Equal Weighting Stocks In Ones Portfolio Might Lead To Higher Returns

In January 2003 Standard and Poor's began tracking an equal weighted S&P 500 Index versus the traditional market cap weighted S&P 500 Index. In the short seven year period, the equal weighted index (EWI) has outperformed the market cap weighted S&P 500 Index.

From HORAN Capital Advisors

To market research theorist, this seems like an odd outcome as it does not conform to the capital asset pricing model (CAPM) or Efficient Market Hypothesis (EMH). So what does CAPM and EMH imply?

According to a recent S&P report that evaluated the performance of the equal weighted and market cap weighted indices, they provide the following summary of EMH and CAPM.

The theoretical underpinnings for market capitalization weighted indices as a basis for investment lie in the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis.

According to the CAPM model, the expected return implicit in the price of a stock should be commensurate with the risk of that stock. However, stocks are subject to two types of risk – systematic risk, resulting from potential movements in market factors; and unsystematic risks, resulting from factors associated with individual assets. Since unsystematic risk can be diversified away, stocks should be priced solely based on systematic risk. This also implies that it is optimal to hold a well diversified portfolio in order to minimize unsystematic risk for a given level of expected return.

According to the efficient market hypothesis, it is impossible to beat the market because prices already incorporate all relevant information. Based on this, the most efficient portfolio would be the entire market and a broad market capitalization index would represent the optimal investment. However, there is much debate as to how efficient the market is in practice. Thus, there are countless different strategies being used in an attempt to beat the market. This has led to indices created based on alternative factors that measure different strategies.

In addition to the question with EMH, there are questions surrounding Modern Portfolio Theory as well. I discussed issues with MPT in an earlier post titled, Modern Portfolio Theory: Is It Over Relied On?

Recent S&P research suggests the EWI outperformance is attributable to a couple of factors. The two prominent ones are size and style. As the below graphic shows, the EWI tends to have more exposure to the mid size companies in the S&P index as well as being more tilted towards value style companies. If one reviews Ibbotson data, the best performing asset class over the long run has been midcap value. As the performance table above shows, the larger sized S&P 100 Index has underperformed the cap weighted and equal weighted S&P 500 Index.

From HORAN Capital Advisors

In conclusion, the equal weighting in the indices has provided an investor with superior returns compared to the market cap weighted indices. Investors should read the entire S&P report as it shows this higher return comes with higher volatility. Additionally, the equal weighted indices have much higher turnover (rebalanced quarterly) in order to maintain the equal weighting of the underlying holdings. This higher turnover level is likely to lead to higher capital gains being realized. And lastly, given the higher volatility in the market today and likely into the foreseeable future, an investment portfolio that has more funds allocated to larger, generally higher quality companies, should hold up better in down market environments.

Source:

Equal Weight Indexing
Standard & Poor's
July 2010
http://tinyurl.com/24hshfn

Earnings Better Than Expectations and Revenues In Line

As the below graphic details, earnings have certainly improved compared to the end of the first quarter (first third of chart).

From HORAN Capital Advisors

According to Thomson Reuters, of the 336 S&P 500 companies that have reported earnings through the end of July, 75% have reported earnings above expectations. In a typical quarter since 1994, 62% of companies have beat expectations.

The market seems focused not only on earnings but on revenues as well. It is true revenues do drive earnings so long as sales are not generated by steep discounting resulting in slim or no gross margins. Again, according to Thomson Reuters, of these 336 companies, 64% reported revenues above analyst expectations, 0% reported revenues in line with analyst expectations, and 36% reported revenues below analyst expectations. Over the past four quarters, 61% of companies beat the estimates, 0% matched and 39% missed estimates. In the aggregate, companies are reporting revenues that are equal to estimates.

One factor to keep an eye on is the preannouncement ratio. For Q3 2010, 46 companies have provided negative earnings guidance while 15 have provided positive guidance. This equates to a negative/positive preannouncement ratio of 3.1. The N/P ratio for Q3 is above the long term N/P ratio of 2.1 for the S&P 500 Index.

From HORAN Capital Advisors

Norfolk Southern's Earnings Support Improving Economic Picture

After the market close today, Norfolk Southern (NSC) reported earnings (PDF) that increased 58.7%. The earnings of $1.04 per share bettered year ago results of 66 cents per share. Additionally, the results were 5 cents higher than analyst expectations of 99 cents per share.

Revenue increased 30.9% to $2.4 billion. During the company's conference call tonight, NSC noted, "effectively, all T&E employees have been returned from furlough status and we've started hiring in areas where traffic levels dictate and based upon expected attrition." Lastly, NSC announced a 6% increase in the company's third quarter dividend to 36 cents per share versus 34 cents per share in the same quarter last year.

From HORAN Capital Advisors

Both FedEx (FDX) yesterday and United Parcel Service (UPS) last week, cited an improving business environment as reasons to raise their outlooks. Other rail companies have reported this earnings season that their business conditions are improving.

These reports are certainly positive signs for the economy. Worries still remain with high unemployment and government and municipal debt issues though. In the end, all the news is not bad and investors can selectively find attractive investments in the current market.

Disclosure: Our firm is long NSC

Indexing Concerns And The Second Derivative Make This A Stock Pickers Market

One issue confronting investors at this point in the market cycle is the fact the growth rate of earnings on the S&P 500 Index are anticipated to slow going into 2011. Although operating earnings for the S&P 500 Index are projected to reach $92.19 per share, this level of earnings represents a lower rate of increase (the second derivative) than the earnings growth achieved in 2010.

From The Blog of HORAN Capital Advisors

For 2010 it is estimated that earnings will go from a -5% rate of growth in 2009 to a 22% growth rate in 2010. This represents a 27 percentage point positive swing in the rate of change in the increase in earnings on a year over year basis. It could be said the market's strong return in 2009 was forecasting this positive earnings change. The market does tend to be a good predictor of the future. As we now sit at mid year 2010, what are the estimated earnings for the S&P 500 Index in 2011 and what can be inferred from these estimates?

Although estimates show near record earnings of $92.19 for 2011 and a 16% increase over 2010 earnings of $79.53, this rate of growth is 6 percentage points lower than the estimated change in the growth rate of 27% in 2010. In other words, the second derivative of the earnings increase for 2011, or rate of change, is a negative 6%. Therefore, what investment strategy should investors pursue at this point in the market's cycle?

At HORAN Capital Advisors, we believe indexed large cap stock investors could be caught in this trading range cycle due to the negative second derivative of earnings, i.e. a negative rate of change in the growth rate. As a result, investors will likely achieve better returns, with less volatility, if they focus on individual high quality companies that exhibit a stable or consistent rate of growth in earnings when looking at earnings estimates for 2011 compared to the growth in earning for 2010. Those companies that can consistently growth earnings 10-15% over time are likely to provide investors with a more consistent return while assuming less downside risk as well. A couple of companies we own for our clients that satisfy this consistent or increasing growth criteria are Waste Management (WM) and Genuine Parts (GPC). As one can see by reviewing the below earnings charts, a steady or rising earnings per share growth rate is estimated for 2011. The 2011 EPS growth is near or better than the growth rate achieved in 2010. This represents just one of a number of variables we analyze, but it is certainly an important one.

From The Blog of HORAN Capital Advisors

One unpredictable variable is the market's potential reaction to the results of the midterm elections in November. What ever the election outcome, it could have a significant impact on sentiment for consumers and business.

Disclosure: Long GPC and WM

Sentiment Swings From Bullish To Bearish

In this week's investor sentiment survey reported by the American Association of Individual Investors, bullish sentiment fell 7.2 percentage points to 32.16%. Bearish sentiment rose by a like amount to 45.03%. The 8-period moving average was reported at 33.2% and is still off of the YTD high reported earlier this year in the low 40% range. The bullish sentiment reading remains below the long term average of 39%.

From The Blog of HORAN Capital Advisors

Data Source: American Association of Individual Investors

Anxious Index

The Anxious Index is published by the Federal Reserve Bank of Philadelphia and refers to the probability of a decline in real GDP, as reported in the Survey of Professional Forecasters. The survey asks panelists to estimate the probability that real GDP will decline in the quarter in which the survey is taken and in each of the following four quarters. According to the Philly Fed the Anxious Index is the probability of a decline in real GDP in the quarter after a survey is taken. For example, in the survey taken in the second quarter of 2010, the anxious index is 9.81 percent, which means that forecasters believe there is a 9.81% chance that real GDP will decline in the third quarter of 2010.

From The Blog of HORAN Capital Advisors

In looking at the index over time beginning in the fourth quarter of 1968, the index often goes up just before recessions begin. For example, the first quarter survey of 2001 (taken in February) reported a 32% anxious index; the National Bureau of Economic Research subsequently declared the start of a recession in March 2001. The anxious index peaks during recessions, then declines when recovery seems near. For example, the index fell to 14 percent in the second quarter of 2002, when economic indicators began improving.

Is The Economy Rolling Over?

The economic data seems to be signaling a slowing of the economy; however, this slowing does not mean a double dip recession yet. Lackshman Achuthan of the Economic Cycle Research Institute noted in a recent Yahoo interview that we are experiencing a "sharp drop" in the weekly leading indicators. On the other hand the coincident indicator continues to show a sharp rise in economic activity.

Source: Briefing.com

One variable not included in the coincident measure and a part of the leading indicators is the direction of stock prices and stock prices have trended lower over the last three months; thus one component that is pulling down the leading indicator. Mark Thoma, a professor of economics at the University of Oregon, notes the relationship between capacity utilization and unemployment. In his article on his Economist's View website, he notes,

"In the past, there was a fairly close contemporaneous relationship between capacity utilization and unemployment. However, much like the relationship between output and unemployment, a lag in the relationship has developed in the last two recessions (see graph). That is, in past recessions an upturn in capacity utilization was matched by an upturn in employment, there was no delay in the relationship, but in recent recessions there has been about a half year delay before unemployment reacts to changes in capacity utilization (or perhaps even a bit longer)."

Thoma goes on to point out two favorable aspects of the above graph.

"First, the "V" in capacity utilization seems steeper than it was in the last two recessions. If the steep recovery of capacity utilization continues and employment follows, the recovery could be a bit faster than I've been anticipating (though the recovery of capacity utilization could certainly flatten out, and that possibility has to be factored into any policy response -- in the past two recessions the initial change in capacity utilization was also steep for the first few months, but it didn't last). Second, the lag between changes in capacity utilization and the change in employment appears to be shorter than the last two recessions. If so, then employment will recover faster. But the word "appears" here is important. Looking at the response of unemployment in the last (2001) recession, there were initial encouraging signs for unemployment just like this time, but then the recovery of unemployment stalled and actually increased a bit more before finally beginning to decline consistently. It's certainly possible that will happen again. Thus, while there are some encouraging signs here -- the steepness of the recovery for capacity utilization and the apparently shorter lag between improvements in capacity usage and improvements in employment -- but neither of these are unqualified, the steepness could change and the shorter lag isn't yet certain..."

The economic recovery we are experiencing is certainly fragile. Much of the support has been provided by the public sector and we need to see the private sector be more of a stimulus. Social, economic and tax policies coming out of Washington are creating potential headwinds. We continue to expect positive economic growth, although the growth is slowing at this time.

Positioning For Higher Interest Rates

In a recent WealthTrack interview, conducted by Consuelo Mack, she talks with Loomis Sayles Bond Fund manager Dan Fuss. Dan Fuss is a two time winner of Morningstar’s Fixed Income Fund Manager of the Year award and has beaten the markets and its peers since the Loomis Sayles Bond Fund’s inception in 1991.

In the below interview, Dan Fuss provides insight into where he is finding value in the bond market. He also describes why he has recently shortened the average maturity of the bonds in the Loomis Sayles Bond Fund. Additionally, he talks about where he is finding value in the bond universe, which includes some global bond investments.

The lead in to the interview contains a performance comparison for treasury STRIPs and equity investments. The treasury investments have outperformed stocks for a very extended period of time. I do not believe the history of outperformance that is shown in the lead-in will repeat itself.

Earnings In Second Quarter 2010 Better Than Expected

Earnings for the 2nd quarter of 2010 are coming in better than expected. A few facts noted by Thomson Reuters:

• Through July 16, 48 companies in the S&P 500 Index have reported earnings for Q2 2010. Of these 48 companies, 75% reported earnings above analyst expectations, 13% reported earnings in line with analyst expectations and 13% reported earnings below analyst expectations. In a typical quarter (since 1994), 62% of companies beat estimates, 18% match and 20% miss estimates.

• Over the past eight quarters, 69% of companies beat the estimates, 9% matched and 22% missed estimates. In the aggregate, companies are reporting earnings that are 16% above the estimates, which is above the 2% long-term (since 1994) average surprise factor and above the -1% surprise factor recorded over the past eight quarters.
  

From The Blog of HORAN Capital Advisors

Waning Consumer Confidence Hits The Market

One factor that contributed to the market's decline on Friday was the decline in the University of Michigan's Sentiment Index. The preliminary results came in at 66.5 versus expectations of 74.5. In prior posts I have noted how this index tends to lag the market's return by about 2-3 months. The recent market correction began in April and the consumer confidence index peaked in June.

(click for larger image)

From The Blog of HORAN Capital Advisors

Negative sentiment can translate into a negative impact on consumer spending as well.

From The Blog of HORAN Capital Advisors

It's not that the government can create jobs, but it can create an environment that translates into more confidence by consumers. The uncertainty created by the recent passage of a number of new policies and regulations is certainly negatively impacting consumer and business confidence. If the mid term elections result in a change in the party that has power in Congress, the market may view this as a positive and begin advancing prior to November. This is one factor that could lead to a more confident consumer.

Second Quarter Investor Insight Letter

The second quarter of this year certainly presented noteworthy headlines, most of which led to downward market pressure. The S&P 500 Index ended down 11.43% and the 10-Year Treasury note rallied sharply as yields fell from 3.83% and settled below 3%, demonstrating a desire for less risky assets. Looking forward, if earnings expectations are met in Q3 and Q4 we believe the market has strong upside potential. Our letter this month will review Q2 and discuss market positioning and thoughts for the remainder of the year.

Read the complete Quarterly Investor Letter.

Bear Attack

Today's individual investor sentiment survey released by the American Association of Individual Investors noted a 15 point increase in investor bearish sentiment. This survey measures investors' six month forward expectations for the market. Additionally, the bullish sentiment fell to 20.9% and is two points above the bullish sentiment reached in the week of March 5, 2009. Since this is a contrarian indicator, the low bullishness level is one technical measure that would be a positive sign for a future move higher in the market. This week's current gain of 4+% is certainly confirmation of this potential outcome.

From The Blog of HORAN Capital Advisors

Signs Are Not Pointing To A Double Dip Recession Yet

Since 1950 every US recession has been preceded by

• A rise in interest rates
• An inverting yield curve
• Increasing oil prices, and
• Falling unit profits for US nonfinancial companies

None of these factors have occurred as of today as the below charts detail.

No Rise In Rates:

From The Blog of HORAN Capital Advisors

Yield Curve Not Inverted:

From The Blog of HORAN Capital Advisors

Oil Prices Stable Last 12-Months:

From The Blog of HORAN Capital Advisors

Nonfinancial Corporate Profits Moving Significantly Higher:

From The Blog of HORAN Capital Advisors

So at the moment, a double dip recession does not seem to be the most probable outcome for the economy. We do not see the Fed tightening monetary policy at this point in time. The economic recovery is a fragile one so investors should not throw caution to the wind. We will be evaluating corporate earnings announcement and more importantly corporate earnings guidance for signs that an economic slowdown might be on the horizon.

Dividend Payers Outperforming

For the month of June and the first six months of 2010, the dividend payers in the S&P 500 Index are outperforming the non-paying stocks. For the month, the payers' return of -5.91% was better than the non-payers' return of -7.30%. Additionally, this year the payers have declined 2.90% versus the non-payers decline of 4.41%.

Source: Standard & Poor's

On a year over year basis as of June, dividend payments were up 5.7%, for the quarter up 2.6% and down 3.2% on a year to date basis. In a further sign that companies view future prospects as improving, ten companies initiated dividends versus 65 that either decreased or suspended payments in the first six months of 2009.

The two negative actions this year fell in the energy sector. Valero (VLO) decreased its dividend by 67% in January and Tesoro (TSO) suspended its 20 cent dividend in February.

Cash Likely To Reduce Overall Investment Returns

The past ten years have been difficult for investors given the extent of the market's volatility. During this time period it may seem that holding onto cash has been the proper investment decision. The question then becomes cash versus what other alternative. As the below chart notes though, on a calendar year basis, not once during the past ten years did cash outperform both stocks (S&P 500 Index) and bonds (BC Aggregate Index).

From The Blog of HORAN Capital Advisors

As a result there was a better investment alternative than sitting on cash if that cash was targeted for longer term investments. Holding some cash is perfectly logical if the cash is needed for short term needs. Since 1926 cash has outperformed equities and bonds in 12% of the calendar years covered.

From The Blog of HORAN Capital Advisors

Source: Fidelity (PDF)

Holding some cash can serve as a useful purpose in reducing ones overall investment volatility. However, holding too much cash can be a drag on an investor's overall returns.

Individual Investors Certainly Not Bullish

Individual investor bullish sentiment declined over nine percentage points this week to 24.7%. This is the lowest bullishness level since November 5, 2009 when the bullish percentage was 22.2%. The 8-period moving average of the bullishness level fell for the sixth consecutive week to 35.1%. The 35.1% reading is the lowest bullishness average since the end of July last year when the 8-period average fell to 35%. The bull/bear spread for the week was reported at -17.3%.

From The Blog of HORAN Capital Advisors

Source: American Association of Individual Investors

The Market Does Track Earnings

If operating earnings for 2010 and 2011 come in as anticipated, the market is certainly likely to end the year at a level that is higher than where the S&P 500 Index closed today, 1,030. As the below chart notes, the market does track reported operating earnings.

Data Source: Standard & Poor's

After what has turned out to be a dismal second quarter for the market, many of the stocks in the S&P 500 Index are trading below their 50 day moving average. In fact, only 5% of the stocks are trading above their 50 day averages. This is a level that was last reached in mid May of this year and March of 2009. So on a short term basis the market certainly qualifies as being short term oversold.

The percentage of stocks trading above their 150 day moving average at the end of June (20%), is lower than the May 2010 level of 26%. This moving average declined to only 2% as of early March 2009. This could be one of those examples where the market can stay irrational longer than an investor can remain solvent.

From The Blog of HORAN Capital Advisors

For investors, company earnings reports for the second quarter, and more importantly, forward earnings guidance, will be critical in determining the direction of the market for the second half of the year. At this point in time at HORAN Capital Advisors, we are finding value in higher quality companies that are generating decent earnings and cash flow growth as well as trading at attractive valuations.

Economically, there are a number of positives that we will touch on in our second quarter newsletter. The two biggest negatives though are housing and employment.

Expect Market To Trade Within A Range

If history doesn't repeat itself perfectly, it often looks similar. As the below chart from Chart of the Day details, it is not uncommon for the market to trade within a range after a strong recovery off of a significant bear market. On top of this, the market tends to be choppy during the summer months. If the presidential election cycle market plays itself out, a better market environment may be upon us beginning in the fourth quarter and carrying over into early next year.

Source: Chart of the Day

Investors can use this opportunity to build positions in higher quality companies that have pulled back in this market correction.

How Low Will New Home Sales Fall?

A Peak In The Leading Indicator Index Indicative Of Mid-Cycle Economic Phase

A number of strategists are citing the fact the economic leading indicators index is rolling over based on April's report and thus the economy is rolling over as well. Investors should note though that this is not an uncommon occurrence when the economy is moving into its mid cycle phase. A recent report from Fidelity provides a chart of the LEI versus the coincident indicator index.

"The number of leading indicators rising on a one-month basis fell significantly from seven out of 10 in March to four out of 10 in April (see Exhibit 3, right). On a more sustained six-month basis, eight out of 10 indicators rose in April—the same as the prior month. The declines on a one month basis were relatively small for all of the leading indicators except building permits, which fell 12% in April from the prior month--a sign of continued stress in the residential housing markets. However, continued strength on a six-month basis and mixed messages on a one-month basis could be indicative of the economy moving into the mid-cycle stage of economic recovery (emphasis added).

While leading indicators tend to rise in near unison immediately following recessions, interpreting them becomes more difficult as the economic recovery gains footing because these indicators tend to rattle around in a more volatile manner. The Conference Board combines these 10 leading indicators into a weighted Leading Economic Indicators (LEI) index that helps paint a broader picture than any one of its subcomponents. As an economic recovery develops, it is helpful to observe these leading indicators alongside other data to gauge a recovery’s strength. The Coincident Economic Indicators (CEI) Index, which helps to gauge current economic conditions as opposed to the leading nature of LEI, is suitable for this purpose."

Source:

Rising Corporate Confidence: Yet to Show Signs of Reversal
Market Analysis, Research & Education
A unit of Fidelity Management & Research Company
June 14, 2010
http://personal.fidelity.com/products/funds/content/pdf/yet_to_show_signs_of_reversal.pdf

Where To Invest In An Inflationary Environment

Inflation has not been a threat to the economy or to asset prices in 2010. In fact, last week's CPI report contained hints of deflation with the seasonally adjusted CPI for May equal to the CPI reported in December. However, James Hamilton, professor of economics at the University of California San Diego notes in a recent article on inflation versus deflation,

"...my concern about long-run inflation comes not from the expansion of the Fed's balance sheet, but instead from worries about the ability of the U.S. government to fund its fiscal expenditures and debt-servicing obligations as we get another 5 or 10 years down the current path"

In the event inflation does take hold, what investments should an investor pursue to protect their assets? To answer that question an investor should determine whether they want to pursue an inflation hedge strategy or whether they desire an inflation protection strategy. The difference between an inflation hedge versus an inflation strategy is best summed up by Bill Ralls, CFA of Fidelity.

"In theory, a perfect inflation hedge would be an investment whose price moves in the same direction, at the same time, and by the same amount as changes in the consumer price index. Of course, there is no perfect inflation hedge, and while past performance is no guarantee of future success, some asset types have been more successful than others. For a successful hedging strategy, an investment’s return should increase at least as much as and at about the same time as the increase in inflation—or the time lag should at least be measured in months rather than years. Whereas building in protection against inflation over the long haul requires a more holistic approach and a consideration of what asset types have tended to do best in different inflationary environments."

From a hedging perspective, Treasury Bills, TIPS and commodities have the highest correlation to CPI as detailed in the below table. A perfect hedge would have a correlation of 1.0.

Although commodities have one of the higher correlations, in periods of low inflation (Quintile 1 in the below table) the average 12-month rolling return for commodities is actually negative for all the rolling periods and commodities generated negative returns in 49% of the 12-month rolling periods evaluated.

In high inflation environments, Quitiles 4 & 5 above, commodities had the best 12-month rolling returns. Given the volatile nature of commodity prices, they still generated negative returns in 16% and 28% of the rolling periods.

As I noted in an article from a few years ago, Are Stocks A Good Hedge Against Inflation?, the important factor to consider is the direction of inflation. If the rate of inflation is slowing, i.e., increasing at a decreasing rate, the market is likely to view this as a positive for stocks. So in a high inflation environment, even stocks can be a good investment if the rate of change in inflation is negative.

The conclusion in my earlier article noted, "in these tough times in the market, stock price returns will be impacted by events happening in the future and not by those that have already occurred. From an emotional standpoint, it is easy to let ones feelings for future stock expectations get clouded by past events. Being able to overcome these past influences is important in achieving positive investment returns."

Source:

Inflation vs. deflation: Prepare for Either
Fidelity Viewpoints
By: Bill Ralls, CFA
June 2, 2010
https://news.fidelity.com/news/article.jhtml?guid=/FidelityNewsPage/pages/fidelity-prepare-for-inflation-or-deflation&topic=investing

Is Gold's Bubble About To Burst?

Oppenheimer's chief investment strategist, Brian Belski, believes gold's price has reached bubble levels. In his recent research piece that was summarized in InvestmentNews, Belski states,

"...even on an inflation-adjusted basis, gold prices are higher now — two standard deviations above their long-term averages —than they've been since the early 1980s, when the U.S. was experiencing double-digit inflation. The metal is also “out of whack” with other commodities, a trend which has caused some puzzlement, even in places like the Federal Reserve."

Source: Chart of the Day

Corporate Cash Levels Continue To Grow

Until several quarters ago, cash on corporate balance sheets remained at a fairly stable level. Recently though, companies have been growing cash balances. A recent Wall Street Journal article noted,

"...nonfinancial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest-ever increase in records going back to 1952. Cash made up about 7% of all company assets, including factories and financial investments, the highest level since 1963."

As the two charts below note, cash has been increasing on an absolute dollar basis (first chart) and also as a percentage of a company's debt level (second chart). For S&P 500 companies, debt has grown by 5.6% over the past two years whicle cash has grown by 42.6%.

Source: Standard & Poor's

With a recent strengthening of the US Dollar versus the Euro and higher capital gain tax rates coming, US companies may use some of the cash to support corporate acquisitions both here and abroad. This same type of scenario played out when then president Reagan adjusted taxes in 1987. Additionally, given the level of cash, companies have the ability to step up dividend payments and dividend growth rates.

At the end of the day, this cash growth does show company business prospects have improved. No doubt corporate level expenses have been cut as well, but growth in revenue and earnings is occurring. I suspect this revenue and earnings growth will continue through year end and into 2011.

HORAN Capital Advisor's Philosophy & Approach

The rules for successful investing do not change just because the environment has become more uncertain. At HORAN Capital Advisors, we believe investing begins by clearly defining one’s philosophy and approach. Managers who stray from their discipline tend to reach for market returns and ultimately get caught in short term situations that can produce negative outcomes. A thoughtful, repeatable approach that emphasizes high quality investments can navigate volatile markets and provide for sustainable long-term outperformance.

Attractive rates of return are achieved with dynamic asset allocation and a focus on high quality investments. Our philosophy emphasizes the importance of fundamentals and valuations. Investor euphoria and asset bubbles occur when fundamentals and valuations are ignored.; therefore, screening for high quality securities takes patience and a disciplined process. The capital markets always present opportunity and value is added when undervalued investments are purchased and overvalued ones are sold.

When we look at specific securities, the screening process must be clearly defined. For example, we approach individual equities by identifying criteria defined by a high quality approach. Companies must exhibit consistent growth, management strength, market dominance, and financial stability. Frequently, the byproduct of these metrics is a consistent dividend distribution. A company with the availability to grow its dividends is a sign of strong cash flow and profitability.

The world has become a different place over the past decade. Household wealth has seen significant variations leading to nervous investors. Volatility may likely remain as the world reacts to sovereign debt issues, geopolitical concerns, and policy changes. Patient investors will find opportunities to invest in securities that have attractive valuations and growth characteristics.

A strong and communicative client relationship enables us to establish an appropriate asset mix utilizing the global opportunity set. Our investment philosophy and core approach helps clients achieve their long-term goals and objectives.

The Market's Bear Case

John Hussman of the Hussman Funds notes in his weekly market commentary that all of the economic growth in this recovery has been fueled by the government's deficit spending. Hussman notes:

...if one removes the impact of deficit spending, "the economy has recovered to the point where the year-over-year growth rate since early 2009 now matches the worst performance of any of the 50 years preceding the recent downturn." In effect, Wall Street's is seeing "legs" where the economy is in fact walking on nothing but crutches.

Hussman's comment cites four variables he evaluates to determine whether we are in a recession or not. An update on the readings for these variables can be read in his weekly comment on the Hussman Funds website.

He does conclude, "From my perspective, the evidence isn't yet sufficient, from a probability standpoint, to firmly anticipate a double dip. But it is notable how close the evidence is to locking in on that conclusion."

Source:

Born on Third Base
Hussman Funds
by: John Hussman
June 14, 2010
http://www.hussman.net/wmc/wmc100614.htm

Contrarian Signs That Bull Market Phase Approaching

Media headlines are now proclaiming that Dow 10,000 is a barrier that may not be surpassed for several years to come. The cover of Bloomberg's June 14th Businessweek magazine features a bear with the article lead in:

"The bearish forecasters who rose to fame in the market crash of 2008 have, for the most part, not surrendered their pessimism. Their moment could be coming back around..."

Last week an issue of the Wall Street Journal featured an article titled, The 11-Year Itch: Still Stuck at Dow 10000, that was written by Jason Zweig. In that article it noted:

"Last week, the Dow Jones Industrial Average rose above 10000—again. Since March 16, 1999, when it first touched 10000 in intraday trading, the Dow has bounced over that threshold and back 63 times. This Friday (6/11/10), the index closed 219.6 points below where it stood exactly 11 years ago."

As the WSJ article notes, the Dow hit 1,000 for the first time in January 1966 and did not convincingly close above that level until December 1982. In November of 1963, with the Dow at 740, Ben Graham said:

"in my nearly 50 years of experience in Wall Street, I've found that I know less and less about what the stock market is going to do but I know more and more about what investors ought to do."

At the end of the day, one will not see the bull market coming, but all the bear market talk tends to be an indicator of a better market environment in the not too distant future.

Dividend Payments Likely To Improve?

As I have noted in past posts, 2009 was the worst year for dividends since the late 1950s. S&P reports that dividends on the S&P 500 Index fell 21%, which was the biggest decline since 1938. Even worse for investors was the fact that the higher quality dividend paying stocks lagged the broader market rebound in 2009 by returning 26% versus 65% for the S&P 500 Index. As Tom Huber, portfolio manager of T. Rowe Price's Dividend Growth Fund notes,

"A dividend-oriented strategy has to be looked at over market cycles—there are times when it will lag, typically coming off a market correction or recession, and times when it does relatively well, usually in periods of market turbulence."

Today, companies are in a position to once again focus on growing their dividends for several reasons.

• Strong Balance Sheets: Many companies are flush with cash. A recent Wall Street journal article noted, "U.S. companies are holding more cash in the bank than at any point on record, underscoring persistent worries about financial markets and about the sustainability of the economic recovery. The Federal Reserve reported Thursday that nonfinancial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest-ever increase in records going back to 1952. Cash made up about 7% of all company assets, including factories and financial investments, the highest level since 1963."

• Sluggish Growth: In periods of slow economic and earnings growth dividends become a more critical part of the total return of a particular company's stock. In this environment companies are likely to respond to the investor's desire for more income from their equity investments. Since 1925, reinvested dividends have accounted for almost 44% of the total return of the S&P 500 Index.

• Less Volatility: Dividend paying stocks tend to be less volatile during downside market volatility. One factor we believe that will be present in the investment markets for the foreseeable future is a more volatile investing climate. A recent T. Rowe Price report notes, "dividend-paying stocks in the S&P 500 outperformed nondividend payers in every bear market since 1973 but tended to lag in bull markets, according to Ned Davis Research (NDR), a market research firm.

  During the bear market from March 24, 2000, to October 9, 2002, the S&P 500 plummeted 49.1%, while the Dividend Aristocrats gained 15.5%, according to Strategas Research Partners, another market research firm. In the recent market decline from October 2007 to March 2009, the Aristocrats declined 49.6%, compared with 56.8% for the S&P 500."

• Long-Term Performance: "NDR calculates that from 1972 through March 31, companies in the S&P 500 that have consistently increased or started making their dividend payouts provided an annualized return of 9.4%, compared with 7.3% for companies that paid dividends but did not increase them and only 1.5% for non-dividend-paying stocks."

• Steady Cash Flow: "From 1980 through 2009, dividends on stocks in the S&P 500 grew at an annual compound rate of 4.7% compared with the 3.7% annual inflation rate."

  Over a longer time period, principal growth of an equity portfolio outpaces that of a fixed income portfolio as well. The T. Rowe Price article cites a Ned Davis Research study showing this performance difference.

  "NDR tracked the performance of two portfolios over the past 25 years. One consisted of the top 50% of dividend payers in the S&P 500. The other was the S&P Long-Term Government Bond Index. The study assumed all interest and dividend payments were taken in cash each year.

  Assuming a $500,000 initial investment in each portfolio at the end of 1984, the equity index provided total dividend payments of more than $2.6 million through 2009, or about $212,000 more than the total interest payments from the bonds. Moreover, in terms of principal value, the original $500,000 investment in the stock portfolio grew to more than $2.8 million compared with about $908,000 in the bond portfolio."

For an investor then, a resumption of dividend growth could be at hand. The stock prices of dividend growers will likely benefit from this growth as well.

Source: T. Rowe Price Report

If history plays itself out, outperformance of dividend payers, over the long run, is likely to continue.

Source:

Dividends, a Casualty of the Crisis, Poised for a Comeback? (pp12-13)
T. Rowe Price Report
Spring 2010
http://individual.troweprice.com/staticFiles/Retail/Shared/PDFs/Spring2010PriceReport.pdf

Market Still Short Term Oversold

Just because the market seems oversold, this does not mean it will move higher in the next day or week. I wrote a post on May 31st titled, Seems Like The Market Is Oversold. At that time the S&P 500 Index was trading at 1,089 and closed today at 1,050 or 3.5% lower than the 5/28 close.

What does seem to be the case though is the selling pressure is subsiding in spite of the late day sell off today. Trading volume on these down days continues to occur on successively lower volume days. Additionally, the percentage of stocks trading above their 50 and 150 day moving averages continues to decline. The percentage above their 50 day M.A. is not too far from the percentage reached in March of last year.

With this recent pullback, there are a number of high quality stocks that are trading at attractive valuations and yields. Investors might use this opportunity to initiate or add to these positions if they have cash set aside for equity purchases.

Dividend Payers Trail Non Payers In May

The performance of the dividend paying stocks in the S&P 500 Index trailed the non payers in May by 1.34 percentage points. The payers returned -7.75% versus -6.41% for the non payers. On a year to date basis the payers have a slight edge, 3.20% to 3.11%, respectively.

Source: Standard & Poor's

Presidential Election Cycle Nearing Its Best Quarters

The market's performance around the presidential election cycle is one technical data point that seems to garner quite a bit of press-so here we go.

Standard & Poor's recently updated the cycle data through the first quarter of 2010 and going back to 1945. What the data suggests is the worst performing period for the market is Q2 and Q3 of the second year of a president's term. As the below table notes, the second quarter averaged a loss of 2.0% and the third quarter averaged a loss of 1.0%. For the quarter to date period in Q2 of this year, the S&P 500 Index is down 8.61% through the market's close on June 4th. This 8.61% decline is far worst than the average decline of 2.0%. In fact May's return of -8.2% is the worst May return for the market since 1962.

For Q4 of the second year, Q1 of the third year and Q2 of the third year, the frequency of positive returns was over 80%. For a sign that the market might achieve these positive returns investors should look for market leadership in the cyclical sectors like, autos, steel and equipment related firms. So seeing positive momentum from the industrial, materials and some consumer discretionary related companies could be a signal that the market will resume its upward advance.

In looking at the chart technicals for the S&P 500 Index, downside volume has been on the decline. One question that jumps out in the chart is whether the red line around the 1,050 level on the S&P is support or whether it is the neckline in a head and shoulder chart pattern. If the market can push through the 1,150 level on the S&P, i.e., break the resistance of the left shoulder of the pattern, technically the market could see additional strength. In the end though, the market will trade on fundamentals.

We are cautiously optimistic about the market through year end. With this recent pullback, there are a number of high quality companies that are trading at attractive valuations and have decent yields. The market will not move higher on a straight line basis and volatility is likely with us for some time. However, investors are getting an opportunity to begin building positions in attractive high quality companies at this point in time.

Source:

Whistling a New Tune in June?
Standard & Poor's
By: Sam Stovall, Chief Investment Strategist
May 28, 2010
http://tinyurl.com/2eegx46

Stocks Undervalued and/or Bonds Overvalued?

Below is research on the difference between stock and bond yields and subsequent 12-month forward stock market returns. The data was pulled together by Argus Research.

"The chart below depicts (on the right axis) the gap between the yields on the benchmark 10-year Treasury note and the S&P 500. Plotted against this series is the performance gap between the return on the S&P 500 and the return on the 10-year Treasury over the subsequent 12-month period.

Generally, a yield gap of 400 basis points or less has proven bullish for stocks. More notable, however, is that extreme levels have been very predictive of the market’s future direction. For example, the yield gap peaked in the fourth quarter of 1999 at 535 basis points, accurately foreshadowing that stocks were quite overvalued relative to bonds. Alternatively, in March of 2003 the gap had shrunk to just 150 basis points as bond yields had plunged and stock prices had sunk to bear market lows (thus pushing up dividend yields). The current readings are even below the March 2003 levels, suggesting that stocks are quite undervalued."

Source: Argus Research & Charles Schwab

Smart Money Optimism On The Increase

One sentiment indicator that has a fairly wide following is the Smart Money Dumb Money Confidence Index pulled together by SentimentTrader.com. As the below chart notes, the smart money indicators of the so called smart investors are starting to signal i more optimistic market environment.

Liz Ann Sonders, Chief Investment Strategist for Charles Schwab & Co notes:

"In general, you want to follow the smart money traders—tracking indicators such as commercial hedger positions and the S&P 100 index (OEX) put/call and open interest ratios. In contrast, you want to do the opposite of what the dumb money traders are doing—tracking indicators such as the equity-only put/call ratio, flows into and out of the Rydex series of funds and small speculators in equity index futures contracts.

As the old adage goes, markets can stay irrational longer than you can stay solvent, so I’m not here to judge the precise end to this correction. As we’ve noted, the market had been overdue for another pullback, one likely to be less benign than those that preceded it in light of stretched technical and sentiment conditions. In fact, it’s usually soon after the first year of a new bull market (cyclical or secular) that the market experiences its first 10%-15% correction."

Source:

Some Days Are Better Than Others ... Just Not These Days
Charles Schwab & Co.
By: Liz Ann Sonders, Chief Investment Strategist
June 1, 2010
http://tinyurl.com/29xcuu5

Better Investing's Most Active

Following is a list of companies attracting the most interest from members of BetterInvesting, based to their recent buy and sell decisions, as reported by a small, informal sampling -- 160 transactions -- for the trailing 4-week period ended Monday, May 31, 2010.

Full View

Figures in parentheses provide the previous ranking four weeks ago. This listing is presented as a source of stock ideas in the current market. No investment recommendation is intended.

Disclosure: Long ABT, GE

Seems Like The Market Is Oversold

The S&P 500 Index return of -7.99% for May 2010 was the worst since May 1962. This poor May performance seems to be validating the mantra, "sell in May and go away." Just as selling in May 2009 was not the right investment approach, could selling now be equaling bad timing given the magnitude of the market's decline in May?

The sharp sell off has resulted in a number of technical indicators suggesting an oversold market. The percentage of S&P 500 stocks selling below their 50-day moving average is near levels achieved in early 2009.

Additionally, individual investor sentiment become significantly more bearish last week. The American Association of Individual Investors reported bullish sentiment declined over 11 percentage points to 29.83%. The bull/bear spread became more negative at -21%.

Lastly, S&P notes that with 99% of companies having reported first quarter earnings, the rolling four quarter reported earnings per share totals $60.93. As the below chart notes, earnings have crossed the value for the S&P 500 index. Could this be a form of the technician's golden cross? Earnings estimates for the S&P in 2010 total $64.84 and the 2011 estimate is $80.92. Company fundamentals do seem to be favorable.


If there is a concern, beyond those in Europe, it is deleveraging that is occurring at the moment. This deleveraging process is taking away some of the strength that would come from the consumer. With job growth weak, consumers are feeling stressed and with out a confident consumer, economic growth might continue, but on the weaker side.

Market Corrections Not Unusual

A bull market is defined as one that achieves a return greater than 20%, conversely a bear market is one that declines over 20%. Market corrections are ones where the decline is greater than 10% , but does not exceed 20%. The market's recent decline from its April high was -12.3%; thus qualifying it as a correction. Corrections do not necessarily lead to bear markets though.

According to a recent report from Fidelity, the following aspects of market corrections are pretty typical:

• It’s been about 14 months since the current bull market began on March 9, 2009, which is in the neighborhood of the average length of time that has passed from the start of prior bull markets to a first correction (17 months, see above table).

• The stock market gained 80% before the recent correction. Historically, the first correction in a new bull market has come after average gains of 57%, implying the current bull market was overdue for a correction on a price appreciation basis.

• The main factor that has differentiated this recent correction is that it has taken place at a fairly swift pace compared to history. It took 27 days for the market to surpass the 10% decline threshold, which is half the time it’s historically taken on average for a correction to occur (54 days).

• Since 1926, there have been 20 stock market corrections during bull markets, meaning 20 times the market declined 10% but did not subsequently fall into bear market territory. Whether the market recovers again from here and avoids a bear market remains to be seen, but at the very least the more surprising development based on historical patterns would have been a continued bull market rally without a 10% pause.

In the short term, the S&P 500 index has bounced 2% off the May 26 low of 1,067. A number of equities are now trading at attractive valuations; maybe giving investors an opportunity to pick up some decent companies at attractive prices/valuations.

Source:

Stock Market Corrections: Unsettling But Not Unusual (PDF)
Fidelity Management & Research Company
By: Dirk Hofschire, CFA
May 21, 2010
http://personal.fidelity.com/products/pdf/stock-market-corrections.pdf

Are You A Contrarian Investor?

Volatility remains the order of the day and the market is down over 13% from its recent high. One can go back to 1998 and the S&P was trading at the 1055 level so in 12-years, on a price only basis, an investor has essentially made no money investing in the S&P 500 Index.

One question might be to determine if you are a contrarian investor. A recent MarketWatch article, The Bearish Bandwagon, noted that as of a couple of weeks ago, market timing newsletters were recommending investors allocate 80% of their Nasdaq-oriented portfolios to stocks. Today they are recommending minus 45%. The article notes, "this represents an extraordinary shift away from excessive bullishness to aggressive bearishness in a remarkably short period of time."

Markets Are Increasingly Volatile

Recently, investors seem to be pulling the sell trigger first and asking questions later during down market days in the stock market. At one time in the not to distant past investors believed 1% daily moves in the market were rare. Now 1% daily moves seem almost commonplace. Now the new standard is 2% daily price swings.

According to Standard & Poor's:

"the number of days in the past year that the S&P 500 fell by 2% or more in a single day began to accelerate. Indeed, May 4 and May 6 were the two most recent times the 500 dropped 2% or more in a single session. In the past 12 months (ended May 14), the 500 fell by 2% or more 13 times vs. an average of seven per year since 1970. Of course, these readings are nowhere near the peak of 54 declines experienced in mid-2009 as a result of the megameltdown in equity prices."

The quick sell mentality of investors seems to be driving higher volume on down days as well. Year to date through May 14th, S&P reports the volume of trades in S&P sector ETFs on down days equals 278.4 million shares. The volume on up days is 177.1 million shares. As a result the percent of down volume to up volume is 61%.

This higher volatility is an aspect of investing that investors need to be aware of going forward. A key focus of the investing approach utilized at HORAN Capital Advisors is to construct the foundation of ones portfolio in a way that minimizes this volatility.

Source:

Learning to Live with Increased Volatility
Standard & Poor's
By: Sam Stovall
May 17, 2010
http://tinyurl.com/28xa4a6