A Dash of Insight

Face-off! Mortgage Interest Rates

In "Face-off" my mission is identifying and writing about the best sources on a topic.  I seek out expertise and explain the arguments.  This is in sharp contrast to most others who purport to be experts on nearly everything.  By comparison, my claim is quite modest!

Background:  The Fed Ends Purchases of Mortgage Securities

After the fall of Lehman the market for mortgage securities evaporated.  Much to the surprise (and dismay?) of the bearish punditry, the Fed stepped into the gap.  It was pretty obvious that there was a temporary need to support mortgage lending.

This set up a debate.  Was the Fed merely delaying the inevitable or was it sound public policy?

Since housing is crucial to the economic recovery, this is an important issue.  Since the home buyer's tax credit is also ending, the threat to housing is even greater.

The Protagonists

Readers should understand that the protagonists in "Face-off" do not know that they are participants.  They have not seen the commentary of their putative opponent.  This is a device for making stark contrasts in opposing viewpoints about issues.  Anyone who is cited is most welcome to join in the discussion.  I guarantee a complete opportunity for rebuttal.  In fact, that would be helpful to everyone.

The Pessimist

Mortgage specialist Barry Habib, in this April 5th commentary featured by John Mauldin (and the bearish blogging network) raises a number of key points:

• The Fed has $1.25 trillion in mortgage securities.  If these were $100 bills, the stack would be 850 miles high.
• Fed purchases pushed down rates, perhaps by 0.5%.
• It is all part of a carry trade.

Check out the full article, but the basic theme is that it will all end badly.  The conclusion from the article refers to the movie Dumb and Dumber.

The Optimist

Brian Wesbury and Robert Stein of First Trust have been aggressively bullish on the economy and the stock market.  Anyone with this perspective should be worried about the withdrawal of stimulus and other government programs.

Here is their take on the end of the Fed purchases:

• The Fed will not be buying, but it is not going to "dump" existing positions.
• A calculation of net new borrowing (new purchases minus debt retirement) shows only a need for $15o billion or so  -- nowhere close to the bearish number.
• Housing prices and the labor market are coming around.

Check out the entire analysis here.

Conclusion

Our initial take was an advantage to Brian Wesbury, mostly because it was the careful marginal impact analysis that we favor.

There is now more information, enough for a "round one" verdict.

Bespoke Investment Group has been tracking mortgage rates since the end of the Fed purchases.  In stark contrast to the predictions of disaster, the market has shown significant interest in this debt.

Readers should check out the full article for the typically excellent analysis from Bespoke.

There is another positive sign, the possible resumption of securitized jumbo mortgages.  The inability to get mortgages for expensive homes has paralyzed potential buyers in that market.  With the cap on government lending, these borrowers need a private market.

Securitization of mortgages now has a bad name, of course.  My view is that it was a good idea, but was poorly implemented.  There are many investors who would now happily embrace sound mortgage securities supported by those with good credit scores buying expensive homes.

To summarize, the early round in the mortgage debate goes to the bulls.  Needless to say, we should all watch very carefully.

Will the Democrats Lose Control of the House?

Important new policy initiatives are in the news every day.  Politics is often a story on the business pages and is relevant for investors.  Some of the Obama initiatives are already in place, but there are many issues still in play.

The Bespoke Investment Group, one of our featured sources, has highlighted the possibility that the GOP will take control of the House in the off-year elections.  They cite Intrade.com which maintains a prediction market on an interesting array of issues.  The Bespoke team noted that the GOP is now a slight favorite in the market.  Here is today's chart:

Background

How should the investor follow political news?  Here are a few suggestions.

1. Do not allow your political opinions to interfere with sound investment decisions.  Join me in being politically agnostic -- willing to make money no matter who is in power.  Remember that the stock market has done very well (or poorly) with various combinations of partisan control .  This is the most important rule.
2. View election news as a backdrop.  A change in partisan control of the House or the Senate is relevant, but not determinative.  It will dictate the nature of future compromises.
3. Analysis of specific legislation is most important.  This is done rather casually by most.  We cover the link between politics and stocks at our sister site, Election Stocks.  The site is a great source of both continuing and emerging themes in policy decisions, with a specific emphasis on investment effects.

Focus on the House

Today I want to focus on the prospects for a change in control of the House of Representatives.  The GOP needs a pickup of 40 seats to take control.  There is often a rebound by the party out of power during the off-year elections, those with no Presidential coattails.  The basic concept is that Presidential voting brings out party loyalists who vote a straight ticket.  This does not mean that all are loyalists, only that it has a marginal effect.

One of the reasons that prediction markets work so well is that the investors in those markets do research and collect information.  The watcher of the market gets the benefit of their research without doing any work.

As a former Political Science/Public Policy prof I like to do my own analysis.  Here are some of the sources I watch.

• Larry J. Sabato's Crystal Ball.  This is a bottoms-up analysis that forecasts a GOP gain of 27.  This approach has been very accurate in past elections.  The forecast has not been updated for nearly two months.
• Prof. Alan Abramowitz of Emory has had the most accurate model in recent years. He sees a GOP gain of 37 seats, but has a "structural minimum" of 20, based on factors already in place.
• Prof. Alfred G. Cuzan, Poli Sci Chair at the University of Western Florida, has a nice model forecasting Presidential approval ratings from various factors.  His conclusion is that the Obama ratings will continue to decline throughout the year -- and this is assuming unemployment falling to 7.7%!  The significance of this work is that Presidential approval is an important input in the Abramowitz model.
• The 538 does a nice review of the academic literature, emphasizing that the Democratic downside might be greater than expected, and adding more statistical work.

Here is the key chart from the Cuzan analysis, forecasting the Obama approval ratings.

Conclusion

It is easy to see why the prediction markets are swinging GOP.  If the Democrats want to maintain House control, they had better hope for a dramatic improvement in the economy and the President's approval ratings.

GOP control does not mean repeal of the Obama agenda, but it would certainly force more compromise on key upcoming issues.  Many observers see this change as generally bullish for the market.  I see it as more relevant on an issue-by-issue basis.

Predictions versus Forecasts

A favorite pastime of market pundits is making sport of those who do forecasting, especially if models are involved.  I am continually amazed at the delight people take in criticizing things where they have no information.  The ongoing mission at "A Dash" is to discover and exploit such errors.

Background Example

Let us suppose that we have a city in an earthquake zone.  There is a fault line.  Our job is to predict something mundane, like revenue over a toll bridge.  We may use various factors to predict traffic and revenue as the basis for the forecast.  Meanwhile, we all know that there is earthquake potential.  If and when the earthquake comes, the revenue forecast will be seriously wrong.

So we could make a prediction:  There will be an earthquake in the next ten years.

Or we can make a forecast:  Here is the expected bridge traffic next year.

Please note that the forecaster is usually correct by ignoring the earthquake.  If he decides to include it, he can be wrong in one of two ways:

• He can deduct something from each year's forecast, making them all incorrect by 10% or so; or
• He can guess the year of the quake. He will be correct one year in ten and wrong in the other years.

Let me consider how people mistakenly confuse the two approaches in analyzing the stock market.

A Conversation with George

(This is a composite conversation with real people, but not a specific one.  It is accurate, in that it reflects the feelings of many, but it is not an actual dialog.)

I got a call from George, an intelligent market observer who reads a lot.

G:  What do you think about the market?  I am getting worried after the big move.

J:  Are you all-in?

G:  Are you kidding?  I am not in at all.  I just heard a prediction that the S&P 500 is going to 400.

J:  Who said that?

G:  Someone with a system.  He said to ignore predicted earnings because analysts are biased.  He uses only actual known earnings.  Everything else is a lie.  His history went back to the time of Paul Revere or something -- great research.  He also pointed out that we had to use a "trough multiple" -- or -- just a second -- that was what we used last year.  Now we should use the peak multiple, but they are actually both the same.  You multiply $50 in S&P earnings by 8, and that is what the market should be.  Do you know what the P/E ratio was in 1840?

J:  Uh.....no.  May we return to the 21st century?

G:  I thought you were a scholar.  But OK.

J:  It has taken 18 months to regain the pre-Lehman levels.  The selling in late '08 and early '09 were predictions of another depression and a total failure of the Obama Administration.  It has taken this long to return to a semblance of sanity.

G:  So what?  There is always a correction after a big move.  We are going lower.  Much, much lower.

J:  Markets do not go straight up, but we are just getting back to a starting point, something that I described as an "initial target" at the start of 2009.  Nearly every indicator, except employment, is better than it was then.  Markets are about earnings, and earnings are showing great strength.

G:  I think that the market will move sideways for many years -- or maybe sell off.

J:  Why?

G:  The economy cannot  grow without the consumer.  I read that consumers are 70% of the economy and that they are tapped out, spent up, unemployed, and leveraged to the hilt.  the market is going nowhere without the consumer.

J:  The mainstream economic forecasts.....

G:  Forecasts!  Don't give me that!  Those economists know nothing!  They know nothing!  They did not see it coming. They use models.  That is just fantasyland.  Everyone knows that models have built-in error.  Economists know nothing.  Obama knows nothing.  Congress knows less than nothing.  These are the guys who got us into trouble and I am not going to believe them.

J:  OK.  Let us put aside the political and methodological rant.

G:  It is just the truth.  We will be lucky to stay sideways in this market.  I have actually been checking out the price of farmland.

J:  How is your ammo?

G:  Locked and loaded.

J:  Returning to the market, you just told me what you expect.  How did you arrive at those conclusions?

G:  I read some great sources, including many who predicted the crash.  They explain that the forecasters are all wrong.  None of the models worked.  The guys I read all saw it coming.

J:  Did any of them change their opinions at any point?  After the fall of Lehman?  After the government policy actions?  After improving economic data?

G:  Change?  No way!!  They got it right.  Lehman and that other stuff made no difference.

...........

The Dilemma

As an investment advisor, how do you help someone with this mind set?   There are several very fundamental problems.  Let me take them one at a time.

Predictions are often very general and completely ignore the time frame.  We started seeing recession forecasts in 2004 or so.  Keeping in mind that a recession happens (on average) every five years, what should be the shelf life for these predictions?  Those who grew impatient started arguing their own definitions for what constituted a recession.

Predictions involve modeling.  The difference is that for many people the models are poorly specified, based on little information, and cannot be tested.  Consider George's assertions.  He actually made a commonly-accepted statement that has hidden modeling and assumptions.

• Economy and the consumer.  Those who cite the 70% statistic do some while ignoring a long list of assumptions.  Most consumer spending holds up even in recession.  Not everyone is affected, and even those who are have various means of support.  There are also new population entrants.  Finally, there are times when business takes the lead, and we might be in such a cycle.
• Economy and the stock market.  Those who point to economic concerns think that the market is a GDP future.  This is quite clearly not correct.  Many companies can and do thrive even in adverse economic circumstances.

My point is not that the predictions from George's pundits will be wrong.  The point is that the reasoning is very sloppy.

Anyone making a prediction is using a model!

Those who make predictions while criticizing modelers simply lack the requisite training.  A professional modeler identifies risks and possible error.  Every modeler understands that the result is a simplification of reality.  Good modelers test results against reality and suggest error ranges.

Compare this highly professional approach with the "laundry list" method of many pundits who have no formal training in models.  They cite lists of "headwinds" and make predictions without time frames.  Those who rail against models and the "folly of forecasting" while still making predictions are still doing modeling, but doing it very poorly.

There will be an earthquake some day.....

Investment Conclusion

Investors should be paying attention to the analysis of the causes of the financial crisis.  There is a complex story including many factors.  Understanding what happened could be important to making the right investment choices.

So how should I explain this to George, whose mind is made up?

ETF Update: The Risk and Reward for Gold

There is always a lively debate about gold, whether one is a trader or an investor.  This week there is disagreement between our two trading models, Felix and Oscar.  Both models see potential reward, but the risk is too great for Felix.

Background

Traders all seek rewards but they have differing appetites for risk.  It is important to find a method that suits your personality and needs.  Our trading systems are basically Trend-following, but also include recognition of Cycles and a touch of Anticipation.  The system reviews a universe of over 270 ETF's.  We have a smaller trading universe, The NewArc 55, chosen for trading properties.  We follow two versions of this method, designed for two clients with different needs.

• Oscar believes in the long-term strength of the economy and the stock market.  He has a lovable and irrepressible enthusiasm.  When things go wrong, he steps back for a bit, but soon tries again.  He expects to do better than others during good times.  Oscar understands that this approach involves more risk.  Oscar is opportunistic.

• Felix also has a positive long-term outlook, but he is something of a fussbudget.  He is much more cautious, with an emphasis on capital preservation.  He is perfectly willing to step aside from the market when there are signs of danger.  He knows that he will miss some moves, but that is OK.  He scores big gains when the market moves lower and he escapes the loss.

There is more detail in this article.  We also have free reports, available upon request to etf at newarc dot com.  These reports describe how we use the system, compare results from Oscar and Felix, and contrast the method with our long-term trading approach.

Gold Mining Stocks

We trade gold mining stocks via the Van Eck Gold Miners ETF (GDX).  I am not going to review the specific ETF characteristics today, since we have already discussed GDX extensively in the following articles:

• Focus on the "fear trade" and inflation, July 2008
• Gold as a trade during the TARP debate, September 2008
• More on the "fear trade" when the market was diving in February 2009
• A look at GDX and alternatives in a range-bound market, September 2009

Today I want to focus on why Oscar and Felix might see this situation differently.  Let us start with the chart.

I added a few common technical indicators for general interest.  In response to some questions, I have suggested that Oscar and Felix are not black box models.  We know and discuss the basic approach and elements.  Humans make the final trading decisions.  Since the exact calculations are proprietary, we might call this a "gray box."

Both models assign solid ratings to GDX and the sector rose rapidly in the ranks during the last week, something you can see in the table below.  A sector can go into the Penalty Box for several reasons, including but not limited to the following:

• A large spike in volume
• A very wide trading range in a single day
• What Vince calls a "whoosh" (gotta love this scientific talk) indicating an unusual move

Essentially, we have studied conditions where our predictive methods are not as accurate.  By putting sectors in the Penalty Box when the future is murky, we try to stay in our trading sweet spot.

In the case of GDX, Felix flagged it to the PB on April 7, coinciding with a big move, extra volume, and moving past the top Bollinger band.  I do not know which specific element was the reason.  Once in the PB, it takes a few days before the sector is eligible to come out.

The key to doing this is careful research and good measurement of relevant indicators.  The rules are chosen to fit our method, but any trader could benefit by following the same process.

Other Viewpoints

We are always interested in the opinions of those in the ETF expert community.  There are some interesting comments on GDX.

ETFdb explains how GDX is attractive to investors who are worried about the possibility of simultaneous inflation and deflation.

Prieur du Plessis likes GDX for technical reasons, not unlike ours.

24/7 Wall St. argues that "gold needs a breather" and there will be better entry prices.

ETF Daily News sees a continuing strong uptrend.

According to the WSJ, some believe that Friday's weakness in gold was related to John Paulson's large holdings and his role in the SEC action against Goldman Sachs.

Weekly TCA-ETF Rankings

We are currently only 16% invested in our ETF programs.  We are happy to report and discuss performance with interested investors.  We also offer a report on how we use the models, and a weekly email update.  (Write to etf at newarc dot com).  Our actual trading is a combination of both models and some weekly timing.

For the moment we are publishing the ratings list as of Thursday's close in our weekend update, a one-day delay.  We are not recommending these sectors, since investor needs and risk tolerance varies.  We hope everyone finds the ratings to be a useful supplement to their own work.

Here are the current rankings for both Oscar and Felix.

Bonus Coverage

Vince did some interesting testing.  He checked out his findings using groups of stocks and time periods totally unrelated to the development of the model.  This is a very professional approach -- and a very unusual one.

He tells me that we can expect Felix to provide excellent ratings for individual stocks -- not just sectors.  We have decided to share the top pick in the Dow and the top pick in the NASDAQ 100.  These are three-week forecasts.  For the moment I am not going to do any further analysis, but I will post the top pick each week.  At some point I will do a recap.

DJIA:  Boeing (BA) was a small loser, but continues as the top pick.  Nearly all DJIA stocks are in the PB.

NASDAQ 100:  eBay (EBAY)  Most of the 100 are in the PB. EBAY has a rating of 39.  GRMN was a small loser last week, despite the extraordinary $1.50 dividend.

Weighing the Week Ahead: Skip the Sideshow

My "Week Ahead" series is all about focus.  There is so much information, so much data, and so much to read.  There is also temptation -- the challenge for next week.

An interesting feature of the American democracy, perhaps better understood by my foreign readers than by those in the USA, is the willingness to opine on nearly any subject.  It is difficult to write something that makes sense 175 years later, especially on a subject like political culture.  For this reason, political science students still read Alexis de Toqueville: 

In the United States, the majority undertakes to supply a multitude of ready-made opinions for the use of individuals, who are thus relieved from the necessity of forming opinions of their own.

In my classes I gave it a modern twist.  Voters did not want to learn about and discuss the intricacies of policy issues.  In those days (about 35 years ago) the big issues were war, the economy, nuclear weapons, the trade deficit, the looming shortage of energy, pollution, and the shortage of doctors.  If the list seems familiar, you might look for a lesson there!

Voters were hopelessly ill-informed about any of these subjects.  What moved them to action?  There was nothing like a good sex scandal!  Powerful members of Congress lost power not because of any policy decisions, but because they hired secretaries who could not type.  Presidential candidates, otherwise qualified, should not be caught misbehaving, especially on private yachts called "Monkey Business."

This is another eternal truth.  Just look at the top ten Google searches or the most popular websites -- all gossip, all the time.

Everyone is focused on the sideshow rather than the main event.  It has all of the key attributes:

• Anyone can play -- no advance training required.
• There are clear heroes and villains.
• There is plenty of room for speculation and guessing about motives.
• Politics!
• Conspiracy!
• It is much easier to understand than stock valuation.

Background on "Weighing the Week Ahead"

There are many good services that do a complete list of every event for the upcoming week, so that is not my mission.  Instead, I try to single out what will be most important in the coming week.  If I am correct, my theme for the week is what 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.  So far, my focus has been pretty good.  Last week my emphasis on earnings was correct until nearly mid-day on Friday (heh heh).

Reviewing Last Week

The news last week was pretty good.

The Good

• Intel earnings were great!  Forrester Research says that the tech downturn is over.  This is yet another piece of support for my 2010 forecast of a Windows 7 upgrade cycle.
• Barron's  articles cite (two articles, check both) a Windows 7 upgrade cycle!
• David Rosenberg says not to worry about Fed rate increases.  He emphasizes the policy relevance of core CPI -- recommended reading for those trying to school the Fed on inflation. (Rosenberg is worried about deflation).
• Building permits were excellent.  I like this indicator better than some of the other housing data.  Permits are costly and involve a real commitment.
• Interest rates moved lower.
• Brian Wesbury, one of the most bullish economists on the rebound, summarizes data with the conclusion that there is plenty of time for investors to profit.  He is no fan of the Obama Administration policies, so his forecast includes this a discount for this popular bearish "headwind."

The Bad

• Initial jobless claims were bearish (484K instead of the expected 425K).  This is a continuing negative indicator for employment prospects, since we need to reduce job losses.
• Consumer sentiment remains weak.  The University of Michigan consumer sentiment series is important because it is a way of capturing new job creation and the overall picture.  It dropped to 69.5 from 73.6 last month.
• The negative data came in the survey week for the monthly jobs report -- a bad sign.
• Some earnings reports did not match elevated expectations (Google).  I still see earnings as very positive on balance, but it is early in the season.  We need data, not a few anecdotes.

The Ugly

Friday's sharp selling wiped out the gains for the week.  The financial stocks took the brunt of the hit, although materials sectors and some commodities were also hit.

Breaking news always has a bigger effect on the day of options expiration, and this was no exception.

The news is surely important to the analysis of the causes of the financial crisis and to further policy formation.  It will be a subject of discussion for many months.

Our Trading Forecast

Our own indicators present an unusual picture.  We switched to neutral for our vote in the weekly Ticker Sense Blogger Sentiment Poll. Here is what we see:

• 95% (93% last week) of our ETF's have positive ratings.  This is very strong.
• The median strength is +30 (down from +41 last week).
• 99%  (up from 92%) of the sectors are in the "penalty box," showing a continued high level of uncertainty and risk.
• Our Index Package now has a solid, positive rating, consistent with a gain in the market over the next three weeks.

Investment Implications

For short-term traders the picture is neutral.  Our "penalty box" concept has a useful meaning.  It is a recognition that there is a lot of uncertainty.  We have little confidence in a prediction for the next three weeks, so we have moved to "neutral."

For investors with a longer time horizon it is a different story.  The earnings prognosis has improved dramatically.  Short-term fluctuations may create an entry point.

Here is sound analysis from Charles Lieberman:

Analyst estimates of earnings have been consistently too low, but if the S&P 500 earns around $80 in 2010, as predicted, then the current price earnings multiple for the index is just 15, dramatically below normal for a period associated with low interest rates and low inflation. Companies are estimated to be sitting on more than $1 trillion in cash. A larger fraction of total market value is made up of cash than ever before. As companies put some of that cash to work, they will raise dividends, invest in themselves, buy back shares, or try to buyout their competitors. M&A activity has already picked up quite noticeably. Companies would hold their cash if they thought the stock prices of their competitors were too high.

The market rally off the lows has garnered very little respect. The dramatic decline in stock prices in 2008 reflected the prospect of a meltdown of the financial system and the economy. There was panic. So the simple fact that the system didn't disintegrate justified a sharp recovery in prices. Even now, stocks have room for yet more gains.

The improving earnings story is more important than the sideshow.  The housing data at week's end will be interesting, but it is still all about earnings.

Long Intel (INTC)

Excuses for Sitting Out the Rally: Lack of Trading Volume

This article is about the continuing market rally and why many are sitting it out.  I want to discuss trading volume, but let me first emphasize another costly distraction for the individual investor.

In my preview for this week I pointed out that backward-looking valuation models were not helpful last year, nor will they be helpful in the near future.  I made the mistake of not sufficiently highlighting one of my best articles from last year, where I explained how a fixation on the valuation argument would be costly for the individual investor.  You can read it here.  It covered all of the key questions, and it did so at exactly the time that would be most helpful for investors.  Please read the comments as well, since the questions helped to spell out the story.

Is it now too late?  Most people find it difficult to "chase" stocks that have made significant rallies.  Think about this.  The four-quarter forward earnings for the S&P 500 are now about $85 and the calendar year 2011 earnings are at $91 or so.  If these estimates are accurate, even a conservative P/E multiple suggests that there is plenty of room to run.  Or you could look deeply into the past......

Part of the reason that I quit writing about valuation -- and praised the Doug Kass approach last year -- is that there were so many strongly-held opinions about overall market valuation and earnings.  People were locked into bad ideas.  It as time to get out of that box.

I suggested thinking in terms of individual stocks.  I currently have a long list of winners that still look cheap on projected earnings, and also many challengers on my watch list.  When I see so many choices, the market is cheap.

The Volume Issue

There is a conspiracy theory about volume, that the low-volume rally implies some kind of market manipulation.  As regular readers know, I regard conspiracy theories as uninformed, naive, and mistaken.  Among Internet readers, most seem to think that these fringe sources have some kind of inside look.  This provides an excellent opportunity to the much smaller readership here at "A Dash"!

Trying to summarize after a rather unhelpful discussion at RealMoney, Jim Cramer notes that several traditional indicators do not seem to have worked well in the last year.  He wrote as follows:

We have had a rally since March of last year that seems totally unverified by volume. That means, to me, that volume just isn't useful right here, right now. That's no sin; lots of the important indicators of my career have been thwarted by this market. Last year the overbought/oversold oscillator didn't work at all -- the market went oversold and stayed oversold for weeks. If you bought in, you were crushed.

Brett Steenbarger, analyzing market moves and volume,  has a typically level-headed, trader's assessment:

The result is a relatively low volume drift upward. I do not necessarily see this as a sign of complacency or as a sign of an imminent market downturn. Rather, I suspect that U.S. stocks are not seeing major capital flows, as traders and investors perceive greater global, macroeconomic opportunity elsewhere: in the perceived safety of high yields and the growth stories of emerging markets.

Some Little-Known Information

Somewhat to my surprise, there is little understanding or information about the impact of high-frequency algorithmic trading.  I do not mean the conspiracy stuff; I mean what these companies really do.  My information comes from well-placed sources, familiar with the trading methods, the personnel, and the actual programs.  Here are a few facts:

• For starters, most people do not know the names of the companies.  They want to fly low.
• Their trades make up over 70% of total volume, up from 30% a few years ago.
• They have an exceptionally high proportion of winning trades, usually small trades in an inside market.
• Their profits come from exceptionally small discrepancies in various markets, and moving swiftly to take advantage.
• They can make money through rebates even when scratching a trade.  These are liquidity providers.
• They are more active on down days than up days.  Why?  There are more price discrepancies and therefore more opportunities to arbitrage.
  
• The net effect of HFT is to reduce volatility by adding liquidity.

Conclusions

For the average trader there are three obvious conclusions:

1. The volume data is no longer meaningful;
2. There is a reason why volume is higher on down days;
3. The price is what it is.  These firms are not moving prices, but rather reducing volatility.

No firm is bigger than the market.  If there is a great opportunity to adjust asset allocation by selling stocks and buying something else, someone will do it.

Anyone who suggests otherwise is leading you astray.

Recession Dating: What the Investor Needs to Know

Today the private National Bureau of Economic Research (NBER) revealed that it was unwilling to call the end of the recession.

Does this have any relevance for investors?  No.

Why the NBER Seems Out of Touch

There is a clear distinction between what we all see in the world around us and the NBER dating system.  Let us make this explicit.

Most of us go by "feel" augmented with a few selected data points.  There is a trend line for economic potential.  It implies relatively low unemployment, solid GDP growth, good corporate earnings, and (sometimes) budget surpluses for government.  The current recession started to "feel" bad before the NBER declared the start.  It still feels bad even though things have bounced a bit. We all know that the employment and housing situations are terrible and that the economy is far from a real recovery.

One popular conclusion is that the leading economists on the committee are a bunch of clueless bozos.  This approach was especially popular a few years ago when CNBC was asking anyone and everyone if they thought that "we were in a recession."

Let's make this as simple as possible.  The NBER is attempting to identify peaks and troughs in the economic cycle for research purposes.  To emphasize:

• It is designed to facilitate economic research;
• The starts and endings of recessions are peaks and troughs in the economic cycle;
• None of the analysis is related to a comparison with the economic potential.

Briefly put, the NBER has a research mission, not a policy mission.  Mark Thoma does a nice job in making this distinction and raising the question of whether the NBER should attempt more timely calls.

NBER Dating

The NBER method is important because everyone uses it to analyze past recessions.  Even those who disagreed with the NBER on the timing for the start of the recession now use that date in their analysis.  It is worth a closer look.

In April of 2008 I wrote an article explaining the process and suggesting that you could probably win a contest about the start of the recession by predicting October or November of 2007.  I missed by a month.  Check out my handicapping of the entrants.

The key to the NBER method is that they need to see a really significant move in several indicators.  While it is an over-simplification, I like to think of this process as involving a "confirming event."

The 2001 recession was eventually dated as starting in March.  The confirming event was 9/11.  If 9/11 had not occurred, there might have been an economic bounce that would have "canceled" the March peak and established a different peak.  Here is what the NBER said:

Q: The NBER has dated the beginning of the recession in March 2001. Does this mean that the attacks of September 11 did not have a role in causing the recession?

A. No. Before the attacks, it is possible that the decline in the economy would have been too mild to qualify as a recession. The attacks clearly deepened the contraction and may have been an important factor in turning the episode into a recession.

I would like to emphasize a metric that I believe to be novel:  The time between the economic peak and the "confirming event."

Think about this for a moment.  If the attacks had come sooner (or later) the timing of the recession confirmation would have been different.  This is important because the confirmation date is generally the start of the government reaction.

This has direct implications for the current recession.  The key date is not the official NBER date.  It is the date of the confirming event.  The collapse of Lehman created the complete cessation of normal lending, the firing of workers, the canceling of expansion plans, and the end of mortgage securitization.

Thinking about Timing

While it is difficult to understand -- we are all blinded by hindsight -- the Lehman failure changed everything.  I realize that it is very difficult to grasp a counter-factual world, one where the crisis was handled better.

Instead let me suggest this minor challenge.  If Bear had failed instead of Lehman, the recession would have been confirmed in March instead of September.  Policy actions would have started sooner and the trough would be sooner.  The recession would be shorter.

If Lehman had been "saved" the confirming event would have been delayed.  For how long I do not know, but the Lehman timing could not have been worse.  It happened at the end of a lame-duck administration.  Even when legislation passed, the key decisions were on hold for months during a Presidential transition.  There was further delay as the Obama team fumbled the ball on key appointments and policy decisions.

My point?  The change a few weeks in timing -- either way -- could have made a big difference.

Investor Implications

The biggest lesson for investors is to ignore all of the charts about how this recession compares to those of the past.  There are not enough examples for inference.  More importantly, the timing before the confirming event has too much variation.

My own approach is to start the shot clock from the time of the confirming event, the fall of Lehman. Here is a nice chart from Calculated Risk.  It shows the recessions centered on the trough.

You will have an investing edge if you think of the recovery in terms of time from the bottom, rather than time from the start.

Here are links to my prior articles where I talked about timing the start of the recession in April of 2008 and the speculation about the end of the recession in September, 2009.

ETF Update: The Appeal of Metals and Mining

I have a strong and interesting sector to write about this week.  That usually makes my job easy, but this week there is a problem.

Because of the tragedy in West Virginia, the worst mine disaster since 1972, we are all acutely aware of the real costs of mining.  The company involved represents about 3.5% of the ETF in our spotlight this week.  Many of the other companies have operations that do not involve the same mining approach, risks, or safety issues.

I am not going to sit in judgment on this.  I am just going to report.  Since the ETF update is intended as news information -- a part of your own review -- you can use the information as you see fit.  Those who choose to avoid the sector, just as others eschew tobacco, alcohol or defense stocks, should feel free to act in accordance with principle.

With that in mind, let us turn to this week's sector spotlight.  For the first time, I am also including a specific stock bonus.

Spotlight on Metals and Mining

We trade the general mining group via the SPDR S&P Metals and Mining ETF (XME).  The ETF has 27 holdings with a roughly equal weighting of 3.5 - 4.5%.  The P/E is nearly 30 on a backward basis and nearly 20 looking forward.  The price-to-cash flow is under 11.  The yield is under 1%.

Short-term traders (like us) are playing on the basis of technical analysis, while longer-term investors must expect a big move in the underlying metals.

Here is the chart:

We have two distinctly different approaches to sector rotation.  For ease of reference, we call them Oscar and Felix.  (This article provides an explanation of the basic difference in approach.  Readers who wish to learn more can write to us at etf at newarc dot com for more detail and an explanation of our approach. )

Felix really likes this chart, while Oscar's rating is lower.  Some readers have asked us to explain the different approaches.  As we see more cases I'll try to do this in coming weeks.  For the moment, let me offer the following points:

• Felix avoids a lot of risk through extra caution.  The draw downs are much lower.
• Felix likes a solid, steady gain with significant volume.
• Felix is slower to get back into a sector, but looks for early signals of potential losses.

Other ETF Experts

Each week I consider what other ETF experts have to say about our featured sector.  There is an interesting but mixed message this week.

• Bespoke Investment Group, a favorite source for me (and nearly everyone else) includes XME on a list of overbought ETFs.  My friends at Think B.I.G. know that "overbought" is a tricky concept.  The sectors can sell off, but they can also move much higher.  One of our objectives is to diagnose danger in these charts via the Penalty Box approach.
• ETF Daily News mentions the sector in the group benefiting from rising commodity prices.
• Tom Lydon reviews the first quarter winners and includes XME among his picks for Q2.

Weekly TCA-ETF Rankings

We are currently fully invested in ETF programs.  We are happy to report and discuss performance with interested investors.  We also offer a report on how we use the models.  (Write to etf at newarc dot com).  Our actually trading is a combination of both models and some weekly timing.

For the moment we are publishing the ratings list as of Thursday's close in our weekend update, a one-day delay.  We are not recommending these sectors, since investor needs and risk tolerance varies.  We hope everyone finds the ratings to be a useful supplement to their own work.

Here are the current rankings for both Oscar and Felix.

Bonus Coverage

Vince did some interesting testing.  He checked out his findings using groups of stocks and time periods totally unrelated to the development of the model.  This is a very professional approach -- and a very unusual one.

He tells me that we can expect Felix to provide excellent ratings for individual stocks -- not just sectors.  We have decided to share the top pick in the Dow and the top pick in the NASDAQ 100.  These are three-week forecasts.  For the moment I am not going to do any further analysis.

DJIA:  Boeing (BA).  Nearly all stocks are in the PB.

NASDAQ 100:  Garmin (GRMN).  Most of the 100 are in the PB.  GRMN is rated 104.

Weighing the Week Ahead: Time for Earnings

Most of the investment world will focus on earnings next week. That will drive the markets.  For others, the earnings story is utterly irrelevant since there is too much to  worry about.  It is a sharp contrast.

Background on "Weighing the Week Ahead"

There are many good services that do a complete list of every event for the upcoming week, so that is not my mission.  Instead, I try to single out what will be most important in the coming week.  If I am correct, my theme for the week is what 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.  So far, my focus has been pretty good, including last week's Fed Fixation piece.

What about Earnings?

When it comes to earnings, the investment world is sharply divided.  There is a great divide about earnings and market valuation.  Over a year ago, right at the market bottom, I wrote an article reviewing the various approaches to valuation and explaining why they would be no help.  You needed to step away from backward-looking methods.

A Small (but humorous) Digression

The earnings debate reminded me of an article from decades ago.  One of my favorite sportswriters, Pete Axthelm, wrote for the New York Herald Tribune and Sports Illustrated.  He brought sports to the masses through Newsweek and also wrote some highly-regarded books.  Last year he was inducted into the US Basketball Writers Hall of Fame.  He died, far too soon, at age 47 in 1991.

In the days before computers, one of Pete's columns reviewed a system for betting on NFL games.  It was a betting wheel, with cardboard overlays and windows.  You lined up one wheel for the point spread, another for the difference in team winning percentage, and a third for.....well, you get the idea.  Then you looked at the "result" window and it said either "Bet" or "No Bet."  Pete's review tried all of the games for that week and he kept getting "No Bet" as the answer.  That was probably good advice, but it was frustrating for a man of action.  He also was the handicapping expert on some of the networks.  His conclusion was that the device must have been put out by Gambler's Anonymous!

We can now see that this was one of the first examples of multi-variate data mining, a precursor to modern predictive methods in sports and the markets.

The Modern Equivalent

What brought this to mind was the many reminders about how over-valued stocks are if you look at trailing earnings.  You can see the Shiller PE ratio in many places, but I favor this chart.

You can see that this approach will make sure that you get a chance to buy stocks every thirty years or so.  The author of the article suggests that forward earnings are "notoriously unreliable."  True enough.  When Pete tried to pick next week's football games he was only about 50-50.  Even a small edge made a lot of money, but you would have to call the forecasts "unreliable."

Meanwhile, the scores of last week's games are available in the newspaper.  Unfortunately, the betting window is closed.

For those participating in the stock market, the earnings season will be important.  For those who are convinced that stocks are overvalued because of write-downs in 2008, you can wait a long time for those earnings to roll out of the ten-year window.

Reviewing Last Week

The news last week was pretty good.

The Good

• The Fed minutes were good.  It is obvious that the various policy accommodations will be removed very slowly, with special attention to economic weakness.  The Fed is not worried about inflation.  There is a little dissent, but nothing to indicate a policy shift.
• The general economic data is beginning to show a pattern.  The ebullient Larry Kudlow sees a lot of "V's" in the data.  Even the curmudgeonly Floyd Norris is noticing the signs of improvement.
• For a level-headed summary of what has been happening, check out the viewpoints from Liz Ann Sonders, Chief Investment Strategist for Schwab.  She carefully parses indicators from many sectors.

The Bad

• The job picture is still terrible.  The BLS JOLTS report shows no improvement in job openings relative to job applicants.
• Long-term rates are edging higher.  Despite some great bond auctions, with strong demand, the rates at the long end of the curve are moving higher.  I am putting this in the "bad" category, since higher rates compete with stocks and imply more costly financing.  At some point, extremely low rates imply deflation concerns, so a return to normal might not be so bad.
• Mortgage rates are edging higher.  The jury is still out on whether this is a part of the general move or linked to the end of the Fed's purchase of mortgage securities.  It bears watching, given the implication of higher rates for the housing market.

The Irrelevant

Dow 11,000?  Who cares about the round number?  What is interesting is that market averages are now approaching pre-Lehman levels.  It might be worth thinking about whether things are more promising now than they were in September of 2008.  Here is an interesting list from Damien Hoffman.

Our Trading Forecast

Our own indicators remain bullish, and that was our vote in the weekly Ticker Sense Blogger Sentiment Poll. Here is what we see:

• 93% (87% last week) of our ETF's have positive ratings.  This is very strong.
• The median strength is +41 (up from +31 last week).
• 92%  (up dramatically from 69%) of the sectors are in the "penalty box," showing a continued high level of uncertainty and risk.
• Our Index Package now has a solid, positive rating, consistent with a gain in the market over the next three weeks.

Investment Implications

Despite the year-long market gains, most people are not really participating.  The 2008 shock may be costly for a generation of investors, as well as the boomer types who need to retire.  The Pragmatic Capitalist captures the sentiment graphically, but read the entire article.

 

For a scorecard on what to watch for in earnings, Matt Phillips has a great story.

And finally, Prof. Shiller is much more modest in his claims than his strident followers.  I suggest that disciples watch this interview with Henry Blodget in its entirety.  Pay special attention to the following points:

• The right PE entry varies by age, circumstances and many other factors
• He is pretty casual about entry ratios over a range of 40% or more -- listen to it.
• He thinks that most people should consider a financial advisor instead of deciding this on their own.  No kidding!

I expect a skeptical reaction to earnings, just as we saw in the last two quarters.  There will be suspicion whenever the earnings, the revenue, and the outlook to not beat expectations.  This means some buying opportunity ahead.

Thinking Like an Economist: When Does it Pay Off?

Few people think like economists or policy analysts.  It requires a combination of facts, methodology, and discipline.  Let me start with some background and  a couple of examples.

Policy Impacts

Most people have a simple test.  They merely want to know what worked.  The prevailing standard is some gut feeling about "what is good."  A true policy comparison looks at the "counterfactual,"  what would have happened in the absence of the policy change.  (If you do not understand this vital concept, please check out an article where I provided a nice illustration.)

Let me be perfectly clear about this.  A candidate for office who tries to talk in these terms is known as a loser.  A President who talks in these terms is likely to be known as a "former President."  The average person has absolutely no interest in what might have happened had things been different.

People want results!  Our political system rewards those who deliver results.  There is no "what if?" calculus.  In the long run, this works pretty well.

Examples

I was recently asked to participate in a poll of bloggers that had a number of dubious questions.  Typical was whether the Las Vegas City Center complex would add new traffic or would cannibalize the existing base.

This was an awful question -- typical "light switch" thinking.  It is what you see on financial TV and opinion blogs.  It encourages a terrible habit for investors -- thinking that something is black or white, instead of a distribution of results.  The honest answer (a little of both) does not make for an exciting story.

The Cash for Clunkers program is a similar example.  I did not care much for the policy, which I analyzed here.  A couple of months after the  program conclusion an old Street.com colleague wrote an article on the subject.  He carefully adjusted for seasonal effects in auto sales and demonstrated that there was a "pull forward" effect.  It was a nice piece of data analysis, but he was on a mission when it came to interpreting the results.  It was pretty obvious that the data also showed an extra sales impacdt.  He completely ignored this effect, even after I privately called him on it.  He was intent on proving his point.

More time has passed, so we now have more data.  The CEA analysis (HT Brad De Long) is clear enough that we can all see the evidence, even without seasonal adjustments.

The chart does not prove that this was a good program, nor that the expenditure was justified.

It does demonstrate that there was something going on in addition to "pulling forward" some sales.  This is  a completely typical effect, which we will eventually see is true of other government programs for housing, small business, and the like.

Investment Implication

I want to apply this lesson in a way that is relevant for current investors.  There is a clear example of the difference between the thinking of economists and investors -- the concern about inflation.

The broad body of market participants -- investors, bloggers, floor traders -- has one viewpoint about inflation.  They do not agree with official definitions or measurements of inflation.  Some think there is a conspiracy.  Others believe that they see things more clearly.  Some think that "bond vigilantes" will eventually enforces their viewpoint.

On the other side we have the economic community and the Fed.  The Fed does not even follow the CPI, preferring the core PCE deflator.  The Fed is not interested in non-core fluctuations, since these are not viewed as responsive to changes in policy.  A WSJ online poll showed that 83% of responding readers felt that inflation was a concern for the markets.

This is crazy!  As an investor, why fight the Fed, their staff, and the entire economic community?

Even if you choose to diasgree, I urge a pragmatic approach.  Feel free to express your opinion in blogs, in comments, at the ballot box, or anywhere else you want -- just not in your investments.

Meanwhile, if you want to join me in making profits no matter who is in power, you should be a political and philosophical agnostic.

Focus on predicting what will happen, not what you think should happen.