The following article was originally posted at The Agile Trader on Sunday, January 15, 2006
If you watched any of Senate's Alito hearings last week, then you may have felt the need for an emetic, as I did. In fact I was so nauseated by the unbridled display of irrational partisanship (from both sides!) that I could barely bring myself to read any of the usual economic reports and commentaries that normally occupy a decent chunk of my weekend.
Because these days it's almost as hard to find an objective economist as it is to find an objective senator. I can count on one of Mickey Mouse's 3-fingered hands the number of macro thinkers who have sung any more than just one tune over the past 5 years. The bears are bearish and the bulls are bullish. So, the way it looks to me right now, none of them are any good to anyone except insofar as they may or may not sing a song that we may find pleasing to our ears! The bears like to listen to the growling of other bears and the bulls like to listen to snorting of other bulls. We all like to have our own predispositions confirmed by the noises that others of our kind make. (But since there are only a hundred senators in the world, and none other, there are very few who like to listen to the long-winded noises that those of THEIR kind make...except themselves.)
Why bring up this subject in this venue? Because it strengthens my resolve to stick to the data (and what it may suggest), and to keep the pontificating and opining to a minimum. And this week, wherever I look, I keep seeing data that looks an awful lot like 1966...
...which I'd like to examine in depth in a moment...but before we do that, let's take a look at our nearer-term Risk-Adjusted Fair Value Target for the SPX.
The SPX has continued to approach our Risk Adjusted Fair Value (RAFV) target for the current move higher. We derive RAFV from this equation: RAFV= E/(TBD+ Median ERP)
- RAFV=Risk Adjusted Fair Value
- E = SPX Forward 52-Week Earnings Per Share (Consensus Estimate) ($85.37)
- TBD=10-Yr Treasury Dividend Yield (4.35%)
- ERP= Equity Risk Premium, defined as the difference between the SPX Forward Earnings Yield and TBD (6.63%-4.35%=2.28%)
- Median ERP= Median post-9/11 (1.94%)
RAFV = $85.37/(.0435+.0194) = 1358
With the SPX now at 1288 and with the 10-Yr Treasury yielding just 4.35%, we may very well see RAFV drop down just a bit toward 1325 as Price pips up to meet it. Once this target is met, then we'll have to reconsider its premises.
With this target expressed, let's turn our attention back to 1966...
First let's look at the SPX's performance since its October 2002 low and compare it to where it stood in 1966.
We've looked at this chart before in this space, but for those of you who are new to our work, it's an important starting point. The correlations among the 3 periods studied here continue to get more and more impressive. The rallies up off the lows of October 1962 and October 1990 both lasted just about 40 months and peaked with gains of 69% and 63% respectively. The SPX has now gained 66% since its October 2002 low. And this analog suggests that we're heading for what could be an important mid-term top between now and early February.
Now, let's look at a chart of the SPX on a logarithmic scale. We use a log scale here so that the market's action at lower price levels is more visually meaningful on the chart.
Here we see the SPX in red and the SPX PE on Forward 52-Week Operating Earnings in black. The blue vertical lines mark the market's 4-Year Cycle tops, which tend to come about 26 months after the 4-Year Cycle lows.
As we've discussed in the past, when the 4-Year Cycle High is translated to the right (which is to say, when the market continues to rise as it moves to the right of the vertical blue line as it did after Decembers 1964, 1984, 1988, 1992, 1996, and 2004), then ensuing drop into the next 4-Year Cycle Low (next one due in Oct. '06) tends to be relatively benign. On the contrary, if the SPX can't muster the momentum to continue higher and translate that cycle high to the right (if the SPX drops either before or from the 4-Year Cycle high as it did in 1968, 1972, 1976, 1980, and 2000) then the risk of a more malignant market retrenchment increases.
In the current context the move from the blue vertical line (December '04 toward February '06) looks a lot like the move from December '64 toward February '66.
Now, look at the PE line (black) on the chart and compare it to the PE line in the '60s. From 1963 to about 1969 the PE spent about 95% of the time fairly stable between 15 and 18. (The 43-year median 15.7 and the current PE is 15.1.) And it wasn't until the hoofbeats of galloping inflation made themselves heard toward the end of the '60s that the market's PE dropped from its stable range in the mid-to-high teens down into single digits.
Now, let's look at what's happening with Inflation, GDP, and the 10-Yr Treasury Yield.
There's a lot going on with this chart, so let's break it down.
- The red line is the 10-Yr Treasury Yield.
- The blue line is the 4-Quarter Average of the Implicit Price Deflator (IPD), which is the headline measure of inflation used in the GDP report.
- The thin grey line is the 4-Quarter Average of Nominal GDP growth.
- The thick grey line is the 10-Period Moving Average of the thin grey line.
I've highlighted in yellow the current period and the period around 1966. Why? Because what I see happening now so closely resembles what happened 40 years ago.
Note how the thick grey line (Nominal GDP Growth) is surging higher. Note also how the red line (10-Yr Yield) is lagging well behind the thick grey line. And further note how the blue line (IPD, which measures inflation) is creeping up just as it did in the mid '60s.
What I see on this chart suggests that the trend in Nominal GDP (thick grey line) tends to lead the trend in inflation (blue line). And that the trend in Inflation may push the trend in interest rates, with rates often being slow to understand the trend changes in Inflation.
In the current situation, with Nominal GDP up near 7%, with the 10-Yr Treasury yielding about 4.35%, and with Headline Inflation now above 3%, we're seeing a confluence of circumstances that greatly resembles that last seen in 1966 (highlighted on the chart above).
And if that's not enough, take a look at this next chart, which plots the Yield Curve (10-Yr Treasury Yield minus the Fed Funds Rate) against the SPX PE on Trailing 52-Week EPS.
The spread is now just .07, which is precisely what it was at the end of January '66. Moreover, in both cases the spread had shrunk from more than 3% at its most recent high.
And how did the market perform in '66? Well, the Yield Curve inverted to about -0.9% during 2H66 and the SPX PE fell briefly to about 13.
That provoked about a 22% retracement into the October '66 low, which was then followed by about a 48% advance, which took the SPX to a December '68 high that was about 15% higher than its early '66 high.
From these data points we can now construct an even more specific base-case scenario than the one we've been building over the past few weeks: If the Yield Curve inverts by something close to -1% during this coming year, then we can look for the SPX PE to contract even more from its current status, perhaps down to about 13 on a Trailing basis. Such a PE contraction could engender something like a -22% retrenchment on the SPX, which, depending on how high the index manages to climb during the next few weeks, could put the SPX in the 1014-1040 range for an October low.
Beyond that October low, we may get set up an upward push created by the inception of a new 4-Year Cycle, with a rally up toward the 1500 area by December '08.
What could go wrong with this scenario? Any number of things. Inflation could begin galloping in earnest ahead of schedule (before '08), which would hurt the market sooner and harder than our base-case anticipates. The Fed could create a softer landing than it did in '66, (more like it did in '95), preventing a serious curve inversion and creating an even more benign (say, 10%) pullback into the 4-Year Cycle low in Oct. '06. The global liquidity glut could collapse, launching an array of unprecedented market seizures and financial crises (that's the song the bears like to sing). Or soaring productivity, the rise of the Asian Middle Class, and the development of cheap, clean energy could spur a new global economic boom (that's a tune the bulls might hum).
Most probably our base-case scenario for'06-'08 will not obtain with anything like precision. But, as we've mentioned before, this template gives us a set of expectations against which to compare actual developments as they occur in real time.
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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 for the most recent period pipped higher by 5 points to +19%. That moved the Cumulative Weighted WENDI (red line) higher by 3 points to a new high at +278. Momentum remained unchanged on the 4-Week Weighted Moving Average (blue line) at +22%.
The flow of economic news remains solidly if unspectacularly positive, sustaining positive momentum near the top of its 18-month range. The expansion remains intact, though risks appear weighted to the downside for the coming quarter as the lagged effects of a flattening yield curve and the waning influences of expiring stimuli could make themselves felt.
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Best regards and have a great week.