You Can Predict Market Direction

July 12th, 2013 by

predicting-stock-marketDespite what a lot of people write and say, you can successfully predict the direction―either up or down―of interest rates, stock market indexes, the price of gold, etc. You cannot predict what will definitely happen, but you can predict what is more likely or, even, what is very likely to happen. You cannot always predict what is more likely or very likely to happen, but you can predict it sometimes.

 

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If anyone tells you that they definitely know what is going to happen, it is a huge signal that they cannot be trusted. No one definitely knows, unless they are privy to related inside information.

In talking about predictions here, I am not talking about predictions of what will happen in the short-term. I am talking about predictions of what will happen in the longer run. What will happen with interest rates in the next trading day or week is almost entirely a roll of the dice. What will happen with interest rates in the years ahead is not.

Think Differently

To be good at predicting markets, you need to think differently than most people think. People tend to think in terms that are too black and white. For example, people tend to think that the stock markets will rise or fall in price; and/or they tend to want you to tell them whether the stock markets will rise or fall in price. This is wrong kind of thinking process to be engaged in. The right thinking process goes something like this:

(1) Is there a clear, significant advantage(s) to be played? If there is not, make no prediction or predict that the market will perform about average, which it may or may not. Average for interest rates is flat. Average for the S&P 500 was, from 1871 thru 2012, 8.92%―although there are better, more sophisticated views of what is currently average for the S&P 500. Average for commodities is the rate of inflation.

(2) If there is an advantage, how strong is it in the context of the other things affecting the market? In other words, how likely is it that the rise or fall in market price(s) will occur and, if it does occur, how large is the move likely to be? Plus, how likely and divergent are the alternate scenarios?

(3) Determine the amount of your related investment or revise the weightings in your investment portfolio based upon the strength of the advantage. If the advantage is small, bet a little or nothing on it. If the advantage is large, bet a lot on it; but remain sufficiently diversified.

“Bet” is a good word to use here. Investing is gambling; but, done correctly, it is gambling where you are the house―that is, it is gambling where the odds are slightly in your favor. Generally, just having your money invested in bonds, CDs, and/or stocks, versus as cash, puts you at an advantage. You are likely to end up with more money than you would have otherwise. Successfully predicting which direction a specific market is likely headed in is like knowing one team will be playing without its star player(s) when many other people do not know this. The team may beat the betting line anyway, but they probably will not. Now you are the house and you have an edge in one of the games being played.

Macro Drivers

In my investing experience so far, I have noticed five macro drivers that make markets predictable:

(1) Prices that have swung too far up or down based on emotions and/or momentum.

(2) Prices which are mathematically too high or low in comparison to those of competing investments.

(3) Prices affected by market intervention.

(4) Prices affected by a disinformation campaign(s).

(5) Prices that reflect the short-term versus a probably significantly different longer term.

Interest Rates

Interest rates are very likely to continue to rise. This is a relatively easy prediction to make. Yes, as of July 10, the 10-year Treasury rate had already increased over 105 basis points in two and one-third months and over 125 basis points, from its low point, in less than a year; but interest rates were, and continue to be, largely abnormally low due to market intervention by the Federal Reserve (Fed) and other factors. On May 7, LearnBonds published an article I wrote detailing what these factors were at the time.

In this article, “How Dangerous Are U.S. Treasury Notes and Bonds?”, I calculated that, based on CBO and Fed projections, 10-year Treasuries should be yielding 3.78%. Today, due to the passage of time, this number is 3.95%. Also, I noted that the CBO projected 10-year Treasury rates to be 5.2% from 2018 onward, and that this projection is consistent with Fed and other quality projections. On July 10, the 10-year Treasury rate was only 2.68%.

We do not know whether interest rates will be up or down in the days and weeks to come. We do know that:

(1) The Fed cannot keep buying Treasuries and residential mortgage-backed securities (RMBSs) anywhere near the current rate of $85 billion per month indefinitely.

(2) The Fed plans to taper and, then, stop buying. The most recent economists’ consensus I read about projected tapering beginning in September ‘13 and stopping occurring in June ’14.

(3) The Fed plans to sell their portfolio of Treasuries and RMBSs and/or not replace these securities upon maturity.

(4) Via quantitative easing (QE), the Fed has successfully engineered the 10-year Treasury rate to be well below its mathematically correct rate of about 3.95%.

(5) Via QE, all or almost all other non-short-term interest rates have been successfully engineered lower as well.

(6) The target federal funds rate can barely get lower than the current 0.00-0.25%.

(7) The Fed projects the target federal funds rate to be about 4% in the longer run.

(8) An increase in the federal funds rate will further increase other interest rates.

The vast majority of people knowledgeable on the topic are predicting interest rates to rise. Normally, this would be concerning. When a vast majority of people predict the same thing in the investment world, it is often a contrary indicator. However, it is only a contrary indicator when too many people have invested based upon the predictions. The fact that the 10-year Treasury rate, and other non-short-term interest rates, are still well below their mathematically correct rates tells me that too many people have not invested based upon the predictions. I know that other non-short-term interest rates are below their mathematically correct rates based upon analyses similar to the one I did for 10-year Treasuries and the relatively normal or normal-enough non-Treasury-to-Treasury rates spreads.

To be clear, I am not predicting that the 10-year Treasury rate will rise to about 3.95% in the short-term. In brief, as long as the Fed is buying or, even, holding Treasuries or RMBSs, they are influencing interest rates lower; and I have almost no clue regarding what will happen with interest rates in the very short-term. “Learn Bonds prediction of the 10-year Treasury rate for the next year is between 2.5% and 3.5%.” This prediction was developed independent of me, reflects the likely continued rise in interest rates, reflects the fact there will be both up and down short-term moves in interest rates, and is elaborated upon here.

The Mathematical Pull

There is another indicator that interest rates are very likely to continue to rise. I call this indicator a mathematical pull. There are many sorts of mathematical pulls; but the one I am referring to here is the one between the expected return of the readily investable U.S. fixed-income bond market, assuming the bonds are held to maturity, the expected return of the U.S. stock markets.

In last week’s article, I calculated that the expected return of the readily investable U.S. fixed-income bond market is about 2.33% per year. Since last week, I made every warranted adjustment to this calculation that I reasonably could, even though I could only make the adjustments crudely.

Downward adjustments were warranted because (1) three of the indexes used have a constituent-bond-shortest-maturity of one year versus the desired one month and (2) municipal bond default losses in the future figure to be somewhat higher. An upward adjustment was warranted because commercial paper tends to have maturities as long as 270 days, versus the maximum 91 days of the commercial paper index used. Including CDs that were bought in competition with bonds and stocks, versus all CDs, (a downward adjustment) and including taxable high yield and not rated municipal bonds (an upward adjustment) are revisions that, ideally, would have been made; but they were not practical to make. The potential impact of all other warranted adjustments is extremely minor.

With the adjustments, the final number, as of close-of-business July 3, came out to 2.11% versus 2.33%. As of close-of-business July 8, this number was 2.17%. About 2.17% per year is what the average to-maturity bond investor will make. Updated to the close-of business on July 8, based on the approximate true (i.e., GAAP vs. operating) forward price/earnings (P/E) ratio of the U.S. stock markets, stocks figure to return 6.25% per year in dividends and capital gains―assuming P/E ratios, which are at least reasonable, remain the same. 6.25% is a lot better than 2.17%. Now that interest rates are no longer falling, and bond principal values are no longer rising, there will be a greater desire to be invested in the stock markets versus the bond markets simply because the stock markets are mathematically more attractive.

A good thing about investing based on a mathematical pull is that, even if the markets do not move in the direction you predicted, you still own or own more of what is probably the more lucrative investment. You tend to eventually come out ahead anyway.

How the Macro Drivers Apply: Interest Rates

Addressing one driver at a time:

(1) Prices that have swung too far up or down based on emotions and/or momentum.

This driver applies somewhat favorably. Interest rates may or may not have swung too far down based on momentum. They definitely swung too far down based on emotions. Many people were too enamored with their non-to-maturity-then-cash (non-TMTC) bond fund investments due to 30 plus years of falling interest rates and the associated capital gains. (See here and here for articles regarding TMTC funds.) They needed or need to lose a significant or large amount of money before ceasing to invest or lessening their investment in these funds.

(2) Prices which are mathematically too high or low in comparison to those of competing investments.

This driver applies very favorably as explained in the Mathematical Pull section above.

(3) Prices affected by market intervention.

This driver applies very favorably in the form of the Fed’s QE.

(4) Prices affected by a disinformation campaign(s).

This driver subtly favors interest rates rising. The Fed and some others have not said and will not say that interest rates are below their mathematically correct rates―and that you should not invest in bonds that you cannot hold to maturity and/or you should invest less in bonds until the correct rates return. One purpose of QE was and is to distort interest rates to aid the economy and, hence, employment. Explicitly explaining that interest rates are unfair due to QE runs counter to the purpose of QE.

(5) Prices that reflect the short-term versus a probably significantly different longer term.

This driver applies very favorably. Interest rates are projected to increase a lot in the longer run, but the short-term direction of rates is rather uncertain.

The Stock Markets

For the vast majority of the last few years, it was relatively simple to predict the likely direction of the stock markets. This direction was up. Now it is not so simple. The easy post-recession-and-financial-crisis earnings increases for companies are behind us, and whether valuations are currently low is somewhat questionable.

In last week’s article, I calculated the fair value true forward P/E of the total U.S. stock market to be 18.36. This number was based on what interest rates will likely be in 2018. Given the adjustments I made to my calculation of the expected return of the readily investable U.S. fixed-income bond market between last week and this week, this number is, more precisely, 20.25. This number includes additional crude adjustments for (1) Treasuries probably having a higher weight within the calculation in the future due to large U.S. budget deficits, (2) municipal bond spreads currently being high, and (3) the Mortgage – Agency MBS yield to worst projection in the chart in last week’s article seeming too high.

Also, last week I stated: “The stock market’s fair value is related to normalized interest rates―not the current (and temporary) unusual interest rates created by quantitative easing and other factors.” Being more precise, I would have said: “The stock market’s fair value is vastly more related to normalized interest rates―versus the current (and temporary) unusual interest rates created by quantitative easing and other factors.” After making an adjustment for the current unusual interest rates, the fair value true forward P/E is, more precisely, 21.74.

There is another factor I did not consider in last week’s article. Bonds tend to trade at a premium to stocks because bond returns are, generally, more certain. They are not more certain over the course of about three decades or more, but they are more certain over shorter timeframes. Some people will pay more for bonds for this reason. Determining how large the premium is requires a separate study; and, even then, we may not be able to determine a fairly dependable number. If we guesstimate the premium at 10%, the fair value true forward P/E is 19.77. As of close-of-business July 9, the approximate true forward P/E of the U.S. stock markets was 16.3. This is 21.27% less than 19.77.

19.77, even beyond accuracy-of-calculation issues, is an uncertain number. The calculation is based on what interest rates will likely be in the future. What interest rates will likely be in the future is uncertain and changes over time. Having a number like 19.77 in mind is important though. There is some fair value true forward P/E like 19.77. If the stock market increases in value beyond this number, it will, likely, eventually lose value or increase in value at less than the usual rate. Likely, many people will eventually say: “Why should I own stocks when I can own bonds with a similar or better, and more certain, return?”

In the years to come, the stock market may increase in value beyond a true forward P/E of 19.77 or the like. People who are investing in gold or longer-term-bonds-for-the-short-term are now betting against non-short-term price direction. Some of these people will now become more inspired to play the stock market. More significantly, as people see the value of their bond holdings fall, there may be an overreaction in favor of stocks―just as there was an overreaction in favor of bonds that is now waning.

An obvious question is: “Why not just use P/E ratios based on historical data to make judgments as to how fair-valued the stock market is?” You often see statistics quoted like the average S&P 500 P/E ratio for the last x number of years, but these statistics are not very useful. The ease-of-investment and costs for the various types of investments were different in the past. For instance, previously, there were no or few exchange-traded funds (ETFs). Also, as I have demonstrated in this article, the value of the stock market is dependent, in part, on the value and price direction of competing potential investments. The value and price direction of competing potential investments varies a lot. U.S. interest rates generally fell for over 30 years. This phenomenon ended only recently, and it had a negative effect on stock market P/E ratios.

How the Macro Drivers Apply: Stock Prices

Addressing one driver at a time:

(1) Prices that have swung too far up or down based on emotions and/or momentum.

There is still an emotional hangover that disinclines people from investing in stocks due to the relatively large 2000-2002 and 2007-2009 market crashes. This effect is waning, which subtly favors stock prices rising.

(2) Prices which are mathematically too high or low in comparison to those of competing investments.

As illustrated above, stock prices are low in comparison to the future expected return of the readily investable U.S. fixed-income bond market, even with an adjustment for bond returns being more certain than stock returns. This favors stock prices rising.

(3) Prices affected by market intervention.

Fed QE injected and is injecting additional money into the system, which aided and is aiding the economy and led and is leading to greater competition to buy stocks. This favors stock prices rising, until about three to six months before the Fed stops injecting money. Market prices tend to rise or fall about three to six months in advance of market-impacting events like this occurring.

Fed QE continues to make non-short-term interest rates lower than their mathematically correct rates. This is both a positive and a negative for stock prices rising. Some people have been chased out of bonds and into stocks due to abnormally low interest rates. Other people are invested in bonds or more invested in bonds because they have not experienced enough pain in bond principal losses yet.

The significant tax increases that took effect at the beginning of this year and sequestration are an indirect form of market intervention. The U.S. economy would be significantly stronger if not for the tax increases, and stock prices would, probably, be higher. This negative effect on the economy is dissipating over time. This favors stock prices rising. The sequester budget cuts occur thru 2021. They favor stock prices falling.

(4) Prices affected by a disinformation campaign(s).

There is no significant related disinformation campaign.

(5) Prices that reflect the short-term versus a probably significantly different longer term.

U.S. GDP growth is projected to be stronger next year and even stronger the year after, which favors stock prices rising.

Conclusion

I know that interest rates are very likely to rise. As of close-of-business July 8, the expected return of the readily investable U.S. fixed-income bond market was about 2.17%. The 2018-projected expected return is about 5.04%. This is a huge difference. In addition, interest rates are being manipulated, temporarily, by the Fed, to be lower than they normally would be. The extended analysis above confirms and strengthens the conclusion that interest rates are very likely to rise.

I think that stock prices are likely to increase more than is usual. Based on the future expected return of the readily investable U.S. fixed-income bond market, the fair value true forward P/E of the U.S. stock markets is about 19.77. This 19.77 figure has a fair amount of uncertainty associated with it though. As of close-of-business July 9, the true forward P/E of the U.S. stock markets was 16.3―21.27% less than 19.77. The extended analysis above confirms and strengthens the conclusion that stock prices are likely to increase more than is usual.

 

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