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)

Earlier this month I mentioned the IBES valuation model and how it was telling us that US equities are extremely undervalued. The Barnes Index is another valuation model which is similar to the IBES.

Keep in mind that these valuation models are really broad strokes. They are not meant for nimble, short term traders. They attempt to outline the general tone of the market and perhaps its long term trajectory.

So what is the Barnes Index? Like the IBES model it compares the stock market to the bond market. But unlike the IBES it considers both the short term yield and the long term yield (the yield curve in other words):

Barnes Index = (Treasury Bond Yield X Treasury Bill Yield) divided by (S&P 500 Dividend Yield X S&P 500 Earnings Yield)

So in essence it pits the “returns” from stocks, in the form of dividends and earnings versus the “return” (yield) from bonds. Market risk is highest when you can make more by investing in risk-free assets. The normalized chart below comes from Decision Point (the excellent technical analysis service run by Carl Swenlin).

Click to Enlarge Graph

Since it began in 1970, the Barnes Index gives us a few more years than the IBES model. The last buy signal was given in early 2003, at the bottom of the bear market. At its current level, it is neutral.

In 1973, when the Barnes Index was also at similar levels, the market topped. Also in 1981. But then again, in 1990-1 although it stood where it does now, the market went much higher.

Notice that similar to the IBES the model imploded into irrelevance due to the “bubble years”. In 1997 it crept into the redline and stayed there almost constantly until late 2001. Which proves that no model or forumla can ever predict or explain the market. All we can ever hope for is a crude approximation.

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