Weekly Wrap-up: Inflection Point: Rising Rates and Risk Premium
The following article was originally published at The Agile Trader on Sunday, March 12, 2006.
Our Dynamic Trading System took a +5% net profit in the Nasdaq 100 futures market last week (NQH6) with numerous of our auto-trade subscribers netting +12% on the trade. Our auto-trade subscribers have netted +346% in position gains since the Index Futures service was launched in July '05 and those who are following our asset allocation model are showing a net total return of +87% or more.
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Aggregate earnings trends on the S&P 500 (SPX) remain healthy.
The consensus of Forward 52-Week Earnings per Share (F52W EPS, blue) ) hit another new all-time high last week at $85.92. (This using +7.5% Y/Y growth for 1Q07 -- we're using this until S&P publishes consensus figures for CY07.) Trailing Operating Earnings (T52W EPS, yellow) also hit a new all-time high at $78.00. Trailing Reported EPS (pink) likewise hit a new all-time high at $75.61 and continued to close the "quality gap," now just 3.1% below T52W Operating EPS.
Projected Y/Y growth for 52 weeks hence stands at +10.9%, which is a deceleration from the 13% growth over the past year, but not a sharp or vicious one.
So, what's the problem? Why do we maintain our cyclically bearish outlook for the period between now and October 2006?
To be sure, Price/Earnings Ratios remain low and stable, suggesting that the stock market is still cheap.
(Note how close the PE on Reported EPS (pink) has come to the PE on Trailing Operating EPS. The quality of earnings is extremely good, meaning that companies are doing very little by way of using accounting gimmicks to cause Operating EPS to vary from Reported EPS.)
Well, the first problem is (or could be) that growth in the consensus F52W EPS estimate is slowing, and appears to be headed for trouble.
Y/Y the F52W EPS figure has decelerated to +13.5%. And while that in itself does not pose a problem, further slowing to below a +10% rate can portend obstacles for the bullish case; we've highlighted the periods when the blue line has been dropping at levels below +10% and you can see how problematic that can be for the SPX.
Moreover, the 3-month annualized growth of the F52W EPS consensus (red line) is abiding below the +5% line. Historically this tends to presage further drops in the blue line to problematic levels.
Sector-by-sector analysis of estimates for CY06 continue to be troublesome as well.
The only sectors of the SPX that are enjoying upward trends in revisions are Energy and Utilities, exacerbating developing inflationary pressures. Over the past year trends in all 8 of the other sectors are flat to down.
Perhaps more than anything else the stock market now appears to have rising interest rates on its mind.
The yield on the 10-Yr Treasury Note (yellow line) has seen its yield rise 40 basis points (0.4%) in the past 8 weeks to 4.75%. And that puts some pressure on the bulls, as higher interest rates decrease the current value of future earnings, thereby diminishing the value of the stock market.
The yield on BAA bonds (pink line) has also risen, in this case 60 basis points since July to 6.41%.
Why are interest rates rising and what does it mean? The stock market probably has some legitimate concerns that a somewhat more inflationary environment is on the horizon. That's what it meant in the latter 1960s when the yield on the 10-Yr Treasury began rising from the 4% area while BAA yields also began to rise over 6%. Rising yields are not good for the stock market not just because they 1) reduce the current value of future earnings but also because they 2) make fixed-income investments more competitive in terms of yield and 3) tighten monetary conditions, which tends to slow economic growth, including real earnings growth.
As you can see on the chart, the SPX is now yielding 6.7% on F52W EPS. With the 10-Yr Treasury now yielding 4.75% the "spread" between these 2 yields has shrunk to: 6.7%-4.75% = 1.95%. We call this spread the Equity Risk Premium (ERP); it represents how much additional forward earnings yield investors are demanding in order to take the risk of investing in the stock market, relative to investing in "risk-free" US Treasuries.
While the current ERP (pink line above) is high by historical standards, it has now descended to its median post-9/11 level (1.95%) and is, at least for the moment, back inside its "one standard deviation envelope" relative to its historical mean. The market is still on the cheap side relative to historical averages, but it is no longer outrageously or improbably cheap on a risk-adjusted basis.
While the Fed calculates Fair Value (FV) by dividing F52W EPS ($85.92) by the 10-Yr Treasury Yield (4.755%), giving us a FV of 1807, that figure appears to be irrelevant in the post-9/11 world. (At least for now.)
We calculate RISK ADJUSTED FAIR VALUE (RAFV) by dividing F52W EPS ($85.92) by the sum of the 10-Yr Treasury Yield (4.755%) and the median post-9/11 ERP:
$85.92/(.04755*.0195) = 1281.
With the rise in the 10-Yr Treasury Yield our RAFV target has fallen below the SPX price for the first time in 21 months. And with yields headed higher, to 4.9-5% in our view (frankly, they HAVE TO head higher toward the level of nominal GDP or else they will be terribly inflationary), we could very well see RAFV drop toward SPX 1235 in the weeks ahead.
If so, then our RAFV equation could well look like this:
$85.92 / (.05+.0195) = 1236
This 1235 target fits hand-in-glove with the technical analogues of 1966 and 1994, which we have been examining for some months now.
The correlations between 2006 and 1966, as well as between 2006 and 1994, continue to improve, albeit fractionally. If these analogues persist in exerting some sort of karmic predictive powers then the SPX has a date with 1235 roughly 8 trading days hence, on or about 3/22/06 (which, incidentally, is just 2 days shy of the 6 th anniversary of the SPX's all-time high, as well as being the 6 th anniversary of my 40 th birthday).
The futures markets are now pricing in a Fed commitment to at least a couple of more rate hikes, which would drive the Fed Funds rate up to at least 5%. In that context, a rise in the 10-Yr Treasury Yield to the 5% area would put the yield curve at roughly flat in the months ahead.
We currently view last week's steepening of the curve (blue line) up to +25 basis points as either a blip or else the deceleration of the downtrend into a trading range. We do not think that the yield curve is headed into a steepening trend. Not at this point.
Consequently, we are not looking for PE expansion, but rather for a stable to down market PE between now and the July-October time frame. We expect to see PE fall back to 14 (forward earnings yield 7.1%) or perhaps even down to the 12.5 area (forward earnings yield 8%) before the 4-year cycle low has been put in place.
What fundamental factors would change our minds? Potentially: Crude Oil below $58, an earlier than anticipated end to the Fed rate-hike regime that would induce a bull steepening of the yield curve (lower Fed Funds rate), marked acceleration in earnings growth, or a high-volume SPX breakout over 1300 that survives a test down to the breakout level.
We'll be out with our shorter-term technical and sentiment work in Monday's Morning Call.
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Best regards and good trading!