November 1st, 2011
by Jeff Miller
Over the past several weeks the market has been dealing with worries on three fronts:
- The European debt issues
- Corporate earnings
- The risk of a US recession
With apparent progress on the first two, market observers have a special interest in economic data. Recent economic reports have been better than expected, but recession worries have not really abated.
My own favorite recession indicators still show odds of below 25% for the next twelve months, but some high-profile forecasters have taken an aggressive, out-of-consensus viewpoint. This week will provide more information on the current economy. Let us first review last week's news and data.
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
Once again, this week's news was very positive and the market responded.
There was a lot of good news, especially the developments in Europe.
- Europe has a plan -- sort of. This is an outline of a work in progress more than a specific plan. Since everyone was intensely skeptical (and many remain so) even the outline of a plan was enough to stimulate the market. I expect non-European participation to grow as the details emerge.
- Earnings season continues to be strong. Many were skeptical, and so far they have been wrong.
- GDP growth was modest, but solid -- 2.5%. Doug Short does a beautiful job of showing a complete picture in one chart -- the GDP trend, the recession effect, and the major components of the change. I love the way he shows the relevance of multiple variables in a single chart.
- The high-frequency indicators, with the exception of gasoline purchases, are all very strong. The Bonddad Blog covers these every week. "With the exception of gasoline usage, this was probably the best week for the high frequency indicators in over 3 months."
There were also some negative events, but much less important
- Forward earnings estimates are still softening. Dr. Ed Yardeni follows this carefully. In this chart you should look at the trajectory of the 2012 "squiggle." Forward estimates are still higher, but also under some pressure. I am watching this closely.
- House prices are still under pressure according to the Case-Shiller readings.
- Weekly initial jobless claims hover around the 400K mark, the realm of sluggish growth.
- Consumer confidence is still terrible -- hovering at recession levels. The deviation between consumer surveys and actual spending is attracting attention. As as student and fan of surveys, especially the Michigan survey, I remain concerned about the economic implications of the record low readings.
The Refreshingly Honest
A key skill for any market participant -- fund manager, investor, pundit, or researcher -- is to stay open minded. Circumstances change. It is important to treat each day as a new opportunity. You cannot do anything about the past except to learn from it.
Contrast these two analysts who have both been bearish and wrong in recent weeks:
Analyst #1 says "I was wrong." He got caught up with a few economic data points, but now sees no European contagion and no recession. He accepts a mildly bullish upside, while still expressing amazement at economic growth in the face of terrible news stories.
Analyst #2 is a frequent TV guest and a featured writer on the most popular blogs. He thinks that recession odds are over 50% (although he has no record of successful recession forecasting). He thinks that earnings could decline by 40% in a recession (although he has no record of earnings forecasts). His commentary last week disparaged the 71% pace of earnings beating expectations. On his personal scoring system he called it a "Gentleman's C", since it was slightly worse than most quarters during over the last two years. Check out the entire article for his heavily negative spin on the data.
Those who are open to new evidence will achieve greater investment success. Here is a message for Analyst #2 and his followers:
Things have gotten better!
If you don't see it, you are not paying attention.
The Indicator Snapshot
It is important to keep the weekly news in perspective. My weekly indicator snapshot includes important summary indicators:
- An Economic/Recession Indicator. I am evaluating several candidates.
- The St. Louis Fed Stress Index
- The key measures from our "Felix" ETF model.
The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has been moving a bit lower, now out of the trigger range of my pre-determined risk alarm. The SLFSI did not signal the major calamity that many deemed a foregone conclusion, but it did move higher. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution.
There will soon be at least one new indicator, and the current choices are under review.
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 "Bullish" this week.
[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 is a big week for economic news and data.
The most important story will be Friday's employment situation report. The market is looking for a relatively modest gain of 100K jobs and little change in the unemployment rate. I'll take a closer look at employment later in the week.
Tuesday brings the ISM index, which many see as a good coincident indicator with some leading components. The Chicago Index, released Monday, has a good correlation with the national ISM.
The FOMC decision on Wednesday is not expected to include any policy changes. As usual we will be parsing the small changes in language and analyzing the extent of dissent. There will also be a Bernanke press conference following this meeting. These are scheduled four times a year, coinciding with official changes in the economic forecasts.
The ADP report on private employment (Wednesday) will influence expectations for the official government numbers on Friday. Thursday's initial jobless claims have continuing interest, but the data for this week are not part of the survey period for the Friday payroll numbers.
There are lesser reports, but it would take a big surprise for anything else (auto sales?) to be relevant.
Meanwhile, earnings season continues.
Trading Time Frame
As I have suggested over the last few weeks, it is time for some buying. We were fully invested last week in trading accounts and remain so for the coming week. This program has a three-week time horizon.
Investor Time Frame
Long-term investors should continue to watch the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. Three weeks ago we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," but it is still high. We have some cash in these accounts, and will use volatility to establish new positions.
Two weeks ago I suggested a concept and a specific stock suggestion for yield-oriented investors. It is still attractive. This week I provided more ideas in advance of the European decision. While there were immediate gains, I still like all of the stocks mentioned.
A Final Question: When is the time right?
Many investors have embraced the warnings about the many economic headwinds, choosing to underweight stocks. Over the last few weeks the worries have been reduced -- at least by any objective assessment. Meanwhile, stock prices have moved higher. Risk-averse investors have been waiting patiently for a more opportune moment to act.
This is the normal pattern of risk and reward. Those willing to reject the hypothesis about a European collapse were in position to get the biggest reward. Next in line will be those who believe that the recession fears are overstated. If you want even more certainty about economic recovery, you must expect to buy stocks at higher prices.
For those who want perfection -- no risk, no "headwinds", no international issues -- they can expect to buy the top of the market. This is when many of us will be cutting positions and selling to them.
Most investors never ask the right question: What balance of risk and reward is right for me?
Instead, they use their intelligence on only half of the problem -- asking whether there are any worries -- any at all. Smart people are very good at spotting potential problems. This is why smart people can virtually guarantee that there will never be a "right time" to invest.
I wrote two weeks ago that the market could break out of the trading range with an initial target of 1400 on the S&P 500. This is still only 13 times next year's earnings, so economic improvement would imply higher earnings and a higher target.
There are reasonable and conservative strategies to participate in an improving economy while still limiting risk.
Pending Home Sales Index Rises YoY in September 2011 by Steve Hansen
Good Gain For Personal Consumption Expenditures in September 2011 by Steve Hansen
Advance Third Quarter 2011 GDP is 2.5% by Steven Hansen and Doug Short
GDP Improves – But Does it Have Legs? by Rick Davis
European Contagion Turns Positive, Will it Last? by Shah Gilani
Residential Housing: The Problem and the Solution by Robert Huebscher
Stocks Move Above Strong Resistance Levels by Erik McCurdy
Retail: Pain in the Middle by Dee Gill
The Great Escape, Part 2: New Update by Chris Kimble
Gundlach: Markets Aren’t Cheap Enough Yet by Robert Huebscher
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.