Energy, Inflationary Pressures and a Cheap Market
Below is a commentary originally posted at www.theagiletrader.com on 9th October 2005.
Weekly Wrap-up/ Closing Bell
Our outlook for the equity markets has to account for a variety of time frames.
At the moment the Dynamic Trading System is short-term bullish, looking for a bounce from an oversold condition.
Our suspicion is that we will, however, see lower lows on the benchmark indices before October is through.
Beyond that we are looking for the markets to break to new highs and enjoy a 4Q05 rally. (The forecast for this rally leg is contingent upon continued moderation in Energy prices. Our view is that we WILL see lower energy prices, but if we're wrong on that score, then equity markets may see only limited upside.)
As for 1Q06 and beyond...that's a very tough call. There are significant structural issues in the economy. (E.g., By the end of '05 the aggregate growth in Federal Debt over the prior 5 years will be at about 104% of aggregate GDP growth over the same period. The consumer is highly leveraged to the bubblicious real estate market. Personal Savings Rates are in negative territory for the first time in history.) On the other hand, the market is extremely cheap right now with the Forward-52-Wk PE at a new cycle low of 14.3
As you can see from this chart, prior trips down into low-PE territory (green highlights) tend to correlate with extremely positive annualized returns over the ensuing 2.5 years.
Of course this inverse correlation, which has been a very strong -0.83 since 1990, could change. But the most likely cause for a de-coupling would be a secular rise in inflation.
That's why we are so keen on monitoring prices in Energy commodities right now. If inflation fears are to end up being well-founded, it will be because of inflating energy prices.
But as we can see below, Energy commodities are most likely involved in mid-term retrenchment phases.
All 4 of these charts are testing demand lines and support levels, with Crude leading to the downside, and probably headed for $58 and a test of the July low.
Natural Gas remains the strongest of the group as supply disruptions in the Gulf of Mexico have not been resolved. But demand growth has already abated with high prices starting to function as the best cure for high prices.
We'll have to continue to monitor these markets as the year progresses in order to get an idea of whether collapsing energy costs will help to provide solid footing for year-end strength in broad equity indices.
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WEEKLY ECONOMIC NEWS DIFFUSION INDEX (WENDI)
For those of you who are new to our Weekly Wrap-up our WENDI work entails reviewing the prior week's major economic reports. We assign each report a value anywhere between -1 and +1 in half-point increments. So, a very bearish report would get a -1, a very bullish report would get a +1, and, say, a qualifiedly bullish report would get a +0.5. We then sum the individual scores, divide by the total number of reports, and multiply that quotient by 100 to derive the Weekly WENDI, which is expressed as a percentage of anywhere between -100% and +100% (the former being maximally bearish and the latter being maximally bullish).
The Cumulative Weighted WENDI is the running sum of the individual scores. And the 4-Wk Weighted WENDI 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 dropped from +13% to +7% this past week, a small decline that leaves the tenor of the economic news flow in "very slightly bullish" territory.
Full-on bullish (+1) readings were seen in the ISM Manufacturing Report and Factory Orders. Bearish numbers (-1) arrived in the ISM Non-Manufacturing Report (the largest monthly drop ever) and Initial Jobless Claims (still above the neutral band of 320-350K, post Katrina). The remainder of the economic reports were either mixed or qualified on our diffusion-index scoring.
The long-term shallow, scalloped trend in economic news flow remains in force as the Cumulative Weighted WENDI pipped up a point to +245. Meanwhile shorter-term momentum, as measured by the 4-Wk Weighted WENDI ticked higher but remains in negative territory in the post-Katrina/Rita period. Whether our WENDI indicators can rally back to more positive levels will likely depend on whether energy prices continue to fall.
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EARNINGS AND YIELDS
The headline earnings numbers for the SPX continue to impress.
The consensus for Forward 52-Wk Operating EPS jumped another $0.49 last week to $83.69. Trailing and Reported EPS continue to rise on-trend as well. With the SPX down about 33 points on the week, however, the PE on forward earnings sank to a new cycle low...LOWER THAN AT THE BEAR-MARKET LOWS IN '02!
This is the cheapest the market has been on a F52-Wk PE basis since late in 1995.
But the difference between 1995 and 2005 is that the 10-Yr Treasury was yielding more than 6% back then while it's yielding about 4.36% now. Back then the yield on the SPX and on risk-free Treasures was about the same. But now the SPX has a forward earnings yield of 7%, fully 2.64% more than the 10-Yr Note.
And that 2.64% is our Equity Risk Premium (ERP)...a measure of how risky (cheap) the market perceives stocks to be. With ERP in the 89 th percentile relative to the past 45 years and in the 98 th percentile relative to the past 10 years, the market has to be considered very cheap (scared).
Of course the issue is whether the market is correct in being scared is the Sixty-four-thousand-dollar question.
The problem for the market continues to be that the lion's share of earnings growth is in the Energy Sector. As the chart above illustrates, F52-Wk Earnings growth is completely dominated by Energy, which has surpassed the Financials as the sector with the highest consensus estimate.
Until we see some other sectors begin to lead growth estimates, the market is likely to remain relatively cheap on a PE basis.
The Fed's FAIR VALUE calculation for the SPX divides F52-Wk EPS by the yield on the 10-Yr Treasury.
$83.69/.04361 = 1919.
Our RISK-ADJUSTED FAIR VALUE calculation divides F52-Wk EPS by the sum of the yield on the 10-Yr Treasury + the median post-9/11 Risk Premium.
$83.69/ (0.4361+.0189) = 1339.
This next chart compares the SPX to our Risk-Adjusted Fair Value price over the past 3 years.
As you can see, the trend is toward convergence, albeit a slow one.
We would expect that trend toward convergence to continue. And if the inflationary pressures exerted by energy prices abate over time, then that convergence should entail the SPX (blue) moving up to meet our Risk-Adjusted Fair Value (red).
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A LOOK DOWN THE MARKET'S THROAT
The SPX has had an interesting relationship with its 12-month moving average over the past 10 years.
This monthly chart shows how important that line has been. The green highlighted areas show where the index is above the moving average. The yellow areas show where it's below the moving average.
As of Friday's close the 12-mma is at 1197. The SPX is now at 1195. A monthly close below the 12-mma would certainly raise the issue of whether the cyclical bull market is over.
A monthly October close below that 12-mma COULD be a fakeout shakeout as it was in October '98. But if we don't see a late-year rally to significant new highs then the markets will be in some technical hot water, with a test of 1129 likely...and perhaps a move down to torture 998.
We'll examine various sector charts for Relative Strength (Weakness) in Monday's Morning Call.
Have a great week!