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November 29, 2005

Weekly Wrap-up: Year-end Prognosis and Risk Factors
by Adam Oliensis

The following was originally published at The Agile Trader on November 28, 2005.

Dear Speculators,

By way of providing a couple views of the US and Global economies that are at polar extremes, I'd like to link you to a couple of writers whose work I often read and appreciate:

Doug Noland of Prudentbear.com wrote in this past weekend's Credit Bubble Bulletin:

Today's securities finance Bubble - certainly including the massive "repo" market - is at a scope unlike any in history. And once a substantial component of a nation's (world's) "money" supply is wrapped up in financing market Bubbles - well, you have one hell of a predicament. On the one hand, such powerful Bubbles are (as we have witnessed) strongly self-sustaining. On the other, the consequences of popping the Bubble ensure policymaker timidity and ongoing accommodation. Dr. Bernanke certainly has no intention of administering any meaningful restraint. Yet, inevitably, financial Bubbles do burst and the downside of boom-time Perceived Moneyness and Marketplace Risk Embracement manifest in financial dislocation and a crisis of confidence.

Meanwhile, Ed Yardeni of Oak Associates published a note this morning on his Website, Yardeni.com, concluding:

During the second stage of the High-Tech Revolution, the IT industry is once again becoming an important source of economic growth, new jobs, and higher incomes as it was during the first stage in the 1990s...The bottom line is that several domestic and global trends are converging to revive the High-Tech Revolution. This should be bullish for both economic growth and for the US stock market during the second half of this decade as it was during the second half of the previous decade.

So, who's right? As near as I can figure it, Noland's peering over the precipice and Yardeni's stargazing. Or as Ludwig Wittgenstein wrote near the end of his Tractatus Logico Philosophicus. "The world of the happy man is a different one from that of the unhappy man."

Whether the happy man or the unhappy man is more prescient will be known only in the fullness of time. But rather than place one large macro bet on one side or the other, we'll continue to take the incremental approach (week by week). Once time has unfolded, crease by crease, we're likely to discover that the truth will have been lying somewhere in between, as it usually does.

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WEEKLY ECONOMIC NEWS DIFFUSION INDEX (WENDI)

For those of you who are new to our Weekly Wrap-up our WENDI work involves reviewing the prior week's major economic reports. We assign each report a value anywhere between -1 and +1 in half-point increments. A very bearish report gets a -1, and a very bullish report gets a +1. And, say, a qualifiedly bullish report gets a +0.5.

We then sum the individual scores, divide by the total number of reports, and multiply that fraction by 100 to derive the Weekly WENDI (black line below), expressed as a percentage of anywhere between -100% and +100%. (The former is maximally bearish and the latter is maximally bullish.)

The Cumulative Weighted WENDI (red line below) is the running sum of the individual scores (raw trend). The 4-Wk Weighted WENDI (blue line below) is the sum of the past 4 weeks' individual scores divided by the total number of reports over the same period, and it tells us about the momentum in the flow of economic news.

Most recently the Weekly WENDI jumped up almost 10 points to +36% its highest reading since late July. That's just a couple of points below its November '04 peaks (38-39%) but still well below the heights achieved in late '03 (67-69%). So, on a seasonal basis we're seeing a solidly positive but unspectacular sort of news flow.

Strength in the Weekly WENDI took the Cumulative Weighted WENDI up to new high at 255; the trend in economic growth is positive. Meanwhile momentum improved from +27% to +36% on the 4-Wk Weighted Average; momentum is as strong as it has been in a couple of years but not as electric as seen earlier in the recovery during '03 and early '04.

Given the stressors of high energy prices and disastrous weather events, the flow macro-economic news is about as good as anyone could have hoped for. Whether the positive trend continues into the new year will likely have much to do with the Energy markets. If Oil moves down into the $45-$52 range then the Fed can ease off of the effort to de-monetize Crude. If Oil heads back up over $60 then short-term rates will keep moving higher for longer, long-term rates will go below short-term rates, the yield curve will invert, and both the economy and the stock market will suffer more than they otherwise would.

Crude is key.

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EARNINGS

The consensus estimate for Forward 52-Week Operating Earnings Per Share (F52W EPS) for the S&P 500 rose by $0.32 last week to $84.76.

That's fully 34% higher than was the consensus at its peak in 2000. Likewise Trailing 52-Week EPS (yellow line above) and Reported EPS (pink) are continuing their uptrends without much impeding them. We see no particular disparity developing among these three measures to indicate a problem with the quality of earnings except for the buttonhook on the blue line, which could, on its face, appear to be a hiccough in growth projections.

Upon closer examination the "button-hook" on the F52W EPS estimate for the S&P 500 is largely a function of a similar formation in the EPS consensus for the Energy sector.

While the trends in most sectors remain positive if modest (e.g., Financials, Industrials, Information Technology, Consumer Discretionary, Telecom Svce), what is of concern is whether the other 9 sectors can weather the huge earnings increases in the Energy stocks without themselves seeing decelerating or declining earnings.

Of course the most productive thing that could happen for the consumer (and hence for the economy and the broad stock market) would be for Energy prices and earnings estimates to fall. So, once again, we will have to watch Energy prices as we move into the new year.

The Price/Earnings multiples on the S&P 500 remains compelling for buyers.

The PE on F52W EPS is now at 15.0 (EPS yield at 6.68%), up from the recent low PE of 14.0, but still very near to its cycle low. Meanwhile the Price/Dividend Ratio on the 10-Yr Treasury is at 22.6 (yield 4.43%).

The spread between those two yields is what we call Equity Risk Premium (ERP) (6.68%-4.43%=2.25%).

As you can see on this chart ERP is still at a very high level. At 2.25% ERP is in the 84 th percentile relative to the past 46 years and in the 93 rd percentile relative to the past 11 years. (That's cheap.)

Meanwhile the Quality Spread (difference in yield) between the BAA Corporate yield and the SPX earnings yield is 1.91%. That's very close to the long-term median Quality Spread of 1.81%. So, while there is only an average-ish amount of extra yield demanded by corporate bond investors for the risks assumed in those investments, there remains a very high yield demanded by investors for the risks assumed by investing in stocks.

Relative to both the Treasury and Corporate Bond markets, stocks remain under-loved.

The Fed's Fair Value calculation divides SPX F52W EPS by the 10-Yr Treasury Yield. ($84.76/.0443=1913). But that calculation doesn't take into account either the riskier post-9/11 world or the "conundrum" of extremely low bond yields.

Our Risk Adjusted Fair Value (RAFV) calculation makes an effort to tune itself to these factors. Our calculation divides F52W EPS by the sum of the 10-Yr Treasury Yield and the median Post-9/11 ERP (1.92%). Or: $84.76/(.0443+.0192)=1334.

Our view is that the 1.92% ERP built into our RAFV calculation is sufficient to account for increased geopolitical risk, high energy prices, and what may be artificially low bond yields. Consequently we are looking for the SPX to move up toward its RAFV target (much as it did in late '03) and into the low 1300s before the year-end rally is done.

What factors could trample our bullish scenario? Firstly, if Crude Oil spikes up above $60/B again. Secondly, if the yield curve (the spread between the Fed Funds Rate and the 10-Yr Treasury Yield) inverts.

Right now that spread is just 40 basis points. And, as you can see on the chart above, when the blue line is falling (yield curve flattening) the PE (pink line) is generally falling (the bubble of the latter '90s notwithstanding). Should the blue line move below ZERO, then there's a high probability that we'll see the Trailing PE fall below 15 (now 16.7), which could translate into at least a 150-point drop on the SPX.

The other valuation metric we want to watch as a leading indicator in the months ahead is the Y/Y growth in the F52W EPS consensus (blue below).

Currently the blue line is holding its own at +16% Y/Y. The market tends to struggle when the blue line is either below 10% and moving down or anywhere below 0%. The market can endure deceleration from +10% levels. But if earnings momentum slows below that rate, then we'll be looking for 2006 to be a rough one for the bullish case. (And an inverted yield curve could bring on just that deceleration.)

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We continue to expect a choppy period between now and December 15. However, underlying positive divergences in the Transports, Financials, and Techs (among others that we'll continue to track closely in our Morning Call) have us looking for further upside in the broad market before the year is out.

Best regards and good trading!

Adam Oliensis,
Editor The Agile Trader

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