Gauging the Future of the Fed

The consensus here on RealMoney and elsewhere seems to be that the Federal Open Market Committee will hold rates steady today; its announcement is slated for 2:15 p.m. EDT today.

But let's look at what the future may hold when it comes to the Fed.

At present, the consensus for forward 52-week earnings per share on the S&P 500 suggests that the Fed will remain on hold for the foreseeable future -- or until something significant changes.

As you can see on the chart below, forward 52-week EPS, which are represented by the blue line, have stagnated, having essentially flattened out over the past three months.

This may partly be a function of the fact that my calculation uses a top-down trend growth rate for the first-quarter 2008 estimate rather than a bottom-up estimate. (That's because Standard & Poor's hasn't yet published analysts' bottom-up estimates for 2008.)

However, we're also seeing deterioration in the trailing 52-week earnings per share, represented by the yellow line on this chart. And that fits with the overall picture of a decelerating economy.

Source: TheAgileTrader

Indeed, the three-month annualized growth rate for forward 52-week EPS, shown by the red line below, has fallen below 0% for the first time since 2002.

Source: TheAgileTrader

And this increases the risk that year-over-year growth in forward 52-week EPS, represented above by the blue line, will fall below 10%.

The stock market tends to struggle when the blue line is either declining below the 10% level or if it is below the 0% level. (A brief dip on the red line to low levels isn't catastrophic as long as it quickly jumps back up, but the dip does raise a warning flag and increases the risk that the blue line will continue to push lower.)

As I've discussed before, it doesn't look as if the Fed is on the verge of cutting the fed funds rate to alleviate the potential perfect storm on the liquidity front.

The fed funds rate's year-over-year change, shown below on the red line, continues to drift down toward 0% as forward 52-week EPS (blue line) drift toward their own mean in the 7%-to-8% range.

Unless and until the blue line breaks meaningfully down below that 7%-to-8% area, the Fed is historically disinclined to push the red line below its own zero line, which would translate into an actual cut in the fed funds rate. As long as analysts continue to predict something at least close to trend earnings growth, the Fed probably won't be cutting rates.

Source: TheAgileTrader

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Considering how the consensus estimate breaks out on a sector-by-sector basis, there may be some genuine cause for concern.

Source: TheAgileTrader

Right now, in seven of 10 S&P 500 sectors, the consensus is predicting earnings growth above the overall market's growth. Only the energy sector shows a consensus for negative growth.

If the Treasury inflation-protected securities, or TIPS, market is close to correct about where the trend in real economic growth will be over the next five years and that number is properly near 2%, and if growth will be near that number over the coming year, then the probabilities remain quite high that we'll see marked deterioration in most of these sectors' earnings growth rates as well as in the S&P 500's aggregate projected earnings growth rate, now at 7.9%.

So let's watch how these estimates evolve in the weeks ahead, especially to see if the consensus begins to project below-trend earnings growth for the broad market. If earnings projections deteriorate to a level noticeably below trend, then the odds will increase greatly that the Fed will start easing.

Maybe perversely and definitely circuitously, it may be weakening economic growth and a decline in earnings projections that ultimately (through the mechanism of Fed easing) spur the stock market to rally later this year.

Nobody ever said it was easy or simple to beat the market. If it were either of those things, then everyone would do it -- and, by definition, everyone can't.

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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.