September Rally Pulls Timing Outlook Back To Positive, But Still Not Re-Entering Market

1. Summary

An early September rally has pulled the Timing Outlook back into positive territory, up to 6.0 this time from a negative 4.5 last time.

For over four months, the S&P 500 has been stuck in a trading range of 1040 to 1130. The Timing Outlook has not performed well during this period, as the market’s drifts up and down have been timed nearly perfectly to repeatedly reverse the Timing Outlook, which I re-compute about every other week. So the Timing Outlook has been out of phase with the market’s short-term “trends.” There has been no long-term trend up or down; it has been sideways.

While the short drifts up and down have been long enough to keep the Timing Outlook off balance, they have been too short to pass my other criteria for being invested in stocks, so my Capital Gains Portfolio has been 100% cash since early May. The additional criteria, again, are:

• 9% rise over two weeks, with at least 7/10 days positive
• 3% rise over 3 weeks, with at least 10/15 days positive
• 4% rise over 4 weeks, with at least 14/20 days positive
• 5% rise over 5 weeks, with at least 17/25 days positive
• Etc.

The criteria are close to being met. Check out the chart above (click on it to enlarge it). It shows that the S&P 500 has risen about 6% during the past 10 trading sessions, with 8 of the past 10 sessions being positive. If the market’s rally continues a few more days, the criteria go to the three-week line, requiring a 3% rise with 10 out of 15 days being positive. We’re almost there. But patience is the watch-word. Don’t plug in hope as a substitute for actual performance. Waiting for the right entry point can be tedious, but avoiding losses is as important to overall success in investing for capital appreciation as scoring gains.

My Dividend Portfolio remains 100% invested after the changes described last time. By the way, I have begun to work on the 2011 edition of The Top 40 Dividend Stocks. I will keep you up to date on its progress. I hope to release it in January.

2. Market Performance Since Last Outlook
(“now” figures are as mid-day, Monday, September 13, 2010)

Last Outlook (8/25/10): 4.5 (negative)
S&P 500 last time (8/25/10): 1048
S&P 500 now: 1122 Change: +7%

S&P 500 at beginning of 2010: 1115
S&P 500 now: 1122 Change in 2010: +1%

S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1122 Change since 3/9/09: +66%

3. Indicators in Detail

• Conference Board Index of Leading Economic Indicators: No new report since last time. This index has been gyrating the past few months, rendering it ambiguous for our purposes. I require three straight monthly increases or decreases to label this as positive or negative. Indicator remains neutral. +5

• Fed Funds Rate: No change. With the Federal Funds rate near zero, this indicator remains positive. +10

• S&P 500 Market Valuation (P/E): Morningstar pegs the current P/E of the S&P 500 at 13.7, down from 15.2 last time. This indicator is in positive territory at any value below 17.4. +10

• Morningstar’s Market Valuation Graph: Morningstar’s proprietary market valuation graph is at 0.96, up from 0.91 last time. It is still in the neutral range, which is any value between 0.90 and 1.10. +5

• S&P 500 Short Term Technical Trend: This short-term technical indicator uses the two shorter simple moving averages (SMAs) of the S&P 500. The configuration (see the blue and green lines on the chart) is Index > 50-day > 20-day. That is ambiguous, reflecting the back-and-forth nature of the market over the past several months. Neutral. +5

• S&P 500 Medium Term Technical Trend: The mid-term indicator uses the two longer SMAs (50-day and 200-day, the blue and red lines on the chart). The lineup is Index > 200-day > 50-day. The recent 2-week rally has flipped this from last time, moving the indicator from negative to neutral. +5

• DJIA Short Term Technical Trend: This chart looks similar to the S&P 500 chart. Neutral. +5

• DJIA Medium Term Technical Trend: Same as the S&P 500. Neutral. +5

• NASDAQ Short Term Technical Trend: The NASDAQ’s chart has the same configuration as the other two. Neutral. +5

• NASDAQ Medium Term Technical Trend: Same as the other two. Neutral. +5

TOTAL POINTS: 60
NEW READING: 60 / 10 = 6.0 = POSITIVE

Buffett May Not Pay Dividends, But He Sure Likes Them

Berkshire Hathaway (BRK), aka Warren Buffett, has paid only one dividend since Buffett gained control. In 1967, Berkshire paid a dividend of 10 cents on its shares. It’s never happened again. Buffett has said he "must have been in the bathroom when the dividend was declared.”

Berkshire Hathaway is famous for not paying dividends despite having billions of dollars in cash. The company has many critics who believe that the company should “reward” or “return money to” shareholders. I am not one of those critics. I believe that Bershire/Buffett has proved itself to be perhaps the best allocator of capital on the planet, and I do not question that they can allocate their capital as well as or better than I could if they gave me some of it. I love dividends, but I don’t think Berkshire should pay a dividend.

Berkshire, while known mainly as an insurance company, is actually a conglomerate. It has a dizzying array of wholly owned companies in businesses as diverse as railroads, carpeting, candy, furniture, and jewelry. It also owns huge stakes in several public companies. It is the latter that I want to focus on, because Berkshire/Buffett has shown a great liking for companies that pay dividends.
Berkshire’s stock holdings are published quarterly. For the most recent quarter (ending June 30), here are its largest holdings, the percent of Berkshire’s stock portfolio represented by that holding, and the stock’s projected yield based on current payout. All information is from Morningstar.

• Coca-Cola (KO), 22%, yield = 3.2%
• Wells Fargo (WFC), 18%, yield = 0.9%
• American Express (AXP), 13%, yield = 1.8%
• Procter & Gamble (PG), 10%, yield = 3.3%
• Kraft (KFT), 6%, yield = 3.9%
• Johnson & Johnson (JNJ), 5%, yield = 3.8%
• Wal-Mart (WMT), 4%, yield = 2.4%
• Wesco Financial (WSC), 4%, yield = 0.5%
• U. S. Bancorp (USB), 3%, yield = 1.0%
• ConocoPhillips (COP), 3%, yield = 4.2%

These top 10 holdings account for 88% of all of Berkshire’s stock holdings—a very concentrated portfolio, especially considering its size. Overall, the company owns more than $46 billion in stocks, spread out over 37 different positions. (These figures do not include foreign investments held abroad.)

In Q2, Berkshire purchased about 17 million shares of Johnson & Johnson, adding to the 24 million it already owned. The total spent was about $1 billion, or about $58 per share. This was the biggest increase in any holding in Berkshire’s portfolio, raising its stake by 70%. What’s that worth in dividends? In June, J&J raised its dividend from $0.49 per share per quarter to $0.54, or $2.16 per year. A year’s worth of dividends at that rate for 24 million shares is $51,840,000. Actually, Berkshire will get more than that in the next 12 months, because J&J will raise its dividend again next June, as it has for 48 straight years.

In fact, 5 of those 10 companies are Dividend Champions—companies that have increased their payouts for 25 years or more consecutively: Procter & Gamble (54 years), Coca-Cola (48), J&J (48), Wesco (38), and Wal-Mart (36). ConocoPhillips has a 10-year streak going. In Q2, the second-largest increase in shares held by Berkshire was in Becton Dickinson (BDX), in which Berkshire increased its position by 8%. Becton Dickinson is a Dividend Champion with a 37-year streak.

Charlie Munger, Buffett’s sidekick at Berkshire, has been quoted as saying, “Investing is where you find a few great companies and then sit on your ass." While dividend-raising companies require attention just as any stock holdings do, it is clear that Berkshire/Buffett have found several great companies with a common characteristic—they pay consistently rising dividends. They have helped make Buffett the richest investor in the world.

Portfolio Forensics

From time to time, one runs across pointless arguments about whether buy-and-hold is dead. Most long-term stock holders know that buy-and-hold really means buy-and-monitor, or buy-and-homework, or some similar phrase that indicates that reasons can arise to sell a long-term holding. The days of the dying grandfather telling his family “Never sell the AT&T” are long gone. While the ideal might be to hold each stock “forever,” life happens, and in doing so it can create reasons to sell any stock.

How do you decide? I advocate periodic Portfolio Reviews. In my Dividend Portfolio, which is devoted to dividend growth stocks and does not require real close attention, I aim to conduct a review twice per year. The point is to impose upon yourself the discipline to really examine your stock portfolio periodically, apply standards designed to reveal whether each stock still deserves a place in your portfolio, and take action on what you find out.

In my Dividend Portfolio, normally the presumption is that each dividend stock will not be sold. But that presumption can be overcome. During a Portfolio Review, the burden shifts to the company to prove why it should be kept. Here are some of the questions I ask:

• What is its yield on cost (YOC)? I don’t penalize a dividend growth stock solely because its current yield may have dropped below qualifying levels. That may be only because the stock’s price has jumped way up. If I purchased it years ago, and I am still satisfied with how it is growing its dividend, the reliability of the dividend, etc., I normally would keep it. It is doing its job. By the way, the formula for YOC is: Yield on Cost = (Current Yield x Current Price) / Acquisition Price. An equivalent formula is Last 12 Months’ Dividends / Acquisition Price.

• Should some profits be taken? If the company’s price has skyrocketed, that may present an opportunity to cash out some or all of it and purchase another stock selling at a better price and offering a higher yield. The goal would be to have the total dividend stream increase after the transactions are completed. Notice that if you have held a stock a long time, its current yield may be low but its YOC may be quite high, difficult to match with a new purchase.

• Is the safety of its dividend in question? As soon as BP’s oil rig blew up, the safety of its dividend became perilous for anyone who thought about it. In a Portfolio Review, update your information on each company and give serious thought to the ongoing reliability of its dividend.

• Is there a chance to improve your portfolio by making a stock swap? There are various ways to improve your portfolio, such as increasing its total yield, increasing the rate of dividend growth, diversifying it, and so on. As to increasing yield, note the discussion above (second bullet) about making sure that the initial yield on a new purchase would exceed the YOC of the stock you would sell. If it wouldn’t, it’s hard to justify the swap. A higher expected rate of increase may tip the scales.

• Did the company cut or freeze its dividend? If so, it is subject to immediate examination. You will probably decide to sell most stocks that cut or freeze their dividend. The main goal of my Dividend Portfolio is to deliver an ever-increasing dividend stream, so obviously a cut or freeze hurts that goal. Also, a cut or freeze often portends a price drop. Confident management teams adhere to established dividend-growth patterns. A company that cuts or freezes its dividend is conserving cash for some reason. Find out why. The company may be in difficulty, and its price may be in for a drop too. Selling early usually brings in the most money you will be able to get for that stock for a long time to come.

• Has the company’s current yield risen above 10 percent? If so, it is subject to immediate review, but this is not an automatic reason to sell. An extremely high yield is usually the result of an extremely low price. Find out why the market has devalued the stock. It may be a clue that the company is having major problems, and upon examination you may discover that the dividend itself is in peril. This may be dividends’ equivalent of a “dead-cat bounce” in price.

• Has the rate of growth of the dividend taken a turn for the worse? Can you figure out why? Many dividend investors regard dividend growth as a key indicator of future prospects, because it reflects management’s view of and confidence in the next few years, often based upon information available to them but not to you.

Let’s look at some examples. Here is how these principles played out for six stocks in a recent Portfolio Review of my Dividend Portfolio.

Abbott Labs (ABT): I own two slugs, purchased in 2008 and 2009. Their yields on cost are 3.2% and 3.7%, respectively. Abbott increased its dividend 10% this year. The stock is working fine. Decision: Hold

Alliant Energy (LNT): Initiated position early in 2010, and it has worked out well. The stock has a 9% price increase and a 4.9% YOC after a 5% dividend hike this year. Decision: Hold.

Diageo (DEO): I bought this in 2008. Diageo is a foreign stock (Britain), and like many foreign stocks, it does not adhere to a predictable dividend-raising schedule. It makes two payments per year, and the first payment is typically less than the second payment, making the total year’s dividend impossible to predict. In its native currency, Diageo has been a steady dividend raiser, but with varying exchange rates, that has sometimes translated into fewer $US, as if it had cut its dividend. Too many headaches to keep track of, despite the company’s strengths. My position was small, and I had a 14% long-term price gain on the stock. Decision: Sell and put the money to work elsewhere.

Emerson Electric (EMR): Also purchased in 2008, EMR has disappointed lately with small dividend increases, just 2% in 2010. Its 2.7% yield on cost (YOC) was pulling the portfolio’s YOC down. Last year, I put it on sort of probation, sticking a 10% trailing sell-stop under it. It survived by steadily moving up in price from what had been a significant capital loss. After nearly hitting the breakeven point, its price began to weaken again. The lousy dividend increase motivated me to put a tighter stop under it (5%), which it hit a couple of weeks later. Decision: Put tight stop under it; the stop was hit, so stock sold.

McDonalds (MCD): Purchased in 2008 and again in 2009. YOC is 3.7% and 4.1% respectively. Blended price increase is more than 20%. Raised its dividend 26% in 2009; awaiting 2010’s increase (which typically comes with the final payment of the year). What’s not to like? Decision: Hold.

Royal Bank of Canada (RY): Purchased in 2008, the stock survived the financial crisis and is a solid, stable bank. But it has not increased its dividend since 2008. I decided to put this small position’s money to work elsewhere. Decision: Sell.

The Dividend Portfolio contained 12 stocks when I did the Portfolio Review. The 3 sells mentioned above are a little misleading, because I wanted to show examples of reasons to sell. Those were the only 3 sales resulting from this review. The other 9 stocks were held. In dollar terms, there is typically less than 10% turnover per year in this portfolio. Sometimes there is none.

A good practice is to keep a Shopping List ready—stocks that will help improve your portfolio in some way and that meet all your criteria for buying a stock. For my Dividend Portfolio, I use my e-book, The Top 40 Dividend Stocks for 2010, as my Shopping List. I make sure to update the information, especially any target’s yield and valuation, before making any purchase. With the proceeds from the 2 immediate sales, I increased my stake in Alliant Energy. At a current yield of 4.5%, that gave a nice boost to the portfolio’s overall YOC (which was 4.1%). When Emerson Electric hit its sell-stop, I used those proceeds to initiate a position in Johnson & Johnson (JNJ), whose price seems depressed, at a 3.6% initial yield. I was pleased to see that Warrren Buffett—through Berkshire Hathaway (BRK)—had made JNJ his single largest stock purchase in Q2, adding 17 million shares to the 24 million he already owned, spending about $1 billion on the purchase. I picked up 50 shares myself. What the hell. Always glad to be in agreement with Mr. Buffett.