March 2016 through August 2016: Above average gains (roughly 8%, 85% chance for break even)

The stock market continues to lag the models’ forecasts, but the gap appears to be closing. The model is saying that once again the market has predicted a recession that didn’t happen. Current forecasts from the model remain optimistic — nothing beats a crazy stock downturn for making the market future look brighter.

February 2016:  U.S. stock market returns well above average
March 2016: U.S. stock market returns well above average
February 2016 through July 2016: Above average gains (roughly 9%, 85% chance for break even)


Last month the short term forecast from my forecasting model proved to be dead wrong. Looks like I have some explaining to do.

The prediction was strongly positive, but the U.S. stock market suffered it’s worst January performance EVER.  So, what does that mean?  Is the model junk? Or is something else going on?

My models focus on a small number of key measures of the economy that have proven over the past several decades to be leading indicators for the broad U.S. stock market.  Together these factors forecast about one-third of the actual variation in the market over 6 month periods. However, that also means that about 2/3 of 6-month market variations are not predicted by my models. The goal here is not to be accurate, but rather to foretell the most likely general direction of the broad stock market

If the model is to be believed, the U.S. stock market should be heading upward fairly soon.

The chart below shows a multi-year plot of the S&P 500 index with buy/hold recommendations from the model in green. The current forecast is positive.

The next chart displays actual 6-month changes in the stock market (blue) and predicted 6-month changes (red).  In the most recently completed periods, the market has performed significantly worse than expected. Note that in previous downturns the market has routinely performed worse than expected.

January 2016:  U.S. stock market returns well above average
February 2016: U.S. stock market returns well above average
January 2016 through June 2016: Above average gains (roughly 7%, 80% chance for break even)

I have more-than-normal confidence in this month’s forecast. My short term (1 to 2 month) stock market forecasting models have been anticipating the timing of market shifts pretty well for the past couple of years. The most recent call for a change in market direction (Buy) was made at the end of August.  The forecast was matched by a market turn around starting in September that now has produced a gain of roughly 7%.  

Looking forward, the short term models remain quite bullish for the first months of 2016. While my longer term models are already starting to worry a bit about market slow downs in May and June, the short term models are optimistic.

The buy/hold calls of the short term model (green) and the sell/avoid calls(red) for the past two years are shown in the chart below.  The model  turned green at the start of September and the market has risen about 7% since then. For January the model remains bullish. It suggests “Buy/Hold”.

Let’s shift to the longer 6 month forecast.  For the past year or so the stock market generally has been following the same course that my 6 month macro economic models had predicted six months months in advance.  On the whole, however, the stock market has come in somewhat below my econometric models’ expectations. Last July, for example, the model expected below average gains for the second half of 2015, but the actual result in the 6 months since then was significantly worse, a loss of about 7%.  I am not too concerned about this difference — as you can see in the chart below, it is more the rule rather than the exception that actual market performance is more extreme than my models had predicted.

Happy New Year!

Summary:
Current prospects for the U.S. stock market are very good: 9% gain over the next 6 months with an 85% probability the the stock market will at least break even.  Immediate prospects are fine (more on this later.)  Maybe the whole world will blow up next week. I don’t know. But, based on roughly 40 years of stock market history, conditions for the U.S. stock market are likely to be favorable.

So, this is a pretty nice forecast– not as good as the fantastic forecasts that came with recovery from the Great Recession — but, still really good compared to long term averages and somewhat typical of this time of year. For this year, this is probably as good as it gets.

Enjoy your holidays and be nice to other people! I love both of my readers and wish them well in the coming year!

Detail:
There is a graph below that, I hope, will become a regular part of this monthly blog. It shows day-to-day prospects for the stock market in the near future. (Please regard this graph of near term stock market prospects with some suspicion.  This is new stuff. The formulas need to prove themselves over time. Be careful with your money. )

Hopefully, what you will see going forward with future months of the graph is:  Two months, or more, before a ‘significant’ market trauma, a yellow marker should start to appear.  Then, (hopefully) a month or more before a market stumble, a red flag should start waving. There will also be an indication of how bad the next market tumble is expected to be.  The picture moves slowly so you shouldn’t need to hold your breath.

At least, that is how the scenario for this near term forecast graph played out this past summer. And, that is what our back-tests showed to often occur.

How can the chart ‘predict’ the future months of stock market behavior ahead of the fact? The answer is easy.  The model is simplistic. The model is almost exclusively based on a small number of long term economic fundamentals. It takes time for the gigantic world economy to actually show the results of either world events or government policy actions. But, investors are on their own time schedules. Historically, investors do not react initially to the full import of new developments in the real world.  Sure, there is a stock market blip to match every news event — but that is not the ‘considered’ view of millions of investors. Overall, investors tend to wait  for confirmation in ‘numbers’ coming from the real world (with a reporting time delay)  to see what is going to happen next.  So, typically, investors react late, and they all react together — resulting in a sharp crash or some other market perturbation.  The model, on the other hand, being too ‘stupid ‘to listen to stock market pundits or ponder over either astrology or ‘technical analysis’, assumes that what is “probably going to happen” actually will happen, and happen when it typically happens  And, surprise!  The typical result usually does happen just about as it usually does.

What the chart, hopefully, shows is that in the past summer a fairly small correction was expected, and that is what occurred. There was plenty of notice for those following this chart. Right now, things look pretty good.

So, let’s turn to what is likely to happen to the market in the next six months. Here is what is coming up. The models’ 6-month U.S. stock market forecast: (much better than average)
U.S. Stock Market Forecast (Value Line Arithmetic Index):
Probable stock market gain 12/1/2015 to 6/1/2016: 9% (Avg. 6 mo. gain since 1984: 4.8%)
Probability of at least breaking even : around 85%  (Average for all months since 1984: 73%

My reason for writing this blog is to track how well my econometric stock market models actually perform. (It has been about 8 years so far. At the start I was considered to be crazy, but now that case isn’t so clear.)

So, how have the models’ forecasts been matching reality in the past half year? Judging from the graph below, it appears that the forecasts this year have basically been on-track.  The forecasts from December through May, had been for a weak first half of 2015. Well, the market did weaken, but  the market fell more than the models had forecast.  Look at the graph below and you will see that this happens frequently — the models expect seasonal weakness, but, to compensate mathematically for those infrequent years with super summer performance, the models dial back their average forecasts.
Here is the lesson: as a rule, the market will usually perform worse than the models negative forecasts and will perform better than the models positive forecasts. At least, that is the way I see the graph below.

Why pay any attention to the stock market forecasts from this forecasting model? It looks like a buy/sell strategy may significantly boost investing returns.

In my last post I introduced a stock market trading strategy based on my 6 month market forecasts. It turns out that the forecasts consistently lead the market by a couple of months, so actual trading works best not by following the most current forecast, but by using a lagged forecast that weights forecasts from a few prior months.  The buy/sell periods called by that strategy are shown in the plot at the end of this piece. That plot shows the strategy produced just a handful of handful of buy/sell points in the period since mid-2007 when I started posting forecasts for my models.

So what?  A few correct buy/sell decisions can have a huge impact on investing returns. In particular, the forecasts of 2008 through early 2009 screamed of likely 6 month market losses of  17%  or more, months before the crash took place.  They turned out to be right. They were worth paying attention to.

A back-test applying the buy/sell strategy to an S&P 500 index fund is shown below running from mid-2007 to the present.  In the stock crash of 2007-2009 the S&P 500 took a big hit, but overall for the period the average has had a 4% annualized rate of growth. The strategy using the 6 month stock market forecasts, however, had an annualized growth rate of 14%, roughly 3 times better.

The big market call of major likely declines made for most of the difference in performance.  Since the bottom of the financial meltdown the strategy has had only a few brief sell periods. So, for mid 2009 to the present the S&P 500 index has had a great rise and has only slightly under-performed the strategy.

The chart below shows the buy/sell calls produced by a strategy based on using a weighted average of 6-month market forecasts.

I am adding a stock market trading strategy to my monthly blog posts, a Buy-Sell-Hold  model for the U.S. stock market based on a weighted average of my forecasts from prior months.

From the start, there has been a problem making use of my six month stock market forecasts:  what’s going to happen in the stock market six months from now has very little correlation with what the market is going to do in the next few days and weeks. (Just because I know it is going to get hot next summer, that’s not much help in knowing whether I need to wear a coat outside in mid-November.)

The solution I have come up with is to develop a stock market trading strategy based on a statistically weighted average of my 6 month stock market forecasts from prior months, not the current prediction.

Below there is a plot of the Buy/Sell calls from the model for the S&P 500 index over the past several years.  Most of the time the strategy yields a clear Buy/Sell opinion, but there are a few spans of time when the model had no real opinion.

Stock market prospects for the next 6 months are strong. There is about a 90% probability that the market will go up.

The stock market forecasting models documented here are based on the premise that the broad U.S. stock market tends to do approximately what it usually tends to do. Over a forecasting horizon of six months the market will respond to the same real economic factors that have moved prices over the past several decades. Shocking, right?

In late August through September the stock market was panicked by fears of things that don’t have large real dollars and cents impact on the U.S. economy (financial uncertainty in China and Greece along with weak world oil prices).  My models had expected typical seasonal market weakness, but not the extra downdraft of international finance fears.  Then, just like the not-at-all-real goblins of Halloween, in October those extreme fears fell away and the market staged a sharp recovery.

Over the long haul my experience-based stock market forecasting results tend to be pretty good. Or, at least they have proven to be fairly accurate since 2007 when I started publishing forecasts in real time.

Here is my 6-month forecast:
U.S. Stock Market Forecast (Value Line Arithmetic Index):
Probable stock market gain 11/1/2015 to 5/1/2016: 11% (Avg. 6 mo. gain since 1984: 4.8%)
Probability of at least breaking even : ~90%  (Average for all months since 1984: 73%

Here is the track record of my 6 month stock market forecasts since 2007:

Last month the title for my stock market forecasting entry was also “Bouncing Back” and that was certainly not the case for the lousy stock market September we just got through!

But, this blog and my stock market prediction models focus on the coming six months, not the next few weeks.  Take a look at the stock market performance versus prediction graph below.  The model had been expecting seasonal weakness for the late summer and that is what occurred, just worse than forecast.   If my macroeconomic model is to be believed, it says that the market is over reacting to international news and things should start to get better over the next few months.

So here is my 6-month forecast:
U.S. Stock Market Forecast (Value Line Arithmetic Index):
Probable stock market gain 10/1/2015 to 4/1/2016: 10% (Avg. 6 mo. gain since 1984: 4.8%)
Probability of at least breaking even : 85%  to 90%  (Average for all months since 1984: 73%

My econometric stock market models are predicting a significant stock market recovery of about 10% over the coming 6 fall and winter months of 2015-2016. That bounce is despite, or more accurately, because my models had not expected the market to tank so badly during August.

Huh?

My forecasting models totally missed expecting the mid-August market panic / correction. The prediction models had been expecting a sub-par market over the summer months, reflecting the statistical fact that stock markets tend to be weak over the summer. But, no way did the models foresee the abrupt market correction that actually, and painfully, happened.

So, how is that useful information?  The answer is that the fears that moved the market (high valuations, economic weakness in China, low commodity prices, and a weak oil market) are not the basic economic forces that typically have a lasting and remarkably predictable longer term impact on U.S. stock prices. In short, the models say that the market over-reacted to bad news that really is not that important to U.S. stock prices. If history is a guide, the positive economic fundamentals will regain their importance fairly soon and the market will recover.

Morningstar.com agrees. Their Market Fair Value graph, based on net present value calculations today says that the overall market is 7% undervalued. Stocks are on a 7% off sale! (I remain convinced that this Morningstar graph is the most useful stock market indicator available for free on the web.)

So here is my 6-month forecast:
U.S. Stock Market Forecast (Value Line Arithmetic Index):
Probable stock market gain 9/1/2015 to 3/1/2015: 10% (Avg. 6 mo. gain since 1984: 4.8%)
Probability of at least breaking even : 85%  to 90%  (Average for all months since 1984: 73%

I love a boring summer stock market.  Nothing much seems to be happening.  We in the U.S. are in the middle of the typically weak summer period. So,looking forward towards winter when the market typically had recovered, 6 month stock market performance will probably be a little better than average.

Here is what my econometric models are predicting:
U.S. Stock Market Forecast (Value Line Arithmetic Index):
Probable stock market gain 8/1/2015 to 2/1/2015: 6% (Avg. 6 mo. gain since 1984: 4.8%)
Probability of at least breaking even : ~ 80%   (Average for all months since 1984: 73%

So, why is a boring stock market wonderful?  Because the market is unlikely to crash really soon. Some things in life are very simple.

If all things happen as they ‘typically’ do in the economy, my personal bet is that the market will have its next serious upset in a couple/few years. (My mathematical models have no opinion on this — they only look 6 months ahead.)

Here is how the the predictions of my forecasting models and actual performance of the stock market have landed over the past 8 years:

As shown in the chart above, the U.S. stock market (measured by the ValueLine Arithmetic Index) has done pretty much what my models had expected for the past year or so. Actually, my forecasts have matched the market unusually well.  Since the models are based directly on what the market usually does in response to macro economic factors, this probably means that no really major strange outside factors are driving the market.

The great protective shield of historically low interest rates that has been maintained by the U,S, Federal Reserve Bank has made this huge bull market happen.  It is pretty easy for businesses to make money when they can borrow money for next to nothing. In a few years the current odds are that the U.S. economy will have become frothy. That’s when the Fed will jack rates up rapidly and ‘take the punch bowl away from the party’.  But, that’s what is likely to happen in a few years — not now.  Enjoy summer!