The following article was originally posted at The Agile Trader on Monday December 26, 2005.
Dear Speculators,
Let's take a quick look at our WENDI and then delve into the specifics of our 2006 forecast.
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 most recent Weekly WENDI came in at +30%, up +12% from the prior period. That goosed the Cumulative Weighted WENDI up +4 points to +270 - another solid if unspectacular advance, in line with its positive trend. Our 4-Wk Weighted Moving Average, which measures the momentum of the flow of economic news held roughly steady, dropping just 1 point to +26% and sustaining near the top of the range in which this momentum measure has lived for the past 18 months.
Last week particularly strong news printed in the PPI, New Residential construction, and the U of M Consumer Sentiment Survey. Sentiment among home builders was notably weak in the NAHB survey. The bulk of reports came in moderately positive, including Oil Inventories, Jobless Claims, Personal Income, the Chicago Fed National Activities Index, Mass Layoff Announcements, and New Home Sales. The SEMI B-T-B Ratio and the Durable Goods Orders reports left something to be desired and gave us a couple of modestly bearish numbers.
Overall the numbers speak to continued growth, if of the slightly decelerated variety, in 2006.
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FORECAST FOR 2006
As this holiday weekend draws to a close I can't stop staring at one particular chart. Or more accurately, I just can't stop thinking about what it means.
The blue line on this chart is the Forward Earnings Yield of the SPX (now 6.71%). And the yellow line is the yield on the 10-Yr Treasury Note (now 4.38%).
I can't help but take note of how similar is the current relationship of the yellow and blue lines to what it was back in the early-to-mid '60s.
The yield on the 10-Yr is currently fluttering between 4 and 4.5%. The 10-Yr's yield was about 4% back then.
The yield on Forward Operating Earnings was in the 6-7% range back then. Likewise today.
In the intervening generations (a couple of them) we saw nothing like what's going on now. Indeed we saw a long-cycle rise in inflation, with concomitant rises in both interest rates and earnings yields, and then a long-cycle deceleration of inflation, with its associated fall-offs in yields. And if the 10-Yr is to be believed, we are now in a period of "well-anchored" (the Fed's word) inflation expectations, and rich earnings yields (on a relative basis) that looks more like the 1960s than it does anything else in our lifetimes.
So, how did the market behave in the '60s?
With the exception of the 1966 drop into its October low (about a 50% retracement of its '62-'66 gain) we saw a significant a low-volatility bull market that measured better than a 100% gain on the SPX over a 6-year span ('62-'68).
By the conclusion of that period, rising inflation expectations had goosed the yield on the 10-Yr up near 6%. At that point (12/68), with all the juice squeezed out of the positive differential between the SPX and 10-Yr yields, and with inflation jacked up into a higher range, the bull market of the '60's had more or less run its course. And it took another 4 years for the SPX to work its way to even a marginal new high, +10% higher than that 12/68 high. (We'll have to keep ours eyes peeled for the bond market's discounting rising inflation.)
So, how does all this pertain to 2006? Well, we have been examining the 4-year cycles in this weekly letter for some time now. Specifically, we have been analyzing the analog between the SPX's behavior off its October 2002 low and its behavior off its October 1990 low.
But now, in looking hard at the market of the '60s, we've discovered an even more astonishing 4-year cycle correlation.
On the chart above the red line represents the SPX performance off its Oct. 2002 low. The blue line represents the SPX performance off the Oct. 1990 low. And now we've added the yellow line, which represents the SPX performance off its Oct. 1962 low.
That yellow line has an even stronger positive correlation with the red line than does the blue line! (As of day #811 on this chart the yellow, blue, and red lines show gains of 66%, 58%, and 63% respectively.)
Moreover, and probably more important for us at this point, is the fact that the market made a push higher into February 1966 in much the same fashion as it made a push higher into February 1994. So, if the analog holds, we'll see the market push higher into February 2006.
At that point, however, the analog tells us that there will be a pull toward a retrenchment of some sort. A more benign retrenchment (soft landing) would look more like 1994 on the blue line above and a more malignant retrenchment (crash and burn) could like 1966's 50% retrenchment on the yellow line above.
Now, since I am both personally and culturally significantly inclined toward spending a decent amount of time and effort figuring out what it makes sense to worry about, let's look at one more specific risk factor: the yield curve.
The difference between the 10-Yr Yield (4.38%) and the Effective Fed Funds Rate (4.25%) is represented by the blue line, now at 13 basis points. As we have discussed in the past, when that spread is flattening (blue line falling) the markets Price/Earnings Ratio (pink line) also generally tends to fall. (The Great Bull Bubble was an exception to this rule.) So, until the Fed takes its foot off the brake (stops hiking rates) the blue line will likely continue to fall and the stock market will have trouble making more than earnings-based gains.
However, when the Fed does stop hiking, and if it starts CUTTING rates (which I suspect will be on the table in 2H06) then the blue line will very likely begin to reverse course and the stock market will likely begin making MORE than earnings-based gains...it will probably start enjoying PE expansion.
So, how does that play into our "skeleton frame" for 2006? While I'm not stupid enough to think I'm smart enough to know exactly what will happen in the stock market, here's our base case:
- A strong January and a high, most likely, by early February. We're still looking for the SPX to approach our Risk Adjusted Fair Value (RAFV) price, now at 1348 (though RAFV could be a bit lower by February if bond yields rise).
- A pullback from early February that at first looks benign and then starts to become scarier...accompanied by the development and exacerbation of an inverted yield curve. (Y/Y change in F52W EPS consensus may roll over and fall below +10%, as discussed below.)
- An impressively scary 4-year cycle low in October, with a Forward Earnings yield in the 7.8-8% range and with all manner of shrieks from the press about the inverted yield curve and how the Fed's (then to be) newly implemented rate-cutting regime is "pushing on a string."
- A rally out of that October low that is met by massive skepticism and more shrieks about how the Fed is artificially using its "money pump" to stimulate the economy...more moaning about how the world will come to an end much sooner than we think.
- Quite possibly a rally that lasts into the spring of '07, with a bullish curve-steepening in full force. Rallies out of 4-year cycle lows can be relentless affairs.
I offer this framework with full cognizance that it could be wrong at each and every step of the way. Its purpose is not for us to be RIGHT, but to give us a basic set of expectations against which to measure how the markets unfold in real time. I also think (not any longer secretly) that, based on how market cycles have a tendency to work, there's a pretty fair chance that this cycle will play out quite a lot like I've described.
We'll post this framework on our wall and return to it throughout '06 to see how it's doing.
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EARNINGS AND VALUATION
The positive trends in Forward 52-Week Earnings Estimates remain positive.
We are seeing no major revisions, nor are we seeing any problems with the quality of earnings (the spread between operating and reported earnings). Over the past 2 years the SPX has been advancing slowly...even more slowly than earnings.
We can see that the trend has been toward PE compression since at least December '03, with the SPX's PE on F52W EPS (blue line) now at 14.9, up less than a multiple of 1 off its cycle low. Meanwhile the Price/Dividend Ratio of the 10-Yr Treasury (black line) remains elevated, more than 50% higher!
What motivates investors to pay a 50% premium for a dollar of Treasury earnings relative to a dollar of SPX earnings? Risk aversion. Equity Risk Premium (ERP) (F52W Earnings Yield minus 10-Yr Treasury Yield) remains at an elevated 2.33%.
Our RISK ADJUSTED FAIR VALUE target (F52W EPS divided by the sum of the 10-Yr Treasury Yield and the median post-9/11 ERP) now stands at 1348.
Despite the fact that the consensus estimate for F52W EPS is now 15.8% higher than it was a year ago...
...investors continue to disbelieve the underlying growth story on the SPX. Meanwhile the stock market continues to display a strong tendency to remain in essentially bullish formations as long as that blue line remains above +10%.
As mentioned in step #2 of our 2006 forecast, we'll be watching to see if this line moves below +10% next year.
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Seasonality remains bullish for the final 4 trading days of the year, though its positive slant is less pronounced than in bygone eras. One has to wonder whether the advent and proliferation of various derivative instruments, many of which can be used to lock in profits while delaying the taxability of gains, hasn't diminished investors' propensity to delay profit-taking until the new year.
Next week in this space we'll examine early January's seasonal tendencies in more detail.
Have a great week!
Best regards and good trading!
