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Weekly Wrap-up: Dueling Valuation Pictures

Dear Speculators,

If I may beg your indulgence and digress from the usual form of this letter, I would like to brag about my father for a moment. Monday is his 80th birthday. Two days shy of becoming an octogenarian my father was slalom waterskiing on Sparkling Lake in northern Wisconsin. And while I'm sure there are other men his age who have battled through the ravages of time and, have for decades filled "each unforgiving minute with 60 seconds worth of distance run" I don't personally know anyone who's done it quite like he has.

My father is, as much as anyone I've ever met, a good man. And in one of the few un-ironical turns that the fates have devised, he is being rewarded with a good long life. At least so far. It's almost enough to make you believe that, karmically speaking, virtue is repaid in kind.

I bring this up for 2 reasons: First, the inspirational nature of my father's persistent exuberance for life, and second, today's Weekly Wrap-Up will be somewhat abbreviated, owing to my travels surrounding the family celebrations.

In the Index Options markets the DTS took gross gain of +7% in SPX options last week. That lifts the Options Service's gross total position gains on closed trades to 1,255% since its launch in April '05 with a gross total portfolio return at +175% in the same time frame. If you would like to read more about about The Agile Trader Index Options Service CLICK HERE. And if you would like a free 30-day trial to the service (the free trial offer has been extended through August 31) CLICK HERE and then click SUBSCRIBE.

In the E-Mini Index Futures markets the DTS netted a gain of +4.5% in the SPX market and +1.5% in the NDX market. Net Position gains in the Futures markets are now at +389% (since July '05) with a net portfolio return of +98%. If you would like to read more about 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)

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.

The behavior of the S&P 500 (SPX) continues to be in line with our broader prognosis of a weak-ish rally up to test the 4-Yr Cycle High of last May. Going forward we are looking for the index to re-test its summer lows during the September-October time frame.

This chart shows roughly the last year of each of the previous 4 "middling" 4-Yr Cycles over the past 44 years. (Y axis scaled as percentage gain off the 4-Yr Cycle Low. Horizontal axis scaled in trading days.) We have been expecting the current cycle (red line) to plot itself between the performance of 1994 (royal blue) and 1978 (light blue) in roughly the trajectory of the red arrows drawn on the chart. And, so far, that's how the last bit of this cycle is indeed playing out.

If you look closely at this chart you see that since November '05 the SPX has been trading in what ends up amounting go a very narrow trading range between 1220 and 1326. And when we boil away all the effluvia of interpreting the news and speculating on energy prices, of secular vs. cyclical inputs, of liquidity excesses and then a weakening housing market, of soaring gold prices and weak-to-nonexistent real wage gains, we end up with 2 revealing (dueling) pictures of how the market is or should be valuing itself.

First, we see that the Yield Curve (defined here as the difference between the Fed Funds Rate of 5.25% and the 10-yr Treasury Note of 4.79%) is inverted at -0.459%.

As you can see, this inversion (blue line below 0) is the steepest of the current cycle. And as you can also see, there has been a strong correlation over the past 3 years between the flattening (and then inverting) yield curve and the contraction of the SPX's Price/Earnings Ratio (PE) on Forward Earnings.

Over the long term, more so than not, a flattening (or inverted) yield curve correlates positively to a contracting PE Ratio. So, the structure of the yield curve is currently bearish.


A big part of the reason that the yield curve is now inverted is strong global demand for US Treasuries. And that strong demand translates into a low yield on the 10-Yr Note.

A low yield on the 10-Yr Treasury tends to suggest that, likewise, there ought to be a (relatively) low earnings yield on the SPX. And a lower earnings yield translates into a higher price.

Indeed the Fed's Fair Value model for the SPX divides the current Consensus for Forward 52-Week Earnings (now $92.45) by the yield on the 10-Yr Treasury (TNX, now 4.79%). Which looks like this:

$92.45 / .0479 = 1930

But that number looks wacky to us in the post-9/11 world, in which increased risk seems to exist around every corner. So, we calculate our Risk Adjusted Fair Value (RAFV) price like this:

The difference between the SPX Forward Earnings Yield and the 10-Yr Treasury Yield is termed the Equity Risk Premium. (ERP, 7.14% - 4.79% = 2.35%)
The median ERP since 9/11 is 1.95%.

RAFV = F52W EPS / (TNX + Median ERP)

RAFV = $92.45 / (4.79% + 1.95%)

RAFV = 1370

In summary: Relative to long-term interest rates, and in the context of the riskier post-9/11 world, the SPX is probably about 6% undervalued at present. However, when we figure in the still-increasing INVERSION of the YIELD CURVE, we expect the SPX PE to either continue to contract or flatten out at best.

In our view the Fed is obliged to continue to keep monetary policy on the tight side as long as Gold and Oil prices remain high. So, we are likely to have to wait until those commodities prices flop before the next serious cyclical bull market can be kicked off in response to the next Fed Regime (which will be one of loosening monetary policy). When the Fed begins to loosen (either late this year or in '07), the SPX is very likely to enjoy a significant PE expansion.

Best regards and good trading!


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