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Zempel Strategic Stock Market Newsletter: January 2017

Zempel Strategic Stock Market Model Newsletter
Getting Wealth Built : Keeping Wealth Safe

January 2017

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Model Signal Unchanged
Bullish


Zempel Strategic Stock Market Model

Overview: Current Model Reading

The Zempel Strategic Stock Market Model remained bullish in December 2016. Corrections can never be ruled out but the stock market is more likely to rise in the months ahead. The model’s rules still indicate that investors should keep their portfolio allocations to common stocks to their asset allocation policy’s maximum levels. The reasons for this relative optimism continue to be that the model’s valuation index component remains below the “irrationally exuberant” level and that no “Zempel Caution Zone” – the zone that precedes recession – has started.

The model has three components – two are fundamental in nature and one is technical. The first component (valuation index – see above) uses simple but proprietary calculations to determine how attractive the stock market is relative to corporate bonds. Valuation approached but did not reach the “irrationally exuberant” level in December 2015. Valuation then retreated sharply and this component remained bullish in December 2016.

The second component measures changes in interest rates like the 10-year T-Note yield, the federal funds rate and others. This component turned bearish in May 2015 and then back to bullish in October 2015. This component turned bearish in August 2016 and remained bearish last month.

The model’s third component – a simple but proprietary momentum or “technical” indicator – turned bullish in April 2016 and remained bullish in December 2016.

With two components bullish, the model remained bullish overall when 2016 ended.

As noted and charted above, the valuation index still stands well below the “irrationally exuberant” level (2.25). At the same time, the yield spread remains quite positive and no “Zempel Caution Zone” has been signaled (see page 12).

Since neither “irrational exuberance” nor a “Zempel Caution Zone” is present, the probability that any stock market weakness that occurs now will turn out to be a “correction” and not a bear market remains very high.

-Clare W. Zempel, CFA, CBE December 31, 2016

P.S. To update the model’s performance, over the 51 years from December 1965 to December 2016, the model earned a 16.1% compound annual total return. For comparison, the compound annual total return for the S&P 500 Common Stock Index over the same period was 9.7%. Excluding dividends, the compound annual return for the S&P 500 Common Stock Index was 6.5%. The compound annual total return on a one-month T-Bill was 5.0%.

P.P.S. Future updates and newsletters will be published when changes so warrant.


Zempel Strategic Stock Market Model
Brief Historical Record and Background (1965 - 2016)

The Zempel Strategic Stock Market Model aims to determine when it is most desirableto be invested in common stocks and when it is not. Over the 50 years from December 1965 to December 2016, the model earned a 16.1% compound annual total return. For comparison, the compound annual total return for the S&P 500 Common Stock Index over the same period was 9.7%. Excluding dividends and dividend reinvestments, the compound annual return for the S&P 500 Common Stock Index was 6.5%. The compound annual total return on a one-month T-Bill was 5.0%.

The Zempel Strategic Stock Market Model’s 16.1% compound annual total return from December 1965 to December 2016 was 6.3% more than the 9.7% compound annual total return or “buy and hold” result for the S&P 500 Index. The model achieved this by being all invested in stocks during most periods when the stock market was rising, and by being all invested in T-Bills in most periods when the stock market was declining.

The Zempel Strategic Stock Market Model is objective. The numbers used in it are facts that are not subject to major revisions. No earnings estimates or any other estimates or forecasts are needed. The calculations involve just basic arithmetic and statistics. The rules used to interpret the calculations are simple and well tested.

The model was developed to eliminate the need to forecast or interpret economic, financial and political variables, because that cannot be done well consistently.

The model was also developed to counter the influence that opinions and emotions can have on investment decisions. Opinions and emotions are built into the stock prices and interest rates used in the model. The model puts those subjective views into perspective and identifies unsustainable extremes in time to take profitable actions.

The model also eliminates the need to react to most if not all economic-political shocks. Shocks that occur when the model is bearish require no defensive reaction because the portfolio has already shifted from stocks to T-Bills. Shocks that occur when the market is not overvalued and the model is bullish produce corrections that tend to be mild and short-lived.

The model is not perfect but it has outperformed the market substantially and with less risk since 1965. And it did so without the need to predict economic trends or forecast political shifts or watch CNBC.


Zempel Strategic Stock Market Model
Valuation Index Component

The model has three components. This one uses simple but proprietary calculations to determine how attractive the stock market is relative to corporate bonds. The calculations compare the interest yield on the BAA corporate bond or equivalent to the trailing operating earnings yield on the S&P 500 Common Stock Index. The result is the S&P 500 Valuation Index which has varied from -2.5 (stocks extremely undervalued) to +4.0 (extremely overvalued) (see chart above). Bear markets have tended to occur after the valuation index has been above 2.25 for some time.

The model’s valuation component was near but not above 2.25 in December 2015. It then fell sharply and was below the troublesome levels last month. This plus the fact that the yield spread remains positive -- and no “Zempel Caution Zone” has been indicated -- implies that a bear market has been and remains unlikely.


Zempel Strategic Stock Market Model
Interest Rate Component

The second component in the model measures changes in interest rates, such as the 10-year T-Note yield and the 3-month T-Bill yield (both charted above), and others.

Based upon extensive testing, the change that matters for future stock market price movements varies from interest rate to interest rate. Those specific changes and the weights used to combine them into a composite stock market indicator are proprietary. In broad terms, however, falling interest rates are bullish and rising rates are bearish for common stock prices.

The model’s interest-rate component has been bearish since August 2016.


Zempel Strategic Stock Market Model
Momentum Component

The third component in the Zempel Strategic Stock Market Model is momentum. The stock market tends to rise (fall) when the valuation index is low (high). It also tends to rise (fall) when interest rates are falling (rising) sharply. The problem is that the stock market has sometimes been slow to react to extremes in valuation and to interest rate changes. Adding a momentum measure to the model is the practical solution to help investors capture more increases in stock prices on the upside and avoid more declines in prices on the downside. Momentum has been bullish since April 2016.

The model uses proprietary weights to combine its three components into one signal and proprietary rules to interpret that signal for investment decisions. The model remained bullish last month. Investors should favor common stocks over “cash” now. Allocations to stocks should be kept at maximum portfolio policy limits.


Longer-Term Perspective

The Zempel Strategic Stock Market Model is not a short-term trading tool. It changed its signal just 51 times over the 51 years from 1965 to 2016. Its aim is to help build and protect wealth over time but its practical (tactical) focus is on the next 1-12 months. The model is bullish and that implies that investors should maximize portfolio allocations to common stocks now. Another reason for optimism about longer-run prospects is that the stock market has not become overvalued in the extreme from an extended historical perspective. The special valuation index charted above reflects how the stock market has been valued relative to interest rates and to cyclically- adjusted (10-year trailing average) earnings since 1924. Based on the patterns in this chart, the stock market was overvalued (undervalued) and headed for a major fall (rise) whenever the valuation index was above +2 (below -2). Based on the chart, the market in early 2009 was more undervalued than ever before – hard evidence that it then discounted the worst. The chart shows that the valuation index fell below -2 just six other times in the past (1932, 1942, 1949, 1974, 1993 and 2002). In all six cases, the stock market then rose sharply. That the market remains “relatively cheap” now implies that worst-case risks and uncertainties are still priced into it. That was the reason that we advised investors with truly extended time horizons (24-60 months) to maximize allocations to common stocks in spring 2009. That advice still holds now.


The Economy

The consensus has fretted ever since the recession ended in 2009 that the economy and stock market were very vulnerable. The Greek debt crisis rekindled fears in summer 2010. Middle Eastern political upheaval, supply disruptions related to Japan’s earthquake, and broader European debt problems raised fears in 2011. European debt concerns returned in 2012 and did cause a mild correction. Fears about federal spending and deficits were constant in 2013. Falling oil prices, European debt problems and fears about China’s economy revived anxieties in 2015. “BREXIT” spurred a deep but brief correction in 2016. The view here was and remains that economic conditions and corporate profits will do better than expected. The positive yield spread (charted above) supports the idea that this will hold true on balance until 2019 ends. Jobless claims (charted below) have never risen to recession levels when the yield spread was as positively sloped as it is now. Problems, threats, risks and uncertainties abound but the stock market still discounts them all. Cautiousness if not pessimism remains overdone and that creates buying opportunities for long-term stock investors. Resist the temptation to join in any headline-driven panics that occur.


Investment Implications

The Zempel Strategic Stock Market Model is imperfect but it has outperformed the market – with less risk, without the need to make economic or political forecasts, and without the need to watch CNBC – since 1965. The model is bullish and investors should remain fully invested in common stocks now.

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Disclaimer

This report was prepared by Clare W. Zempel and reflects his current opinion. It is based upon sources and data believed to be accurate and reliable. This information contains forward- looking statements about various economic and investment trends and strategies. Such forward-looking statements are subject to significant uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time. This information does not constitute a solicitation or an offer to buy or sell any security.


Zempel Strategic Stock Market Model Newsletter Supplement
The Next Recession and the Next Bear Market

This chart reviews and updates “Zempel Zones” – a new proprietary method for anticipating economic slowdowns, recessions and bear markets. In essence, a sharp rise in interest rates initiates a “Zempel Alert Zone” in which an economic slowdown will occur. “Alert Zones” often precede “Zempel Caution Zones.” “Zempel Caution Zones” start when the yield spread inverts and always precede recessions. Interest rates have risen some but the yield spread has widened and is far from inverted. Neither zone has been triggered, so neither major slowdown nor recession threatens. If the yield spread follows the same path that it did in 2004-07 (see page 10), then it will not become inverted until January 2018. If the economy follows the same path that it did in 2004-09, the next recession will not start until December 2019. The stock market has never peaked and fallen in bear-market fashion until after interest rates rose sharply (“Alert Zone”) or the yield spread became inverted (“Caution Zone”), and the Zempel Strategic Stock Model turned bearish. Neither a recession nor a bear market threatens now. The Zempel Strategic Stock Market Model and the Zempel Zones should warn us in time to take protective actions whenever they do.

-Clare Zempel, December 31, 2016

Clare Zempel