March 19th, 2012
by Jeff Miller
If you are looking for safety, you are not alone. Many people who lost money in stocks and real estate have become more risk averse. The problem?
They are looking for safety in all the wrong places!
Owners of (formerly AAA-rated) US debt experienced this last week. If you own a ten-year Treasury note, you lost 2.5% in market value as the yield increased 30 basis points in a few days. What if the yield moves to 3%, a level that is still quite low by historical standards? That would cost another 6%, or more than 8.5% in total. You will still get your investment back if you hold until maturity, but I suspect that many seeking safety might need access to these funds in the interim. (Check here to learn about bond pricing and use a free online calculator).
The same is true for bond funds, where the long bull market has created the impression that values can move only one way.
Gold investors also took it on the chin last week, losing 3.3%. Gold is attractive to two distinctly different camps: those expecting rampant inflation and those predicting a gloomy deflationary spiral with desperate consequences. Sometimes the sellers of gold (and fear) offer both propositions -- either in the alternative or simultaneously. Two years ago I described these as the "golden goal posts."
Right now the prospects for either alternative have been reduced, making gold less attractive. Since there is no fundamental method for valuing gold, the presence of these fears makes the difference. Right now the fear trade is not working, since the ball is going through the uprights.
I'll offer some suggestions about the search for safety in the conclusion. First, let's do our regular review of last week's news and economic data.
Background on "Weighing the Week Ahead"
There are many good sources for a comprehensive weekly review. I single out what will be most important in the coming week. My theme is an expert guess about 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
Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:
- The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
- It is better than expectations.
The news was mostly good last week.
- Global earnings estimates are moving higher (via the FT). Eventually, this is the most important data point for investors.
- Wall Street strategists are bearish. Bespoke has their expected great chart and this explanation:
If strategists as a whole were particularly prescient, this would be a bearish sign, but fortunately that's not the case. The peak recommended stock weighting came just after the peak of the Internet bubble in early 2001, while the lowest recommended weighting came just after the lows of the financial crisis.
- Tame inflation data. As measured by the government, inflation is under control. The Fed seeks 2% inflation as a target consistent with its dual mandate of price stability and full employment. The current policy is designed to increase inflation expectations to that level to avoid what economists call a "liquidity trap." While many disagree with the economic theory and the policy, investors should accept the reality. Doug Short provides this fine chart of long-term inflation, as well as a discussion of some of the alternative viewpoints.
- Initial jobless claims returned to the 350K range, the lowest since 2008. Calculated Risk has a helpful chart.
There was also some bad news last week.
- Budget deficits. The Obama budget has higher near-term deficits according to the CBO. This is a complex subject, since there is a trade-off of near-term deficits versus long-term savings. There are also assumptions about whether or not the Bush-era tax cuts are extended. Finally, we have ongoing debates about the debt limit compromise and whether one side or the other will look for a way to weasel out. Stay tuned!
- Consumer sentiment (via the University of Michigan) is weaker. This was lower and missed expectations. I place a lot of emphasis on this series because of the excellent methodology, not because it is my school. This series usually informs us about employment, but currently includes political effects as well as high gas prices. Despite the issues, I regard this as important information and a cause for concern until it gets back to normal levels.
- Industrial production was flat, missing expectations. There was only a small market reaction, but this is one of the factors followed by the NBER in dating recessions. Steven Hansen has a more positive take, focusing on manufacturing and de-emphasizing utilities. Here is the key chart.
- More estimates on the impact of the Iran situation on the price of gas. This is worse than I have been citing, possibly as much as $6/gallon.
- We are at a "Bradley turning point." Ordinarily I would not even mention this, but it is the latest cause celebre of the bearish punditry. Two of my favorite sources, Charles Kirk in his commentary, and my astute colleague at Wall Street All Stars, Bob Marcin, have mentioned this method. Neither endorses this approach, based upon the alignment of the stars, but both cite recent accuracy. As Charles notes in his members only commentary, if Friday turns out to be a market top, everyone on trading desks will be talking about this. [If it is not, there will soon be a new candidate. Time for another article along the lines of the Hindenburg Omen.]
- Federal tax receipts are soft. Here is Dr. Ed's chart:
Campaign advertising! With the Illinois primary coming up on Tuesday, voter attention has turned from our last Governor (finally) starting his prison stretch with one more press conference, to the avalanche of attack ads interrupting the basketball.
There is a simple reason that political campaigns use these ads: They work! While voters claim to be high-minded, in fact these deceptive ads swing many opinions.
For an investment angle, you might compare this with advertising about Gold, a staple of certain talk shows, investment TV and radio, and commanding multiple-page spreads in the newspaper.
If so many people think they can get great investment ideas from ads on talk radio, what can we expect for their voting decisions?
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 more about the C-Score soon. (I know that I am behind schedule on this. The message remains comforting.)
The second is the SuperIndex from PowerStocks research. I am a big fan of Dwaine van Vuuren, whose excellent statistical work is giving us better insight into a wide range of recession forecasting methods. The data point that I cite each week (the four-month recession outlook) is only one aspect of a comprehensive report. The SuperIndex includes nine different methods, including the ECRI. The analysis has a very strong, practical market application which has paid off richly for subscribers over the last few months. How? Mostly by putting the ECRI recession forecast into better perspective.
Spend a few minutes at their site and you will see the following:
- A description of the SuperIndex components and methods.
- A collection of research reports, including how to improve the ECRI method, using the Conference Board's LEI, and deciding how much recession warning you need.
- A sample report. This shows the richness of the weekly information, including differing time frames for recession warnings as well as an updated GDP forecast.
This is all driven by the most recent data from all of the indicators.
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. This week we are continuing our neutral vote, a position started last week, for the first time since December.
[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. For daily ETF commentary from Felix, you can sign up for Wall Street All-Stars, where I still have a few discounted memberships available. You can also write personally to me with questions or comments, and I'll do my best to answer.]
A Note on the Recession Outlook
We should note that the ECRI is still pounding the table on their recession forecast. Even if this eventually proves to be correct, the timing was terrible for investors who took heed right away, missing a 25% gain. I have been highlighting sources with better recession forecasts, including those that have better timing using the ECRI's own data.
My weekly review describes my conclusions. It is not a place where I develop an argument, so let us save that for later. Meanwhile, please read New Deal Democrat at The Bonddad Blog for a good analysis (calling BS) of the key issues. The ECRI has not responded to the many critics, and they get very polite questioning in interviews. It is past time for some real explaining.
The Week Ahead
This is not a big week for economic data other than housing. I covered my thoughts about housing a month ago, and nothing has changed. It is interesting that Calculated Risk thinks we might have a bottom. This week's Barron's had the housing rebound story on the cover.
There are a raft of housing releases. My focus will be building permits on Tuesday (a leading indicator) and new home sales on Friday.
Initial claims on Thursday is the most important weekly data series. We also get the latest version of the Conference Board's leading indicators, which are expected to remain positive.
Fed Chair Bernanke gives a couple of college lectures. Everyone will be watching for any policy hints, but don't hold your breath on that one.
There are some other Fed speeches.
To summarize, this is a week with little data, except for housing where nothing is likely to turn sentiment. It is a week as quiet as they come, and right after options expiration. Volatility has moved lower.
Trading Time Frame
Our trading accounts have been 100% invested since December. Felix caught the current rally quite well, buying in on December 19th. There are now only a few sectors in the buy range. The overall ratings have deteriorated. 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, and has stayed invested in the face of a lot of skepticism. This illustrates the importance of watching objective indicators instead of headlines. Despite the weakening overall ratings, Felix kept us fully invested for trading accounts last week.
We have 28 sectors in the universe, so we can be fully invested if there are three strong sectors, even if the market overall is neutral or negative.
Investor Time Frame
Long-term investors should be aware of the rapid decline in 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 declined 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 has become much less conservative. Gone are positions in bonds and gold. DAA responds to the message of the market, cashing in on extended moves. It is rather like what some call a "lazy portfolio" but better.
The Final Word on Safety
The most important question for any investor is the first one I ask of a prospective client: Do you need to preserve wealth or to create wealth?
Left to their own devices, many people mistakenly go "all in" or "all out" instead of thinking about the right answer.
Once deciding on a level of safety, it is time to consider the risks, including those often ignored:
- Gradual inflation, of 3-4%. This will cut your purchasing power in half in twenty years. Owning stocks that reflect price increases can help.
- Weaker dollar. This can also hurt your purchasing power, but can be offset by owning foreign stocks or US stocks with significant foreign exposure.
- Rising energy prices. If you own some energy stocks, you can actually benefit from this trend.
There are other examples, but my point is to open minds to a reasonable level of stock ownership. This can be done through a very conservative plan of dividend stocks with enhanced yield or a more aggressive apporach. The key is matching your personal needs to a plan.
The traditional concepts of safety are fine for those who are preserving wealth. For the rest, this is an illusion.
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.