August, 2014 Six month Stock Market Forecast

(Ignore the small stuff. Please read the disclaimer that follows this post.)

The next six months finishing 2014 and starting 2015 should be significantly better than average for the stock market. At least, that is what my stock market forecasting models say.

Why are the models optimistic?  It is mainly because there is room for the economy to improve: GDP is still below it's potential;  construction activity remains subpar; unemployment and under employment are still too high; the chance of a recession is remote; and the Federal Reserve continues to apply low interest rates and  massive amounts of newly created money.

Today was pretty grim for the U.S. stock market -- and there is nothing like a rotten day to make the forecasts coming from my stock market model brighter!  When things are bad they can get better, but when all is well, the only way to go is down. A further drop in the next month or so is still likely.

Here is the model's stock market forecast for the tail end of 2014 and the start of 2015:

Probable market gain from 8/1/2014 to 2/1/2015:  8%  (Average 6 months since 1984: 4.8%)
Probability of at least breaking even :    84%  (Average for all months since 1984: 73%).

For the past year or so the stock market has been performing roughly 5% better than the models had forecasted. You can't complain about a strong market, but the model suggests that investor optimism has been building up and some sort of pullback remains likely.  Beyond that the broader prospects for the U.S. stock market are better than average.

(Click on image to enlarge.)

(Disclaimer: Please do not pay much attention to these 6 month stock market forecasts until there is a great big forecast coming from the models that completely contradicts how the market is currently moving. When you feel the forecast is crazy, that is probably the time to give the models' forecasts some real consideration.   Until then, not so much.  The' noise' of normal market vibrations is probably greater than the 'signal' coming from economic fundamentals. Yes, the market can be very crazy in the short term and the models simply are not that accurate. The forecasting models presented here are not precise and the losses that come through high taxes on short term capital gains will kill any real gains coming through short term market maneuvers.)

Three reasons the stock market may not peak before 2016 or 2017

Many commentators say today's stock market is seriously overvalued. I do not disagree, but three major factors indicate that the bull market will probably continue for well over a year, probably until 2016 or 2017.

First, the skeptics. Either the market cynics are right, or they are creating the greatest Wall of Worry that I have ever seen. There are many shouts of warning, but I will just point to two of them. Mark Hulbert at MarketWatch.com cites six factors that indicate the current market already is priced higher than the vast majority of prior market peaks.  The factors are: price/earnings ratio; price to 10-year cycle price/earnings ratio; price/book ratios; price/sales ratio; Tobin's Q ratio; and relative dividend yield. Neil Irwin in the NY Times goes further, writing "Welcome to the Everything Boom, or Maybe the Everything Bubble."  Few of the naysayers are pointing to an imminent market crash, instead they generally stress that high current valuations point to disappointing overall market growth over the next decade or so. 

So, when will the over-priced stock market come crashing down? Hopefully, my stock market models will scream warnings a month to six months ahead of the eventual market collapse. Or, at least, hope of an early warning is the main reason I created forecasting models in the first place. In the meantime the models have not turned seriously pessimistic.

The economy still has not fully recovered from the Great Recession.  As shown in the graph below Real Gross Domestic Product suffered the worst decline in several generations during the recession.  It has been recovering, but it still has not equaled Real Potential GDP.  The Congressional Budget Office has generated the Real Potential GDP calculation for many years and the match with actual GDP results has been incredible -- the Coefficient of Determination, R-Squared, is greater than .99! That is amazingly close. Maybe everything truly is different this time, but more likely, GDP will 'regress to the mean', reaching its potential before the next market crash. Increasing employment by increasing GDP, after all, is what the massive intervention of the Federal Reserve has been trying to accomplish.

Three things need to happen for GPD to reach potential: employment needs to increase, both for the unemployed and the millions of workers currently underemployed;  business investment must rise.; and world trade needs to get back to normal, meaning that the rest of the world needs to recover from the recession as well. At best, it will take a couple of years before GDP (i.e. the economy) is back to normal performance.  There is still plenty of slack in the economy leaving room for stock prices to grow.

(Click on image to enlarge.)

Interest rates need to rise 3% or more.  The Federal Reserve and other central banks promote economic growth by lowering interest rates and increasing the money supply. Raising interest rates and limiting lending cools down the economy, often dramatically.  The graph below shows the U.S. bank prime lending rate from 1950.  The overall story of the graph is that raising interest rates by 3% to 5% above the previous low point is enough to slow the economy and bring on a recession.

Typically, the Federal Reserve takes a year or more to increase lending rates enough to slow the economy. Then, the impact of higher interest rates takes roughly a year before it shows in the real economy.  The Fed already has indicated that it is unlikely to start increasing interest rates for another half year.  Once the rate increase process has started it likely to proceed very, very slowly.  Otherwise, trillions of dollars in outstanding long term loans will plummet in value, exposing the world to a financial crisis similar to 2007 - 2008.  Overall, it seems unlikely that interest rates will increase in the next 2-3 years enough to slow the economy.

(Click on image to enlarge.)

Speculative fever needs to build.  Margin Debt, is money that investors/speculators borrow from their brokers to use to buy more stock.  As such, the Margin Debt level is a solid measure of investor optimism. Margin Debt has a long record of fairly steady increase as the total capitalization of stocks has increased. In fact, Margin Debt follows a path of simple compounding growth extremely closely. (R-squared = .99).  But, the match with simple exponential growth is not perfect.  The graph below shows New York Stock Exchange reports of margin loans, but the factor of steady growth over time has been removed. The result is a chart showing how margin levels at any point in time compare to the base value of regular steady growth.  The general picture is that in the case of most significant market collapses, margin debt increases for a period of several years prior to a crash.  The last few months usually see margin debt shooting up as speculation reaches frenzy levels. Generally, margin has grown to a level of 50% above trend before the speculative bubble bursts.  Current levels of margin debt have not even reached the long term trend level.  If the current market cycle is in any way typical, margin will increase for a couple of years or more before getting to a breaking level.