by Jeff Miller
In the short-term world of trading, your job is to anticipate the short-term behavior of others. Click on graphic for one definition of anticipation.
In the world of investing, your job is to take advantage of the short-term behavior of others.
Markets render a short-term verdict, but only professors believe them to be efficient. Warren Buffett famously notes (see here for more wisdom):
“I’d be a bum on the street with a tin cup if the markets were always efficient.” Fortune April 3, 1995
“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.” Berkshire Hathaway 2004 Chairman’s Letter
This is great advice, but difficult for most to follow. How can we tell when the market is inefficient and fearful. We need evidence! Should we bail out of the market? Should we buy puts (even at high prices) to protect our risk? Let us turn to another expert– Perry Mason (actual historical ad — and many others — available here).
Let us take the advice of these two great iconic figures, seeking edge through evidence.
Since the recent European elections there has been a dramatic change in risk appetite. Ed Yardeni sees this as a switch for risk on/risk off.
“The big switch was flipped to the off position following the May 6 French and Greek elections, which could upend all the bailout deal and fiscal pacts worked out by European leaders over the past two years. Such an outcome could push Europe deeper into a recession and weaken global economic activity. In other words, Risk On tends to be associated with widespread confidence in the outlook for global economic growth, while Risk Off indicates widespread fears that the global economy will sputter.”
Investors need evidence! Is the pessimistic outlook warranted? This week will provide more data.
As usual, I will offer some ideas in the conclusion, but first let us do our regular review of 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.
The US economic data last week was mixed, but had some high spots.
- Housing and Car Sales Lead. The Bonddad Blog takes a page from UCLA Prof Ed Leamer to reach the following conclusion and chart:
Put simply, as an economic expansion ages, housing is the first sector to weaken, followed by cars. If they are strengthening rather than weakening, a recession is not near. And to be blunt, both sectors are indeed strengthening.
Let’s look at this three ways. First here are the raw numbers of housing permits (left scale) and vehicle sales (right scale), measured quarterly to limit some of the noise. Both peaked well before any recession started, even in the case of the brief expansion in the middle of the 1980-81 “double dip”:
- Signs of GOP compromise. Fewer GOP candidates are signing the Grover Norquist “pledge.” I cite this not from a partisan perspective, but as one who seeks solutions and compromise. Concessions by either party are good. (More to come on the “fiscal cliff” issue.)
- Michigan Consumer Sentiment hit a four-year high. While this was helped by lower gas prices, it also reflected perceptions of better job prospects. Check out the chart from Doug Short — still not at peaks, but also not confirming the recession scare.
- Zillow data suggests that home prices are moving higher (via Calculated Risk).
- New home sales strengthen. Calculated Risk has been authoritative on this subject for years, so I am watching the analysis and forecast (a long and gradual recovery) with great interest. Here is Bill’s comment on the recent data:
“Clearly new home sales have bottomed. Although sales are still historically very weak, sales are up 25% from the low, and up about 15% from the May 2010 through September 2011 average.”
There was plenty of bad news on the economic data front. Here are the most important items.
- Downticks in “flash” PMI reports. These are getting a big play for those with a short time horizon. The question is whether the captured data is really accurate. The initial forecast for the US PMI was released by Markit Economics, predicting a dip. There were also negative reports on various European countries. This is an interesting new data source for the US, worth watching with interest.
- Durable goods sales were weaker. Steven Hansen has a thoughtful analysis, looking more deeply into the headline data.
- Facebook should be worth only $23. Or even $13.80. Who could have known?
- The informal European Summit disappointed. While the Eurobond concept was floated and stronger deposit insurance mentioned, there was no solid outcome. The market wants immediate answers, and the European leaders have a different time frame.
- Spanish bank problems threaten escalation and contagion. Spain has stepped in to assist with bad housing loans at the fourth-largest bank. While this is a pro-active move, investors immediately raised questions about the status of other banks. How much more help will be needed?
The “fiscal cliff” grabs the ugly award for this week. The authoritative Congressional Budget Office (CBO) reported on what would happen in the absence of any policy changes. Assorted tax cuts and stimulus programs will expire. This is headline-grabbing stuff, especially for those who have not been paying any attention.
Hardly anyone expects even a fraction of this to take place, but it makes for good headlines. The marginal effect is clearly negative as the average investor acts in a way that he/she believes to be smart and well-informed.
It is wall-to-wall crisis coverage. I plan to write more extensively on this topic.
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. None of the methods are 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.
This week’s big news on the recession forecasting front this week came from New Deal Democrat writing at The Bonddad Blog. He notes that the ECRI has retreated from a robust method with many leading indicators, seasonally adjusted, to a single reed. NDD snips that reed, showing why the year-over-year real income indicator is misleading.
Meanwhile, there are many others who have developed recession forecasting methods that have matched or beaten the ECRI, while providing transparency for consumers. These are the methods that I have been highlighting for many months.
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 continued as “bearish” although we do not (yet) have any short positions. Felix respects the market action, and the last three 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. You can also write personally to me with questions or comments, and I’ll do my best to answer.]
The Week Ahead
Sometimes the quirks of the calendar mean that we get a lot of important data in a short time frame. That is the story this week.
Friday is the big day since it includes the employment situation report along with the ISM manufacturing data (a good input for estimating the jobs report.) We will also get personal income and construction spending.
Thursday is the big tee-up for Friday. The Chicago PMI is the best guess about the ISM index. The ADP report is the best guess for the non-farm payroll number. We also get the (backward looking) adjusted Q112 GDP data and initial jobless claims (not part of the Friday reporting periods, but more recent and relevant).
Tuesday and Wednesday will provide housing price data from Case Shiller (a bit old) and Conference Board consumer confidence.
While there are no big decisions scheduled from Europe, we know that there can be headlines — plus or minus.
With all of this in mind, the US employment story is the feature for the week.
Trading Time Frame
We have been partially invested in trading accounts, in a bearish position with 1/3 of our position profitably in bond ETFs. It reflected our “bearish” 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.
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 should not be a “buy and hold” investor, but instead engage in active management. Think about 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 the Economic Evidence
Factual evidence consists of actual economic data and – -more importantly — reported corporate earnings. So far, the factual data has been strong.
Speculation from many sources includes a European collapse and a US recession, leading to lower earnings.
Does the current market reflect the speculation or the facts? Here are some interesting perspectives:
- Brian Gilmartin, a favorite of Real Money fans, has a new blog. Fundamentalis features corporate-specific earnings news as well as a macro take. Brian is off to a great start, and we will all enjoy reading his work. On the current earnings front he notes,
“…(N)o matter how earnings act, the market p/e continues to compress over the last 12 years. In fact, despite 20% – 30% growth off the 2009 bottom, the S&P 500 hasn’t traded much over 15(x) earnings since then. Even during the 2003 – 2007 rally, the S&P 500 multiple stayed roughly even with earnings growth at about 15(x) earnings.”
- Scott Grannis agrees, suggesting that the market is pricing in plenty of bad news.
“As a reminder, the chart above shows the trailing PE ratio of the S&P 500. At 13.4 today, it is approximately equal to what it was at the end of 2008, when the market fully expected a multi-year global recession/depression and years of deflation.”
- Eddy Elfenbein writes that the market is looking cheap, and the dip is centered in economically sensitive names.
The pessimists are expecting a decline in economic growth, earnings, and profit margins.
This week should provide more solid evidence about whether the negative expectations have any justification.
No matter what evidence we get, do not expect a Perry Mason style “confession!”
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.