Interesting column by Mark Hulbert in the Sunday NYT about an econometric model I have observed over the years and have been impressed with.
What makes it so interesting is the deceptively simple system for assessing risk versus reward in the market place. It does so by tracking just three items: Stock market Dividend Yield, interest on the 90-day T bill, and the median 3 Year Value Line analyst earnings projection.
Taken together, they forecast trouble for the next 6 quarters:
"The model arose from research conducted some 15 years ago by William
Reichenstein, a professor of investments at Baylor University, and
Steven P. Rich, a finance professor there. They reported their results
in an article in the summer 1993 issue of The Journal of Portfolio
The model is quite simple, especially when compared with many
econometric models. It has just three ingredients: the stock market’s
dividend yield, the interest rate on 90-day Treasury bills and the
median of projections from analysts at Value Line, the investment
research firm, of how much the 1,700 stocks they monitor will
appreciate over the next three to five years. The first two numbers are
readily available at many financial Web sites, and the third is
published weekly in the Value Line Investment Survey. The formula for
combining the three pieces of data can be easily figured with a
spreadsheet program or a calculator.
Despite the model’s simplicity, the professors found in back testing
over the period from 1968 through 1989 that its periodic readings had
done an impressive job of forecasting the stock market’s gains and
losses over the subsequent six calendar quarters."
What makes this so fascinating is that the three elements are unbiased and uncorrupted: the market’s dividend yield is real money paid by companies to shareholders, so it cannot be phonied up (even the dividend tax cut only had a minor impact on it); the 90 day T bill interest is also a market determined element. While it is impacted short term by the Fed, it is ultimately set by the bond market; Lastly, the median of projections from analysts at Value Line are free from Investment Banking and/.or Marketing pressures (and other stupidity). Value line has an outstanding track record, and they are completely unbiased and objective, untainted by sellside conflicts.
Here’s a chart of the timing model’s forecasting history:
graphic courtesy of NYT
The model forecasts that "the market is likely to underperform garden-variety money market funds through the end of next year." That gloomy forecast is quite consistent with out expectations.
Hulbert notes that the market-timing model "while
not perfect, has had an impressive track record over the long run." He writes:
"To be sure, the model has had a mixed record in the 13 years since their study appeared. Though the model has performed well in the current decade, its record in the 1990′s was poor. Through much of that decade, it projected below-average performance for the stock market, thereby greatly underestimating equities’ actual returns.
The model’s failure in the 1990′s, however, may be the exception that proves the rule. In an interview, Professor Reichenstein contended that the stock market’s outsized returns in that decade were in large part attributable to investor "irrationality," and that the model should therefore not be faulted for failing to forecast them. The model aims to forecast what the market’s level would be if investors were rational, and "no model built on rational pricing is able to explain irrational behavior," he said.
A study by The Hulbert Financial Digest provides further support for the notion that the model’s failure during the 1990′s was an anomaly. The study focused on its performance from 1968 through 2006 — a period that includes the 22 years covered in the professors’ original study and the 17 years since. Even after the incorrect forecasts in the 1990′s are taken into account, the model’s overall record is good enough to be statistically meaningful and not likely to be mere luck."
My only issue is that the time period involved is kinda short and limited — it covers most of one bear market (1970-82) and all of the next bull market (1982-2000). Valueline started in 1931, so it would be interesting to see how this system did during the prior post WWII Bull market — especially given the model’s miss during the late 1990s moonshot.
That might provide some insight into whether the system misses these types of strong markets. Or, it might just suggest that the 1995-2000 period was extremely aberational. Either way, it could provide insight into that one predictive failure.
An Old Formula That Points to New Worry
MARK HULBERT, Strategies
NYTimes, June 18, 2006
"AS WE WERE SAYING BEFORE WE WERE SO rudely interrupted by a man dressed in a white smock and wielding a scalpel (thank heavens he left his box-cutter at home), the stock market looks a bit worse for the wear."
So says Barron’s Alan Abelson, usually one of Wall Street’s most visible Bears. Just his luck — or was it the Trading Gods having some fun? — that he managed to be out of service for the most bearish period in 3 years. Traders, being a superstitious lot, will soon be begging Abelson to "let us know the next time you go in for a procedure" – so they can get short.
Regardless, whatever the man dressed in a white smock removed, it wasn’t his arch sense of humor or acid tinged tongue:
"The impact of the massive disturbance was global in every sense: Not only were its terrible tremors felt far beyond the narrow canyon of capitalism in lower Manhattan, but they commanded notice in quarters much loftier than trading floors or commodity pits. We’ve not the slightest doubt, for example, that what prompted the famed cosmologist Stephen Hawking early last week to urge earthlings to create settlements in space was, pure and simple, fear of the effect of crashing markets on the human race."
But the key to Abelson’s return is his clear eyed take on inflation, which comports squarely with our own views:
"FOR OPENERS, OUR HUNCH IS THAT MR. BERNANKE’S concerns about inflation, despite his mucking up the message with all that rubbish about inflationary expectations, have more than a modicum of merit. And our conviction on this score is only strengthened, of course, by the fact that so many pundits pooh-pooh inflation as a problem. Indeed, if anything, we fault the chairman for his evident sympathy with the argument that the fearsome upward spiral in the price of crude, so far, anyway, hasn’t been exerting all that much impact in the economy at large.
Apparently, Mr. Bernanke, like his critics, needs to get out more. Oil is a very sneaky commodity. Our old friend and revered Barron’s contributor, Abe Briloff, likes to describe certain stealth accounting practices as comparable to a bikini: what they reveal is interesting, what they conceal is vital. Oil is something like that: Its uses are readily manifest, but it plays a far bigger and more critical role in our lives than is easily perceived.