by Jeff Miller
Many are expecting the Fed meeting this week to produce something big. Speculation abounds.
To get some perspective on this, please consider the following quotation from 2005. The statement comes from someone who is obviously aware of potential asset bubbles, and thinks that the Fed should act in response:
…(A)s I have mentioned previously, something that has become very evident in recent years is that overall asset prices worldwide, both equity and debt, are rising a good deal faster than product prices. And they are picking up because of—indeed, the rise in asset prices is being engendered by—the fact that interest rates are getting ever lower. Interest rates in emerging-market economies are as low as one can remember. And aside from the surprisingly high equity premium in the United States, we have very significant upward momentum in asset values. … (It) is clearly the potential for speculative activity—and its effect on asset prices—which is generating an assessment that we need to move, as far as evaluating the outlook for the overall economy.
I’ll give the citation for this early and accurate observation at the end of the article.As we watch the news for this week, you should keep in mind that many (most?) of those pontificating about the Fed do not really have much information. They have strange ideas about conspiracies, lying, open market operations, buying futures, propping up asset markets, and the like. As a starting point in evaluating these ideas, we might well start with a picture of the FOMC in action.
I trust that most will get the idea. One feature of an open and democratic society is that the true story comes out. In the case of the Fed, we get announcements, minutes, and eventually actual meeting transcripts.
As I will explain in my conclusion, I am not expecting anything exciting from this week’s meeting. But first, let us do our regular review of last week’s events.
Background on “Weighing the Week Ahead”
There are many good sources for a comprehensive weekly review. My mission is different. I single out what will be most important in the coming week. 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.
Unlike my other articles at “A Dash” I am not trying to develop a focused, logical argument with supporting data on a single theme. I am sharing conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am trying to put the news in context.
Readers often disagree with my conclusions. (A commenter recently suggested that was proof that I was wrong — an amazing interpretation!) Do not be bashful. Join in and comment about what we should expect. 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 feel free to disagree. That is what makes a market!
Last Week’s Data
While the stock market had a great week, the news was really not very good. Most observers attributed this to oversold conditions and short-covering during expiration week.
There was a little good news.
- Central banks co-ordinated actions to address dollar liquidity in Europe. While this only addresses dollar liquidity — not solvency — it was helpful.
- European leaders emphasized the Eurozone commitment and Greece increased some taxes. There are various analyses that tote up assets and liabilities and conclude that falling dominoes are inevitable. In fact, the most recent actions have moved Greek default out to October, at least. I tried to explain this week why markets were too extreme when it came to interpreting news about Europe and alsounder-estimated the Chinese.
- Industrial production was up 0.2%. Good news, but this series is not on my “A” list and has also been downgraded by the National Bureau of Economic Research (NBER) in their recession dating.
- 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. There is also evidence that commercial lending is increasing, one of the first effects we would expect from a policy that works with “long and variable lags.” The Bonddad Blog has been covering this effectively, including a discussion of whether M2 growth is artificially influenced by inflows from European banks. It is well worth reading the entire piece. To be accurate, Bonddad’s overall view is getting pretty dark, but I want to emphasize the excellent weekly articles on high frequency data.
- Actual earnings from a company that has broad economic exposure — Cummings (CMI).
- And finally, we can escape the Coppock Killer Wave! There seems to be an inexhaustible supply of contrived disaster indicators. We get omens, signatures, bad times to invest, death crosses, sinking ships, and other assorted scary notions. The Coppock wave was originally supposed to be a buy signal based upon an economist helping Episcopals trying to go long. Coppock identified a “period of mourning.” SocGen’s perma-bear Albert Edwards figured out a way to contrive a sell signal from this — the “Killer Wave.” Fortunately, Mark Gongloff highlighted the evidence to refute this silliness. What a relief! This sort of thing invokes all of our warnings about tweaking and back-fitting data to create a result.
There was a very discouraging week for economic data.
- The CPI increased by 0.4% last month. Year-over-year it is up 3.8%. The core rate is up 2.0%, the stated Fed target. I am more tolerant than most about the concept of the core rate. I also think that the economy is best with a modest rate of inflation. Having said this, we are now in a zone that deserves attention– not a “stagflation” scare — but worth watching.
- The ECRI growth index dropped further into negative territory. The official ECRI interpretation is a heightened recession risk. The ECRI warns against over-reacting without a persistent change in this indicator, but we are watching with interest. The WLI is now at the average level for the last year, but there is a decline as measured by the growth index. This is a smoothed growth factor, but the exact time frame and smoothing are not specified. They have not yet suggested an official recession forecast, sticking with the story of the lower global growth that they first talked about in May.
- Initial jobless claims climbed to 428K. This is an unacceptable level, and the trend is in the wrong direction.
- Retail sales showed no growth. ‘Nuff said — el stinko.
- The Philly Fed Survey was “less bad.” It was still terrible! Check out Steven Hansen for the full story.
- The poverty rate hit 15.1% and median income fell to 1996 levels.
The ugliest news of the week is the continuing story about consumer confidence. The Michigan preliminary numbers for September were stuck at recession levels. As I noted last week, consumer confidence is absolutely vital to job growth and an improving economy.
A typical headline was “Consumer Sentiment Improves.” What? The coverage of the data is from the red planet! These numbers are just terrible.
Sentiment remains terrible and is the biggest current market threat. Doug Short provides the best look with this typically excellent chart. You can see several variables with one look.
There are plenty of other great charts at Doug’s new home (Congratulations!) at Advisor Perspectives, another of our favorite sources.
Consumer confidence remains a crucial factor for us to watch.
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. Bob’s most recent report (official release on Monday) does an exhaustive review of indicators, concluding that a cycle top is (at least) six months away. Meanwhile, the ECRI has a “long leading” series that is available only to subscribers, which they refer to in media appearances.
The indicators show continuing sluggish economic growth, and the rate of growth continues to get weaker. Five weeks ago there was an increase in the SLFSI, generated by a slight increase in LIBOR rates and a big jump in the VIX. The SLFSI has been stable since then. I have been doing extensive research on this indicator. It was not designed to predict the stock market. It is a reflection of financial risk, based upon what happened in past crises. I believe that it will prove valuable as a tool for investors who prefer data to story telling. My interpretation is that it shows that European concerns should not yet be a warning to US equity investors. This article helps to explain how to interpret the values and also provides historical context.
The ECRI WLI is still at about its average for the last year and significantly higher than in 2009. The growth index uses an unspecified formula to smooth the changes in the index over an unspecified time. The ECRI warns against making too much out of declines in this indicator alone unless it is persistent. Their most recent public announcements repeat a multi-month theme: Sluggish growth increases the risk of recession. This makes sense to me.
Our “Felix” model 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.
We voted “Bearish” this week, with terrible ratings and two of the inverse ETFs emerging from the Penalty Box.
[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
There is some interesting economic data this week including reports on housing starts, mortgages, and the FHFA price index. My choice from this lot is the building permits series, which shows a genuine advance commitment for new homes.
The initial jobless claims data demands attention, as the series drifts further above the 400K level. There will also be a report on “leading economic indicators” which are important to some.
But these are sideshows.
The two big stories will be:
- The Fed — where I do not expect anything exciting. Even something like ‘Operation Twist” (if it is even adopted) will not be regarded as significant by the market (and I agree). Here is a good academic article on this topic (HT Tom Brakke whom I read every day and you should,too). Keep in mind that the FOMC (as a group) is less pessimistic on the economy than are traders, pundits, the media, and the public.
- Europe. At the time of writing, I have no clear idea about the actual outcome of the ongoing meetings this weekend. I expect a disappointing result. Most market pundits are looking for some kind of grand plan or silver bullet. There might be an eventual solution, but it will not be so clear and easy. Leaders will first buy time, which will be called a band aid or kicking the can. The final compromise package will have multiple moving parts, and require sacrifices on many fronts. As I have written for several weeks, we have many months ahead of us where early trading will be based upon some European news, no matter how minor it seems.
Trading Time Frame
In trading accounts we went 40% short the market on Friday afternoon, since two inverse ETFs emerged from the penalty box. This is a bearish vote on the market with a three-week time horizon.
Contrast this with last week. While our official vote was “bearish” last week, I noted that “abstain” might be better. In fact, we had no positions, as I reported in last week’s article. We did not join in on the rally, since Felix does not try to call market tops and bottoms, but we were not short. This week we will begin with a short position, re-evaluated daily.
Investor Time Frame
In our ETF-based Dynamic Asset Allocation program, the portfolio remains very conservative. This cautionary posture includes bonds, gold ETFs, and utilities. It is conservative, but has no short positions at this time.
Long-term investors should buy and maintain core holdings of an appropriate size. This does not mean “buy and hold.” I recommend an actively managed portfolio, adjusted with conditions, but one that includes stocks. The mid-year selling has tested the resolve of many investors. It is one thing to state a risk tolerance and another matter to watch it in action. Investors who are staying the course have “right-sized” their positions and maintained confidence in their methods.
To see this clearly, compare the return of the 10-year Treasury note (formerly regarded as risk free and better than French bonds by S&P) to the dividends on the Dow or the S&P 500. For help, see Chuck Carnevale, who has a long and thoughtful post on the asset allocation question. Regular readers know that I am a big fan of Chuck’s approach. Anyone wondering about the best investment for a ten-year time horizon should be looking carefully at his charts of interest rates versus dividends.
Citation for the Fed Policy Quote
I suppose that many readers will have guessed Fed Chair Alan Greenspan as the source. The quotation is from the December, 2005 Fed transcript where he is explaining why rates should move higher.
His position and reasoning differ sharply from the forecasts of leading bloggers and other observers from that era. Even those writing popular books about Greenspan have not done the basic research on source material that would normally be expected.
We are about to enter a time when blog predictions from that era can be compared with actual Fed transcripts. Some have shamelessly mis-represented FOMC motives, what was considered, the evidence available, the intelligence of participants, and possible biases.
It would be interesting to compare some of these aggressive statements with the actual meeting transcripts.
The Killer Wave by John Lounsbury
Flag Signals by David Grandey
The DAX Crash by Doug Short
Real Returns: Nikeii and S&P 500 by Doug Short
Market Red Ink Update 9/6/11 by John Lounsbury
Markets Will Rally to Year End by Ben Warwick
August Investment Review by MacroTides
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 he 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.