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May 22, 2006

Weekly Wrap-up: Roller-coaster to the 4-Year
by Adam Oliensis

Dear Speculators,

The Dynamic Trading System took a -25% loss in the futures market this past week, jumping into some long positions on its buy signal, which, in light of the market's overdone sell-down, came early, and giving back most of the gains made in the prior week. That said, even in light of that loss, the System has accrued 463% in net position gains since its launch in July, 2005 with 154% in net total return in its model portfolio.

If you would like to read more about The Dynamic Trading System or subscribe to The Agile Trader Index Futures Service, please click HERE.

Or if you would like a free 30-day trial to The Agile Trader (in which we trade the less volatile QQQQ/SPY and the Rydex Funds) CLICK HERE.

Last week's article included the subtitle, "Something's Gotta Give..." and this past week something did indeed give: commodities. Last week in this space I wrote:

If the FOMC stops raising rates, commodities will continue to soar, foreign investors will continue to flee the dollar (as they seek higher yields in other currencies), and inflation will rise. (Not good.) But if the FOMC continues to raise rates, the yield curve will invert, economic growth will slow, and earnings growth will roll over. (Also not good.) The committee is caught between the proverbial Rock and the Hard Place, with just about no room in between the two.

If the market ISN'T willing to take some near-term pain and show the world a reasonably scary correction between now and October? Then the odds will favor a much more aggressive paroxysm of cyclicality in the ensuing 12-18 months. (Even worse.)

Maybe there's a "3rd way." Maybe there's a way out of the box that I don't see. I'm always open to that. If there's someone who could imagine it, I don't doubt that it's Bernanke. (I've read that he scored 1590 on his S.A.T's.) But so far, if Bernanke has said it, the markets haven't heard it.

In light of the scary Core CPI numbers this past week (CPI +3.5% Y/Y and Core CPI up by +0.2% to +2.3% Y/Y)...

...the stock market's twin fears of rising inflation and higher interest rates came to the fore.

As we discussed in Thursday's Morning Call:

By "threatening" to pause (stop hiking rates) Bernanke has allowed the market to worry more about rising inflation. Increased worry about rising inflation has raised fears that the Fed might have to tighten even more than previously anticipated. Fears of a too-tight Fed have raised the issue of whether GROWTH is sustainable. Anxiety about growth prospects have brought sellers to commodities and commodities stocks and those markets have begun correcting in serious fashion. Those corrections may in turn help to quell the rate of inflation, which quelling could allow the Fed to stop tightening sooner than it otherwise would.

Net net, by threatening to pause, Bernanke may have (perversely -- and financial markets are nothing if not perverse) helped to induce the market corrections necessary to set the table for launching the next positive economic cycle.

... increased uncertainty about the Fed's course of action may function to raise risk premiums in the markets, which functionally tightens monetary policy, doing some of the Fed's work for it. If that's what Bernanke has in mind, then he's a really smart guy and a worthy successor to Greenspan. Jawboning the markets may not be on the job description of Fed Chairman, but it's a key function of the position.

This past week's action is, in my view, firmly in the "short-term pain, long-term gain" camp, and COULD be a function of Bernanke's only-obliquely articulated "3rd Way."

The sell-down in the broad stock market has been led by those cyclically sensitive sectors that we have long-since identified as being beneficiaries of excessively loose money.

This table identifies the percentage change in the SPX and each of 13 key Exchange Traded Funds (ETFs) that we watch closely over periods of 1, 4, and 13 weeks. The table is sorted inversely to performance over the past 1 week. (The biggest 1-wk losers are at the top and the best 1-wk performers are at the bottom.)

Note how the biggest losers over the past 1 week are also the largest gainers over the past 13 weeks. Meanwhile Biotech (BBH), a speculative sector that has been much shunned and has displayed negative Relative Strength since November, may have become washed out and actually closed up on the week.

Should QQQQ and SMH (Semiconductors) begin to meaningfully outperform, we would regard that as bullish...but we would suspect that we won't see that sort of action until deep into the 2nd half of the year.

The pressures exerted by the 4-year cycle on the SPX are now fully evident, as is the 1966 analogue in particular.

If the market's current behavior continues to take its cues from these 2 prior cycles, which the current cycle most closely resembles, then we would expect the SPX to have a choppy downside bias over the next 2 ½ months with a downside target at roughly the +46% level (i.e. 46% above the October 2002 closing low: 804 * 1.46 = 1174.).

As for whether the projected cycle lows would more resemble the 1966 analogue (a hard landing all the way down to +30% at 1045) or the 1995 analogue (soft landing with higher lows in the fall), that remains to be seen and will depend on a host of fundamental and geopolitical factors as well as policy decisions.

Given the extreme right translation of the highs of this cycle, we would expect something more like a soft landing than a hard landing, but that is an educated expectation and nothing more.

In terms of market valuations, we have been anticipating that the SPX would decline such that the yield on Forward 52-Week Earnings projections would rise toward 8%.

Currently the F52W EPS yield is 6.99%. With the consensus for CY07 now at $95.52 (according to Standard & Poors)...

...the Forward 52-Week consensus is on course to be right around $93 by September (3/4 of the way from CY06's $85.29 to CY07's $95.52). Should the SPX drop to a level that raises the Forward earnings yield to 8% (as it did in 1995) then the SPX target would be calculated like this:

8% * X = 93
X = 93 / 8%
X = 1163

That's just 11 points below the 1174 target created by the technical analogue to 1995.

Of course, if earnings estimates start coming down for CY07, as discussed last week (the consensus estimate requires profit margins to rise to unprecedented heights), then we could see the cycle play out differently, and perhaps we would see the SPX chasing the 1045 target around the beginning of 4Q06.

The real story may be told, however, in the distribution of earnings among sectors.

The juggernaut in Energy earnings dominates this story. And we have to continue to be skeptical of earnings growth especially in Information Technology and Consumer Discretionary stocks if Energy prices and Commodities prices continue to rise. So, on this chart, either the yellow line (Energy) has to turn around and head down or else we are very likely to see some of the others do likewise. (Information Technology is already deteriorating but if energy prices remain elevated then other consumer-sensitive areas should get hurt as well.)

Bonds rallied last week as commodities sold off and the market began discounting further rate hikes from the Fed. Again, paradoxically, long-term yields fell as the prospects for short-term rate hikes increased. That flattened out the yield curve again (defined for our purposes as the difference between the yield on the 10-Yr Treasury and the Fed Funds Rate).

This spread narrowed to 0.05% and with the Fed now likely to go at least to 5.25 or 5.5%, the curve is all but destined to get dunked underwater.

As you can see on this chart, a flattening yield curve is highly correlated to a contracting PE on the SPX. And, if this correlation were to continue, we could easily see a curve inversion of -0.5% or -1% generating a PE in the 12.5 - 13 area.

Largely because of the decline in the 10-Yr Treasury Yield (TNX) our Risk Adjusted Fair Value price of the SPX has climbed to exactly meet the SPX price.

RAFV = SPX F52W EPS / (TNX + Median ERP)

Where:

RAFV = Risk Adjusted Fair Value<br>
F52W EPS = the consensus of Forward 52-Week EPS for the SPX ($88.58)<br>
TNX = 10-Yr Treasury Yield (5.05%)<br>
ERP = Difference between SPX Forward EPS Yield and TNX (6.99%-5.05% = 1.94%)<br>
Median ERP = Median Post-9/11 Equity Risk Premium (1.94%)<br>

$88.58 / (0.0505+.0194) = 1267.

That said, we have quite a number of indicators suggesting that after last week's precipitous decline into Options Expiration, the market is on the verge of giving us a buy signal that is likely to see the market rise for a period of 2 weeks or more from here.

We'll explore these indicators at some length this week in our Morning Call, but one such indicator is the Put/Call Ratio 20-dma.

The top pane here shows the SPX on a log scale. The middle pane shows the Put/Call Ratio 20-dma. The bottom pane shows the divergence between the P/C 20-dma and the 50-dma of that line. (This momentum indicator helps to normalize the momentum, making the chart easier to read.) The green highlights indicate points at which the PC 20 Momentum has reversed from a level of +16% or more. And while it's hard to read on this chart because it's zoomed way out to show the past 10 years, rallies of at least 2 weeks almost always follow such buy signals.

We will almost certainly see just such a buy signal in the next 1-2 days.

So, while our mid-term outlook is bearish (between now and roughly the beginning of 4Q06, our short-term outlook (the next 2 weeks) is for a bounce-back rally.

If you would like to read more about The Dynamic Trading System or subscribe to The Agile Trader Index Futures Service, please click HERE.

Or if you would like a free 30-day trial to The Agile Trader (in which we trade the less volatile QQQQ/SPY and the Rydex Funds) CLICK HERE.

Best regards and good trading!

Adam Oliensis,
Editor The Agile Trader

IMPORTANT DISCLOSURES

ALL PERFORMANCE RESULTS ARE HYPOTHETICAL.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKET IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

DOG DREAMS UNLIMITED INC.(DDUI), WHICH OWNS AND OPERATES THE AGILE TRADER, HAS HAD LITTLE OR NO EXPERIENCE IN TRADING ACTUAL ACCOUNTS FOR ITSELF OR FOR CUSTOMERS. BECAUSE THERE ARE NO ACTUAL TRADING RESULTS TO COMPARE TO THE HYPOTHETICAL RESULTS, CUSTOMERS SHOULD BE PARTICULARLY WARY OF PLACING UNDUE RELIANCE ON THESE HYPOTHETICAL PERFORMANCE RESULTS.

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