The Week Ahead: Time for a Breather?

by Jeff Miller

After last week’s data and the recent market run, I sense that it might be time for a deep breath.

There have been solid reasons behind the market rally, including all of the following:

• Improving economic reports
• Progress in Europe
• Reasonable growth in earnings
• A backdrop of low P/E multiples

Last week I accurately suggested that it would be all about the avalanche of economic data with a big focus on Friday. This was correct.

This week is light on important data. While there are continuing earnings reports, it provides a time to reassess. I am intrigued by the trading perspective from Derek Hernquist (belatedly added to our list of featured sources. I only do this when there is an article that hits a theme I am working. Maybe I should share more of the sources that I regularly read). Even when I am wearing my “investment hat” rather than the trading one, I am always looking for the best entry and exit points. I think that Derek nails it with this comment:

Everyone knows the following:

1) Stocks are in a raging uptrend showing no signs of letup

2) They’ve travelled a long way in a short time and are entitled to a break

As traders, we constantly walk a tightrope between identifying an emerging opportunity and recognizing when it’s too obvious. I’ve learned through many mistakes that obvious doesn’t mean sell(or cover); for me, it just means find something else to buy or short. Is there a way outside of the fuzzy sentiment polls to measure “obviousness”?

Check out the article for Derek’s answer. Whether or not you agree, it is something that all of us should be thinking about, and I believe it will be the theme for the week.

More about this in my conclusion. But first, let us do our regular review of last week’s economic data and 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. 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

Last week continued the shift in tone that I have been observed for a few weeks — more about the US economy, less concern about Europe and China. This was not absolute, since every day started with a look abroad, as I chronicle daily in my daily investment diary.

The Good

There was some very good news this week.

• Employment. The official jobs report was unambiguously positive. The worst thing you can say is that we need more of the same. Employment seems to be stronger than the other economic readings would suggest, something that I covered in my preview piece.  I am in general agreement with Steven Hansen at GEI, who has an excellent comprehensive summary.
• The ISM manufacturing report came in at 54.1. This is consistent with an annualized GDP of 3.9%. All fo the “internals” were solid. It is a much better read on low inventories than the dated GDP news from last week. People report this number without ever reading about the methods. Amazing.
• The ISM services report was also solid. See Calculated Risk.
• Chinese manufacturing is expanding faster than expected.
• The Chinese are evaluating participation in the European bailout, just as I have been telling you would happen. Great coverage by the FT.
• Truck sales, the economic signal from the heartland, are much stronger.

The Bad

There was some bad economic news last week.

• Housing data continues to disappoint. The Case Shiller series is a little old because of the method, but it is widely followed. At this point little is expected. Most people do not realize that a simple end to the decline in construction would add about 1.5% to GDP. Here is the Calculated Risk take on home prices:

• Savers are out of luck. Fed Chair Ben Bernanke underscored the Fed message in his Congressional testimony. Get real! The Fed does not have a third mandate.
• Conference Board consumer confidence was terrible. See Doug Short for his “sobering look” and the expected great charts, including this one:

• Earnings are still a bit below historical averages with a “beat rate” of 60.7%. This is below the average from the recession rebound period, but a little better than we were seeing early in the earnings season. Here is the scoop from Bespoke:
  

• A million condoms fail in South Africa. You would not know this if you were not monitor the range of sources we do at “A Dash.” This story is from NPR, where you can also learn how Consumer Reports does the testing. (No, they are not seeking applicants!)

The Ugly

The market news was pretty good, so it might be easy to be distracted from world events. I have highlighted the Iran nuclear developments as one such concern. At the TD Ameritrade Conference in Orlando, former Defense Secretary and CIA Director was the key note speaker. After launching a few one-liners, his message turned rather grim. Read this helpful account for the full inventory of concerns, but a key theme is rapid change in government. Think about this idea:

The tectonic plates in the Middle East have shattered. Remember that only one revolution turned out relatively well in its first decade, and that is our own.

There is a good inventory of what to think about around the world.

See also this scary report from the current intelligence team.

There is no good way to hedge against these fears — a good topic for another article.

The Silver Bullet

I have occasionally recognized leadership in data analysis. We need more of it, and more recognition of those who do it. When you embark on such a story, you are like the Lone Ranger. In the spirit of encouraging this type of work I hope to mention a “silver bullet” story as often as possible. I invite readers to send suggestions.

This week’s award goes to (jointly) Steve Liesman and Silver Oz.

In a desperate attempt at negative spin on the employment report, the anonymous bloggers at the most popular investment site decided, as usual, to shoot first and read later. This was breathlessly picked up by Drudge and Santelli, and then republished in many places. It was a big blunder. The Census Bureau provided information from the 2010 census, as you would expect. It turns out that the population and makeup were not exactly what had been estimated during the year-by-year process. The BLS accepts the new and more accurate data on the population — does anyone really thing they should ignore this? — and then must decide how to deal with the discontinuity from the new info. Instead of retroactively changing 10 years of old data, they post the new values and explain the change.

First on the job calling “Hogwash” was Steve Liesman. In the same time frame, Silver Oz posted at The Bonddad Blog. Joe Weisenthal also picked up the story early, getting it out to his big audience. I did some retweeting, as did others. Barry Ritholtz republished Silver Oz as well, and Calculated Risk also ran a strong piece. so honorable mention to those sources. Here are the early stories:

No Rick Santelli and Zero Hedge, One Million People Did Not Drop Out of the Labor Force Last Month

Steve Liesman Calls “Hogwash” on Santelli Blunder

I am encouraged that there is more instant refutation when something is definitely wrong. Despite this I now from continuing misguided posts and comments that the damage was done. The degree of difficulty on this exceeded the ability of the average reader to figure out.

The Indicator Snapshot

It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

• Economic/Recession Indicators. This week continues two new measures for our table. The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli’s “aggregate spread.” I’ll explain the link to the C-Score next week. The second is the Super Index. You can read more about it in this article, which is merely an introduction, and also my WTWA from last week. It reflects extensive research and testing, and is well worth monitoring. (The Super Index includes the ECRI approach). I am going to do a complete review of the work very soon. Meanwhile, I think it is important enough to watch every week. Check out the latest summary from Doug Short, who has been monitoring the growing ECRI controversy and the vibrant discussion among leading theorists on this subject:

• 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.

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 “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.]

The Week Ahead

This is a lighter week on economic data. There will be important earnings reports all week, and eventually that is what matters.

On the data front I am not very interested until Thursday. The initial claims series continues to be important. I am also a big fan of the UM Consumer Confidence reports. I’ll be watching this with interest on Friday, especially given the weakness in the Conference Board survey.

Earnings reports continue, and will get a daily focus.

We are still waiting for the final verdict on the Greek debt negotiations. Amazingly, the market seems to have accepted some level of bad news about Greece, including something that triggers a “credit event.” This illustrates what I have been writing for nine months — delay is a positive when it provides time to prepare.

I appreciate the full calendar from the WSJ.

Trading Time Frame

Our trading accounts have been 100% invested for many weeks. Felix caught the current rally quite well, buying in on December 19th. There are now many solid sectors in the buy range. The overall ratings have improved, helping us to stay invested while many have been in denial for the entire rally. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated. Felix has been more confident than I have been on the trading time frame. This illustrates the importance of watching objective indicators.

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. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our “trigger range,” and is declining further. This sort of decline has been a good time to buy stocks on past occasions. Worry is still high, but is declining.

Even though stock prices are higher than in October, the risks are much lower. I am increasing position size for risk-adjusted accounts. (We cut back by about 30%). I am also looking more aggressively for positions in new accounts.

Our Dynamic Asset Allocation model is still very conservative, featuring bonds and other defensive holdings. It is rather like the Nouriel Roubini of our methods. What if things go wrong? Investors should understand that cautious, hedge-oriented positions may be slow to rebound. Most investors should have a mixture of approaches.

To summarize, we are adopting a less conservative posture in most of our programs, There is still risk, but as it is reduced we can and should become more aggressive. For new accounts we are establishing immediate partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program. This program continues to work very well, meeting the objectives of conservative, yield-oriented investors. It follows our key precept:

Take what the market is giving you.

Right now that continues to be dividend stocks at reasonable prices with the chance to sell call options at inflated prices. If the stocks do nothing, you can still get almost 10% per year from dividends and call premiums.

This does not work for those selling long-dated calls. It requires some active management, selling calls with a month or two before expiration to capture the most rapid time decay.

The Final Word

The biggest mistake for long-term investors is time frame confusion — taking a short-term market view.

Let us suppose that you have been on the sidelines for a few months, worried about Europe or the ECRI recession call. The market has rallied, so you might think that you have missed out.

Not so! You made a decision to wait until risk was lower. Your wish has been granted!

You have the opportunity you have been waiting for. Many investors have a fear fixation — the time will never be right.

These investors will never achieve their retirement objectives, since they decide based on emotions rather than evidence. You might want to consider this viewpoint from Bob Doll, BlackRock CEO:

Three months ago, stocks were pricing in about a 50% chance of a US recession and it looked increasingly likely that the European debt crisis would escalate into an Armageddon scenario. Today, while we would hardly say that the United States is poised to enter boom conditions or that the eurozone crisis has been solved, these risks have clearly receded, which has helped stocks to regain some footing. Our base case outlook is that these improving trends will continue along an uneven path, suggesting that stocks are poised for additional outperformance in the months ahead.

[Full Disclosure: We hold BLK as part of our enhanced yield program– good dividends, great prospects, good call sale potential.]

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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.