Still Blue Skies Ahead

10/21/2009 11:00 am EST

Focus: MARKETS

David Fried

Editor, The Buyback Letter

David Fried, editor of The Buyback Letter, says his favorite indicators point to continued gains for stocks in the coming months.

Underneath the market noise are solid realities that ultimately rule the day no matter what investors’ near-term hopes or fears may be.

Big trend #1: The inflation trend (positive). Since 1920, the Standard & Poor’s 500 index has gone up an average of 15.5% when inflation was in the 2%-5% range.

When inflation topped 5%, the S&P average rose just 1.3% per year. Currently, inflation is running below 5%.

Big trend #2: The long-term bond yield vs. S&P yield (positive). Peter Lynch, the famed manager of Fidelity Magellan Fund during its glory days, [said that] when yields on long-term government bonds exceed the yield on the S&P 500 by 6% or more, sell stocks and buy bonds. The current yield on the S&P 500 is 2.0%, while the yield on 30-year government bonds [was recently] about 3.99%. The difference between the two yields is 2.00%.

Big trend #3: Action of the Federal Reserve (positive). The Fed has cut rates from 5.25% in September 2007 to the current rate of 0.25% and has stated that it will keep rates low for the time being.

Big trend # 4: The yield curve (positive). The 30-year bond [recently yielded] 3.99%, 3.12% more than the two-year, [while] the spread between two-year paper and the 10-year note is 2.35%. The yield curve spread is in order.

Big trend # 5: Valuation (neutral). Given the current low interest rate environment, it is hard to make the case that stocks are drastically overvalued or undervalued at this time.

Big trend #6: Investor sentiment (neutral). We add the total bullish percentage readings of Investors Intelligence, Consensus Index, American Association of Individual Investors Index and Market Vane and average this figure for the month. We consider an average reading of more than 200 to be negative while readings of less than 150 are positive. The average total reading for the month ending September 30, 2009 was 184.15.

Big trend #7: Money supply (neutral). The broadest measure of money supply available is called M2, and counts forms of money held for immediate transactions (all coins and paper cash in circulation, plus the amount in checking or demand deposit accounts) and money held as a store of value (various savings and money market accounts, certificates of deposit, deposits of euros, and overnight bank repurchase agreements). Currently, M2 is up about 7% from the same time last year.

However, most of that expansion happened prior to March 2009. Since then, the increase in the money supply has waned.

Four of our seven indicators are positive (inflation, dividend yield, yield curve, and the Fed), and three are neutral (valuation, money supply, and sentiment). None of our indicators is negative. Our indicators are telling us the investment climate is positive at this time.

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