April 8th, 2013
by Jeff Miller, A Dash of Insight
As the market averages reach new highs, there is a sharp divergence in advice. While we digest last week's economic news and wait for earnings reports, I expect a new theme this week.
How should you react to new market highs and first-quarter trends in various sectors? Should you reduce exposure, expecting a sharp correction? Or should you shop for bargains among sectors and stocks that have lagged in performance?
As he does so often, Eddy Elfenbein provides a savvy summary of recent events and focuses on the key question:
"Let me give you the briefest summation of Wall Street over the last six months: Investors worry about something that's unlikely to happen, the financial media amplifies said worry, calming voices are ignored, the markets trends downward, the financial media then calls for civility and public-spiritedness to address the needless worry they just promoted, incredibly the world doesn't end, the worries fade away, volatility falls and the market quietly rallies.
We've repeated this dance so many times I'm beginning to lose count. There was the Fiscal Cliff, the debt ceiling (remember the $1-trillion coin), the elections in Italy, the fiasco in Cyprus and the Great Rotation out of bonds."
Eddy takes note of the recent market shift into defensive stocks and away from gold and risk. He is expecting more of the same. (His article also includes some great stock ideas).
Michael Santoli writes about the "grandma stocks" and how investors have moved into stocks that look like bonds.
There are at least three choices:
- Sell in May (a topic we covered last week, Signs of another Economic Soft Patch?).
- Be defensive with grandma stocks and bonds.
- Look for bargains in lagging sectors.
There are advocates for each. I have some thoughts which I'll report in the conclusion. First, let us do our regular update of last week's news and data.
Background on "Weighing the Week Ahead"
There are many good lists of upcoming events. One source I regularly follow is the weekly calendar from Investing.com. For best results you need to select the date range from the calendar displayed on the site. You will be rewarded with a comprehensive list of data and events from all over the world. It takes a little practice, but it is worth it.
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.
This was a generally negative week, but there were a few bright spots.
- Some movement toward a budget compromise by Obama. Few understand the various inflation measures and therefore do not grasp the significance of changing to a chained-CPI method for Social Security benefit increases. The simple version is that it represents a big future cut without reducing current defined benefits. The change is hated by key Democratic groups and senior citizens. (see The Hill). Presidential second-term behavior sometimes encourages compromise. Many with a political agenda predicted a more partisan Obama after the election. It seems that the jury is still out. Here is a good account of the issue ---- from NPR!
- Auto sales were good and mortgage delinquency down. Daniel Gross suggests looking at these as fundamental factors. (The data on sales were pretty much in line with expectations – "solid start to the year" via Calculated Risk).
- Construction spending was up 1.2% (February data over January, seasonally adjusted). It is even better if you focus on private construction, since public construction has been a drag for four years – excellent analysis and this chart from Calculated Risk:
The economic news was mostly negative this week.
- Initial jobless claims spiked to 385,000. There could be some effects from the Good Friday holiday, since the varying date is challenging for seasonal adjustments (via Scott Grannis).
- ISM Manufacturing declined to 51.3, a disappointing drop of 2.9 from February. The ISM sees this level as indicative of a 2.8% GDP, but the relationship they use seems to have overstated the GDP level recently. Another good research project for someone. Read the comments for a little more color. Scott Grannis charts the relationship and offers further analysis:
- ISM Services dropped to 54.4, down 1.6 from February. Steven Hansen of GEI focuses on two important subcomponents, helping us to navigate this noisy series.
- Employment is weaker – no matter how you measure it. The official BLS report of a net addition of 88K jobs was far below most estimates (although I suggested some warning signs in my monthly preview). The labor force declined by 500K workers, giving an artificial improvement to the unemployment rate. Prior months were revised higher, but that simply sharpens the monthly decline. Hours worked improved slightly, but the hourly wage did not.
It is a serious mistake to place too much weight on this report. There are several alternative methods of gauging employment. Truth emerges when you look at all of the evidence. The news reports do not have time to explain the methodology or that there is a sampling error of +/- 100K jobs. The error band in the household survey and the estimates of the labor market is over 400K (since the sample is smaller). This was a weak report that was pretty consistent with other recent employment data. There is a very good discussion of the labor force participation rate at Calculated Risk. It is time to look once again at Bill's popular chart comparing the most recent recession with those of the past. I like the version that aligns at the bottom. It is clear that we have come a long way, but much more is needed.
We all share the loss of Roger Ebert, who finally lost his battle with cancer this week. Millions know him from his TV show and the "two thumbs up" approach. Those of us from Chicago have enjoyed the Sun Times review of this Illinois alum for many decades. Roger was passionate and outspoken. Even after he lost his speaking voice, he maintained visibility through prolific written reviews and blogging. His work will live on for many years.
North Korea takes the "ugly" award again this week. Living in a world where unstable leaders have nuclear power presents special challenges. Most leaders operate with a concern for their people. For a special insight into North Korea, readers might take a few minutes to listen to this account from SnapJudgment (the fast-paced NPR storytelling show). Here is their summary:
The only father Kim Yong ever knew was the first leader of North Korea. He grew up an orphan after the Korean War and was raised to be utterly devoted to the state; blindly loyal, even. So blind that he couldn't see what was coming.
More on the policy challenge from CFR—great background!
If negotiation is challenging, the challenge for investors is even worse. I recall an old story from Art Cashin about his training during the Cuban Missile Crisis (1963). Most of the trainees thought that the crisis meant to sell. The instructor explained the error. If the leaders did not resolve the problems, it would not matter anyway….
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.
Anyone who has followed these objective indicators over the last two years has had a significant advantage in trading and investing. Each has contributed to the result. Here is how.
The St. Louis Financial Stress Index
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." I have now added a series of videos, where Dr. Dieli explains the rationale for his indicator and how it applied in each recession since the 50's. I have organized this so that you can pick a particular recession and see the discussion for that case. Those who are skeptics about the method should start by reviewing the video for that recession. Anyone who spends some time with this will learn a great deal about the history of recessions from a veteran observer.
I have promised another installment on how I use Bob's information to improve investing. I hope to have that soon. Anyone watching the videos will quickly learn that the aggregate spread (and the C Score) provides an early warning. Bob also has a collection of coincident indicators and is always questioning his own methods.
I feature RecessionAlert, which combines a variety of different methods, including the ECRI, in developing a Super Index. They 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 also has an excellent data update, demonstrating how the coincident data have reduced recession prospects. There are seven sample reports available, including Dwaine's latest country-by-country analysis of the global recession status. Good reading!
Georg Vrba is a great "quant guy" with an excellent variety of useful tools, some available via a free subscription. His take on a possible recession? Based upon unemployment data, the ECRI is wrong. His latest article questions the use of M2 as part of the ECRI's WLI.
Doug Short has excellent continuing coverage of the ECRI recession prediction, now eighteen months old. Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting. Doug also continues to refresh the best chart update of the major indicators used by the NBER in recession dating --- now reflecting the most recent personal income data. Here is Doug's latest opinion on the ECRI forecast:
Ultimately my opinion remains unchanged from my position in recent weeks: The ECRI's current position is best understood as an effort to salvage credibility in hopes that major revisions to the key economic indicators -- notably the July annual revisions to GDP -- will validate their early recession call.
Readers might also want to review my 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. About a month ago we switched to a bullish position. These are one-month forecasts for the poll, but Felix has a three-week horizon. Felix's ratings stabilized at a low level. 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 remains elevated, so we have less confidence in short-term trading.
[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 includes a bit of a lull in economic data.
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. Special interest after last week's spike.
- Retail Sales (F). The consumer remains central to understanding the economy.
- Michigan sentiment (F). Important for both consumer behavior and a read on employment.
The "B List" includes the following:
- FOMC minutes (W). A policy change is far in the future, but it is good background to monitor the Fed.
- PPI (F). Inflation data will become more important when there is some sign of actual price increases.
Earnings season has the traditional kickoff with Alcoa on Monday. Some big names, including Wells Fargo and JP Morgan Chase report on Friday.
My personal week will include the Kauffman Foundation's 2013 Economic Blogger Conference. I always attend with questions in mind, and I often find answers that will benefit investors. Berkeley Prof Brad DeLong has put together a great program. Anyone can watch the live feed and send questions and comments via twitter. Last year's conference featured panelists responding to tweets from on stage as well as questions from attendees.
Please use the comments to raise the questions that you would most like to see addressed. I'll do my best to get answers.
Trading Time Frame
Felix has continued a bullish posture, but the ratings have weakened. Felix sent one of our holdings to the penalty box on Thursday. The replacement candidates had modest ratings. Since I was concerned about a weak employment report (as I described here) I called an audible and we reduced our Felix exposure to 2/3 long.
This week's Felix forecast remains bullish, but only marginally so. I would not be surprised to see a further reduction in positions this week.
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.
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."
Sometimes the challenge is buying the unloved stocks and sectors. It is difficult to see the opportunity when everything you read is so negative. Writers and pundits want to look smart, so they "explain" what is happening just as if they had predicted it! I will go a bit farther on this in the conclusion.
Investors who have been underinvested in stocks wonder if it is too late to invest. Those who have enjoyed the current rally are bombarded with warnings about the need to sell.
I do not see this year's current gains as a game changer for the market, and the hoopla about the new record highs is also a distraction. The early move this year mostly reflected an unwinding of fear in front of the fiscal cliff decision. I explained my rationale and emphasized the need to be flexible in adjusting your price targets in this article. The post highlights the reasoning of many analysts who have updated the market prospects rather than remaining locked into a concept created in December.
In case you missed it, please read the assessment from fellow Seeking Alpha contributor Alan Brochstein, Up 10%, Are Stocks Now too Dangerous to Hold? He touches all of the bases in his answer to the key investor question – market valuation, overheated sectors, the profit margin issue, interest rates, and even some technical analysis. There is no good way to summarize this excellent overview article, so I encourage you to read it.
But please beware! General ideas are not for everyone. Each person needs unique treatment. We have several different approaches, including one that emphasizes dividend stocks with enhanced yield from writing near-term call options – a conservative, yield-based approach.
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).
One of the best ways to take the pulse of the market is by watching sector trends. I do this daily with the help of a real sector expert --- Felix, our trading model. Felix has highlighted the defensive sectors for many weeks. To illustrate I have once again opened to the public my weekly Felix column at Wall Street All Stars, where we have a vibrant community with many good ideas.
The article features iShares S&P Global Healthcare ETF -- IXJ. As I do each week I look at the featured ETF both from a trading perspective and also the viewpoint of a long-term investor. The difference is often dramatic.
As further research for today's WTWA post I checked out the top ten stocks for overall valuation using Chuck Carnevale's excellent F.A.S.T. Graphs method.
The result? The sector has a yield of 2.11% and a P/E of 16. Neither is very exciting. The individual stocks are all pretty fairly valued. Most importantly, the risk is greater than you might think. The beta versus the S&P 500 is 1.07, but something much worse could happen if and when interest rates rise.
The answer to the questions I posed in the introduction varies with your investment objective and time frame. I expect a rotation to stocks and sectors that have so far lagged in this year's rally. Traders can play the trend. For investors, it is a good time to look for bargains.