April 15th, 2012
by Jeff Miller
Game time! Earnings season -- with special significance.
It is always important.
- Owners of growth stocks can be especially vulnerable to a missed quarter, since an earnings miss affects both the "E" in the P/E ratio and may also lead to a lower multiple.
- Owners of cyclical stocks
- Even owners of dividend stocks need enough growth to provide support for current and future yield.
This time the earnings story is even bigger. It is objective, non-government evidence of the state of the economy. Market skeptics insist that earnings estimates are too high and "must move lower." They expect that the reduced pace of economic growth and problems in Europe have put pressure on profits.
Follow up:I'll offer some thoughts about the earnings season in the conclusion, but first let us take our regular look at last week's data and events.
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.
Despite the stock market reaction, there were some bright spots in last week's news. These were probably less important than the bad news, but still worth noting.
- The trade deficit for February was "only" $46 billion, much lower than the expected $51.7 billion. The significance is that this is a boost to Q1 GDP, as everyone will soon see. Check out the coverage and charts at Calculated Risk.
- Bank lending is improving at a six-month annualized rate, a post-recession high (see the chart from Scott Grannis).
- The quit rate is higher, according to the JOLTS report. People quit jobs more frequently when confident about the employment market. Churn is also good. Check out Mark Perry for a further explanation. Mark's chart shows the improvement, but also that we have a long way to go.
- Sentiment indicators are bearish. Since these are all interpreted as contrarian signals, this is bullish. Pragmatic Capitalism cites the AAII survey at a seven-month low. Mark Hulbert draws a similar conclusion from his index of market timers.
- Inflation reports were pretty good, whether you looked at PPI or CPI, core or headline. For the most comprehensive analysis and comparisons, see Doug Short's chart collection and commentary. There is something for everyone -- even those of the ShadowStats persuasion can see some relevant comparisons. With the current focus on energy prices, I would like to feature this informative chart:
The most important economic news was negative.
- Multiple Fed speeches did not satisfy. There was a lot of talk, but the market does not have confidence in the Fed management of the economy and craves more QE.
- Rail traffic declined again. Steven Hansen's thoughtful article has plenty of helpful charts. In the past he has identified coal shipments as the main cause, but now sees a broader decline.
- China's GDP growth was still above 8%, but lower than the whisper numbers (close to 9%) that helped to fuel the Wed-Thur market rally. Global Economic Intersection has a good summary article that shows both the weakness as well as some bright spots while citing varied perspectives.
- Spanish debt yields pushed back to the 6% level seen by many as a trigger point for membership in the bailout club. This was a big factor in Friday's stock market weakness, since it is interpreted as a failure of the ECB's LTRO policy. Has it worn off so soon? One good indicator is the spread versus German bonds, illustrated in this great chart from Sober Look.
- Initial jobless claims moved sharply higher to 380K and prior weeks were also revised upward. There is discussion of seasonality and the "early Easter" holiday affecting the timing of claims. We all watch the four-week moving average to avoid some of the noise, but the current pattern is troubling. We need more data, but I am concerned.
- Michigan sentiment was a little light. Unlike market sentiment, this is important as a coincident indicator of employment and spending. It seems to have stalled in a range usually more associated with recession than with healthy economic growth.
North Korea had another failed rocket launch. This seems to signal that Kim Jong-un is continuing his father's policies of confrontation rather than negotiation and conciliation. Some think it is too soon to expect a change from policies that were already in motion.
It is difficult to gauge all of the consequences of a military confrontation at this flash point. It has the immediate effect of altering the perspective on defense spending. There is good coverage of this, as well as the likely political implications, in this article from The Hill.
The Silver Bullet
I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. Think of The Lone Ranger.
This week's award goes to David Merkel, a proven ally of the individual investor, who is on the warpath against penny stock promoters. This problem does not get the attention it deserves. The get-rich schemes are always tempting. Losses in stocks and real estate have made matters worse. You might think that only foolish investors could be taken in, but you would be wrong. Some very intelligent people are among the victims, including friends who would not listen......
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. Bob also has a group of coincident indicators. Like most of the top recession forecasters, he uses these to confirm the long-term prediction. These indicators are not close to a recession signal.
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. I am publishing the one-month delayed Leading SuperIndex estimate of recession probability in the near future -- three or four months. This is plenty of time to have value for public followers of their reports.
Last week they added another interesting recession indicator, finding states that show economic changes in advance of the nation. You will be surprised at which states are the "canaries in the coal mine."
Here is the latest example, which does a great job of explaining the current ECRI changes in methods.
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 shifted to bearish for the first time since last fall. Last week was a close call and so is this one. The ratings have deteriorated quite a bit. The inverse ETFs are still in the penalty box, but I would not be surprised to see one or more of the in the top three spots this week. Check here for a look at the full list of ratings as of Wednesday's close.
[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
I expect earnings to be the main story of the week, although news from Europe was more important last week. Germany has bond auctions on Wednesday, while France and Spain conduct auctions on Thursday. These could be significant.
There are a number of minor reports, but I will be watching retail sales (Monday), building permits (Tuesday), initial claims (Thursday), and leading indicators (Friday). The various regional Fed reports might move the market if far from expectations.
I expect plenty of attention to company statements about global economic effects and their outlook. This is dangerous because there is little reason for management to go out on a limb.
Trading Time Frame
This week marked a dramatic change in our trading accounts. We have been 100% invested since December. Felix caught the current rally quite well, buying in on December 19th, but the picture is now very different as I showed in this article.
We are now only 33% invested and I would not be surprised to see a purchase of one or more inverse ETFs during the coming week. 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 has now changed.
Investor Time Frame
It is always challenging to explain why time frame is important.
There are many roads to market success. Whatever approach you choose, you must test it, believe it and follow it.
If you are a trader like Felix, you will be trying to outguess the other traders, not caring about market fundamentals. If you are an investor (like Warren) you treat short term price fluctuations as an opportunity to buy or sell, dependent solely on your own valuation of your holdings.
If you are an investor who has been frustrated by a market that ground relentlessly higher, providing no opportunity for entry ---- well--- what are you waiting for now?
I want to emphasize that being an investor does not mean "buy-and-hold" or a "forever" portfolio. I believe in active management of investment accounts, adjusting for changed circumstances. We need to look beyond the headlines, political commentary, and those profiting from the climate of fear.
There is an important difference between short-term market timing and active management of your holdings.
I look at the following:
- Recession risk -- now very low.
- Earnings growth -- excellent and undervalued.
- Financial stress -- high on the headlines, but modest on the data, falling rapidly.
I have been more aggressive in adding investment positions. For those who are more worried, I recommend a combination of dividend stocks and the sale of short-term calls for enhanced yield. You can achieve 8-9% in a sideways market.
Our Dynamic Asset Allocation model has also 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 DAA approach is finding some of the best sectors over the last year.
Final Thoughts on Earnings
My recommended sentiment gauge for asset allocation is the equity risk premium. It gets to a very high level when there is intense skepticism about earnings -- something we see right now.
The skeptics are elusive and often contradict themselves. They variously maintain the following:
- Earnings estimates are too high and need further reduction
- Earnings estimates are crashing and need to move even lower
- When earnings beat expectations it was because the bar was lowered.
There is no accountability. If a pundit wants to opine on what earnings estimates should be, then how about checking the record of his past comments on earnings?
I prefer relying on facts. If estimates are too high, then we should accept stronger earnings as evidence that things are better than expected.
My personal guess, based partly on reading research reports, is that stock analysts have unwisely become amateur economists. They are incorporating their own opinions about the economy, drawn from reading the newspaper, into their earnings projections. The result is that expectations are pretty low, as you can see from previews in The FT and in Barron's.
The great team at Bespoke Investment Group is on the job. Here is the story so far -- a good record, but not always rewarded with higher stock prices.
It will be an interesting week on the earnings front.
Left out of this week's analysis was the Romney victory in the GOP nomination. This is important, of course, but we need to figure out how and why.
This is not a blog about politics, but we do analyze the impact of politics on our investing. I have expected the Romney victory all along. As the issues are more clearly defined, I will generate some investment forecasts.
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.