Will The Tortoise Rally Continue?
Thursday, August 30th, 2012 @ 11:02AM
In This Issue:
Will The Tortoise Rally Continue?
Interest Rates Are Still The Key
Every Silver Cloud Has A Dark Lining
Our Portfolio Is Still Doing Well
Current Yield Is Just A Starting Point
The Bottom Line
The stock market shrugged off its correction in early August and resumed its upward climb. It was a little like watching a tortoise make a U turn, but at least prices are now moving in the right direction.
In any event, any investors who didn’t fall asleep during the reversal were rewarded by seeing the S&P 500 inch its way to a four year high. As unexciting as the milestone was, it was welcome.
Will The Tortoise Rally Continue?
The big question now, of course, is will stocks continue to move forward, or will they drop back again?
Many analysts think the rally won’t last much longer because so much of the financial news is bad. The economy is continuing to slow down despite the uptick in the housing market. Growth is likely to remain below 2% for the next few months, and perhaps longer. Job growth is also very weak. That outlook isn’t a recipe for a strong stock market.
Optimists agree that the economic situation isn’t great now, but they think it will improve. Retail sales inched up last month and so did some home sales. In addition, the fall season is typically good for consumer spending as parents outfit their kids for school, and the whole family gets ready for winter. The holiday season is also near at hand, which always loosens purse strings. Since consumers support about 70% of the economy, even a modest increase in their trips to the mall can have a big impact on growth.
Investors are also encouraged by the expectation that the Fed is about to launch another stimulus program. During his August address, Mr. Bernanke said that he stood ready to support the economy fairly soon unless it managed to turn around by itself. Since the latter seems unlikely, we think quantative easing number three (QE3) is on the agenda. If so, stocks should benefit.
Interest Rates Are Still The Key
The outlook for the economy is important, but that hasn’t been the driving force in the stock market this year. Instead, what investors are watching closely is interest rates.
Stocks are attractive primarily because dividend yields remain significantly above what bonds pay. In fact, several dozen blue chips boast returns that are twice Uncle Sam’s rates. Several successful companies pay a lot more than that.
As a result, pension funds, university endowments, insurance companies, and other deep pocket investors have been moving billions of dollars into top quality stocks that have a long history of paying generous dividends. As long as interest rates stay low, we think money will continue to favor stocks.
That brings us back to the Fed and QE3. The program will buy mortgage and government bonds in an attempt to reduce long term interest rates even more and stimulate economic growth. For the near term at least, we think the interest rate outlook will remain favorable.
Every Silver Cloud Has A Dark Lining
QE3 will have the opposite impact on senior citizens who count on fixed income returns to pay the bills. Interest rates are already so low that many retired people are having a rough time making ends meet. The last thing our seniors need is for interest rates to be pushed down even more.
Someday, of course, the interest rate pendulum will swing back up again. We think such a tidal shift will scare a lot of investors and the stock market party will start to break up.
Rising interest rates will also be bad news for people who own bonds. That’s because investors won’t buy previously-issued bonds that pay lower rates unless their prices are reduced.
When interest rates start to go up again the biggest loser will be Uncle Sugar. Right now, Washington pays only 1.56% on its 10-year bonds – a record low. As a result, the government can borrow money like a madman to pay its obligations, and that’s what it has been doing. If interest rates rise, so will the cost of servicing the national debt.
Rising interest rates will also be accompanied by rising inflation, a plague that will hurt everyone. Fortunately, it seems unlikely that higher interest rates will show up anytime soon.
Our Portfolio Is Still Doing Well
The blue chip portfolio that we have been following closely for over a year is continuing to do well. The attached table lists the individual stocks and their performance since July 23.
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The AIA Advocate Select Blue Chip Portfolio
For An Emphasis On Current Income:
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The biggest gainers were Caterpillar, Goldman Sachs, Alcoa, and Procter & Gamble. Also going up were Colgate Palmolive, ExxonMobil, General Electric, Wal-Mart, and Eli Lilly.
The biggest decliner was Coca-Cola that appeared to be correcting from earlier gains. Deere also posted a decline due to concerns about the effect of the drought on farm machine sales. Smaller declines were registered by Johnson & Johnson,Consolidated Edison, and Kinder Morgan. All three are attractive income stocks with yields of 3.60%, 3.90% and 6.00% respectively.
Current Yield Is Just A Starting Point
Speaking of dividend yields, some investors won’t buy a stock if the payout is not exciting. That can be a mistake. Unlike the fixed interest rates paid on bonds, stock yields can grow from year to year.
For example, you may purchase a successful blue chip stock when its current yield is 3.0%. If the company increases its dividend 15% a year, the effective yield in five years will be 5.3%. In ten years it will be 10.7%. Those are great returns. Many retired people who purchased blue chips in their 20s and early 30s are collecting more in dividends than they paid for their stocks.
Dividends also reduce the volatility of blue chip prices. If a stock gets too expensive, its dividend yield (price divided by earnings) will drop. In that case, many investors will sell the stock and its price will move back down.
Likewise, if the price drops and yields become more attractive, investors will push the stock back up. Unless something significant happens that surprises investors, blue chips don’t usually make big short term moves.
Many successful companies with large overseas operations have more than enough cash to boost their dividends by as much as 50%. However, if the profits earned overseas are brought home they will be subjected to Washington’s usurious taxes. As a result, the funds can’t be distributed to investors.
However, profits that are kept offshore are not lost to shareholders. Companies often use the money to buy back their own stock, which they can do tax free. Of course, the purchases push stock prices up.
The Bottom Line
The stock market continues to be driven primarily by low interest rates. That’s likely to remain the case unless economic developments deteriorate markedly and dividend yields come into question.
Stocks are also moving up in anticipation of an announcement by the Fed that another stimulus program will be launched. That decision could be made as early as today (Thursday).
After any rally we must expect a correction. If you don’t want to risk your hard-earned profits, you should take at least some of them off the table. Protect everything else with stop loss orders.
Until Next Time
The AIA “Advocate For Absolute Returns”, a publication of The Association for Investor Awareness, Inc., tracks market trends, industry news, the SEC, global trade and finance and Washington developments for you because they affect your investments. But who doesn’t? Many sources report these issues as abstract facts. We feel that’s not enough. The AIA Advocate’s job is to warn you of what’s important and how these developments translate to ground-level forces and threats that directly affect your wealth as well as your current investment opportunities. Not just information, but information you can use. Until next time…
Posted by AIA Research & Editorial Staff
Categories: AIA Newsletter
Executive Director
John M. Casson
Mr. Casson has been Executive Director of The Association for Investor Awareness, Inc., since inception. He also serves as President/CEO of Casson Media Group, Inc., a publishing, media and communications holding company.