June 24th, 2012
by Jeff Miller
When nearly everything you see or read seems to carry the same message, it is time to take a deeper look. The mainstream thought now seems to include an obligatory nod to the "mess in Europe" featuring their clueless leaders, the fiscal cliff, the recessionary US economy, and the upcoming hard landing in China.
Follow up:It is reminiscent of early 2009, when everyone searched to explain relentless selling in the absence of any fresh news. I started writing a four-part series and only finished three before things changed.
When it is least expected, something might go right.
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 actually pretty good.
- The Greek election was the best possible news, opening the way for a reasonable compromise solution. The New Athenian is a great source, covering the various possible outcomes.
- The Fed paved the way for further action. The official policy extended Operation Twist as I (and most others) expected. In the press conference (apparently ignored by many who heard what they wanted to hear) Bernanke was quite clear in stating that the Fed would not be stopped by politics. The disparity between the economic forecasts and stated objectives is clear -- the subject of several questions. Bill McBride at Calculated Risk thinks this means action at the August 1st meeting, but he notes that others see a further delay. See also top Fed watcher Tim Duy's analysis.
- The Conference Board's leading indicators recorded a surprising gain of 0.3. See Steven Hansen's analysis.
- The most important housing data showed strength -- especially building permits. (See Calculated Risk for the good charts and analysis. Bonus! Shadow demand is increasing).
- The G20 meetings were positive for the Europe situation. The coverage of these meetings in the regular financial media is so bad that it is almost impossible to track the progress. If you want to track progress, you need to have good sources. Here is a key point from the Council on Foreign Relations:
'What were the main takeaways of the summit?
The two key takeaways are: first, the additional commitment of funds to the IMF by the large emerging markets, which indicates that they have accepted to continue a longer-term process of IMF quota reform, despite the Obama administration's inability to get Congressional approval for the 2010 agreement before the October 2012 deadline. Secondly, it is the detailed commitment of the euro area, which "will"--rather than intend, or should--"take all necessary measures to safeguard the integrity and stability of the area, improve the functioning of financial markets and break the feedback loop between sovereigns and banks."'
- Sentiment is more negative than in early 2009 (via Bespoke).
- Conditions in Europe have improved. You would never know this unless you looked at data instead of headlines! I read FT Alphaville to follow this news, and so should you. Spanish bond yields are the single simplest measure of progress:
Scott Grannis notes this as well as swap spreads, adding more good charts. He writes as follows:
"The 10 bps decline in swap spreads in the past week or so is impressive by itself, and more so since it takes swap spreads back to the levels of late July last year, when the Eurozone crisis was just beginning to heat up. The ECB's liquidity injections have managed to restore a lot of confidence and liquidity to the Eurozone financial market, and that is an essential first step to allowing the crisis to play itself out."
Most of the economic news reflected weaker than expected results. This continues the pattern of sluggish growth we have seen for several months.
- Even the highway bill despite bipartisan support, seems to be stalled.
- Earnings estimates are falling. The Q212 estimates for the S&P 500 have declined dramatically (via Reuters). Dr. Ed. has a helpful chart showing the decline for the quarterly estimates. The overall estimate is still a healthy increase over last year, but it bears watching.
- The Philly Fed Index had an alarming decline. For years I have expressed little confidence in this indicator -- one region, with no information on the sample, response rate, margin of error, etc. It also is a diffusion index, so it shows direction rather than level. We all know that the direction is lower. The market is pretty uncritical about this. See Steven Hansen's discussion for a comprehensive analysis and a lot more history.
- Chinese Economic Data are Suspect. This is a repeat item from last week, but with new evidence. At the moment the concern is that the Chinese government (not known for Freedom of Information) might be overstating growth. Fair enough, but the motives and biases may not always be clear. There are many reasons for understating growth. They may simply wish to disguise motives, perhaps acquiring assets cheaply. Here at "A Dash" we are equal opportunity skeptics.
- Home Loans are Declining, despite lower rates. The problem? Potential borrowers cannot qualify (from Dr. Ed.)
Are the Chinese taking over Toledo?
Actually, I don't think this is bad news, but it was sent to me by one of the many active emailers who make sure that investors are able to find the worst in anything. The story about foreign purchases of US real estate is an old one for veterans. A highlight is the Japanese purchase of the famous Pebble Beach Golf course in 1990.
As long as the US has a trade deficit, our trading partners will make investments in US assets.
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. The most recent take on the ECRI approach suggests a 37% recession probability. If there is no improvement, there might be a warning in two or three months -- still not close to the ECRI's own prediction.
Doug Short has a complete history of the ECRI call, updates from fresh data, a list of sources, and the famous Short Charts that you would expect.
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 "bullish." Last week we noted that the "neutral" 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 both about the FOMC decision and the week-long focus. This week has more possible themes, including the Supreme Court decision on health care and speculation about the European Summit.
There are three housing reports including new home sales (Monday), Case-Shiller home prices (Tuesday), and pending home sales (Wednesday). Taken together with last week's housing data, these could be interesting.
In order of importance, we have the regular Thursday report on initial jobless claims, consumer confidence (Tuesday), personal income and spending (Friday), and durable goods (Wednesday). There are various regional Fed reports during the week, but they will be less important unless we get a big change like last week's Philly survey. The Chicago PMI is interesting as an early read on the national ISM number, especially when there is a weekend in between as is the case next week.
Trading Time Frame
Our trading positions were unchanged last week. We remain 2/3 invested in long positions. Felix is not a range trader, but is excellent at getting on the right side for big moves. There are several highly-rated sectors in the penalty box, while the inverse ETFs are at the bottom of the chart. I expect to add new long positions during the week.
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 big threat is for investors is the apparent safety of bond funds. The consensus expectation is that rates are rising, as shown in this clever and important chart from Doug Short:
Each line represents the forecasts for a new year. You can see that the consensus of economists expects interest rates to move much higher. Unless you think you are smarter, you might want to pay attention.
If that happens, I outlined last week why you should be worried about holding bond funds instead of individual bonds. It is the biggest investor threat right now.
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 two examples, I buy Apple (AAPL) and Caterpillar (CAT) on day one for every new client. There are many others.
- 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 Possible Surprises
The investor quest for yield has taken sector valuations to extreme levels. Take a look at this chart from Bespoke.
No wonder we see tech stocks as cheap.
There are several sources for a surprise in the next few weeks.
- The Supreme Court health care decision will provide clarity. Business leaders have complained about a lack of predictability. If the law is struck down, many will celebrate immediately and certain health sectors will rally. Even if it is maintained, the rules will be known.
- Housing is showing signs of bottoming. Many forget that the economy will be 1 to 1.5% better on GDP merely by avoiding further declines. If the 2.25 million people under age 34 decide to move out of the basement and into their own homes, it will be even better.
- European Summit decisions. Since the consensus now is that these are all meetings with no substantive progress, the stage is set for a surprise. Most US investors might be surprised to learn that the European leaders actually have access to all of the same information they have, via newspapers printed in other languages.
- Increased confidence from lower fuel prices.
These are just the most obvious. Readers are invited to suggest other ideas. Please try for something new!
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.