Let’s contemplate the future – economically speaking!
As president and chair of the board at my local golf course some years ago I made the observation that it’s not the one or two big decisions that a general manger makes during the summer season that made the annual break even budget fall into line with the actual revenue and expenses. It was the general manager’s daily decision making, the small and numerous decisions, that carried the day.
The same is true with our open and complex economic systems. Hundreds and thousands of decisions are made daily by policy-makers and government officials that cumulatively could have massive impacts on economic growth for each country participating in the global economy. And size does matter. Favorable or unfavorable policy decisions in the United States, China, Japan and the European Union have a large impact on worldwide economic growth. Which of these mostly secret decisions will have a positive or negative impact on economic growth, we as market observers, will never know.
As I said in earlier blogs, individual markets, especially equity markets, are about feedback. Good economic policies provide a backdrop for positive economic results. When the economic tide is rising this helps everybody globally. Combining a good economic backdrop along with a company gaining market share provides a stimulus for healthy stock gains in the future. This makes sense.
The issue I have with market punditry is the predictability of market forecasting. Can anyone confidently predict the future when hundreds of thousands of daily decisions on economic policy that could have huge impacts on feedback mechanisms, like equity and treasury markets (interest rates), that coincide with the time frame of said prediction? Yes, the combinations and permutations are mathematically endless. Therefore in my mind economic and market related predictions and forecasts are useless.
So if one cannot predict the future with any accuracy, from a top down perspective how about from the bottom up?
This is the basis for Model Price Theory (MPT). By observing the feedback of primarily equity markets a MPT user can gain confidence on the economic road map ahead.
Want a good example of this?
Back in April of 2013, the S&P 500 had a positive transit of EBV+3. Here is the conclusion of my blog that I wrote back in May 2, 2013.
For the month of April, 2013 the S&P 500 Index had a positive transit of EBV+3. This is an historic occasion in our model price work and noteworthy. The traffic light is “green” in that the risk and reward for long-term US equity investments is heavily skewed towards reward side of the ledger. In other words, the proverbial wind is at your back when choosing quality US large cap companies. This could be the beginning of a secular run in US large capitalized equities that could last years. And of course this positive transit doesn’t preclude some future hiccups in terms of monetary policy, and a million other macro considerations that have yet been imagined or forecasted but the market is speaking to you and it’s saying as of today and the foreseeable future all is well!
From a bottom up perspective, looking at all the companies in the S&P 500, through the S&P Index itself, the US equity markets were providing feedback to users of Model Price Theory (MPT) that all was well, economically speaking of course. Could I or anyone else predict this positive transit? No. But, of course, once there was a positive transit of EBV+3 by the S&P 500 an easy ride in terms of market gains was indeed predictable.
Don’t tell me about the past, what about the future hotshot?
As always let’s start with our model price chart of the S&P 500 Index.
S&P 500 Index with weekly price bars and EBV Lines (colored lines).
As a reminder we aggregate all companies in the S&P 500 Index into one chart on a market capitalized basis (like the S&P 500 Index itself), so we can see where the market – S&P 500 – is trading relative to its EBV lines.
Observables from the above model price chart
1. Since our noted positive transit back in April 2013 of EBV+3, the S&P 500 Index has traded up to the middle of the zone between EBV+3 and EBV+4 with little to no volatility. (Small price bars)
2. Our calculated EBV+4 is 2040 as of January 2014, leaving a further 11.35% possible upside for the S&P Index from the market close on January 2, 2014.
3. Our calculated EBV+3 is 1631, giving the US equity market a possible downside of 10.97%.
4. What I didn’t annotate on our model price chart are our calculated EBV levels one year from when the model price chart was produced. In other words, EBV+3 is projected to be 1800 in January of 2015 and EBV+4 is estimated to be 2252. Even if the S&P 500 stalls and consolidates mid way through the zone, market support in terms of EBV+3 is constantly rising reflecting the growth in the balance sheets of the companies. (An market optimist can forecast a rise in the S&P 500 over 2014 to be 23% – from the market close on January 2 of 1831 to the top of the zone in January 2014 of 2252.)
Risk levels have increased, though!
So what to make of this analysis? To me, risk levels have increased. As I have stated back in my May blog, when the S&P transited above EBV+3 investor risk level was low. Why? Because market support levels were close to where the market was trading. As the S&P 500 gets further away from EBV+3, investor risk level increases – this should make sense.
Would I get out of the market because of this increased risk? Of course not. Risk as well as reward must be judged carefully when making investments. I am always mindful where this market is relative to where in the zone the market is trading. As the market moves upward, closer to EBV+4, the possible downside risk increases while the upside gets squeezed. As market euphoria increases MPT users will get more cautious – counter cyclical.
2013 was an eventful year in terms of economic political rankling. Budget sequestration and the US Federal government shutdown gave market bears plenty of grist for negative forecasts. The US equity markets thought otherwise. Broadly, the economic decisions made by US policy-makers and global leaders have had a positive feedback in terms of US equity markets increasing equity valuations across the board. This positive signal was given back in April of 2013, as the S&P 500 transited above EBV+3.
As the US equity market drives higher, as market participants get more confident, risk and reward levels have to be adjusted by the users of Model Price. Yes, the S&P is gaining momentum and will probably reach for the top of the zone or EBV+4 in the ensuing year however risks do rise as the S&P 500 climbs higher in the zone.
Prediction of higher equity prices is a fool’s game. If the S&P 500 were to pull back to EBV+3 (and the Index still remaining in the zone) – an implied 10% correction – nothing would have changed in my MPT analysis except for my and your favorite stocks could hopefully be purchased at lower prices.