The following article was originally at The Agile Trader on Sunday, January 29, 2006
Since we're in the midst of Earnings Season, let's spend a big chunk of time this week looking at where things stand on the earnings front.
First off, because Standard & Poors has not begun publishing a Consensus Estimate for 2007 we are forced to use some sort of proxy for 1Q07's estimate in order to derive a Forward 52-Week estimate for the SPX. We are using a 7.5% Y/Y quarterly estimate until S&P begins publishing a figure. That growth rate is the long-term mean and well below the 2006 growth consensus of 10.7%, so our estimate reckons that regression to the mean will begin to be the order of the day in '07.
The Quality of Earnings looks strong with Reported EPS (pink line) just 6.1% below Trailing Operating EPS (yellow line). Meanwhile EPS growth over the coming 52 weeks is slated to be about 10.4%. (We'll know more about that once S&P begins publishing numbers for '07.)
Note that the current F52W consensus is $22.25 above the peak in '00, or up 35% peak to peak (so far).
The market's PE has risen a bit lately but remains low by recent historical standards.
While the blue line on this chart (PE on F52W EPS) is up a multiple of 1.1 off its cycle low, it remains extremely low relative to the Price/Dividend Ratio on the 10-Yr Treasury Note. With a PE of 15.1 the SPX earnings yield is 6.64%. With a Price/Dividend Ratio of 22.2 the earnings yield on the 10-Yr Treasury is 4.5%.
The difference between these earnings yields (6.64%-4.5%=2.14%) is what we call Equity Risk Premium (ERP), shown as the pink line on the chart below.
With ERP still at very high levels, we have to take the view that the market is pricing in a high degree of fear...which is to say that it remains cheap relative to bonds. Moreover, historically speaking, the market has an extremely strong tendency toward positive long-term returns (defined as the next 2.5 years) subsequent to an ERP level elevated to the 2-3% range as it is now.
The Fed's Fair Value calculations for the SPX is :
FV= Fair Value
E= F52W EPS ($85.23)
TBD= Yield on the 10-Yr Treasury. (4.5%)
We continue to think that FV figure is more than a little wacky in the post-9/11 world.
As a saner response we derive our Risk Adjusted Fair Value ( RAFV) from this equation:
RAFV= E/(TBD+ Median ERP)
RAFV=Risk Adjusted Fair Value
E = SPX Forward 52-Week Earnings Per Share ($85.23)
TBD=10-Yr Treasury Dividend Yield (4.5%)ERP= Median post-9/11 Equity Risk Premium (1.94%)
RAFV = $85.23/(.045+.0194) = 1324
We have, for some time, been looking for the RAFV figure to settle into the 1325 area. And we have been looking for the SPX (blue line) to rally up to meet that RAFV target (kiss the red line) before this rally phase expires. With just 40 points separating the SPX from our RAFV target, we would not be surprised if an important rally phase is one push away from a terminal top.
Our 4-Year Cycle analogs suggest that that top is close at hand.
The rally leg off the October '02 low continues to display remarkable congruence to the rallies off the 1962 and 1990 lows. The '90-'94 rally topped out after 839 trading days on February 2 with a 63.1% rise. The '60-'64 rally peaked after 848 trading days on February 9 with a 69.5% gain. The current rally has lasted 833 trading days so far and has a 65.3% gain under its belt. The correlations among these 3 analogous periods continue to improve from their already impressive levels. Unless and until those correlations begin to deteriorate, we'll have an eye peeled for an important market top between now and the middle of February.
That said, we continue to anticipate that a market decline into October '06, while violent and portfolio-rending (to dyed-in-the leather bulls) on a shorter-term basis, will be of the essentially benign variety on a longer-term basis.
Why? Because relative valuations are low enough (and ERP high enough) that, statistically speaking, a major bear market is unlikely.
It's all about the earnings...
How important is the Consensus of Forward 52-Wk. Earnings Estimates for the SPX to the price performance of the SPX? Generally the answer is, "Very." From 1995, at the commencement of our database for the Consensus of F52W EPS, until the spring of 2004 the correlation between the Y/Y change in the F52W Consensus Estimate and the Y/Y change in the SPX was a very strong +0.69 (where +1 is a perfect correlation and -1 is a perfectly inverse correlation.). However, over the past 22 months or so that correlation has weakened considerably to just +0.22.
The Consensus for F52W EPS has continued to rise while the price of the SPX has lagged on a relative basis. This scatter chart shows what we're talking about.
The horizontal axis of this chart is the SPX Y/Y change in price. The vertical axis shows the Y/Y change in the F52W EPS consensus. The red dots show the weekly coordinates for April '95 through March '04. The black dots show the weekly coordinates for April 2004 through January 2006. The red line describes the linear trend for the red dots.
What we see on the red trendline is the positive correlation (mentioned above) between Y/Y SPX price appreciation and the Y/Y growth of the Consensus Estimate for F52W EPS. And here are the things that strike my eye most vividly:
- Out of over 500 data points (dots) there are only 2 dots that are in the lower-right quadrant. That is, when the consensus is looking for earnings growth to be positive the SPX is showing a Y/Y decline only about 0.4% of the time.
- Over the past 22 months projections for EPS growth have been extremely strong (black dots are high on the vertical axis) while price appreciation has been slow. Consequently the black dots are in the main situated far to the left relative to where one would normally see dots that are that high on the vertical axis. Normally the black dots that high would be farther to the right, inside the yellow ellipse, expressing a faster level of stock-market price appreciation.
- The market generally overreacts. That is, the SPX price (horizontal axis) enjoys/endures bigger swings than does earnings growth (vertical axis). The Y/Y consensus estimate generally swings within the + or – 20% range while the SPX price may swing as much as + 48% or -33%. However, over the past 22 months Earnings growth has been much stronger than price appreciation. The market may be UNDER-reacting.
This chart of the growth of the F52W EPS Consensus shows projections that remain robust.
We are seeing deceleration on the blue line here, but generally real trouble doesn't show up until the blue line dips under the +10% level. (Note: the deceleration on the blue line is partly due to the use of our +7.5% Y/Y Quarterly EPS proxy for 1Q07. These figures may well be revised when more specific estimates are published.)
So, where will the problems come from later this year?
From rising Energy prices (Energy stocks are the only ones showing significant upward revisions to '06 estimates) and from the inexorable nexus of Energy prices and the potential inversion of the yield curve.
It's really probably about this simple: If Crude breaks out above $70/barrel then the Fed will have to continue to try to de-monetize exorbitant Energy prices by continuing to tighten rates. (If they don't de-monetize Crude, then the bleed-through of headline inflation into core inflation will increase.) If the Fed continues to tighten and inverts the Yield Curve then, whether or not we actually have a recession, economic growth will slow. Even if growth doesn't slow dramatically, once the Curve is inverted, institutions will be anticipating slowing growth or recession, which will kick in Sell Programs in the stock market...and a stock-market sell-off will itself be an agent of self-reinforcing economic slowing. And such slowdown could then hit the market right where it lives, in its Earnings Projections, taking the growth rate of F52W EPS projections down into some (at least temporarily) dicey territory.
On the other hand, if Crude prices come back to earth (as have Natural Gas Price, down more than 50% off their December highs at one point last week), then the new Bernanke Fed will likely go somewhat easier on the brake pedal. In that case, the market COULD provide significant upside surprises.
Oil and interest rates!
In our daily work we'll continue to trade the Dynamic Trading System's signals. The System continues to be productive in a variety of market environments. Our Auto-Trade Futures subscribers took net profits of +2.5% and +3.6% last week. And the System has traded at a 68% win rate since the The Agile Trader Index Futures System was launched in mid July.
Best regards and good trading!