Our PAR Model six month forecast for the S&P 500 fell to 0.4% at the end of March, from 5.5% just a month ago.
A low positive return forecast for the S&P, between 0% and 2% (which doesn't happen often), means that our Tactical Strategy allocations match their balanced benchmark. Low expected returns on both stocks and bonds don't justify taking risk over benchmark in either asset class. Accordingly, we are changing the stocks-bonds allocation in our U.S. Tactical ETF Strategies to 60% stocks, 40% bonds.
The equity rally continued in full force so far in March, with the S&P 500 adding another 3% for a year-to-date return of 6.7%, and 10.2% from the end of November of 2012 - the month of the last moderate downturn in the market. Having been positive since June of 2012, our model produced a very high return forecast in November (19.2%), which we considered to be a rare buying opportunity. The Dow Jones Industrial Average made headlines this month when it broke through its all-time high made in October of 2007. The S&P, currently around 1560, is itself almost at its recent all-time high of 1570.25.
Longer-term, the rally has been based on solid earnings, which is what matters the most for stock owners in the long run. The total earnings for the S&P 500 index companies exceeded their previous 2007 peak back in 2011, while the index level was below the peak until now.
However, with such a rapid rally in equities (+13.4% in 2012, for example), and with earnings not keeping up (4% growth in 2012), valuation ratios are no longer attractive. In our model, the Valuation group of factors turned negative at the end of February, and is now even more negative, contributing -12.0% to the S&P return forecast over the next six months.
We are changing our Tactical stock-bond allocation to 60% stocks (SPY), 40% bonds. In order to determine whether to allocate to short-term or long-term (LQD, IEF) bonds, we look at how well investors are compensated for taking duration risk. The duration of IEF, for example, is 7.5. If long-term Treasury yields move up by their average volatility of 0.46% their value would drop by about 3.5%
With such a rapid rally in the S&P (+13.4% in 2012, excluding dividends), it is no surprise that valuation ratios are no longer attractive. Earnings were growing at a reasonable rate of about 6% in the first half of 2012, but slowed in the second half for overall growth of only 4% in 2012. Of course, earnings growth did not keep up with the double-digit rally in the index.
The following factors contributed to the March total return forecast of 0.4%:
Valuation: -13.4%, Negative
The effect of Valuation factors dropped again so far in March, due to the continued rally in the index. This trend continued from last month, when the contribution of the Valuation group of factors as part of the PAR Model™ changed to Negative for the first time since April, 2010. The combined contribution of earnings to the return forecast is -5.5%, including both the P/E Ratio and Earnings Quality. The effect of the Price to Book Ratio is -6.4%
(click to enlarge)
Economic: 16.8%, Positive
The effect of housing indicators is 13.5%, which continues to be the main positive driver. Housing continues to propel economic activity (and to regularly attract the attention of financial media), with median home sale prices rising by 8% in nine months from their lowest level in a decade, and by 6% from a year ago. The Economic Cycles Research Institute's (ECRI) leading index contributes the remaining 3.1%.
Market: -3.0%, Net-negative
This factor group consists of Oil Price, with -1.9% contribution, and an investor sentiment indicator based on the AAII survey, contributing -0.4%.