by Jeff Miller
The turmoil in Greece and the potential contagion have once again taken center stage.
While the economic and debt problems are well-known, the question for many is why should Greece be so important? The answer lies in whether there is a threat to global financial stability, or whether the rest of the world will experience secondary effects from reduced European growth.
A year ago the systemic risk question seemed to be off the table as a result of more aggressive policies, especially the ECB’s LTRO program. What happened?The Greek and French elections have underscored the limits of the austerity solution. The severe, multi-year recession in Greece is worse than ever and government programs face future cuts. This account from The New Athenian has a nice summary:
- 72% of Greeks believe the parties should make concessions to each other and form a government, while 23% believe Greece should have repeat elections
- 78% want Greece to stay in the euro, while 12% want a return to the drachma
- In answer to the question “which of the parties elected to parliament would you like to see participating in the government?” the top two are (radical) Syriza and (moderate) Democratic Left, so it seems absolutely correct for conservatives and socialists not to try and build a government that skirts around them
- Asked whether they find Syriza’s proposal realistic, 35% say quite realistic or very, while 62% say a little or not at all, which suggests that while the great majority don’t believe Syriza can implement what they say, it still wants them in to hopefully change things in the right direction, even if it doesn’t go all the way.
The Greeks expect and hope for further concessions, but want to remain in the euro. Many (most?) believe that this will not be possible, but it really depends upon what concessions the rest of Europe will make. There is also a wide range of possible outcomes, some of which are illustrated in this WSJ review.
I will have some thoughts about Europe in the conclusion, but first let us review last week’s news and 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.
There are occasionally some noteworthy “neutral” events. Initial jobless claims are hovering in a range that we would like to see move lower, but are still better than what we were seeing a month ago. Consumer economic confidence (via Gallup) is unchanged.
Despite the market reaction, the US economic data last week was pretty good.
- Fed appointments approved. Jay Powell and Jeremy Stein were approved by the Senate to positions as Fed Governors. This is good for a variety of reasons, especially given the regulatory demands on the Fed. The approval process has been excessively political for many years — both parties — so this is a welcome change. More from Macroadvisers.
- High frequency (but less important) indicators remain mildly positive (via Bonddad).
- American Association of Individual Investors (AAII) sentiment is very bearish — which is bullish for the recommended contrarian interpretation. Here is the chart from Bespoke.
- The increase in industrial production (up 1.1%) was good and capacity utilization was even better. There is no recessionary indication in this data series, as you can see in the chart from Calculated Risk.
- CPI was unchanged (mostly due to energy prices) and the core rate was up 0.2%, as expected.
- Housing was better. Housing starts were solid and NAHB builder confidence was also stronger. See Calculated Risk for a full chart pack on housing and Karl Smith at Modeled Behavior for ideas about the data revisions are finally catching up with actual growth. CR also notes The Return of Multiple Offers. Mark Perry highlights a report from the Demand Institute suggesting single-digit increases in housing prices over the next five years — not huge, but it would be a welcome change.
There was also some bad news on the US economic front and the Facebook IPO did not earn a “like.”
- Transportation data remains weak. Cullen Roche calls rail data “mixed.” Steven Hansen calls sea container data an indication of a “struggling economy.”
- The Fed minutes disappointed, largely because there was little additional support for more QE. The key market participants may not agree with the Fed on methods or policy, but they are convinced that QE juices returns. Steven Russolillo covers the story nicely at the WSJ.
- The Philly Fed was a big disappointment. Readers know that I do not put a lot of emphasis on this indicator, but it moves markets when the deviation from expectations is great. It is more important than the Empire State index, which was positive last week. Doug Short sees a bright spot, using the Philly data to show pressure easing on profit margins. I found this interesting, and you might, too.
- The Conference Board Leading Economic Indicators declined by 0.1% versus an expected gain of 0.1%. While it is only one point, this is an element significant for some recession forecasters. From Doug Short:
US Stocks. The stock market paid little heed to US data. Doug Short tells the whole story with one of his great charts.
The S&P 500 is threatening to move below the 200-day moving average, an event that would spark additional selling by some system followers.
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. We are working on a modification that will make this method even more sensitive, although no variant is worrisome. 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 also not close to a recession signal.
The big news on the recession forecasting front this week came from New Deal Democrat writing at The Bonddad Blog. He notes that since their recession forecast last September the ECRI has made several changes both in their methods and in which indicator is highlighted. He provides enough charts to satisfy inquiring minds, so take a look. Basically, the ECRI is no longer discussing their long leading indicators or their weekly growth index (supposedly thrown off by seasonality). They are now pointing to a single indicator using a year-over-year comparison. Steven Hansen, who is pretty charitable in assuming that the ECRI has some secret sauce, points out the shortcomings of excessive focus on the sole remaining indicator.
Todd Sullivan also covers the entire topic with plenty of charts. This should be a splash of cold water for those objective enough to look at some real evidence. ECRI fans should watch both of the videos he includes and then look at the charts.
Meanwhile, there are many others who have developed recession forecasting methods that have matched or beaten the ECRI, while providing transparency for consumers.
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. This week we switched to “bearish” although we do not (yet) have any short positions. Felix respects the market action, and the last two weeks have been convincing.
[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 the market reaction to the G8 meetings. Since this is mostly talk, I am not expecting much — even though the statement seems to be aimed in the right direction.
The European leaders have an “informal” summit on Wednesday, and this might be an occasion for them to try to get in front of developments. This is worthy of interest.
We have new and pending home sales on Tuesday and Wednesday. I have had little interest in these reports for many months, but (as I noted last week) there is evidence of a turning point.
Thursday’s initial claims data will be the last information relevant to next month’s employment report. Durable goods orders are of secondary interest, and I am not expecting much change in the final Michigan sentiment survey.
There may also be some options expiration “hangover” which usually leans against the prior week.
Trading Time Frame
We have been partially invested in trading accounts, with 1/3 of our position profitably in bond ETFs and another 1/3 in utilities. It reflected our “neutral” posture, and I would not be surprised to see a “buy” recommendation for an inverse ETF next week. Felix does not try to call market tops and bottoms, but respects trends in the three-week range.
For now, we have a neutral posture and lean bearish.
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. You can contrast this with the many pundits who claim miracles of market timing.
The single most difficult thing for me to explain is that investors should often embrace opportunity just as traders are trying to do some fancy footwork. Investors should not be trying to guess the next market move. Instead, take what the market is giving you. You do not need to be a “buy and hold” investor, but active management should relate to risk control rather than market timing.
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.
Final Thoughts on Europe
The market does not like the political dynamic in the European decision making. The consensus opinion is that European leaders have been too slow, too inept, and too self-interested to solve the economic and deficit questions. Some also believe that there is no solution to an inherently failed structure. For most observers the only questions are how fast the Eurozone will dissolve and the extent of the Lehman-like contagion.
My contrarian take has been that government leaders naturally do as little as required, especially when painful sacrifices and compromises are involved. Policy makers experiment, note the effects, and choose to do more of what works and less of what doesn’t. The recent trend is to note that austerity has not succeeded in reducing deficits. (Just as well that was not the only policy a year ago). Negotiations will probably now provide more assistance, more stimulus, and more time. The strong parties (especially Germany and China) have a powerful self-interest in the outcome.
The most important thing investors can do is to realize that there are actually many possible outcomes and time frames. I provided a sampling here. For a complete recap of my approach on Europe, check out this summary of ten articles.
The St. Louis Financial Stress Index provides a good, objective indicator showing that the headline risk from Europe is not reflected in financial spreads — except, of course, for stock prices. Scott Grannis does a chart-filled review of financial spreads reaching a similar conclusion.
Three Things that Could Change the Story
There are three specific steps that could change the Europe discussion very quickly.
- A strong deposit insurance program — basically ending the bank run theory.
- The creation of a Eurobond — lowering interest rates for the weaker nations and addressing liquidity.
- Increased lending or banking powers for the ESM — basically eliminating the questions about the size of a response.
Whether or not one likes these ideas, they would all dramatically change the terms of the current debate. The US 2008 experience involved many innovative and widely-criticized programs. They were introduced gradually, one at a time.
Each of these ideas has been mentioned before and could get a serious play as soon as this week, either at the Wednesday summit or through the media.
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.