'Barnyard Forecast' Smells Good for Stocks

By Randy Alsman, Vice-President, Portfolio Manager, and Member of Donaldson Capital Management's Investment Policy Committee. Please read more about Randy here.

Donaldson Capital Management for years has developed our long-term stock market forecast through a set of analyses that we call the"Barnyard Forecast." It is also known by its mnemonic, "E+I+E+I= O.

E I E I O stands for Economy+ Inflation+Earnings+Interest Rates = the Opportunity for Stocks. We believe the interplay and trends of these measures of the economic environment will dictate the direction of stocks over the next 12 months.

Each of the four elements is 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 between zero and 8. An overall score of 4 is considered neutral. Anything above 4 is considered a positive environment for stocks; anything below 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 accomodative, neutral, or restrictive toward economic and ultimately stock market growth? This can lead to scores that are counter intuitive.

For instance a low GDP reading 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 EIEIO framework to guide our weekly investment policy discussions.

What follows is our current market outlook as seen through the eyes of our EIEIO model?

Economy: Score 2 - Positive

Note: Three percent GDP growth is considered optimal, non-inflationary growth. Our model scores any 12 month GDP growth greater than 3% as negative, and vice versa. We do take into consideration the recent GDP trend and outlook. But the latest 12 month's GDP has historically had the greatest impact on Fed actions.

This sounds counter intuitive, because it is. But remember we are talking about whether the Fed is going to add stimulus or restriction based on the GDP level.

On a year over year basis, the most recent data show that GDP stands at negative 2.5%. With GDP in negative territory we believe the Fed is still in an aggressive stimulative phase that should return the US economy to growth in the coming months. The weak economy is positive for stocks.

Inflation: Score 2 - Positive

Note: The Fed has said the optimum level for core inflation is approximately 2%, year over year. The core inflation rate excludes food and energy. Core Inflation greater than 2% will cause the Fed to tightened credit and slow the economy. Inflation under 2% will allow the Fed to stimulate the economy.

Moderate inflation of 2% - 2.5% is actually necessary for healthy economic growth. Core inflation for the year ended 07/31/09 was 1.5%. 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. The current core inflation rate is positive for stocks.

Earnings: Score 0 - Negative

Note: Year over year corporate earnings growth has averaged about 7% over the long term. Therefore, EPS YOY growth greater than 7% is positive for stocks, and less than 7% is negative.

Q2 '09 earnings were much better than expected. However, they were still 30% below Q2 '08. Cost cutting has helped profits, but until revenues actually begin increasing again, earnings will likely not increase over the prior year. The Earnings element of our model receives a negative score.

Interest Rates: Score 2 Points - Positive

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 the prior year – positive for stocks. If the current rate is higher – negative.

This one’s easy. The Federal Funds Rate (a key rate that determines many others) is at 0% to 0.25%, and 10-year T-Notes are only yielding 3.5%. Both of these rates are lower than a year ago. This is very positive for stocks.

Outlook for Stocks Score: Total 6 Points - Positive

EIEIO is currently signally 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 is 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, that stocks will enjoy a positive rate of return in the year ahead.

Comments

[logicalthought:]

I think that the big problem with your ""E+I+E+I" formula is that you equal-weight all of its elements when, in fact, you should heavily overweight the importance of your second "E" (earnings). Interestingly, that was the only one of your parameters that you rated "negative".

On the other hand, you seem to assume that once "I" (inflation) gets out of control, the Fed will automatically step in and raise rates enough to crush it. What if it doesn't, and stocks continue to go up purely in nominal terms due to a declining dollar (as they recently apparently have been)?

Frankly, these are the two issues I'm wrestling with in trying to figure out when (if?) to get heavily short this market: crappy earnings that will crush stock prices vs. a destroyed dollar that will let them keep rising. The only thing of which I'm certain is that if the dollar rebounds, equities will get crushed. The problem is that I can't figure out what would make the dollar rebound, other than the fact that no one (including myself) expects it to happen.

Aug 23 10:30 AM

[derryl:]

I also "smell" a saw tooth path on an ongoing upward trend. This suggests going long and sticking with your guns will pay off, while shorting will be expensive. Trading profits can be taken once your gains are satisfactory. For investors, buy and hold of good dividend paying companies is a hedge against dollar devaluation, especially among companies who enjoy the pricing power to raise prices in an inflationary environment.

On the other hand there are still sheer dropoffs lurking in real estate and the financial system that holds real estate as a large portion of its assets, including the securitization market. There's no telling when or if these cliffs will be plunged over, or what that might do to stocks. And there's no telling what extreme measures the Fed and administration might take to reflate parachutes rather than plunging off these cliffs.

We live in uncertain times, moreso than usual.

Aug 23 06:34 PM

[whidbey:]

Emotion is minimized with this formula E+I,E+I = Mkt prospect.

I think some of us get too emotional and this might help us realize that bias hurts most times.

Aug 23 07:59 PM

[The Economi...:]

Let's put some lipstick on this pig. EIEIO

more cheerleading is just what we need!

Aug 23 11:34 PM

[Tack:]

One of the misleading debates of currency devaluation, through inflationary minting of new currency, is that this means that "real" values, be it markets, company profits, or whatever, must decline. What is overlooked is that there are no "real" values; everything is measured relatively and has been since the first dollar (franc, etc.)was printed.

One can look at the history of fiat currencies, company profits, stock markets and price inflation and see clearly that betting against the rising tide of nominal value that inflation presents is a very poor bet indeed. The equation is simple: over time, more currency equals higher nominal prices for anything, higher revenues and higher profits, higher share prices, across the board.

On Aug 23 10:30 AM logicalthought wrote:

> I think that the big problem with your ""E+I+E+I" formula is that
> you equal-weight all of its elements when, in fact, you should heavily
> overweight the importance of your second "E" (earnings). Interestingly,
> that was the only one of your parameters that you rated "negative".
>
>
> On the other hand, you seem to assume that once "I" (inflation) gets
> out of control, the Fed will automatically step in and raise rates
> enough to crush it. What if it doesn't, and stocks continue to go
> up purely in nominal terms due to a declining dollar (as they recently
> apparently have been)?
>
> Frankly, these are the two issues I'm wrestling with in trying to
> figure out when (if?) to get heavily short this market: crappy earnings
> that will crush stock prices vs. a destroyed dollar that will let
> them keep rising. The only thing of which I'm certain is that if
> the dollar rebounds, equities will get crushed. The problem is that
> I can't figure out what would make the dollar rebound, other than
> the fact that no one (including myself) expects it to happen.

Aug 24 12:22 AM

[Rising Divi...:]

Responding to logical thought: I will do a multiple regression of the inputs one of these days and share the results here. That would give us weightings mathematically for the inputs. In this case, however, we use EIEIO as a kind of diffusion index. It is really a Fed watcher, and it is well researched that the attitude and interest rate strategy of the Fed has a big long-term impact on stock prices. We, too, are watching the dollar, but we belive it will continue to be weak because with the budget deficit the US has, there will be a steady supply of dollars in foreign coffers that will need to be exchanged for local currencies.

Finally, our model in for long-term investors. It is essentially useless for traders, other than to give a sort of momentum indicator.

Aug 24 10:08 AM