June 16th, 2013
by Jeff Miller, A Dash of Insight
After weeks of speculation based upon speeches, newspaper columns, and pundit pontification we will finally have some hard information. Maybe. The two-day FOMC meeting will include not only the regular announcement of the decision, but also revised economic forecasts and a press conference by Chairman Bernanke. Everyone will be watching for any hints of a change in policy.
- Will the Fed reduce the pace of the current QE purchasing?
- If not, will it provide more information about the timing of a possible change?
- What might be the size of any reduction?
Those expecting early action seem to focus on September. Tim Duy reviews the most recent data and concludes,
"Bottom Line: Today's data appears consistent with Fed expectations that they can begin tapering asset purchases this year. Still a horse race between September and December, although I think the Fed is aiming for the earlier date if data allows."
Those expecting later action point to the lack of inflation. Recoveries from recession are usually stronger and faster; that usually means inflation. Rex Nutting notes that it is the lowest core inflation in history.
If the Fed does change course, what will be the result?
Most market observers expect a major reaction at the first sign of a Fed policy change. They are not waiting for an actual increase in interest rates, but getting ready to head for the exits at the first sign of a policy shift. This analysis from Barclays, cited in The Economist, is typical. It shows the "sensitivity" of various markets to changes in the Fed balance sheet. There is no attempt to show a causal mechanism.
Intone after me:
Fed prints money. Liquidity, liquidity. POMO, POMO. Asset prices move higher – all of them!
I have some contrarian thoughts about what to expect from the Fed. I'll elaborate in the conclusion, but 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.
On balance, this was a good week for economic data.
- S&P revised the outlook on U.S. debt to stable from negative. Do we really care?
- Year-over-year growth in expected earnings is stronger (via Brian Gilmartin). This comparison deserves more attention.
- Initial jobless claims surprised and declined to 334K. There is less firing, but we still need more hiring!
- Retail sales showed a surprising gain, even after subtracting higher gasoline sales. There is solid growth but less than expected from a normal recovery. Scott Grannis has a good analysis with a Fed related theme and many helpful charts. Here is the retail sales "control" group version:
There was some bad news, but probably not as important. Feel free to add in the comments anything you think I missed!
- Pump and dump is back. Investors who feel like they have missed the rally are trying to catch up in the wrong way. The SEC and FINRA are warning about an increase in scams.
- The PPI increased by 0.5%, mostly reflecting energy prices. In the long run, we care about food and energy costs, but the year-over year change was only 1.7%.
- Another debt ceiling debate looms (via The Hill). This can put a lid on job growth.
- Rail traffic is stagnating (via Cullen Roche). Contrary view from GEI, using different comparisons.
- Industrial production was flat, missing expectations. James Picerno has a nice analysis, advising that the indicator bears watching but is not yet a "smoking gun." Here is one of the useful charts:
- Chinese growth is losing some momentum, but still relatively high (via Ed Yardeni).
Congress is a repeat winner of the "ugly" award. It seems like there is often something new. Gallup reports that confidence in Congress has hit an all-time low of 10%, down 3% from last year. One reason for poor performance might be lack of knowledge and attention. The Hill reports that the majority of the Senate preferred to check out early for the weekend rather than to attend a classified briefing on NSA snooping.
There were some other candidates this week, so feel free to add your own ideas in the comments!
The Indicator Snapshot
It is important to keep the current news in perspective. I am always searching for the best indicators for our weekly snapshot. I make changes when the evidence warrants. At the moment, my weekly snapshot includes these important summary indicators:
- For financial risk, the St. Louis Financial Stress Index.
- An updated analysis of recession probability from key sources.
- For market trends, the key measures from our "Felix" ETF model.
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 recently edged a bit higher, reflecting increased market volatility. It remains at historically low levels, well 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.
I feature the C-Score, 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. Meanwhile, 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 also 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. RecessionAlert has developed a comprehensive package of economic forecasting and market indicators, well worth your consideration.
Georg Vrba's four-input recession indicator is also benign.
"Based on the historic patterns of the unemployment rate indicators prior to recessions one can reasonably conclude that the U.S. economy is not likely to go into recession anytime soon."
Georg has other excellent indicators for stocks, bonds, and precious metals at iMarketSignals.
Calculated Risk joins us in concluding that there will be no recession for "some time" and also in placing a high priority on this analysis.
Unfortunately, and despite the inaccuracy of their forecast, the mainstream media features the ECRI. Doug Short has excellent continuing coverage of the ECRI recession prediction, now over 18 months old. Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting. His latest comment points out that the public data series has not been helpful or consistent with the announced ECRI posture. Doug also continues to refresh the best chart update of the major indicators used by the NBER in recession dating.
The average investor has lost track of this long ago, and that is unfortunate. The original ECRI claim and the supporting public data was expensive for many. The reason that I track this weekly, emphasizing the best methods, is that it is important for corporate earnings and for stock prices. It has been worth the effort for me, and for anyone reading each week.
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. We recently switched our stance to neutral, but it is a close call. Felix might switch to a bearish posture if the overall market drifts lower. The inverse ETFs are more highly rated than positive sectors by a small margin, but remain in the penalty box. These are one-month forecasts for the poll, but Felix has a three-week horizon. Felix's ratings seem to have 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 brings little data and scheduled news, an artifact of the calendar and the holidays.
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.
- Building permits and housing starts (T). Building permits are an excellent leading indicator for housing, and housing is what we should be watching.
- FOMC decision and press conference (W). The key point for the week.
The "B List" includes the following:
- CPI (T). At some point the inflation data will be more important. For now it is benign.
- Existing home sales (Th). This is a key element of the economic rebound, so it is important to follow.
- Leading economic indicators (Th). This report is still widely followed and used by some in recession forecasting.
I am not very interested in the Empire State index or the Philly Fed report, but people will pay attention to extreme moves.
There will also be continuing news from President Obama's travel abroad, but I am not expecting a specific market impact.
How to Use the Weekly Data Updates
In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a "one size fits all" approach.
To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?
My weekly insights often suggest a different course of action depending upon your objectives and time frames. They also accurately describe what I am doing in the programs I manage.
Insight for Traders
Felix has continued a neutral posture, now fully reflected in trading accounts which have no position in equities. Our partial position includes a bond inverse fund and a commodity. The overall ratings are slightly negative, so we are close to an outright bearish call. This could easily be the case by the end of next week. While it is a three-week forecast, we update the model every day and trade accordingly. It is fair to say that Felix is cautious about the next few weeks. Felix did well to avoid the premature correction calls that have been prevalent since the first few days of 2013, accompanied by various slogans and omens.
Insight for Investors
This is a time of danger for investors – a potential market turning point. My recent themes are still quite valid. If you have not followed the links, find a little time to give yourself a checkup. You can follow the steps below:
- What NOT to do
Let us start with the most dangerous investments, especially those traditionally regarded as safe. Interest rates have been falling for so long that investors in fixed income are accustomed to collecting both yield and capital appreciation. An increase in interest rates will prove very costly for these investments. It has already started. Bespoke Investment Group has a great chart package showing how the rush into yield-based investments is going South in a big way! Anyone focused on yield should read this post and look at the charts. The most recent victim is the preferred stock, as you can see here:
I also recommend the excellent analysis by Kurt Shrout at LearnBonds. It is a careful, quantitative discussion of the factors behind the current low interest rates and what can happen when rates normalize.
- Find a safer source of yield: Take what the market is giving you!
For the conservative investor, you can buy stocks with a reasonable yield, attractive valuation, and a strong balance sheet. You can then sell near-term calls against your position and target returns close to 10%. The risk is far lower than for a general stock portfolio. This strategy has worked well for over two years and continues to do so. (I freely share how we do it and you can try it yourself. Follow here, and scroll to the bottom).
- Balance risk and reward
There is always risk. Investors often see a distorted balance of upside and downside, focusing too much on new events and not enough on earnings and value. Check out the ten suggestions from Barry Ritholtz, specifically aimed at those who feel they missed out on the latest market move.
Three years ago, in the midst of a 10% correction and plenty of Dow 5000 predictions, I challenged readers to think about Dow 20K. I knew that it would take time, but investors waiting for a perfect world would miss the whole rally. In my next installment on this theme I reviewed the logic behind the prediction. It is important to realize that there is plenty of eventual upside left in the rally. To illustrate, check out Chuck Carnevale's bottoms-up analysis of the Dow components showing that the Dow "remains cheaply valued."
- Get Started
Too many long-term investors try to go all-in or all-out, thinking they can time the market. There is no reason for these extremes. There are many attractive stocks right now – great names in sectors that have lagged the market recovery. Ignore all of the talk about the Fed and focus on stocks. One of my favorite sources, Bill Nygren of Oakmark refused to play the game in his CNBC interview this week. He would not answer the standard questions about the short term, and carefully explained why investors should take advantage of volatility to buy cheap stocks. This is also my message, and I agree with many of his specific stock suggestions. For those who were not monitoring CNBC two hours before the opening, you might have missed this great interview.
And finally, 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).
What should we expect from the Fed?
It has actually been pretty easy so far. Here are the rules:
- Pay attention to Bernanke, not speeches by others. They are free to talk in the modern era, but the message is not orchestrated.
- Do not expect a road map when there is no specific plan. When the message is that policy is "data dependent" that is clear communication. It is silly to expect more specificity from a committee. They are all looking at the evidence.
- Do not over-estimate the Fed impact. This is the most important lesson. Everyone who has been wrong about their forecasts – recessions, interest rates, stocks – has blamed it on the Fed.
These are the same people who told you that the Fed was "out of bullets." They argued that the Fed would not be effective. That the Dow was going to 5000. These are sources that are using the Fed as a fig leaf to cover up their own mistaken analysis.
The reality is that the Fed has had a modest impact on both interest rates and the recovery in stocks. The facile, two-variable correlations between QE and various markets are flawed. Anyone doing serious economic analysis understands that many variables are changing at the same time. Consider the Barclay's graph I cited the introduction.
Do you really think that Turkish stocks will get crushed if the Fed eases off on QE? What happened to the "correlations" that we saw with food prices and energy on the last round of QE? Notice how the comparisons change when convenient?
Fed policy has been a modest substitute for better fiscal policy. It had a modest economic effect when implemented, and will have a modest economic effect when withdrawn.
The psychological effect is another matter, and a problem for another day.
Ultimately, interest rates and stock prices will both move higher. For more explanation check out my post from the start of 2011 I predicted ten things that would be more normal. Some have proved accurate while others are a work in progress. Former Goldman Sachs Asset Management Chairman Jim O'Neill reaches a similar conclusion:
In the short term, getting back to normal probably means some fallout across equity markets, too -- but this is much less likely to be lasting. Longer-term investors will want more exposure to equities, not less. Normality means a reversal in the popularity of the two main asset classes: As people fall out of love with bonds, they'll fall back in love with equities.