is encouraging everyone to write a letter to your senator or representative in congress to push for relief from mark-to-market accounting.  I believe that Brian’s arguments make sense.  I sent my letter today.  Will you take the time to send a letter too?
Brian has provided a sample letter on his firm’s website.  Click on the link to download it, personalize it, and send it to your elected officials.

Dow Discussion – Part 1 of 3

It today’s environment, it’s hard to get through a news broadcast or cocktail conversation without hearing about the Dow. Was it up, was it down, did it blow up today, were we in the green or the red? These are all questions that swirl around this index, yet few people truly understand what makes up this index or how it works. My goal is to provide a high level summary of the Dow…just enough so the next time you hear it referred to, you know a little more about what it is.

The Dow Jones Industrial Average (NYSE: DJI, also called the DJIA, Dow 30, INDP, or informally the Dow Jones or The Dow) is one of several stock market indices, created by nineteenth-century Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow. It is an index that shows how certain stocks have traded. Dow compiled the index to gauge the performance of the industrial sector of the American stock market. It is the second-oldest U.S. market index, after the Dow Jones Transportation Average, which Dow also created.

The average is computed from the stock prices of 30 of the largest and most widely held public companies in the United States. The “industrial” portion of the name is largely historical—many of the 30 modern components have little to do with traditional heavy industry. The average is price-weighted. (Keep this in mind as I will discuss this in future posts). To compensate for the effects of stock splits and other adjustments, it is currently a scaled average, not the actual average of the prices of its component stocks—the sum of the component prices is divided by a divisor, which changes whenever one of the component stocks has a stock split or stock dividend, to generate the value of the index. At the end of 2008, the divisor stood at 0.125552709. Since the divisor is currently less than one, the value of the index is higher than the sum of the component prices.

Currently, the Dow consists of the following 30 companies:

Company

Symbol

Sector

Year Added

3M

MMM

Industrials

1976

Alcoa

AA

Materials

1959

American Express

AXP

Financials

1982

AT&T

T

Telecommunication

1999

Bank of America

BAC

Financials

2008

Boeing

BA

Industrials

1987

Caterpillar

CAT

Industrials

1991

Chevron Corp

CVX

Energy

2008

Citigroup

C

Financials

1997

Coca-Cola

KO

Consumer Staples

1987

DuPont

DD

Materials

1935

ExxonMobil

XOM

Energy

1928

General Electric

GE

Industrials

1907

General Motors

GM

Consumer Discretionary

1925

Hewlett-Packard

HPQ

Information Technology

1997

Home Depot

HD

Consumer Discretionary

1999

Intel

INTC

Information Technology

1999

IBM

IBM

Information Technology

1979

Johnson & Johnson

JNJ

Health Care

1997

JPMorgan Chase

JPM

Financials

1991

Kraft Foods

KFT

Consumer Staples

2008

McDonald’s

MCD

Consumer Discretionary

1985

Merck

MRK

Health Care

1979

Microsoft

MSFT

Information Technology

1999

Pfizer

PFE

Health Care

2004

Proctor & Gamble

PG

Consumer Staples

1932

United Technologies Corp.

UTX

Industrials

1939

Verizon Communications

VZ

Telecommunication

2004

Wal-Mart

WMT

Consumer Staples

1997

Walt Disney

DIS

Consumer Discretionary

1991

 

Interestingly, General Electric is the only component company that has remained in the index since its creation. Stay tuned for a few more tidbits about the Dow that I think you’ll find helpful in your understanding of this important index.

Sources:     www.wikipedia.com

        www.djaverage.com

 

Brian Wesbury’s Economic Forecast

Today I had the privilege of hearing Brian Wesbury speak over lunch at the Findlay Country Club. Brian is the Chief Economist for First Trust Advisors.

Brian is advertised as one of the nation’s top 10 economic forecasters. This is interesting because all of the talk before lunch today was about how wrong Brian’s prediction was one year ago. Last year at this time Brian predicted that the Dow would end the year at 15,000. I wish he was right on with that prediction, but the fact is that today the Dow is less than half of that target.

Even though Brian was a bit off with his prediction last year, I still think he is a very thoughtful economist. I always enjoy hearing him speak. I think it’s probably because his presentations are very insightful.

Here are my notes from today’s presentation:

  • Brian is convinced that the US was not in a recession until September of 2008. When he made his Dow 15,000 prediction last year at this time the economy was actually doing quite well. Excluding housing, the economy grew almost 2% during the first quarter of 2008 and nearly 4% during the second quarter. It wasn’t until the third quarter that the economy (ex-housing) stalled, and then the fourth quarter when we actually saw a decline of about 3%.
  • Housing is only 5% of the whole economy.
  • In the fall of 2008 we saw a textbook example of a panic. Food sales fell for the first quarter in 50 years. For the first time we collectively dug into the food pantry and grabbed that jar of Campbell’s soup that we’ve had since college.
  • Every dollar that is spent changes hands about 7 times per year. In 2008 dollars only changed hands 6 times.
  • We haven’t seen a panic like this since 1907. That panic lasted about a year and included runs on banks, a stock market collapse of about 50% from its peak the previous year, and a decline in business activity. Sound familiar? Read about the Panic of 1907 on Wikipedia.
  • The Fed is doing the right thing by increasing money supply (printing money).
  • At the current rate of economic activity it will be 25 years before we replace our cars and 280 years before we replace our houses. You can’t have activity like this forever. We have hit rock bottom!
  • Dogs bark. Banks make loans. People shop. This can’t last!
  • The Baltic Dry Index is up 60% from the bottom. Goods are being shipped again!
  • Business is starting to pick up again. Brian got his shoes shined in Chicago last week. The shoe shiner typically averages $150 per day during normal times. He was making $40 per day a few weeks before Thanksgiving 2008. Today, he is back to making $150 per day. Another case in point: Restaurants. It’s hard to get a table on Friday or Saturday night…last November there was no problem getting a table.
  • Brian thinks that 85% of today’s problems were created by Washington and 15% by Wall Street. Much of the damage was created by the Fed lowering interest rates to 1% back in 2004. This created massive demand in the housing market. The government creates excess demand and leverage in the market by moving interest rates.
  • The price of oil per barrel was $2.92 in 1965, $11.00 in 1975, and $40.00 in 1980.
  • Mark to market accounting rules have created a mess. These rules force every bank to take losses before they even happen. The market would rally if we suspended or terminated mark to market accounting.
  • There is a lot of worry about deleveraging today. Brian made the point that deleveraging does not mean that money disappears…it just goes somewhere else. There’s no less money out there, just lower asset values.
  • In the last 9 months we have seen more growth in government than any time since the Great Depression.
  • The government will even make up problems. “I believe global warming is one of the biggest frauds ever perpetrated on the people of this world.” [followed by an applause]
  • Brian is frustrated by how much the government is involved in the economy. He provided a chart that shows that government spending (as a % of GDP) is highly correlated with the unemployment rate. In other words, the chart proves that the more the government has spent the higher the unemployment rate.
  • Here’s the problem with government spending more money to create more jobs: Every dollar that the government spends comes from the private sector (you and me) through taxes or borrowing (Treasury securities). For increased government spending to effectively create more jobs, the government would have to allocate those dollars more effectively than the private sector could. Do we really believe that the government will allocate dollars more effectively than the private sector could? If it’s as simple as spending more money, then why isn’t everybody rich? We can’t spend our way back to prosperity.
  • Increasing taxes are not the answer. Think about it. We raise taxes on cigarettes because we want people to smoke less. Why do we raise taxes on income and profits? Do we want people to earn less?
  • Brian is worried long-term that the increased government intervention will create even more problems.
  • Brian believes we are in a V-shaped bottom of a panic that began in September of 2008. He forecasts that the next 12-18 months are gonna rock n’ roll. He predicts that we will have an opportunity to make a lot of money in the stock market and in business. He is expecting a massive rally in the stock market that will last 12-15 months.
  • Brian is expecting higher inflation and higher unemployment rates in the next five years. Inflation is likely to be in the 4% to 4.5% range by 2010 or 2011.
  • Commodities are cheap again. Buy a diversified basket of commodities through an ETF as a hedge against inflation.
  • Someone in the audience suggested that we all turn off the TV for 60 days and see if half our problems would be solved. [Good idea!] Brian reminded us that the media is in business to make money too. News that sells is the “out of the ordinary” news. People won’t watch if the news is boring and normal.
Overall, I was impressed with Brian’s presentation today. It was nice to hear a positive outlook that was packed with insight. I would like to thank GreaterFindlayInc. and Commercial Savings Bank for sponsoring Brian presentation. I hope this will continue to be an annual event.

Abbott Increases Dividend 11%

In light of all the negative economic news we are hearing lately I would like to pass on some positive news. Abbott Laboratories (ABT) increased the company’s dividend by 11% today. This makes 37 straight years of dividend increases for ABT. The company has been paying a dividend for 85 years (since 1924).

ABT is a global health care company devoted to the discovery, development, manufacture and marketing of pharmaceuticals and medical products. ABT reported fourth quarter earnings about a month ago. The company posted 14% year-over-year earnings growth. The company’s ability to grow earnings and increase its dividend is impressive in this challenging economic envioronment. ABT is also well positioned to be able to post solid growth again in the upcoming year as the company confirmed its 2009 forecast of double-digit earnings growth.

ABT is a great example of a company that meets the investment criteria of our firm’s Focused Equity Portfolio. We have been investors in ABT since 2004 and we currently maintain a long position in client accounts.

Dudes, You’re About to Make the Worst Mistake of Your Lives

Our friends at Litman/Gregory recently shared the following outtake from Bob Turner’s February client commentary. Turner, lead portfolio manager of Turner Concentrated Growth (TTOPX), wrote that his view of the prospects of the stock market reminded him of an experience 15 years ago at a Philadelphia Eagles football game:

Seated in front of me at the game were three motorcycle-club members, their club’s logo emblazoned on the back of their jackets. They were big, loud, and drinking heavily. Seated beside them was a young man whose laid-back manner suggested a California surfer who had some familiarity with the recreational uses of marijuana. No fool he: his attitude toward the three motorcycle guys was utterly respectful and deferential. At the end of the third quarter, the three motorcyclists vacated their seats temporarily, presumably to take a bathroom break and buy more beers before last call.

While they were gone, two preppie-looking guys who appeared to be of college age descended from an upper section of the stadium to claim what seemed unoccupied seats. The surfer sized up the situation, looked at the two preppie interlopers, and said in a deadpan tone, “Dudes, you’re about to make the worst mistake of your lives.” The preppies initially looked at him with puzzled expressions, but they got up and left, perhaps motivated by some divinely sent forebodings of trouble and bodily harm.

The motorcycle-club members did indeed return to their seats shortly thereafter, unaware that, to everyone’s great relief, an affront to their fraternal honor had been averted, an affront that almost certainly would have inspired a bruising retaliatory response on their part.

So in closing, I offer the following advice to those of you who may be thinking of bailing out of the stock market or giving up on a growth-stock manager like us: ‘Dudes, you’re about to make the worst mistake of your lives.’

As we see it, it would be an enormous error to forsake the stock market or us now. By just about any criteria you choose — whether it be valuation, investor sentiment, technical readings, past patterns of performance, you name it — stocks look as compelling as they’ve ever been in modern times, in our view.

I agree with Mr. Turner’s view. Now is not the time to give up on stocks. It would be a huge mistake to abandon the stock market at this point in the cycle. Stocks today are compelling long-term investments by many measures. Investor sentiment today is very low. Investors are gripped by fear and some have panicked leading them to give up on stocks completely.

The extreme downtrend we are currently experiencing in the stock market is not unlike previous downturns throughout history. The stock market has been through periods of high inflation, rising energy prices, bursting of the technology bubble, terrorist attacks, wars, and other crises. Yet, through all that, the long-term upward progress of the stock market has not been derailed. Today, we are faced with uncertainty and turmoil in the financial services industry. I don’t believe that we should let uncertainty scare us. Successful investors do not let fear force them out of the market.