A Dash of Insight

Weighing the Week Ahead: Understanding the Wall of Worry

One of the most difficult challenges for investors is understanding what information is already "in the market" and what constitutes fresh news.  The recent market rally is a great example.

There is widespread agreement about current economic problems.  Many observers express surprise that the market can rally in spite of "the fundamentals."

This is the wrong question.  The best time to invest is when things look terrible and prices reflect the poor current condidtions.  I wrote an article on this topic in mid-April of 2009 that I thought was one of my best.  A commenter, probably reflecting many others, offered a skeptical "Good luck with that."  It is difficult, unpopular, and profitable to have a bullish market viewpoint when the general news flow is so negative.

This concept is crucial for investors.  Let us bring it up to date.

Current Worries

To find out what is on the minds of savvy investors, just look to Abnormal Returns.  Each week Tadas posts a list of the most popular articles, a "must read" for my weekly prepration.  This week two of my favorite sources provided a list of worries:

1. Doug Kass is rightly worried about the decline of trust and confidence.
2. Barry Ritholtz, despite a more bullish investment posture, has a list of ten worries.

Both articles are worth reading in full.  There are interesting nuances and considerations, and my summary cannot possibly do justice to the entire articles.

Getting Beyond the Problems

How can stocks rally with so much to worry about?  To answer this question you need to consider what these lists would have been like a month ago.  Some of the worries have been crossed off!  Others have been reduced.

• The crash of the Euro, the sovereign debt crisis, and the "cockroach theory" have not come to pass.
• Corporate earnings have remained strong -- both current and prospective -- despite skepticism.
• None of the extreme "technical" forecasts -- Hindenburg Omen, head-and-shoulders top, Death Cross, or Dow Theory signals came to pass.  Some are now reversing.

(We have been pretty solid on these points, predicting all three accurately in real time).

If you watch the lists of worries as they change over time, you can see that some important concerns drop off.  This climbing of the "wall of worry" best explains both the current market action, and also the week ahead.  Let us start with our regular review of last week.

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

Last week's call was pretty accurate -- thin volume with the emphasis on housing data.  Here are the highlights.

The Good

• Market action.  The reaction to mixed data was positive, and it happened at a point of technical significance.
• Durable goods, ex-transportation, showed firming in business investment.

•  The ECRI indicators improved.  Most people remain confused by the picture of "weaker" growth, but it is consistent with all other economic data.  I am putting it in the "good" category since there is positive growth, less deceleration, and a continuing statement from the ECRI that this does not imply another imminent recession.

• Rail traffic is back to the highs for the year.

The Bad

My biggest worries -- factors prominently featured on the list of worries -- are employment and housing.

• Initial jobless claims slipped higher.  The rate is still nowhere near the level needed for sustainable job growth.

• Housing data -- sales, prices, and foreclosure rates -- all remain poor.  I really wish that someone on the Obama policy team would think about really solving the problem instead of throwing money via "macro" approaches.  One bright spot:  Bonddad takes a look at permits and sees a bottom.  I agree that permits are the best leading indicators.  We shall see.

 The Confusing

Some of the big stories last week did not really add anything new.

• The Fed reaffirmed existing policy with some wording tweaks.  The general posture  -- guarding against deflation -- has been frequently and clearly stated, so this was not really fresh news.

• The NBER finally decided that the recession was over -- as of June 2009!  This news provided a source for humor.  We could all joke around and act smarter than the big-shot economists.  In fact, they are simply dating the trough of the cycle, after confirming an actual rebound.  These dates are interesting for research purposes, but do not coincide with popular perceptions of economic health.

The Week Ahead

The most important data will be consumer confidence and the ISM index, since these both relate to next week's employment report.  Thursday's initial jobless claims data is important, but part of a noisy series.

Congress will break for the election recess.  At this point, it seems unlikely that there will be a vote on extending the Bush tax cuts in either house.  I continue to expect an extension, probably for everyone and for two years, but it may not happen until after the mid-term elections.

There will also be end-of-quarter action.  Anyone with a trading viewpoint should join me in spending a few minutes each weekend with Charles Kirk's excellent chart show (subscription only, and well worth it).  This week Charles does a beautiful job with the "three scenario" problem from two weeks ago.  His current take is bullish, but he also has specific ideas about the quarter end.  One of the best things about his forecasts is that he tells us what to watch for as the story develops.

Our Own Forecast

We remain bullish but cautious, with most sectors in the penalty box.  This is a recognition that we cannot have great confidence in most short-term prediction.  When a sector is in the penalty box, we know that forecasting future moves will be challenging.  Despite this, the picture has improved enough to continue our multi-week bullish posture in the weekly Ticker Sense Blogger Sentiment Poll.   Here is what we see:

•  95% of our 55 ETF's have a positive rating, up from 93% last week.
• 80% of our 55 sectors are in our "penalty box," down from 91% last week.  This means that uncertainty remains high for short-term trading.
• Our universe has a median strength of +32, up slightly from +29 last week.

For trading accounts, we had full exposure during the past 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.]

Conclusion

The market moved closer to a viewpoint we have espoused for the last several weeks.  It had several voices, including this one:

"The concept of a double-dip recession has been replaced with slow and steady improvement, and even if we don't get it, we have a Federal Reserve that's ready to step in and support the rally," said Art Hogan, chief market analyst at Jefferies.

The futures got a big pop Friday morning after a similar statement from David Tepper.  For me, this was hardly fresh news, but it is nice to see people joining in.

I continue to see a bullish environment for both traders and investors, and our accounts reflect this.

ETF Spotlight: The Controversy over Retail

Investing in retail stocks has involved a double-pronged controversy.  The first problem is the fundamental merits of the sector -- questions related to the consumer and the economy.  There is a second problem about the structure of the ETF and the possible risks.

An additional theme for all investors is why some of the biggest names in financial journalism ran with a story that was basically inaccurate.  This is something that would not have happened in the days when editors required fact-checking before publishing.

It is also an interesting story for ETF investors, but first, let me provide some background on our perspective.

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 short-term trading systems are basically Trend-following, but also include recognition of Cycles and a touch of Anticipation.  Since we apply the method to ETFs, we call it the TCA-ETF system.  We follow two versions of this method, designed for two hypothetical clients (Oscar and Felix) with different needs and risk appetite.  [New readers can find more information about the models at the end of this article.]  For convenience, we have named the models based upon the intended clients.

Featuring Retail Stocks

We trade retail stocks via SPDR S&P Retail ETF (XRT).  The fund has 68 holdings with nearly equal weightings, so there is no major concentration.  The P/E ratio is about 14, which is in line with expected long-term growth.  The dividend yield is only 1.36%

Here is the chart.

We have enjoyed part of the rally, and we still own the position. Whether we stay with it will depend on trading over the next week.  There could be a breakout to the April highs, but we could also see selling or continued consolidation.  Felix likes this position, as you can see from the details in our full table of sector ratings.

Other Opinions

We always survey commentary from other experts on the ETFs in our buy zone.  There has not been much commentary on the merits of owning XRT, but there has been controversy over the large short position.

Raising a warning is Andrew Bogan, a PhD biophysicist, university scientist, and venture capitalist.  He described a theory of ETF implosion based upon his understanding of how the ETF redemptions worked.  His story was quickly picked up by big name sources like this one and that one (to pick just two examples).  Bogan claimed that the actual holders of XRT outnumbered the stock held by the ETF managers due to massive short selling.  The concern was that redemptions might leave the XRT "longs" holding the bag.

There were some comments on the stories that explained why this reasoning was incorrect, but the best actual article I found was this post from Kid Dynamite (now added to our featured sources):

Now, Bogan fears a "run" on the ETF.  That's not going to happen (at least not for the reasons he fears), for a few reasons.  Let's start with the more complicated one, using Bogan's own numbers:  as Bogan notes, now 95mm people think they "own" the XRT.  Well, we know that only 17mm of them actually have possession of the XRT, since the other 78mm have lent their shares out to others.  You can't redeem something you don't have (remember, you've lent it out), so it's not possible for 95mm shares to be redeemed.  If some of the people who have lent their XRT out (maybe they even lent it out unknowingly) decide they want their shares back, it's not the end of the world!  The short sellers of XRT will have a few choices to return the XRT that they "owe."  They might go out in the marketplace and simply cover their short positions, or they might buy the underlying basket of XRT stocks, deliver them in to the trust, and "create" new XRT shares to deliver to the person they borrowed them from.   As Swaldman puts it, "The missing supply of ETFs would create itself."

 Anyone interested in ETFs should read the entire Kid Dynamite article.  In fact, they should read it twice.  There is a lot of information, but it is all something that you should know.

Meanwhile, we are all left to wonder why the Bogan piece got such widespread attention with so little checking.  I hope that the Kid Dynamite response gets equal billing.

 This Week's Results

Felix, the cautious approach, has continued to be mostly on the sideline with a slight negative lean.  Nearly everything is in the penalty box.  Felix sees the world as too unpredictable right now, but we are seeing a few attractive candidates.

Oscar, the more aggressive approach, is always looking for a way to win.  Oscar is unafraid of the volatility and now has many suggestions for fresh buys -- mostly energy and emerging markets.

Weekly TCA-ETF Rankings

We are currently fully invested in our Felix ETF program and also for those following Oscar.  (We are happy to report and discuss performance with interested investors.  We also offer a report on how we use the models, and a free weekly email update.  Write to etf at newarc dot com.  Our actual trading is a combination of both models and some weekly timing).

Please note that these are not recommendations.  Investor needs and risk tolerance varies.  We hope everyone finds the ratings to be a useful supplement to their own work.  The recommendations can change quite rapidly in this environment.  It is quite possible for investors with different time frames to reach opposite conclusions about a specific trade.

Here are the current rankings for both Oscar and Felix.  I also note the nice move in XME and QQQQ.

 

Note for New Readers

Our weekly ETF Update is designed to assist both investors and traders interested in ETF's and Sector Rotation.  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.

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

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

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

Oscar and Felix. 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 on Oscar and Felix in this article.  There is more about the Penalty Box here.

How President Obama Can Help Housing -- Right Now!

The two biggest economic challenges are employment and housing.  Furthermore, they are related.  Weak employment increases foreclosures.  Weak housing decreases aggregate demand and reduces net employment.

There is a cycle here -- an interaction between these two problems.

Obama Policies Miss the Target

Here at "A Dash" we try to remain objective about public poicy and the outcomes.  Not everything works as expected.  It is best not to be doctrinatire in your evaluation.

Briefly put, I am not a critic that will find error in anything and everything President Obama does -- just as I was not such a critic of President Bush.  My concerns are specific and well-grounded.

Mistakes

As the President changes his economic team, here are some key points to keep in mind:

1. There have been too many voices.  The original team lacked direction.  Even if Obama is expert at identifying and drawing out viewpoints (as Warren Buffett maintains), that was not the task here.  This was not a "single-issue" problem like the Cuban Missile Crisis.  There are many dimensions.
2. It is not just a matter of political or economic philosophy.  Even if a Keyensian stimulation was correct, that is a temporary solution.
3. There has been a disconnect between political types, trying to identify jobs saved or created on a website, and real economists.  The most important job effects can only be identified through macro-economic modeling.  This is not the way to win elections.
4. The transition delay -- the wrong people, questionable credentials, and a delay in everything that needed to be done.
5. Excessive emphasis on "macro" solutions.

 

No one won a Nobel Prize for analyzing the 2008 economic problems.

The people opining on this topic supported various theories that were not on point for the specific problems of the day. (I am not interested in a vaguely political/philosophical position about overall debt).

What Now?

The President has -- so far -- missed an opportunity for cheap, non-political policies that would have a big effect.  Here are two key facts:

• The role of government should be to facilitate the effective operation of private markets.

• There is a huge current appetite for securities with a good yield and moderate risk.

 

What Could We Do?  Restore Mortgage Securitization

Securitizing mortgages is a great idea that was poorly implemented.  Investors are reaching for yield in the current low-rate environment.  Meanwhile, the CDO market in mortgages has evaporated because of the crisis.

If we wish to move away from government as the backer of all mortgage debt-- and who doesn't -- it is time to restore this market.

The steps are simple:

• Make sure that CDO's meet specific criteria -- no complexity of tranches.  They should be plain vanilla.  Risk is OK, if the product reflects this.  The market will determine the right price.
• Mortgage originators need some "skin in the game."  This is the only way to keep the process honest.
• Ratings agencies need to be strong and appropriate.  This cannot be a "rubber stamp" process.
• Ideally, the securities would be traded on a public exchange.

Providing a regulatory environment that would facilitate securitization would unleash the private market to connect borrowers and lenders.  Unfortunately, none of the alphabet soup of temporary programs addresses these issues.

Meanwhile, should we be surprised at a decline in housing prices?  There is no market for jumbo mortgages.  The high end of the market has no liquidity.  People cannot move from job to job, from city to city.  The inability to borrow forces the market lower, generating more foreclosures.

Conclusion

Until we have a solid mortgage securitization process, we are stuck with government.  That means there will be no real solution.

It is ironic that the solutions I suggest cost very little.  There are no subsidies.  It is a role for government -- providing the right environment for free markets to work -- that has widespread philosophical support.

Apparently the solution is too "micro" or too "technical" for the big thinkers.  They are all engaged in a political debate, with an election at stake.

We have a moderate economic reobound that could be really exciting of we could address the housing problem effectively.

 

 

 

As I noted in my regular market preview, this week would see a focus on housing.  I regard building permits as important.

Weighing the Week Ahead: Focus on Housing

Forecasting market moves is always a challenge, but the recent months have been especially difficult.  I see three reasons:

1. Fundamental data have not provided a clear direction.  This is typical in times of modest growth.  Economic data provide an inconsistent pattern, although most observers impose their own interpretation on the results.
2. Technical data do not provide a clear direction.  Most observers impose their own interpretation on the results.
3. Everything is correlated.  The reward for stock and sector selection is lower, since there is much less variation from the overall market.  The focus on the simplisticly named "risk on, risk off" trade does seem to capture the current lack of imagination.  The correlation of stocks is .81, double the historical value.

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

Last week's call was pretty accurate -- thin volume with the opportunity for varying interpretations.  Here is what I found to be most important.

The Good

• Industrial production upticked and capacity utilization is at the highest level in two years.

• The ECRI Index improved to the highest level since June.  The debate continues between those who created the index and employ additional data in making recession calls and those who are making inferences from published-only data without even knowing the index constituents.

• Earnings, despite skepticism, continue to show strength.  For many of us the market seem to be mispricing technology stocks.  I especially apprecitated the data-based work of Chuck Carnevale, who compared earnings growth and stock prices in Oracle (ORCL) and Research in Motion (RIMM).   The article shows the opportunity for strong fundamental analsyis.  If you read the comments, you get a good picture of the opinons of partisans, and why you might want to be a contrarian.  [Full disclosure - I am long both stocks in personal and client accounts.]

• The market reaction -- solid in the face of modest economic data.  The S&P 500 is back above the 200-day moving average, testing technical resistance at the high end of the recent trading range.

 

The Bad

There was bad news, but it had a mixed quality.

• The small business index is still in "weak or recession territory" although it registered a small uptick this week.

• The Philly Fed report was slightly negative (-0.7), but an improvement from last month's -7.7.  This was a little worse than the consensus forecast and the fact that it was negative got a big media play.  This is a diffusion index (are things better or worse on various factors) and a a survey.  No one asks about a margin of error or worries about late-arriving answers.  I am interested in the report, but it is very noisy.  People make too much out of small changes.

• The housing stories were all very bearish -- three-year inventory, foreclosures higher, prices falling.  The inventory is a little deceptive, since it is based on the last month's annualized sales.  If sales were to move higher, the inventory could change a lot.

• Weekly jobless claims were 450,000.  I continue to call this a negative, since it is not close to the level needed for solid net job growth.  On the other hand, those who claimed last week that the improvement was due to seasonal factors or a holiday-shortened week were wrong.

 

The Ugly

• Consumer sentiment, as measured by the University of Michigan, declined to 66.6, the lowest level in more than a year.  Calculated Risk rightly observes (check out the article for the helpful chart) that this is a lower level than the market-moving July reading.  Regulare readers know that this is an important element of my employment model, since it captures information about job creation as well as layoffs.

• In a curious juxtoposition, investor sentiment is turning bullish, another negative for the contrarian observers.  Is this confusing enough for you?  Recession fears subside and the year-end market is called higher.

Check out the charts on both, with all of the bearish implications at a new site, Global Economic Intersections, featuring some of my most popular contributing colleagues at Seeking Alpha, Steve Hansen and John Lounsbury.  I wish them well.

The Week Ahead

The housing stories already have our attention, and this week provides fresh data.  We will see data on housing starts, building permits (my own favorite leading indicator of housing), existing home sales, and new home sales.

The political debate over extending the Bush tax cuts will continue, as will the various jobs programs.

I do not view the so-called leading economic indicators as very important, but I am always interested in the initial claims.  The week after options expiration often has a slight negative bias.

Finally, we will all be wondering whether the trading range breaks to the upside.

Our Own Forecast

We remain bullish but cautious, with most sectors in the penalty box.  This is a recognition that we cannot have great confidence in most short-term prediction.  When a sector is in the penalty box, we know that forecasting future moves will be challenging.  Despite this, the picture has improved enough to continue our bullish posture, in the weekly Ticker Sense Blogger Sentiment Poll.   Here is what we see:

•  93% of our 55 ETF's have a positive rating, up from 78% last week.
• 91% 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 +29, up from +18 last week.

For trading accounts, we had a 60-80% exposure during the past 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.]

Conclusion

Our short-term and long-term models are back in bullish agreement.  The short-term model can and often does change quickly.  It should be another interesting and challenging week.  Readers my agree or disagree with my conclusions.  That is fine.  I hope that most find my "thinking out loud" exercise to be helpful.

The Investor Sentiment Cycle: An Interesting Survey from Charles Kirk

Charles Kirk has many innovative ideas that help us all think about the market in new and constructive ways.  This week he conducted a private poll including 100 top professionals.

To get the maximum benefit from this exercise, I encourage readers to make their own answer the following question:  Where do you think we are in the investor sentiment cycle and why?  Choose a specific answer from the figure below.

No cheating!  Answer first, and write down your reason in three sentences.  You will learn much more by doing it that way.

The Survey Results

While Charles makes no pretense of science in determining his original sample, his work attracts a widespread following.  People with varying market "ideologies" regularly read and use his recommended links and watch his new weekly chart videos (small membership fee required, and well worth it).  Personally, I was quite curious about what the results would be.  Here is the basic summary:

Of those who dared to offer take the poll and go on record (most I asked never responded), 63% thought the cycle had already bottomed out while 37% see further downside to go in this cycle.

Check out the article for the full distribution of results as well as many excellent comments from participants.

My Vote

Regular readers of "A Dash" could probably guess my vote.  I was in the "depression" camp.  As usual, I am willing to go on the record.  We were asked for a three-sentence comment, and I wrote as follows:

“Sentiment reflects reality, so we hit bottom post-Lehman. The depression and capitulation came in March, 2009. The slow and halting economic recovery will be accompanied by improved sentiment — a process including feedback.” – Jeff Miller, Dash Of Insight

If I had written a bit more, I would have elaborated on the feedback point.  One problem in the economic recovery is the pervasive lack of confidence.  Nearly every poll shows that people do not believe that any policies are working.  Most think that the recession never ended.  This is true across a wide swath of demographic groups, including bankers and CEO's who control investment and lending.

A successful president could lead and inspire the country: "We have nothing to fear but fear itself."  Instead, we have a skeptical public asking, "Where's the beef?"

My vote reflects my confidence in the recovery (a reflection of our country and our people as much as policy), but an acknowledgment that it is a difficult and slow process.  The economic rebound could have been faster and more robust.

Investment Conclusion

My oft-stated conclusion for long-term investors is that we are at a point of substantially above-average opportunity for stocks.  There are many companies that record great earnings with little change in the stock price.  That means that P/E multiples have moved lower.

Improving sentiment means that multiples will move higher.  This means that stocks will do even better than the earnings growth rate, but it is going to take time.

Meanwhile, I really liked the survey idea.  It was useful to think about my own answer and to read those of others.  It is a tool that I might consider using as well.

What the Obama Economic Changes Mean for Investors

It is normal for a Presidential Administration to have leadership turnover at the two-year mark.  The change in people often reflects a change in policy as well.

Does this mean anything for investors, or is it just business as usual?

Interesting Perspectives

There is a relentless criticism of an overt political nature.  This is to be expected as a normal part of the electoral process.  Feel free to join me in voting as we wish;  as investors we need to make careful distinctions between rhetoric and reality.

The macro perspective is presented nicely by Bob McTeer, one of my favorite sources.  He is a solid, conservative Republican.  He is also a pragmatist.  I very much enjoyed his article about a speaking invitation he recently received. Here is his description:

I was recently invited to speak on the topic of “Whether the Obama Administration’s policies are making the recession worse” and asked to recommend someone to appear with me who would take the opposite position from mine. The interesting thing to me is what do they think my position is on that topic. I’m not sure myself.

He goes on to analyze various Administration policies with typically strong comments -- well worth reading.  In his conclusion he struck one of my favorite themes as "A Dash, "  writing as follows:

The stimulus program and other spending obviously contributed greatly to the deficit and the debt, but, to be evenhanded in our consideration of counter-factuals, we must acknowledge that the fiscal deficits might conceivably have been worse without the spending. Spending adds to deficits, but so do tax revenue losses resulting from declining economic activity and increased unemployment. The debate would sound more respectable if it discussed degrees rather than absolutes—dials rather than switches.

In my own work I have described this as "light switch" thinking.  One of the best things you can learn from the study of economics is to think in terms of distributions of results rather than black and white.  Unfortunately, the public debate is not so sophisticated. (There is a nice summary of the topic here.)

Mark Thoma uses strong evidence to present a specific example.  He takes up the problem of small business.  It is popular rhetoric to say that small business is unwilling to expand because of uncertainty and fear of regulations.  Prof. Thoma produces the evidence:

If you actually ask small businesses what they are worried about instead of asserting what's politically convenient, and do so consistently over time so you can detect where big swings occur, it's clear that small business believe that lack of demand is the biggest problem they face right now...

Read the entire article to see the survey results emphasizing lack of demand -- followed by several other factors.

My Own Conclusions

Like everyone else, I am disappointed in Obama's failure to address issues that I regard as most important -- a subject for a different article.

Meanwhile, what can we conclude from the current signals?

• No new policies will be called "stimulus" since the symbolic debate has been lost on that front.
• The new investment programs have some merit, but are mostly political.  They are too small to turn the tide, and are chosen to embarrass the GOP.
• The Bush tax cut extension is also a bargaining position.  It will be difficult to pass a partial extension, the current Obama position, and no one wants the responsibility for a passive tax increase.

Gridlock?

Finally, I am amazed at the glib commentary celebrating the potential for gridlock.  None of the problems we face can be solved by inaction.  None of the policies already passed can be reversed or repealed by a split government.

What is needed is bipartisan cooperation, negotiation, and compromise.  This has been in short supply for the last two years.  It will not be an instant result from this fall's election.

Investment Conclusion

It is a sad commentary on the times in the investment blogosphere that every publisher wants immediate, actionable advice from every article.  I guess it has something to do with page views and revenue.

Meanwhile, consider the following two ideas:

Maybe you do too much trading, thrashing around in search of the next thing.

Maybe you need to spend more time learning -- getting ready to act at the right time.

In this case, it may mean watching for signs of cooperation.  My own test is whether it happens before the election.

Weighing the Week Ahead: Perception versus Objectivity

In the ongoing debate over market prospects, confirmation bias is probably the most powerful force.

We all look at fresh evidence, but it is a challenge to do so with an open mind.  Each weekend I prepare for the upcoming market action with a look at the week ahead.  I am helped by our sector-oriented trading models.  I view the models as wise advisors, focused on data, and operating without emotion.

Some market participants rely upon technical analysis to provide objectivity.  This has always bothered me, since it is difficult to backtest or otherwise evaluate this advice.

A Little Ruse

When I made the career change from college professor to investment research, I did a lot of research and data analysis.  One day, my boss described a suspicion about our lead technical analyst.  My boss was a shrewd person with both imagination and a fine sense of humor.  He asked our technical analyst to evaluate the stock charts of a number of unnamed companies.  The verdict was pretty bullish.  Next, he asked me to create a second group of charts;  each was a fake, the exact inverse of the real chart.  After a week or so he asked our analyst to interpret these charts.  Once again, all bullish!

This was long before the popularity of the behavioral finance work, but it did prove an important point for us.

A Lesson for All

The little ruse is a universal lesson.  In my regular review of the week, I would like to emphasize how we all see what we want, regardless of the methods we choose.  In so doing, I am including (with permission) some insightful stock charts from Carter Braxton Worth, the Chief Market Technician for Oppenheimer.  His entire report is available here.  If you want to see more of his work, reach out to your Oppenheimer representative.  If you need to find a contact, send me an email and I will put you in touch with a wise and valued friend from Oppenheimer.

But, first, a little background for those new to this series.

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

Last week's call was pretty accurate -- thin volume and focus on politics.  With the holidays over and the "A Teams" returning, this week will be more important.

In my weekly review I am going to combine my traditional analysis of data (fundamental analysis) with a look at the technical perspective.

The Good

• Initial jobless claims declined to 451,000, a substantial decrease and the lowest level since early July.  For many this relieves the fears from the spike to 500K, perhaps influenced by Census jobs and unusual seasonal factors.

• There has been an increase on job openings, now exceeding 3 million.  Many people who do not look at data would be surprised at this.  The JOLTS report deserves more attention.

• The trade balance returned to recent norms.  This implies higher GDP.

• The ECRI indicators rose to 122.0, the highest level since August.

• Basel II requirements are in line with expectations and provide time to comply.

• There is a positive technical picture.

 

The Bad

• Initial jobless claims remain at an unacceptable level.  Since some states did not have complete data in a week shortened by Labor Day, it was necessary to make estimates from existing data.  Many in the blogosphere see this as suspicious.

• The ECRI growth indicator remains at a level never before seen in the published series without a subsequent recession.

• Leading economists have reduced their economic outlook for the rest of 2010.

• Basel II requirements show that the European stress tests did not reflect capital needs.

• Technical indicators are negative.

The Mixed

There is a third viewpoint -- economic data suggesting slow growth.  It is neither a "double-dip" nor a robust recovery.  Improvement in employment is slight, but corporate profits continue to grow.

Technical indicators are neutral, showing a trading range.

 

The Week Ahead

The upcoming week features many economic reports, mostly of lesser significance.  I have modest interest in the Philly Fed report as the early indicator for September.  Capacity utilization has shown solid and consistent growth with little attention.  While any single week of initial claims has a lot of noise, there will be special attention this time because of the skepticism concerning government estimates.

None of this information will be compelling, so I expect more of the same:  We can all see what we want and expect to see!

Our Own Forecast

Our own indicators shifted to neutral from bearish three weeks ago.  We remain cautious, with most sectors in the penalty box.  This is a recognition that we cannot have great confidence in most short-term prediction.  When a sector is in the penalty box, we know that forecasting future moves will be challenging.  Despite this, the picture has improved enough to shift to a bullish posture, our  vote was neutral in the weekly Ticker Sense Blogger Sentiment Poll.   Here is what we see:

•  78% of our 55 ETF's have a positive rating, up from 24% last week.
• 93% 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, up from -14 last week.

For trading accounts, we have had a 50-70% exposure during the past 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.]

Conclusion

I hope readers enjoyed this look at how the same information can lead different observers to different conclusions.  In particular, I find that a chart with a few trendlines or labels can have a powerful effect.  Thanks again to CB Worth for the great inspiration and for sharing his work.

Meanwhile, our model looks for a breakout from the range, so that explains why we are edging into more bullish positions.

Asset Allocation: It is not like Poker!

In the ongoing debate about prospects for various asset classes, there is a misleading question.

Are you in the market, or out?

The investment decision is not like the World Series of Poker, where players win by going "all in" at the right moment.  No one really knows what will happen in the next few months, and there is no reason to make an unhedged bet.  The investor may choose stocks, bonds, commodities, real estate, cash, emerging markets, or the latest Wall Street product asserting uncorrelated returns.  Why not a Chinese restaurant approach?  Get some stock exposure -- -right now!

A few years ago many investors (fortunately not mine) were feeling the sting of losses from the 2000-01 post Y2K tech crash.  They were stampeding into real estate, since there was a limited supply of land. We all "knew" that these prices could not go down.

Here is a quotation from July, 2005.

The major problem facing investment advisors is helping clients with asset allocation.  Your client is intelligent and engaged.  The problem is that they are focused on what worked last year, and your job is to help them with what will work next year....People have the idea that real estate cannot decline in value -- a dangerous notion.

It may surprise some recent readers to learn that the source is "A Dash" from five years ago.  I am going to wait to announce our official five-year anniversary until later in the year, when I took this up in earnest.  Before that my investment commentaries went only to clients.

I will do some reliving of five years ago, and this is a start.  I warned many clients and friends who were buying three or more properties.  Like many others, I was early in this warning.

Current Investment Implication

There is an overwhelming reaction to losses, especially those suffered recently.  As a new investment advisor in 2000, despite more than ten years advising big-time traders, I struggled to gain new clients.  They could all double their money by throwing a dart at a list of Internet IPO's.  Logic and traditional metrics were irrelevant.

A few years later, investors  missed a great rebound in stocks since so many had gone "all in" on the NASDAQ and lost 90% of their assets.  That was no fun at the cocktail party!

The most recent investor reaction is to 2008.  My greatest fear, shared by many excellent advisor colleagues with whom I correspond, is that a generation of investors will overreact to the 2008 experience.  It is beyond my scope here to analyze everything that happened.  Regular readers know that I am reviewing all of the books and the official findings, but too many are simply turned off on the prospects for major companies and too pessimistic on America.

Investors who wait for the final verdict on what went wrong in 2008 will miss the party.

It is not Poker

You do not need to go "all in."  You need to find a handful of good stocks to buy at a good price.

Use the News and Lose: Survivor Bias and the Worst Books of All Time

We all love a winner!  It is so natural to admire those who have been the best at what they do.  It is the essence of celebrity, and it is fun.

As the basis for investing, admiring the recent winners is fraught with peril.

Background

I enjoy reading the work of Geoffrey James.  In my own business we spend most of our effort on analysis and trading and not enough on telling our story.  The James columns help us a little on that front.  So I am a regular reader and a fan.  He often uses the popular "list" formula.  Today's topic was the ten worst investment books of all time.

The article is outrageous and provocative.  How could he have read the worst books?  Why would he bother?  How would he even know about them?   Still, we are tempted to look at his list and see whether our own candidates are among the losers!

I found both irony and controversy in his list.  I am not going to argue with his top choice, Leadership Secrets of Attila the Hun, NOT added to our recommended readings.  There are a couple of other controversial entries, but here are two good lessons.

1. James includes Dow, 30,000 by 2008.  There is no analysis of the content.  Apparently it is on the list because the forecast was incorrect.  (I have not read the book, so I have no opinion on the merits).  He could have included other books calling for Dow 36000 or even Dow 40,000.  These all make me feel like a piker for my ongoing Dow 20K analysis!  Meanwhile, if the market had moved higher, would the crash books be on the "worst list" instead?  What will the "worst list" look like in ten years?
2. #3 on the list is the still-popular In Search of Excellence.  Here is James's takedown:

Why It’s On the List: Based on a study of forty-three of America’s best-run companies from a diverse array of business sectors, describes eight basic principles of management - action-stimulating, people-oriented, profit-maximizing practices - that made these organizations successful. Unfortunately, the “excellent” companies featured in the book mostly went smack down the toilet not long after it was first published.  Curiously, it’s still considered a classic, which goes to show you that P.T. Barnum was right: a sucker IS born every minute.

I objected to this book at the time of publication.  It played upon all of the behavioral economics issues, not well known at the time.  Astute readers will immediately see the parallel with my recent analysis of the Hindenburg Omen.  If you start with a known conclusion and then look for the apparent causes, your analysis cannot be refuted with the evidence then at hand.  It is a flawed approach with a popular but meaningless result.

Investment Lesson

The survivor bias is a big challenge for investors.  You do not see the results from unsuccessful mutual funds.  They are gone.

We celebrate the results of the recently-successful, perhaps being fooled by randomness.  When we start with the known result, we inaccurately infer causation.

Current examples include the investment advice of those who profited from the housing crisis.  Michael Burry, a hero in The Big Short (reviewed here), no longer accepts your investments, but is sharing his thoughts.  If you agree with him, it should be on the basis of logic and method, not because he was right about 2008.  Good luck in buying farmland with water.

What are your own nominees for the worst business books of all time?  (James includes investment books in the list).

I find a touch of irony in his list.  It involves some of the same survivor bias for which he criticizes Peters.

Whatever we think, his choice of Attila the Hun will probably stand the test of time!

Weighing the Week Ahead: Your Move, Mr. President

Each weekend I review events and data from the past week and prepare for trading by thinking about the week ahead.  While I always do the review, I do not always have the time to write about it.  Like many other writers, I find that the process imposes a discipline and logic.  It can be a helpful antidote for the temptation to lazily follow preconceived notions.

Last week I expected a focus on jobs with special emphasis in front of the Labor Day weekend.  This was the right idea, and apparently a surprise to some.  Art Cashin, a faithful reporter of the buzz on the NYSE floor, stated the following:

“There was great speculation overnight that the reason he scheduled a meeting was that maybe the employment numbers were going to be very bad, and that’s what caused an overreaction.”

Cashin said traders are hoping that the Obama administration will come out with a suspension of the payroll tax and give companies that are hiring further incentive to do so.

“If they don’t announce that…if there is no Christmas package coming at 10am, then people may rethink the rally a little bit.”

Traders look so deeply into the tea leaves that they often read what is not really there.  There is always speculation about the President getting an early report on employment and tipping it off, despite repeated explanations about the timing of the release.  Scheduling a brief appearance to comment on the employment news the day before Labor Day weekend is completely routine, requiring no further explanation.  Finally, such an appearance would not be the way to introduce a new policy initiative.  Some of the trading firms might benefit from hiring a few Poli Sci grads!

The lukewarm employment news sets the stage for next week, which will highlight politics rather than economic data.  I have some specific predictions, but first let us review last week's key events.

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

While many were on vacation the data provided trading opportunities nearly every day.  As I noted last week, the backdrop was so negative, that even modest data might be celebrated.

The Good

• The ISM manufacturing report surprised most with an uptick to 56.3.  This is consistent with GDP growth of about 4.8%.  It continues to be the most bullish economic indicator.

• State tax sales tax receipts, a good concurrent measure of consumption, continue to improve.  Check out The Bonddad Blog for a comprehensive and readable analysis.

• Unexpected strength in China's PMI and Australia's GDP helped stocks to a big day on Wednesday.

• Sentiment remained negative despite these indicators.  Todd Sullivan highlighted two good examples.

The Bad

• The ECRI WLI dipped after rebounding a tad in recent weeks.  While still not predicting a recession, Lakshman Achuthan has upped the risk to about 50-50.  (I think he uses a two-year horizon).  This is higher than the risk seen by most economists, but still not as bad as some consumers of his data who think recession is a near certainty.

• The ISM Services Index was weaker than expected at 51.5.  While still positive (signaling expansion) it is the lowest reading in eight months.

• Initial jobless claims were 472,000.  While this is better than the 5-handle from two weeks ago it is nowhere close to levels needed for a solid recovery.

The Mixed

The employment gains exceeded the depressed expectations, including my own.  (I did my regular monthly preview on Wednesday).  In reality, it was a mixed picture, hardly worthy of cheering.

The payroll employment survey showed a small gain if you ignore the layoff of temporary census workers.  The past two months were revised to show smaller pre-census losses, so the net private sector gain has been 133,000 over three months.  While this is an improvement over last year, it is not even close to the net job creation rate that is needed.  Total hours worked were revised higher in July and unchanged for August, increasing at an annual rate of nearly 3 percent.  This is also a small positive, but not as good as new jobs.

The household survey, as noted by Gene Epstein, showed a gain of 848,000 jobs in the category that most closely represents private jobs.  The household survey has a smaller sample and a larger confidence interval (=/- 400,000) so it is not wise to focus much on one month.  Epstein points out that we have had a monthly growth rate of 328,000 for the January-April period and 285,000 since then.  Despite these additional jobs, the unemployment rate moved slightly higher as people joined and re-entered the labor force.

Epstein conjectures that the household survey is doing a better job of picking up the self-employed and new small businesses.  This would be nice, if true, but the most recent benchmark revisions for the payroll report moved the job estimates much lower.

The employment data may be confusing, but it is difficult to challenge the general perception: Employment remains the major economic challenge.

The Week Ahead

The four-day trading week will be even shorter with many market participants observing Rosh Hashanah on Thursday and Friday.  There is little in the way of economic data.  The Fed Beige Book comes out on Tuesday.  Bob Pisani reported on Friday that traders were focused on whether the Fed would retain the same language on manufacturing activity.  Wow!

I do not question Pisani's reporting (since he reports what he hears), but his report made no sense.  The Beige Book is prepared before each FOMC meeting by a different regional Fed bank on a rotating basis.  There is unique authorship and no reason to expect editorial consistency.  It is in no way similar to the official statement accompanying the FOMC decision, which we all carefully parse after each meeting.  Here is the content of the Beige Book:

Commonly known as the Beige Book, this report is published eight times per year. Each Federal Reserve Bank gathers anecdotal information on current economic conditions in its District through reports from Bank and Branch directors and interviews with key business contacts, economists, market experts, and other sources. The Beige Book summarizes this information by District and sector. An overall summary of the twelve district reports is prepared by a designated Federal Reserve Bank on a rotating basis.

It is fine to look at the Beige Book, which will be part of the FOMC decision process at the next meeting.  It is a mistake to put too much emphasis on specific language.

Far more important is the political front, even (or especially) with Congress still on recess.

Your Move, Mr. President....

As we approach the mid-term elections, control of both Houses of Congress is at stake.  This is the home stretch.  Each side has staked out a position.  (Note to new readers:  Put your political opinions aside for a few minutes and consider my approach.  You can and should do whatever you want in the voting booth, but you should join me as a political agnostic when it comes to investing.  I call them as I see them on this front, and I have been doing it for over 40 years.  Do not let your political viewpoint interfere with your investment decisions).

Republicans expect to make big gains, but they are also looking ahead to 2012.  They are delighted with the Tea Party success, but struggling to cope with it.  GOP leaders have mused that even Ronald Reagan, who appealed to a wide swath of "Reagan Democrats" might not get the GOP nomination in the current environment!

GOP stalwarts attack the Obama stimulus program as totally ineffective.  They emphasize the growing deficits and dismiss Keynesian economics.  At the same time, they seek to preserve the Bush-era tax cuts.  While most observers see this as inconsistent, GOP leaders offer various arguments about why the cuts should be preserved, even for the wealthiest.

Democrats are stuck with a bad situation.  Despite a stimulus program that most regarded as massive when it passed, unemployment remains stubbornly close to the 10% level.  Since the package was advertised as something that would bring unemployment below 8%, it is viewed as a failure by nearly everyone.  I was surprised and impressed by CNBC's Erin Burnett's strong performance with some roundtable heavyweights on Meet the Press.  She aggressively and insistently noted that the conclusion from all of her reporting (economists and CEO's alike) was that the stimulus had averted a much worse situation.  This conclusion is accurate, but it is also quite unhelpful to Democrats.  Barney Frank has noted that no one ever won an election by campaigning against a counterfactual.

Dem stalwarts keep reaching back to Bush-era comparisons, but voters have long tired of that approach.  The current economic results, the focus for most voters, are not encouraging.  Democrats are unlikely to succeed in shifting attention to a new focus on the future.

Meanwhile, Republicans may win seats while losing a clear message for the future.

My Political Forecast

It is early, but here are a few fearless forecasts on the political front.

• Democrats will not propose anything called stimulus.  The "S Word" is gone!  The retiring Christine Romer emphasized this in her last official employment day CNBC interview.  Stimulus has a bad name.  She repeatedly avoided the label.
• Democrats will propose jobs programs. Christine Romer, in her final speech, will address these issues.  The Wall Street Journal, missing the memo about stimulus (!??) headlined the story, Romer Calls for More Stimulus.  The title aside, it is a good preview.
• There will be other new Obama initiatives, with a clear partisan challenge.  This was obvious last week, and it is now confirmed in the Washington Post and also confirmed in the New York Times.

Briefly put, there will be some new ideas that can be pitched in November as well as some trial balloons.

As I have repeatedly noted, I expect some of the Bush-era cuts to be extended.  If Republicans currently in Congress play their cards right, they could win an extension for the very rich as part of the deal.  I cannot predict GOP strategy, but all of the various scenarios involve some extension of tax cuts.

This development, whenever it happens, will be bullish for US stocks, since there are so many skeptics.

Our Own Forecast

Our own indicators shifted to neutral two weeks ago.  We are cautious, with most sectors in the penalty box.  This is a recognition that we cannot have great confidence in most 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:

•  24% of our 55 ETF's have a positive rating.
• 95% 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 -14.

For trading accounts, we have had 20-50% exposure during the past 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

I like to contrast the short-term trading perspective with the opportunity for investors, many of whom are missing the boat.  Legg Mason's Bill Miller (no relation, despite sharing my dad's name) was a legend when he beat the S&P 500 year after year.  Performance records vary with the times, but I have always admired Miller's methods.

He sees large-cap stocks as the bargain of a lifetime.  In March of 2009 Doug Kass said that stock prices were at a generational bottom.  By many valuation metrics, including those that I favor, stocks are as cheap as they were in March, 2009.  It is something to think about.  Investors who cannot find any good stock ideas in this market, should seek out some help.