The following article was originally published at The Agile Trader on Sunday, November 6, 2005.
Throughout 2005 we have been working under the assumption that the stock market (represented by the SPX) would behave a lot like it did during 2004, which is to say that it would "goof around" in a trading range until late in the year when seasonal factors would drive the SPX higher. We had anticipated that 2005 would form a "base over base," which means that for the most part the 2005 trading range would sit atop the 2004 trading range until the 4Q rally would work to break the market up and out of that range for a run to new cycle highs.
And that's pretty much what has transpired this year (pending the upside breakout) despite all the noise in the media and in the markets themselves that has functioned to force us to "disremember" just what's actually going on. With only brief exceptions, in 2005 the SPX has traded between 1163 and 1225. And each breach of that range has been met with a swift regression back inside the envelope.
A "base over base" is generally accepted as a bullish formation and the highest likelihood is for an upside resolution to the pattern. Last week the market continued the anticipated high-volume upside move that fits with metronomic precision into our forecast for a rise out of a late-October low. But this coming week will be telling as the SPX encounters resistance in the 1225-45 band.
As we discussed last week, a move over 1253 projects a test up to 1291 (66.7% retracement of the '00-'02 bear market) and a move above 1291 would bring 1368 into play as a target (76.4% retracement of the bear market).
But what comes next? What's in store for 2006? As we move toward the end of this year all eyes will focus on next year.
In studying the congruence of SPX performance from Oct. 1990 – Nov. 1993 to its performance from Oct. 2002-Nov. 2005 we may have stumbled on to something of paradigmatic importance.
On this chart the blue line tracks the SPX performance beginning 10/11/90, which was the low prior to Operation Desert Storm launched in early '91. The red line tracks the SPX performance beginning at the 10/9/02, which was the low prior to the Iraq Incursion launched in early '03. The correlation coefficient for these 2 series is +0.90 (where +1 is perfect and -1 is perfectly inverse). As of trading-day #776 in both series the SPX gain is 57%.
In 1993-4 the SPX had another 4% upside left in it from the analogous moment in time, topping out on January 31.
Now, whether this particular analogue will continue to display such a shockingly close fit remains to be seen. But after studying this chart I became curious about the larger context and so I had a look at the SPX 4-year cycles.
There's a lot going on in this next monthly SPX chart, so let's break it down:
- The black line in the top pane is the SPX. It's scaled logarithmically so that the action at much lower price levels is readable.
- The dotted blue vertical lines represent the 4-year cycle lows (every 48 months).
- The dotted red vertical lines come 26 months (2 years & 2 months) after each cycle low.
- The squiggly red line in the bottom pane is the 12-Month Disparity Index (12-mdi). The 12-mdi shows the SPX monthly close relative to the 12-month moving average (12-mma). E.g., a 12-mdi of +0.10 means that the SPX closed 10% above its 12-mma.
We learn several important things about market history from this study.
Since 1962 each 4-year cycle low (blue line) except for 1986's has brought the SPX down below its 12-mma (12-mdi below ZERO). The lone exception in 1986 was not really an exception but more of a delay with a steep price paid for the delay in October 1987. So, we can expect, based on history, that the SPX will be below its 12-mma sometime around September 2006.
Point A on this chart marks the October '90 low studied on the prior chart. And point B marks the October '02 low also studied in that prior chart. So, the remarkable similarity in performance between the 2 periods is at least partly driven by the fact that each was launched at the 4-year cycle low.
Now look at the dotted red vertical lines on the chart above. Here's what caught my eye. In each cycle, if the market topped out at or prior to the vertical red line (26 months after the cycle low or sooner) the fall into the subsequent 4-year low (blue dotted line) tended to be quite harsh (points C, D, E, F, and G). But when the market "translated" its top to the right (when it kept going higher after the 26-month point in the cycle at the dotted red lines) the ensuing 4-year low tended to be relatively modest with subsequent rallies bounding to new highs ( points 1, 2, 3, and 4).
So, where does that leave us? The most recent red dotted line came at the end of 2004 with the monthly SPX close at 1217. Since then we have seen incrementally higher monthly closes (as high as 1234 last July), but no marked upside progress (the SPX is now at 1220). If the 4Q rally gains some significant traction and heads for 1291 or 1368 (higher highs MORE THAN 26 months into the 4-year cycle), then the odds favor a relatively shallower decline into the 4-year cycle low in September '06. But if the 4Q rally CANNOT produce a significant breakout then the decline into the Sep '06 low is likely to be nastier and more aggressive.
To sum up: A 4-year cycle low that will take the SPX below its 12-month moving average is due in September '06. If the market can push to significant new '05 highs during 4Q05, then the Sep. '06 low is likely to be relatively mild. If the SPX cannot move aggressively to new highs in 4Q05, then the retrenchment into the Sep. '06 low is likely to get nastier.
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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. 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 most recent Weekly WENDI jumped up from -9% to +24%, a decided turn for the better.
WENDI rode the back of strong data from Worldwide Semiconductor Billings, the Chicago PMI, Construction Spending, both ISM Indices (Manufacturing and Services), and extremely positive Productivity numbers. On the negative side were poor Vehicle Sales Data, weak Factory Sales, and poor Consumer Comfort indications.
The Cumulative Weighted WENDI popped up by +4 points to +245, turning momentum slightly positive after deterioration in the post-Katrina September-October period. The 4-Wk Weighted Moving Average pipped up again to +1% after having dropped as low as -19% in mid September.
The flow of economic news appears to be on the mend as the negative effects of Hurricanes Katrina, Rita, and Wilma slowly recede. And we expect WENDI to dance somewhat higher as 4Q05 progresses toward the holiday season.
For the propeller-heads among us, here are the components of our WENDI score. If you left your propeller hat at home, feel free to skip ahead:
- SEMICONDUCTOR BILLINGS: (+1) Stronger-than-seasonal upturn
- PERSONAL INCOME: (0) Slightly improved wages and income but still-negative savings rate.
- NAPM-NY: (+0.5) Generally strong but decelerating.
- CHICAGO PMI: (1) Greater than 60, better than the consensus, and higher than last month.
- VEHICLE SALES: (-1) Slowest pace since '98. The downside (in the shadow) of the summer's incentive plans.
- CHAIN STORE: (+0.5) W/W M/M and Y/Y growth accelerated. Job and Wage gains along w/ declining gas prices helped. High debt burdens and negative savings rate will hurt, but didn't do so this month.
- CONSTRUCTION SPENDING: (+1) Rose for the 3rd straight month. Rebuilding New Orleans will continue to goose this series.
- ISM: (+1) Strong headline reading (59.1). Orders decelerated but remain above 60. Prices Paid accelerated (a negative) but declining energy prices should ease that pressure soon.
- ABC NEWS/ WASH. POST CONSUMER COMFORT INDEX: (-1) Fell 2 points to -21. Has not responded to falling energy prices.
- MBA MORTGAGE APPLICATIONS: (0) If series falls much more it will go negative.
- CHALLENGER REPORT: (+0.5) Layoff announcements declined -20% Y/Y for October. But the yearly total is still +4% Y/Y
- OIL AND GAS INVENTORIES: (0) Mixed data on inventories and consolidating energy prices this past week.
- INITIAL JOBLESS CLAIMS: (0) Pressuring the bottom of the neutral zone (320-350K) but not quite through into positive territory after Katrina.
- PRODUCTIVITY AND COSTS: (1) Productivity surged in 3Q05. Unit Labor Costs fell. Helpful to the Goldilocks thesis.
- FACTORY ORDERS: (-1) September's orders fell -1.7% with Core New Orders down -1.5%. The outlook is probably OK for 4Q but 3Q GDP revisions will be down a bit.
- ISM NON-MANUFACTURING: (1) Rebounded sharply (7 points to 60) after the post-Katrina dip. Should continue strong at least through 4Q.
- PAYROLLS: (-0.5) Headline Payrolls number was a disappointment (+56K) and revisions were net negative. Post-Katrina data is a bit iffy, however.
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The consensus estimate of Forward 52-Week EPS for the SPX fell last week from $85.02 to $84.56 (blue line below).
In consensus for EPS growth over the coming year is 12.6%. Trailing 52W EPS fell from $75.48 to $75.31. Ordinarily that could be cause for concern. It would be except that the Energy sector experienced a -2.75% decline in its consensus F52W EPS estimate. So, by the same token that the market has been somewhat skeptical of the surge in the F52W consensus as estimates for the Energy sector were rising, the market may become more enamored of its prospects as Energy prices decline and estimates for that sector retrench.
There has been some deterioration in the consensus for Consumer Discretionaries and the Materials sector, but the story has been so monopolized by Energy that it's hard to see anything but the yellow line on the chart above. Meanwhile, however, since July '04 the consensus for EPS growth in each of the SPX's 10 sectors continues to rise (from +5% for Health Care to + 34% for Telecom Services).
The SPX PE on F52W EPS has risen by +0.4 to 14.4 over the last 3 weeks.
The market remains inexpensive relative to historical means as well as relative to the 10-Yr Treasury (Price/Dividend Ratio of 21.5).
Equity Risk Premium (ERP), defined as the Forward Earnings Yield on the SPX (6.93%) minus the 10-Yr Note's Dividend Yield (4.66%) is now at 2.27%, still quite high by historical standards but noticeably lower than the recent high of 2.77%. With interest rates rising and the stock market rallying ERP is shrinking back toward its post 9/11 median of +1.90%. We would continue to expect ERP to shrink and for the 10-Yr's dividend yield and the SPX's earnings yield to move toward one another.
The FED'S FAIR VALUE calculation (F52W EPS divided by the 10-Yr Yield) yields: $84.56/.0466 = 1816.
Our RISK ADJUSTED FAIR VALUE calculation (F52W EPS divided by the sum of the 10-Yr Yield and Average Post 9/11 ERP) yields: $84.56/(.0466+.0190)=1289.
We would expect that before the year is out the trend toward convergence of the SPX and our Fair Value Calculation will have the blue and red lines on this chart "kissing" somewhere in that 1290 area suggested by our Fair Value calculation and the "66.7% retracement of the bear market" target discussed early in this report.
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In Monday's Morning Call we'll look at some important sector charts. But we'll be watching for continued leadership in the Transportation sector (the Dow Transports have broken to new all-time highs), the Nasdaq 100, and the Financials. We'll need to see the Semiconductors contribute some positive Relative Strength, however, if this rally is to sustain its strength.
Let's continue to watch for Crude Oil's breaking below $58. If that happens, then prospects become more sustainably bull for both the market and the US economy.
Note: Our mechanical trading model (the Dynamic Trading System) now has profits on 10 out of its past 11 trades on the SPYders and the Qs, including our two open positions. With the return of more normal volatility to the stock market we expect that the System will continue to display its historically profitable returns.
Best regards and have a great week trading!