Understanding the Stock and Bond Barometers
The Bond Barometer
The Bond Barometer is shown in Chart 2-1. It has performed reasonably well because it would have kept investors out of the bond market for most of the postwar period prior to the secular, or very long-term, peak in interest rates in 1981. Since 1981, it has been able to capture most of the bull moves, although from time to time, it does experience difficulty. One such example occurred in 1980 where a sharp reversal in monetary policy caught the Barometer off guard during the early phase of a bear market. In 1995, the buy signal came well after the bull market began, while the sell signal was given at a lower price in 1996. However, when the rallies of 1982, 1985/86, 1991/93 and 1997/98 are considered, the overall performance was quite satisfactory. At the same time, itís important to remember that most of the 1981,1984, 1987 and 1994 declines were avoided.
The Stock Barometer
Because stock prices are influenced more by psychology than economic events, this has been the least accurate of our three Barometers (Chart 2-2). Also, the 1980ís and 1990ís experienced the most bullish period for equities in the 200-years of stock market history. Therefore, a conservatively designed model, such as our Stock Barometer, gave a more cautious outlook than was called for in reality. Since such a strong period is unlikely to be repeated in the future, we will probably find this Barometer will eventually give more accurate signals, along the lines of those given in the 1950ís,1960ís and 1970ís. This particular instrument is largely influenced by the rate of change of interest rates. Normally when rates rise, stocks, after a long lag, decline.
The interest rate environment was particularly hostile in 1989, yet stocks rallied sharply. This was due to a large extent on an unprecedented amount of corporate stock retirement. This reduced supply and placed additional cash in the hands of investors (raised demand). These types of factors are unusual and cannot be measured by normal cyclical indicators.
The Rule of 12
The Rule of 12 is a very profitable, yet simple, technique for identifying positive periods for equity prices. It takes advantage of the fact that declining short-term interest rates are positive for equity prices once they start to respond. Remember, in most cycles short-term interest rates lead stock prices, but the lead varies from cycle to cycle. The trick is knowing how long the lag might be.
The Rule of 12 uses two 12-month moving averages, one for the S&P Composite and one for short-term interest rates. The rule states that when the yield on 3-month Commercial Paper is below its moving average and the S&P Composite is above its average, it is a very positive environment for equities. Chart 2-3 shows this in the marketplace while Figure 2-3 indicates the performance that was obtained for the period between 1948 and 1991.
As you can see, the average annualize rate of return was just under 25%. This compares to the buy/hold approach (labeled "the entire period") of just under 10%. Also, the risk factor, measured as volatility, was very low when the Rule of 12 was in force, compared to the average period for holding stocks, which was much greater. Thus, in a period when the Rule is operating, the rewards are substantial and the risk minimal - an ideal combination.
Itís important to understand that when the Rule is not operating it doesnít mean that returns are negative ó sometimes they are and sometimes theyíre not. It merely states that when the Rule of 12 is in force, a well above average allocation to equities is recommended.
Excerpted from Understanding the KST and Asset Allocation
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