The Barnyard Forecast Smells Good for Stocks

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.

Diverging From the Consensus for 2010

When we said that the stock market was turning in mid March of this year, cries of "pollyanna" rang out. When we said that second quarter earnings were going to be better than expected --much better--cries of "you've got to be kidding me" landed all around us. It is now clear that the naysayers were wrong on both counts. I believe they were wrong because most people in and out of the investment business believe that whatever happens today is destined to happen forever. There are economic principles, however, that tell us that this linear thinking does not and has never worked. Investors simply mistake the power of the Federal Reserve over and over. If anyone doubts what I am saying all you have to do is to look at the Tech boom of the late 1990s to see the evidence of the Fed's power. Booms and bubbles do carry the seeds of their own destruction, but the Tech bubble was popped by the Fed and any serious student of the markets and the economy knows it. They popped the Tech bubble by slowly raising interest rates until the overall economy slowed. This ultimately took the wind out of the Tech stocks' sails as their quarter-over-quarter earnings growth stopped and their stock prices collapsed. The consensus of pundits are now saying that for a variety of reasons the economy and stock prices in 2010 and beyond will be sub-par. The biggest argument for this belief is that the US consumer is tapped out and are being forced to become savers instead of spenders. This may or may not be true, but I have learned over the years that the consensus is almost always wrong. Thus, in my mind that means that either there will be no growth in 2010 and beyond, or growth will be much higher than most investors now are thinking. Of these two scenarios, I land on the higher-than-average growth view. That would mean that economic growth in 2010 will exceed the 80-year average of 3% . If that is the case, stocks will grow much faster than the 10% estimates that I regularly see for the year ahead. But that's not all. We Americans have a lot of trouble understanding that we now represent only about a third of world GDP growth. Europe, on a GDP basis, is slightly greater in economic size than we are. Surprisingly several countries in Europe are reporting positive growth for this quarter, again, much better than expected. The other third of the world's economic growth comes from China, India and the other developing nations. The key thing here is China and India have cruised through this deep recession without ever reporting a negative quarter. S&P stated a few weeks ago that international sales of S&P 500 companies are now greater than 50% of total sales. The percentage of foreign earnings is even higher. Too many people have written off the US economy. I think they are wrong, and even if they are correct, foreign economies could lift S&P 500 company earnings to levels much higher than are now being forecast. My bottom line is that 2010 will be a much better year than most people think. There are many fundamental reaons for this belief, but the main reason I believe we are in for a surprise is because so many people are sure the economy will be lukewarm.

The Fair Value of the Dow Jones Industrial Average

I have no idea how high the stock market can go over the next year. I have the theory that stocks trade at fair value about once every three years. Having just come through one of the most destructive bear markets since the Great Depression, it is unlikely that the market will suddenly become efficient and sit on top of its statistical fair value in the coming year. Having said that, our Dow Jones Fair Value Model is signaling that stocks have a long way to go just to reach their statistical fair value. The chart at the right shows the Dow Jones 30's actual price (red line) versus our Fair Value Model (blue bars) over the last 50 years. A quick glance at the chart shows that the fit between the actual prices of the Dow and the Fair Value model has been reasonably good. The model, indeed, shows that stock prices were way too high relative to values in the late 1990s. Currently, the model is saying that stocks are modestly undervalued, as shown by the price line being buried in the value bar at the far right. The top of the value bar, or the statistical Fair Value of the Dow Jones 30 is at 10,900. If stocks were to reach our model's Fair Value over the next twelve months it would produce a return of over 18%. Thinking of gains when we just went through a 55% fall in prices is a difficult notion to grab on to. However, we believe the path of least resistance for stocks is now higher, and we believe our model's calculation of where stocks might be in a year is as good a guess as we can make. The model is a multiple regression of trailing twelve-month Dow Jones 30 earnings, dividends, interest rates, and prices. It has an R2 in excess of .90 over the last 50 years.