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Stock Market Timing Model
June 3, 2007
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Title: LTSMTM UPDATE June 3, 2007
Author: Steve Thompson (with editorial comments "EC" by David Korn)
Note 1: This LTSMTM Update was first published in David Korn's June 3, 2007 Newsletter. Members of our mailing list get a discount on David Korn's newsletter that includes summaries of monologues and key calls. For an example, see David's summary of the show following Bob Brinker's announcement to his radio audience he was returning to fully invested in March 2003. Just ask us for details on how to get the discount.
Note 2: Charts for DJIA - S&P500 - NASDAQ - NYSE Composite - QQQQ - Russell 2000 -
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SteveT: May was a phenomenal month for equity investors. The major U.S. indices made new all time highs with the exception of the Nasdaq Composite. The Nasdaq is still nearly 50% below its all time high of March 2000. The S&P 500 finally reached a new all time closing record high on May 30th after enticing us several times with intra-day records only to drop below the March 24, 2000 closing level of 1527.46. I would not anticipate monthly stock market gains to continue in excess of three percent. Some consolidation is likely to occur during the months ahead, although this is far from assured. Strong earnings by corporations have not gone unnoticed by investors. Takeovers and private equity deals also seem to be driving some of the market action.
Those veteran David Korn subscribers have in the past seen my interpretations of Bob Brinker's model. The purpose of this guest editorial is to give my thoughts on how I think Bob sees his model at this time.
DavidK EC: For the benefit of my new subscribers, and as a refresher for the rest, we refer to Bob's model as the "LTSMTM" an acronym for Bob Brinker's Long Term Stock Market Timing Model. Mr. Brinker's timing model has four major components, all with approximate equal weighting. They include: (1) Valuation; (2) Monetary policy; (3) Economic; and, (4) Sentiment.
SteveT is quite modest, but he has accumulated quite a bit of knowledge about Bob Brinker, his timing model and methodology. I think Steve has great insights into Brinker's operations. Quite frankly, I know that Brinker knows about Steve's work, and I don't think he is all that happy about it, as Steve hits the mark quite often!
SteveT: A while back I got to wondering what causes Bob's model to change from bullish to bearish or bearish to bullish. Is it simply his personal expectation for future market returns? Does he really have a "model" that he completely relies on? Over the years, certain things kept coming up repeatedly that led to a hunch on my part about "the model." I have looked back in time trying to identify what triggered a change in Bob's model and I believe I am on to something.
(LTSMTM UPDATE Continued)
SteveT: Continues: I have written in the past about how I thought Bob viewed his “model” at that particular point in time and how I believe the “model” is constructed. We all know Bob looks at numerous indicators and the “model” is quantitative and does ultimately depend on Bob making a subjective judgment at some point to alter his allocation. The “model” was originally entirely comprised of fundamental analysis indicators. After Bob made a major mis-timing move, getting out of a bull market in 1988 and not becoming fully invested again until January 1991 when the DOW was some 20% higher, he added the Technical analysis component. Technical analysis ("TA") relies on things happening a certain way because they acted that way before under the same conditions. Detractors often say TA is not reliable since things are never exactly the same as they have been in the past. In one sense, Bob’s “model” in entirely technical analysis since he is relying on things falling into place this time because they did previously. You can see how it is easy to go in circles trying to follow this stuff. I will say having a model to study does have the advantage of partially eliminating some of the emotions we all face at the tops and bottoms of the market cycle.
We all know from listening to Bob on the radio that he claims to be able to know when to be in the stock market and when not to be. I believe Bob's model is simple but logical. Everyone knows the stock market is uncomfortable with things like inflation and a tight money supply. We also know that trees don't grow to the sky, and there is a limit to how much people will pay for the prospect of future earnings. When economies grow to fast and future inflation fears arise, interest rates will increase and that has historically put pressure on share prices.
It has been said that the stock market is a discounting mechanism. It tries to anticipate what a stock or group of stocks will be worth 6-12 month down the road. In the interim, volatility can move stock prices widely, offering opportunity for both buying and selling of stocks at favorable prices. Or at least that is the theory.
I have always believed that Bob has a great deal of respect for valuation. Every Monday when he examines his model, I believe Bob starts by calculating the current P/E ratio of the S&P 500 -- the Index which Bob says his current timing model tracks. Determining the market's valuation can be a daunting task since there are many methods to choose from. We do know the stock market is a forward looking device. Based on Bob's past statements, I believe he looks at forward operating earnings.
In going back to look at what makes his model tick, I found it practical to use actual earnings for the period in question. This minor adjustment would cause my figures to fluctuate from the actual numbers Bob may have used.
I believe after making the initial P/E calculation, Bob compares that to the P/E of the FED model. What is that you say? Simply put, you take the yield of the ten-year Treasury bond and divide that by 1. For example, if the current yield is 4.726%, you use the formula (1/4.726)*100 = 21.15. If the current P/E is below 21.15 the market could be deemed undervalued and if over 21.15 it could be classified as over valued.
DavidK EC: Bob has been consistent in saying that his model is "either bullish or bearish." In other words, there is no in between which suggests that he might actually assign a number based on the data points which triggers the decision to issue a buy or sell recommendation. That said, Bob's own "interpretation" of his timing model has suggested that he assigns various degrees of the bearishness or bullishness of the model.
SteveT continued: It is important to separate historic valuation from current valuation. Bob's method allows you to stay invested in equities when valuations are high historically, provided we are in a low interest rate and low inflation environment. You might be tempted to go back to the 1988 to 1991 and check this theory. I'll save you the trouble. It doesn't jive, but remember Bob's timing model failed during that time, and he allegedly changed it after wrongly exiting a bull market in the late 1980s.
After making the first calculation, I believe Bob quickly reviews the other segments of his model. My guess is that he starts with the Monetary policy indicator, followed by the Economic indicator. Then, he finishes up with his newest indicator, Sentiment, which seems to be evolving to this day. I suspect that even if the last three indicators were in conflict with the Valuation Indicator, Bob would still be hard pressed to announce a change in his model outlook. In fact, I believe he uses these secondary indicators to confirm what the Valuation Indicator is saying. He may even look to these secondary indicators to pick a precise time to pull the trigger.
The art and science in all of this, is trying it assimilate the information and determine which indicators deserve the most weighting at any particular time. With that said, and with DavidK's help, let's look at the individual components of the model with an eye toward how they might translate now.
SteveT: Bob dramatically increased his 2007 S&P 500 operating earnings estimates to $92 in May, up from $89 in March. In the past, Bob has talked about how important earnings momentum is for on-going bull markets. Solid earnings growth makes stocks more attractive as it allows higher stock prices without spiking up valuations, or the Price-to-Earnings multiple. As long as earnings growth keeps pace with prices, valuation can remain attractive. Using the S&P 500 level of 1536.34, along with Bob's earning estimate of $92, we get a P/E of 16.69, This is certainly in Bob's comfort zone. If we look to the FED model as a valuation metric, using the inverse yield of the ten-year Treasury of 4.96%, we get a fair market P/E of 20.16. We are well below that level so I believe Brinker views valuation as Bullish.
DavidK EC: Bob Brinker tracks the P/E ratio of the S&P 500 when analyzing the valuation component of his timing model. Contrary to what some people think, he does not use the Dow, nor does he use the Wilshire 5000. With the first quarter earnings now largely complete, actual earnings-per-share growth for the S&P 500 came in at 8 per cent year-on-year according to earnings tracker Thompson Financial. This is down from the mid-teens growth we saw in 2006, but still not too shabby. However, going forward is what counts and there is some signs that growth will continue to slow. For starters, the net decline in the S&P 500 share count (based on buy backs and issuance of stock), contributed to about 1 percentage point in earnings per share growth. In addition, first quarter revenue growth slowed to 5%, which is about half the level of 2006. I think the market is not over-valued at this juncture, but I don't think its super cheap either. I think as part of the overall market, however, valuation is not yet at a place where Bob would be inclined to issue a sell signal.
SteveT: The FOMC is coming up on the one year anniversary of their last rate increase after two years of steady rate hikes. Many folks hope that they will decrease rates sooner rather than later. I know Bob Brinker is strongly in favor of quickly lowering short term rates but as I see it, the FED is locked into the status quo until inflation fears subside or unemployment increases significantly. The preliminary GDP report came in weaker than expected at a mere 0.6%. This shocked some, but remember this data is lagging going back to the end of March. Many economy watchers foresee stronger economic growth as early as the second quarter of 2007. I see no chance of any action by the FED in June. The following meeting will be after we get the advance report of 2nd quarter GDP. Things very well could be much different by that time. As long as GDP is in positive territory and core inflation is outside their comfort zone, the odds of a race cut are essentially zero. In fact, there is a growing camp of economy observers that feel faster growth could lead to rate hikes by the end of 2007. The all important seasonally adjusted M-2 money supply is beginning to show signs of that spark that can provide the fuel for stronger economic growth going forward. At the start of 2007, it was nominally 4s and low 5s on a percentage basis, with real growth around 2s and low 3s. This has recently been inching higher with nominal rates mostly in the 6s and real growth (after subtracting CPI) of high 3s and 4s. I have been rating the Monetary Indicator as neutral for some time and will continue for now. If stronger money supply continues, this indicator could go into the bullish category soon.
DavidK EC: Bob follows the monetary supply to determine the necessary liquidity for continued expansion in the United States economy. Bob has referred to the M-2 money supply as "the fuel of our economic growth." In early December 2006, Bob was pounding on the table that the Fed would have to cut rates early this year. At that time, the Fed Funds futures were reflecting a 70% odds that a rate cut would be implemented in the first quarter. As you read in my newsletter this weekend, Bob is now on record as saying that he doesn't see the Fed cutting rates anytime soon unless the employment data shows signs of weakness. I rate this indicator as neutral right now as well.
SteveT: The U.S. jobs market remains resilient and company profits strong. The housing slowdown does have folks worried, but the spill over into the broader economy is thus far well contained. Yet the upturn in our economy has yet to take firm footing. Should energy costs stabilize and food prices moderate, we will be in fine shape going forward. What if they don't? Should that occur long enough the FED would likely increase rates to keep inflation in check even if it would lead to a recession. I don't think we will have to worry about that this month. ECRI's leading indicators are making new highs so they are expecting the economy to expand. I see no reason to think we are headed for a recession, but expect our solid foundation of low inflation and benign interest rates will lead to sustainable growth later this year. I suspect that this is why Bob increased his earnings last month. I doubt we are headed towards recession as long as unemployment is low, consumers are willing to spend and personal income increases. I rate this indicator as Bullish.
DavidK EC: Bob has also mentioned that "forward earnings momentum" and "economic momentum" comprise this indicator. What is important relative to this indicator is the rate of growth in the economy. I have a hunch he also looks at productivity as a way to see just how much growth we can enjoy without inflation becoming a problem. The economic indicator is one of the toughest to rate. The economic data we get monthly is based on what happened in the past. You have probably heard the famous quip that economists have forecasted 9 of the last 5 recessions. Still, when you are a market timer forecasting is your "stock" in trade, so to speak. That's why things like the "yield curve" are important to track as an inverted yield curve has often been a precursor for recessions.
One thing that I follow closely which Steve mentioned and I know Brinker looks at as well is the Economic Cycle Research Institute (ECRI)'s Weekly Leading Index (WLI) which is a gauge of future U.S. economic growth. On June 1, the ECRI announced that its Weekly Leading Index held at 142.4 in the week ended May 25th. Higher interest rates and jobless claims were offset by higher stock prices. The annualized growth rate in the WLI fell to 6.3%, from 6.4% the prior week. According to Lakshman Achuthan, ECRI's managing director, "With WLI growth holding near a three-year high, the U.S. economic growth outlook remains positive." Read the article where he is quoted saying this at the following url:
I am going to go with a neutral to bullish reading on this one.
Kirk's Comment: Chart of ECRI's WLI Growth Rate & US GDP
SteveT: Analyzing sentiment is something that Bob added to his “model” after the poor performance he suffered in the 1987 to 1991 time frame. Lately, Bob seems enamored with the 60-day Put/Call ratio. This has been perhaps the one sentiment sub-indicator that has been consistently supportive of his stock market bullish stance. It is currently at 0.99, while the 10-day is 1.0. When Bob first started analyzing sentiment, the primary data point was the Investors Intelligence survey. That indicator is showing 53.8% bulls and 21.5% bears giving us a sentiment ratio of 71.45%. This is in Bob's caution area above 70%. The four week moving average of Bulls/(Bulls + Bears) is even higher at 72.5%. No reason to panic, but merely a signal to check the other indicators. As a side note, I have never heard Bob make mention of the American Association of Individual Investors (AAII) survey, but they are looking at things very differently right now. The four week moving average of Bulls/(Bulls + Bears) is 48.28%. This data point along would signal a buy analyzed by itself. I rate the Sentiment Indicator has having enough pessimism to keep pullbacks limited to health restoring corrections. Bullish.
DavidK EC#1: Bob views Sentiment as a contrarian indicator. As Steve accurately noted, I believe Bob began with primarily the weekly poll of investment newsletter writers done by Investors Intelligence. Bob uses the formula bulls/(bulls + bears) to yield a percentage. When the number comes in between 50% and 70%, Bob views it as a neutral sentiment data point. When the number comes in under 50%, it is viewed as a bullish indicator as it means the majority of newsletter editors are out of the market, and the only way they can affect the market is by buying back into it. If the percentage drops to under 50% (after checking the other indicators) it often in the 1990's indicated a buying opportunity or as Bob said, a "Gift Horse Buying Opportunity." Again when it drops to under 50% that means that one or more of every two newsletter writers are bearish. They are out of the market when they should be buying. Bob has referred to the newsletter writers who are in the "Correction" category as "clueless" and do not factor into his calculations. When the number is over 70%, it represents a lot of bullishness among advisors, which is a dangerous level from a contrarian standpoint. Bob attempts to smooth out the weekly bumps by looking at the 4-week moving average of this percentage. In recent times, it appears Bob added the TRIN and the VIX to the mix and there are quite a few more. Overall, the Sentiment picture is mixed right now, and not an extreme in either direction. This bull market has risen against the proverbial wall of worry. A correction can occur at any given time, but we aren't seeing rapid bullishness that normally is found at the end of bull markets.
Kirk's Comment: Sentiment Charts of :
SteveT: As I see it, Bob Brinker would interpret his model with three bullish and one neutral main indicator. Solidly in the bullish camp. The summer season historically has had periods of market weakness and if we saw that, I would expect Bob to change from a dollar cost average recommendation to a lump sum by signal if the S&P 500 reached the 1430 level.
DavidK EC: I agree with Steve and would interpret Bob's timing model as bullish at this juncture. I want to extend my thanks to SteveT for providing this guest editorial and doing a great job as always!This LTSMTM Update was first published in David Korn's June 3, 2007 Newsletter. Members of our mailing list get a discount on David Korn's newsletter that includes summaries of monologues and key calls. For an example, see David's summary of the show following Bob Brinker's announcement to his radio audience he was returning to fully invested in March 2003. Just ask us for details on how to get the discount.
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