Thank You To Our Clients, Prospects And Readers Of Our Content

As 2012 comes to a close, all of us at HORAN want to thank our clients for allowing us to work with them this past year. We wish all of our clients, prospects and readers of our content a Happy, Healthy and Prosperous New Year!

The past 12-months were certainly volatile with the S&P 500 Index up 13% through early April, then up only 2% by the end of May. As the market closes out the year today, the S&P will be higher by more than 15%. Not a bad year for equity investors. Fixed income investors enjoyed good returns due to our exposure to high yield, floating rate and global bonds.

At HORAN, all of our investment categories generated a positive return over the course of the year. I suppose one could say it seemed like a rising tide lifted all market segments: equity, fixed and alternatives. We did steer clear of commodities and that seemed to be a winning decision. Soft commodities had a difficult year while Gold and Silver did generate positive returns, but less than the market and with higher volatility. Our lowest returning investment was our absolute return investment. More detail on 2012 and more importantly, our outlook for 2013, will be forthcoming in our fourth Quarterly Investment Letter.

Again, thank you and Happy New Year to our clients and to the readers of our content.

Volumes Near Ten Year Low

Equity volume for the NYSE is closing out 2012 at near a ten year low.  Investors seem to be giving up on the equity markets if this volume data is any indication.

From The Blog of HORAN Capital Advisors

Data Source: NYSE

Related to this low equity volume is the continued flow of funds out of equity mutual funds. The equity outflows appear to be finding their way into fixed income mutual funds.

From The Blog of HORAN Capital Advisors

Lastly, margin debt as of November 2012 is at a level last seen prior to the Lehman crisis. In addition to the high margin debt level, net free credit is also negative. The takeaway from this is these margin investors are mostly fully invested at this point in time, i.e., limited additional cash to push the market higher. Investors should keep in mind that margin debt is a better longer term indicator (at least 1-year) of potential market performance.

From The Blog of HORAN Capital Advisors

Data Source: NYSE

Dividend Strategies Underperform In 2012

One of the hot investment topics of 2012 has centered around dividend paying stocks. With the Federal Reserve pursuing a near zero interest rate policy, the yield on treasury bonds as well as cash have been pegged at a very low level. For investors relying on income, some investment strategists have extolled the virtues of dividend paying stocks with many of the dividend strategies generating yields higher than treasury bonds and cash. For example, the iShares Dow Jones Select Dividend Index (DVY) yields more than 3% while the 10-year treasury yields little more than 1.5%. Now bond risk is a far cry from equity risk; however, the point of this commentary is one might expect dividend paying stocks to be top performers given all the attention they have received this year. Top performers they haven't been though.

As the below chart comparing the Powershares Dividend Achievers Portfolio (PFM) to the S&P 500 Index shows, the PFM ETF has underperformed the S&P index over the last 12-months (top chart). However, over a 2-year period (bottom chart), the PFM dividend achievers portfolio has generated a return better than the S&P 500 Index.

From The Blog of HORAN Capital Advisors

For investors then, keep a longer term focus in mind. Outperformance can be achieved while at the same time assuming a lower level of risk, that is, a lower standard deviation. The end result is an investor is likely to generate a higher risk adjusted return. Some Modern Portfolio Theory statistic for the Dividend Achievers Index is outlined below.

From The Blog of HORAN Capital Advisors

Lastly, the Dividend Achievers strategy has outperformed the S&P 500 Index in each down market going back to 2011.

From The Blog of HORAN Capital Advisors

Importantly, for investors that rely on regular distributions from their assets, minimizing downside returns is important. Certainly there are other investment allocation strategies that can be employed that will minimize an investor's downside returns, i.e., holding cash, alternative hedged investments, etc., however, for the core equity portion of ones portfolio, employing a dividend focused strategy has the potential to reduce the overall portfolio's potential downside volatility.

Dividend Growth More Consistent Than Buybacks In Q3 2012

Late last week Standard and Poor's reported dividend and buyback data for S&P 500 companies through the third quarter of 2012. Year over year and quarter over quarter dividend growth was reported at 17.4% and 3.2% respectively. Buyback activity was actually lower on a year over year and quarter over quarter basis. YOY buybacks declined 12.4% and QOQ buybacks fell 7.2%.

Howard Silverblatt, Senior Index Analyst at S&P Dow Jones Indices notes, "Company buyback activity has been erratic over the past three months, given the continued uncertainty of the fiscal cliff and the potential impact on spending, companies may have taken a cautious approach to stock buybacks in the fourth quarter. In the background, however, is some talk of companies needing more shares to meet employee options, with more being exercised near year-end due to the anticipated tax change."

From The Blog of HORAN Capital Advisors

Silverblatt also notes the top heavy nature of the buyback activity. For the quarter the top 20 companies in the S&P 500 Index accounted for over 53% of the quarter's buybacks.

From The Blog of HORAN Capital Advisors

A Look At The Top 1% Of Taxpayers, Government Revenues/Expenses And The Deficit

Politicians have just a few days remaining to come up with some resolution to the fiscal cliff facing the country. It appears the resolution will be another "can kick" that mostly increases taxes. The President's income break point is often stated to by $250,000 while House Speaker John Boehner's Plan B had higher taxes for those with incomes above $1 million. The problem with focusing only on increasing taxes and generating more revenue is the fact that the expense side of the budget needs to be dealt with as well. The revenue generated from the higher proposed tax rates would only fund the government for eight days. As the below chart shows, expenses have spiked significantly subsequent to the recession with a deficit that remains alarmingly high at over $1 trillion per year.

From The Blog of HORAN Capital Advisors

Mark Perry, Professor of Economics at the University of Michigan, recently analyzed IRS data available through 2010 for taxpayers in the top 1% versus those in the bottom 95%. Taxpayers with income above $221,000 would fall in the top 1% of income earners in 2010. What his analysis of the data shows is:

• "the 1.35 million taxpayers that represent the highest-earning one percent of the Americans who filed federal income tax returns in 2010 earned 18.9% of the total gross income and paid 37.4% of all federal income taxes paid in that year."

• "the 128.3 million taxpayers in the bottom 95% of all U.S. taxpayers in 2010 earned 66.2% of gross income and that group paid 40.9% of all taxes paid."

• "in other words, the top 1 percent (1.35 million) of American taxpayers paid almost as much federal income tax in 2010 ($354.8 billion) as the entire bottom 95% of American tax filers ($388.4 billion)."

• "about half (58 million) of the bottom 95% of American “taxpayers” paid nothing or got a tax refund."

The below chart, which appears in his article, details the the increasing share of taxes paid by the top 1% of taxpayers since 1980.

From The Blog of HORAN Capital Advisors

Broadening the base of taxpayers, even at a minimal level, would get more of the population in tune to the budget consequences facing the U.S. The below chart displays a ten year time period, but the same holds true going back to the 1980's, noting there has not been a single year since the 80's where the government actually cut spending. That is, the absolute dollar level of spending never declined. The spending side of the government's ledger is as large of an issue as is the revenue side.

From The Blog of HORAN Capital Advisors

A Need To Focus On Government Outlays

It would be hard to envision that the public has not heard about the fast approaching fiscal cliff. What seems lost in the narrative of the media and their focus on raising tax rates, is the fact government spending continues to consume a larger share of the government's budget.

As the below chart indicates, the CBO is forecasting social security and medicare payments to account for a larger and larger share of the budget as far as the eye can see. Addressing the growth in these programs will be required in order to provide any dent in the current budget deficit.

From The Blog of HORAN Capital Advisors

The result of going over the fiscal cliff doesn't address the spending either. The cliff impact has tax hikes exceeding spending cuts by a 3:1 margin. One reason for this outcome is the fact Washington's "baseline" budgeting definition means simply lowering the growth rate of spending counts as a cut in spending. A recent Wall Street Journal article, The Baseline Budget Con ($), addressed this budget gimmick.

From The Blog of HORAN Capital Advisors

Fiscal Cliff Not Resulting In Dividend Cliff

One of the most popular investment topics in the fourth quarter has to do with the impending fiscal cliff discussion taking place in Washington, DC as can be seen in the Google Trends graph below. One area of interest for investors is the impact on the taxation of dividends if Washington policy succumbs to going over the cliff. Going over the cliff would result in the tax rate on dividend income increasing to as high as 43.4% versus the current 15% rate.


Interestingly, this potentially higher tax rate does not seem to be having a "negative" impact on the long term dividend policy for companies. Factset Research notes in their Dividend Quarterly report for Q3:

• aggregate dividends per share (“DPS”) grew 15.5% year-over-year at the end of Q3.

• the number of companies paying a dividend in the trailing twelve-month period again surpassed 400 (80% of the S&P 500 index).

• the S&P 500 also hasn’t shown a slowdown in companies initiating dividend payments. In Q3, 3.0% of non-payers “initiated” dividends, which is nearly triple the average over ten years (1.2%).

• the aggregate dividend payout ratio is 2.0% below the ten-year median, it is at its highest level (29.1% at the end of Q3) since the recession (when payout ratios were distorted by low aggregate earnings during the recession...).

• while there have been a number of companies that are signaling short-term changes in dividend policy or a shift towards more share buybacks..., a majority of companies have not yet responded, including the top ten dividend-payers in the S&P 500.

• the aggregate, forward twelve-month DPS estimate for the S&P 500 was 10% above the actual trailing twelve-month (“TTM”) payout at the end of November, which is a premium that is well above the ten-year average of 3%... Also, even when excluding the periods during the financial crisis (when forward DPS estimates fell below trailing figures), the forward consensus premium is in-line with the stabilized average starting in 2011.

One reason dividend practices may not be changing for a large majority of companies may be due to the fact that many shareholders own company stock in retirement accounts and/or shares are held by foreign investors. In Factset's Dividend Quarterly one Treasurer cites this very fact.

Lastly, just to reiterate a point about dividends versus buybacks we have made on this blog in the past is the fact divdend payments are more consequential when evaluating companies. We prefer dividends since company practices around their dividend policy offer more insight into potentially negative financial outcomes since firm's are less likely to cut dividends. For example, companies may take on debt in order to maintain adherence to a certain dividend growth rate. This may result in debt/equity levels increasing as well as payout ratios increasing. These are red flags for investors and may enable investors to reduce positions before negative financial results are reported. Conversely, company buyback announcements maybe just that and do not equate to a longer term commitment of a company's cash flow. It is far easier for a company to come up short on their buyback program than to announce a change in their dividend policy. As the below chart notes, the number of companies making buybacks and the aggregate dollars spent on buybacks has been on the decline since the fourth quarter of last year.

Source:

Factset Dividend Quarterly (PDF)
By: Michael Amenta, Research Analyst
Facset Research
December 19, 2012
http://www.factset.com/websitefiles/PDFs/dividend/dividend_12.19.12

Factset Buyback Quarterly (PDF)
By: Michael Amenta, Research Analyst
Facset Research
December 20, 2012
http://www.factset.com/websitefiles/PDFs/buyback/buyback_12.20.12

Technology Sector Largest Contributor To S&P 500 Yield

As of December 11, 2012, the dividend yield for the S&P 500 Index equaled 2.27%. The largest contributor to the index's yield is now the technology sector, contributing 14.6% of the index's dividend income. This compares to the technology sector's income contribution at the end of 2011 of 10.29%. The sector experiencing the largest decline in contribution to the index yield is the consumer staples sector, declining from 15.6% in 2011 to 14.0% as of the close on 12/11/2012.

From The Blog of HORAN Capital Advisors

Given the technology sector's weighting in the index at 18.9%, and the popularity of dividends, it is not surprising that technology stocks are a significant contributor to the income yield for the index in spite of the tech sector having the second lowest yield at 1.74%. Additionally, the index is cap weighted and three of the top 10 index stocks are technology ones, Apple (2.1% yield), IBM (1.8% yield) and Microsoft (3.4% yield). These three stocks account for nearly 40% of the weighting of the stocks in the technology sector.

From The Blog of HORAN Capital Advisors

Data Source: Standard & Poor's

The Arithmetic Of Equities

The research paper noted below, a good read, has been making the rounds over the weekend. The report discusses bond valuations relative to stocks and when one asset class appears more attractive than the other. The paper's author, Andrew J. Redleaf of The White Box Advisor, states he is really a "bond guy" but notes the following:

"Basically I am a bond guy. I like fat coupons. And I like return of principal. But I take my bonds where I can find them. And these days the place to find fat coupons and return of principal is among blue chip equities."

Arithmetic-of-Equities

h/t: Market Folly

Another Record In Food Stamp Usage

The United Stated Department of Agriculture reported individuals receiving food stamps (Supplemental Nutrition Assistance Program) increased by 607,559 to 47,710,324 individuals in September versus August's enrollment. The number of households receiving food stamps increased just under 300,000 to 22,973,698. These are record levels of usage for the program with monthly cost totaling over $6.4 billion, nearly doubling in just four years. This data is further confirmation that Friday's job report (discussed yesterday's post: Not So Golden Retirement Years Is Fallout From Weak Friday Employment Report) was not as strong as the reported unemployment rate might suggest.

Chart Source: Zero Hedge

Fiscal Cliff Creating A Spike In Extra Dividends

An outcome of going over the fiscal cliff is the tax rate on dividends would increase to as high as 43.4% versus the current rate of 15%. In response to this higher dividend tax rate companies are initiating special dividends to be paid before year end. As the below chart shows, in the month of November, 228 companies have announced their intention of paying a special dividend as compared to the 97 companies last year. These numbers are based on common stocks (non-funds) listed on the ASE, NYSE, NGM, NNM and NSC. The pace of extra dividends does not seem to be slowing in December.

Source: Standard and Poor's

Not So Golden Retirement Years Is Fallout From Weak Friday Employment Report

Although Friday's Employment Situation Report (PDF) indicated non farm payrolls rose 146,000, not much else was positive about this report.

• those not in the labor force rose 542,000
• the civilian labor force fell by 350,000
• the number of employed declined 122,000
• discouraged workers rose 166,000, and
• the participation rate fell two tenths of a percent to 63.6%

From The Blog of HORAN Capital Advisors

For those nearing retirement age, it is turning into a not so golden one as more seem to be working longer. Certainly the fact individuals are living longer is contributing to older workers working longer. However, the retirement nest egg for those nearing retirement has been damaged over the last 12-years by the technology bubble, the real estate bubble and the Fed's effort to keep interest rates at record low levels.

From The Blog of HORAN Capital Advisors

A consequence of older Americans working longer along with an anemic pace of economic growth is the employment level for those under age 55 has declined. As the below charts shows, the number of employed for those age 16 - 19 is at a level last seen in the mid 1960s. Additionally, for those under the age of 55, the employment level is no higher than where it was in 1997.

From The Blog of HORAN Capital Advisors

Chart: h/t: ZeroHedge

Additionally, the slow pace of economic growth has resulted in a low (if at all) level of private sector job growth generating less revenue  for the government and increasing government payments on food stamps and unemployment claims. The government's new fiscal year began on October 1st and since that time, it is borrowing 46 cents for every dollar spent. This is a path that is not sustainable. The uncertainty or circus taking place in Washington at this point in time is perpetuating an environment that makes it difficult for business to plan. The end result is an economy that is stuck in neutral.

Implications Of An Elevated Equity Risk Premium For Asset Allocation

Assessing the equity risk premium (ERP) is an important factor for investment professionals and corporate finance officers. I will forgo discussing the importance to a CFO in assessing the ERP and focus on investment professionals. Given the importance of the ERP one will find a surprising amount of disagreement around how to determine the appropriate ERP level. One can perform a "Google search" on "equity risk premium" and find an inordinate amount of research on the topic.

For investors though, determining the appropriate ERP level should play a part in ones asset allocation decision. In short, the equity risk premium quantifies the additional rate of return an investor requires to compensate for the risk of investing in stocks versus a risk free asset, the 10-year treasury bond in this case. If an investor has a view that the market is under valued and likely to go higher, then one's view is the ERP will decline in the future. Conversely, if the investor has a view that the market is over valued and likely to go lower, then the investor believes the ERP will increase in the future. As can be seen with the green line in the below chart, the ERP is trading at near a historically high level. The basis for the calculation of the ERP is the earnings yield for the S&P 500, that is, the inverse of the index's P/E ratio.

From The Blog of HORAN Capital Advisors

As I noted, the ERP calculation used in the above chart is based on the market's earnings yield. Essentially, this is an ex post calculation and what is most important for an investor is the prospective expected market returns or ERP. For readers that are interested in a more detailed discussion of the ERP, Aswath Damodaran, a professor at Stern School of Business at New York University, published a paper (and is frequently updated) on the various methods utilized in calculating the ERP.

Based on the current ERP level, the high excess return expected for the market, an investor should consider allocating a larger percentage of their assets to equities versus the risk free treasury bond asset. However, I have discussed several times about the fact investors continue to seek out bond investments versus equity investments based on fund flow data. The recent fund flow release from ICI continues to note the flow of funds out of equities and into bonds. Given the relatively high ERP, why are investors not allocating more investment dollars to stocks versus bonds?

Although investors my not allocate larger dollars to equities, this doesn't mean stocks won't generate returns in excess of bonds. From a behavioral perspective investors tend to fear losses more than missing out on gains. With the number of negative market shocks investors have experienced since the year 2000, tech bubble, financial market crisis and the real estate bubble, this fear of loss is not surprising. Additionally, the markets hate uncertainty and events in Washington, D.C. have done anything but create more uncertainty.

The below chart of the U.S. Economic Uncertainty Index is at its highest level other than the level reported at the height of the debt ceiling debate in August last year. The on again off again fiscal cliff discussions in Washington also include approval to raise the U.S.'s debt ceiling. The debt ceiling debate in 2011 was not a positive for the equity markets.

From The Blog of HORAN Capital Advisors

At the end of the day, investors not only need to have a longer term horizon to invest in equities, but they need to have tools to help evaluate the potential direction of the ERP. There are several variables investors can utilize, like the Index of Leading Economic Indicators. This is important as it provides insight into the direction of the economy and hence the impact on corporate earnings. Also, investors can look at the consumer confidence index due to its inverse correlation to the ERP.

From The Blog of HORAN Capital Advisors

An article in the Journal of Investment Consulting, Does the Stock Market's Equity Risk Premium Respond to Consumer Confidence or Is It the Other Way Around?, provides support that so long as consumer confidence does not remain at near historical lows, long term investors can find the current risk/reward of the equity market attractive. The cited research in the article indicates satisfactory equity returns can be achieved with relatively low downside risk.

Dogs Of The Dow Performance Update

For the first eleven months of the year, the Dow Dogs price only performance has matched the Dow Index return with both returning about 6.6%. The S&P 500 Index return of 12.6% is nearly double the Dow Jones Industrial Average return. The Dow Dogs do have a yield higher than the index which results in slight outperformance for the Dow Dogs.

As noted in prior posts, the Dow Dog strategy consists of selecting the ten stocks that have the highest dividend yield from the stocks in the Dow Jones Industrial Index (DJIA) after the close of business on the last trading day of the year. Once the ten stocks are determined, an investor would invest an equal dollar amount in each of the ten stocks and hold them for the entire year. Investors should note the strategy has generated mixed results over the years.