Below is a commentary originally posted at www.theagiletrader.com on 16th October, 2005.
In the September 18 edition of this letter, with the 10-Yr Treasury yielding 4.26% I wrote about the bond market and how it was sewing the seeds of its own underperformance. How? By long-term rates remaining sharply lower than nominal GDP:
...history suggests that unless long-term bond yields rise significantly, that the plain old cheapness of money at the long end of the curve will tend to increase long-term inflationary pressures in the economy.
The negative spread (between the yield on the 10-Yr Note and Nominal GDP) will resolve itself. Maybe a little sooner or maybe a little later, but it will resolve either with rising inflation or with a fall in GDP growth; most likely with a rise in inflation that brings about a rise in long-term interest rates and a fall in real growth. So, in a perverse way, it is precisely the excessive complacency about inflation (causing bonds to be well loved) that could bring about the rise in inflation that will cause bond yields to rise (prices to fall).
The Fed is watching for that reversal, I suspect. And when they see it, that's when they'll say, OK, we've hit "neutral" and we can stop raising rates at the short end.
The Fed has done its damnedest, through the use of rhetoric as well as interest-rate hikes, to induce precisely the sell-off at the long end of the curve discussed above. And they have been having some success, with the 10-Yr Yield now up from the 4% area to almost 4.5% over the past 6 weeks.
The Fed is on an anti-inflation rampage. And the twin targets are Home Prices and Energy.
Inflation is, pretty-much by definition, too much money chasing too few goods. But what happens when the "goods" aren't too few...and there's inflation anyway? Then the inflation is essentially (and in a "one-armed" way) a monetary phenomenon. And that's precisely the case with both Home Prices and Energy commodities right now.
This chart shows the Housing Affordability Index in pink, as defined by the National Association of Realtors. Since January the index has fallen from 135.2 to 115.4 as the median home price has risen more than 17% from $186K to >$219K. Meanwhile the median income has risen just about 2.5%. (All this as of the August report.)
There's no shortage of housing! Inventories are in a range, not declining. Fixed-rate mortgages are about the same price as they were a year ago and ARMs are more expensive. Nevertheless, home-price appreciation has spiked higher, probably from a systemic excess of liquidity.
Now, let's look at the price of oil and compare it to domestic inventory levels.
This chart has a lot going on in it. The pink line is the Days' Inventory out there in the market. The blue line is the Days' Inventory in the Strategic Petroleum Reserve. The yellow line is the sum of the pink and the blue lines. And the black line is the spot price of Crude (all from the Energy Information Administration).
The pink line is now about where it was in '96. And while there was a long-cycle downward trend on the pink line, that's in line with US businesses becoming more efficient in managing supply chains and a range-bound energy market. But while there is some evidence of some small-cycle inverse correlation between the inventories (pink) and the price of Crude, the sudden spike in the price of Crude, up from the $30s into the $60s, is virtually unrelated to the pink line.
There is some correlation between the recent big spike in the black line and the 4-year rise in the blue line, however. So, it looks as though the build-up of the SPR has had some relationship to the high price of Crude. But, given the size of the re-stocking, it's probably not a really significant causative relationship.
More likely, the same fears that are driving the US government to build its SPR are also driving energy prices higher: geopolitical threats and a panic over global supply. But let's look at the relationship between global supply and demand for Crude Oil.
There has been some acceleration in demand for Crude. The average annual growth rate of oil consumption from 1997-2001 was +1.5%. The average annual growth rate for the growth of oil consumption from 2002-2006 (using EIA's estimates for '05 and '06) is +2.2%. But that acceleration is not extreme.
Meanwhile the match between consumption and production looks set to be pretty good - much better, in fact, than it was in the recent past.
So, what's my point?
The run-up in Crude Oil quotes is by no means function of a lack of supply. It's about 2 other things...the FEAR of the lack of supply and a surfeit of capital looking to profit from that fear.
The Fed is doing its best to sop up the excess capital/liquidity and de-monetize these asset and commodity bubbles. Just when (or if) the fear premium will come out of the oil market remains to be seen.
Could Oil go higher in price? Sure. Prognosticating the zenith of a parabolic chart is difficult, and we may not have hit the top.
But, in our view, if Crude can't get up and over $70 again and make a run at $80 (near the top of its parabolic envelope), then we could well see a 38% retracement of the 2-year advance, down to the May '05 gap in the $52-$53 area (blue highlight). And if that can't hold as support, then a 50% retracement down to the February gap (yellow) near $48.
To be sure, demand for energy is increasing and supply of oil may indeed be more difficult and expensive to extract going forward than it has been in the past. My point, however, is that the market has, as it usually does, probably gone farther on the back of speculation than the fundamentals would warrant. And a 38-50% retracement is something to watch out for in the absence of new highs.
Moreover, if the Fed can bust these bubbles - or WHEN they bust these bubbles - they'll have gone a long way toward diminishing inflationary pressures.
**** **** ****
WEEKLY ECONOMIC NEWS DIFFUSION INDEX (WENDI)
For those of you who are new to our Weekly Wrap-up our WENDI work entails reviewing the prior week's major economic reports. We assign each report a value anywhere between -1 and +1 in half-point increments. So, a very bearish report would get a -1, a very bullish report would get a +1, and, say, a qualifiedly bullish report would get a +0.5. We then sum the individual scores, divide by the total number of reports, and multiply that quotient by 100 to derive the Weekly WENDI, which is expressed as a percentage of anywhere between -100% and +100% (the former being maximally bearish and the latter being maximally bullish).
The Cumulative Weighted WENDI is the running sum of the individual scores. And the 4-Wk Weighted WENDI 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.
The Weekly WENDI dropped -38% last week to -31% indicating a negative bias in the flow of economic news. Full-on bearish (-1) readings came in on Initial Jobless Claims (above the neutral band of 320-350K), the Trade Deficit (-$59B), Industrial Production (both IP and Capacity Utilization fell sharply), and the U of M Consumer Sentiment Survey. There were no +1 readings last week.
Mitigating the bearish implications of the week's negative reading, however, is the fact that a significant chunk of the poor data owes to the after-effects of Katrina and Rita. For instance, the fall in Industrial Production was precipitated by a drop in drilling and refining.
The shallow, scalloped uptrend on the Cumulative Weighted WENDI (red) is now being threatened. It fell 4 points last week to 241, putting in a short-term lower high. And the momentum as measured by the 4-Wk Weighted WENDI (blue) remains in negative territory at -3%, albeit only slightly.
Once the after-effects of Katrina and Rita are behind us (Oh, those "Category-Five Women who done the Economy Six Kindsa Wrong!"), whether the economic news flow picks up for the rest of 4Q05 will likely hinge on the interplay between energy prices and the Fed.
Stay tuned. If the Cumulative WENDI (red line) heads up over 250, then it's "Game on!" for the 4Q rally in the broad indices. If the news can't drive that red line up over that level, then it's going to be rough going for the market and for the broad economy.
**** **** ****
On the earnings front not much happened last week to the consensus estimates except that a week passed.
The consensus for Forward 52-Wk EPS on the SPX rose to $83.88, up $0.19 on the week, almost entirely from the increased weighting of 4Q06 and the decreased weighting of 4Q04 in the calculation. The market's valuation became even cheaper as the SPX dropped on the week.
The PE on F52Wk EPS is now down to 14.1 (earnings yield 7.07%). That's the lowest PE and highest yield since November 1995.
With the 10-Yr Note yielding 4.49% (Price/Dividend 22.3) the Equity Risk Premium (ERP) is at 2.58%, which is extremely high by historical standards, meaning that the stock market remains very cheap on a relative basis.
The Fed's Fair Value calculation now yields a quotient of SPX 1868. (F52W EPS divided by the yield on the 10-Yr Note: $83.88/.0449 = 1868)
Our Risk Adjusted Fair Value formula yields SPX 1315. (F52W EPS divided by the sum of the yield on the 10-Yr Note plus the median post 9/11 ERP: $83.88/(.0449+.0189) = 1315)
Should energy prices moderate from here we're looking for the SPX to rally toward 1315.
**** **** ****
A LOOK DOWN THE MARKET'S THROAT
This monthly chart of the SPX shows the 12-month moving average. When the SPX closes the month above the 12-mma then the background is green. When the SPX closes below the 12-mma then the background is yellow. On Friday the SPX closed at 1186.57. The 12-mma is at 1196.73. If the SPX can't rally back up over its 12-mma for the monthly close then the door is open to a severe decline.
That door open, however, it should be noted that Octobers often flirt with the moving average and may even give a rare shakeout fakeout (as happened in '98) before rallying.
The continuing theme of crosscurrents makes its appearance in our Relative Strength (RS) charts today.
The RS line divides the charted index's price by the SPX price. If a chart's RS line is rising then the index is outperforming the SPX. If the chart's RS line is falling then the index is underperforming the SPX.
The Nasdaq Composite has been displaying poor RS since early August and violated its summer lows before bouncing late last week . Meanwhile the Nasdaq Composite has been holding its own on its RS line and remains smartly above its summer low near 1500.. The SOX, which had been displaying flat RS has recently begun to break down on that RS line but remains above its summer low.
The Dow Jones Industrial Average has just lately begun to show some positive RS, but it comes cheaply via a slower decline than the SPX and not any real show of strength. The index is testing the support/resistance levels of the summer.
The Transports are holding up well above their summer lows and have been displaying positive RS since mid September. Meanwhile the Utilities (as we have predicted) have tanked to support, giving up their bubblicious rise to the 440 level. Rising interest rates at the long end of the curve have made the dividend yields on Utilities stocks relatively less appealing.
**** **** ****
Options Expiration arrives this coming Friday. Seasonally speaking the markets tend to be choppy into October 20 or so and then negative until about the 25 th. After the 25 th the markets tend toward strength right through the end of the year. Of course, that's just a description of a broad statistical tendency, not a guarantee. But it gives us a sort of skeleton of expectations against which to measure the action as it unfolds.
We'll have a look at our Dynamic Trading System, the Momentum of Sentiment, and our New Highs Percent studies in Monday's Morning Call.
Have a great week!