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January 09, 2006

Weekly Wrap-up: Two Steps Forward, One Step Back
by Adam Oliensis

The following article was originally published at The Agile Trader site on January 8, 2006.

Dear Speculators,

Let's start our work this week with a look at the SPX's history in terms of its 4-year cycles.

The blue vertical lines on this chart represent the 4-year cycle lows. Each positive percentage value (in green) represents the percentage gain the market enjoyed as it rose up out of each 4-year cycle low. Each negative percentage value on the chart (in red) represents the percentage fall from its cycle high that the market suffered as it dropped to each 4-year cycle low.

What surprised the bejeepers out of me when I did this study was the relative consistency of the sizes of the moves. With just 2 exceptions, each cycle has seen an advance of between 51% and 86%. (The median cyclical advance is 70% and if we exclude the 2 exceptional cases [138% and 169%] the average cyclical advance is also 70%, with a standard deviation of just 10%.) And with just one exception each major retrenchment has been between 21% and 51%.

What does that mean to us? It means that the current advance off the 2002 low is, so far, just about precisely what one would expect. It's smack-dab AVERAGE. And, as we head into the teeth of this calendar year, we are likely to see both a 4-year high (if we haven't already established it) and a 4-year cycle low (most likely in the October time frame). Moreover, the chart suggests a strong probability that the 4-year cycle low (October?) will be at least 20% below whatever is the established highest high of the year.

(Note: Given that the most recent 4-year cycle low was a severe -51% decline, I'm going to provisionally posit that the coming 4-year cycle low will be of the more modest -20% variety , as historically "ruthless" 4-year lows tend to be followed by more "merciful" ones. But this is just a provisional position, and is not carved in granite.)

The study above also puts the specific 4-year cycles that we've recently been studying in broader context.

The blue line on this chart shows the SPX's performance off its October, 2002 low. The red line shows the SPX's performance off its October, 1990 low. And the black line shows the SPX's performance off its October, 1962 low. These correlations remain extremely tight. And they are calling for a top around the end of January or beginning of February, with 10-20% declines to follow.

So, now we can get specific about target prices.

First, we have our Risk Adjusted Fair Value (RAFV) target for the current move higher. We derive RAFV from this equation:

RAFV= E/(TBD+ Median ERP)

where

• RAFV=Risk Adjusted Fair Value
• E = SPX Forward 52-Week Earnings Per Share (Consensus Estimate) ($85.38)
• TBD=10-Yr Treasury Dividend Yield (4.38%)
• ERP= Equity Risk Premium, defined as the difference between the SPX Forward Earnings Yield and TBD (6.64%-4.38%=2.26%)
• Median ERP= Median post-9/11 (1.93%)

Or

RAFV = $85.38/(.0438+.0193) = 1353

We continue to expect the SPX, now at 1285, to "hook up" with that RAFV line (red), before the early '06 high is finally made. However, we would also look for the 10-Yr Treasury Yield (TBD) to move a bit higher, which could bring RAFV down into the lower 1300s. E.g., if TBD were currently 4.5%, RAFV would move down to 1327. And if TBD were 4.6%, then TBD would be 1307. So, with the SPX now at 1285 the index could very well be within, say, 2-3% of a dynamic RAFV target.

Could the market move higher than the 1307-53 band? It sure could. With the Fed now talking openly about nearing the end of its rate-hike regime we could see the SPX blow off to the upside toward 1400. But that would likely involve a shrinking of ERP down below recent norms and would involve a kind of risk-embracement that equity investors have not been keen to show since before the 9/11 tragedy. We'll be watching for it, but we're not expecting it.

As for our initial price target for the 4-year cycle low, due in October, let's make couple of suppositions. Suppose that the SPX hits 1325 in the next month. Now, suppose that we get a relatively benign retrenchment of 20%. That would take the SPX to 1060. Not a bad price to aim for, as it's within a point of the 2004 low, and would represent a give-back of 2 years' progress.

We like this 1160 area as a target for another reason. In a market sell-off we would expect 8% to be about as high as the Forward Earnings Yield would climb. (That's as high as it got in'94, and as high as we've seen it since Treasuries were yielding 9%!)

If F52W EPS were to climb just 7.5% from its current level of $85.38 to $91.78, then an SPX price of 1147 would put the SPX Forward Earnings Yield at that 8% target.

Of course in an ultra-benevolent down cycle, we could see just a 10% decline, which would take the SPX down to 1192 for its cycle low, but we've only seen one 4-year cycle low in the past 45 years that was that merciful. And the odds would appear to be against such a benign retrenchment.

**** **** ****

WEEKLY ECONOMIC NEWS DIFFUSION INDEX (WENDI)

For those of you who are new to our Weekly Wrap-up our WENDI work involves reviewing the prior week's major economic reports. We assign each report a value anywhere between -1 and +1 in half-point increments. A very bearish report gets a -1, and a very bullish report gets a +1. And, say, a qualifiedly bullish report gets a +0.5.

We then sum the individual scores, divide by the total number of reports, and multiply that fraction by 100 to derive the Weekly WENDI (black line below), expressed as a percentage of anywhere between -100% and +100%. (The former is maximally bearish and the latter is maximally bullish.)

The Cumulative Weighted WENDI (red line below) is the running sum of the individual scores (raw trend). The 4-Wk Weighted WENDI (blue line below) is the sum of the past 4 weeks' individual scores divided by the total number of reports over the same period, and it tells us about the momentum in the flow of economic news.

The Weekly WENDI came in at +14%, down 11 points W/W, but still on the plus side. The trend in the flow of economic news remains positive, as you can see on the Cumulative Weighted WENDI line (red), which is now at a new high. Momentum is rolling over a bit after the usual 4Q surge, but remains near the upper end of the range in which it has been bouncing for the past 18 months or so, now at +22%.

We expect that momentum will remain positive, but will decelerate in 1Q06. So, while the economic expansion should remain intact, there is some question as to whether momentum might not slow enough to put a scare into asset markets. And we'll be especially cautious if we start getting some Weekly WENDI readings below 0%.

**** **** ****

A LOOK DOWN THE MARKET'S THROAT

The S&P 500 (SPX) and Nasdaq Composite (COMP) both enjoyed breakouts to new highs last week and both breakouts came on strong volume and positive readings on our OVM indicator (Oliensis Volume Momentum - a proprietary measure of volume-weighted momentum).

The Morgan Stanley Cyclical Index (CYC), Nasdaq 100 (NDX), and S&P MidCap 400 Index (MID) are all enjoying similar breakouts and positive Relative Strength readings, which confirm the SPX and COMP breakouts. Only the Dow Transports, which had been showing leadership, are now showing some signs of exhaustion.

Meanwhile the Russell 2000 (RUT) and Philly Semiconductor Index (SOX) are also confirming the breakouts. However, while the SOX is showing impressive Relative Strength the RUT is merely keeping pace with the SPX.

Cumulative Volume has definitively broken to a new high. Meanwhile the Advance/Decline Line is struggling to break resistance.

With Cum. Vol. leading the A/D line, and with the RUT showing no especial RS, it looks as though larger-cap names (which trade heavier volume) are where money is being put to work hardest.

The rally appears to be on essentially solid footing for the time being. And we would expect it to begin failing only when marketeers begin to question the newly embraced premise that the Fed is almost done hiking rates.

Watch out for data that suggests stronger than expected inflation. And let's be careful of Crude Oil near $70 again. The Fed still wants to de-monetize Energy. Strong inflation figures and high Energy prices will bring on new prognoses of a heavier-handed Fed.

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Best regards and have a great week!

Adam Oliensis,
Editor The Agile Trader

IMPORTANT DISCLOSURES

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