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April 17, 2006

Weekly Wrap-up: Earnings Growth Slowing, Interest Rates Rising
by Adam Oliensis

Dear Speculators,

The Dynamic Trading System exited 2 trades in the E-Mini futures markets last week. In the NDX June contracts our auto-trading accounts grossed "breakeven," taking a -1% loss net of commissions and fees. In the June SPX futures the System netted a +13% gain. The System has +407% in net position gains since we launched the Index Futures service 9 months ago, with a net total return of +122% in that same time frame.

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INTEREST RATES RISING

Any discussion of the stock market at this moment should probably begin with at least a mention of the bond market.

The yield on the benchmark 10-Yr Treasury note (TNX) has broken 5% for the first time in 46 months (just shy of 4 years). A move to 5.5% is now entirely possible and we would have to suspect that TNX will be trading in the 5-5.5% band until it makes a definitive statement to the contrary.

Of significant interest on this chart is the fact that the 3 primary trends show the SPX and the TNX positively correlated. (From 10/98 to 4/00 both SPX and TNX rose. From 4/00 to 3/03 both charts fell. And since 3/03 both primary trends have been modestly upward again.)

Why is this of interest? Because when the YIELD on the 10-Yr Note moves WITH the stock market it means that the PRICE of the 10-Yr Note is moving in the OPPOSITE direction from the stock market. And the inverse correlation between the price of the 10-Yr Note and the SPX speaks to a market that is more strongly driven by LIQUIDITY FACTORS than by fundamental valuation factors. That is, over the past 8 years, these 2 asset classes have COMPETED for liquidity (stocks go up as bonds go down and stocks go down as bonds go up) to an extent that is so powerful that considerations of VALUATION are overwhelmed. (In a valuation-drive market the current value of future earnings of stocks is actually HIGHER when bonds rise[bond yields fall] than when bonds fall [bond yields rise] because future earnings are discounted at a lower interest rate!)

Historically it is not unusual to see stocks and bonds compete for liquidity, as they have done since 1998. However, periods such as this one are almost always followed by periods in which the inverse correlation between stocks and bonds (positive correlation between stocks and yields) is reversed, and stocks move INVERSELY TO YIELDS and WITH BONDS.

Of course the $64,000,000 question is when that will happen. When will the stock market return to being valuation-driven and not so liquidity-driven? And the answer is that that will happen sometime after the Fed becomes less activist than it has been since October '98. (Remember, the Fed dropped rates to deal with a variety of crises in '98, flooded the market with liquidity as Y2K approached, sopped up that excess liquidity when there was no Y2K catastrophe as it raised rates to pop the Nasdaq Asset Bubble into '00, then eased aggressively to cope with the aftermath of 9/11, and finally launched a protracted tightening regime in mid '04.)

In this context it becomes extremely important to consider how long that rate-hike regime will last. And the answer to that question is, I think, "longer." And here are some reasons why.

Gold.

After consolidating and testing support, April Gold futures have broken to the upside, sustaining the uptrend. This is an asset bubble, also known as a form of inflation (the dollar has deflated relative to this asset). The Fed is targeting asset bubbles. Until the uptrend in Gold breaks (and it will, someday...we just don't know when), the rising price of this asset/commodity/inflation-indicator adds pressure for the Fed to tighten.

Oil.

The May Crude Oil futures contract is challenging resistance in the $70 area. With summer driving season fast approaching, it would be difficult to fathom Crude's not breaking to new highs. Given the depth of the "base" that has formed over the past 8 months, if this chart breaks through $70, we're looking for Oil to trade in the $70-$82 range into early August.

Crude at new all-time highs would both slow growth (by -0.5%ish for each $10 rise) and exacerbate inflationary pressures. (Can you say, "Stagflation?" If Crude breaks out, listen for pundits crawling out of the woodwork with that word.)

CPI

While the Fed likes the Core PCE Deflator better than the Headline CPI, it cannot ignore the importance of this chart, which has lately pressured the upper limit of the range in which it has traded for the better part of the past 23 years.

The fact is, consumers do have to pay for food and energy (which are left out of the Core measures of inflation). So, while one could argue that inflation is not a terrible problem right now, the risk of excessive inflation is definitely greater than the risk of deflation. The Fed is obligated to remain vigilant against inflationary pressures and this chart is part of what we believe will prevent the Fed from ending the rate-hike regime as soon as the market has lately been hoping.

CAPACITY UTILIZATION

This chart plots Capacity Utilization (CU, blue) against the Yearly percentage change in the Fed Funds Rate (red).

In last week's report CU hit 81.3%, just 0.1% below its long-term median. In each of the past 3 economic cycles the Fed's deceleration of the red line (slowing the pace of raising the FF Rate or actually lower the FF Rate) has been virtually coincident with CU rolling over and heading lower.

While it's true that the red line is at a height that is consistent with previous examples of CU being up in the 83-84% range, given Gold and Oil prices, and given the strength of the CPI and of CU and the labor market, there's nothing on the table that suggests that the Fed is ready to stop hiking rates.

EARNINGS DECLERATION

This next chart plots the FF Rate's Yearly Change (red below, as it is above) against the Y/Y change in the consensus for Forward 52-Week Operating EPS (blue below).

Over the past 11 years the correlation of these 2 lines is a very high +0.88. At this point, however, the Fed remains constrictive (the red line is holding at a high level) even as the blue line drops. The very fact of the widening gap between these 2 lines suggests that the Fed will be lowering rates in the not-too-distant future, and the red line will chase the blue line down. But given what's apparent on this next chart, we suspect that the stock market will endure a difficult period before the Fed's easing off the brake will have any accelerating effect on the stock market.

The blue line on this chart is the same one represented on the prior one. The black line is the SPX price. The red line is the 3-month annualized rate of change of the F52W EPS consensus for the SPX.

The red line on this chart is leading the blue line lower. And once the blue line is decelerating below +10% the stock market tends to have a rough time of it. With the consensus for 2006 at +10.9% and the consensus for CY07 at +5.5% the deceleration in earnings projections forecasts for choppy seas, especially in the context of the expected 4-year cycle low due this coming October.

Our Risk Adjusted Fair Value price is now 51 points below the SPX price. We have not seen RAFV significantly below the SPX since the local market top of late 2001, and we suspect that RAFV will exert a downward pull on the SPX in the weeks and months ahead.

We derive the RAFV target using this equation:

F52W EPS / (TNX + Med ERP)

Where

F52W EPS = Forward 52-Week EPS ($86.47)
TNX = 10-Yr Treasury Yield (5.036%)
ERP = SPX Earnings Yield - TNX (6.71% - 5.036% = 1.67%)
Med ERP = Median Post-9/11 ERP (1.95%)

$86.47 / (0.05036+ 0.0195) = 1238

Summing all this up, we are holding the line on our mid-term market view...the odds favor a correction on the SPX of more than 5% but less than 20% between now and October (10-15% is a sensible target band). Beyond that, it would appear likely that the index will make a higher high by the spring of '07, if not before.

In our daily issue of the Morning Call we'll examine the technical charts on the leading and lagging indices this coming week, as we seek confirmations and divergences on the major market indices. If you're interested in auto-trading futures based on our Dynamic Trading System (model portfolio has netted +407% in realized position gains since July '05), click on The Agile Trader Index Futures Service to read more about our service and to subscribe.

Best regards and good trading!

Adam Oliensis,
Editor The Agile Trader

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