by Steve Thompson

Steve gives his update of Bob Brinker's Market timing model indicators. At the end of the article, Steve predicts if Brinker will remain bullish or turn bearish.

12/31/06

In our Bob Brinker Free Discussion Forum we've been talking about Bob Brinker's market timing model. He uses this in his "Marketimer Newsletter" for predicting the stock market in the months ahead. This month, Steve Thompson gives his update on Brinker's timing model.

Steve Thompson's Bob Brinker Timing Model Update For December 31, 2006

As we begin 2007, the economy is predictably unpredictable. After a long period of strong gains in productivity, we could be going through a period where productivity growth slows. Meanwhile, employment costs are on the rise. If this becomes a trend, it could be regarded as inflationary. I am sure the Federal Open Market Committee (FOMC) will be monitoring closely to see if such trends develop before making any decision on the fed funds target rate. Fewer new homes could cause some mild increases in unemployment and it seems core inflation may have peaked. This could be a sign that gives the Federal Reserve reasons to stimulate the economy. Moderate growth in the economy should help balance out inflation fears and overall growth concerns into 2007, keeping the Federal Reserve neutral in the short term and perhaps opening the door to rate decreases later in 2007.

What does all this mean for investors? Patience. We had a remarkable year in the equity markets for 2006 all things considered. Many were calling for muted returns and a major autumn correction, neither of which materialized. There remains a great deal of cash sitting on the sidelines. We have many international economies that are seemingly poised for further upside. They also seem to be less concerned about inflation in their local economies. This should be great news for investors, particularly in the U.S. large cap stocks. If you doubt this, select a diverse group of U.S. mega cap multi national stocks and look at free cash flow and balance sheets. These companies have lots of flexibility to increase dividends and buy back shares and should have no major earnings worries. This is never a bad thing for equity investors. My feeling is this bull market still has legs.

A while back I got to wondering what causes Bob's model to change from bullish to bearish or bearish to bullish. Is it simply his personal expectation for future market returns? Does he really have a "model" that he completely relies on? Over the years, certain things kept coming up repeatedly that led to a hunch on my part about "the model." I have looked back in time trying to identify what triggered a change in Bob's model and I believe I am on to something.

I have written in the past about how I thought Bob viewed his "model" at that particular point in time and how I believe the "model" is constructed. We all know Bob looks at numerous indicators and the "model" is quantitative and does ultimately depend on Bob making a subjective judgment at some point to alter his allocation. The "model" was originally entirely comprised of fundamental analysis indicators. After Bob made a major mis-timing move, getting out of a bull market in 1988 and not becoming fully invested again until January 1991 when the DOW was some 20% higher, he added the Technical analysis component. Technical analysis ("TA") relies on things happening a certain way because they acted that way before under the same conditions. Detractors often say TA is not reliable since things are never exactly the same as they have been in the past. In one sense, Bob¹s "model" in entirely technical analysis since he is relying on things falling into place this time because they did previously. You can see how it is easy to go in circles trying to follow this stuff. I will say having a model to study does have the advantage of partially eliminating some of the emotions we all face at the tops and bottoms of the market cycle.

We all know from listening to Bob on the radio that he claims to be able to know when to be in the stock market and when not to be. I believe Bob's model is simple but logical. Everyone knows the stock market is uncomfortable with things like inflation and a tight money supply. We also know that trees don't grow to the sky, and there is a limit to how much people will pay for the prospect of future earnings. When economies grow to fast and future inflation fears arise, interest rates will increase and that has historically put pressure on share prices.

It has been said that the stock market is a discounting mechanism. It tries to anticipate what a stock or group of stocks will be worth 6-12 month down the road. In the interim, volatility can move stock prices widely, offering opportunity for both buying and selling of stocks at favorable prices. Or at least that is the theory.

Methodology.

I have always believed that Bob has a great deal of respect for valuation. Every Monday when he examines his model, I believe Bob starts by calculating the current P/E ratio of the S&P 500 -- the Index which Bob says his current timing model tracks. Determining the market's valuation can be a daunting task since there are many methods to choose from. We do know the stock market is a forward looking device. Based on Bob's past statements, I believe he looks at forward operating earnings.

In going back to look at what makes his model tick, I found it practical to use actual earnings for the period in question. This minor adjustment would cause my figures to fluctuate from the actual numbers Bob may have used.

I believe after making the initial P/E calculation, Bob compares that to the P/E of the FED model. What is that you say? Simply put, you take the yield of the ten-year Treasury bond and divide that by 1. For example, if the current yield is 4.726%, you use the formula (1/4.726)*100 = 21.15. If the current P/E is below 21.15 the market could be deemed undervalued and if over 21.15 it could be classified as over valued.

It is important to separate historic valuation from current valuation. Bob's method allows you to stay invested in equities when valuations are high historically, provided we are in a low interest rate and low inflation environment. You might be tempted to go back to the 1988 to 1991 and check this theory. I'll save you the trouble. It doesn't jive, but remember Bob's timing model failed during that time, and he allegedly changed it after wrongly exiting a bull market in the late 1980s.

After making the first calculation, I believe Bob quickly reviews the other segments of his model. My guess is that he starts with the Monetary policy indicator, followed by the Economic indicator. Then, he finishes up with his newest indicator, Sentiment, which seems to be evolving to this day. I suspect that even if the last three indicators were in conflict with the Valuation Indicator, Bob would still be hard pressed to announce a change in his model outlook. In fact, I believe he uses these secondary indicators to confirm what the Valuation Indicator is saying. He may even look to these secondary indicators to pick a precise time to pull the trigger.

The art and science in all of this, is trying it assimilate the information and determine which indicators deserve the most weighting at any particular time. With that said, and with DavidK's help, let's look at the individual components of the model with an eye toward how they might translate now.

MODEL ANALYSIS

VALUATION INDICATOR

I must say I was surprised when in October of this year, Bob revealed his 2007 S&P 500 earnings estimate of $87.75. The figure that Bob is using seemed like a huge leap from his prior 2006 estimate of $82 which was closer to his forecast of $79 that he started the year making. I wonder if Bob's forecast is a little high this time. If we use Bob's $87.75 figure and the present level of 1,418.30, we get a price-to-earnings ratio of just over 16. The FED model used by Ed Yardeni suggests a P/E of 21.23 would be fairly valued. If Bob is right on his earnings estimate and we get some modest multiple expansion, 2007 could easily see new all time highs in the S&P 500 with a P/E of 18! If the long bond rises to 5.55%, the FED model would suggest a P/E of 18 is reasonable. I can see why Bob would be bullish when the foundation of his model at this time is sanguine. I rate this indicator as bullish.

MONETARY POLICY

Bob looks at short term rates and real money supply growth in connection with the Monetary Policy Indicator of his timing model. Last month, Ben Bernanke stated that the money supply has become unreliable as a tool for forecasting inflation and growth. Still, it is a component of Bob's model so let's take a look at where it is now. Real seasonally adjusted growth in M-2 is showing a decent gain of 2.78%. This is due to, in part, the latest CPI number of 2.0%. I had written a few months ago that I felt the next two CPI reports would be noteworthy. My thinking was that the year-over-year comparisons would be easy since they spiked up in the post Katrina/Rita period due to higher energy prices. So now with lower oil costs we are showing minimal CPI increases. Real growth in M-2 is starting to look like it could provide some fuel for a growing economy. I don't see the FED changing short-term rates soon since they worked so hard to normalize them. The Core PCE came in December 22, 2006 at 2.2%. This is down from the previous report of 2.4%. Should future reports come in under 2%, we may be able to start looking for a cut in short-term rates from the FED. I see the monetary indicator as neutral.

ECONOMIC INDICATOR

The final third quarter GDP number came in at 2.0%. That was a slight disappointment since the preliminary figure was 2.2% a month earlier. The good news is this sluggishness gives the FED no cause to take action to slow the economy. As the first week of the New Year ends, all eyes will be on the employment report, particularly the closely followed nonfarm payrolls which will be announced on Friday. We shall have to grind this one out and see if growth has bottomed and will turn upwards into 2007. The fourth quarter advanced GDP report comes out January 31st. For now, I rate this indicator as bullish.

SENTIMENT INDICATOR

Analyzing sentiment is something that Bob added to his "model" after the poor performance he suffered in the 1987 to 1991 time frame. When I first recall him mentioning it, the primary data point was the Investors Intelligence four week moving average of Bulls/Bulls + Bears. That data point has been in the 50s for most of the summer through the correction which is a neutral reading. In mid-October, it bumped up into the 60s. It has been in the low 70s since mid-November and has been inching toward the mid-70s the past two weeks. The four-week moving average is now 73.32%. That is in Bob's caution zone. Conversely, the Put/Call ratio continues to show healthy levels of doubt. The 10-day is 0.94, while the 60-day is at 0.88. Though it is not part of Bob's model, the American Association of Individual Investors has been a more reliable sentiment measure at least this year, and is currently at 56.1% and the four week moving average is 54.02%. I would rate the sentiment indicator as bullish right now.

I believe that as time goes by, Bob has learned more about technical analysis and added other data points to this Indicator in an attempt to diversify and avoid mistakes. During the panic of autumn 1998, Bob started talking about other indicators such as the Put/Call ratio. It was also then he seemed to key in on market internals such as new highs/new lows, advance/decline, volume, etc. He liked to see the market make a bottom and then drift higher, then retest the low on lighter volume. The theory was that those that were going to sell already did and that only left buyers left to move the market. To my way of thinking, the Sentiment Indicator is BULLISH.

CONCLUSION

To summarize, I believe Bob Brinker's timing model is still Bullish with three bullish and one neutral indicators. With valuations so reasonable and the large increase in earnings estimates, I would say that Bob Brinker views the future as bright for the U.S. equity markets, but at the same time realizes corrections do happen. I don't think Bob would be panicked to see a correction take the S&P 500 back under 1300. In fact, I would expect Bob to see that as a buying opportunity.

Steve Thompson

Thanks Steve.

Make sure you read Dec. 2006: Bob Brinker's 5 root causes for a bear market and Steve's earlier updates to see how they worked out:

• Steve's Nov. 01, 2006 update
• Steve's Oct. 02, 2006 update
• Steve's July 5, 2006 update
• Steve's April 6, 2006 update

Discuss This Article

What do you think? Ask questions about this article and discuss Bob Brinker In our Bob Brinker Discussion Forum.

Kirk Lindstrom: DISCLAIMER: Answers & my words are general in nature, are not meant as specific investment advice, and do not necessarily represent the opinion of anyone but Kirk. Individuals should consult with their own advisors for specific investment advice.