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Dave & Donald Moenning

Mr. David Moenning is a full-time professional money manager and is the President and Chief Investment Officer for his Chicago-based Registered Investment Advisory firm, Heritage Capital Management (...

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What's The Message From The Market Math?

At this time of year, it is natural for investors to want to make adjustments to their portfolios.

This is also the time when folks tend to peer into their crystal ball and try to figure out what to expect next from Ms. Market. Everywhere one turns these days there are predictions. Predictions for stocks, bonds, oil, gold, real estate, currencies, etc.

However, the bottom line is this is essentially a useless exercise.

Think about it. Do you really know what moves the market each day?

Do you know how the market will react to tomorrow's data?

Do you know anyone that can tell you with any degree of consistency what the market will do today? Or tomorrow? Or the day after?

No. In reality, all investors can really do is attempt to humbly understand Ms. Market's moods and try to play the game accordingly. As professional investors, this means monitoring a vast array of indicators designed to put the odds of success in our favor. To be sure, such an approach doesn't always work perfectly. However, treating this game as a business and using some math along the way can indeed improve your results over time.

Making Sense of the Game

In our shop, investment decisions are guided by models, indicators, and rules. Our goals are to (a) stay in line with the major trends in the market and (b) try not to get creamed when the bears come to call. Before you get too excited though, it is VITAL to recognize that there is no perfect indicator, signal, or system. But if one understands what generally drives the market and how the game tends to turn out over time, you just might stand a fighting chance of succeeding.

See also: What Do The Cycles Say About January 2014?

As such, let's spend the rest of our time together today reviewing some key market models and indicators in order to see if there isn't a message to be gleaned.

The Monetary Conditions Model

You've likely heard the phrase, "Don't fight the Fed." The idea here is that when the Federal Reserve is on a mission, they usually accomplish their goal in the long run. Think about Paul Volcker's battle with inflation in the early 1980's. Think about Alan Greenspan's response to the stock market crash of 1987, the emerging markets crisis in 1998 and what the Fed did after 9/11. Think about everything Ben Bernanke did during and after the credit crisis.

The key here is if one understands the relationship between the Fed, interest rates and the markets, knowing what the Fed is trying to accomplish can help investors get the really big, really important moves right.

So, where are we now with regard to monetary policy, the Fed and interest rates, you ask?

Unless you've been living in a cave for the past five years, it is probably clear that Ben Bernanke and his band of central bankers have done everything in their power to keep the U.S. out of, first, a depression, and then a recessionary/deflationary cycle. Heck, the Bernanke Fed even had to dream up new weapons to combat the crises that have occurred since Lehman went belly up in 2008.

Okay, enough of the history lesson. The important thing here is to recognize that monetary conditions remain "loose," meaning that interest rates are low. And rates are expected to stay low for quite some time yet.

See also: 2014 Planning - Buy Signals To Watch For

Historically, low rates - and remember, the Fed's targeted interest rates have never been lower - have been good for stocks. To corporate America, low rates mean low borrowing costs and opportunities to expand and grow.

The bears will argue that the Fed is "pushing on a string" at the present time.

The thinking is that rates have been so low, for so long, that the effectiveness of the strategy is waning. Our furry friends contend that low rates are just part of the "new normal" and that the Fed is out of bullets.

At the same time, those looking at life and the markets through their rose-colored Ray Ban's suggest that as long as the central bankers of the world continue to print money, stocks are likely going to go higher. As investors learned in 2013, all that cash created by the QE programs in the U.S, the UK, and Japan has to go somewhere, right?

As you can likely tell, this argument can go round and round. So, in getting back to the theme of today's missive, let's apply some math to some indicators and check on the current reading of our monetary model.

What's the Monetary Model Say?

If you understand the connection between Fed policy, rates, and the markets, it probably won't surprise you to learn that our monetary model is currently sporting a positive reading. Rates are low and the Fed is in an easing mode - which is essentially the very definition of a positive monetary environment.

Looking back over the last 33 years, the stock market has performed quite well when the monetary model has been positive. In fact, the S&P 500 has gained ground at a rate of more than 25 percent a year when the model has been positive.

However, when the model has been negative, stocks have lost ground at a rate of 8 percent per year. And when the model has been neutral, the market has rallied at the rather paltry rate of just 4.9 percent.

Doing the math, this means that there is a more than 33 percent spread between the returns of the stock market when the monetary model is positive and negative. As such, this would appear to be a pretty important model to stay in line with from a big-picture standpoint.

The Next Signal Is Going To Be...

So, if the monetary model is positive, investors should be long. Check.

But, Bernanke, Yellen, and friends have gone out of their way to tell us that they will be tapering the QE program to zero this year and that rates will likely rise sometime in 2015. This means that the next signal the monetary model is likely to give is first a neutral, then a negative reading.

You see, once the Fed starts to raise rates, they will likely continue to do so for quite some time. Thus, this model could conceivably stay negative for several years. And since stocks haven't performed well at all when the monetary model is negative, well...

In conclusion, following the monetary model can be REALLY boring as it doesn't change very often. Yet the model remains a very powerful, very effective tool. As such, this is something that investors may want to check in on every week or so. We do.

What's Next?

Given that our exploration of the monetary model went about 10X what was originally intended, we will stop here today. Coming up next, we will look at our models for the economy, sentiment, trend and momentum, inflation, and valuation.

Hopefully, by the time we've concluded our journey through market-model land, a message will arise from all the market math.

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Posted in: Markets Trading Ideas