September 13th, 2011
by Jeff Miller
I'm sure that readers of my blog, "A Dash of Insight," have watched some of the ceremonies commemorating the events of 9/11, and some have probably participated. It is a time to remember our losses and pay respects. We have all also read retrospective pieces about how things have changed in the last ten years.
Perhaps the only common theme is the well-deserved recognition of those who serve others by putting themselves in harm's way.
Sticking to the narrow focus of implications for investors and the economy, the effects of 9/11 were greater than most would have guessed at the time. I mean these points to be descriptions of effects, not commentary about any particular decision or leader.
- While the 2001 recession officially started in March that was not confirmed as a peak until November. The drop in confidence, travel, and spending provided the recession creating shock to a fragile economy. (When the shock occurs, the recession is confirmed and the NBER dating committee then defines the start as the last peak. The recession ended in November, 2001, a close call made by the NBER in July. Yes, that means that the recession was officially ending just as the NBER decided that it was a recession and when it started).
- It soon became clear that the US would be waging war with Iraq, first developing whatever measure of international support could be mustered. Business spending and hiring went on hold with executives citing "uncertainty" as the reason.
- The Iraq conflict and the multi-year aftermath most importantly cost more lives, but also contributed to growing budget deficits.
- War and the related economic issues had the effect of polarizing public opinion and making elections even more aggressively antagonistic.
After a few months of feeling a sense of common purpose, things have turned bitter and aggressive. The most dramatic example is the debt ceiling issue. Polling firm Public Opinion Strategies has an interesting and disturbing report on the current consumer and voter discontent. They rank the biggest events of the last 30 years by the two-month impact on consumer confidence. The debt ceiling issue was second on the list, much more significant than 9/11.
There is no comparison between these events on any rational measure of significance. The debt ceiling issue was not even a crisis. The limit had been routinely extended in the past, and those in the know had little doubt that it would be again. The US deficit question is a serious problem, but attaching a specific date for a solution created a false sense of urgency and crisis.
Why did this artificial "crisis" (POS correctly does not call it that) have such a great effect? Mostly because it worked to the advantage of so many to treat it that way. As a long-time observer, I correctly saw a lot of posturing and hard ball negotiating leading to an eventual compromise -- business as usual. What the public, including foreigners and debt-rating agencies, saw was a close look at sausage getting made.
Public Opinion Strategies created a word cloud of reactions. It captures the effect quite clearly.
The report also makes things look pretty grim for incumbents. Obama has almost no chance by their measures, but Congressional Republicans rate even worse.
This subject is far too big for my weekly summary article, but it is timely and important. I will return to the theme frequently over the next few weeks. Meanwhile, I do expect improvement including both more responsible behavior and some solutions.
In the conclusion, I will highlight some ideas for traders and investors with differing time frames. Let us first turn to the events of last week.
Background on "Weighing the Week Ahead"
There are many good sources for a comprehensive weekly review. My mission is different. I single out what will be most important in the coming week. 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.
Unlike my other articles at "A Dash" I am not trying to develop a focused, logical argument with supporting data on a single theme. I am sharing conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am trying to put the news in context.
Readers often disagree with my conclusions. (A commenter recently suggested that was proof that I was wrong -- an amazing interpretation!) Do not be bashful. Join in and comment about what we should expect. 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 feel free to disagree. That is what makes a market!
Last Week's Data
As I expected in last week's preview, the data took a back seat this week.
The actual economic data were encouraging. I wish to remind readers that in this listing "good" means "market-friendly." We do not need to be partisan supporters of Obama, for example, to hope for some economic improvement without waiting for the next election.
- Mortgage rates hit a record low of 4.12% for thirty years. Combined with low housing prices, this is excellent news for those who can qualify for a loan -- either for refinancing or new purchases.
- Trade figures for July were surprisingly good. It only represents one month of the quarter, but it is a positive for Q3 GDP. Check out Steven Hansen's careful analysis.
- The Obama proposals are a start. I expect that the growing acceptance of a need for action will lead to a compromise incorporating some of the elements. More here. Most economists evaluated the proposals as positive for the economy. If you want to see careful reasoning for such a conclusion, and not just an opinion, check out Econbrowser.
- 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. There is also evidence that commercial lending is increasing, one of the first effects we would expect from a policy that works with "long and variable lags." The Bonddad Blog has been covering this effectively, including a discussion of whether M2 growth is artificially influenced by inflows from European banks. It is well worth reading the entire piece.
There was some important negative news.
- Greek debt yields spiked as new payment fears arose. How about nearly 50% on a two-year obligation?
- The ECRI growth index dropped further into negative territory. The ECRI warns against over-reacting without a persistent change in this indicator, but we are watching with interest. The WLI is now at the average level for the last year, but there is a decline as measured by the growth index. This is a smoothed growth factor, but the exact time frame and smoothing are not specified. They have not yet suggested an official recession forecast, sticking with the story of the lower global growth that they first talked about in May.
- Initial jobless claims climbed to 414K. While this is still in the 400K range it is not what we need. You can put this high frequency data point in better perspective by reading this article.
Anything related to Europe was newsworthy and most of it was ugly.
- Merkel lost a local election, calling German support for a broader bailout into question.
- The S&P ruled that under some versions of a planned solution, a eurobond would have the rating of the weakest partipant: Greece.
- Greek interest rates and CDS prices spiked even higher.
- Portugal and Italy had somewhat higher rates.
- A top ECB economist, a proponent of higher intereest rates, announced his resignation. He will probably be replacedby someone with a more accomodating attitude, but the initial interpretation was intensely negative for stocks.
- The Germans are said to be considering a "Plan B" involving allowing Greece to default.
- As of Friday, a Greek default was thought to be imminent, perhaps over the weekend. This was denied by Greece.
To summarize. There is a three step process here involving sovereign debt failure, bank failure and European contagion, and finally a spread outside of Europe. Any news relating to the first of these steps has immediate consequences for European banks, but also for US banks and other stocks. Everything is trading in a correlated fashion.
As you will see below, the contagion risk does not show up in our indicators.
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 sluggish economic growth, but the rate of growth continues to get weaker. Four weeks ago there was an increase in the SLFSI, generated by a slight increase in LIBOR rates and a big jump in the VIX. The SLFSI has been stable since then. I have been doing extensive research on this indicator. It was not designed to predict the stock market. It is a reflection of financial risk, based upon what happened in past crises. 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.
The ECRI WLI is at about its average for the last year and significantly higher than in 2009. The growth index uses an unspecified formula to smooth the changes in the index over an unspecified time. The ECRI warns against making too much out of declines in this indicator alone unless it is persistent.
Our "Felix" model 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.
While we voted "Bearish" this week, "abstain" might have been a better description, since both long and short ETFs are in the Penalty Box.
[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
This week there is a little economic data, but not much of great interest. Regular readers know that I do not regard the Philly Fed index as very important, but the reading was so bad last month that it will attract attention. I do not see the CPI as very important right now, especially given the Fed policy. Industrial production and capacity utilization will be significant only with a major shift. Most people are expecting little from retail sales.
For me, the initial jobless claim series continues to be important as a part of my labor dynamics analysis. It covers the job loss side. Also important is the University of Michigan consumer sentiment index, which I use to assist in estimating job creation. It was so bad last month, that it also has captured attention. The U of M index is also emphasized in the Public Opinion Strategies work cited above.
The reality is that it will be all about Europe until this situation gets more clarity.
Trading Time Frame
In trading accounts we were only in the market for two days last week, making a timely exit. Felix sent everything to the penalty box.
Investor Time Frame
In our ETF-based Dynamic Asset Allocation program, the portfolio remains very conservative. This cautionary posture includes bonds, gold ETFs, and utilities, but covered the "short" position represented by one inverse ETF.
Long-term investors should be paying attention to the discrepancy between recession fears and actual data. Here is a simple exercise that will take less than five minutes and prove to be time well spent. Go to Scott Grannis's 20 Bullish Charts Revisited. He looked at these indicators during the "rampant" pessimism of one year ago. Take him up on his offer to put the charts up side-by-side. There are some changes in a couple of them, but the picture is mostly the same. He concludes as follows:
In conclusion, most of these charts still support a bullish outlook (albeit a less bullish outlook compared to a year ago), especially in the context of a market that once again has become extremely bearish. Although there has been some deterioration in the economy's growth fundamentals over the past year and in recent months, but there is still no indication that the economy is at risk of another recession.
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Market Red Ink Update 9/6/11 by John Lounsbury
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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 he 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.