Weekly Wrap-Up: Cyclically Optimistic
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There are a number of factors operating in the stock market at the moment that are worth being optimistic about. However, there are certainly some legitimate sources of concern. Let's start this week with the good news.
The trends in Earnings (Reported EPS (pink), Trailing Operating EPS (yellow), and the Forward 52-Week Consensus of Operating EPS (blue)) are all essentially healthy.
Historically there is a strong correlation between these Earnings lines rising and the SPX being in a bullish trend. And the current market environment is no exception.
Moreover, as this next chart illustrates in the bottom pane (blue line), the SPX PE on the Forward 52-Week Consensus remains quite modest.
There are a number of interesting features in this chart:
- Note that the SPX (black in the top pane) has been in a solid uptrend since the Triple Bottom in '02-'03.
- The PE Ratio (blue in the bottom pane) is arguably still in a downtrend that is now more than 6 years old.
- In the bull market of the '90s, the bear market of '00-'02, and the first leg of the cyclical bull market of '03-'04, the SPX PE (blue line) moved essentially in a positive correlation with the SPX (black line). When the SPX was rising the PE was rising and when the SPX was falling the PE was falling. Since February '04, however, the SPX PE has been falling (from 18.4 to 13.7) while the SPX has been rising (from 1140 to 1381). That is, earnings have been rising faster than the stock market, which has functioned to compress the aggregate PE Ratio of the SPX quite significantly.
- The downward trend in the market's PE Ratio is now under some pressure to break to the upside, which suggests that PE-multiple expansion is quite possible over the next 1-2 years.
This next chart plots the SPX annualized price appreciation over the prior 2 ½ years (red, upper X axis) against the SPX PE of 2 ½ years ago (blue, lower X axis). Or, put differently, we have set forward the SPX price appreciation (red) so that we can see how PE works as a leading prognosticator of PE.
As one might expect the correlation of these 2 series is strongly inverse. Which is to say that when the SPX PE is low the SPX tends to rise more strongly over the ensuing 2 ½ years than when the SPX PE is high.
The blue line (PE) spiked up sharply to peak just after December '03. And, as expected, 2 ½ years later (June-July '06) the SPX pulled back to the point that its annualized 2 ½ year return had shrunk to just 3.4%.
Now, since the summer lows on the SPX the market has rallied sharply. And the blue line suggests by its continued decline since its early '04 peak at 18.4, that the market's trend is likely to be toward PE expansion for a period of roughly 2 ½ years, or until roughly the end of 2008.
This prognosis fits hand in glove with the SPX 4-Year Cycle. We expected that the SPX would put in a significant low in the September-October '06 time frame, but the index never did even tip its hat to the summer low and instead rallied straight from its July low up through the early autumn. As near as we can figure, the precipitous drop in Crude Oil from $78 to $58 along with the market's low PE Ratio trumped the 4-Yr Cycle. And the Fed's combination of policy and rhetoric joined in to persuade the market that the current economic slow-down would come in the form of a very soft landing, one so gentle and benign that its footprints were not even worth putting on the stock market (hence the rally).
One more reason to take a cyclically bullish stance at this point is that our Equity Risk Premium (ERP) calculation continues to show a stock market that is extremely cheap relative to risk-free interest rates.
Currently the SPX Forward Earnings Yield stands at 6.8%. Meanwhile the 10-Yr Treasury (TNX) is yielding about 4.6%. That is, the SPX is yielding 2.2% more than TNX. And that 2.2% is our ERP.
This chart plots ERP (pink) against the spread between BAA Yields and TNX (blue), which we call the Quality Spread. The pink line represents the yield premium that investors require to take the risk of investing in the stock market. And the blue line represents the yield premium that investors require to invest in the BAA Bond Market. Historically the median Quality Spread is about +2%. Meanwhile, historically ERP is about 0%.
As you can see the Quality Spread remains fairly tight (+1.65%), well below its historical median. That is, investors in BAA Bonds require less premium than the historical median in order to take the risk of investing in those bonds.
Meanwhile ERP remains quite elevated at +2.2%. Investors continue to demand quite a lot more earnings yield in order to take the risk of investing in stocks than has historically been the case.
Investors in stocks are quite a bit more risk averse than usual while investors in bonds are somewhat eager to accept risk in exchange for a smaller-than-usual increase in yield. The high ERP suggests that investors have already priced a high level of risk into the stock market and that, going forward, returns are likely to be strong until ERP has diminished significantly.
OK. That was the good news. Here are some factors that have us cautious for the near-term and mid-term.
First, the market has enjoyed a very strong rally recently, so much so that it has put our Quarterly Dynamic Trading System Oscillator, which measures the relative preponderance of Buying vs. Selling Pressure over the previous 3 months, into a significantly overbought condition.
As you can see, over the past 9 years, except immediately subsequent to the severe market low formed in '02-'03, when this oscillator has become overbought (yellow highlights), the market has either paused or retrenched, even in bull markets. (Indeed, it appears that this oscillator only becomes truly overbought in a bull market.)
Secondly, Crude Oil has been consolidating in the mid $50s during what oil traders call the "shoulder months" between the high-demand summer-driving season and the cold winter months during which demand for heating oil increases.
Given the recent sharp decline in the price of oil, and the strong inverse correlation visible on this chart between Oil and the SPX, if Oil moves back up over $62, that could push the SPX down and out of the high-level consolidation it has established since late October.
That said, if Crude breaks down below the $57 area, that could be productive for both the economy and the stock market.
The third thing on our worry list is the growth of earnings going forward. This next chart plots the SPX (on a log scale) against the Y/Y growth in the F52W EPS consensus.
Yellow highlights appears where growth is below 11% and falling or else where growth is below 0% and moving in either direction.
As you can see, the market often struggles when growth in the F52W EPS consensus slows. And, given the recent economic data (3QGDP at 1.6%, flagging manufacturing surveys, etc.) it is reasonable to expect that growth in earnings projections may come down further.
As you can see on this chart, Energy Companies have enjoyed the lion's share of upward revisions to Forward Earnings projections over the past year.
Of special note is the fact that the F52W EPS consensus for the SPX EX-Energy now shows just 8.2% Y/Y growth, well below the 11% threshold mentioned above.
Further exacerbating the slowing in economic growth and earnings is the inverted Yield Curve. The Effective Fed Funds Rate (now 5.22%) is currently 0.63% above the 10-Yr Treasury Yield. (now 4.59%).
Historically periods of PE expansion, such as the period we anticipate over the next 2 years are not associated with an inverted yield curve. Should inflation remain sticky, as recently-strong wage growth may imply, and as we discussed at length last week (much less should inflation begin galloping, to mix metaphors), then the Fed will be forced to postpone any easing of the Fed Funds Rate. And should that easing fail to occur in, say, 1H07, then the likelihood of significant PE expansion will be diminished.
Given the market's overbought condition, the potential for another rise in Oil prices, slowing economic growth, and the inverted Yield Curve our view is that quite a lot of good news is currently priced into the stock market and that any negative catalysts have a high likelihood of forcing optimistic investors to re-think their rosy, "perfect soft landing" projections and inducing some profit-taking.
While our outlook is for a 6-12 week consolidation period, our cyclical view remains cautiously bullish.
Best regards and good trading!