by Jeff Miller
Many have high hopes for this Friday's speech from Fed Chair Ben Bernanke. Everyone remembers the market reaction after last year's Jackson Hole speech. Some believe that we are about to see a replay. In CNBC's monthly survey of "market pros" there is now an expectation of QE 3. There are many other interesting findings on recession odds, the S&P downgrade, and Europe, but the QE 3 summary is as follows:
QE3 may be coming after all.
Follow up:In a dramatic turnabout, market participants now believe the Federal Reserve is more likely than not to resume purchasing assets during the next year in a third round of quantitative easing the August CNBC Fed Survey shows.
Mark Gongloff nicely captures the reality in his WSJ article, Jackson Hole Might Be a Big Disappointment Sandwich For Market. He supports this theme with some well-chosen quotations from prominent Street economists. Collectively the sources believe that a higher rate of core inflation and uncertainty about fiscal policy make action less likely.
I'll provide my own forecast below. First, let us do our regular review of the past week.
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
In general, the news is consistent with continuing sluggish economic growth.
There were some bright spots.
- Initial jobless claims continued around 400K. This is still not what we need, but it is better than recent levels and much better than many were forecasting a few weeks ago. It is not a recessionary level, nor a sign of robust growth.
- The money supply rebound continues. This is a major forward-looking indicator that is widely ignored. It is a leading indicator, giving it extra significance. I have been writing about this for several weeks, highlighting the weekly updates from Bonddad. Last week I observed that everyone knows that monetary policy works with a lag, but no one is paying any attention to this story. That has now changed. We are seeing the first spinning of this important data source, with the allegation that it means that "people are going to cash." These are the same sources that are happy to point to M2 as meaningful and inflationary when it suits their purpose. Beware!
- Earnings strength continues. The earnings beat rate is better than last quarter. More companies have raised guidance rather than lowered it. Both rates are weaker than the trend from the last two years, but still positive. See the story and chart at Bespoke Investment Group.
- Leading indicators moved higher. How can this be? Steven Hansen doubts the data. I generally believe in taking data at face value, but I am not a fan of this indicator.
- First hint of compromise on the Supercommittee. No one expects much from the debt limit compromise. My contrarian estimate for success is 2-1. We now have one GOP member who does not want to cut entitlements. This is going to be a big story over the next three months, so read this article to prepare yourself for breaking news.
There was plenty of negative news.
- Reaction to Earnings. The title from Bespoke Investment Group is dramatic -- Earnings Season Blowups, Bombs, and Disasters -- By Far the Worst Earnings Season on Record. The accompanying data show the futility of reporting good earnings in a time of market turmoil.
- The Philly Fed Index cratered to -30. Regular readers know that I have little respect for this series, but I acknowledge that it is important when it makes a major move. Since the reading is back to March of 2009 levels, I guess that qualifies! This is a survey of businesses and a diffusion index. It is volatile and poorly correlated with indicators like the ISM or GDP, but this was a very, very bad report.
- The Fed is worried about European banks. Or maybe not. There were two stories. The first said that the Fed was doing some checking to make sure that European effects would not spill over to the US, and quoted anonymous officials as expressing concern. The second included an official denial of the first, and said that European banks were treated just like those in the US. Guess which one the market believed.
- The ECRI growth index dropped slightly into negative territory. The ECRI warns against over-reacting without a persistent change in this indicator. Get perspective from Doug Short and one of his great charts.
- Building permits declined. I see this as more important than current home sales since it has a leading quality. The news was bad, as is the continuing story for the housing front.
The stock market reaction, especially Thursday, gets the nod for this week's "ugly" award. The market news may become a cause as well as an effect, influencing consumer confidence, business confidence, spending, and economic growth.
Economists are lowering growth forecasts. Check out Calculated Risk for details.
Reduced growth increases the vulnerability to a recession if there is some additional shock, so those odds are now higher 30% according to some surveys.
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.
As I have often noted in the past, the ECRI and the SLFSI report with a one-week lag. This means that the reported values do not include last week's market action. In my research, I take account of this lag. In my daily monitoring of the market I look at the underlying elements in the SLFSI. I cannot do this with reliability for the ECRI since the indicators are secret. The SLFSI will increase next week, but not to the level that would trigger the "risk alarm."
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 ECRI has a "long leading" series that is available only to subscribers, which they refer to in media appearances.
The indicators show continuing modest growth at a slowing pace. This week there was an increase in the SLFSI, generated by a slight increase in LIBOR rates and a big jump in the VIX. I have been doing extensive research on this indicator. It was not designed to predict the stock market. It is a reflection of actual risk. I believe that it will prove valuable as a tool for investors who prefer data to story telling. This article helps to explain how to interpret the values and also provides historical context.
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 are a number of minor reports this week, but the big story will be the Jackson Hole speech on Friday.
News from Europe is a continuing backdrop. Thursday's initial claims data will be important only if there is a major change. It is still vacation time for many, but that has not led to quiet markets this summer.
Trading Time Frame
In trading accounts we were out of the market all week, after a well-timed close of short positions. Our Felix model is not calling a market bottom, but is reacting to volatility. When sectors go into our Penalty Box it indicates reduced confidence in short-term predictions.
While our official vote this week is "bearish," it would be more accurate to say that we are abstaining. The power ratings are actually quite solid, so we will be buying aggressively as sectors emerge from the Penalty Box. That may not happen this week, but it might.
Investor Time Frame
In our ETF-based Dynamic Asset Allocation program, the portfolio is also very conservative. This cautionary posture includes bonds, gold ETFs, and utilities. The DAA will eventually include inverse ETFs if adverse conditions persist.
For long-term investors little has changed. As I noted last week, my contrarian view is 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. The market is pricing in a high level of systemic risk and recession potential, even though these outcomes are not supported by quantitative indicators.
Let me add some comments from a source that I have found valuable over the years, Liz Ann Sonders and her Schwab team. There is a mistaken viewpoint about motivations for various pundits. I often see this in comments, especially from those who seek reinforcement of their ideas.
Here is a brief guide: Guys from bond funds are selling bonds. Those pitching gold are usually selling fear. Mutual fund managers are selling their funds. Sources like Schwab profit from the success of their investors. This is also true of Registered Investment Advisors like myself. Our success depends upon how well clients do. This does not require that they be invested in stocks.
Many readers will not normally see the excellent source, Advisor Perspectives. Those of us seeking a wide range of information read it religiously. Speaking of Schwab, I want to share this week's commentary:
Also lending credence to the "panic is not a strategy" argument, although consumer confidence remains low at 59.5, the contrarian nature of the market is illustrated by the Dow Jones Industrial Average gaining an average of 14.4% annually when confidence is less than 66, more than double the average gain when the reading is above that number. Of course, past performance is no guarantee of future results.
We don't pretend to know what's coming for the markets in the next couple of days or weeks, as heightened sensitivity could result in continued volatility—in both directions. We continue to believe we'll avoid a recession due to continued positive leading economic indicators, an improving jobs picture, solid corporate balance sheets and a still-steep yield curve.
We're encouraged that we're seeing some nascent signs of confidence on the corporate side as demand for loans has increased and stock buybacks are at their highest level since October 2008, according to Birinyi Associates. We continue to urge investors to keep their long-term goals in mind, match their portfolios to their risk tolerance, and remind them that trying to time the market, in our experience, tends to be a losing game.
Timing and Jackson Hole
When looking forward to a major event, it makes sense to be cautious. This is especially true when you are not optimistic about the result. Bernanke's speech will include a combination of policy, promise, and leadership. I am not expecting much on any of these fronts.
The Fed does not share the typical trader viewpoint --- not on the effects of QE 2, not on the current economic prospects, and not on the need for QE 3. The Fed, especially the dissenters, are more sanguine about the economy. They understand that the large Fed balance sheet from QE 2 is still working to increase the money supply.
Bernanke is not going to adopt a policy just because it is what the market wants. There might be a hint of flexibility and new ideas. I am not expecting any inspirational leadership.
German Chancellor Merkel has a similar choice. Here is her reaction:
“Politicians can’t and won’t simply run after the markets,” Merkel said in the chancellery interview, her first since returning from a three-week summer break. “The markets want to force us to do certain things. That we won’t do. Politicians have to make sure that we’re unassailable, that we can make policy for the people.”
The juxtaposition of decision makers and markets is the key investment question for the coming year.
Investing Blog articles by Jeff Miller
It’s Time to Bail on Bank Stocks by Martin Hutchinson
Bond-GDP Correlation and the U.S. Bond Bubble by Andrew Butter
Investing in a Volatile Market by David Grandey
Gundlach Sees Cusp of a Global Banking Panic by Robert Huebscher
Death of the Risk-Free Investment by Martin Hutchinson
Is the End Near – Or Is It Different This Time? by Ed Easterling
Analyzing the Supercommittee by Jeff Miller
Conference Board: Indicators Rising and Economy Falling (?!!?) by Steven Hansen
CFNAI Says Economy Both Better and Worse in July 2011 by Steven Hansen
Recession Is Not In View, But Economy Is Ugly by Steven Hansen
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.