Barnyard Forecast: Year End 2008 Looks Good

It's a dark night, the dog ate my speech. Actually I left the speech on the desk in the hotel in Indianapolis. I am to give that speech in 30 minutes to a crowd of maybe 100 people. I am not worried too much because the speech is about the economy and prospects for stocks. I can wing that with an overhead slide or two. Then I see flashing yellow lights ahead and an illuminated sign that says: Return to Marked Detour. Now I am worried, because I did not see any detour signs for the last 20 miles. There will be no backtracking and still make the speech on time. Then in the cornfield on my left I see the unmistakable signs of a solution to my problem: the moonlit dust of a fellow traveler. There is a back road around this detour and it follows the contour of this cornfield. Fifteen minutes later I am in the room where I will give the speech. I am greatly relieved to have arrived on time, but now I am faced with the task of saying something intelligent to the gathering crowd from a speech I do not possess. I do as I always do. I mentally work through the acronym E+I+E+I = O. Economy plus Inflation plus Earnings plus Interest Rates equals Opportunity. As many of you know, this is what has come to be known as the Barnyard Forecast. The Barnyard Forecast is a rule of thumb method to ascertain the "on balance" forces driving the stock market at any particular time. The story of the Barnyard Forecast began 20 years ago as I sat in front of that detour sign, but I still use it today, even when I have lots of time. The reason is simple: it is a quick way to wade through the underbrush of conflicting economic data and see the current status of the Fed's efforts to stimulate economic growth while containing inflation. Each component of the forecast is rated as positive for stocks (2 points), negative for stocks (0 points), or neutral for stocks (1 point). Economy: The economy is growing at a rate less than its optimal rate of 2.5%-3%. 2 points. This is counter-intuitive. Why should a poor economy be good for stocks? The reason is simple. The Fed will be making money cheaper in a weak economy. Lower rates will ultimately spur economic growth. In this case, the weak economy, for purposes of the model, is counted as a positive. Inflation: I have always scored inflation both on a headline rate and on a core rate. The headline rate is above the optimal rate of 2%, thus it gets 0 points. The core rate is near 2%, resulting in a score of 1point. The average of the two is .5 of a point. Earnings: Earnings are positive if the expected earnings growth is above the 80 year average of 7% and negative if they are projected to be below that level. Year-ahead earnings growth for the S&P 500 is currently projected to be 8.3%. That merits a positive score of 2 points. Interest Rates: To score interest rates, I also use two measures: the current rate on Fed Funds verses it rate of a year ago, and the same measurement for the rates on 10-year Treasury bonds. Both Fed Funds and 10-year Treasury bond yields are lower than they were a year ago. 2 points. Opportunity: Since there are 2 points for each component of the Barnyard Forecast, anything above 4 points would be a positive reading for stocks over the coming year. A score under 4 would be considered negative. Economy: 2.0 points. Inflation: 0.5 points Earnings: 2.0 points Int. Rates 2.0 points ........Total 6.5 points Wow, 6.5 points is about as high a score as is possible for the model to produce. That would mean it is signalling that stocks should have a very strong performance over the remainder of 2008. Earnings, however, are a wild card in the forecast. While earnings are expected to grow 8.3% for the year, most of that growth is expected to come in the fourth quarter, when comparisons against 2007 are easy. Thus, while I am optimistic that stocks will end the year much higher than they are now, I think they are in for the summer blahs, while we work our way toward easier comparisons in the fourth quarter. The single biggest exception to this forecast would be better-than-expected bank earnings in the second and third quarters of the year. If bank write-offs end, stocks will rally, no matter when it comes.