August 10th, 2014
by Jeff Miller, A Dash of Insight
In the past week there has been a dramatic change for the worse in everything we have been tracking in our "Ugly" section. Risks that are generally described with the euphemism of "geopolitical" have become expanded military actions - Ukraine, Gaza, and Iraq.
With no sign of an early resolution, the crises deserve additional thought.
I expect financial media to ask: How will the "headline risk" from crises affect financial markets?
Prior Theme Recap
In last week's WTWA I expected that attention would focus on the Fed and the end of QE. That was accurate only for about two days! World events quickly provided more dramatic stories. We face much the same problem this week. In the absence of a clear economic or earnings theme, the impact from the world's hot spots become even more important to financial 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.
San Francisco Appearance
I have agreed to speak at the San Francisco Money Show on August 23rd. Here is more information. I am working on some special themes. We will have some fun and also identify some good investment ideas. I look forward to meeting some readers in person.
This Week's Theme
The stock market's small change on the week masked some big daily swings. Doug Short always captures the week in a single great chart. There was pretty strong selling from Monday afternoon through Friday morning, giving the week a very negative feel. Many active traders were satisfied with short positions, which reached peak value during the overnight hours before the Friday opening. The chart dramatically shows how quickly a headline or two can change the markets in the current environment.
What explains last week's market action? The answer helps in deciding what to expect in the week ahead. The headlines started on Tuesday afternoon, with a statement by Polish Foreign Minister Sikorski speculating about the meaning of massed Russian troops on the border with Ukraine.
- Technical factors. Art Cashin (via Barry Ritholtz) argues that the Monday and Tuesday action represented a rally and a failed retest of prior highs. Cashin also notes that gold and oil markets did not react as one would expect in a crisis. He concluded that the Sikorski comments were merely coincidental.
- Ukraine effects. Others (including Jim Cramer) saw the market reaction as trading directly with the Ukraine news. This viewpoint gained support when Thursday news of a possible Putin "emergency" speech coincided with mid-day selling. There was further support when Friday's stock rally followed news that Russian troops had "completed" a military exercise.
- Iraq. Overnight futures declined with news of US air strikes in Iraq.
What does this mean for the coming week? In the low-volume August trading environment, it takes less real news to move the market. This may be especially true during options expiration week.
The Schwab team thinks the market has a "binary feel" with the chance of a big move in either direction.
Jim Cramer thinks that Putin's use of sanctions (rather than a military action) is bullish. His sources see this as a sign of an eventual diplomatic resolution.
Ian Bremmer, President of political risk research and consulting firm Eurasia Group, thinks that a Russian invasion of Ukraine remains very likely. He sees humanitarian aid as a cover for such an action.
Mario Draghi sees the economic impacts from Ukraine as limited, instead emphasizing the possible energy effects from Middle East issues.
As usual, I have a few thoughts to help in sorting through these diverse viewpoints. 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.
Most of the important news last week was very good.
- ISM Services did even better than the manufacturing version, hitting a post-recession high at 58.7. Scott Grannis looks at the internals and concludes, "All of this adds to the already-long list of indicators pointing to continued growth and forward economic momentum." This chart also adds the Eurozone service index:
- Rail traffic was strong - the best July in history. See GEI for complete analysis and charts.
- Congressional approval hits an innovative new low. Historically people have had disapproval for Congress as a whole while supporting their own representative. This implied little chance for change even when performance was very poor, especially since incumbents already enjoy a big advantage. Vox highlights the findings, but warns not to expect big changes any time soon.
- The failure of Portugal's Banco Espirito Santo is an exception, showing that European banking regulation is getting better. George Hay at Breakingviews contrasts the process and outcomes with the Cypriot bank rescue as well as the bailouts of five years ago.
- The prime working-age group is growing again. Calculated Risk has an analysis of the demographic trends as well as some helpful charts. He concludes that this is a positive for future economic growth.
- Earnings growth remains solid. Brian Gilmartin reports on the strong (and almost final) results from Q2 and also notes that, unlike most recent years, the estimates for the rest of the year have not been revised much lower. Brian's updates are very helpful for investors trying to focus on fundamentals.
- Banks are easing lending standards. This is part of the answer to the low velocity of money and the high level of excess reserves. The Fed's QE programs, despite the hype, have not really had the hoped-for impact on economic activity. Commercial lending is especially important. Calculated Risk examines the survey results (see also Sober Look on loan growth) and provides the following chart for commercial real estate (CRE):
- High frequency indicators remain positive. Sometimes it is difficult to find the "hook" for the excellent weekly update from New Deal Democrat. I always read it, and so should you. (I wish he had a different pseudonym since some people probably do not give sufficient credit to the economic analysis. I feature a very wide range of perspectives, including economic analysis from conservative Republicans and Libertarians, but these may not be so easily recognized because of the names). This week there is a nice summary of the entire picture. I am going to quote at length, hoping that readers will embrace this source:
Summary: There was no big change this week. All of the long leading indicators, excepting mortgage applications, were positive, including money supply, bank lending rates, real estate loans, corporate and treasury bonds.
The short leading indicators also all positive. The 4 week average for Initial jobless claims is at a decade+ low. Credit spreads have widened slightly in the last few months but remain near their post-recession low. Temporary jobs were again close to their seasonal all-time high. Commodities were positive. The Oil choke collar has seasonally disengaged. Housing prices still appear to be at or near an interim peak.
The coincident indicators were mixed. Two measures of consumer spending was positive, but Gallup has turned negative again. Steel production was positive, as was rail traffic although less so than recently. Shipping has declined recently but has stabilized.
Growth for the rest of 2014, and early 2015, looks intact. But weakness in the housing market evident in the first part of this year may be spreading into the rest of the economy, suggesting that growth will slow down.
- Bearish sentiment hits a 52-week high. This is viewed as a contrarian indicator, so it is a market positive. Bespoke has the analysis and charts, including this one:
There was also some negative news.
- Wholesale inventories were disappointing. This is difficult data to interpret. It is noisy and we also always wonder how much is actually planned. Steven Hansen at GEI has a thorough analysis, concluding that it is a mixed picture. I am calling it "bad news" since I expect it to be a negative adjustment to Q2 GDP.
- US Households are in poor financial shape according to a recent survey by the Fed.Matthew C. Klein at FT Alphaville has a good report, noting the following highlights along with a helpful chart of retirement plans:
- Among Americans aged 18-59, only a third had sufficient emergency savings to cover three months of expenses.
- Only 48 per cent of Americans could come up with $400 on short notice without borrowing money or sell something.
- 45 per cent of Americans save none of their income.
- Home price increases are slowing. The CoreLogic data confirms other sources. The year over year increase is 7.5%, but Calculated Risk notes the reduction in the pace of increases and expects the trend to continue. See the full report for details and charts.
- 1/3 of Adults have Debt in Collection. Jeanne Sahadi at CNN Money has the story.
- Housing drag on GDP continues. Nick Timiraos of the WSJ highlights five charts - all interesting and helpful. Here is one that illustrates the specific GDP impact:
- Italy has a triple-dip recession. Much of the concern about worldwide growth funnels through Europe with Italy a major drag - economic performance even worse than Japan. Matt O'Brien at Wonkblog has a good analysis, summarized with this chart:
Our "ugly" list for last week was unfortunately accurate. We had headline news from all conflicts with plenty of violence and death competing for our attention. The Ebola crisis, cited a few weeks, has spread to Lagos, a densely populated city of 21 million and a center for travel. With a few US cases from foreign travel, Gwynn Guilford at Quartz explains that people should not be "freaking out" over the risk. Check out her thoughtful piece, which corrects a lot of misinformation. (Also great info from Rand).
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.
Last week I asked whether readers might point out the obvious problems with this chart:
The most important thing to note is that the series begins in the middle of a recession. This should always be a warning, especially when it is a subject like tightness in labor markets. Later in the post I provided the reference to the Washington Post article about favorite FRED charts. This was #4, from Michael R. Strain. As you can see, the current levels are not overly tight by historical standards. John Lounsbury of GEI notes that they covered this truncated chart "behind their wall." Good work!
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
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.
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.
RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. Dwaine's "liquidity crunch" signal played out as projected. His market timing method is "armed for the next possible long signal."
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. Georg now has another new program, with ideas for minimum volatility stocks for tax-efficient returns. He also has new advice for those seeking a safe withdrawal rate, now featuring the use of put options to protect against extreme events.
Dr. Ed Yardeni also sees little chance of a recession unless the Fed acts much sooner than expected.
Neil Irwin of the NYT looks at the GDP contribution of various market sectors, analyzing the main sources of the continuing below-trend growth. Biggest laggard? Housing.
The Week Ahead
We have a rather quiet week for economic data and events.
The "A List" includes the following:
- Initial jobless claims (Th). The best concurrent news on employment trends.
- Michigan sentiment (F). Watch closely for any rebound from recent weakness.
- Retail sales (W). Not much expected from this important coincident growth indicator.
- JOLTS report (T). I am promoting this in importance because it provides information on structural unemployment.
The "B List" includes the following:
- PPI (F). Inflation is still not a matter of key concern and this report does not yet have much impact.
- Industrial production (F). A noisy series, but a key element of GDP.
- Business inventories (W). June data relevant to Q2 GDP revisions.
Earnings news is winding down, but there are still some important reports from retailers. There is only a little reported from the Fed "Speakers Bureau." Vice-Chair Fischer will speak in Stockholm on the Great Recession and the NY and Boston Presidents speak at a conference on Tuesday. While policy comments are not part of the plan, sometimes questions elicit new information.
Breaking news from world hot spots will command attention.
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 turned bearish, but it is a close call with little conviction. Uncertainty remains high - typical for a trading range market. This week we were only partially invested for most of the week and one of the positions is in bonds. Inverse ETFs have positive ratings, but are still in the penalty box. Felix remains cautious, but has not yet gone short.
Noah Smith at Bloomberg View warns about blindly following trends. He has a creative example of a strategy that seems to work on that basis (check it out) and this warning as his conclusion:
The moral of this story is simple: The trend is your friend till the bend at the end. Don't be fooled by it. Sometimes the world really has shifted under your feet, but most of the time the risk is just hidden, and normality is waiting for the chance to reassert itself with a vengeance.
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. In addition, be sure to read this week's final thought.
The market has finally provided some volatility. This is attractive for long-term investors who have a good shopping list. We may some position changes and also added to our Enhanced Yield positions (dividend stocks versus near-term short call options). These new positions are best established on down days.
Here are some key themes and the best investment posts we saw last week.
Looking for the best investment advice? I emphasize this theme, recommending against sources that make macro commentary designed to sell a single product, be it bonds, stocks, gold, or annuities. But what about those who recommend stocks that they already own? Seeking Alpha's David Jackson explains why this is both legitimate and valuable. I agree about the concept and the value of the comments at SA. It is important to verify and to monitor anonymous authors so that there is genuine accountability.
Shopping lists? Here are some interesting ideas:
- Cheap stocks with big dividends. YCharts continues the flow of great analysis and ideas with this article.
- Russia plays? I am not ready to move on this, but it is an interesting theme to watch. At some point there will be news of improvement in the Ukraine conflict. You might miss the initial pop, but there will still be opportunity. The bold could start to nibble early. Here is another YChart article with ideas.
- Cheap stocks according to CAPE? If you want to use the Shiller method to pick stocks instead of to time the market, here is a list - ten cheapest and ten most expensive - to consider (via Josh Brown).
Worried about market valuation? Many discussions about how to value stocks seem rather biased, emphasizing only part of the story. LPL Financial takes a more careful look at data concerning the length of bull markets and also the oft-cited CAPE ratio.
Investors should not be trying to time a possible market correction. Barry Ritholtz spells it out in plain language, citing all of the bogus catalysts that have preceded the current issues:
Consider the various narratives that have been used as an excuse for a correction. The downgrade of U.S. debt by Standard & Poor's was going to be a deathblow; it wasn't. Treasuries rallied on the downgrade, just to prove that no one knows nuthin'. The sequestration of government spending was sure to cause a slow down in markets; it didn't. Rising interest rates, the Federal Reserve's taper, earnings misses, and of course, our winter of discontent, were all cited as triggers for corrections. And did I mention the Hindenburg Omen?
The punditry then shifted to valuations: We have heard repeatedly that markets are wildly overpriced, that we are in a bubble. Or if not a broad market bubble, then a tech bubble or an initial-public-offering bubble or a merger bubble. Some advanced the theory that Twenty-First Century Fox's bid for Time Warner was itself proof of a top.
Evaluating dividend stocks versus bonds is a big question for most investors. This analysis from Alliance Bernstein compares the income from dividend investing to gains from bonds, testing rolling ten-year periods starting in 1968. In nearly all of the cases, investors get back the original capital and earn significantly higher returns from the equity approach.
If you sell near-term calls against your dividend stocks, you can imitate our Enhanced Yield program and collect call premiums as well as dividends. (We will share how we do it if you request info from main at newarc dot com).
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).
There is some truth in each of the explanations for last week's trading. Much of the daily activity reflects the actions of traders who are watching key levels of perceived support and resistance. Trading algorithms parse fees of breaking news emphasizing speed over nuance. Headline risk (in both directions) is great.
My sense is that the reciprocal sanction story was a negative for stocks last week. Why? There are direct economic consequences for Europe, and it hit at a time of concern about slowing growth in Italy and even in Germany. Anything that suggests an end to the Ukraine conflict could spark a nice rally in stocks.
The other conflicts are all very important in a human sense, but translate into economic impacts only through the effect on energy prices. Steven Russolillo of the WSJ has a nice Friday wrap-up piece explaining why stocks could rally with the world on edge.
Dividend stocks like utilities seem to be trading with the bonds - part of what I have called the quest for yield. The lower bond yields seem to be following lower European yields. Those seem to be dropping with the European economic news and the recalibration of the impact of reciprocal sanctions. Some market participants are trading each of these relationships, or at least reacting to the relative value.
The potential for extreme volatility can provide an opportunity if you have a plan. Beware of instant experts on geopolitics - all willing and eager to guess Putin's next move!