August 26th, 2012
by Jeff Miller
After weeks of anticipation, we may get the answer to a key question:
Will the Fed launch another round of Quantitative Easing?
Stocks rallied as the Fed minutes seemed to show a greater receptiveness for more QE. Stocks sold off when St. Louis Fed President, a non-voting member whose hawkish views are well-known, said that the minutes were "stale" and that data had improved. Stocks then rallied a bit when Chicago Fed President Evans basically said the opposite.
Finally, there was a significant reversal on Friday when WSJ reporter Jon Hilsenrath released a letter from Bernanke to Congressman Darrell Issa (R, Cal.), responding to some questions he had posed by mail. The answers contained nothing new, but market participants seized upon the date of the letter! The idea is that this is the most recent information.
Here's more evidence of confusion, dedicated to those who are always opining about the "message of the market."
- Headline in LA Times: Price of gold surges on Fed stimulus hopes; is it headed for $2,000?
- And from Reuters: Wall St falls on dimmed Fed stimulus hopes, data
Two stories -- published within minutes of each other. For the flexible pundit, it is easy to derive whatever message you want!
Figuring out what the market really expects is a big challenge this week. 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.
- Rail traffic is modestly higher (via Cullen Roche).
- Taxpayers cashing in on toxic assets. While we are still toting up the net results, some of the bailout decisions have paid off on the specific investments, in addition to the possible benefit for the overall economy. Here is a nice article on the subject by Todd Sullivan (always worth reading).
- Durable goods set a record high. Some definitely embraced the bright side. Here is Mark Perry's chart (but also see below under 'The Bad").
- Auto sales are solid. In support of the full durable goods metric, Mark Perry also cites the authoritative JD Power survey, suggesting that car sales will reach a 4 1/2 year high. This is clearly helping employment and GDP, so it seems relevant.
- New home sales continue to improve. Here is the chart from Scott Grannis:
The was a little negative news.
- Gasoline prices moved higher, up another eight cents (via Doug Short) and getting into dangerous "choke collar" territory (via Bonddad).
- Individual investors are more bullish in the American Association of Individual Investors Survey. This is a contrarian indicator, of course, suggesting that those in the survey are mistaken. Here is the helpful chart from Bespoke. Because of the honest depiction of data, you can judge for yourself whether the relationship is strong and enduring.
- Chinese growth is overstated and falling. Here at "A Dash" I have frequently mentioned this concern. There is additional evidence (via The Big Picture) that official data exaggerates the story in China. Meanwhile, the flash PMI from HSBC showed contraction in the headline number and also specific categories. It is important to monitor developments in China.
- Core durable goods are weak, especially in real terms. Doug Short does a series of adjustments for population, inflation, and non-transportation expenditures. His take is much more discouraging than Mark Perry's (above). Steven Hansen claims the middle ground. Here is Doug's summary chart, but it is important to read the entire article and see the complete series of charts if you want to understand the argument.
- Bearish indicators -- both short and long term -from Dr. Ed Yardeni. Here is the chart for his three-variable fundamental method.
His conclusion is as follows:
"On balance, I think that stock prices may move sideways between now and the November elections. It’s certainly hard to characterize the rally since June 1 as a “Romney Rally” given that the presidential race remains in a dead heat. A few pundits have suggested that it’s actually been an “Obama Rally,” figuring that the market favors the devil we all know rather than the one we don’t."
The fiscal cliff -- as explained by the CBO. The nonpartisan Congressional source sees an economic contraction of 0.5% if Congress fails to act on the looming changes to current law.
James Hamilton has A Dream, and it is a good one! He accurately notes that the problem lies with a system of government where we reward pandering to specific interests. Here is his very sensible assessment:
"Let me begin by making clear my personal position up front. I think America faces a serious long-term fiscal challenge. Not one that needs to be addressed in 2013-- trying to fix this all at once would be highly counterproductive. But I believe that the American political system is badly broken. The voting public expects to get something for nothing, and the two parties compete to promise to give them exactly that. I'm persuaded that both tax increases and drastic entitlement reform will eventually be necessary. I would like to see debate and even a consensus reached today on exactly how we plan to implement both measures over time."
If only we could see such wisdom. Professor Hamilton suggests that either or both candidates might benefit from demonstrating the ability to compromise. We'll see the first act this week in Tampa.
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.
This week's award goes to New Deal Democrat at the Bonddad Blog. He takes on the latest oddball recession indicator: Trash!
Michael McDonough from Bloomberg hit the circuit with this chart:
He had some fun by "talking trash" in the interviews. The chart aligns the two series based upon the most recent and most dramatic decline in 2009. It is pretty rough before that. The eyes can deceive.
But NDD delves more deeply. He also has fun by "trashing a garbage indicator" and invoking GIGO. He notes that the data is based upon quarterly results, but McDonough rushed to print and the talk show circuit with only part of a quarter.
In fact, the data from last year -- not this year -- seems to have been distorted by some abnormal results in the first part of the quarter.
We will not know the final verdict until the end of the quarter, but that is not the point. This is an error in data analysis and a premature announcement. I wonder if Bloomberg or NPR will follow up, as they should. Why not interview NDD?
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 recently did some videos 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. I showed the significance of this last week by explaining the relationship to the business cycle.
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. This week's article, Economic Data Continues to Refute ECRI's Recession Call describes the complete history, the critics, and how it has played out.
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
This is a big week for economic data.
On my A List are the following:
- Initial claims (Th) which continue to provide the most up-to-date read on jobs and the economy
- Consumer confidence (Conference Board - T; Michigan -F) important for employment and spending
- Beige Book (W) which normally does not surprise, but will have heightened attention this month
Also important are these:
- Housing data includine Case-Shiller prices (T) and Pending home sales (W)
- Chicago PMI (F) which is important as a pre-weekend clue about the national ISM report
- Personal income and spending (Th). July data, but interesting to confirm retail sales
- Q2 GDP revisions. Backward looking but still important given the modest growth levels.
The GOP convention will grab some headlines. It will be interesting, but I do not see an immediate market angle.
Most important of all will be the Jackson Hole symposium, with Bernanke's morning speech on Friday and Draghi scheduled on Saturday.
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 summer 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. We had one "neutral" forecast about a month ago, but things never got weak enough to reduce positions.
Investor Time Frame
More sources are joining us in warning about chasing yield. Jacqueline Doherty does a great job on this front in the current issue of Barron's, The Danger in Dividend Stocks. She looks a valuations on a sector-by-sector basis, noting "nosebleed valuations" for popular companies like Southern Company (SO) and Verizon (VZ).
Dividend investing is fine, but you must look past the dividend yield and study the earnings, earnings growth rate, cash flow, balance sheet, and payout ratio.
Scott Murray astutely observes that the volatility indexes seem out of line with reality. He notes the potential for some sophisticated arbitrage opportunities, but these are not available to the average investor. The most important lesson is his warning about buying volatility because you have read about headline risks. How many times must we repeat that the market has already priced what you read in your morning paper?
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.
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 Jackson Hole
Last week I predicted that the Fed will eventually act, but perhaps with something other than another round of QE. Jon Hilsenrath's take plays this down, and he has good connections. Perhaps I am wrong. I remain open to new information.
I do not expect anything significant from Jackson Hole, so there is potential for a market disappointment. It would not be the first time that I have disagreed with Felix, and the verdict has been mixed!
Here is my rationale:
- Jackson Hole is typically not the forum for policy announcements. It is an occasion for mixing and exchanging ideas. Most speeches by the Fed Chair are of the cerebral and background variety.
- The 2010 Bernanke speech is a piece of Wall Street truthiness. In fact, there was little immediate market reaction. Stocks were lower a few days later. It was only after a big rally that those seeking a bogus correlation reached back to the "hints" from the Jackson Hole speech. In fact, there was nothing new in these hints, and the official policy did not start until November. When someone is on a mission to prove something, and has a choice of starting dates, it makes it easier to create bogus correlations.
- The jury is still out. There is no reason for Bernanke to tip his hand before getting the employment report for August.
I have a dozen links (not included) to stories speculating about this and forcefully explaining what the Fed should do. Most of them confuse personal opinion and politics with forecasting.
For those seeking investment success, the key question is what the Fed will do, not what you think it should do.
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.