Targets for the S&P 500 in 2007

In Wednesday's article, Questions for the Four-Year Cycle, I mentioned the quandary presented by the absence of a cycle-ending sell-down on the S&P 500 in autumn 2006 from which we could measure the start of the new four-year cycle (2006-10).

After further study, it appears that the best launch point is the SPX July 17 low, associated with the Nasdaq's summer low of July 21.

We'll use this low (1234) as the start for the time being, and going forward, we'll monitor how things are proceeding and whether there's some indication that we should be looking at things differently.

The blue line on the first chart is the median performance of all the four-year cycles since 1962. Each cycle is launched from the autumn low of every fourth year (e.g., 1962, 1966 ... 2002, 2006).

The red line is the average performance from that same point, and the gray lines represent one standard deviation from the average. (That is, given the volatility of these series, about 68% of these cycles should fall inside the envelope created by the gray lines; only about 16% of cases should be above the gray envelope and 16% of cases below.) The black line represents the SPX performance since the July 17 low, as discussed above.

While we discussed in some detail the behavior of the red and blue lines in Wednesday's article, what we need to examine more closely is what these cyclical norms suggest would be normal behavior for the current cycle.

If indeed the July 17 SPX low is the correct launch point, then we're about five months into the current cycle (117 trading days).

Given that there was no significant sell-down to end the '02-'06 cycle and begin the '06-'10 cycle, we would expect the current cycle to slightly underperform the norms on a percentage-gain basis. So, assuming that our July launch point is correct, we would be looking for the SPX to rally to the +25% to +30% area off the starting point by trading day 369, which is near the end of this year. That would give us a "cyclically based" year-end '07 target zone of 1542-1604.

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Earnings, Yields and a Valuation-Based Target

The trends in all of our earnings per share lines for the SPX remain healthy. The consensus for forward 52-week operating EPS (F52W) (blue line) has hit yet another all-time high at $96.06. That's 12.6% above a year ago and 9.4% above trailing 52-week operating EPS (yellow line). Earnings growth will likely decelerate from the 14.4% growth enjoyed this past year (especially in light of at or near-record profit margins and slowing GDP growth), but current forecasts remain essentially constructive.

Additionally constructive for the market is the close correlation between operating earnings and reported earnings (pink line). We are not seeing the wide spread between the yellow and pink lines that we saw during the bear market of 2000-02. That speaks to the good quality of earnings.

Currently, the forward earnings yield on the SPX stands at $96.06/1418 = 6.77%. The 10-year Treasury yield is at 4.71%. The spread between these two yields is 6.77% - 4.71% = 2.06%. That 2.06% is our equity risk premium, which is the amount of excess yield that investors in the equities market require to take the risk of investing in equities relative to the "riskless" 10-year Treasury.

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At the time of publication, Oliensis held no positions in the stocks mentioned, although positions may change at any time.

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.