Weekly Wrap-up: What's Earnings Got to do with It?
The following article was originally published at The Agile Trader on November 13, 2005.
Our WEEKLY ECONOMIC NEWS DIFFUSION INDEX (WENDI) reveals an economy that continues to climb back up to its feet (albeit on wobbly legs) after being sent to the canvas by the 3-punch combination of Katrina, Rita, and Wilma.
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. 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.
Our Weekly WENDI dropped -7 points to +17% last week but remains in modestly positive territory.
In a week that was light on economic news, strength in Chain Store Sales and Wholesale Trade was partially offset by a record Trade Deficit. Consumer sentiment remained a bit shaky as the moderation in energy prices, slowed.
The Cumulative Weighted WENDI popped +2 to +247, regaining some of the ground lost late in the summer. The momentum of the trend improved somewhat, jumping +10 points to +11%--while that's better, it's still simmering more than boiling.
We would expect that the flow of economic news will continue to improve modestly as the economy gears up for the holiday season, though just how much could depend quite a lot on how far the prices of Energy commodities continue to fall (or rise).
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I have a running dialogue with a good friend of mine (a physician with a scientific and skeptical mind) about the value of tracking the consensus of SPX Forward Earnings Estimates. He's a smart guy and whenever he's at his most irritating, chances are that I have some homework to do in order to "show" in some sort of quantitative way what it is that I'd like to be able to prove.
Indeed, his prodding is what spurred me on to develop the Dynamic Trading System, which has lately been so productive in the stock, futures, and options markets. (In back-testing the System trades at a 70% win-rate on the NDX and a 77% win-rate on the SPX over the past 6-7 years, and since the System's real-time launch in April it's trading at a 67% win-rate, close enough to our back-test data to leave us quite encouraged by the results, especially with 10 of the past 11 trades in the green.)
This first chart shows the SPX weekly close (black line), the consensus estimate of Forward 52-Week Operating EPS (F52W EPS, blue line), Trailing 52-Week Operating EPS (T52W EPS, yellow), and Reported EPS (pink).
The first feature of this chart that we should note is that the correlation between F52W EPS (blue) and the SPX has been, over the past 10 years, stronger (+0.75) than has been the correlation of the SPX to either of the other 2 lines (+0.68 and +0.60). Moreover, before this past year the prior 9 years showed an even stronger correlation between F52W EPS (the blue line) and the SPX (+0.83). In the past year the correlation has weakened because earnings estimates have risen much more sharply than has the SPX, which leaves the SPX in the enviable position of having some upward pull exerted upon it by the blue line. But the long-term superiority of the blue line's correlation to the SPX leads us to conclude that indeed the market discounts F52W EPS much more so than Trailing or Reported EPS.
"But," my friend objects, "The consumer's tapped out, home prices are rolling over, there's no more free money as interest rates are rising, wages are lagging, the Federal Deficit is rising (and understated on account of the cost of the Iraq War being off the books), energy prices are still very high even if falling, and the 4-year cycle low is due next year. The blue line is bound to roll over as it did in 2000 and when it does, it will lag by at least a couple of months, just like it did then, and the bulls will be left holding the bag!"
Good points all. So, I went back to the drawing board (spreadsheets) to see if we could find a way to parse the data such that we could get a LEADING indication of whether forward earnings are likely to pose a problem for the market.
Now, some of you may have heard the expression that Wall Street is in love with the 2nd Derivative. The 2nd Derivative is the rate of change of the rate of change. And if we look at the 2nd Derivative of F52W EPS we see something extremely interesting, and potentially prescient.
The blue line on this chart shows the Y/Y percentage change of F52W EPS. Over the past 10 years the market has had notable difficulties when either: 1) the blue line was declining below 10% (negative 2nd derivative below +10% value) or, 2) the blue line was below 0% (a negative value).
Currently the blue line is at +16.8%, decelerating, but well above the +10% threshold line that would be indicative of a potentially problematic situation. This study is not particularly a short-term indicator, but can function as an excellent warning alarm for mid-to-long-term risk. Should the blue line begin to drop sharply below +10% (and it very well may do so in '06), then we will be looking for the SPX to struggle and retrace its cyclical-bull advance. And we'll be especially keen on watching for that kind of deterioration since, indeed, the 4-year cycle low is due in the fall of '06.
For the present, however, despite the precipitous rise in estimates for the earnings of the Energy stocks, analysts' estimates for the other 9 SPX sectors are in the main constructive.
The Energy sector (yellow) jumps right out at you and dominates this chart. But I've stretched it vertically so that we can see that solid and positive trends remain in the Financials (light blue), Industrials (brown), Information Technology (lime green), Consumer Discretionary (navy blue), Utilities (red), and Telecom Services (royal blue). The trends in forward EPS for Healthcare (purple), Consumer Staples (pink), and Materials (dark green) are more questionable.
Thus far estimates for the non-Energy sectors have been able to survive the surge in Energy-sector earnings. But, if the market is going to fall apart in '06, with aggregate F52W EPS growth deteriorating, as discussed above, then it will show up in failing trends in the non-Energy sectors on this chart.
That said, with the SPX PE barely up off its cycle low of 14, now at 14.6 (earnings yield of 6.86%), the market does not currently appear primed for a major crash...
... especially with the Price/Dividend Ratio on the 10-Yr Treasury at 21.9 (yield of just 4.56%). The +2.3% spread between those yields (6.86%-4.56%=2.3%) remains at an elevated level relative to historical norms, and is what we call our EQUITY RISK PREMIUM (ERP).
When ERP is high (as it is now), the stock market is cheap relative to Treasuries. And when ERP is low, the stock market is expensive relative to bonds. Indeed the Fed's Fair Value Calculation, which divides F52W EPS by the Yield on the 10-Yr Note goes like this: 84.65/.0456= 1855. According to this model the SPX is about 50% undervalued.
But that result is probably a little wacky in the riskier Post-9/11 world. So, we derive our Risk Adjusted Fair Value Calculation with this equation: F52W EPS divided by the sum of the yield on the 10-Yr Treasury plus the average Post-9/11 ERP. In numbers it goes like this: $84.65/(.0456+.0191)= 1307. According to this model the SPX is about 6% undervalued.
As you can see on this chart, the overall trend since the fall of '02 has been for the gap between the SPX and the Risk Adjusted Fair Value calculation to close. And we would expect that gap to close completely before year-end somewhere pretty darn close to the 1290-1300 level.
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A LOOK DOWN THE MARKET'S THROAT
The monthly SPX chart shows the index sustaining itself above its 12-Month Moving Average (12-mma), which, more than 3 years into this 4-year cycle, is bullish.
This chart marks the 4-year cycle lows with dashed blue vertical lines. Then 26 months after each 4-year low we show a dashed pink vertical line. As we discussed at more length last week, when the SPX makes higher highs later than 26 months into the 4-year cycle (to the right of the pink line) then it tend to see further upside continuation after the 4-year cycle low.
With seasonal and valuation factors now working bullishly, we would expect momentum to pick up and for the 12-Month Disparity Index (which measures how high above its 12-mma the SPX is) to gain some loft above its ZERO line before year-end as the SPX breaks out to the upside.. Should the SPX break above 1253 (61.8% retracement of the bear market), then we continue to look for 1291 (67% retracement of the bear market). And if 1291 breaks, then we'll have our eye on 1368 (76.4% retracement).
That said, if the SPX cannot penetrate up through 1253 before year-end, then the trip down to the next 4-year cycle low in the autumn of '06 is likely to test at least as low as 1068 with a possible trip to 1030.
Below we look at some important sector charts:
BBH: The biotech ETF has broken out to the upside on positive relative strength. The positive divergence shows a desire for high beta and a willingness to assume risk. It's a positive for the broad market.
QQQQ: Broke to new rally highs on positive relative strength. The wish for high beta and the willingness to increase risk shows up here as well. A positive divergence for the broad market.
GLD: This ETF trades in lockstep with the price of Gold, at 1/10 the value. There appears to be a Head & Shoulders Top developing. Currently at $46.80. A move over $48 would negate the H&S Top. But a move below the briefly-broken neckline at $45.98 would confirm that a top is in. Why is this important? Well, Gold breaks down, then INFLATION is probably not a problem.
SMH: If the year-end rally is to be even modestly durable then the semis, which have been strengthening since the beginning of the month, should assume real leadership, which would entail breaking the line of declining tops and then cracking horizontal levels between $37 and $38.32. A move up through $38.32 could trigger a buying frenzy that could take SMH toward $45.
XLF: The Financials are on a tear, with this ETF at new all-time highs on positive relative strength. Is the market signaling that the Fed is almost done tightening?
XLU: The Utilities have broken. Rising interest rates have diminished the relative value of yields from utility stocks and the search for higher-beta names has made this recently fashionable sector a pariah.
XLB: This ETF has been in a trading range. There's some short-term relative strength but it has a lot to prove, especially in light of deteriorating earnings estimates in the Materials sector as discussed above.
XLE: The Energy stocks have collapse as energy commodities have retrenched in price. If $45 breaks then this ETF could head all the way to $38.
DJ-20: The Dow Transportation Average shows an extremely positive divergence as falling energy prices and solid economic growth have been supportive of this sector. As long as the Trannies hold above 3900 they support a broad-market rally.
In summary: With leadership in the Transports, the Nasdaq 100, the Financials, and Biotech, this rally appears to be gaining some solid footing. With weakness in the Utilities, Energy, and Gold it appears that fears of inflation are waning and defensive names are out of fashion. We'd like to see the Semiconductors really join the party for further confirmation.
Best regards, good trading, and have a great week!