One of the fundamental ideas of macroeconomics is that of a conceptual cycle underlying the dynamics of the economy. This cycle consists of four phases: the trough, the recovery/expansion, the peak, and the recession/contraction. It should not be hard to understand that different asset classes (as investments) will produce different returns during the various phases of the cycle.

For example, when the economy is in a vigorous expansion phase, strong corporate profit growth propels the stock market higher, while bonds may be impacted negatively as the Federal Reserve Board raises interest rates to control inflationary pressures. Conversely, during recessions, the bond market benefits from Federal Reserve actions to stimulate the economy by lowering interest rates, while the stock market declines due to disappointing corporate profits and uncertain economic prospects.

To this point, from January 2000 to December 2002, investors in stocks suffered a cumulative loss of over 37%. During the same time, long-term bonds (as measured by the Vanguard Long-Term Treasury Fund) delivered a 45% cumulative gain. The difference in outcomes between stocks and bonds during this time period totaled over 80%. Clearly, the ability to project the relative future returns for stocks versus bonds would provide the basis for an investment strategy that delivers above-average performance at below-average risk.

This is the prime objective of our Stock and Bond Barometers. They were specifically developed to determine the prospects for stocks and bonds based on the current status and direction of the U.S. economy.

The process utilized an underlying database covering 27 years of history, from January 1980 through December of 2007, incorporating a broad range of relevant variables over the course of several economic cycles, three wars, and a wide range of political developments. The database provides the basis for testing economic theories and relationships in a quantitative and statistically verifiable manner. Conjectured relationships that do not prove statistically significant in linking the markets to the economy are discarded. Relationships that repeatedly stand rigorous statistical testing are incorporated into objective, econometric decision rules.

Each month our Barometers generate readings that gauge the outlook for stock and bond investments at that particular juncture in the U.S. economic cycle. Based on historical performance, the readings indicate whether the prospects are favorable or unfavorable over the next twelve months. The validity of this approach is evidenced by the 12-month forward performance of the stock and bond markets over the last 27 years, partitioned into periods when the beginning Barometer readings were favorable versus unfavorable:

Our approach is in sharp contrast to the advice offered by the financial press and media about the direction of the markets, where the views expressed by various “experts” are often speculative, untested, and conflicting. Missing in these discussions are objective evaluations, based on rigid historical testing, that determine which of the proposed theories has actually proven successful in the past. Our proprietary Barometers were specifically developed to address this problem.

If you are interested in understanding how our Stock and Bond Barometers are incorporated into a comprehensive dynamic portfolio strategy, you should reference our presentation, the Barometer Investment Strategy.