Friday, September 02, 2011

Barnyard Forecast: Conditions Are Still Positive for Higher Stock Prices

Periodically, we publish an update of our Barnyard Forecast (BF).  The BF is a back-of-the-envelope quick method of predicting how stocks will perform over the next 6-18 months.  If you do a search on our blogsite, you can see our previous updates.  On the whole, the BF has been reasonably good over the years at giving a sort of directional bias for the market.  As you remember the BF is taken from the acronym Economy+Inflation+Earnings+Interest Rates=Opportunity, in short EIEI=O.

For many years, the BF was calculated using a very simple scoring system that gave a thumbs up or down for the indicator as it related to its historical relationship with stock prices.  Over the last year we have made few updates that we believe improve the statistical integrity of the model.

Our last update on the BF was an audio blog by Randy Alsman on September 23, 2010.  In that blog, Randy went over each of the indicators and concluded that the model was forecasting rising stock prices over the next year.  Since that time, The Dow Jones 30, including dividends, is up almost 8.60%, even with the recent sell-off.

The following is the Barnyard Forecast's estimate of the next 6-18 months for the major stock market averages.

Economy: The first indicator is counter intuitive.  US GDP growth above 3.5% gives 0 points.  GDP growth of 2.0%-3.5% produces a neutral score of 1 point, and GDP growth below 2.0% is considered positive and produces the maximum score of 2 points.  The counter intuitive quality of this indicator is attempting to gauge the Fed's year-ahead bias.  Historically stock markets haven't done well when the Fed is hiking interest rates and vice versa.    With GDP currently running under 2.0% on a year over year basis, this indicator is positive for stocks and receives 2 points.

Inflation: The fulcrum level for inflation is Core CPI Inflation of 2.5%.  Above that level receives 0 points, near that level gets 1 point, and below that level receives the full 2 points.  Core CPI has stayed well below 2.5% for the entirety of the last year.  That performance is considered positive for stocks and receives the maximum of 2 points.

Earnings:  The fulcrum point on corporate earnings is year over year growth of 7%.  Seven per cent is the 80 year average of corporate earnings and has proved to be a good predictor of stock prices.  Again this indicator receives the full 2 points with S&P 500 earnings having risen nearly 12% over the last twelve months.

Interest Rates:  This is the indicator that we have sharpened up a bit.  We used to measure only the relative change in interest rates on a year over year basis: falling interest rates were positive and rising interest rates were negative.  Statistically, we found, however, that the yield spread between the 10-year US Treasury Bond and the 2-year US Treasury Note had better predictive qualities than the original method.  In this case, the fulcrum point is 0.  This means that if 10-year interest rates are higher than 2-year interest rates, the model receives the full 2 points.  If 2-year Treasury Notes are yielding more than 10-year T-bonds, the model would receive 0 points.  Currently, 10-year T-bonds yield 2.0% more than 2-year notes and receive the maximum 2 points.

Opportunity: With all of the indicators in the Barnyard Forecast receiving the maximum of 2 points, the model's total score is 8 points.  That is a score that I don't believe I have ever seen in the last 15 years and would indicate that stocks should perform well over the next 6-18 months.  Indeed, with a score that high, one could say that stocks should perform "better than well."  However, let me offer just a few words of caution.  This is not an econometric model.  additionally, it is really not a pure forecast of what stocks will do over the next year.  It is simply a measure of how the stock market has acted in the past when the EIEI=O indicators scored as they do today.  I will add, however, that the model's buy and sell signals have been correct about 77% of the time.  The only problem is that it has spent up to a year and a half giving the wrong signal, so it is not an indicator that we follow blindly.  

It is saying, however, that in the past when the the aforementioned indicators have scored as they do today, that there has been a good probability that stocks have gone higher.