Good Evening: U.S. stocks powered higher again today in what could almost be described as a minor feeding frenzy. A combination of solid earnings news, decent economic data, and some accommodative testimony by Chairman Bernanke before Congress helped lift equity prices, weigh on bond prices, pinch the dollar, and levitate commodities. Wall Street technicians were also happy to report that, while volume still isn’t great, advancing stocks outnumbered declining stocks by a 5 to 1 margin and the S&P easily surmounted the 1200 resistance level. The 13 month rally off the March 2009 lows is perplexing to many investors, some of whom are just now deciding whether to jump back in. Since investors are forever seeking the one, true timing indicator,, perhaps examining ones involving the still-trusted Fed will make their decision easier.

Harkening back to the days of bull markets gone by, Intel, JP Morgan, and CSX all reported positive earnings before trading commenced on Wednesday. Stock index futures were already well into green territory this morning when cheery retail sales figures and becalmed CPI data were announced. Once the opening bell rang in New York, it looked as if no sector would be left behind. The only lingering worry was that Fed chief, Ben Bernanke, might peer at the recently strong economic data and drop unwelcome hints of future interest rate hikes when he testified before Congress this morning. The worriers obviously didn’t know either the man (Bernanke) or his audience (Congress), and the Chairman was as docile as a dove in front of the folks who are deciding the Fed’s role in the financial reform legislation now before them.

With no monetary threat in sight, investors pushed stocks steadily higher as the day wore on, and the major averages went out at their best levels of the session. The Dow’s 1% gain was actually the laggard among them, while both the Dow Transports and Russell 2000 each tacked on more than 2% to lead the way. Treasurys were mixed, with the front of the curve mostly flat and the long end under some pressure. Yields fell between 0 and 5 bps as the curve once again steepened. The dollar retreated 0.3%, while commodities tried in vain to match the strength in stocks. A broad advance among its components left the CRB index almost 1% higher on Wednesday.

Investors are always looking for shortcuts to investing success, and I’m often asked for one simple rule they can follow to investing heaven. During the 1980′s, fund manager Marty Zweig became somewhat famous for sharing with Wall Street Week viewers his two most important pieces of advice: “Don’t fight the Fed, and don’t fight the tape”. Mr. Zweig used to assert that to ignore current trends in both monetary policy and market momentum could wreak havoc on one’s portfolio, and perhaps one’s stomach lining. Right now, the Fed’s throttle is wide open and the tape is on fire, so I’m guessing Mr. Zweig would be pretty darn bullish right now. Mr. Zweig has long since stepped out of the limelight, but some other ideas involving the Fed have come to the fore.

The first is the Greenspan Fed’s absurd “fair value model” for stock prices, which made its debut in 1997. Casting about for a way to rationalize the rather elevated equity markets of the Internet era, the Maestro’s staff proposed what they thought was a simple and elegant way to compare the relative values of stock and bond prices. All one had to do was compare the current yield of the 10 year Treasury note to the expected “earnings yield” for the S&P 500 (i.e. the latest 12 month forward earnings estimate for the S&P 500, divided by the latest price quote for the index itself — or E/P, the opposite of the more commonly cited P/E).

Using the Fed model, today’s estimated earnings yield for the S&P 500 is 6.86% (assuming $83 in S&P earnings this year, divided by the closing price of 1210.65). The 10 year Treasury note closed with a yield of 3.86%, so, compared to bonds it appears that stocks are what Jim Cramer would call a “BUY, BUY, BUY!”. For reasons that are many and proper, most analysts and investors have stopped paying attention to this type of “fair value” model. To cite just one objection, comparing an actual yield on a fixed stream of coupon payments from a government to a fictional “yield” on the hoped-for earnings of the equity securities of corporations is of the apples to oranges variety — at best! I just hope the Fed no longer employs this useless tool during FOMC meetings.

The search for simple and predictive tools unfortunately doesn’t end there. During the mid 1990′s a well known mutual fund manager who shall remain nameless stood before a large audience at a conference and received the following question: “How do us little guys who don’t have access to the type of information — computer data, models, and research — that you guys have access to make good decisions about when to enter and exit the stock market?” The manager smiled and offered the audience a simple and what he called a “basically fool-proof” way to time the market. He told his questioner to simply take into account the last interest rate policy move by the Fed. “Buy and stay long when the last move was an ease”, he said, “and sell and remain in cash whenever the previous move was a tightening. I’ve back-tested it, and it works as well or better than any other model or theory I’ve seen”.

This bit of advice served our little guy investor quite well for the next few years, but it has been a destroyer of wealth during the last decade. You can refer to theFed’s own table of the changes it’s made to the funds rate here. Referencing this data, I’ve compiled the results for using this timing indicator since July of 1995, which is approximately when our nameless fund manager offered it up to the public. The 1994 tightening cycle had already ended and the FOMC lowered the funds rate on July 6, 1995. Here is my estimation of how a “just follow the Fed” model of investing has performed since:

IN market at S&P 545 when Fed lowers funds rate on 7/6/95
OUT of market at S&P 800 when Fed raises funds rate on 3/25/97 (gain of 255 pts. or 46.8%
IN market at S&P 1000 when Fed lowers funds rate on 9/29/98 (note S&P is now 25% higher)
OUT of market at S&P 1373 when Fed hikes rates on 6/30/99 (gain of 373 pts. or 37.3%)
IN market at S&P 1300 when Fed eases on 1/3/01
OUT of market at S&P 1140 when Fed finally tightens on 6/30/04 (loss of 160 pts or -12.3%)
IN market at S&P 1520 when Fed starts latest easing cycle on 9/18/07 (current loss is 310 pts or – 20.4%)

As you can see, simply following the last policy move of the FOMC as an investing tool not only doesn’t work, it can be disastrous. Investors following this “rule” have had to sit through two of the most grueling bear markets of the past century. But hey, those who got long using this indicator in September of 2007 can rightly claim their trade is still open and they might yet get their money back. All it will take is a long string of days like today, though I somehow doubt this strategy can be found in Jim Cramer’s 2009 book, “Getting Back to Even”. If we have learned during the past 10 years, it’s that shortcuts to wealth creation ultimately lead to wealth destruction. Judging by today’s market action, that lesson is fading among market participants. It might even be a bit of a timing indicator itself, though I personally think we’ll see more upside first. As Warren Buffett has said, “be fearful when others are greedy and greedy when others are fearful”. We may not be there yet, but there is less fear and more greed with each passing day.

– Jack McHugh

Stocks, Commodities Gain as Earnings, Data Boost Optimism
Bernanke Sees ‘Moderate’ Growth Amid ‘Restraints’
Dow 12 Month Rate-of-Change Sends Warning Signal

Category: Markets, Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

4 Responses to “A Simple(ton’s) Market Timing Indicator”

  1. I-Man says:

    Thanks Jack McHugh! Excellent work…

  2. In8land says:

    Good article, but I’m so sick and tired of that Buffett quote.

  3. Simon says:

    Well… I’ve finished The Intelligent Investor and Balance Sheet Analysis by Ben Graham and I’ve browsed Securities Analysis. Now I’m reading Value Investing Tools and Techniques and The Little Book on Behavioral Investing by James Montier.

    I’m not yet really anywhere near making any new investments but fortunately I don’t think Mr Market is anywhere near making any new deep value offers so I’ll just have to keep trying to get ready for the days that he does.

    Thanks for your insights Jack.

  4. The shortest distance between two points is not a straight line except in Geometry and the human brain.