by Jeff Miller
Economic growth continues at weak, below trend levels just at the time the stimulus programs are wearing off. For some this implies that the next recession is just around the corner.
From another perspective the current economic growth has occurred in spite of a major drag from reductions in government programs (see Gene Epstein in this week’s Barron’s) and contraction in housing. If these two factors just got back to neutral, it would reduce the drag by two percent or so, revealing the true underlying strength of the private economy.
Is there any hope from the housing sector? Even some stability?
I will have some ideas in the conclusion, but first let us review last week’s data.
Background on “Weighing the Week Ahead”
There are many good sources for a list of upcoming events. In contrast, I single out what will be most important in the coming week. My theme is an expert guess about 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.
This is unlike my other articles at “A Dash” where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting 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
Each week I break down events into good and bad. Often there is “ugly” and on rare occasion something really good. My working definition of “good” has two components:
- The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially — no politics.
- It is better than expectations.
The general economic data was a little better this week, while earnings were softer.
- The US posts a monthly budget surplus! Let us not get carried away, however. Tax revenues are better, but April is usually a good month. Here is a chart from Scott Grannis. We seem to have more balance.
- Job openings are better. I tend to view this as information about structural unemployment, but The Bonddad Blog sees it as a predictor of better employment data ahead. It is an interesting analysis. If you can figure out this chart you do not read to need the article. For the 0ther 99.9% of you, check out the whole story!
- Economists from a variety of sources see continuing economic growth. These are really intelligent people who have professional careers in trying to get this right. They are not employees of firms trying to sell stocks. Despite this, many readers will decide that these sources are misguided. They will instead listen to bloggers who have zilch as a track record (except maybe being “early” in forecasting the 2008 recession). Go figure.
“Compared to last month’s assessment, the CLIs for Japan and the United States show stronger signs of improvements in economic activity, pointing towards an expansion. In the Euro area, the CLIs for France and Italy continue to point to sluggish economic activity below long term trend. The CLIs for Germany and most other Euro area economies show slightly more positive signals.
The CLI for the United Kingdom and major emerging economies, in particular China, where the assessment points to above trend growth, are showing stronger positive signals compared to last month’s assessment.”
- Consumer sentiment reached pre-recession levels according to the University of Michigan. This probably reflected lower gas prices, although initial jobless claims have also been better.
- Producer price increases were lower than expected — thanks to energy prices.
- Initial jobless claims continued in the 360K range, suggesting that the April spike was seasonal. We should continue to watch this series.
The general economic news was not that bad, but some important specific stories dragged the market lower.
- The earnings beat rate really tanked since the start of the season (via Bespoke). The overall rate declined to 60% — not terrible, but lower than the average of 62%. Read their entire article to see the post-earnings performance of specific companies.
- JP Morgan announced a surprise trading loss. The stock plunged, but that was only the start of the story. Owners (like me) had to re-consider our positions. Analysts like my colleague Scott Rothbort considered whether this story had broader implications. I especially like this comprehensive analysis from Lisa Pollack at FT Alphaville. After considering the evidence, you might enjoy voting in the poll at Wall Street All-Stars.
- The trade deficit was higher. This seems like bad news, but Steven Hansen explains that it shows higher economic activity. (I’m scoring it as “bad” because that is the market interpretation, but I urge the deeper reading).
- European governments are in flux. Since the elections called into question the various austerity plans, the market reaction was negative. For those of us who see the European situation as an ongoing multi-party process of negotiation and compromise, this seems like business as usual — not a reason for panic.
The US Constitution. I am tired of listening to those blaming Congress and the politicians. The individual actors are doing what you might expect to gain re-election. Democratic government is supposed to hold them accountable, so what do we expect?
The real problem is our system of government. Winston Churchill famously said that democracy was the worst form of government except for all others. The particular US flavor may have finally lost touch with the times. We have what seem like perpetual elections and gridlock. Our legislative process emphasizes the ability to block any change — especially when the Senate now requires a super-majority to do anything.
Those blaming specific leaders — or politicians generally — have it wrong. Those in the US live in a world where changes is difficult to accomplish.
This might be fine for most social questions, but it is not good for financial markets.
Here is an example of the GOP passing a bill to violate the debt ceiling agreement to accept defense spending and cut food stamps. This is not serious legislation, but a political statement. The Democrats are doing the same thing.
And meanwhile we have a study of a study about studies. I despair at trying to explain how this makes sense.
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
- The St. Louis Financial Stress Index.
- The key measures from our “Felix” ETF model.
- An updated analysis of recession probability.
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.
The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli’s “aggregate spread.” I’ll explain more about the C-Score soon. Bob also has a group of coincident indicators. Like most of the top recession forecasters, he uses these to confirm the long-term prediction. These indicators are not close to a recession signal. Bob has graciously offered a recent report as a free sample for our readers.
The big news on the recession forecasting front this week came from the ECRI, which is clinging by a thread to their recession forecast from last September. They are now acting like the forecast was for June, 2012 and that we cannot possibly know the real verdict for six months after that. In the meantime they have changed their methods, blaming seasonal adjustments.
It is about time to face the facts, since the indicators they follow have probably improved. Everyone in the financial world makes mistakes. The real pros accept responsibility, figure out what went wrong, and move on. Take a look at their recent CNBC appearance (via Business Insider), the Bloomberg appearance (via Doug Short – with great charts) and the analysis at The Bonddad Blog and decide for yourself.
We follow the excellent work of Georg Vrba, who has a top-rated coincident recession indicator as well as a successful stock/bond asset allocation model. Here is his most recent comment:
“My own composite short leading economic indicator, which has the highest score of all indicators so far tested, does not support the notion of a recession anytime soon.”
I listen to Georg, and you should, too.
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. Four weeks ago we shifted from bearish back to neutral. The last several weeks have been pretty close calls. The ratings have dropped off a bit.
[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. For daily ETF commentary from Felix, you can sign up for Wall Street All-Stars, where I still have a few discounted memberships available. You can also write personally to me with questions or comments, and I’ll do my best to answer.]
The Week Ahead
Before the US week even gets started we’ll have updates on the progress (or lack thereof) in forming a coalition government in Greece.
We will have a number of economic reports that are probably of secondary significance — retail sales on Tuesday along with the CPI. On Wednesday we see industrial production and capacity utilization. On Thursday we have the more important initial claims data. Any of these reports could have a significant effect, so I will be watching closely.
Throughout the week we get regional Fed surveys, which add little information to my own assessment unless there is a dramatic move.
The Facebook IPO will continue to be a big story. People like to follow what they can understand, and they think they know Facebook. There is an important difference between understanding a product, and evaluating a business model and stock valuation.
Trading Time Frame
We have been fully invested in trading accounts, with 1/3 of our position profitably in bond ETFs. It was still a losing week. Felix finds the current dip to be an attractive buying opportunity, so we are back in the market. The Felix forecast is for a three-week horizon, so it is best not to judge too quickly. We have long experience with this program, which does not try to call market tops and bottoms.
If Felix is wrong, it will soon send sectors back to the penalty box. For now, we are looking for rebounds in several ETFs.
Investor Time Frame
For investment accounts I have been buying on dips in stocks that we like. I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look.
Investors should not be trying to guess the next market move. Instead, take what the market is giving you. I have been offering this advice for months, and it led to a great quarter for anyone taking heed. We seem to have another buying opportunity — especially in tech and cyclical stocks.
If you are really worried, you can imitate our enhanced yield program. Buy good dividend stocks and sell short-term calls. I am targeting 8-9% returns on this approach, and achieving it no matter what the market is doing. You can, too. This has been meeting objectives in spite of the market twists and turns.
Final Thoughts on Housing
The housing story has been a multi-year drag on the economy. Even switching to neutral would add a point or two to GDP. This week’s economic data feature housing. This might start to get interesting given the recent surge in building permits. Calculated Risk has suggested that we might be seeing some bottoming in housing. Our own ETF model supports this idea, so we are watching carefully. Here is a provocative chart from CR:
Hardly anyone expects any strength from this source, so it is (yet another) contrarian play.
And a Warning
I continue to worry about holdings in bond funds. Check out the excellent analysis from Tom Brakke, which shows in a single chart both the temptation and the threat to those buying bond funds.
I urge you to read the article carefully. If bonds are right for your portfolio, you should consider buying individual bonds instead of bond funds.
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.