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October 26, 2003

Closing Bell
by Adam Oliensis

Weekly Economic News Diffusion Index (WENDI)

The focus this past week was on earnings, and graciously the folks who release all those economic reports stepped significantly out of the way. Our WENDI tally only had 7 components (average is 13) and the result was pretty close to neutral with a net score of -0.5.

Positive contributors were the lower level of Mass Layoffs reported and the slightly improving jobs picture. Detractors (negative contributors) were the still-weak Semiconductor Equipment Book-to-Bill Ratio, a weak Leading Indicators report out of the Conference Board, and the continuingly moribund ABC News Consumer Comfort Index.

Our Weekly WENDI score was -7%. Because the -21% reading of 5 weeks ago fell off the back of the 4-Week Weighted Moving Averages look-back period the 4-Wk line moved up 5 points to 22%.

I've slightly revamped the Cumulative WENDI to reflect the cumulative raw scores rather than the cumulative weekly percentages. This adjustment weights the red line and prevents a very slow weak like this past one from making an inappropriately large impression on that line. The new Weighted Cumulative WENDI line dropped 0.5 to 7.25 and remains in its solid uptrend launched off last July's low.

Before those of you who are interested look at the WENDI components specifically I'd like to talk about something I have noticed in the writings of a number of bearish pundits...but let me preface this by telling a slightly off-color tale.

Back in the early '80s a friend of a friend was caught inflagrante delicto by his girlfriend. Before he could think (and just before she stormed away) he blurted out, "Wait...Honey...It's not what it looks like!"

The friend who told me the story and I joked that his next line would have to be, "Who're you gonna believe? ME, or your LYIN' EYES?"

Well, it looks like that's the question the bearish analysts are asking of us. Who're we gonna believe THEM or our lyin' eyes?

We all remember the argument dating back to the bubble that, "This time it's different!" At that point many believed that the business cycle had been repealed and that untrammeled growth stretched before us as far as the eye could see (and then some). Even Greenspan and Congress had that in their budget projections!

We all learned a lesson, didn't we?

But now Economist Stephen Roach of Morgan Stanley has ripped a page from the latter '90s, turned it upside down and pasted it up for all to see as a bearish argument. (And I pick on Mr. Roach again this week not because I believe he's a bad economist or anything. Quite the contrary. He's a VERY smart dude and I recommend his piece again this week at The Cyclical-Structural Tradeoff. Rather I just want to make a very specific point about the dangers of becoming entrenched in a particular ideology when trying to make money in the stock market, which is to essentially ask the question, At what point does "conviction" become "stubborn refusal to accept reality?" And the answer at a heuristic level (though not an epistemological one) is "hopefully well after you have been stopped out of any trade that's gone wrong.")

Back to Mr. Roach. Here's what he writes:
...I continue to have serious doubts that we can use the cycles of yesteryear as a model for what to expect today. In my view, many ... structural headwinds ... are attacking the very cyclicality of forces that traditionally shape the vigor and tone of economic recovery.

Now, while Roach makes some excellent and compelling points in his article (not enumerated here) his argument really boils down to, "This time it's different!" That is, he's saying, Sure we're in some sort of recovery cycle right now, but THIS TIME WON'T BE LIKE THE OTHER TIMES! THIS TIME WHAT HAS ALWAYS HAPPENED BEFORE ISN'T GOING TO HAPPEN AGAIN! THIS TIME THE RECOVERY WILL FAIL!

The point I want to make here is that Roach's point is precisely the obverse of the bullish argument that was so compelling at the top of the bubble. The belief then was that structural tailwinds had overwhelmed the business cycle that, "THIS TIME" WAS DIFFERENT! "

Hey, maybe this time it IS different! Maybe this time the recovery WILL FAIL! But the "this time it's different" argument is always fraught with danger, and who're we gonna believe? Mr. Roach or our lyin' eyes?

Here are the viscera of this week's WENDI report. We'll see more with our lyin' eyes below:

Conference Board Leading Indicators: Declined in September for the first time since March and missed the consensus estimate. While this was a disappointing number the trend is still positive. Qualified Bearish (-0.5)
Semi Equipment Book-to-Bill: Rose to 0.95 for September from 0.92 in August. But that's still below 1 and that's a negative. In the context of the chart immediately following the improvement is Lilliputian. This sector of the market has jumped WAY out ahead of the fundamentals.(While the case can be made for the broad market being fairly or undervalued, I do not believe that case can be made soundly for the semiconductor equipment stocks right now. In this sector Roach's argument from above looks pretty good, which is to say, My lyin' eyes say this chart is a problem!)

BT-M Chain Store Sales Snapshot: For October 18 the W/W results were flat. Y/Y growth slacked off a bit but remained strong at 4.6%. This report has been positive lately as consumers have maintained a healthy rate of spending on the back of tax rebates and REFIs. Both those sources are drying up now, so there's some reason to keep a worried eye out here. So far it hasn't turned ugly, but it has backed off to Neutral (0).
ABC News/Money Mag Consumer Comfort Index: For October 19 remained unchanged at a low level (-19). Qualified Bearish (-0.5).
MBA Mortgage Applications Survey: For October 17 there was a slight uptick in Purchase Applications but a smallish dip in REFIs. Still at a robust level but no positive acceleration here. Neutral (0).
Jobless Claims: Initial Claims for October 18 were 386K, nicely below the benchmark 400K level. However the prior week enjoyed its usual upward revision, by 6K to 390K. Continuing Claims fell for the first time in a while. Are we actually getting people back to work? If the positive trends continue, then we'll give this sort of number an unqualified score. For now the improvement is still pretty trepid and there are miles to go before we sleep...so we'll give it a Qualifed Bullish (0.5)
Monthly Mass Layoffs: For September mass layoff events involved 82.6K workers. This is a volatile series but that's the lowest number since mid '00 and has to be regarded as Bullish (1).

Earnings

As of Friday 60% of the SPX companies have reported. On an unweighted basis EPS are up 23.5% Y/Y. There is a developing consensus that the final weighted growth will be in the 20% neighborhood.

The SPX consensus estimate for Forward 12-Month (FTM) Earnings Per Share now stands at $60.08. That's calculated by time-weighting Standard & Poors' quarterly estimates.

Trailing 12-Month (TTM) Operating EPS now stand at $51.62, up 24% Y/Y.

TTM Reported EPS are at $37.77, up 26% Y/Y.

The earnings picture definitely has a constructive look to it, but there may be an issue developing.

The blue line on this chart shows the 3-month annualized growth rate of SPX FTM earnings estimates. As you can see, historically the cycle tends to find a peak in the 20% area, which it has just done, dropping down from 20% to 17% this past week. Why? Not because earnings projections are deteriorating but because 3Q02 was better than 2Q02 so as 3Q03 reports pour in the Y/Y comparisons are suddenly tougher.

As we know the market likes the 2nd Derivative (the rate-of-change of the rate-of-change). The 1st Derivative (rate-of-change) shows up on the above chart as the HEIGHT of the blue line. The 2nd Derivative shows up as the SLOPE of the blue line.

The slope of the blue line is not going to continue to rise. Historically when the blue line peaks (yellow) the market suffers at least a bump down of 4-6 weeks. If the blue line can hold at a high level (and 4Q03 estimates currently suggest that it will do so through year-end at least) then the bump should be mild.

The $64B question is whether the blue line can hold some altitude as it did back in '95, again in '96 & '97...and then in '98-'00, or whether it's going to head back down below 0% and force the market down with it.

That's something we'll certainly keep our eyes on going forward.

Risk Premium

Last week in this space we drilled down into one way of measuring risk premium in the stock market relative to US Treasuries (See Closing Bell, October 19, 2003.) We saw that on this reckoning risk premium could be considered "high" relative to the past 43 years and "very high" relative to the last 23 years. (Since 1960 the average risk premium was 0% and One Standard Deviation from that average was 2.2%, so 68% of the time the risk premium was between 2.2% and -2.2%.) Well, this week it's somewhat higher than last week

Because FTM estimates have risen and interest rates have fallen the risk premium has jumped from 1.37% to 1.61%. That suggests that the market is somewhat more scared (cheap) this week than it was last week. Assuming that the yield on the 10-yr Treasury moves up to 5% (an adjustment up of 79 basis points from current levels, a conservative one that the Fed model does not make) the Fair Value on the SPX would now be 1201.

So the US Treasury Market is saying that stocks are currently cheap. How about the Corporate Bond Market? The following chart plots SPX against the BAA Corporate Bond Yield minus the 10yr Treasury Yield.

In going over my data base back to 1986 the mean spread is 2.1%. That means that on average investors require 2.1% in additional yield for investing in BAA Corporates over investing in Treasuries. One standard deviation from the mean during this time is 0.54%. So, 68% of the time the spread is between 2.64% and 1.56%. Right now this Quality Spread stands at 2.41%, somewhat high, but not extreme.

Basically the corporate bond market is confirming what the US Treasury market has to say. Both measures of risk are historically high, but not nearly as extreme as they were, say, a year ago. We're back within very roughly normal ranges, though levels of fear are still somewhat elevated.

Bear in mind that these barometers of risk are not short-term trading tools. But they do suggest that, over time, as the shocks of the market crash, the tragedy of 9/11, the earnings collapse, the wars in Afghanistan and Iraq, and the Corporate Governance scandals wear off the market has the relative value potential to achieve some higher prices.

A Look Down the Market's Throat

Last week's short-term expectation of a pullback came on schedule. Our benchmark indices have mostly retreated back below their September highs and now are oversold on our short-term momentum oscillators.

Of the above 8 charts only the Dow Transports, the S&P MidCap 400, and the Advance Decline Line have held above September's highs. On a short-term basis we should see some upside this coming week, though Monday & Tuesday may be a bit spongy in anticipation of the Fed announcement on Tuesday afternoon.

In our Tech indices below, all our charts have dipped back down below last month's highs.

Net, net 3 of our 12 charts are positively divergent (above their yellow zones) from the other 9 (back into the yellow). If they all start popping back up and out of the yellow zones then we may become more short-term bullish. But if volume picks up to the downside, well "failed breakouts" can set off some wicked selling.

In the following graphic (2 charts) we look at 2 of our short-term timing tools, the Put/Call Ratio, and the Buy/Sell Pressure. Both of the charts below confirm what the Stochastic %K lines (light blue) are telling us in the charts above.

In the first chart below we can see that the Put/Call Ratio 3-dma is closing in on its upper Bollinger Band, indicating that we're very close to an oversold condition. (The red line moves inversely to the SPX.)

In the second chart just above the Buy/Sell Pressure 5-dma is closing in on its lower Bollinger Band (this one moves in waves WITH the SPX), confirming that we're approaching short-term oversold.

The 20-day Buy/Sell Pressure line is currently caught in a consolidation pattern (triangle). A clear break out of that triangle should tell us more about the next mid-term direction.

So, we're looking for a bounce this coming week. For a variety of reasons,though (not the least of which is the extreme complacency present in the VIX), our initial bias is to expect a short-term rally attempt this week to fail to break above the highs already in for the month. If the market stalls out before breaking to new highs then we'll look for another more serious test down. A break to the upside over SPX 1054 still has us looking for 1070.

Bottom Line

Short-Term: Looking for softness early in the week with a bounce beginning by mid-week.

Mid-Term: Expecting some struggles as the market digests good earnings news. Why the struggles? The peak in the 2nd derivative of the earnings growth line. But we could be done with that bump in the road by around Thanksgiving.

Long-Term: Looking for higher prices toward year-end and into early next year. Earnings New and Guidance, as well as Economic News should continue to be positive in that time frame.

If you'd like to join us during the week for our Pre-Market Updates, Afternoon Notes, and Intraday Trading Alerts, feel free to visit us at The Agile Trader, Free 30-day Trial.

Best regards and good trading!

Adam Oliensis,
Editor The Agile Trader

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