August 19th, 2012
by Jeff Miller
The official calendar is pretty quiet. Earnings season is over. Politicians are on vacation in the US and European leaders are just returning. Beginning with the annual Kansas City Fed gathering at Jackson Hole and proceeding through a series of meetings in Europe, and the US political conventions, we will have a flurry of activity by key policymakers. Calculated Risk has a nice, long-term calendar of these events. Here are the questions that could have the biggest market effects:
- Will the Fed initiate another round of QE at the September meeting?
- Will European leaders (including various institutions like the German Supreme Court) take more aggressive action to help the periphery countries?
- How might the US election affect stocks and specific market sectors?
Follow up: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 quite a bit of economic data last week, and it had a generally positive tone.
- The economic surprise index from Citigroup is reversing the recent decline (via Cullen Roche).
- Building permits are very strong. This is important, since a rebound in housing would really help the economy after a multi-year drag. Steven Hansen has a good analysis.
- Inflation data remained tame. The CPI charts are not very interesting, and the Fed expects to be on hold for years. I prefer to look at Doug Short's CPI components. This will help us predict future Fed actions.
- Good news on profit margins, from Doug Short's innovative comparison of indicators.
- Leading Economic indicators from the Conference Board turned nicely higher.
- Retail sales spiked higher. This is good news and important since it is the only one of the major recession indicators that has turned lower in recent months. We still need more data to have real confidence. Shortly after the announcement, the typical bogus story made the rounds: The entire gain was the result of fictitious seasonal adjustments, out of line with anything from the last ten years.
I have tried to explain the pernicious effect of sources that have no clue about data analysis -- no one who has actually done a seasonal adjustment. The story often starts with a site that is bigger than any of the reputable bloggers -- bigger than Barry or Calculated Risk. The story is immediately repeated on dozens of other sites. It is repeated on CNBC.
There is a huge market for fear and conspiracy. Each week I get reader inquiries about some bogus chart, but I cannot be a one-man truth squad. There is only one of me, and there are many Tyler Durdens!
On this particular topic, there is an obvious answer. Retail sales are seasonally adjusted for the number of weekends. It is just what you and I would do if we looked at a long data history, since weekends make a difference. July 2012 had only four weekends instead of five. Also the 4th of July was mid-week, affecting travel and other factors. The conspiracy site chopped off their analysis at ten years. If one of the several Tyler Durdens had wanted to be honest, he would have looked back two more years, where there were 4 1/2 weekend days and mid-week holidays. It takes very little effort to be honest, but apparently that is not the way to become the leading financial blog, so they chop their analysis without including the relevant years.
Also, you should note that seasonal adjustments net to zero over the course of a year. Why doesn't Tyler ever highlight the times the adjustments suggest better data?
And finally, there is no conspiracy. Government statisticians cannot change the procedures in a heartbeat to make things look better. Sheesh! This is so aggravating. So many people are being duped -- including those who should know better. This stuff is repeated via email, mostly because it fits the bearish pre-disposition.
The was a little negative news.
- Gasoline prices moved higher, up another seven cents and higher than a year ago (via Bonddad, with other high frequency indicators as well). This implies less discretionary spending for the average consumer.
- The earnings beat rate drifted south as did that for revenues. Bespoke has the story and great charts. I am showing the revenue chart, which reflects Europe effects. We should all note that part of the reason that revenue is worse than earnings it the currency effect. Companies with significant foreign revenues also have lower costs. Scott Rothbort, who writes a great daily column at Wall Street All Stars (subscription required, but I have some discounts available so write me if interested), noted this effect, which seems to have eluded the general punditry.
- Facebook after the lockup (preventing insider sales) expired Bad for those who bought the IPO and also for individual investor confidence. Abnormal Returns had a great post exploring the nuances of this experience. Everyone appreciates the daily links from AR, but when Tadas has the time for this type of story, it is especially helpful. Bespoke has a dramatic chart, comparing to Google at the IPO stage.
- The drought. Some readers have taken me up on my invitation to comment, wondering why I have not featured this bad news. I agree that the drought is bad on many fronts. The problem in fitting it into my weekly series is "when?" We have a short-term focus. But I agree. Barry Ritholtz has an excellent post with great charts. Take a look.
- Regional Fed surveys were poor. I do not regard these as very important, but I do emphasize the ISM survey. Calculated Risk explains why I should pay attention -- a good correlation.
- There may be real demographic limits on GDP growth -- demographics and productivity. Kate Mackenzie at the FT has a fine article explaining this problem.
- Unemployment might be much worse this month (via the Gallup Poll).
Financial fraud. This time it is Peregrine Financial -- a guy in Iowa. It is difficult for honest advisors when the stories of fraud keep pouring in. Eddy Elfenbein has a great post on how to spot these frauds. Here are the key elements:
"Specifically, [investors] should learn to recognize Ponzi schemes, of both the Waserdorf and the Bernie Madoff variety. These schemes have several tell-tale traits:
- They promise minimum or steady returns;
- They claim their opportunities are exclusive, available only to a select few;
- Their means of making money is too complicated or secret to explain;
- They make it difficult to withdraw your money, saying that funds have been frozen;
- They issue statements that lack detail, or that frequently show discrepancies that cannot be explained;
- They are frequently run by a single individual whose charm and charisma allow him maximum leverage over investors’ fears—and greed."
Reputable advisors participate with a major brokerage where you can check your positions online and have full insurance protection. Mailed statements need to be verified.
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.
I was trying to earn my own award this week by alerting investors to bogus stories on election correlations. I decided to write an outrageous headline and follow a silly premise, explaining the "rest of the story" in the conclusion.
While many readers enjoyed the approach, many others did not read past the headline and the first few paragraphs. Humor and irony are difficult to achieve online. After seeing the reaction, I was reminded of Doug Kass's April Fools joke in 2008. At the time he had been pretty bearish, but he flipped bullish in the joke article. The story was actually picked up by clueless editors at major news sources.
If you look at my story, please keep in mind that I am trying to illustrate a point on statistical inference, not something about politics!
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.
Bob and I did some videos last week explaining the recession history. I am working on a post that will show how to use this method. As I have written for many months, there is no imminent recession concern.
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. I urge readers to check out the list of excellent updates from prior posts.
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 continued as bullish. We have been bullish since June 23rd, with a one-week move to neutral a few weeks ago. These are one-month forecasts for the poll, but Felix has a three-week horizon. The ratings are higher, and the confidence is improving.
[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
There is not much to look for in terms of economic data this week.
The big item will be initial jobless claims on Thursday.
Housing data include existing and new home sales on Wednesday and Thursday. We also get the FHFA home price report, although this gets less attention than the competing measures. Friday brings the durable goods report.
There will be Fed news, with speeches by two regional bank presidents (Lockhart and Evans) on Tuesday and Wednesday, and the FOMC minutes on Wednesday. There has been some market reaction to various Fed commentary in recent weeks, mostly for hints of another round of QE.
Angela Merkel, mostly late in the week, will have meetings with leaders from Greece, France, and the head of the eurozone finance ministers. Nothing definite will be decided, but everyone is interested in the German position toward both bailouts and ECB bond purchases.
I am expecting a quiet week, but with so much interest in Fed and European policy, expect pundits to pounce on any hints.
Trading Time Frame Our trading positions continued in fully invested mode last week. Felix became more aggressive in a timely fashion, near the start of the recent rally. Since we only require three buyable sectors, the trading accounts look for the "bull market somewhere" even when the overall picture is neutral. As the tape has improved, the ratings from Felix have gotten stronger.
Felix does not try to call tops and bottoms, but keeps us on the right side of major moves.
Investor Time Frame
A problem with market timing is the wide variety of methods with varying conclusions. This week I saw an interesting and unusual contrast.
- Morgan Stanley's Adam Parker is sticking with his forecast for the S&P 500 to close the year at 1167, a decline of nearly 18% before the end of the year.
- Georg Vrba, whose excellent work on recession forecasting has helped our readers, has two different market-timing methods. His most recent article explains that the next great bull market might already be here.
The interesting contrast is that Parker uses forward earnings and Vrba uses backward-looking Shiller data! You should read both articles to see the rationale.
Which of them is right? A great deal depends upon what is already anticipated by the markets. The average investor reads the financial news and thinks that gives him an edge. That only tells him what everyone else knows and is worried about.
Scott Grannis raises a great question: What if something goes right?
In short, if you don't know that the world is beset with problems and threats of mega proportions, then you just haven't been paying attention. And if you have been paying attention, you're extremely worried about all the things that could wrong, and it's a good bet that your portfolio is extremely conservative. The charts above tell the story: for the past three years, investors have been pulling money out of equity funds and stuffing it into the relatively safety of bond funds, despite the ongoing rise in equity prices. Markets everywhere are depressed because of all the concerns over all the things that might go wrong. Forecasts for future growth range from a depression to, at best, 2.5-3% real growth. Contrarians take note: no one is forecasting growth in excess of 3-4%.
If you have been following our regular advice, you have done the following:
- Replaced your bond mutual funds with individual bonds;
- Sold some calls against your modest dividend stocks to enhance yield to the 10% range; and
- Added some octane with a reasonable input of good stocks.
There is nothing more satisfying than collecting good returns in a sideways market.
Beware of "pure dividend stocks", as explained by Bespoke.
If you have not done so, it is certainly not too late. We have collected some of our recent recommendations in a new investor resource page -- a starting point for the long-term investor. (Comments welcome!)
Final Thoughts on the Lull and the Storm
Here are a few fearless forecasts. The Fed will act, but not another round of quantitative easing. They might link action to actual lending by member banks and/or quit paying interest on reserves. The problem is increasing the money supply, so that might be the focus.
Europe will continue the incremental progress toward the final solution, a patchwork compromise that is not a plan. It will be the result of a process. The epiphany for investors will come when it is too late for most.
Nothing in the political campaign will be helpful for markets. The fiscal cliff will be with us until after the election, as will the resulting anticipation and fear.
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.