January 8th, 2012
by Jeff Miller
The theme has been the same for many weeks: Reasonable US data, bad news from Europe.
We start each trading day looking at the latest headline and how the Euro is trading. While the US economy has shown improvement, the European story is a huge overhang. This is mostly because no one knows how to quantify the possible impacts. The story plays in three different ways:
- Systemic risk;
- A second-order recession effect;
- A direct effect on corporate earnings.
Follow up:For most of last week, the answer was "no," but Friday's trading was a bit different. The CNBC subtitle kept running as "Dow lower after employment report." This is true, but very uninformative. If all we knew about Friday was that the Euro was trading lower, dollar higher, and Italian ten-year yields were over 7%, where would we expect the US market to be trading? The tone was a little better.
Another indication of the tone change was the nature of the commentary. Even the most bearish of pundits shifted from saying that the economic data is terrible, to saying that it is not good enough. I think we can all agree with that.
Can we have more, please?
Felix remains bullish for the near-term. While I have been more skeptical I am gradually coming around.
Can we really make headway in a week dominated by Fedspeak?
I'll explain further in the conclusion, but first, a review of last week's news.
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 US economic data was pretty solid, continuing the mult-month pattern of modest economic growth.
As I noted in last week's preview, this was a week to focus on jobs.
- The employment report was solid. The net job gain of 200K is good, but not yet what we need. The unemployment rate of 8.5% shows continuing improvement. Hours worked increased by 0.1 of an hour. This may seem small, but it is equal to 35oK to 400K jobs. The hourly wage was higher. Gains were spread across many sectors. The only real reason to complain was to ask for "more please."
- The ISM report was very good at 53.9. This corresponds to an annualized GDP growth rate of 4%. The internals of the report were even stronger, since the weaknesses were in prices paid and the strength in employment and new orders.
- Initial jobless claims of 372K were better than expected and continued the trend lower. This was outside the sample period for the employment report, so it constitutes fresh data.
The negative news was less significant, with more emphasis on the future.
- The ISM services report was a little lower than expectations, but still expanding.
- There are continuing questions about seasonality in employment data. This chart from Doug Short (based on the initial claims series) shows the extreme nature of employment seasonality.
It is obvious that seasonal adjustment is necessary, but what is the best method. The question this December relates to the number of people hired as couriers, thought to be larger because of online purchases. Is this really greater than the regular seasonal adjustment? Is there an offsetting loss of retail clerks? We'll know more next month.
- Investor sentiment (measured by the AAII) is at the highest level since February. Check out The Bespoke Investment Group for their interpretation of this helpful chart:
- Labor force participation still lags. Regular readers know that I regard the Y2K era as a high that will never be reached again -- lots of demand pulled forward for replacement computers and COBOL programmers dragged out of retirement. I also believe that demographics mean earlier retirement for many. Even with this in mind, the employment to population ratio would be higher in a really healthy economy. Here is the picture from Doug Short.
Falling corporate earnings estimates have not yet reached our normal standards of ugliness, but it is a trend worth watching. The story is getting a lot of play.
Brian Gilmartin, tracking this at Wall Street All-Stars, writes as follows:
We’ve written about this before but i continue to be puzzled by the degree of “p/e compression” occurring in today’s market. Although we start to hear q4 ’11 results next week with Alcoa, the fact is S&P 500 earnings rose 14% – 15% in 2011, and yet the index finished flat on the year. Mathematically, if the denominator rises 15%, and your numerator remains flat, you get p/e compression, which is the same thing that happened in 2010. (Earnings up 30%, S&P 500 up 15%, etc.)
Dr. Ed Yardeni has a nice chart illustrating this story.
This is a key story, which reflects the high level of skepticism about the sustainability of current earnings. I think this will be resolved to the upside, but I expected the same thing last year. Instead, we got another year of extreme macro worries and recession predictions.
I have not said much about the 2012 election, mostly because the investment implications are not very clear. As the field narrows, the issues may become sharper. My team has been working on a generic Republican policy to compare to Obama's. As an indication of this type of analysis can be helpful, I suggest you take a look at this example:
And for an early start on your own voting, here is a test that is both educational and fun. You get to decide the importance of a number of key issues, figure out your own policy position, and then learn which candidate best matches your own views. The shadowy candidates rise in the background as you make each choice. You may be surprised at what you learn.....
For now I am going to monitor developments in Europe in a separate section. My general approach, which is based upon my experience in the messy process of policymaking in democracies, is that the eventual solution will include a combination of many programs and participants, some of which we do not yet know. I have been doing a separate series of articles on this theme. So far I have the following:
How Investors Should Think about Europe -- an overview with a general conclusion.
How to Predict Policy Decisions -- Focusing on Europe -- comments on the players and motives.
The single best market measure is the Italian 10-year bond. That was bad news, since the ending yield was over 7%, a level widely thought to signal trouble. UniCredit, the largest Italian bank conducted a rights offering to raise additional capital from current investors. Despite the steep discount (65% or so) the participation was lower than hoped. The stock cratered all week, raising concerns for other banks needing capital.
Despite this news, there were a number of auctions during the week, most importantly that of the EFSF. The story's next big turn will be the report of Monday's meeting between Merkel and Sarkozy. The market expectations for results of meetings is now pretty low. For a change, perhaps no one is expecting a magical solution.
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
- Economic/Recession Indicators. This week marks the introduction of two new measures for our table. The C-Score is a weekly interpretation of the only indicator I found that met the stringent tests outlined when I started the search. I will explain more about the search and the decision, but it is going to take a four-article series. I'll have the first installment this week. The Super Index does not itself meet all of these tests, but some of the nine members do. You can read more about it in this article. It reflects extensive research and testing, and is well worth monitoring. (The Super Index includes the ECRI approach).
- 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 will be a lot of news this week. As usual, I am highlighting the events that I see as most important.
- We start the week with a report of the Merkel/Sarkozy meeting. There will be additional commentary, auctions, downgrades by credit agencies, and assorted newspaper "scoops."
- The Fed will release the Beige Book, showing the anecdotal information that the FOMC will use at the next meeting. Since we are outside the Fed quiet period, there will be speeches nearly every day.
- The most important economic data comes on Thursday (retail sales and initial claims) and Friday (trade data and Michigan sentiment).
- Earnings season starts, with Alcoa on Monday and JP Morgan 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 been 100% invested for several weeks. Felix caught the recent rally quite well and still has several strong sectors in the buy range. While the overall ratings are not strong, it remains a marginally bullish forecast. 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. In early October 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 am watching the decline in risk with great interest.
Our Dynamic Asset Allocation model is also very conservative, featuring bonds and other defensive holdings.
To summarize, we have a very conservative posture in most of our programs, recognizing the uncertainty and volatility. For new accounts we are establishing partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program. This program has been meeting the objectives of conservative, yield-oriented investors. It follows our key precept:
Take what the market is giving you.
The Final Word
The market does not move in line with calendar years. Many of the best themes may require a little more evidence for most to be convinced. It is fine to be cautious, but we should still monitor the actual data. Avoid emotion when doing your own year-end tune up (email main at newarc dot com for a free report on how we do it and some other investing ideas).
You can also get a lot of good advice by checking out the forecasts from The Bespoke Investment Group Roundtable, which I described last week.
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.