A Dash of Insight

Weighing the Week Ahead: Bring on the (Economic) Evidence!

In the short-term world of trading, your job is to anticipate the short-term behavior of others.

In the world of investing, your job is to take advantage of the short-term behavior of others.

Markets render a short-term verdict, but only professors believe them to be efficient.  Warren Buffett famously notes (see here for more wisdom):

“I’d be a bum on the street with a tin cup if the markets were always efficient.” Fortune April 3, 1995

“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.”  Berkshire Hathaway 2004 Chairman’s Letter

This is great advice, but difficult for most to follow.  How can we tell when the market is inefficient and fearful.  We need evidence!  Should we bail out of the market?  Should we buy puts (even at high prices) to protect our risk?  Let us turn to another expert-- Perry Mason (actual historical ad -- and many others -- available here).

Let us take the advice of these two great iconic figures, seeking edge through evidence.

Since the recent European elections  there has been a dramatic change in risk appetite.  Ed Yardeni sees this as a switch for risk on/risk off.

"The big switch was flipped to the off position following the May 6 French and Greek elections, which could upend all the bailout deal and fiscal pacts worked out by European leaders over the past two years. Such an outcome could push Europe deeper into a recession and weaken global economic activity. In other words, Risk On tends to be associated with widespread confidence in the outlook for global economic growth, while Risk Off indicates widespread fears that the global economy will sputter."

Investors need evidence!  Is the pessimistic outlook warranted?  This week will provide more data.

As usual, I will offer some ideas in the conclusion, but first let us do our regular review of last week's news and data.

Background on "Weighing the Week Ahead"

There are many good sources for a list of upcoming events. In contrast, I single out what will be most important in the coming week.  My theme is an expert guess about what we will be watching on TV and reading in the mainstream media.  It is a focus on what I think is important for my trading and client portfolios.

This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting the news in context.

Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!

Last Week's Data

Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:

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

The US economic data last week was mixed, but had some high spots.

• Housing and Car Sales Lead.  The Bonddad Blog takes a page from UCLA Prof Ed Leamer to reach the following conclusion and chart:

Put simply, as an economic expansion ages, housing is the first sector to weaken, followed by cars. If they are strengthening rather than weakening, a recession is not near. And to be blunt, both sectors are indeed strengthening.

Let's look at this three ways. First here are the raw numbers of housing permits (left scale) and vehicle sales (right scale), measured quarterly to limit some of the noise. Both peaked well before any recession started, even in the case of the brief expansion in the middle of the 1980-81 "double dip":

• Signs of GOP compromise.  Fewer GOP candidates are signing the Grover Norquist "pledge."  I cite this not from a partisan perspective, but as one who seeks solutions and compromise.  Concessions by either party are good.  (More to come on the "fiscal cliff" issue.)
• Michigan Consumer Sentiment hit a four-year high.  While this was helped by lower gas prices, it also reflected perceptions of better job prospects.  Check out the chart from Doug Short -- still not at peaks, but also not confirming the recession scare.

• Zillow data suggests that home prices are moving higher (via Calculated Risk).
• New home sales strengthen.  Calculated Risk has been authoritative on this subject for years, so I am watching the analysis and forecast (a long and gradual recovery) with great interest.  Here is Bill's comment on the recent data:

"Clearly new home sales have bottomed. Although sales are still historically very weak, sales are up 25% from the low, and up about 15% from the May 2010 through September 2011 average."

The Bad

There was plenty of bad news on the economic data front.  Here are the most important items.

• Downticks in "flash" PMI reports.  These are getting a big play for those with a short time horizon.  The question is whether the captured data is really accurate.  The initial forecast for the US PMI was released by Markit Economics, predicting a dip.  There were also negative reports on various European countries.  This is an interesting new data source for the US, worth watching with interest.
• Durable goods sales were weaker.  Steven Hansen has a thoughtful analysis, looking more deeply into the headline data.
• Facebook should be worth only $23.  Or even $13.80.  Who could have known?
• The informal European Summit disappointed.  While the Eurobond concept was floated and stronger deposit insurance mentioned, there was no solid outcome.  The market wants immediate answers, and the European leaders have a different time frame.
• Spanish bank problems threaten escalation and contagion.  Spain has stepped in to assist  with bad housing loans at the fourth-largest bank.  While this is a pro-active move, investors immediately raised questions about the status of other banks.  How much more help will be needed?

The Ugly

The "fiscal cliff" grabs the ugly award for this week.  The authoritative Congressional Budget Office (CBO) reported on what would happen in the absence of any policy changes.  Assorted tax cuts and stimulus programs will expire.  This is headline-grabbing stuff, especially for those who have not been paying any attention.

Hardly anyone expects even a fraction of this to take place, but it makes for good headlines.  The marginal effect is clearly negative as the average investor acts in a way that he/she believes to be smart and well-informed.

It is wall-to-wall crisis coverage.  I plan to write more extensively on this topic.

The Indicator Snapshot

It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.
• An updated analysis of recession probability.

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon.  We are working on a modification that will make this method even more sensitive.  None of the methods are worrisome.  Bob also has a group of coincident indicators. Like most of the top recession forecasters, he uses these to confirm the long-term prediction. These indicators are also not close to a recession signal.

This week's big news on the recession forecasting front this week came from New Deal Democrat writing at The Bonddad Blog.  He notes that the ECRI has retreated from a robust method with many leading indicators, seasonally adjusted, to a single reed.  NDD snips that reed, showing why the year-over-year real income indicator is misleading.

Meanwhile, there are many others who have developed recession forecasting methods that have matched or beaten the ECRI, while providing transparency for consumers.  These are the methods that I have been highlighting for many months.

 

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions.  This week we continued as "bearish" although we do not (yet) have any short positions.  Felix respects the market action, and the last three weeks have been convincing.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list.  You can also write personally to me with questions or comments, and I'll do my best to answer.]

The Week Ahead

Sometimes the quirks of the calendar mean that we get a lot of important data in a short time frame. That is the story this week.

Friday is the big day since it includes the employment situation report along with the ISM manufacturing data (a good input for estimating the jobs report.)  We will also get personal income and construction spending.

Thursday is the big tee-up for Friday.  The Chicago PMI is the best guess about the ISM index.  The ADP report is the best guess for the non-farm payroll number.  We also get the (backward looking) adjusted Q112 GDP data and initial jobless claims (not part of the Friday reporting periods, but more recent and relevant).

Tuesday and Wednesday will provide housing price data from Case Shiller (a bit old) and Conference Board consumer confidence.

While there are no big decisions scheduled from Europe, we know that there can be headlines -- plus or minus.

With all of this in mind, the US employment story is the feature for the week.

Trading Time Frame

We have been partially invested in trading accounts, in a bearish position with 1/3 of our position profitably in bond ETFs.  It reflected our "bearish" posture, and I would not be surprised to see  a "buy" recommendation for an inverse ETF next week.  Felix does not try to call market tops and bottoms, but respects trends in the three-week range.

Investor Time Frame

For investment accounts I have been buying on dips in stocks that we like. I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look.  You can contrast this with the many  pundits who claim miracles of market timing.

The single most difficult thing for me to explain is that investors should often embrace opportunity just as traders are trying to do some fancy footwork.  Investors should not be trying to guess the next market move. Instead, take what the market is giving you.  You should not be a "buy and hold" investor, but instead engage in  active management.  Think about risk control rather than market timing.

If you are really worried, you can imitate our enhanced yield program. Buy good dividend stocks and sell short-term calls. I am targeting 8-9% returns on this approach, and achieving it no matter what the market is doing. You can, too.

Final Thoughts on the Economic Evidence

Factual evidence consists of actual economic data and - -more importantly -- reported corporate earnings.  So far, the factual data has been strong.

Speculation from many sources includes a European collapse and a US recession, leading to lower earnings.

Does the current market reflect the speculation or the facts?  Here are some interesting perspectives:

• Brian Gilmartin, a favorite of Real Money fans, has a new blog.  Fundamentalis features corporate-specific earnings news as well as a macro take.  Brian is off to a great start, and we will all enjoy reading his work.  On the current earnings front he notes,   "...(N)o matter how earnings act, the market p/e continues to compress over the last 12 years. In fact, despite 20% – 30% growth off the 2009 bottom, the S&P 500 hasn't traded much over 15(x) earnings since then. Even during the 2003 – 2007 rally, the S&P 500 multiple stayed roughly even with earnings growth at about 15(x) earnings."

•  Scott Grannis agrees, suggesting that the market is pricing in plenty of bad news.

"As a reminder, the chart above shows the trailing PE ratio of the S&P 500. At 13.4 today, it is approximately equal to what it was at the end of 2008, when the market fully expected a multi-year global recession/depression and years of deflation."

• Eddy Elfenbein writes that the market is looking cheap, and the dip is centered in economically sensitive names.

The pessimists are expecting a decline in economic growth, earnings, and profit margins.

This week should provide more solid evidence about whether the negative expectations have any justification.

No matter what evidence we get, do not expect a Perry Mason style "confession!" 

A Question for Shiller Disciples: Why the interest in profit margins?

I love great questions from readers.  These are often the source of new ideas for articles.  That is the case tonight, but there is a twist:  The commenters have conflicting perspectives.

I want to write something on this theme, but before doing so I solicit comments.  Here is the dilemma:

1. Shiller disciples use this approach to earnings:  "Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10 — FAQ."
2. At the same time, Shiller disciples frequently express concern about profit margins because they currently exceed historical averages.

My simple question is, "Why does a Shiller disciple care about profit margins?"

If your method only looks at the trailing earnings from the last ten years, and you think that stocks need to decline 30% or so before you would consider buying, then why the interest in profit margins?  This only affects current and forward earnings, which have little effect on your metrics.

This would seem to be a question of far greater interest for those who see expected earnings as relevant.  Before attempting to answer these questions on a familiar topic, I solicit reader input...

Thanks in advance!

Weighing the Week Ahead: Any Help from the European Summit?

The turmoil in Greece and the potential contagion have once again taken center stage.

While the economic and debt problems are well-known, the question for many is why should Greece be so important?  The answer lies in whether there is a threat to global financial stability, or whether the rest of the world will experience secondary effects from reduced European growth.

A year ago the systemic risk question seemed to be off the table as a result of more aggressive policies, especially the ECB's LTRO program.  What happened?

The Greek and French elections have underscored the limits of the austerity solution.  The severe, multi-year recession in Greece is worse than ever and government programs face future cuts.  This account from The New Athenian has a nice summary:

• 72% of Greeks believe the parties should make concessions to each other and form a government, while 23% believe Greece should have repeat elections
• 78% want Greece to stay in the euro, while 12% want a return to the drachma
• In answer to the question "which of the parties elected to parliament would you like to see participating in the government?" the top two are (radical) Syriza and (moderate) Democratic Left, so it seems absolutely correct for conservatives and socialists not to try and build a government that skirts around them
• Asked whether they find Syriza's proposal realistic, 35% say quite realistic or very, while 62% say a little or not at all, which suggests that while the great majority don't believe Syriza can implement what they say, it still wants them in to hopefully change things in the right direction, even if it doesn't go all the way. 

The Greeks expect and hope for further concessions, but want to remain in the euro.  Many (most?) believe that this will not be possible, but it really depends upon what concessions the rest of Europe will make.  There is also a wide range of possible outcomes, some of which are illustrated in this WSJ review.

I will have some thoughts about Europe in the conclusion, but first let us review last week's news and data.

Background on "Weighing the Week Ahead"

There are many good sources for a list of upcoming events. In contrast, I single out what will be most important in the coming week.  My theme is an expert guess about what we will be watching on TV and reading in the mainstream media.  It is a focus on what I think is important for my trading and client portfolios.

This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting the news in context.

Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!

Last Week's Data

Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:

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.

There are occasionally some noteworthy "neutral" events.  Initial jobless claims are hovering in a range that we would like to see move lower, but are still better than what we were seeing a month ago.  Consumer economic confidence (via Gallup) is unchanged.

The Good

Despite the market reaction, the US economic data last week was pretty good.

• Fed appointments approved.  Jay Powell and Jeremy Stein were approved by the Senate to positions as Fed Governors.  This is good for a variety of reasons, especially given the regulatory demands on the Fed.  The approval process has been excessively political for many years -- both parties -- so this is a welcome change.  More from Macroadvisers.
• High frequency (but less important) indicators remain mildly positive (via Bonddad).
• American Association of Individual Investors (AAII) sentiment is very bearish -- which is bullish for the recommended contrarian interpretation.  Here is the chart from Bespoke.

• The increase in industrial production (up 1.1%) was good and capacity utilization was even better.  There is no recessionary indication in this data series, as you can see in the chart from Calculated Risk.

• CPI was unchanged (mostly due to energy prices) and the core rate was up 0.2%, as expected. 
• Housing was better.  Housing starts were solid and NAHB builder confidence was also stronger.  See Calculated Risk for a full chart pack on housing and Karl Smith at Modeled Behavior for ideas about the data revisions are finally catching up with actual growth.  CR also notes The Return of Multiple Offers.  Mark Perry highlights a report from the Demand Institute suggesting single-digit increases in housing prices over the next five years -- not huge, but it would be a welcome change.

The Bad

There was also some bad news on the US economic front and the Facebook IPO did not earn a "like."

• Transportation data remains weak.  Cullen Roche calls rail data "mixed."  Steven Hansen calls sea container data an indication of a "struggling economy."
• The Fed minutes disappointed, largely because there was little additional support for more QE.  The key market participants may not agree with the Fed on methods or policy, but they are convinced that QE juices returns.  Steven Russolillo covers the story nicely at the WSJ.
• The Philly Fed was a big disappointment.  Readers know that I do not put a lot of emphasis on this indicator, but it moves markets when the deviation from expectations is great.  It is more important than the Empire State index, which was positive last week.   Doug Short sees a bright spot, using the Philly data to show pressure easing on profit margins.  I found this interesting, and you might, too.
• The Conference Board Leading Economic Indicators declined by 0.1% versus an expected gain of 0.1%.  While it is only one point, this is an element significant for some recession forecasters.  From Doug Short:

 

The Ugly

US Stocks.  The stock market paid little heed to US data.  Doug Short tells the whole story with one of his great charts.

The S&P 500 is threatening to move below the 200-day moving average, an event that would spark additional selling by some system followers.

The Indicator Snapshot

It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.
• An updated analysis of recession probability.

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon.  We are working on a modification that will make this method even more sensitive, although no variant is 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.

The big news on the recession forecasting front this week came from New Deal Democrat writing at The Bonddad Blog.  He notes that since their recession forecast last September the ECRI has made several changes both in their methods and in which indicator is highlighted.  He provides enough charts to satisfy inquiring minds, so take a look.  Basically, the ECRI is no longer discussing their long leading indicators or their weekly growth index (supposedly thrown off by seasonality).  They are now pointing to a single indicator using a year-over-year comparison.  Steven Hansen, who is pretty charitable in assuming that the ECRI has some secret sauce, points out the shortcomings of excessive focus on the sole remaining indicator.

Todd Sullivan also covers the entire topic with plenty of charts.  This should be a splash of cold water for those objective enough to look at some real evidence.  ECRI fans should watch both of the videos he includes and then look at the charts.

Meanwhile, there are many others who have developed recession forecasting methods that have matched or beaten the ECRI, while providing transparency for consumers.

 

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 "bearish" although we do not (yet) have any short positions.  Felix respects the market action, and the last two weeks have been convincing.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. For daily ETF commentary from Felix, you can sign up for Wall Street All-Stars, where I still have a few discounted memberships available. You can also write personally to me with questions or comments, and I'll do my best to answer.]

The Week Ahead

Before the US week even gets started we'll have the market reaction to the G8 meetings.  Since this is mostly talk, I am not expecting much -- even though the statement seems to be aimed in the right direction.

The European leaders have an "informal" summit on Wednesday, and this might be an occasion for them to try to get in front of developments.  This is worthy of interest.

We have new and pending home sales on Tuesday and Wednesday.  I have had little interest in these reports for many months, but (as I noted last week) there is evidence of a turning point.

Thursday's initial claims data will be the last information relevant to next month's employment report.  Durable goods orders  are of secondary interest, and I am not expecting much change in the final Michigan sentiment survey.

There may also be some options expiration "hangover" which usually leans against the prior week.

Trading Time Frame

We have been partially invested in trading accounts, with 1/3 of our position profitably in bond ETFs and another 1/3 in utilities.  It reflected our "neutral" posture, and I would not be surprised to see  a "buy" recommendation for an inverse ETF next week.  Felix does not try to call market tops and bottoms, but respects trends in the three-week range.

For now, we have a neutral posture and lean bearish.

Investor Time Frame

For investment accounts I have been buying on dips in stocks that we like. I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look.  You can contrast this with the many  pundits who claim miracles of market timing.

The single most difficult thing for me to explain is that investors should often embrace opportunity just as traders are trying to do some fancy footwork.  Investors should not be trying to guess the next market move. Instead, take what the market is giving you.  You do not need to be a "buy and hold" investor, but active management should relate to risk control rather than market timing.

If you are really worried, you can imitate our enhanced yield program. Buy good dividend stocks and sell short-term calls. I am targeting 8-9% returns on this approach, and achieving it no matter what the market is doing. You can, too.

Final Thoughts on Europe

The market does not like the political dynamic in the European decision making.  The consensus opinion is that European leaders have been too slow, too inept, and too self-interested to solve the economic and deficit questions.  Some also believe that there is no solution to an inherently failed structure.  For most observers the only questions are how fast the Eurozone will dissolve and the extent of the Lehman-like contagion.

My contrarian take has been that government leaders naturally do as little as required, especially when painful sacrifices and compromises are involved.  Policy makers experiment, note the effects, and choose to do more of what works and less of what doesn't.  The recent trend is to note that austerity has not succeeded in reducing deficits.  (Just as well that was not the only policy a year ago).  Negotiations will probably now provide more assistance, more stimulus, and more time.  The strong parties (especially Germany and China) have a powerful self-interest in the outcome.

The most important thing investors can do is to realize that there are actually many possible outcomes and time frames.  I provided a sampling here.  For a complete recap of my approach on Europe, check out this summary of ten articles.

The St. Louis Financial Stress Index provides a good, objective indicator showing that the headline risk from Europe is not reflected in financial spreads -- except, of course, for stock prices.  Scott Grannis does a chart-filled review of financial spreads reaching a similar conclusion.

Three Things that Could Change the Story

There are three specific steps that could change the Europe discussion very quickly.

1. A strong deposit insurance program -- basically ending the bank run theory.
2. The creation of a Eurobond -- lowering interest rates for the weaker nations and addressing liquidity.
3. Increased lending or banking powers for the ESM -- basically eliminating the questions about the size of a response.

Whether or not one likes these ideas, they would all dramatically change the terms of the current debate.  The US 2008 experience involved many innovative and widely-criticized programs.  They were introduced gradually, one at a time.

Each of these ideas has been mentioned before and could get a serious play as soon as this week, either at the Wednesday summit or through the media.

 

Possible Endings for the Greek Drama

I did not set out to write a trilogy about Europe, but the market is telling us that nothing else matters right now.

My long-standing position is that Europe is engaged in a normal democratic political process with a very large number of contending parties.  In such matters it is difficult to predict the exact outcome beyond saying that no one will be completely happy.

My approach is pretty modest in terms of forecasts.  I do not know what the exact outcome will be.  My current guess includes the following:

1. The eventual outcome will include a bit less austerity because of recent election results;
2. European leaders will manage to avoid the very worst outcomes; and
3. The nature of the political process leads to eleventh-hour solutions, permitting everyone to fear the worst as long as possible.

Nearly everyone else, regardless of credentials, claims a better crystal ball than mine.  There is actually a wide range of possible outcomes worthy of review.

Possible Endgame for Europe

Let me rank these from worst to best.

• Doomsday!  This is the story getting the buzz.  There will be a bank run in Greece based upon fear of leaving the EuroZone.  This will rapidly spread to other countries.  Advocates of this concept point to the sequential attack on banks in 2008 to prove their point.

Nearly every media source has now highlighted this graphic possibility, so it is already familiar to everyone.  CNBC now promises to show lines at Greek ATM machines, in the same way they helpfully showed us oil spilling into the Gulf during the time of the BP oil spill.

• The slow-moving train wreck.  This is the analysis from Nouriel Roubini. 

"...there are only four ways to achieve such real depreciation:

1. First, a sharp weakening of the euro. But this is unlikely as Germany is strong, the U.S. economy is weak and running twin deficits and the ECB is not aggressively easing monetary policy;
2. Second, a rapid reduction in unit labor costs through structural reforms that increase productivity growth in excess of wages. But this is just as unlikely: It took 10 years for Germany to restore its competitiveness this way; and Greece cannot stay in a depression for a decade, until reforms start to have a real impact;
3. Third, a rapid deflation in prices and wages, known as an “internal devaluation.” But this would lead to five years of ever-deepening depression, while making public debts more unsustainable as the fall in prices would increase the real value of such debts (the balance-sheet effect of debt deflation);
4. Fourth, if the first three options are impossible, the only path left for Greece is an EZ exit: A return to a national currency and a sharp depreciation would quickly restore competitiveness, improve the trade balance and rejuvenate economic growth.

The full analysis from Dr. Roubini is available at his website ( subscription required, and where I am a long-time contributor).

The Roubini analysis is very pessimistic for the EuroZone.  My only objection is that it is a pure economic approach with little allowance for changes by the leadership.  Meanwhile, I find it interesting that Dr. Roubini sees the process as playing out over time.  My guess is that most would be astounded to discover that he is personally 70% invested in stocks with a 50-50 split between global and the US.  You can see a full CNBC interview here.

• The PBS Newshour balanced viewpoint.  I understand that some may disagree about balance, but PBS does try to get a strong representative for differing viewpoints.   They had a great segment featuring an Athens source I have featured, a prof from the Kennedy School at Harvard, and Fred Bergsten from the Peterson Institute.  Here is Bergsten's comment:

"My bet is that they would get back with the program. And despite the abhorrence of the program by the Greek electorate, understandably, their desire to avoid being kicked out of the euro would be even greater. So, it's going to be messy, but I think the outcome, whether driven by bank runs or by a new election, is going to be to force them back into the fold, at least to an important degree, enough that the Europeans can keep lending them money.

 

Everybody saves face. A growth element will be added to the package. There will be a little modification in the austerity requirements. But it will be basically back to the program as has existed for the last couple years."

Here is the entire video from PBS.  I urge readers to watch it -- a nice change of pace from their regular diet of financial news.

 

• The Marshall Plan for Europe.  London-based journalist Matthew Lynn offers  an intriguing alternative.  Germany, recognizing self-interest, decides that the EuroZone breakup is not such a good idea.

Investment Conclusion

Getting great investment returns means going against the flow.  If you just followed the market, you would be average.  If you try to guess the market, you are usually blundering at the major turning points.

Most investors are looking only at the worst case of the possibilities listed above.  Meanwhile, those who focus on fundamentals will be right on Europe, right on the economy, right on earnings, and (eventually) right on stock prices.

Prior pieces in the trilogy include the following:

Why not to Panic about Europe

The Investor Edge from Europe

 

The Investor Edge from Europe

Here is a surprise for you.  European leaders did better than your favorite pundit!

They will also do better in the future.

For the last two weeks the dollar has moved higher versus the Euro and stocks have moved lower -- almost an unbroken string.

The European story fit nicely with trader pre-conceptions about selling in May, following the pattern of the last two (count 'em!) years, and the lack of more QE.

Setting this up  was a revival of the disaster scenario -- a 2008-style Lehman like event where banks would topple and the financial system would crumble.  Everyone's favorite conspiracy website teed this up by multiple posts predicting a continent-wide bank run.  The leading CNBC commentators are bombarded with email and tweets from traders.  In the modern age, the tweeters influence the content.

The bank run story has gotten widespread play, with journalists all solemnly agreeing that a Greek exit from the Euro would be a disaster.

The traders and pundits see European leaders as clueless bozos who did not do what they thought was correct, and did not do it in the time frame they thought was right.

Let us put aside that many pundits sought austerity while many others advocated growth.  They all agreed that leaders were wrong for ignoring their recommendations.

An Objective View

This is going to be difficult for most people, but try to be objective about the various parties in Europe.  Here is the question:

Has delay and bargaining improved things?  Let us start by considering it party by party.

• Greece.  Clearly improved.  Negotiated a better deal on debt on round one, and in the bargaining for round 2.  The citizens want to stay in the Eurozone and they want less austerity.  They may well get both.
• France.  Much the same story.  Some agreement to reforms followed by pushing back from voters.
• Germany.  Position improved from last year.  There were concessions on political sovereignty and commitment to more austerity.  Last year it was a cliff-diving scenario.
• ECB.  Better now.  The ECB exacted concessions for austerity and structural reforms before agreeing to more liberal lending.  This was much better than caving in a year ago.
• IMF.  Better now.  By bringing together various European parties, the story was improved and the incentive for the rest of the world to participate was enhanced.  The IMF has not yet reached the target in raising funds, but it is doing much better than it would have a year ago.  Wasn't that when DSK had his problems?
• Other Potential Investors.  Also better now than a year ago.  I am still expecting China and Middle Eastern sovereign wealth funds to join in.  Why?  Because it is in their self-interest to do so. Europe is China's biggest trading partner.  No nation benefits from a European collapse.  The terms for involvement are better than a year ago, and the concessions from the various parties are better.

Turning from the particular participants to the collective, are things better or worse?

In the best case, things are much better than a year ago.  Banks have more capital.  They have lending from the ECB, with the chance to profit on the spread.

In the worst case, things are also much better.  The original Greek debt with the threat of CDS payoffs was a major systemic threat a year ago.  Those debts were negotiated, and things are a bit different.  There are various current paths for Greece.  Whether it is an exit from the EZ or another discount on debt, the stakes are lower than a year ago.

Investment Lesson

This is a continuing story of compromise and negotiation.  Each party is benefiting from the delay.  So far, it has also helped the collective.

Those complaining about "kicking the can" have been wrong.  Those criticizing European officials have been wrong.  Those predicting disaster have been wrong.  Do you see a pattern?

The mainstream media has a fixation for trader/pundits who have all of the answers, even if they did not take Poli Sci 101.  They translate everything into how they would do it in their own business --- immediate and decisive action.

No matter that the recommended actions are in complete opposition, depending upon the political predispositions of the pundit.

Investment Conclusion

Markets can and do pursue irrational themes.  You can almost guarantee that it will happen each year.  When this occurs, the long-term, Warren Buffett style investor should be prepared to step up.

Mr. Buffett uses his own values and treats the market as giving him mis-priced opportunities.  This is a concept that some investors understand in theory, but few can implement.

I have been following all of the Europe news closely.  I will try to provide a range of useful perspectives in the next installment.  At the moment, everything is on sale.  I especially like cyclical stocks like Caterpillar that do not even emphasize Europe, technology stocks like Oracle, which has been very resistant to slowdowns, and growth stocks like Apple, which seems to be trading in line with the dollar.

Weighing the Week Ahead: Any Help from Housing?

Economic growth continues at weak, below trend levels just at the time the stimulus programs are wearing off.  For some this implies that the next recession is just around the corner.

From another perspective the current economic growth has occurred in spite of a major drag from reductions in government programs (see Gene Epstein in this week's Barron's) and contraction in housing.  If these two factors just got back to neutral, it would reduce the drag by two percent or so, revealing the true underlying strength of the private economy

Is there any hope from the housing sector?  Even some stability?

I will have some ideas in the conclusion, but first let us review last week's data.

 Background on "Weighing the Week Ahead"

There are many good sources for a list of upcoming events. In contrast, I single out what will be most important in the coming week.  My theme is an expert guess about what we will be watching on TV and reading in the mainstream media.  It is a focus on what I think is important for my trading and client portfolios.

This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting the news in context.

Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!

Last Week's Data

Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:

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

The general economic data was a little better this week, while earnings were softer.

• The US posts a monthly budget surplus!  Let us not get carried away, however.  Tax revenues are better, but April is usually a good month.  Here is a chart from Scott Grannis.  We seem to have more balance.

 

• Job openings are better.  I tend to view this as information about structural unemployment, but The Bonddad Blog sees it as a predictor of better employment data ahead.  It is an interesting analysis.  If you can figure out this chart you do not read to need the article.  For the 0ther 99.9% of you, check out the whole story!

• Economists from a variety of sources see continuing economic growth.  These are really intelligent people who have professional careers in trying to get this right.  They are not employees of firms trying to sell stocks.  Despite this, many readers will decide that these sources are misguided.  They will instead listen to bloggers who have zilch as a track record (except maybe being "early" in forecasting the 2008 recession).  Go figure.
  
  • The Federal Reserve Bank of Philadelphia.  (These are independent bank studies -- not something directed by Bernanke).
  • The NY Fed sees growth of 2.5 to 3%.
  • The OECD sees better growth for Europe.

 

"Compared to last month's assessment, the CLIs for Japan and the United States show stronger signs of improvements in economic activity, pointing towards an expansion. In the Euro area, the CLIs for France and Italy continue to point to sluggish economic activity below long term trend. The CLIs for Germany and most other Euro area economies show slightly more positive signals.

The CLI for the United Kingdom and major emerging economies, in particular China, where the assessment points to above trend growth, are showing stronger positive signals compared to last month's assessment."

• Consumer sentiment reached pre-recession levels according to the University of Michigan.  This probably reflected lower gas prices, although initial jobless claims have also been better.
• Producer price increases were lower than expected -- thanks to energy prices.

• Initial jobless claims continued in the 360K range, suggesting that the April spike was seasonal.  We should continue to watch this series.

The Bad

The general economic news was not that bad, but some important specific stories dragged the market lower.

• The earnings beat rate really tanked since the start of the season (via Bespoke).  The overall rate declined to 60% -- not terrible, but lower than the average of 62%.  Read their entire article to see the post-earnings performance of specific companies.
• JP Morgan announced a surprise trading loss.   The stock plunged, but that was only the start of the story.  Owners (like me) had to re-consider our positions.   Analysts like my colleague Scott Rothbort considered whether this story had broader implications.  I especially like this comprehensive analysis from Lisa Pollack at FT Alphaville.  After considering the evidence, you might enjoy voting in the poll at Wall Street All-Stars.
• The trade deficit was higher.  This seems like bad news, but Steven Hansen explains that it shows higher economic activity.  (I'm scoring it as "bad" because that is the market interpretation, but I urge the deeper reading).
• European governments are in flux.  Since the elections called into question the various austerity plans, the market reaction was negative.  For those of us who see the European situation as an ongoing multi-party process of negotiation and compromise, this seems like business as usual -- not a reason for panic.

The Ugly

The US Constitution.  I am tired of listening to those blaming Congress and the politicians.  The individual actors are doing what you might expect to gain re-election.  Democratic government is supposed to hold them accountable, so what do we expect?

The real problem is our system of government.  Winston Churchill famously said that democracy was the worst form of government except for all others.  The particular US flavor may have finally lost touch with the times.  We have what seem like perpetual elections and gridlock.  Our legislative process emphasizes the ability to block any change -- especially when the Senate now requires a super-majority to do anything.

Those  blaming specific leaders -- or politicians generally -- have it wrong.  Those in the US live in a world where changes is difficult to accomplish.

This might be fine for most social questions, but it is not good for financial markets.

Here is an example of the GOP passing a bill to violate the debt ceiling agreement to accept defense spending and cut food stamps.  This is not serious legislation, but a political statement.  The Democrats are doing the same thing.

And meanwhile we have a study of a study about studies.   I despair at trying to explain how this makes sense.

The Indicator Snapshot

It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.
• An updated analysis of recession probability.

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon. 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 not close to a recession signal. Bob has graciously offered a recent report as a free sample for our readers.

The big news on the recession forecasting front this week came from the ECRI, which is clinging by a thread to their recession forecast from last September.  They are now acting like the forecast was for June, 2012 and that we cannot possibly know the real verdict for six months after that.  In the meantime they have changed their methods, blaming seasonal adjustments.

It is about time to face the facts, since the indicators they follow  have probably improved.  Everyone in the financial world makes mistakes.  The real pros accept responsibility, figure out what went wrong, and move on.  Take a look at their recent CNBC appearance (via Business Insider), the Bloomberg appearance (via Doug Short - with great charts) and the analysis at The Bonddad Blog and decide for yourself.

We follow the excellent work of Georg Vrba, who has a top-rated coincident recession indicator as well as a successful stock/bond asset allocation model.  Here is his most recent comment:   

"My own composite short leading economic indicator, which has the highest score of all indicators so far tested, does not support the notion of a recession anytime soon."

I listen to Georg, and you should, too.

 

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. Four weeks ago we shifted from bearish back to neutral. The last several weeks have been pretty close calls. The ratings have dropped off a bit.

[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. For daily ETF commentary from Felix, you can sign up for Wall Street All-Stars, where I still have a few discounted memberships available. You can also write personally to me with questions or comments, and I'll do my best to answer.]

The Week Ahead

Before the US week even gets started we'll have updates on the progress (or lack thereof) in forming a coalition government in Greece. 

We will have a number of economic reports that are probably of secondary significance -- retail sales on Tuesday along with the CPI.  On Wednesday we see industrial production and capacity utilization.  On Thursday we have the more important initial claims data.  Any of these reports could have a significant effect, so I will be watching closely.

Throughout the week we get regional Fed surveys, which add little information to my own assessment unless there is a dramatic move.

The Facebook IPO will continue to be a big story.  People like to follow what they can understand, and they think they know Facebook.  There is an important difference between understanding a product, and evaluating a business model and stock valuation.

Trading Time Frame

We have been fully invested in trading accounts, with 1/3 of our position profitably in bond ETFs.  It was still a losing week.  Felix finds the current dip to be an attractive buying opportunity, so we are back in the market. The Felix forecast is for a three-week horizon, so it is best not to judge too quickly.  We have long experience with this program, which does not try to call market tops and bottoms.

If Felix is wrong, it will soon send sectors back to the penalty box.  For now, we are looking for rebounds in several ETFs.

Investor Time Frame

For investment accounts I have been buying on dips in stocks that we like. I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look.

Investors should not be trying to guess the next market move. Instead, take what the market is giving you. I have been offering this advice for months, and it led to a great quarter for anyone taking heed.  We seem to have another buying opportunity -- especially in tech and cyclical stocks.

If you are really worried, you can imitate our enhanced yield program. Buy good dividend stocks and sell short-term calls. I am targeting 8-9% returns on this approach, and achieving it no matter what the market is doing. You can, too. This has been meeting objectives in spite of the market twists and turns.

Final Thoughts on Housing

The housing story has been a multi-year drag on the economy.  Even switching to neutral would add a point or two to GDP.  This week's economic data feature housing.  This might start to get interesting given the recent surge in building permits.  Calculated Risk has suggested that we might be seeing some bottoming in housing.  Our own ETF model supports this idea, so we are watching carefully.  Here is a provocative chart from CR:

Hardly anyone expects any strength from this source, so it is (yet another) contrarian play.

And a Warning

I continue to worry about holdings in bond funds.  Check out the excellent analysis from Tom Brakke, which shows in a single chart both the temptation and the threat to those buying bond funds.

 

I urge you to read the article carefully.  If bonds are right for your portfolio, you should consider buying individual bonds instead of bond funds.

When Something Goes Wrong: The Case of JP Morgan Chase

Managing your investments would be easy if you just bought stocks and watched them move higher.

In your dreams!

In the real world, even the best managers must deal with adversity.  Our choices, no matter how carefully chosen, do not perform as expected.  Something goes wrong.

Dealing with adversity is crucial to investment success.  Tonight we have an informative case study in JP Morgan Chase (JPM), a company that I have cited favorably several times and include in my flagship investment program.  My most recent favorable mention was just this week in my discussion of Europe.

While it is more fun to write about triumphs, it is just as important to think about losses.  Despite my overall record, I certainly make choices that do not work out.  I do not endorse "buy-and-hold." I actively manage every program and every position, constantly reviewing the changing prospects for each investment.

Let us take a closer look at how to handle adversity.

What NOT to Do

There are two basic investment mistakes -- mirror images of failure to analyze.

1. Blindly holding the position hoping that it gets back to your original "buy" point.  This is typical for the average investor.  It is about psychology rather than analysis.  It is buyer's remorse, a desire to undo the losing decision.  "If only I had another chance.....,"  the investor thinks.  This is really stupid.  If the investment is a mistake, this mentality can turn a moderate loss into a  big one.  Some of the biggest companies have gone to zero -- or nearly so.  Check out Worldcom, Enron, GM, Lucent, and many others.  Meanwhile, if the stock actually does recover, it is probably wrong to sell it at the original entry point.
2. Selling instantly and without analysis.  This is a trader mentality, which is fine if you are a trader.  We have all heard about cutting losses and letting winners run.  We also know about "buy low and sell high."  It is more difficult than a slogan.  I listened to some traders discussing this stock and they opinions were mixed.

Analysis, not Paralysis

I can summarize what investors should do in one simple statement:

Review your investment process with the new information and decide accordingly.

You cannot go back and sell at yesterday's or last week's prices.  Each day is a new one.  Suppose that you had no position in this stock.  Would you buy it at the current price?  Is the investment thesis intact?

There are many excellent methods for finding great stocks, so the general advice is to review your own conclusions.  In an effort to be more helpful, I am going to review my own process.

Here is a very brief summary of my own method (further details available on request).

Sector Choice

I try to find a sector that is depressed and unloved.  This is where you shop for value.  You must be prepared for a constant bombardment of pundits on why you are wrong.

Stock Choice

I look for a stock that qualifies on four criteria:

1. It must have a great  business, with strong profit potential.
2. There must be strong management.
3. There must be a near-term catalyst, since no one wants to have "dead money."
4. Corporate financials  -- earnings, cash flow, balance sheet, and risk -- must all be strong.

Regular Review

I constantly review every stock in the portfolio, asking if it still meets the tests.  Analysts who set a stock price target and then wait until it is hit are doing a poor job.  I adjust price targets constantly.  This is why I was able to buy Apple (AAPL) at 63 and hold it through the gains (trimming size to balance the portfolio).  There is no substitute for regular review.

Addressing the Bad News

With this in mind, let us go back to  JP Morgan.  If you are a current investor you should focus on whether the stock is attractive at the current price.  I do not yet have a personal conclusion, since I prefer to analyze more data, but I will share my thought process.

1. Is this still the premier financial business?  Do I still want some exposure to the sector?
2. Have I lost confidence in Jamie Dimon?  On his show tonight Cramer (long the stock in his charitable trust) announced that Dimon was "just like all of the others."  This might be a little harsh, but I have relied on his interviews where he assessed overall risk.  Were these misleading?  Mostly they discussed counter-party risk, but I need to look deeper.
3. Has the potential catalyst changed?
4. What about the new financials?  The question is whether this is a one-time hit or something that affects future operating earnings.  In my experience there have been many "one-hit wonders" where stocks decline on bad news that is a one-time charge (Tylenol poisoning, Intel floating point processor).  The market sells first and thinks later.  The overall earnings picture before the news was very good, as we can see from this chart from Chuck Carnevale's invaluable site.

Preliminary Conclusion

I wanted to write a timely story, and that meant doing it tonight.  We'll know much more tomorrow.  Depending on what I see, I might sell or I might add to the position.  I have clearly stated the criteria.

Emaphsizing the main point:  Do not fall in love with a position.

Each day is a new start.  Be cool and analytical.  If you have a proven method, use it!

Why Not to Panic about Europe

I feel no panic about Europe.

This is a typical test.  Every long-term investor considers the question of risk tolerance and understands that markets will fluctuate for mysterious reasons.  So far, so good.

Then, when the event actually happens, it is accompanied by a cacophony of fear mongers -- all claiming that this is "the big one."

How can the average person tell the difference?

Knowing What to Ask

The first step in critical thinking about a problem is asking the right questions.  How about these?

1. Is there systemic risk?  By this I am asking whether we have another "Lehman event" where there is a lot of unknown counter-party risk and the credit system freezing up.
2. How big is the problem?  Let us suppose that Greece defaults on debt.  Or leaves the Eurozone.  What is the worst case?
3. How do political events affect the prognosis?  We have election results where leaders and parties less willing to accept austerity have done well.  What does this mean?
4. If some countries back off from "extreme austerity," what will be the response?  Will other institutions step up?  Can there be a new bargain?
5. If everything goes wrong -- absolutely no mitigation from the ECB, the IMF, or other participants --what will be the effect on the European economy?
6. If the European economy falls into a deeper recession, what are the implications for the US economy?
7. If the US economy is weaker, what does it mean for corporate earnings?

The Superficial Answers

Most of the commentary we see has three steps:

1. Some problem in Europe
2. Cockroach/contagion/domino
3. Disaster for the world

This type of  commentary ignores any policy reaction, and also often insults the leadership of European nations, the IMF, and the ECB.

This approach is popular and gets a lot of page views since there is an active response network making these the most popular  media sites -- whether blogs, online MSM, or TV.  It is an easy story, playing to preconceptions and simple analogies.

The Danger for Investors -- and What to Watch

As is always the case, fanning the flames on these stories is what drives ratings and page views.  When the market dips, it seems to provide a confirmation of accuracy, even though the evidence is skimpy.

It is challenging to refute.  You must write an article about what is not happening!

It is doubly challenging since some of the best sources are the big-time private research firms.  Their business models are based upon fees, not page views.  This means that most investors -- including readers of "A Dash" -- do not have direct access to this information.

I suggest that investors read very critically when a story suggests causal relationships that lack specificity or quantification.  Be even more suspicious when the story ignores policy responses.  And finally, how about some quantification concerning Europe's impact on the US economy?

My own conclusion -- familiar to regular readers -- is that the European story is an ongoing process of bargaining and compromise.  US observers are far too ready to impose their own value judgments on other countries and cultures.  The exact trade off of austerity, bank recapitalization, central bank intervention, and rescue funds is a work in progress.  The exact nature will change and I still expect new entrants.

The long-term impact on the US is exaggerated by these fears.  The short-term impact reflects currency trading and (perhaps) the need for some European institutions to repatriate funds.

A Final Thought

For the average investor, a subscription to the prestigious BCA Research reports is not practical.  If you have an advisor with access, you would at least have indirect knowledge of their most recent macro commentary, including the following as part of "Apocalypse (Not) Now":

• Euroskepticism in Europe: Overstated and understudied, mainly since the media does not do its homework.
• Firewalls sufficient to protect Spain.
• The expected fiscal drag from pending policy decisions is limited, manageable, and subject to improvement if risks increase.

These conclusions mirror my own.  I will try to elaborate further on each theme, but I want to emphasize the most important point:

Policymakers have been responsive and flexible.  Skeptics have consistently underestimated the willingness and resourcefulness of the relevant institutions.

The dumbest commentary is from those who use the phrase "out of bullets."  This is exactly what people said about the Fed before the alphabet avalanche.  Whether you liked those programs or not, they were unexpected and powerful.

The current result is that economically sensitive stocks are on sale, including those (like CAT) which have little European exposure.  US financials that will benefit from European asset sales (JPM) are also moving lower for no good reason.  The over-simplified "Risk-off" mentality confers an advantage on those who do stock picking.

 

Weighing the Week Ahead: Here Come the Candidates!

In a light week for economic data, we can expect more attention to elections both in Europe and the US.

Political activity provides both an opportunity and a trap for most investors.  It is so easy to use our own electoral preferences in forming conclusions about economic and investment prospects.

Just as Democrats did when President Bush was in office, Republicans now want to make the economy seem as bad as possible -- and hopeless unless Obama is defeated.  This means super-spinning of every story.  This week's employment report is a good example.  Read Derek Thompson's fine article, The Official Guide to Spinning the April Jobs Report, to get your inoculation against the upcoming silly season.

Now that the Republican candidate is known this will get much worse.  The Hill notes that for Obama, the gloves are coming off.

In the conclusion, I'll offer some thoughts on how investors  can take advantage of the political noise.  First, let us do our regular review of last week's news and data.

Background on "Weighing the Week Ahead"

There are many good sources for a list of upcoming events. In contrast, I single out what will be most important in the coming week.  My theme is an expert guess about what we will be watching on TV and reading in the mainstream media.  It is a focus on what I think is important for my trading and client portfolios.

This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting the news in context.

Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!

Last Week's Data

Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:

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

The general economic data continues to be soft, while earnings have been very good.

• The debt ceiling issue will not be revisited until after the election (via The Hill).  This is one of those worries that people keep bringing up, but is then ignored when it proves not to be true.  There is still a lot of heavy lifting scheduled for after the election, of course, but that is a very different problem.
• Corporate earnings have been stronger than expected and so have revenues. Some observers continually write that earnings estimates are too optimistic. When the beat rate is excellent, they then say that the bar was set too low.  Which is it?  Here is a good chart from Dr. Ed:

• ISM Manufacturing rebounded to 54.8.  The "internals" in this report were all good.
• Gasoline pump prices may move lower, a boost for the consumer.  The Bespoke Investment Group observes, "No matter how you look at it, current prices for gasoline are high, but if the recent trend of lower prices continues, it could provide a strong boost to the consumer."  Here is one chart, but check out the article for further analysis.

• Initial jobless claims (not part of the employment survey period) moved back to the prior range.  Here is the nice chart from Doug Short (but see the full article for much more):

The Bad

The most important economic news of the week was the jobs story -- a big disappointment. There was some other bad news as well.  I warned in my regular employment preview last week that we could have a disappointing number with big revisions.  The BLS method for estimating new job creation has been missing on the low side, according to the most recent actual data.

• The earnings beat rate is declining since the start of the season (via Bespoke).

• The ISM services index dropped sharply and missed expectations.  Steven Hansen notes the decline, but focuses on the overall trend.  See his complete report.
• Employment growth for April was poor.  The payroll jobs gain was not enough to reduce unemployment.  The reduction in the unemployment rate came from a reduced labor force, not more jobs.  We did not see improvement on hours worked or the hourly wage.  The household survey showed a decline in jobs.  Steven Hansen at GEI includes some ideas and charts you probably did not see elsewhere, concluding that it is not pretty, but there is continuing  modest economic expansion.

Steven is consistent in his analysis, unlike others who, for example, only talk about the household survey when it declines.  It has actually been showing much greater increases than the payroll approach.  Eventually the two come into line.

This was the big report of the week.  It turned out to be an anti-Goldilocks number:  Not strong enough to reassure about growth, nor weak enough to suggest more QE from the Fed.

The Ugly

This week's "ugly" award has to go to the stock market, where the reaction was disproportionate to the employment data.  There were clearly many itchy fingers looking for confirmation of the "sell in May" meme.  Charles Kirk provides the evidence:

 

Part of the decline was a reaction to stories about Apple suppliers.  Jay Somaney, in his trading diary at Wall Street All Stars) pointed to the real story -- a change in the needed parts -- bad for suppliers but not for Apple.

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 Silver Oz, writing at The Bonddad Blog, for his article, Once Again Zero Hedge is Completely Clueless.  One of the Tyler Durdens at ZH managed to mis-represent both the seasonal adjustment process and the birth/death adjustment in making the jobs report seem even worse.  Silver Oz points out the errors and concludes as follows:  

"Chalk this up as yet another reason to NEVER, EVER listen to Zero Hedge when it comes to interpretations of statistical reports."

Trying to correct these errors is a really thankless task.  Many of the ZH arguments have just enough data and apparent plausibility that effective refutation is very time consuming and provides little payoff.  This is why so much bogus analysis lead the Internet hit parade.

The Indicator Snapshot

It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.
• An updated analysis of recession probability.

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon. 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 not close to a recession signal. Bob has graciously offered the most recent report as a free sample for our readers.

The big news on the recession forecasting front this week came from The Bonddad Blog's continuing coverage of John Hussman's recession prediction.  (Since the Hussman recession forecasting started relatively recently and relied on tweaking and backfitting, I have not included it in the group that we analyze at "A Dash.")  This sort of "modeling" should not be expected to provide solid forecasts and it is not doing so in real time.  Check out John Hussman's recession index just blew up for the full story.

"The icing on the cake is that the "all clear" signal that Hussman said he would recognize -- the ECRI WLI growth index turning positive -- has also come into existence for the last 3 weeks. I really don't see any wiggle room left. Under the terms he himself set, Hussman's recession index says we are in expansion."

 

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. Three weeks ago we shifted from bearish back to neutral. The last several weeks have been pretty close calls. The ratings have improved a bit.

[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. For daily ETF commentary from Felix, you can sign up for Wall Street All-Stars, where I still have a few discounted memberships available. 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 light week for economic data.  We will start the week with news from the French elections, where Sarkozy is expected to lose.  This is widely projected to be negative for Europe and therefore for US stocks, but it should be reflected in markets by now.  The story will get continuing buzz, especially on Monday.  We will also have election results from Greece, where no majority winner is expected.

There are a number of minor reports early in the week, but I am interested in trade data, jobless claims, and Bernanke's speech on Thursday.  On Friday we'll have the Michigan sentiment index and PPI.  We could see a surprise from either.

We will also have some news from Omaha and the Facebook IPO where Cody Willard sees $100 B as an important dividing line.

Trading Time Frame

We mostly out of the market until late in the week for trading accounts.  Felix likes the current dip, so we are back in the market. The Felix forecast is for a three-week horizon, so it is best not to judge too quickly.  We have long experience with this program, which does not try to call market tops and bottoms.

If Felix is wrong, it will be back to the penalty box.  For now, we are looking for rebounds in several sectors.

Investor Time Frame

For investment accounts I have been buying on dips in stocks that we like. I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look.

Investors should not be trying to guess the next market move. Instead, take what the market is giving you. I have been offering this advice for months, and it led to a great quarter for anyone taking heed.  We seem to have another buying opportunity -- especially in tech and cyclical stocks.

If you are really worried, you can imitate our enhanced yield program. Buy good dividend stocks and sell short-term calls. I am targeting 8-9% returns on this approach, and achieving it no matter what the market is doing. You can, too. This has been meeting objectives in spite of the market twists and turns.

Thursday and Friday were excellent days for finding new positions for this system.

Final Thoughts on Politics, Headlines, and Fear

In principle, investors know that the right time to buy is when others are fearful.  In practice, they join in the fear.

Bill Luby, in a nice guest column for Barron's, Be Greedy While Others Are Fearful, writes as follows:

"Fear is good business on Wall Street. For starters, fear helps to encourage impulsive and emotional decisions on the part of retail and institutional investors alike. It is contagious, capable of spreading extremely quickly and can sometimes appear to be unbounded. 

Fear also has been responsible for the development of a wide range of structured products tailored for institutional investors who wish to protect principal, minimize volatility and take other steps to counteract potential risks. The ugly side of fear is that it impels many people to sell at the bottom and wait to get long until markets are near a top. 

These are all good reasons to want to sell fear, but not why I choose to do so.  No, I am short fear because fear is almost always overpriced – and by a large margin."

Successful investing is not reckless, but it is fearless.  To achieve this requires a system and confidence in that system.  I recommend the following:

• Ignore the political noise and spinning.
• Note the low level of financial stress -- the European systemic failure is off the table.
• Note the low recession odds from the best sources.
• Observe the continuing growth in corporate earnings, and the low forward multiple.

These are all encouraging conditions for long-term investment.  Even conservative investors can own some dividend stocks and sell calls against them.

This is what the market is giving us, and we should take it.

[long AAPL]

April Employment Report Preview

Employment is crucial.  Everyone wants to know whether the economy is improving and, if so, by how much. Employment is the key metric since it is fundamental for consumption, corporate profits, tax revenues, deficit reduction, and financial markets.

We have an accurate count on employment gains from state unemployment insurance offices, but there is a significant delay in compiling and reporting the data.  We just got the numbers for Q311.  We would all like to have this information sooner.

Let us call the actual data what it is:  The Ultimate Truth.

The truth for the April report is something that we will not know for about eight months.  There are various methods for estimating what the Ultimate Truth will be.  The BLS has one method, but there are other approaches.

To get the sense of this let us revisit the most recent actual data, from Q311.  We now know that total employment increased by 750K jobs during that quarter.

The difference between the number of gross job gains and gross job
losses yielded a net employment change of 753,000 jobs in the private
sector during the third quarter of 2011. This is the largest net job
gain since the first quarter of 2006.

So what were we really thinking at the time?

The total of the initial BLS reports was 220K, including a scary "0" for the month of August.  The initial ADP estimates (private employment only) totaled 296K.  If you look at a BLS data series now it shows the reports for that quarter to total 383K, including the "benchmark revision" from last March.  The final series will be revised even higher when we get the new benchmark revisions next March, since the BLS estimates seem to be running lower than reality.

How Wrong this Is

One of the talking heads on CNBC today was saying that ADP "missed" the BLS number by an average of 48K per month.  This is complete silliness, since the scorecard used was based on the initial BLS estimate.  It is like asking a forecaster to predict someone else's erroneous estimate instead of the truth.

The investing world should belatedly accept a proposition that I have been offering for years:

The BLS method is one of several approaches for estimating the truth.  Those seeking truth should consider each sound alternative method, and draw conclusions from the composite.

This previous article in the series summarized the various blunders the experts make each month.

I will have more on the investment perspective in the conclusion, but first, what are we looking for tomorrow?

The Data

We would like to know the net addition of jobs in the month of April.

To provide an estimate of monthly job changes the BLS has a complex methodology that includes the following steps:

1. An initial report of a survey of establishments. Even if the survey sample was perfect (and we all know that it is not) and the response rate was 100% (which it is not) the sampling error alone for a 90% confidence interval is +/- 100K jobs.
2. The report is revised to reflect additional responses over the next two months.
3. There is an adjustment to account for job creation -- much maligned and misunderstood by nearly everyone.
4. The final data are benchmarked against the state employment data every year. This usually shows that the overall process was very good, but it led to major downward adjustments at the time of the recession. More recently, the BLS estimates have been too low. (See my prior preview for a more detailed account of this, along with supporting data).

I think the BLS is honest and does a good job, which seems to put me in a small minority of observers.

In particular, I want to highlight the many know-nothing pundits who roll their eyes about the birth/death adjustment whenever it helps their spin.  Two points:

1. The  birth/death adjustment is one of two methods for estimating new job creation, and it is far less important than the imputation step.  This is where the BLS assumes that companies dropping out of the sample are replaced by new companies with similar job characteristics.  Don't hold your breath waiting for someone on CNBC to describe this, since they never have -- despite the importance.
2. The birth/death adjustment has been very accurate.  Here the data from the latest update showing a total error of only 12K jobs in a year.  Amazing!

 

Why doesn't anyone ever explain how the birth/death adjustment works, the imputation step, or how accurate it has been.  Instead, the media endorses the wrong-headed and pervasive skepticism about job creation.

Competing Estimates

The BLS report is really an initial estimate, not the ultimate answer. What we are all looking for is information about job growth. There are several competing sources using different methods and with different answers.

• ADP has actual, real-time data from firms that use their services. The firms are not completely representative of the entire universe, but it is a different and interesting source. ADP reports gains of only 119K private jobs. Steven Hansen at Global Economic Intersection endorses the ADP method over the BLS result. He has a strong analysis covering many nuances in the data. For those who really want to understand the jobs story, it is well worth reading.

• TrimTabs looks at income tax withholding data. The idea is that this is the best current method for determining real job growth. TrimTabs forecasts gains of about 116,000. They have been pretty bearish on job growth, but their approach is worth serious consideration.

• Economic correlations. Most Wall Street economists use a method that employs data from various inputs, sometimes including ADP (which I think is cheating -- you should make an independent estimate). I use the four-week moving average of initial claims, the ISM manufacturing index, and the University of Michigan sentiment index. I do this to embrace both job creation (running at over 2.3 million jobs per month) and job destruction (running at about 2.1 million jobs per month). In mid-2011 the sentiment index started reflecting gas prices and the debt ceiling debate rather than broader concerns. When you know there is a problem with an input variable, you need to review the model. For the moment, the Jeff model is on the sidelines.
• Briefing.com cites the consensus estimate as 167K and their own forecast is for 145K.

Trading Implications

What does this mean for our trading and investing?  Caution.

I am concerned about a big miss this month.  There is too much focus on the initial number.  Take a look at this assessment of revisions from Scott Murray at The Stock Sleuth (now added to our featured sites).

2011              Initial Release            Revision           Net Change

August                           0                            104,000            +104,000

September           103,000                       210,000            +107,000

October                  80,000                       120,000              +40,000

November          120,000                       157,000               +37,000

December           200,000                       223,000               +23,000

January               243,000                       275,000               +32,000

February            227,000                       240,000                +13,000 

March                 120,000                                  ????

In the past I have suggested that revisions were not predictable.  The first two come mostly from additional responses to the survey.  More recently we have the effects of "concurrent seasonal adjustments" as well as the benchmark revisions.   I have a concern that the seasonal adjustment method does not work as well at market turning points, helping to explain why the initial reports have been too low.

While the evidence all suggests continuing economic growth in the 2- 2.5% range, this report could easily be a disappointment.  While I am seeking buying opportunities  and new positions for long-term accounts, it  usually pays to be cautious before the employment report.  That may be especially true this month.