FMX | Connect – www.fmxconnect.com - (Reported 7/1/2010)

The following is an excerpt from the Commodity Trader’s Chart Book by Dan Wantrobski.

Taking a break from the day to day battle between risk aversion and risk tolerance, we wanted to update our longer-term charts to get a sense of where we may be within the secular cycle.

Remember that from a macro standpoint, our thesis remains intact: we are in a deflationary bear market cycle where stock markets carve out a massive trading range via multiple ‘crisis / recovery’ cycles. Against this backdrop we anticipated (and continue to anticipate) low interest rates and strength in commodity prices relative to equities. This model is hashed out in the following diagram (which many readers have seen before):

As a supplement to this secular model, past reports have focused on key developments (in our opinion) that lead to the emergence of the next secular uptrend. We have found that- based on historical studies- cycle transitions correspond to developments in the following areas:

· Technicals: the markets need to break out to new all-time highs- past the secular peak of the previous bull market. It is this achievement that fuels the ‘long-term upward bias’ of the stock markets (every secular bull market has broken out and away from the secular bear range that preceded it). In our current cycle, we have been building a range for the last ten years which has rendered the following highs: SPX= 1600 area; Dow= 14,000 region; COMP=5000 zone. In the next secular bull market, these will be taken out completely- en route to making historic highs amidst an expanding economy. The average duration of these ‘secular markets’ is 15-20 years.

· Credit environment: our historical studies also suggest that secular bull markets have never occurred against the backdrop of a contracting credit environment. Rather, expanding demand for -and supply of- credit appeared to be one of the drivers of the general market tide during secular bull markets.

· Demographics: population booms and busts follow their own cycle, and we have noted that past secular bull markets coincided with boom populations ‘nesting.’ The next boom here in the U.S. are the ‘Millenials,’ which in our opinion still may be a few years away from driving a new secular expansion.

· Valuations: our studies have also indicated that a key component to secular market swings are valuation trends. Secular bear markets tend to coincide with stock valuations trending from ‘expensive’ to ‘cheap’; while secular bull markets coincide with the general movement of stock valuations from ‘cheap’ to ‘expensive.’ Since approximately the early-1900s, this cycle has had an average duration of 15-20 years- corresponding to movements of the nominal price charts for benchmarks such as the S&P 500.

It is this last point –valuations- that we would like to expand upon today- and we do so in light of recent market weakness which has pushed this metric lower into what some investors would deem cheap territory. While we do not disagree that there are some compelling valuations out there, our general take based on the charts is that stocks right now are more likely fairly valued- en route to becoming undervalued in the years ahead. This analysis is based on data points provided by Robert Schiller (through Yale University) and Bloomberg.

The Charts

Using the Schiller PE

In the chart above, we plot the S&P 500 against its P/E ratio dating back to 1900. The data used for this calculation is provided by Robert Schiller of Yale University and is based on average inflation-adjusted earnings from the previous 10 years (known as the PE10 or Schiller PE). Because this factors in earnings from the previous ten years, it is less prone to wild swings in any one year (we will show examples of this later when we plot the S&P’s trailing-12 PE). CPI data is used to adjust for inflation.

As one of key components listed in the bullet points earlier, we can see via the chart above how stock valuations tend to trend through 15-20 year cycles. These cycles correspond to the secular bull and bear markets we experience in benchmarks such as the S&P 500. It also shows that high valuations mark the end of secular bull markets, while low valuations mark the end of secular bear markets. There are two key takeaways from this chart:

1. In the past, secular bear cycles ended when levels on the Schiller PE were at 10 or less on a monthly closing basis. 1920; 1942; and 1982 all marked the beginning of a new secular bull market in stocks, while 1932 marked the beginning of a 5-year cyclical bull run during the Great Depression.

2. Current data shows a PE value of 21.67 for May 2010 followed by an estimated value of 18.96 (subject to revision) for June 2010. Dating back to 1900, the mean/average PE in the data set was 16.28 while the median was 15.02. This suggests that at current levels, the PE on the S&P is still north of its ‘technical fair value’ range, as well as being above the level (<= 10) that marked new secular bull markets in the past.

Our PE Oscillator

We also used the PE data on the S&P to build an oscillator. This led to the discovery (we published the findings last year) that the PE itself can become ‘oversold’ and signal major market movements on the S&P.

In the chart above, we plot the PE oscillator around a zero line above the S&P 500. Studies indicate that the PE can become very oversold during bear markets and thus trigger a large cyclical uptrend in stocks (as gauged by the S&P). The most recent examples (from right to left) are 2009, 2002, 1974 and 1970- all major cyclical market bottoms here in the U.S. We have found that readings of -12% or lower pointed to impending market bottoms (major ones). Current readings have the oscillator at -1.2%- it recently breached the zero line after hitting a reading of +10.9% one month ago. This recent breach back into negative territory is not necessarily a cause for alarm in our opinion, as past violations proved inconclusive for short-term trend determination. Rather we provide this updated chart to further illustrate our belief that 1. stocks are not necessarily ‘historically’ cheap at current valuations; and 2. recent developments in the PE level do not show it to be in ‘oversold’ territory from a cyclical perspective.

Using Trailing 12

Bloomberg also provides data on the trailing 12-month PE of the S&P dating back to 1954. As mentioned earlier, market volatility can trigger ‘spikes’ in the data- which is why we prefer to use the Schiller PE:

S&P w/ Trailing-12 PE:

The general trending cycle of the PE ratio remains intact when we use TTM, although ‘volatility’ seems to increase rather dramatically due to the lack of a smoothing element. At current levels, Bloomberg calculates the PE on the S&P at 15.05, where 16.39 is the historical mean/average, and 16.74 the median dating back to 1954. This puts our current levels in more of a positive light, although we note that in the late -1970s and into the early 1980s, this ratio moved below 10 to signal to the start of the new secular bull market (from approximately 1982 to 2000).

Using Forward PE Estimates:

Our data here is inconclusive due to the lack of historical data available- but we included the chart to point out the (obviously) very high correlation this has to the price action of the S&P 500:

S&P vs Forward PE

We are in the process of tracking down more historical data with respect to this ratio, and will present new charts when completed. The quick takeaway here in our opinion is that aside from tracking closely to the nominal price action of the S&P 500, the forward looking PE is likely to be considered undervalued at current levels (just under 13 per Bloomberg Analytics)- if not extremely so, then at least moderately so. This is an important aspect to note in our current situation, as cheap valuations may start to draw out real buyers in a market where rallies have been driven primarily by short covering. Of course, nothing’s to say things cannot get even cheaper over the short-run, especially if bear sentiment morphs into panic off some negative macro outlier not currently priced in to the markets. Still, there is certainly a strong argument here that stocks are not expensive at current levels.

Bottom Line:

The good news in our opinion is that stocks have been getting cheaper over the last decade. This is evidenced by both the Schiller PE as well as the trailing 12 PE of the S&P 500. Such a downtrend in general valuations is typical during a secular bear market, and it paves the way for the eventual transition into the next secular uptrend. The downside to this is that it appears we have yet to fully complete the cycle: though stocks look to be fairly- or even under-valued per the charts above, history suggests that they may indeed get cheaper still in the months / possibly years ahead. Keep in mind that another market crash is not the only way to lower PE levels: in the late-1970s and even in the late-1930s, companies were somehow able to grow the “E” while the “P” essentially traded sideways. We do believe the U.S. has entered this particular phase of the secular bear market cycle: a more muted trading range for stocks against a slowly recovering economic picture which will allow valuations to grind lower going forward. Call it a ‘brave new world;’ call it the ‘new normal,’- there’s no difference in our view: the tail-end of this deflationary bear cycle will continue to be marked by a range-bound stock market until the major stars (technicals, credit conditions, demographics, and valuations) all begin to align- a process which is likely to take at least a few more years in our view.

Dan Wantrobski, CMT

Janney Montgomery Scott LLC

Director | Technical Research

1801 Market Street | Philadelphia | PA 19103

O: 215.665.4446 | M: 215.495.3738

Technical opinions expressed in this report are not dependent upon the opinion of the fundamental analyst covering any security. Accordingly, the Technical opinions contained herein may differ from those of the fundamental analysts. Copies of the Fundamental Analysis reports are available upon request. All charts courtesy of TradeStation and or Bloomberg.

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