by Jeff Miller
What’s going on? This is supposed to be summer, with quiet low-volume trading and a lot of people on vacation. Instead we have volatility higher than at any time since 2008. If you look only at earnings (fine) and economic data (still in the sluggish 1.5-2% growth range, you would expect little market movement. There are plenty of rumors about banks — all denied quite vigorously as I noted in this article about panic. This focus on headlines and the accompanying market moves have important implications. Here are two important perspectives.
US Fiscal Policy
The novel political tactic by House Republicans to link the promise to pay our debts to spending reductions was, perhaps unwisely, embraced by President Obama. The immediate outcome was fine. The US did not default on debt, and the resulting compromise does no immediate damage. The Supercommittee will probably lead to an eventual solution. It all played out in a way that I accurately predicted over a period of months. A reader observed, quite accurately, that I did not predict the resulting market reaction. Guilty as charged. I did not realize that the process would completely change the market perceptions so that success would be defined as fixing the deficit problem RIGHT NOW!!! This highly political question got a boost from the S&P with their misguided and ill-timed move to downgrade US debt. (If you want to understand this issue, read here). The answer to what US policymakers should do right now is quite simple and obvious: Focus on job creation! The immediate attention to deficits does not help on this front. There is an Orwellian notion, something I saw on a billboard in Wisconsin before the 2010 election, that DEFICITS=UNEMPLOYMENT. It is a way of capturing two things that people do not like, putting them together, and appealing to the lowest common denominator of the voting public. In fact, nearly everyone who is not an extremist realizes that the deficit should be addressed after the economy is on track. Here are viewpoints from two differing ideological perspectives.
The Investor Reaction
Investors must deal with a market that seems to be clamoring for bad public policy. The deficit is a legitimate issue,but the facile comparisons to the family budget play to the conventional wisdom. We can all agree that economic progress has been poor. The result is that traders and pundits are calling for something that is not going to happen — at least not in the time frame and fashion that they want. The result is that stock prices have moved much lower. This has moved beyond the normal debates about market valuation, how to measure earnings, etc. Many sources are highlighting the wide gap between expected returns from stocks and alternative investments. The best of these explanations comes from Matt Busigin of Macro Fugure Analytics (now added to our featured sources). This article must be read from start to finish with special attention to the charts. There are many similar viewpoints this week, but Matt is capturing the whole story and it is brilliant from start to end.
Equities are now cheaper than they were in 1998, or even 1987, 2002 & 2008 by measurement of Equity Risk Premium (earnings yield minus risk-free yield) of 5.86%. The last time the ERP was this large, 1975, earnings actually declined 18% while prices rose 32%. The significance of the equity risk premium is doubled with nominal rates so low: pension funds, insurance companies & other institutions require 6-8% annual returns to be solvent, and with the 30-year UST yielding a miniscule 3.54%, it is difficult to see how they can achieve this without substantial allocation to more risky assets. They buy, or have shortfalls. (I’m assuming there will be examples of both).
I’ll get more specific about our own investment posture in the conclusion, but let’s first review last week’s data.
Background on “Weighing the Week Ahead”
There are many good services that do a complete list of every event. That is not my mission. Instead, I try to single out what will be most important in the coming week. If I am correct, my theme for the week is what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios. Readers often disagree with my conclusions. That is fine! Join in and comment. In most of my articles I build a careful case for each point. My purpose here is different. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but some will disagree. That is what makes a market!
Last Week’s Data
The economic news was generally weak, consistent with economic growth of 1.5 – 2%.
The Good
There were some bright spots.
- Initial jobless claims nudged below 400K. This is still not what we need, but it is better than recent levels and much better than many were forecasting a few weeks ago. It is not a recessionary level, nor a sign of robust growth.
- The money supply rebound continues. This is a major forward-looking indicator that is widely ignored. It is a leading indicator, giving it extra significance. I have been writing about this for several weeks, highlighting the weekly updates from Bonddad. Everyone knows that monetary policy works with a lag, but no one is paying any attention to this story. Here is the most recent take from Bonddad, a source that everyone should follow:
In summary, the last three weeks of high frequency data have suggested an end to the March – July declining trend into contraction in the data sets, chiefly Oil prices and gasoline usage, but also rail traffic and initial jobless claims. Additionally, BAA bonds in comparison with treasuries have gone from negative to neutral. Real M2 has improved, as have same store sales, and housing prices continue to move towards stabilization. Real M1, retail sales, and purchase mortgage applications remain solidly positive. Temporary staffing and rail traffic in particular continue to be areas of concern, and whether there has been any important positive trend break in gasoline usage will be watched closely.
- Earnings strength continues. Back to Matt for this one. “So far in this earnings season, the S&P 500 has a 91% beat rate, and has smashed top-line, bottom-line & operating margin estimates.”
- Muni Bond Market Improves. GEI has a nice take on a good Fed study. This was a major market concern via Meredith Whitney, but it seems to be exaggerated.
The Bad
There was plenty of negative news.
- Consumer sentiment from the University of Michigan was terrible. This would qualify for the “ugly” category in most weeks. I really like this survey, and not just because of my Michigan roots. The methodology includes a panel, people carried over from one month to the next. I regard it as a very good read on what people think. Normally this is a good indicator of employment prospects. More recently the effects of gas prices have been involved. This week one has to wonder whether the debt ceiling debate and the S&P downgrade had an effect. In my own small and anecdotal poll, many casual observers attributed the stock market volatility to the S&P decision. I do not like to make excuses about data, and this result was truly terrible.
- Mutual Fund Outflows increased. Investors have dumped equities in favor of…..something else.
- A lot of random people have increased their recession forecasts. This is especially true for those giving no time frame. My own recession forecast (without time frame) is 100%. What is yours? More on this later.
The Ugly
Market volatility gets the ugly award for this week. There were 6% moves in overnight futures and a similar move on Fed day. This calls into question the concept of efficient markets. How can the variation be so great in a single day? It also frightens the individual investor. Not surprisingly, some point to High Frequency Traders as a reason for exaggerated volatility. In past articles I have been open-minded about the role of HFT. I think that markets eventually go to a point that reflects fair value, and that HFT firms often add liquidity. I was deeply distrubed by this report, suggesting that standing orders in eMini’s, the most important market, have been reduced by 90% as a result of HFT. I am investigating further.
The Indicator Snapshot
It is important to keep the weekly news in perspective. My weekly indicator snapshot includes important summary indicators:
- The ECRI Weekly Leading Index and the derivative Growth Index
- The St. Louis Fed Stress Index
- The key measures from our “Felix” ETF model.
As I have often noted in the past, the ECRI and the SLFSI report with a one-week lag. This means that the reported values do not include last week’s market action. In my research, I take account of this lag. In my daily monitoring of the market I look at the underlying elements in the SLFSI. I cannot do this with reliability for the ECRI since the indicators are secret. The SLFSI will increase next week, but not to the level that would trigger the “risk alarm.”
There will soon be at least one new indicator, and the current choices are under review. In particular, I am considering replacing the ECRI method with the equally effective and more transparent approach from Bob Dieli.
The indicators show continuing modest growth at a slowing pace, with little indication of economic risk. This is in sharp contrast to market fears — much greater than indicated from the data.
Felix is the basis for our “official” vote in the weekly Ticker Sense Blogger Sentiment Poll, now recorded on Thursday after the market close. We have a long public record for these positions.
[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 ETF email list. You can also write personally to me with questions or comments, and I’ll do my best to answer.]
The Week Ahead
Normally this would be a quiet week with most people on vacation and the “B team” handling trades. I like the building permit results as a good leading indicator, but most others do not care. No one realliy expects that the PPI or CPI will lead to Fed policy changes. The week’s trading is all about Europe rumors and the market effect, possibly exacerbated by options expiration.
Trading Time Frame
A long-standing theme at “A Dash” has been understanding your time frame. Someone has called to my attention that a few dimwits have been comparing my long-term calls with their own trading calls and claiming superior results. (If they had been wrong, we would never have heard about it). In fact, our trading calls have been quite good, as regular readers have noticed.
When you do a public weekly commentary for investors with differing time frames, it is easy for the trolls to misrepresent the results. In an effort to empahsize the distinction, I am going to split the weekly conclusion into two sections. While nothing can stop people from taking things out of context, it might help to clarify.
In trading accounts we started the week net short, invested in invesrse ETFs. We closed these positions at a great time on Monday. It was not because Felix called a bottom in the market. Instead, everything went into the Penalty Box. This means that we do not believe that we can make a short-term market prediction.
While our official vote this week is “bearish,” we are out of the market and poised to act.
I note that our own short-term forecast differs from astute technical traders like Charles Kirk. As always, we encourage people to view his weekly chart show. There is a modest membership required (which Charles donates to charity) and it is well worth the cost. Charles is 30% net long for trading, but his overall market take is quite different from ours. Since I always encourage understanding of different opinions, I think readers should take a look. The key question is whether the Fed will appease the markets with another round of quantitative easing. More later.
Meanwhile, the must-watch weekly chart show gives an excellent insight into how traders view the current market. For investors thinking of entry or exit, you can find the key levels.
Investment Implications
For investment accounts we continued our multi-week caution in establishing new positions. I still believe that holdings with more economic exposure will excel in the second half of the year. These include technology and cyclical stocks. As I have noted in recent weeks, the investment time frame requires looking for opportunity when traders are scrambling.
Research for Long-Term Investors
Our team has been working on our ongoing projects: Risk and Good Times to Invest. It would be nice to work faster, but it would also be nice to have a team of twenty instead of five. My researchers are first-rate. Here is a preliminary finding that I coaxed out last night.
We looked at all of the instances for over 50 years where there had been a decline of 10% or more in a single month. The next year result was a gain of over 10%, and over 15% if you leave out 2008. Results were even stronger over a two-year period.
I have a similar study based on the St. Louis Fed Index. Much of this comes down to whether you think we are experiencing another 2008-style situation. The general topic is one for another day, but I was impressed by this week’s analysis on the subject from Doug Kass.
Circumstances are far different as, in 2008, stocks crashed based on a nearly insolvent banking system and a domestic economy in contraction.
The headline risk story all depends upon whether this is another 2008. This is a seductive story for the media, and a natural for those selling gold and structured annuity products.
As usual, astute investing requires the combination of knowledge, intelligence, analytical skill, and a good bozo filter!
Related Articles
The Week Ahead: Pundits on Parade by Jeff Miller
What the $VIX is Telling Investors by Shah Gilani
An Update on the $VIX by Doug Short
The Real Reason for the Aug. 4 Sell-Off by Shah Gilani
Investors: Looking at a Post Debt Ceiling Crisis World by Warren Mosler
Elliott Waves: Potential High for Stocks and Low for Dollar by Avi Gilburt
Handle the Debt Downgrade like the Smart Money Does by David Grandey
The Market Matrix by David Grandey
Investors: The News is Getting Even Worse by Art Patten
Ranking a World of Red Ink by John Lounsbury
Death of Risk-Free Investment by Martin Hutchinson
Is the End Near – Or Is It Different This Time? by Ed Easterling
About the Author
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.
