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Weekly Wrap-up: Why a Cheap Market Won't Rally

The following article was originally published at The Agile Trader on Sunday, February 26, 2006.

Dear Speculators,

The Dynamic Trading System took neither gains nor losses last week as the market was essentially frozen in place. The SPX netted a whopping 2.19-point gain while the NDX made the SPX look like the soul of volatility, rallying by 1.29 points on the week.

The SPX is now 851 trading days into its rise from its October '02 low (blue line below).

This rally is now 4 trading days older than the rally of '62-'64 (black line) and 12 trading days older than the rally of '90-'94 (red line). So, it's put-up or shut-up time for this set of analogues. The correlations among the different series have not begun to deteriorate, but if the SPX does not roll over and start to decline, then we will begin to see divergences.

Technically we continue to see mixed signals in both the Dow Transports, representing the Old Economy, and in the Philly Semiconductor Index, representing the New Economy.

The Transports continue to move in an uptrend, showing positive Relative Strength. However the "ascending wedge" formation should give the bulls cause for pause. This continues to be a perilous setup. A break over the upper limit of ascending wedge and over 4500 would negate the negative implications of the formation. However, in the absence of such a breakout, we would expect the wedge to crack to the downside and for the 4100 area to endure a test from above.

The SOX, by contrast, has suffered a loss of Relative Strength as it has failed to penetrate through 560.

The lower limit of the index's parallel trend zone is undergoing a test as Relative Strength fails its moving averages. A move over 560 would be bullish. In the absence of such a move we would look for a test down to the 480-500 band.

We suspect that these two indices cannot sustain their recent divergence. The SOX over 560 with the Trannies over 4500 would be bullish. The SOX below 524 with the Trannies below 4300 would be bearish.

EARNINGS, VALUATION, AND THE YIELD CURVE

The trend in the consensus for Forward 52-Wk Operating EPS on the SPX remains positive (blue line below).

Using a conservative proxy of +7.5% Y/Y growth for 1Q07 the consensus for F52W EPS now stands at an all-time high of $85.72. That's about +36% higher than at the prior peak in 2000. (Note: since CY07 estimates are not yet published this number is subject to revision.) Trailing Operating EPS (yellow line) and Reported EPS (pink line) continue to trend higher as well.

Growth in the F52W EPS consensus remains in constructive territory with the blue line up 13.8% Y/Y (illustrated below).

As we have discussed at length in the past, as long as the blue line on this chart remains above +10% the market generally maintains a bullish bias. However, with the blue line now down from almost +18.8% in early October to +13.8% we could very well be headed for the kind of deterioration that provokes the market to become skittish. Moreover, the 3-month annualized growth rate for the consensus F52W EPS estimate (red line) is currently floundering well below +10% and could be "priming the pump" for further corrosion on the blue line.

That said, there are a lot of cross-currents in the Earnings picture, just as there are in the Technical picture.

This chart depicts the SPX EPS a bit differently. The weightings here are different from those used estimate the aggregate index's numbers, so the dollar figures are different. The black line represents the sum of sector-by-sector EPS estimates for CY05. And the red line shows the same figure for CY06. The grey line represents CY05 less the Energy sector and the pink line represents CY06 less Energy.

Over the past 9 months the CY06 consensus estimate for SPX EPS has risen at a +6.1% annualized rate. Meanwhile the CY06 consensus estimate for SPX Less Energy EPS has fallen at a -2.3% annualized rate. Energy is eating everyone else's lunch.

However...CY06 EPS Growth for the SPX will be +10.9%, according to the consensus, and CY06 EPS Growth for the SPX Less Energy will be an equally robust +11%. So, while Energy is eating everyone else's lunch, everyone else's moms packed their lunch-boxes full enough to withstand Energy's acting like a thieving bully.

So far, while there are some issues to be concerned about, there doesn't appear to be anything particularly dire going on.

Valuations in the stock market remain near cyclical lows with the SPX PE on F52W EPS now at 14.9 (up just +0.9 from the cycle low), with a Forward Earnings Yield of 6.65%. Meanwhile the 10-Yr Treasury has Price/Dividend Ratio (black line) of 21.9, with a Yield of 4.57%. And that leaves a difference of 6.65% - 4.57% = 2.08%.

The market is willing to pay about $22 for $1 of risk-free yield while the market is only willing to pay about 68% as much ($14.90) for $1 of "risky" earnings in the stock market. That +2.08% difference is our Equity Risk Premium, which we had been expecting to shrink to +1.95% (post-9/11 median) before the market hit a cyclical top.

While we would like to remain bullish on a stock market that is, by our reckoning, cheap, and we would have liked to see the SPX hit our Risk Adjusted Fair Value target in the low 1300s, our forecast for the next 9 months continues to be provisionally pessimistic, based on our view that the Yield Curve will not enjoy a "bull steepening" in the very near future, as the market now anticipates.

This chart shows the strong correlation between the flattening Yield Curve (blue line: 10-Yr Treasury Yield minus the Fed Funds Rate) and the market's declining PE (red line). Most recently the PE has risen from 14 to about 15 and consolidated at that level. However, in the interim the Curve has continued to flatten to almost ZERO.

Note: a bull steepening occurs when the Yield Curve steepens (blue line rises) because the Fed is lowering rates to make short-term borrowing cheaper than long-term borrowing. Such a steepening increases the built-in profit margin for institutions that borrow short-term and lend long-term, thereby encouraging lending, which in turn promotes economic growth.

Our view is that the stock market is anticipating that the Fed will take its foot off the "brakes" (stop tightening) sooner than later. But given recent developments in both the Consumer Price Index (CPI) and Weekly Wages, we suspect that the market is in for a rude surprise.

Despite the fact that Core Inflation numbers are fairly benign, both the headline CPI (red line above) and Weekly Wages (blue line above) have recently surged. Both are now well above their 10-yr averages. CPI is at +4% Y/Y (average +2.5%) and Weekly Wages are up +3.6% (+3.1% average). And perhaps more importantly, the trends in these series are decidedly northerly.

The stock market has lately been enchanted by new Fed Chairman Bernanke's rhetoric and has probably experienced some relief over a relatively smooth transition out of the Greenspan era. But, with the Fed expressly in a "data dependent" mode, it's hard to believe that they'll be taking their foot off the brake in the context of the accelerations visible on this chart. Or with Crude Oil above $60 and Gold in the $560 area.

**** **** ****

Could we see the SPX enjoy a surge toward our Risk Adjusted Fair Value Target now at 1315? Yes, we could. But unless we see significant easing in commodity prices and resource utilization our suspicion is that the Yield Curve will head for a serious sort of inversion and that the stock market will endure a rough patch between now and October.

A breakout over SPX 1300 with a successful re-test down to that level would be the first step toward changing our bearish cyclical forecast.

Have a great week! Best regards and good trading!

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