Weekly Wrap-up: What You'd Have to Believe...
The Dynamic Trading System took no profits and no losses last week, but remains on active signals, fully involved in the market, as it heads into mid April. Using E-Mini Index Futures the System has netted +393% in position gains on closed trades since the portfolio was launched in July '05 (9 months ago), garnering a total return of +115%,net of all commissions and fees since inception. (Note: for regulatory and compliance purposes these results are to be considered hypothetical as described in the disclaimer below.)
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As for the outlook on the stock market, I'd like to reiterate something from Friday's Afternoon Note:
... regarding rising interest rates, gold prices, and oil prices, I keep wondering what's it going to take to get the market's attention on these issues...?
I guess the answer to my brooding question was, "Good Payrolls numbers."
The stock market is nothing if not perverse.
If you GOOGLE "Things you have to believe to be a Republican," or "Things you have to believe to be a Democrat," you'll find links to some fairly funny, ironic articles that make points on both sides. (I have my politics--strong politics--but good fun can be made bi-directionally.)
By contrast, here are some un-funny things you have to believe to be bullish on the stock market right now (almost all of which we have studied at length in (this space):
- Rising interest rates don't matter. (Last time they "didn't matter" was in '99-'00.)
- A flat or inverted yield curve doesn't matter. Or a "bear steepening" (steepening of the curve because long-term rates are rising) doesn't matter.
- Rising Gold prices are not prognosticating higher inflation.
- Other rising Industrial Metals prices don't matter.
- Rising Oil prices are no problem.
- The Bernanke Fed is not targeting commodities prices and won't "break something" before they're finished tightening.
- The 4-Year Cycle doesn't matter.
- The market's going "uncorrected" for long periods of time doesn't matter.
- The market can break out to the upside at a point in the 4-Year Cycle from which it has never in the past broken out to the upside.
- Investors unwinding the Yen Carry Trade (repatriating Yen now that Quantitative Easing in Japan is over) doesn't matter. (We haven't studied this one, but we'll try to in the future.)
Individually any of these things might not matter. In aggregate, I continue to suspect that they do and will matter over the coming 7 months. (Please keep in mind that I am not normally one of the nattering nabobs of negativity. My normal predisposition is bullish on the great American Economy and on the stock market, and I've had an SPX target of 1280-1320 dating back at least as far December '04.)
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Building upon last week's discussion in this space about the contrast between the statistical nature of risk and how we, as human beings with particular sorts of emotional lives and predispositions, experience risk, I'd like to direct you to John Mauldin's discussion of Fingers of Instability:
The whole article is worth reading, but here is a paragraph that is so outstandingly clear that it's worth pasting:
Nobel laureate Hyman Minsky points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist; and then when the trend fails, the more dramatic the correction is. The problem with long-term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings for current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.
(Emphasis mine. -- The same point made last week in this space on the subject of feeling that a catastrophic event is less and less likely even as it is becoming statistically more and more likely.)
Now, all due praises to Mr. Mauldin for his intelligent discussion, but I'd like to also take umbrage with a point he admittedly cribs from John Hussman to the effect that the market should be valued based on "prior peak earnings..." and that indeed near the peak of the earnings cycle it should be trading at something like 9 times prior peak earnings.
The argument goes roughly like this: since the EPS line is near the top of its channel, it is likely that that line will regress toward the bottom of the channel. Consequently, at the top of the cycle the market should be discounting earnings based on the prior peak and not on the current peak in earnings.
But let's look at what the market would have to do in order to trade at 9 times Trailing Earnings from the prior peak. The SPX would have to trade at
9 * $56.79 = 511
That would put the SPX at less than 6 times the Forward 52-Week EPS consensus. And the last time the SPX traded at 6 times F52W EPS? Well, it got down to about 6.6 in 1978 when the 10-Yr Treasury was yielding over 10% and was on its way to 14%, and with the Consumer Price Index on a similar glide path.
Currently the 10-Yr Note is at about 4.9% and the CPI is trending at about 3.6%. If the SPX dropped its PE to 6, the Forward Earnings Yield would be 16.67% or about 11.7% higher than the 10-Yr Treasury Yield. (If that were to happen, the call you'd want to make would not be to your broker, but to your FAMILY, 'cause that would be a function of a major international catastrophe.)
This chart makes clear some of what's (at best) awkward about trying to discount the stock market based on prior peak earnings. In February 2001 the PE on Prior Peak EPS dropped from about 53 to about 21. And, indeed, while a positive correlation does exist between PE on Prior Peak EPS and the SPX's annualized growth rate over the ensuing 2.5 years (+0.63 on this chart), the correlation is much stronger between F52W EPS and the SPX's forward annualized growth rate over the ensuing 2.5 years (+0.89).
I have studied these relationships going back to 1950 and, while there are periods during which the red line (Prior Peak PE) mimics the blue line (F52W PE), its prognostications for forward 2.5-yr performance on the SPX are at best almost equal to the blue line's, and are often much worse.
...which only makes sense. Why would you want to value the stock market based on EPS of 5-10 years earlier when the market, a forward discounting mechanism, gives you much more current and timely data? And if EPS are going endure a big flush (as they did from '00 to '02), we will see it on this chart, which is flashing warning signs, but not horribly severe ones.
- Black line: SPX, scaled at right.
- Red line: 3-month annualized growth rate of Forward 52-Week EPS Consensus (now at +3.5%).
- Blue line: Y/Y growth rate of F52W EPS Consensus (now 12.7%)
The red line continues to lead the blue line lower. And we continue to expect that the black line will get "all gnarly" by the time the blue line is declining at a level below +10%. However, with the market's PE on F52W EPS still fairly well suppressed, down near 15, our call continues to be for a merely cyclical bear between now and October and not for continuation of any sort of secular decline.
With that disclaimer on the subject of magnitude under our belts, let's look at some other pictures that we think should worry the stock market.
All 4 quarterly estimates for CY06 fell sharply this past week, led lower by downward revisions for Information Technology stocks, for Utilities, and for Consumer Staples.
Despite a sharp rise in interest rates (the 10-Yr Treasury Yield is tickling 5%, up from less than 4.3% in January) the Yield Curve is not notably steepening. In my view it's arguable whether the flat-to-inverted curve will cause a recession. But, other things equal, a flatter curve and higher rates will be harder on the economy and on the stock market. So, we see no evidence presently to indicate that the market's PE should be expanding at this point in the cycle.
Crude Oil appears to be on its way to challenging the double top formed in the Fall-Winter time frame.
Memorial Day, which kicks off the summer driving season is just 7 weeks away!
While I have been skeptical of the rise in energy prices, I would suspect that the $70 price level will not hold as resistance through the summer. On a purely technical basis, a break above $70 could put Crude into the $82 area in a hurry.
Do we honestly think that the Fed is going to stop raising interest rates with Crude breaking out to new highs? The FOMC has to target commodities markets. That's where inflationary pressures are coming from. And if they keep raising at a measured pace, then the deterioration we're seeing on this next chart will be further exacerbated.
Growth in earnings projections is weakening and will very likely continue to do so. The blue line on this chart (that's the same blue line that we saw 4 charts up) is now more than 70% of the way toward the problem zone, below +10%. But the Fed is going to have a hard time dropping the red line down to chase the blue line (they would have to at least slow the rate of rate hikes) with Gold and Oil breaking out to the upside. (Gold hit $600 last week!)
Further rate hikes will tighten monetary conditions, may well push the curve into a serious state of inversion, and will choke growth. But failure to hike rates will encourage continued speculation in runaway commodities markets, which will raise inflationary pressures. I'm sorry to repeat myself, but for the Fed the Rock and the Hard Place are real close together right now.
Since inflation-fighting holds primacy for the Fed, odds are they'll be hiking longer than the stock market currently wants to believe.
Our Risk Adjusted Fair Value price is now 48 points below the SPX price. We have not seen RAFV significantly below the SPX during this market cycle, and we suspect that RAFV will exert a downward pull on the SPX in the weeks and months ahead.
We derive the RAFV target using this equation:
F52W EPS / (TNX + Med ERP)
F52W EPS = Forward 52-Week EPS ($86.23)
TNX = 10-Yr Treasury Yield (4.963%)
ERP = SPX Earnings Yield - TNX (6.66% - 4.936% = 1.69%%)
Med ERP = Median Post-9/11 ERP (1.95%)
$86.23 / (0.04963+ 0.0195) = 1247.50
Summing all this up, we are holding the line on last week's conclusion...the odds favor a correction on the SPX of more than 5% but less than 20% between now and October (10-15% is a sensible target band). Beyond that, it would appear likely that the index will make a higher high by the spring of '07, if not before.
In our daily issue of the Morning Call we'll examine the technical charts on the leading and lagging indices this coming week, as we seek confirmations and divergences on the major market indices.
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Best regards and good trading!