The Week Ahead 2-28-11

by Jeff Miller

There was some good news last week, but the spike in energy prices was the big story. Let’s do our good, bad and ugly review before looking at what to expect in the current week.

The Good

Most major economic indicators remain in positive territory. There is growing recognition that the economic rally now has a self-sustaining character.

• Economic growth is still improving. The ECRI Weekly Leading Index moved higher. The growth index reached another fresh peak, 6.1%, the highest since May, 2010. This is a signal of solid growth for as far ahead as they are willing to forecast.
• Risk as measured by the St. Louis Fed Stress Index, stayed in negative territory. This measure tracks a lot of market data in the eighteen inputs. It is not a poll, nor opinions, nor a collection of anecdotes. We should all pay attention to some real data. The value moved to -.017, slightly higher than the -.024 from last week. For more interpretation, the St. Louis Fed published a short paper with a very nice chart that helps to interpret this index. The chart does not reflect the recent continued decline in stress, but it identifies the dates for important recent events. The paper also has a longer version of the chart, illustrating past stress periods. I am not going to run the chart each week, but I strongly recommend that readers look at the paper. In the 2008 decline there was plenty of warning from this index — no sign right now. The report cites data as of 2/18, reported on 2/24. I would expect the index to move a little higher next week.
• Michigan Consumer Sentiment. The Michigan index hit a surprising 77.5. This is still not in strong territory, but it is moving the right way.
• Initial Jobless Claims are improving, below 400K again and the lowest 4-week moving average since 2008.

The Bad

The bad news, once again, included housing data, but that is not the whole story.

• Case-Shiller Sales and Pricing Weak. Calculated Risk reports: “The Case-Shiller house price index showed house prices are still falling – for the sixth consecutive month – and more house price declines are expected with the high levels of inventory and a high percentage of distressed sales. Eleven of the twenty Case-Shiller cities are now at new post-bubble lows…” However, Steven Hansen’s analysis found reason to ask whether the rate of housing decline was slowing. Steve has been quite negative on the outlook for housing for most of 2010, so maybe housing is going to get less bad?
• Energy prices spiked higher as investors wondered whether popular uprisings in Egypt and Libya would spread to other Middle East countries.

The Ugly

The growth and spread of democracy can be messy and disruptive. To call it “ugly” is unfair, since experienced observers know that nothing good comes easy. Market participants, however, do not take the detached, academic view of these developments.

Markets hate uncertainty. Democratic revolts in the Middle East, state legislators leaving their states to delay votes, and a possible federal government shutdown are all sources of fear.

Experts, such as Fawaz Gerges (London School of Economics), have suggested that the current events are the equivalent, for the Arab world, to the fall of the Berlin Wall for Europe. Ultimately the ugly duckling could become a swan.

The Big Worries

Here is how I assess the big worries.

I am pretty close to the Wisconsin story, and it does have implications for other states. It has political interest and important policy implications for the employees and services provided in the states, but the investment angle is not as important.

The shutdown of the federal government would be a major negative for services, consumption, and the markets. I expect that the cooler heads in Congress will negotiate a temporary compromise. This will solve the immediate issue, but keep the question of deficits and spending cuts in the front burner.

My current read is that there are limits to the Middle East oil disruption. There does not seem to be an imminent Saudi threat — the biggest concern — and the implications in Libya are still unclear.

Current oil prices are like a foreign tax on the US economy. There is a loss in GDP and no corresponding gain in benefits. We all agree that it is a negative, but those who invoke “stagflation” are going too far. As usual, James Hamilton at Econbrowser is the go-to expert on oil prices and economic effects. At current levels, he sees the risk as much lower than in past crises.

My bottom line is that events as they have unfolded so far are not in the same ballpark as the major historical oil supply disruptions, and are unlikely to produce big enough economic multipliers that they could precipitate a new economic downturn. They might shave a half percent off annual GDP growth, but I don’t anticipate a whole lot worse than that.

In addition, the Fed does not see current oil prices as a trigger for action.

Our Own Forecast

We base our “official” weekly posture on ratings from our TCA-ETF “Felix” model. After a mostly bullish posture for several months, Felix has turned more cautious. Four weeks ago we said it was a close call, and switched to neutral. Three weeks ago it was still close, but we shifted back to bullish in the weekly Ticker Sense Blogger Sentiment Poll. We remained bullish this week. Here is what we see:

• 82% of our 56 ETF’s have a positive rating, up from 77% last week.
• 45% of our 56 sectors are in our “penalty box,” down from 55% last week. This is an indication of significant, but reduced short-term risk.
• Our universe has a median strength of +20, about the same as +19 last week.

The overall picture remains slightly bullish. We are fully invested in trading accounts since there are several strong sectors, but we are watching the indicators quite carefully. This has been a very close call for several weeks.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly email list. You can also write personally to me with questions or comments, and I’ll do my best to answer.]

The Week Ahead

There are a number of reports this week, but here is what I will be watching.

• The ongoing protests in Wisconsin and the Middle East — what a juxtaposition! I don’t see a big link to stock prices right now, but I am watching.
• The chances for a federal government shutdown. It seems stupid, but who knows?
• Energy prices.
• Jobs, jobs, jobs. I’ll have my regular employment preview on Wednesday, but I think things are looking a little better on the jobs front.

Investment Implications

The reaction of investors last week was quite interesting. Many were willing to sell at the first sign of trouble–in this case rising energy prices. For many, this was the start of the long-awaited correction.

There has only been minor selling, but we are already seeing some doomsday forecasts. Those fully-invested wonder whether they should sell to lock in gains. Those under-invested were looking for a chance to buy, but are now having second thoughts.

This is not a matter of psychology; it is a matter of system.

If you do not know how to deal with a correction during an extended rally, you do not have a system. You are just guessing.

Each week I try to share solid indicators that provide some guidance — an approach that I have used successfully for many years.

This week you can do even better: Listen to Mr. Buffett! His annual letter has a lot of advice about fear. You should kick back and spend some time with his advice.

You can and should also read some expert commentaries. I like David Merkel’s take. Abnormal Returns also cites several good reviews. This is strong advice on figuring out your approach to investing and starting a plan.

My own first question to new clients is whether the goal is preserving wealth or creating wealth. The next questions determine how much risk is appropriate. I try to put the Buffett approach into practice and so should you.

Jeff Miller has been a partner in New Arc Investments since 1997, managing investment partnerships and individual accounts.  He has worked for market makers at the Chicago Board Options Exchange, where found anomalies in the standard option pricing models and developed new forecasting techniques.  Jeff is a Public Policy analyst and formerly taught advanced research methods at the University of Wisconsin.  He analyzed many issues related to state tax policy and provided quantitative modeling which helped inform state and local officials in Wisconsin for more than a decade.  Jeff writes at his blog, A Dash of Insight.