Palos Mgt. of Montreal on Stock Market Forecasting methods,

How Palos Passes Judgment on, Makes Assessments of, and Forecasts Stock Market Returns

Over the short term, stock prices can from to time run far-away above or below fair value.
However, over the fullness of time, price stability, economic growth and monetary policy
are the three main fuels that propel stock market returns. In this connection, it is crucial, with the use of metrics, to numerically define what fair value is, and what constitutes price stability,
causes economic growth and determines monetary policy.

A. The stock market represents fair value when the P/E ratios are close to 16.0X, within a range
from 14.0X to 18.0X. It is also often suggested that when the E/Y (earnings as a % of stock
price) is near Baa Bond yields and/or D/Y (dividends as a % of stock price) are fetching
about as much yield as a ten year treasury, stocks are commonly considered to be justly and
appropriately priced.

B. Consumer prices are judged to be stable when 1) they increase annually between 1% and
3% in a sustainable manner, 2) inflationary expectation does not deviate from the ongoing
inflation rate and 3) both cost push and demand pull pressures are contained.

C. Economic Growth is the product of employment and productivity. In this regard, the
former is usually dependent on demographics like population growth, age and mix; and the
latter on good technology advancement, innovation and incentives.

D. Monetary Policy is based on a dual mandate of maintaining price stability and encouraging
full employment. A neutral monetary stance is one where the policy ought to be tepid, neither
too hot nor too cold. History shows that monetary policy should be normal when price
inflation and full employment is within range of the objectives established by the Fed while

1) keeping the balance of payment viable,

2)securing sustainable economic growth at 2.25 %,

3) maintaining total cyclical interest sensitive expenditures like consumer spending on durable
goods, inventory accumulation, residential construction and fixed business investment
around 25% of R-GDP and

4) providing appropriate market conditions to fund Federal budget deficits that are not more than 3.0% of NGDP.

As one can appreciate the Federal Reserve is pulled in several different directions at the
same time. The mechanism that the authorities use to transmit their actions on the economy is
through the money markets.

In monetary and market terms, normalcy exists when:

1) the short cost of money is about 50% of the long cost of
bonds,

2) the yield on ten year treasuries equals about 75% of the nominal growth of GDP,

3)real money rates equal the expected annual rate of increase in R-GDP,

4) the annual pace of the money supply exceeds that of N-GDP and

5) the cost of capital is about 1/3 less than the return on invested capital and

6) the current policy rate is close to the secular neutral rate.

The secular neutral rate is the composition of the ten year average of real rates on two year treasuries plus the Fed’s inflation target of 2.00%. Normalcy is like an even keel monetary stance.