Weekly Wrap-up: This Time it's Different
The following article was posted on The Agile Trader on Monday, January 2, 2006.
The titular phrase has become a big red warning flag for investors, especially since the "this time it's different" Nasdaq blew up in the New Economy's face back in 2000. The phrase may be antonymic to the more philosophically familiar, "The more things change the more they stay the same." (Though I often wonder whether it may also be the case that the more things stay the same, the more they change--see Paul Mcculley's terrific writings on the subject of Stable Disequilibria at Pimco's Website.) And it is undoubtedly true, as Mark Twain wrote, that while history may not repeat itself, it does rhyme.
Then again, in refutation to the above paragraph (which paragraph makes a number of contradictory assertions, each of which, could stand its own individualized rebuttal), as Lee Benson wrote, "(just because) generations of historians have resorted to what might be called 'proof by haphazard quotation' does not make the procedure valid or reliable; it only makes it traditional."
Why take the "long way 'round" into the subject of the stock market? Because there's a lot of hooey floating around the financial media about what, historically, an inversion of the yield curve means and whether the stock market is currently cheap or expensive. And now that we've cleared up the larger subjects of our human relationship to history as well as history's relationship to the future (not so hard, eh?), let's try to sort out some easy stuff, like what it means, historically, when the Yield Curve inverts, when the PE is where it is, and when Equity Risk Premium is very high (as it is now).
This first chart plots the Yield Curve (defined as the difference between the 10-Yr Treasury Yield and the Fed Funds Rate) on the X axis. On the Y axis the chart plots the SPX's Price/Earnings Ratio on Forward 52-Week Operating Earnings.
This chart scatter plots weekly data going back to 1960. On it we can see from the Linear Regression line that there is a discernible tendency for the SPX's PE to be higher when the Yield Curve is steeper and for the PE to be lower when the Yield Curve is shallower or inverted. But as we can also see, the scatter plot is not terribly tight. Indeed, during this period the correlation coefficient is +0.29, which is statistically significant but not statistically magnificent. (Note: the SPX PE on T52W EPS is currently 16.26, which is a multiple of about ONE below its 45-year median and just about ON the linear regression line. So, on these bases, the market looks to have something very close to an average or median value.)
Over the past 18 months, however, the correlation between the Yield Curve and the market's PE has been a much stronger +0.77 as the PE has shrunk while the Yield Curve has flattened.
Of course, the million-dollar question is whether the Fed will continue to tighten, driving the curve into a serious and sustained inversion or if they'll stop roughly where they are, leaving he Curve near the ZERO line as they did in the latter '50s, early '60s, and in 1995. The problem is, I suspect, that the Fed doesn't know what they're going to do either. Why? Because they're still targeting Housing and Energy.
The Fed tightening has driven down both Housing stocks and Energy commodities from their summer highs. The Residential Construction sector (candlesticks) is leading Light Sweet Crude Oil (XOIL, red line) by 24 days with a very strong +0.80 correlation. The big question, in my view, is whether Residential Construction is forming a Head & Shoulders Top. If so, then the odds favor Crude Oil's doing the same. And if these 2 charts break down, then the Fed will likely breathe a lot easier and let up on the brakes.
Now, while breakdowns in Housing and Energy prices might hit the benchmark stock indices in the short-run, the prognosis for '06 would look a lot more bullish with an easier Fed and lower Energy prices. So, we'll be watching to see whether the Residential Construction Sector will break below 1700 and if Crude will find a home below $60.
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EARNINGS AND VALUATION
Projections for the SPX's earnings momentum are sustaining at a high level.
Y/Y the consensus estimate for F52W EPS moved up by +0.4% to +15.8%. We continue to view anything above +10% as constructive. (The consensus is currently projecting 11.1% EPS growth for CY06.)
The index's PE on F52W EPS dropped down by -0.3 to 14.6 last week. That's just +0.6 above its cycle low of 14.0. The Forward Earnings Yield is 6.83%.
That's just +0.6 above its cycle low of 14.0.
The 10-Yr Treasury has a Price/Dividend Ratio of 22.8 (yield of 4.40%).
Meanwhile Equity Risk Premium (ERP), defined as the difference between the SPX Forward Earnings Yield and the 10-Yr Treasury Yield is 6.83%-4.40% = 2.43%.
As far as the market's longer-term prospects go, these numbers suggest a very high probability that the market will be higher in 2.5 years than it is now.
This chart shows the past 20 years' PE on the Y axis and the market's annualized price change over the ensuing 2.5 years on the X axis.
On this chart there is a very strong tendency for a low PE to show a positive return and for a high PE to show a less positive or negative return. (The 2 series have a strong -0.68 inverse correlation.)
I've highlighted in yellow the spots at which the SPX has had a PE near 14.6 during this time frame. As you can see, the annualized returns over the ensuing 2.5 years have all been on the plus side, ranging from about +1% to +31%.
Moreover, with ERP up at +2.43%, the market shows a tendency toward positive longer-term returns. The following chart looks at the past 46 years' data.
This chart plots ERP on the X axis and annualized price change over the ensuing 2.5 years on the Y axis. Because the data spans such disparate periods in our economic history the scatter plot doesn't immediately display a terrifically obvious pattern. But if you look at the highlighted area, with ERP between 2 and 3%, you'll see just how biased to the upside is the reaction to a high ERP. Indeed, the market displays negative annualized returns in the 2.5 years subsequent to ERP in the 2-3% range less than 10% of the time.
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Late December showed uncharacteristic weakness on seasonally light volume on both the SPX and the NDX as well as on most benchmark indices. That said, when late December is weak, early January tends to be strong; and the 4-year cycle pattern, discussed at length last week, continues to suggest that January is likely to see a higher high than we was seen in December.
Now, let's return to the phrase we began with. "This time it's different."
While the market can always surprise and while there are certainly structural issues with which the economy will have to cope going forward (most especially a surfeit of debt), in order for the stock market to enter into a protracted bear market from its current posture (PE of 14.6 and ERP of 2.43%) it would indeed have to be different this time. More likely, in our view, the market could sell down as we approach the 4-year Cycle Low (October), but with another constructive 4-year cycle emerging out of that low.
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Best regards and have a great week!