Weekly Wrap-up: Benevolent or Malevolent!
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Since last December we have been studying the 4-Year Cycle in the SPX and how that cycle would likely inform the index's performance for CY06. As we are now into the teeth of the anticipated market correction, it would behoove us to get as specific as possible about where we stand in that cycle and what market conditions will determine the most probable market course through the remainder of the year.
Here's a picture (busy though it may be) of all the SPX 4-Yr Cycles since 1962.
Each of these cycles is launched at the market low of 9/30-11/19 of year-one of the cycle. The thick red line is the current cycle ('02-'06).
As you can see, there have been 4 cycles that peaked out shortly after the mid-point (trading-day 504). Those are '70-'74, '98-'02, '66-'70, and '78-'82. In 1982 the SPX dipped to a low of +5%, with each of the others in the group regressing to less-than +0%.
As you can also see, 2 of the cycles ran to new bubblicious highs in July of year 4. Those are '94-'98 and '82-'86. (The bubblicious highs were followed shortly thereafter by the respective crashes of October '98 and October '87. So the implications of such unfettered market enthusiasm in this part of the cycle are pretty clearly spooky, but we are not concerned with those scenarios here, as the current setup does not fall in this group.)
The group we're concerned with is the MIDDLING one. This group includes the current cycle ('02-'06) along with '62-'66, '86-'90, '90-'94, and '74-'78. So, let's cull this middling group from the mish-mosh of the chart above and see what we can see.
Examining the 4 previous cycles in this middling group, we can see 2 different types of outcomes. The first is the "soft landing" outcome exhibited in the '74-'78 and '90-'94 cycles. In each of these 2 cases the market moved to a new local high in the late-August-early-September time frame before testing down in the September-October time frame to finish off the cycle.
The second type of outcome among these middling cycles is the "hard landing" scenario. In both 1966 and 1990 the SPX spent the May-July time frame chopping around the +50% area before collapsing in August and running lower into October.
So, which is it going to be for the current ('02-'06) cycle?
While anything is possible, our view is that we are more likely to see a relatively benevolent "soft landing" scenario play out than the more malevolent "hard landing." And the reason we hold this view has everything to do with valuation.
Here's what we mean.
Currently the consensus estimate for Forward 52-Week Operating Earnings is $89.95, a new all-time high. Trailing 52-Week Operating EPS now stands at $80.83, also a new all-time high. The growth in EPS (Forward, Trailing, and Reported) has been nothing short of remarkable. And the consensus estimate is for 11.3% growth in the coming 52 weeks:
($89.95/$80.83) - 1 = 11.3%.
These earnings put Price/Earnings Ratios at their lowest in more than a decade.
The SPX PE on F52W Operating EPS is now at 13.8, lower than it was at the bear-market lows of '02 or at any other time since 1995. And the PE on T52W Operating EPS, at 15.4 is lower than at any time since January 1991 (when, incidentally the yield on the 10-Yr Treasury was over 8%)!
Earnings projections for 2006 and 2007 show a consensus opinion that earnings growth will continue apace.
It's tough for the market to crash hard when earnings growth continues at 12% +, with very little sign of slowing.
Meanwhile both the Y/Y and 3-month annualized growth of F52W EPS projections remain robust. And indeed the 3-month annualized growth rate is pulling the Y/Y growth rate higher again.
Note: The market tends to have trouble when the Y/Y growth rate is falling (has a negative 2nd derivative) at a level below +10% or if it is below 0% (irrespective of the 2nd derivative). And we have highlighted those areas in yellow.
So, how does the current cycle stack up in terms of valuation relative to these 4 previous middling cycles? Here are some key valuation metrics for the end of June of year-4 for each of these cycles.
As you can see the SPX PE on F52W EPS in June of both 1966 and 1990 was 17.1. Currently the PE is 13.8. While that's not as low as the June '78 PE, it's much closer to the June '94 PE than those of '66 and '90.
The EPS yield is simply the inverse of the PE.
We've included the TNX (10-Yr Treasury Yield) to help us gauge the valuation of stocks relative to bonds using our Equity Risk Premium (ERP) calculation. ERP is simply the difference between the F52W EPS yield and TNX. (Currently 7.2% - 5.2% = +2%). When ERP is high stocks are cheap relative to bonds. When ERP is low (or negative) stocks are expensive relative to bonds. (The long-term median ERP is very close to ZERO, representing that in the long term stocks and bonds have had roughly equal yields. The implications being that "growth" and "risk" are about equally baked into stock prices.)
Based on this valuation study, we would be looking for the July-October performance of the SPX to be less positive than 1978's performance but decidedly more positive than 1966 and 1990.
Relative to 1994, the SPX currently has a slightly higher PE but also a higher Risk Premium. So, compared to 1994 the market is slightly more expensive on an absolute basis, but somewhat cheaper relative to bonds.
In sum: we continue to look for a choppy market over the summer with a cyclically climactic low most likely in the September-October time frame.
WHAT COULD GO WRONG WITH OUR FORECAST?
Obviously our forecast is a paradigm against which to compare reality as it unfolds, not a prescription written in stone.
If the FOMC takes its foot off the brake earlier than anticipated (say they are finished after this coming week's confab) then the yield curve will likely steepen and the SPX PE is likely to expand. If such is the case, then it's possible that we have already seen the low for this cycle.
We do not think this is terribly likely given the accelerating behavior of the CPI and PCE Deflator as well as the still-high prices most especially of Gold and Oil. But it's possible.
On the other hand, if economic growth slows such that the consensus estimates for Forward Earnings begin to deteriorate, then we could see our forecast of a "benevolent" 4-Yr low become itself too complacent. If the 3-month annualized growth rate of F52W EPS drops back down and begins pulling the Y/Y growth rate under +10%, then we could see some genuine nastiness as summer morphs into autumn. So, we will be watching closely what happens with analysts' estimates in the weeks ahead.
BEYOND OCTOBER 2006
If you take a close look at the first chart above, you'll note that 2 years into the 4-year cycle (trading day #504) the market has an incredibly strong tendency to be quite a bit higher than it had been 2 years earlier.
Perhaps the market is happiest during the last 2 years of a sitting president's term. But that's just speculation on my part. For whatever reason, the lows that are created between now and October are extremely likely to serve as the foot-holds from which a new cyclical bull market propels itself upward.
This new bull market is extremely likely to have new and unexpected properties. In as many ways as possible it will NOT resemble the market of the current cycle. It will have new leadership, new breadth characteristics, different kinds of liquidity flows, different volatility characteristics, and likely a different relationship to "risk."
What will it look like? We don't know for sure. But we suspect that Large-Caps will outperform Small-Caps. Health Care and perhaps Semiconductors and Tech could emerge as leaders. Energy and Materials stocks are unlikely to carry the ball in a new cyclical bull, as they have been the leaders in the current cycle.
These are a few hypotheses. But we'll be trying to nail down the changes to come as they emerge in the weeks and months ahead. So, stay tuned!
Have a great week!
Best regards and good trading!