The PAR (Performance Analytics Return) Model* changed to a less negative position in May.

Our model is a factor model designed to estimate the expected equity return over a six-month period. The model is based on a dynamic multi-factor regression of the S&P 500 returns over economic, valuation and market variables. The factors are chosen each month as part of the model run, based on their statistical significance, from the set of 15 factors that have proven to be significant over time.

The model provides answers that tactical asset allocation managers need, such as:

- What's the expected return for equities right now?

- What are the factors that we should be looking at, that really affect equities?

**S&P 500 (NYSEARCA:SPY) 6-m expected return:****−****4.4%**

Recommended allocation: Underweight

Prior month -6.8%

Change 2.3%

The model had predicted a 6-month market drop, at -5.2% in March, confirmed by -6.8% forecast in April, and we recommended an Underweight to equities starting from the March report. The S&P 500 dropped by about 6% in May. As of May 31st, the model changed its stance to a smaller, but still negative, expected return of -4.4%. Based on this result, we recommend to continue being underweight public equities relative to your benchmark.

**Significant Factors**

The P/E ratio is the key measure of index valuation in the model. The healthy trend in U.S. corporate earnings contributed lately to below-average P/E ratio, and in turn, to the significant positive contribution of this factor to the model's expected return, at 1.2 standard deviations (S.D.) (see the chart above). This is partly offset by the negative effect from our measure of Earnings Quality, at -0.6 S.D.

The index valuation improved in May, with the P/E ratio dropping from 14.1 to 13.2, driven mainly by the index drop of about 6% in May.

With almost all of the S&P 500 companies having reported for Q1 2012, earnings grew at a healthy rate of 6.1% YoY (compared to the average estimate for this number of 0.1% as of March 31st). As can be seen from the graph above, the TTM P/E ratio continues to be attractive by historical standards, being well below the five-year average of 15.7. This explains why the P/E provides a significant positive contribution to the expected return as part of the model (the green "Contribution" line on the graph).

It appears that earnings will grow at a slower rate for the rest of this year that has been expected, driven by the European recessionary environment and by slower growth in the U.S. and everywhere else in the world. The following negative trends are worth mentioning. Q2 2012 earnings are being revised down, now estimated to grow at 4.3%, compared to the estimate of 6.3% growth as of March 31st. The ratio of positive to negative Q2 EPS pre-announcements is so far 32/70. Excluding the largest two contributors to Q2 earnings growth, Bank of America (NYSE:BAC) (which has an easy comparison to the large loss a year ago) and Apple (NASDAQ:AAPL), earnings growth becomes negative, at -1.6%.

** The "PAR Model" is a service mark of Performance Analytics Inc.*

**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.