Tuesday, September 11, 2007

Developing an Overall Stock Market Outlook

Are you bullish, bearish, or neutral in your near-term stock market outlook? Your answer is a very important one because it greatly influences your specific investment decisions -- and it should. But how did you develop your current market outlook anyway? To stimulate your thinking in this regard, the Covered Calls Advisor summarizes the five key metrics currently used to arrive at its Overall Stock Market Outlook. Ultimately, the overall outlook is categorized as either Very Bearish, Bearish, Slightly Bearish, Neutral, Slightly Bullish, Bullish, or Very Bullish.

1. Earnings Yield and Bond Yield Spread --This is the Covered Calls Advisor's single favorite indicator. It is calculated as the difference between the S&P 500 Earnings Yield and the 10-Year Treasury Bond Yield where the earnings yield is simply the inverse of the P/E Ratio. The current trailing twelve months(ttm) P/E for the S&P 500 is 17.1, so its earnings yield is 1/17.1 = 5.35%. The current yield on 10-Year U.S. Treasury Bonds is 4.37%. Thus, the current 'Earnings Yield and Bond Yield Spread' is +0.98% (5.35%-4.37%), for which the chart below shows to be a slightly bullish indicator.
To appreciate why this 0.98% spread is slightly bullish for stocks, please consider this question: Would you prefer to invest in bonds at 4.37% or companies that generate an average after-tax earnings yield of 5.35%?
Unless and until the 'Earnings Yield and Bond Yield Spread' narrows to a point where the yields are much closer to each other, stocks will remain as the preferred investment. This is true regardless of the type of investor you are -- an individual investor; a large hedge fund manager; or even a corporate CEO or CFO who are deciding whether to buy back their own company shares, or whether to merge with or acquire an attractively-priced company.

Earnings Yield and Bond Yield Spread:
>+2.5% is Very Bullish
+1.5% to +2.5% is Bullish
+0.5% to +1.5% is Slightly Bullish
-0.2% to +0.5% is Neutral
-1.0% to -0.2% is Slightly Bearish
-2.0% to -1.0% is Bearish
<-2.0% is Very Bearish

2. Inflation -- Inflation has always been and will remain a critically important factor in evaluating the economy's ability to sustain and support adequate growth. Several measures of inflation are widely reported, including the Producers Price Index (PPI), the Consumers Price Index (CPI), and Personal Consumption Expenditures (PCE). This advisor's preference is to look at the 1-Year PCE, a rate calculated by the Federal Reserve from data supplied by the Department of Commerce's Bureau of Economic Analysis. Currently, the 1-Year PCE inflation is at 2.1%, a bullish indicator:

< 2.0% is Very Bullish
2.0 to 3.0% is Bullish
3.0 to 4.5% is Slightly Bullish
4.5 to 5.0% is Neutral
5.0 to 6.0% is Slightly Bearish
6.0 to 7.0% is Bearish
>7.0% is Very Bearish

3. Current Versus Expected P/E Ratios -- Historically in the U.S. stock markets, inflation and P/E ratios have usually been inversely related. That is, when inflation has been high (say >6%) P/E ratios have been low (below 10 on average). Conversely, low inflation (say <2.5%) has normally been accompanied by relatively high (above 18) P/E ratios. Where are we now? As stated above, the S&P 500 P/E is now at 17.1 and inflation, as measured by the One-Year PCE is 2.1%. During the past half century, when inflation is below 2.5%, the average P/E exceeds 18 and has often been in the 20s. Given the current 2.1% inflation rate, the 'Expected P/E Ratio' of around 20 is now 16.4% (20-17.1/17.1) higher than the Current P/E. This does not imply that the market is precisely 16.4% undervalued, but it is nevertheless a bullish signal:

Current Versus Expected P/E Ratios:
>+30% is Very Bullish
+15% to +30% is Bullish
+5% to +15% is Slightly Bullish
-3% to +5% is Neutral
-7% to -3% is Slightly Bearish
-15% to -7% is Bearish
<-15% is Very Bearish

4. Price Momentum -- This is simply a measure of the extent to which the overall market is higher or lower than 9 months ago. I like to use the Russell 3000 as a total market benchmark and the relevant ranges are:

>+18% is Very Bullish
+10% to +18% is Bullish
+4% to +10% is Slightly Bullish
-2% to +4% is Neutral
-5% to -2% is Slightly Bearish
-10% to -5% is Bearish
< -10% is Very Bearish

The Russell 3000 (symbol RUA) closed yesterday at 850.82 and it closed on the same day 9 months ago at 821.21. This is a 3.5% increase which provides a neutral reading from the chart above.

5. Gut Feeling -- Each of the four metrics described above are highly quantitative and objective in their measurement. However, successful investing is as much an art as it is a science. Some consideration for the investor's own vision of the market's near-term outlook is appropriate. Actually, it is much more than appropriate; it is essential! Let's term the investor's own sense of the market's near-term direction as his/her 'gut feeling'.
This Covered Call Advisor's gut feeling right now is neutral in the sense that there are roughly equal measures of both negative and positive factors. The primary 'positive' is the market's modest pricing relative to historic valuations -- this is demonstrated by the bullish indicators in metrics 1-3 above. This, however, is countered by investors' discomfort regarding the current decline in the rate of economic growth and, more specifically, whether a recession can be avoided and the desired soft-landing achieved. This discomfort is manifest in the more than doubling of the Volatility Index (VIX) in recent weeks, as well as the seemingly daily 100+ point market swings -- sometimes up and sometimes down. Until a greater measure of market stability is achieved, a neutral investing posture seems to be the most prudent rating at this time for the 'gut feeling' indicator.

In summary, the current outlook for each of the five market indicators is:
Earnings Yield and Bond Yield Spread -- Slightly Bullish
Inflation -- Bullish
Current Versus Expected P/E Ratios -- Bullish
Price Momentum -- Neutral
Gut Feeling -- Neutral
Two bullish, one slightly bullish, and two neutral indicators. All things considered, let's call it a Slightly Bullish Overall Market Outlook.

The use of these five indicators to determine an overall stock market outlook at any given time is definitely a work in progress. These measures will continue to be modified and improved upon over time.

Note: Although this discussion has focused solely on the U.S. stock market, similar measures can and will be developed for various international markets as well.

As always, I value your thoughts and insights highly, and would appreciate you sharing any 'comments' at the link shown below.

Regards and Godspeed to All

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