February 12th, 2012
by Jeff Miller
I am going to take a little risk with my recent hot streak on the WTWA series. I am not highlighting Greece as the key story.
It would be easy to say that we will be focused on Greece, since that is the issue as I write this on Saturday night. There will probably be some sort of resolution by mid-week. Whatever it is, most will not be convinced.
The market seems to have digested the European story: No immediate threat of systemic risk, less risk for Italy and Spain, attention shifting to European recession/growth and impact on world markets. Regular readers know that this is what I have been predicting for nearly a year -- the incremental solution.
Follow up:This week I expect a lot of commentary about the state of the market after Q4 earnings reports and the strong results from January. Those who predicted a down year or an increase of 8% for 2012 should now be advising caution, but they will instead be reconsidering their forecasts. Things are getting better.
Even Barron's is featuring a cover story on Dow 15,000. Here is their own synopsis:
Even by conservative measures, the Dow Jones Industrials could top 15,000 in two years. Dow 17,000 is a 50-50 bet.
(Like my readers, I appreciate free content. You can get this article on a free preview by pasting the author and title into Google. I pay reasonable prices for good journalism, currently including the FT, the WSJ, and Barron's. I'll try to highlight the best, and let you do the rest.)
After a year of improving facts and a stagnant market, we will see more stories on this theme. I'll look into this more deeply in the conclusion, but first let's do our regular review of last week's economic data and 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
Last week had mixed economic news and disappointment from Europe. The market held up surprisingly well.
There was some very good news this week.
- Initial jobless claims. This is important data, more current than most. The decrease in initial claims encourages us that the employment picture continues to improve. There is a lot of weekly noise, but the widely-followed four-week moving average is also very good.
- An imminent recession is less likely. There is some great work on this subject, mostly refuting Hussman and the ECRI. A group of analysts has reverse-engineered some of these indicators and actually improved the predictive quality. Here are the leading examples:
Doug Short features the PowerStocks analysis of the ECRI data.
The Bonddad Blog refutes Hussman. Once again, a careful analyst shows the flaws in some research that never had peer review. This is technical, but important for those who care about recession forecasting.
Dwaine van Vuuren wisely asks: How Much Recession Warning is Useful? Read the full article for great charts and data. Dwaine's focus is on economic forecasting and stock market reaction. It does not pay to be too early, and possibly quite wrong.
Dwaine teams up with Georg Vrba to outdo the ECRI in using their WLI. Their results are better and also not so negative right now.
- There is more borrowing. (I realize that this is a negative for those emphasizing ideology, but our working definition of good news is "market-friendly.") Here is the chart from Scott Grannis:
There was some bad economic news last week.
- Earnings growth seems to have stalled. Brian Gilmartin does a great job of tracking forward earnings reports. He also previews and reviews earnings for many important companies at the new Wall Street All Stars Site. I read his work every day, both for ideas and to interpret the earnings news. Here is his key quote:
...(T)he latest “forward 4-quarter” estimate for the S&P 500 is $105.88, still below the peak of $107 hit in July, 11, October ’11 and then again in January ’12, so corporate earnings ahve clearly flattened out, as the year-over-year growth rate has slowed to 7.5% or so for the key benchmark.
- Consumer confidence (University of Michigan style) disappointed again. I regard this series as an important indicator of both jobs and consumer spending. The chart from Doug Short makes the problem clear.
- Tax withholding and gasoline purchases continue to decline. The Bonddad blog (upbeat on other indicators) covers all elements of the story.
Even if we get a satisfactory ending, the violent protests in Greece highlight the intensity of feeling. The New Athenian calls it a Political Meltdown. The outcome of tomorrow's vote on austerity measures is in some doubt, as it the reaction of the troika to the latest plan revision, due at mid-week.
The Silver Bullet
I have occasionally recognized leadership in data analysis. We need more of it, and more recognition of those who do it. When you embark on such a story, you are like the Lone Ranger. In the spirit of encouraging this type of work I hope to mention a "silver bullet" story as often as possible. I invite readers to send suggestions.
There is a continuing complex story on the interpretation of last week's employment data. Serial spinning by those determined to find something negative in the results has now turned to the topic of seasonal adjustments. Menzie Chinn at Econbrowser takes a careful look at the reasons for seasonal adjustment and the various possible approaches. He demonstrates that the BLS has a reasonable method, consistent with other possibilities. If you really want to understand this issue, read the article. If you are not willing to do a little work, than you ought not to pontificiate (TM OldProf euphemism for what more colorful bloggers mysteriously refer to as STFU). Dr. Chinn has a few nominations on this front!
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
- The St. Louis Financial Stress Index.
- The key measures from our "Felix" ETF model.
- An updated analysis of recession probability.
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.
This week continues two new measures for our table. The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain the link to the C-Score next week. The second is the Super Index. You can read more about it in this article, which is merely an introduction, and also my WTWA from two weeks ago. It reflects extensive research and testing, and is well worth monitoring. (The Super Index includes the ECRI approach). I am going to do a complete review of the work very soon. Meanwhile, I think it is important enough to watch every week.
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
This week has a lot of economic news on the calendar, but few of the reports are on my "A List."
Most important is the initial claims report on Thursday. Everyone cares about employment. This series is improving and will count in next month's employment situation report. Tuesday's retail sales data could also be important, and we might get something interesting from industrial production and capacity utilization on Wednesday.
If inflation were an issue, the PPI and CPI would bear watching (Thursday and Friday). I'm not expecting anything here.
There are many other scheduled reports. There is not much market reaction to the regional Fed surveys or the small business survey.
We will also get the FOMC minutes, but after the highest transparency session in history (long-term forecasts plus a press conference), followed by Congressional testimony, I doubt that we are going to learn anything new.
I monitor news and economic data every day in my diary at Wall Street All Stars (subscription required, but I have a few free trials left to offer).
Trading Time Frame
Our trading accounts have been 100% invested for many weeks. Felix caught the current rally quite well, buying in on December 19th. There are now many solid sectors in the buy range. The overall ratings have improved, helping us to stay invested while many have been in denial for the entire rally. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated. Felix has been more confident than I have been on the trading time frame. This illustrates the importance of watching objective indicators instead of headlines.
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," and is declining further. This sort of decline has been a good time to buy stocks on past occasions. Worry is still high, but has now delinced to a more comfortable level.
Even though stock prices are higher than in October, the risks are much lower. I am increasing position size for risk-adjusted accounts. (We cut back by about 30%). I am also looking more aggressively for positions in new accounts.
Our Dynamic Asset Allocation model is still very conservative, but starting to become more aggressive. For several weeks I have joked that it is rather like the Nouriel Roubini of our methods. Dr. Roubini is now becoming more bullish. There is nothing wrong with this! There are many successful market strategies. The risk/reward balance is a personal matter.
To summarize, we have become less conservative in all of our programs, There is still risk, but as our indicators become more positive, we can and should become more aggressive. For new accounts we are establishing immediate partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program. This program continues to work very well, meeting the objectives of conservative, yield-oriented investors. It follows our key precept:
Take what the market is giving you.
Right now that continues to be dividend stocks at reasonable prices with the chance to sell call options at inflated prices. If the stocks do nothing, you can still get almost 10% per year from dividends and call premiums.
This does not work for those selling long-dated calls. It requires some active management, selling calls with a month or two before expiration to capture the most rapid time decay.
The Final Word
What about the prospects for Dow 15,000?
In early 2010 I suggested that investors needed to consider the "upside risk" of being left behind instead of buidling their retirement portfolios. At a time when many were warning of Dow 5000, I predicted that the DJIA would double to 20K rather than fall to 5000. I got quite a few skeptics in the comments, since many seem to have lost confidence in the basic strength of the US economy and the free enterprise system.
Since I wrote that in May of 2010, we have gained 28% in 626 days -- despite no progress in calendar 2011. This pace would result in Dow 17K by the end of 2013 (which is rated as a 50-50 chance in the Barron's article) and Dow 20K in early 2015. Astute active managers who regularly beat the market averages can expect more.
To understand the progress you need to think of market averages in terms of underlying data instead of headlines. Here are two good approaches.
Ed Yardeni shares Brian Gilmartin's concern about the leveling of forward earnings and the P/E multiple. Take a look at his helpful chart on this subject:
Notice the frequency of trading at the P/E 14 level. A return to P/E 14 would mean an increase of more than 17% in stocks, even without a change in earnings. The low market multiples reflect intense skepticism about whether earnings will be delivered. This changes as evidence accrues.
Jim Paulsen, Chief Investment Strategist at Wells Capital Mangement, explains this effectively, calling the recent rebound an undwinding of this skepticism. Watch the full interview for a complete analysis and some good ideas.
He makes a powerful argument that should be considered by those who (like most of us) still need to create wealth.
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.