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December 11, 2006

Weekly Wrap-up: Can Everyone Be Right?
by Adam Oliensis

Dear Speculators,

The consensus estimate for Forward 52-Week Operating Earnings on the S&P 500 (F52W EPS, represented in blue below) continues to tell a constructive story for the index.

The blue line broke over $95 this past week, hitting yet another all-time high. And Trailing Operating EPS (yellow line) along with Reported EPS (pink line) continued in their uptrends, remaining similarly constructive. Moreover, there are no wide gaps or developing divergences among these lines to tell a story of deteriorating quality of earnings. So all remains rosy, at least on its face. (Or does it? There's at least one fly in the ointment, but we'll look at that below.)

On a relative basis the SPX remains cheap. The Forward Earnings Yield on the index is now 6.74%. Meanwhile the 10-Yr Treasury Yield (TNX) is at 4.55%.

The difference between these 2 yields is our Equity Risk Premium (ERP), now quite high by historical standards at 2.19%.

However, ERP is in merely a bit high relative to its post-9/11 range. Generally speaking, when ERP is high that means that the market has priced in a lot of risk, which suggests that forward returns will be fairly strong. We can also get a slightly different angle on the same data by looking at the market's PE ratios, which is the inverse of the Earnings Yield (as well as the TNX Price/Dividend ratio).

As you can see the PE on F52W EPS (blue) has risen from a cycle low of 13.7 up to 14.8. But relative to the past 7 years, the SPX PE ratio remains fairly depressed. (Likewise for the PE on Trailing EPS (yellow) and Reported EPS (pink).)

Meanwhile, however, the Price/Dividend Ratio on TNX (black line) has risen sharply from a sub-20 level to 22.6. Investors are willing to pay quite a hefty premium to be guaranteed the TNX yield relative to what they will pay for earnings yield on the SPX. (Note: historically the 2 yields' averages are extremely close to one another.)

Measuring annualized 2.5-year appreciation on the SPX (red line below) against the PE on F52W EPS (blue line) we see a powerful result. We've set the blue line (lower axis) ahead of the red line (upper axis) by 2.5 years, establishing quite a strong inverse correlation using this offset.

By setting the blue line ahead we've made it easy to see what this chart predicts. So, for example, in December '03 (at the yellow highlight) the PE (blue) peaked at around 18. By June of '06 about 2.5 years later, the annualized forward appreciation of the SPX (red line, also at the yellow highlight because the blue line is set forward by 2.5 years)) had troughed, falling to about 3%.

Beginning in early '04 the PE (blue) began to fall. And 2.5 years later (June '06) the annualized 2.5 year return (red) began to rise.

The implications of the strong inverse correlation on this chart are that the SPX is likely to show continued improvement on the red line through January '07. By Feb '07 things may become wobbly into the spring, and then the positive SPX trend is likely to ultimately continue (though not without some hiccoughs) through 2008. At that point the market should be ready for an important mid-cycle top.

Having tipped our hats to the market's relative cheapness and to the bullsih cyclical influences now operating, there remain some troubling factors at play, foremost in my mind being the relationships among GDP growth, Bond Yields, and Earnings Growth.

Currently the consensus estimate for Forward 52-Week Earnings Growth is right around +9% ($95.06/$87.27-1 = 9%). Nominal GDP growth will likely come in around +6% for 2006 (that's Real GDP + Inflation). And finally, the Bond market appears to be anticipating something like 4.5% Nominal GDP over some longish-term forward period. Why 4.5%?

Because that's the level toward which TNX has been gravitating and, as you can see on this chart, there is a very strong correlation between Nominal GDP and the 10-Yr Yield (TNX). Indeed since 1930 Nominal GDP has averaged 6.8% and TNX has averaged 6.4% (close enough for government work). But today, rather than the normal-ish 0.4% spread we have something close to a 1.5% spread.

And historically, we have seen Nominal GDP lead TNX both higher and lower as, apparently, the bond market is more a lagging than a leading indicator of the aggregate sum of real growth plus inflation.

But here's where the rubber meets the road...

If you want to know what someone means when they say that the stock market is a leveraged play on economic growth, here's about as good a picture as you could find on the subject. Look at the very strong correlation between Nominal GDP growth (blue line) and Trailing Operating Earnings per Share on the SPX (red line). And note the differences in the scales (blue at left, red at right). Earnings growth tends to move with GDP growth but swings with much greater volatility (leverage).

And here's the troubling part. If the bond market is correct and Nominal GDP is going to remain low, near +4.5% in the longer term (yellow highlight on the chart above), then it is very likely that EPS growth (the red line) is going to fall quite sharply from the giddy +23% level that it achieved in 3Q06.

In fact, over the span of this chart, dating back to 1988, any time the blue line has fallen to 4.5% or below EPS growth has fallen to sub-zero levels.

But now suppose that he bond market is not correct about GDP, just as it was not correct in the mid '60s. Then it is remaining far too low for far too long, and is likely again slow to recognize burgeoning inflation just as it was 40 years ago.

In short, if the bond market is correct in its current pricing, then Earnings Growth is going to disappoint. On the other hand, if the stock market is correct in being optimistic about earnings growth, then the odds are very high that the bond market is incorrectly pricing in too-low inflation for too long.

On a more bullish note, last week the US Dollar Index bounced and did not break down below 80. Gold fell and did not break above $650/oz. And Crude Oil did not break above $65/barrel. The fact that none of these potentially destabilizing breaks of support or resistance occurred probably works to stabilize global markets and increase investor confidence. But we'll certainly be watching these charts for significant technical moves.

Best regards and good trading!

Adam Oliensis,
Editor The Agile Trader

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