Weekly Wrap-up: The Diciest Part of the Cycle
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I'd like to start this week's look at our world with someone else's work that made a deep impression upon me. If you have a subscription to the New York Times Online, you can find a broader, deeper story on the subject at The Rise of the Super-Rich. In this story, Teresa Tritsch cites the work of a number of economists, a smattering of which we'll look at here.
The last year for which complete data is available on the subject of income distribution in the US is 2004.
This table shows us the change between 2003 and 2004. The bottom 99% of the population lost -1.9% as a share of National Pre-Tax Income.. The top 1% gained +1.9%, with the top 0.1% of the population accounting for about 68% of that change, gaining +1.3% as a share of National Pre-Tax Income.
What the hell, we're capitalists, right? If the rich are getting richer, that's a good thing! It means the markets are working and those who are most able to move capital are the ones reaping the benefits. That's a perfectly legitimate theory.
But let's looks what happens when we plot the Share of Total Pre-Tax Income Held by the Highest-Income 1% against the Dow Jones Industrial Average on a log scale. (The red line on this next chart is from the study by Piketty and Saez, with data through 2004. I have overlain the Dow chart, with data through Friday, using the appropriate time scale.)
We don't have the data for the red line beyond 2004, but, it is extremely likely, given the trends in wages and real hourly earnings, that the red line is higher now than it was at the end of '04 (that's why I've drawn in the red arrow at right). And as you can see, when the red line spikes up to the 20% area, that has, in the past, generally spelled trouble for the Dow.
Now, one could also make the case that when the red line drops too low, down below 10%, that the market also suffers, as it did in the '70s. So, don't think that I'm taking a socialist stand here, advocating complete equality of income distribution. But what I am suggesting is that this data implies that there is an optimal range of income held by the Highest-Income 1% (perhaps, as an initial crude guess, between 11-18%) at which the economy and the stock market may function most optimally. Moreover, it would appear that when that ratio either rises too high or sinks too low, problems for the economy and the market ensue.
Why? Perhaps when the red line is too low there is insufficient incentive for those with capital to take the risks involved in putting capital productively to work. And perhaps when the red line is too high, those who do the bulk of the consuming (the bottom 99%) are insufficiently funded to continue growing aggregate demand (or as Henry Ford knew, if you want to create a market for a $600 Model T, the best thing you can do is pay your workers $5/day so they can buy that Model T)! But these are just a couple of reasonable hypotheses. What appears more important is that both too MUCH equality and too LITTLE equality seem to be less beneficial for the stock market than an intermediate level of equality/inequality. And right now our economy is in the process of distributing an unproductively high level of wealth to the top 1% while distributing an unproductively low level of wealth to the bottom 99%.
Does that mean that a major market crash is inevitable? I don't think so. But it does suggest that the risks of something really bad happening are heightened, if not in this 4-Yr Cycle, then perhaps beginning in late '08 or early '09, after the peak of the next 4-Yr Cycle. (And interestingly enough, that will be shortly after the Beijing Olympics, which I've had my eye on for the past couple of years as an event that could turn out to be a fulcrum on which the world economy turns. Why? Because once the Chinese have pulled off that event, on which many of their economic sights have been set, their policies and goals may shift. And that shift COULD turn out to be destabilizing for the global economy.)
Food for thought.
As far as the current 4-Yr Cycle goes, the SPX is at its own fulcrum. Having completed Trading Day #951 in the cycle, the market's next direction should make itself clear as July turns into August.
This chart plots the performance of this, the final year of the current SPX 4-Yr Cycle, (red line, now +54% up off its October '02 low) along with 4 of the past 10 cycles -- the group we have labeled as "middling."
Remarkably, these 5 cycles have bunched up around Trading Day #951 into just a 3% range, between +51% and +54%. From this point forward, however, the variability of performance increases markedly, as you can see. Whether this cycle will play out benignly (like 1994 and 1978) or malignantly (like 1966 and 1990) remains to be seen. But we should get clear indication of direction over the next 1-2 weeks, by Trading Day # 958-960 at the latest.
By contrast to the SPX, the Nasdaq 100 (NDX) has fallen much farther since Double Topping in January-April '06.
While the SPX has retraced just 18% of its cyclical rise, the NDX has given up 32% of its advance. And while the NDX remains up more than 80% since the start of the cycle, because the NDX tends to lead the SPX (both up and down), as long as the NDX continues to underperform, the SPX remains at risk of a more serious breakdown.
As our daily subscribers are aware, the Dow Transports are also flashing a major warning signal.
With the Friday's intraday violation of the June low, the Trannies have been put on notice that a breakdown from their own May-July Double Top near 5K may be imminent. And if this index does not quickly climb back up over 4500 (now 4456), then a trip down into the yellow zone (4100-4300, a 50-62% retracement of the October-May rally) is likely. (And I'd bet dollars-to-doughnuts that we'd see 4000 on that breakdown.)
Should the 38% retracement level hold as support on the Trannies, then we could look for a test up toward 5K again, and an SPX rally up toward 1300 to test its own spring highs.
The headline trend in SPX earnings growth continues along its robust path on all 3 of our EPS lines.
The consensus estimate for Forward 52-Wk Operating Earnings per Share (F52W EPS) reached a new high last week at $90.63, which is 43.6% above the Y2K peak of $63.08. Both Trailing 52-Wk Operating EPS (T52W EPS) and Reported EPS likewise reached new all-time highs (44% and 39% above their Y2K highs respectively).
The questions that have haunted the markets, however, have derived from the sector-by-sector distribution of those earnings, and the sustainability of earnings growth, specifically the prospects for forward earnings and their distribution.
A subscriber asked last week about SPX earnings growth and how that stacked up against SPX earnings growth Less Energy. It took some digging through a vast array of numbers, but here's what I've come up with.
Relative to July 15, 2005, and using Standard & Poors Sector-by-Sector earnings (which may have some small variance in weighting from the aggregate numbers) SPX sectors including Energy have enjoyed +15.8% Trailing 52-Week growth in earnings. The same calculation Ex-Energy shows a +10.2% rise in EPS.
I have to say that honestly that +10.2% surprises me to the upside. And perhaps what's most interesting about it is the acceleration one sees in the growth of Earnings Ex-Energy (the red line above) since April '06, since which the red line has pretty-much kept pace with the blue line.
This past week the market's Price/Earnings Ratios held essentially unchanged at low levels (the market remains cheap). The Yield Curve, defined here as the spread between the 10-Yr Treasury Yield and the Fed Funds Rate also remains slightly inverted (by roughly 20 basis points). And we continue to suspect that until the curve starts to steepen, the market's PE ratio will have trouble doing anything much but contracting.
The Fed Funds Rate is, in our view, restrictive.
As this chart illustrates, over the past 11 years the Y/Y change in the Fed Funds Rate has been highly correlated with the Y/Y Change the consensus for F52W EPS on the SPX (the correlation is about +0.88). When the red line is above the blue line the Fed is probably being restrictive. And when the blue line is above the red line, the Fed is probably being accommodative.
At present our prognosis is for the Fed to remain restrictive for a bit longer in order to make up for its extra accommodativeness in '04 and '05 when it delayed raising rates (raising the red line above ZERO) in response to soaring earnings projections (the rising blue line).
Keep in mind that all the Fed has to do to get the red line to fall is to stop hiking. It doesn't have to cut rates...at least not yet.
But if the Fed allows the blue line to drop below +10% and to continue falling from there, then the SPX is likely to endure protracted difficulties. And unless the Fed stops hiking sometime during 3Q06, that blue line is probably going to start "talking about" a HARD LANDING for the economy.
As we discussed above, the NDX and the Dow Transports are making or threatening to make some seriously bearish noises. Earnings and Valuations suggest to us that a soft landing and a relatively benevolent 4-Yr Cycle Low will play out in 3Q06 for both the economy and the markets. But if inflationary pressures continue to mount (as we have studied at length in the past), if commodity prices continue to make and/or threaten to make new all-time highs, then the Fed will be forced to remain restrictive, and the economic and financial-market difficulties could very well turn more malevolent.
We are now smack at the decision point for the economy and the markets as we head into the diciest part of the 4-Yr Cycle, due to arrive between now and October.
Stay tuned. Whichever way it goes, it should be interesting.
Best regards and good trading!