July 18th, 2011
by Jeff Miller
Most investors do not know how to measure risk. Usually they do not even try.
Risk is difficult to define and more difficult to measure. Risk is often confused with volatility, which is easy to measure. Most investors do not understand that volatility measures variation in both directions. They care about the downside, but are delighted with upside volatility. Follow up:
Follow up:I have tried to explain one of the most important issues for the individual investor by explaining the concept of "upside risk."
When I first started in the investment business, clearing firms analyzed the positions of options traders in terms of normal curves and standard deviations. After the 1987 crash, the definitions all changed.
The notion of the "black swan" was very much in evidence in 1987, as clearing firms "stress tested" trading positions with moves of six standard deviations. These were moves that one would never see in a lifetime if the outcomes were really represented by a normal curve. You certainly would not see these results twice!
The problem of assessing risk is nothing new. What you hear from most sources is also not new. The task for most of us is to turn the constant stream of worrying anecdotal evidence into something meaningful.
This week we saw the following sources of market volatility, none of which represented actual risk:
- Various interpretations of Bernanke's comments and the potential for QE 3. I am at a loss for words to describe how stupid this is. A large portion of the trading world seems to think that QE 2 was important, the mythical end of QE 2 was important, and the possible invocation of QE 3 would be important. Credit the entire financial media world for leading everyone astray. Meanwhile, Bernanke did not say much to encourage the QE 3 idea. Start here.
- Italy. They have a plan. Their short-term rates spiked. They voted for their plan.
- Debt ceiling drama. Various leaders are posturing, making claims to constituents, telling favorable stories in the media. This is exactly what we have been predicting for months and has no relevance to the final outcome. It fills pages and creates drama --- and volatility.
- Ratings agency downgrade threats -- also entirely predictable and adding no value.
In times of volatility -- as opposed to meaningful changes in actual risk -- the wise investor has the chance to step in. It is important to know the difference.
One of the things we do, communicated in this weekly column, is to distinguish between the anecdotes about risk and what can be objectively measured. Let us begin with our regular review of last week's data.
Background on "Weighing the Week Ahead"
There are many good services that do a complete list of every event. That is not my mission. Instead, I try to single out what will be most important in the coming week. If I am correct, my theme for the week is what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.
Readers often disagree with my conclusions. That is fine! Join in and comment. In most of my articles I build a careful case for each point. My purpose here is different. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but some will disagree. That is what makes a market!
Last Week's Data
The economic news may have seem mixed to most, but I think the balance is turning positive.
There was good news in important indicators.
- Money Supply Rebound. There are a number of "stealth indicators.'' These are getting little attention right now, so readers of "A Dash" will have an edge. We need more bank lending, so this week let us focus on the money supply. Bonddad tracks this, and summarizes as follows:
Both M1 and M2 have surged in the last 2 weeks. Real M1 remains very bullish, and Real M2 has now re-entered the green zone above 2.5%.
- Inflation Data. The measurement of increases in prices gets my vote for the most misunderstood government data. It is so easy to be a demagogue by telling readers how stupid the government is. The idea that there might be a difference between one's personal market basket and the measure that is best for forecasting is completely lost on a public that is better able to name the Three Stooges than the three branches of government. Many pundits point to the headline data when that will scare you, but ignore it when it declines. For those who have missed the message, we do not have an inflation problem and the Fed is going to stay in easy money mode for a long time. Check out this chart and read the entire supporting analysis from our featured source, Econbrowser:
The pattern of weak economic data continues to show up in several indicators:
- Initial jobless claims of 405,000 -- still too high to expect solid job growth. If this is a temporary story from the auto parts supply shortage, we should soon be seeing some improvement. Very soon!
- Gasoline prices bounced back. So much for the Obama initiative with the Strategic Petroleum Reserve. Higher fuel prices threaten consumer spending. This deserves careful monitoring. There has been a simplistic "risk on" trade where stock prices were correlated with energy prices. This is starting to break down, as noted by Bespoke Investment Group.
- The UM Confidence Index was very weak. I am calling this a negative factor, since I stick to the data. Calculated Risk is attributing the decline to the debt ceiling "charade. Normally confidence provides a good read on job creation, but there is a lot of confusion right now. Here is the excellent chart.
- Lesser indicators are also very weak. The Bonddad Blog monitors all of the shipping and rail factors, and they are still pretty glum.
It is time to take notice of some very bad doomsday predictions.
- Meredith Whitney, who understood what mark-to-mark accounting would do to banks in 2008, has been off base on the prediction for widespread municipal defaults. Bloomberg notes that defaults are actually down 60%. The WSJ is also on the case. This is what we hope for from good journalists.
- Bill Gross asked who would buy US debt after QE II ended. Many pundits, as usual, repeated his words like parrots. They confused the percentage of debt issuance with the percentage of trading in the market, something that we repeatedly pointed out. They were wrong -- at least according to last week's bond auctions and the analysis from the team at Bespoke Investment Group.
- Carmageddon. Didn't happen. It was a way of getting buzz.
The Indicator Snapshot
It is important to keep the weekly news in perspective. My weekly indicator snapshot includes important summary indicators:
- The ECRI Weekly Leading Index and the derivative Growth Index
- The St. Louis Fed Stress Index
- The key measures from our "Felix" ETF model.
There will soon be at least one new indicator, and the current choices are under review. In particular, I am considering replacing the ECRI method with the equally effective and more transparent approach from Bob Dieli.
The indicators show continuing modest growth at a slowing pace, with little indication of economic risk. The market fears, as is often the case, are greater than one might expect from the data.
Felix is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll, now recorded on Thursday after the market close. We have a long public record for these positions.
[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
There will be some housing data of interest. Regular readers know that I like to follow building permits which have a leading indicator quality.
The real story will be the second big week of earnings. Everyone is skeptical, looking for anything wrong. This can range from profit margin compression from Q2 inflation, extrapolating any Q2 soft patch, and questioning any positive outlook. This is not like a trifecta, since the bearish pundits only need to win on one of these points, not all three. Any bad story will be trumpeted as the start of a trend. Bespoke Investment Group has a great chart featuring the most important reports.
Skeptics will also highlight the fact that the earnings beat rate, which I expect to be in the 60% range, is due to reduced expectations. Some of these sources will be the same people who consistently tell you that the market is overvalued because forward earnings estimates are too optimistic. I invite readers to send pointers to those who take both sides of this argument. They definitely need more publicity -- and an opportunity to explain!
I expect the debt ceiling news to grab center stage, with a continuing crossfire of zingers. I also believe that by next weekend we will have a deal ready for a vote.
In trading accounts last week we bought throughout the week, and we are now fully invested. Felix has reluctantly recognized sectors emerging from the penalty box. It is a very conservative approach -- not trying to call the bottom. Felix likes to see significant trading in a sector at a given price point before venturing back in.
For investment accounts we were cautious last week in establishing new positions. I still believe that holdings with more economic exposure will excel in the second half of the year. These include technology and cyclical stocks. As I have noted in recent weeks, the investment time frame requires looking for opportunity when traders are scrambling.
Michigan Consumer Sentiment Crashes by Doug Short
Consumer Continues to Get Stronger by Rick Davis
Weighing the Week Ahead: Earnings to the Forefront by Jeff Miller
A New Way for Income Investors to Get Ahead by Larry Spears
What the $VIX is Telling Investors by Shah Gilani
ETF Market Growth: Opportunity and Risk by John Lounsbury
Why Oil Price Spikes Feel Worse? by Lance Roberts
The Truth About the American Economy by Robert Reich
U.S. Macroeconomic Overview by MacroTides
About the Author
Jeff Miller has been a partner in New Arc Investments since 1997, managing investment partnerships and individual accounts. He has worked for market makers at the Chicago Board Options Exchange, where found anomalies in the standard option pricing models and developed new forecasting techniques. Jeff is a Public Policy analyst and formerly taught advanced research methods at the University of Wisconsin. He analyzed many issues related to state tax policy and provided quantitative modeling which helped inform state and local officials in Wisconsin for more than a decade. Jeff writes at his blog, A Dash of Insight.