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<<ECONOMETRIC MODEL>>
ECON
Version 2.0
ECONOMETRIC MODEL
DC Econometrics
1001-A East Harmony #349
Fort Collins, CO 80525
Copyright 1994
Table of Contents
Software License
Warranty
1. Introduction
2. Getting Started
2.1 Required Hardware and Software
2.2 Installing Econ
2.3 Running the Program
3. Main Menu
3.1 Data Entry
3.1.1 Add New Data
3.1.2 Edit Data
3.1.3 Adjust File to New Baseline
3.1.4 Make ASCII Data File
3.2 Forecasts
3.2.1 Current Forecast
3.2.2 Historical Forecasts
3.2.3 What If Forecasts
3.3 Graphics
3.3.1 Data vs. Time
3.3.2 Actual vs. Predicted
3.3.3 Predicted and Actual vs. Time
3.3.4 One Variable vs. Another
3.3.5 Past Trading History
3.4 Setups
3.4.1 Asset Allocation Setup
3.4.2 Opening Screen Setup
3.4.3 Famous Sayings
3.4.4 Printer Setup
3.5 Registration
3.6 Quit
3.7 Help
3.8 If Econ won't run (errors)
4. Using the Forecasts
5. The Econometric Models
5.1 Checking the Forecasts
5.2 Details on the Regressions
6. Recommended Reading
7. Placing an Order
Software License
Read this user agreement before using the software. By using the software,
you agree to be bound by the following terms of the license and warranty.
The Econ software recorded on disk is copyrighted software of DC
Econometrics, and all rights are reserved. DC Econometrics authorizes you to
make archival copies of the software for the purpose of backing-up our
software and protecting your investment from loss. You may give away copies
of this shareware program to others and you may make it publicly available on
bulletin board systems. You may not distribute printed copies of this manual
or copies of the output forecasts of the program without written permission
from DC Econometrics.
You agree that the liability of DC Econometrics, its affiliates, agents, and
licensors, if any, arising out of any kind of legal claim (whether in
contract, tort, or otherwise) in any way connected with the software shall
not exceed the amount you paid to DC Econometrics for the software and
documentation.
Warranty
With respect to the physical diskette and physical documentation provided, DC
Econometrics warrants them to be free of defects in materials and
workmanship for a period of 90 days from date of purchase. In the event of
notification within the warranty period, DC Econometrics will replace the
defective diskette or documentation. The remedy for breach of this warranty
shall be limited to replacement and shall not encompass any other damages,
including but not limited to loss of profit, and special, incidental,
consequential, or other similar claims.
DC Econometrics excludes and disclaims any and all other warranties
expressed or implied, including but not limited to implied warranties of
merchantability and fitness for a particular application.
DC Econometrics and its affiliates cannot and do not warrant the accuracy,
completeness, currentness, merchantability, or fitness for a particular
purpose of its software or data. In no event will DC Econometrics, its
affiliates, agents, or licensors be liable to you or anyone else for any
decision made or action taken by you in reliance upon this software or its
output. The entire risk as to its quality and performance is assumed by the
purchaser. The purchaser relies on the software entirely on his own risk.
In no event will DC Econometrics be liable for any loss of profit or any other
commercial damage, including but not limited to special, incidental,
consequential, or other damages. DC Econometrics and its affiliates are not
responsible for any cost of recovering, reprogramming, or reproducing any
program or data, or damages arising out of the use of this product, even if DC
Econometrics has been advised of the possibility of such damages.
This statement shall be construed, interpreted, and governed by the laws of
the state of Colorado.
1. Introduction
This program contains several econometric models to forecast the stock
market, T Bond and T Bill interest rates, gold prices, and inflation. It
forecasts all of them 3 months, 6 months, and 12 months in the future. There
is also an asset allocation routine to calculate suggested portfolios.
Once a month, you enter 9 numbers: S&P 500 index, Prime rate, T Bond and
T Bill rates, gold price, S&P 500 P/E ratio, S&P 500 dividend yield, CPI, and
unemployment rate. These are available from many sources, but I find
Barron's most timely and convenient. The software stores the new numbers
and uses its historical database to calculate predictions that you can use to
invest profitably.
2. Getting Started
2.1 Required Hardware and Software
The program is designed for IBM personal computers and compatibles with
MS-DOS 3.3 or above. It will work with IBM PC, XT, AT, and PS/2
machines. You also need 640K of internal memory and one 5 1/4 inch or
3 1/2 inch disk drive. A mouse, a hard disk and a color monitor are
recommended. If you do not have a hard disk, Econ can be installed and run
on any high density floppy. Econ requires about one megabyte of disk space
to install.
IBM, AT, and XT are registered trademarks of International Business
Machines Corporation. MS-DOS is a registered trademark of Microsoft
Corporation.
2.2 Installing Econ
Boot up in MS-DOS, or open a DOS window from Windows.
Insert the Econ disk in your floppy drive. Your floppy drive is probably
called A: or B:. If it is A:, type:
a:install (If it is B:, type: b:install)
Econ program files will be installed on the C: drive in the directory \econ.
You can press Enter to accept the drive and the directory, or you may type in
your own drive and directory. When you are satisfied with them, answer Yes
to install Econ.
Press Enter to begin installation. The files will be uncompressed and written
to \econ or the directory you have chosen.
2.3 Running the Program
Boot up in MS-DOS, or open a DOS window from Windows.
type: cd \econ (and press Enter) to change to the \econ directory (unless
you installed Econ elsewhere).
type: econ (and press Enter).
The program will load and the opening screen will come up. Hit any key and
the main menu will appear.
If Econ will not run, the most common problem is insufficient memory. You
need 640K total memory and 512K free. If you have 512K total, Econ 2.0
will not run. You can use the chkdsk command from a DOS prompt to see how
much total and free memory you have.
3. Main Menu
Press enter to get past the opening screen, and you will see the main menu at
the top of the screen. Your choices are:
Data Entry Forecasts Graphics Setups Registration Quit Help
You can select an item in 3 ways:
1. Move to one of the choices with your mouse and click the left
mouse button.
2. Hold down the Alt key and press the highlighted letter
(e.g. Alt D for Data entry, or Alt F for Forecasts).
3. Move with the arrow keys and press Enter.
3.1 Data Entry (Alt D)
The choices under Data Entry are:
Add New Data
Edit Data
Adjust File to New Baseline
Make ASCII Data File
As before, you can select your choice with the mouse, the Alt commands, or
the arrow keys. Alt commands are powerful because they take you directly to
an item without sub-menus. You could choose Alt A to add new data directly
from the main menu without first selecting Data Entry. You may want to
memorize two common commands: Alt A to Add Data, and Alt C for Current
Forecast.
3.1.1 Add New Data (Alt A)
Once a month, new data needs to be entered. This data can be obtained from
Barron's or other sources. Use data from the first Friday of each month.
Barron's is available on Mondays with numbers from the previous week, so if
Friday was in the new month, use those numbers. If you cannot get the data
for the first Friday in the month it is OK to use the following week's
numbers. Small changes do not affect the forecasts, but it is best to be
consistent.
To subscribe to Barron's write to: Barron's, 200 Burnett Road, Chicopee,
MA 01021. Or call 1-800-328-6800, Ext 292. DC Econometrics is not
affiliated with Barron's; Barron's is simply one of many sources to obtain
data necessary for the program.
The 9 numbers needed are as follows:
1. S&P 500 Close: This is the closing value of the S&P 500 index, an
average of the 500 stocks. It is not the futures, industrials, utilities, or
financials. It is the close from the first Friday in the month.
2. Prime Rate: This is the Prime interest rate charged by United States
banks. It is hard to make a mistake on this familiar number. It is the
latest available rate as of Friday.
3. 90 Day Treasury Bill Rate: This is the latest week's rate on 13 week T
Bills. It is the Average Discount Rate, not the Coupon Equivalent Yield.
This is a small but important difference. The yield will be higher than the
discount rate.
4. 30 Year Treasury Bond Rate: This is the latest week's rate on 30 year
Treasury bonds. It is reported under "Adjustable Rate Mortgage Base Rates"
in Barron's.
5. S&P 500 Dividend %: This is the dividend yield of the S&P 500 in
percent. It is reported in Barron's under "Indexes' P/Es & Yields".
6. S&P 500 P/E Ratio: This is the Price/Earning ratio of the S&P 500 and is
usually reported near where the dividends are reported.
7. Gold Price: This is the current price in dollars per Troy ounce. It is
reported in Barron's under "Gold & Silver Prices".
8. Consumer Price Index (CPI): CPI is a familiar number used each month
to gauge inflation. Due to reporting delays, it lags the others by two months
so October's entries include the August CPI. This is reported in "Pulse of
Industry and Trade" in Barron's.
9. Percent Unemployment: This is the Unemployment Rate in percent. It,
too, lags the others by two months and is also found in the Pulse of Industry
and Trade in Barron's.
3.1.2 Edit Data (Alt E)
If you make a mistake adding new data, Edit Data will allow you to fix it.
You can change any number in the database, so be careful.
Move around with the mouse if you have one. Move to the bottom of the
screen and hold down the right mouse button. The data will scroll down.
Move to the top of the screen, hold down the right mouse button, and the data
will scroll up. Or you can move with arrow keys, or page up and page down
keys. Control page down takes you to the end of the list, control page up
takes you to the top.
When the month of numbers you want to change is highlighted, select Change
at the bottom of the screen. Or you can double-click the left mouse button on
the row of numbers. Then move to the number you want to fix and type in the
new number. If you are satisfied, select OK, or select Cancel to leave the
file unchanged.
You can print out a list of data by month with the Print command. Select
Print and then enter a number for the start and end month.
Exit will take you back to the main menu.
3.1.3 Adjust File to New Baseline (Alt B)
This routine is rarely used. Prices are subject to large changes over decades
and occasionally the Commerce Department will make a major adjustment.
Consumer prices use 1982 to 1984 for the base year (1982-1984=100). The
base year was once 1967. This adjustment caused CPI values near 300 to
plunge to 100 when prices actually hardly changed. The program could
interpret this as a crash in prices. Therefore, the historical data must be
revised to the new index.
First choose which index to adjust, S&P 500 or Consumer Price Index.
Then enter a number from the old index and the equivalent value from the new
index. The program will adjust all numbers. If one of the new numbers has
already been entered, this routine will adjust it improperly. Use Edit Data
to verify that everything is OK after adjusting the file to the new baseline.
Only CPI and Stock prices will ever need this adjustment since the others are
expressed in percent, except for gold.
3.1.4 Make ASCII Data File (Alt M)
This choice will save the monthly data to an ASCII file. The file created is
named datafile.dat. You can import this ASCII file to Lotus 123 or other
spreadsheets to plot or manipulate the data. This provides easy access to
years of historical monthly data.
3.2 Forecasts (Alt F)
The choices under Forecasts are:
Current Forecast
Historical Forecasts
What If Forecasts
Select your choice with the mouse, the Alt commands, or the arrow keys.
3.2.1 Current Forecast (Alt C)
After entering the new data, choose this option. The predictions will be
displayed on the screen. Scroll up and down to see the entire forecast using
the mouse, the arrow keys, or the page up and page down keys. Send a copy
to the printer with the Print option at the bottom of the screen. Forecasts
include the S&P 500, 30 year T bonds, 90 day T bills, gold, and inflation.
All forecasts are 3 months, 6 months and 1 year in the future.
The program calculates recommended asset allocations . The 3 month, 6
month, and 12 month forecasts are combined to produce an estimated return
for the near term. The calculated yields are displayed on an annualized basis
for easy comparison. The dividend return is added to stocks' return from
appreciation. The asset allocation routine looks at a portfolio containing a
mix of five assets: S&P 500 stocks, 30 year T bonds, 30 year zero coupon
bonds, 90 day T bills, and gold.
The estimated return and annual standard deviation of return for each asset is
displayed.
Four portfolios are calculated and displayed.
1. The Minimum Risk Portfolio is always 100% T Bills. Do not follow it as
your strategy, but use it as a benchmark to compare with the others. If the
Conservative and Aggressive portfolios are not giving you a better return by
at least 2%, you should probably avoid the risk and hold only T Bills, CD's,
or money market funds.
2. The Conservative Portfolio has a low risk. The standard deviation of
actual results from the forecasted return should be 4% or less. Losses are
possible, but should be rare. The 4% standard deviation is not the maximum
possible loss. It is more like the typical error of the forecasts from the
actual results.
3. The Aggressive Portfolio carries a risk of 7.5% standard deviation. It is
the portfolio with maximum expected return at an expected standard deviation
below 7.5%. Losses as well as large gains are both possible.
4. The Maximum Return Portfolio is the best return possible within the
limits set in asset allocation setups. Default limits are 10% gold and 50%
zero coupon bonds (zeros). Other assets are allowed to reach 100%
allocations. Gold and zeros are limited due to their high risk. Feel free,
however, to pick your own limits. The maximum return portfolio will often
take large risks unsuitable for most investors.
If you want to get more aggressive, add more of the highest yielding asset.
There is an "efficient frontier" of portfolios which achieve the best return
possible at a given risk. Usually, higher returns are possible at higher
risks.
The efficient frontier can be thought of as a curved line starting at 100% T
Bills, passing through the Conservative Portfolio, passing through the
Aggressive Portfolio and ending at 100% of the highest yielding asset. You
can get a good approximation of intermediate points with simple averaging of
the above portfolios.
Futures and Options Suggestions are printed only for very aggressive traders.
They are not for novices. Most people should not gamble with futures and
options. They are extremely volatile and you can lose all your money. If you
still want to risk it, start small and plan for occasional disasters. Set
aside a small fund for speculation, and bet one-third of it on a recommended
option. A three month option is reasonable. Econ will recommend stock or
bond futures and options when a large gain or loss is expected; usually there
are no recommended positions. Most sensible people should ignore this
wildman portfolio.
Standard deviation is a term from statistics. It quantifies your risk. It
can be thought of as the average error of past forecasts from 1963 to 1993.
The average error can be calculated more precisely as 0.80 times the standard
deviation. Standard deviation is the root mean square error, or the square
root of the average of the squared errors. If you invest in an asset with a
big standard deviation, you are taking a big risk. It could drop by 3
standard deviations, and no statistician would be surprised, because some
errors are bigger than average.
3.2.2 Historical Forecasts (Alt I)
Choose a year and month from the past and the program will use its database
and models to give you its forecast and asset allocation for that time. This
allows you to check the program's ability to spot past market movements. For
example, look at the great bull markets starting August 1982 or December
1974. Test it against using the August 1987 peak before the October crash.
The historical forecasts are calculated from data available at that time,
using the same models used to make the current forecasts and the same asset
allocation routine. The linear regressions which created the models used data
from 1963 to 1993, so the models will perform well over that time. They
cannot be guaranteed to continue to perform as well in the future.
3.2.3 What If Forecasts (Alt W)
This option allows you to enter data and get forecasts without storing the
numbers. It is useful for checking effects of surprises such as market
crashes, big up days, prime rate increases, or other news which causes
concern. It also allows you to enter imaginary data and play with the
numbers to get a feel for what is bullish or bearish. Use this routine to
enter the most current data to get forecasts weekly if you like.
All 9 numbers described in "Add New Data" must be entered. For reference,
the most recent data is displayed. To re-use last month's number, just hit
Enter while zero is shown for its value
After you enter all the numbers, click OK. Then you will see the numbers
listed. The choices at the bottom of the screen are Add Record, Change, Exit,
Help, and View Forecast.
Add Record allows you to add another month of data.
Change allows you to change a number you just entered.
Exit takes you back to the main menu.
Help gives you help on the What If Forecast.
View Forecast displays the What If Forecast on the screen.
3.3 Graphics (Alt G)
XY plots can be produced. There are 5 choices under Graphics:
1. Data vs. Time
2. Actual vs. Predicted
3. Predicted and Actual vs. Time
4. One Variable vs. Another
5. Past Trading History
Choose one with the left mouse button, or arrow keys and Enter, or the Alt
commands.
3.3.1 Data vs. Time (Alt 1)
Any of the 9 monthly data files by date can be plotted. The last 5 years are
shown. Select one to plot, then select Plot to see the graph. To print the
graph, use the Print Screen key on your keyboard.
3.3.2 Actual vs. Predicted (Alt 2)
Select a type of forecast (3, 6, or 12 months ahead) and a variable (for
example T Bond rates). Then select Plot. This plots the last 5 years of
predicted changes versus actual changes. A correlation coefficient is
calculated and displayed.
The changes are plotted in percent. A +10% change in the S&P 500 could be
from 400 to 440. A -10% change in T Bill rates could be from 5.0% to 4.5%
yield, for example. This allows you to see how accurate the forecasts from
Econ have been during the last 5 years.
The correlation coefficient shown at the top of the graph is the correlation
for the past 5 years of data. It may differ from the correlation
coefficients listed in this manual. The correlations listed in the manual
are for 30 years of data 1963 to 1993, not the past 5 years of data shown on
the plots.
3.3.3 Predicted and Actual vs. Time (Alt 3)
Select the forecast time period (3, 6, or 12 months ahead) and the variable to
graph (for example S&P 500). Then select Plot to display the graph. The last
5 years are plotted by date.
3.3.4 One Variable vs. Another (Alt 4)
Select a variable for the X-axis (horizontal). Select a variable for the
Y-axis (vertical). Select Plot to display the graph. Each point on the
graph is a pair of numbers from a past month over the last 5 years.
3.3.5 Past Trading History (Alt 5)
Past trading history is displayed as a table of numbers, not a graph. Past
forecasts are used to choose one asset every 6 months. Only the asset
forecasted to do the best is held. The actual return is then computed. These
returns are used to show the value of a hypothetical portfolio which invested
in Econ's best recommended asset and traded once every 6 months, in January
and July.
Putting all your eggs in one basket like this is a risky strategy, but it
produces big returns when the forecasts work out. Trading costs and taxes
are not subtracted in this simulation. Trading more frequently than every
6 months does not increase your return much because the forecasts tend to
have a 6 month time horizon.
The results from January 1971 to January 1994 are impressive. $100 grew to
$206,385. This is a compound annual return of 39.4% per year. The volatile
assets, gold and zero coupon bonds, are used heavily. There are losses in 7
of 46 six-month periods. If you implement a bet-the-farm strategy like this
one, you can expect losses too.
If you run Past Trading History in January or July, you may see a small
return for the current month at the end of the list. Of course that gain
has not happened yet. It is the return projected if nothing changes for
6 months. It is the bond coupon, or the stock dividend yield.
To implement the trading strategy used here, go into Setups and raise the
asset allocation limits to 100% for all assets. Then follow the maximum
return portfolio.
3.4 Setups (Alt S)
There are 4 choices:
Asset Allocation Setup
Opening Screen Setup
Famous Sayings
Printer Setup
Choose one with the left mouse button, or arrow keys and Enter, or the Alt
commands.
3.4.1 Asset Allocation Setup (Alt L)
This lets you to set the maximum percentage allocations allowed for various
assets in your portfolios. Whatever is entered will be used as limits to
determine your asset allocations. To restore the program's default values,
select Restore Default Values.
Gold and zero coupon bonds are risky. They fluctuate in price more than the
S&P 500, T Bonds, or T Bills. Because of the risk, the default limits are
set at 10% maximum for gold, and 50% maximum for zero coupon bonds. The
other assets are allowed to reach 100% allocations.
3.4.2 Opening Screen Setup (Alt O)
Select Yes or No to turn the opening screen on or off. Experienced users
often turn this screen off to save a keystroke every time the program is run.
3.4.3 Famous Sayings (Alt Y)
Scroll up and down to select a saying using the right mouse button, the arrow
keys, or page up and page down keys. Select Change to edit a saying.
Deletion is not allowed, but you can change one you do not like to one you do.
Select Insert to add a saying of your own. Select Print to print the entire
list of famous sayings. Exit or the Escape key returns you to the main menu.
3.4.4 Printer Setup (Alt P)
A list of printer devices is displayed. Econ uses LPT1, the most common
printer device, as the default. You may choose another LPT, or COM device,
or send output to a file.
3.5 Registration (Alt R)
Please register your copy of Econ. Select Registration from the main menu
and fill in the blanks from your keyboard. Print the form and mail it to us.
As a registered user of Econ, you will receive:
1. A printed manual describing Econ and all of its features.
2. The latest version of software.
3. Current data files containing the latest month's entries.
4. Information about new versions as they become available.
Registered users can order a new disk with all current data anytime for
$10.00. This is handy if you forget to enter data for a few months, or if
your hard disk should crash. Please specify 3.5 or 5.25 inch disk and high
or low density disk. If you do not specify, we will send 3.5 inch low
density.
Econ is shareware, not freeware. It is distributed via bulletin boards,
catalogs, and rack vendors. It is made available to you on a try-before-you-
buy basis. The author receives no money until you register. Catalogs and
rack vendors do not pay royalties. If you are using the program regularly,
you are expected to register it.
If you ordered this program directly from DC Econometrics, you are already
registered.
3.6 Quit (Alt Q, Enter)
You can choose to quit by selecting Quit on the main menu with your left
mouse button, with arrow keys and Enter, or with Alt Q. It will ask "OK to
Quit? Alt+K". Press Enter or click on the question with your mouse to exit
the program. Alt K will also exit you out of the program.
3.7 Help (Alt H or F1)
Help provides information to assist you with the program. To get into Help,
press F1, Alt H, or click on a Help box with your left mouse button. The
help in Econ is context-sensitive. The help screen displayed will contain
information about the section of the program you are currently in. Use help
anywhere in the program to obtain additional information. You can press F1
from any screen to see help on that part of Econ.
You may scroll up and down the help text with arrow keys, right mouse button,
or page up and page down keys. To see help on other topics, select the
Sections box at the bottom of the screen. Move to the chapter you need and
press Enter or click the left mouse button.
An Exit box is displayed on the bottom portion of some screens. You may
click on this button with the mouse, hit the Escape key, or Alt X, to exit
those screens. If you are in Help, you need to Exit before you can select
anything else on the menu.
To print the entire help file, quit to DOS and type: copy helpfile.txt prn
There is also a manual stored as econ.txt. You can print it from DOS by
typing: copy econ.txt prn
3.8 IF ECON WON'T RUN (ERRORS)
You need 640K memory and DOS 3.3 or above. You can find out how much
memory you have by typing chkdsk at a DOS prompt. It will tell you how
much memory you have and how many bytes are free. You need 640K (655360)
total memory and at least 512K (524288) free.
Note to Windows PIF users:
If you set Econ up in Windows using the PIF editor, be sure use full
screen, not windowed. Set it up using File, New, New Program Object
from the Windows menu and this will not be a problem.
If you get Error 4: Too many files open:
Edit your config.sys file in your root directory.
cd \
edit config.sys
Find the line that says "FILES=10" or files=anything.
Change it to "FILES=30"
4. Using the Forecasts
Many profitable strategies exist. One should be chosen that fits your
available capital and tolerance for risk. The less capital you have, the more
commissions will consume. Frequent trading can be very expensive. This
program tries to find the large moves which continue for months or years. It
is recommended that you do not make every change called for monthly in the
asset allocation section due to the commissions charged.
Remember, these forecasts are not perfect. Like weather forecasts, they are
subject to error. Expected standard deviations provide an idea of the
potential error rate. These are the standard deviations observed from 1963
to 1993. Standard deviation is a term from statistics describing a bell
curve distribution. 68% of the time, the actual return will be within a
range of plus or minus one standard deviation from the predicted return.
95% of the time, it will be within 2 standard deviations. Occasionally,
there will be larger errors. The stock market has larger tails than a normal
bell curve and there is reason to believe the standard deviation is not
stable.
Think of the standard deviation as the average difference of actual results
versus forecasted results. It is not your maximum possible loss. Some people
familiar with statistics tend to think of 3 standard deviations as the maximum
possible loss, but even this is too small. On October 19, 1987, the S&P 500
dropped 20.5% in one day. That was over 20 times its daily standard
deviation. Big moves like this are rare, but they are possible. We hope Econ
will keep you on the right side of such moves, but there are no guarantees.
No-load mutual funds that allow telephone switching are ideal for avoiding
brokerage fees. Money market funds are similar to T bills but do not have a
$10,000 minimums or commissions.
You may want to simply hold the top 2 assets in the conservative portfolio,
50% of each. Or split your money between the 2 assets with the highest
weights in the aggressive portfolio. This reduces trading and saves you
commissions.
If you are very risk-averse, just buy CD's from a bank, or invest in money
market funds, US savings bonds, or 90 day T Bills. You do not need this
program. Econ is for people who are willing to accept some risk in order to
achieve higher average returns than is possible with CD's. Because of the
risk, you will experience occasional losses.
The minimum risk portfolio: In Econ 1.0, the conservative portfolio was
always 98% T Bills. It was the portfolio with minimum possible risk. It was
too boring to be of any real value. Let's just forget about the 1% stock and
1% bond portion, round it off to 100% T Bills, and consider that as the
portfolio of minimum possible risk. It is one endpoint of the efficient
frontier; the best return you can get at its risk.
The current conservative portfolio has a 4% standard deviation or less. This
is suitable for retired people, or those who will need the money soon, perhaps
for a college education. To get less risk than the conservative portfolio,
just add more T Bills, CD's, or money market funds.
The aggressive portfolio is my favorite. It has a 7.5% standard deviation or
less. You get some diversity and some action from the stock and bond
markets. If history is a useful guide, you will be on the right side of major
moves. Although its name is aggressive, there are strategies which are far
more aggressive (and more dangerous).
The maximum return portfolio aims only for yield, not caring about risk. It
is limited only by the maximum percentage allocations which are set in asset
allocation setups. The default limits are 10% gold, 50% zero coupon bonds,
100% S&P 500, 100% T Bonds, and 100% T Bills.
To get really aggressive, hold 100% of the asset predicted to do best at the
beginning of the asset allocation printout. The program gives its expected
returns on stocks, bonds, zero coupon bonds, gold, and T bills. Note that
stock returns include dividends, and all returns average the annualized yields
forecast for 3, 6, and 12 month periods. The aggressive portfolio is not as
aggressive as this strategy and you can expect to get burned occasionally.
If stocks are predicted to do quite well, you can buy them on margin and
nearly double your return in a bull market. But you more than double your
risk. A 50% market drop will wipe you out. The risk from stocks is doubled
and you have added the risk due to fluctuations in the interest rate on your
margin borrowing. Due to interest costs, your return does not double. This
strategy and all the ones described previously lie on the efficient frontier.
The efficient frontier is the imaginary line connecting portfolios with
minimum risk for their expected return. The line starts at 100% T Bills,
passes through the Conservative portfolio, passes through the Aggressive
portfolio, and continues to 100% of the highest yield asset. If the return on
the highest yield asset is greater than the margin interest rate, the
efficient frontier extends to a fully margined account containing the highest
yield asset. Minimum risk for their expected return does not imply that they
are all safe or that you should take such risks. A fully margined stock
market account would have been wiped out several times over the past century.
Expected returns and actual returns will differ.
Futures and Options Suggestions: Very aggressive traders who want to
speculate can use the options and futures markets. Econ will suggest buying
futures and options when a large move is expected in T bonds or the S&P 500.
Usually, there are no recommended positions. It is easy to lose all your
money if you are wrong, so treat this like gambling and bet only what you can
afford to lose. It is speculation, not investing. Please remember that these
suggestions are only for very aggressive traders. Options are safer than
futures because you can only lose what you pay for the option.
For the totally crazy gamblers, there are the futures markets. 90% of the
players lose money here, so I do not recommend it. You can lose more than
your original investment and limit moves mean you can be stuck in a losing
position. The advantage is that you get the gain or loss on a large block of
stock represented by the S&P 500 index for a reasonable commission. It is a
game for experts only, armed with more knowledge than this program
provides. Large sums of disposable income and capital are required. T bills
and T bonds also have futures markets.
If you are playing the futures, this program is useful to help you find the
major trends. The trend is your friend. More money is made in the direction
of the trend than on the reactions against it. You can be bailed out of
losing trades when the trend re-asserts itself. Bull markets can be bought
on 5% dips but not bear markets. If you have short term indicators, use them
too, but only play in the direction of the longer term move.
Diversify your holdings. Do not bet everything you have on the output of
this Econ program. Consider some alternative investments. Here are some
ideas:
1. Pay off debt, especially credit card debt, but also automobile and
mortgage debt. Your return will be the interest rate on the loan.
2. Put 60% of an investment account in an S&P 500 index fund, and 40% of
the account in a long term bond index fund. Rebalance to 60/40 once a year.
Past returns for this strategy are about 11% per year. This method is used by
a number of pension funds.
3. Buy the ten highest dividend yield stocks of the thirty Dow Jones
Industrial stocks. These stocks are often out of favor and undervalued.
Past returns for this strategy are 18% per year. Replace stocks once a year.
(See the book Beating the Dow by Michael O'Higgins with John Downes.)
A Warning on Gold: Gold is volatile. If you think the S&P 500 is a roller
coaster ride, gold is more like a train wreck. The annual standard deviation
of the S&P 500 is 14.6% per year. The annual standard deviation of gold is
30.0% per year! The standard deviations from the forecasts are 7.5% per year
for the S&P 500, versus 18.6% per year for gold. The models fit the S&P 500
better than they fit gold.
Add in the dividend yield on the S&P 500, and gold looks even worse. If you
want to play gold, I suggest gold mining stocks. At least they have earnings.
Combining capital, labor, and natural resources seems like a better way to
create wealth than locking metal in a vault. Gold stocks will be volatile too,
since small changes in gold price can mean big changes in earnings.
Central banks in industrial countries hold an average of 40% of their foreign
reserves in gold, 35,000 tons, equal to 17 years of mine output. In
Switzerland, at a bond interest rate of 5.5%, and a gold price of $330 per
ounce, the cost of holding this gold amounts to $550 per year for every
taxpayer. In 1992, Holland's central bank sold 400 tons of gold, a quarter of
its stock. Central bankers could earn $20 billion per year by switching their
gold to government bonds. See The Economist, January 23, 1993, page 17.
Gold can be moved by a single investor, as the Hunt brothers demonstrated in
the early 1980's, and George Soros proved again in 1993. The value of
outstanding contracts in the gold futures market was $4 billion in 1993.
Exxon's market value was $81 billion, twice the value of all gold mining
stocks.
The advance of technology will hurt gold prices in two ways. As earthmoving
gets cheaper, and extraction gets more efficient, mine output should rise.
The volume produced grew 60% from 1981 to 1991, to 2,157 tons. Also, as
substitutes are found for industrial users, demand will fall.
I admit to a personal bias against gold. Due to its volatility and lack of a
dividend, I consider it a speculation, not an investment. The default limit
is 10% of any portfolio in asset allocation. If you are a gold bug, change
the asset allocation setup to a higher limit.
Zero Coupon Bonds are also volatile. For every 1% decline in interest rates,
30 year zeros will rise 33.5% in value. Conversely. when interest rates rise
1%, 30 year zeros will decline 25.0% in value. It does not matter whether the
drop in rates is from 14% to 13% or from 6% to 5%, the 30 year zero will
move up 33.5% in either case.
30 year Treasury bonds are less volatile. Their price changes do depend on
interest rates. If rates fall from 6% to 5%, the 30 year T bond will rise
15.4%. If rates fall from 10% to 9%, the 30 year T bond will rise 10.3%. So
30 year zeros are usually more than twice as volatile as 30 year T bonds.
If you wish to use zeros but get the same risk as 30 year T bonds, consider
buying zeros with 10 to 15 year maturities. A 15 year zero will move about
15% for every 1% change in interest rates. A 10 year zero will move about
10% for every 1% change in rates. Bond prices and interest rates move in
opposite directions.
5. The Econometric Models
The econometric models used in this program are based on multivariate linear
regressions. The variables used were chosen from hundreds of others because
they performed the best.
In 1987, I used two advisors' models to forecast the stock market. Neither
one predicted the crash that happened in October. Fortunately, I had sold
most of my stock that summer because I was afraid of the rising interest
rates and high P/E ratios. Still, I couldn't believe how many advisors and
other models missed this major move. The crash of 1987 led to the
development of Econ in 1989. In 1993, I added models for gold, improved all
the models with better regressions, added graphics, and pull-down menus.
Gold and zero coupon bonds were added to asset allocation.
One problem with mathematical models is that they become obsolete. Stock
Index futures make it possible to short stock and be neutral or long in the
market. They also give institutions more reason to hold cash. Therefore
short interest and mutual fund cash, 2 good indicators, have changed in
meaning. The options market is larger now by far than it was 10 years ago.
Odd lot traders now use options. Models constructed ten years ago often did
not plan for such changes.
To avoid these pitfalls, I chose the simplest, most elementary variables I
could find. They also produce good correlations, which should not be
surprising, since they are basic measures of value.
Interest rates tell about the attractiveness of alternatives to the stock
market. They also tell whether the economy is booming or busting. Interest
Rates are a measure of the supply and demand of money. When rates are high
and rising, stocks will be falling. If I could have only one indicator, it
would be short-term interest rates.
Consider market history 1948 to 1987. When T bill rates fell December to
December, the return on the S&P 500 averaged 23.4% in the following year.
When T bill rates rose, returns averaged 6.7%. T bill rates were rising going
into the crash of 1987.
The yield curve compares short term rates to long term rates. When short
rates are higher, the yield curve is said to be inverted. This is not normal
and usually precedes recessions. Stocks usually fall during these times. In
his book Stock Market Logic, Norman Fosback reports the impact of the yield
curve. Normal yield curves were followed by an average 11.5% per year gain
on the S&P 500 in the years 1941 to 1975. Inverted yield curves were
followed by an average 0.7% loss.
Consumer prices are a measure of inflation. When inflation is low, interest
rates stay low, and the stock market rises. High or rising inflation can be
curbed by raising interest rates to choke off demand. This also strangles the
stock market. High inflation offers people an alternative to the stock
market. It is better to spend the money on goods before prices rise, or
invest in real estate.
Unemployment also exerts political pressure on the Fed. They are hesitant to
raise interest rates during high unemployment. The economy needs
stimulation, not restraint. A good time to buy stocks is when unemployment is
rising in a recession.
Dividend yields are an excellent long term forecaster. They set record lows
before the October 1987 crash. They were low in 1929 and also in 1973
before bear markets. Low dividends predicted the sharp 1962 drop. High
dividends predicted the 1982 bull market, the 1975 bull market, and the long
advance of the 1950s.
In the years 1948 to 1987, dividend yields above 4% on the S&P 500 led to an
average 20.0% return on the S&P 500 the following year. Dividend yields
below 4% were followed by an average 5.1% return.
Price/Earning (P/E) ratios are another good measure of value. It is always
safe to buy the S&P 500 at low P/Es. The long term average is about 14, so a
P/E of 8 for the S&P 500 is cheap. Recessions can depress earnings, so it is
safe to buy at higher P/Es then because good times will return and carry
earnings higher.
I believe these variables are so important that change in our markets or
economy will not change the effects of the variables much. But if you have
reason to suspect these variables, do not follow this model blindly.
5.1 Checking the Forecasts
The following is an easy way to check the model's forecasts for the S&P 500.
Using just two variables, T bill rates and dividend yields, you can forecast
the market in your head. We have seen the high returns on the S&P 500 with
falling T bill rates, and with dividend yields above 4%. Combining these 2
variables is even better. With both variables bullish, the average return on
the S&P 500 is 30.8% per year. With only one of them bullish, the return is
9.7% per year. With both in bearish territory (rising T bill rates on a 12
month basis, and dividend yield on the S&P 500 less than 4%), the average
return on the S&P 500 is only 3.7% per year.
Of course the models in the program are much more complex, and should be
more accurate. The above example demonstrates the power of a two-variable
model. The average return was calculated using data from 1948 to 1987.
The business cycle provides an independent check on the forecasts. For
details, see Bowker's book Strategic Market Timing. Events may occur
somewhat out of order, but you will get an idea of where the economy is
heading. The sequence of events is:
1. Stock market bottom
2. Leading indicator bottom
3. Coincident indicator bottom
4. Unemployment peak
5. Official announcement of expansion
6. Gold price bottom
7. Lagging indicator bottom
8. Inflation rate bottom
9. T bill interest rate bottom
10. T bond interest rate bottom
11. Stock market peak
12. Leading indicator peak
13. Unemployment bottom
14. Coincident indicator peak
15. Official announcement of recession
16. Gold price peak
17. Lagging indicator peak
18. Inflation rate peak
19. T bill interest rate peak
20. T bond interest rate peak
21. Back to stock market bottom
To obtain graphs of these indicators, subscribe to the Survey of Current
Business. Call 202-783-3238, FAX 202-512-2250, or write Superintendent of
Documents, P.O. Box 371954, Pittsburg, PA 15250-7954. The subscription
cost is currently $43.00 per year.
5.2 Details on the Regressions
Stepwise multivariate linear regression was used on 30 years of data spanning
1963 to 1993. In stepwise regression, the best variable is found and its
effect is subtracted out. The multivariable model is corrected for
correlations of the new variable to the existing variables. All variables
are then examined again for correlations to the residuals. Econ 1.0 used
stagewise regression, which did not adjust the models for the small
correlations of new variables to those already in the model. The superiority
of stepwise regression over stagewise regression means the new models are
better in Econ 2.0. Also, the new models were regressed to 30 years of data
versus 25 years used in Econ 1.0.
To enter the model, a variable must show 99% confidence that its correlation
is not due to random variations. An F test was used for this. The process
continues until no more variables can pass the F test.
Many predictor variables can be constructed from the database. The prime rate
can be compared to moving averages from 3 months to 4 years in length.
Dividend yields can be compared to T bill yields. The yield curve can be
computed as T bill/T bond rates. The rates of change of each of the 9 numbers
were computed over 1 month to 2 year time spans. 176 such predictor
variables were examined for each model. Only the most effective variables are
used in this program.
Correlation coefficients are a measure of a model's fit to the data. They
range from -1.0 (perfect negative correlation) to 0.0 (no correlation) to 1.0
(perfect correlation). Here is a list of the model's correlation
coefficients:
S&P 500 (3 months ahead) R = .52
S&P 500 (6 months ahead) R = .69
S&P 500 (1 year ahead) R = .90
T Bonds (3 months ahead) R = .46
T Bonds (6 months ahead) R = .54
T Bonds (1 year ahead) R = .78
T Bills (3 months ahead) R = .64
T Bills (6 months ahead) R = .70
T Bills (1 year ahead) R = .74
Inflation (3 months ahead) R = .39
Inflation (6 months ahead) R = .55
Inflation (1 year ahead) R = .69
Gold (3 months ahead) R = .50
Gold (6 months ahead) R = .68
Gold. (1 year ahead) R = .76
R values are not the only measure of a model's effectiveness. There are
several ways to get a high R value. One way is to include many variables
which have a low confidence. My 99% standard is more rigorous than many
others. Another way is to regress to something easy. I am regressing to the
changes in my predicted variables, not to their levels. Over a 25 year
period, the previous day's level of S&P 500 correlates with R > .99 to the
next day's level, but tells you nothing about which way the market will go.
The money is made on the changes, not on the day's closing value.
6. Recommended Reading
The Encyclopedia of Technical Market Indicators
Robert W. Colby and Thomas A. Meyers
Dow Jones-Irwin, 1988
A comprehensive collection of graphs and computer research
on over 110 indicators.
Stock Market Logic
Norman G. Fosback
The Institute for Econometric Research, 1976, 1984
This book is a thorough discussion of virtually every stock
market indicator in use. Norman Fosback's scholarly
approach to stock market forecasting is without equal among
advisory services.
Winning on Wall Street
Martin Zweig
Warner Books, Inc., 1986
Marty Zweig's emphasis on interest rates and tape action first
influenced me in 1982. He talks about the market in
scientific terms I can relate to as an engineer. His record
proves he is right.
Tight Money Timing
Wilfred R. George
Praeger Publishers, 1982
This book shows the effect of interest rates on the stock
market from 1914 to 1981. When interest rates go down, the
stock market will go up.
Asset Allocation
Robert D. Arnott and Frank J. Fabozzi
Probus Publishing Co., 1988
Everything you ever wanted to know about asset allocation
and then some. It has a complete discussion of theory and
application. Many contributing authors present their views.
A Consensus Approach to the Determination of Not-So-Good Years to Own
Common Stock
Edward Renshaw
Financial Analysts Journal/January-February 1989
This article shows how to forecast the S&P 500 using T bill
rates and dividend yields. This easy method is similar to the
simple model mentioned earlier, and will usually agree with
the complex models in the software.
Strategic Market Timing
Robert M. Bowker
New York Institute of Finance, 1989
Use predictable turning points in the business cycle to
forecast the direction of interest rates, stock prices, and other
economic indicators. This method provides an independent
check on Econ's forecasts.
The Practical Forecaster's Almanac
Edward Renshaw
Richard D. Irwin, Inc., 1992
137 reliable indicators for investors, hedgers, and
speculators. Forecast the stock market, GNP, inflation,
interest rates, and recessions. Use indicators published by
the Department of Commerce. This is a very thorough, well-
researched book.
Plan Z
Morry Markovitz
The Philip Lief Group, Inc., 1993
The new strategy for safe and lucrative investing in the
money markets. When interest rates are high, buy long
maturity zero coupon bonds. When interest rates are low,
sell them and invest in money market funds. It is a long-
term strategy which is guaranteed to eventually make money.
Returns averaging 24% per year are possible. However,
there is a lot of volatility year to year.
How to Forecast Interest Rates
Martin Pring
Interest rates are a lagging indicator. They go up after the
economy goes up.
7. Placing an Order
Current Data Files Anytime for Registered Users:
Registered users may obtain a disk with current data files for $10.00. This
is handy if your disk is destroyed, or if you forget to enter data for a while
but want to use the program. Specify 5 1/4" or 3 1/2" disk and high or low
density. If you do not specify disk size, we will send 3.5 inch.
To register Econ 2.0 and obtain current data files and manual:
Order by mail. Payment may be made by credit card, check, or money order.
Use the order form below. Shipping is free. You will receive a disk with
current software and data files, and a printed manual. Use the form below
or select Registration from the Main Menu of the program.
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