Printer Friendly

eMail Article

July 18, 2006

Weekly Wrap-up: Earnings, Fair Value, and the 4-Yr Cycle
by Adam Oliensis

(Published on Tuesday, July 18 rather than on Sunday, July 16.)

Dear Speculators,

If you would like to read more about The Agile Trader Index Options Service CLICK HERE.

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

The 4-Year Cycle, which we have been exploring at length and in detail, has reached an important precipice, and will very likely make the choice between a benevolent 4-Yr Cycle Low (defined for our purposes as a drop down no lower than +46% on the chart below (1173-ish on the SPX)) and a more malevolent low down near +30% (1045-ish) between now and October.

As you can see on this chart, the 4 prior cycles that most closely resemble the current one show an intense "bunching" around Trading Day # 950 in the cycle (red arrow). And as July turns into August, we should see this cycle either follow the more benign examples of 1978 and 1994 or else the more malignant precedents of 1966 and 1990.

While the market has a lot of geopolitical concerns (the Israeli-Hezbollah conflict, Iran, Iraq, North Korea, as well as inflated commodities and assets like Oil and Gold, just to name some headline-catchers lately) market valuation, on its face supports the more bullish/benevolent/benign case.

The consensus Forward Operating 52-Week Earnings Estimate (F52W EPS) for the SPX has risen to yet-another all-time high of $90.44. Meanwhile both Trailing Operating EPS ($81.40) and Reported EPS ($75.55) have done likewise. The trends on these Headline numbers remain extremely positive, with F52W EPS now 44% higher than it was at its peak in 2000, but with the SPX about 20% lower.

The Rates of Growth of F52W EPS remain constructive on both Y/Y and 3-month annualized bases.

At 13.9% and 19.7% respectively, there is no indication that the consensus for EPS growth is rolling over toward the danger zone, defined for our purposes here as either declining at below +10% or else below 0% (going in either direction).

Previous periods during which Y/Y growth in F52W EPS projections have fallen into our danger zone are highlighted in yellow on the chart above, and as you can see, the market has a tendency to struggle during such periods.

Price/Earnings Ratios are at extremely low levels at present, especially when placed in the context of prevailing interest and inflation rates.

The SPX PE on F52W EPS is now at a new cyclical low of 13.7 (earnings yield of 7.32%), and is a lower PE than it has been at any point since 1994. As you can see, PE on both T52W EPS and Reported EPS are also at or near cyclical lows. Meanwhile, with a Price/Dividend Ratio of 19.8, the Yield on the 10-Yr Treasury is now at 5.06%. The difference between these yields (7.32% - 5.06%) now stands at 2.26%. We call this difference, which represents how much excess yield investors require in order to suffer the risk of investing in the equities markets, our Equity Risk Premium (ERP). The Post-9/11 median ERP is 1.95%, so, even by the extremely "scared" standard of the Post-9/11 norm, ERP is currently quite high, representing a high level of skepticism/fear in investors' hearts and minds vis-à-vis the Equities Markets.

Are there other factors that the markets fear other than Geopolitical Risk? Yes.

Let's look at a sector-by-sector chart of the Consensus Forward 52-Wk Earnings Estimate.

As you can see, the Telecom Services sector is projected to grow earnings at +26.1%. Materials are projected to grow EPS at +17.6%. Consumer Discretionary, +14.8%, Info Tech at +14.7%, and so on. And, notably, Energy is projected to grow EPS at just +3.6% going forward.

But look at what Trailing EPS growth has been...

Telecom Services stocks have grown EPS at just +1.5% on a Trailing basis. Materials, just +4.9%. Consumer Discretionary stocks, +11.2%, Tech, +10.8%, and so on...with Energy stocks' EPS have grown +41.5% on a Trailing basis.

So, what are we to believe? With the Yield Curve now inverted (which correlates strongly to a contracting PE Ratio)...

...and with economic growth projected to slow to the +3% or less, depending on which economist you want to listen to (probably none, if you ask me), are we really supposed to believe that EPS growth in Telecom, Materials, Consumer Discretionary, Tech, Financials, and Consumer Staples are going to ACCELERATE?

Are we really supposed to believe that Earnings can grow in the current environment at 11% while the economy grows at <3%? (Especially in the context of already-record-level profit margins?) Doesn't that stretch credulity? It certainly seems to, at least in the market's mind at present.

To sum up: The market is currently cheap on a headline basis, and relative to bonds (Equity Risk Premium is very high at 2.26%, as above). But the market is cheap relative to Forward Earnings projections because nobody believes that those projections will come true.

So, we'll be keeping our eye on the growth rate of the F52W Consensus Estimate as well as on sector-by-sector projections in the weeks and months ahead. And while we expect that the market will get even cheaper (SPX as low as 1173 even in a benevolent scenario, and perhaps as low as 1045 in a malevolent environment.), we continue to anticipate an extremely good buying opportunity once the 4-Yr Cycle Low is formed, most likely in the September-October time frame.

At present our Risk Adjusted Fair Value (RAFV) price for the SPX is at 1291, 45 points or more above the SPX price.

RAFV = F52W EPS / (TNX + Med ERP)

Where

RAFV = Risk Adjusted Fair Value (1291)
F52W EPS = Forward 52-Week EPS Consensus ($90.44)
TNX = 10-Yr Treasury Yield (5.06%)
Med ERP = Median Post 9/11 Equity Risk Premium (1.95%)

1291 = $90.44 / (5.06% + 1.95%)

While our RAFV is now exerting a slightly bullish influence, we would expect that the SPX will drop somewhat farther below RAFV before the 4-Yr Cycle Low has been formed.

Have a great week!

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.

Trading commodity futures may involve large potential rewards, but also carries large potential risks. You must be aware of the risks and be willing to accept them in order to invest in the futures markets. Dont trade with money that you cannot afford to lose. The past performance of any trading system or methodology is not necessarily indicative of future results.

The Agile Trader and all individuals affiliated with The Agile Trader assume no responsibilities for your trading and investment results.

As a publisher of a financial newsletter of general and regular circulation, The Agile Trader cannot tender individual investment advice on the suitability and performance of your portfolio or specific investments. Refer to your registered investment adviser for individualized advice.

In making any investment decision, you will rely solely on your own review and examination of the facts and the records relating to such investments. Past performance of our recommendations is not an indication of future performance. The publisher shall have no liability of whatever nature in respect to any claims, damage, loss, or expense arising out of or in connection with the reliance by you on the contents of our Web site, any promotion, published material, alert, or update.

Trading commodity futures involves substantial risk of loss. DDUI and all individuals affiliated with DDUI assume no responsibilities for your trading and investment results.

Copyright © 2003-2008 The Agile Trader, LLC All rights reserved.

Image rendition and html coding Copyright © 2000-2008 SafeHaven.com

« BullionVault.com -- Buy gold online - quickly, safely and at low prices »
« Honest Money: A History of U.S. Gold & Silver Currency -- by Douglas V. Gnazzo »

« Opinions expressed at SafeHaven are those of the individual authors and do not necessarily represent the opinion of SafeHaven or its management. Articles are available via RSS/XML. Please visit RSSHelp for instructions. »