A Dash of Insight

How to Plan for 2011

Should investors pay attention to the turn of the calendar?

Putting aside the seasonal effects -- the Santa Claus rally, the January effect, and the Presidential mid-term rally -- it is an important psychological time.  People reflect and plan.  Here are a few simple but important suggestions for 2011.

Four Simple Ideas

• Look inward, not at the pundits.

Most investors pay far too much attention to the market, the global economy, Fed policy, the Obama administration, and the advice of various pundits.  They pay too little attention to their own personal needs and risk tolerance.  There is a great irony here, since most people are terrible at economic and market forecasting, but experts on their personal situation.  Why not focus on what you do well?

• Don't play poker with your investing.

This is not like a TV poker tournament where you win by guessing when to go "all in."  Develop a sound plan that recognizes your personal objectives.  The most important question is whether you are preserving wealth or whether you still need to create wealth.  It makes a difference.  You should set aside any money you will definitely need in the next few years and develop a strong plan for the rest.

• Recognize and plan for risk.

The investments with the greatest potential payoff usually come with the greatest risk.  Investors emphasizing income often underestimate risk.  Investors in stocks do not appreciate the corrections that are part of normal volatility.  While we all try to dodge the big declines, it is not so easy.  Here is a rule of thumb.

The historical volatility for the S&P 500 is about 16.  The VIX is currently at 17.5, but VIX futures for next year are higher -- in the twenties.  What does this mean?  This is merely a general rule of thumb, but it is good enough for general planning purposes.

A volatility of 20 implies a 16% chance that the market will be 20% lower than the expected annual change.  It also implies a similar chance that the market will be 20% higher.  If you expect a gain of 10% in 2011, the implied volatility of the market suggests a distribution of possible returns with a mean of 10%, a possiblity of a small loss, and a possibility of a big gain.

To summarize:  Investors should plan for a distrbution of possible returns, not just the expected outcome.

And also:  The path might be rocky.  The nice gains in 2009 and 2010 came after significant losses.  During these times there were many sources warning that this was another collapse like 2008.

You need to plan for risk in advance, knowing what is acceptable to you.  If a 16% loss at some point in the year is too much, your stock exposure is too great.  It is much better to have a reasonable risk level that lets you hold a position through expected declines, than too get too big and bail out at the market bottom.

• And Finally -- Don't Get Scammed.

Every year the scammers find new ideas.  This can happen to anyone.  My recent article citing some of the biggest scams includes things that entrapped many intelligent people.

The "too good to be true" voice in your head is your initial line of defense.  If you do not see the trap, call your investment advisor before making a commitment.

Conclusion

The simple steps I have outlined take only a few minutes.  Your investment advisor can help, but no one can do it for you.  Analyzing risk and reward is a personal thing.  Please read this article carefully and plan in advance how you will handle the market fluctuations that we already know will happen.

As I will demonstrate in my annual preview, this is a good time to invest.  It means that you can be a little more aggressive than your normal posture, but you still need to plan.

Best of luck to all of my friends and readers for 2011!

 

The Insight Awards: Exposing Scams

As I reviewed the events of 2010, I noticed that many of the most helpful stories of the year did not seem to attract much notice.  I decided to give an "Insight Award" to bloggers who provided the most help to individual investors.

I am starting with an important topic:  Avoiding Scams.

We must always deal with scams, but in times of stress the temptation is greater.  Whenever I write about a topic like this I get comments and emails saying that the article is irrelevant.  The person writing the comment explains how obvious the trap really is.  Why would anyone reveal personal information to an unkown person in Nigeria?

Why indeed?

The scams I am mentioning attracted many investors -- people who want to believe that you can get huge rewards without taking any risk.  The biggest problem is that the victims do not read "A Dash" or any of the sources cited here.  The people victimized in these scams had major losses, sometimes an entire fortune. 

Despite this sense of futility, here are the nominees for the Insight Award for Exposing Scams.

David Merkel and "Structured Products"

Regular readers of "A Dash" know that we are long-time Merkel fans.  In this article from June, Yield, the Oldest Scam in the Books, David explains how the scam artist preys upon the victim:

There are two ways to fleece (cheat) someone: appeal to their greed, or appeal to their fear.  But the most effective approach that I know of is to appeal to elderly investors who did not save enough, and are finding it difficult to make ends meet.  They don’t want to take big chances, but they do need the yield.

David's article explains the flaw in some of the "guaranteed yield" programs.  They are so many of them that specific refutation is impossible.  Meanwhile, I know several investors who have been victimized by these programs.  Not surprisingly, they all carry a high commission, paid up front.

Lisa Caccioppoli and the Scam Overview

Minyanville offers a wide variety of commentary and helpful advice.  This article from Lisa Caccioppoli highlights several of the big scams that threaten the individual investor.   She writes as follows:

Clinging to a promise of high returns or a chance to replenish a retirement account, the desperate (or shall we say, hopeful?) all too often end up grabbing opportunities that turn out to be straight-up frauds. And as we all should have learned from a crash course in Ponzinomics in 2008, the most cliché rule is still the most spot-on: If it sounds too good to be true, it probably is.

 She goes on to analyze five scam themes, all of which deserve your attention.

"The Worm" and Penny Stocks

Here at "A Dash" I typically do not discuss the penny stock world.  There is a climate of something for nothing--a name-calling discussion among anonymous "pumpers" and "bashers."  The stock prices are low, so percentage gains do not require a major move.

The temptation is very great, especially for investors who are trying to recover from losses.

I am also reluctant, for a variety of strong reasons, to feature anonymous writers.

Despite these reservations I want to suggest skepticism about penny stocks and I do so by highlighting "The Worm" whom I do not know.  The Worm accurately analyzed scams in 2010, both on his blog and on the discussion boards.  Anyone thinking of making a major investment in penny stocks should be monitoring "The Worm" and similar sources.  It is a different world, and one that I do not recommend.  If you are contemplating a speculative move into a penny stock, you might want to study some of the past scams first.  Reading archives from the Worm is a good place to start.

Gold Scams -- Nomination Open

I could not find a good gold scam expose' among my regular sources.  Please take careful note.  There are some very legitimate ways to invest in gold.  I have often reported my own investments for myself and for clients in gold stocks and ETFs.

In sharp contrast, I see television and newspaper ads that obviously prey upon the weak and fearful.  The ads talk about private minted coins with dollar denominations of $50 and throw in a silver coin supposedly worth $20.  The entire charge is twenty bucks plus shipping and handling.  The actual gold in this "gold clad" coin is not worth much and the aftermarket is nonexistent.  This is so tempting for the uninformed.

No one writes up the scams, perhaps because writing anything negative about gold is very unpopular.

Many of the "legitimate" gold sites are on the edge of the rules.  The programs featured on talk radio and financial TV are not complete frauds, but they have high commissions, low liquidity, and instant losses if you try to sell.  There is an obvious network of investment funds selling fear and advertising gold.  No one points this out, so the nomination for this important class is open.

Decision and Reader Participation

I realize that I may have missed some strong entrants in the scam derby, so I invite additional nominations or other categories of scam investments.  You can help other investors avoid losing money.

I am also reviewing some other categories, including the best technical forecast and the best fundamental forecast.  Suggestions are most welcome.

Weighing the Week Ahead: Interpreting Sentiment Indicators

Here is the question of the week:

If everyone else is bullish, should you be bearish?

and a corollary -- How do you know?

Most traders take this as an article of faith.  Everyone wants to be a contrarian.  We all know that a "crowded trade" can easily go wrong as everyone else tries to get out.

This issue must be important, since it was the headline (Sentiment Concerns) in today's Abnormal Returns, the place where I and many other investment pros start our daily reading about the markets. Tadas always presents alternative viewpoints, but the sentiment question is more difficult than most.

I'll return to the question of interpreting sentiment.  But first, a 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.

In most of my articles I build a careful case for each point.  My purpose here is different.  This weekly piece emphasizes my opinions about what is really important and how to put the news in context.  Others will disagree.  That is what makes a market!

Last Week's Data

Last week's data continued the long term story of a slow but solid improvement and lower risk.

The Good

Economic news continues to beat expectations.

• Economic growth is improving.  The ECRI weekly leading index is at a 32-week high and the growth index, now in positive territory, is at a 30-week high. The ECRI said several weeks ago ago that a near-term recession was off of the table.  Each week we have more evidence that they are correct.  It is also quite apparent that those who made dubious interpretations of the ECRI indicator were wrong.  I tried to demonstrate their error back when readers could still profit from the knowledge.
• Risk as measured by the St. Louis Fed Stress Index, again moved lower during the week.  This measure tracks a lot of market data in the eighteen inputs.  It is not a poll, nor opinions, nor a collection of anecdotes.  The value moved to .23 from .27 last week and .34 two weeks ago.  This has been a very nice decrease.
• Risk as measured by the VIX is also lower.  (VIX is one of the elements in the SLFSI as well).  Some try to place a contrarian interpretation a low VIX level.  In this nice guest column for Barron's, Adam Warner (one of our featured sources) explains why current VIX levels make sense but that wilder days may be coming.
• Bonds signal an improving economy.  Prof. Hamilton explains why.
• Holiday sales look good.  From Bonddad:

The ICSC reported same store sales for the week ending December 18 increased 4.2% YoY, and increased 1.7% week over week. Likewise, Shoppertrak reported that sales increased 5.5% YoY in the last weekend before Christmas. Most of the retailing reports are indicating that this will end up being a strong holiday shopping season.

• The dog not barking.  I am not seeing many earnings pre-announcements.  It is something I will be watching closely in January.

The Bad

It was a light week for data, but there was some discouraging news.

• Initial jobless claims (420K) continued in the recent range which is unacceptable for a recovery.  Many pundits incorrectly equate reduced initial claims with job creation.  They are wrong in their reasoning, but might be right in the conclusion.  We need a combination of fewer layoffs and more hiring.  Both should be monitored.
• Existing home sales data were terrible.  While I think that building permits are a better leading indicator, those have also been awful.  The listed supply of existing homes now represents a 9 1/2 month inventory.  Most observers think that the shadow inventory adds more months.  Calculated Risk has a full analysis and some nice charts, along with some useful interpretive comments.
• Municipality and state debt constitute another looming crisis according to Meredith Whitney.  It may not be news to most of us, since she has been on this theme for several months.  Telling the story on 60 Minutes raised public awareness, so that was important for the markets.  Bond market veterans strongly disputed Whitney's conclusions about the scope of the problem.  One of the best published refutations came from Joe Mysak, who challenges the argument that this problem is fifteen or twenty times worse than any prior incident in history. At least Whitney has a time frame on her doomsday prediction.  We can all monitor the pace of defaults.  As regular readers know, we like to settle questions with data!
• Monetary growth lags, although you would never know it from the incessant and ill-informed commentary about the Fed printing money.  Looking at data is always helpful, as Bonddad shows every week:

M1 was down -0.5% for the week and vs. last month, and +7.5% YoY, meaning "real M1" is up 6.5%. M2 was up +0.2% for the week, up +0.3% vs. last month, and 3.1% YoY, meaning "real M2" is up 2.1%. Real M2 remains stalled without being able to break out of the "red zone" below +2.5% YoY.

The Ugly -- Sentiment?

You’d think that the complete recovery from the worst economic downturn since the Great Depression would be big news.  You would be wrong. It hasn’t been widely picked up by the mainstream press.

Why not?

Mark Hulbert, wondering why no one noticed the market climb to pre-Lehman levels,  cites Norman Fosback:

Therein lies a tale, which Fosback finds very significant when assessing the stock market’s potential. The lack of attention to the magnitude of the recovery has been caused, in his opinion, by “the extraordinary pessimism enveloping the consumer investing population, fanned by a fear-mongering financial media.” That skepticism, in turn, has played a big role in holding the stock market back from even bigger gains in recent months.

The Pragmatic Capitalist strikes a similar theme:

While high levels of bullish sentiment among advisors, investors, and money managers usually occur at market tops, market tops do not always occur when sentiment is very bullish. Sometimes people respond to the obvious and correctly align their market posture with the price trend. In situations like this we have to wonder whether or not they are wrong.

Bottom Line: An excess of bullish sentiment is a caution sign and should cause concern because such sentiment peaks are often followed by price corrections, if not bull market tops; however, we do not use sentiment as a timing tool, just a indicator to help paint a picture of the market environment. So far we have no indication from our trend-following models that there are major problems ahead.

 

My Explanation

Regular readers know that over the years I have placed little emphasis on the various sentiment indicators as trading signals.  I have three main reasons for my decision:

1. The oft-cited sentiment figures have polling issues.  The samples are terrible.  More importantly the universe of those polled is even worse.  I simply do not believe that a poll of fund managers, individual investors, or newsletter writers tells me much.  I am much more interested in the actual flow of funds.  Behavior trumps poll responses.  And this comes from a guy who actually believes in well-executed survey research.  Current surveys assert that the AAII people are wildly bullish.  I guess I do not know any members!!  Every prospective investor I speak with is scared silly, mostly from reading scare stories.
2. The marginal dollar in the market represents big pension funds.  (No one seems to grasp this, and my data are still sketchy). There is asset allocation going on.  When there are changes in expected earnings, corporate bond rates, or similar variables, the asset allocation changes.  It is only marginally related to retail investors and mutual funds, the sources most follow.
3. I use real measurable data.  The actual research does not support the popular contrarian interpretation of evidence like the AAII sentiment poll.  CXO Advisory cites a study showing the following:

In summary, German investor sentiment correctly anticipates equity market moves over the next few months to some degree. U.S. investor sentiment used to to be a contrarian indicator for equity market moves over coming months, but its predictive power has disappeared.

The main conclusion?  The "contrarian interpretation" worked many years ago, then faded, and has not worked for about ten years.  You really need to read the entire article, which has the typical strong CXO methods and explanation.

To summarize, I do not rely on the sentiment polls for market timing, although the Michigan survey is an important input in my employment model.

A Variant Viewpoint

Here is a completely different viewpoint.  This source has rocketed to the top of the popularity ratings, despite a multi-year record of inaccurate market forecasts and excuses.  Whenever something good happens, it is attributed to a conspiracy.  I mention this only because Zero Hedge has a knack for seeing the negative in any indicator.  Most recently, ZH has taken the standard view that if sentiment was bullish, it was time to be bearish.  This raises the interesting question:  What was the ZH viewpoint when sentiment was negative?

Conspiracy.

So, again, because we fear the bulls may keep their mouths shut here, if the AAII data last month anticipated a massive surge in stocks based on contrarian expectation, today's data confirms that the market is poised for a plunge. Will it? Of course not, because this BS metric has nothing to do with the psychology of the marginal determinant of actual stock prices - the quote stuffers, the primary dealers, and of course, the Federal Reserve itself, which is controlled by a ruthless sith lord completely impervious to such things as mere human "psychological" weakness.

To be clear, I think he means that the AAII data mean nothing, although the recent ZH posts make it seem like sentiment is the death knell for the market.  Perhaps some readers can explain this to me.

To keep this in scale, readers of "A Dash" have the equivalent of inside information!  The popularity of the big bearish blogs like Zero Hedge is just awesome.  As an investment advisor who can sell any product --- gold, inverse ETFs, structured settlements, and all of the other big commission things -- I have obviously blundered.  The far easier path to new clients is to sell fear...

 

Our Own Forecast

We base our "official" weekly posture on ratings from our TCA-ETF "Felix" model.  Felix caught most of the recent rally, moved to neutral (but with several trading positions) and turned positive several weeks ago.  The number of sectors in the penalty box, a sign of near-term risk, has moved much lower in recent weeks.  We are continuing our bullish position in the weekly Ticker Sense Blogger Sentiment Poll.   Here is what we see:

• 88% of our 56 ETF's have a positive rating, down slightly from 91% last week.
• Only 32% of our 55 sectors are in our "penalty box," down from 39% last week.
• Our universe has a median strength of +28, down from +33 last week.

The overall picture was positive during the week, and we maintened a 100% long posture.

[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.]

The Week Ahead

There is not much economic data due out next week.  I do not expect the various regional surveys to provide market-moving information.  The politicians will have a lower profile!!  Every blip in the market will be obsessively explained by the non-vacationing financial journalists.

CXO Advisory has a nice article on the year-end calendar effects, mostly showing that we should not expect much.

As I said last week, if there is any year-end volatility it is an opportunity for long-term investors.  I am using dips to buy for new accounts.  Trading accounts remain fully invested.

I also had some advice for long-term investors, advice which is still in force:

The spike in interest rates is also an opportunity for those trying to build a bond ladder.  We need to seize chances when they come.  We are finding some much better opportunities for yield-oriented investors.

In summary, this is a time to get some focus.  Which concerns are real, and which are illusory?  If you have a specific concern, can you measure it?  How will you know when that worry has been lessened?

If you cannot answer these questions, you need an approach that is more driven by data.

 

Interpreting Market Worries: The Year in Review

When looking ahead, it is often helpful to know where you have been.  The calendar provides an arbitrary dividing line.  It is better to do a constant process of re-evaluation and review.  Since most people need a nudge, we all take a special look at the start of a new year.

As I work on my forecast, I have already reached two important conclusions about 2010:

1. Many of the market worries were resolved -- some quite decisively -- as the year progressed.
2. The overall level of concern was undiminished.

This is quite remarkable.

The single most important thing for the investor to understand -- right now -- is the value of worries.  If you are looking for good investment returns, you need a time when others are worried.

The concept of the "wall of worry" is difficult for the average investor.  They seem to think it is bad when there are many worries.  In fact, the lack of worry is a sign of a market top.  Let me simplify.

Here is the image of the market top:  "What?  Me Worry?"

When there are plenty of things to worry about, we are not yet at a market top.  If all of the worries were resolved we would be at Dow 20K.  (At the end of May, with the Dow at 10K, I wrote that it would double rather than getting cut in half, despite all of the doomsday predictions.  We are now 15% of the way there.)

The Worries of 2010

I am working on an article that will review the "Worries of 2010."  My starting idea for classification includes the following:

• Valid concerns that are still with us;
• Valid concerns that declined during the year;
• Concerns that were mostly political -- better ignored by investors;
• Totally bogus concerns that got a lot of publicity.

I am open to the suggestion of new categories.

Here is a list of worries that I have noted, in no particular order:

• ETF liquidation doomsday scenario
• Flash crash -- and overall worries about market manipulation
• Bush-era tax cut expiration
• Collapse of the euro and/or European Union
• The Hindenburg Omen
• Increase in US budget deficits
• Ominous head-and-shoulders pattern in market averages
• Dow 5000
• Dow 2000
• Dow 1000
• The collapse of the US consumer
• The double-dip recession
• Sell in May
• Sell in October
• Sell, Mortimer, Sell  (OK, I sneaked that one in for those who know).
• The BP spill
• Fear of Obama
• Obamacare
• Weakness in the dollar
• Strength in the dollar
• Weakness in China's economy
• Strength in China, leading to higher rates
• Korea
• Iran
• Initial claims spiking to over 500K
• Initial claims falling, but results skewed by seasonality
• Shadow housing inventory
• Foreclosure robo signing
• Overstated and exaggerated corporate earnings
• Fed blunders -- QE II
• High frequency trading
• Worldwide collapse and deflation
• Worldwide hyperinflation

Please help me in adding to this list.  Comments very welcome.

Help in getting started

Some of the worries have proven to be either false or dramatically overstated.  Without arguing about the data, let us just look at the Google Trend on "double dip recession."  While a recession is always possible through an expected shock, anyone making this as his base case scenario has lost touch with the data.  Google Trends is a nice "wisdom of crowds" sort of indicator.

Here is another good case, the big scare about the Hindenburg Omen.

This was another case where many people were scared out of their investments because of a contrived indicator that I exposed in August, near the peak of the bogus fear.  (The Dow closed at 9985 that day.)

Conclusion

My working conclusion is that many worries have been resolved, but new ones are created at an equal pace.  As long as there is so much to fear, we are not close to a market top.

I am going to follow up on this, but I hope to stimulate comments and suggestions as part of my framework.

A Word about Risk

Worries imply risk.  Each investor is different.  During 2010 I have frequently cited the need for each investor to analyze his own needs and risk tolerance.  Too many investors missed out on 2010 because of a feeling that they needed to guess the market -- all in or all out.  This is weak.  An investment program is a carefully designed mixture of approaches.

Investors need to understand whether they are protecting assests, or growing assets.  Wealth preservation or wealth creation.  Then they need to analyze risk.

Investors spend too much time thinking about the market, and too little time thinking about their own needs.

 

 

 

When is the Best Time to Invest?

Here at "A Dash" I often try to stimulate objective thought by taking the reader outside of the normal market discussion.  Sometimes when you see the point in a context where you do not already have an opinion, it is easier to bring the conclusion back to your investing.

Are you ready for some football?

On Sunday afternoon there was a great AFC matchup of the Jets and the Steelers.  The Jets returned the opening kickoff for a touchdown, a surprising and exciting start.  At 11:03 of the 1st Quarter, CBS displayed a graphic informing us that the Jets were 9-0 when scoring a TD.  Quite remarkable.  Scoring a TD is certainly good to do, but it is far from a guarantee of victory.  Apparently the Jets were 1-3 in games where they did not score a TD.  That is much easier to understand!

At the end of the 1st Quarter the score was Jets 7, Steelers 0.  But wait, Steeler fans!  CBS sent another message, informing us that Pittsburgh was 6-1 when the opponents scored first.  Doing a little subtraction in the standings shows the Steelers were 4-2 when they scored first, a smaller percentage.  Does this mean that it would be good strategy for Steeler Coach Mike Tomlin to allow an early score by the Jets?  Maybe he should try to allow only a field goal, or take an intentional safety, since we know that the Jets always win when they score a touchdown.  Hmm!

Even if you are not a football fan, you should be able to see the lack of logic in these arguments.

What is Wrong

The problem is that the CBS analysts are now able to look at hundreds of different variables, looking for something interesting to report.  The logic, or lack thereof, makes no difference.  My colleague Allen Russell lectured his college methods classes on the topic of statistical signficance in a very innovative fashion.  On a monitor in the corner of the classroom he was tracking results from a computer program.  The program generated a random data set with a few hundred variables.  It then looked for "statistically significant" relationships between each pair of variables.  When one was found, the monitor would flash, Significant! Significant!  (Allen was a great and innovative teacher, and I continue to benefit from his thoughtful comments and research).

(This story is from the era of slow computers.  Nowadays the monitor would be continuously flashing).

Back to the Investment World

The same type of analysis occurs all of the time in the investment world.  I am particularly disturbed by this approach from a powerful and influential voice.  First, the list of independent variables:

1) S&P 500 more than 8% above its 52 week (exponential) average 
2) S&P 500 more than 50% above its 4-year low 
3) Shiller P/E greater than 18 
4) 10-year Treasury yield higher than 6 months earlier 
5) Advisory bullishness > 47%, with bearishness < 27%

You should note that we actually have many more than five variables.  The statements include multiple conditions, each one of which can be massaged to a specific level.  Why not 10% above a simple moving average?  Why not 30% above a 2-year low?  Why not bullishness > 53%.  Etc.

This is a well known statistical problem.  There are too many degrees of freedom in the independent variables compared to the number of cases to be explained.  The resulting list of ten "bad times to invest" shows adverse effects within either a few weeks or within 21 months.  How long must we wait to know the answer?  Meanwhile, we are warned that right now is one of those bad times.

The Missing Variable

The missing variable is this one:

A 50% market decline within the prior three years.  Or how about: Negative Quarterly S&P earnings within the last three years.

Viewed in the context of the Great Recession, where stock prices declined to Depression levels and have only recently rebounded to where they were before the fall of Lehman in 2008, the factors are easier to understand.  A 50% rebound is still far from the highs.  As long as the economy is improving, the S&P is going to be above its moving average, and that might continue for a long time.  The Shiller P/E is going to be saddled with 2008 earnings for as long as this backward-looking method keeps it in the calculation.  The 10-year yield, which collapsed to levels reflecting expected deflation, has rebounded somewhat, but is still near historic lows.

If you actually think about the variables, nothing is a real surprise.  There is also no historical precedent, so there is no good basis for prediction.

An Alternative Approach

Last week I noted that a widely circulated email provided analysis that demonstrated the important difference between current conditions and the other nine cases on the "bad times" list.  I am delighted to report that Georg Vrba has now published those results.  I urge you to read his article.

Rather than trying to explain certain situations -- incorrectly beginning with the dependent variable -- Vrba uses a number of indicators that can be applied to any time period.  In fact, his own published work was completely independent of the list of "bad times" to invest.  He is taking a method and applying it to someone else's suggestion of timing.  This adds to the interest.

Two Final Notes

1. I hope that readers will understand that this is a debate on the merits.  The Vrba article is written with care and respect and I have tried to follow his lead.  In the academic world disagreements about methods and conclusion are commonplace and vigorous.  Somehow we are having trouble translating this honest engagement into the 21st century blogosphere.  Maybe we can all try harder to explain our intentions in 2011.  At the moment the discussion has been conducted in the pages of Advisor Perspectives.  This influential publication (while available to the public) is read mainly by my colleagues in the advisory business.  The articles and commentaries reflect this more sophisticated audience.
2. This topic is important.  I have limited time to write, and I choose my topics with relevance and importance in mind.  I currently have more than 50 items on my "blog agenda."  I selected today's subject because something like a "list of bad times" is seductively dangerous for investors.  I disagree strongly with the conclusion that this is a bad time to invest.  I think quite the opposite.  It is my responsibility to state that position, and to explain my reasoning.

 

 

 

Weighing the Week Ahead: Old Worries, New Worries

For the investor, there is always something to worry about.  If worries meant "Do not invest!" no one would ever own stocks.

Interpreting worries is a continuing challenge for most.  Here at "A Dash" I emphasize objective indicators in my weekly look at market conditions.  If you find yourself switching around, or making excuses for dropping a favorite measure, it is a warning sign.

'Tis the Season

It is the season for making forecasts.  I joined a group of my favorite blogging colleagues in the Bespoke Roundtable.  The questions were excellent.  I will amplify a few themes in the coming days.  Meanwhile, here are some interesting takes from sources that I follow closely.

• A list of worries from Credit Suisse (via The Pragmatic Capitalist).  These are all things that I plan to watch, and you should also.  Credit Suisse currently expects that all are manageable and forecasts a 13% gain in the S&P 500 next year.

• A list of things to quit worrying about from The Reformed Broker.  This is an excellent article.  I will add that preoccupation with the themes Josh recommends against would have cost you plenty in 2010.

We should all be compiling our lists.

1. What is a real concern?
2. What is an illusion?
3. How should we measure the things that really count?

With this in mind, let us turn to the data.  But first, a little background for readers 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.

In most of my articles I build a careful case for each point.  My purpose here is different.  This weekly piece emphasizes my opinions about what is really important and how to put the news in context.  Others will disagree.  That is what makes a market!

Last Week's Data

Last week's data continued the long term story of a slow but solid improvement.

The Good

Economic news continues to beat expectations.

• The ECRI weekly leading index is at a 30-week high and the growth index is at a 28-week high. The ECRI said several weeks ago ago that a near-term recession was off of the table.  Each week we have more evidence that they are correct.  It is also quite apparent that those who made dubious interpretations of the ECRI indicator were wrong.  I tried to demonstrate their error back when readers could still profit from the knowledge.
• Retail sales, especially in real terms, solidly beat expectations.  I am impressed by the analysis from Bonddad.  I always like sources that use data rather than opinion, and there is a good argument that retail sales lead employment.  My team will take another look at our employment model, since we did not really consider retail sales as a leading independent variable.  Meanwhile, those who have been predicting a "spent up" consumer have been wrong.
• The Philly Fed number was strong.  This is the best of the regional Fed survey indicators, but there is a lot of mystery in the diffusion index.
• Risk as measured by my new source, the St. Louis Fed Stress Index, moved significantly lower during the week.  This measure tracks a lot of market data in the eighteen inputs, so there is something of a one-week delay.  The value moved to .27 from .34 last week, a very nice decrease.
• Congress came through with the tax cut extension.  I have predicted this for nine months, and gradually others have come around.  There were still some skeptics last week, so it has been an ongoing positive for the markets.

The Bad

There was also a bit of discouraging news.

• Jobless claims are a little better but still terrible.  Many pundits incorrectly equate reduced initial claims with job creation.  They are wrong in their reasoning, but might be right in the conclusion.  We need a combination of fewer layoffs and more hiring.  Both should be monitored.
• The housing data were terrible.  I have frequently noted that building permits, terrible last week, are a good indicator.  Paying for a building permit is a serious commitment.  Most of my colleagues do not give enough weight to this series.
• Mortgage rates moved higher.  This is an expected result of higher interest rates -- a trend that most expect to continue and may challenge the appetite for buying homes.  In the absence of overall price movements, affordability will be lower.

Our Own Forecast

We base our "official" weekly posture on ratings from our TCA-ETF "Felix" model.  Felix caught most of the recent rally, moved to neutral (but with several trading positions) and turned positive several weeks ago.  The number of sectors in the penalty box, a sign of near-term risk, remains high.  We are continuing our bullish position in the weekly Ticker Sense Blogger Sentiment Poll.   Here is what we see:

• 91% of our 55 ETF's have a positive rating, up strongl;y from 84% last week.
• Only 39% of our 55 sectors are in our "penalty box," down dramatically from 84% last week.
• Our universe has a median strength of +33, up from +27 last week.

The overall picture was positive and improving during the week, and we maintened a 100% long posture.

[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.]

The Week Ahead

We will have some personal spending data next week, but there is really not much to feature on the economic front.  Most of the "A teams" will be on vacation, so market volatility could be higher.  The lame duck Congress will pack it in.

The year-end volatility may provide some opportunities for long-term investors.  I am using dips to buy for new accounts.  Trading accounts remain fully invested.

The spike in interest rates is also an opportunity for those trying to build a bond ladder.  We need to seize chances when they come.  We are finding some much better opportunities for yield-oriented investors.

In summary, this is a time to get some focus.  Which concerns are real, and which are illusory?  If you have a specific concern, can you measure it?  How will you know when that worry has been lessened?

If you cannot answer these questions, you need an approach that is more driven by data.

The 2011 Bespoke Roundtable

Bespoke Investment Group, a popular and valued source of investment research, has once again conducted a virtual roundtable featuring financial bloggers.  This is the second year for this great idea, and I appreciate the opportunity to participate.

They did a wonderful job, starting with an interesting list of questions.    I am enjoying reading the answers of my blogging colleagues.  It is a nice range of opinion.  The question format seemed to get each of us onto themes a bit different from our regular posts.

To get some specific investing ideas, you should read the individual responses as well as the summary article.  

Here is a segment from the article, just to get started.

At the end of each year, the big financial media outlets typically conduct roundtables to get outlooks from key players in the financial markets.  Over the past few years, the individuals that run the best financial blogs and websites have become key players in their own rights, and their opinions are highly regarded by millions of loyal readers.  Below is our 2nd annual Bespoke Roundtable with some of the major names in the online financial community, and it's all available for free to anyone with Internet access!

Twelve of the most popular financial blogs/websites agreed to participate in the roundtable.  Each participant was asked to respond to the same 34 questions regarding their 2011 outlooks and their take on 2010.  Once again we got some incredibly insightful commentary from each participant, and we feel that readers will thoroughly enjoy it.

Below is a list of our roundtable participants.  We have created a page for each of them that has all of their responses, and we encourage you to visit their websites as well if you haven't already done so.

• A Dash of Insight - 2011 Bespoke Roundtable Q&A
• Crossing Wall Street - 2011 Bespoke Roundtable Q&A
• Financial Armageddon - 2011 Bespoke Roundtable Q&A
• Footnoted.org - 2011 Bespoke Roundtable Q&A
• Paul Kedrosky's Infectious Greed - 2011 Bespoke Roundtable Q&A
• Investment Postcards - 2011 Bespoke Roundtable Q&A
• The Kirk Report - 2011 Bespoke Roundtable Q&A
• Random Roger - 2011 Bespoke Roundtable Q&A
• The Reformed Broker - 2011 Bespoke Roundtable Q&A
• VIX and More - 2011 Bespoke Roundtable Q&A
• Wall St. Cheat Sheet - 2011 Bespoke Roundtable Q&A
• World Beta - 2011 Bespoke Roundtable Q&A

The matrix below summarizes some of the specific forecasts.  The article itself is the place to start, since it provides a good sense of the range of opinions.  If you want more, you can click through on the list above.  You can see every response to every question.

 

 

It is the season for taking a look ahead.  The 2011 Roundtable offers some healthy debate and some specific ideas, all in a user-friendly format.

ETF Update: Dr. Chu Points to Nuclear Energy

Dr. Steven Chu is the Nobel Prize winning physicist who now serves as the U.S. Secretary of Energy.  He is a brilliant man from a family of leading researchers and scholars.  He is also charming, engaging, and influential.  From my perspective, the conclusion is an easy one:  When Dr. Chu speaks, we should listen.

I was a bit skeptical about the pop in the "nuclear stocks" after the mid-term elections, but the political landscape seems to be changing.  We can see the effect in our weekly analysis of the ETF markets, but I want first to discuss the background factors.

The Obama administration started off with a tilt toward alternative energy, but last week there was a significant change.  As part of what is being hailed as a new era of compromise with Republicans, Dr. Chu included nuclear as part of the alternative energy program.  This shift recognizes regional and political differences, so it could be important.  As is the case with any compromise, there was an instant reaction from nuclear opponents.  I have no firm prediction on how it will eventually play out, but the odds clearly have shifted.

The fundamental change is reflected in the behavior of the stocks.  I'll get to that, but first a little background on how we approach sector analysis.

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 Nuclear Energy

We trade nuclear energy via the Van Eck Global Nuclear Energy ETF.  The fund "seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the DAXglobal® Nuclear Energy Index."  There are only 24 holdings, with a range of market caps.  The top five make up about 40% of the fund and the top ten another 25%.  The holdings include uranium mining, storage, and enrichment stocks as well as those involved in plant construction and power generation.  The largest geographical weight is in Canada with the U.S. second.  44% of the fund is outside of North America.

The price and fundamentals are attractive and interesting.  The P/E ratio is about 20 with a dividend yield of 1.7%  The beta is only 1.2.  The sector has recently moved by nearly 20%, but is up less than 10% on the year.  Here is the chart.

You can see the recent move as well as the price consolidation over the last few weeks.  Some might see an upside down head and shoulders, although our models do not identify that type of pattern.  I always look at various time frames in charts, and this time it is especially illuminating.

This chart highlights a period I regard as important -- the time right before the fall of Lehman in September of 2008.  With any stock or sector it is interesting to ask whether this initial price target has been regained, and whether conditions now are better or worse.  By that test, there is room to run.

Other Opinions

We always survey commentary from other experts on the ETFs in our buy zone.  There are some interesting comments on NLR.

• Joseph L. Schaefer at ETF Daily News points out the need for some common sense in analyzing the role of atomic energy.  The article has a nice historical perspective.
• Another ETF Daily News story emphasizes the role of the uranium stocks.  Good stuff from Tony D'Altorio.

There is not too much discussion of this sector, despite the fundamental and technical changes.  It is currently our top-rated holding for Felix.

This Week's Results

Felix, the cautious approach, has fully participated in the market rally.  The sector ratings have reflected the strength, and nearly 70% of the stocks are out of the penalty box.

I am seeing new sectors emerge from the penalty box on a daily basis.  We are closely watching KBE, for example.

Weekly TCA-ETF Rankings

We are currently fully invested in our Felix ETF program and also for those following Oscar.  This flows from the positive market ratings that we report in our (almost) weekly update on the market.  (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. 

 

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.

Blogiversary Themes: Analyzing Earnings

Since I started regular posting in December of 2005, I am going to declare this to be my five-year blogiversary.  The posts were a little sporadic in that first month, but I was trying hard to explain my purpose.  Here is a quotation from an early article:

It isn't difficult to convince investors that stock prices are volatile. Something less known, though, is that corporate profits fluctuate even more. Using a ratio of these two volatile measures is sure to give you misleading signals now and again.

The misleading signal often comes near the end of recession, when earnings plummet. During the 1991 economic recession, for example, the composite earnings of the companies in the S&P 500 fell by 27 percent to about $16 a share. Their stock prices actually rose during that period, as investors looked ahead to better days. The P/E multiple quickly soared to 26 from 15, as earnings fell and prices rose. Since a P/E of 26 is high compared to long-term averages, investors focused on this ratio would have likely missed the beginning of a nearly decade-long rally.

The P/E multiple is much lower now, even though we are at the end of a recession, so the advice should carry extra weight.  Regular readers know that I have taken a consistent and disciplined approach to fundamental market valuation, so I suspect that few will be surprised at this quotation.

Here is the surprise:  The quotation is from John Hussman!

My own take in 2005 was a bit different.  I questioned his failure to incorporate changes in interest rates as part of his valuation model.  Here was my position:

Unfortunately, his method ignores interest rates.  In a couple of the low PE examples he gives, like 1974 and 1982, stocks should have a low PE since interest rates were in double digits.  Just ask yourself: Would take an 8% return from stocks if bonds had a rate of 12%?  What if the bonds were 4%?

Experts may disagree about how to incorporate interest rates into analysis, but there should be no debate about whether to do so.

 The Hussman approach to fundamentals still does not recognize the importance of interest rates as an alternative asset class.

Five Years Later

During the ensuing five years I have written many articles about stock valuation, often emphasizing the differing time frames.  My position, recorded weekly, has changed with the circumstances.  Quite frankly, I expected John Hussman to be a big winner at the end of the recession.  His "peak earnings" concept was going to come into its own.  To my surprise, instead of cashing in on his theory he did something that I abhor.  He arbitrarily discarded some of his data, the time period that did not fit his multi-year market opinion.

Let's be completely clear about this.  Anyone who reaches far back into the past has many time periods of data that are dissimilar in many ways.  If you take some recent period that you do not like and throw it out, meanwhile not giving the same examination to the rest of history, it is cherry-picking.

We can all make post-facto decisions to throw out data that we do not like, but that is not part of the researcher's creed.  I now see an article where he has used multiple variables to find something that he calls a "Who's Who of Awful Times to Invest."  Big problem!  He has changed the variables from his original 2007 article, which you can check out here.

It is easy to look at past data and a large number of variables and back-fit a result, especially if you keep changing the independent variables.  If you have a big staff it is even easier.  The real test is whether the methods that were specified in advance -- that would be the methods written about in 2007 -- actually worked.  It is perfectly acceptable to change methods if circumstances warrant, but you should not pretend that it is simply an "update" of a past approach.

An Alternative Viewpoint

The Hussman viewpoint is one of the most popular reads for individual investors and for investment advisors.  By email I received an update from Georg Vrba, P.E.  Georg has written some fine articles drawing upon a number of variables to improve on the buy-and-hold approach.  Here is an example.  Georg kindly mentioned my article demonstrating why an increase in the forward P/E multiple is merely a return to normal.

I hope that Georg will publish his results soon.  To summarize, his methods confirm the first nine Hussman examples but disagree violently with the current case.  How interesing!

A Warning

I know that my readers include many Hussman fans.  I also enjoy reading his analysis.  This is really about methods and changes over time.  I am stating in advance that I am too busy with year end analysis and forecasts to do a detailed debate in the comments.  I will read and note arguments.  Next year I'll take another look, but I am not going to engage in instant rebuttal.

 

Weighing the Week Ahead: Evaluating Risks

There is a story about a personal financial advisor who saved a client several thousand dollars in expenses during his first year of service.  The client, quite satisfied with the result, asked how the savings had been accomplished.   The advisor replied that he had not paid any insurance premiums for the prior year.

Since nothing untoward happened, the client had saved money.

We all see the shortcoming in this apocryphal story, but can we really apply the lesson to our investing?

Most investors cannot since they look only at past results.  This tells them little, since we all know what worked in the past.  We did not need to buy insurance because our house did not burn down.

The better question relates to risk-adjusted returns.  Even better, the question should be what return should be expected for someone with your own specific appetite and tolerance for risk.  Briefly put:  Are you emphasizing wealth preservation or wealth creation?

If you learn to ask both about risk and reward, you can expect investment results that better match your needs.

I will explore the topic more deeply, but let us first review last week's data.

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.

In most of my articles I build a careful case for each point.  My purpose here is different.  This weekly piece emphasizes my opinions about what is really important and how to put the news in context.  Others will disagree.  That is what makes a market!

Last Week's Data

There was little significant data last week, but is supported the continuing encouraging story.  Let's take a closer look.

The Good

Economic news continues to beat expectations.

• Initial jobless claims moved slightly lower to 421K.  This is still not a good "recovery" level, but it is getting extra attention after the poor employment situation report for November.  The jobless claims data is much better than the recession level.  Since some pundits were attributing the recent improvement to seasonal adjustments, it is encouraging to see even a slight improvement.
• The ECRI growth index is at a 29-week high and the growth index is at a 27-week high., but at the best levels since mid-May.  The ECRI said five weeks ago that a near-term recession was off of the table.  Each week we have more evidence that they are correct.  It is also apparent that those who made dubious interpretations of the ECRI indicator were wrong.  I tried to demonstrate their error back when readers could still profit from the knowledge.
• The U of M sentiment survey beat expectations, coming in at 74.2  I regard this as a good concurrent indicator, helping us to understand employment and income.  Here is a chart from Briefing.com that will show how much we have improved from the bottom -- and how much farther we have to go.

As you can see, we are back to 2007 levels and the trend looks good.

• The trade data showed a nice improvement in exports.  This is good news for the economy and the official GDP data.  (Export growth helps).

The Bad

There was also a bit of discouraging news.

• Political posturing prevented a resolution on extending the Bush-era tax cuts.  I am listing this in the "bad" category, but it is not really surprising.  Before any final votes are taken, the various procedural votes give politicians the chance to take a position.  Astute observers know that these positions are symbolic, but that does not make them less important.  I still expect compromise legislation to pass soon, despite opposition from some in both parties.
• Mortgage rates moved higher.  This is an expected result of higher interest rates -- a trend that most expect to continue and may challenge the appetite for buying homes.  In the absence of overall price movements, affordability will be lower.

The Risky

Last week I highlighted two themes that are part of my prepraration for my 2011 preview.  The risk for stocks is much better than it was in May of 2009, but the P/E multiple is even more attractive.  I also think that these P/E multiples are poised to move higher.

I expected that many would disagree, mostly  because there is so much bearish sentiment.  I was surprised at some comments (from thoughtful readers) suggesting that risks were higher now than in May of 2009.  Quite frankly, I am amazed that anyone would think that.  (Feel free to check the comments for the arguments posed.)

While I find those arguments completely unpersuasive, I recognize that I need to add some risk commentary to my weekly review.  I always read Bill Luby, who started Vix and More and then expanded to discuss many measures of risk.  Here is Bill's discussion of the St. Louis Fed's Stress Index.

There are several firms trying to cash in on the "risk business."  Colin Barr does a typically fine job in this survey of a new entry in the "fear" landscape.

I have always monitored a number of risk measures, but I am now going to add risk assessment as a formal part of this weekly review.  I am going to use the St. Louis Fed's Stress measure.  It is objective, includes a wide range of factors (broader than VIX), not subject to manipulation, and updated weekly.

Last week shows a small uptick, but the overall risk level has declined dramatically.

 

 

 

It is very important to have some objective measure of risk.  If you operate from anecdotes, there is no way of telling whether things are bad or good.  A surprising number of comments on my articles refer to vague things like "more shoes to drop."

When you look at an index that includes eighteen different weekly series, selected through a careful research process, it provides more confidence in objectivity.

To summarize, risk is much lower than it was in 2009, but is still at a somewhat elevated level on a historic basis.

Our Own Forecast

We base our "official" weekly posture on ratings from our TCA-ETF "Felix" model.  Felix caught most of the recent rally, moved to neutral (but with several trading positions) and has turned postive again this week.  The number of sectors in the penalty box, a sign of near-term risk, remains high.  We are continuing our bullish position in the weekly Ticker Sense Blogger Sentiment Poll.   Here is what we see:

• 84% of our 55 ETF's have a positive rating, up strongl;y from 64% last week.
• 84% of our 55 sectors are in our "penalty box," down slightly from 89% last week.
• Our universe has a median strength of +27, up nicely from +9 last week.

The overall picture was positive during the week, and we maintened a 100% long posture.

[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.]

The Week Ahead

There is a lot of economic data next week, but most is not really important.  The inflation data will not be relevant unless widely outside of expectations.  I do not expect the FOMC decision to suprise.  I am always interested in building permits.

The key will be in Washington.  Decisions about tax policy and "pseudo-stimulus" will be more important than data.

Investing

Investing decisions reflect several dimensions.  Most important are the risk/reward tradeoff and the investement time frame.

So many pundits give an answer as if one size fits all.  In my weekly review I try to provide a more nuanced approach.

With this in mind, it does seem like a good time to invest for a wide group of candidates.  If risk went to the "below zero" range of the St. Louis Fed chart, we might well be at Dow 20K.