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Sunday, December 20, 2009

Overall Market Meter -- An Updated Rating Process

The "Overall Market Meter" on the right sidebar of this blog always reflects the Covered Calls Advisor's current overall stock market outlook. Currently, this indicator is "SLIGHTLY BULLISH." This meter also shows each of the seven possible market sentiment indicators: Very Bullish, Bullish, Slightly Bullish, Neutral, Slightly Bearish, Bearish, and Very Bearish. A recent blog article link described the Covered Calls Advisor's preferred covered calls investing strategy for each of these seven possible indicators. To determine which indicator is most representative of this advisor's overall stock market outlook at any given time, a quantitative-based, multi-factor decision model is used.

Since late 2007, the decision model used to determine which one of the seven sentiment indicators is most representative of this Covered Calls Advisor's current "Overall Stock Market Outlook" consisted of a total of six factors. Detailed explanations of each of these factors are presented in these two prior articles on this blog from 2007:
link to "Developing an Overall Market Outlook"
link to "Changes in Overall Market Outlook"

This article describes an update to the rating process that is now being used by the Covered Calls Advisor. The process used to-date has been beneficial, but additional reading on the subject of overall market forecasting has revealed some additional macroeconomic and valuation-based indicators that should further improve the decision model -- which now extends from six factors to a total of nine factors. A summary presentation of the current ratings for each of these nine factors is presented on the chart below. The overall "Market Meter Average" rating shown by the blue line at the bottom of the chart is the average of the nine factors and as such is this advisor's current "Overall Market Meter" rating, which is now closest to "SLIGHTLY BULLISH." The covered calls investing strategy corresponding to this overall Slightly Bullish sentiment is to, on-average, sell 2% out-of-the-money covered calls for the nearest expiration month.






















These nine factors were detailed from four generic categories: macroeconomic, momentum, value, and growth. The first three factors (Bank Lending Practices, Baltic Dry Index, and the Business Cycle-to-Unemployment Comparison Matrix) are macroeconomic indicators. The next two factors (Market Price Trend and Interest Rate Changes) are momentum indicators. The next three factors (Earnings Yield to Bond Yield Spreads, Total Market Index divided by GDP, and Current Versus Expected Price/Earnings Ratios) are valuation-oriented indicators. The ninth and final factor (Market Expected Earnings Growth Rate) is a growth-related metric. For anyone interested in the methods used to obtain the rating for each of the nine factors, the remainder of this article summarizes that process.

1. Bank Lending -- A measure of overall bank lending practices is released quarterly by the Federal Reserve Board in their "Senior Loan Officer Opinion Survey on Bank Lending Practices." The "Chart Data" for large and medium sized firms presents the "Net Percentage of Domestic Respondents Tightening Standards for Commercial and Industrial Loans." Currently, this level is 14.0, which has decreased from an average in the prior three readings of 45.1. Applying this data to this advisor's evaluation matrix below, the current Bank Lending factor has a rating of Neutral:







2. Baltic Dry Index -- This is an index that measures the cost of ocean freight shipping of a variety of dry bulk commodities and is useful for monitoring the relative activity level of worldwide commerce. As such, the current Baltic Dry Index (BDI) is measured relative to the BDI from one year ago. The following ratings apply for this BDI factor:
- More than a 10% increase is Bullish.
- A change between -10% and +10% is Slightly Bullish.
- A decline of more than 10% is Bearish.
The current rating for BDI is more than double that of 12 months ago; thus the BDI factor currently rates as Bullish.

3. Bus. Cycle & Unempl -- This factor looks at the relationship between the current business cycle (either expansion or contraction) and the trend of seasonally-adjusted initial claims for unemployment. The current business cycle is based on the National Bureau of Economic Research's (NBER) determination as to whether the U.S. economy is currently in an expansionary cycle or a contraction cycle. Initial Claims for Unemployment are reported weekly by the Department of Labor and a comparison is made between the current week versus the prior 30-week simple moving average to determine if the unemployment trend is increasing, neutral, or decreasing. Applying this data to this advisor's evaluation matrix below determines the rating for this Business Cycle and Unemployment Claims factor. Currently, NBER rates the economy as being in contraction and unemployment claims are declining, so this factor is currently rated as Bullish:







4. Price Trend -- This is an overall stock market momentum factor and returns either a Bullish or a Bearish result. It compares the current price of the S&P 500 index (SPY) against SPY's prior 150-day simple moving average(SMA). A current reading above the prior 150-day SMA is a Bullish reading and below is a Bearish reading. A 5% tolerance is necessary before a rating change is made. The current Price Trend factor rates as Bullish.

5. Interest Rates -- This factor considers the 5-Year U.S. Treasury Note rate, both on an absolute interest rate level basis as well as whether this current interest rate is increasing, neutral (within + or - 10%), or decreasing relative to the 5-Year Note rate as of 6 months ago. The current interest rate is 2.28% which is neutral compared with the comparable rate 6 months ago. Applying this data to this advisor's evaluation matrix below, the current Interest Rates factor has a rating of Neutral:







6. Erngs-to-Bond Yld Sprd -- This Earnings Yield to Bond Yield Spread factor is similar to what is referred to as the Fed Model. The average bond yield is subtracted from the average earnings yield and is rated based on this advisor's ranges as follows:
Very Bullish if average spread is greater than +3.5%
Bullish if average spread is between +2.5% and +3.5%
Slightly Bullish if average spread is between +1.0% and +2.5%
Neutral if average spread is between -0.2% and +1.0%
Slightly Bearish if average spread is between -1.5% and -0.2%
Bearish if average spread is between -2.5% and -1.5%
Very Bearish if average spread is less than -2.5%
The current average spread is +.78% which is a Neutral rating for this factor.

7. Total Mkt Index/GDP -- This is a very broad overall valuation measure of the U.S. stock market. It is calculated as the Wilshire 5000 Total Market Index divided by the U.S. Gross Domestic Product(in $Billions). The current value of this metric is .797 = 11,373.85/14,266.3. The ratings ranges are as follows:
Very Bullish if <.55
Bullish if .55-.62
Slightly Bullish if .62-.72
Neutral if .72-.81
Slightly Bearish if .81-.92
Bearish if .92-1.09
Very Bearish if >1.09

Thus, the current value of .797 is a Neutral rating for this factor.

8. P/E Ratios -- This is another valuation factor which compares the current Price/Earnings ratio (from Standard & Poor's S&P 500 Operating Earnings (last 2 quarters actual plus next 2 quarters estimated) against the Expected P/E ratio. The Expected P/E ratio is determined based on the trailing twelve months actual inflation [from the Federal Reserve's Trimmed mean Personal Consumption Expenditures(PCE) index]. The relationship between inflation and P/E ratios is determined from Goldman Sachs' research results during the most recent 55 years and is as follows:










In comparing the Expected P/E Ratio to the Current P/E Ratio, the factor rating is:
Very Bullish if the Expected is more than 30% higher than the Current
Bullish if the Expected is between 15% and 30% greater than the Current
Slightly Bullish if the Expected is between 6% and 15% greater than the Current
Neutral if the Expected is between 2% less and 6% greater than the Current
Slightly Bearish if the Expected is between 9% less and 2% less than the Current
Bearish if the Expected is between 20% less and 9% less than the Current
Very Bearish if the Expected is more than 20% less than the Current.

With 12-month PCE Inflation currently at only 1.4%, the corresponding Expected P/E Ratio is 18.6 which is 5.7% greater than the Current P/E of 17.6. Thus the current factor rating for this P/E Ratio metric is Neutral.

9. Earnings -- This is the sole growth-based factor in this decision model and it compares the actual most recent 12 months operating earnings for the S&P 500 companies versus S&P's estimated operating earnings for the next 12 months. The Earnings factor ratings ranges are as follows:
Very Bullish if next year's estimated earnings are more than 30% above the most recent 12 month's actual earnings.
Bullish if next year's estimated earnings are between 15% and 30% above the most recent 12 month's actual earnings.
Slightly Bullish if next year's estimated earnings are between 6% and 15% above the most recent 12 month's actual earnings.
Neutral if next year's estimated earnings are between 2% below and 6% above the most recent 12 month's actual earnings.
Slightly Bearish if next year's estimated earnings are between 9% below and 2% below the most recent 12 month's actual earnings.
Bearish if next year's estimated earnings are between 20% below and 9% below the most recent 12 month's actual earnings.
Very Bearish if next year's estimated earnings are more than 30% below the most recent 12 month's actual earnings.

With the next 12 month's earnings currently expected to be 27% above the most recent 12 month's actual operating earnings, the corresponding rating for this Earnings factor is Bullish.

The nine factors that comprise the "Overall Market Meter" rating will be updated periodically, but no less than once per month. The most current rating will always be shown on the "Overall Market Meter" and shown in the upper right sidebar of this blog.

If you have comments or questions related to the contents of this article, please feel free to submit them by clicking on the "comments" link below. If you prefer confidential communications, my email address is listed at the top-right sidebar of this blog site. Your comments are always welcomed.

Regards and Godspeed,
Jeff

3 comments:

  1. This is very interesting. I am working on some models (prediction, probability, heat, etc..) that I hope enables me to stay focused and strategically alert. I am doing this in excel.

    Your rules, which can be adapted/modified has given me several ideas for my own predictor models. I must re-read your Market Meter Model again -- because this is something you are familiar with and I am not this "focused" or "organized".

    About a year ago - I attempted to make your market meter into a "predictor" spreadsheet. I had to adapt it as I did not have all the information that you were using at that time. This simplified model and the use of SMF-addin may now provide this ability. Is your "Market Meter" in a spreadsheet?

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  2. DaveW if you end up putting together a spread sheet are you going to post it? This is for you and all of the conservative investors at Yahoo Cover Call site: Enjoy!

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  3. Dave and Donald,

    Thanks for your comments. Unfortunately, my methodology in this matter remains completely manual at this time.

    Jeff

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