Trader’s Narrative

This is just a quick follow up. For further details see my first message from last summer on the I/B/E/S Valuation Model for the stock exchange.

What’s amazing is that according to this model, we are even more undervalued now. Pretty much as “cheap” as the bear market bottom in 2002. So, when a fairly good historical indicator goes totally berserk like this, it can be two things:

1. circumstances have changed (GIGO principle)
2. something real is going on

If you like the first option, you can trot out the 10 Year Note’s crazy low yield and blame it for the outlier result.

If you like the second, you can retort with, “Pshaw! We had the same rates in 2002 and look how far equities ran.”

In either case, it’s your call.

(FYI:I’m leaning towards #2)

It wasn’t that long ago when people were running around pulling their hair out because of a swift sell off in the bond market. As yields spiked in the 10 year and 30 year notes, a lot of attention was invested in trying to explain what this meant.

In early July I showed one simple indicator based on the 10 year Treasury Notes and how it has a very good record of finding market tops - something most indicators are loath to do.

Here is the indicator again, going back three years:

As you can see, this is able to not only find tops, but bottoms as well. Whenever the rate of change of the 10 year T-Notes drops into negative territory, we start to see a high probability of the equity market bottoming. It isn’t perfect, as you can see. It missed the October 2005 bottom (or was early depending on how you want to think about it).

The rational argument is that as bond yields fall, equities become more appealing compared to bonds. And so funds flow from bonds to stocks. Although not simple, it is both logical and fairly consistent. What else can you ask from an indicator?

No that isn’t a typo, I really do mean undervalued. And extremely is the correct adjective also.

Sometimes a graph just speaks for itself:

So what is this graph ?

It comes from the Institutional Brokers’ Estimate System (sometimes written as I/B/E/S) which started in 1976 for US equities and 1987 for international equities. IBES is a huge database that gathers the different estimates of earnings by stock analysts for the majority of U.S. publicly traded companies.

The IBES valuation model compares the 12-month forward estimate earnings yield (earnings/price x 100) of the S&P 500 to the current yield of the 10-year Treasury note.

Lets see how one would have done following its guidance:

• it got you in at the start of the bull market in the 1980’s
• it cautioned you just before the crash of 1987
• it flashed a warning again in late 1991
• but it was premature as the market dipped only a little bit and went much higher
• it got you back in in late 1993 which was during the plateau - just before another dramatic liftoff
• it told you to buy again when the market dipped in late 1995 (fantastic!)
• it signalled caution in 1997 which resulted in a sideways trading range 2-3 years
• it repeatedly signalled caution during the bubble years
• it told you to buy again in mid 2002 - almost the exact bottom of the bear market!
• it has remained stubbornly flashing a buy signal ever since