by Jeff Miller
After a holiday-shortened week of trading, there will be a deluge of data — the most important reports in many weeks. Will it matter? Normally Friday’s employment situation report would be the big news of the week. If last week is a guide, the story will be all about Europe.
The US story has been one of continuing modest growth and excellent earnings. Gavyn Davies draws the distinction between the US and Europe:
In sharp contrast to the eurozone, the US economy has been performing better than was generally expected a couple of months ago, but it remains very vulnerable to the fiscal tightening which now seems likely next year, and to a worsening in the eurozone financial shock. This shock has not yet crossed the Atlantic with any force, but might do so before too long.
This is pretty gloomy about the US prospects, but nearly every other source is even darker. Hardly anyone sees a chance for the Eurozone to avoid a serious recession and most expect the US to be dragged down as well.
One exception is Daniel Indiviglio, whose monthly compilation of indicators (check out his helpful table) shows improvement nearly everywhere. He makes the obligatory nod to the European threat.
I’ll have some thoughts about this for investors in the conclusion. First, let’s take our regular look at the news and data from last week.
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. Do not be bashful. Join in and comment about what we should expect in the days ahead. 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
The economic data last week was positive on all important fronts. It made no difference. Once again the Europe-related headlines dominated over anything else.
The economic story showed continuing improvement. There is no indication of a current recession, and economic forecasts are moving higher.
- Tax withholding rebounded. The Bonddad blog highlighted the reversal from the prior week report. One of the reasons I feature this source is the commitment to accuracy and honesty. They have been adjusting this series for the tax law changes and they are on top of every move.
- Initial jobless claims continued to move lower. This is an important data series — hard data, very timely — and continuing to improve. Doug Short shows the key relationship, but also the seasonal nature of the data. Check out the full article to learn why seasonality is important in labor stats.
- Corporate profits are very strong (via Scott Grannis). The news is widely ignored because of the European focus — no one trusts earnings estimates, even though they are becoming more cautious. Meanwhile, look at the data:
- Congress is not giving up on tax reform and deficits. We have the return of the Gang of Six. If Congress takes the sequestration of funds for defense seriously, there might yet be some progress.
- Personal spending moved higher, but not as much as income. Dr. Ed Yardeni makes the controversial suggestion that long-term unemployment compensation should be curtailed. He thinks that some are working “off the books.” That would help to explain high spending levels.
The negative news came from many sources.
- The worst US economic news was the downward revision in Q311 GDP, from 2.5% to 2.0%.
- The Supercommittee was not so super. I am disappointed at the missed opportunity and also concerned about the effect on public confidence. I wrote about the results, trying to emphasize the investment angles. As is always the case with anything that has a partisan political angle, this is how many chose to spin the results. This Washington Post/Bloomberg article suggests that the payroll tax reductions will expire as a result. I do not think it is that simple or obvious, but that is a subject for another day. Meanwhile, the news was a market negative this week.
- People flipped out over the Fed’s new stress test assumptions. In the past many questioned whether the assumptions were stressful enough. This time the Fed seemed to go all out (-8% growth, -13% GDP). Others took the mere statement of the assumptions as lending some credibility to that possibility, the “black sky” scenario.
- The Chinese “flash PMI” edged a little below 50. Edward Harrison thinks this means some credit easing from China, writing as follows:
Near-term, we think China has the means and the will to fend off a hard landing, but acknowledge that China is by no means immune to global developments, and will find it harder and harder to fend off the growth headwinds.
This week’s Ugly Award goes to Europe — shared by the various leaders. This is a summary article, so I am mostly just pointing to what I see as significant.
- The “failed” German bond auction. The Economist called the auction “terrible” and said that it might push leaders to faster action. Spiegel Online chose to highlight analysts who called it “a complete disaster. FT Alphaville quotes a “bund bull” who thinks the ECB is still some distance from making a decision to act more aggressively. For a calm, analytical viewpoint, The Economist interviewed an expert from Pimco’s European team who saw the result as not so unusual.
The Bundesbank is not financing Germany; it just operates as an agency for Finanzagentur. It is worth repeating that Finanzagentur always retains part of the bonds, so this part of the process is normal. Today the retention was larger than usual. This is probably due to low liquidity across market, lower incentive to place certain minimum size bids by dealers, and richness of bunds in general.
- Independent Greek negotiations. On Friday the news hit that the Greeks were embarking on negotiations with various bond holders for a bigger haircut. The news was important for various reasons. Would the actions trigger a credit event and a payoff on credit default swaps? Would these actions result in the loss of the next tranche of assistance? If you really want the answers to this complex subject, you must do some work. I recomment the fine article from Peter Tchir, someone who trades these markets and carefully studies the issues. I think he is a little too gloomy in his estimates for political change. He thinks that I am too optimistic. I value his work.
- The leadership. Despite various meetings, European leaders seem no closer to progress toward a solution. I have noted that the problem has (at least) four important variables. Economic growth, spending levels, interest rates, and time. The market pressure on interest rates threatens all three other variables. Regardless of what is accomplished through additional capital, lower interest rates are essential.
European interest rates have become more relevant to US stock trading than any of the regular data releases.
Bob McTeer explains why the ECB could choose to act aggressivley, even though their mandate focuses on inflation.
The ECB should not be overly concerned that bond purchases would lead to inflation if they are not sterilized. The massive bond purchases by the Fed did not lead to massive inflation; indeed, until recently, their impact on the money supply was muted by the desire of U.S. banks to hold excess reserves, just as they did in the 1930s. The same is likely to be true of distressed European banks.
The Vatican agrees.
Wise words, but who is listening?
The Indicator Snapshot
It is important to keep the weekly news in perspective. My weekly indicator snapshot includes important summary indicators:
- An Economic/Recession Indicator. I am evaluating several candidates. None confirm the ECRI forecast of an inevitable and imminent recession. None of the leading candidates agree with the ECRI. These are sources that have a similar track record, greater transparency, but less PR. I realize that I am (long) overdue for making the choice for a new indicator, and it will be at least another ten days. It has been a careful research process, and I expect the explanation to require multiple articles. Meanwhile, if something really bad were taking place, I would make it clear in the weekly updates. I see the recession odds over the next nine months as being less than 25%.
- The St. Louis Financial 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 has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a “warning range” that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.
We did so a few weeks ago, as you can see from this chart.
This indicator deserves more respect and more attention. Here is the full array.
Our “Felix” model is the basis for our “official” vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions. We voted “Bearish” 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.]
The Week Ahead
This is a big week for economic data. The most important will be Friday’s employment situation report. Jobs remain at the core of investor and popular concern as well as a key economic indicator. The big question about the report is how well it captures the current picture.
On Thursday we get the ISM index, perhaps the most widely misperceived indicator, as well as the next installment of initial jobless claims. The jobless claims are not part of the survey period for the employment report, so this report actually provides even fresher data.
Wednesday we have Chicago purchasing managers, a predictor of ISM, and the ADP employment report, which might actually be better than the official data. We also get the Fed’s Beige Book, a look at the anecdotal economic evidence that will be in front of the FOMC at its next meeting. The Fed is probably on hold with the current position, so this should not be a big factor.
We will also get Case-Shiller and FHFA home price data early in the week, along with updates on pending home sales as well as the Conference Board’s version of consumer confidence.
A deluge of data. While I monitor everything, the late-week releases have more potential for market-moving effects.
Trading Time Frame
Our trading accounts have not had any US equity exposure for several weeks. Last week’s correlated selling in nearly everything sent most ETFs to the penalty box. This suggests that a vote of “abstain” is more accurate, but the general picture is negative. Felix initiated a small short position on Monday via purchase of the S&P inverse ETF (SH). This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated.
Investor Time Frame
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. A month or so 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. For investors desiring this risk management approach we raised cash when the trigger hit the range. We have also been cautious with new accounts. We still do not have an “all clear” signal.
Our Dynamic Asset Allocation model is also very conservative, with holdings in bonds and gold.
To summarize, we have a very conservative posture in most of our programs, recognizing the uncertainty and volatility.
A Final Thought
Last week I wrote that we were “waiting for the ECB.” This is still true. European leaders are not ignorant and unaware of their problems. Leading reluctant constituents is often not easy. The messy process of compromise is still a work in progress.
Long-term investors are supposed to go shopping when others are fearful. Instead, most have adopted a herd mentality. This is a good time to take what the market is offering. You need not go “all in.” You can buy solid dividend stocks at low prices and write calls against your position. This adds income and provides some additional protection.
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.