A Dash of Insight

A Profitable Pattern

I have noticed a profitable pattern.  I am going to cast this from the bearish perspective, but in theory it could work either way.  I have a few other historical examples, but let us focus on the present.

Background

Investors have many time frames, and so do those managing money.  When you see someone interviewed on CNBC it could be a mutual fund manager, a hedge fund manager, or a trader.  It is natural for everyone to talk his book, but the time frame is relevant.

A mutual fund manager likes to see holding increase, get publicity, and attract new assets.  Having said this, these managers are not likely to sell into rallies.  Instead, new money in their funds gets invested at current prices in current holdings.

A hedge fund manager or trader is different.  Their disclosures warn that they may change opinions and trades in a heartbeat.  They can, and should, do so.  A five percent move in a stock is a major trading profit.

The Process

A portion of the hedge fund community takes a position.  For this example, it is a short in semiconductor stocks.  The position is supported with plenty of reasoning they deem to be rigorous and also by technical analysis.  It is especially desirable to find a situation where a sector has made a big run.  A chart of the SOX tells the story.

I haven't added any lines in this, and readers should ignore the last decline, since that is the end of the story.  The point is that analysts could have a field day with this chart -- before the decline.

Cocking the Hammer

Those establishing a bearish position wish to highlight major concerns.  In this case the "hammer" was the question of double booking of orders.  This occurs when inventories are so low that those building mother boards want to be assured of needed parts.  To do this, the theory holds, they place multiple orders for needed parts in short supply, canceling some orders when their needs are met.

It is an argument that raises a question about the validity of reported orders, and creates fear that the orders will decline.

Pulling the Trigger

One might think that actual evidence of order decline would be necessary to trigger the fear.  That assumption is incorrect.  It is easy to grasp any news as evidence that this prophecy has been fulfilled.

Yesterday the B of A/Merrill analyst downgraded the entire sector.  The resulting report, which I have read carefully, is based upon an inventory model and some assumptions about where we are in the cycle.  It does not specifically refer to any double booking, and the resulting forecasts are still above many other Street observers.  It was a big call, getting a lot of play, and knocking down the stocks by 5 percent or so, as the chart indicates.

Bearish observers incorrectly cited the double booking argument, not actually mentioned in the report.  It talks about a small "overshoot" in inventories, not mentioning any double booking.  It is based upon a theoretical model, without a lot of supporting evidence.  Since few actually read these reports, the inaccurate summaries gain credence.

The Result

Anyone with a short position can cover for a nice trade.  It was a nice setup.  Any downgrade could be cited as evidence.  When the analyst from a big firm downgrades, everyone pays respect, at least in the short term.  That is long enough for traders and hedge fund types.

The Facts

There is plenty of evidence contradicting the double-counting argument:

From iSupplyCorp we have the following:

In their earnings announcements, leading semiconductor suppliers, including Texas Instruments, STMicroelectronics and Intersil, all reported they saw no signs of double-booking during the third quarter, said Ciriello. “This should give the semiconductor industry confidence that the magnitude of the current recovery accurately reflects real demand levels.”

A balanced article at the WSJ mentions the double-booking issue:

Another analyst, FBR Capital's Craig Berger, also cited signs of weakening PC demand, though he said in a note, "We do not want to get overly bearish on the PC space given improving global demand and still-unknown holiday sell-through trends."

Berger said he remains "bullish" on the semiconductor sector. "We think fears of a first half of 2010 estimate cuts from double ordering are overblown, that global supply chain inventories are at or near all-time lows, that global demand trends will continue to recover in 2010." 

Astute tech stock observer Bob Faulkner writes as follows (see the full article for his nice inventory charts and complete analysis):

I've tracked inventory in the electronics-supply chain for years. While it’s too early in earnings season to draw any final conclusions, I think it’s very safe to say that inventory is quite tight on a relative basis.

Steve Ballmer reports that Microsoft sees "fantastic sales" for Windows 7.  If this is accurate, it should stimulate a new cycle of purchases.  More people and businesses replace computers -- especially those who avoided VISTA -- than upgrade existing machines.  The current hardware may not be adequate and is difficult to configure.

Our Take

The trading setup is a real dilemma for managers with a long-run horizon.  It was completely predictable that something -- anything -- would be seized upon as confirmation for the double-booking argument.  There was no need to wait for actual evidence.  Even knowing this, should the manager blow out all of his chip holdings, expecting a pull back of unknown size?

The real answer for those with a longer perspective is to focus on the actual time frame and ignore the bumps in the road.  The traders will make their profits, and eventually the results will tell the story.  It is an opportunity to add to positions for those who disagree with the thesis.

An Interesting Exercise

There was a similar setup -- hammer pulled back -- on car sales after the Cash for Clunkers expired.  Perhaps this is a good topic for an example where we now have more evidence -- an immediate decline, followed by a restoration in sales.

I invite other examples -- both long and short -- from readers.  Look for the setup -- what we all should watch for-- and then look for evidence.

Our position:  Long INTC, MSFT, and AAPL.

Specific Expertise: Insisting on the Best Information

Here at "A Dash" we have emphasized that we are all consumers.  We are consumers of data, of analysis, and of opinion.  Our principal mission is helping readers understand their role as consumers and figure out what sources and information to follow.

Background

Here are two widely-accepted findings to consider.  Both have strong support from empirical evidence on market returns.

1. Stock analyst ratings often lag, so the wise contrarian investor fades the consensus opinion.
2. Chasing performance is a major source of losses.  Those who "called the last move" are often the mean-reverting cases.  One needs to look at long-term performance.

These precepts are widely accepted in the investing community.  (I will add that both are part of my own approach to stock-picking, with a nice long-term return.)

Meredith Whitney

Yesterday afternoon CNBC indicated that Meredith Whitney would be featured on Maria Bartiromo's program.  Regular readers know that we are big fans of Maria.  We think that she asks the right questions and draws out interesting answers from high-profile guests.  Many market participants guessed at the nature of the interview and sold the market before and during her interview.

You can check out the key points of the Whitney interview here.

Our Take

Meredith Whitney, in her prior role as bank analyst with Oppenheimer, did one thing well --- very well.  She accurately predicted that banks would need to write down assets.  She accurately predicted that there would be no FAS 157 relief on mark-to-market accounting, so there would be a death spiral of bank value declines.  Those following her predictions made significant profits and/or avoided losses.

Since starting her own firm, Whitney has expanded her universe of predictions.  She is now making forecasts about the economy, the housing market, and consumer behavior.  (I regularly read her work via my helpful Oppenheimer rep when she worked there, but now I get the information along with everyone else).

It is quite fair to question Whitney's skill at economic forecasting.  Her success related to analyzing bank holdings, not forecasting the economy.  Personally, I prefer a different approach to economic forecasting, and so should you.

Her current bearishness is grounded in valuation -- financial stocks should return to tangible book value.  When asked what would make her bullish, she responded in valuation terms, giving the example of BAC at 3.  She does not believe that banks have sound core earnings, despite an attractive yield curve.

Others have commented on Whitney's bearishness, with varying conclusions.  Quite frankly, most of them use the wrong criterion.  They talk about how well she has predicted the market -- either last year, or this year, or both.  This is a very small universe for inference, dependent on a couple of key conclusions in each case.  The circumstance this year, including marking assets to market, are quite different from last year.  Whether or not one agrees with government policy, the various arms of our Federal government are all on a concerted mission.

A More General Conclusion

We are all bombarded each day with fresh opinions about our investments.  These are now taking the form of the CEO interview.  I modestly suggest the following guidelines:

• CEO's are great at discussing their current business;
• CEO's are sometimes helpful in discussing what is in their pipeline (analyze this skeptically and carefully);
• CEO's have no added advantage when offering opinions about the future of the economy, beyond what they see in their own business.  They are reading and analyzing the same news that we are.

Readers might enjoy revisiting our Ted Williams strike zone article --- emphasizing the importance of staying in your "happy zone."

[I am long GS in personal and client accounts and hold a small BAC position as well.  I am slightly long in trading accounts and remain fully invested in long-term accounts.]

ETF Update: Rebound in China?

President Obama's China visit will be a news focus for the next few days.  Investors will follow developments closely for hints about trade, the dollar, implications for the U.S. economy, as well as several important challenges to international cooperation.  Because China is the biggest lender to the US, the relationship is changing.

This occasion is also a good time to consider the prospects for direct Chinese investments.  We identify such opportunities through our sector rotation model.

In our disciplined system, we study sectors continually, looking at the charts and ratings for hundreds of ETF's.  Each week we provide a list of our top-rated sectors for the next three weeks, along with some of our current observations.  ETF investors can check out the list and compare our findings with their own conclusions.

In our analysis, we consider Trends, Cycles, and a bit of Anticipation.  Since we apply the model to nearly 300 ETF's, we call it the TCA-ETF system.  (For new readers, there is a more complete description of our methods at the end of the article.  We also have a free report with more detail on the system and results, available on request.)

The model also provides a nice feel for the overall potential of the market.  I'll take a look at the macro picture first, and then take a look at our featured sector of the week.

The Macro View

From an overall market viewpoint, our indicators remained weak.  The key elements are as follows:

• 31% of our ETF's in positive territory ( up from 23% last week).  The median strength rating for the overall list is a negative 6 (up slightly from -9 last week).   A score of "0" implies the average long-term ETF expectancy.
• 93% (down from 98%) of our sectors are in the "penalty box."  This means that they are currently disqualified from the buy list for technical reasons.  You can think of this as a sophisticated "stop loss" rule, often applied in advance.  See our article here for a further explanation of this method.
• Our index package is neutral.  For this rating we look at the ETF's (both long and short)  for the S&P 500, the Dow, and the Nasdaq.  You can see these ratings is the results table for this week.

Spotlighting China

This week we see a number of China plays near the top of our list.  While the Thursday closing ratings listed below show the various China sectors in our penalty box (described in some detail last week), some of the ETF's emerged from the penalty box on Friday.  In an effort to be both topical and timely, I am going to highlight one of the ETF's we bought, the FTSE China (HK Listed) Index Fund (FCHI).

As the fund name indicates, it tracks the FTSE China Index, emphasizing Chinese companies available for international investment.  The holdings are pretty concentrated with the top ten names constituting over 62% of the fund.  The P/E ratio is about 23, and price-to-book over 3.  The beta is only 0.78.

Here is the chart.

The model may be reacting to the pattern of higher highs, and higher lows.

Expert Commentary

Gary Gordon reviews several China plays and wisely calls attention to the varying levels of concentration in financial stocks.  FCHI has about 45% exposure.  While Gary does not object to Chinese financial stocks per se, he warns about excessive concentration in any sector.

Michael Johnston at the ETF Database reviews a number of attractive choices for US investors.  He notes that Burton Malkiel  has maintained that US investors are underexposed to China.

Tom Lydon emphasizes the fundamentals of the Chinese economic rebound.

Weekly TCA-ETF Rankings

We were mostly out of the market this week.  Since the S&P gained about 2.5%, we lost ground against our benchmark.

We provide these ratings as information for readers who may not trade as frequently as we do.  Those signing up for our free weekly email update can also get the entire list.

As noted above, the macro market indicators are in the penalty box, and most other ETF's are in the penalty box.  Based upon the current model signals, we have continued our neutral position in the Ticker Sense Blogger Sentiment poll, despite the slight negative edge in the ratings.

Here are the top sectors from our expanded universe of 280 ETF's.  The list also includes the values for the broad market ETF's and their inverses.

Note for New Readers

Our weekly ETF Update is designed to assist both investors and traders interested in ETF's and Sector Rotation.  Before turning to the current rankings, let us undertake a review for readers new to this series.

Our Method.  In this past article, we described our basic methodology and why we believe the rankings are useful for fundamental traders and technical traders alike.  While we urge readers to check out the entire article, the key point is that ETF's pose challenges and opportunities different from investment in individual stocks.  The fundamentals may be more difficult to assess.  Even with a good grasp on fundamental trends, there is a lot of technically-based trading in ETF's.  This means that those trading with a fundamental approach (and we do this as well) want to monitor the "hot money" moves.  Here is an article on that point.

The system synopsis. We look at Trending sectors, Cyclical Sectors, and build in an element of Anticipation for both entry and exit -- thus the name of the model, TCA-ETF.  While we do not reveal the exact methodology for spotting trends and cycles, the system is not a "black box."  The basic elements are used by many, and widely reported.  We even discuss the need for human analysis as opposed to black box trading.

We report the rankings each week, now on the weekend with a one-day delay, using the Thursday output from the model.  We monitor and trade this daily, and offer a free report (request via the email address on the top left of the site) for those interested in our weekly trading program.

Dollar Weakness and Stock Market Strength -- the Data

Anyone who is following the market on a daily basis is paying attention to the strength of the dollar versus other currencies.  It can be confusing.  While a strong dollar might seem like a good thing, there is actually an inverse market relationship with stocks -- at least in recent times.

I described the basics of the dollar debate here:  Understanding the Debate on the Dollar.  There are many opinions -- prescriptive, political, and descriptive.  The next step is to consider some data.

Dollar Strength and U.S. Equity Market Returns

In my last article I highlighted the inverse relationship between a strong dollar and the stock market.  This chart provides a dramatic illustration of the relationship for calendar 2009.

 
Sometimes a chart tells the story in a glance, but I always like to look at data as well.  I used the Fed's measure of the dollar versus a broad basket of currencies, weighted by trade.  The series started in 1995.

The correlation for this year is an almost perfect negative relationship:   -.96.

A negative relationship sometimes stands out even more if you invert one of the scales.  Here is that chart.

The data are the same, but the tight relationship is especially clear using the inverted scale.

So much for what we know.  An obvious question for investors in stocks is what would happen if the dollar gets stronger.  Perhaps we should look at more data.

A Longer Perspective

Some believe that a strong dollar is consistent with economic growth and a strong stock market.  To examine this concept, we need to consider more data.

If we look at the full data series, we see long periods where dollar strength was consistent with a rising stock market.  In fact, the correlation between the two series is a positive value:  .35.

For an objective analyst of data, the chart suggests three conclusions:

1. The relationship changes over time;
2. The last year is quite atypical;
3. There are other important variables at work.

The Carry Trade

The prevailing hypothesis about the dollar/stock relationship is the "carry trade."  Supposedly there are investors/companies/speculators who are able to borrow in dollars at a very low interest rate.  This makes the dollar the "funding currency."  Most outspoken on this subject is Nouriel Roubini, who sees disaster ahead.  [Full disclosure -- I am a contributor at Nouriel's valuable site.  I respect and appreciate his encouragement of alternative viewpoints.]

The borrowers do not then do the obvious -- lend in another currency, hedging the difference with a forex trade.  Instead they supposedly use the borrowed funds to engage in a variety of speculative trades -- emerging markets, real estate, and, of course, US stocks.

Following this logic, there is now a speculative bubble of major proportions.  This seems implausible.

My skepticism comes partly from the lack of any real data supporting this viewpoint, and partly from the daily trading.  If you really had this trade on, would you really take it off if the dollar moved by 0.4%?  The carry trade hypothesis does not explain the closely calibrated trade between the dollar and stocks, but we see this every day.

For now, let us stick to conclusions supported by data.  There is a strong inverse relationship.  If you are a trader, you had better pay attention.  If you are a long-term investor, you need to understand the long-term relationship.

Meanwhile, I invite reader comments, citations for new data, and fresh hypotheses.  I will pursue this for at least one more article, considering various causal models.

Understanding the Debate on the Dollar

A strong dollar seems patriotic.  It is also meaningful to long-term purchasing power.  Weaker dollars mean a higher cost for foreign products, and that is inflationary for the US consumer.

This natural impulse is at odds with current equity trading.  A friend asked why the market had 200+ rally in the DJIA on Monday.  My answer -- dollar weakness-- was counter-intuitive and unsatisfying, but accurate. 

Dollar's Drop Helps Dow Hit New 2009 High, explained Briefing.com.

Today the Dow declined 100 points.  Why?  Many cited dollar strength.

Investors and traders alike need to pay attention to the dollar.

The Prescriptive Viewpoint

Some commentators who choose to advise the government on preferred policy are outspoken on both the need for dollar strength and the policies required.  David Merkel calls for the Fed to raise interest rates and the Obama Administration to balance the budget.  The prescription embraces a willingness, perhaps even a necessity, for the recession to become much deeper.  The resulting unemployment and business failures are part of a needed cleansing process that will avert an inevitable deeper economic decline.  This viewpoint is based upon economic theory, not a political viewpoint.

Others seem to advocate similar views with politics in mind.  You can watch any nightly Kudlow show to get this argument about "king dollar."

A third viewpoint, represented by Bob McTeer, suggests an alternative.  McTeer is a free-market Republican, but he has a pragmatic approach.  He recognizes the need for dollar strength in the long run, but notes a short-term problem.

So, my conclusion is there is a strong argument to be made for a strong currency. It just doesn’t apply in the midst of a deep recession when the main problem is inadequate aggregate demand. Many people who don’t acknowledge that are, in my opinion, trying to avoid sounding “Keynesian.”

I’ve said this many times before. My position on a strong dollar is similar to St.Augustine’s position on chastity in his famous prayer: “Lord, make me chaste, but not just yet.” My prayer is, “Lord give us a strong dollar, but not just yet.”

His reason?  No individual country can control the currency.  All act in accord with internal political mandates.

The positive jolt to domestic GDP caused by a depreciating home currency is well known all over the world. That is why during a global slump such as we are in today we have to guard against competitive devaluations where each country tries to boost its economy through depreciation or devaluation which has the opposite effect on its trading partners. The term of art is “beggar thy neighbor” policies, sometimes called “beggar my neighbor” policies.

The Descriptive Perspective.

David Merkel and other observers are quite correct in noting the divergence between stated and actual public policy.  Investors need to understand this.

There is an inverse relationship between the dollar and equity strength.  There are several hypotheses (and little evidence) to explain the daily trading.

Investment Implication

There is more here than I can cover in a single piece, so I will take a deeper look.  We need to investigate the dollar carry trade, the alternative causal models in the relationships, and the time frames for the various arguments.  There may not be enough data for an objective answer, but I will give it a shot.

Meanwhile, investors should realize that actual policy is aimed at improving economic performance, even if the dollar declines.  If you are an investor, put aside your opinion about whether the policy is correct.

ETF Update: Recognizing and Reacting to Risk

Let us consider this interesting question:  What distinguishes the "smart money" from the average investor?

My nomination is a better understanding of risk.  The individual investor is always looking backwards and focuses excessively on returns.  The pros try to measure risk in many ways -- valuation, economics, or even finding the next black swan.  They also implement risk control through the use of sophisticated option positions, long-short trades, or outright short positions.

Determining Equity Risk

Non-quantified measures.  There is a group of forecasters who make predictions about consumer behavior (spent-up) or the dollar (under massive pressure), or growing debt and Fed policy (out of control).  While the specific contention can be quantified, the relationship to stocks usually is not.  The result is a convincing argument about a problem, but lacking a quantifiable relationship to stocks, and especially lacking a time frame.  Those taking these views all see higher market risk.

Gold.  Gold has an interesting dynamic.  It is a gauge of inflation, a verdict on the dollar, and a refuge for those who see systemic risk.  The dollar price of gold is an objective measure.  It is moving higher, even when near-term inflation risk by many measures seems subdued.  The daily newspapers, many blogs,  and television advertising play to these fears.  It is an interesting measure of perceived risk.

Options volatility.   The implied volatility of equity options is an excellent measure of perceived risk.  While most think of volatility as downside risk, it can actually work either way.  There are excellent sources on this topic, two of which we feature regularly.

• Bill Luby at VIX and More has an excellent recent series on using VIX, the most popular volatility measure, as an investment indicator.  Start here, but read the linked articles for a more complete understanding of the issues.
• Adam Warner also tracks the VIX.  He notes both the ascent and the sharp recent decline.

We have our own approach to risk.

Background

We have a disciplined system, where we study sectors continually, looking at the charts and ratings for hundreds of ETF's.  Each week we provide a list of our top-rated sectors for the next three weeks, along with some of our current observations.  ETF investors can check out the list and compare our findings with their own conclusions.

In our analysis, we consider Trends, Cycles, and a bit of Anticipation.  Since we apply the model to nearly 300 ETF's, we call it the TCA-ETF system.  (For new readers, there is a more complete description of our methods at the end of the article.  We also have a free report with more detail on the system and results, available on request.)

As part of this analysis, we show ETF's that are in the "Penalty Box."  Many readers have asked what this means, so let us explain a bit more.

Our modeling guru, Vince Castelli, recently updated our emphasis on risk analysis.  Our concept is the "penalty box."  The general interpretation of this approach is that the specific ETF might rise or decline in price, but the potential reward is no longer worth the risk.  Here are the key features:

• A stock or sector in the penalty box does not merit an investment within our three-week time frame, regardless of recent price appreciation.
• The penalty box is derived from an array of technical factors.  While price movement is part of the picture, it also includes other key technical elements.
• In determining the criteria, we began with key hypotheses about risk, and then sought confirmation.  This is not an exercise in data mining or back-fitting results.
• The relationships Vince discovered proved out, on balance, in thousands of cases from many different time frames.

Does the penalty box always predict a declining price?  Of course not.  Risky sectors might move even higher.  No one ever knows, in retrospect, how much risk was accepted for a given return.  As a simple assumption, pretend that you did not pay your insurance premium last year.  If you are still alive or your home did not burn down or you did not have an auto accident, you showed a profit.  Was your failure to pay a wise investment?

Understanding risk is crucial to investing in any time frame.

The Macro View

From an overall market viewpoint, our indicators continue to weaken, and now reach negative territory.  The key elements are as follows:

• We now find only 23% of our ETF's in positive territory (99% last week).  The median strength rating for the overall list is only -9 (down from +8 last week).   A score of "0" implies the average long-term ETF expectancy.
• 98% (up from 91%) of our sectors are in the "penalty box."  This means that they are currently disqualified from the buy list for technical reasons.  You can think of this as a sophisticated "stop loss" rule, often applied in advance.  See our article here for a further explanation of this method.
• Our index package is neutral.  For this rating we look at the ETF's (both long and short)  for the S&P 500, the Dow, and the Nasdaq.  You can see these ratings is the results table for this week.  While the index ETF's have positive ratings, both the longs and the shorts are in the penalty box.

Weekly TCA-ETF Rankings

We were mostly out of the market this week.  Since the S&P gained over 3%, we lost ground against our benchmark.  We had mid-week sales and did a rare update for readers.  We may have some mid-week buying if sectors come out of the penalty box.

We provide these ratings as information for readers who may not trade as frequently as we do.  Those signing up for our free weekly email update can also get the entire list.

As noted above, the macro market indicators are in the penalty box, and most other ETF's are in the penalty box.  Based upon the current model signals, we have continued our neutral position in the Ticker Sense Blogger Sentiment poll, despite the negative edge in the ratings.

Here are the top sectors from our expanded universe of 280 ETF's.  The list also includes the values for the broad market ETF's and their inverses.

Note for New Readers

Our weekly ETF Update is designed to assist both investors and traders interested in ETF's and Sector Rotation.  Before turning to the current rankings, let us undertake a review for readers new to this series.

Our Method.  In this past article, we described our basic methodology and why we believe the rankings are useful for fundamental traders and technical traders alike.  While we urge readers to check out the entire article, the key point is that ETF's pose challenges and opportunities different from investment in individual stocks.  The fundamentals may be more difficult to assess.  Even with a good grasp on fundamental trends, there is a lot of technically-based trading in ETF's.  This means that those trading with a fundamental approach (and we do this as well) want to monitor the "hot money" moves.  Here is an article on that point.

The system synopsis. We look at Trending sectors, Cyclical Sectors, and build in an element of Anticipation for both entry and exit -- thus the name of the model, TCA-ETF.  While we do not reveal the exact methodology for spotting trends and cycles, the system is not a "black box."  The basic elements are used by many, and widely reported.  We even discuss the need for human analysis as opposed to black box trading.

We report the rankings each week, now on the weekend with a one-day delay, using the Thursday output from the model.  We monitor and trade this daily, and offer a free report (request via the email address on the top left of the site) for those interested in our weekly trading program.

Interpreting Conflicting Information

A wise and valued friend called my attention to an article on municipal bonds, Short Seller:  Dump Munis.

James Chanos, noted for highlighting collapses including Enron, sees bad days ahead for municipalities.  State and local governments already have fiscal pressure.  They have defined benefit pension programs and "platinum" health care plans.  He also raises the specter of the loss of the federal tax exemption if there is a bailout.

To balance this perspective, author Tom Sullivan also cites Gary Pollack, head of fixed-income trading at Deutsche Bank Private Wealth Management.  Pollack sees "headline  and downgrade risk" but notes the power of these governments to raise taxes.

Even if one hates the idea of tax increases, this is an article about the creditworthiness of bonds, not one about politics.  It is easy and tempting to confuse the two.

Our Take

So often these questions are posed in black and white.  Either one should buy municipal bonds -- or not.

The answer might be quite different.  Suppose that both Chanos and Pollack are correct.  Frankly, that is my vote!  We should expect a higher than normal rate of failures by municipalities.  There will probably also be tax increases.

The real investment question is not which of these experts is correct.  It is the following:

Do current municipal bond prices reflect the acknowledged current risks?

The article invites us to choose one side or the other.  The market presents a more nuanced challenge.  Municipal bonds are not right for everyone.  Tax considerations are an important issues.  Having said this, there are two possibilities:

1. An investor who has confidence in a given jurisdiction may find an attractive opportunity; and
2. An investor who thinks the overall market is too pessimistic may find an attractive muni fund, avoiding the locality-specific risk.

A Further Conclusion

Too many market questions are posed in the form of one side being right and the other wrong.  In fact, the market prices usually reflect the debate.  You are only looking for an edge.

October Employment Report Preview

The monthly employment situation report is the most watched economic release.  The attention has never been greater.

• Everyone is interested in the unemployment rate, especially when it is approaching 10%.  It is a natural topic for the media.
• Partisan politics has a jobs focus.  While the Obama Administration may be claiming jobs "created or saved," this is of little interest to most.  The bottom line for most voters will be whether the net job change turns positive and the unemployment rate declines.  Few care about hypothetical results.
• Investors and traders question the economic recovery, despite improving data.  As long as unemployment remains high, people will question the economic recovery as artificial and temporary.

The massive attention is no surprise.

Lack of Timely Data

Most casual observers take the reports at face value.  Those watching closely understand the challenges in trying to do contemporaneous estimates of employment changes.  This is not like an election, where we can have a "polling place" to determine who is working and who is not.

We actually have excellent employment data, a hard count from state employment agencies.  The problem is that it takes six to nine months to get the solid results.  I wrote about this three years ago in my article, Data We Have vs Data We Need.

Real-Time Measurements

I am going to repeat a careful explanation that I suggested two months ago.  There are many sources trying to measure monthly employment changes.  Eventually the state data will show who was right.

Each of the sources we cite is attempting to measure the actual net job change.  A wise stat prof once said, "Suppose God whispered into your ear and told you the TRUTH."

The BLS is attempting to do the same thing, with dramatically different methods.  The BLS result is not TRUTH.  It is a statistical estimate.  Actual TRUTH for a specific month will not be known for many months, when the state employment data are analyzed.  The BLS tries to count all of the jobs in one month, all of the jobs in the next month, and then report the difference.  They do this very well, but it is inherently difficult.  It does not focus directly on the actual changes, as other methods attempt to do.

Meanwhile, the forecasters will all be graded by how well they predicted the BLS number -- the BLS estimate of TRUTH.

That is the wrong attitude.  The BLS number is just another estimate -- and one which will not be official until all of the revisions are in.  Despite this, the market will trade on the preliminary estimate revealed Friday morning.

Briefly put, everyone is trying to estimate monthly changes in a work force of over 130 million.  The error band is small.  The BLS -- and all of the other sources -- are doing a great job with various differing approaches.

Market participants would like to have more data, faster data, more accurate data.

It is my long-held position that too much emphasis is placed upon the BLS estimate as "official."  The BLS does excellent and honest work, but other approaches deserve attention.

Few observers understand the nature and sources of error in the BLS estimate.  Pundits routinely draw major conclusions from discrepancies of 50,000 jobs, when the sampling error alone is +/- 100,000+ jobs.  And this does not include assorted non-sampling problems, like dealing with new job creation.

The BLS versus the Critics

The BLS approach is to make an estimate of the total payroll jobs in one month, make another estimate for the next month, and subtract the two to determine the change.  They use an excellent and sophisticated survey technique to do this.  Their historical record, judged by the eventual count from the states, has been very good -- until quite recently.

Some readers have asked me why the BLS even attempts to include job creation in their estimates, using their much-maligned Birth/Death adjustment.  I will attempt the simplest possible explanation.

Any time you do a survey, there will be non-respondents.  When the question is something like "How many people favor health care with a public option?" the non-respondent problem takes a simple form.  You need only ask whether the non-respondents are similar to those who actually answered.  Most polls make this assumption.

The employment question is qualitatively different.  We are not asking the opinions of non-respondents.  We are asking whether they are even still in business.  If the BLS were to assume that non-respondents had all ceased operations, they would seriously underestimate total employment.  Historical data conclusively show that the non-respondents are split between those who did not answer and those who are out of business.  The data also show that new job creation, running at about 2 million jobs per month even in recessions, are a predictable function of dying businesses.

Because of this, the BLS employs a two-step process.  The imputation step forecasts job creation from job destruction, and includes a cyclical component..  The Birth/Death adjustment, (the only thing cited by most critics, who ignore the more important imputation step), is a residual.  For many years this residual was stable.  The most recent test against the state data indicated a significant error, showing that the BLS estimates have been wrong for nearly a year, especially starting in Q1 09.

Were the Critics Correct?

The BLS critics do not look at the ultimate scorecard, the state data.  I expect that most of them will "claim victory" in their criticisms, even though they never looked at the many years when they were wrong and the BLS was right.  We should note the following:

• There was no intentional distortion of data or results, dictated by whomever was President, as many allege.
• The method worked well for more than five years, as measured by the final data.
• The breakdown did not come at a "turning point" as many suggested it would.  That would have happened at the end of 2007.
• The breakdown did not occur because the model worked in expansion and not in recession.  The big divergence happened in the first quarter of this  year.  The big job losses right after the Lehman downfall were not that far from the truth.  Job creation seemed to stall a few months after the major credit contraction in September, 2008.

The actual breakdown in the BLS method happened one full quarter after the biggest job losses in many years.  It means that job creation was seriously impaired from January to March of this year.  At the moment, this is all we really know from hard data.

There may be some critic who predicted the timing of this breakdown, but I have not seen one -- and I follow this carefully.  Whether or not the long-term BLS relationships resume the multi-year pattern is yet to be determined.

To repeat my main theme --- there are several methods of estimating the monthly job change.  No one has a monopoly on the truth.  I invite reader comment on this point.  Any critic who actually looked at the state data, acknowledged the BLS when it was accurate, and forecast when their model would break down deserves some recognition.

Our Approach

Each month we ask the question, "What change in payroll employment would be consistent with other economic data from the same time period (the middle of the prior month)?

This is not a forecast, per se, since we do not posit any causal relationship among these variables.  They are all concomitant indicators of economic activity. 

• We use the four-week moving average of initial unemployment claims, culminating in the week of the employment survey.  This is the best direct indicator of new lob losses.  This has improved in the last two months to a loss of 532K

• We look at the University of Michigan sentiment survey, which we found more useful than the Conference Board's sentiment index.  Michigan uses a panel, where some families are carried over from month to month.  This is a good technique.    Sentiment is influenced by employment.  When people have lost jobs, or are worried about losing jobs, it shows up in sentiment.  It is a good concurrent indicator.  The Michigan index is now at 70.6, about the same as last month.

• We us the ISM manufacturing index, which showed improvement from 52.6 to 55.7  This is solid expansion in the manufacturing sector, it is quite bullish for the overall economy.  The ISM's research shows that this rating, if annualized, corresponds to a 4.5% increase in GDP, better than the preliminary report for the 3rd quarter, and occurring after the cash for clunkers and homeowner stimulus boosts.

Our long-term record has been pretty good, especially when compared to the final revised data.  This makes sense because our model was derived from the final data.  In recent months we have been too bearish.  The BLS benchmark revisions suggest that we have been much better than first thought.

This Month's Prediction

Our indicators suggest a net job loss of about 140,000, a little better than the Street estimates of -175K.

Our estimate reflects two contradictory forces.  The initial claims are still elevated, not indicating economic expansion.  The ISM data are strongly positive.  Our forecast suggests that we are still a few months away from real job growth.  We need to see lower unemployment claims before there will be net job gains.

Other Forecasts

It is always interesting to compare the job forecasts from different sources.  We follow several because of the interesting and widely varying methods they use.  A wise interpretation would be to consider all of  these disparate sources of information.

ADP has proprietary data because of its payroll management business.  ADP sees losses of 203K.

TrimTabs also uses real time data.  Their estimates are based upon tax deposits for salaried employees.  They see a net job loss of 284K.

WANTED Technologies, a relatively new entrant in this field, has a model based upon online help-wanted advertising.  This is an innovative and different approach to real-time data.  They see a net job loss of 224k.

Conclusion

While we are (for a change) less bearish than other forecasters this month, we do not see it as the basis for a change in our trading outlook.  We expect the usual full assault on the integrity and methods of the BLS, with the spinmeisters out in full force.  The short-term risk/reward still leans to the short side.

Has the Market Already Made the High for the Year?

Market followers love to make timing predictions.  They come in all time frames and flavors:

• The market has made the high for the day, and will now trade down.  Or the opposite.
• This is the bottom.  Or the top.
• We have seen the highs (or lows) for the year.
• Or when the Dow was at 9500, would we see 10000 before 9000?

Bold Predictions

Doug Kass, on August 26th, called the high.  He was off by a few weeks and a few percentage points, but he has continued to argue for this viewpoint in columns at TheStreet.com and in appearances on CNBC.

His colleague Jim Cramer has now agreed, and recommends reducing portfolios.

James Altucher sees explosive potential, after reviewing a list of inaccurate bearish predictions, writes as follows:

The economy is recovering nicely, says Altucher, and 2010 is going to be a huge year.  Companies that stopped making things and fired thousands of employees last winter out of fear of a second Great Depression will restock their shelves and start hiring like mad. The federal stimulus, which has barely kicked in yet, will really get cranking. Consumers will find jobs much easier to get, and the resulting optimism (and income) will prompt them to start spending again.

And the market?

It's going to the moon, says Altucher.

Ken Fisher is looking for a 20-25% gain "by January" which is not quite the end of the year.  Fisher earns one of the highest ratings from CXO Advisory, one of our featured sites.

Less Bold Predictions

Barry Ritholtz on October 27th predicted a possible 5% to 15% correction, after leaning bullish for much of the year.

Our own official predictions, recorded weekly, were correctly bullish through September, but shifted to neutral two weeks ago.  We use a three-week time horizon for this forecast.

What Does it All Mean?

It all depends upon one's time frame.  Are you trying to trade the market intra-day?  Are you using a one-month time horizon?  Do you have the long run in mind?

Each investor is different -- different in risk tolerance, time to retirement, time to a need for college funds, mix of asset allocation.  It is not all about market timing.

In my conversations I find that most investors are missing the big picture.  Peter Lynch (with the Dow at 4000 or so) famously noted that he could not predict the next 1000 point move, but he was confident of the next 10,000 points.

I agree, and here is the main problem:

Most investors are still responding to fear.

The current fear dates from last year, causing most to miss the market rebound.  Now many feel that they have "missed the move" and what they read reinforces the fear.

Here are some thoughts that I am sharing with my own clients:

• My initial target for this year was the pre-Lehman level from last fall.  We have not yet reached this target, but we will.  We have averted the Great Depression that the market was forecasting at that time.
• There are many attractive stocks.  I am selling some holdings only because there are others that offer even better chances.  Try to focus on specific company chances instead of general market commentary.
• The analysis of economic prospects is polluted by political punditry.  Many commentators have a vested interest in a certain political outcome.  Others are trying to sell books or high commission products.  It is a minefield for the general and inexperienced reader.
• Economic data continues to improve, despite a well-orchestrated chorus of critics.
• The stimulus efforts have worked, and there is plenty more in the pipeline.  Most of the pop economists have the viewpoint that the stimulus will stop and the economy will fail.

Reactions on the Economy

Stimulus efforts may jump start a real move.  Check out today's auto sales data, after the cash for clunkers initiative, and you will see a real improvement -- small, but a start, not a bubble.

1. Most of the stimulus funds are still in the pipeline.
2. The Obama Administration is committed to keeping this going until it works, including things like the incentives for home buyers.
3. The major complaints -- deficit spending -- are in a different time frame.
4. Watch Warren Buffett, who made the deal of his lifetime buying a railroad today.

It is a time to separate one's political viewpoint from one's investment viewpoint.  Those who are fighting the Fed, fighting Obama, and fighting Congress are spitting into the wind.

ETF Position Update

Each week we publish the ratings from our TCA-ETF model.  Regular readers know that we use sector information to take a market perspective, but also choose individual ETF's.

I also choose a sector to highlight each week, providing fundamental information, a chart, our reasoning, and comments from other experts.

As we always note, this is not intended as investment advice.  A sector rotation program is not suitable for all investors.  Our time frame may be different from the reader's.  It is news information, intended to be an additional source of information -- only a part of your own due diligence.

We strongly recommend that readers who like the system should just call me and consider becoming a client.  We run the model twice a day (at least) and respond immediately to any changes.  I try to keep costs low and deliver a service that adds value.  We help investors determine suitability, needed account size, and expected trading costs.

Having said this, I know that some readers are trading the (delayed) signals on their own.  I try very hard to highlight sectors that I think will be strong candidates, at least for the upcoming week.  In yesterday's article I noted that many sectors were getting a penalty box flag, and that this might happen mid-week.

In general, I do not provide mid-week updates on ETF's.  This is mostly out of respect to our clients, who pay for a real-time service.  Having said this, I am uncomfortable with yesterday's highlight of VGT, which hit our penalty box today.  I still like VGT for a longer-term play, but we will sell tomorrow in trading accounts.  Given the swift change, I feel it appropriate to give a "mid-week" update.  We respect the current level of risk in the market, and hold only partial positions in our ETF trading.