Mile High Insights

Catch 22

01/15/06

"Catch-22 is a critique of bureaucracy in general. The phrase Catch 22 has come into common use to mean a cyclical conundrum, or "no-win situation" based on its meaning in the book as described below. A catch-22 situation is also inherently self-defeating: the very act of performing it prevents it from happening." Wikipedia Stocks started the year with a bang. In a little less than 2 weeks, the major indices rose as much as in all of 2005, The Christmas Season had not been as bad as retailers had feared, but had not been as good as Wall Street had hoped. Still, the first two trading weeks were mighty impressive. But then again, almost every asset class was up big. Bonds, stocks, gold, oil, foreign currencies - everything started the year with a breathtaking rally. One major reason is the big institutions propensity to perform major asset re-allocations at the beginning of each year. Gold and gold stocks were major beneficiary this January. Last January it was oil and oil stocks. The fireworks should subside this week and investors can return from asset re-allocation to watching the Fed-watchers and their interest rate forecasts and anticipating the earnings-anticipators and their earnings forecasts.

1. Interest rates and the yield curve will preoccupy us first and foremost. The Federal Reserve already made clear that further interest moves will be determined by incoming economic data, particularly data regarding inflation and the strength of the economy. In this sense the December employment report hit the sweet spot for investors in that it showed a "not-too-hot-not-too-cold" economy.

The data landed in the sweet spot because they were strong enough to suggest that the economy will remain on a self-reinforcing growth path, but not so strong as to suggest that more interest rate hikes will be needed. The December gain in Non-farm payrolls (top left) itself was weak at just 108,000, but net upward revisions of 71,000 put the data at a statistically insignificant distance of just 20,000 below the consensus forecast. Thus, when the revisions are included, the payroll count is about 180,000 higher than previously reported. The average of the past three months (blue line) takes out some fluctuations and stands only marginally above the monthly growth in the labor force, which tends to run at about 150,000 per month. The economy needs to create about 150,000 new jobs every month for the unemployment rate to remain unchanged and to absorb new entrants that come into the labor market. Modest wage gains (top right) will help to keep inflation pressures at bay, given that labor accounts for about 70% of the inflation picture. The modest wage gain is extremely important to the markets, because investors are currently focusing much more on inflation indicators than on growth indicators. Any indicator that points toward strong economic growth is currently being seen as transitory and not likely to impact the inflation picture over and above the already known factors. Inflationary indicators , however, will receive immediate attention, since those forces are already in the pipeline and may still be building strength. Inflationary indictors, especially in the labor markets, will be taken seriously since they might influence the Federal Reserve directly. Fortunately, inflation has been moderating, so that the inflation picture is improving for bond- and stock-markets.

2. Earnings, season is upon us and the quarterly numbers will determine again, if stocks should have been bought or sold. Is hindsight not wonderful? Standard & Poors expects that the companies included in its S&P 500 Index will report "as reported earnings" (incl. non-recurring items) of around $76.80 and that its "operating earnings" (excluding non-recurring items) will be around $85.38. This amounts to a year-over-year increase in earnings of roughly 10%. Stocks should be able to rise by 10% then, right? Depends. Lets look at one valuation measure that Alan Greenspan and the Federal Reserve proposed in the 1990s. It is called the "Fed Model": This model calculates the "Earnings-Yield" for the S&P 500 by dividing estimated earnings of all 500 companies ($85) that make up the index for the year 2006, into the Price of the Index (Friday's close was 1,288). In this case: 85/1288 = 6.6% as the S&P 500 "earnings yield". To determine whether this is a "fair" earnings yield, we must compare this to "risk-less" investments such as 10 year Treasury Notes which currently yield 4.35%. Since in this case the earnings yield on stocks is about 34% higher than the yield on 10 year T-Notes, proponents of the Fed Model argue that the Stock Market (or at least the S&P 500) is undervalued by that amount. Does this mean that the index should rally 34% from here. It could, it depends on whether earnings rise indeed by 10% and whether 10-year note yields indeed stay at 4.35%.

Assumption: 10% earnings gain, 4.5% bond yield ||-|| Assumption: 5% earnings gain, 5.5% bond yield"

The left chart shows the Fed Model and the attractiveness of stocks under the assumption that S&P 500 earnings grow by 10%, that the index remains at Friday's close of 1287 throughout the year 2006 and that interest rates stay around 4.5%. The result shows that the index is undervalued by 34% if one uses operating earnings and by 27% if one uses "as reported" earnings. The right chart shows the Fed Model under the assumption that earnings only grow by half as much as Wall Street expects and that yields on the 10-year bond rise to 5.5% by the end of the year. In this case, the index would be already fairly valued on the basis of "as reported earnings" and only slightly undervalued if one uses "operating earnings". The exercise makes especially clear, that in this current environment, interest rates influence the Fed Model much more than earnings, because 10-year bond yields vary by 5% or more almost every month. Earnings estimates vary also, but they are a work in progress and develop slowly throughout the course of the year. This is important and makes the progress of the stock market more than ever dependent on expectations, interpretations and actions by the Federal Reserve. This august body however is caught in a Catch-22! Just think about it. The economy is strong but not too strong, the Fed is almost finished raising interest rates, 10-year yields are currently at 4.35%, stocks are undervalued by 34%. Result: Stocks rally! Interpretation: Stocks anticipate an improving economy while accelerating earnings and low interest rates justify higher stock prices. High stock prices represent easy financial conditions and rising expectations for accelerating economic activity. At an unemployment rate of 5%, the economy can not absorb all this activity. Resources will become stretched, inflation starts, ... better raise interest rates, before it is too late. ... "But wait, we did not even get to the rally phase yet." That's it: Catch-22 This schizophrenic situation will produce rising volatility in the stock market. Get ready for a year where volatility is going to explode, which will be good for flexible investors, but bad for big Mutual Funds.

Hermann Vohs

Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.

This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.