The following article was originally published at The Agile Trader on Sunday, January 22, 2006.
Dear Speculators,
It has been our view in this space that the Fed, despite all rhetorical posturing to the contrary, is indeed targeting asset prices with its current program of measured rate hikes. And the Fed is only likely to take a seat on the sidelines when the speculative excesses in the assets being targeted have had the breath squeezed out of them by the belt-tightening.
The Fed has a lot of exposure as it plays out this gambit. On the one hand, we have commodity and home prices inflating relative to the US Dollar and most other currencies. (Solution? Hike rates.). On the other hand we have goods and services that are DE-flating relative to hard stores of value such as Gold (solution? hike rates), and are only modestly inflating relative to DE-flating currencies. And on the 3rd hand (only economists have 3 hands) domestic labor markets are tightening (<5% unemployment - hike rates) while Real Wage Growth is shrinking and consumer balance sheets are overstretched (cut rates). And all this in the context of rapidly expanding global growth in credit and Money Supply (hike rates).
Now, add in the "conundrum" of intense global demand for long-dated Treasuries, which has flattened the yield curve (is it because of a Global Savings Glut, diminishing Home Bias among foreign investors, or because the bond market is predicting slowing US economic growth, or benign inflation?)... and the Fed isn't caught in a simple dyadic dilemma, between a rock and a hard place, rather it's got to dance between (among) a cloud-burst's worth of raindrops and hope it doesn't get soaked!
And how does that translate into concrete terms for the stock market? Let's have a look.
This first chart tracks the SPX PE on the Consensus Estimate of Forward 52-Wk Operating EPS (red). In blue we see the spread between the 10-Yr Treasury Yield and the Fed Funds Rate. During roughly the past 2.5 years, using weekly data, the correlation has been a very strong +0.83. That is, the yield curve has flattened as the PE has compressed.
Indeed one could make the case that 83% of the PE compression is a function of the flattening of the curve.
This chart quantifies the relationship in an interesting way. Using the linear regression line, we can see that, on average, for roughly every 1% that the curve has flattened the PE has compressed by about a multiple of 1. If that relationship were to sustain, then, if/when the Fed decides take its foot off the market's neck and allow the Curve to steepen again, then the PE is likely to begin to expand again.
Should the curve steepen to the +3% area again, then we might expect the SPX PE to regain as much as a multiple of 2.4 times its F52W EPS (2.4*$85.30=205), or about 200 points (to 1461-ish). Should the curve steepen to its 25-year median of about 1.5%, then we might expect the SPX to return to a PE of about 15.5 - 15.75 times F52W EPS or to about 1322-1344.
Interestingly, that's precisely the area that our Risk Adjusted Fair Value calculation has been pointing to for quite some time. (See the Earnings section below.)
But what's going to get the Fed to cease and desist from all the belt-cinching?
First and foremost, the calming down of Home and Energy prices.
On this chart we see the Residential Construction Sector (candlesticks) plotted against the Light Sweet Crude Oil Index, set back by 24 trading days (red line). The correlation between these two had been extremely strong at +0.80. However most recently Crude has strengthened much more than did Residential Construction a month earlier.
What does this mean?
The Fed's tightening has begun to have serious effects on the Housing Sector. The rate of Home-Price Appreciation has slowed markedly. New Construction and Permit Issuance have both softened and slowed. The Cash-Out REFI boom is over and some sort of "landing" (most likely soft, but perhaps jarring) is in the making. And that's visible on the chart where a large topping formation is in progress in the Residential Construction sector.
That said, geopolitical fears have most recently propelled Crude back up to test its summer high. While tightening monetary conditions were having a negative effect on Oil prices during the autumn, the early '06 price breakout in the Oil market may well begin to reignite fears of broad-based increases in inflation. (Or, heaven forefend, STAGflation!)
And Gold is responding in similar fashion.
Since the beginning of the year GLD, the ETF that tracks the price of Gold, has risen from $51.58 up as high as $56.60 on Friday. Normally GLD trades at roughly the same volatility as the SPX. Right now GLD is trading at twice the volatility of the SPX. When commodities are trading like Tech stocks, then there's either a major supply disruption, a war, or a significant liquidity play going on.
Right now fears of supply disruption and war (terrorism) have liquidity pouring into Gold and Oil among other commodities and THAT (soaring commodity prices) may work to keep the Fed in tightening mode for longer than it otherwise would be.
And why is that especially problematic? Because, as we have discussed in our January 8 Weekly Wrap-Up, TWO STEPS FORWARD, ONE STEP BACK, we are expecting a 4-Year Cycle Low in October '06. And if the Yield Curve goes "upside down" (inverted) as the market heads into an extremely vulnerable period, with skyrocketing "input" prices and rampant geopolitical uncertainty, the potential for a very nasty correction into that 4-Year Low exists.
If the Fed can find a set of reasons to prevent such a Curve Inversion and allow the Curve to begin to steepen in the early part of '06 then we should begin to see signs of PE expansion and the retrenchment into the 4-Year low should be relatively benign.
With Greenspan leaving at the end of the month and Bernanke taking the helm, these promise to be interesting times.
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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 sank by -12 points to +7%. The flow of economic news on the week was still positive, but just barely so. The trend remains to the upside as the Cumulative Weighted WENDI rose 1 point to +279 but momentum is deteriorating as evidenced by the rolling over of the 4-Wk Weighted WENDI, which dropped by -6 points to +16%.
Overall we are seeing deceleration in the economy, which is what we have expected for early '06.
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EARNINGS
The trends on all the earnings lines for the SPX remain positive.
Expectations remain for positive growth with the consensus for Forward Earnings about 11% above Trailing Earnings. The quality of earnings is actually improving as Trailing Reported EPS is now just 6.2% below Trailing Operating EPS.
Consensus estimates for 2007 are not out yet, so we are using +7.5% EPS growth for 1Q06, which is the long-term growth rate of SPX earnings. Once estimates for '07 are published we may see some changes on the blue line above.
The Y/Y change in the F52W EPS line remains robust at +15.2%
The market appears to run into serious trouble when the blue line on this chart is descending below +10% or when it's anywhere below 0%. Of course we'll be watching this chart closely as '06 progresses.
The SPX PE remains low both on relative and absolute bases.
The PE on F52W EPS (blue) is at 14.8, up just +0.8 from its cycle low.
The SPX backed off on its approach of our Risk Adjusted Fair Value (RAFV) target for the current move higher. We derive RAFV from this equation: RAFV= E/(TBD+ Median ERP)
Where
- RAFV=Risk Adjusted Fair Value<
- E = SPX Forward 52-Week Earnings Per Share (Consensus Estimate) ($85.30)
- TBD=10-Yr Treasury Dividend Yield (4.36%)
- ERP= Equity Risk Premium, defined as the difference between the SPX Forward Earnings Yield and TBD (6.76%-4.36%=2.4%)
- Median ERP= Median post-9/11 (1.94%)
Or
RAFV = $85.30/(.0436+.0194) = 1355
Our fundamental expectation is that the SPX (blue line) will end up kissing the RAFV (red line) somewhere in the low 1300s (near 1325). However, if Crude Oil and Gold continue to soar, then we may not get to watch those two lines "make out."
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