by Jeff Miller, A Dash of Insight
Last week I predicted that the major theme for the week would focus on whether or not to book profits for the year – especially given the test of 1700 in the S&P 500. That turned out to be pretty accurate, and it may have some staying power this week as well.
The reaction to last week’s economic data and the quiet calendar both suggest a slightly sharper focus this week: Will rising interest rates end the rally in stocks?
There are two sharply divergent viewpoints:
- It is all about the Fed. Every market move can and should be interpreted in the light of a potential reduction in Fed asset purchases. A slowing of stimulation is tantamount to tightening Fed policy. The first signs of tapering will cause a rush for the exits, sending markets back to a value implied by higher interest rates, lower profit margins, and a return to the historic Shiller P/E ratio.
- It is all about the economy. Interest rates respond mostly to fundamental factors. The Fed will withdraw gradually, in line with emerging evidence.
At the moment, the first viewpoint commands most attention. The mere hint of “tapering” talk has some market effect. The media loves a story, and the Fed drama is much easier than analyzing data. The improved odds of a Summers nomination as Fed Chair seemed to weigh on the markets. Felix Salmon provides the updated analysis on the Fed Chair race, with an insightful twist on the right criterion: Should the choice emphasize crisis skills? Meanwhile, the market has a knee-jerk reaction based upon QE.
Expert Fed watcher Tim Duy continues to believe that tapering is near.
Even if interest rates move higher, what will be the effect upon stocks?
I have some thoughts on interest rates and the Fed which I’ll report 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 regularly follow is the weekly calendar from Investing.com. For best results you need to select the date range from the calendar displayed on the site. You will be rewarded with a comprehensive list of data and events from all over the world. It takes a little practice, but it is worth it.
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. Each week I consider the upcoming calendar and the current market, predicting the main theme we should expect. This step is an important part of my trading preparation and planning. It takes more hours than you can imagine.
My record is pretty good. If you review the list of titles it looks like a history of market concerns. Wrong! The thing to note is that I highlighted each topicthe week before it grabbed the attention. I find it useful to reflect on the key theme for the week ahead, and I hope you will as well.
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.
This was some good news, despite the overall reaction of the stock and bond markets.
- Earnings season finished with better results than the (lowered) expectations on both earnings and revenue. Here is the revenue tally from Bespoke. Take a look at their summary post for more detail. Subscribers to their premium service get a very nice analysis by sector – also including the best and worst stocks.
- Inflation results were tame – as expected. Doug Short takes a helpful long-term look at inflation and also updates a series on theFed’s favorite measure. Both are worth checking out. Even if you believe that your personal inflation is higher than the government estimates, it pays to know what the Fed is thinking.
- The recession in Europe is ending. Joe Weisenthal updates a story that he has covered accurately for months. This is also a good investment theme. (See Felix discussion below).
- Bullish sentiment declined – which is bullish on a contrarian basis. Bespoke has the story in one of their great charts – see the full post for the helpful discussion.
- Jobless claims made a new low. Scott Grannis has a solid analysis and a helpful chart:
“Can there be any doubt that the economic fundamentals continue to improve? That there is no sign of recession or incipient economic weakness? After more than four years of improvement, it’s amazing to me that there can still be so many who moan and groan about how this recovery is so awful. Yes, we should and could have had a lot more people working now, but that doesn’t negate the fact that things have been improving relentlessly for over four years.
Claims are rapidly approaching the lowest level that we have ever seen relative to the size of the workforce. What’s not to like?“
There was more than a little bad news.
- More Hindenburg sightings. But check out Cardiff Garcia’s reaction at FTAlphaville – and get your coin ready to flip! See also the analysis from Chris Puplava, where he adjusts for the distortion of closed-end bond funds.
- Sentiment via the Michigan survey declined and missed expectations. I am especially bothered when this happens at a time when there is relatively little interference from fuel prices and politics. Doug Short’s analysis is excellent and his chart illustrates the important economic relationships:
- Retail earnings stunk. The series of bad reports this week were part of the market decline. Some analysts tried to characterize earnings season by throwing out financials – the strongest sector. I saw no one who did the opposite, throwing out retail. It seems obvious to be buying in the strong sectors and de-emphasizing the weaker, but it is not overall market commentary. (BTW, I am overweight financials and seriously underweight retail).
- Q3 earnings estimates are falling. Ed Yardeni notes that Q3 estimates dropped as much as Q2 gained. The one-year forward earnings have not changed. Here is the picture:
- Another round of budget politics looms. Congress is still onvacation recess, but we are allowed to look ahead a bit. Joe Weisenthal is tracking the story, including some other elements. Experienced analyst Stan Collender is worried. Bill McBriderepeats his concern about this issue.
- We might have hit “peak car.” What would this mean for the general economy? Emily Badger’s intriguing analysis suggests that this is a pre-recession phenomenon.
- The technical picture is more negative (via Charles Kirk). You need to see the weekly chart show to get the entire flavor (inexpensive subscription required, and worth it). Charles is always flexible – what might work and what probably won’t. His readers learn what to watch for. Last week caused what some call “technical damage.” It always interests me when Charles and Felix get on the same page.
- Housing starts disappointed. Building permits were better, but it was mostly multi-family. Calculated Risk has the full story. By contrast, Steven Hansen at GEI also analyzes the data in various time frames and without seasonal adjustments.
Egypt. These stories always have elements far beyond the obvious implications for investors. There is some irony. As the world seems to grow smaller, we feel compassion with many more groups – especially those that seem to identify with Western definitions of freedom and democracy. There are tough choices for policymakers as well.
I always try to separate the important human reactions from the need to consider investment implications, but it is part of the job. Popular media often confuse the two. The bottom line for investors relates to the Suez Canal. Oil prices have spiked, but there are good reasons to believe that the canal will remain open.
Meanwhile, we all hope for a resolution that ends the violence.
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 to Dave Altig, writing at the Atlanta Fed’s Macroblog. His creative use of charts and data reveals the truth about employment and low-paying jobs. There is a recurring theme that recent job creation has emphasized the worst jobs. Dave started with a recent WSJ story that captured mainstream thinking. I cannot possibly do justice to this post in a few words. There is a fascinating animated gif that shows wage changes by sector over time, so check out the full article.
Meanwhile, the following chart illustrates one of the themes: The changes are part of a long trend, not a post-recession effect.
The Indicator Snapshot
It is important to keep the current news in perspective. I am always searching for the best indicators for our weekly snapshot. I make changes when the evidence warrants. At the moment, my weekly snapshot includes these important summary indicators:
- For financial risk, the St. Louis Financial Stress Index.
- An updated analysis of recession probability from key sources.
- For market trends, the key measures from our “Felix” ETF model.
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 recently edged a bit higher, reflecting increased market volatility. It remains at historically low levels, well 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.
I feature the C-Score, 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 am not worried about an imminent recession. In fact, the evidence suggests that we are in the middle innings of a longer than normal business cycle. This is a concept that Bob monitors closely – and so do I.
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. RecessionAlert has developed a comprehensive package of economic forecasting and market indicators, well worth your consideration. Dwaine has also developed a market-timing approach which follows ten bear market signals. His latest installment provides detail and a current look.
Georg Vrba’s four-input recession indicator is also benign. “Based on the historic patterns of the unemployment rate indicators prior to recessions one can reasonably conclude that the U.S. economy is not likely to go into recession anytime soon.” Georg has other excellent indicators for stocks, bonds, and precious metals at iMarketSignals. For those interested in gold, he has a recent update, asking when there will be a fresh buy signal.
Unfortunately, and despite the inaccuracy of their forecast, the mainstream media features the ECRI. Doug Short has excellent continuing coverage of the ECRI recession prediction, now almost two years 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 points out that the public data series has not been helpful or consistent with the announced ECRI posture. Doug also continues to refresh the best chart update of the major indicators used by the NBER in recession dating.
The average investor has lost track of this long ago, and that is unfortunate. The original ECRI claim and the supporting public data was expensive for many. The reason that I track this weekly, emphasizing the best methods, is that it is important for corporate earnings and for stock prices. It has been worth the effort for me, and for anyone reading each week.
Why hasn’t the ECRI changed its tune in the face of the evidence? Doug is showing extremely great patience in his gracious, open-minded look at the evidence.
Readers should review my Recession Resource Page, where I explain why investors should pay attention to the official recession definition, instead of casual estimates.
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. Over the summer Felix has ranged from bearish to bullish, but without a strong signal either way. Last week’s readings were the best in several weeks, but the overall strength has again weakened. Because I update these results weekly, some readers treat it as a prediction for the coming week. Not so. Felix has a three-week time horizon and the poll (published weekly) asks for a one-month forecast. To gauge the accuracy you need to look at a three-week outcome.
Felix does best at getting on the right side of sustained moves, enjoying most of the year’s rally while others were bailing out. Felix has also done well in highlighting recent uncertainty, with high “penalty box” readings. We have adjusted this week’s forecast to neutral, despite the slightly bullish readings. Some of the recommended sectors are foreign ETFs and the major index ETFs are mixed. The relatively high penalty box rating underscores the difficulty in making short-term forecasts in the current market.
[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 is relatively light on data.
The “A List” includes the following:
- Initial jobless claims (Th). Employment remains the focal point in evaluating the economy, and this is the most responsive indicator. It is especially important after last week’s improvement.
- New home sales (F). Have higher rates had an effect?
- FOMC minutes (W). Someday there will be less interest in a summary of old news. For the moment, the market wants to squeeze out any sign of new information – maybe even if nothing is there.
The “B List” includes the following:
- Leading economic indicators (Th). Still favored by many, despite various changes over the years.
- Existing home sales (W). An indicator of well-being and possible consumption.
The annual KC Fed symposium at Jackson Hole normally attracts plenty of market interest. This year no one is expecting much. Courtesy of Merrill Lynch, which broke the news embargo on the confidential agenda, we know that there will be no keynote speech on Friday morning. This is normally given by the Fed Chair and Bernanke is not attending. Larry Summers will not be there. Janet Yellen is chairing a panel, but there does not seem to be much that will hint at policy direction. There could be a surprise.
Dallas Fed President Fisher also speaks on Thursday, and might deliver some hawkish comments.
How to Use the Weekly Data Updates
In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.
To get the maximum benefit from my updates you need to make a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?
My weekly insights often suggest a different course of action depending upon your objectives and time frames. They also accurately describe what I am doing in the programs I manage.
Insight for Traders
Felix has turned less bullish, although we are still fully invested in trading accounts. Felix dodged the selling pretty well last week, mostly by emphasizing Europe and Canada, including (as I noted last week) theVanguard FTSE Europe ETF (VGK). There are still several attractive choices. While I do not expect Felix to head for the sidelines during the week, we re-evaluate positions each day.
Insight for Investors
The most helpful article this week came from Abnormal Returns. (We all benefit when Tadas takes the time to write on a general theme, in addition to his regular citation of the best links).
The concept is that market timing easily leads investors out of the market, but there is no good signal for re-entry. Cash becomes an addiction! This is animportant post, which should be a jarring dose of reality for many investors who have mistimed the market. Tadas writes, “I think that “cash is a drug” for most investors. Easy to start, difficult to kick. Always a reason to NOT get back in.”
This is also the message I have emphasized. Do not be seduced by the idea that you can time the market, calling every 10% correction. Many claim this ability, but few have a documented record to prove it. Most who claim past success are using a back-tested model. Please see The Seduction of Market Timing.
This is an opportunity for reflection. Think of it as a mid-year checkup.
- For several weeks, I have accurately emphasized the danger of yield-based investments – yesterday’s source of safety. The popular name for this is “The Great Rotation.” It is still in the early innings, since bond fund investors are only getting the bad news from their statements. Even the best bond managers (like Gross and Gundlach) cannot win when interest rates are rising. The exodus from their funds is starting. Most investors are emphasizing cash, real estate, and gold. .333 is good in the major leagues, but not for your investments!
It may be a “generational selling opportunity” for bonds.
- Find a safer source of yield: Take what the market is giving you!
For the conservative investor, you can buy stocks with a reasonable yield, attractive valuation, and a strong balance sheet. You can then sell near-term calls against your position and target returns close to 10%. The risk is far lower than for a general stock portfolio. This strategy has worked well for over two years and continues to do so. (I freely share how we do it and you can try it yourself. Follow here).
- Ask yourself how you are doing? Josh Brown’s powerful piece earned the top admiration score from any blogger: I wish I had written it! Here is the start, but you need to read it all.
“If you had twenty five years left to live, how much time would you spend worrying about the daily ups and downs of the stock market?
If you had twenty years left to live, how much time would you spend trying to time the stock markets and the economy and other things that are both unpredictable and completely out of your control?
If you had fifteen years left to live, how much time would you spend trying to buy or sell a specific stock at the perfect price?”
And much more… For many investors there comes a time when they should focus on fun, and maybe also improve performance.
- Lose the focus on fear! Many are rewarded for making sure that you are “scared witless” (TM OldProf euphemism). If you are addicted to gold and allegedly safe yield stocks, you need a checkup. Gold works in times of hyperinflation or deflation/crisis. When neither happens, the ball is going between these Golden Goalposts. There is a good transition plan for those with a fixation and fear and gold.
And finally, 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).
There is a distinction between perception and reality, between media buzz and the economy. In the short term, perceptions and buzz may dominate. Eventually, the actual economic effects will be more important.
In my own analysis I emphasize data, since that will eventually prove out. Other factors may seem more important in the short term. Since these are difficult to time or predict, most investors are better off sticking to the fundamentals.
This does not mean “buy and hold.” It means a focus on actual risks rather than headlines.
At the moment, it means getting some perspective on interest rates and the Fed. At some point, high interest rates might be a negative for stocks — but not yet.
- QE critics have an untenable and inconsistent position. Interest rateshave actually moved higher during QE. It is not all about the Fed.
- The Fed does not control rates at the long end of the market. The Fed is a big buyer, but still less than 1% of the market. Other forces prevail, as I showed here.
- As interest rates move higher, the economy has become stronger. This will be good news for corporate profits – especially for cyclicals, financials, technology, and consumer discretionary.
The very low interest rates have reflected intense deflationary skepticism. This creates an exaggerated risk premium for stocks and an artificially depressed P/E multiple. If the economy had any respect, the multiple might be 20 on forward earnings (a common prior level). That would still be a big discount to a 4% 10-year treasury note.
“…(I)t might be years still before another recession hits. Every recession in my lifetime has been the by-product of a tightening of monetary policy. The market is in fits these days not because the Fed is tightening, but because the Fed is nearing the point at which it will begin to ease less. Tapering—buying fewer bonds each month—is still accommodative policy, it’s just policy that on the margin is becoming less accommodative.”
There are various threats to corporate profitability and stock prices, but the start of a long process of Fed “tapering” is not one of them. I find it helpful to think about a likely destination for the economy and financial markets. This is helpful in avoiding excessive focus on any single variable in a world where so many things are correlated. I expect the economy to improve, interest rates to move higher (starting with the long end), PE ratios to increase (as is usually the case when rates go to 4% or so), profit margins to decrease somewhat, and the U.S. deficit to decrease. This climate will be very negative for some stocks and sectors and very positive for others. (I provide more detail here.)
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