Tuesday, September 27, 2005

The Barnyard Forecast Revisited

On August 18, prior to the Hurricanes Katrina and Rita, we took a look at the prospects for the stock market in the year ahead via our Barnyard Forecast. The forecast is a big picture analysis of the position of the major components of the economy and how they resolve themselves on-balance. You may want to review the previous post for a more expansive explanation of how we view each component. Economy: In the Barnyard model, economic growth above 3.5% is considered negative because its means the Federal Reserve will be applying the brakes by raising interest rates. Prior to the hurricanes, GDP had been growing at about 3.6%, which we ranked as neutral for stocks. The hurricanes are now expected to chop near 2% off GDP growth over the remainder of this year. That would seem to imply that the Fed's long string of rate hikes is nearing an end, which would be good for stocks. The only problem with this view is that the rebuilding of the Gulf Coast area will provide a huge stimulus to the economy and probably push economic growth in the early part of 2006 back above the caution level of 3.5%. I still rate the economy neutral for stocks, 1 point. Inflation: This is the wild card in the deck. The stop and go nature of the economy for the coming year assures volatile readings. I believe the core CPI will average near the caution level of 2.5%. This will be neutral for stocks, 1 point. Earnings: There will also be a stop and go quality to corporate earnings during the next twelve months. With business currently slowed or stopped in the Gulf Coast region, in the near term, earnings will be lower than expected; but the uptick in the rebuilding process will also lift earnings growth next year above 7%, which is the threshold required to achieve a positive score. Positive 2 points. Interest Rates: I still rate interest rates neutral. The 10-year T-bond is currently yielding 4.25%. That is about the same as it was at the beginning of the year, as well as a year ago. Interest rates could drift a little higher in the early part of 2006, but I do not see long-term bond yields or mortgage rates being much higher a year from now. Neutral 1 point. Opportunity: The model scores 5 points (1+1+2+1), which is the same as it did on August 18, before the hurricanes. It may be hard to believe, but the hurricanes have done little to the longer-term outlook for growth of the economy or corporate earnings. Certainly, there will be some rearranging, with a slowing followed by a return to stronger growth, but the net effect is a reading that is about the same as a month ago. I do believe, however, that the Fed will stop raising rates in 2006, and as it becomes clear that they will do so, stocks will likely have a strong advance. Stocks are very cheap now. Earnings are up nearly 13% over a year ago, yet prices are down. This divergence cannot hold, and I believe it will be resolved by stocks moving higher.