April 13th, 2014
by Jeff Miller, A Dash of Insight
This week brings the makings of an explosive volatility cocktail:
- Important economic data;
- Key Q1 earnings reports;
- Options expiration;
- A short trading week; and
- An edgy market environment.
This is a very unusual combination, and the various elements will compete for attention.
Prior Theme Recap
Last week I expected the theme to test the divergence between economic fundamentals and what I called "fluff." The latter term referring to the collection of top-calling, market-rigging, crash charts, and "This is the big one" stories. This was one of my better forecasts. The economic news was excellent. The market was terrible. Everyone had an explanation - all different, all dubious.
This is another good 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.
Naturally we would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react.
This Week's Theme
I have almost 27 years of experience as a market professional. I cannot remember planning for a week like this one. Much depends upon the corporate earnings reports.
If earnings disappoint, it will be seized upon as conformation of the bad economy, expensive stocks meme. Volatility will increase. Moves during options expiration can be exaggerated, since strike prices formerly thought to be irrelevant come into play. Markets could move much lower.
If earnings satisfy, it might have a calming effect. This will be especially true if we get a little more confidence in forward outlook, some hints about future hiring, and more planned capital expenditures. In that case we could have a rebound, with plenty of reduction in the VIX.
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 not a lot of economic data, but it was almost all good.
- Aluminum demand is strong and growing. Whatever you think about Alcoa as a company or an investment (CrackerJack likes it), it is well-placed to comment on certain markets. Sam Ro has a good post on this topic, featuring the following chart:
- Greece re-entered the bond market. There was a successful sale of 10-year bonds with a six handle instead of the 30% from a few years ago. Your favorite perma-bear or conspiracy site either did not mention this news, or asserted that disaster still looms. It is interesting that some use "kicking the can" to apply to policies, but not to their own errant predictions. I reviewed this in one of my occasional "Faceoff" pieces - Jeff versus John Mauldin on the record.
- The Fed clarified the timing on short-term rate cuts. This seemed to walk back Chair Yellen's explanation during her maiden first press conference. (I would have written "maiden" for a man..... hmmm). The problem is that the Fed reports the forward guidance from the committee as a whole, but also the forecasts of individual members and staff. She warned not to focus too much on the individual forecasts, which have a specialized set of guidelines. There have been plenty of complaints about an excess of transparency leading to a confused message, and this seems to be an example. John Hilsenrath has a good explanation of the difference. The market celebrated the clarification from the Fed minutes.
- Fewer people are going without health insurance. As always, I do not want to get involved in the politics of this subject. The overall solution is elusive. Meanwhile, there seems to be some progress. John Lounsbury at GEI picks up some key results from Gallup.
- Jobless claims hit a new low, the best in nearly seven years. Bespoke has the full story and captures the importance for stocks in one of their great charts:
- Job openings have increased to 4.2 million. Calculated Risk has good coverage. Personally, I would have liked to see a higher "quit rate."
- The Ukraine reaction has been muted. I am certainly not saying that the issue is unimportant. It is crucial for the people involved and as a matter of foreign policy. Those are subjects for us as citizens. As investors, we merely note that the market has moved on. Scott Grannis has one of his full chart packs showing the best indicators for evaluating this topic.
- Sentiment became more negative. AAII bullishness dropped to 28.5%. This is a contrarian indicator which has been recently highlighted by bearish pundits when it reached bullish extremes.
- Michigan sentiment beat expectations. The current value is still in a range somewhere between healthy and bad. I have a special fondness for this report, and it extends beyond institutional loyalty to my old school. I like the methodology, with a continuing panel as part of the survey. My own research has shown a link between these findings and important variables like employment and spending. Doug Short, as he does so often, brings the data to life by showing the current level, past values, the GDP, and recessions - all in a single chart.
There was also some bad news, but not much. I am sure that some of my commenting community will want to add some bad news, but remember that it is supposed to be something that happened last week.
- China reported weak trade data, down 6.6% from a year ago (via CNBC). I am scoring this as negative, and it was a big disappointment. Asian stocks were lower and it pressured the US. Everyone understands the significance of China for the world economy and especially emerging markets. I track this news, good or bad, with reluctance because I do not really trust the reports. In this particular case, the bad news may be exaggerated because last year was inflated. Bloomberg and Business Insider both have good stories. We need more and better data on China. I do not have a good answer for this.
"We believe the real situation is not that bad, and could be quite normal, by analyzing two distortions, namely the Lunar New Year (LNY) and fabricated trades last year," Bank of America's Ting Lu wrote in a note to clients.
The impact of the Lunar New Year holiday was expected and Ting thinks frontloading exports, gave the January data a boost.
It's the impact of the inflated trade data from last year which is getting a lot of attention.
- Technical indicators are more negative. Assorted moving averages have been breached and bullish setups violated. Even Felix (see below) has become more cautious, on the verge of an outright bearish three-week forecast.
- Market reaction. I generally stick to the underlying data, but sometimes the market mood is the story. When good news gets ignored, it is noteworthy. One of the best ways to track the market week is Doug Short's excellent summary and chart:
The NSA. Reports are that they have long been aware of that Heartbeat Bug that we have been hearing so much about - the one that might be compromising our passwords and online transactions. Bloomberg reports that they chose to use the information for their own purposes. Let the denials begin....
We all deserve some laughs, so how about this one? Fargo sixth-graders beat college investors in a stock-picking contest! (AP with HT to The Kirk Report's excellent weekly magazine). The contest organizer made his first ever trip to ND. Here is his reaction and the comment of one of the entrants:
Walia said he was "blown away" with the level of thinking by the Oak Grove investors. Not all of the students were taking credit, however. Ben Swenson, who invested in Stratus Properties Inc., had another explanation for the high returns.
"I think it was sheer luck," he said.
I recommend taking a look at the winning portfolio (which probably did not do well last week). There is a good lesson in this, in addition to the fun.
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 unemployment rate recession indicator, confirming that there is no recession signal. Georg's BCI index also shows no recession in sight. For those interested in Canadian stocks, Georg has unveiled a new system.
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 (2 ½ years after their recession call), you should be reading this carefully.
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." His analysis shows that none of the next nine months could qualify. I respect this because Bob (whose career has been with banks and private clients) has been far more accurate than the high-profile punditry.
Prof. Robert Shiller joins those who believe that recession odds are low. Rob Wile of Business Insider has the story, featuring this chart as the key reason:
The Week Ahead
We have plenty of news and data in a short trading week.
The "A List" includes the following:
- Housing starts and building permits (W). An important read economic growth for the rest of 2014.
- Initial jobless claims (Th). Best concurrent read on employment. Will the improvement be maintained?
- Fed Beige Book (W). Anything from the Fed is still getting a big market reaction. This is the collection of anecdotal evidence that policymakers will have in front of them at the next meeting.
- Retail sales (M). Rebound after the weather effects?
The "B List" includes:
- Industrial production (W). Key GDP element.
- CPI (T). Eventually inflation will matter, but not yet.
- Business inventories (M) February data, but useful in interpreting GDP and ISM data.
It is a quiet week for Fed speechifying. I do not expect much from the regional Fed surveys.
The big news is the serious start to earnings season.
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 with a neutral rating. We have been completely out of US equities and enjoyed a brief, but profitable, investment in bonds (via TLT). By the end of the week we were fully invested for trading accounts - all in Latin American or China. Those who want to follow Felix more closely can tune in at http://www.scutify.com/, where he makes a daily appearance - assuming that I can awaken him from his Spring fever and the attractions of those "high-frequency" models so popular here in Chicago.
Felix emphasizes momentum, but with many modifications. Cam Hui has a great post on how many methods work, but not all at the same time. So true.
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.
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 day 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.
When Mrs. OldProf wasn't looking, I violated our "no work on celebration nights" agreement to post an update on how we were trading the market volatility. If you have been reading the WTWA series, you were not surprised. (And thanks for all of the kind Birthday wishes in comments and emails).
Because we have been selling in our "long stock" program, we have prepared to buy on dips. We are following the rules that I have recommended for you. I have not added to these positions yet, but we are shopping. I am especially interested in regional banks, energy and some "old tech."
Those following our Enhanced Yield approach should also be doing fine. We have experienced only modest volatility, continuing to beat our upside target for the year despite overall market losses. It is important and helpful to own value stocks that pay dividends and add some hedging via short calls.
Here are some key themes and the best investment posts we saw last week.
Bonds continue to beat stocks. Brian Gilmartin has a thoughtful post that reflects how many of us feel. This demand for Treasuries is unrelenting. There is no easy explanation. Most of those claiming victory were asking "Who will buy our bonds?" only a few weeks ago when the QE tapering became clear. The economy is better. There are new pundit ideas, but they all seem like reaching.
The bond yields make sense only if the economy gets worse. The evidence is against this, so I expect the bond to stock rotation to resume.
To this advice, I add that most people lack the discipline to buy and sell at the right times. Every week I hear about people who bailed out of the market in 2009 and never got back in. You can be a do it yourselfer, but you need to ignore most of the pundits, popular web sites that promote fear, and focus on hard data. Howard Gold provides evidence about the results and the various errors:
The mistake concept is supported by academic research as well. Cass R. Sunstein writes about a personal investment mistake, over-estimating risk and the probability of loss. This is a smart person (like you) who has the same human tendencies. Check out the full article for the three causes of his error.
If you simply must do some hedging of your portfolio, beware the leveraged ETFs. Read this article carefully if your time horizon is more than a single day.
As usual, Barry Ritholtz has some great advice for the individual investor. He hits on the popular theme of the week: "I was right!" Of course that is claimed by many pundits with different explanations. Nothing has changed, but all of a sudden their pet theory has gained traction. He writes as follows:
Of course, all of these narratives serve a singular purpose: They give the appearance of meaning and rationality to actions that are meaningless and irrational. The daily action in the markets is a form of noisy, random, Brownian motion. If you are looking for a clear reason as to why stocks did what they did, then you are in the wrong line of business.
Given that truth, it was with great pleasure this morning I read a headline in the Wall Street Journal that accidentally reflected this reality: "Biotech Stocks' Rout Perplexes Analysts."
If you are obsessed about possible market declines, you have plenty of company. This is one of the problems where we can help. It is possible to get reasonable returns while controlling risk. 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).
While it is easier to say than to do, investors should focus on risk and fundamentals - not stock prices. The post-2000 market results have frightened an entire generation of investors. Whenever there is a bad stretch in the market, however brief, they are afraid of another "big one."
You can imitate what I do for clients.
- Use our recession and financial stress indicators to warn of major risk. None of the major market declines occurred without a warning from these signals. When we get an elevated level, we reduce positions.
- Right-size your positions. Expect that there will be 15-20% market drawdowns without a fundamental explanation. If this move will be too upsetting, your position is too big and you will bail out at the wrong moment. This is how I approach it with investors, and it is better than the silly questionnaires that some big firms use for CYA compliance.
- If your position is the right size, then you are ready to be greedy when others are fearful - and vice-versa.
- And most importantly, be willing to change with your indicators. If we see heightened risk, we will cut back on position size, just as we did in 2011.
And keep in mind, what we saw last week is a minor pullback from fresh highs. It is not even close to a full-blown correction, despite the media coverage. If what you see makes you uncomfortable and interferes with your regular life, your position is too big.
The fundamental story is an improving economy and a reduction in risk that we can measure objectively. Calculated Risk has a nice summary of the economic prospects for the rest of the year. Bill is drawing upon the work of Goldman's Ian Hatzius, who is no perma-bull. Hatzius was Nate Silver's "hero" in the 2007-08 cycle. Here is the outlook:
US economic growth is accelerating as the economy bounces back from the inventory and weather-related weakness of the first quarter. Our current activity indicator (CAI) is up a preliminary 3.6% in March, well above the 2% pace of the prior three months and consistent with our forecast for a rebound into the 3%-3.5% range for real GDP growth in the remainder of 2014.
If this is accurate - or even close, we will see stronger corporate earnings, higher bond yields, and higher stock prices.