Dear Speculators,

This past week the Dynamic Trading System (DTS) took profits on an array of leveraged trading positions on both bullish and bearish trades.

In the Index Options markets the DTS took gross gains of +21% and +56% in QQQQ options. That lifts the Options Service's gross total position gains to 1,123% (since its launch in April '05) with a gross total portfolio return at +138% in the same time frame. If you would like to read more about The Agile Trader Index Options Service CLICK HERE. And if you would like a free 30-day trial to the service (offered only between now and July 9), CLICK HERE and then click SUBSCRIBE.

In the E-Mini Index Futures markets the DTS netted gains of +10% and +23%. Net Position gains in the Futures markets are now at +361% (since July '05) with a net portfolio return of +80%. If you would like to read more about The Dynamic Trading System in the Index Futures markets or subscribe to The Agile Trader Index Futures Service, please click HERE.

Of if you would like a free 30-day trial to The Agile Trader (in which we trade the less volatile QQQQ/SPY and the Rydex Funds) CLICK HERE.

Last week we explored in depth our outlook first for the period between now and the early fall, and then for "Beyond October 2006."

In sum: we continue to look for a choppy market over the summer with a cyclically climactic low most likely in the September-October time frame.... the lows that are created between now and October are extremely likely to serve as the foot-holds from which a new cyclical bull market propels itself upward.

In as many ways as possible (this new cyclical bull) will NOT resemble the market of the current cycle. It will have new leadership, new breadth characteristics, different kinds of liquidity flows, different volatility characteristics, and likely a different relationship to "risk."

...we suspect that Large-Caps will outperform Small-Caps. Health Care and perhaps Semiconductors and Tech could emerge as leaders. Energy and Materials stocks are unlikely to carry the ball in a new cyclical bull, as they have been the leaders in the current cycle.

These are a few hypotheses. But we'll be trying to nail down the changes to come as they emerge in the weeks and months ahead.

In the week just past nothing has occurred that would change this view.

That said, a subscriber emailed me and I thought that his question was worth sharing in this public forum He wrote:

It amazes me that you can't or won't quit using earnings in your valuation work. You must be the last person alive trying to make intelligent decisions using numbers that can vary by 150% based on the accounting choices made by management.

If a company can go from $1 of earnings to $2 just by choice, then what value is the number to any analysis in the first place? Your work could have real meaning if not based on earnings!

What I gleaned from this note was that I should make a few things clear about how we use Earnings in our work and why.

First, let's look at the chart of the Forward 52-Week EPS Consensus as published by Standard & Poors.

Since 1995 the correlation coefficient for the SPX (black line) and F52W EPS (blue line) is a very strong +0.73. Since 1985 the correlation coefficient is +0.92 (outrageously strong). These correlations are stronger than those for T52W EPS (yellow line +0.67 and +0.88 respectively) or for Reported EPS (pink line, +0.61 and +0.61).

The reason blue line's correlation coefficient for the past 11 years is lower for the past than for the past 21 years is that the SPX has recently risen more SLOWLY than the blue line as the market's PE has shriveled. If the correlation is to return to a higher level (likely over the next 2-3 years) then either the blue line must fall or the black line must rise.

Now, let's look at the stock SPX's PE on F52W EPS (we use the F52W number because it has the highest correlation to the SPX) plotted against the SPX's annualized 2 ½-yr price appreciation.

As you can see the SPX PE is at a very low level. In fact, at 14.1 the PE is in the 20th percentile of PE readings over the past 20 years and in the 35th percentile of PE readings over the past 46 years (and that includes the hyperinflationary period of the '70s and early '80s).

As you can also see, over the past 20 years there has been an extremely strong inverse correlation between PE and annualized forward 2 ½-year return. Which is to say no more than one should buy low and sell high. But which is also to say that "buying low" means buying when the PE is low...which is still further to say that using E (earnings) as the denominator is indeed worth doing and is not in fact a stupid idea.

Why? Why is it not a stupid idea to take E seriously when we all know that games can be played with E? I don't know the precise answer to that question, but I would speculate that, despite the fact that SOME companies play games with E, the fact of the matter is that in aggregate E tells us something important about how companies are performing. (I'm actually being too modest here. I'm not SPECULATING that that's the case, I'm CONCLUDING that that's the case based on the very strong long-term inverse correlations between PE and annualized forward 2 ½-yr price appreciation.)

Now, look at the above chart again. Note that the early '04 peak in PE (blue line) has been met by a dip in the red line. Annualized price appreciation for the SPX since Jan '03 has sunk to just greater than +5%

Now, look at where PE is today (14.1). It is from troughs like this one that annualized price tends to show its strongest annualized price appreciation.

The important question now appears simply to be whether PE has already bottomed or if it is going to show us an even better buying opportunity either in 2H July or in the September-October time frame.

And the answer to that question probably has more to do with the Fed than with anything else.

As you can see on this chart, there has been, for quite some time, a very strong correlation between the flattening (inverting?) yield curve and the market's contracting PE. At this point the 10-Yr Treasury is yielding 11 beeps (basis points) less than the Fed Funds Rate.

The yield curve will not begin to steepen unless/until the market becomes fairly thoroughly convinced that the FOMC is going to stop hiking interest rates. And right now, even after the FOMC's more-dovish-than-expected Statement of Policy last week, the futures markets are still pricing in a 65% probability of yet another hike in August.

WHY is the Fed still raising rates (despite a flat-to-inverted yield curve)? Because inflationary pressures are in fact still building, despite prospects for a slowing economy.

The Headline PCE Deflator and CPI are at +3.3% and +3.9% Y/Y respectively. While the Core PCE Deflator and CPI are at just +2.1% and +2.3%, just a couple of ticks above the top of the Fed's comfort zone of +1%-+2%, the PERSISTENCE of the spread between the Headline numbers and the Core numbers suggests to this analyst, at least, that the importance of the Core numbers are somewhat diminished relative to the past. That is, historically one worried more about the Core than the Headline because the Headline numbers normally reverted quickly toward the Core numbers. But, given the persistent elevation of Energy prices, there is an increased likelihood that the Core numbers will rise to meet the Headline numbers.

Indeed with Crude Oil poised to challenge its all-time highs above $75/barrel, and with Driving Season now in full swing...and with Hurricane Season now upon us, there is little chance that Energy prices will moderate between now and September. Moreover, Gold, a much-revered prognosticator of inflation, has just formed an extremely bullish technical pattern.

Technical purists may argue, but the chart of GLD (which trades at 1/10 the price of bullion) has, after testing down and penetrating into congestion, formed what looks like a bullish Island Reversal. This Island Reversal (note the gaps on either side of the "isolated" island) represents extremely strong buying pressure. And what prompted this market to form this bullish island on Friday? The FOMC's more-dovish-than-expected Statement of Policy.

It is our view that the Fed's dovish statement has made their job that much more difficult. In order to control inflation going forward the Committee must rein in Commodities markets. But as we can see, these bellwether Commodities markets (Oil and Gold) are responding to the Committee's dovishness by spiking higher.

One would only wish that the Committee would be less eager to reassure the markets so that the markets could continue to do the heavy lifting (by retrenching) that they had been doing since early May. It is the Fed's own eagerness to reassure that makes the Committee's work all the harder.

Returning now to the subject of stocks, it is important to ask, "What could cause the extremely strong inverse correlation between PE and annualized Forward 2 ½ yr. return to break down?"

In our view, either or both of 2 things: 1) If economic growth were to fall off the table, 2) If inflation were to rocket higher, up and out of the range in which it has been abiding since the mid '80s, below 5% on the Headline CPI.

In answer to #1, at this point it appears that growth is NOT about to fall off the table.

Forward EPS projections for the SPX are currently up +14.6% Y/Y. The 3-month annualized growth rate of these same projections are up +17.9%. If the economy were about to roll over, we would very likely see footprints of that action in these numbers.

Will growth moderate? We think so. Will these numbers show signs of deceleration in the months ahead? We think they will. But while growth will likely moderate, we so no signs that it is poised to fall out of bed (or off the table, or down the toilet). Could that view change? Absolutely it could...if the incoming data begin to tell a story that's different than the one they're telling now.

In answer to # 2, the risks of inflation rising at what could become a dangerous rate appear to be greater than the current risks of a weakening economy.

Note on this long-term chart the extremely unusual sustained spread between the Headline and Core numbers. Previously there have been brief spiky disparities, but not such sustained divergences.

The trend in Headline inflation is accelerating. If the Core numbers begin to chase the Headline numbers higher, then Bernanke et al are going to be tromping on the brakes with both feet. And it is precisely the risk of just that that could have the stock market tracing out a wobbly drunkard's path with perhaps a stumble or two into the gutter over the coming 4 months.

Best regards and good trading!