The Week Ahead: More Cyprus Fallout?

by Jeff Miller, A Dash of Insight

Editor’s note: After this was written there was an announcement of an agreement which may cool the “Cyprus fever”.  See GEI News.

In a holiday-shortened week I expect the Cyprus story to remain on the front burner this week. As I write this post, there is no firm proposal. Whatever is proposed will be bad news for some and therefore great news for pundits and the media. Since we have little earnings or economic news, the field is open for speculative commentary.

The best case in Cyprus will still have negative features. Can the fallout be contained?

I intentionally used the “C word” despite knowing that it invites the smart-aleck comments. Many believe that a major lesson from the subprime debacle was that policymakers (famously Bernanke) thought that the impacts could be contained. This example is raised whenever someone tries to get a handle on the possible impact of some event.

You might be able to guess what I think about this, but I’ll elaborate in the conclusion. First, let us do our regular update of last week’s news and data.

Background on “Weighing the Week Ahead”

There are many good lists of upcoming events. One source I especially like is the weekly post from the WSJ’s Market Beat blog. There is a nice combination of data, speeches, and other events.

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:

1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially — no politics.
2. It is better than expectations.

The Good

This was a good week on the economic front, and there was some positive political news as well.

• The Senate passed a budget. It was the first time in four years and had only a one-vote margin, but you have to start somewhere! (See The Hill for details).
• Obama’s trip to Israel might help. The early reviews applaud the Israel/Turkey effect as well as the general reception.
• Hotel occupancy is back to pre-recession levels (See Calculated Risk for chart and analysis).
• Housing starts are higher and that is nicely correlated with employment. Here is the chart from Calculated Risk:

• Revenue growth for Q212 was 3.6%, much better than expected. Remember when many were saying that earnings would come without revenue gains? Brian Gilmartin has the data and also a discussion of earnings by sector.
• Leading Economic Indicators from the Conference Board were strong. Steven Hansen at GEI has the analysis and charts. Here is a sample:

The Bad

There is always some negative news, and this week included economic data, earnings, and Europe. The market performed worse than the economic data, suggesting an emphasis on Europe. Feel free to join in the comments with anything else that was market-unfriendly.

• The Fed downshifted on its economic forecast. Scott Grannis analyzes why everyone is so gloomy, noting that the Fed forecast suggests that the US will never recover the growth path. (Scott deserves respect as a Republican and libertarian who does not allow political viewpoints to sway his economic analysis). See the many key charts showing crucial variables, which support his conclusion, as follows:
  

  “In short, companies are holding back on their hiring plans, worried about regulatory burdens and big increases in mandated costs. And many individuals have probably decided that the rewards to working harder or returning to work are outweighed by the costs (e.g., higher taxes) to doing so.”

• The Markit “flash” PMI numbers suggest a continuing economic decline in the Eurozone (via GEI).
• Earnings reports were sparse but negative in tone. ORCL and FDX were two cases in point.

The Ugly

Syria is the latest hot spot, with the civil war spilling over into Israel. (latest via Reuters).

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 have now added a series of videos, where Dr. Dieli explains the rationale for his indicator and how it applied in each recession since the 50’s. I have organized this so that you can pick a particular recession and see the discussion for that case. Those who are skeptics about the method should start by reviewing the video for that recession. Anyone who spends some time with this will learn a great deal about the history of recessions from a veteran observer.

I have promised another installment on how I use Bob’s information to improve investing. I hope to have that soon. Anyone watching the videos will quickly learn that the aggregate spread (and the C Score) provides an early warning. Bob also has a collection of coincident indicators and is always questioning his own methods.

I also feature RecessionAlert, which combines a variety of different methods, including the ECRI, in developing a Super Index. They offer a free sample report. Anyone following them over the last year would have had useful and profitable guidance on the economy. Dwaine Van Vuuren also has an excellent data update, demonstrating how the coincident data have reduced recession prospects. There are seven sample reports available, including Dwaine’s latest country-by-country analysis of the global recession status. Good reading!

Georg Vrba is a great “quant guy” with an excellent variety of useful tools, some available via a free subscription. His take on a possible recession? Based upon unemployment data, the ECRI is wrong.

Doug Short has excellent continuing coverage of the ECRI recession prediction, now well over a year old. Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting. His latest comment provides a detailed critique of the most recent ECRI media blitz, suggesting that it is “an effort to salvage credibility in hopes that major revisions to the key economic indicators — notably the July annual revisions to GDP — will validate their position.” Read the entire post for full details. Doug also continues to refresh the best chart update of the major indicators used by the NBER in recession dating.

Readers might also want to review my Recession Resource Page, which explains many of the concepts people get wrong.

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. About a month ago we switched to a bullish position. These are one-month forecasts for the poll, but Felix has a three-week horizon. Felix’s ratings stabilized at a low level and improved over the last few weeks. The penalty box percentage measures our confidence in the forecast. A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings. That measure is improving, so we have a little more confidence in the bullish forecast.

[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 week brings less data and scheduled news, an artifact of the calendar and the holidays.

The “A List” includes the following:

• Initial jobless claims (Th). Employment will continue as the focal point in evaluating the economy, and this is the most responsive indicator.
• Consumer Confidence (T). The Conference Board version has special significance given the weakness in the Michigan survey.
• Chicago PMI (Th). Upgraded in importance this week since the national ISM index will not come out until Monday – two trading days later due to the holiday. The Chicago PMI is a reasonable directional indicator for the ISM index.
• Personal Income (F). This is important for recession analysis. It will be reported on Friday even though the market is closed.

The “B List” includes the following:

• Durable Goods (T). This is a key element of the economic rebound, so it is important to follow.
• Case-Shiller home prices (T). Because of the method and Prof. Shiller’s consistently dour interpretation, this seems to be lagging the other home price measures. It gets a lot of attention.
• New Home sales (T). Another piece of the housing puzzle. Will the improvement continue?

I am not very interested in the final Michigan sentiment numbers, unless there is a big change. We also have speeches from Bernanke and some other Fed figures, but the topics do not suggest major market effects.

The bond market stops trading early on Thursday, so this rates to be a very short week for market action.

Trading Time Frame

Felix has continued a bullish posture, now fully reflected in trading accounts. It was a close call for several weeks. Felix has been long, but in cautious sector choices. At one point we were down to 1/3 long in trading accounts, and it the overall ratings are still not strong.

Investor Time Frame

Each week I think about the market from the perspective of different participants. The right move often depends upon your time frame and risk tolerance.

Buying in times of fear is easy to say, but so difficult to implement. Almost everyone I talk with wants to out-guess the market. The problem? Value is more readily determined than price! Individual investors too frequently try to imitate traders, guessing whether to be “all in” or “all out.”

This approach would be especially poor right now!

Warren Buffett recently spent a few hours on CNBC’s Squawk Box. As regular readers know I use TIVO and mute to find the best stories from this source. CNBC helped with some highlights – only nine well-spent minutes and you can see the best of the Buffett advice.

I particularly enjoyed one observation. Mr. Buffett said that the market offered you a quote on your holdings every day. This should be an advantage, but most people made poor use of it by trading at the wrong times. They would be better off to check on their portfolio every five years or so! It explains why most people make big mistakes in trying to time the market.

So do most “experts.” I exposed the false claims of many pundits. You can check out the overall issue and also pundit ranks by reading The Seduction of Market Timing.

While there are no miracles available from market timing, you can definitely improve your risk/reward balance. I explained how in my 2013 preview for Seeking Alpha. This covers some key investor catalysts, as well as some specific stock and sector ideas. My recommendations did well last year, and we are off to another good start. You need to be comfortable in taking the other side of one of the most hated rallies in history.

But please beware! General ideas are not for everyone. Each person needs unique treatment. We have several different approaches, including one that emphasizes dividend stocks with enhanced yield from writing near-term call options.

We have collected some of our recent recommendations in a new investor resource page — a starting point for the long-term investor. (Comments and suggestions welcome. I am trying to be helpful and I love feedback).

Final Thought

How worried should we be about Cyprus?

For almost two years I have encouraged investors to view the European problem is a multi-party bargaining process, moving slowly toward compromise. The eventual solution will be a compromise – loved by no one. Since most market gurus, including the most prominent, have no experience with this type of situation, they are prone to mistakes. They want to criticize European leaders for being too slow and especially for not making the same decisions they would prefer.

Since the process of creating compromise takes time, it can always be criticized as “can-kicking.” Other lame analyses involve dominoes and cockroaches.

Sadly, these conclusions are voiced by some very respected analysts. These are often people who are good at one thing – bonds, corporate finance, marketing to create more assets, telling people what they want to hear – but they have absolutely no credentials in political science or policymaking.

I suggest two specific conclusions:

1. The initial proposals had the effect of a trial balloon – drawing out criticism and sharpening up the final proposal.
2. Objective measures like the St. Louis Financial Stress Index are more helpful than scary headlines.

If you followed my suggestions from last week, you were able to profit from scare-induced volatility. If not, you might get another chance this week!

And finally, Scott Grannis offers eighteen charts worth considering. The overall picture can be summarized in this final comment (and one chart offered as a sample):

“It never pays to underestimate the ability of the U.S. economy to overcome adversity and grow. That’s why I remain optimistic, especially because I see that markets are still obsessed by the negatives.”