Barnyard Forecast

Our Barnyard Forecast
Note: Overall EIEI=O Score Last Changed 12/28/09
Commentaries updated 03/08/10

Economy Score:   2   positive for stocks    Score last changed 12/28/09

Note: 3% GDP is considered optimal, non-inflationary growth.  Any 12 month GDP reading of < 3% is positive for stocks; GDP > 3% is negative.  We do consider the recent GDP trend and outlook.  But the past 12 month GDP has historically had the greatest impact on Fed actions.   This sounds counterintuitive, because it is.  Remember, we’re talking about whether the Fed will try to add stimulus or restriction based on the GDP level.

The second estimate of Q4 GDP growth released last week was an increase of 5.9% (vs the initial estimate of +5.7%).  This was over a full point above expectations, and included a stronger than expected consumer spending element.  Inventories declined at a much slower rate than in Q3, accounting for about 3.7% of the 5.9% GDP growth.   The majority of economists expect Q1, 2010 GDP growth to be roughly similar to Q4 09, but then to drop off for a total 2010 GDP growth average of 2% - 3%.  The annual 2009 GDP change is still less than 3% over 2008.

We therefore are holding the Economy score for the Barnyard Forecast at 2, positive for stocks.

GDP and the economy do appear to be recovering, although modestly and unevenly:

·    Jan durable goods orders rose 3%, but fell 0.6% w/o transportation
·    Jan personal income was up only 0.1%
·    Jan continuing unemployment claims rise slightly to 4.6 million
·    Jan leading economic indicators were up only 0.3%
    

Inflation Score:    2  positive for stocks    Score last changed 08/10/09
Note: The Fed has said the optimum level for core inflation is 2% year over year.   The core inflation rate excludes food and energy.  Inflation < 2% is positive for stocks.  Inflation > 2% will cause the Fed to restrict money supply and growth.

Moderate inflation (2% - 3%) is actually necessary for healthy economic growth.  Core inflation for the year ended 01/31//10 was 1.6% vs. 1.8% for the year ended 12/31/09.  A reading this much below the optimal level is positive for stocks because it means inflation fears will not thwart the Fed’s initiatives to stimulate economic growth.

Further, total M2 money supply (currency, bank deposits, consumer money-market accounts) has actually been flat the past 18 months.  Historically, M2 has grown 5% per year.   This means there is less liquidity in the system, not more, making deflation more of a risk right now than inflation.

The following data points would seem to indicate that inflation will remain low.

·    Jan month Core CPI = -0.1%. vs +0.1% in Dec
·    Jan unemployment remained high at 9.7%
·    Jan personal income was up 0.1% from Dec - less than expected
·    Jan Capacity Utilization remained at a low 72.6%

Low inflation is positive for stocks.

Earnings Score:    0  negative for stocks    Score last changed 08/10/09
Note: Year over year corporate earnings growth has averaged about 7% over the long term.  Therefore, any EPS YOY growth >7% is positive for stocks, and <7% is negative.

Q3 09 earnings “beat ratio” (% of companies exceeding analysts’ earnings estimates)  was the highest since 1955.   However, earnings were still quite a bit lower than Q3 08.  Revenue performance improved somewhat from Q2, but also was still on average much lower than a year ago.

Roughly 93% of S&P 500 companies have reported Q4 and Annual 2009 earnings so far.  Q4 EPS growth is a very strong 108%, and about 5% above expectations.  Revenues for that 93% increased an average 10% over prior year, the first increase in over a year.  However, full year 2009 earnings for the 93% reporting are still lower than in 2008 by 7%.  Therefore corporate earnings remain negative for stocks.


Interest Rates Score:    1  Neutral for stocks       Score last changed 08/10/09
Note: We generally look at the current rates for both the Federal Funds Rate and the 10-Year U.S. Treasury Note vs. the prior year.   If the current rate is less than prior year – positive for stocks.  If the current rate is higher – negative.

The Federal Funds Rate (a key rate that determines many others) is at 0% to 0.25%.  And, as recently as the January, 2010 meeting, the Federal Reserve Board has said they will keep this rate very low “…for an extended period.”  This is unchanged from a year ago.  

10-year T-Notes rates have risen to 3.6%.  This is significantly higher than the roughly 2% of a year ago.   However, in early 2009, the world was in a credit crisis and recession panic.  Investors were even buying short-term Treasury Bills at negative interest rates because they were terrified that every other debt security out there was at extreme risk of default.   The panic-level concern lasted for only a few months, making the comparison to a year less reliable.

The blending of the two measures for interest rates results in an overall score of 1 or Neutral for stocks.


Additional interest rate information:
·    Interest rates on money market and short term CDs near 0%
·    30-year home mortgage rates have hovered near 5%
·    The Fed pledged to keep its key rate low “for an extended period”
·    The consensus of Fed watchers is that the Fed Funds Rate won’t increase until late 2010


Outlook for Stocks Score = 5    Positive    Last changed 11/09/09

EIEI=O is currently signaling a positive environment for stocks in the year ahead.  That does not mean stocks will go straight up.  Indeed, we believe they will continue a “saw tooth” path higher.  There are still many unknowns and much healing needed in many parts of our economy.  Nevertheless, our model has a good track record of anticipating stock market trends and we are in agreement with its findings at this point.

   E - I - E - I = O Explained

 The DCM Investment Policy Committee has for years developed our long-term market outlook in part through the use of a set of analyses that we call our "Barnyard Forecast." It is also known by its mnemonic: "EIEI=O."

E I E I = O, stands for Economy + Inflation + Earnings + Interest rates = Opportunity for Stocks. We believe the interplay and trends of these measures of the financial environment will dictate the direction of stocks over the next six-twelve months.

Each of the four elements of the model are rated as positive for stocks (2 points), neutral for stocks (1 point), or negative for stocks (0 points). The total points are then added to arrive at a final score ranging from zero to 8. An overall score of 4 is considered neutral for stocks in the year ahead. Anything higher than 4 indicates a positive environment for stocks; anything lower, a negative environment.

The score we give each element is based on our historical analysis of its effect on Federal Reserve policy. That is, will the element’s status likely cause the Fed to be accommodative, neutral, or restrictive toward economic and ultimately stock market growth? This can lead to a scoring scheme that is not intuitive. For instance, a low GDP score is positive for stock market growth, as the Fed will likely be stimulating the economy, which will ultimately be good for stocks.

We also use this framework to guide our weekly investment policy discussions. What follows is our current market outlook as seen through the EIEIO model. We revisit this equation at least weekly, but we will only change the discussion of each element if the element itself  (back to top)