A Dash of Insight

Using Forward Earnings

Regular readers of "A Dash" know that I like to present sports analogies to help investors escape their biases about the market.  Since we are at the start of a new football season, let us engage in some football forecasting.

Suppose that you have an opportunity to invest in a season-long football pool.  You can take one of two approaches:

Plan A.  Look at the exact records and statistics for each of the teams over the past ten years.  You have perfect data for this period, so you cannot be criticized for your analysis.  Your method of prediction is to choose the teams in each division that did the best over the last decade.

In short, you are using past performance over a set time frame to predict the future.  You pick a time period long enough to escape short-term fluctuations and find long term team strengths.

Plan B.  Look at how each team did last year.  Look at scouting reports for each team for the upcoming season.  Take the predictions from a group of scouts and use their average forecast as the starting point for your analysis.  You are allowed to tweak it a bit, since some of the scouts may be biased locals.

In short, you rely mainly on interpretation of current information -- coaching changes, injuries, retired players, new acquisitions, strength of schedule -- to make a forecast for each team's record.

The Contrast

In one case you are using known data -- rock-solid information.  The problem is that you must then make guesses about how these trends may have changed.  In the other case you use micro-level data which includes estimates and speculation.  You are relying upon the expertise of the sources.

Please note that you cannot avoid making an estimate as part of your forecast.  It is only the nature of the estimate that has changed.

The Market Application

There is a constant drumbeat of criticism about market valuation using forward earnings.  The most common criticism, that estimates are too optimistic, is open to challenge.  If the estimates are too high, why is the beat rate consistently in the 65% range?

The key choice is the same as our football example.  The fans of the Shiller 10-year past earnings method take pride in having solid data.  Then they make a wild guess about whether the trend will continue.  Those praising this method point to a few notable successes, mostly times when P/E ratios were very low since interest rates were very high.

Those interested in forward earnings are taking the aggregate work of dozens of specialists.  If you think they are a little high, you can feel free to add an error range.  If you do so, you should look at past data -- especially that of recent years.

Time Frame for Testing

Pundits choose time frames to suit their purpose.

Many critics of forward earnings use data from before 1980, mostly because that suits their purpose.  Since we did not have forward earnings data before then, all of those sources are misleading at best and deceptive at worst.

There is also a logical question about comparisons from ancient times.  Here is a surprise.  The same critics who now complain about the effects of high frequency trading think it is completely appropriate to cite data from the 1930's or the 1970's.

Markets have changed dramatically as information became more widely available to all and the bid-ask spreads narrowed.  In the 1970's, the average investor had no idea what the sell-side earnings estimates were and had to pay a huge commission to act even if he did.  It is different now.

Conclusion

These points are blindingly obvious, yet widely ignored.

Here is an offer for anyone who thinks that using ten years of past data is the best method:  Send me an email and I'll show you how to enter a nice football pool.  The smart money will welcome you and Dr. Shiller.

Weighing the Week Ahead: Jobs

The upcoming market week will feature a focus on the continuing employment issues.  With the monthly payroll employment situation report on Friday, just before the Labor Day weekend, it is a natural theme.  Expect both politicians and the media to highlight the problems of the sluggish rebound in employment and what might be done to create jobs.

The discouraging job news is closely linked to negative sentiment about the economy and the prospects for economically sensitive stocks.  These continue to be key topics for both investors and traders.

Before looking ahead, let's do our regular review of events.  It is easier to look ahead when you have a good perspective on where you are.

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  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.

Last Week's Data

With earnings season ending market participants are pouncing on every bit of information about the economy, even when the importance is marginal.  Last week's news was mixed, with plenty of room for interpretation.

The Good

The very best news of the week is ironic and contrarian.  It concerns sentiment.  Perceptions have gotten so negative that many see the signs of a rebound for stocks.  This was the big news of the week and the real reason for Friday's rebound.

• The single best, one-stop summary of the sentiment story is Friday screencast: panic rarely pays, from Abnormal Returns.  These screencasts are an enjoyable addition to the regular daily links we have all come to rely upon.  The video presentation allows curator Tadas Viskanta to provide a little more color in his commentary.  (And of course, we are always honored to be included.)
• The highlights include historically low levels of bullishness in investor surveys, Mark Hulbert's own index of newsletter writers, now net short (in the aggregate), and a New York Times article that reminds many of the famous 1979 Business Week cover.
  

Fed Chair Bernanke used his widely-anticipated speech at the annual Jackson Hole gathering to describe more about potential future Fed policies and emphasize vigilance about deflation concerns.  This did not seem like fresh news to many, but some saw it as clarifying the conflicting signals from individual Fed members.

Truck fuel usage in the US and Canada is rebounding sharply.  Todd Sullivan highlights the strong relationship between these data and employment.

Rail volumes were also strong, with new highs in intermodal transport.

The Bad

Initial jobless claims were reported as 473K.  While this was an improvement over the 5-handle figure of the prior week, we cannot expect improvement in employment with so many new job losses.

Q210 GDP was revised to an annualized gain of 1.6% from the originally reported 2.4%.  Much of the revision was due to higher imports, a widely-misunderstood interaction with GDP.  (read here to learn more). Check out the Bonddad Blog for good news about consumption and other "hidden positives" from this report.

The Ugly

Housing was bad -- very bad.  Everyone anticipated weak sales numbers in the aftermath of the tax credit expiration.  The actual numbers were even worse.  Since inventory is calculated in months using current annualized sales rates, these numbers also look terrible.

Calculated Risk covers the data as well as providing great analysis of this important story.

The Week Ahead

It could be an exciting week.  The big news will come with Friday's employment situation report, especially coming right before Labor Day weekend.  Leading up to that report will be forecasts from ADP and other sources.  I'll do our own regular employment preview on Wednesday, including data from the ISM manufacturing report.

Many people will be slipping in a vacation during summer's last week, so trading volumes will be low.  Moves could well be exaggerated.

Despite the policy elaboration from Bernanke's Jackson Hole speech, some will look to the release of the FOMC minutes (Tuesday) for more information on internal Fed debate.  I do not expect any fresh news from that source, since the topic was thoroughly examined last week.

There will be housing data and more information on jobless claims, but the focus will still be political.  We are in the dog days of summer.  Many will be on vacation and the political debate will still command attention in business stories.

Our Own Forecast

Our own indicators shifted to neutral last week.  We are cautious, with many sectors in the penalty box.  This is a recognition that we cannot make a solid short-term prediction.  When a sector is in the penalty box, we know that forecasting future moves will be challenging.  As a result our vote was neutral in the weekly Ticker Sense Blogger Sentiment Poll.   Here is what we see compared to two weeks ago:

•  84% of our 55 ETF's have a positive rating, down from 96% last week.
• 100% of our 55 sectors are in our "penalty box," similar to recent weeks.  This means that uncertainty remains high for short-term trading.
• Our universe has a median strength of +18, down from +33 last week.

For trading accounts, we have been mostly out of the market during the last 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 email list.  You can also write personally to me with questions or comments, and I'll do my best to answer.]

Investment Implications

The continuing volatility has makes this a difficult time for trading accounts.  Some wise observers see opportunity.  Doug Kass, in a thoughtful overview of many factors, including valuation, economic fundamentals, sentiment, and others -- draws this conclusion:

It is time to fade the growing negative consensus and adopt a variant view by becoming more constructive on stocks.

Others emphasize the long-term opportunity.  The Schwab economic team reviews a wide range of economic data and concludes that fears exaggerate the reality.  Their article, worth reading in its entirety, echoes many of the themes I have emphasized this summer.

How (not) to Build a Market Indicator: The Hindenburg Omen

A recurring theme at "A Dash" has been the seductive power of charts and trading systems.  Televised commercials from brokerage firms suggest that anyone with a computer can develop and test a system.  One of my articles about this danger was the story of a rookie trader, who failed despite his intelligence and system testing.  (Thanks to the Internet Wayback Machine for saving this story.)

In last week's market preview I suggested that people should know enough to dismiss stories like "The Hindenburg Omen."  I got a number of emails from readers who asked me to elaborate.  It is a topic that will not die as Barry Ritholtz shows with his discussion of the searches on Google Trends.

My Purpose

In this article I hope to provide a simple, non-technical explanation of why you should pay no attention to this "omen." I will do this by describing several important steps in building a system or indicator, and the perils of going wrong.  I hope to demonstrate that it is nearly impossible to detect a flawed system, even for experts.  As a result, even skeptics and fair-minded journalists have trouble showing what might be wrong with the Hindenburg Omen.

How (not) to Build a System

Here are the key steps to building a trading system or indicator that will look fantastic on paper, but be totally ineffective in practice.

1. Start with the conclusion.  Do not being by thinking about the problem or generating hypotheses, since those might not work.  Instead, look directly at the dependent variable (what you are trying to predict).
2. Take the result you seek on the dependent variable and run a correlation matrix with hundreds of possible "causes."This is easy to do with so many technical indicators available.  Pure chance results in a correlation when you have so many possibilities.
3. Find a plausible hypothesis.  This is an easy task for smart people.  In this article I showed how a group of graduate students at a leading university were tricked by a clever professor.  People do not realize how easy it is to find "explanations" when given the answer unless they have had an experience like this.
4. Start optimizing!  Your original relationship will not be perfect.  You can make it better by looking at the failing cases and getting rid of them.  You can do this by adding new variables to rule out the "bad cases."  You can get really precise with values, specifying a very narrow range that qualify.  You can cleverly combine variables.
5. Use as many variables as needed.  This violates a statistical principle about "degrees of freedom" but who cares?  The idea is that if you have very few cases and too many variables you are overfitting your model.

If you follow these steps, you have a system or indicator that looks excellent.  Even an expert cannot prove it wrong from existing data.  This is why the expert is interested in how the model was built, not just the final result.

Evaluating the Hindenburg Omen

After reading scores of articles on this subject, I think this is the best explanation of the development of the model and subsequent tweaking.  If you look at the many parts of the "Omen", the carefully optimized parameters and the subsequent tweaks, you will see that all of the system development rules have been violated.  The only one we cannot see for sure is the original "hypothesis" which referred to the divergence in new highs and new lows.

Even if you accept the system as stated, the key feature, the number of new highs and new lows, is flawed.  Here is the take from Jeffrey Saut of Raymond James, referring to the current signal:

...(T)he vast majority of “stocks” making new highs were interest sensitive closed-end funds, preferred stocks, or some other kind of fixed income product, which by my pencil are not stocks. Therefore I'll say the same thing I said two weeks ago, “I don't think a Hindenburg Omen has been registered; and even if it has, its track record is spotty.”

CXO Advisory, one of our featured sites, does a typically professional job in analyzing this indicator.  The technically minded should read the entire article and compare the analysis to the summary here.

Why This Story is Important

The hype around this topic is incredible.  Conclusions range from those who see a near-certain market crash to those suggesting a 25% possibility.  People are taking this very seriously.  Art Cashin, who is the voice of the NYSE traders, talks about it on CNBC.  The original Zero Hedge article, a typically uber-bearish scare piece, instantly went viral.  I got multiple emails, including some from brokers at big-name firms.  There is an eagerness to confirm the bearish bias in this summer of negativity.

Many observers who do not have specific training in research methods find the results to be very persuasive.  Even if they sense a problem, they still see it as some kind of warning signal, since the correlation of the signal to the result is so clear.  It is not a matter of intelligence or good intentions.  Smart people are easily fooled on this one.

This problem is not obvious to people lacking specific training in research methods or system development.  This can and does include mathematicians, engineers, and physicists.

The power tools of system development have outstripped the capabilities of the users, with a dangerous result.

It is  now deceptively easy to create a trading indicator that is only useful for "predicting" the past.

Skeptical Observers, Great Opportunity

Concerning the Hindenburg Omen, several savvy market observers show skepticism -- Barry Ritholtz (calling it "a backward-looking indicator that doesn't consider causation. He labels it 'recession porn,'"  Josh Brown,  Mark Hulbert, and Tobias Lefkovich.

I hope that this analysis has added some additional reasoning and explanation.

Meanwhile, for investors, I strongly urge a focus on the actual performance of corporations.  While our official posture for trading accounts has been neutral or bearish for several months, our models have now started to identify good trading opportunities.  For long-term investors the picture is even more decisive.  There are many stocks trading at prices that value-oriented managers see as a generational opportunity.

It is important not to be sidetracked by pseudo-science.

Book Review: The Big Short by Michael Lewis

I have been reading books about the financial crisis, and I plan to write a review of each.  A reviewer should have an audience in mind.  Mine is the financial community, especially those of us wanting to learn.  I look specifically for what lessons we might find -- the unusual idea you might not see anywhere else.

This book has an insight on the most important issue for current investors:  Evaluating forecasters.

It is a good time for you to read these books, think about them, and learn the lessons.  My own interest is a bit broader than most of the financial punditry.  I am looking at books by policy makers as well as financial journalists or analysts.

My starting point in this series was Barry Ritholtz's Bailout Nation, highly recommended and now available in paperback with updated material.

The Big Short by Michael Lewis

The book, now added to our recommend readings, tells the story of the crisis from the perspective of three obscure hedge fund managers and a bond salesman.  The personal approach makes the material both interesting and accessible.  Reading it will help you understand some of the key factors behind the crisis.  The author makes technical subjects easy to understand, and includes plenty of examples.

Michael Lewis fans will not be disappointed.  This is a great tale, well told.  The characters are interesting and colorful.  Even though we know how it all will turn out, we appreciate the twists and turns on the way.  The author captures the tone and nuance of the insider -- descriptions of meetings, the isolation of the fledgling hedge fund managers who are the protagonists, and the drive for profit from the big firms.  The book is very well-written.

We really get into the lives of the major characters, and that is part of the lesson.

My Favorite Lessons

This is a very important book.  There are several points, extensively documented and described, that you will not find in other sources.  These are not necessarily highlighted in the book, but I find them worthy of emphasis.

• The details about rating agencies and how loans got their ratings.
• The story took a long time to play out -- a very long time.  The heroes had to deal with angry investors.  One fund manager even resorted to an aggressive legal move to stop investors from withdrawing funds.  We read the story knowing that the heroes would be vindicated, but the challenges they faced were awesome.  Colleagues, family, and investors all challenged their wisdom.
• Taking the winning positions was costly.  While the heroes thought that the insurance premium was cheap, investors disagreed.  The monthly costs were significant and they went on for years.  The managers kept buying, even when everyone thought they were wrong.
• Nearly everyone involved was ignorant of the process.  The heroes could not figure out why there was an insatiable demand for the other side of their trade -- why they continued to lose on daily mark-to-market in the face of a deteriorating housing market.  They did not even know what a CDO was or that there were CDO managers.
• And most importantly, how the synthetic CDO market came to dwarf the actual market for loans -- subprime or otherwise.

My Objections

I want to go gently on the objections, since I like the book so much.  It is natural for an author to look for the main themes from his work.  I happen not to agree, but you might.  The author finds implications for Obama priorities and sees the root of the trouble in investment banks becoming public companies.  I found myself shaking my head at each unconvincing point.

This should not in any way detract from the wonderful story, with rich characterization and authentic detail.

Investor Conclusions

There is important information that you will not see anywhere else.  If the author was more attuned to the current debate over economic policy and forecasting, he might have better appreciated the significance of the first point.

Any current discussion of economic forecasts or investment decisions begins with the question of whether someone was right about 2008.  Lewis's work is illuminating on this subject.

Why did so many get this wrong?

Why did so many underestimate the effect of the subprime crisis?  Why did they think it would be "contained?"  Why did they think that various policy actions might deal with the problem?  Why were recession forecasts by economists so far off?

The answer?  No one knew the extent of the synthetic market.  Lewis makes it clear that this market dwarfed the  actual market in subprime loans.  More investors were "betting" on this synthetic market than were actually invested in mortgage securities.

Let me illustrate this with some charts.  Here is the Google Trends chart for searches on CDO's.

Now let's compare that to searches for synthetic CDO's.

The difference in interest and knowledge is obvious.

Even analysts who recognized the potential for a collapse in subprime lending would seriously underestimate the total impact.  This statement is just as true of the heroes in the book -- the ones betting against the market -- as it is of Ben Bernanke or others.  No one really new the magnitude of bets in the unregulated market for synthetic securities.  As the book describes, it was a huge market of people who had no direct interest in the loans, betting on the outcome.

The current assessment of blame and credit about forecasting is seriously flawed.  None of those "getting it right" understood the synthetic market.  They over-estimated the regular market.  Mainstream economists did the opposite.

We need to understand the tough trade

Any investment manager understands this.  Investors think in terms of a few months.  A year is supposed to be a good test of a strategy.  The stalwart successful fund managers in this book had to withstand negative returns for several years before collecting a huge return.

They also did so in the face of near-universal conviction that they were wrong.

The demand for yield

There is an enduring investor perception that yield is good and is (somehow) a guaranteed return.  A fundamental factor in the crisis was the willingness of investors to believe that they could get outsized yields on AAA securities.  Without this belief, The Big Short would not have been possible.

We can see the same behavior in today's market -- coupons over variable stock returns, regardless of potential.

Enjoy the book and you may find your own lessons.  If you have already read it, please feel free to share observations in the comments.

Weighing the Week Ahead: The Confusing Effect of Politics

Each week I ask myself about the biggest challenge for the average investor.  This week it involves the political debate.

Free speech is a founding principle of the US version of democratic government.  That includes wide-ranging and open debate where facts are exaggerated, opposing positions distorted, and evidence chosen for emotional impact.

Let's take a simple example, chosen because it is obvious.  This week there was a lot of publicity about a poll by the universally respected Pew Research Center.  They asked about President Obama's religion.  18% (incorrectly) believe that he is a Muslim and 43% do not know his religion.  Both of these numbers are up dramatically from past polls.

There is a similar increase in people believing that he was not born in the US.  34% of Republicans believe that he is a Muslim.  Many people do not know that the stimulus package included tax cuts.

The significance?

The strident political debate is costly to investors!

Let us extrapolate a bit.  There are many questions that are not simple matters of fact -- the stimulus effect, employment, housing -- etc.  These require more interpretation.  If the slam dunk facts are interpreted incorrectly, what do you think is happening on issues requiring more nuance?

Please note that this is not an endorsement of current Obama policies.  Regular readers know that I have many objections.  I evaluate policy by expected effect, no matter which party is in power.

My position is that of political agnostic, seeking profit no matter who is in power.  Meanwhile, many sources are aligned to tell you that everything is terrible.

Let us review the past week, and then return to the main theme.

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  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.

Last Week's Data

Since it has been two weeks since my last market update I am going to reach back a little more than a week for my review.

The Good

The corporate earnings season concluded with a 65.8% beat rate (63% on revenues).  Check out the great charts from Bespoke Investment Group to see the comparisons with past years.

The Fed decision to maintain, for a time, the current size of its balance sheet.  Allowing mortgage investments to "run off" through current refinancing actions would have been a de facto monetary tightening at a bad time.  Similarly, expanding to a new program of quantitative easing does not seem warranted.  Those pundits who linked the "delayed market reaction" of the next day to a message from the Fed are overreaching for an explanation.  I do not believe in delayed reactions.  Too many are watching, and watching closely.

Industrial production was good and so was freight traffic.  See If the economic road is so bumpy, why are all those trucks on the move?

Business dynamics data show that job creation from new businesses strengthened at the end of 2009.  While these are old data, they contradict a popular perception about job creation and are a distinct improvement over the last report.  As usual, I'll follow up on in detail on the employment picture.  No one else seems to have noticed.

Middle East peace talks.  With so many failures, can we be optimistic about a solution?  At least it is a start.  At at time when everyone notes vague "market headwinds" it seems only fair to take notice of progress.

The Bad

Initial jobless claims spiked to 500K and the four-week moving average to 483K.  This level of job loss is not consistent with strong net job growth.  Some believe that there are misleading seasonal factors at work, but it will take a dramatic change to affect the four-week average.

The Philly Fed Index plummeted into negative territory.  I do not regard this as very important since it is a small and atypical region of the country.  When the move is a big one, the market reacts.  Bill Luby (one of our featured sources) does a fine job of looking at the index components. Bill points out that there is optimism about future orders, but not so much about employment.

The ECRI index downticked again.  It really has not changed much.  The ECRI team still sees weakness but no recession call.  Others interpreting the data see a different picture.

Building permits were a little light.  Permits are an excellent read on future construction.  Economic growth from housing is still a remote prospect.

The Ugly

The market and pundit reaction has been extremely negative.  Since this is a summary of my conclusions -- what I think is useful for various time frames -- I am not going to argue out each point.  Some topics I have covered in the past.  Others are on the agenda.  Feel free to disagree in the comments.

The market scaremongers.  There are many highly-publicized predictions of a market crash.  There is no accountability.  There is no fact-checking or record-checking on the extremists.  Some of the warning messages "go viral."  People want to believe the scary fantasy and they want to pass it along.  Anyone who understands the scientific method, back-fitting of data, and similar topics will easily dismiss illusions like the "Hindenburg Omen."  Most investors lack these skills.  That is bad news for them, but good news for the astute.

The economic scaremongers.  There is a wide and obvious disparity in economic expectations.  In general -- and there are a few notable exceptions -- the mainstream economic community sees modest economic growth and little near-term chance of a recession.  The "pop economists" blogging on the topic are far more pessimistic.  Those who do not do formal forecasts are more pessimistic.  Those who have a political agenda are pessimistic.  Those who need blog hits (a group that distressingly now includes mainstream media) are pessimistic.

The political scaremongers.  There is a natural market for negativity.  Those out of power can and should attack, claiming nothing has worked and nothing will work.  It is great political theater.

The Week Ahead

There will be housing data and more information on jobless claims, but the focus will still be political.  We are in the dog days of summer.  Many will be on vacation and the political debate will still command attention in business stories.

Our Own Forecast

Our own indicators moved to bullish last week.  We are still cautious, with many sectors in the penalty box.  This is a recognition that we cannot make a solid prediction.  That is the purpose of our "penalty box."  When a sector is in the penalty box, we know that forecasting future moves will be challenging.  Despite this, the overall rating is positive and we have a few buy signals. As a result, the model is still bullish, and that is our vote in the weekly Ticker Sense Blogger Sentiment Poll.   Here is what we see compared to two weeks ago:

•  96% of our 55 ETF's have a positive rating.  This is up from 86% a few weeks ago.
• 96% of our 55 sectors are in our "penalty box," similar to recent weeks.  This means that uncertainty remains high.
• Our universe has a median strength of +33, up slightly from +28 two weeks ago.

We have been partly invested in various sectors over the last week, reflecting a modestly bullish position.

[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 email list.  You can also write personally to me with questions or comments, and I'll do my best to answer.]

Investment Implications

The confluence of negativity should be attractive for long-term investors.  Since our models also join in with a buy signal, this is a particularly good time for equity investors.

Dirty Deficits and GDP

This week we'll see the first revision to the GDP estimate for Q210. Most observers expect a downward revision. Brian Wesbury of First Trust Advisors explains why:

…the pessimists are all talking about the fact that real GDP will be revised downwardly to an annualized growth rate of about 1% in the second quarter. What they don't tell you is that this low number was caused by a 35% surge in imports. That's right, consumers and businesses bought more from overseas (lot's more), and since imports are a negative in the GDP accounts, it made the economy look worse. When we adjust for this, American households and businesses increased their spending at a 4% annual rate in the second quarter – over and above inflation. 

The average investor thinks that trade deficits are bad, imports are bad, and a lower GDP is bad. There is little understanding about the relationship between trade and GDP.

The article below is a generous contribution from my brother, Steven L. Miller, Ph.D., recently retired from Ohio State. Steve continues to improve economic education around the world with his frequent trips and seminars. His article follows several of our frequent themes including causal relationships, media coverage of the economy, and general understanding of economic data. I urge a careful reading, and as usual, checking out the links.

You will be surprised and enlightened by the conclusion.

Dirty Deficits by Steven L. Miller, Ph.D.

This post is prompted by "Return of Killer Deficits," an editorial in the NYT from 8/15 (http://www.nytimes.com/2010/08/16/opinion/16mon1.html?_r=1). In essence, it says that the US trade deficit has "ballooned" again, as US consumers are on another import binge while China (with its "artificially cheap goods") and Germany are pushing exports. This threatens the weak US recovery and "isn't sustainable."

What is happening with the trade balance is especially newsworthy during periods of high unemployment. The increasing trade deficit was the major factor in the possible downward revision of the GDP Q2 estimate, net exports being a component of that calculation. That was perceived immediately as bad for jobs and bad for the stock market. Moreover, a widespread public perception is that every import that could have been made in the US represents jobs that have been lost. This prompts political leaders to act in ways they think will promote exports and reduce imports—consider the "Make It In America Bills" recently passed in the US House of Representatives (http://www.speaker.gov/newsroom/legislation?id=0390).

It is tempting to do as the NYT editorial does and chalk the trade deficits up to US demand for imports, foreigners not doing their part, and the Chinese gaming the system.

But, the iron logic of CA+K=0 forces us to consider whether the trade deficit might be a result of the continuing inflow of capital into the US, despite concerns about long-term government deficits. The equation simply states that whatever happens in the current account is matched by offsetting items in the capital account. In the US, the current account (CA) is overwhelmingly the balance of trade; the capital account (K) is the net of capital flows. This suggests that a trade deficit (-CA) might be the result of net capital inflows (+K). Positive capital flows maintain a higher value for the dollar relative to other currencies making US exports more expensive and imports cheaper than they would have been otherwise. Hence, the trade deficit.

William Poole, when he was still President of the St. Louis Fed, noted:

A common mistake is to treat international capital flows as though they are passively responding to what is happening in the current account. The trade deficit, it is said, is financed by U.S. borrowing abroad. In fact, investors abroad buy U.S. assets not for the purpose of financing the U.S. trade deficit but because they believe these are sound investments promising a good combination of safety and return. http://research.stlouisfed.org/publications/review/04/01/poole.pdf

He suggested that there are multiple reasons why this might be the case, and that different ones of these might have been the major suspect at different periods of time (We are looking at a long period of trade deficits). For example, the 1980s "twin deficits theory" of inadequate US savings combined with large government deficits was seen as the prescription for capital inflows. While Poole points out that this theory breaks down in the 90s, he more generally maintains that the relative safety, liquidity, transparency, and efficiency of US capital markets makes them attractive to foreigner investors and governments, even in periods when US government borrowing or interest rates are low.

So, now? One explanation consistent with Poole is that the US is currently seen as the world's "Safe Haven," as is explained at http://www.forexblog.org/ and http://www.nytimes.com/2010/08/16/business/economy/16rate.html?hp

All of this could mean that foreign demand for US assets, including US government obligations, is likely to continue, and with it sizable net capital inflows and corresponding current account deficits.

There is any number of significant conclusions from this analysis. One is that policies designed presumably to create jobs by chopping into imports might not work as expected. Rather, it could be like plugging a leak in one place, but another opens. An inflow of capital means there will be a trade deficit—maybe not in the industry or with the country where the leak was plugged—but with somebody. In this scenario, the voracious demands of future government deficits presumably also mean higher interest rates eventually, since the government simply has to get the requisite funds, no matter the cost (See Kitchen and Chen at http://www.econbrowser.com/archives/2010/08/financing_us_de.html).

So, at least in the shorter run (however long that is), the US looks like it will need to continue to be a net importer of capital. As Poole noted "…whether continuing infusions of financial capital are sustainable depends on how the financial capital is employed." Maybe trade deficits aren't such a bad thing.

Investing 101

Most of my work on "A Dash" is written for the individual investor who is trying to make sense out of conflicting information. I am delighted to get responses from other financial advisors and from sophisticated investors with alternative viewpoints. Meanwhile, I also get occasional messages from another group – people who are just getting started in the investment world.

In fact, some of my best clients were people who asked the question, "How do I get started?" and began with a small program. There is nothing like having an actual investment to focus your attention. In our office Feray Alin handles most of our routine investor contact (in addition to several dozen other things). We share a sensitivity to client needs. She recently wrote a nice summary of how to get started. I would like to share it via "A Dash." Perhaps some in our audience will add some suggestions.

Feray wrote:

This article is for those that have never looked at a 10-Q, do not have an IRA and have never executed a trade. This is an article for the beginner.

Step One: Look at your spending – not an online form budget (these rarely include everything). Look at all of your expenses for the last 12-24 months and figure the total for one month on average, then add a little extra for the months where you spent more and configure that into your monthly expenditures.

Step Two: Calculate your monthly base income. If you work extra hours some months and not others, do not include these (save these for the months where you spend more – i.e. major holidays, months where everyone seems to have a birthday, etc.) The extra pay needs to go straight into a savings account to be used in those months of high expenditure.

Step Three: The difference between Step One and Step Two is what to do with that extra money. It depends upon each individual and what exactly that dollar amount is – could be $10, could be $50. If you have $10 or $50 extra a month this should go straight into a savings account, saved over time to build up and open up your very own IRA account. Why? Because if it is in your checking account, you will most likely spend it. You should open up a retirement account, build and save for when you cannot and do not want to work anymore.

Step Four: Look at the companies that you and those around you like and use every day. What are the companies that have a long life? What are the companies that will be here in 10+ years? What companies have made it through the hard times? What do you see around you? Pick a company and research it. Remember to diversify. Don't own only one stock or several stocks in the same sector. For example, you wouldn't want to own three cell phone stocks.

Step Five: This is the hardest – the financial part of the process. What is the value of the company? What is the growth of the company? What is the sustainability of the company? What are the dividends? What is the VALUE of the company? What is the FUTURE VALUE of the company?

Former hedge fund manager and current host of CNBC's Mad Money Jim Cramer says: "Do your homework... we should be spending at least one hour per week researching every stock that we own". This is sound advice and one of the hardest for an individual…one hour per stock per week. If you own ten, this ends up being ten hours of your time per week. And yet, you need to know what is happening – if you want more than interest in your checking/savings account with or without an advisor, you need to do the homework.

Step Six: Cost Basis. Keep a list of the stocks that you own and the price you paid. You need to recognize and keep an eye out for a stock that is performing abnormally (good or bad) and learn why. If you are investing $1000 per stock, keep in mind that some stocks may be too high and may not give back enough to you (profit) to make it worthwhile.

Cost basis:

(Price of stock (share price) x the # of shares bought) + the trading commission = your cost to buy the stock

Determining profit/loss:

(Price of stock (share price) x the # of shares bought) – cost – trading commission = Profit or Loss

Examples:

I am going to use two financials. These two stocks have a large difference in their stock price and are good examples as to why the price of a stock needs to be a part of your choice. The first line in each table is the initial cost: $996.69 for Citigroup and $971.39 for American Express.

Citigroup (C): at $3.90/share with a $1000 to use, you can buy 253 shares. I have the stock price going up by 10 cents.

American Express (AXP): at $41.80/share with a $1000 to use, you can buy 23 shares. I have the stock price going up by 10 cents.

Citigroup, Inc. can go up $0.50 and make $100 gain. American Express has to rise $0.90 before you gain $1 and over $5 to gain $100.

Step Seven: Make sure that when you are starting out, you are using money that you can afford to lose. You will have gains and losses. Keep an idea of what the target price that you want to sell your stock and the timeframe in which you want to accomplish that goal. Don't be greedy; do not stay in a stock because you want to see one more rally in price. Keep looking at the financial statements and determine at what price you would sell, and if nothing changes financially within the company, sell it.

We would like to close with a quote by prominent investor Warren Buffett:

"Risk comes from not knowing what you're doing."

Remember always that trading is a learning process. It will take time before you can become an experienced investor.

Feray Alin, NewArc Investments, Inc.

What the Bond Rally Means for Stocks

Comparing bonds and stocks is crucial for investors.  Here is a good current lesson

Bespoke Investment Group does a great job of analyzing trends and historical results.  Co-Founder Paul Hickey was featured today on CNBC.  As usual, he had some great observations.  Without disparaging the other guests, I would like to focus on the hard data he presented.

Paul noted that bonds had rallied 10% in four months.  This has happened 14 times in the past and the S&P 500 has been up about 15% on thirteen out of fourteen times.  If you add in the combined effect of the stock decline and the bond rally, there are only four occasions and the rally (in all cases) becomes 25%.

Here is the entire interview.  Paul's key comments start at about the 3:30 mark.

Paul's key point is one that a few others are noting -- the relative valuation of stocks and bonds.

Stocks versus Bonds

Many large players constantly review asset allocation among major investment categories.  The forward earnings yield of stocks (perhaps adjusted for some skepticism) is constantly compared to bond yields.  I am always surprised when I learn that someone who is basically an equity investor is unaware of the potential yield from alternatives.

One problem is that the projected yields do not reflect overall interest rate changes.  It is fine to expect 4.5% or so from long-term corporate bonds, but you will have capital losses if interest rates increase.  My analysis suggests that the forward earnings yield of the market has roughly paralleled the rates of lower-grade bonds.  You can "reach for yield" and find something that generates 8.5%.  That looks good on a day when the market is down two percent.

For most investors, it is better to take a longer view.  I find most individual stocks to be more attractive than the corresponding bonds, and the overall stock market more attractive than the overall bond market.  This does not mean that you have to be "all in" like the players in the World Series of Poker.  Most investors are making the opposite mistake.  They are opting for minuscule yields without any attention to long-term growth and inflation.

Meanwhile, most investors are doing the opposite.  They see yield as some sort of guarantee while worrying about the risk in stocks.

Investment Conclusion

I wish that more people could have heard the highlighted CNBC segment.  It seems like the dramatic predictions -- Dow 5000, Dow 1000, the "New Normal -- get all of the attention.  Not a week goes by without a message from someone who is worried about a market collapse.  It is an imbalance of writing, media coverage, and commentary.  Most people would do well to consider the likelihood of Dow 20K.  A recent CNBC poll found a third of their audience predicting that the market would NEVER reach Dow 12,000.  A generation of investors is missing on a chance to own a share of America.  It has become fashionable to be negative.

By contrast, take a look at an excellent article by James Altucher.  He analyzes trends in earnings, employment, China, and the GDP.  Careful readers will note that he accurately cites data.  He also has a number of stock suggestions which are now on my watch list for analysis.  Meanwhile, the comments section is typical of current feedback for those of us writing on the Internet.  The reader feedback can be directly discouraging to authors, but it also influences editors and those hiring writers.  The comments of a small minority may affect what regular readers get to see.

Comments could be the ultimate sentiment indicator if someone could figure out a good measure.

What Can You Know, and When Can You Know It?

Access to information is crucial for investors and traders.  Even a small advantage in timing can make a big difference.  An enduring theme is access for the "little guy" versus big-time traders.

An interesting chapter in that story is playing out with little attention from the financial media.  The story is worth our attention.

The US Court of Appeals for the Second Circuit just heard an appeal from Theflyonthewall.com.  The Fly picks up research reports from the big name firms and distributes the results to their clients before the market actually opens.  This interferes with the business model of brokers at the big name firms, who want to use the research as a basis for recommending client trades.  If everyone already knows the story, what advantage is there from the expensive research?

Historical Background

In a practical sense, this issue was settled fifteen years ago through the pioneering efforts of Maria Bartiromo.   Starting work each day long before most people awakened, she cultivated a network of sources that revealed the big "calls" from the major firms.  As the first person to report daily from the floor of the New York Stock Exchange, she made a major difference in what information was available to the average investor.

She endured a lot of hazing from those who objected to her presence.  I remember it all very well and I would like to share it with those who were not around for this part of history.  Please enjoy this video, and also note that she sees "breaking open the research call" as the biggest accomplishment.

Maria Bartiromo has moved on to become a top-notch interviewer, getting the very best subjects. She also has the knack of bringing out their story, instead of making herself more important than the subject matter.  This is easier to do when you are confident of your own accomplishments.

The Legal Issue

On one side of the current issue we have the big-name firms.  Why are they picking on The Fly and not going after CNBC, The New York Times, Briefing.com, or other firms?  Here is the explanation from their attorney:

Attorney Bruce Rich told a three-judge panel of the 2nd U.S. Circuit Court of Appeals that several financial services firms sued Theflyonthewall.com because the company made a business of widely releasing their expensive-to-produce research findings before their clients could act on the information, weakening the value of the reports.

He said the firms, including Barclays Capital Inc., Bank of America Corp.'s Merrill Lynch & Co. and Morgan Stanley Inc., did not see a similar threat to their business from news outlets such as CNBC.

"The difference is that Fly does it for a living," he said. "CNBC delivers a broad spectrum of news reporting."

This makes no sense.  It suggests that publication may or may not be legal depending upon the business model of the publisher.  Really?  Why not look at the impact?  These sources all have more reach than The Fly.

The Sides

On one side of the issue -- agreeing with The Fly -- we have Google and Twitter.  On the other side we have the rest of mainstream media, supporting a concept of "hot news."  Here is a simple explanation:

Attorney Andrew Deutsch, who represented a dozen media outlets including The Associated Press at the hearing, said Sullivan had misinterpreted the law by insisting there was not more protection for the original distributors of information.

"The position taken by Google is absolutely wrong," he said.

The media outlets were not asking the court to rule one way or the other. They were asking the judges to leave intact the legal standards that currently govern when "hot news" has been misappropriated. The "hot news" doctrine was established in a 1918 Supreme Court case involving the AP. The principle holds that while facts cannot be copyrighted, media organizations can sue when competitors copy time-sensitive news.

A Final Take

The main advantage of a research report comes from the direction of the move (downgrade or upgrade) and who is saying it.  I love reading the reports for detailed analysis and long-term strategies, but I am among the few.  The shelf life of these calls is very short.  Most market pundits know the direction of the major calls, but they could not utter two coherent sentences about the content.  The summary is everything.

Maria had it right and we all have something at stake in the outcome.  It is a developing story and one worth watching.

Hat tip to Talking Biz News, one of our featured sites, and a great way to follow business journalism.

Weighing the Week Ahead: Will There be a Signal from the Fed?

Investors continue to monitor three themes, often moving in different directions:

1. The slowing rate of economic growth;
2. Continuing strength in corporate earnings; and
3. Confusing and contradictory technical market indicators.

Looking ahead, the Fed's decision will be a focus of attention.

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  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.

Last Week's Data

I'll consider data related to each of the key themes -- the economy, earnings, and the market.  As usual, there is a mixed picture of good and bad.

The Good

With gains of 1.5% for the major indexes there rates to  be some good news.

The earnings season showed continued strength, especially for the large-cap companies in the S&P 500.  Bespoke Investment Group has the beat rate at 79%.  Check out their site for comparisons, great charts, and a summary of the biggest stock reactions (more down than up).

The beat rate is even better than the typical 2-1.  Did you ever notice how most people say that analysts are too optimistic in their estimates and then many also dismiss the beat rate since estimates are too low?  There is a story in there somewhere!

The political front saw some improvement, with signals from the Democrats that there is room to deal on the Bush-era tax cuts.  Please note that by calling this "good" I mean that it is a market-friendly development.  I described my reasons and reported the results of the poll of economic bloggers in this article.

The ECRI indicators finally upticked.  Their official reading is that the overall collection of their indicators does not signal a near-term recession, but that economic weakness increases the vulnerability to a shock.  Mish takes issue with the past ECRI interpretations, and makes some good points.  The ECRI addresses interpretations that they see as excessively bearish or bullish, nicely highlighted by Barry Ritholtz.  Many others are placing their own interpretations on this indicator.  Doug Short has some nice charts including some other variables.

I understand that the ECRI is trying to market a valuable service, so they need some secret sauce.  I am reluctant to base my own forecasts on an index when I do not know how it is constructed.  For that reason, I tend to stick with the official ECRI interpretation -- at least when the statement is clear, as it is now.

Investors should also note that a recession forecast is dramatically out of consensus.  Note, for example, this New York Times article featuring dueling perspectives.  Even those economists who see very weak growth do not expect a recession unless there is an additional shock to the economy.

The various doomsday warnings from before my vacation did not play out as predicted.  In this article, I listed some factors and asked readers to help spot anyone who had actually changed his/her opinion with the data.  Thanks to those who offered comments.  If you missed this piece, I am still interested in reactions.

Meanwhile, Charles Kirk is a leading trader who successfully identified a rebound while everyone else was worried.  His weekly chart video (members only, but worth it) provides a good overview, plenty of ideas, and some specific advice.  This week, for example, he has suggestions for those who hate the US market so much that they cannot pull the trigger, even for a short-term long trade.

The Bad

The employment picture is still unacceptably weak.  Friday's employment situation report was not a surprise for my readers, since it was consistent with our other key economic indicators.  The downward revisions continue to bring the data more in line with other evidence.

Menzie Chinn at Econbrowser, one of our featured sources, takes a data-based view in his article, A Sputtering Economy?  He strips out the census effects in analyzing seasonally adjusted data on a log scale.  I agree that it is important to look at the changes both with and without government jobs, and also on an hours worked basis.  Here is one of his charts, but see the full article for a complete analysis.

The growth in jobs is not at a recession level, but it is unacceptably weak given the needs.

Let me summarize the issues:

• We need monthly net growth in payroll jobs of 150K or so just to absorb growth in the labor force.  We need something like 250-300K to cut into unemployment before the next recession.
• The levels of under-employment and work force drop out are still unacceptably high, 16.5% on U-6, and possibly moving higher.
• The average duration of unemployment (despite a slight downtick) is at nearly 35 weeks, nearly twice normal levels.
• Initial claims remain persistently high, even though layoff rates have stabilized.  Steve Hansen suggests that this is an indicator of low job creation.
• The churning of job creation and job loss makes the effect much broader than most people realize.  I have written about this frequently, emphasizing the need for studying labor dynamics.  Today's Chicago Tribune cites the Trib/WGN poll as showing that 50% of local residents fear job loss.  No wonder consumer confidence is low.

A divergent view comes from Brian Wesbury, who writes as follows:

Goods-producing industries have pushed their workweek back to pre-recession levels – meaning further production gains will translate into more employment. Meanwhile, average hourly earnings increased 0.2%. We can use data on total hours and hourly earnings to figure out total earnings, which increased at a 6.2% annual rate in July and are up at a 4.1% annual rate in the past nine months. This is more than enough for workers to both increase consumption and, if they want, increase their saving. Although the size of the labor force (workers and those who say they’re looking for work) remains stagnant, at levels first reached in early 2008, this may be related to a drop in the number of illegal immigrants, many of whom worked in residential construction, one of the sectors hit the hardest in the recession. So far this year, private payrolls are up 90,000 per month while civilian employment – minus the government sector – is up 200,000 per month.

Wesbury often has ideas not given much attention elsewhere.  Even when I do not agree with a specific interpretation, I find the argument interesting.

The economic data paint a dismal picture as interpreted by the economic blogging community.  Tim Kane at Growthology (now added to our featured sites) has been doing a nice series on the results from the poll of economic bloggers.  Among other things, 44% expect a double-dip recession and 47% think things are worse than shown in government data.  I say "Wow!" to that.  Check out the site for the full summary and graphics, including an impressive word cloud from my blogging colleagues.

The Week Ahead

There is plenty of economic data for next week, but the focus will be on the FOMC decision.  No one expects any move on interest rates, but there may be something about the Fed's balance sheet.  The long-running debate over reducing the balance sheet may spark attention to the commentary, as well as the usual parsing of hints about the duration of low rates.

Bob McTeer suggests that the Fed may allow mortgage securities to roll off, but not reduce the overall balance sheet size just yet.  Whatever the Fed does will be interpreted as a sign of their actual read on the economy and the inflation/deflation risks.  While I do not expect anything significant, it will be a carefully-watched event.

Our Own Forecast

Our own indicators have remained in a neutral mode.  This helped us to avoid the recent correction, but it also missed the rebound.  It is important to understand that this is just fine.  It is better to recognize situations where you cannot make a solid prediction.  That is the purpose of our "penalty box."  When a sector is in the penalty box, we know that forecasting future moves will be challenging.  As a result, the model is still neutral, and that is our vote in the weekly Ticker Sense Blogger Sentiment Poll.   Here is what we see compared to my last public update on July 11th:

• Only 85% of our 55 ETF's have a positive rating and three of these are inverse ETFs.  This is up from 25% a few weeks ago.
• 100% of our 55 sectors are in our "penalty box," continuing from recent weeks.
• Our universe has a median strength of +28, up nicely from -21 in mid-July.

If current market levels hold, I expect some sector buying next 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 email list.  You can also write personally to me with questions or comments, and I'll do my best to answer.]