November 23, 2010
Just over a year ago, Ned Davis correctly forecast a continuation of the cyclical bull market in stocks. In February of 2008, he foresaw that year’s market upheaval, and a year later he predicted the rally that began in March of 2009.
Today, Davis is moderately bullish on stocks, as long as the Fed maintains its policy of quantitative easing.
Davis, president and senior investment strategist of the Florida-based institutional research firm Ned Davis Research, spoke at last week’s Financial Advisor Money Show in Orlando.
The hallmark of Davis’ approach is synthesizing a range of objective data points into a model that, working from a lengthy historical track record, yields predictive signals for market movements. In his presentation, he illuminated many of the key data points on which his model is currently relying.
Momentum, liquidity and other key indicators
Davis is guided by two overriding principles: Don’t fight either the tape or the Fed, at least without a lot of contrary evidence. His main cyclical indicator of the “tape” (overall market direction) is something he calls “big mo” – for momentum. According to Big Mo, 82% of the industry groups Davis follows are in “healthy” trends – a bullish reading.
Investment-grade bond yields, as measured by Moody’s Baa index, are Davis’ guidepost for Federal Reserve monetary conditions. Davis noted a strong inverse correlation between those yields and equity prices; when yield momentum is falling by more than 3%, stocks typically rise by 16.5% annually. He said interest rates are still falling but have moved up a little bit recently, and that uptick has moved this indicator from bullish to a neutral zone.
Davis presented a chart showing the M2 money supply, adjusted for commodities and industrial production. Because the Fed supplies a certain amount of liquidity to the market, and because the economy uses up some of it while inflation eats up another portion, Davis said it is telling. It shows that when there is excess liquidity – “which there certainly was in 2009,” he said – “a monster stock rally” usually ensues.
In the spring of this year, this measure of liquidity was low – an ominous sign for the market. However, once the Fed announced its QE2 policy and its plans for fighting inflation, the indicator started to improve a bit. He also noted that the other monetary aggregates – MZM and M1 – “are showing pretty strong growth rates.”
“Clearly, we think the Fed is friendly,” he said, “and that is positive for the market.”
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