December 16th, 2012
by Jeff Miller, A Dash of Insight
After several weeks of noise -- from both data and politicians -- it may finally be time for some clarity. I have predicted this with my theme for the last few weeks, and we are starting to see the results:
- The Fed -- aggressive policy, clearly stated, but still not well understood (more below).
- US economic data -- the Sandy weakness is proving temporary.
- China -- signs of an end to the slow slide, and not a hard landing.
- Housing -- several signs of a bottom and some for a real bounce.
- Europe -- none of the really bad things happening, but further delays in a final solution.
- The fiscal cliff -- the biggest unresolved issue.
The problem with this list is that the fiscal cliff issues are so important that we really need some answers -- and soon! As I wrote in my first installment of "Cliff Notes," there has been little real information so far. I refuse to join in the daily discussion of non-events, but it will now start to get interesting. I will write more installments of Cliff Notes as circumstances warrant.
For the purpose of our weekly review, I will simplify this in two dimensions -- content and timing.
Many issues have been lumped together as part of the Fiscal Cliff discussion, just as last year's debt ceiling debate turned a routine matter into a threat to US credibility. I am putting all of the issues into two categories
- Tax matters -- Bush-era rates, AMT, doc fix, inheritance, capital gains, and dividends.
- Long-term deficit issues -- Sequestration, entitlements, payroll tax "holiday," higher retirement age, higher Medicare age, and the like.
There are also issues concerning the renewal of long-term unemployment benefits and whether the debt ceiling will be a regular pinata for Congress. These might be taken up in either group. The first group is most important to the economy since it would have an immediate effect.
I have predicted that this issue would go to the last possible moment. How is that defined? I am reminded of my college days when I lived in Indiana. The State legislature was Constitutionally required to pass a budget by a certain date. Each year the legislative session ended, with no further options possible. They regularly missed the deadline, although they were always close. The Sergeant-at-Arms would go to the back of the chamber and stop the grandfather clock, halting it a little before midnight. Time stood still! Eventually the budget was passed, meeting the official deadline.
There are four possible deadlines to consider:
- This week, allowing a Christmas break.
- Before the end of the year.
- In the first few days of the new Congressional session.
- Weeks or months later.
The timing track for tax matters is more urgent than for deficit matters.
I'll offer my own take on what to expect on the fiscal cliff in the conclusion. Let us first do our regular review of last week's news and data.
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 other events.
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 good.
- Initial jobless claims dropped to 343K range. This was not quite as good as forecast by New Deal Democrat from The Bonddad Blog, whom we cited last week. He caught a mistake in his initial work and posted a very honorable correction. (It would be a better world if more bloggers caught their own mistakes and corrected them). As I noted last week, this is a very noisy series with many adjustments. It is great information, and I watch it closely.
- The world will not be ending on Friday. The Mayans predicted 12/21/12 as the day. NASA says "no." From The Telegraph: In America Ron Hubbard, a manufacturer of hi-tech underground survival shelters, has seen his business explode. "We've gone from one a month to one a day," he said. "I don't have an opinion on the Mayan calendar but, when astrophysicists come to me, buy my shelters and tell me to be prepared for solar flares, radiation, EMPs (electromagnetic pulses) ... I'm going underground on the 19th and coming out on the 23rd. It's just in case anybody's right."
- The Fed gets more aggressive, with pedal to the metal for a long time. Despite the ho-hum market reaction, this is market-friendly news. It is going to require more than I can do in the weekly summary, so here are two hints:
- This will increase the money supply, monitored weekly at The Bonddad Blog. Their weekly indicators are mostly positive, but those who are monetarists should be encouraged by the resumption of growth in real M2, now 5.6% year-over-year. This works with a lag on the economy, so we have not seen it yet. Read the full story to see the other high frequency indicators.
- Josh Brown jumps fast on the instant analysis of the punditry. Below is his chart, but you need to read the entire post (The Dumbest Thing You'll Hear...) to understand the message.
- Industrial production bounced 1.1% in post-Sandy data. See Calculated Risk for details.
- China's flash PMI moved nicely higher. See GEI for complete details and charts.
- German investor confidence is "materially better" (via the Big Picture).
- Inflation data of all types was benign.
- The JOLTS report shows more job openings (good analysis from Steven Hansen).
There was some bad news last week, but not very much.
- Retail sales rebounded to a gain of 0.3%, a bit short of expectations.
- Wholesale inventories increased 0.6%, a bit more than expectations. Inventories are a "fudge factor" for everyone. Increased inventory is great of it augurs a perceived future need. Inventory is not so good if unplanned.
- Q4 earnings growth is still positive, but declining each week (via Bespoke).
- The cliff diving odds increased to 75% according to one good source.
- The small business optimism index plummets. This was planned as my highlight for the worst news of the week. Here (via Macroblog) is the key chart:
When you read the entire article, you understand that the story is mixed. The "young firms" are actually optimistic. A loyal reader also pointed me to this story, suggesting that the survey results might reflect partisanship more than business plans.
Regular readers know by now that I am trying to find evidence that will help us all in making the right news. I try to evaluate each piece of news. Small business is important for job growth. It is an interesting question. David Beckworth looks for the answer, leaning to the absence of demand rather than regulation, based mostly on this chart:
This is a great article, but you need to see the other charts to get a full understanding.
All of the other nominees for "ugly" were pushed aside by what happened to our kids in Connecticut. We parents understand instantly, but we are not alone. Events like this always focus attention on what to do. It is too soon to think about that.
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 uncomfortable in even mentioning a bullet this week, but that is going too far. The Lone Ranger and his trappings are symbols of a better time and place -- one that we do not need to lose).
This week's award goes to Tom Brakke. He highlights a problem that I see every week. Someone sends me a chart which has been manipulated to fit a specific scale and time period. It looks compelling and powerful. It is dangerous. Here is Tom's candidate of the week, two ways of looking at Apple.
The full article is recommended, but here is the key quote:
"I have written before about the ease with which the producers of charts (including me) can deceive, even if not trying to do so. Some of the most common ways include picking a starting point for a chart that maximizes a particular point of view, using price instead of total return for longer periods, and putting lines together on a chart without comparing them on a percentage basis. Today’s topic is an example of the latter.
In a given day, you probably see lots of charts with multiple axes. Most all of them give you a distorted view of the world. You might get an idea that something is going up when something else is going up — and down when it is going down. That can be of interest, but multiple-axes charts, which are popular with investment professionals and bloggers, give false indications."
This is very strong work, mostly because the misleading techniques are so common. Whenever you see a chart like this you should be asking what it looks like in different time frames and scales.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."
Despite the recent media blitz from the ECRI, there is no evidence of an imminent recession concern.
Joining the discussion this week is University of Oregon economist and veteran Fed-watcher Tim Duy. Prof. Duy takes up all of the indicators and does a slam-dunk refutation of the ECRI.
"I think that even a cursory glance of all the data the NBER cites as elements in recession dating, even ignoring the important issue of first identifying broad-based indicators, would lead one to be very skeptical about a July recession call on the basis of "eyeball econometrics" alone."
Doug Short has excellent continuing coverage of the ECRI recession prediction, now well over a year old. Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting. He remains open-minded about the upcoming evidence. In the latest article, ECRI Weekly Update: Walking the Recession Plank he notes that the ECRI seems to have gone too far, "ECRI, however, has "walked the plank" with the company's recession call. And and at this point there's no "Peter Pan" recession to save them from a sea of crocodiles."
For the current time period to be viewed as the start of a recession, we would need to have a significant decline in the economy. Then the NBER goes back and dates the start of the recession at the last peak. As yet we have only small declines, and only in some indicators. None of the best methods I follow shows anything like this.
RecessionAlert uses a variety of different methods, including the ECRI, in developing a Super Index. They also offer a free sample report. Anyone following them over the last year would have had useful and profitable guidance on the economy. Dwaine Van Vuuren notes that the effects of Sandy have pushed industrial production into recession territory, sending the current chance of a recession over 11% according to one of his indicators. His latest article emphasizes his short-term indicators. He is not identifying a recession in any of the various covered time frames.
Georg Vrba explicitly and carefully refutes the ECRI approach. I encourage a thorough reading of Georg's work -- a few minutes well spent.
Readers might also want to review my new Recession Resource Page, which explains many of the concepts people get wrong. Newly added to the list of errors this week was the popular but bogus 100% recession chart. Amazingly, this is still getting buzz. Confirmation bias in action!
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. Two weeks ago we switched to a bullish position, and the outlook has become even more positive. These are one-month forecasts for the poll, but Felix has a three-week horizon. Felix's ratings stabilized at a low level and improved significantly over the last few weeks. The penalty box percentage measures our confidence in the forecast. A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings. That measure has recently moved lower, so we are becoming more aggressive.
[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 week brings a lot of economic data, but not the most important reports.
The "A List" includes the following:
- Initial jobless claims (Th). Employment will continue as the focal point in evaluating the economy, and this is the most responsive indicator. We will look for confirmation that the Sandy effects are over and seasonal adjustments have been reasonable.
- Building Permits (W). This is the best leading indicator on housing.
- Personal inome and spending (F). I am promoting this to "A" status because of the bogus claims that a recession started in July. This is a factor to monitor.
The "B" List" includes these entries:
- Housing starts (W). Lags permits, but still important.
- Durable goods (F). A good post-Sandy read.
- Michigan confidence (F). The preliminary reading was really bad.
We get the various regional Fed surveys which mean little for me. They are not important unless deviating dramatically from expectations. I also do not care about the final GDP revisions for a quarter in the rear-view mirror.
There will also be assorted Fed speeches, including one by Fisher (a leading hawk).
And most importantly -- Congress's decision on whether they want to take vacation for a week.
Trading Time Frame
Felix has moved to a more bullish posture, now fully reflected in trading accounts. It has been a close call for several weeks. Felix has done very well this year, becoming more aggressive in a timely fashion, near the start of the summer rally, and getting out a couple of months ago. Since we only require three buyable sectors, the trading accounts look for the "bull market somewhere" even when the overall picture is neutral. The ratings have moved much higher in the last two weeks. We noted last week that we expected more buying, and that was what happened.
Investor Time Frame
Each week I think about the market from the perspective of different participants. The right move often depends upon your time frame and risk tolerance.
This week I want to highlight Cullen Roche's article, The Bull Market in Fear. He captures the key point nicely in this comment:
"One thing I’ve really battled with in this industry (and in life) over the years is overcoming emotions. In particular, overcoming fear. If you have a portfolio you’re probably worried about something (to some degree). It’s natural. You’ve accumulated all this savings and you’re worried it might just disappear on a computer screen because of a few bad decisions."
This really captures the problem facing so many. Cullen goes on to illustrate the high levels of current fear, loosely correlated with past results. Even that has broken down.
Buying in times of fear is easy to say, but so difficult to implement. Almost everyone I talk with wants to out-guess the market. The problem? Value is more readily determined than price!Individual investors too frequently try to imitate traders, guessing whether to be "all in" or "all out." This usually leads to mistakes in market timing. There are plenty of stocks at attractive values right now. Here is what to think about:
- Risk. If you are like the average investor you have it all wrong. You have been piling into bonds, gold, and dividend funds. All of these categories are now over-valued, the result of this stampede. Some of the risk is showing up right now, and you will see more in the next few weeks.
- A portfolio anchor. You need stability. If you are trying to do it with bond funds, you need to understand the risks. I prefer owning specific bonds.
- Stretching yield. My approach is to find some reasonable dividend stocks and sell near-term calls against the positions. If you did this skillfully, you could hit double-digit annual returns with significantly less risk than simply owning dividend stocks. The range-bound market of the last few weeks has been ideal for this approach.
- A little octane. Many investors do not think carefully about asset allocation. There is always volatility, so the key is to "right-size" your position. Instead of trying to time the market, try to be a player in the right sectors, the right stocks, and the right size. There are plenty of stocks selling cheaply in terms of their historic P/E multiples.
We have collected some of our recent recommendations in a new investor resource page -- a starting point for the long-term investor. (Comments and suggestions welcome. I am trying to be helpful and I love feedback).
Final Thoughts on the Cliff
After weeks of no movement, this might now become a fast-breaking story. I'll do more Cliff Notes summaries as indicated.
So far the story has developed as I expected. Some are changing their odds since nothing has happened. This is fine for those following all of the commentary, but silly if you did not expect any action in the first place!
There has not been much polling of members or advance work --- "whipping" in Congressional parlance. This means little since positions are pretty well known on these issues.
My forecast calls for a resolution of the tax issues before any real economic impact occurs. Republican constituents are most dramatically affected by the AMT and the doc fix. Every poll shows that the GOP will be held accountable. Over 80% of Congressional insiders expect higher taxes on the rich in 2013. It is only a matter of when and how the tax policy will be changed. The publicized sticking point of rates for those with incomes over $250,000 is subject to compromise on the level of income, the exact rate, and adding some limits on deductions. Both sides can claim victory in a compromise.
If the GOP can bargain this for an attractive commitment on spending cuts, we could see something major before Friday. This would not include the "details" that everyone is foolishly discussing. Any agreement will involve guidelines with various Congressional committees to work out the implementation. For those who never took a class about Congress, think of it this way. Management is making some kind of across-the-board spending cut and looking to departments for specific proposals. This is a rough approximation for Congress. It could be stated more strongly since in this case the departments consist of various fiefdoms, all jealously protecting long-held power.
If there is nothing before Friday, we will see Congress in session for a final week of the year. No one wants this. The GOP might even vote "present" in the House to get the tax matters passed.
If the GOP cannot get an attractive deal on the deficit issues, those will be taken up next year with the debt ceiling as the key leverage point.
Since opinion is widely divided on the fiscal cliff issues, the market should move significantly when we know the outcome. Much will depend on whether a two-part agreement (tax matters now, deficit matters soon) is effectively communicated.
It is also options expiration week, so things could get interesting.