October 31st, 2012
by Jeff Miller, A Dash of Insight
Hurricane Sandy has been uppermost in everyone's concerns. We have the greatest sympathy for those who have lost loved ones, homes, and businesses. The effects of weather are often devastating in any setting. Here in the midwest, it is often a tornado that strikes with little warning. When a hurricane hits highly-populated areas, the effects are even greater.
One mission of the investment manager is to think about the financial effects and prospects no matter what else is going on. We now have more clarity about this week's schedule, so I will do my regular preview of the upcoming abbreviated week.
I see this as a three-day homestretch leading to an important inflection point -- next week's theme. The key elements are the following:
- Continuing corporate earnings reports, where a mixed story continues;
- The looming concerns over the fiscal cliff, with increasing prominence and visibility;
- The election, with potential for significant change.
I'll offer my own take on these themes 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 lists of upcoming events. One source I especially like is the weekly post from the WSJ's Market Beat blog. There is a nice combination of data, speeches, and earnings reports. Their schedule for this week has been thrown off, of course, but it is still valuable.
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 economic news last week was mostly positive, including these highlights.
- Obama's Hint. During the last debate, President Obama basically dismissed the idea that the sequestration of defense funds would be allowed to happen. This was read in different ways by different observers. I think the outlines of a compromise are in place no matter who wins. Here is a good account.
- Forward earnings estimates are still strong. Brian Gilmartin follows this trend, and also notes that we lack forward revenue estimates -- the latest metric for the skeptic. Brian is very objective in his reports, and he presents important data and ideas that you do not see elsewhere.
- Economic growth measured by GDP beat expectations. The 2% increase is certainly not consistent with the gloom of the recessionistas. Some immediately noted the spike in defense spending (as if the Commander in Chief could orchestrate a big spending push). Meanwhile, the drought subtracted about 0.4% from the GDP growth. The defense spending may be uneven, but housing and more normal weather will help. Scott Grannis notes that there is improvement, but that we are still well below trend.
The actual data last week was pretty good, but the stock result was bad. This happens, and it can be meaningful. Let us take a closer look.
- The revenue "beat rate" is terrible. Earnings beats have been mostly in line with expectations, taking advantaged of reduced expectations, as usual. Those who think that profit margins and cost savings are unsustainable have focused on revenues. Bespoke's fine chart tells the story:
- Pending home sales were disappointing. I am scoring this as "bad" because that was the market reaction and the general commentary. Calculated Risk is not as convinced by this particular data point. Regular readers know that I favor building permits. Interpreting housing data is a challenge on many levels, partly because of the continuing distressed sales.
- Real income less transfer payments declined. Doug Short points out that this is more important than the nominal change in real income. Here is his crucial "big four" chart where he monitors the indicators followed by the NBER in dating recessions.
- GDP growth was disappointing. (Yes, the opposite of the entry in "the good." This is the viewpoint of Prof. Hamilton, who is not prone to spinning data to fit an agenda. Here is his take and a key chart:
Sandy. Enough said.
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. Bob and I are meeting again this week to facilitate this. As I have written for many months, there is no imminent recession concern. I recently showed the significance of by explaining the relationship to the business cycle.
The ECRI recession call is now over a year old. Many have forgotten that at the time of the original prediction, the ECRI claimed that the recession was already underway by September of 2011. See New Deal Democrat's carefully documented discussion, including the original video, at the Bonddad Blog.
RecessionAlert offers a free sample report. Anyone following them over the last year would have had useful and profitable guidance on the economy.
The most recent news from the ECRI states that they are "Assessing the Current Optimism." This is apparently available only to paid subscribers, the ones who had early access to the 2011 forecast.
The public will await this report with some interest. Meanwhile, their WLI has turned higher, which everyone following their data sees as good news. Maybe it is time for them to "predict" that the recession will end within the next few months!
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.