Weekly Wrap-up: The Dollar, The Rock and a Hard Place
(Something's gotta give...)
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Two weeks ago in this space I wrote an article entitled Meatballs: It Just Doesn't Matter. That article included this paragraph.
Frankly, it makes no sense to suppose that the FOMC, which has described its own policy stance as data-dependent, would not react hawkishly to the developments of the past 4 weeks in the commodity and interest-rate markets. And it would make just as little sense to suppose that the SPX should feel no effects from these price spikes.
Last week I wrote:
With this new and fairly convincing breakout of the SPX (now 1326), which leaves the key 1295-1300 congestion level behind, we are forced to abandon our mid-term downside projections <b>until market conditions dictate otherwise. As long as the SPX maintains some "loft" above 1300, we would now be looking for the index to move higher...A quick drop below 1300 would zip us back into our bear suits, and put the 1966 analogue back in play.
Well, with the SPX having fallen back to 1291, it appears as though investors have come to their senses and recognized that "IT DOES MATTER." The SPX IS feeling some ill effects from developments in commodities and interest-rate markets, the breakout over 1300 has failed (at least for the moment), and we have zipped on our bear suits again, for a roller-coast ride toward the 4-Yr. Cycle low in the 2nd half of this year (most likely in Sep-Oct).
The 1966 analogue (navy blue line above) is now in play again.
Now, hold on a cotton-picken minute! How can we be bearish when economic and earnings growth are sizzling!?
The consensus estimate for Forward 52-Week Earnings (blue line above) is at yet-another all-time high at $88.14, 10.5% above Trailing 52-Week Operating EPS (yellow line).
And the F52W Consensus is now +13% above where the consensus was a year ago.
Moreover, the 3-Month Annualized Growth Rate of the F52W EPS consensus (red line above) has bounced up from +3%-ish to almost +13%, indicating that shorter-term momentum of the consensus estimate has improved and is no longer acting as a drag on the Y/Y figure (blue line).
To add weight to the bullish case, the SPX's valuation is barely above its cycle lows.
With a PE on F52W EPS of 14.6 (blue line) the SPX is "richer" by a multiple of just +0.6 than it was at its October '05 low, and is just a multiple of +0.1 richer than it was at its October 2002 multi-year low.
The answer to the how we can be bearish is two-fold: First, the RELATIVE valuation of the stock market compared to the bond market has deteriorated markedly despite the very small appreciation in PE Ratios. (That is, interest rates are rising so sharply that the value of the stock market is likely to suffer some sort measurable shock at some point soon.) And second, there's a problem on the horizon vis-à-vis anslyts' consensus estimate; a problem that derives from the intense volatility in the commodity, interest-rate, and currency markets.
Here's what I mean. These are the premises I'm working with on the next chart:
- Nominal GDP will grow at +7.5% in each of the CY06 and CY07. That's roughly +3.75% for Real GDP and +3.75% for headline inflation. (We could quibble a percentage point here or there, but this is probably a reasonable ball park.)
- Corporate Profits (after tax, with Inventory Adjustments and Cost of Capital Adjustment) will grow at +11.5% in CY06 and at +11.7% in CY07. Again, we could argue about these figures, but they represent the consensus estimate for SPX companies according to Standard & Poors.
Now, let's look at something very odd that happens if we use these premises.
Profits as a percentage of GDP would soar to levels not seen since... well... EVER! (Of course we have to qualify "ever" to mean "since 1929," which is when the BEA's spread sheets start giving us the figures.)
There's another interesting feature on this chart. On the X (horizontal) axis we have labeled every 4th year, each of which is the final year of a 4-year cycle. In year-4 of the cycle the SPX tends to form a low from which it has a propensity to rally for at least 2 years.
About 70% of the time this proxy for profit margins also troughs during that same year-4 of the cycle (black arrows). And the "30% of the time" that margins PEAK in year-4 (green arrows), the subsequent decline in margins tends to be severe, by roughly a minimum of 2% of GDP. That is, if the 4-year cycle doesn't play itself out on schedule then the amplitude of the decline in Profits as a % of GDP tends to be quite severe on its subsequent trip south. Or put differently, if you don't pay the piper on schedule, you pay him more later.)
Now, how's this increase in corporate Profits as a % of GDP (from a near-record high of 7.8% to an unprecedented high of 8.4%) supposed to work over the next 19 months? Is it going to come from declining inputs prices?
Not hardly. Two of the three primary SUBSTRATES of doing business (commodities and money) are becoming more expensive at an extremely rapid rate. And the curious thing is that the rise in interest rates is having virtually no effect on projections for economic growth, nor upon its corollary, prognostications for the rate of increase of the use of commodities.
The third substrate? The cost of labor. But if commodities prices don't soon take a southerly turn, consumers' inflationary expectations will rise and pressure for higher wages will begin to mount. (Note: The U of M's Consumer Sentiment Survey last week showed a huge 13-point drop in Present Conditions to 96.2 while Expectations dropped 5 points to a moribund level of 68.0. Gas near $4/gallon may be playing an important role in the deterioration of sentiment.)
Should that 3rd and final important substrate (cost of labor) begin to accelerate along with the costs of commodities and money, businesses will have no choice but to either raise prices (that's inflation) or take a hit to profit margins (not remotely discounted into the consensus of Forward Earnings Estimates at present).
Now, let's look at what the interest-rate and currency markets are up to.
This chart illustrates the sell-off in both the US Dollar and the 10-Yr Treasury Note since Fed Chairman Bernanke's inaugural statement of policy on March 28, '06.
This is the flight from all things dollar-denominated that has long been expected. And it's problematic, especially in light of the necessity for foreign investment in the U.S. to finance our Current Account Deficit. Without that inflow of foreign investment (from both foreign central banks and private investors) to keep both the U.S. Dollar and U.S Treasuries well bid, the lifestyle of the U.S. Consumer will suffer; interest rates will rise and the purchasing power of the Dollar will decline (inflation will rise). Money, commodities, goods, and services are all in danger of becoming markedly more expensive in dollar terms.
The only way that our currency can decline, our interest rates soar, our commodities prices shoot higher, and inflation remain low (all concurrently) would be for productivity to rocket ahead even more rapidly than has been the trend. True, productivity has been a workhorse in terms of supporting the "Goldilocks" scenario for the U.S. Economy. But it would appear unlikely that productivity alone would continue to provide the impetus carry Goldilocks through the woods in (the fading) light of the diminishing energy provided by foreign investors (as evidenced by the flight from all things dollar-denominated).
At some point all the pressures brought to bear by the "perfect storm" of rising commodities prices, rising interest rates, a deteriorating currency, and the disenchantment of foreign investors, will very likely show up in the Economy and in the Stock Market. And we are now at the point in the 4-year cycle, as we head into the summer of year-4 of the cycle, when just these kinds of perfect storms tend to find the moment opportune for self-expression.
If the FOMC stops raising rates, commodities will continue to soar, foreign investors will continue to flee the dollar (as they seek higher yields in other currencies), and inflation will rise. (Not good.) But if the FOMC continues to raise rates, the yield curve will invert, economic growth will slow, and earnings growth will roll over. (Also not good.) The committee is caught between the proverbial Rock and the Hard Place, with just about no room in between the two.
What's a girl to do?
Suck it up. Walk it off. Take it like a man!
If the market ISN'T willing to take some near-term pain and show the world a reasonably scary correction between now and October? Then the odds will favor a much more aggressive paroxysm of cyclicality in the ensuing 12-18 months. (Even worse.)
Maybe there's a "3rd way." Maybe there's a way out of the box that I don't see. I'm always open to that. If there's someone who could imagine it, I don't doubt that it's Bernanke. (I've read that he scored 1590 on his S.A.T's.) But so far, if Bernanke has said it, the markets haven't heard it.
Because of the rise in the 10-Yr Treasury Yield (TNX) our Risk Adjusted Fair Value price of the SPX continues to exert a negative drag on the SPX.
RAFV = SPX F52W EPS / (TNX + Median ERP)
RAFV = Risk Adjusted Fair Value
F52W EPS = the consensus of Forward 52-Week EPS for the SPX ($88.14)
TNX = 10-Yr Treasury Yield (5.19%)
ERP = Difference between SPX Forward EPS Yield and TNX (6.83%-5.19% = 1.64%)
Median ERP = Median Post-9/11 Equity Risk Premium (1.94%)
$88.14 / (0.0519+.0194) = 1237.
At some point in the future investors will demand less Equity Risk Premium for the privilege of investing in the growth of the U.S. Economy. But given the array of risks to which the market is now exposed in the post-9/11 world, it is our view that the time to demand LESS Equity Risk Premium is NOT NOW.
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Best regards and good trading!