Each month, our Barometer Capital Report publishes the current readings for both our Stock and Bond Barometers, with a clear statement as to whether the prospects are favorable or unfavorable for these asset classes under current economic and market conditions. Based on these readings and our dynamic portfolio management system, we also publish a recommended asset allocation for an investor’s core portfolio.

Investors wishing to have their own portfolio track our Model Portfolio should make the appropriate adjustments prior to the end of the month. All performance statistics published in our newsletter assume that such transactions are made on the last day of the month at closing prices.

Because our recommended allocations can range anywhere from 100% stocks to 100% bonds, some investors may find this range of outcomes to be too aggressive for their particular requirements or risk tolerance. For example, a more conservative investor may not want the allocation to bonds to drop below 20% or the allocation to stocks to drop below 30%. Under these circumstances, we suggest that our recommendation be applied to the percentage of the portfolio the investors wishes to be variable over the course of an economic cycle (that is, in this case, the 50% that is not committed to minimum levels of stocks and bonds).

That said, our Stock Barometer readings can also be helpful to an investor considering near-term investment decisions that are outside his/her core portfolio. Such decisions might involve stock that has been acquired in a side transaction, such as the exercise of employee stock options or the inheritance of stock from an estate. An unfavorable Stock Barometer reading should cause an investor to consider selling such a position to avoid a loss of capital due to a down market.

As well, many investors like to “play the market” in a side pool of funds that they manage in a more active and speculative manner. Consider such an investor who has determined that ABC stock is undervalued and likely to out-perform the market in the months ahead. One problem: it is well known that most of an individual stock’s movements are driven by general movements in the market and the sector in which it participates – rather than the performance of the company itself. Therefore, an investment in ABC could out-perform the market and still register a loss, if the stock market as a whole is down significantly for the period.

To be clear, the prospects for any individual stock investment are strongly dependent on the prospects of the market as a whole. Therefore, in making an individual stock investment decision, it also important to consider the overall market climate at the time, as objectively gauged by our Stock Barometer.

Although our Barometers have been constructed specifically to assess prospects for the next twelve months, it has been determined that they also provide valuable information over a considerably wider range of investment time horizons, from as little as six months to as long as eighteen months. To demonstrate this, the following table has been constructed to illustrate the average results for stock investments when the beginning Barometer reading was favorable versus unfavorable for the fifteen-year period from 1992 to 2006.

For example, given an investment horizon of six months and an initially favorable Stock Barometer reading, the stock market has historically delivered an average return of 8.8%, while recording losses in 8% of the relevant periods. In contrast, when the reading was unfavorable, the market yielded a return of only 0.5%, while experiencing losses 40% of the time. These market-level differences of 8.3% in average return and 32% in frequency of losses are certainly large enough to have a significant impact on the prospects of most individual securities as well.

These same effects are seen when the investment time horizon is stretched to eighteen months. With a favorable initial Stock Barometer reading, the market delivered average returns of 30.7% while experiencing losses only 1% of the time. Unfavorable readings led to average returns of -0.1% (more than 30% lower!) with losses experienced 46% of the time.

In terms of the old phase, “a rising tide lifts all ships”, a favorable Stock Barometer reading indicates the tide is coming in, while an unfavorable reading cautions that it is going out. And, our Stock Barometer has been shown to have validity for investment time horizons stretching from six months all the way to eighteen months. Similar results are observed when our Bond Barometer readings are analyzed in the same manner.

So, in addition to using our Barometer readings to establish the optimal asset allocation of your core portfolio, you should strongly consider their implications in making specific investment decisions outside of your core portfolio as well.