Daily Speculations

2004 Forecast

One of the best methods of forecasting the market in a year is to use the Fed Model. We wrote articles in 2003 on the model's operational predictive validity ("Overvalued? Stocks Look Cheap to Us," May 8, 2003; "We Road-Test a Rule of Thumb," May 15, 2003). The gist is that if you quantify it by using predicted  earnings for the next year , and compare this to current price, and then relate this to the 10-year note rate, a fairly accurate forecast has been possible over the last 20 years.

Last year, stocks were wildly undervalued. This year, the same thing.

We asked Tom Downing, formerly chief assistant to the great Sam Eisenstadt at Value Line, to run these numbers for us. He reports as follows:

With SPX at 1138, one-year forecast earnings $60.3 for P/E of 18.9 (yield 5.3%), the Fed Model is currently showing a fair value of 1489, a 31% premium to current levels. This corresponds to a forecast return of 12.6%.

Another version of the Fed Model (expected return = forward earnings yield less 10-year yield) currently forecasts a 19% return.

See Tom's Fed Model Analysis

The Other Pillar of our optimistic forecast last year was the seasoned stock-to-total capital ratio developed by Jeffrey Wurgler and Malcolm Baker. We used their ratio as the basis of a forecast for a 20% rise in the S&P last year.

We heard recently of another indicator that is reportedly consistent with the Wurgler-Baker stock-to-capital ratio. Mr. Hui Guo, an economist in the research department of the Federal Reserve Bank of St. Louis, has written a very interesting paper on the consumption wealth ratio (CAY). We cite Mr. Guo's findings in our upcoming cover story on volatility in the March issue of Active Trader magazine.  

We recently asked Mr. Guo to comment on the relation between idiosyncratic volatility (IV) and the consumption-wealth ratio. He responded:

Actually we are making some progress to understand the relation between IV and CAY. We  decompose a shock to a stock return into cash-flow flow shock and discount rate shock, and find that the former is more relevant to the predictive power of IV.  This evidence lead us to the following hypothesis:

When CAY is low or stocks are overvalued, a firm's cost of capital is  lower, leading to the acceptance of more new capital investment projects, which can result in an increase in the firm's idiosyncratic volatility. Therefore, IV forecasts returns possibly because of its co-movements with CAY.

This hypothesis is consistent with Wurgler and Baker (2000), who  argue that the share of new equity issues forecasts returns because firms  try to time the stock market.

Hui Guo

(Read our preliminary thinking on volatility here,  and don't miss J.T's essay, Volatility and Cows, a story from a Southern childhood on the correlation of cows, grasshoppers and red-eye bass.)