November 20th, 2011
by Jeff Miller
Sometimes stock market moves defy a sensible interpretation.
The news directly related to US equities was pretty good last week, but the market reaction was negative. If you were watching daily trading, you could focus on one indicator: The yield on the Italian ten-year bonds. With 7% perceived as the danger zone that presaged problems in Greece and Ireland, there is special concern when this level is approached.
As rates move higher, current holders are increasing their selling. The New York Times highlights the risk of a downward spiral. When the euro moves lower, the dollar moves higher and stocks decline. Correlations among all stocks and sectors remain high, so the story is all about Europe.
The sensitivity to the Europe situation is so great that even a mild statement about a possible ratings change for US banks with European exposure sparked a late-day swoon in all stocks. (Check here for a more complete analysis). I'll discuss Europe further in the conclusion, but first let's do our regular review of 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. Do not be bashful. Join in and comment about what we should expect in the days ahead. 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
The economic data last week was positive on all important fronts. It made no difference. Once again the Europe-related headlines dominated over anything else.
The economic story showed continuing improvement. There is no indication of a current recession, and economic forecasts are moving higher.
- Initial jobless claims continued to move lower. This is an important data series -- hard data, very timely -- and continuing to improve.
- Retail sales were very good, up 0.5% and 7.3% year over year.
- Building permits made a nice move higher. We do not yet see the effects in housing, but I view this as a leading indicator.
- The Leading Economic Indicators beat expectations, as did various lesser economic reports. Steven Hansen provides analysis, noting the Conference Board's viewpoint that economic growth will continue into the Spring.
- Economic growth forecasts moved nicely higher. Several big firms raised estimates based on recent data. Doug Short provides a good chart of the range of predictions from the WSJ survey of economists. He also notes that their average recession odds are about 25%.
The negative news was mostly from Europe, but also included some indicators I view as significant.
- The worst news from Europe was the spike above 7% in Italian ten-year bond rates. More on this in the conclusion.
- Tax revenues are (surprisingly) lower. This should not be happening with a positive GDP, and it has many implications. There is nice coverage from the Bonddad Blog.
- Oil and gasoline prices are still at the point that threatens a recession. (Bonddad).
- Job creation is lagging. The BLS publishes the Business Dynamics report using actual data from state employment offices. It provides the basis for benchmarking the payroll employment report as well as adjusting the BLS birth/death methods. Despite this significance, I think I am the only expert on labor economics who pays any attention. The problem is that the data are eight months old, so no one sees the relevance. The current payroll employment series shows job gains of about 500K for the first quarter. The actual data show only 250K, with big reductions in both job losses and job creation. I am troubled by this, since employment is very important.
- Technical damage last week leaves the market vulnerable to further selling. Charles Kirk's excellent weekly chart show explains what traders should watch at this crucial point.
This week's Ugly Award goes to the Congressional Supercommittee. Back in August I put the odds of Supercomittee success at 2-1. My reason was pretty simple. There were two big differences from the debt celing debate.
- Failure on the debt ceiling would mostly be blamed on the President. The aggressive GOP House members successfully played chicken to turn something that was normally a routine process into a major policy question. Failure of the Supercommittee is much different, with significant defense cuts to prod the Republicans. One element of predicting political outcomes is to look at what will happen if there is no action. This is not like August.
- The Supercommittee requires only a simple majority -- seven votes out of twelve. It is not like the super majorities required in most legislative processes. A solution requires one "defector" either way.
With the bar lowered and the penalty for inaction higher, I expected at least the minimum target of $1.2 billion in cuts to be achieved. Two weeks ago experts like Alice Rivlin were predicting an agreement. Rivlin is the first director of the CBO, a former Fed Vice-chair, and a member of the Deficit Commission. She is one of the best sources on a subject like this. In interviews last week Rivlin still expected a deal, but showed less confidence. Follow the two links and you will see the change in her confidence -- and she has been one of the few observers predicting success.
Readers may remember that I was exactly correct in my predictions of an eleventh-hour deal on the debt limit. I am not seeing the same reads from leadership on this measure. There are indications from both sides that they might be willing to accept the sequester of funds that will occur in the absence of a decision.
The consequences of inaction should not -- at least in theory -- have a negative effect on deficit projections or the US credit rating. The sequestrations and the expiration of the Bush-era tax cuts are enough to meet these tests, as Josh Brown notes in his summary.
The public perception is another matter. The debt ceiling debate was concluded with no substantive impact, but it still was a disaster for public confidence. Leaders of both parties -- and the President -- seem not to have learned this lesson.
There may be some investment ideas here somewhere....but mostly we deserve a break from the data.
- You pay more taxes than GE, although their 57,000 page return is longer.
- Pizza is a vegetable.
- Want to beat the S&P 500? Buy stocks in an index following Michigan man Tom Brady's wife.
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. None confirm the ECRI forecast of an inevitable and imminent recession. I hope to have the final verdict this week.
- The St. Louis Financial 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 moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. 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 still under review. I note that the Cleveland Fed has a Financial Stess Index using a strong approach that differs from the St. Louis Fed's.
Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions. We voted "Neutral" 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
There is little data on tap in this holiday-shortened week. Initial jobless claims will be reported on Wednesday as will personal income and spending.
The FOMC minutes release on Tuesday will provide a little color, but we already know the key story. There will also be updates on GDP and consumer sentiment.
The real story will continue to be Europe and especially the bond rates for Italy and Greece. There is also the chance of a "surprise" downgrade of debt ratings.
One effect of High Frequency Trading is the reduction in standing orders in futures contracts. This means that a move (in either direction) may have greater amplitude than might have occurred a few years ago.
The most important news from Europe will come from the ECB. While everyone waits for action from them, their new President, Mario Draghi, is calling for further action by European governments.
To summarize -- nearly anything can happen in thin, holiday week trading with ECB and Supercommittee news expected.
Trading Time Frame
Our trading accounts were fully invested last week, but with no exposure to US equities. We were invested in oil, REITs, and gold. 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. A month or so 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 continue to use volatility to establish new positions.
Our Dynamic Asset Allocation model is also very conservative, with holdings in bonds and gold.
To summarize, we have a very conservative posture in most of our programs, recognizing the uncertainty and volatility.
Thoughts on Europe
I continue to see the European situation as a work in progress including the following issues:
- Economic growth
- Interest rates
- Cooperation and political will
A final solution will not be wrapped up in a package with a bow on it. There has been progress on four of the five points, with interest rates being the biggest problem. Anyone who wants to chart progress objectively should be watching all of these factors.
Joe Weisenthal explains why the ECB is needed and shows that they have the legal authority to act.
Elliott Morss questions whether bailout recipients can meet the IMF/ECB tests, providing a long list of specific regulations to make his point. He maintains that the ECB cannot and will not be a complete answer.
The Final Word
For long-term investors in US stocks, the first question to ask about Europe is the level of systemic risk. I like the SLFSI for this purpose, but let us also check some other authorities. Prof. James Hamilton looks at various indicators of risk in the US and abroad. In a careful and thoughtful article he nervously concludes that the situation is under control so far.
Scott Grannis takes a careful look at the disparity between the low level of systemic risk shown in credit markets and the extreme fear in US markets. Read the entire article for full analysis and great charts.
I'm not sure I have a good explanation for these disconnects. Spreads in the U.S. are priced to a modest level of concern, while spreads in Europe are priced to an extremely high level of concern. Treasury yields and PE ratios, in contrast, are priced to the gloomiest of outlooks. But however you look at it, there appears to be no shortage of pessimism in today's market pricing. In fact, optimism is very difficult, if not impossible, to find. AAPL, for example, has a forward-looking PE ratio of only 10.9 according to Bloomberg, which means the market is extremely skeptical of analyst's earnings projections. AAPL's current PE of 13.6 is only slightly higher than the S&P 500's 12.8, and this for a company that has grown earnings at a spectacular rate for years.
So I come back to the theme that has been dominant for the past three years: markets are very, if not extremely, pessimistic, and valuations are therefore very attractive if one believes that the U.S. and global economies are not going down the toilet. Even holding only a modestly positive outlook for the future makes one extremely optimistic relative to the outlook embedded in market pricing. By the same logic, being bearish today (i.e., hiding out in cash that pays nothing) is a very expensive proposition, and is likely to pay off only if the U.S. and global economy really get bad.
There is also the chance that a European solution may be achieved, despite the intense skepticism.
Was the Rally Just a Melt Up? by Pretzel Logic
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.