Friday, September 06, 2013

Barnyard Forecast is Bull-ish on Stocks

The Barnyard Forecast is a basic model we use to determine whether the current monetary policy environment is accommodative, neutral or restrictive towards stock market growth.  Since 1990, the Barnyard model has correctly predicted the general direction of the market over the next 6 to 18 months approximately 80% of the time.  Our last published Barnyard analysis appeared in 2012.

The Forecast gets its name from the acronym of its components: economy, inflation, earnings, and interest rates = opportunity for stock market appreciation (E+I+E+I=O).  Each factor is rated as positive (2 points), neutral (1 point), or negative (0 points) for stocks based upon historical relationships between that component's economic data and its likely effect on the Federal Reserve's monetary policy.  The total points are added up to arrive at a score between 0 and 8.  A score above 4 indicates a positive environment for stocks.  

Economy - 2 Points

When the economy is growing slowly, the Federal Reserve's projected actions over the next 12 months should favor stocks.  The Forecast score is positive when economic growth is less than the optimal, non-inflationary rate of economic growth of 3%.

The 2nd quarter GDP growth revised up to 2.5% was significantly better than the paltry 1.7% original number.  However, the revision was mostly as a result of business spending readjustments with little change to consumer spending - which is more important.  The muddling economy is still not growing fast enough to warrant monetary policy tightening.  Positive for stocks - 2 points.     

Interest Rates - 2 points

Historically, the yield curve spread (difference between long-term and short-term interest rates) has been a predictor of the economic performance.  The chart below shows the relationship between the yield curve spread (blue line) and the S&P 500 price (red line).  As long as the spread remains positive, stock markets tend to rise.  When it turns negative, that is a danger signal for stocks.  

Yield Curve Spread (3-Mo and 10 Yr U.S. Treasuries) and S&P 500 Since 1990
Spreads between long-term and short-term rates are currently very positive.  The 2-year U.S. Treasury is yielding around 0.5% versus nearly 3% on the U.S. Treasury, a positive spread of 2.5%.  The spread between the 10-year and Fed Funds rate is even more positive.  Since we are nowhere near a negative yield curve, this component of the model strongly suggests a favorable environment for stocks.  2 points.

Earnings - 0 points

Earnings growth is a statistically significant driver of stock market prices.  Over the long-term, earnings growth for U.S. corporations has been 7%.  The Forecast scores growth greater than 7% as being positive for stocks.  On a year-over-year basis, the recent 2nd quarter earnings were 3%, well under the 7% level.  Negative for stocks - 0 points.

Inflation - 2 points

The Federal Reserve's optimal level for core inflation is approximately 2% to 2.5% year-over-year.  Core inflation under 2% allows the Fed to stimulate the economy without creating inflationary problems and is positive for stocks.  Inflation greater than 2% is negative for stocks.

Low inflation is currently the biggest argument against any substantial tapering of QE.  Core inflation is 1.7%, which is well below the Federal Reserve's target of 2.5%.  Minutes from the last Federal Open Market Committee (FOMC) meeting mentioned several members voicing concerns about the low level of inflation.  While inflation levels remain low, the Fed will continue to support the economy going forward.  Positive for stocks - 2 points.

= Opportunity for Stocks - 6 out of 8 (Positive)

Adding each of the 4 factors totals a score of 6, which indicates conditions are favorable for stocks.  Our Barnyard Forecast has historically done a good job of indicating the general trend of the market.  While there are many unknowns surrounding Syria and the Federal Reserve's next moves, we agree with the Forecast's projection of continued positive returns for the market over the next 6 to 18 months.