The following missive was published on Sunday, February 5, 2006 at The Agile Trader Web site.
Our baseline forecast is for the market to be topping out sometime in 1H February, and then to struggle until it puts in a significant low in the vicinity of the end of 3Q06. The analogues that we've been looking to are the 4-Year Cycle Tops of 1966 and 1994.
In all 3 cases the market rallied out of a 4-Year Cycle Low in October and charged ahead for 3+ years, ultimately gaining more than 60%.
But this cyclical bull is now long in the tooth and ripe for at least a consolidation if not a more severe pullback. We've now completed trading-day #838 of the rally with a maximum gain of +65% prior to this past week's sell-down. In 1966 the rally peaked on trading-day #848 at +63% while in 1994 the rally peaked at trading-day #840 at +69.5%. (Remarkable similarites, with correlations above +0.90.) So, relative to these precedents, there could be another 2-10 trading days to go. But, we're looking for an important high to be put in over the next 2 weeks (if it hasn't been made already).
In support of the call for a pullback as we head toward 2H06 I'd like to show you a longer-term charts that reveals some uncanny correlations.
On this chart the blue line represents the SPX's PE on Forward 52-Week Operating EPS. And the red line represents the SPX's annualized price appreciation over the ensuing 2.5 years (30 months). Note that the most recent data point on the red line is always 30 months ago. Why? Because we can't know how the market performed over the "next" 30 months for any date more recent than that.
What we notice on this chart is a distinct inverse correlation between the red and blue lines (-0.68 since 1985 and -0.88 since 1992). Now, look at the spike higher on the blue line in February '04. If the market's 2.5-year annualized price appreciation (red line) continues to display the kind of inverse relationship to its PE (blue line) that it has over the past 14 years, then we will see the red line dropping down toward the 0% line as it heads toward its own appointment with the implications of the PE spike of Feb. 2004.
Note: The way the red line works is this: the height of the red line on the vertical axis represents the SPX's annualized return over the next 2.5 years. So, if the red line drops to 0% on this lagged chart in Feb. 2004, that suggests that 30 months later (Aug. '06) the SPX would be at the same price level as it was in Feb. 2004. And where would that be?
In the 1125-50 band, which would represent about a 12-15% correction from a high of 1300. A sensible target, that one, as it represents a re-test of the November '04 breakout as well as of the April '05 breakout re-test.
Such a 3Q06 low would be, in my mind, extremely benign. In a more malignant environment the target could easily stretch down to 1050 (the Aug. '04 low), down about 20% from 1300.
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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 has recovered from a soft spot over the past 2 weeks and now sits at +20%, which is on the plus side, but modestly so. The Cumulative Weighted WENDI has jogged up to a new all-time high, indicating that the positive trend in the economic news flow is intact. Momentum remains at the upper end of the range in which it has been fluctuating since late 2004 and is sustaining its bounce off last fall's Katrina-related drop.
For the most part Employment data are looking solid, if unspectacular. Consumers' income is likely to accelerate a bit, though probably not enough to keep up with spending. And while growing consumers' income is a positive for aggregate demand, it's possible that inflationary pressures will also pick up. So, while present momentum is solid, structural debt overloads and savings shortfalls remain as long-term bugaboos.
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The consensus SPX F52W EPS, as published by Standard & Poors, now calls for EPS of $85.63. (Note: we're using the conservative assumption of Y/Y quarterly EPS growth of 7.5% for 1Q07. This until S&P starts publishing CY07 estimates.) That's a new all-time high.
Quality of Earnings (represented by the spread between Trailing Operating EPS (yellow) and Reported EPS (pink)) remains in excellent shape with the spread continuing to diminish over time).
Price/Earnings Ratios remain cheap by recent historical standards.
The SPX PE's have rallied hardly at all off their cycle lows. And with ERP still over +2%, which is a very wide spread, we continue to suspect that the much expected bear retrenchment after this 3+-year rally, will be milder than many expect.
We will continue to monitor the growth of F52W EPS estimates.
Currently growth in the Y/Y figure (blue line) remains solid, well above the key +10% level. However, signs of weakness exist in the 3-month annualized growth rate for the consensus, (red line) which is now down under +5%. So, we have a sort of shot across the bow for the bullish case, warning us that deterioration on the blue line could be imminent.
Further clouding the picture is the continuing fact of the Energy sector's preeminence in both Earnings growth and Price appreciation.
The catalyst for some nasty action in the market this year could be the market's re-awakening to the troubles created by outrageously high energy prices, which tap out both the consumer's and non-energy-related businesses' balance sheets.
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The Dynamic Trading System continues to perform up to and beyond our expectations. And we continue to view futures contracts as the optimal tool for taking advantage of the System's characteristics and properties. As of Sunday night our auto-trade subscribers are sitting on e-mini SPX and NDX open positions with 24% and 26% gains, respectively. If you would like information about trading the Dynamic Trading System in the futures market, email us at email@example.com.
Have a great week!
Best regards and good trading!