Dear Speculators,

On its face one can understand the market's current infatuation with itself. This chart of the 3 basic kinds of Earnings per Share (EPS) for the S&P 500 (SPX) is indeed attractive.

The trends in all 3 of our Earnings per Share (EPS) lines remain robust. And quality of earnings is solid, with the disparity between Trailing Operating EPS (yellow) and Trailing Reported EPS (pink) on the small and non-volatile side. (Corporations are not taking big, bogus write-offs or one-time charges that tend to create big disparities between the yellow and pink lines.)

That said, the increasing weight of the Energy sector's importance in aggregate SPX earnings is worth a moment's concern.

Both Trailing and Forward EPS growth for the SPX Ex-Energy are considerably lower than for the SPX including Energy, which is to say that an outsized portion of earnings growth in the SPX is derived from the Energy patch, even in the context of recently stabilized energy prices. And that tends toward being inflationary, which is not a good thing for stocks.

Over the next 52 weeks growth in 7 of the 10 SPX sectors is now expected to be above the trend rate of growth for the broad index's earnings (trend growth is about 7%).

And while that looks like a very good thing (30% of sectors showing +14% growth or better!), one ought to keep in mind the market's capacity to disappoint, especially when disappointment is least expected.

Can the market live up to the expectations now being priced in? Let's look at that subject more closely.

Paul McCulley of PIMCO often discusses what he calls the Federal Open Market Committee's (FOMC's) "reaction function," by which I take him to mean roughly what the Fed will do in response to various inputs.

One of the more interesting inputs that appears to correlate quite strongly to the Y/Y change in the Fed Funds Rate (red line below) is the Y/Y change in the consensus of Forward 52-Week Operating Earnings per Share on the SPX (F52W EPS, blue line below).

The strength of this correlation looks meaningful as "all git-out" to me.

Of course, for about a year, beginning in September 2003 (black arrow) the Fed left rates quite low even as Y/Y growth in F52W EPS (the blue line) shot higher. The Fed was worried about deflation and consequently remained accommodative to a much greater extent than it had done previously. And that created a large if temporary gap between the soaring blue line and the depressed red line.

Subsequently, growth in F52W EPS slowed, dropping the blue line down from +20% down closer to +10%, creating a gap in the other direction between the blue and red lines. As one would expect, the Fed has followed suit, pausing, which has decelerated the Y/Y change in the Fed Funds rate to its current level of +0.9%, dropping the red line down again toward the falling blue line.

So, what now? Now that the Fed has removed much of the monetary stimulus provided by holding Fed Funds down at +1% (which allowed F52W EPS to soar to +20%), and then paused as growth in F52W EPS has decelerated, the question is, in the next year will the Fed remain on hold, cut rates, or raise rates?

And the answer lies, at least in part, in what happens to earnings. Currently F52W EPS are +12.5% higher than they were a year ago. And the consensus is calling for +9.4% growth relative to Trailing Operating EPS.

Should earnings growth continue to decelerate slowly toward the +7% area, which is the long-term trend rate of growth, then the Fed is likely to remain on hold. Should earnings reaccelerate, then the Fed is likely to begin tightening again. And if earnings growth slows to less than the +7% area, then we're probably due for rate cuts in 2007.

Now, as we discussed last week, forecasts are for about +2.5% real growth in GDP in 2007 (that's the Blue Chip Economists' November report) with the TIPS market projecting about +2.3% inflation. Add real GDP and inflation and you get Nominal GDP near +4.8%.

We looked at this chart last week, but it bears examining again.

With Nominal GDP (blue line) near +4.8% (yellow highlight), there is a strong tendency for earnings growth (red line) to be on the south side of zero. (Note: we did see EPS shoot up in '02-'04, ahead of GDP, but that was during the period of extreme monetary accommodation discussed above, and we suspect that such a period will not recur in the very near future.)

So, what does all this mean?

That it would be unlikely for economic growth to slow as much as, say, the bond market is discounting while stock market earnings growth continued at the above-trend rate that stocks appear to be discounting.

Could the normal-ish correlations that we're looking at break down? Yes, they could. The unusual is always possible. But in all likelihood, someone is wrong about what's going to happen. Either economic growth is going to be higher than now expected (in which case the Fed may be forced to raise the Fed Funds Rate, further inverting the Yield Curve and making PE expansion "iffy" at best) or else earnings growth is going to be slower than is now expected (which could also work at cross purposes to the PE Expansion thesis).

And what I'm talking about here is also represented in this next chart, which plots the market's PE on F52W EPS against the Yield Curve (spread between Fed Funds Rate and the 10yr Treasury Yield).

While last week's sell-off in bonds bounced the Yield Curve up and flatter to -0.63%, the trend in the curve continues to be underwater and down. Meanwhile the trend in the SPX PE continues to be up over the past 5 months.

The Yield Curve is saying "economic slowdown" while the stock market's PE continues to express relatively unqualified exuberance. Even if "all is well" as the SPX sounds like it's suggesting, it would be a healthier, less vulnerable market if it weren't quite so in love with its own prospects as well as with itself.

All that said, the stock market tends to be strong from the middle of December through the end of the year. So, it may take until early 2007 before the current surfeit of market euphoria plays itself out as choppier or falling stock prices.

Our cyclical view remains bullish through late in '07. But we would be looking for a period of consolidation and retrenchment to be coming sooner than later. The SPX is now tickling an important upside target and may well react with some distribution after hitting this target.

The May-June pullback of 107 points (from 1326 to 1219) has virtually been matched by the rally almost 107 points up over 1326. In this case the breakout is almost equal in height to the depth of the range from which the breakout occurred. This is a common measuring tool in Technical Analysis. And with the SPX having moved pretty much in a straight line up to the 1433-4 area (high of 1431 on Friday), it would make sense to look for signs of exhaustion.

Best regards and good trading!