March 25th, 2012
by Jeff Miller
Last week featured more than the usual quota of Dueling Experts.
Goldman Sachs grabbed headlines with a long report proclaiming this to be a "generational opportunity" to buy stocks. Here is a good summary from Joe Weisenthal. Several other top strategists are pretty bearish and sticking to their calls.
Market Watch rounded up the usual suspects to explain why the markets will soon crash and what you should do about it.
By the end of the week the discussion had moved to the topic of Chinese economic growth. The pundit parade featured people who have recently been employed as experts on why European leaders were failing at their jobs. They have now moved seamlessly onto the topic of China, talking about hard landings, mal-investment, and what the leaders of the world's largest country should be doing.
At least they can probably find China on a map!
Investors should protect themselves with knowledge. This includes knowing about sources. With so many advising you to go "all-in" or "all-out" it is wise to check the record. I offered some suggestions in this article about experts and market timing.
The same argument applies to China. Investors are consumers of information. Being a good consumer involves doing the homework of checking your sources. The big concern this week was a declining Chinese PMI. Most people discussing this could not write three sentences on the topic, but they certainly have opinions. I would just love for some interviewer to ask an "expert" what the difference was between the flash PMI and the official version. Or what the components are. Or who is surveyed. Or how it compares to the US equivalents (which most people also do not understand).
I'll offer some suggestions about the search for good information about China 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.
- Economic prospects look better to CEOs in a global survey by McKinsey. Instead of government data, this is based upon executives with information about their own companies. The conclusions are reached in spite of lingering Eurozone concern and higher oil prices.
- Building permits increased by over 5%. This is the best leading indicator for housing. For a more comprehensive look at all of the housing data, check out John Lounsbury and Steven Hansen at Global Economic Intersection. Their year-over-year analysis removes some of the issues with seasonality, and they have many great charts. The Bonddad Blog is also positive on the housing data.
- Bank lending is increasing nicely. Scott Grannis reports on several indicators -- all hard data -- that suggest improvement for the economy and the markets. Here is a sample chart -- one of several:
- Congress bans insider trading --- by members of Congress! Better late than never, I guess. The Senate vote was 96-3. Hmm....
- Initial jobless claims edged lower again to 348K.
- The Conference Board's leading economic indicators beat expectations and continue to look strong. See Doug Short's analysis for multiple charts and background on how to interpret the data. Here is a sample:
There was also some bad news last week, mostly from abroad.
- The HARPEX index shows a weakening global economy. See the interesting analysis of this relatively new index by Prieur du Plessis, including a helpful comparison to the Baltic Dry Index.
- Real estate shadow inventory is still high, via GEI.
- Rail traffic is still weak, via GEI.
- European sovereign debt rates edged higher. The Italian 10-year, for example, moved back above a 5% yield. While much lower than a few months ago, that is the highest rate in about three weeks. I am also watching Spanish bonds.
- European and Chinese PMI's moved below 50, indicative of economic contraction. This was probably the most worrisome event of the week.
- Gasoline prices continued the upward march. War game results show the likely results of a conflict with Iran. The oil market reacts in a jittery fashion to each rumor. The Saudi's are trying to provide more oil, but Russia would like to see higher prices. There is no easy and imminent solution here.
MF Global and customers' money. It now appears that Jon Corzine did authorize transfers of customer funds. There will be close scrutiny of his sworn testimony before Congress. This sort of news further reduces investor confidence in financial institutions.
The Silver Bullet
The silver bullet is given only occasionally when someone is willing to act like the Lone Ranger, pointing out errors that have been widely embraced. Nominations are always welcome.
This week's award goes to New Deal Democrat at The Bonddad Blog and Invictus writing at The Big Picture. The latest employment report error comes via Art Cashin quoting The King Report. Cashin is a favorite source of ours, mostly because he accurately conveys what people on the NYSE floor are thinking. At the moment they are reaching to find economic data that does not support a recovery. In this case, they looked at job changes, not seasonally adjusted, for the first two months of the year and cited job losses of 1.8 million. The fact that this is below normal for that time period means nothing when you are on a mission. Here is how NDD puts it:
"On a YoY basis, the last 12 months have seen the 3rd best job growth in the last 12 years.
There is not a shred of credibility in the claim made by the King Report, the original Cashin claim, or the revised Cashin claim. Rather than repeating the claims at other business sites, it's time to throw out the garbage."
Both articles are worth reading in full to get a real understanding of the data.
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.
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 SuperIndex from PowerStocks research is adjusting what information to make publicly available and in what time frame. 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.
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 two weeks ago, 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.]
The Week Ahead
There are more housing reports this week, including pending home sales and Case-Shiller prices on Monday and Tuesday.
Durable Goods (Wed), Initial Claims (Thurs), and Personal Income and Spending (Fri) are all key reports.
Conference Board consumer sentiment (Tues) and Michigan sentiment (Fri) have continuing importance.
Fed Chair Bernanke has a number of speeches, including more college lectures. These are unlikely occasions for any new hints on policy.
The final GDP revision and various regional Fed surveys are unlikely to be market-moving.
There are many scheduled reports this week, but most are minor. We are also a little ahead of the new earnings season. This absence of information may permit even more attention to economic news from abroad. Daily trading continues to show this effect.
China's economic growth rate is the major concern for many.
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, but the overall ratings have improved a little. 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 modest 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 continue to increase position size for risk-adjusted accounts. I am also looking more aggressively for positions in new accounts.
The continuing reduction in volatility is helping our existing covered call positions.
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.
Final Thoughts on China
Getting good information about China can be a challenge. Bloomberg reports that Chinese companies have been "forced" to falsify data. We cannot expect this to change soon. Nor can we assume that we know the direction of any distortions, since government motives are not always clear.
The "flash PMI" from HSBC, the one that caused the stir last week, has been running lower than the official result which is published later. This chart (via Blackswan) shows the pattern as well as the current trend:
To be a good consumer of information about China, you need to identify the best sources. One of the best is Stephen Roach, who was Morgan Stanley's point man in Asia for many years and is now teaching at Yale. He sees the current reactions as vastly exaggerated:
"I would definitely subscribe to the view that these fears over a hard landing are vastly overblown. You've had a lot of people on your show and other shows talking about a banking crisis, that China's a massive property bubble, that there's a runaway inflation problem. Like most of these stories there's a shed of truth to some aspects of it, but it's a shred. It's been vastly exaggerated."
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.