June 29th, 2014
by Jeff Miller, A Dash of Insight
With the stunning decline in Q1 GDP, the health of the US economy has once again taken center stage. The week ahead is shortened by a Friday holiday, but is packed with important data releases. It will all be over Thursday morning, when many will quit early and head for the beach.
In a quiet, low volume trading environment, we could see some early fireworks!
Prior Theme Recap
Last week I expected plenty of inflation talk leading up to the release of the Fed's preferred measure, the PCE index. That assessment was accurate. I also speculated that there might be a final GDP revision exceeding 2%. That was an underbid! The story made plenty of news, but caused only a temporary reaction in stocks. Bonds strengthened (lower yield) emphasizing the continuing disparity between those markets.
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. That is the purpose of considering possible themes for the week ahead.
This Week's Theme
With the Q114 GDP decline as context, the economic debate is once again wide open. It is time for a mid-year reality check, with possible fireworks in store. I expect the media and punditry to examine a full range of economic possibilities. Here are the candidates.
- Stagflation - Combine economic weakness with inflation and it is the road to the 70's. The Fed is "boxed in" and "between a rock and a hard place." Watch the early warning signs. Here is an example of this thinking.
- Poor economic policy - ObamaCare, tax policy, regulation. (WSJ commentary reflects this viewpoint).
- Exceptional circumstances - weather, sluggish health care enrollment, inventories. (Analysis and charts from Hale Stewart).
- Things turned in March - noted by those who follow frequent data. (Extensive discussion from New Deal Democrat).
- Expect a rebound -- weather delayed demand, health care rebounded, inventories will be rebuilt. (Morningstar). (Also Jared Bernstein via Mark Thoma).
Same data, many interpretations. Some positions reflect underlying policy and political preferences. Investors must use care, especially on issues of this type. We must not confuse what we hope for with reality and sound investments.
Which of these viewpoints is correct? 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 some encouraging news last week.
- Consumer confidence registered 85.2. This beat expectations via the Conference Board. The Michigan Sentiment report also showed a slight beat. Doug Short updates both indicators (and the NFIB optimism index as well). The charts are all great, but I will highlight the Conference Board result - now beating the declining trend, but well off of historic highs.
- Stock Buybacks support the market. Ed Yardeni shows the trend and the data. He describes the causality and warns about the impact of a recession. If this does not seem like good news, check out TrimTabs (below).
As I have often observed in the past, corporations have an incentive to borrow in the bond market and use the proceeds to buy back shares when their earnings yield exceeds the corporate bond yield. That's been the case since 2004 thanks to the Fed's easy monetary policies under both Alan Greenspan and Ben Bernanke, and now Janet Yellen.
Buybacks are a form of financial engineering since they boost earnings per share whether a company's fundamentals are improving or not. They've certainly contributed to the bull market's great run in an economic environment that has been widely described as "subpar."
- Earnings estimates grind higher. Brian Gilmartin does a great job on this topic, as well as coverage of many specific companies. We think of him as the earnings guru. His current update post reflects some conversations we have had in recent years. I like to think we have both benefitted from a focus on the truth in earnings forecasts. Most observers casually dismiss one of their most helpful sources. Earnings estimates start out as too bullish, mostly when made two years in advance. By the time the report is announced, the beat rate is over 60%. They have to be right at some point!
- Housing data improved. New home sales were up over 18%. Calculated Risk, our favorite source on housing, has a more measured take - less enthusiasm about the spike in new home sales (up 2% y-o-y), less pessimism about the decline in existing home sales (reflecting fewer foreclosures and short sales).
The economic news included some negatives as well.
- Boomerang kids won't leave. The sluggish recovery is playing havoc with "traditional" family life. Young adults are returning home. This can be financial necessity, but it can also make sense. Adam Davidson's NYT Magazine piece attracted plenty of attention this week. There are implications both for employment and housing.
- Margin debt increased at the NYSE. I am scoring this as "bad" because that is the way it is generally portrayed. Doug Short posts it with a question mark, but others using his work are less equivocal. Some also see a decline in debt as bad, since that triggers the warning for stocks (which is either 3 months or 6 months or a little longer). I am uncomfortable with indicators that are viewed as positive (or negative) no matter whether they go up or down!
- Planned stock buybacks are in a dramatic decline. The overall levels are still high, but down significantly from Q1. (TrimTabs viaMarketWatch).
- Personal spending disappointed. The personal income gain met expectations with a growth of 0.4%, but spending was only up 0.2%. (Via Calculated Risk). Steven Hansen at GEI sees this as bad sign for Q2 GDP.
- Durable goods orders declined 1%. (See WSJ). Also several helpful comparisons and charts from Doug Short.
- GDP declined 2.9% for Q114. The decline is much greater than we typically see outside of a recession. Even if the recovery is continuing, it underscores how dramatically economic performance lags potential. Scott Grannis discusses these relationships, including a good chart on each point:
Ukraine. The ceasefire in eastern Ukraine is "under stress." (Via BBC).
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.
Normally the award goes for a single refutation of a single bad claim. Barry Ritholtz often uses a weapon that is both more modern and more powerful than the Lone Ranger's. Please read his analysis of a general failure in causal reasoning. Here are some recent examples, cut down with a Gatling gun instead of a six-shooter.
What are a few examples of the single factors that have been making the rounds these days?
GDP: "We have never had a negative 2.96 percent GDP report and not gone into recession..."
Rising Rates: "The U.S. stock market doesn't do well when interest rates are rising."
Earnings Surprises: "Earnings are good this quarter, better than expected, and therefore, the market's going higher."
New Financial Products: "These new products are being adopted, therefore it means the bull market is coming to its peak."
Death Cross/Golden Cross: "When the 50 and 200 day moving average cross to the upside (downside), it bodes well (poorly) for any trading vehicle."
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
RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis.
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.
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 hasunveiled 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. Doug includes the most recent ECRI discussion, which has been consistently bearish, including the blown call on the recession.
Doug also continually updates the "Big Four" indicators used in recession dating by the National Bureau of Economic Research (NBER). With all of the data for May in the books, it is time for another look at the key chart, but see the full article for comprehensive discussion.
The Week Ahead
We have plenty of news in a holiday-shortened week.
The "A List" includes the following:
- Employment report (Th). The complex, heavily revised report is still the most important evidence for markets.
- ISM index (T). Good read on manufacturing trends with some leading qualities. Continuing strength?
- Auto sales (T). After the seasonal fluctuations, will strength continue? And check out the F150 small business indicator.
- ADP employment report (W). An alternative measurement of private job growth. Deserves more respect.
The "B List" includes the following:
- ISM Services (Th). Covers more of the economy than manufacturing, but still not as influential. Many will be on the way to the beach by the time this is released!
- Construction spending (T). Important sector - May data.
- Chicago PMI (M). The regional survey most reflective of the national data.
- Pending home sales (M). May data, but everyone cares about all things housing.
- Trade balance (Th). May data relevant for Q2 GDP.
Despite the start of summer, the speaking calendar includes SF Fed President on Tuesday and Chair Yellen on Wednesday.
While the financial markets have adjusted to the current Iraq story (see herefor confirmation), there is plenty of attention to any breaking news. There is also the possibility of increased conflict in Ukraine.
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 remains cautiously bullish. The positive elements are modest in strength and uncertainty remains high - typical for a trading range market. This week we were fully invested in three of the top sectors for our trading accounts. That remains our position going into the week ahead, although some of the strength is outside of the US.
You can sign up for Felix's weekly ratings updates via email to etf at newarc dot com.
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.
The market still did not provide much opportunity for fresh buys. The gentle upward action is fine for long-term investors and excellent for those trying out our Enhanced Yield approach.
Here are some key themes and the best investment posts we saw last week.
Often the best advice helps the investor learn what to ignore.
- Worry about low volatility. The scary stories say that it reflects dangerous "complacency." Dan McCrum at FT Alphaville highlights some great research from Citi. There is less volatility in earnings. The research also shows the complete lack of correlation between volatility and stock returns for the next year. Case closed.
QE has not just propped up asset prices, it has also helped to stabilize economies and corporate profits. As long as the eventual withdrawal of QE coincides with continued fundamental stability, then there may be less of an increase in market volatility than many fear.
- Worry about housing. The market is not over-valued, except in a few places. Real estate is local. Other areas are undervalued. Steven Russolillo has the full story with some good tables. The undervalued areas seem to include much of my part of the world while overvalued areas are in California.
- Avoid "Glamour Stocks." A great company is not always a great stock. Josh Brown has (yet another) post helping the individual investor. He cites James O'Shaughnessy on the subject of value versus momentum. Check out the post and watch the video.
- Bond funds are a continuing source of risk. Is there really consideration of an "exit fee?" I rather doubt it, and also question whether it would work. The very idea of this discussion is something of a warning. (Fortune). People expect these investments to represent the safe part of their portfolio. If we really do get the inflation that the Fed is seeking, interest rates will rise and bond prices will fall.
- Worry about bogus charts. Stick a fork in the 1929 chart says Steven Russolillo. This chart was the most circulated in market circles. It would not die. It was costly for many investors. Meanwhile, Philosophical Economics has a very dramatic conclusion that you will probably not believe. So read the full post. If you were a 30-year investor, you would have done better starting in 1929 than in 1980 - the worst of times (using CAPE and other indicators) versus the best of times.
On the positive side, there are some good stock ideas.
Goldman Sachs shares some choices (via Steven Russolillo at MarketWatch for the underlying rationale). Skeptics may ask why they would share ideas, but that is the modern method of the big firms. They need to show a little. We own some of the names and others are on our watch lists for various programs, so the ideas are interesting.
If you are worried 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. You can get our report package with a simple email request to main at newarc dot com. Also 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 weakness in Q1 GDP is not consistent with the wide range of economic data that we track. There is no indication of a recession using the indicators tracked by the NBER, even during the first quarter. Growth has been sluggish, but steady. This feels like a recession to most average people, who consistently respond to surveys that the Great Recession has not ended.
Meanwhile, the business cycle hit a trough in 2009 and shows no sign of reaching a peak. Michigan economist Justin Wolfers, writing in the New York Times, observes as follows:
The most important indicators of our economic health are telling very different stories. On Wednesday, news reports made much of the fact that gross domestic product fell at an annual rate of 2.9 percent in the first quarter of this year, a decline largely attributable to bad weather. That brings growth over the past year to a disappointing 1.5 percent. Yet the labor market continues to deliver good news, and over the same period, the unemployment rate fell by more than a full percentage point.
He notes that the past year has defied the relationship between unemployment and economic growth, Okun's Law. The chart below shows that current results represent a dramatic outlier.
I do not expect any instant economic solutions, but the evidence supports continued reversion to the long-term growth trend. This will continue until we see more signs of a tight labor market -- not just more jobs, but more hours and higher wages.
That is why the data this week are especially important. Any break from the recent trend of modest growth could lead to some early holiday fireworks!