December 23rd, 2012
by Jeff Miller, A Dash of Insight
After many months of debate, sparring, and posturing, the deadline has arrived for U.S. policymakers to resolve the various matters that are popularly described as the "fiscal cliff." This is a handy simplification. In the finest American tradition it allows everyone to have an opinion whether or not they have any information!
The average person knows only that something really bad is about to happen, and it will send taxes higher. Observers in other parts of the world see the U.S. as unable to address major problems while still offering plenty of advice to every other country. Many of the media sources are unable to distinguish between political commentary and analysis of developments.
The oversimplification adopted by a leading financial TV network is that leaders should "rise above" politics and simply do what is right. An obvious problem with this approach is that no one elected the network to tell the rest of us what is right.
Some Helpful Distinctions
There are two major mistakes that account for most of the bogus analysis.
Emphasis on politics. During elections issues are sharply framed. Appeals are directed at the most extreme and partisan elements. Television ads are negative. In the time between elections the U.S. has historically enjoyed periods of bipartisan cooperation, especially when there was a widely recognized problem or a common enemy.
Those who have followed the hard-hitting elections of the last decade often lose perspective. They cannot imagine a person they voted against behaving in a cooperative fashion.
Blaming participants rather than the process. It is entirely possible for everyone involved to be intelligent, well-intentioned, and hard-working -- and yet we still have a terrible outcome. The U.S. has a very conservative political process; it is easy to block change. Here's why a policy desired by the majority can often be easily blocked:
- Either House of Congress or the President can stop a proposal. All must agree to any changes.
- The Senate requires a 60% super majority on most legislation, since a minority can delay indefinitely through the filibuster. Ending a filibuster requires a cloture motion, and 60 of the 100 votes. (It used to take 67!)
- The House Speaker can block proposals from reaching the floor for a vote. This is true even when a majority would support the proposal if a vote were to be taken. The Republicans follow something called the "Hastert Rule" (named after former Speaker Dennis Hastert). This custom (not a legal procedure) says that the Speaker should only allow a vote on legislation supported by a majority of Republicans -- a majority of the majority. Since the GOP has a slim majority in the House, it means that 27% could block the wishes of the entire House. (There are some arcane methods for avoiding this, but not effective in the current case).
Despite these obstacles, the process has worked well enough for over 200 years. Has something gone wrong? Are things somehow different?
Yes, there have been changes, and not for the good. 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 were back to the pre-Sandy range at 361K. We continue to follow the work of New Deal Democrat from The Bonddad Blog, who is trying to work through the distortions in this important data series.
- Building permits increased, but the gain was mostly for multi-family.
- Personal income and spending were quite strong.
- Rail traffic showed a surprising increase versus seasonal expectations. We need more data, but Todd Sullivan suggests that we pay close attention.
- The Chicago Fed economic activity index is improving. See Steven Hansen at GEI for a full analysis.
There was some bad news last week, but not very much.
- Leading economic indicators from the Conference Board were a big disappointment. The six-month gain has evaporated (via Doug Short).
- Michigan sentiment was even lower than the depressed expectations. The fiscal cliff is hitting confidence (and possibly holiday spending) even before our leaders have decided. People have underestimated the continuing economic effects of these issues, pretending that the end-of-year deadline is adequate for a decision.
- Inaction on the fiscal cliff was the big item.
I propose that we take a break from "the ugly" this week. There is plenty to worry about, and I have a long list of candidates. We have had enough ugliness in the last few weeks, and we'll get back to worrying about everything in the next installment.
Meanwhile, Scott Grannis strikes an interesting note. He has a paragraph on worries, but then goes to a collection of ten comforting charts. My favorite is the one on building permits, up 27% in the last year. Scott and I agree that this is a good leading indicator.
Read the article for the other nine charts and the list of worries.
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 Warren Buffett. The political content on CNBC has increased, but at least some of the material is labeled as an editorial. It should still be accurate. Gary Kaminsky attacked Buffett and Berkshire Hathaway for a stock buyback that he called "hypocritical." He characterized it as an attempt to help an early investor avoid a possible increase in capital gains taxes. It was a thinly-veiled attack on Buffett's political viewpoint. Kaja Whitehouse's NY Post story provides the background as well as the Buffett response -- a sharp lesson for Kaminsky both in tax law and also the stated Berkshire policies on buybacks.
I understand that Mr. Buffett would rather beat me at bridge than win the Silver Bullet award. He is also defending his own position, unlike prior award recipients. We should still take note of his action, partly because it forced CNBC to acknowledge the error. They never do this when I send them corrections!
Meanwhile, CNBC continues to lose ratings ground. Instead of helping the individual investor, they are trying to "outFox" the competition.
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. Bob Dieli's most recent report to his clients includes the following:
"From what we know now, a cycle peak does not appear to be immediately in prospect. And if the number of cars in the parking lots of the malls I drive by every day are any indicator, it does not look like consumers are being reticent in their spending. At a recent client briefing, I referred to this expansion as “the recovery with no friends.“ It has been fashionable in both the political and the business communities to bad mouth the performance of the economy. I cannot recall another instance where we have had an expansion last the better part of four years without some sector taking the lead and one of the political parties acting as cheerleader."
This is an important observation for those of us who want to invest effectively via a contrarian approach! (Write to us at main at newarc dot com if you are interested in a free sample report from Bob).
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 he writes as follows:
"In my opinion the economic data does not support a recession call. If we have reasonably good holiday sales, recession risk declines further. Of course, our politicians could torpedo the economy by mishandling the Fiscal Cliff budget issues."
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.
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.
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. Three 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
The holiday-shortened week brings little data and scheduled news.
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.
- Consumer confidence (Th). The confidence news is becoming more important as a concurrent indicator of response to the fiscal cliff debate.
The "B" List" includes these entries:
- Chicago PMI (F). Important mostly as the best early read on the national ISM index.
- New home sales (Th). Housing coming to the fore.
- Pending home sales (F).
The decision on the fiscal cliff issues will be most important. While nothing official will happen before Thursday, we might expect some hints on Wednesday.
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 three weeks. Felix does not follow the fiscal cliff news, responding only to the message from the market.
For a fine illustration of the trader versus investor question, see Josh Brown's post (from reading his book I know that he does not do "articles") on investment maxims. I love this one:
"And to cap off this talk (and it was a good talk, thanks for coming) I'd like to share two quotes from two of the most successful market participants of the last century:
"The only sound reason for my buying a stock is that it is rising in price." -- Nicholas Darvas
"The dumbest reason in the world to buy a stock is because it's going up." -- Warren Buffett
If that doesn't sum up the value investor / momentum investor in a nutshell, I don't know what does."
As someone who is both a trader and an investor, I understand completely!
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 Barry Ritholtz's Washington Post article, also published on his blog, Why Don't Bad Ideas Ever Die?
Barry has a great, thought-provoking list. You may not agree with every entry (I did not), but that is part of the point. You should take up the challenge and do some self-examination. I strongly recommend reading the entire article, but let me cite my favorite from the list:
"8 Gurus, shamans and prognosticators: Wall Street produces market wizards at a prodigious pace. It may be NYC’s single-biggest export. We love experts to tell us what is going to happen in the future. Never mind that their track record is awful, we prefer the mysticism of the television guru to actual thought.
The data about these experts should give us pause: The more confident an expert sounds, the more likely he is to be believed by TV viewers. Unfortunately, the more self-confident an expert appears, the worse his/her track record is likely to be. And forecasters who get one single big outlier correct are more likely to underperform the rest of the time."
Right now, most of the highly-publicized experts are telling you what you already know, since that is how they can seem smart.
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
Why is compromise such a challenge?
It used to be that the party leaders had real power. There was party discipline, with members punished when they did not play ball. The rule was, to get along, go along. Rookies were not supposed to create problems.
Speaker Boehner is trying to follow this tradition, but it does not seem to be working. Why not?
In the "old days" (and that would be only a few years ago) a member from a safe seat was free to exercise some discretion. Every ten years there is a census and states get to redraw the boundaries for Congressional districts. How this is done depends upon which party is in power in that state. In the past, this has lubricated the wheels of compromise -- senior members of Congress who had some freedom to vote their consciences.
The safe seats are now safe in the general election, but open to primary challenge. This means that Tea Party (or liberal) extremists can threaten a challenge. This has captured the attention of relatively new GOP members who are therefore not tempted to "rise above."
Let's just say that if Maria or one of her colleagues (or you or me) were a member from one of these districts, she would not be acting like Mr. Smith. Can you say "former Congressman?" It is much easier to be a media pundit and critic than to assume actual responsibility. A legislator must balance personal conclusions with the feedback from constituents.
This trend has been exacerbated by changes in rules on campaign funding. Serious challenges are easier to finance.
Result: Members from safe seats are less willing to compromise than they were in the past.
This does not imply an impossible dilemma, but it does represent a new era. I continue to see leaders as trying to compromise while dealing with the new electoral reality.
The single most important thing to understand is that your electoral enemies/icons are now playing a different role from that you saw during the campaign.
- If you did not notice any movement in the Obama position, you have a political fixation and will miss the deal when it comes.
- If you did not notice any movement in the Boehner position., you have a political fixation and will miss the deal when it comes.
What we learned last week was that there will be 30-45 defections from any proposal that can be characterized as a tax increase. This was information that Speaker Boehner did not have before.
It is now obvious that any deal will require support from both parties. This is completely consistent with history, but a new concept for the recent GOP majority.
This week we will learn whether the current combination of leaders can achieve a compromise. I am sticking with my forecast from last week:
"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."
I follow a number of inside sources on Washington and Congress. Some raise the concern that Boehner is worrying about his re-election as Speaker and therefore completely beholden to the Tea party extremists. On the first day of the new Congress he needs an absolute majority of those voting. Normally this means that the majority party picks a candidate in their own caucus and then votes unanimously for that candidate. There are several stories suggesting that seventeen or more votes might defect from Boehner in a surprise coup. This could lead to repeated votes, until the GOP came up with a new candidate. There is already some opposition to Boehner because of his use of committee assignments to maintain loyalty.
What if a few Democrats voted for Boehner? The Dems might figure that a Tea Party- approved candidate would be worse. This would be a totally novel move.....
Note to Readers
I am working through the holidays, but emphasizing the 2013 outlook. I will do updates on my Cliff Notes series as needed, but will probably not do this Week Ahead article next week.