June 17th, 2012
by Jeff Miller
In the absence of any action on fiscal policy, economic responsibility rests with monetary authorities. Investors rightly ask:
What more can the Fed do? Will it be enough?
In normal times, this would be the big story. This time the week ahead will start with the Greek election and the aftermath, which I covered in a special preview. This article focuses on what to watch after we digest the news from Greece.
Christina Romer, back at the Berkeley econ department after serving as Chair for the Council of Economic Advisers for the Obama Administration offers this assessment in the New York Times.
"...(W)e need more effective fiscal and housing policies. But neither is likely to happen, at least not before the presidential election. As a result, the Fed is the only plausible source of immediate help for the American economy. It was set up as an independent body precisely so that somebody can do what’s right when politicians can’t or won’t.
I find a related argument even more frustrating: that the Fed shouldn’t act because Congress wouldn’t like it and might retaliate. This argument exposes the important truth that the Fed is only as independent as Congress lets it be".
Cardiff Garcia at FT Alphaville has a nice FOMC preview with odds, a good flowchart from Credit Suisse, and a number of helpful links. Conclusion: Something, probably more twisting.
Everyone wants to politicize the Fed, making it much more difficult for investors. We should focus on how the actual decisions will affect the economy.
I'll offer some more thoughts on this in the conclusion, but first let's do our regular review of the events and data from last week.
Background on "Weighing the Week Ahead"
There are many good sources for a list of upcoming events. With foreign markets setting the tone for US trading on many days, I especially like the comprehensive calendar from Forexpros. There is also helpful descriptive and historical information on each item.
In contrast, I highlight a smaller group of events. 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.
This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting 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 US economic data last week was generally weak. There were many bright spots, but not on the most important factors.
- Home equity increase the highest in 60 years. (via Financial Advisor and Bloomberg). Household balance sheets are improving.
- Business inventories are improving. Excessive inventories are a negative. This does not get enough attention because the component parts come out in several different releases. Steven Hansen does a very nice job of explaining how the different pieces fit and providing informative charts.
- Inflation -- both wholesale and consumer --remains benign. Steven Hansen covers the PPI report. Doug Short looks at each CPI component with the energy threat in the background.
- OPEC is maintaining oil supplies at current levels. This helps with the continuing decline in gas prices. Doug Short has an informative chart and good analysis.
- The off-season earnings beat rate has been good, including the great chart we expect from Bespoke Investment Group. I have a sense of greater negative pre-announcements, however, but I did not see a solid report on this.
- Housing inventory -- both regular and shadow is lower (via Calculated Risk). Any improvement in housing would be very helpful.
Most of the economic news reflected weaker than expected results. This continues the pattern of sluggish growth we have seen for several months.
- Chinese Economic Data are Suspect. How could we have known? It seems that auto sales data include some channel stuffing. Come to think of it, that might also happen in the US!
- Biggest US asset is student loans. I am not sure this meets my criteria for "bad" but it does not feel right. Here is the chart from Doug Short.
- Industrial production was slightly lower and capacity utilitzation was below expectations. Calculated Risk has charts and analysis. Scott Grannis is a bit more positive on the longer trends.
- Jobless claims moved higher, further from the non-recession comfort zone. This is a special concern for me.
- Retail sales declined 0.2% which was pretty much in line, but the ex-auto decline was disappointing. Given the recession concerns, there is special focus on consumer activity.
- Michigan sentiment declined to 74.1 from 79.3 last month. This is especially bad with a background of falling gas prices. In the absence of gas prices and political factors, this is a fair read on employment. It is worrisome, as you can see from Doug Short's chart.
Making fun of those recovering from handicaps.
When you make a public mistake it is best to acknowledge it and move on. I have had some occasions on this blog. One of my hardest lessons was to quit trying for the academic "perfection in writing." I soon realized that I would never get anything done. Mistakes will happen.
President Obama decided to admit his mistake last week where he said that the private economy is fine.
The financial media expects this sort of behavior from politicians, but not from themselves. When a leading TV program and pundit has an embrassing and insensitive gaffe, an apology is in order. The person involved was so out of touch with the event that she did not actually name the stroke victim who was the object of her scorn, but it is clear from the context.
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 SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events. It uses data, mostly from credit markets, to reach an objective risk assessment. The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.
Tim Duy has a nice update on financial stress, including the SLFSI and some alternatives. He has expert analysis and helpful charts.
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. We are working on a modification that will make this method even more sensitive. None of the recession methods are worrisome. 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 also not close to a recession signal.
For comprehensive recession forecasting we recommend the RecessionAlert team. They have reverse-engineered the ECRI approach and improved on the recession forecasting power. Since they have not gotten the mainstream recognition they deserve, you can still enjoy the advantage from their methods. You should consider subscribing for more detailed reports covering various time frames and GDP forecasting. They have also initiated a new service -- the Shadow Weekly Leading Index. If you like the ECRI approach, you can get an advance read before their weekly announcement.
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 switched to "neutral" and the ratings are actually marginally bullish. Last week we noted that the "bearish" call was marginal. Remember that these predictions, although made each week, are supposed to represent expectations over the upcoming month.
[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
I was correct last week in my prediction that we would be focused on leadership, or maybe the lack thereof! This week will start with the results of the Greek election and the implications both for Europe and for global economic growth.
The focal point for this week will be the FOMC announcement and the Bernanke press conference on Wednesday, the culmination of a two-day meeting. This will include an update of economic forecasts as well as any policy announcement.
G20 leaders meet in Mexico on Monday and Tuesday. This is the wrong group for decisive action on Europe, but there could be some interesting news.
This is a big week for housing data. I find the building permits quite helpful (Tuesday), especially given recent weakness. We'll also have housing starts at the same time, and existing home sales and FHFA home prices on Thursday.
Thursday is the big day for data, including initial jobless claims (important), leading indicators and the Philly Fed index.
Trading Time Frame
Our trading positions changed dramatically last week. The "cautious short" that I described was sold early and we are now 2/3 invested in long positions. Felix is not a range trader, but is excellent at getting on the right side for big moves.
Every week I prepare by consulting Charles Kirk's weekend chart show. This week it is available a day early, as we all prepare to celebrate Father's day. It is interesting that Charles is waiting for more evidence of a breakout, not unlike Felix. (Investors and traders alike would benefit from an inexpensive membership to The Kirk Report). Traders spend a lot of time trying to call tops and bottoms for "selling the rips and buying the dips." There are many ways to trade successfully.
Investor Time Frame
The successful investment strategy differs markedly from trading. It is especially important to establish good, long-term positions when prices are favorable. I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look. You can contrast this with the many pundits who claim miracles of market timing.
The single most difficult thing for me to explain is that investors should often embrace opportunity just as traders are trying to do some fancy footwork. Investors should not be trying to guess the next market move. Instead, take what the market is giving you. You should not be a "buy and hold" investor, but instead engage in active management. Think about risk control rather than market timing.
Right now the market is giving you two things:
- Plenty of great stocks that are as cheap as they were at the market bottom in 2009, on a price-to-earnings basis. To pick one example, I buy Apple (AAPL) and Caterpillar (CAT) on day one for every new client. There are many other great examples.
- Good dividend stocks where you can sell short-term calls. I am doing this as a "bond substitute" providing the yield we need in a low-rate environment. I am targeting 8-9% returns on this approach, and achieving it through an up and down market cycle. You can, too, but it takes some work.
Investors who play these themes will do well, regardless of the headlines.
Final Thoughts on the Fed
Expectations for the Fed are unrealistic and wide-ranging. This makes it easy to disappoint.
- Communications. If the Fed reduces growth estimates and acknowledges some economic weakening, many will criticize, saying that they are frightening the markets. If the Fed maintains that conditions are acceptable, the same people will say they are out of touch. There is no satisfying some!
- Decision. Whatever the Fed decides to do some will say that it is inadequate - -more was needed. Others will decry the move as inflationary stimulus. And of course we will see many repetitions of "pushing on a string."
Expert Fed watcher Tim Duy plays "devil's advocate" in this post:
"Bottom Line: I think you can tell a story that the most recent data is not sufficient to move Fed forecasts, in which case it remains possible that the Fed does not implement any changes next week. I have to admit to being a little nervous that we get a Fed "leak" over the next few days in an effort to reset expectations ahead of the meeting. Still, given the increased downside risks to the forecast, it is hard for me to make this my baseline scenario, especially given the very dovish Yellen/Williams/Evan contingent, which is why I expect some action next week. But much still rests on Bernanke, who has surprised by positioning himself to the hawkish side of the center. After all, if he believed the Yellen/Williams/Evans stories, he would have eased already. He hasn't, suggesting that he has a pretty high bar to additional easing, and we just might not have crossed that bar."
The entire article is worth a careful read.
Here is the key point that the market pundits do not get: It is not all about you!
The Fed is responding to economic needs. The tools all have marginal economic impact. They often use the market response like a poll, to gauge the instant sentiment. Who wouldn't? But that is not the major purpose. The "wealth effect" on the economy is modest, but the occasional Fed comments on this topic have created a sense that the Fed objective is to drive up stock prices.
Anyone maintaining this position should be able to find evidence in the detailed transcripts of past meetings. Put up or shut up!
My vote? I am expecting some sort of extension of Operation Twist, but the Fed is running out of short-term assets to sell. This is a small, token move.
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.