by Jeff Miller
Last week’s big story was a stock market rally based upon heightened expectations of further stimulus from both the Fed and the ECB. So much for my expectation of a low volatility week!
The calendar for this week includes plenty of important data and more earnings reports. Normally the Friday jobs report would be the most important news of the week. With last week’s big three-day rally in mind, we must ask:
Are we expecting too much from the Fed and the ECB?
In the case of the Fed, the suggestion that action is near came from John Hilsenrath of the Wall Street Journal. While his article was published in Wednesday’s edition, the online version hit just before the market closed on Tuesday, sparking a hundred-point rally in the Dow. Most of the analysis recapped past statements by FOMC members and mused on the recent data. The New York Times ran a similar piece hours later. Nonetheless some speculated that the source was meaningful, and even suggested that Hilsenrath might be “too close” to the Fed. For these sources the mere fact and timing of the article suggests a near certainty of action.
There were questions raised about the Draghi speech as well, especially when Bundesbank officials seemed not to agree.
I’ll offer my own expectations in the conclusion, but first let us do our regular review of last week’s news.
Background on “Weighing the Week Ahead”
There are many good sources for a list of upcoming events. With foreign markets setting the tone for US trading on many days, I especially like the comprehensive calendar from Forexpros. There is also helpful descriptive and historical information on each item.
In contrast, I highlight a smaller group of events. 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 good news all seemed to come with an asterisk.
- ECB chief Mario Draghi vows to do whatever it takes, and assures that it will be enough. There is additional support from political leaders in France and Germany.
- Initial jobless claims declined 35,000 to 353K. This continues a wild series of gyrations, possibly influenced by fewer auto plant closings this year. It does provide another decline in the four-week moving average, and it looks nothing like recession territory (as noted by Bonddad with some great charts well worth checking). These data were not part of the survey period for next week’s employment situation report.
- Durable goods orders were up 1.6%. (The asterisk is that the “core value” which excludes transportation and defense, declined 4.4%).
- Earnings reports have continued to beat the lowered expectations, and revenues are also a little better. Here is the chart from Bespoke.
- Money supply growth (M2) is starting to look stronger at 7% real growth Y0Y. (Bonddad)
- Home values are higher than last year according to Zillow. There are several different measurement approaches with differing universes and time frames. The widely-followed Case Shiller method uses a trailing three-month average, so we should not look for a turn there just yet.
The bad news also earned asterisks, as some stories had mixed features.
- The Q212 GDP report, 1.5% annualized growth, continues a weakening and sluggish pattern. I am classifying this as a negative, although it beat (reduced) expectations. There were also revisions to past quarters. For a comprehensive look at the GDP report, check out Doug Short’s analysis. Here is one chart showing the revisions.
- Pending home sales declined 1.4%. (More from Calculated Risk).
- Chinese economic data continues to look suspect. This is a theme we have covered in several past articles. Dr. Ed has an interesting analysis of revenue data, concluding that Chinese growth may be weaker than expected.
- Michigan Sentiment on the final read for July was still very weak at 72.3 (a small increase over the preliminary number). This is not a good omen for the jobs report, especially in light of the reduction in gas prices. See Doug Short for his great chart, showing the relationship with recessions.
- Sentiment in Europe continues to decline, as noted by Rebecca Wilder. She has a nice analysis of several indicators and plenty of charts. Here is a good example.
The Silver Bullet
I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. Think of The Lone Ranger.
This week’s award goes jointly to Georg Vrba and Doug Short. They each take on the most recent effort to scare investors with some obscure technical indicator of dubious provenance. This time it is perma-bear Albert Edwards warning investors about the “Ultimate Death Cross” taking the S&P 500 back to 666.
Doug Short analyzes this “bizarre concept” which he conclusively demonstrates to be a “worthless indicator for the market or the economy.”
Georg Vrba takes the analysis even further. He shows that Edwards’ prediction is almost impossible to accomplish if you actually do the math on the moving averages involved. In addition, he demonstrates that the current indicator conditions are actually bullish based on historical data.
There is so much misinformation, and so few who work to correct the errors. We should recognize those who do.
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 SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events. It uses data, mostly from credit markets, to reach an objective risk assessment. The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.
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 recession 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.
There is a lot of activity from the recession forecasters. The basic summary is that those with the best records still see little chance of a recession in the next six months or so. The people that get featured in the press and on TV are sticking by their guns, even though the evidence is mounting against them.
We are now at the end of the nine-month forecast window that the ECRI adjusted to after their September, 2011 call (recession imminent, maybe already here, and unavoidable) seemed to prove wrong. Since then they have been adjusting indicators and trying to extend the window, which supposedly ends right now — mid-year 2012. Instead of agreeing to this, the ECRI has now raised the notion that there is already a recession, but it has not yet been recognized. For the last two weeks there have been numerous refutations of this claim. Meanwhile, I recommend this article where I did a rather comprehensive list leading up to last week and also my new Recession Resource Page, which explains many of the concepts people get wrong.
The group using the ECRI data for recession forecasts — with a better fit that the ECRI has themselves — has lowered their “alert stage” based on the most recent data.
The single best resource for the ECRI call and the ongoing debate is Doug Short, who has a complete and balanced story with frequent updates.
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 neutral. We have been bullish since June 23rd.
[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 really big week for data, and we also have more earnings news.
Lesser (but important) items include the following:
- Personal income and spending (Tues).
- Case-Shiller home prices (Tues).
- Chicago Purchasing Managers Index (Tues).
The biggest items are the following:
- ADP employment report (Wed).
- ISM manufacturing (Wed).
- Initial jobless claims (Thur).
- Employment situation report (Fri).
In addition we have the FOMC announcement on Wednesday and the ECB on Thursday.
It is a jam-packed week for data and potential policy announcements. The calendar creates some quirks, as I’ll discuss in the conclusion.
Trading Time Frame
Our trading positions continued in fully invested mode last week. Felix is not a range trader, but is excellent at getting on the right side for big moves. The positions have become more conservative and I would not be surprised to see a move to cash — at least partially — in the coming week.
Investor Time Frame
The successful investment strategy differs markedly from trading. It is especially important to establish good, long-term positions when prices are favorable. Most individual investors seriously underperform long-term results by selling low and buying high. Most successful professionals, of course, do the opposite.
This is easier said than done. With everyone on TV explaining with great confidence what just happened (please check out my article on the “message of the markets”) it is easy for the average person to think he is out of step. For several weeks I have emphasized the folly of attempts at short-term market timing.
There is no magic moment. Resolving market worries is a process, not an event.
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 market action in the last two weeks has once again illustrated market moves based on unpredictable factors. Who would have guessed on Tuesday afternoon that the market would be 2% higher on the week?
Our single best strategy through the various gyrations has been buying dividend stocks and selling calls for enhanced yield. This week provided great opportunities to set new positions early in the week and sell calls against existing holdings late in the week, just as we suggested last week. Anyone unhappy with bonds should be doing this for a yield of 8-10% with greater safety than pure stock ownership. Take what the market is offering!
Final Thoughts on Draghi and Bernanke
There is certainly potential for disappointment this week.
While Draghi was decisive in his rhetoric, we were all left to imagine the specific policy actions that might result. In particular, my concern is one of pace and timing. Market participants show little patience for the democratic political process, demanding instant gratification. Draghi may have a different time frame in mind.
David Wessel in the WSJ quotes David Mackie of JP Morgan Chase with a list of possibilities, in descending order of probability.
- European Financial Stability Facility/ European Stability Mechanism purchases in primary and secondary bond markets.
- A reactivation of Securities Markets Programme, or SMP, which made bond purchases, on the basis of constructive ambiguity.
- A decline in the ECB’s interest-rate corridor, pushing the deposit rate into negative territory.
- More long-term refinancing operations with significantly less aggressive collateral haircuts, with the financing rate linked to the pace of bank lending.
- A precautionary credit line from the EFSF/ESM for Spain.
- A statement removing perceived seniority of EFSF/ESM and ECB interventions.
- A full EFSF/ESM bailout for Spain.
- An ECB commitment to buy EFSF/ESM debt in the secondary markets.
- Large scale asset purchases along the lines seen in the U.S. and U.K.
- A reactivation of SMP program with yield targets for Spain and Italy.
- ECB taking a write-down on holdings of Greek debt to reinforce that it stands on equal footing with official interventions.
- Giving the ESM a banking license.
This is a good list, further explained in the article. I think we will eventually see several of these items, but only over time.
Despite the “perfect record” of Hilsenrath, I am not convinced about FOMC action this week. It seems more natural for them to accumulate more data, including Friday’s employment report, with some hints coming at the annual Jackson Hole meeting. This is only a guess. With more certainty I will predict that many will use whatever the Fed does on Wednesday as an indicator of Friday’s employment data. This is because most market observers make several important mistakes about the Fed, as I explained here. The Fed will not know the data.
This is a very difficult week for specific investment conclusions. I did come across an intriguing nugget.
Hedge funds are not profiting from Europe, mostly because there are no trends and there is an unpredictable news flow. (Maybe they should hire a few recent poli sci grads to assist their quants!) The Economist observes:
“Perhaps too many people are looking for the next “big short” and instead should be looking for the next “big long”. Mr Paulson (whose fund has done badly of late) was able to buy CDSs cheaply because everyone else was bullish on American housing. Should the euro crisis somehow see a swift resolution, the optimists who defied consensus could be the ones counting their billions.”
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.