An eclectic approach to better trading and investing. Finding market inefficiency. Discussing and applying the best ideas and methods from several disciplines.
Often there is a persuasive argument, apparently supported by data, that can be misleading for the long-term investor. Sometimes this relates simply to facts, but it can also involve analysis. Such is the case with what you see about profit margins.
The basic thesis is that profit margins are mean reverting. If any company gets an excessive margin, competition will arise and bring the profits to a more normal level. This is a persuasive argument, consistent with how we expect capitalistic economies to work.
Let us suppose that we agree that profit margins will return to long-term norms. (Good here!)
What are the implications?
The Bearish Viewpoint
Those with a bearish perspective take current revenues and do what they refer to as "normalizing" to chop the earnings down to lower levels. If you reduce S&P 500 earnings by 30% or so, you can easily conclude that most stocks (and the market as a whole) is richly valued.
I do not want to give this viewpoint short shrift, but it gets a lot of visibility, and the basic contention is simple.
Yes, the Fed is loose and is holding interest rates down artificially. But even if we assume more normal interest rates and stable profits (with implies declining margins), stocks are very cheap. Cheap enough in our view to take us to 14,500 on the Dow and 1475 on the S&P 500 by year end 2012.
Using a capitalized-profits approach, we divide corporate profits by the current 10-year Treasury yield of 2% and then compare the current level of this index from each quarter for the past 60 years. Hold on to your hats…this method estimates a fair-value for the Dow at 46,000. But, this extremely bullish result is largely due to artificially low interest rates. Current levels on inflation are above the 10-year Treasury yield and we believe that once the Fed normalizes its policy stance interest rates will climb to much higher levels.
If we use a more realistic discount rate of 5% for the 10-year Treasury, we get a fair value of 18,800 on the Dow and 1,975 for the S&P 500.
Another potential problem is that profits have been an unusually large share of GDP – currently almost 13%. If profits revert to a historical norm of about 9.5% of GDP at the same time the 10-year Treasury yield is 5%, fair value would be 13,900 for the Dow and 1460 for the S&P 500. Just to be clear, that would be in a world where profits fall roughly 25% and interest rates more than double from their current levels. In other words, this doesn’t look like a dead cat bounce to us.
Our Conclusion
Let's face it. The argument about mean reversion in profits is several years old. Profits keep rising and margins have held up pretty well, mostly because companies have been slow to bring back employees. The P/E multiple declines, partly because the world is full of skeptics about future profits.
The leading advocate of profit mean reversion is Vitaliy N. Katsenelson. I did a favorable review of his excellent book, which has excellent advice on stock picking. A book about a sideways market is a coup on many fronts, and I enjoyed reading it.
Unfortunately, many investors are convinced from these arguments that profits are about to decline. This conclusion is not supported by the data.
High profit margins came when companies held down costs and new hiring. If the margins fall, it implies that new workers have been added. That is the basis for additional costs. This means that employment, GDP, and tax revenue are all moving higher.
Briefly put -- Those who look at mean reversion in profits alone, without any attention to changes in employment, are guilty of an inconsistent forecast.
I have a simple challenge for those forecasting a mean reversion in profits: Do you really expect the overall S&P earnings forecast to move lower?
Since the start of the Great Recession there has been little reason for enthusiasm about the US housing market. The home construction industry and related sectors have been a continuing drag on the recovery.
In my circle of friends I know of several first-time home purchases in the last couple of years. I was reminded of this last night when visiting my niece and her husband, seeing their beautiful new urban home and enjoying a wonderful "Restaurant Week" dinner at a place new to us all. It is too easy for us stodgy old analysts to forget that successful young people want their own homes. For them, the time to buy is now.
Regular readers know that I embrace the illustrative power of the anecdote, but I live on data. Taking a look at this week's calendar, I expect more media attention to the prospects for improvement in housing.
With an open mind, no specific positions, and a multi-year record of skepticism on this sector, I am receptive to the question: Is it time for a turn in housing?
I'll look at this more deeply in the conclusion, but first, our regular look at the news and data from last week.
Background on "Weighing the Week Ahead"
There are many good sources for a comprehensive weekly review. You cannot read all of them. It is actually possible for your work to be counter-productive as I tried to explain in Read a Lot, Get Squat.
Instead of trying to drink from a fire hose, why not be more selective?
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.
Unlike my other articles at "A Dash" I am not trying to develop a focused, logical argument with supporting data on a single theme. I am sharing conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am trying to put the news in context.
Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!
Last Week's Data
Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:
The news is market-friendly.
It is better than expectations.
A valued reader, noting the high unemployment levels, asked how I can ever write about employment as "good." I agree that we are far below what is needed for economic health and general prosperity, but that is not my mission. I am explaining how events will be interpreted by the market. You might disagree on political or policy grounds, but that is not the subject. When the news is "less bad" it is market-friendly.
The Good
There was some very good news this week.
Initial jobless claims. This is important data, more current than most. The decrease in initial claims encourages us that the employment picture continues to improve. There is a lot of weekly noise, but the widely-followed four-week moving average is also very good. Ed Yardeni puts this in perspective, also questioning the PIMCO meme of the "new normal." He thinks it is the real normal, and you should read his thoughts.
Sentiment is more bearish. In the world of investing, this is bullish. Go figure! Here is the chart from The Bespoke Investment Group.
Leading Indicators are stronger. This is the Conference Board report, better despite the umpteenth adjustment. See Steven Hansen for a thoughtful analysis of this data series
Congress managed to extend the payroll tax cuts. Everyone is claiming credit.
The Bad
There was some bad economic news last week.
Greek debt is even worse than we thought. The IMF has an update. See Calculated Risk for some helpful analysis.
Fed POMO operations will be less aggressive. As regular readers know, I completely disagree with the POMO interpretation of the market. There is no logical connection. The charts are sloppy in starting and ending points. This source (HT Charles Kirk) is guilty on all counts, but I present it because it has had a major effect on traders. Self-fulfilling prophecy?
Inflation is a little hotter than we want. This is a tricky topic, since the Fed wants to see inflation of about 2% on PCE. The choice of the PCE as the index dates back to the Greenspan days. It is a more accurate read of what people buy, avoiding many of the housing issues, and it is less volatile. It has been the Fed choice even when the inflation rate was higher than the CPI. Doug Short does a great job of explaining this, including his matchless charts. Here's one:
The Ugly
The respected folks at the Gallup Poll report that employment looks much worse as of mid-February. I saw the interview on CNBC from my hotel room in Seattle, but I want to investigate further. Here is the Gallup chart:
This looks terrible. The report has already sparked a blogger debate (Mish and Bonddad). Someone may be getting our Silver Bullet award next week!
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
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.
This week continues two new measures for our table. The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain the link to the C-Score next week. (I now that I am behind schedule on this, especially with last week's travel and options expiration. This is important, but not urgent. The message is comforting.) The second is the Super Index. You can read more about it in this article, which is merely an introduction, and also my WTWA from three weeks ago. It reflects extensive research and testing, and is well worth monitoring. (The Super Index includes the ECRI approach). I am going to do a complete review of the work very soon. Meanwhile, I think it is important enough to watch every week.
The team working on recession forecasting and the SuperIndex continues to produce work that is absolutely first-rate. They are generating a suite of measures with differing time frames. For the investment world the key question is how much notice do we need? Here is a great answer:
Assume an investor is following a business cycle expansion buy-and-hold strategy, where the aim is to remain vested in the stock market for as long as possible before the onset of recession. Any defensive action longer than 4.8 months on average before a recession is going to be counterproductive for him or her. Think about this – in the 4.5 months since ECRI's recession call the stock market has rallied more than 22%. Is that counterproductive enough for you?
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. We voted "Bullish" this week.
[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
This a light week for A-list economic data. It is a short week, influenced by the effect of last week's options expiration.
The initial claims series is the single most important report to watch right now, and we'll have an update on Thursday. There are revisions to Michigan confidence (Friday), and also some housing data, which might grab the focus.
Europe news is a wild card, but I see less concern and more emphasis on the US economy.
I monitor news and economic data every day in my diary at Wall Street All Stars (subscription required, but I have some membership discounts available for my readers).
Trading Time Frame
Our trading accounts have been 100% invested since December. Felix caught the current rally quite well, buying in on December 19th. There are now many solid sectors in the buy range. The overall ratings have improved, helping us to stay invested while many have been in denial for the entire rally. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated. Felix has been more confident than I have been on the trading time frame. This illustrates the importance of watching objective indicators instead of headlines.
Investor Time Frame
Long-term investors should be aware of the rapid decline in the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," and is declining further. This sort of decline has been a good time to buy stocks on past occasions. Worry is still high, but has now declined to a more comfortable level.
Even though stock prices are higher than in October, the risks are much lower. I am increasing position size for risk-adjusted accounts. (We cut back by about 30%). I am also looking more aggressively for positions in new accounts.
Our Dynamic Asset Allocation model is still very conservative, but starting to change into equities. For several weeks I have joked that it is rather like the Nouriel Roubini of our methods. Dr. Roubini is now becoming more bullish. There is nothing wrong with this! There are many successful market strategies. The risk/reward balance is a personal matter.
To summarize, we have become much less conservative in all of our programs, There is still risk, but as our indicators become more positive, we can and should become more aggressive. For new accounts we are establishing immediate partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program. This program continues to work very well, meeting the objectives of conservative, yield-oriented investors. It follows our key precept:
Take what the market is giving you.
I have been repeating this each week, because it is by far the most important message. It is better than trying to time the market. You can buy great dividend stocks at reasonable prices with the chance to sell call options at inflated prices. If the stocks do nothing, you can still get almost 10% per year from dividends and call premiums.
This does not work for those selling long-dated calls. It requires some active management, selling calls with a month or two before expiration to capture the most rapid time decay.
The Final Word on Housing
I do not have a strong personal feeling on housing. I understand the need to work off the inventory of abandoned homes and to deal with foreclosures. This is the widely-cited shadow supply. I know also that there is shadow demand from new families and people unwillingly living with parents.
Housing demand is linked to perceived affordability and employment. Here are some sources that we should all consider:
Building Permits show increasing strength. This is a favorite indicator for me. Steven Hansen does a nice, in-depth look at the growth trend.
Affordability of housing requires looking at both down payments and monthly payments. Check out The Bonddad Blog for a good analysis of both.
Hard Data on Construction has improved, despite some builder confidence surveys (via Calculated Risk).
And finally, the conclusion from Calculated Risk, a source we all respect from the early and accurate analysis of the housing market decline. This conclusion is careful and nuanced, distinguishing a bottom in prices from a bottom in sales. Read the entire article, but here is the key takeaway:
And it now appears we can look for the bottom in prices. My guess is that nominal house prices, using the national repeat sales indexes and not seasonally adjusted, will bottom in March 2012.
I expect this to be an active topic of discussion this week and during the Spring. Any sign of life in housing would help the economy, and would provide some new sector and stock ideas.
I have a great question from a valued reader. It hits a theme that I am hearing from many new clients.
Despite many hours of work, I am trailing the market.
This is a great topic and a good time for me to revisit some old articles. There is a basic principle involved. It is surprising and very different from our personal experience. In most things, the more we learn the better we do. This is not true for investment research!
The basic answer has three parts:
Your emotions get in the way. You are human, and we are hard-wired to react to risk. Much of the advantage of the top-flight managers is steely nerve in the Warren Buffett tradition. It is easy to say that you should buy when others are needy and sell when they are greedy. When the time comes, most individual investors cave in. They sell bottoms, and buy tops.
You are reading the wrong material, not understanding the natural bias of bloggers, TV, and the sites formerly prized for journalism. Consider the phrase "Man bites dog" for a minute or so and let your intelligence tell you why you are being misled. Learn to look for facts and data. Learn to discover when you are always getting the worst case -- or the best.
Understand that you are not alone. Most of the hot-shot pundits you read about or see on TV have similar results. You do not hear about some of the losers since they are gone. Others are featured with "Street Cred" showing that they keep getting hired somewhere. Understand that most of the hot shots you see have not done any better than you, but they have good PR departments!
A Simple Test
This excellent question deserves more analysis, and I will continue to work on the subject. Meanwhile, I suggest a simple test.
One of the most important questions for the US market is the European debt crisis. There is a very simplistic approach (followed by nearly everyone) that adds up everything that is a debt in Europe, ignores assets, and compares it to what Germany might step in to provide. Not surprisingly, this approach is rather pessimistic about the fate of the world.
Those pushing that thesis (often also selling gold, structured products, speeches, conferences, or other fear-sustained business models) completely dismiss the idea that anyone outside of Europe has an interest in the outcome.
I am struggling for a nice word for this thinking, but "stupid" is the best I can do.
Many of the most popular investment blogs featured a segment with a finger-pointing lecture from Jin Liqun. This also got repeated reviews on CNBC.
The news now is a little different, and completely consistent with what I have been suggesting for nearly a year. The Chinese are not going to bail out Europe. If there is a constructive plan, they will play a big role.
Why? Self interest. Europe is their biggest export market. If there is a reasonable plan in place, they will join in. I explained this in November, and it reads very well right now.
The Test
Just see how many sites explain to you about the current visit of Xi Jinping and his openness to participating in the European solution. If your favorite site does not explain his openness toward helping a European solution, you should delete or downgrade it in your thinking.
Putting it more strongly, anyone who does not recognize an improvement in the European situation over the last six months is not tracking the best data.
I am going to take a little risk with my recent hot streak on the WTWA series. I am not highlighting Greece as the key story.
It would be easy to say that we will be focused on Greece, since that is the issue as I write this on Saturday night. There will probably be some sort of resolution by mid-week. Whatever it is, most will not be convinced.
The market seems to have digested the European story: No immediate threat of systemic risk, less risk for Italy and Spain, attention shifting to European recession/growth and impact on world markets. Regular readers know that this is what I have been predicting for nearly a year -- the incremental solution.
This week I expect a lot of commentary about the state of the market after Q4 earnings reports and the strong results from January. Those who predicted a down year or an increase of 8% for 2012 should now be advising caution, but they will instead be reconsidering their forecasts. Things are getting better.
Even Barron's is featuring a cover story on Dow 15,000. Here is their own synopsis:
Even by conservative measures, the Dow Jones Industrials could top 15,000 in two years. Dow 17,000 is a 50-50 bet.
(Like my readers, I appreciate free content. You can get this article on a free preview by pasting the author and title into Google. I pay reasonable prices for good journalism, currently including the FT, the WSJ, and Barron's. I'll try to highlight the best, and let you do the rest.)
After a year of improving facts and a stagnant market, we will see more stories on this theme. I'll look into this more deeply in the conclusion, but first let's do our regular review of last week's economic data and news.
Background on "Weighing the Week Ahead"
There are many good sources for a comprehensive weekly review. My mission is different. I single out what will be most important in the coming week. My theme for the week is 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.
Unlike my other articles at "A Dash" I am not trying to develop a focused, logical argument with supporting data on a single theme. I am sharing conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am trying to put 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
Last week had mixed economic news and disappointment from Europe. The market held up surprisingly well.
The Good
There was some very good news this week.
Initial jobless claims. This is important data, more current than most. The decrease in initial claims encourages us that the employment picture continues to improve. There is a lot of weekly noise, but the widely-followed four-week moving average is also very good.
An imminent recession is less likely. There is some great work on this subject, mostly refuting Hussman and the ECRI. A group of analysts has reverse-engineered some of these indicators and actually improved the predictive quality. Here are the leading examples:
Doug Short features the PowerStocks analysis of the ECRI data.
The Bonddad Blog refutes Hussman. Once again, a careful analyst shows the flaws in some research that never had peer review. This is technical, but important for those who care about recession forecasting.
Dwaine van Vuuren wisely asks: How Much Recession Warning is Useful? Read the full article for great charts and data. Dwaine's focus is on economic forecasting and stock market reaction. It does not pay to be too early, and possibly quite wrong.
Dwaine teams up with Georg Vrba to outdo the ECRI in using their WLI. Their results are better and also not so negative right now.
There is more borrowing. (I realize that this is a negative for those emphasizing ideology, but our working definition of good news is "market-friendly.") Here is the chart from Scott Grannis:
The Bad
There was some bad economic news last week.
Earnings growth seems to have stalled. Brian Gilmartin does a great job of tracking forward earnings reports. He also previews and reviews earnings for many important companies at the new Wall Street All Stars Site. I read his work every day, both for ideas and to interpret the earnings news. Here is his key quote:
...(T)he latest “forward 4-quarter” estimate for the S&P 500 is $105.88, still below the peak of $107 hit in July, 11, October ’11 and then again in January ’12, so corporate earnings ahve clearly flattened out, as the year-over-year growth rate has slowed to 7.5% or so for the key benchmark.
Consumer confidence (University of Michigan style) disappointed again. I regard this series as an important indicator of both jobs and consumer spending. The chart from Doug Short makes the problem clear.
Tax withholding and gasoline purchases continue to decline. The Bonddad blog (upbeat on other indicators) covers all elements of the story.
The Ugly
Even if we get a satisfactory ending, the violent protests in Greece highlight the intensity of feeling. The New Athenian calls it a Political Meltdown. The outcome of tomorrow's vote on austerity measures is in some doubt, as it the reaction of the troika to the latest plan revision, due at mid-week.
The Silver Bullet
I have occasionally recognized leadership in data analysis. We need more of it, and more recognition of those who do it. When you embark on such a story, you are like the Lone Ranger. In the spirit of encouraging this type of work I hope to mention a "silver bullet" story as often as possible. I invite readers to send suggestions.
There is a continuing complex story on the interpretation of last week's employment data. Serial spinning by those determined to find something negative in the results has now turned to the topic of seasonal adjustments. Menzie Chinn at Econbrowser takes a careful look at the reasons for seasonal adjustment and the various possible approaches. He demonstrates that the BLS has a reasonable method, consistent with other possibilities. If you really want to understand this issue, read the article. If you are not willing to do a little work, than you ought not to pontificate (TM OldProf euphemism for what more colorful bloggers mysteriously refer to as STFU). Dr. Chinn has a few nominations on this front!
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
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.
This week continues two new measures for our table. The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain the link to the C-Score next week. The second is the Super Index. You can read more about it in this article, which is merely an introduction, and also my WTWA from two weeks ago. It reflects extensive research and testing, and is well worth monitoring. (The Super Index includes the ECRI approach). I am going to do a complete review of the work very soon. Meanwhile, I think it is important enough to watch every week.
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. We voted "Bullish" this week.
[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
This week has a lot of economic news on the calendar, but few of the reports are on my "A List."
Most important is the initial claims report on Thursday. Everyone cares about employment. This series is improving and will count in next month's employment situation report. Tuesday's retail sales data could also be important, and we might get something interesting from industrial production and capacity utilization on Wednesday.
If inflation were an issue, the PPI and CPI would bear watching (Thursday and Friday). I'm not expecting anything here.
There are many other scheduled reports. There is not much market reaction to the regional Fed surveys or the small business survey.
We will also get the FOMC minutes, but after the highest transparency session in history (long-term forecasts plus a press conference), followed by Congressional testimony, I doubt that we are going to learn anything new.
I monitor news and economic data every day in my diary at Wall Street All Stars (subscription required, but I have a few free trials left to offer).
Trading Time Frame
Our trading accounts have been 100% invested for many weeks. Felix caught the current rally quite well, buying in on December 19th. There are now many solid sectors in the buy range. The overall ratings have improved, helping us to stay invested while many have been in denial for the entire rally. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated. Felix has been more confident than I have been on the trading time frame. This illustrates the importance of watching objective indicators instead of headlines.
Investor Time Frame
Long-term investors should continue to watch the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," and is declining further. This sort of decline has been a good time to buy stocks on past occasions. Worry is still high, but has now declined to a more comfortable level.
Even though stock prices are higher than in October, the risks are much lower. I am increasing position size for risk-adjusted accounts. (We cut back by about 30%). I am also looking more aggressively for positions in new accounts.
Our Dynamic Asset Allocation model is still very conservative, but starting to become more aggressive. For several weeks I have joked that it is rather like the Nouriel Roubini of our methods. Dr. Roubini is now becoming more bullish. There is nothing wrong with this! There are many successful market strategies. The risk/reward balance is a personal matter.
To summarize, we have become less conservative in all of our programs, There is still risk, but as our indicators become more positive, we can and should become more aggressive. For new accounts we are establishing immediate partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program. This program continues to work very well, meeting the objectives of conservative, yield-oriented investors. It follows our key precept:
Take what the market is giving you.
Right now that continues to be dividend stocks at reasonable prices with the chance to sell call options at inflated prices. If the stocks do nothing, you can still get almost 10% per year from dividends and call premiums.
This does not work for those selling long-dated calls. It requires some active management, selling calls with a month or two before expiration to capture the most rapid time decay.
Since I wrote that in May of 2010, we have gained 28% in 626 days -- despite no progress in calendar 2011. This pace would result in Dow 17K by the end of 2013 (which is rated as a 50-50 chance in the Barron's article) and Dow 20K in early 2015. Astute active managers who regularly beat the market averages can expect more.
To understand the progress you need to think of market averages in terms of underlying data instead of headlines. Here are two good approaches.
Ed Yardeni shares Brian Gilmartin's concern about the leveling of forward earnings and the P/E multiple. Take a look at his helpful chart on this subject:
Notice the frequency of trading at the P/E 14 level. A return to P/E 14 would mean an increase of more than 17% in stocks, even without a change in earnings. The low market multiples reflect intense skepticism about whether earnings will be delivered. This changes as evidence accrues.
Jim Paulsen, Chief Investment Strategist at Wells Capital Management, explains this effectively, calling the recent rebound an unwinding of this skepticism. Watch the full interview for a complete analysis and some good ideas.
He makes a powerful argument that should be considered by those who (like most of us) still need to create wealth.
When politics takes the fore, we have what I call "silly season." This is a time when many investors get caught up in the emotion of politics and make bad investment decisions.
For those who can keep a clear head, it is a time of opportunity. I'll start with some background, and then turn to the investment implications.
The Democratic Perspective
This is a pretty simple proposition. It has the following legs:
Obama inherited a bad situation;
He has made many right moves, and been blocked on others;
Things would be even worse without his efforts.
You should read every economic story with a critical eye to these themes.
The GOP Perspective
This is also a simple argument, with a few legs:
Obama promised unemployment below 8% and did not deliver;
Obama killed new business with additional regulations and general uncertainty;
Obama tax policy threatens job creators -- various ways.
You should read every economic story with a critical eye to these themes.
Interpreting Data
Investors need to have a sharper eye. Right now the GOP is reaching to deny progress. Here is how you can spot this.
Visibility without credentials
There is a group of people who get visibility only because they have had it in the past. There is no test about education, success in past jobs, or accuracy of prior forecasts. These guys are part of a club where they get on TV because they have been featured in the past. Check out this example, the bio of someone who has gone through more (unmentioned) firms that I can remember, while never changing his incorrect message.
Mr. X is the President of X Portfolio Strategies and serves as Senior Market Analyst for research firm XYZ Financial.
X Portfolio Strategies provides a nexus between prospective clients and a select group of the country’s finest and most seasoned investment advisors, who utilize X’s economic models in developing their portfolio strategies. XYZ Financial publishes award-winning newsletters, critically acclaimed feature documentaries and international best-selling books.
Mr. X is a well-established specialist in the Austrian School of economics and a regular guest on CNBC, Bloomberg, FOX Business News and other national media outlets. His market analysis can also be read in most major financial publications, including the Wall Street Journal. He also acts as a Financial Columnist for Forbes and is a blogger at the Huffington Post.
Prior to starting X Portfolio Strategies and joining XYZ Financial, Mr. X served as a senior economist and vice president of the managed products division of another financial firm. There, he also led an external sales division that marketed their managed products to outside broker-dealers and registered investment advisors.
Additionally, Mr. X has worked for an investment advisory firm where he helped create ETFs and UITs that were sold throughout Wall Street. Earlier in his career Mr. X spent two years on the floor of the New York Stock Exchange. He has carried series 7, 63, 65, 55 and Life and Health Insurance Licenses. Mr. X graduated from Rowan University in 1991.
So this guy worked for several unnamed firms, had an undergrad degree in an unknown subject, and has gotten on TV a lot. His resume includes the most dangerous phrase for investors: Self-taught in Austrian Economics.
Actually it says that he is a self-proclaimed expert, but that is the same thing. It is possible to study Austrian Economics, as my George Mason friends at the Kauffman Conference regularly highlight. I find that most people who claim this credential without formal study have started with an ideology and then sought an economic fig leaf to support a viewpoint.
The Super Bowl Shuffle
When the data do not support your argument it is time to spin! The employment report always has a lot of room for interpretation and error, something that I always emphasize. Last week's report had a bigger opportunity than most for the spinmeisters, since the Census Bureau did updates based upon the 2010 Census results.
This led to horrific blunders by the "shoot first, think later" crowd, as I noted in my weekly market review. Since then, there has been a rapid retreat --without apology -- by the sources that got this wrong. They are now shifting the argument to a ten-year analysis of employment participation.
We should recognize this for what it is.
My Take on Employment Participation
Let's get real on this subject. We all know the following:
The Y2K high was induced by a "buy forward" of computers. We will never see this high again;
The aging population means that employment participation will naturally decline; and
The extended recession has created early retirements, extended studies, travel abroad, and other elements reducing labor participation.
But, with one big exception, the economy is increasingly clicking on all cylinders. Adjusted for inflation, personal spending is up, business investment is up, and – finally – home building is growing as well.
January data from automakers show sales are up 53% from the bottom in early 2009. If the economy is so bad and credit is impossible to get, how is it possible for Americans to be driving so many cars and trucks off dealer lots?
And notice that the recent improvement in job creation comes several months after we hit an upward inflection point in home building, which is a labor intensive industry.
The major outlier is government, where purchases in 2011 were down the most in more than forty years. (For GDP purposes, transfer payments are not counted as government spending.)
Ultimately, we believe most of the disbelief is driven by politics. Back in 1992, President George H. W. Bush was never given credit for a recovering economy by those who wanted to see someone else in the White House. Now, from the opposite side of the political spectrum, there are those who want to see President Obama replaced so badly that they refuse to believe signs of improvement no matter how clear.
Investment Conclusion
The implication is that we are still early in the business cycle -- something that is bullish for cyclical and technology companies that I have highlighted, including CAT, INTC, MSFT, as examples.
After last week's data and the recent market run, I sense that it might be time for a deep breath.
There have been solid reasons behind the market rally, including all of the following:
Improving economic reports
Progress in Europe
Reasonable growth in earnings
A backdrop of low P/E multiples
Last week I accurately suggested that it would be all about the avalanche of economic data with a big focus on Friday. This was correct.
This week is light on important data. While there are continuing earnings reports, it provides a time to reassess. I am intrigued by the trading perspective from Derek Hernquist (belatedly added to our list of featured sources. I only do this when there is an article that hits a theme I am working. Maybe I should share more of the sources that I regularly read). Even when I am wearing my "investment hat" rather than the trading one, I am always looking for the best entry and exit points. I think that Derek nails it with this comment:
Everyone knows the following:
1) Stocks are in a raging uptrend showing no signs of letup
2) They’ve travelled a long way in a short time and are entitled to a break
As traders, we constantly walk a tightrope between identifying an emerging opportunity and recognizing when it’s too obvious. I’ve learned through many mistakes that obvious doesn’t mean sell(or cover); for me, it just means find something else to buy or short. Is there a way outside of the fuzzy sentiment polls to measure “obviousness”?
Check out the article for Derek's answer. Whether or not you agree, it is something that all of us should be thinking about, and I believe it will be the theme for the week.
More about this in my conclusion. But first, let us do our regular review of last week's economic data and events.
Background on "Weighing the Week Ahead"
There are many good sources for a comprehensive weekly review. My mission is different. I single out what will be most important in the coming week. My theme for the week is 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.
Unlike my other articles at "A Dash" I am not trying to develop a focused, logical argument with supporting data on a single theme. I am sharing conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am trying to put 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
Last week continued the shift in tone that I have been observed for a few weeks -- more about the US economy, less concern about Europe and China. This was not absolute, since every day started with a look abroad, as I chronicle daily in my daily investment diary.
The Good
There was some very good news this week.
Employment. The official jobs report was unambiguously positive. The worst thing you can say is that we need more of the same. Employment seems to be stronger than the other economic readings would suggest, something that I covered in my preview piece. I am in general agreement with Steven Hansen at GEI, who has an excellent comprehensive summary.
The ISM manufacturing report came in at 54.1. This is consistent with an annualized GDP of 3.9%. All fo the "internals" were solid. It is a much better read on low inventories than the dated GDP news from last week. People report this number without ever reading about the methods. Amazing.
The ISM services report was also solid. See Calculated Risk.
Chinese manufacturingis expanding faster than expected.
The Chinese are evaluating participation in the European bailout, just as I have been telling you would happen. Great coverage by the FT.
Truck sales, the economic signal from the heartland, are much stronger.
The Bad
There was some bad economic news last week.
Housing data continues to disappoint. The Case Shiller series is a little old because of the method, but it is widely followed. At this point little is expected. Most people do not realize that a simple end to the decline in construction would add about 1.5% to GDP. Here is the Calculated Risk take on home prices:
Savers are out of luck. Fed Chair Ben Bernanke underscored the Fed message in his Congressional testimony. Get real! The Fed does not have a third mandate.
Conference Board consumer confidence was terrible. See Doug Short for his "sobering look" and the expected great charts, including this one:
Earnings are still a bit below historical averages with a "beat rate" of 60.7%. This is below the average from the recession rebound period, but a little better than we were seeing early in the earnings season. Here is the scoop from Bespoke:
A million condoms fail in South Africa. You would not know this if you were not monitor the range of sources we do at "A Dash." This story is from NPR, where you can also learn how Consumer Reports does the testing. (No, they are not seeking applicants!)
The Ugly
The market news was pretty good, so it might be easy to be distracted from world events. I have highlighted the Iran nuclear developments as one such concern. At the TD Ameritrade Conference in Orlando, former Defense Secretary and CIA Director was the key note speaker. After launching a few one-liners, his message turned rather grim. Read this helpful account for the full inventory of concerns, but a key theme is rapid change in government. Think about this idea:
The tectonic plates in the Middle East have shattered. Remember that only one revolution turned out relatively well in its first decade, and that is our own.
There is a good inventory of what to think about around the world.
There is no good way to hedge against these fears -- a good topic for another article.
The Silver Bullet
I have occasionally recognized leadership in data analysis. We need more of it, and more recognition of those who do it. When you embark on such a story, you are like the Lone Ranger. In the spirit of encouraging this type of work I hope to mention a "silver bullet" story as often as possible. I invite readers to send suggestions.
This week's award goes to (jointly) Steve Liesman and Silver Oz.
In a desperate attempt at negative spin on the employment report, the anonymous bloggers at the most popular investment site decided, as usual, to shoot first and read later. This was breathlessly picked up by Drudge and Santelli, and then republished in many places. It was a big blunder. The Census Bureau provided information from the 2010 census, as you would expect. It turns out that the population and makeup were not exactly what had been estimated during the year-by-year process. The BLS accepts the new and more accurate data on the population -- does anyone really thing they should ignore this? -- and then must decide how to deal with the discontinuity from the new info. Instead of retroactively changing 10 years of old data, they post the new values and explain the change.
First on the job calling "Hogwash" was Steve Liesman. In the same time frame, Silver Oz posted at The Bonddad Blog. Joe Weisenthal also picked up the story early, getting it out to his big audience. I did some retweeting, as did others. Barry Ritholtz republished Silver Oz as well, and Calculated Risk also ran a strong piece. so honorable mention to those sources. Here are the early stories:
I am encouraged that there is more instant refutation when something is definitely wrong. Despite this I now from continuing misguided posts and comments that the damage was done. The degree of difficulty on this exceeded the ability of the average reader to figure out.
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
Economic/Recession Indicators. This week continues two new measures for our table. The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain the link to the C-Score next week. The second is the Super Index. You can read more about it in this article, which is merely an introduction, and also my WTWA from last week. It reflects extensive research and testing, and is well worth monitoring. (The Super Index includes the ECRI approach). I am going to do a complete review of the work very soon. Meanwhile, I think it is important enough to watch every week. Check out the latest summary from Doug Short, who has been monitoring the growing ECRI controversy and the vibrant discussion among leading theorists on this subject:
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.
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. We voted "Bullish" this week.
[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
This is a lighter week on economic data. There will be important earnings reports all week, and eventually that is what matters.
On the data front I am not very interested until Thursday. The initial claims series continues to be important. I am also a big fan of the UM Consumer Confidence reports. I'll be watching this with interest on Friday, especially given the weakness in the Conference Board survey.
Earnings reports continue, and will get a daily focus.
We are still waiting for the final verdict on the Greek debt negotiations. Amazingly, the market seems to have accepted some level of bad news about Greece, including something that triggers a "credit event." This illustrates what I have been writing for nine months -- delay is a positive when it provides time to prepare.
Our trading accounts have been 100% invested for many weeks. Felix caught the current rally quite well, buying in on December 19th. There are now many solid sectors in the buy range. The overall ratings have improved, helping us to stay invested while many have been in denial for the entire rally. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated. Felix has been more confident than I have been on the trading time frame. This illustrates the importance of watching objective indicators.
Investor Time Frame
Long-term investors should continue to watch the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," and is declining further. This sort of decline has been a good time to buy stocks on past occasions. Worry is still high, but is declining.
Even though stock prices are higher than in October, the risks are much lower. I am increasing position size for risk-adjusted accounts. (We cut back by about 30%). I am also looking more aggressively for positions in new accounts.
Our Dynamic Asset Allocation model is still very conservative, featuring bonds and other defensive holdings. It is rather like the Nouriel Roubini of our methods. What if things go wrong? Investors should understand that cautious, hedge-oriented positions may be slow to rebound. Most investors should have a mixture of approaches.
To summarize, we are adopting a less conservative posture in most of our programs, There is still risk, but as it is reduced we can and should become more aggressive. For new accounts we are establishing immediate partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program. This program continues to work very well, meeting the objectives of conservative, yield-oriented investors. It follows our key precept:
Take what the market is giving you.
Right now that continues to be dividend stocks at reasonable prices with the chance to sell call options at inflated prices. If the stocks do nothing, you can still get almost 10% per year from dividends and call premiums.
This does not work for those selling long-dated calls. It requires some active management, selling calls with a month or two before expiration to capture the most rapid time decay.
The Final Word
The biggest mistake for long-term investors is time frame confusion -- taking a short-term market view.
Let us suppose that you have been on the sidelines for a few months, worried about Europe or the ECRI recession call. The market has rallied, so you might think that you have missed out.
Not so! You made a decision to wait until risk was lower. Your wish has been granted!
You have the opportunity you have been waiting for. Many investors have a fear fixation -- the time will never be right.
These investors will never achieve their retirement objectives, since they decide based on emotions rather than evidence. You might want to consider this viewpoint from Bob Doll, BlackRock CEO:
Three months ago, stocks were pricing in about a 50% chance of a US recession and it looked increasingly likely that the European debt crisis would escalate into an Armageddon scenario. Today, while we would hardly say that the United States is poised to enter boom conditions or that the eurozone crisis has been solved, these risks have clearly receded, which has helped stocks to regain some footing. Our base case outlook is that these improving trends will continue along an uneven path, suggesting that stocks are poised for additional outperformance in the months ahead.
[Full Disclosure: We hold BLK as part of our enhanced yield program-- good dividends, great prospects, good call sale potential.]
While we wait for tomorrow's employment report, there was another big story today --- the Fed treatment of savers.
Fed Chair Bernanke testified before the House Budget Committee, responding to some illuminating questions from Committee Chair Paul Ryan (R. WI). Joe Weisenthal, who is usually on the track of the biggest story, anticipated this one yesterday:
And while we sympathize with people not getting returns on their money, the fact of the matter is that the big problem we have right now is that people have too much debt, not an abundance of cash that's just sitting there not returning anything.
The bottom line is this: Yes, it sucks that pensioners and garden-variety savers aren't getting returns, but it also sucks for everyone in the U.S. right now, because the economic outlook seems to be so mediocre. Welcome to the club!
Until growth and inflation return to anything that looks robust, savers will have to be stuck with the same garbage returns boat the rest of us are in.
The confirmation came in Congressional testimony by Fed Chair Ben Bernanke and the ensuing questions.
There is a lot of buzz about the role of the Fed and also the leadership of Bernanke. The leading Republican candidates all want to fire Bernanke, and some of them even want to abolish the Fed. Some of the GOP House Budget Committee members have joined the criticism.
Here at "A Dash" I focus on investments, not politics. Years ago some readers called me a "Bush apologist" and a blatant "supply sider." I have tried to explain that I do not have a partisan perspective, but an investment perspective. I want to find the best investments no matter who is in power. My perspective changes with the evidence.
With that in mind, let me suggest a few propositions for your consideration. If these are not obvious, I recommend more research.
Bernanke is a Republican, with a conservative background. This is typical for Fed Chairs.
If President Bush had been re-elected, the current GOP fiscal argument would be different. There would be support for stimulus, including both tax cuts or spending. If you do not believe this, look back in history to the end of the Bush administration.
If President Bush had been re-elected, the GOP monetary story would be different. They would be screaming for easy money, as both parties have always done, including past GOP administrations, and including Bush senior.
Paul Ryan is an ambitious and aspiring VP candidate who has a theme that resonates --- balancing the budget. It is an effective political argument -- for the party out of power.
Meanwhile, the Fed is doing a good job of ignoring politics and focusing on the economy.
Investment Conclusion
I continue my plea: Look beyond politics. Most recently, look beyond the popular ploy of making a villain out of the Fed.
The Fed has a dual mandate including both price stability and employment. Here is the official statement:
The Congress established two key objectives for monetary policy--maximum employment and stable prices--in the Federal Reserve Act. These objectives are sometimes referred to as the Federal Reserve's dual mandate.
There are many who have criticized the US approach suggesting that there should be only a single mandate - price stability.
So let us all be clear about this -- very clear.
The Fed has no Third Mandate. There is no interest rate guarantee for savers!
It is difficult enough to balance economic growth and price stability. The idea that the Fed should be judged by a third criterion -- maintaining interest rates for savers -- is misguided, politically biased, displaying favoritism for one group, and basically wrong.
More importantly, it is not going to happen. Our investment decisions should be based upon reality, not the wishful thinking of those with a partisan agenda.
I understand the plight of savers and senior citizens. I work with such investors every day, helping them find a combination of a bond ladder, dividend stocks, and enhanced yield. Those who do not have a job at all face a more difficult problem. Until we have a stronger economic recovery, we are all in this together.
Friday's employment situation report is the big statistical release of the week. Billions in market cap will swing on speculative conclusions about preliminary survey data.
The question is so important that we insist on making unwarranted inferences.
This month we have a special treat. We have a timely update on how the BLS is doing with their estimates. If you (unwisely) choose not to think about the problems in the competing methods, then skip to the conclusion for some data you will not see anywhere else.
The Data
We all want 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 would like to know the net addition of jobs in the month of January. This data point is actually a fact, but something that we do not know yet. Eventually we will have this information with a high degree of certainty. It takes about eight months. State employment offices provide data that are used for the benchmarking of the official BLS data. This information is solid, since businesses do not exaggerate employment when it comes to paying taxes.
By the time we have this information, everyone will treat it as "old news." Markets, news sources, and pundits all want to talk about something, and like a spoiled child, they want it RIGHT NOW!
To provide an estimate of monthly job changes the BLS has a complex methodology that includes the following steps:
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.
The report is revised to reflect additional responses over the next two months.
There is an adjustment to account for job creation -- much maligned and misunderstood by nearly everyone.
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.
I think the BLS is honest and does a good job, which seems to put me in a small minority of observers. Despite this support, I question the general concept. The BLS tries to estimate total employment in one month, total employment in another, and subtract the two to determine the difference. When you are talking total payroll employment of over 130 million jobs, even small errors are in the range of 100K jobs or more. Meanwhile, smaller discrepancies from expectations are unwisely viewed as significant.
Competing Estimates
If you accept the idea that the final benchmarking is accurate, then the BLS approach should be viewed as 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 sees gains of 170K private jobs. There is a continuing trend of losses in government jobs.
TrimTabs looks at income tax withholding data. The idea is that this is the best current method for determining real job growth. They see job gains of only 45,000.
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 2.5 million jobs per month) and job destruction (running at about 2.3 million jobs per month). In mid-year 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.
The problem with all of these methods is the scoring system. Everyone foolishly takes the BLS estimate as "official" even if the other approaches eventually turn out to be more accurate. Let us look more closely at this question.
The Final Verdict
As noted in the introduction, we eventually have actual hard data from state employment agencies. This is reported via the business dynamics series, which was updated today. Eventually the big-time pundits will pay some attention to this, but for now I am virtually alone in citing these data. Here is a crucial chart:
The last column shows the error from the current BLS estimate and the final data. I am working on sharpening this up, since it is using not the original BLS estimates, but the revised version. The interpretation is that the BLS was too optimistic for the quarter ending in March -- something that I noted as a concern a few months ago. We now know that they were too pessimistic for the quarter ending in June.
I believe that TrimTabs, ADP, NewArc, and other forecasters actually do as well as the BLS in the preliminary estimates. This means that the market should embrace various estimates.
It is also clear that the knee-jerk criticism of the BLS and the job creation estimation process is completely wrong. The BLS has been pretty accurate over the last year, and is actually under-estimating new job creation.
New jobs are created at a pace of nearly 7 million per quarter. If you do not know this, you don't know Jack about employment. I am still waiting to hear this information on CNBC's Friday morning report.
One of the many reasons that individual investors are scared witless (TM euphemism by OldProf) is a complete misunderstanding of the role of central banks and a distortion of current policies.
The critics of the Fed -- and now the ECB and other European banks -- have an easy path to page views and affirmation by readers who never took the class in Money and Banking.
This has the usual result. Anyone who is willing to spend a little time while keeping an open mind can gain a significant investment advantage.
The Current Scare
Let us begin by summarizing the story that I hear from so many people through comments, emails, or calls. It runs something like this:
The Fed is printing money with reckless abandon.
Other Central banks are now doing the same.
Bank balance sheets are exploding and have huge leverage ratios.
Gains in equity markets are a "sugar high."
Central banks could be wiped out with the smallest downturn.
Or if forced to unwind these trades, stocks would collapse.
A Typical Argument
Perhaps the most prestigious of those making such arguments is Jim Bianco. Since he is regularly featured on CNBC, has his work published at Barry Ritholtz's blog, and has institutional clients, everyone takes his research output quite seriously.
His recent piece at The Big Picture touched all of the bases described above, and also threw in a comparison of balance sheets with aggregate stock market values. I am going to stick to the Fed balance sheet in this analysis, but it should illustrate the point.
Here is the chart of the Fed balance sheet provided by Bianco.
This chart repeats many of the errors from the Michael Pento arguments that I refuted here. If Bianco had read this research, his article might have been stronger.
To start with, long-term data series should be described on a log scale. This means that a proportional change is constant over time. Let's look at the Fed's monetary base.
This better demonstrates the recession response as well as QE II. It also makes clear that everything else is irrelevant.
The most crucial thing to understand is that the balance sheet does not represent "printing money." This happens when reserves are created for participating banks and they make additional loans. This has not been happening. Essentially, the Fed has stepped in to (temporarily) take up the slack in the money supply. Disciples of Milton Friedman know that the long-term money supply is aligned with nominal GDP growth, so money creation is important.
To emphasize: Printing money is necessary and appropriate -- at the right pace.
The question is whether the growth in M2 has been excessive. Here is the key chart. As you can see, the long-term growth looks pretty reasonable.
The Conference Board (and I suspect the ECRI) have dropped M2 from their indicator series since the modest result described above is apparently too bullish.
Conclusion
The Bianco analysis is another example of Wall Street Truthiness. Since so many are primed to hate the Fed, the ECB, and the entire concept of central banking, it is popular for many to rant on this every day.
The comparison of central bank holdings with equity markets is an egregious blunder. There is absolutely no reason to compare debt holdings with anything other than the debt market. I have frequently analyzed the Fed purchases of debt and shown these to be a modest fraction of the trading volume in Treasuries. Experts estimate the impact on yields to be modest.
When and if the time comes to unwind these positions, it will have little long-term effect on either bond or stock markets. I explained this in several past articles, but the most important is here.
This is an interesting choice for investors. Most of them cannot really grasp the money and banking aspects of money creation. It is a pretty tricky concept.
This makes it prime fodder for those who want to fool you by calling the balance sheet "printing money" when that is not correct.
There is so much mis-information and so little time.
I am now told by an investor that the GDP increase of 2.8% proves that the ECRI recession forecast is correct. Amazing! It takes very little for the confirmation bias effect to kick in.
[Note to readers -- sorry for the delay. As everyone knows, I always plan for the week ahead and I usually write about it. Sometimes I have a recreational weekend, so the writing is delayed. I did some covered writes on dividend stocks today, but that will not be a surprise for regular readers. I suspect that there will be more opportunities this week.]
In a sharp change from recent times, this week will be all about US economic data. With recession worries still prominent, each release will be subject to special scrutiny. This will be especially true of Friday's employment situation report.
There will be continuing earnings news, although we have passed the peak of the season. The Greek default story has legs. Despite the headline potential from these sources, I see signs that there is less focus on Europe, and more attention (worry?) about the US economy.
I'll have some further thoughts in the conclusion, but first, let us do our regular review of last week's news.
Last Week's Data
In last week's report I observed that there was a change in tone. We saw more of the same this week. In the absence of specific bad news from Europe, the market "wants to move higher." All of a sudden there is more attention paid to specific stock news, and a general upward trend. I'll consider this important development further in the conclusion.
The Good
There was some very good news this week.
GDP was up at an annualized rate of 2.8%. This looks really great. The best chart of this shows the components, and (no surprise) comes from Doug Short.
Initial jobless claims were only 375K, down 25K from two weeks ago.
The Fed ushered in a new era of transparency, revealing forecasts and promising low interest rates as far as the eye can see. Here is why this is good news.
Corporate earnings reports, widely thought to be too high, beat expectations at a rate of 59%.
The Bad
There was some bad economic news last week.
GDP was up at an annualized rate of 2.8%. This looks really great. The problem is that it is heavily dependent on an increase in inventories, not real buying. See my take on WSAS for one of the first discussions of this problem. Inventories play both ways. For a complete discussion you can't beat the analysis from Steven Hansen and Doug Short at GEI -- charts galore.
Initial jobless claims were 375K, up 25K from last week.
The Fed ushered in a new era of transparency, revealing forecasts and promising low interest rates as far as the eye can see. Here is why this is bad news.
Corporate earnings reports, widely thought to be too high, beat expectations at a rate of 59%. Unfortunately, advance guidance is weak. Check out the chart from Bespoke Investment Group:
The Ugly
There is always good news and bad news, but not always ugly news. As a fan of both the Brewers (NL) and the White Sox (AL), the ugly news for me was Brewer's slugger Prince Fielder going to White Sox rival Detroit. Drat it!
The Beautiful
We cannot always dwell on "the ugly." Sometimes there is noteworthy work. Let us call it "the beautiful." There was a lot of negative anticipation about the Conference Board's change in the Leading Economic Indicators. Some felt that the change would augur another recession. Regular readers already know how I feel about the constant changing of indicators to provide a better back-tested performance.
I am a big fan of Dwaine van Vuuren, whose excellent statistical work is giving us better insight into a wide range of recession forecasting methods. I am featuring the PowerStocks forecast each week, and I also want to recommend Dwaine's analysis of the new LEI method. Here is a key quote from the article:
Composite LEI's such as the e-forecasting.com eLEI, the Conference Board US-LEI, the OECD US-LEI and the ECRI Weekly Leading Index (WLI) are generally composed of a small set (no more than 10) of well selected leading economic indicators that as a composite are subjected to rigorous statistical and out-of-sample testing. You can see a perfect example of the rigors of such statistical selection in the white paper produced by the Conference Board on the construction of their new LEI. For that reason we lean toward the use of these composites for recession forecasting purposes rather than large sets of seemingly unrelated economic leading indicators cobbled together. There is the well-known saying that if you torture large arbitrary data series enough, they will tell you any story you wish them to.
The article does not name any alternative methods, but anyone following the debate can identify the culprits from the method cited.
Here at "A Dash" we look forward to continuing sophisticated quantitative research from this source.
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
Economic/Recession Indicators. This week continues two new measures for our table. The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain the link to the C-Score next week. The second is the Super Index. You can read more about it in this article, which is merely an introduction. It reflects extensive research and testing, and is well worth monitoring. (The Super Index includes the ECRI approach). I am going to do a complete review of the work very soon. Meanwhile, I think it is important enough to watch every week.
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.
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. We voted "Bullish" this week.
[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
There will be important earnings reports all week. Eventually that is what matters.
Competing with earnings news we have the data avalanche.
Tuesday is the warm-up with housing price data (Case-Shiller), the Chicago PMI (a hint at the ISM report), and consumer confidence.
Wednesday brings the ADP private employment estimate, which has moved markets and opinions in recent weeks, as well as the ISM manufacturing survey.
Thursday we get news on auto and truck sales, as well as the best coincident read on employment, initial jobless claims. Finally, we get a report on Q4 productivity.
Friday is the big day for employment news (payroll employment, the household survey, hours worked and hourly wages) as well as the ISM services index.
It is a quirk of the calendar that so many important reports hit in a single week.
The European story continues, of course, but the focus has been changing a bit.
Trading Time Frame
Our trading accounts have been 100% invested for several weeks. Felix caught the recent rally quite well, buying in on December 19th. There are now many solid sectors in the buy range. The overall ratings have improved, helping us to stay invested while many have been in denial for the entire rally. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated. Felix has been more confident than I have been on the trading time frame. This illustrates the importance of watching objective indicators.
Investor Time Frame
Long-term investors should continue to watch the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," and is declining further. This sort of decline has been a good time to buy stocks on past occasions. Worry is still high, but is declining.
Even though stock prices are higher than in October, the risks are much lower. I am increasing position size for risk-adjusted accounts. (We cut back by about 30%). I am also looking more aggressively for positions in new accounts.
Our Dynamic Asset Allocation model is still very conservative, featuring bonds and other defensive holdings. It is rather like the Nouriel Roubini of our methods. What if things go wrong? Investors should understand that cautious, hedge-oriented positions may be slow to rebound.
To summarize, we continue a conservative posture in most of our programs, recognizing the uncertainty and volatility, but we are becoming more aggressive. For new accounts we are establishing partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program. This program has been working very well, meeting the objectives of conservative, yield-oriented investors. It follows our key precept:
Take what the market is giving you.
Right now that continues to be dividend stocks at reasonable prices with the chance to sell call options at inflated prices. If the stocks do nothing, you can still get almost 10% per year from dividends and call premiums.
This does not work for those selling long-dated calls. It requires some active management, selling calls with a month or two before expiration to capture the most rapid time decay.
The Final Word
For starters, I hope some readers enjoyed my bit of whimsy in the good and the bad......
The continuing story is the disconnect between stocks and bonds. Scott Grannis has a good take with this chart:
He offers this explanation:
In my view, this disconnect reflects a buildup of tension in the market—something is likely to break pretty soon. Bond yields have been depressed because risk-averse investors have been seeking shelter from a potential Eurozone collapse that might trigger another global recession/depression/deflation. But equity prices have been rising because in the meantime, while the world waits for the Eurozone to implode (and we've been waiting for at least 18 months now), the U.S. economy continues to improve. Bonds are the doomsday trade, while equities are more realistic about what's happening right now.
I agree, and that is how I am trading and investing.
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