August 5th, 2012
by Jeff Miller
Many times we can plan for the week ahead by considering the calendar of data releases and the schedule for official policy announcements. This week is extremely light on all fronts. Even Congress has left town for the "August recess." It is still a little early for election intensity. Many are enjoying vacations and the Olympics.
Just as nature abhors a vacuum, the market media must fill all of that space and air time. How?
I expect a week with a focus on reassessment. Journalists and pundits (at least those who are not at the beach) can digest the recent economic data, the Q2 earnings results, the promises of policy leaders, and the latest political polls. With all of this information at hand, I expect a series of stories looking ahead to the rest of the year -- economy, politics, and markets.
There are a lot of exciting investment themes right now, but most investors are missing them. While this weekly article focuses on short-term events, I always include a special section for long-term investors. This week I have more to say, but I also suggest four ideas that illustrate the many good themes available right now.
I'll offer some of my own expectations in the conclusion, but first let us do our regular review of last week's news.
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.
There was plenty of news the market liked, but it is still a mixed picture.
- ECB chief Mario Draghi (Day 2) Before the ink was dry on stories about Draghi's failure to deliver on last week's promise, the revisionist thinking began. See one of the best examples here.
- Initial jobless claims declined 35,000 to 353K. This continues a wild series of gyrations, possibly influenced by fewer auto plant closings this year. It does provide another decline in the four-week moving average, and it looks nothing like recession territory (as noted by Bonddad with some great charts well worth checking). These data were not part of the survey period for next week's employment situation report.
- Rail traffic is stronger, now at the highest level of the year. Todd Sullivan writes, "I think the economy is slugging along and growing, not running but certainly not falling backwards. When you couple rail data with what is happening in both the auto sector and now the housing sector we have to discount the recession talk."
- Earnings reports have continued to beat the lowered expectations, and revenues are also a little better. (via Bespoke with the expected great chart.) The recent upturn in economic surprises is good news for earnings expectations.
- The growth of payroll jobs at 163,000 beat expectations nicely and broke the trend of lower growth. (See Steven Hansen's strong analysis of the data). Like every monthly report, the story has a lot of complexity (see below in "The Bad). One factor is the continuing discussion about seasonal adjustments, typically quite large in July. The key question is whether this year's adjustment is over-stated because of unusually small auto plant closings. The growth was actually about the same as last year for private employment. The difference? The loss of government jobs was lower. Bob Dieli's clients get his monthly analysis of the jobs data. This was a key insight.
If you compare the blue columns from last year and this, and then also compare the red and black columns, you will see the key point.
- A surprising economic indicator from the creative Josh Brown, one of my favorite sources in print, online, and on TV.
The was a lot of negative news. Everything seems to come with spin.
- Bernanke did nothing -- except talk. Those looking for an instant QE buzz were disappointed. As i noted in last week's preview, the expectations were too high. The FOMC statement did seem to indicate higher awareness.....
- Draghi did nothing --- except talk. Markets sold off hard on the disappointment. The initial reaction was that he had made bold and impulsive promises, but could not deliver. Most market pundits see this as part of a continuing pattern of vague solutions for Europe.
- ISM Manufacturing was once again below 50, indicating contraction in that sector. While this is still roughly consistent with other growth indicators, it is discouraging. Tim Duy has a complete analysis and charts for the overall index and key subgroups.
- The household component of the employment situation report disappointed on all fronts. The labor force was smaller. The number of employed was smaller. The unemployment rate upticked to 8.3% from 8.2%. While this change was overstated by rounding, this is the data point that most captures public attention. While the household survey has "only" 60,000 participants, this is adequate for the purpose of avoiding sampling error. It is plausible that this survey captures the people who are working outside of traditional jobs. Scott Grannis notes that the two approaches are coming together in the overall forecast, and that it is not recessionary.
- Job gains may be overstated. Here is some negative news you will not see anywhere else. Each month I suggest that there are multiple estimates of "the truth" which is not known until we have the reports from state employment agencies. Since we do not have that for eight months or so, no one pays much attention. This should be featured as a way of keeping score. On Thursday we got the most recent update, and it was very disappointing.
This shows that job gains were only 368K in Q411, not the 550K or so that we thought. The ADP estimates of private employment were even higher. The BLS now tries to do "concurrent adjustments" in the birth/death model to reflect new data. There will eventually be revisions to job growth, and some may come quickly.
The "Knightmare" trading glitch wins the ugly award for this week. Professionals (just as in the flash crash) could see quickly that something was wrong in certain stocks. The average investor requires some protection, so the big story is about risk:
- Do the computers and algorithms endanger investors?
- Do exchange procedures offer enough protection?
- Is government regulation adequate?
These themes are newsworthy, so expect plenty of continuing attention. It contributes to a sense that the average investor has no chance to succeed in a rigged market.
I especially like the analysis from Tom Brakke, who looks both at Knight Trading and a "high-yield product" that some investors bought:
"I put these different situations together because they seem symptomatic of today’s world. We are promised wonderful execution in the markets, but can pay a tremendous price when the machinery doesn’t work correctly. Desperate for yield, we buy the sausage from the structured finance factory and don’t know what is in it, liking the taste of the income and not paying attention to the poisoning that might come our way.
The game is out of control. We have engineered in everything except common sense."
See Tom's analysis and chart. My own take is that the biggest dangers are for those who blindly seek yield and those who have inflated ideas about their own short-term trading skills.
The threat to the average long-term investor is exaggerated.
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.
The evidence against the ECRI recession forecast continues to mount. It is disappointing that those with the best forecasting records get so much less media attention. The idea that a recession has already started is losing credibility with most observers. Here are some of the best stories from last week:
- New Deal Democrat (writing at The Bonddad Blog) does a long, thoughtful and careful analysis of the ever-changing story from the ECRI. He shows how the story has changed over the last 10 months --- timing, which indicators, how to measure the variables, and finally the current claim that the recession has started. This article is chock-full of detailed evidence and charts. Here is the key conclusion (but you really need to read the whole article):
With yesterday's release of June real income, we now have full data through midyear 2012. Unless there are downward revisions to the critical series upon which the NBER relies, it can confidently be stated that no recession began by that time.
- Doug Short also does a comprehensive update, with great charts of the NBER's big four factors. Here is the key summary:
Doug also cites Dwaine van Vuuren of Recession Alert using a shorter time frame from the one we include each week.
"Dwaine's analysis now puts the implied probability of recession at 2.1%. For more on his analytical approach, see his The NBER co-incident Recession Model – "confirmation of last resort"."
Readers might also want to review my new Recession Resource Page, which explains many of the concepts people get wrong.
The single best resource for the ECRI call and the ongoing debate is Doug Short, who has a complete and balanced story with frequent updates.
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 back to bullish. We have been bullish since June 23rd, with a one-week move to neutral last week. These are one-month forecasts for the poll, but Felix has a three-week horizon. This week's decision shows the ratings strength, but we assign a low confidence rating.
[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
This is a very light week for data and also for other news. On Thursday we have trade data (significant for the current quarter GDP) as well as the weekly installment on initial jobless claims. We will also get the JOLTS report on labor turnover, but this is older and less significant than last week's data.
In the quiet environment, we can expect any story about Europe or politics to get a bigger play.
Trading Time Frame
Our trading positions continued in fully invested mode last week. This surprised me, since I was expecting a move to the sidelines. Felix actually became more aggressive in a timely fashion. Since we only require three buyable sectors, the trading accounts look for the "bull market somewhere" even when the overall picture is neutral.
Having said this, the overall advice from Felix remains cautious.
Investor Time Frame
This is a very important time for the individual investor, so I want to emphasize some key points. Most individual investors are making serious mistakes. Here they are:
They try to be traders
The successful investment strategy differs markedly from trading. It is especially important to establish good, long-term positions when prices are favorable. Most individual investors seriously underperform long-term results by selling low and buying high. Most successful professionals, of course, do the opposite.
Even successful years have significant drawdowns. 15% is not unusual. The investor needs to expect this. If it feels stressful, then your asset allocation is wrong.
They think they are experts on world events
Taking a long-term perspective is easier said than done. With everyone on TV explaining with great confidence what just happened (please check out my article on the "message of the markets") it is easy for the average person to think he is out of step. For several weeks I have emphasized the folly of attempts at short-term market timing.
They want to wait too long -- until there are no problems
This is the single most costly mistake. If there were no problems, the market would be at 20K or higher. Investing requires balancing risk and reward, not waiting for complete safety.
There is no magic moment. Resolving market worries is a process, not an event.
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 market action in the last three weeks has once again illustrated market moves based on unpredictable factors. After Bernanke and Draghi, who would have guessed that the market would move 3% in a few hours and finish higher on the week?
They fail to see what is working
Our single best strategy through the various gyrations has been buying dividend stocks and selling calls for enhanced yield. This week provided great opportunities to set new positions early in the week and sell calls against existing holdings late in the week, just as we suggested last week. 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!
...and here are my examples.
Final Thoughts on the Mid-Year Assessment
There are a number of key themes, all of which are on my agenda. As usual in the weekly column, I am sharing my conclusions, but I'll write more on the various themes.
- Recession. Not close. Recessions start (by definition) at cycle peaks. This market cycle will be longer than average. We might be in the third inning.
- Europe. The market is gradually learning how this works. It is a multi-part bargaining process. Draghi held out the carrot and then explained the requirements. The ECB gets a better deal as a result. It is happening one step at a time, but few of the market pseudo-experts have the vision to see the outcome.
- Earnings. Revenues are a bit lower partly due to currency effects (which also helped costs). Earnings are OK and multiples are low because of expected declines.
- Politics. Plenty of news to come, with the market (incorrectly) viewing a Romney victory as bullish. It is a lot more complicated. More later.
- Cliff Diving. Great media story, but it will not happen. The election outcome does not matter to this one. The nature of the solution will change, but something will get done.
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.