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How Scared is Scared Enough?


Is there risk in the Equity Markets? You bet. The $64,000 question is whether the stock market has sufficiently priced in that risk or if it is currently too sanguine on the subject.

Since we're now in the full flush of Earnings Season, let's start with the ANALYSTS' earnings expectations and what may be wrong with those expectations. After that we'll look at what the MARKET appears to expect and what may or may not be wrong with those expectations.

The analysts' consensus for Forward 52-Week Operating EPS (F52W EPS - blue line above) rose by +$0.58 last week to $84.40, yet another in a seemingly unending series of new all-time. Trailing Operating EPS (T52W EPS - yellow) fell by -$0.06 to $75.04 mainly on downward revisions to the 3Q05 consensus in Financials and Consumer Discretionaries. Trailing Reported EPS continued to climb, up +$0.26 to $68.15, which is also a new all-time high.

The aggregate projection is for F52W EPS growth of 12.5%.

As we have been outlining for months now, the bullish appearance of the headline F52W EPS consensus masks an internal deterioration that's clarified by this next chart.

The lion's share of the EPS growth expectations are in the Energy sector, which has recently passed Financials as the sector with the highest consensus estimate.

F52W EPS expectations for Energy are now up +72% Y/Y, dwarfing expectations for every other sector. And the consensus for the Materials sector is up +18%. But the problem with estimates runs even deeper than just that. All the other sectors are ALSO set to show EPS growth that is either as great as or GREATER than NOMINAL GDP GROWTH.

In order for reality to rise to meet the consensus, profit margins will have to rise from current all-time highs in an environment of rising input prices (Energy and Materials). And this with a consumer (70% of GDP) whose real income is FALLING and whose 2 reserves of spendable cash--the REFI market and Personal Savings--are historically tapped out.

Now, I'm not a big fan of the "Rapture" and "Day of Reckoning" apocalyptic metaphysics, but it's pretty clear that there's some stress building up in the system in terms of leverage - stress that will one day have to be reckoned with. And from whence all this spending is supposed to come that will goose profit margins from already-record levels...well, that's a bit of a mystery.

The best and brightest hope for the economy and the stock market continues to be a drop in energy prices. And they continue to oblige, at least in the mid-term.

The December Crude Oil futures contract still has a date with $58, which is at the bottom of its downtrend zone and an important horizontal level. And if $58 breaks, we're still looking for $52. That said, if $58 holds as support, then we could very well see a range-bound market in the $58-$64 band. (A trip to $52 would be constructive for the economy.)

Unleaded Gas for December is now toying with the top of key congestion in the $1.50-$1.60 band.

If $1.50 breaks, then we could be looking at $1.25 (good for the economy). If $1.60 holds, then we could see this chart congest in the $1.60-$1.80 band (not so good).

Anecdotally, I have seen prices at the pump in northern New Jersey drop from the $3.20 area down to the $2.50 level. If the average family drives 2 cars and puts 1,000 miles per month on each car at 20 miles/gallon, a $0.70/gallon savings adds up to $840 per year. With the median family income at $40,000 and the middle quintile paying 16.7% in total federal taxes (income, payroll, and excise taxes) that $840 per year is 2.52% of after-federal-tax income. Just that one adjustment could take the savings rate from negative into positive territory for the median family. Drop gas down to $2.00 and you give the same family back $1,440 per year or 4.3% of their after-federal-tax income (relative to recent peak prices).

Spread across just 50 million households that's 0.7% of GDP. That's a HUGE variable for economic prognosticators to try to factor in. That figure may be too low by half (100M households is more like it). And this back-of-the-envelope calculation only includes the gas used by the average family's cars. It doesn't include residential utility costs, public or commercial transportation, or any other kind of energy consumption. So, the total effects of fluctuations in energy prices are probably be some multiple of that 0.7%-of-GDP figure.


The SPX's Price/Earnings Ratio on F52W EPS is now at 14.0. That's the lowest PE since November 1995. The PE on T52W EPS is down at 15.7 and the PE on Reported EPS is at 17.3.

Now, here are a few metrics to consider:

  1. The 46-yr median PE on F52W EPS is 15.9. With F52W EPS now at $84.40, giving the market a median PE would add 169 points to the SPX (target 1349).
  2. The market's current PE on T52W EPS (15.7) is about the same as the 46-yr median PE on F52W EPS (15.9).
  3. The 46-yr median PE on T52W EPS (17.1) is about the same as the market's current PE on Reported EPS (17.3).
  4. The F52W EPS yield on the SPX is now 7.16% while the yield on the 10-Yr Treasury is 4.39%. Put differently the consensus says that he SPX will yield 2.77% more than the 10-Yr Note. And we call that spread the Equity Risk Premium (ERP).

Since June 1980 (when the yield on the 10-Yr Note was around 10%) there have only been 6 weeks on which the ERP was as high as it is now. Overall the average annualized appreciation on the SPX during the period was 10.5%. Since 1980 when the ERP was as high as it is now the average annualized return over the ensuing 2.5 years has been 15.9% (52% better than the 25-yr average)

Going back to 1953 (52+ years) the average annual gain on the SPX has been +7.9%. For weeks in which the ERP was at its current height or higher the 2.5-yr annualized return has averaged 11%. That is, in the 2.5 years subsequent to an ERP at 2.77% or higher the SPX had an annual appreciation that was 39% higher than its long-term average.

So, what can we conclude from all of the above? That while the market has no shortage of things to worry about, the ODDS FAVOR the thesis that the market is currently MORE WORRIED THAN IT IS STATISTICALLY BENEFICIAL TO BE. The stock market has probably already discounted much of the bad news...and then some!

The Fed's Fair Value for the SPX (F52W EPS divided by the 10-Yr Treasury Yield) is now 1923. ($84.40/.0439 = 1923).

Our Risk Adjusted Fair Value accounts for the riskier world in which we now live, post 9/11. We do it like this: (F52W EPS divided by the sum of the 10-Yr Treasury Yield and the average post-9//1 ERP). Or: $84.40/(.0439+.0189) = 1343. Of some interest is the fact that our Risk Adjusted Fair Value target is a mere 6 points lower than our Median PE target in #1 just above.

**** **** ****


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.

Our Weekly WENDI improved markedly last week, rising from -31%, but to a still-modest +15%. The only full-on bullish reading (+1) came out of the Philly Fed Manufacturing Survey. However, of the 13 reports included in our Diffusion Index there were 5 qualified bullish releases: California Manufacturing Survey, NY Empire State Manufacturing Survey, the NAHB Housing Index, New Residential Construction, and a rise in Oil and Gas Inventories. On the negative side of the ledger, the PPI (stronger than expected) and Leading Economic Indicators (weaker than expected) argued the bearish case.

The positive up-tick on the Weekly WENDI moved the Cumulative Weighted WENDI (red) up 2 points to +243. While the absolute level on that line speaks to a sustained positive trend in the flow of economic news, momentum is by no means robust...as measured by our 4-Wk Weighted WENDI, which has risen, but only to an anemic level of +2%.

The flow of economic news is improving in the aftermath of Hurricanes Katrina and Rita, but with oil prices still high and the consumer easing off the gas pedal the recovery has been tepid so far.

**** **** ****


As we have been discussing in our daily Morning Call letter, we have numerous indications that a fairly important market low is in the process of being made. In Monday's Morning Call we'll look at which sectors may be giving off some sparks and which may be flaming out in order to get a better bead on from whence leadership might emerge in the anticipated 4Q rally.

At the moment, however, the SPX is threatening to give a long-term bearish signal.

This monthly chart of the SPX shows us the 12-month moving average in red. The green highlights indicate SPX monthly closes above the 12-mma. The yellow areas indicate monthly closes below the 12-mma. As you can see, this has been a reliable trend indicator for about the last 10 years, with only one significant violation in late '98.

Currently the SPX 12-mma is at 1196. If the SPX can't rally above that level for its monthly close a week from Monday, then the door will be open for a new bear market. A durable rally back up over that level will give the month the same look as so many prior Octobers in which the market's job was to scare investors enough hat it could rally into the end of the year.

The NDX chart shows a 12-mma that has also been important over a number of years, but that has lately given some false signals as the NDX has consolidated.

Over the past 2 years the NDX has been essentially trendless. Brief oscillations above or below the 12-mma have not been terribly meaningful in this time frame. But, as you can see, the NDX has not been able to get much if any distance between itself and its moving average. With the NDX now at about 1555 and the 12-mma at 1542, we would need to see a bold move away from the 12-mma on increasing volume to kick off indications that a new market trend is underway.

Until the market proves otherwise it is stuck in the 1400-1600 range, give or take a little skid. Our suspicion is that we will see a move to the upside on volume over the next 2 months. And we should have a clear indication of that move within the next 2 weeks.

Have a great week.

Best regards and good trading!

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