Equity model update

Regular readers will doubtless the recall the equity model that Macro Man has run for the past eight-plus years.  As a reminder, this model uses a few fundamental inputs to generate 12 month return forecasts for the SPX.   While the absolute magnitude of the forecast is generally not to be taken literally, Macro Man has derived a great deal of utility (and profits) over the years by tracking the trajectory of the forecast in both an absolute sense and relative to the level of volatility.

He runs a similar model using a scorecard approach, where five fundamental factors are given grades of +1 or -1.  Research suggests that any market delivering fewer than four +1's isn't worth owning, and that market returns with five +1's are generally much higher than those with four.  This scorecard model saw one factor turn negative in January, and retains the same profile through May.

What's interesting is that the regression return model is also deteriorating...and for fairly predictable reasons.   It's not at the point where it recommends exodus from longs, but as Macro Man has elucidated previously there are reasons to expect this model to lag somewhat in the current cycle.   In any event, the current 12m forecast is the lowest of the past couple of years:

As mentioned above, the reasons for this are entirely predictable.   Macro Man likes to break down the forecast components into what he likes to call "economic" and "liquidity" factors.     The former have been sluggish for some time, while the latter have been at astronomical levels for the past several years.   Over the last few months, the liquidity support for stocks has begun to ebb (while remaining ample) even as the economic factors have remained weak.

Ultimately, the regression model still likes owning stocks, but the case is much less compelling than it was even a year ago.  Macro Man has found that as long as the forecast Sharpe ratio is above 1, the model generally profits from owning stocks.  The forecast Sharpe is currently 1.5, down from as high as 4 eighteen months ago.  It's now realistic to contemplate the model going flat for the first time in nearly five years.

Of course, models are not the be all and end all, particularly on time frames that they're not designed to capture.   It didn't take Nostradamus to predict that the the liquidity support for US stocks would begin to decline, and it seems likely that the trend will continue for a while longer.   With Spooz still knocking against old highs without breaking through, Macro Man is happy enough to retain his tactical short.   When the time comes to be more strategic, he'd like to think that the model will capture it.