More Forecasting Follies Hi Guys,
From the mind of 6th Century BC Chinese Poet Lao Tzu: “Those who have knowledge, don't predict. Those who predict, don't have knowledge. "
And another beauty that represents one of the most egregiously inaccurate predictions made by astute IBM founder Thomas Watson in 1943: "I think there's a world market for maybe five computers."
And another beauty from an Anonymous source: "A good forecaster is not smarter than everyone else, he merely has his ignorance better organized.”
So with those cautionary quotes as an introduction, I offer my humble and likely inept forecasts for the equity market action for the remainder of the year.
I’m optimistic. At this posting, using the S&P 500 Index as a proxy for the equity marketplace, the year-to-date return is 5.8 %. At year’s end, I project that the S&P 500 Index will finish with a 9 % to 15 % annual return. I suspect the 15 % return is more likely. Here’s how I reached that forecast; it was not purely, but mostly, guesswork.
In simplified form, real equity returns are given by the sum of (1) dividend yields, (2) corporate profits, and (3) speculative expansion of the Price to Earnings (P/E) ratio. The anticipated actual return over the real return incorporates an adjustment for inflation.
The formula summarized in the previous paragraph captures market rewards with high fidelity over longer-term periods like ten years. Since the speculative component is hard (more likely impossible) to anticipate, sudden changes in the P/E ratio wreak havoc on any short-term prediction. That’s why market gurus often fail on an annual basis.
Nevertheless, I accept the challenge fully cognizant of the inherent risks. It may prove to be a totally useless market projection, but I’m sure it will stimulate a hot debate on this Forum. That’s its main purpose since I’m committed for the remainder of the year.
Here is my ignorant, but organized forecast.
Let’s start with the fundamental earnings growth and dividend yield portions of the expected returns equation. Just today, the WSJ reported the adjusted annual GDP growth rate prediction from Deutsche Bank, Goldman Sachs, JP Morgan, and Bank of America. The average real growth rate from these four exemplary sources is 2.68 % for 2011.
The S&P 500 reported dividend yield is 1.9 %. The Journal also shows a total CRB inflation rate of 2.3 %. Because of the deficit government spending policy, I expect this rate to increase: For the purposes of these analyses, I’ll use an annual expected inflation rate of 2.6 %.
Based on earlier studies, I have developed a very tight correlation between corporate earnings and GDP levels. If GDP grows 1 %, company profits will rise by 1.7 %.
Therefore, my forecast for the fundamental real market return will be (1.7 X 2.68) + 1.9 or about 6.5 %. Converting the real return to an actual return that reflects the inflation rate gives a fundamental forecasted equity market return of 9.1 % (6.5 + 2.6).
This analysis does not yet include any possible speculative contribution.
What can propel a positive speculative component? Many unclear factors like momentum, competitive returns from the bond vigilantes, liquidity, and investor sentiment. From my current perspective, these are mostly positive now, and reinforce and/or augment the forecasted returns based on market fundamentals. Here are some assessments.
The current market P/E ratio hovers around 16 depending on rearward or forward looking estimates. The annual dividend yields for the 10-year treasury and the DJ Corporate bond index are 3.1 % and 3.6 %, respectively. The modified Greenspan-Yardeni Fed model contrasts the equity market yield (inverse of the P/E ratio) against these baseline standards. That comparison demonstrates that the equity marketplace is presently undervalued. A regression to the mean belief system would suggest an incremental market price increase.
Presently, the S&P 500 Index is at about its 65-day moving average and approximately 6.5 % above its 200-day moving average. This is a positive momentum indicator and signals an equity commitment. That 6.5 % cushion offers a safety-net. If the 65-day average penetrates the 200-day moving average, a danger signal is transmitted. That’s not the scenario now.
Additionally, the 4-year Presidential cycle data set shows that the third year in that cycle is particularly rewarding to the equity investor. It has never delivered a negative performance during its history. The third year incremental output should enhance 2011 performance by 2 % to 5 % conservatively.
Liquidity has returned to the economy. The M2 money supply drop was arrested several months ago, and is presently reported by the St. Louis Fed to be at a 5 % annual growth rate. That’s sufficient funding to support an annual GDP growth rate that is at one-half that level. In fact, it adds somewhat to the inflationary pressures by providing excess liquidity. So the current government fiscal and monetary policies are both inflationary by design to stimulate the economy.
Investment sentiment has both fear and greed elements. The VIX Index is at its highest reading in over 2 months although its YTD trend is downward; that recent implied volatility denotes an increase in investor uncertainty and fear. The Investment Company Institute (ICI) data resource reports that investors are recovering confidence with a YTD money flow into stocks, hybrids, and bond entities, and fleeing money market products. That’s a mixed signal since investors are typically late into a bull market.
Finally, the AAII has maintained a sentiment indicator for many years. The historical long-term averages are that 39 % of AAII members are Bullish, 31 % are Neutral, and 30 % are Bearish. Today, 26 % are Bulls, 33 % are Neutral, and 41 % are Bears. Most market gurus use this cohort as a contrarian’s indicator. Since the current Bulls are below the historical average, the marketplace must have an upward trajectory from this contrarian’s viewpoint. Boy, we individual investors are held in low esteem.
Well, that’s my forecast, and I’m sticking to it. Overall, I’m hoping for a minimum of 9.1 % from fundamental considerations alone. Add some speculative components and the Presidential cycle consideration, and I’m forecasting a double-digit 2011 return of perhaps 15 %. That’s 9 % higher then the present S&P 500 YTD performance.
So, I’m staying the course, and I’m keeping costs to a minimum.
What are your assessments of the equity markets and my analysis? Your comments are encouraged and greatly appreciated.
Best Regards,
