March 9th, 2014
by Jeff Miller, A Dash of Insight
With stocks hitting new highs and the bull market reaching age five, the potential for a market top is a popular subject. There is a light schedule of economic releases, so pundits will be free to spend nearly full time explaining the rally and offering their forecasts.
Expect even more articles like "Six reasons this is a market top" and "How to protect your portfolio."
I could get more page views with a title like that, but let us try to put this more neutrally and make it forecast-free:
What is the risk/reward for stocks?
Last Week's Theme Recap
I expected last week's theme to be focused on employment and that was mostly correct. I also noted that there would be continuing attention on the Ukraine situation, with events changing rapidly. The market was reacting to the potential for armed conflict. I provided several balanced sources to help your assessment of events, concluding as follows:
If you are too lazy to read these brief and helpful articles, here is the one-sentence summary: We are very distant from a US/Russia armed conflict. There are umpteen diplomatic steps along the way, starting with skipping a planned trip to Sochi.
This is a perfect illustration of the reason for my weekly post - planning for the week ahead. Readers are invited to play along with the "theme forecast." I spend a lot of time on it each week. It helps to prepare your game plan for the week ahead, and it is not as easy as you might think.
This Week's Theme
How should we evaluate the overall market risk and reward? There are three basic positions:
- Skeptics and top-callers. Stocks are over-valued, supported only by the Fed. Compare to what happened when stocks visited these levels before. The cycle is extended and overdue for a correction.This article is typical of many.
- Reasonable valuation. Modest growth has supported the market ascent. Stocks are fairly priced and can continue single-digit growth if sales and earnings keep pace. Josh Brown cites distinctions between now and 2007.
- Bullish prospects. The economic cycle has not yet reached trend levels. A rebound in economic growth could spark a strong second half to 2014. Some even worry about a melt-up, with both increased earnings and multiples.
No one can make a confident forecast for the next market move, but it may be possible to define some limits. I have some thoughts that I will share in the conclusion. First, let us do our regular update of the last week's news and data. Readers, especially those new to this series, will benefit from reading the background information.
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.
There was plenty of good news.
- Eurozone PMIs are improving. Hale Stewart reports on the Markit index at 53.0 and above the earlier flash estimate. I am still cautious about the interpretation of these reports. I suspect that a sharp journalist will soon make a deep dive into the methodology. There is definitely a market impact, reflected in overnight futures. We care about Europe, but is this the best measure. (Same question for China).
- Bullish sentiment (a contrarian indicator) is still low. Our favorite chart of this via Bespoke:
- ISM manufacturing beat expectations, signaling expansion with a reading of 53.2. Steven Hansen at GEI has a comprehensive analysis. Read his full story for charts, comparisons with regional Fed surveys, and discussion of the component categories. It is a comprehensive look at an important report.
- The PCE price index is up only 1.18% year-over-year. This is the measure of inflation watched by the Fed, with a target of 2% and a willingness for a temporary increase at a higher level. If you want to profit through understanding the Fed, you had better start with following the PCE. Doug Short has the analysis and charts we have grown to expect, including this one:
- Americans are richer than ever. US household assets increased by $9.8 trillion or 14%. Scott Grannis has the story and also several charts. This one shows that we are almost back to trend growth:
- Four million properties returned to positive equity in 2013. CoreLogic data via Calculated Risk.
- The Fed's Beige Book shows modest growth. Calculated Risk has a great analysis, noting the regional differentials and weather effects. Scott Grannis explains why modest growth has been working just fine for stocks. (Chart lovers should check this out).
- Personal spending increased 0.4%, beating expectations.
- Employment growth was mixed, but generally a market positive. It was better than expected on several fronts
- Payroll growth showed 175K net gain in jobs.
- Labor force participation increased.
- Higher unemployment rate is probably a more accurate reflection of reality and gives the Fed a little room to remain aggressive.
- State governments are no longer a source of job losses. (WSJ analysis and charts).
- Initial jobless claims declined 26K, back to the bottom of the range.
Matt Phillips at Quartz has a great chart package. Here are two of special interest, showing weather effects and the decline in involuntary part-time employment (still a problem, but much better).
There was also some bad news.
- High frequency indicators are weaker. I always read carefully the fine weekly summary from New Deal Democrat. He collects many concurrent indicators that each might seem minor, but collectively are quite significant. There is an overall soft patch. Weather?
- Auto sales were weak. Another weather effect? Any catching up in the Spring?
- Private job growth was modest -- only 139K as reported by ADP. Since I view this report as a useful independent read on employment growth, I treat it with respect.
- Ukraine. The conflict continues, with potential impact on trade and energy prices, but far from the much-feared military effects. George Friedman of Stratfor (Courtesy GEI) has an excellent background piece with some thoughtful ideas about the future.
- China PMI fell to 48.5, in line with expectations, but showing contraction. This is sending copper prices, viewed by many as a general economic indicator, to the biggest decline in over two years. (WSJ).
- ISM services was very weak at 51.6. While still indicating expansion, it was the lowest reading since 2010, as shown in this chart from Bespoke:
- Margin debt hit an all-time high. Doug Short has the story and great charts. This is widely viewed as a market negative, but I wonder. It seems to be a concurrent indicator and it applies equally to those buying stocks and those selling short. Either way, there can be margin calls when big moves take place.
The Pentagon - spending $300,000 per year to study body language of world leaders like Putin. Apparently realizing that people might find this to be an unreliable method, the Pentagon press secretary Rear Adm. John Kirby did his best to distance them from Defense Secretary Hagel's office, stating,
"The secretary has not read these reports. And I don't believe that - I can tell you for sure that they have not informed any policy decisions by the Department of Defense."
So we are spending for information that is not being used. Also, the information is not classified but also not available to the public. (The Hill).
Late Friday afternoon CNBC announced that Larry Kudlow was retiring from his regular evening show, a staple of the network's evening programming for nearly a decade. Other sources suggested that he was pushed out because of declining ratings. Some have complained about his optimistic views on the stock market and the economy.
There is a lot of tension in a program that combines politics, the economy, and financial markets. I suspect that I have viewed as many episodes as anyone over the years, often citing what I saw in my regular posts. I record each episode (and also the PBS Newshour) and watch them both via TIVO every night. I fast forward through segments of less interest. Over the years, I have found that I have skipped more of the politics and focused on the interesting market debates.
It is distressing that many critics see the exact opposite in the strengths and weaknesses. Some complain that Kudlow sought effective responses to bearish pundits like Peter Schiff and Michael Pento. This is a lame argument, mostly because the show sought effective debate. It is difficult for anyone to engage aggressive participants who do not play nicely - interrupting and talking over your points.
It is also interesting that these complaints come even though Kudlow has been correct on both the economy and the markets. Political conservatives who listened to him did much better than those who followed his critics.
I note that another CNBC alum, Maria Bartiromo, bemoans the political talking points and wants to provide better grounding for investors. This is exactly what is needed, but it does not score in the ratings. We will all watch with interest as she attempts to reach this goal.
Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. For more information on each source, check here.
Recent Expert Commentary on Recession Odds and Market Trends
Georg Vrba: Updates his newest recession indicator, maintaining an increase in the "weeks to recession" from 26 to 27. This does not mean that there will be a recession in 27 weeks. Instead, it shows that the chance is "statistically remote" that a recession would start during that time. For those interested in gold, Georg also sees a possible buy signal next month. Stay tuned!
Doug Short: An update of the regular ECRI analysis with a good history, commentary, detailed analysis and charts. If you are still listening to the ECRI, you should be reading this update. Doug also has updated the big four indicators important to the NBER in recession dating. Everything except employment is showing a decline - small so far. This is the single best summary of concurrent indicators, so join me in watching it closely. Here is the updated chart:
- Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured "C Score." One of his conclusions is whether a month is "recession eligible." None so far - and Bob has been far more accurate than the high-profile punditry. See also a good yield spread article via Barry Ritholtz, part of Bob's method.
The Week Ahead
This is a very light week for data.
The "A List" includes the following:
- Initial jobless claims (Th). Best concurrent read on the most important subject.
- Michigan sentiment (F). Crucial for consumer spending and as a read on jobs.
- Retail sales (W). February data, so the weather debate will continue.
The "B List" includes:
- JOLTS report (M). Labor turnover is getting more attention, but most use it incorrectly. Do not try to "back into" some job creation estimate from this. Other methods are better. Look at the quit rate and job vacancies.
- PPI (F). Inflation will be a factor someday, but not yet.
There will be some FedSpeak, including Vice-Chair nominee Stanley Fischer on Friday.
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
Three weeks ago Felix made a dramatic switch from neutral to bullish adding trading positions throughout the week. That has worked pretty well. We remain fully invested. Most sectors have emerged from the penalty box, reflecting greater overall confidence in the three-week forecast.
In case you missed it last week, I want to highlight the return to blogging of my friend and former Naperville resident, Brett Steenbarger. There is plenty of good fresh content on his blog, but I especially like the post on Ted Williams and the need to pick your spots.
This was also one of my themes back in 2008, when I posted the same chart of Ted and his strike zone. It is a concept behind our Felix model and the penalty box, but it can readily be applied for investors with a longer time frame.
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. The current "actionable investment advice" is summarized here.
This is still an important time for long-term investors. We all know that market corrections of 15% or so occur regularly without any special provocation. Recent years have been the exception. Over the last several weeks I have emphasized the need to maintain perspective, using market declines to add to positions. I did this for my clients last Monday.
It helps if you have been actively rebalancing your portfolio and trimming winners. Then you have some cash. Some readers have asked me to write more on this topic, so I have placed it on the agenda. For now, let me do a quick summary.
- Review your holdings regularly. (For me, that means at least weekly, but it is my job. Quarterly is probably enough for most people, perhaps with some price alerts). Make sure that your original reasons for the investment are still valid. Revise your fair value and price target estimates.
- Do not fall in love with a position. If hanging on to a disappointing holding, make sure your reasons are sound.
- Sell if your price target is hit.
- Rebalance by trimming if a stock appreciates massively, but remains below the price target.
Each week I highlight some of the best advice I see. Here are some highlights.
Warren Buffett continues to grab the headlines, and we are happy to glean what we can. Most people probably did not see his early-morning appearance on CNBC, covering many interesting topics: Ukraine (he was ready to buy), Stock market rigged? (No), his will (Stocks, with a little cash for needed expenses), and some specific stock advice. Great stuff from Brooklyn Investor.
See also David Merkel's nice treatment of intrinsic value - a deep dive into the annual report that you will not get anywhere else.
Barry Ritholtz emphasizes the importance of process versus outcome. I see this frequently, as investors talk about what has worked recently without analyzing why. Here is a key quote:
Outcome is simply the final score: Who won the game; what numbers came up in a roll of the dice; how high did a stock go. Outcome is the result, regardless of the method used to achieve it. It is not controllable. You can blow on the dice all you want, but whether they come up "seven" is still a function of random luck.
Process, on the other hand, is a specific methodology. It is a repeatable approach to any challenge or endeavor, be it construction or medicine or investing. And you can control a process.
What kind of people are outcome-oriented? Gamblers, many (but not all) sports fans and, of course, speculators.
What about the process-oriented people? They include airline pilots, professional sports coaches and, of course, long-term investors.
And finally, many investors are sitting in cash (Yahoo Finance). This is one of the problems where we can help. Check out our recent recommendations in our 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 and use feedback).
Most of the arguments comparing current markets to past tops rely heavily on anecdotal evidence of the infamous charts that try to match up prior times by distorting the scales. It is easy to find similarities between now and any point in history - both good and bad. It is a method that starts with a conclusion and then looks for "evidence." People should know better, but such analogies are difficult to refute and persuasive to those who want to believe.
Downside risk is greatest when there is a recession or a financial crisis. Both risks are extremely low. Even without much growth investors can profit from a sideways market, as I have frequently explained.
There is little discussion about upside potential. Even modest forecasts draw scoffing from the peanut gallery. A few weeks ago Laszlo Birinyi predictedthat the S&P 500 could rebound to 1900 by July. His most recent report notes that all of the comments on his article were negative. No wonder the media cater to the scare pieces.
Meanwhile, it is easy to imagine more upside. If the economy strengthens in the second half of the year, there will be less skepticism about the current 2014 S&P earnings of almost $119. The forward earnings yield of 6.33% is an attractive alternative to bonds. (Data but not conclusion from Brian Gilmartin's excellent weekly earnings update). Stir in a little improvement in sentiment and you get forecasts like that of JP Morgan's Thomas Lee - Up 20% for the year with a 1 in 3 chance of a 30% gain.
Many observers cite the slow economic recovery without realizing the implication: This is a longer and slower business cycle. Trying to call a market top based upon average cycle length is an error that everyone is itching to make.
Risk and reward are not as negative as most seem to think.