Performance is not an outcome, it is a discipline...

"Leveling off"

In the Fed’s FOMC release on Wednesday, Bernanke and Co. asserted that from their vantage point, the economy is "leveling off". This shift in language from "stabilizing" is both subtle and profound. Essentially the Fed has communicated to the markets that we have bottomed, but that they will continue to provide stimulus until more significant signs of recovery appear (i.e., job gains). Economic data released last week was mixed. Retail sales volume came in light, but homebuilder announcements showed promise. Weekly job data disappointed, while productivity numbers surged. Our trade deficit widened, but both imports and exports logged marginal gains.

This mixed bag simply represents the realities of "leveling off." Economic recoveries never simply progress straight from negative releases to positive releases. As we shift gears, the economic transmission system will have negative resistance and positive force confronting one another. We have shifted out of reverse and into neutral; we have yet to slide into drive. Signs of leveling off in the markets surround us. Looking at our leader, China, the Chinese stock market hit its highest point on August 4^th and has retreated nearly 10% since then (it’s still up 73% this year). Oil prices peaked in early June at $74, trading today at $68 (still up 55% this year). So, those markets to reach euphoria first should also be first to test that euphoria, which is exactly what is occurring. We have moved into the pause that refreshes phase.

Remember a few emails back when I stated that the current market cycle will likely be a stair step pattern marked by anticipation, trepidation and confirmation phases? The earnings and economic news over the last month and a half confirmed the move from the March lows to 950 on the S&P 500. The move above that has been gratifying but probably a touch ahead of schedule. Now the trepidation has begun and will likely continue until the next anticipation round occurs in late October. Remember that market pullbacks are healthy and not in themselves reasons to trade (although we would take advantage of temporary mispricings in energy and/or emerging markets). Pullbacks will likely be seen as purchase opportunities for those who have yet to re-commit. For evidence of this, simply pull a Yahoo chart on the S&P 500 and look at the intra-day activity. The S&P has not closed the day at its lowest point since June 22^nd.

Peak Seeking

A great deal of typeset has been devoted to defining the lower bounds on the current market. We sit today on the S&P 500 at 1,000, and we bottomed at 666; if we retrace, how low do we go? Although I have an answer on this (nowhere near 666), let’s explore the opposite question. How high could we go? To answer this question, we need to look at previous earnings cycles and see if we can find wisdom in the data. Given the severity of the earnings decline since their peak in 2007, let’s look at previous periods of extreme weakness and see where we went from there.

Period                                              Earnings Decline    Next Peak     Advance

June 2007 – March 2009                        -92%                     ???              ???

December 1916 – December 1921             -81%             Dec 1929          455%

December 1929 – January 1933               -75%             Sept 1937          198%

September 2000 – December 2001          -54%            June 2006        244%

January 1937 – January 1938                  -49%             Sept 1941          92%

June 1989 – January 1992                       -36%              Sept 1997         153%

So based upon this extreme data (compiled by Robert Shiller), after a trough in S&P 500 earnings, they have historically advanced between 100-500%. That’s interesting, but it might be more insightful to see how much higher new earnings peaks have climbed over old earnings peaks.

Peak Dates                    Peak Earnings                Increase over Previous Peak

June 2007                         $84.92                                           58%

September 2000               $53.70                                            32%

September 1997                $40.64                                           61%

June 1989                         $25.22                                            52%

You get the idea. I ran this analysis all the way back to 1906 and the average advance for a new peak in earnings from an old peak in earnings is around 40%. Assuming history rhymes, if not repeats itself, that would put the next eventual earnings peak at $119 (40% above the $84.92 from June 2007). Applying a historically appropriate multiple of 15 times earnings, that would project an S&P 500 target of 1800 for the next bull run. 1800 may seem like quite a distance from the 1000 where we are today, but I will remind you that the index stood over 1500 in the year 2000. What’s my point? While everyone is trying to guess how deep the next pullback will be, let’s look further forward and try to determine how high the next advance could be. If history lends any credibility to this forecasting effort, the end of the next bull market might occur around S&P 2000. Make mine a double!

Seasoning

August and September have historically been the weakest months in the S&P 500, logging returns of .1% and -.5% respectively since 1950. With the crosscurrents created by the great "leveling off," and the historical weakness of this period, this makes a terrific time to ladder money into the markets. Late October, November, December, and January represent the months of greatest historical returns. Consider using this pause in the data and various markets to get positioned prior to the 4^th quarter. For those fully invested, keep your focus further down the line and avoid pullback anxiety.

Remember: Performance is not an outcome, it’s a discipline!