The following article was originally posted at The Agile Trader on Sunday, December 4, 2005.
Dear Speculators,
This economic expansion is driving econometricians nuts. Why? Because it's full of apparent contradictions. Like what?
- The Current Account Deficit is at record levels and yet the dollar fails to really weaken (now up better than 14% on the USD Index in the past year).
- Despite soaring Energy prices, measures of core inflation remain extremely tame.
- Long-term interest rates remain historically low despite (or perhaps because of) more than a dozen consecutive Fed rate hikes.
- Consumer Sentiment remains moribund even in the face of above-trend economic growth.
- Assets and commodities continue to inflate while finished goods and services continue to DISinflate.
- The consumer continues to spend like mad despite being over-leveraged and in possession of a negative savings rate.
- Corporate Profits are at all-time highs even as real median family income (adjusted for inflation) continues to fall.
As a measure of just how bizarre this recovery is, look at the following chart. The one thing we've all taken for granted is that there's a housing bubble. And yet if we denominate the price of the median home in ounces of gold (ostensibly the truest measure of value), something really strange emerges.
The median home price denominated in the year's average price of gold cost 512 ounces of the yellow metal. of in 1998. In 2001 the median home cost 624 oz of gold. In 2005 the median home costs 491 oz. of gold. (And we're using $440/oz for '05. If we use the CURRENT price of gold, this year's median home costs just 429 oz. That's 31% below the 2001 level!
Housing Bubble?
Not hardly. Not in terms of gold.
What we have seen is a weirdly asymmetrical devaluation of the US Dollar. The dollar has devalued against assets and commodities, but not nearly as much against other currencies, and barely at all against goods and services. So, we have asset and commodity inflation (in dollar terms) but relative price stability in terms of goods (both durable and nondurable) and services.
And how long will this continue? As long as Asian countries continue to try to build up wealth by exporting cheap goods and services...or, until their levels of internal demand build up sufficiently to support their desired levels of economic growth.
In other words, in a world in which barriers to international trade and investment continue to fall, the flow of "wealth" from the US economy into less wealthy economies (in the form of our importing "tradables" and exporting money) will continue until such time as those less wealthy economies are no longer notably less wealthy. Or until our economy becomes much more protectionist (which will create inflation in goods and services).
Food for thought. Especially in the context of Fed Chairman Greenspan's remarks on International Imbalances presented last Friday before the Advancing Enterprise Conference in London, England. And especially in the context of the increasing desire on the part of foreign money to invest itself in the US economy.
This is not your grandfather's economy. And it may go on a lot longer than many think possible.
Ultimately, however, the net result will be the leveling of the global playing field in terms of the wealth of nations.
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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.
The Weekly WENDI dropped -6 points last week to +30%. The flow of economic news was solid with an upward revision to 3Q05 GDP (+4.3%) leading the way and solid monthly jobs growth (+215K) in a strong supporting role. It was a heavy week on the news front with 20 WENDI components printing. The Cumulative Weighted WENDI jumped up by 6 clicks to 261, continuing the positive, if scalloped, uptrend. Meanwhile our measure of momentum, the 4-Week Weighted Average rose by +2% to +28%, pressing against its highest readings in over 18 months.
The strength of the economic news in this cheery holiday season is sufficient to support the breakouts we're seeing on an array of stock indices.
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EARNINGS
The consensus of Forward 52 Week Earnings Estimates moved higher by $0.23 last week to $84.99, still $0.03 below its recent all-time high, but still within its relentless uptrend.
The trends in Trailing 52-Week EPS and Reported EPS continue to rise as well, with no particular problem developing in terms of the quality of earnings (no notable divergences among the 3 lines).
The Y/Y growth rate of the F52W EPS consensus also continues to be supportive of the bullish thesis.
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In the blue line on the chart above we see that the Y/Y growth rate of the consensus estimate of F52W EPS pipped up by +0.2% to +16.2%. As long as that line is not either 1) declining and below +10% or 2) below 0% the market has a tendency to remain in a bullish trend.
The SPX PE on F52W EPS fell by -0.1 last week to 14.9.
This chart continues to paint a picture of a market with high Equity Risk Premium (ERP). The forward earnings yield on the SPX is now 6.72%. The yield on the 10-Yr Treasury is now at 4.52%. The difference between those 2 figures, now 2.2%, is our ERP, still well above the post-9/11 median of 1.93%. (The market remains cheap.)
The FED'S FAIR VALUE CALCULATION divides F52W EPS by the 10-Yr Yield. That's $84.99/.0452=1881.
Our RISK ADJUSTED FAIR VALUE CALCUATION (RAFV) tunes the Fed's equation to the riskier post-9/11 world. We divide F52W EPS by the sum of the 10-Yr Yield and the median post-9/11 ERP (now +1.93%). That's $84.99/(.0452+.0193)=1319.
We continue to expect that the SPX will rally up to kiss its RAFV before the 4Q05 rally is finished.
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A LOOK DOWN THE MARKET'S THROAT
The broad market is in rally mode.
The SPX has broken above its prior cycle high, retested the breakout and bounced up on heavy volume. Our proprietary measure of volume-weighted momentum (OVM) is confirming the breakout with a breakout of its own. (Note how last summer's failed pip to a new high was unconfirmed by the OVM line.)
In terms of confirming indices:
The Nasdaq Composite, the S&P MidCap 400, the SOX, and the Transports are all either leading or confirming the SPX breakout and are showing positive Relative Strength. Of some interest is the fact that both the LargeCaps on the OEX and the SmallCaps on the Russell 2000 have failed to break to new rally highs.
At this stage of the economic expansion we would expect to see the OEX follow the SPX and break to the upside. Should the OEX fail to push through 590, that could be cause for concern.
On a short-term basis, we would look for the markets to be choppy and sloppy until December 15. Beyond that we continue to look for further upside into year-end.
Best regards and have a great week!
