May 18th, 2014
by Jeff Miller, A Dash of Insight
To the surprise of most, bonds have rallied while stocks have move sideways. In a week with very little data, and many thinking about an early Memorial Day vacation, the bond/stock tradeoff to be a favorite topic for the punditry.
Prior Theme Recap
Last week I expected a focus on market divergences, especially the decline of small cap stocks. While the financial media also featured news from hedge fund gurus and Fed speakers, the divergence notion was an important theme all week. It will probably continue.
Since I do not regard these divergences as an important leading indicator, the planning was helpful in doing some shopping.
Forecasting the theme is an exercise in planning and being prepared. 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
What should we make of the rally in bonds, a surprise to nearly everyone? Does it provide an important signal of weakness in stocks?
It is a complex topic, with many angles.
- It was the contrarian reaction. Ryan Detrick made a timely call using this reasoning. He expects a continued drop in yield. Check out his reasoning!
- The Fed is on a long-term low-rate policy. While this directly affects the short end, it also alters the term structure and therefore the long end. Ben Bernanke has been tipping this to those attending his $250K sessions. (Also here).
- Short covering by everyone who was wrong. (Barron's)
- Pension plans are locking in safe gains. (See Doug Kass via Josh Brown for this and other ideas)
- The economy is weakening. For the "structural deflation" hypothesis,see here.
- Prices are attractive compared to European bonds. (Gundlach).
- There is less Treasury issuance. (Guggenheim).
For investors trying to make stock/bond asset allocations, the explanation is important. Past speculation (Woe is us! After QE ends, no one will buy US bonds!) has been unhelpful.
As usual, 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 little news, but it was mostly good.
- Sea containers set another record for growth in April. This is a good trade indicator. See Steven Hansen's comprehensive analysis and charts at GEI.
- Small business optimism has improved. Dr. Ed Yardeni highlightsthe percentage of those citing "poor sales" and shows the correlation with the unemployment rate.
- Rail traffic strength continues. This is true for all time frames, as Steven Hansen shows in a helpful analysis at GEI.
- Weekly jobless claims hit a seven-year low. Bespoke has a good post and several helpful charts, including this one:
- Looser rules for mortgage lending. (Via WSJ). While some will decry this as subprime 2.0, our scoring is based on whether something is market friendly. The initial impact of this will be positive for home construction and the economy.
- Earnings guidance turned positive. For the last ten quarters - and despite the rally in stocks - a regular feature of earnings season has been a weaker outlook. While forward guidance is not strong, it is finally positive, as noted by Bespoke.
- Japan's economy is perking up. The Q1 rate was 5.9%, the best in three years.
- Housing starts (and building permits) improved sharply. There is a contra argument since much of the increase is multi-family. Calculated Risk has some nuanced commentary and also the basic chart.
There was also plenty of bad news.
- Michigan sentiment was weak. The preliminary number is sometimes revised, and the market did not seem to have much reaction, but I take this seriously. This series provides good information on both consumption and the overall employment market. It is still far from the levels we expect in a robust economy.Doug Short has a full analysis, and my favorite chart of this series.
- Tax withholding is lower. This is inconsistent with economic news about employment, so it is troubling. New Deal Democrat ponders possible reasons. Taxpayers claiming more exemptions? This is worth watching.
- Retail sales disappointed. The 0.1% gain was short of 0.4% expectations. Regular readers know that I do not like excuses, but I also take note of unusual circumstances. When you had census worker hiring, it affected employment. When the government instituted "cash for clunkers" there was a distortion in car buying. This is reality. This year there are some weather effects that are not captured with the seasonal adjustments. Some stores seem to have been affected more than others. First Trust argues that the late Easter shifted some sales. Weekly data from Johnson Redbook (here and here) have been better. I am scoring this as bad news, but watching carefully.
- Industrial production declined. The 0.4% decrease is not consistent with current economic growth. Once again we have an unusual weather effect. The prior month reflected an increase in utility production (cold weather) which has now been reversed. That is not the whole story, but it is something to keep in mind. Note the effect on the Big Four indicators in the Quant corner chart below.
The drought, now affecting half of the US with 15% experiencing extreme conditions. Vox has a great article and charts, including this one (click map to enlarge):
The Silver Bullet
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. No award this week. Reader nominations are always appreciated!
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 hedging their large-cap exposure, Georg has unveiled a new system.
RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis.
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. He notes that the ECRI has emerged from hibernation. "Interestingly, the interview includes no reference to ECRI's recession call, instead focusing on whether the winter economic downturn was weather-related or reflective of a cyclical downturn."
With Q1 weakness in the economy, it is important to monitor Doug's Big Four indicators. There is clearly some weakness, analyzed in detail in the full post.
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 TV pundits.
One of his key charts illustrates where we are in the business cycle - crucial for the long-term investor. Here is his most recent chart (click graphic to enlarge):
The Week Ahead
We have a very light week for news and data.
The "A List" includes the following:
- Initial jobless claims (Th). Best concurrent read on employment.
- New home sales (F). Important as a concurrent read on the economy and also a leading indicator for future employment and consumption.
The "B List" includes the following:
- FOMC Minutes (W). Unlikely to produce fresh news, but that won't stop the punditry.
- Existing home sales (Th). Important concurrent read on a significant economic element.
There are more regional Fed surveys. I do not regard these as very important (at least not individually) and it takes a big move in one for any real market impact. It is another active week for FedSpeak, including more from Chair Yellen.
Ukraine remains a wild card. I am not expecting much excitement from European elections either (preview here).
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 the bullish rating, and the choices have become more aggressive. The broad market ETFs look a little worse than last week. IWM (The Russell 2000), which is now negative. Wither fewer sectors in the penalty box, we have higher confidence in the ratings.
Those who want to follow Felix more closely can check us out at Scutify, where he makes a daily appearance to join in vigorous discussions about trading.
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.
We finally had enough volatility to do some buying - two down days in a row.
Those trying out our Enhanced Yield approach should have enjoyed yet another good week in a sideways market. It is important and helpful to own value stocks that pay dividends and add some hedging via short calls. I have written several times about examples that you can try on your own. It reduces your risk. Start small and get the sense of how to do it.
Here are some key themes and the best investment posts we saw last week
David Merkel warns about risk and reward in his post, Playing for Pennies, Risking Dollars. He says the following about junk bonds:
I try to avoid investments where the upside is limited, but the downside is unlimited. That's the way I feel about junk bonds now. Have junk yields been lower before? No, we have eclipsed the time in 2013 when the junk market was in a yield frenzy, until Bernanke uttered the word "taper."
I think he is too conservative about stocks, which have similar risk to the junk bonds but much more upside, but read his entire post.
Bubble talk? Since the bubble stories get the headlines, the average investor can easily be persuaded that current stock prices are an artifact of Fed policy. In truth, a combination of stronger corporate earnings, a better economy, and reduced financial stress fully justify the market rally.
Eddy Elfenbein, one of the best allies for the individual investor, updates his helpful earnings chart.
Scott Grannis looks directly at overall corporate profits with this chart:
Chuck Carnevale, whose F.A.S.T. graphs tool is an indispensable resource for investors, has ideas for you. In addition to illustrating how to use his approach, he provides ten stock ideas, each from a different sector. Great work, and worth reading the entire post carefully.
Beware of the micro-cap marijuana stocks. The SEC warns of misrepresentation of facts and market manipulation in some cases. Who could have guessed?
Hedge fund manager David Tepper has turned cautious. Jason Zweig reports his "nervous time" comment. This is interesting information for investors, who should always make sure to "right size" their risk. I warn that Warren Buffett's advice that stocks are better than bonds is not appropriate for all investors. The same is true of Tepper. You are unique.
Chuck Jaffe also has a great column on analyzing your personal risk/reward balance. You must be realistic. This is where I begin with each new client.
Stocks could be undervalued. Investors are bombarded with negative stories on valuation. Here is Jeff Saut with a standard metric (and not the only one) that you hear little about. He thinks it is "too optimistic" but worth noting:
If Graham and Dodd's estimated P/E formula is anywhere near the mark (P/E = 8.5 + 2x Growth Rate), the SPX's correct P/E should be 20.3, not the 16.6 times it is currently trading for on a trailing 12-month basis. Recall Graham observed the average no-growth stock traded at 8.5 times earnings, and that P/E ratios increased by twice the rate of earnings growth, therefore 8.5 + 2(5.9%) = a P/E ratio of 20.3, or a price objective of 2781 for the SPX.
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).
The cause of the bond rally? There is no single reason. Most persuasive are the arguments about fund flows from Europe and conservative decisions by pension funds (finally closer to their targets).
Those inferring economic weakness include the usual collection of "bond guys" talking their book and assorted pundits who never seem to find the "buy" button for stocks. It is great fun to criticize economic forecasts, but most of the critics do even worse themselves.
Nearly everyone is just itching to call the "end of the cycle" because it has lasted a long time. I have been accurate in my patience. This was a prolonged economic cycle, featuring a slow recovery from a sharp decline. I recommend two key points to follow:
- A recession remains very unlikely in the near term - and that is the source of major market declines.
- The best economic forecasts remain solidly positive. If you prefer to follow some pop economist who did not actually take Econ 101, you should understand that he is seducing you with an image of reality and has no real track record. Contrast this with this take from one of our featured sources, Menzie Chinn at Econbrowser:
- Rebound in monthly GDP
- Continuing output gap of 3.2%
- No inflation concern
Most market pundits are not even thinking about what could happen if the output gap is closed.
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