Monday, December 10, 2007

Changes to Overall Market Outlook Indicators

At the top of the right-hand column of this blog, the Covered Calls Advisor provides an Overall Market Meter that shows this advisor's current overall stock market forecast -- which at any given time can range from very bearish to very bullish or anywhere in between. To date, the Market Meter has been a composite rating of five indicators. These indicators were described in detail in a prior post on this blog link to 'Developing an Overall Stock Market Outlook'.
Today, two changes are being made to the list of five indicators. One is a change of an existing indicator and the other is a completely new indicator:

1. Change 'Inflation' Indicator to 'Real Earnings Growth' Indicator
This advisor has compared annual inflation rates with annual stock market returns going back for the past century and has determined that inflation rates by themselves are not a good predictor of stock returns. Previously, it was surmised that a low inflation (<+2%) environment would normally be bullish for stocks and high rates (>+6%) would be bearish. Regardless of its apparent logic, history does not support this conclusion. However, the first statement on inflation from the prior blog post referenced above is true; namely, "inflation has always been and will remain a critically important factor in evaluating the economy's ability to sustain and support adequate growth."
Corporate earnings growth is key -- annualized % increases in total corporate earnings is superior to interest rates alone as a metric for predicting stock market returns. The 'nominal' corporate earnings percentage increase needs to be adjusted to the extent that inflation reduces the 'real' impact of those earnings. Thus, 'Real Earnings Growth' is calculated as total annual corporate earnings growth percent minus the annual inflation rate percent.
The 'real earnings growth' indicator ratings will be:
>20% Very Bullish
12 to 20% Bullish
7 to 12% Slightly Bullish
2 to 7% Neutral
-2 to 2% Slightly Bearish
-7 to -2% Bearish
< -7% Very Bearish
The difficulty herein lies in being able to reasonably accurately forecast the average corporate earnings growth % for the next six months. This advisor begins with the forecast provided by Standard and Poor's and then adjusts their S&P 500 projection by an amount consistent with the Covered Calls Advisor's own overall assessment. Presently, S&P is forecasting a 2.4% increase in S&P 500 6-month forward operating earnings. This advisor believes the earnings slowdown will be more pronounced, and is forecasting a 1.0% increase. This combined with an 2.0% inflation estimate results in a 'real earnings growth' of -1.0% (+1.0% nominal earnings growth minus 2.0% inflation) which, as shown above, is a 'slightly bearish' rating for this indicator.

2. Add a 'Rest-of-World Earnings and Bond Yield Spread' Indicator
Presently, a 'U.S. Earnings and Bond Yield Spread' indicator is used as one metric of the overall market analysis. This indicator provides an investor's perspective on the desirability of investing in U.S.-based stocks rather than bonds or vice versa. However, since the U.S. market represents less than one-half of the world's market capitalization, a 'Rest-of-World Earnings and Bond Yield Spread' indicator is added to provide the same perspective for non-U.S. companies that is provided by this indicator for U.S.-based companies. The iShares EAFE ETF Index (EFA), a composite of the 21 most highly developed countries in the world (excluding the U.S. and Canada) will be utilized for this purpose. Presently, the relevant spread is 2.03%, which is a 'bullish' rating for this indicator.

Both of these indicators will be used after the market closes tomorrow, when the next weekly analysis is completed, for each of the six indicators now used to determine the Overall Market Meter rating. The results of this analysis will be posted on this blog tomorrow evening and will be reflected on the 'Overall Market Meter' shown at the top of the right-side column at that time.