December 15th, 2013
Last week I asked the question of whether the fixation on "tapering" would finally come to an end. The question was on target, but the answer seems to be "No!"
With the FOMC reporting on Wednesday, including Bernanke's last press conference, I expect the week to be like one of those dedicated radio stations: All Fed, all of the time.
There are two basic viewpoints on likely policy:
- The Fed balance sheet is too large. Unwinding already involves unknown complications. It is time to taper.
- The dual mandate is lagging on the improving employment and inflation is no threat. There is no rush to reduce stimulus of any sort.
If there is a policy shift, there is a second question about the likely effects on interest rates and stocks.
- Those who believe that QE policies have pumped up asset prices without helping the overall economy. These observers await – some eagerly – for the market correction/collapse that will be the result. Proponents of this idea also do not see any gradual nature to a change in policy. The moment that "tapering" begins, they see this as a signal of Fed tightening.
- Those who see a shift in Fed policy as a gradual change – easing off on the accelerator without hitting the brakes. This viewpoint is the "official" Fed message.
Complicating this is the market reaction to the hints last May that a policy shift was planned. The market hates uncertainty. Explaining that a policy decision will be "data dependent" is a level of nuance that does not satisfy most traders.
I have written extensively on QE and the related misperceptions, so my conclusions will not be surprising to regular readers. The current purchase program has only a small effect – maybe 10-15 bps on the ten-year note. The market forces are much more responsible for the increase in long-term rates. Shifting policy to an emphasis on forward guidance would be helpful, but it will take education and selling.
I have some further thoughts 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, including some you have not seen elsewhere. 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. Each week I consider the upcoming calendar and the current market, predicting the main theme we should expect. This step is an important part of my trading preparation and planning. It takes more hours than you can imagine.
My record is pretty good. If you review the list of titles it looks like a history of market concerns. Wrong! The thing to note is that I highlighted each topic the week before it grabbed the attention. I find it useful to reflect on the key theme for the week ahead, and I hope you will as well.
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.
Most of the recent news has been very good.
- Congress reached a deal on the budget, as I predicted last week. This represents a major shift toward more negotiation and compromise. Cooler heads seem to have more power and respect. Partly this is a tactical decision on the part of the GOP to focus on ObamaCare before the mid-term elections. As investors, we should focus on the economic and market implications. This will avoid another round of debt ceiling and shutdown crises, and it may even open the door to immigration reform.
- Seasonal strength – the best time of the year. See Eddy Elfenbein for discussion and a helpful chart.
- Retail sales beat expectations. Steven Hansen analyzes the trends from several time frames.
- Employment is much better when measured in terms of job openings. I was an early fan of the JOLTS report, which takes a very different look at the employment survey data. Most analysts do not make the best use of this wonderful resource, trying to make it (yet another) take on net job creation. The BLS has released a chart package with comments that provides a rich perspective on employment. This is chockfull of results that no one knows, including several that I have tried to highlight in the past. (Did you know that there are 3.6 million job openings? That more people quit their jobs than are laid off?) Here is a good chart showing how much better things are.
- Stanley Fischer's appointment as deputy Fed Chair. The market reaction to this was somewhat negative. The early reach is to label everyone as a hawk or a dove. Public TV attributed the slightly lower market to this cause on the day of the announcement. The truth is much more nuanced on policy leanings, but very encouraging on credentials. Cardiff Garcia at FT Alphaville has an excellent profile. Max Nisen at Business Insider also rounds up some top opinions. And last but not least, Wonkblog.
- World economic growth prospects are strong according to the IMF. Calculated Risk also does a nice job of summarizing the US prospects, with attention to several important elements. David Rosenberg (via Eddy Elfenbein) agrees, using an interesting source – the Beige Book.
- Household balance sheets are strong and improving. Scott Grannis provides analysis and charts.
- Rail traffic is strong. See Cullen Roche for discussion and chart.
There was not much bad news. I understand that the stock market feels soft, but that is not a reflection of the news flow. I score the news each week based on objective criteria. Things have gotten better. Feel free to add suggestions in the comments. These should be items from the current week, not the repetition of something you could have said (and probably did) six months ago!
- Investment sentiment is very bullish. Josh Brown says that it is "officially embarrassing" and notes that we need more fear.
- Bitcoin ownership is skewed, with 927 people owning half of the circulation. This does not seem to reflect the popular roots behind this phenomenon. For those who want to learn the basics, I recommend this primer from the Chicago Fed.
Sell side analyst stock picks get an ugly award, and perhaps earned one last year as well. Morgan Housel of The Motley Fool compared the ten stocks with the most sell recommendations to those with the most "buys." The average gain was 75% to 20%. It is a nice article, suggesting the reasons behind the discrepancy (wrong incentives, contrarian trades, etc.) and it has the full table of stocks. Maybe we can convince him to generate a list of the bottom choices for 2014!
I was not surprised by this result. Analyst ratings have long been a part of my stock-picking method – on a contrarian basis. It is better to own stocks where analyst upgrades are possible, especially when there is heavy institutional ownership. This is completely consistent with my support for the analyst community when it comes to earnings forecasts. The reports and underlying work are often excellent. I prefer to draw my own conclusions from the data. (Thanks again to reader C.S.)
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.
How about some year-end awards to readers? Let's see how you can do with this problem.
A popular theme is putting together a group of charts and comments from various sources. Charts are powerful and often deceptive. People get the intended impression without spending the time to use their critical thinking skills. Here is an article with many charts, including the one below. There is an obvious error. See if you can figure it out and then check the answer in the conclusion. There is at least one other chart with a major discrepancy between data and title. Maybe more.
China becomes the US's top trading partner
These are items that I found interesting, but which do not fit any other category.
Shawn Langlois does not aspire to cover the investment scene like Abnormal Returns, but the daily posts are interesting and draw on widely varied sources. The commentary is cheeky and fun, and enjoyable to read. (Example here).
Both sources mentioned the favorite books from Bill Gates, who was playing bridge across the room from me last week at the North American Bridge Championship. He is a pretty good player for someone with his experience. His team played four-handed. This meant that he played 100% of the time. Most teams with a wealthy sponsor (e.g., Jimmy Cayne, Carolyn [Mrs. Peter] Lynch) have six players, and the sponsor qualifies by playing half of the time. Gates wants to play, and he has talent. Warren Buffett was not on the team this time, but their favorite partner, Sharon Osberg joined other professional players.
The bridge players are very good about allowing big celebrities to enjoy the competition without undue fuss. The Gates team qualified for the second day of the three-day event – an excellent finish in a very strong field including international stars. My guess is that his personal reading list includes some bridge books!
Josh Brown highlights the major investment themes from 2013 and places them in context. This is an excellent way to keep perspective.
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 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. Theirmost recent report provides a market-timing update for those considering whether to "buy the dips."
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. His most recent update revisits Albert Edwards's year-old prediction that the Ultimate Death Cross was imminent. Georg refuted the claim at the time, and now takes a more complete look.
Unfortunately, and despite the inaccuracy of their forecast, the mainstream media features the ECRI. Doug Short has excellent continuing coverageof the ECRI recession prediction, now two years 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. The ECRI approach has been so misleading and so costly for investors, that I will soon drop it from the update. The other methods we follow have proved to be far superior.
Readers should review my Recession Resource Page, which explains many of the concepts people get wrong.
Here is our overall summary of the important indicators.
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. Over the last three months Felix has ranged over the full spectrum – twice! The market has been moving back and forth around important technical levels, driven mostly by news. The current values are now neutral. There are still many positive sectors, but few with real strength.
Felix does not react to news events, and certainly does not anticipate effects from the headlines. This is usually a sound idea, helping the trading program to stay on the right side of major market moves. Abrupt changes in market direction will send sectors to the penalty box. The Ticker Sense poll asks for a one-month forecast. Felix has a three-week horizon, which is pretty close. We run the model daily, and adjust our outlook as needed.
The penalty box percentage has increased dramatically, meaning that we have less confidence in the overall ratings.
[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
There is plenty of news and data ahead this week.
The "A List" includes the following:
- FOMC rate decision (W). A new policy direction?
- Initial jobless claims (Th). Resuming a key role as the most responsive employment measure.
- Building permits and housing starts (W). Housing is a key component for next year's growth and permits provide a good leading indicator.
- Leading indicators (Th). Still a favorite of many economic forecasters.
The "B List" includes:
- Industrial production (M). Remains important as a concurrent economic gauge.
- CPI (T). Inflation data remains tame, so this is not likely to move the markets.
- Existing home sales (Th). Important, but less relevant to the economy than new construction.
The FOMC announcement and press conference will be the highlight of the week. The rest of the Fed types are quiet during this period. Options expiration may exaggerate a move in either direction.
I am not very interested in the regional Fed surveys or the final revision to GDP, now far in the rear view mirror.
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 shifted into neutral, although we are still fully invested in the top three sectors. Felix's ratings have been in a fairly narrow range for several months. The rapid news-driven shifts are not the ideal conditions for Felix's three-week horizon. This week we see much lower ratings, and many more sectors in the penalty box. There are still three attractive sectors, but it would not be surprising to see reduced position size in the week ahead.
Insight for Investors
I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Each week I try to highlight something special for the long-term investor.
Chuck Carnevale is one of my favorite sources of market wisdom as well as stock ideas. His F.A.S.T. Graphs site provides an indispensable market tool that I consult before any trading or investment decision. Perhaps the strongest endorsement I can make is that the site does what I did myself for decades – long-term study of earnings trends, cash flow, and balance sheets. It has saved me many hours of staff time in collecting data, and made it easy to study trends in different time frames.
Chuck wrote a long and thoughtful article last week with first-rate advice for the long-term investor: Why It's A Mistake To Hold Cash In This Market.
This will take a few minutes for you to read, but it will be time well spent. It has been very popular and attracted hundreds of comments, including many from those who do not grasp the major theme. Settle back with your favorite beverage and give this great post the time it deserves.
And BTW, it does not imply "buy and hold" since your market themes can change. I also believe in strict risk control, adjusted for each investor. This is not the same as predicting bubbles or short-term market corrections.
Barry Ritholtz is also firmly in the camp of the individual investor. There are many new products touting access to hedge fund performance. This can have a mystical quality when presented as a sales pitch. It is best to look at the facts, which Barry lays out in this excellent Bloomberg article, The Five Reasons Hedge Funds Underperform.
He summarizes the data as follows, with plenty of supporting analysis:
The numbers cited above are eye-popping: The average hedge fund is underperforming the S&P 500 by more than 2000 basis points this year alone. That is an astonishingly poor showing.
Josh Brown refutes the bubble talk with analysis from Merrill Lynch, including an excellent summary of valuation measures. Twelve of fifteen show stocks to be cheap.
Here is a summary of our own current recommendations for the individual investor.
- Headlines. The challenge for investors is to distinguish between the major trends and the short-term uncertainty. The main themes are not related to headlines news, even though sentiment may drive market fluctuations. Do not be seduced by the idea that you can time the market, calling every 10% correction. Many claim this ability, but few have a documented record to prove it. Most who claim past success are using a back-tested model. Please see The Seduction of Market Timing.
- Risk Management. It is far better to manage your risk, specifically considering the role of bonds and the risk of bond mutual funds. As I emphasized, "You need to choose the right level of risk!"Right now, it is the most important question for investors. There is plenty of "headline risk" that may not really translate into lower stock prices. Instead of reacting to news, the long-term investor should emphasize broad themes.
- Bond Funds are Risky. Investors have been surprised at the losses, which will continue as the long end of the interest rate curve moves higher. You need to have the right mix of stocks to benefit from a rising rate environment.
- Stepping in gradually. If you are completely out of the market, you are not alone. Consider buying dividend stocks and selling calls against them. This strategy has been working great both for our clients and for many readers. (Thanks for the email responses!) This will work in a sideways market. You can also buy some stock in the sectors with the best P/E ratios.
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).
Any hint of a taper will generate some negative market reaction, but how much? This topic is getting old. The market has digested the rate increase during the past several months. If you join in my conclusion that stock gains rest on fundamentals – better earnings and reduced worries – rather than the Fed, then you should not be worried. Once we get past the knee-jerk reaction, the pension fund investors will step in. The market can easily absorb a lower level of Fed purchases, which represent less than 1% of daily trading.
There is a clear distinction between fact and perception. Repeating a theme I have hit repeatedly, Cullen Roche joins in explaining that stocks can do quite well in a period of rising interest rates – at least at current levels.
Chart Problem Answer
The insightful investor knows that Canada is the top trading partner for the US. The original source for the chart was trying to argue a point about protectionism and selected three specific countries. It was not portrayed as the top trading partners.
It is true that China has now edged out Canada on the import front, but that is not what the chart title said. There are many errors like this. Some are accidents because the rush to post and young editors without background. Some have more malicious intent. Whatever the reason, readers need to be careful.