Indicators  |  DEC 2001

Stochastics Of Earnings Yields by Mark Vakkur, M.D.

Stochastics Of Earnings Yields by Mark Vakkur, M.D. By combining technicals and fundamentals, you can make a realistic analysis of the market. Pure stock market technicians ignore fundamentals. To them, the chart tells the whole story, while the fundamentals are distracting and misleading. Pure fundamental analysts, on the other hand, ignore price action. Here’s a method that synthesizes the best of both: converting a fundamental variable — the interest rate–adjusted earnings yield on the Standard & Poor’s 500 index — into a technical indicator to maximize risk-adjusted returns. VALUATION Most technicians view price relative to a derivative of price, such as a moving average. The objective is either to identify a trend or identify periods when the market is extremely overbought or oversold. However, all of these approaches suffer from a common problem: Viewing price in a vacuum may completely disconnect it from any underlying reality. This happened during the Internet stock bubble of 2000, for example, when so many momentum players rode the trend that it took on a life of its own. The fault of many pure fundamentalists is the opposite: in an often vain attempt to peg an “appropriate” valuation level on stocks, they may buy or sell prematurely. For example, until 1959, the dividend yield on the S&P 500 was an excellent gauge of market value. Whenever the yield on the S&P 500 dropped below that of high-grade corporate bonds, the stock market was overvalued and tended to fall. A profitable strategy was to sell stocks when the dividend yield dropped below the bond yield and buy when the dividend yield rose again.

by Mark Vakkur, M.D.