My preferred investing method is by due diligence. Still, some investors can make money by analyzing public numbers, looking at vast quant models and drawing conclusions. One such investor is Jeremy Grantham, a Boston Brahmin whose distinction is in occasionally overriding his models when in his judgment they are wrong. This is true investment versatility - which even due-diligence experts could emulate, by paying attention to key economic factors when these are at an extreme - such as now.
Why do I mention models? Because in the early nineties I sojourned in Silicon Valley for a study sabbatical, but also invested, and so fell in with some Stanford eggheads who tried to "forecast the market" with neural nets, genetic algorithms and non-linear regressions. I happily played along, and in 1993 even foolishly published an article in Barron's, forecasting a strong market rise. As dumb luck would have it, the market did rise, so for several years I kept getting e-mails from nerds who wanted to learn the forecasting secrets I surely had kept for myself.
Well, there are no secrets. What my model found was that the factors that matter are those common sense would indicate; and they matter only at extremes. In between these points, you had better get exclusive info about companies. But when the factors are at an extreme, all stocks often move together, and then you need to look at past extremes to see where this one is going.
Which brings me to the present, because I just re-read my long-ago notes and some of those long-ago books - among which is Stephen Leeb's Market Timing for the Nineties, describing five economic factors that, at extremes, can indicate where the market might be heading. Here they are:
Commodity prices - when they soar, they often tank the market. But when they plunge deeply, they can lead to a market rise (unless falling money supply leads to deflation).
Unemployment claims - when they soar, the Fed often prints money, boosting the market. When they plunge, it's a sign the economy is hot and the Fed tries to cool it - often tanking the market.
Real interest rates are key - corporate triple-A bond rates less inflation (say, one-year change in the producer price index). The higher the RIR, the better, because it means the economy is hot while inflation is not. That's excellent for stocks. When real rates are low or negative, it's the opposite.
Watch out for the "real" price/earnings. This is defined by the model as the PE plus the inflation rate. The reason for the adjustment: Inflation is bad for stocks, so even seemingly-low PEs come out as expensive on a "real" basis, while low inflation can make even higher PEs seem reasonable.
Finally, money supply growth, which is the exception to extremes - it must be medium to middling-high but not too high. If it's too low and falling, a crash may ensue. If too high and getting higher, it can cause a market boom - which will tank eventually, due to inflation. That's what happened under former U.S. Federal Reserve chairman Alan Greenspan - and it may happen again because of current chairman Ben Bernanke's cash avalanche and President Barack Obama's mega-stimulus.
Now, you can't invest in individual stocks just based on these factors - you must do specific company research. But when all these factors are at an extreme edge such as now, you better pay attention. In mid-2008, commodity prices soared, real PEs zoomed and the real interest rate was severely negative. This was just before the market tanked.
Commodity prices have tanked, and there is no deflation. Money supply (M3) soared well north of 20 per cent - others estimate as much as 75 per cent - either way it is soaring, so a Depression this is not. What of unemployment claims? These just rose so much that they are basically off the chart - up 70 per cent from a year ago. Admittedly from a very low base, but the Fed panicked just the same: Just see increased money supply and the hefty stimulus.
As for real rates, they are an astonishing 11 per cent (PPI fell nearly 6 per cent last month!), meaning the economy is not as bad as you think because inflation is snoozing - for now.
As for real PEs, with the market halved and inflation low, they, too, are comparatively low. The conclusion? If we plug these extremes into the California model (thanks for BMO for the data to update it), we get a hefty expected market rise from here. Can it be? It sure is possible.
Back to Mr. Grantham, the Boston Brahmin - he has been bearish for more than five years because of his models. But in a recent interview with Steve Forbes he said the market is finally at fair value, and he would start buying - cautiously. What of my own estimate? I noted a few months ago that the Dow's fair value is about 6,600, which is mere 7 per cent below here. Panic has solidified into stupor, few investors seem to care, there are trillions of dollars on the sidelines, the Fed is shovelling money out the door and berates banks who don't lend it.
Yes, there's fear, and it may be justified. But the models that had worked before, now suggest that maybe, perhaps, just possibly, the decline could be a wee bit overdone. If history repeats, we can get another market boomlet here, before rising inflation threatens to knock it down yet again.