More Forecasting Follies Hi Guys,
From the mind of 6th Century BC Chinese Poet Lao Tzu: “Those who have knowledge, don't predict. Those who predict, don't have knowledge. "
And another beauty that represents one of the most egregiously inaccurate predictions made by astute IBM founder Thomas Watson in 1943: "I think there's a world market for maybe five computers."
And another beauty from an Anonymous source: "A good forecaster is not smarter than everyone else, he merely has his ignorance better organized.”
So with those cautionary quotes as an introduction, I offer my humble and likely inept forecasts for the equity market action for the remainder of the year.
I’m optimistic. At this posting, using the S&P 500 Index as a proxy for the equity marketplace, the year-to-date return is 5.8 %. At year’s end, I project that the S&P 500 Index will finish with a 9 % to 15 % annual return. I suspect the 15 % return is more likely. Here’s how I reached that forecast; it was not purely, but mostly, guesswork.
In simplified form, real equity returns are given by the sum of (1) dividend yields, (2) corporate profits, and (3) speculative expansion of the Price to Earnings (P/E) ratio. The anticipated actual return over the real return incorporates an adjustment for inflation.
The formula summarized in the previous paragraph captures market rewards with high fidelity over longer-term periods like ten years. Since the speculative component is hard (more likely impossible) to anticipate, sudden changes in the P/E ratio wreak havoc on any short-term prediction. That’s why market gurus often fail on an annual basis.
Nevertheless, I accept the challenge fully cognizant of the inherent risks. It may prove to be a totally useless market projection, but I’m sure it will stimulate a hot debate on this Forum. That’s its main purpose since I’m committed for the remainder of the year.
Here is my ignorant, but organized forecast.
Let’s start with the fundamental earnings growth and dividend yield portions of the expected returns equation. Just today, the WSJ reported the adjusted annual GDP growth rate prediction from Deutsche Bank, Goldman Sachs, JP Morgan, and Bank of America. The average real growth rate from these four exemplary sources is 2.68 % for 2011.
The S&P 500 reported dividend yield is 1.9 %. The Journal also shows a total CRB inflation rate of 2.3 %. Because of the deficit government spending policy, I expect this rate to increase: For the purposes of these analyses, I’ll use an annual expected inflation rate of 2.6 %.
Based on earlier studies, I have developed a very tight correlation between corporate earnings and GDP levels. If GDP grows 1 %, company profits will rise by 1.7 %.
Therefore, my forecast for the fundamental real market return will be (1.7 X 2.68) + 1.9 or about 6.5 %. Converting the real return to an actual return that reflects the inflation rate gives a fundamental forecasted equity market return of 9.1 % (6.5 + 2.6).
This analysis does not yet include any possible speculative contribution.
What can propel a positive speculative component? Many unclear factors like momentum, competitive returns from the bond vigilantes, liquidity, and investor sentiment. From my current perspective, these are mostly positive now, and reinforce and/or augment the forecasted returns based on market fundamentals. Here are some assessments.
The current market P/E ratio hovers around 16 depending on rearward or forward looking estimates. The annual dividend yields for the 10-year treasury and the DJ Corporate bond index are 3.1 % and 3.6 %, respectively. The modified Greenspan-Yardeni Fed model contrasts the equity market yield (inverse of the P/E ratio) against these baseline standards. That comparison demonstrates that the equity marketplace is presently undervalued. A regression to the mean belief system would suggest an incremental market price increase.
Presently, the S&P 500 Index is at about its 65-day moving average and approximately 6.5 % above its 200-day moving average. This is a positive momentum indicator and signals an equity commitment. That 6.5 % cushion offers a safety-net. If the 65-day average penetrates the 200-day moving average, a danger signal is transmitted. That’s not the scenario now.
Additionally, the 4-year Presidential cycle data set shows that the third year in that cycle is particularly rewarding to the equity investor. It has never delivered a negative performance during its history. The third year incremental output should enhance 2011 performance by 2 % to 5 % conservatively.
Liquidity has returned to the economy. The M2 money supply drop was arrested several months ago, and is presently reported by the St. Louis Fed to be at a 5 % annual growth rate. That’s sufficient funding to support an annual GDP growth rate that is at one-half that level. In fact, it adds somewhat to the inflationary pressures by providing excess liquidity. So the current government fiscal and monetary policies are both inflationary by design to stimulate the economy.
Investment sentiment has both fear and greed elements. The VIX Index is at its highest reading in over 2 months although its YTD trend is downward; that recent implied volatility denotes an increase in investor uncertainty and fear. The Investment Company Institute (ICI) data resource reports that investors are recovering confidence with a YTD money flow into stocks, hybrids, and bond entities, and fleeing money market products. That’s a mixed signal since investors are typically late into a bull market.
Finally, the AAII has maintained a sentiment indicator for many years. The historical long-term averages are that 39 % of AAII members are Bullish, 31 % are Neutral, and 30 % are Bearish. Today, 26 % are Bulls, 33 % are Neutral, and 41 % are Bears. Most market gurus use this cohort as a contrarian’s indicator. Since the current Bulls are below the historical average, the marketplace must have an upward trajectory from this contrarian’s viewpoint. Boy, we individual investors are held in low esteem.
Well, that’s my forecast, and I’m sticking to it. Overall, I’m hoping for a minimum of 9.1 % from fundamental considerations alone. Add some speculative components and the Presidential cycle consideration, and I’m forecasting a double-digit 2011 return of perhaps 15 %. That’s 9 % higher then the present S&P 500 YTD performance.
So, I’m staying the course, and I’m keeping costs to a minimum.
What are your assessments of the equity markets and my analysis? Your comments are encouraged and greatly appreciated.
Best Regards,
A Candidate Global Macro Investing Approach (P: MJG) It is all too easy to be the victim of Information Overload when preparing to make an investment decision. The term Information Overload was originally introduced by Alvin Toffler in his 1970 classic book, “Future Shock”. The ubiquitous Internet and the 24/7 news cycle have only reinforced this exacerbating and exhaustive circumstance.
The search to contain this epidemic has directed some folks to a more global macro approach to the investment puzzle. Whereas historically, significant effort was focused on individual stock selection, academic research and professional money managers are more likely today to concentrate on more macro-oriented analyses such as asset allocation judgments, category dynamics evaluations, and sector rotation assessments. The likelihood of more meaningful payoffs are enhanced, and, concurrently the required time commitment is reduced, with this broader lens policy.
Research has confirmed that the most reliable rewards are delivered from broad asset allocation decisions and not from rare, individual super-performer stock picking. Also, a more global approach that embraces wide diversification minimizes overall downside risk. Significant risk reduction (as measured by portfolio volatility) is achieved as investments flow from separate stock holdings to sector holdings to international marketplace assignments to a top-tier equity/fixed income mix decision tree.
How now to make these challenging and complex decisions?
One answer that is gaining popular professional acceptance because it is relatively simple to implement, and, at least attempts to avoid the Information Overload scenario, is to embrace a factor model. The fundamental concept is to make a buy/sell/hold decision on a pre-selected and limited number of dominating factors.
What are these factors and what market metrics are needed to assess them? Here are a few factors proposed by several market gurus who subscribe to the limited generic factor approach as applied to investment class groupings.
The two market professionals that I reference are Elaine Garzarelli of the 1987 market crash prescience fame and Jack Albin, chief investment guru from Harris Private Bank.
Jack Albin documented his global macro investment concept in a 2009 book titled “Reading Minds and Markets”. His basic methodology is to assemble a short list of fundamental, technical, and behavioral factors to drive the investment decision-making process. It’s a philosophy to tilt the odds just slightly. It emphasizes sector and category investment selections over specific stock/bond choices.
The Albin 5-factor model includes Valuations, Momentum, Economy, Liquidity, and Sentiment components. Of these 5 elements, Albin rates Valuation and Momentum at the highest level. He endorses the other three elements as more confirmatory in character. He will not consider the lower tiered criteria unless the dominant two are blinking the go-ahead, flashing Green-light signal.
Some of the metrics that measure the current state of the Valuation factor include elements such as the conventional Price to Earnings ratio, the Price to Cash Flow and the Price to Sales ratios (the usual suspects), and the famous Greenspan/Yardeni Fed Model that uses both the 10-year treasury and triple-B rated bond data for comparison purposes. The Momentum factor metrics include longer term moving averages criteria and market/sector breath indicators such as the advance/decline line, the number of highs to lows ratio, and the ARMs data sets.
For the Economy factor, Albin lists bond yield curve direction, the gap between corporate and government bonds, and the Conference Boards 10 leading indicator array as useful metric tools. He recognized that short term data exhibited too much noise to be reliable, so data collection periods often exceeded 9 months. Albin recommends monitoring the M2 money supply, yield spreads, and closed-end mutual fund money flows that impact premium/discount NAV numbers to gage Liquidity. Remember that Liquidity is the fuel that fires the business engine.
Albin acknowledges Market Psychology/Sentiment as the fifth factor. This was the last factor unit added both by Albin and by Garzarelli. Albin uses it as a confirmatory signal, not as a primary indicator. He identifies the AAII sentiment indicator, the VIX index, and short selling lists as contrarian signals.
Behavioral scholars have concluded that we are not totally rational investors. Fear and greed always enter into the investment equation. Therefore, none of these signals are without residual risk. Sometimes the herd is right; sometimes the wisdom of the crowd persists, but trigger points that generate bubbles ad panics exist.
Today, Garzarelli’s factor model incorporates 14 separate metrics in four generic categories. Her four generic categories are: Cyclical, Monetary, Value, and Market Sentiment units.
Her Cyclical grouping metric includes industrial production and corporate earnings metrics. The Monetary unit incorporates 7 separate metrics such as interest rate, yield curve shape, interest rate class gaps, and money supply that quantify monetary policy. The Value category features an earnings yield to interest rate ratio and a Price to Earnings equation.
The Sentiment array incorporates a mutual fund cash level metric and a composite of a bullish professional advisors strength metric. Her model influence coefficients (the weighting constants) are updated regularly, and these coefficients take both positive and negative (contrarian) values.
Note the similarity between many of the Albin and Garzrelli category factors and the metrics used to evaluate these broad indicators.
How effective have these global macro indicators been in defining tipping points and investment opportunities?
Their track record is surely imperfect, but many successes have been registered as well as some highly notorious public failures.
My purpose in submitting this posting is to encourage all Board members to consider a top-down investment approach. In at least a partial sense, we all currently deploy some form of the analyses type advocated. We purchase mutual funds and/or ETFs for the major portion of our portfolios. We typically eschew separate stock holdings. As a cohort, we tend to establish longer-term positions. The global macro investment approach seems to be an integral part of our investment DNA.
Simplifications in the investment process is a very desirable goal. But caution must be respected when putting this guiding principle into practice. Albert Einstein noted that "Everything must be made as simple as possible. But not simpler.”
Best Regards,
MJG
