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If you have been a student of Presidential Debates, at least over the past couple of decades, you'll notice that media coverage of those debates has changed in at least one important (despicable) way. While, in the past, TV anchors would discuss whom they discerned to have been the victor in the encounters and why, more recent coverage has focused less and less on substance, and more and more on how the anchors expected viewers would respond to the presentation. Rather than discussing positions and policies, the coverage has honed in on perception -- but not even measurable perception, they don't even wait for the polls to come out, they argue over how they ANTICIPATE the polls WILL come out.
I bring this up to you this today after reading over the Minutes of the Federal Open Market Committee, May 10, 2006. First, there's the pertinent "content" part:
...the Committee judged that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance, but reiterated that in any event the Committee would respond to changes in economic prospects as needed to foster these objectives.
(Hikes may be needed, but the Committee decisions will be data dependent.) But then there's the weirdly reflexive part:
Investors anticipated the FOMC's decision at its March meeting to raise the target federal funds rate 25 basis points, but the Committee's post-meeting statement evidently led them to mark up somewhat their expected path for the federal funds rate. Subsequently, the path was pushed up further by data releases that were, on balance, stronger than market participants had expected. Speeches by Federal Reserve officials, the minutes of the March meeting, and Congressional testimony by the Chairman combined to restrain policy expectations some. On net, the anticipated path of the federal funds rate over the next two years nonetheless rotated upward.
The FOMC's discussions of what policy should be now include how "investors" (the market) reacted to its most recent policy statement as well as to committee-members' jawboning (speeches) and to the release of the minutes from the prior meeting! In other words, the Committee is looking in the mirror and asking itself, "How are we doing on TV!?"
Now, in light of the above, do we really think that the Committee is NOT targeting Asset Prices? Do we really believe that they are NOT jawboning the markets?
There's an expression in Rock Climbing, "If it's there, it's fair." Meaning that if you're climbing for your life, it's OK to grab whatever you can reach (a tree branch, a bush, whatever). I guess the Feds feel the same way. They're using every sort of "proprioceptive" feedback they can find. And perhaps that's as it should be. But let's not kid ourselves into believing that they're ignoring what the stock market is doing...or the commodities markets for that matter.
And in light of THAT, let's note that front-month Gold futures are down FROM $728 TO $635 as of Friday...
The uptrend is still intact, with support still a ways away in the $585-$600 band. What the Fed does will affect Gold's behavior and Gold's behavior will figure into the FOMC's policy decisions.
Meanwhile Crude Oil futures have been challenging support in the $68-$70 area
That said, on Friday Crude spiked up again on geopolitical anxieties, especially vis-à-vis Iran.
But if hawkish Fed jawboning can help to bring these formerly parabolic charts back down to Earth, then after the Energy and Commodities stocks get momentum players flushed out of their ranks, the table could be set for a much healthier new bull market. (Most likely to begin in earnest in 4Q06.)
In the meanwhile we are left to try to comprehend myriad crosscurrents in the stock market as we move toward the most treacherous months of the 4-year cycle.
As we look at the SPX performance since the October '02 low (red line) plotted against the 2 prior 4-Year Cycles that most closely resemble the current one, we see that the coming 6 weeks in the market are likely to be choppy and trendless with "swirling" seasonal winds blowing to and for alternating periods of a couple of weeks at a time.
Beyond that, seasonal weakness is likely to kick in by mid July with the greatest risks to the market present from around July's Options Expiration into late October.
With the 4-Yr Cycle's downward pull in mind, our view remains that as 4-Yr Cycles go, the downside on this one is likely to be fairly benign.
Why do we hold this view? For several concrete reasons:
RIGHT TRANSLATION: assuming that the May SPX high is the high of the cycle, it formed 43 months into the cycle, well after its mid-point of 24 months. And that extreme right translation has generally bullish implications. (Even 1966's sharp decline only retraced 50% of the cycle's advance.)
STRONG EARNINGS: The consensus for Forward 52-Week Operating EPS (blue line on the chart below) has hit yet another all-time high at $89.06
Trailing Operating EPS (yellow line) also at a new all-time high of $80.23 with Reported EPS (pink line and also at a new all-time high) supporting the trends and speaking to the high quality of Earnings.
Moreover, the recent deceleration in EPS projections is rebounding from a winter/spring dip.
The growth in F52W EPS projections (blue line above) has rebounded from +13% to +14%. But more telling is the 3-month annualized rate of growth (red line), which has bounced up from +3.5% to +16% and appears to be leading Y/Y growth higher again.
As long as the blue line remains above +10% it will be difficult for the stock market to crash hard.
That said, given projections for a slow-down in GDP growth that are gushing from all manner of economists' and market pundits' keyboards, and given record-high profit margins that Corporate America has continued to enjoy, we are left to wonder just HOW profits will continue to grow at some multiple of GDP even as inflationary pressures (input prices) continue to mount (That should put the squeeze on those very same profit margins). And that question goes to the heart of our "crosscurrents" theme today.
The narrow space afforded the FOMC between the Rock (the need to prevent inflation) and the Hard Place (the wish to prevent a recession), MAY have been levered open just a bit by extremely tame Employment Cost and Unit Labor Cost data last week. (Labor costs are about 2/3 of the cost of doing business, so as long as growth in labor costs remain quiescent, that's helpful for the margin story.) And if Crude Oil and Metals prices continue to decline (Copper futures are probably trying to top after a parabolic run from the low $2s to $4), then it's possible that the Fed Tightening Regime could be over (or very near to it).
But that's a lot of "ifs." And while some of these commodities charts are looking toppy, they're a long ways from breaking their uptrends.
As a function of these tumultuous factors among others, we would be skeptical of the idea that there will not be at least one big scare in the markets between now and October that would drive the SPX to some sort of recognizably panicked lower low.
Indeed the Yield Curve (the difference between the 10-Yr Treasury Yield and the Fed Funds Rate, blue line below) has inverted.
And as we can see on this chart, as long as the Yield Curve is traveling south (and especially when it is underwater), it is very difficult for the market's PE to expand. This flat-to-inverted Yield Curve is very likely to, at some point, lead to a noticeable Liquidity Event, by which I mean a forced liquidation of Carry Trades that is unrelated to any reasonable considerations of valuation. And this sort of Liquidity Event is just the kind of thing that often marks an important market low.
Following is a chart of the SPX Forward Earnings Yield (blue) plotted against the 10-Yr Treasury Yield.
We've labeled the 1966 and 1994 market lows, which, on this chart are visible as spikes up on the blue line.
We would expect the Forward Earnings Yield on the SPX to top out in the 7.25-8.25% range in the July - October time frame. In the best case scenario that would point to an SPX bottoming near 1240, not too far below its May print low of 1245. However, in a larger scare, we could see the SPX near 1090 (8.25% yield), or roughly an 18% decline from May high near 1327.
Recently I've read and heard quite a bit of commentary about the similarities between the current market environment and the context that immediately preceded the crash of 1987. While there are certainly some similarities I'd like to point out some significant differences. (Also on the subject of why I continue to expect the market's downside to be more modest in this cycle than in many.)
This chart plots the SPX (top pane, red) against the SPX Trailing Earnings Yield (lower pane, black) and the 10-Yr Treasury Yield (TNX, lower pane, pink).
Note that the Trailing Earnings Yield in August 1987 was +4.1% (PE of 24.4). Currently the Trailing Earnings Yield is +6.2% (PE 16.1). Now look at where TNX was in 1987: +8.7%. And where TNX is now: +5%.
Now, let's look at our Equity Risk Premium calculation (ERP = difference between SPX EPS Yield and TNX). But because we're skeptical of Forward Earnings projections, let's be more conservative and do the ERP calculation on Trailing Earnings Yield. In 1987 Trailing Equity Risk Premium was -4.6%. That is, the SPX was yielding 4.6% LESS than TNX. By contrast at present the SPX is yielding 1.2% MORE than TNX.
The difference between 1987 and the current situation on this metric is 5.8%!
Put simply, the SPX is much cheaper than it was in 1987 both in absolute terms (the earnings yield is now +2.1% higher than it was then) and in relative terms (not only is the earnings yield higher now, but interest rates and inflation are much lower than they were then).
Our Risk Adjusted Fair Value price for the SPX now stands at 1285, just 3 points below the SPX Friday close.
RAFV is derived by the following equation:
RAFV = F52W EPS / (TNX + Med ERP)
RAFV = Risk Adjusted Fair Value
F52W EPS = $89.03
TNX = 4.99% (10-Yr Treasury Yield)
ERP = 1.92% (SPX Forward Earnings Yield - TNX )
Med ERP = 1.94% (Median Post 9/11 ERP)
RAFV = $89.03/ (4.99%+ 1.94%)
RAFV = 1285
There is a cyclical negative pressure on the SPX, we continue to expect a negative Liquidity Event , and we remain essentially bearish on the market between now and the July-October time frame. However, we do NOT see a valuation bubble in the stock market at present (quite the contraray), and we expect the SPX lows of the cycle to be roughly 5-15% below the highs. (That's pretty mellow for a 4-Yr Low.)
The 4-Year Cycle will turn extremely bullish once a summer-autumn low has been formed.
Best regards and good trading!