Barnyard Forecast

Our Barnyard Forecast
Note: Overall EIEI=O Score Last Changed 12/28/09
Commentaries updated 07/26/10

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 revision of Q1 2010 GDP growth was lowered June 27 to 2.7%.  On a year over year (YOY) basis, real GDP (inflation-adjusted) is up 2.4%.  Some encouragings sign include larger than expected increases in personal spending, mostly on durable goods, and lower government spending as the stimulus programs wind down.   All signs are for continued GDP growth, but not nearly as strong as in past recoveries, and lower in the back half of this year than the front hafl.  Since EIEIO uses historical, not projected data, and YOY real GDP us up only 2.4%, the score for GDP remains unchanged at 2.

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:

·    Purchasing Managers continue to see economic expansion
·    June new home sales came in 26% higher than in May
·    Initial and continuing unemployment claims dropped June 26
·    June leading economic indicators were down -0.2%
   

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%-2.5% 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 CPI (consumer price index)in the U.S. for the year ended 05/31/10 increased 0.1% from April putting year over year core CPI at 0.9%.  Readings this much below the optimal level are positive for stocks because they make it very likely 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) is up 7% from a year ago.  For reference, M2 hasn’t grown less than 5% in any year since 1995.  Also, money in interest-bearing deposits (i.e. on the sidelines) is nearly $5 trillion, almost 25% higher than one year ago. 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.

·    May Core CPI was up only 0.9% vs year ago (lowest since Jan, 1966)
·    May Core PPI was up only 0.1% from April
·    June average hourly earnings were up 2.4% from a year ago
·    The average price of the 5.7 mil. existing homes sold was up 2.8%
·    The average price of the 300 thousand new homes sold was down 9.6%

Low inflation is positive for stocks, so the score remains at 2.

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.

Companies are just now beginning to report earnings for Q2, 2010.  With roughly 1/3 of companies having reported Q2 earnings as of 7/26, the average earnings were 59% over Q2 2009 and 12% higher than expected.  So far, no major company has lowered its 2010 earnings outlook, and several have increased it.  This quarter’s results, and especially any change in annual earnings guidance or outlook are very important for calibrating stock market prices over the next few months.  If the current outlook of $82/share for
S&P 500 companies holds, then the market is likely very undervalued.   If the earnings outlook drops significantly, then we probably won’t see much movement in stock prices.

However, we have only one quarter of complete results, and 12-month earnings are not yet overall positive.   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 their June 23, 2010 statement, 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 fell briefly below 3.0% after topping 4.0% early this year.  They have since rebounded, but only to about 3.0%.  This rate is about the same as 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:
·    As of July 12, the national average interest rate on a 1-year CD is only 0.68%
·    30-year home mortgage rates have dropped further to 4.6%
·    The Fed continues its pledge to keep its key rate low “for an extended period”
·    The consensus is that the Fed Funds Rate won’t increase until early 2011


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 changes.

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