For the future ---The Only Indicators You'll Ever Need
With these five keys to the market's direction, your stock strategy can't stray off course.
By Christopher Graja and Elizabeth Ungar Bloomberg Personal Finance January/February 2001
One can never be too rich or too thin, the late Duchess of Windsor reputedly said. Maybe, maybe not. But an investor can be too informed. Every month, scores of economic and business statistics are released, and while each has merit, anyone who tries to digest them all will have no time left to invest. The 40th piece of data adds little that can't be gleaned from the first 39. In fact, you can get most of the information you need to map out basic stock strategy by following just five market indicators.
Of course, you must choose the right five. They should be unbiased and impossible to manipulate, and they should reflect investors' actions rather than their words. They should also be proven performers that have been thoroughly studied and used by market professionals with credible records. We have selected five that are essential for investors in U.S. equities because they measure factors crucial to success in that market: Three pertain to sustainability of growth (in both earnings and the economy), one to valuation, and one to sentiment. These five indicators-- particularly when considered in combination--provide signals that will help you tweak your equity allocation, determine which styles to favor and which sectors to under- or overweight, and how aggressive or cautious you should be in investing.
One of the quickest and easiest ways to get a handle on future economic growth is to study the slope of the Treasury yield curve. The curve plots Treasury yields against a range of maturities, from 3 months to 30 years. Its slope--the difference, or spread, between the 10-year and 3-month yields--indicates the bond market's expectations about the future course of the economy. The curve's normal slope is gently positive (slightly higher at the long than at the short end), reflecting the fact that bondholders generally demand higher rewards to compensate them for the higher risks associated with longer holding periods.
The longer the maturity, for instance, the more danger there is that inflation will erode the purchasing power of the coupon payments and of the principal when it is returned. A steeper curve signals expectations of an accelerating economy that could spark inflation, pushing up longer-term yields; a flatter curve means few inflation qualms and the expectation of only moderate growth. An inverted curve, where 3-month bills yield more than 10-year notes, signals recession. Last year, the yield spread dropped steeply, from a high of about 130 basis points (1.3 percent) in January to a low of about -74 basis points in late November, reflecting expectations of an economic slowdown.
Equities in general do better in expansions than in recessions. Corporate earnings, after all, drive share price, and money flows more freely when the economy is growing. Small stocks are even more sensitive to the economic environment than large ones. Steve Kim, an equity derivatives strategist at Merrill Lynch, has found that during recessions large-cap stocks generate average annual returns of 6 percent, with annualized volatility of more than 20 percent, whereas during expansions they return 22 percent, with 13.5 percent volatility. Small-cap stocks, according to Daniel Coker in his book Mastering Microcaps (Bloomberg Press), lose 30 percent in the first half of a recession and gain 44 percent in the first six months of an economic acceleration. Growth and value stocks also perform differently at various stages of the economic cycle. The beginning of an upturn, for instance, tends to be a good environment for companies that have fallen from favor, allowing them to rebound by registering jumps in profits that attract the attention of investors. In contrast, the end of an expansion favors growth companies, which tend to maintain their earnings momentum longer than value companies do.
Academic and Federal Reserve studies have shown that the yield curve is very accurate in its economic forecasts. Merrill Lynch's quantitative research group has found that since 1970 every inverted yield curve was followed by a period in which S&P 500 earnings growth was negative. And that signal is not only reliable, but early. According to Lakshman Achuthan, managing director of the Economic Cycle Research Institute in New York City, the yield curve predicts economic events more than 12 months in advance, compared with the 6-month warning the stock market delivers. So by watching the curve, you have time to modify your equity strategy before events overtake you.
You can check on how the yield curve is shaping up in the financial pages of major newspapers. One caveat: The data have been a bit skewed lately (and may continue to be so for some time) by the Treasury buyback of 10-year notes. The Treasury's action has raised the notes' prices and depressed their yields, thus artificially flattening the curve. For this reason, the Fed has been watching the triple-A corporate curve as well.
Unfortunately, because their provisions vary wildly, corporates are difficult for the individual investor to get a fix on. You can, however, try three approaches: First, ask your broker to check the corporate curves created on the Bloomberg terminal. Second, look at the "Credit Markets" column in The Wall Street Journal. In the "comparisons box," you can compare the yields on two Merrill Lynch high-quality bond indices, one for maturities of less than 10 years, the other for 10 years and more. Finally, you can glean some clues from the yields on New York Stock Exchange- traded bonds, which are listed in most financial pages. As of mid- November, for example, the triple-A industrial curve was still positively sloped, indicating that the yield curve might be sending overly pessimistic signals. However, the 28-basis point spread represented a flattening of about 108 basis points from the beginning of the year. So the market's outlook was still far from rosy. It's important to remember, moreover, that investors in corporate bonds tend to be more sensitive to default possibilities than those in Treasuries and so demand a greater yield differential for longer maturities. The corporate curve, therefore, should always be somewhat more positive than the Treasury one.
The yield curve reveals the bond traders' view of the economic future. The Federal Reserve's job is shaping that future. The goal: sustained growth with limited inflation. The prime tool: monetary policy, implemented in part through manipulation of short- term rates. But the task is a delicate one, and the tool can easily be wielded too aggressively. An inverted yield curve, for instance, is almost always caused by the Fed sharply raising short rates. Since such action shows a commitment to fighting inflation, it cheers bondholders, and the long end of the curve falls, or at least rises less than the short end. But though bondholders may be happy, other sectors of the economy generally aren't: The tightening squeezes businesses, which must pay more to finance their growth plans. This in turn affects stocks. Coker has done research on market performance following changes in Federal Reserve monetary policy. He found that, since 1948, stocks were always up 12 months after an initial easing but registered gains only 75 percent of the time after an initial tightening; returns in those two situations averaged 26 and 10 percent, respectively. The effect is exaggerated for smaller stocks. Coker determined that average one-month declines for large-, small-, and micro-cap stocks in response to a Fed tightening were 1.9, 2.5, and 2.6 percent, respectively; after an easing, the same groups rose 2.2, 4.9, and 6.1 percent.
For clues to monetary moves the Federal Reserve may be contemplating, go to www.bloomberg.com. Clicking on News, then Fed Watch, accesses interviews with Fed governors and bank presidents, as well as stories on factors in their decisions and commentary by Bloomberg's Caroline Baum.
As with economic growth, however, the market itself is often the best prognosticator of policy. Specifically, yields on the Fed funds futures contracts indicate which way traders believe the Fed is leaning. Federal funds are the money banks lend each other overnight. The interest rate they charge on these loans--the Fed funds rate--is closely linked to the discount rate, the short rate set by the Federal Reserve for loans to its member banks. Fed funds futures are bets on the direction of this rate. Subtracting the contract price from 100 indicates the Fed funds rate that the market expects to be in effect at contract expiration (if the actual rate at expiration is lower than when the contract was purchased, the contract price rises and the holder makes money). So to discover what changes in monetary policy traders anticipate, all you have to do is look at the prices of the contracts ending just after the upcoming Federal Open Market Committee meetings. For 2001, they are January 30/31, March 20, May 15, June 26/27, August 21, October 2, November 6, and December 11. The Wall Street Journal lists Fed funds futures contracts. Select the date you're interested in, subtract its price--indicated in the "Settle" column--from 100, and you have a rough estimate of the rate.
In November, the futures contracts suggested that the Fed was done tightening and that the next move would be a rate reduction--after the first quarter of 2001. What might this mean for the economy? Achuthan, for one, fears that the longer the rates remain at last year's levels, the greater the risk of a hard landing. A quick loosening, on the other hand, would increase the chances of a gentle slowdown.
the yield curve and fed funds futures reveal the market's opinions about the economy and its potential for growth. Credit spreads-- the difference in yield between Treasury debt and corporate bonds- -indicate how easy or difficult the market believes it will be for companies to maintain or increase their profitability. A closely watched spread is the difference between yields on Treasuries and high-yield bonds--those with ratings below BBB.
Earnings growth is the most important criterion for long-term investors, period. Over time, the price appreciation of the U.S. stock market tracks the rate of earnings growth of the Standard & Poor's 500 Stock Index closely. But to make money, companies generally must spend it first. And one of the major ways they acquire the money to spend is through the debt markets. Low interest rates mean cheap funding for projects that can boost revenues and profitability; high rates mean less investment and slower growth.
Conversely, strong profitability can lower the rate a borrower must pay, since a company with steady cash flow will be better able to make coupon payments on time and return principal in full at bond maturity. When credit spreads between Treasuries and low- rated corporate bonds narrow, high-yield bond traders are showing confidence that a strong economy will buoy the earnings of riskier businesses. Small-cap stocks, which tend to fall into the high- risk group, usually do well in this environment. In contrast, widening spreads, such as those seen since the Asian crisis, signal pessimism and consequent unwillingness to take risks. This attitude spells trouble for small caps. Because investors in lower-rated bonds can lose their entire bankrolls if the economy stalls, they focus on factors that could gum up the works. This makes credit spreads an invaluable aid for risk-averse investors, particularly when the spreads are read in conjunction with the Treasury yield curve. The spread between Treasuries and low-credit corporates, for instance, can help you determine if you are better off pursuing value stocks (which tend to have volatile earnings) or companies with stable earnings growth. Merrill Lynch research has found a 70 percent correlation between the performance of high-quality bonds and stocks with stable growth.
As Pimco's William Gross, who manages the world's largest bond fund, Pimco Total Return, remarked at a press conference last October in New York City, slowing growth in gross domestic product is "good for bonds, but not all bonds." That is, a slowdown may quiet fears of inflation, which can increase bond prices in general, but it may raise other fears--that shakier companies might not be able to honor their obligations--which can weigh down prices of lower-rated debt.
That indeed seemed to be the case last fall, leading Merrill Lynch's Martin Fridson to remark, during his November 1 induction into the Fixed Income Analysts Society Hall of Fame, that then- current high-yield bond prices reflected a "more dire default outlook than the most pessimistic authorities project." Which view was more accurate? Only time will tell. But for stock investors, the solution seems to be overweighting high-quality stocks.
Fridson also noted how interconnected the three growth indicators are--and how uncertain is the future they forecast. "History strongly suggests that the resurgence in high-yield bond prices will occur when the Treasury yield curve, from three months to 10 years, turns positive and steepens dramatically," he said, adding that "nobody--not even Alan Greenspan--knows when short-term rates will come down, causing the yield curve to steepen."
Earnings growth is important, but how much should you pay for it? One of the best ways to determine whether or not the stock market is overvalued is to use a model that Deutsche Bank Securities chief economist Ed Yardeni found buried in the Fed's July 1997 Monetary Policy Report to the Congress. Building on the insight that, since stocks are riskier than Treasuries, they should offer investors a higher return, the model compares the 10-year Treasury yield with the earnings yield of the S&P 500. Earnings yield is computed by dividing share price--in this case, the price of the index--into expected corporate earnings.
You can look at it as the return you would get on an equity investment if the company paid out all its profits as dividends. If the earnings yield is lower than the Treasury yield, the model considers stocks expensive. By this measure, the market in November was overvalued by 25 percent. This, however, represented a decrease from about 63 percent at the beginning of 2000, reflecting in part the significant drop in the S&P 500's price-to- earnings ratio. Still, even 25 percent overvaluation can be a bad omen.
As explained in the July/August 2000 issue ("High Noon," page 19), Yardeni believes the proper relationship between Treasury and earnings yields can be restored in three ways: an increase in expected earnings, a decrease in the Treasury yield, or a severe drop in stock prices. The first, of course, is the best scenario. But how realistic is it to think earnings can accelerate? The second course is possible, but it might result in an inverted yield curve, which presages economic woes. That leaves the grim stock market scenario. Indeed, Yardeni's research shows that stock returns tend to be lower 12 to 24 months after the model showed the market to be expensive. On the bright side, returns rise following a "cheap" signal.
Yardeni keeps the earnings-yield model current on his Website, www.yardeni.com. In November, it indicated a yield of about 4.5%, below the 10-year Treasury bond yield of 5.66%. He also has an enhanced version, which considers earnings growth over a longer term than the 12 months used by the Fed.
Fear and greed play big roles in moving the stock market. History has shown that investors tend to go to extremes, gobbling up mediocre, overvalued shares in the heat of a bull market and shunning solid ones during a correction. Since such excesses are precursors of market reversals, the key is to wait for sentiment to reach an extreme and then make a move contrary to the market trend. How do you know when an extreme has been reached? A proprietary sentiment indicator developed by Richard Bernstein at Merrill Lynch can help.
In the kind of rich irony contrarians live for, Bernstein, who is a top-ranked quantitative strategist on Wall Street, has found the average equity allocation prescribed by his fellow strategists to be his most reliable market-timing barometer. When these professionals recommend putting more than 60 percent of a portfolio into stocks, the market tends to do poorly; when the allocation is less than 50 percent, stocks pick up. In November, the indicator posted its highest reading in the past 16 years: 62.3 percent. Bernstein notes that in 1993, in the six months following the previous record of 61.8 percent, the S&P 500 and the Nasdaq dropped 2.3 and 5.8 percent, respectively.
Merrill Lynch research is available as part of the 30-day free trial at multexinvestor.com. As an alternative, subscribers can go to www.bloomberg.com/personal for a close facsimile, Bloomberg's own weekly survey of strategists at major firms. Results for November 24 are shown in the table on this page.
Each of these five indicators is informative on its own. But they're most potent in combination. The best environment for investing aggressively in stocks, for example, is when sentiment is negative, valuation low, earnings growth accelerating, and the Fed easing, causing the yield curve to steepen and credit spreads to narrow. In this situation, you might consider pushing the equity portion of your portfolio to the upper end of the range dictated by your allocation strategy. At the other extreme, you have the environment that existed through much of 2000. No one watching our five indicators would have been surprised at the Nasdaq's 37 percent plunge through November 30. The S&P 500 was as much as 63 percent overvalued at the beginning of 2000, according to Yardeni's model, and sentiment remained bullish even as the Fed raised interest rates, inverting the yield curve. If that wasn't enough, credit spreads in the summer and autumn were wider than during the Asia-Russia-Long-Term Capital crisis of 1998, reflecting serious worries about companies' ability to pay their bills.
Most of the time, though, the indicators will be mixed, not pointing strongly to either aggressive or defensive investing. In these instances, you should stick to a bottom-up stock-picking discipline. That means looking for quality companies with good management teams and prospects for increasing their dominance. Then buy those that are reasonably priced. You shouldn't try to time the market. Nor should you change your strategic asset allocation. But you can tweak it, as the indicators dictate, to either increase or protect your wealth.
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