Thursday, August 18, 2005
Every day we get a new dose of economic data and depending upon the source(and political persuasion), of your news, you might conclude on some days that the the sky is falling, or on others that the sky's the limit. This is not a new phenomenon. We think it goes with the territory, so it is important to be able to zero in on just those few indicators that drive the markets. To provide a means of taking the pulse of the stock market's near-term prospects, many years ago we devised a very simple acronym, EIEIO, which helps us to focus our attention on the fewest and most important data points. Over time the acronym has become known as the Barnyard Forecast because EIEIO sounds like the chorus from the children's song, Old McDonald's Farm . EIEIO is taken from the first letter of Economy, Inflation, Earnings, Interest Rates and Opportunity. Each of the indicators is scored on a three point scale for its positive or negative implications for stocks in the coming 6-12 months. We give each indicator 2 points if we believe the trend of the indicator is positive for the stock market, 1 point if it is neutral, and 0 points if it is negative. Economy: The 80-year average of GDP is just over 3%, and we believe the ouch point for the Federal Reserve is 3.5% real growth. On a year over year basis, the GDP has grown at 3.6%. That is very good news for the economy, but not great news for the stock market because it means the Fed may well continue to raise short-term interest rates until the economy slows toward the 3-3.5% range. We rank the economy neutral for stocks, not because if its weakness, but because its strength will keep the Fed on the alert. 1 point. Inflation: We believe the Fed's inflation ouch point is 2.5% on the core CPI. On a year over year basis, the core CPI has risen 2.6%. That's close enough to the acceptable level of 2.5% that we will give it a neutral score. 1 point. Earnings: Earnings are nothing short of outstanding. Economy wide after-tax corporate earnings have risen nearly 20% in the last 12 months. That's good news anyway you look at it. 2 points. Interest Rates: While the Fed has consistently pushed short rates higher, our model looks at 10-year bond yields and long-term mortgage rates. Both of these long-term interest rates are almost exactly where they were a year ago. We rate them neutral for stocks. 1 point. Opportunity: Totaling the scores gives us a kind of short-hand view of the prospects for stocks in the next 6-12 months. At a total of 5 points (1+1+2+1) out of a total of 8 points, our model is suggesting a modestly positive rating for stocks. We believe the Barnyard Forecast is suggesting the sideways motion of the major indices may continue at least until the Fed sees economic growth slow a bit. However, we continue to believe that companies with above average dividend yields and growth can escape this sideways motion. A stock with a 3% dividend yield and expected dividend growth of 7% offers an implied rate of return of 10%. With 10-year rates at 4.25%, these solid dividend payers are too cheap, and investors are increasingly recognizing it. We will take a more in depth view of some the companies we like in the coming weeks.