by Jeff Miller
Forecasting fireworks this week should be pretty safe!
I will have trouble outdoing last week's WTWA theme: Upside Surprises. Nearly everyone in the comments disagreed with me. Sentiment is so negative that you can hardly get a good discussion about what might go right.
The current climate is a torture test for the average investor!
It invites people to act on their least-effective instincts, leading to the worst results. I tried to explain why this happens in an article last week about those who "explain" the message of the market. The key point is that most pundits talk about things after the fact and pretend that they predicted it. Contrast this with last week where I was pretty much alone in suggesting that things might go right.
In sharp contrast, if you look at the markets objectively, most of the big-shot pundits have been proven wrong:
- Wrong on recession forecasts - -made as imminent and unavoidable over nine months ago;
- Wrong on earnings and profit margins -- a multi-year prediction of disaster;
- Wrong on Europe;
- And soon to be wrong on upcoming worries like the "fiscal cliff."
I love Barry Ritholtz's blast from the past. He questions the current worries about "uncertainty" and compares it to the cold war era. We both remember that time. Most people thought that their lives would end from a nuclear war. Can things possibly be worse now? He wisely notes that markets thrive on uncertainty.
This is a nice way of describing the "wall of worry" concept that many investors have found to be a valuable idea (0nce they get it).
The fireworks this week may illuminate events and reduce uncertainty. Only losers will wait for all of the answers. It is not that easy!
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 most important news of the week was very good.
- Important steps in Europe. Last week's EU Summit significantly reduces the immediate contagion threat that has affected US stocks. It improves prospects for European economic growth. It demonstrates that the process of negotiation and compromise is working. This is exactly what I have been predicting for over a year -- a process of incremental change with concessions by many parties. The next thing to expect is more action by the ECB as well as the IMF and others. (See here for past articles with more detail on what to expect).
- Congress passed legislation on transportation and student loans. It was a bipartisan effort with significant margins. Now what about that fiscal cliff?
- US household deleveraging is nearly over. It shows a path that Europe could follow. The result is potential for spending if confidence improves. The entire Scott Grannis article deserves attention and you should enjoy the great charts. Here is a key quote:
"In any event, households' aggregate debt and financial burdens are now about as low as they have been for the past three decades. That amounts to some considerable adjustments, and I would argue that these adjustments have set the stage for some big changes in the years to come. For example, if confidence in the future increases, households' risk aversion is likely to decline, and the demand for money is likely to decline as well. There are trillions of dollars in savings deposits that households could decide to spend."
- New home sales are stronger. Bill McBride at Calculated Risk has taken the lead on forecasting this. He is not getting carried away on the rate of the rebound. It is the thoughtful and careful analysis that you would expect from him. I also like Steven Hansen's discussion. My own role is in helping investors find the best sources. The key point to keep in mind is that just getting a bottom in housing -- not a rebound -- will help GDP by 1 to 1.5%.
...and by the way, for those who expect an avalanche of foreclosure homes on the market, Bill does not see that either.
- Rail traffic was good, if one adjusts for the coal distortion. Todd Sullivan has an innovative chart on a topic we have reviewed on past weeks.
- US Consumers have another $250 billion to spend through reduced energy costs. Great analysis from Prof. James Hamilton.
Most of the economic data was a little weaker than expected. This continues the pattern of sluggish growth we have seen for several months.
- Initial jobless claims remain at the 385K level. This rate of job loss is inconsistent with more robust growth and solid net job gains. (contra - Scott Grannis looks at year-over-year and sees nothing close to recession levels).
- Personal consumption is weakening. See Steven Hansen's balanced analysis of all factors and also note the contrast with the deleveraging cited in the good news.
- Corporate profits fell last quarter for the first time since the recession -- on a seasonally adjusted basis. (via Catherine Rampell in the NYT).
- Consumer confidence remains weak -- in spite of falling gasoline prices. This suggests continuing weak employment, concern about poor policy decisions, or both. There are many charts of this, but I prefer Doug Short's analysis. It compares the principal confidence measures and also shows past recessions. Here is the Conference Board chart:
- US Consumers are bearish on stocks via Bespoke. This impacts spending, so it is not contrarian.
- Earnings estimates are declining. The Q212 forecast now calls for a decline of 1.1% via Bespoke.
Dr. Ed shows the impact on forward earnings.
The estimates are a bit lower, but there are still solid growth forecasts for the year. This bears watching.
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.
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.
There is a lot of activity from the recession forecasters. The basic summary is that those with the best records still see little chance of a recession in the next six months or so. The people that get featured in the press and on TV are sticking by their guns, even though the evidence is mounting against them.
We are now at the end of the nine-month forecast window that the ECRI adjusted to after their September, 2011 call (recession imminent, maybe already here, and unavoidable) seemed to prove wrong. Since then they have been adjusting indicators and trying to extend the window, which supposedly ends right now -- mid-year 2012. Here are some good updates:
- The Bonddad Blog notes the failure of the ECRI forecast.
- Georg Vrba asks whether the ECRI is still relevant. Great analysis and charts.
- Doug Short has the latest economic forecasts. (look for the charts we have come to expect).
- Doug Short has an ongoing analysis of the ECRI call, including evidence from various sources. This is the single best source for updates, including a weekly chart of the ECRI leading index and comparison to other sources.
There are many threads on this theme, and I am overdue for a full update. I'll try to bring them together.
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 continued as "bullish." These are 30-day forecasts.
[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
Last week was one of our best in identifying both the focus and the potential outcomes. This week is very different. For many firms the "A Team" will be on vacation. Some will take five days off going through the mid-week holiday. Others will take five days starting with Wednesday. Still others will take all week! Here at "A Dash" we'll be on duty all week:)
This may dampen trading activity. Monday morning will provide the ISM manufacturing index, which is an important indicator. Then things will get quiet until Thursday.
On Thursday we will get the ECB rate decision, ADP private payrolls, and initial jobless claims. Friday will bring the employment situation report.
To summarize, the fireworks will come on Thursday and Friday.
Trading Time Frame
Our trading positions geared up last week. After Monday we were fully invested. Felix is not a range trader, but is excellent at getting on the right side for big moves. As I predicted last week, this was the week of opportunity for trading.
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 best strategy through the various gyrations has been buying dividend stocks and selling calls for enhanced yield. Anyone unhappy with bonds should be doing this for a yield of 8-10% with greater safety than pure stock ownership. Take what the market is offering!
Final Thoughts on Fireworks
This week marks an especially important time for most individual investors. While my audience includes traders and investment advisors, it is the individual investor who is most likely to be led astray. I often try to write as if I were speaking directly to one of my clients or friends, face-to face. I relate to their biggest fears and try to provide some reassurance.
Here is the dilemma:
The best investment advice comes from contrarian approaches.
Most investors pay too much attention to recent results.
This provides a challenge for investment advisors.
When I interview a new client, I have six different programs available. They all beat their benchmarkrs on a long-term basis, but they differ widely in risk and reward. To take two simple examples:
- If you want to make 8-9% a year with reduced risk, I have a program for that.
- If you want complete safety, we can do that also.
These are not the right moves for most people who have a longer time horizon. Even older investors need a touch of octane in the tank!
And that is where we are right now. Most of the people you read or see on TV are looking at the past and pretending -- bad advice.
While I do not give specific investment advice on the blog, my general assessment is that each investor should be a little more aggressive than usual (adjusted for personal circumstances). When I speak with individuals, I find that most are scared witless (TM OldProf euphemism), and therefore not prepared to participate in the upcoming rally as problems are solved.
This week is a good example.
Best Investment Advice of the Week
For my strongest advice this week I recommend Matt Busigin's first rate article, The REAL Cult Of Equity.
This is the single best piece I saw last week, and I read hundreds of articles. Take a few minutes. No, take more than a few minutes and read it twice.
Matt covers the key quesitons about whether we are in a recession, why stocks are cheap, the risk/reward for stocks, and some refutation about those "bad times to invest" guys -- although he is too polite to name them.
He is especially powerful in explaining marginal forces on asset allocation -- something totally ignored by most pundits. Here is one example:
If the chart seems a little wonky and does not make immediate sense to you, all the more reason to read the article. You will see why! (It shows the powerful mean reversion of stocks and bonds -- a key concept).
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.