The following article was first published at The Agile Trader on Sunday, February 25, 2007.

In 2007 the Agile Trader Index Options Service has closed trades for gross gains of +31%, +15%, +8%, +34%, +122%, and +64% for a total of +274% in position gains with no losing trades. In 2006 the System grossed +682% in position gains. (Of course, gross portfolio performance depends upon asset allocation.) 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 trial to the service (offered for a limited time), CLICK HERE and then click SUBSCRIBE.

Dear Speculators,

The consensus estimate of Forward 52-Week Earnings per Share for the SPX (F52W EPS, blue line below) rose by $0.02 last week to $95.51.

Given that Trailing 52-Week EPS (T52W EPS, yellow line) rose by $0.06 last week the consensus for F52W EPS / T52W EPS growth shrank another tick to 7.7%, moving toward the long-term trend of about 7.3%.

On a sector-by-sector basis the week was fairly uneventful.

There was some improvement in the growth prospects for the Health Care (purple) and Industrials (brown) sectors, as well as for the Financial sector. But all in all the consensus for slow deceleration in earnings growth continued to work its way through the market.

Looking at the Y/Y change in F52W EPS (we looked at F52W EPS / T52W EPS above), we see that this slow deceleration toward the long-term trend is likely to continue to keep the Fed on hold.

Note the strong correlation between the Y/Y change in F52W EPS (blue line) and the Y/Y Change in the Fed Funds Rate (red line).

And we would expect the Fed to remain on hold until the blue line on this chart either breaks below the 7% area (in which case the Fed would likely cut rates) or until the blue line turns higher, representing accelerating earnings growth (in which case the Fed would likely raise rates).

In terms of the SPX's 4-year cycle our working assumption is that we are now about 153 trading days into the new cycle (launched on July 17). We will continue to use this launch date until we see evidence that makes some reasonably strong case to the contrary.

The following chart shows the mean and performance of the first 2 years of all the 4-year cycles since 1962.

Given our current assumptions, the SPX is statistically likely to be working its way through an increasingly choppy, decreasingly "trending" period that is likely to last at least 6 weeks or so (yellow highlight).

This next chart plots the SPX PE on F52W EPS (blue line) against the SPX Annualized Trailing 2.5-Yr Return (red line). And it sets the blue line 2.5 years forward on the X axis. So we can see that there is a historically strong inverse correlation (-0.86 on this chart) between the SPX PE ratio and how the SPX performs over the ensuing 2.5 years.

Put differently, when the market's PE is low it tends to appreciate more over the coming 2.5 years than when the PE is high. Of course that's in line with what's intuitive, but the value added by this chart is that we can see the time frame over which PE tends to be important in terms of predicting performance. (The 2.5-yr time frame is provides the strongest inverse correlation.)

Now, if you look closely at the yellow highlighted area on the chart, you can see that from the time the PE (blue line) hit a local low in August '04 through mid February '06 (2.5 years) the SPX appreciated at a 13.1% annualized rate (the red line rose to that level).

However, also note that from August '04 through December '04 (yellow highlight) the SPX PE (blue line) rose from about 15 to about 16.5.

If the inverse correlation between these 2 series holds up, that would suggest that the SPX's 2.5-yr annualized appreciation will decelerate down toward roughly the 8% level between now and the end of June.

Now, 2.5 years prior to June 30, 2006 was December 31, 2004. At that point the SPX was at 1215. So, if we calculate 8% annualized appreciation over 2.5 years starting at that point, it looks like this:

1215 * 1.08^2.5 = 1473.

Given that the SPX is now at 1451, that's a pretty "flat" target.

Is that written in stone? By no means. But within the context of our bullish cyclical outlook and our year-end target range of 1550-1600, this expresses our mid-term expectation for some consolidation of the market's strong July-February performance between now and the summer.

Why would the market slow down and consolidate?

Well, for one thing, the Treasury Inflation Protected Securities (TIPS) markets have recently been discounting both slower economic growth and stronger inflation. The 5-year TIPS yields look like this:

The Real Yield (red line, which is pretty close to what the market expects Real GDP to be) has shrunk down from about 2.63% in October to 2.26%. And the Breakeven Inflation Rate (the expected rate of inflation) has risen from about 2.11% last November up to 2.41% on Friday.

With front-month Crude Oil up from $50 on January 19 to $61 on Friday, we can understand why fears of both slower growth and higher inflation have been roused.

This weekly candlestick chart shows that Crude Oil has bounced up and retraced about 38% of its July-January decline.

The resolution of this formation that would be least inflammatory to inflationary fears would be for Crude to fall back and live in the $50-$58 range. However, if Crude enjoys a durable breakout over the $64 area (about a 50% retracement of the decline), then we may see more serious inflationary fears emerge. And a sustained move above $68 could easily engender loud stagflationary talk in the media.

Looking at a weekly candlestick chart of the SPX we can see the clear deceleration that has occurred since mid December.

At that point the yellow trend zone gave way to a shallower (pink) rising wedge. The wedge is a potentially bearish formation as the shallower slope of the upper limit of the wedge represents diminished buying enthusiasm at higher levels. And if the wedge breaks to the downside, especially after a multi-month advance such as the one that has been enjoyed since July, then profit-taking can become compelling motivation for selling.

In summary: While our cyclical outlook remains bullish for 2007 (SPX target 1550-1600) it is our view that the context is ripe for profit-taking and a choppy consolidating market as winter turns to spring.

Best regards and good trading!