by Jeff Miller
A basic lesson on getting attention is how to frame the question. If you are interviewing a corporate executive you can ask either:
A) How is your business doing? Do you see any need to expand? Are you changing the size of your work force?
B) Do you think we are in a recession?
If you are interviewing one of the ubiquitous parrots of Wall Street -- who might have the title of "investment strategist" or even "chief economist" -- you also have a choice of questions. [If you read the biographical information for these sources, you will often find an array of non-economists whose chief credential is that they are interviewed a lot on TV.]
A) What is your current investment allocation? How have you done through the last business cycle? What is your best idea?
B) Do you think we are in a recession?
I'm sure you get the idea. While some journalists ask questions where they can get an informed answer, those topics are not very exciting for headlines and ratings. It is more seductive to ask about the R word!!
This is even better when there is no definition for what is meant by a recession. For the average citizen, we never emerged from the last recession, since employment and growth have not returned to normal levels. I completely understand. This is a fine common-sense definition, but it is a bit imprecise for official purposes.
Recession "forecasters" can pontificate about the odds without specifying either a time frame or an exact definition. They can further insist that corporate earnings will be crushed and a lower P/E multiple will surely follow. Is this a great country, or what? Freedom of speech!
The recession question deserves more detail than I can do in the weekly market preview. Since it is at the forefront of concern, we must keep it in mind. Those who like charts should consider this analysis from Eddy Elfenbein (click to enlarge):
This does not have the look of a recession. It looks like the 2/10 spread would need to go much, much lower to signal a recession.
Last week I warned not to expect any magic from the Fed or European leaders. That was pretty accurate. I will try to do as well for this week, but first --- our regular review of the past week's events.
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 here, 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
While the stock market had a great week, the news was really not very good. Most observers attributed this to oversold conditions and short-covering during expiration week.
Despite the stock market results, there was actually some good news.
- Building permits popped nicely, up 3.2 %. This is a leading indicator. I do not pay much attention to the increased sales and price data, because of foreclosure effects.
- Greece is cooperating. So far the austerity and tax increase moves are in place. I understand that nearly everyone has written off Greece and started playing dominoes, a simplistic viewpoint. Whatever solution emerges in Europe will be incremental, fragmented, and delayed. Buying time is helpful when you need many different actors to coordinate. I expect a Greek restructuring, but the domino analysis goes too far.
- Europe is (finally) acting faster. Will it be fast enough? This is why delays in the Greek scenario are good. There is a race against time. The knee-jerk article you read (see anything by Mauldin) totals up every conceivable liability and concludes that disaster impends. For a refreshing contrast, take a look (noting the leverage potential) at this Bloomberg piece:
“It is very important that we look at the possibility of leveraging the EFSF resources and funding to have a stronger impact and make it more effective,” European Union Monetary Affairs Commissioner Olli Rehn said in Washington yesterday. French Finance Minister Francois Baroin said separately that policy makers “need the right firewall to prevent contagion” and can discuss giving the fund “the necessary strength.”
Weidmann has said he opposes turning the EFSF into a bank that can refinance itself at the ECB as it would amount to “monetizing state debt.” Coene also said he’s “not sure that will be a good idea.”
Coene signaled reluctance to step up the central bank’s government bond purchase program even after the IMF said Sept. 20 the ECB “must continue to intervene strongly” in European debt markets to “maintain orderly conditions.”
“I think it has been a helpful element in the beginning but of course it cannot be a structural element of the system,” the Belgian central banker said. “The main reason was that we wanted to keep the transmission of monetary policy as good as possible until the moment that the EFSF will be able to take over” the bond buying, he said.
There were also some negative events.
- The ECRI growth index dropped further into negative territory. The official ECRI interpretation is a heightened recession risk. The ECRI warns against over-reacting without a persistent change in this indicator, but we are watching with interest. The WLI is still 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. They have also revised some past data. I will take this up further below, in my weekly forecast.
- Initial jobless claims declined slightly to 423K. This is an unacceptable level, and the trend is still in the wrong direction.
- Top Fed Official John Williams "Raises Questions on Fed's Latest Move" (via Reuters).
- The money supply rebound stalls. This is a major forward-looking indicator that is widely ignored. It is a leading indicator, giving it extra significance. I think that the money growth in the system is bullish, but I want to be fair. The Bonddad Blog covers this and other high-frequency indicators, and they are getting more worried.
- Congress might shut down the government! Well -- this is not going to happen, but we have a replay of July. Outside observers of our political process do not understand. These repeated crises make US policymaking look like the Keystone Cops.
The ugliest story of the week was the stock market reaction. There was a complex news story from various fronts. The facile and incorrect take was to blame everything on the Fed. I showed why this was wrong . In addition to the sources I cited, my Kauffman blogging colleague Felix Salmon agrees. I saw a lot of stories blaming the Fed for the market decline. Most of these had a political agenda. Beware.
The Indicator Snapshot
It is important to keep the weekly news in perspective. My weekly indicator snapshot includes important summary indicators:
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. Meanwhile, the ECRI has a "long leading" series that is available only to subscribers, which they refer to in media appearances.Click to enlarge:
The indicators show continuing sluggish economic growth, and the rate of growth continues to get weaker. Six 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. My interpretation is that it shows that European concerns should not yet be a warning to US equity investors. This article helps to explain how to interpret the values and also provides historical context.
The ECRI WLI is still 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. Their most recent public announcements repeat a multi-month theme: Sluggish growth increases the risk of recession. This makes sense to me.
My favorite source on the ECRI, carefully comparing it to other sources, comes from Doug Short. His masterful charts capture a lot of information in a helpful way. Here is his latest take on the ECRI:
This is very interesting, but none of us likes a black box where the reported series is not the best source and we need an official interpretation from the actual "long leading indicators." We also had a number of backward revisions this month. I am exploring alternatives, and I hope to interest Doug in the quest.
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.
We voted "Bearish" this week, reflecting the terrible overall ratings and our long position in one of the inverse ETFs.
[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 is nothing much on the economic front until Friday. There will be some housing data, but it is not very timely.
Various Fed speeches are on the docket, including one by Bernanke. Fresh news from anyone would be a big surprise.
I am also not too interested in the various regional Fed surveys. The initial claims report on Thursday will be important, Personal consumption expenditures and the Chicago Purchasing managers (both on Friday) are also of interest.
Trading Time Frame
In trading accounts we were 40% short the market at the start of the week and covered half of that position on Thursday afternoon. We still have a bearish vote on the market with a three-week time horizon. Nearly all of our ETF positions are in the Penalty Box, meaning that confidence in forecasts is low for us. It should be for you as well!
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. It is conservative, but has no short positions at this time.
Long-term investors should buy and maintain core holdings of an appropriate size. This does not mean "buy and hold." I recommend an actively managed portfolio, adjusted with conditions, but one that includes stocks. The mid-year selling has tested the resolve of many investors. It is one thing to state a risk tolerance and another matter to watch it in action. Investors who are staying the course have "right-sized" their positions and maintained confidence in their methods. There are many stocks that are attractive on an earnings or dividend basis, despite all of the fear.
I am still doing a careful analysis of recession forecasting methods. What if we had a method that had multi-decade accuracy in real time? Not something that someone conjoured up later, but a method that was in the public domain and actually used.
The fascination with the ECRI data series is interesting. Big-time economists make forecasts based on this series with no knowledge of the composition --- even when warned that the "better series" is not published.
Suppose that we had access to a method that was just as good or better as the ECRI on past data, but we also knew the components.
The advantage would be transparency. That is also the disadvantage, since whichever spinmeisters did not like the outcome could criticize the indicators, something that no one can do with the ECRI.
Do we really want good indicators? Transparency? Information at a small cost -- or free?
I do -- and you should, too.
Check out my 2008 versus 2009 analysis.
[And yes, the Williams good/bad is a joke.]
Recession Odds Challenge
My highest-rated sources see a recession as no more likely than in an average year -- 15-20%. A number of Street economists have nudged their odds up to 30%, without any real explanation.
I understand that there are many current sources who now think that a recession is a certainty. Can interested readers provide pointers to any of these sources who had an effective real-time method for past recessions. Every time I read one of these stories it is from someone who either expects a recession every year or who did some data mining to analyze history and back-fit their forecasting variables.
Articles by Jeff Miller:
Will the Week Ahead Give Recession Indications? 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 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.