Weekly Wrap-up: We'll Know It When We See It

By: Adam Oliensis | Thu, Mar 9, 2006
Print Email

The following article was originally published at The Agile Trader on Sunday, March 5, 2006.

Dear Speculators,

The most interesting chart to my eye at the moment is this one.

The yield on the 10-Yr Treasury Note is making noises like it wants to breakout of a 19-month trading range (4% - 4.5%) and challenge its 2004 highs in the 4.9 - 5% area.

A move higher in long-term rates, should it occur and sustain, presents a complex matrix of implications.

On the one hand, with short-term rates now at 4.5% and likely to head higher this spring, there would be no place left on the curve where money would be really cheap to borrow. Pretty cheap, yeah, but not really cheap. Put differently, that would tighten monetary conditions and could slow aggregate consumption (final demand).

On the other hand, the Yield Curve (for our purposes the difference between the yield on the 10-Yr Treasury Note and the Fed Funds Rate) could steepen or at least remain flat, avoiding the inversion so much discussed in the financial media.

Indeed this Yield Curve (blue line above) widened to +0.18% last week, up from a low of +0.06%, providing at least some preliminary support for the idea that the market's PE could perhaps begin to expand rather than continuing to contract (or at least stop contracting).

That said, one has to wonder whether the nascent breakout in the 10-Yr Yield isn't perhaps a function of a US Dollar that is starting to weaken.

With the US Dollar Index having broken the lower limit of its rising wedge (and then having rallied to kiss that lower limit goodbye before again dropping below 90), it's possible that rising bond yields are less a function of renewed optimism about the US Economy and more a function of a waning interest in all financial paper that's dollar denominated.

And if that's the case then the risk arises of a somewhat less robust interest on the part of foreign investors to finance US deficits of a variety of kinds: US Government, US Trade Deficit, US Consumer's mortgage debt, you name it. What has been the self-reinforcing strength of "riskless" US assets (high price, low yield of long-term Treasuries) could unwind itself in a hurry if foreign investors perceive a decrease in "risklessness" (increase in risk) carried by the currency itself. And a mass flight from this asset class could itself develop a repellant sort of magnetic charge that expresses itself as a frenzy to exit, driving longer-term rates higher than expected.

The risk, of course, is that the debt-fed consumption party in the US economy would run into the brick wall of "no place to borrow cheap," leaving consumers no place to hide from the nasty "morning after" that follows binge partying.

"Ah," says apologist for our finance-based economy, "support for the US Consumer's consumption will come from new-found income growth engendered by a rebounding jobs market." But let's take a look at what that really amounts to.

Economist Paul Krugman, professor of Economics and International Affairs at Princeton University and Op-Ed columnist for the NY Times writes: "The 2006 Economic Report of the President tells us that the real earnings of college graduates actually fell more than 5 percent between 2000 and 2004." And that's the group that's supposed to be benefiting the most from the transition to a knowledge-based economy!

Krugman continues, talking about a new research paper by Ian Dew-Becker and Robert Gordon of Northwestern University, "Where Did the Productivity Growth Go?"

Between 1972 and 2001 the wage and salary income of Americans at the 90th percentile of the income distribution rose only 34 percent, or about 1 percent per year. So being in the top 10 percent of the income distribution, like being a college graduate, wasn't a ticket to big income gains.

But income at the 99th percentile rose 87 percent; income at the 99.9th percentile rose 181 percent; and income at the 99.99th percentile rose 497 percent. No, that's not a misprint.

Just to give you a sense of who we're talking about: the nonpartisan Tax Policy Center estimates that this year the 99th percentile will correspond to an income of $402,306, and the 99.9th percentile to an income of $1,672,726. The center doesn't give a number for the 99.99th percentile, but it's probably well over $6 million a year.

While aggregate real income gains may be at least modestly healthy in the US, the distribution of those gains is so increasingly lopsided as to pose a real threat to final demand once the debt bubble pops. With interest rates now showing signs of starting to rise across the Curve, "dawn" of the "morning after" could be coming sooner than many expect.

The problem with a "steepening yield curve" that's created by rising long-term rates, rather than by falling short-term rates, is that it functionally tightens monetary conditions, and indeed it can be considered a "bearish steepening."

In this context our Risk Adjusted Fair Value target for the SPX has begun to fall.

Indeed there is only a 6-point spread between our RAFV target and the SPX price. This RAFV price is derived by

RAFV = SPX F52W EPS / (TNX + Median ERP)

Where:

RAFV = Risk Adjusted Fair Value
F52W EPS = the consensus of Forward 52-Week EPS for the SPX ($85.81)
TNX = 10-Yr Treasury Yield
Median ERP = Median Post-9/11 Equity Risk Premium (where ERP is the difference between the SPX Forward Earnings Yield and the 10-Yr Treasury Yield).

In this case: $85.81 / (.04684+.0195) = 1293.

What this convergence of the red and blue lines above is telling us is that the market is about as sanguine about risk as it has been on average since 9/11. And that any significant further upside would have to be motivated either by prospects for accelerating earnings growth or by a diminution of perceived risk.

Given that Crude Oil is trading smack in the middle of its recent range of $58-$68, it hardly appears that the perceived risk is diminishing. And given this chart...

...we continue to perceive a high degree of risk to the stock market for the period between now and October.

Of course, a durable breakout over SPX 1300 (one that survives tests down to that level and shows some upside resilience following those tests) would force us to alter our view and "go with the flow" of the "tape." COULD there be a very "soft landing?" Sure there could. But we regard that as the less likely scenario.

Absent a durable breakout of the SPX over 1300, we will continue to anticipate that the Fed will not ease up on raising short-term rates until something big in the economy is broken in some obvious sort of way.

We expect such a break to occur between now and the fall of this year. We don't know what it will be, but we'll know it when we see it.

Best regards and good trading!


 

Adam Oliensis

Author: Adam Oliensis

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 © 2003-2010 The Agile Trader, LLC All rights reserved.

All Images, XHTML Renderings, and Source Code Copyright © Safehaven.com