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 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. 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 Print 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. Print 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 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. ECON 2.0 REGISTRATION FORM: Where did you obtain your copy of Econ? _____________________ DESCRIPTION QUANTITY PRICE 3 1/2" diskette and manual ________ $49.95 5 1/4" diskette and manual ________ $49.95 Density _____ High _____ Low If you do not specify, we will send 3 1/2 inch low density. 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