Understanding of the 1-2-3 Model:
A Conversation with Van Tharp
K. Tharp Ph.D.
In our book Safe Strategies for
Financial Freedom, Steve Sjuggerud presented his 1-2-3 model as
a guide for when you should and should not invest in stocks.
I currently update you on that model once each month in Tharp’s
Thoughts and I’ve gotten lots of questions on the model.
I’ll have a new update for next week so this is a good time
for me to answer some of those questions here.
To get the best understanding of this model, if you have not
done so already, read Steve’s original thoughts in Chapter 5 on
pages 65 – 74 of Safe Strategies for Financial Freedom.
Question: What’s the
least confusing aspect of the 1-2-3 Model?
Steve did extensive research on conditions in which the stock market
performs well and he found three that he likes.
We don’t get many questions on the first one, "Is
the market acting badly?"
so I’ll deal with that first.
When stocks are going up, we expect that to continue and when
stocks are going down, we also expect that to continue.
Steve basically picked the 45 week moving average as his
barometer and he found that when stocks were above the 45 week
moving average, they returned 12.6% per year and when they were
below it, they lost 1.2% per year.
As a result, the first barometer is to determine whether they
are above or below the 45 week moving average.
If they are below, then it’s one strike against us and we
cannot be in Green Light Mode.
Question: The next part is “Is the Fed in the Way?”
What does that mean and how do you use it?
It really means “Is the Federal Reserve tightening or lowering interest
rates?” When interest
rates go down, corporations can borrow much more cheaply and use it
for expansion. As a
result, it’s good for the stock market.
In addition, people are less likely to put their money into
bonds (when interest rates are low) because their return is lower
and this is also good for the stock market.
Steve found that when the Federal Reserve is not in the way
(i.e., they are not raising interest rates), that stocks make 10.9%
per year. But when the Feds are raising interest rates, stocks only
return 1% per year.
Question: But what does “in the way” mean?
Steve defined “in the way” as the Feds raising the discount rate
within the last six month period.
If they haven’t done anything in the last six month, then
they are not considered to be in the way.
Now there are several aspects of this that probably confuse people.
Question: When interest rates go down, isn’t that good for bond
Yes, it is good for people who already hold the bonds because the value
of the bond will go up. For
example, if you buy a bond for $1000 paying 8%, then you should get
$80 per year in interest rates.
But if interest rates go down to 4%, and you are still
getting paid $80 per year, then your bond is really worth twice as
much and so it should be priced at about $2000. That is, 4% (the
current rate) of $2000 produces the $80 per year that you are
getting. Thus, if you
are holding bonds, it is good for interest rates to go down.
People certainly won’t be selling their bonds under these
conditions. But once
interest rates are low, it’s not good for bonds because 1) you can
get better returns in the stock market and 2) interest rates could
go up, which would decrease the value of your bonds.
Thus, when interest rates are low, people put their money
into stocks rather than bonds.
In other words low interest rates are good for the stock market.
High interest rates that are starting to go down are not
necessarily good for the stock market; expect that people tend to
anticipate what will happen to stocks in the future if interest
rates continue to go down.
Question: But you don’t measure long term rates, like the rates on
bonds, do you?
No, we don’t look at long term interest rates, we look at the Federal
Reserve discount rate. And
this rate could go up or down without affecting long term rates
usually is some relationship, but the last time the Fed raised
rates, it had little impact on bonds – long term rates stayed low
and that was generally good for stocks.
Question: But shouldn’t lower rates then lead to the stock market
performing well, which is not seen in reality?
Steve’s research covered over 100 years, and generally when interest
rates go down the market improves.
However, that action doesn’t always happen immediately.
Sometimes rates have to become low (not be going down) for
the impact to be seen in the stock market.
For example, during most of the decline seen in 2001 through
2002, the Federal Reserve was lowering the discount rate, but the
market was still going down. However,
once rates became low, as in 2003, the market took off.
Thus, the relationship is not always clear.
However, one exception does not invalidate the rule.
Generally, when the Fed is lowering rates, the stock market
Question: What do you mean
by number three: Are stocks expensive?
Expensive really means with respect to earnings.
This is measured by the price-to-earnings ratio of the
S&P 500. Steve found
in his research that when the PE ratio is above 17, that stocks only
make on the average 0.3% per year.
But when the PE ratio is below 17, stocks make 12.4% per
Question: But haven’t you said that we’re in a secular bear market
for the next 15 years or so and that PE ratios will continue to fall
during that time?
I have the most difficulty with this aspect of Steve’s model for the
following reasons: First,
Steve only did his research on a 75 year period, which is not
enough. However, he
probably couldn’t find data before the 75 year window.
And second, we are in a secular bear market.
In secular bear markets, PE ratios keep going down (even if
stock prices go up). And
secular bear markets usually do not end until PE ratios get in the
single digit range. When
we reach a PE ratio of 17 on the S&P 500, which is where we are
right now, we still have a long way to fall to get to single digit
Question: An inflationary
bear market seems to be a more conventional interpretation as
inflation means higher interest rates and low performing stocks.
I tend to agree with you. But
actually PE ratios can go to single digits while stocks could easily
double or triple in price with high enough inflation.
For example, let’s say the S&P has a price of 1500 and
a PE ratio of 30. That
means the average S&P 500 stock earned about $50. Then for the
next 10 years, inflation eats into the value of the dollar and
it’s now only worth 10 cents.
Let’s also say that company earnings keep up with inflation
and the average S&P 500 stock now earns about $500.
And that PE ratios are now just under 10.
That would put the S&P 500 price just under $5000.
Thus, price will have gone up more than 3 times.
But PE ratios are now in single digit ranges.
And the inflation adjusted price of the S&P 500 is now
only about $500. Thus,
prices can definitely go up while PE ratios go down.
Question: Hasn’t that
Yes, in 2003-5, the prices of stocks have generally been going up.
But during that time PE ratios continued to fall.
It’s exactly what I expected.
And the dollar has also fallen with respect to other
currencies (i.e., which is a different sort of decline from
inflation). In 2003, for
example, the dollar fell about 40% versus the Euro while the S&P
500 only went up about 17%. That’s
a real loss when measured on an international basis.
Question: So what’s the
overall interpretation of the 1-2-3 model?
When you only have one of the three factors in your favor, Steve
considers it Red Light Mode. Stocks,
according to Steve’s research, return a negative 9.7% each year.
When you have two factors in your favor, Steve considers it to be Yellow
Light Mode. Stocks
return 10.7% per year.
But when all three factors are in your favor (i.e., prices are above the
45 week moving average, PE ratios are below 17, and the Fed is not
raising interest rates), then stocks return 19.5% per year.
Question: Do you really
The model provides a good overall framework to guide my thinking,
although I think the sample size could be a lot bigger.
I’d be much happier with the results if they were based
upon 300 years of research, but we just don’t have the data.
In addition, I expect PE to be below 17 for much of the next ten years or
so, but I don’t expect it to be a great climate for the stock
market. We could have
green light periods that are not so great simply because of the
secular bear market.
Question: Do you really believe that we’re in a secular bear market?
Yes, I believe that, but it is simply a belief supported by 200 years of
research. It’s just a
concept that guides my thinking, just as the 1-2-3 model is a
concept. The market will
always be the final answer in telling us what it’s going to do.
It doesn’t care what you or I believe.
And that belief (again it is also a belief) is probably more
useful than either the idea of secular markets or 1-2-3 models.
About Van Tharp: Trading
coach, and author Dr. Van K. Tharp, is widely recognized for his
best-selling book Trade Your Way to Financial Fre-edom and
his outstanding Peak Performance Home Study program - a highly
regarded classic that is suitable for all levels of traders and
investors. You can learn more about Van Tharp at www.iitm.com.