Friday, August 21, 2009
Randy Alsman authored this blog. Randy is Vice-President, Portfolio Manager, and Member of Donaldson Capital Management's Investment Policy Committee. Please read more about Randy here. Donaldson Capital Management for years has developed our long-term stock market forecast through a set of analyses that we call the"Barnyard Forecast." It is also known by its mnemonic, "E+I+E+I= O. E I E I O stands for Economy+ Inflation+Earnings+Interest Rates = the Opportunity for Stocks. We believe the interplay and trends of these measures of the economic environment will dictate the direction of stocks over the next 12 months. Each of the four elements is rated as positive for stocks (2 points), neutral for stocks (1 point), or negative for stocks (0 points). The total points are then added to arrive at a final score between zero and 8. An overall score of 4 is considered neutral. Anything above 4 is considered a positive environment for stocks; anything below a negative environment. The score we give each element is based on our historical analysis of its effect on Federal Reserve Policy. That is, will the element's status likely cause the Fed to be accomodative, neutral, or restrictive toward economic and ultimately stock market growth? This can lead to scores that are counter intuitive. For instance a low GDP reading is positive for stock market growth, as the Fed will likely be stimulating the economy, which will ultimately be good for stocks. We also use this EIEIO framework to guide our weekly investment policy discussions. What follows is our current market outlook as seen through the eyes of our EIEIO model? Economy: Score 2 - Positive Note: Three percent GDP growth is considered optimal, non-inflationary growth. Our model scores any 12 month GDP growth greater than 3% as negative, and vice versa. We do take into consideration the recent GDP trend and outlook. But the latest 12 month's GDP has historically had the greatest impact on Fed actions. This sounds counter intuitive, because it is. But remember we are talking about whether the Fed is going to add stimulus or restriction based on the GDP level. On a year over year basis, the most recent data show that GDP stands at negative 2.5%. With GDP in negative territory we believe the Fed is still in an aggressive stimulative phase that should return the US economy to growth in the coming months. The weak economy is positive for stocks. Inflation: Score 2 - Positive Note: The Fed has said the optimum level for core inflation is approximately 2%, year over year. The core inflation rate excludes food and energy. Core Inflation greater than 2% will cause the Fed to tightened credit and slow the economy. Inflation under 2% will allow the Fed to stimulate the economy. Moderate inflation of 2% - 2.5% is actually necessary for healthy economic growth. Core inflation for the year ended 07/31/09 was 1.5%. A reading this much below the optimal level is positive for stocks because it means inflation fears will not thwart the Fed’s initiatives to stimulate economic growth. The current core inflation rate is positive for stocks. Earnings: Score 0 - Negative Note: Year over year corporate earnings growth has averaged about 7% over the long term. Therefore, EPS YOY growth greater than 7% is positive for stocks, and less than 7% is negative. Q2 '09 earnings were much better than expected. However, they were still 30% below Q2 '08. Cost cutting has helped profits, but until revenues actually begin increasing again, earnings will likely not increase over the prior year. The Earnings element of our model receives a negative score. Interest Rates: Score 2 Points - Positive Note: We generally look at the current rates for both the Federal Funds Rate and the 10-Year U.S. Treasury Note vs. the prior year. If the current rate is less than the prior year – positive for stocks. If the current rate is higher – negative. This one’s easy. The Federal Funds Rate (a key rate that determines many others) is at 0% to 0.25%, and 10-year T-Notes are only yielding 3.5%. Both of these rates are lower than a year ago. This is very positive for stocks. Outlook for Stocks Score: Total 6 Points - Positive EIEIO is currently signally a positive environment for stocks in the year ahead. That does not mean stocks will go straight up. Indeed, we believe they will continue a “saw tooth” path higher. There are still many unknowns and much healing is needed in many parts of our economy. Nevertheless, our model has a good track record of anticipating stock market trends, and we are in agreement with its findings, that stocks will enjoy a positive rate of return in the year ahead.