by Jeff Miller
With so many interesting market issues — earnings, recession worries, technical factors — there is plenty to think about. All of these topics have taken a back seat because of the ongoing story in Europe.
What is the market looking for? Gavyn Davies provides a nice checklist of key points to watch for and the needed size of the European “bazooka.”
What are the latest developments? Calculated Risk has a good update of breaking news — positive on negotiations but negative on Greece.
The story is changing quickly. I’ll offer my own forecast in the conclusion, but let us start with 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
This week’s news was very positive and the market responded.
There was a lot of good news. Without the backdrop of Europe, the effect might have been stronger.
- Earnings season has been strong. Many were skeptical, and so far they have been wrong. I keep reading that companies are beating lowered expectations, which is an over-generalization usually not accompanied by any data. Check out the Bespoke Investment Group for news on earnings and revenue beat rates, and the charts you expect.
- The trading range has been broken. I cited this as the key element to watch last week. I am putting this in the “good” category, but we all know that we could be back in the range as early as Monday morning. The Bespoke Investment Group has an excellent chart:
- The Philly Fed was surprisingly positive. I don’t place much stock in this indicator, but everyone pays attention when it makes a big swing. Most recently it has been very bearish, and that now seems to have ended in dramatic fashion.
- Building permits were encouraging. Check out Bonddad’s chart and coverage.
- Investor sentiment is bearish, which is bullish. Check out Dr. Ed Yardeni’s chart.
- Retail Sales are looking good. Crackerjack uses back-to-school to forecast holiday spending.
- Military operations are ending in Libya and Iraq. This is positive both for spending and for oil prices.
There were also some negative events. I am going to highlight some worries that you might not have seen elsewhere.
- Tax revenues are weakening. Is this a sign of bigger investment deductions or weaker earnings? See Dr. Ed for the analysis.
- Earnings results are juiced (a little) by accounting trickery. Mark Gongloff has this story.
- Forward earnings estimates are softening. Brian Gilmartin has long been one of the best sources on earnings, and he is tracking the recent trends. His work is now more accessible since he is writing at the promising new site Wall Street All-Stars (where I am honored to be a contributor). There are many public articles and also some good intra-day discussion, as well as premium memberships. (Free trials available for readers of “A Dash.”)
- The Fed’s beige book was pretty downbeat. Bonddad tracked the key elements with emphasis on “modest” growth.
- Inflation data ran a bit higher than expected, but close to the Fed’s target on the measures they follow. Check out the Cleveland Fed report for a range of interesting measures.
There is a crisis in political leadership, and it is not very well understood by the sources upon which we depend. Take the European crisis as an example.
Most market observers have a singular and quite simplistic viewpoint: Here is what the market wants. If European leaders are not delivering, it proves that they are (pick one) stupid, incompetent, self-serving, or unware of the consequences.
This criticism of the participants is misplaced. It is quite possible that each and every policy participant is acting responsibly — representing his/her constiutents — but the general outcome may still be poor. Put another way, it is the process, the combination of institutions and procedures, that is the problem. Can the representatives of 17 different countries reach agreement on the key issues?
The result is a race. European leaders are making progress, but the costs of a solution continue to rise. My survey of analysts shows near-unanimity: No one expects a satisfactory outcome this week.
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) has been dropped because it does not provide meaningful independent data. Past articles in this series have highlighted our concern over the last several months. See especially this discussion. A few comments have suggested that I dumped this index because I did not like the result. As regular readers know, I have had this measure under review since May, when it was still firmly positive. There are alternatives with equal or better track records and more transparency.
- The St. Louis Fed Stress Index
- The key measures from our “Felix” ETF model.
The SLFSI reports with a one-week lag. This means that the reported values do not include last week’s market action. The SLFSI continues to edge higher, now in the trigger range of my pre-determined risk alarm. This is partly the result of the VIX. Another rising element is LIBOR. The SLFSI is still not signalling the major calamity that many deem a foregone conclusion, but it is moving higher. This is an excellent tool for managing risk objectively, so we must respect the verdict — a slight reduction in the long-term portfolio size. More caution is warranted.
There will soon be at least one new indicator, and the current choices are under review.
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 “Bullish” this week.
[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.]
Pending our choice of a new economic indicator to feature, here is a summary of some leading authorities.
- ECRI — On record as predicting a 100% chance of recession — inevitable no matter what policy decisions are reached. The time frame has not been specified, although many speculate six months. The most recent reading shows another “annualized” decrease. As nearly as I can tell, the current reading (essentially unchanged from last week) is lower than a cluster of readings six months ago. The real problem is that the ECRI has informed us that the published index is not the main source of their recession forecasts — it is not a long leading indicator. Check out Mark Gongloff in the WSJ for the chart and continuing coverage of the ECRI forecasts.
- Mike Deuker’s Business Cycle Index is updated monthly. It has an excellent fit, including calling the 2007-08 recession in real time. Here is their take on the ECRI forecast:
On September 30, the Economic Cycle Research Institute (ECRI) declared that the U.S. economy is currently in the process of dipping into recession if it is not in recession already. We disagree – the probability of a U.S. recession within the next six months implied by the Business Cycle Index model is about 25%. The key difference in the messages from the BCI model and ECRI is whether new negative shocks are needed to drive the U.S. economy into recession or not. We maintain that the current trajectory of the U.S. economy—barring additional negative shocks, most likely emanating from Europe—is non-recessionary.
- Bob Dieli’s Mr. Model has matched the ECRI performance in real time for several decades. His latest report will be released on Monday, but he shared the following chart:
The model identifies economic peaks and troughs (which later get translated into official NBER recession starting and ending points). It has a nine-month lead, so this chart is advanced by nine months to emphasize the fit with past recessions. The interpretation is that when the indicator reaches the 200 level, the economic peak signal has been reached. As you can see, according to this method we are not even close to the nine-month warning.
Since general economic and earnings forecasts do not include a “recession discount” it is important to monitor these probabilities. I appreciate the reader suggestions I have received.
The Week Ahead
There is some interesting economic data on tap for this week.
Case-Shiller and FHFA both release housing price data on Tuesday, but I do not expect anything exciting.
Conference Board consumer confidence will be announced on Wednesday, along with durable goods and new home sales.
The first estimate of Q3 GDP will come out on Thursday. It will be seen as backward looking and subject to revision, but will of interest as an important broad measure. Initial jobless claims have stayed around the 400K level, with many watching for a change.
Friday will include data on personal spending, followed by many as the key to economic growth, and an update on Michigan’s consumer confidence.
Earnings season continues.
Nothing will be more important for the markets than the ongoing European developments. At the time I am writing, Wednesday seems to be the key day, although the story seems to change several times within each day. My expectation is for continuing gradual progress, but probably short of market expectations.
It is a time of opportunity tempered with caution.
Trading Time Frame
As I predicted last week, it was time to do some buying. In trading accounts we took a 1/3 position early in the week and were fully invested by Thursday afternoon. We have shifted to a bullish vote on the market with a three-week time horizon. It was successful timing, although the model is using a three-week time horizon.
Investor Time Frame
In our ETF-based Dynamic Asset Allocation program, has also become less conservative. At mid-week we added a position in the QQQ’s.
Long-term investors should continue to watch the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. Two weeks ago we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our “trigger range,” but it is still high. We have some cash in these accounts, and will use volatility to establish new positions.
This week I had an idea and a specific stock suggestion for yield-oriented investors. It is still attractive.
A Final Thought: What is the Market Expecting?
One perspective is that stocks are dramatically over-valued and that any gains are in complete defiance of the many identified headwinds.
Representing this viewpoint, here is John Hussman’s interpretation:
Last week, the financial markets mounted a striking shift back to the “risk-on” trade, as investor concerns about a recession were abandoned, and Wall Street came to believe that Europe will easily contain its banking problems. Accordingly, downside protection was largely discarded (as reflected by a plunge in the CBOE volatility index), price-volume action reflected eager short-covering, and investor interest shifted strongly away from defensive sectors to speculative ones.
The alternative perspective is that there is pervasive fear among investors, only slightly affected by the recent market rally.
Representing this viewpoint is Scott Grannis (The market is up, but still terrified) :
The following charts recap just how nervous the market still is. The rally this month has not been driven by optimism; equities are up because things haven’t been as bad as the market had been expecting.
[This is followed by nine charts. While not specifically mentioning Hussman, the charts make it clear that all of the normal “worry” measures are still quite elevated. But don’t take my word for it. Read both articles for yourself!]
The Grannis conclusion?
No one has the answer to these questions of course. But markets are braced for a very unpleasant and possibly catastrophic outcome. If the denouement of the sovereign debt crisis results in anything less that a deep and prolonged global recession, the chances are good that risk markets could stage an impressive rally. And anyway, the world has been worrying about this for the past 18 months, so it can’t possibly be the sort of “black swan” event that comes out of nowhere and catches markets completely off guard. I think there is still lots of room for optimism these days, considering the rampant pessimism that is still pervasive in almost every market.
Profiting from the Collapse of Europe’s Lehman by Keith Fitz-Gerald
Retail: Pain in the Middle by Dee Gill
The Great Escape, Part 2: New Update by Chris Kimble
Gundlach: Markets Aren’t Cheap Enough Yet by Robert Huebscher
Gold Price Fundamental 2012 by Andrew Butter
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.