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Strategies & Market Trends : A.I.M Users Group Bulletin Board

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To: OldAIMGuy who wrote (5388)	8/19/1998 9:55:00 AM
From: JZGalt	Read Replies (1) of 18928

Tom, I think I wrote to you about this privately, but it might be useful to discuss it in public also. Like you one of the things that I track is a relative valuation tool for the market to get a feel for the backdrop. In your Relative Valuation you said you use the Value Line p/e and the 13 week treasury rate. I use the S&P500 p/e plus the inflation rate. In addition I follow inflation rate shocks. In general these should show relatively the same thing. Now for the difference. In your universe you look at the magnitude of the value to try to determine if the market is overvalued. I use the rate at which the p/e plus inflation number has changed. In looking back thru the data from the mid-1960's onward, I found that a fairly reliable indicator of a market that will stall or run into a correction is if the p/e plus inflation moves higher in an unsustainable manner. For an inflation rate shock, I look for a yr/yr inflation rate jump of greater than 1%. How does this work? If you look at the components, you will see. The first component of p/e will expand rapidly only if the price growth is exceeding the growth in earnings. On the other hand the p/e component can only contract when the earnings growth is exceeding the price growth. The inflation component takes care of inflation shocks not sufficiently discounted by the market and is a very similar to your indicator of the t-bill rate. The next thing I look at is how rapidly this level is changing. For the inflation shock component, I view it as a mechanism for looking at how inflation will impact future earnings. Industry is very good at dealing with relatively stable enviornments and not as good when dealing with periods of turmoil. A rapid rise in inflation usually precedes a drop in the earnings and lower stock prices. My overall premise is that you cannot sustain a long term upward bias in the market without either sustained earnings growth, or a decrease in the inflation rate. Around that general trend you will have periods when the market is far above the trend and periods when the market is below the trend. Consequently the rate at which the combined component is moving is more important than the level. If you can imagine a sine wave around an upward or downward sloping line I think you can see what I am talking about. If you look at the period from 1990 onwards, my guess is that your component of Relative Valuation has been stuck in the overvalued area for the majority of that time. FWIW. What I have been using has been fairly accurate at determining declines of 10% or more, but it is not useful in determining when to re-enter the market. This indicator went to a "sell" condition in April as earnings started to fall faster than the inflation rate. I might be willing to use the ITBM chart indicator I gave you the other day as the buy side rentry, but I haven't looked at the data yet. Discussion, comments? ---- Dave

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