A Dash of Insight

Another Round of Panic

Trading and investing are quite different things, a matter of time frames.

Today's trading was sparked by the ISM services report, something that has not attracted much attention in recent years.  The Market has focused more on the traditional ISM manufacturing survey, partly because it has a longer history, and a clear link to GDP.  For those who have forgotten that report, released two trading days ago, it suggested GDP growth of 3% as of mid-January, the time of the survey.

The ISM service release was surrounded by some controversy because of a change in the method of calculation and the early release of the data.  The ISM, in circumstances nicely reported by Kelly Evans of the WSJ,  admitted in a conference call that information might have leaked, so they announced the result before the opening.  We are always amazed to see that people do not realize that big traders can always find a way to play information when regular stock markets are closed.  Globex futures trading, anyone?

Significance of the Report

Most market participants realize that the service economy has assumed greater importance in recent years.  The large move in the index played into the recession fears of many.  As the market declined, this seemed to be confirmation of increasing recession odds.

The market and media reaction was that if many react to a piece of data, it must be right.   Let us look a bit deeper into this information.  When so many stampede, there may be a contrarian opportunity.

We have tested the ISM service series against employment changes and other economic data, and we find it to be pretty good.  When comparing it to the ISM manufacturing index we discovered that it did not add much information.  We now have a single data point where there is a significant divergence.  This would be nice to test, but there are not many other divergences to use.

Our review of today's news did not find anyone else who highlighted this statistical fact, or wondered about the meaning.  This provides an edge for our readers.

Other Interpretations and Advice

We realize that those with a predisposition to seize upon any evidence of incipient recession are touting today's number, even if they never mentioned it before.  Readers might want to compare the current interpretations from these sources with those from past months when the services figure was stronger than manufacturing.  There is a lot of selective perception at work.  Pick your favorite source and do a search to find out whether this number was ever highlighted when it was strong.

Briefing.com, an unbiased interpreter of information, reports as follows:

The data seem inconsistent with the harder figures on spending and investment and world trade which really provide the trends for domestic growth.  We also believe that the intent of this ISM index -- to reflect on growth for the entire economy outside of manufacturing -- is a mighty grand objective given the simplicity of the survey questions. 

For each component (e.g.  activity, employment, orders), the question to the survey respondents is simply, "Are conditions stronger, unchanged or weaker than the prior month?"

Gary D. Smith, who has a strong multi-year record of market forecasting, provides excellent daily commentary on his blog.  Unlike some other providers of links,  Gary cites information from every possible source.  He tells the "whole truth" without any cherry-picking of information.  Here is his take:

I continue to see the US Fed as now “ahead of the curve” and the odds of an intermeeting rate cut are rising meaningfully. The VIX is rising 8.0% today to a high 28.0. The ISE Sentiment Index hit a below average 102.0 and the total put/call is hitting an above average 1.12. Finally, the NYSE Arms has been running very high again all day at 2.47, which is also a positive. I still view the odds of a full retest or new lows in the market as unlikely and further weakness providing good entry points in favorite longs for investors.

Read the entire article to get the full context.

The Earnings Mythology

The recession hypothesis is getting an additional boost from commentators who claim that forward earnings are in decline.  Briefing.com has some great information on this:

According to Thomson Financial, fourth quarter 2007 earnings are expected to decline by 20.7%.  The main reason for the decline is the financial sector's whopping 105% decrease in earnings.  If the sector was removed, earnings would grow by 11.0%.  Homebuilders are also a drag.  For example, the consumer discretionary sector's earnings would grow by 7%, instead of declining by 15%, if homebuilders were removed from the calculation.

In general, we do not like throwing out the worst or best sectors from the overall S&P 500 earnings.  This might be an exception.  The last quarter is a bit unusual because of the forced write downs of mortgage securities.  Some believe that there are many more write downs to come.  We think that the FAS 157 losses might actually overstate the impact on these firms.  They voluntarily chose to keep securities on the balance sheet, probably because the expected performance to exceed current value in an illiquid market.  The jury is out on that question.

Meanwhile, the rest of the market sectors are not showing mean reversion, recession, or any other sort of earnings decline.  For example, Colin Barr's nice review of the Disney report highlights a good past quarter, and good future prospects.  This is a company that one would expect to be hit by consumer distress, if it were already an important factor.

Forward earnings will depend greatly upon how financial stocks rebound from current conditions.

Conclusion

Markets look forward.  Even in recessionary times, a fact not yet in evidence, forward earnings look through the recession, setting the stage for rebounds in stocks prices.

The Stress Test

As we write this, foreign markets have plunged over the weekend.  Stocks will open lower -- much lower -- at a frightening level.  Individual investors may well panic.  Some traders will see this as the indicator they have been seeking - a dramatically lower opening that provides a buying signal.

We reported our own short-term indicators (negative) and our intermediate-term indicators (waiting for the washout).  We will be buyers on the opening.

The Problem:  A Crisis of Confidence

There has quite obviously been a leadership crisis.  Any appearance by a government official -- Bernanke, Paulson, Bush -- seems to lead to another decline of 200 or so in the Dow.

What should we make of this?

During the weekend we have not only read the typical Internet sources, but talked with various fund managers and astute observers.  There are two common themes:

1. No one has any confidence in the various fiscal stimulus plans or in Fed Chair Bernanke.  No one.
2. The conclusions seem to be based upon market reaction, not actual economic data.

When there is such a unanimous viewpoint, it suggests opportunity.

Staying Calm

The best opportunities for trading and investing come when others react on emotion rather than facts.  Let us take a look.

Market commentary has dismissed anything positive, and has done so for at least a month.  Economic data suggesting economic growth of about 1.5% -- jobless claims, ISM report, Michigan consumer confidence -- is ignored.  None of these readings is close to normal recession levels, but the market sees a recession as a fait accompli.

Fiscal stimulus has been dismissed, largely because the President's package lacked specifics.  This commentary comes from those who have no particular expertise in public policy development.

Almost no one in the blogosphere provides public policy insight, especially when combined with a knowledge of economics, politics, and hands-on investment experience.  Our individual accounts under management have beaten the S&P 500 by about 6 points per year for ten years.  How?  The biggest gains come when we find a solid contrarian theme.

The Plan for Fiscal Stimulus

The Bush plan has been criticized for a lack of specificity.  We are amazed at this reaction!

Anyone who understands politics knows that the key to policymaking is compromise.  Markets should give more credit to the President's advisors, who urged him to take a moderate course.  Anyone really interested in understanding this should read the Pulitzer Prize winning work of Robert Caro, Master of the Senate:  The Years of Lyndon Johnson.

Politics is the art of compromise.  Republicans and Democrats alike have a motive to stimulate the economy during this election year.  They will probably get it done, with a combination of individual and business incentives.

They will be joined by additional Fed rate cuts.  Monetary and Fiscal policy will both be in force.  If a recession is imminent (something that has yet to be determined, despite the widespread commentary) these actions will mitigate the effects.  Meanwhile, stocks are already reflecting a severe reaction.

Bond Insurers

We are aware of the continuing speculation about bond insurers.  The worst-case speculation is a series of falling dominoes as credit market counter-parties cannot pay up.

This is exactly the sort of case where government acts swiftly and decisively.  The historical precedents include, among others,  Long Term Capital Management, Mexican Debt, Brady Bonds, and the Resolution Trust action after the Savings and Loan issues.

The key point to understand is that when private errors start to have major impacts on the general public, government gets in gear.  This will not be immediately apparent to the talking heads on CNBC or the Internet punditry, since they are not public policy experts.

When reading these discussions, one should compare the projected losses to the overall stock market losses -- those hitting average investors and pension funds.  That is the comparison that government officials will make.  Our own estimate is that tomorrow's opening losses alone -- one day -- will dwarf the entire cost of backing up the bond insurers.

Government officials look at cost/benefit analyses.

Our Conclusion

A crisis in confidence always provides a stress test.  Government may seem very slow to react.  A few weeks is really fast!  In "trader time" the reactions take an eternity.  In terms of actual economic impact, the delays are modest.

Despite the widespread speculation, no one really knows the extent of the slowing in economic growth.  Policy actions will have an effect, either to prevent or to mitigate a recession.

Meanwhile, equity investors seem to be selling without reason.  Short-term traders may look for indicators like our Gong Model.  Average investors should take a longer view.

Market Response to Recessions

Each day the market gets "new information" about a slowing rate of economic growth.  If the rate of economic growth slows enough, it can and will be interpreted as a recession, when the NBER does a retrospective analysis of the data.  What does this mean for investors?

An Interesting Table

Let us take a good look at some data from the Wall Street Journal, and highlighted by The Big Picture.

An objective look at this table suggests a major disparity between events of the 70's -- Watergate, Arab Oil Boycott, double-digit inflation and unemployment, double-digit interest rates -- and the more recent history of the last forty years.  The only significant decline associated with a recession happened from the over-valued market of the Internet bubble.  Current market PE ratios are vividly different from that era.

A second question relates to recession dating.  For almost a year, starting with the low GDP reports in Q1 '07 and especially now, many pundits have suggested that we are already in a recession.

The "official" recession dating takes place after a major decline has been observed.  At that point, the NBER dates the recession, the points used in these charts, as the prior peak in output.

Our Take

The most important question for investors and traders is how much of the slowing economy is already reflected in forecasts, earnings projections, and stock prices.  Careful readers of bearish pundits should be asking the question raised by the table:

If the recession really is underway, hasn't the market already reflected reduced earning potential?

Regular readers of "A Dash" know that we believe that forward earnings have reflected recession expectations for many months, driving forward earnings yields to low levels when compared to other asset classes.

Each day brings new and redundant information, completely consistent with slowing  GDP growth.  The market responds, each time, as if this is fresh information.  Slowing growth implies a mixed picture from companies.  We cannot expect them to make wildly bullish comments on prospects.

Those who wait for this optimistic look from companies will have waited too long.

When to Pull the Trigger

There is a special psychological barrier for those contemplating the purchase of U.S. equities -- long-term investors and traders alike.  The memories of losses in the 2000 era are still fresh.  Those who do not study the fundamentals of market valuation -- forward earnings and interest rates -- see a market reaching the old highs as a sign of danger.

Background

Consider the following key facts:

• In the long run, stocks outperform bonds;
• The current expected yield from stocks is significantly higher than the risk-free bond yield; and
• The overall market, and many of the most attractive growth stocks, have now pulled back significantly from recent highs.  (We see many attractive stocks.)

Paralysis

We talk with many individual investors, nearly all of whom have lagged market averages in their own accounts.  The biggest single mistake is that they can always find reasons not to invest.   One very intelligent person was referred to us in 2004.  He was worried about the outcome of the Presidential election.  That was about 30% ago in the S&P 500, but he was buying condos instead.  He still does not own any stocks.

There are always many things to worry about.  The leading Internet financial sites emphasize the "wall of worry."  Unfortunately, they do not explain it.  A market plagued with many concerns, like this one, is actually the best opportunity.  When the issues are known, market prices reflect the worries.

How NOT to Act

Here is what we often see.

The market makes new highs.  The investor says, "It is is too late.  I missed the best time to get in.  I can't chase this.  I made a mistake earlier, but I cannot buy now."

The market pulls back.  The investor says, " Wow!  I'm glad I did not invest a month ago.  There are plenty of problems.  Look at the selling.  The market is going lower."

Notice that the investor cites the direction of the market when it is moving lower, and the level of prices when it has moved higher..

Using this approach there will NEVER be a correct time to invest.

A Solution

The best approach for investors is to have a disciplined method.  This can be based upon fundamentals or system.

But this is easy to say.  We know that the real problem is getting started.  So here is our best investment advice as 2007 comes to an end:

Do something!  Buy a partial position.

This is what the pros do when in doubt about timing.  Establish a position.  If prices go lower, you can buy more.  If prices go higher, at least you are participating in the gains.  This is much better than following a method that leaves you permanently on the sidelines.

New Market Highs: What's the Downside?

As the market reaches new highs, investor fear increases.  Much of this relates to a focus on price without regard to what has happened to earnings and the economy since the 2000 era.  How should the investor consider this?  Is the story different for traders?

One approach is to consider the downside risk.  This means more than just speculation about recession odds and the other elements of the Bear Playbook.  While no one can say with certainty what will happen with equity markets, there are ways to get a handle on the probabilities.

The Intermediate Time Horizon

Many investors and their managers operate on a time horizon measured in months, not days. There is a lot of discussion about short-term market moves and sentiment indicators. We are interested in a longer term sentiment measure. The forward market P/E is good for that purpose.

We use the cap weighted S&P 500 for this purpose because that is the vehicle for the millions of investors who buy index funds or closet index funds. We use forward earnings because we are trying to predict.

When the forward earnings yield on the S&P 500 is 6.7% and the ten-year note is about 4.5%, that shows a high level of skepticism about earnings. You can call it a risk premium, but if so, it is a big one. It shows that the powerful voices of market bears have been heard. Over half of the country thinks we are in a recession or about to be. A recent online poll of investment advisors (!) showed over 25% expecting a 1987 style market crash. Wow!

Gary D. Smith calls this a negativity bubble and we agree. The fact that an index is at a new high does not necessarily imply euphoria using this approach. The risk premium is an objective measure which also worked well in 2000.

Using Data on Forward Earnings

Here is a good question.  What would happen to the market if forward earnings declined by as much as they did in any year-over-year period since 1979 and the market got a small P/E bump to 15.5. (That's when the First Call series starts).

The answer: A decline of 14.4%. The biggest forward earnings decline (almost 18%) came in the year ending with November of 2001. If forward earnings now fell by that amount and the P/E moved to 16 (still a very high risk premium), the S&P would be down less than 12%. It is difficult for market to crash when so much risk is built in.

The time period includes both the 1987 crash and the 2000 bubble, so it is quite relevant.

Conclusion

The market, despite new highs, reflects a lot of skepticism.  It is ironic that the many pundits predicting recession and a market decline believe that they have had no impact.  In any market there is a chance of decline.  Meanwhile, any reduction in worries could lead to a much higher P/E multiple.

It is all about risk versus reward.  To analyze this, the investor must know what is already built into the market, not just a black-and-white doomsday scenario.

For traders, this analysis shows why there is a continuing bid under the market, even in  corrections.  Active traders who have recognized this have profited in the last month.

ETF Update: Are you missing the rally?

How has your portfolio been doing?   If you are not happy with the answer, it might be time to ask why.

Best Use of ETF's

We know that many investors and fund managers have been caught in the negativity bubble.  They focus on a macro-economic debate, mostly between economists and non-economists.  Regular readers know that we have tried to expose this.

Meanwhile, the market is conveying a very different message, as noted in Dr. Brett Steenbarger's must-read article, "Why Aren't Stocks Forecasting Recession?"

Those following a disciplined investment method, adjusting for market cap size and style, have captured the move.  My friend and RealMoney colleague, Steve Birenberg of Northlake Capital Management, graciously provides occasional updates for his system.  On September 5th, he wrote on RealMoney (subscription required and worth it) as follows:

For the third consecutive month there were no changes to my Market Cap and Style models. The signals remain large cap and growth. Client portfolios own the S&P 500 Spyder (SPY) and the iShares Russell 1000 Growth (IWF) to take advantage of the current signals. The large cap signal from the Market Cap model remains one of the strongest readings in the monthly data I have going back to 1980. All ten factors covering a breadth of economic, interest rate, and stock market technical indicators are flashing a large cap signal. On their own, each factor has in the past shown predictive ability for anticipating relative performance of large caps vs. small caps as measured by the S&P 500 and Russell 2000. With the weight of the evidence from a broad array of previously accurate indicators lined up so solidly in favor of large caps, I feel very good about the prospects for large cap outperformance to continue for at least a few more months.

Our Own Method

Our own TCA-ETF model has captured another dimension, the decline of the dollar.  The effect is described in a good column from MarketWatch.  Since we use an iShares universe that includes foreign ETF's, we capture all of these effects through computer-based technical analysis.  This is the complete set of rankings, showing our actual holdings, entry dates, and returns through yesterday.   (you can click to enlarge)

This is a complete set of sector ratings.  The IEZ position was closed and IXC purchased because of the relative rankings.  The sectors marked with an asterisk are in what we call "The Penalty Box," stopped out for violating specific criteria.

The Sector Message

The most important conclusion from the rankings is that almost forty sectors qualify as a "buy" based upon our analysis.  The positive expectancy is broad-based.

The next message is that certain themes -- especially foreign ETF's, energy, and basic materials, show the greatest strength.

Why Not All Top Sectors

Our investment discipline attends to risk considerations and diversification, so we have limits on sector concentration.  Overweighting some groups is an element in beating the market, but risk control is important.

Stops and Exits

Part of risk control is the use of "stops."  This is a tricky topic, worthy of a separate analysis, so it will be part of a future weekly update.  All good things have an end, and exits are important.  The perceptive Adam Warner highlights the risk in one of our key holdings.

Fundamentals

Some investors focused on fundamentals have enjoyed similar gains.  Unlike our partnerships, our individual accounts include no foreign ETF's but there is considerable overlap in holdings.  Many US corporations have significant earnings from abroad and strong earnings prospects.

At "A Dash" we view fundamentals in terms of forward earnings prospects versus alternative investments.  The market is recognizing that bonds and real estate have weak prospects relative to stocks.  This is another way of saying "Fed Model," a valuation topic familiar to regular readers.

Implications for Investors

There are many traps for the investor.  Spending a lot of time reading pundits who start with the conclusion and then find the evidence is the single biggest trap.  Amazingly, some of these sites are the most popular and highest-rated on the Internet.  Go figure.

Another trap comes from the financial media.  The stories seem always to focus on the worries.  That seems to get reader attention.  Few provide good information on the multi-year growth of earnings -- far outstripping stock performance.

Meanwhile, the online brokerage commercials are a huge trap.  They lead the investor to think that his/her own market "feel" can beat the experts.  Some even encourage one to develop and backtest a trading system.  The main purpose of our TCA-ETF series is to describe the challenges in system development and testing, including dealing with the inevitable losing streaks.  Most people trying this at home will make all of the common mistakes and get terrible results, as described here.

A thoughtful reader can learn to do better.

John Hussman and the Fed Model

John Hussman has written a piece about market valuation and the Fed model that breaks some new ground.  It is sufficiently different from his past work to deserve some special attention.

Background

At "A Dash" we believe that thinking about valuation is important.  Some idea of overall market valuation helps both individual investors and traders by providing context about risk and reward.  Significant deviations in market prices from the "fair value" of one's model provide a signal of what we call long-term sentiment, be it euphoria or a "negativity bubble."

Dr. Hussman agrees about the importance of valuation, since he writes about it on a regular basis.  He is an outspoken critic of the Fed model, preferring his own approach.  He uses something he calls peak earnings, referring to the highest past level of GAAP earnings.  While he writes with the objective of explaining hedging strategy to his own investors, his work is widely cited.

In another element of common ground, the Hussman articles frequently cite those using an approach like the Fed model, but not naming it explicitly.  The many market commentators who view current stock prices as cheap, comparing forward earnings to interest rates, are doing something akin to the Fed model, but without citing it explicitly.  Our guess is that many commentators wish to avoid the debate about this approach--the intellectual baggage associated with naming it.

We have not been bashful about analyzing and naming the Fed model.  We get frequent questions, from readers and our own investors, asking why our approach differs so much in its conclusion.

The Key Issues

While the purpose of this article is the current Hussman argument, readers  can understand the problem better by understanding the following key issues:

• Looking backward.  Hussman (and other noted commentators) prefer to look at documented past earnings rather than the forward projections of analysts.  We prefer prediction based upon the forward look.  Our basic rationale is that a backward view misses turning points in the market and that analyst estimates are much better and more honest now than in times past.  We like to take the work of hundreds of specialists, trying to do their jobs.  Our daily reading of these reports suggest that there is plenty of skepticism built into their work.
• Using interest rates. Most of Hussman's work looks at interest rates OR earnings, not putting the two together.  We believe this misses the major valuation point.  When interest rates were at extreme levels, stocks deservedly had a low P/E (or high earnings return if one inverts the equation) to merit investor consideration.  When interest rates are low, the opposite argument holds.
• Interest rate trend. Hussman feels that the trend in interest rates is an important element.  We disagree.  At any point in time, Mr. Market is offering the investor a choice between stocks and bonds.  The investor can lock in a return via a bond purchase.  The key element is NOT the direction of interest rates, but rather is investor skepticism about earnings estimates.  One factor is known, the other is a matter of forecasting.
• Relevant time period.  The Fed model uses data from 1980, because that is the time when forward earnings forecasts for the S&P 500 were available.  Hussman believes that this period is atypical.  Readers should read his work and consider his argument carefully.  We believe that the time period includes a lot of interesting variation, and provides a lot of useful information.  Like any researchers, we always wish we had more data, covering more time.  Having said this, going back too far can also be a mistake.  The investment world is much different in the time from the mid-70's to now.  The use of computers by all participants and the availability of information, and the growth of options and futures are all important changes.

The Current Question

Dr. Hussman reports research that is innovative in two important respects.  First, he combines interest rates and expected earnings.  Second, he uses the known period of forward earnings to create an intriguing model.  He uses information about past earnings and economic trends to create a model for forward earnings. He then takes the model and applies it to the past - the period before forward earnings were readily available -- to simulate what those forecasts would have shown had they been available.

He writes as follows:

Operating earnings are a “smooth” measure of earnings that, as it turns out, can be cleanly and accurately approximated using variables that are available historically - specifically, the highest level of S&P 500 (trailing net) earnings achieved to-date, the actual level of S&P 500 trailing net earnings, and the U.S. unemployment rate (which helps to capture business cycle fluctuations). The ISM Purchasing Managers Index provides slightly better accuracy than the unemployment rate, but has a shorter history. The results below are not very sensitive to the choice, so in the interest of data availability and to make it easy for others to replicate and verify these results, I've used the unemployment rate.

From this starting point, he derives the following regression equation:

forward operating earnings = k * record trailing net earnings to-date

where

k = 1.2721 + 0.3115 (current trailing net earnings / record trailing net earnings – 1)
  - 0.5011 (unemployment rate / 16-month average of unemployment rate – 1)
  - 0.5985 ( (record trailing net / record trailing net 5 years prior) ^ (1/5) – 1)

From this equation he develops a chart showing that in the pre-1980 era, going back to 1948, the Fed model did not have a good fit.

What the Equation Means

The essential problem is that very few readers have the methodological skills to interpret the Hussman equation  (which is missing some parentheses, but we get the point).  That means that people will focus uncritically on the conclusion.

At "A Dash" we believe in using experts whenever possible.  Our own expertise is in choosing the right experts and in research methods.  Let us try to interpret the Hussman findings.

The constant term of the model shows a "starting point" of 27%  earnings growth.  The next variable boosts that growth by a percentage calculated by looking at current trailing earnings versus record earnings. This is the hallmark Hussman variable.

The next variable considers the unemployment rate compared to the prior 16 months, giving  earnings a reduction if the rate is higher. Fine.

The final variable looks at the "record trailing net" versus the record for the last five years and gives a major haircut to estimates if the record is higher.  Hmm.  We do not see the logic from this variable.

Perspective

Before stating our analysis of this research, the differing  perspective should be made clear to readers.  Dr. Hussman is a developer of a valuation method which he has used to guide his fund management.  He has skin in the game, and frequently writes to investors to justify his approach.  If his messages were private, we would have nothing to say.  The problem is that his work gets broad exposure, including our investors and many people we are trying to help with our work.

If we believed that the Hussman method to be superior, we would adopt it in a heartbeat.  Regular readers know that we follow a disciplined approach that reacts to market conditions.  We represent the consumers of valuation methods, open to any approach.

Our Analysis

We have done thousands of regression models over the years, and taught the classes for grad students.  What may make eyes glaze over for most is routine  for us.

Here are some key thoughts, all of which come from old class notes:

• Think about the logic of the  model.  The key concept of the Fed model is that investors compare forward earnings to interest rates.  In the pre-1980 days they did not have this information.  More importantly, they did not have access to the Hussman model!  The 1948 investors could not make the relevant comparison.  They were not looking at past record earnings versus the prior five years or any of his other variables.  We do not know what they were thinking.  While we would love to have data about this era, we do not.
• Technique of model development.  Let us suppose that we know about one period of time and wish to backtest a different period - the exact Hussman problem.  We would divide the known period into two groups, developing the regression equation for one and testing it against the other.  If the fit is not good, how can one make a forecast for the unknown period?  Hussman did not do this, and we suspect that the correct method would generate a very different regression equation.
• The logic of each variable. Each variable should have an independent contribution, meaningful in theory as well as in improving the fit. In particular, we suspect the "record earnings" variables.  If removing these variables creates wild swings -- even swings in the sign --of the other variables, then the model lacks intellectual integrity.  We suspect that this is true, but cannot prove it without the data.
• Optimizing parameters.  Whenever we see something like "16 months" we say "hmm."  The question is why this value was chosen and whether the variable is "robust."

Dr. Hussman's work is not offered as a proprietary model.  He is an advocate for his approach.  Given this, he should be willing to share the data and invite alternative analysis.

Summarizing

Dr. Hussman's quest is a good one.  He is an excellent business person and advocate for his method.  If he is confident of his results, he should be willing to have peer review of his work, they way it is done in academic circles.

Meanwhile, we do not see the advantages of this approach.

The Fed Model and the Wall of Worry

There are two interesting themes in current market commentary.  There is a connection that is not recognized by either group.  Let us introduce the writers to each other.

Critics of the Fed Model - the First Group

At "A Dash" we have discussed criticisms of the Fed Model, a simple tool that can give the individual investor a feel for the important asset allocation decision.

Many critics test the Fed Model for market timing.  Here is one recent example.  The CXO Advisory blog also has a good summary of research taking this approach.

We believe that this is the wrong way to use the model.  It is better viewed as a gauge of long-term sentiment.  In the bubble era, the model correctly signaled that stocks were overvalued.  When interest rates hit bottom, the  model showed stocks to be vastly undervalued.

The market did not agree  because there was a palpable fear of global deflation.  To take the argument to an extreme, would one pay a 50 P/E multiple for the S&P 500 if interest rates were 2%?  The fear of a recession undermined expectations about forward earnings.  Those fears proved to be unfounded, but the concern was a real one.  The Fed Model showed the sentiment of the time.

Bearish Market Pundits -- the Second Group

There is widespread coverage of various threats to stock prices from the usual suspects, frequently cited on "A Dash".  The issues involved  include topics like the following:

• Housing price declines and an inventory of homes for sale
• Continuing predictions of "mean reversion" in corporate profits
• The collapse of consumer spending
• High energy prices
• A "boxed-in" Fed raising interest rates
• Terrorist threats
• Middle East geopolitical concerns
• Democrats winning the 2008 elections
• And now -- hedge fund blowups like the Bear Stearns case

We may have missed a few, but the idea is clear.  To those writing on these topics, the market has rallied to new highs in the face of these important fundamental factors.  The pundit conclusion is that everyone buying stocks has foolishly ignored the signs that only they can see.

Bringing the Groups Together

An experienced market observer might wonder how so many could have missed the list of concerns.  All of the items on the list get frequent attention in the press, on TV, and in many blogs.  This is not fresh information.

A more plausible explanation is that the market trades at a significant discount to the normal "fair value" for the very reason that investors are very worried about the list of worries.  The Fed Model, currently showing a discount of about 25% on the S&P 500, is a good reflection of the market sentiment.

The bearish pundits focus on worries rather than quantification.  In fact, US stocks have never caught up to the multi-year, double-digit expansion in profits.

Private Equity

Private equity funds have actively exploited the loose arbitrage between low interest rates and high forward earnings expectations from stocks.  The resources for these funds are growing as many institutions seek alternative investments.

We will write more on this topic, describing our conclusion that private equity actions are based upon fundamental valuation rather than a "bubble" phenomenon.  We can only do so much in each post.

There may also be a quiet period in this activity as participants all go on vacation in August.  Some will, no doubt, seize upon this as proof of a "bubble."

Conclusion

US stocks currently trade at a significant discount because of the long list of worries.  These concerns do not represent fresh information.  Most of the arguments raised have been out there for years.  Here is the real contrarian position:

• The Fed continues to steer a wise course toward modest growth and low inflation expectations.  No one seems to believe this, even though predictions of failure by the Fed were the most costly investment research  of 2006 for those who believed it.
• Corporate profits continue to grow.  Many are skeptical about this also.
• The consumer, supported by strong employment, continues to buy.   Many are buying the "spent up consumer" hypothesis.
• Corporations increase investment.  Another surprise.

It is a classic case of scaling a wall of worry, the classic pattern for market strength.  We will see the top in the market when there is massive short-covering, piling in by individual investors, and finally, investment in US equities by foreigners.  We are not even close to these signals.  For the best discussion of these issues, by someone who has been absolutely right for several years, check out the commentary at Between the Hedges.  Take some time to look back at the archives to appreciate the accuracy of the forecasts.

That is why we expect stocks to move much higher this year.

The Fed Model in 1981: Responding to a Surprising Question

How did the Fed Model do in 1981?  Commenting on our site here, Barry Ritholtz states:

...according to the Fed Model, in 1981 stocks with depressed earnings and sky high interest rates were crazy expensive -- just as the greatest bull market in US history began.

That is a VERY significant flaw in the Fed Model. Missing what may very well be the greatest buying opportunity in a generation raises some very serious questions about any model that proclaims to be able to determine valuation.

Listed below are the monthly data we have for the time in question:

Date            FV                       S&P

1-Jan-81	140.9	133
1-Feb-81	128.9	128.4
1-Mar-81	135.7	133.2
1-Apr-81	130.6	134.4
1-May-81	128.1	131.7
1-Jun-81	135.3	132.3
1-Jul-81	128	129.1
1-Aug-81	123.6	129.6
1-Sep-81	121.9	118.3
1-Oct-81	123.6	119.8
1-Nov-81	139.1	122.9
1-Dec-81	134.8	123.8
1-Jan-82	127.9	117.3
1-Feb-82	120.5	114.5
1-Mar-82	128.2	110.8
1-Apr-82	126.7	116.3
1-May-82	127.2	116.4
1-Jun-82	120.3	109.7
1-Jul-82	121.7	109.4
1-Aug-82	127.6	109.7
1-Sep-82	134.8	122.4
1-Oct-82	151.7	132.7
1-Nov-82	156.4	138.1
1-Dec-82	157.2	139.4
1-Jan-83	158.6	144.3

While the comparison shows the market as slightly overvalued in April and May of 1981, and again in August of 1981, those are the only such months.  We have repeatedly said that the Fed Model is not a short-term timing method, but it actually would have worked in 1981.  An investor selling in the cited months would have had ample opportunity to enter the market at better prices.

There is nothing to suggest that an investor would have missed out on a major move.  We covered the history of valuation deviations in this article, including the chart below.
As we noted in our review, many researchers do not actually use forward earnings.  They attempt to "simulate" expected earnings through some arithmetic method.  We wonder if Barry is using data from such a source.  Perhaps he will enlighten us with an actual data series or chart illustrating his point.

Critics of the Fed Model

Yesterday' we took note of the Bloomberg story, Cheapest Stocks in Two Decades Signal Bull Market, which quoted several large and successful fund managers.  This story stimulated a post from Barry Ritholtz at the Big Picture, where he said that the Bloomberg story was based upon the “flawed Fed Model.”

This is a timely occasion to summarize our series on valuation, including some of the prominent criticisms.

Our Perspective

Our readers should understand that like them, we are consumers of models.  My own model-developing days ended about ten years ago.  (At least for stocks.  I still dabble in "recreational" modeling.)  Since then I have tested and reviewed many suggested stock market models, and provided feedback for my partner, Vince.

We did not develop the Fed Model, nor have we published any academic reviews.  We have no allegiance to those who created it.  We are perfectly willing to abandon it in favor of some other approach if we could find one that was better.

Some have suggested that the Fed Model is used by bullish pundits and managers.  We find the causation in this statement to be backwards.  The Fed Model helped us and our investors to avoid losses in the bubble era.  Methods precede conclusions, at least for those who have intellectual integrity.

Briefly put, we are just like the average reader seeking methods to improve investment performance.  The only difference is that we bring to the job more than thirty years of experience in developing and evaluating models of all types.  Also, unlike many of those citing critics of the Fed Model, we have actually read the papers and articles involved.

Our work at "A Dash" is not intended as an article in an economic journal, so we are not going to initiate some scholarly debate that few in our audience will understand.  Our conclusions and reasons are simply and clearly stated.  We intend our work to benefit individual investors and some thoughtful traders.

Background

As background, let us say what it is that we like most about the Fed Model.

• It captures the right level of complexity.  It is much, much better than valuation models that look at trailing earnings and/or ignore interest rates.  It is superior to models that add more variables without much more explanatory power.
• The model is based upon a plausible process.  The investor in a particular stock looks at expected earnings for the company and compares that return with the return of a bond.  The summation of millions of such decisions for the 500 S&P stocks is that the equity market as a whole has an expected asset return of bonds.

No other approach shares these virtues.  Anyone with experience in building systems and models will appreciate why these elements are important.

The Criticisms

First, from Barry Ritholtz's column we have the following.

The Fed Model is Imperfect.  This criticism comes from two sources:

1. Those who have never developed a model.  If they had, they would realize that all models are imperfect.  If you read such a criticism, you might ask whether the critic can do any better?
2. Those who are trying to write a journal article or book.  The relevant knowledge quickly gets to the point of practical value and beyond.  A good test is to ask whether a proposed "tweak" to a model really corresponds to the reality of the investment process.

The Fed Model "double counts" interest rates. The idea is that low interest rates are good for corporate profits and also suggest that stock P/E ratios should be higher.

We do not see the point.  The investor has a choice between two assets.  If interest rates rise, the gap narrows.  Maybe the narrowing occurs more quickly if rates rise.  So what?

The Fed Model "assumes" facts about earnings and interest rates.  Barry writes as follows:

The biggest problem with the so-called Fed model is that its built on two assumptions: 1) That profits will stay high, despite being a cyclical peak and decellerating; and 2) that interest rates will stay low.

This is quite incorrect.  The model makes no assumptions.  It takes current data about earnings projections and interest rates.  If earnings fall or interest rates rise, those following the model should adjust their behavior.

It is Barry who is making the assumption.  He believes that earnings are at a cyclical peak, a question that is very much in doubt.  He believes that interest rates are going higher.  Unlike the model, which is based upon current (and forward-looking) data, Barry is saying that he knows better than all of the analysts doing earnings estimates and better than the deep and liquid bond market.  Wow!

One might wish to note that earnings estimates have beaten the published expectation for several consecutive years, not missing a quarter.  In fact, the standard Wall Street line is that companies have attempted to lower the bar so that they can beat estimates.  If this is true, why should we believe that the sum of these forward estimates is overstated?

Valuation models are poor timing tools.  We agree!  We see valuation as a gauge of long-term sentiment.  Sentiment was euphoric in the bubble era, clearly identified by the model.  The current era shows that sentiment is very negative.  Investors have clearly accepted many of the bearish arguments about recession chances, housing problems, oil prices, the Fed, and a variety of misleading charts and anecdotal evidence.

The current valuation gap is useful in showing how much negativity is already reflected in the market.  The risks to earnings and interest rates are not the private knowledge of bloggers and bearish pundits.  Their widespread public recognition has had a major impact on mainstream thinking.  What if things are not as bad as they suggest?  The Fed Model shows what can happen in a return to normalcy -- not roaring good times, just normalcy.

A valuation model imposes discipline on one's thinking.  It provides a way of measuring negative effects.  It is not only the Fed Model.  Various other approaches that include forward earnings and interest rates give similar results.  Without the discipline of a quantitative model, one is free to speculate about each data point.  This is useful for those writing a daily blog, who want freedom to cherry-pick evidence.  It is less useful for understanding what is already "baked in" the market.

The Wall Street Journal Article

Barry cites a breezy two-year old article where Jonathan Clements interviewed some Fed Model critics.  Let us consider those criticisms.

The Fed Model uses operating earnings, not actual earnings.  Right!  And correct for modeling!  Investors making individual stock decisions look forward.  They tend to dismiss one-time events.  Those paying attention have noted that the serial "one-time" charges of the 2000 era are less prevalent.  It is done on a stock-by-stock basis, and the result is a market of stocks.

Bond returns are known and stock returns are not.  This statement is not correct if the investor plans to rebalance asset allocations every year or two, as the model changes.  It is possible to have major capital losses in bonds if interest rates increase.  Meanwhile, the return from stocks has more volatility, but also more upside.  This occurs both with higher inflation or with better than forecast economic conditions.  When Ed Yardeni studied this problem in 2003, he chose not to include a special risk premium for stocks.  It was not that there was no risk -- just that the risk/reward calculation did not favor bonds.  The available data supports his conclusion.  One might also note that the earnings return from stocks was dramatically under-estimated at the time Clements wrote the article.  Maybe it is time for the critics to freshen their data sets.

Summary of Our Work

We believe that an individual investor could spend some time wisely by reviewing our rather extensive material on this topic.

We showed the Fed Model in three time frames.  Look at the data and make your own decision.

We showed why valuation models revealed long-term sentiment, and the factors behind the current cycle of negativity.

We showed the importance of forward earnings.  Many of the critics of the model do not really use forward earnings.  They use some assumed trend, an approach that is frequently erroneous.

We discussed the merits of "tweaking models" like this one, and the pitfalls in trying to over-fit data to recent conditions.

We showed how a leading analyst from a bulge-bracket firm could get it completely wrong by trying to tweak the Fed model.

Finally, we summarized what this all means for the current market.  Understanding this topic shows why the current market is so resilient to negative factors, and why there is so much upside potential.  It is the kindling for what Gary D. Smith has called the "mother of all short squeezes."

There are some other specific criticisms of the Fed Model, including our own.  We shall revisit the topic for these questions, but this summary article captures the key points for an investor who is alert to opportunity.