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Weekly Wrap-up: Inflation Still in the Pipeline

Dear Speculators,

The Dynamic Trading System (DTS) took profits on positions in both the SPX and NDX markets last week.

In the Index Options markets the DTS took a gross gain of +33% in QQQQ options. In the SPY options market the DTS took a +78% gross profit. That lifts the Options Service's gross total position gains to 1,247% since its launch in April ‘05 with a gross total portfolio return of +174% 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 1-month free trial to the service (available now through August 31), CLICK HERE and then click SUBSCRIBE.

In the E-Mini Index Futures markets the DTS netted gains of +18.6% in the NDX market and +36.9% in the SPX market. Net Position gains in the Futures markets are now at +383% since its launch in July '05 with a net portfolio return of +95%. 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.

(Note: All trades were executed in customer accounts in real time on the Dynamic Trading System's signals. However, because these results are representative of a compilation of accounts (and not one single account) and trades were executed by the Futures Commission Merchants and/or Securities Brokers who held limited power of attorney for the customer accounts, and not directly by The Agile Trader or by Dog Dreams Unlimited Inc., results are, for all regulatory and compliance purposes, hypothetical, with all disclosures and caveats applicable as disclosed below. Please see the Important Disclosures below my signature. -AO)

Returning, to the subject of inflation, as we have over the past 3 weeks in this space, we continue to interpret the trend as being northbound.

This chart of the Y/Y growth in the CPI, the Core CPI, the PCE Deflator, and the Core PCE Deflator shows acceleration on 3 of 4 measures of growth in the most recent data.

While this chart is a visually busy, the point is well made; both Headline and Core Inflation are accelerating on a Y/Y basis.

Some would argue that the surge in the CPI is primarily a function of a slowdown in the Housing market; that the imputed cost of rents is rising because of statistical fluke that is a function of decelerating/falling home prices. But if the CPI is overstated now as a function of rising imputed rents, then it was understated during the housing boom as a function of the disinflationary effect on rents created by then-accelerating home prices. So, this argument stands on shaky ground in my view. And the recent surge in the PCE Deflator and Core PCE Deflator, neither of which suffer the ill effects of this statistical fluke, puts the lie to "CPI is bogus" argument.

We have discussed at length the fact that economic growth and Payrolls numbers each show negative or very little correlation to inflation. We have also illustrated how Average Hourly Earnings (now accelerating) show a strong (+0.70) correlation to inflation. This week we discovered an even stronger link between the PCE Deflator and the Producer Price Index. (No surprise as an idea, but the strength of the correlation is impressive.)

While the PPI spiked up to +6.6% Y/Y growth in the immediate aftermath of Hurricane Katrina (Sep. '05) and has backed off to its most recent reading of +4.8%, the 4 ½-yr rising trend remains intact. These 2 series have a very strong +0.91 correlation, and with the PPI still well above the PCE Deflator it would appear that early-in-the-pipeline increases in inflation will be exerting an upward tug on the PCE Deflator for some time to come. So the thesis that inflation is slowing has very little support.

With the Fed now in "pause" mode the risks of further increases in inflation persist despite what is projected to be slowing economic growth.


In the context of the much-vaunted impending slowdown in economic growth the Consensus Estimate for Forward 52-Week Earnings Per Share on the SPX (F52W EPS) continues to surge higher.

At $92.50 F52W EPS is now almost 47% higher than it was at its peak in 2000. Meanwhile Trailing EPS and Reported EPS continue to support the positive trend in the Forward Earnings outlook.

These positive trends notwithstanding, the internal distribution of earnings by sector continues to deteriorate.

The increase in the F52W EPS Consensus for the SPX Energy sector continues to absolutely dominate the scene. Y/Y F52W EPS for Energy is up 28.3%. Ex-Energy the other sectors' aggregate F52W EPS Consensus is up just +12.2% Y/Y.

We continue to be skeptical of...well...something-or-other here.

With the Fed's Central Tendency Forecast for the US Economy at 3.25-3.5% for 2006 and at 2.5-3.25% for 2007, how are non-Energy companies going to grow EPS at double-digit rates relative to year-ago forecasts even as Energy companies' EPS grow at +28% relative to those forecasts? (Energy earnings have to come out of consumers' pockets and out of non-Energy corporations' earnings! The only way that GDP can slow down, and both Energy and non-Energy earnings can grow as predicted is if Productivity accelerates and Unit Labor Costs fall at some multiple of their historic rates.

There's a wacky disconnect; a circular kind of self-reinforcing logic that would appear to be divorced from certain simple economic and accounting truths. Profit Margins can only grow faster than GDP for some finite period or else profits will grow to be larger than GDP (not possible). And analysts are generally pretty bad at predicting in advance when the trend in profit margins will change.

So, over the next year we're going to have to watch to see how GDP, Profit Margins, Energy costs and Earnings, and non-Energy Earnings relate to one another, especially in the context of what we suspect will be rising inflation.


For our purposes here we define the 4-Yr Cycle as beginning at the low that has formed every 4 years (the year of the mid-term elections) going back to 1962 between September 30 and November 19.

The red line represents the SPX performance (percentage gain) since its October '02 (4-yr Cycle) low. Each of the other line represents the percentage gain off a similar 4-Yr Cycle low, as labeled.

This chart is extremely busy and hard to interpret without a guide. But we had some questions last week re: why we were only studying the middling cycles, which are those inside the black oval at right. And the reason is that these 4 cycles have displayed distinct similarities while the 4 more-bearish and the 2 more-bullish cycles had unique and distinct properties of their own, which we have not regarded as important in terms of prognosticating how the current cycle will play out.

In this next chart we have zoomed in on the last year of the cycle, and especially on those 4 middling iterations.

We continue to suspect that this cycle will play out roughly according to the red arrows, with performance between that of 1978 (light blue) and 1994 (royal blue), with a final low forming during the early part of the coming autumn.

It would be very difficult for the SPX to break to new cycle highs during the light-volume August period (it would also be unprecedented in a middling iteration of the 4-Yr Cycle). Moreover, until the Yield Curve (defined for our purposes as the difference between the 10-Yr Treasury Yield and the Fed Funds Rate) begins to dis-invert and widen out, it will be hard for the SPX's Price/Earnings Ratio to expand.

You can see on this chart the marked tendency for the falling (and then inverting) yield curve to be correlated with a contracting PE Ratio.

So, what does that mean for the stock market? Well, in order for its PE to begin expanding, we probably either need to see the Fed cutting rates or else longer-dated notes selling down (longer-term yields rising) and money moving from risk-free assets into riskier, more growth-sensitive investments like stocks.

But between here and there, there are miles (or at least a couple of months) to go before we sleep...

Have a great week!

Best regards and good trading!


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