December 11th, 2011
by Jeff Miller, A Dash of Insight
Now that the political leaders in Europe have acted, we are all left to wonder whether anything has changed.
You can still weigh in on which TV Series most resembles the European soap opera!
I will offer some suggestions in the conclusion. First, let's take a look at the data and news from last week. Click on picture for larger image of Europe held together with bandaids.
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
Last week was a bit light on data, and it was also a little soft. This was in contrast to the heavy-duty reports from the week before, which were all solid. It has not mattered for many weeks, with Europe-related headlines dominating over anything else. Eventually the news and data will matter. This week, as usual, we had mixed signals.
The economic story was mixed, but there is no indication of a current recession.
- Europe moves closer to the required policy changes. I have encouraged readers to evaluate incremental progress rather than looking for a single bold solution. This continues to be the story. The concessions in national sovereignty related to budget control constitute significant progress.
- Initial jobless claims fell to 381K, offsetting last week's +400K result. The seasonal adjustments can be difficult at this time of year, so everyone watches the four-week moving average, which is also improving.
- Consumer sentiment is recovering. It is difficult to measure job creation, but sentiment helps. The Michigan survey is strong, partly because it includes a continuing panel that changes over time. The effect of the debt ceiling pseudo-crisis and gas prices have influenced sentiment, but it is still relevant. Current levels remain poor, but the rebound is encouraging. I especially like Doug Short's chart shows sentiment changes and recessions.
- Income tax receipts are booming. Scott Grannis reports with good analysis (worth reading) and a nice chart.
- Rail traffic -- however measured -- was higher. (Calculated Risk).
The negative news reflects diverse fronts.
- Forward earning estimates have stalled. My WSAS colleague Brian Gilmartin has been all over this story for months. Regular readers know that I think forward earnings provide a good valuation metric. I accept the bad with the good, so a stall in earnings growth is bad news. Brian does a great job of laying out the issues -- profit margins, PE multiples, and what is at stake.
- ISM Services was a bit light. The US increasingly has a service economy, so this matters. Steven Hansen has a somewhat contrary take. Steven has an effective and eccentric viewpoint on data, often finding angles that others miss. His analysis is worthy of respect.
- The ECRI reaffirms the recession call. About two months ago the ECRI stated that we were "tipping into recession" but no time frame was provided. The ECRI has now (finally) provided a time frame for the prediction -- the middle of 2012. The loud confirmation of their position is bad news (market unfriendly) for this week, but I regard it as questionable. At least we now have a time frame for their 100% forecast. My sources have a 25% or lower estimate for the same time period. I am working on a comprehensive analysis.
Instead of giving another "Ugly" award to politicians, this week I want to emphasize some real winners. Here at "A Dash" I try to recognize strong data analysis and to expose hype. This week there were three excellent stories that used sophisticated data analysis to debunk stories that got widespread attention. We can only wish that as many people will read these great analytical articles as those who read the initial hype.
- Barry Ritholtz exposes the Black Friday surveys. While the final Black Friday numbers were strong, the original data from surveys was overstated. This is an annual pattern from the survey which Barry has identified and highlighted. See the full story here.
- Bonddad corrects the WSJ and Mish on interpreting temporary employment. This is an absolutely first-rate article, which I urge everyone to read. It illustrates the problems in using year-over-year changes and trying to make sharp interpretations of monthly moves. It is a testament to the difficulty of correcting superficial analysis, no matter how well-intended it might be.
- Prof. James Hamilton exposes the "secret Fed loan" myth. The story about the secret Fed loans of $7.77 trillion suited politicians, Fed bashers, and perma-bears. That trifecta sent the story into Internet overdrive with hundreds of links and a gazillion readers. It is completely deceptive, including a questionable citation of Bloomberg.
I'll get back to the "ugly" next week. It is much easier to find!
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. These are sources that have a similar track record, greater transparency, but less PR. I realize that I am (long) overdue for making the choice for a new indicator. It has been a careful research process, and I expect the explanation to require multiple articles. Meanwhile, if something really bad were taking place, I would make it clear in the weekly updates. I see the recession odds over the next nine months as being less than 25%.
- 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. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.
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 "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
There are a number of economic reports this week, but I do not expect many surprises. Thursday's initial claims add another data point in an important series.
The inflation data (wholesale and retail) are unlikely to surprise. Similarly, the Empire State Index is minor. Thursday's capacity utilization will be significant when we reach capacity and see inflationary pressures.
Tuesday's retail sales data will be important. The FOMC decision itself is not important, but the accompanying statement will be carefully parsed for any hint of a change in policy. The market (incorrectly) sees weakness and craves more aggressive Fed policy. The Fed disagrees, so I expect nothing.
In the aftermath of the FOMC announcement the Fed members are free to speak, so we will start hearing from them. Draghi is also on tap on Friday.
As usual, Mark Gongloff has the comprehensive data/earnings/speechifying calendar which we should all put on the bulletin board.
Trading Time Frame
Our trading accounts have not had any US equity exposure for several weeks. Felix has relegated everything to the penalty box. This suggests that a vote of "abstain" is more accurate, but the general picture is quite postive. I expect new trading positions this week. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated.
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. Six 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. For investors desiring this risk management approach we raised cash when the trigger hit the range. We have also been cautious with new accounts. We still do not have an "all clear" signal, but I expect the SLFSI to decline next week. I am doing some buying, especially in energy.
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. This week marks a more positive outlook.
A European Update
The story continues to play out as expected. Traders and market pundits want an instant and comprehensive solution. They think that government leaders are craven, stupid, or both. Economists write about ideal solutions and the ignorance of leaders.
It is pretty easy for the punditry to criticize, since none of them have ever had the actual responsibility of leadership. While it is not happening fast enough to suit traders, the leaders of European countries have been nudging their constituents toward a solution.
With the political commitment resolved, I expect more pieces to fall into place, including a leveraged EFSF and participation from China, the IMF, and sovereign wealth funds.
Investors who have played the volatility in line with my recommendations should be doing well. The strategy of buying fear and selling calls is winning on both ends.
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.