Cyclicality Calls for Tough Upside on S&P

On Wednesday we discussed the S&P 500's sensitivity to expansion and contraction of the price-to-earnings ratio. We also found that in time frames of less than 45 years, fluctuations in P/E are more powerful than earnings growth as drivers of market prices. Today I'd like to get more specific about the mechanics of P/E expansion and the market's cyclicality.

In particular, I've drawn some conclusions about the broader market environment from my analysis. First, correlations between the S&P's P/E and the yield curve show just how connected these two macro factors are. And a look at the S&P's performance against its P/E -- set forward 2.5 years -- suggests we're due for a another year or so of volatile upside. However, increasing globalization could break down these correlations, so I offer them as a framework against which to compare reality and not as gospel.

Ease, Fed, Ease

Cyclically speaking, the S&P's P/E (blue line) was in a clear downtrend from January 2004 until July 2006. Then, beginning last July when the market bottomed, the P/E trend may have begun to reverse itself.

Click here for larger image.

Source: The Agile Trader

Now, as I discussed on Jan. 4, I expect the S&P's P/E to continue to expand for at least a year, and probably two years. However, as you can see, there has been a strong correlation since 2004 between the P/E line's contraction and the yield curve's decline (and finally its inversion). (I define the yield curve here as the difference between the fed funds rate and the 10-year Treasury yield.)

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Adam Oliensis is president of Dog Dreams Unlimited, a guaranteed introducing futures brokerage, and editor of the trading service The Agile Trader. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Oliensis appreciates your feedback; click here to send him an email.