A Dash of Insight

Weighing the Week Ahead: Investing in a Time of Turmoil

In the modern media age the world community has comprehensive and detailed knowledge of important news, no matter where it is happening.  We have satellite pictures, professional commentary, interviews -- and more recently -- the individual testimony of hundreds of thousands of participants.  Whether through tweets, twitters, social network sites, text messages, or videos, there is plenty of raw information.

While the human and political issues have greater global significance, the investment consequences will have more important personal significance.

Images of riots and revolt make for good television and a scary investment climate.  I'll take a deeper look.  First, let us do our regular weekly review of the 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.  I have had great success with my approach, but some will disagree.  That is what makes a market!

Last Week's Data

It was an active week for eonomic data and earnings, and the picture was mixed.

The Good

Major economic indicators continue to show growth.

• Economic growth is improving.  The ECRI weekly leading index dropped to a six-week low last week, and  the growth index, while still in positive territory also moved somewhat lower.  Both are still at reasonably strong levels with no apparent recession risk.
• Risk as measured by the St. Louis Fed Stress Index, edged slightly lower, remaining at a very low level.  This measure tracks a lot of market data in the eighteen inputs.  It is not a poll, nor opinions, nor a collection of anecdotes.  We should all pay attention to some real data.  The value moved to .052, almost the same as .053 last week.  For more interpretation, the St. Louis Fed published a short paper with a very nice chart that helps to interpret this index.  The chart does not reflect the recent continued decline in stress, but it identifies the dates for important recent events.  The paper also has a longer version of the chart, illustrating past stress periods.  I am not going to run the chart each week, but I strongly recommend that readers look at the paper.  In the 2008 decline there was plenty of warning from this index -- no sign right now.
•  Q410 GDP was Stronger.  The official reading of 3.2% was a touch below expectations and everyone knows that it will be revised, perhaps significantly.  The strongest source of growth was consumer spending while inventories were a drag.  I have read several analyses with a negative spin.  In general these same sources have been wrong about recession chances, wrong about the consumer, and wrong about inventories.  In sharp contrast Bob McTeer thinks it is a strong number, precisely because it was achieved in the face of declining inventories.  For objective analysis, I also suggest that you read Prof. James Hamilton's take -- a good report, but with plenty of work to be done.
  
• The State of the Union Address.  The President has been delivering a market friendly message, as I explained in my SOTU analysis.  His approval ratings are back in positive territory.  Whether you like him or not, you should be checking out the investment effect.
• Earnings News.  The beat rate is still above average and some big international companies are showing good revenues, including those that reflect many aspects of the economy.

The Bad

The bad news continued for two important concerns -- employment and housing.

• Jobless claims spiked higher.  While weather might have been a factor in changing the seasonal pattern, the overall trend is much lower than needed to reduce unemployment significantly.
• Housing remains very weak.  There was a bright spot in pending home sales, but the Case-Shiller pricing is still weak.  Check out the analysis and charts at Global Economic Intersection.

The overall conclusion:  A continuing economic expansion, avoiding recession, but slower than needed.

The Ugly

The Egyptian revolt and the market impact on Friday get the "ugly" award for the week.  While there may eventually be a positive outcome, social upheaval that involves injury and death is a distrubing process.

This will be a key factor for the week ahead.

Our Own Forecast

We base our "official" weekly posture on ratings from our TCA-ETF "Felix" model.  After a mostly bullish posture for several months, Felix has turned cautious.  Last week we said it was a close call, and this week we shifted to neutral in the weekly Ticker Sense Blogger Sentiment Poll.   The poll is now conducted on Thursday night, so it does not reflect Friday trading.  Here is what we see:

• 63% of our 56 ETF's have a positive rating, down from 79% last week.
• 69% of our 56 sectors are in our "penalty box," up from 46% last week, an indication of significant short-term risk.
• Our universe has a median strength of  only +4, down from +14 last week.

The overall picture is significantly weaker.  While we remained fully invested in trading accounts, we are watching the indicators quite carefully.

[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

The employment report on Friday will be the most important economic data.  It is also the month for the annual benchmark revisions and the introduction of more frequent updates to the BLS method for estimating job creation.  I'll look at this more closely at mid-week, but I am not expecting a strong job gain.

It is the heart of earnings season.  We are seeing some stocks moving significantly lower despite reports that seem solid.

In short, there seem to be many ready to sell.  We'll see how many are looking for chances to buy.

Investment Implication

There are two completely different ways to analyze events like the crisis in Egypt.

The psychological approach is pretty obvious.  The televised images play into a deep-seated investor concern.  The "lost decade", the tech bubble, the Great Decession, and all of the other worries have conditioned a generation of investors to expect the worst.  Many accounts talk about "contagion."  What now?  Especially for those who have looked away from the US for their investments?

Technical analysis is one way of interpreting psychology.  I always look at the weekly chart show from Charles Kirk.  He acknowledges bullish, bearish, and range-trading scenarios, but he is not trying to have it all ways.  Charles highlights some specific support and resistance levels to consider, helping you to decide which scenario is most likely.  (You'll earn back the small annual fee in a heartbeat.)

The fundamental approach requires some discipline and detachment.  There are obvious impacts on oil prices, a significant negative for the US economy.  The Suez Canal carries 10% of world freight and 2 million barrels of oil per day.  The key question is whether the crisis will spread, affecting oil production and distribution in the region.  This could lead to an oil price spike.

There is also some possible positive outcomes.  Leave it to Doug Kass to think clearly about ideas ignored by most others.  In this CNBC segment, Kass argues that the most likely outcomes are probably positive for the "risk trade" and negative for gold.

 

 

Like many investment managers I have been looking for a buying opportunity, especially for new accounts.  We did a little buying on Friday, but we are waiting to see a little more clarity about the extent of the issues.

It figures to be a challenging week.

A Lighter Note

We do know that the Super Bowl indicator will provide a market positive this year, since both Green Bay and Pittsburgh qualify as old line NFL teams.  It has an 85% success rate, something that you should keep in mind when looking at pseudo-scientific market indicators with similar predictive power!

Five Minutes to Change or Five Minutes to Midnight?

Veteran Public Television commentator Mark Shields had an interesting take on The State of the Union Address.  He noted that conservative criticism came in two different forms:  Some saw current policy as "five minutes to change" while others saw it as "five minutes to midnight."  This is a useful perspective for investors.

Shields placed President Reagan in the former, hopeful category, and Wisconsin GOP House member and new Budget Committe Chair, Paul Ryan, as part of the midnight group.

The Obama Speech

President Obama had a number of Reaganesque flourishes, including highlighting audience members and special recognition of some political opponents.  There was an effort to charm and to cross the aisle.  Even crossing the aisle had a new feeling, since the parties were not seated in separate sections, helping to create the appearance (and perhaps even the actuality) of bipartisan support for the President's remarks.

Here are the highlights most relevant for investors:

• A spending freeze. This is aimed at cutting the deficit.  It is not intended to replace the Deficit Commission recommendations, but rather to be part of the solution.
• Education investment.  The President invoked the Sputnik era to explain why the US needs to prepare 100,000 new math, science, and engineering teachers.  The definition of investment employed here is one of the sharp differences between the parties.
• Corporate taxes.  President Obama is in favor of cutting rates -- a market friendly move -- but he also wants revenue neturality by cutting loopholes.  He also came out for cuts in favorable tax treatment for energy companies.  This is a mixed bag for investors.
• Technology Goals.  Mr. Obama cited the need for clean energy sources, high-speed rail, and more high-speed wireless.  The federal government commitment to these programs was rather vague.
• Vetoing earmarks.  Mr. Obama says that he is prepared to veto bills with spending earmarks.  Many members of Congress agree with this in principle, but still have earmarked spending for their own districts.  The question is who can best allocation appropriations.
• Social Security.  The President is open to changes in Social Security, but opposed to permitting private investment programs.
• Tort Reform.  This was a big surprise.  The door for bipartisan cooperation on medical malpractice suits is now open.

GOP Response

The response to the SOTU address by someone from the party out of power is an unfair challenge.  Even placed in a setting with some trappings of power, nothing can equal the symbolism of addressing a joint session of Congress.

Paul Ryan's response was, as Shields observed, part of the five minutes to midnight variety.  There is a different viewpoint to represent -- less emphasis on government, lower taxes, dramatic spending cuts -- and Ryan made these points.  He did so strongly, in a well-written presentation.  I suspect that the reception will not give him full credit because of the setting and a rather stilted presentation.

What to Expect Next

We will now see some early tests of the potential for cooperation.  Will there be compromise on modifying health care legislation?  Can we succeed in cutting corporate tax rates?  The deficit?

Neither party is going to cave in, so it is a test for leadership.  The debt ceiling debate will be an early test.

Market Response

On balance, I thought the speech hit most of the notes that I had listed on my wish list for investors.  There were a few extra positives, and nothing that seemed discordant.  I expect the market reaction to be mildly positive.  By the end of the day we'll be back to analyzing the Fed, QE II, and corporate earnings.

My usual warning:  Don't let your strong partisan viewpoints interfere with your investment decisions!

 

ETF Forecast for 2011: Seeking Alpha Interviews Jeff Miller

This article is based upon a recent interview I did with Seeking Alpha.  SA has graciously included me in their annual preview series for three years.  This year's focus was on ETFs, so I revealed something about our Dynamic Asset Allocation (DAA) method.  I have not written about this system before, so it should be of interest to readers at "A Dash."

There were many good questions, drawing out ideas about the market as well as specific stock recommendations.  It does a good job of explaining my bullish posture for 2011.

A Little Background

I am sometimes asked why I use both "A Dash" and Seeking Alpha, as well as other republishing outlets.  The answer is simple:  The audiences are very different.  I can tell this from the comments and the email that I get.

Seeking Alpha has a wonderful editor who works with me and makes suggestions.  They carry most of my work, but not everything.  While I applaud their new program to compensate authors, I am not joining in.  That is not why I write.

Update

Each year I write two or three pieces that are published first at a different source and later republished here.  Since the original interview ran there have been two important changes in the model output.  Readers should note that I warned that the recommendations might be different in two weeks!

Our DAA model asks about the best ETFs for the next twelve months, but we ask the quesiton every day!  This means that we can adapt to changing circumstances.  The DAA is great for situations like 2008, where the model shifted to bonds, gold, and eventually to inverse ETFs.

For those reading the article today it is only fair to update the forecast to the most current recommendations.  Once again readers should understand that the actual positions change many times during the year.  With that in mind, GDX and KOL have dropped from the list, replaced by IYR and XLY.

And now, the actual interview -- thanks again to Seeking Alpha for selecting me as a participant and allowing the republication.

The Seeking Alpha Interview

Jeffrey A. Miller, PhD, is CEO and President of New Arc Investments. Also a fund manager at the firm, he has guided the Sector Rotation Fund throughout its exceptional history. Before beginning his financial career in October 1987, Jeff was a college professor who worked extensively with quantitative modeling of sophisticated state and local tax issues. He is the author of the A Dash of Insight blog.

Seeking Alpha's Jonathan Liss recently spoke with Miller to find out how he planned to position clients in 2011 in light of his understanding of how a range of macro-economic trends were likely to unfold in the coming year:

Seeking Alpha (SA): How do you arrive at your investment decisions? Do you have specific recommendations for our readers as we begin a new year?

Jeff Miller (JM): Thanks for inviting me to participate. My company has a variety of programs. We start with the client, not with our specific program offerings. Once we determine the client needs, we match up a blend of programs.

Some of our methods are driven by a scientific approach -- models developed by experts, models that I personally test in ways the developer could not have imagined. Other methods reflect my personal analysis of the investment horizon. The answers in this interview reflect my own analysis, stock picks, and sector picks. These have done very well over our company's history.

Meanwhile, I would like to share some current output from our Dynamic Asset Allocation model. Each day we ask the question: Which five ETFs are the best choices for the coming twelve months?

We include a carefully selected universe of 56 ETFs. We chose this fund universe to avoid a situation where our "top five" were all from the chip sector, all Latin America, or the like. We picked a top representative for each sector group, based on liquidity and a narrow bid/ask spread.

I want to be clear. We ask the question each day. We are not "buy-and-hold" so we do not hold the positions for a year. This is active management. If you ask the "one year" question every day, you get about thirty changes in the portfolio. The portfolio also includes fixed income ETFs and three inverse ETFs. We can get very conservative, and even go short if that is indicated.

As long as readers understand that our recommendations might be somewhat different in two weeks, I would like to share our current best recommendations for 2011 with a line on the logic behind them.

• KOL -- Energy demand, global economy, a cheap source.
• XME -- Metals and mining -- economic strength, the dollar.
• PXQ -- Networking -- an emerging global trend.
• XRT -- Retail -- the consumer has been stronger than expected.
• GDX -- Gold -- a store of value and a hedge against inflation.

As you will see in the rest of the discussion, my own choices differ from some of the model recommendations, but that is just fine. It is good to have the discipline of a model, and also to have programs with different philosophies.

If you look at a chart of these ETFs you will see plenty of strength. This is a winning long-term strategy that deserves respect. It may miss smaller trades, but it keeps you on the right side of major moves. An easy way to get a feel for this is to compare the stock price to the 50 and 200-day moving averages over the last year. GDX has started the year poorly, but is still among the leaders in our ETF universe.

click to enlarge

SA: Despite predictions of a dip in equities amid slow global growth in 2010, stocks were clearly the better choice than bonds in 2010, especially in Q4 where bonds sold off almost across the board whereas stock returns remained robust. How are you planning to position clients with a longer-term horizon in 2011 in terms of an equities/bond mix?

JM: I like the distinction about the "longer-term" horizon. Each client is different. The first question to ask is whether the client needs wealth preservation or wealth creation. Next you need to know about risk -- and I mean a very specific discussion. Even investors who enjoyed nice returns in the last two years still needed to deal with some corrections.

With that in mind, I am recommending an adjustment of at least 10% more stocks to one's normal stock/bond allocation. Many stocks and sectors are attractive in terms of earnings and earnings growth. With interest rates so low, there is a lot of risk in long-dated bonds. I am keeping bond portfolios in shorter maturities -- seven years max.

SA: Name one ETF investment that worked out particularly well in 2010 and one that was a bust.

JM: This is a little tricky for me. We have two ETF trading programs with differing time horizons. Both were profitable in 2010. As is the case with every trading system there were winners and losers.

Playing along with the question, we had one of our biggest trading losses in XLY in July. The consumer discretionary concept was not working in July, although it did well as the year wore on. We sold the position and moved on.

One of our best trades was picking up the move in GDX during September. We locked this one in for a nice gain.

In a trading system you need to consider both your batting average and the amount of the win.

SA: Are we likely to see a continued sell-off in fixed income ETFs into 2011? Where can income investors turn for safety while still getting a reasonable yield?

JM: I have written about various income opportunities in my "Quest for Yield" series. I am looking outside the ETF universe to solve this problem: building bond ladders, writing covered calls, and finding great dividend stocks with the potential for appreciation. There are some ETFs that attempt these same goals, but I expect to continue better performance with my own picks.

SA: Which bond sector are you angling towards – Treasurys, Corporates (and if so Investment Grade or Junk?), Munis, Sovereign Debt?

JM: My bond program emphasizes investment grade corporates. Some investors are reaching for yield in risky places. My bond program is very conservative. For those who need more yield we use strong dividend stocks and covered writes.

SA: In which sectors do you expect strength in 2011 and beyond? Where do you expect particular weakness?

JM: The economic recovery has been sluggish so far, but there are many signs of improvement in the data. The Goldman Sachs economic team just upped their forecast for 2011, citing the start of a "real recovery."

This is bullish for cyclical stocks, the technology sector, and financials.

SA: Any specific ETFs or stocks (beyond XRT) you’ll be recommending clients add to the equity portion of their portfolios?

JM: Caterpillar (CAT) benefits from worldwide earnings growth. Apple (AAPL) is still cheap on an earnings or cash flow basis. Many investors get stuck on the absolute price of the stock instead of thinking in terms of earnings. XLK picks up the technology theme for those who do not want to analyze specific stocks.

Financial stocks are still cheap and are benefitting from the yield curve. JP Morgan (JPM) is a good example, and I also hold Goldman Sachs (GS).

I have re-established some energy positions, after avoiding the BP-related problems last year.

Health care has lagged. Eventually the market will quote focusing on the political debate and see the demographic forces. XLV is one way to play this.

SA: What are your expectations for commodities, the dollar and precious metals in 2011 and beyond? Will we finally start to see some real inflation in the coming year?

JM: As long as we have a current account deficit (let's call it a negative trade balance for the average reader) there will be pressure on the dollar. It seems like a lot of that has already been felt, but no one really knows. We need a change in China's exchange rate policy, but that has been true for years.

The emergence of real inflation in an era of high unemployment is very unlikely. This interview is not the place for detailed arguments, so I'll merely note that past times of stagflation share little with current times.

To summarize, I like stocks better than commodities for the coming year, although my long-term model has GDX in the top five.

SA: But no actual commodities exposure? GDX is made up of gold miner stocks.

JM: That is right. We invest in gold via the miners. We do not have direct commodity holdings.

SA: Let's move on to some specific issues that will affect equity returns in 2011 and beyond. In November the Fed implemented another round of QE. Will we get a third round of fiscal stimulus in 2011?

JM: No one knows whether there will be another round of QE, including the Fed! This entire discussion has been a sideshow -- fun to debate, but missing the message for investors. I'll state that message quite simply: The Fed is going to maintain low interest rates and QE until there is greater confidence of economic recovery, including some improvement in employment. If the economy recovers as briskly as the Goldman team believes, there will be no more QE. It will not be needed.

SA: How does the incoming Republican House majority affect the economic outlook for the next two years? Is gridlock ultimately good or bad for equity returns?

JM: I do not expect gridlock. There will be action on issues requiring it.

The GOP success will change the nature of compromise. The deals will lead to more moderate policies. We have already seen this in the lame duck session, even before the new members were seated. Those deals would not have been achieved without a recognition of the new reality.

There is a perception that gridlock is good, but I do not think it is very relevant for the market at this juncture. The key economic policies are already in place.

SA: How about the situation in the EU. Have you lightened up on European stock/bond exposure in client portfolios as a result of continuing contagion there? Are there any bright spots you'd focus on in terms of European equity allocation?

JM: Like everyone else, I carefully monitor developments in the EU. So far the policies seem to have been reasonably effective. The EU and the IMF stand ready to do more.

Unlike those who merely point and worry, I like to monitor actual data. My weekly update features the St. Louis Fed's Financial Stress Index. I recommend monitoring this compilation of eighteen financial indicators (including many interest rates and spreads). This lets you enjoy market gains when stress is low, and reconsider if things actually get worse.

SA: Do your clients currently have any Europe exposure? In stocks, bonds, both?

JM: Europe does not figure in my own themes right now, and it is not near the top of our model lists. It is an important story, and I am more optimistic than most about a solution, but it is important enough already without taking on direct exposure.

SA: Same question but for U.S. states like California and Illinois. Will a government bailout ultimately
be necessary to backstop state debt as defaults pile up? Are muni bond funds something you're avoiding going into 2011, or do their significant tax benefits still outweigh the possible downside of one or more states defaulting?

JM: I do not expect state defaults. The defaults will come in specific sub-municipal bond programs. I also do not expect a magical solution, and certainly no federal bailout. Each state will need to find a combination of tax increases and spending cuts. It is not easy.

I follow this closely as an investment manager. I am also a former professor who taught public finance and a member of a financial advisory board for one of the largest school districts in Illinois. I have a front-row seat on this one.

This is a problem that defied solution during an election campaign and a deep recession. We will now take a closer look at the alternatives.

And by the way, there is once again a choice for investors. You can get obsessive about the anecdotes, or you can follow a real market indicator, the credit default swaps on state debt. The numbers have been rising, but they are nowhere close to panic level.

I do not currently hold any muni funds, but I find current yields much more attractive. Like Bill Gross, I see the risk/reward as pretty good for clients who benefit from the tax break.

SA: Are you likely to recommend munis to appropriate clients in the near term?

JM: Yes. The muni yields are very attractive for clients who want the tax advantage. Some care is required in making these choices, of course.

SA: The U.S. housing market seems to be in the midst of another prolonged leg down. How are you playing this via ETFs? Is the commercial real estate market a better bet going forward? How much weight are you giving to REIT funds in client portfolios?

JM: I do not know if we are in the midst of another prolonged leg down in housing. Many sources indicate that we may have a bottom in 2011, at least in some areas. I currently have no long-term position in these markets or in REITs, but I would not be surprised at a change. Our short-term model has signaled a buy on homebuilders in recent weeks.

SA: If you decide to go that route, are you more likely to play homebuilders with individual names, or via ETFs like XHB or ITB?

JM: This is another sector where it seems early to call a turn. Typically we play via the ETFs. If housing starts to look interesting, I will take a closer look at individual names.

SA: Finally, one of the great economic stories of our time is the emergence of China and to a lesser extent, India as global economic powerhouses. How much weight do you recommend for emerging market ETFs in both stock and bond ETF allocations?

I would expand the question to include Russia and Latin America. It is wise to take a step back and see the broad global trends.

All of my investment programs reflect global demand. In my stock selection I make sure to include companies with significant revenue from abroad. Think Caterpillar (CAT). Our ETF programs are model driven, but have frequently participated in the emerging market rally. I have often written about this in my periodic ETF Updates.

Having said this, I think that the foreign ETFs and commodities had a very good run, while the US market lagged. I expect to see some "mean reversion" here this year, as the relationships return to normal.

SA: How do you plan on getting most of your U.S. equity exposure? Any broad funds, or do you generally prefer sector and single stock exposure?

JM: We have never advocated a buy-and-hold approach. Many broad funds are closet indexers, so you are just buying the market. We find investment themes, and then choose ETFs and stocks to fit. While we do not beat the market every year, we do over time. We did not have a “lost decade.”

There are many companies that are developing new technology, introducing new products, and breaking into new markets. Productivity is better. The opportunities are there, and the prices are quite reasonable.

Disclosure: I own CAT, AAPL, JPM and GS personally and in client accounts, as well as the ETF names as model choices.

Weighing the Week Ahead: Priced for Perfection?

With a stumble in tech stocks this week, nearly everyone is asking two questions:

1. Is the long-awaited correction upon us?
2. Will it be a normal pull back, with buyers stepping in, or the start of a big decline?

If you really want to frighten people, just use the phrase "priced for perfection," as Herb Greenberg did in this CNBC segment.

 

I am a long-time Greenberg fan, back from his SF Chronicle days.  He does good investigative reporting.  His sources have always been mostly bears and short-sellers, so he has needed to learn how to use this information without being manipulated.  In general he does a good job in navigating these waters.

The piece I am citing raises some issues.  How typical are the stocks cited?  Let us suppose that we have a stock with forward earnings of $1.50 and earnings growth of 40%.  Some investors might give this a P/E multiple of 40 (a PEG ratio of only one) and figure it is a $60 stock.  Now let us suppose that the stock reports a quarter of 30 cents instead of the expected 35 cents.  Two bad things happen:

1. The expected forward earnings come down a notch -- perhaps to $1.35.
2. The growth rate goes to (maybe) 25% instead of 40.

Now the growth investor does a 25 multiple on $1.35  and it is a $34 stock.  In growth stocks, an earnings miss affects both the earnings forecast and the growth rate.  This changes the multiple accorded by the market.

A stock price that reflects maximum potential earnings and growth is the definition of "priced to perfection."

Greenberg came up with some examples, but are these typical?  And what about the "weak hands" thesis?

I'll conclude with my own answer, but first let me do my regular weekly review of 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

We had some important data last week and it was pretty positive.

The Good

Major economic indicators continue to beat expectations.

• Economic growth is improving.  The ECRI weekly leading index rose to a 36-week high last week, and  the growth index, now in positive territory for a fourth week, is at a 34-week high. The ECRI said several weeks ago that a near-term recession was off of the table.  Each week we have more evidence that they are correct.  Investors should think about the growth index as an acceleration term, while the WLI is a level.  The bearish punditry focused on the acceleration term when it was negative.  Please check out this interview to contrast the ECRI posture with outsiders trying to interpret their data, especially David Rosenberg.  The current ECRI verdict?  "With WLI growth rising for ten straight weeks to a 33-week high, U.S. economic growth will soon begin to revive," said Lakshman Achuthan, managing director of ECRI.
• Risk as measured by the St. Louis Fed Stress Index, edged slightly lower, remaining at a very low level.  This measure tracks a lot of market data in the eighteen inputs.  It is not a poll, nor opinions, nor a collection of anecdotes.  We should all pay attention to some real data.  The value moved to .056, down slightly from .122 last week.  For more interpretation, the St. Louis Fed published a short paper with a very nice chart that helps to interpret this index.  The chart does not reflect the recent continued decline in stress, but it identifies the dates for important recent events.  The paper also has a longer version of the chart, illustrating past stress periods.  I am not going to run the chart each week, but I strongly recommend that readers look at the paper.  In the 2008 decline there was plenty of warning from this index -- no sign right now.
• China, Obama, and Policy Changes.  The relationship is complex and everyone is spinning away.  There was some meaningful trade and currency progress, but intellectual property is still a key issue.  Meanwhile, The Old Prof remembers Nixon and Kissinger in 1972.  No Democrat could have pulled this off.  It defined a new era.  Clinton and NAFTA did the same.  Those who think that Obama and and the 2010 election means gridlock have a poor sense of history.  Big changes sometimes come when the leadership goes against traditional party positions.  We are already seeing this.
• Jobless claims -- still not good, but reversing last week's spike.  I'm calling it good news on a weekly basis.
• Building permits.  The overall housing report was not impressive, but building permits surged 16.7%.  Regular readers know that I am not cherry picking this as an indicator.  I have always maintained that this is the best forward look at housing.  Permits require a serious commitment.

The Bad

The bad news centered on inflation potential and housing.

• The Philly Fed Index was actually good economic news, but the market, poised to anticipate any possible correction, seized upon the uptick in pricing expectations.  Calculated Risk covered this in a balanced way and Rick Santelli explained the market reaction.  Objective readers may well wonder how one can move seamlessly from worry about deflation and economic collapse to inflation.
• Existing home sales still lag.  Calculated Risk explains why the picture is not as good as the official data suggest.
• Earnings reaction.  The earnings news has been solid, but the reaction has been skeptical.  Every pro watches this as a sign of how much the market has "built in" earnings growth.

The Ugly

The ugliest thing I see this week comes from my email flow.  There are three distinctly different distrubing sources:

1. One guy sends me the worst possible news every day -- what the US is doing wrong, what Europe is doing wrong, the fragile nature of all economies, etc.  A typical piece highlighted an aritcle in ZH with a hat tip to a breathlessely appreciative guy who had been published there recently with hundreds of comments.  He is explaining why the ZH exposure is so much better than SA.  The fawning guy cited a piece in the Bond Buyer showing how investors were getting paid back a few cents on the dollar.  The same issue showed an article warning that the crisis was overblown.  There is no attempt at balance in this.  I do not know exactly how everyone profits from selling fear, but the industry is a big one.  60 minutes and CNBC should spend some time on this topic.
2. An old and dear friend celebrated her 70th birthday today.  She has decided to spend her time forwarding Internet lies and trash to hundreds of people.  This includes dozens of stories refuted on Snopes -- basically attacks on Obama, immigration, taxes, and the economy.  The most recent one falsely stated that the President canceled national prayer day and prayed with Muslims instead.  It showed a picture of one of his world travels in a scene that might have applied to any President.
3. There are comprehensive reports showing numerous similar periods in history.  Many of these go back to the 19th century to show people why the current rally cannot possible move further.  Why we care about the "dead ball era" amazes me.  I am also surprised that people who look at a rally do not look at the starting point.  If earnings are growing faster than stock prices, the rally is not overdone.  End of story.  But that part is not mentioned in these reports.

This email is hateful deception.  The stories are unbalanced coverage at the best, and blatant lies at the worst.

There are victims -- real victims.  I am going to pick two different clients, both discussing investments with me last September.  One potential client reads all of the Internet pundits every day.  She was worried about all of the stories about Ben Bernanke and QEII, so she stayed in cash.  The other worked with me to develop a balanced portfolio related to personal needs -- ignoring the noise about politics.

The first potential client was the victim of the Internet noise, the stupid bunnies, and the general climate of fear.  The second had the wisdom to focus on his personal mission and ignore the noise and the politics.

I admit to some emotion tonight.  I am unhappy with my old friend for peddling fear because she does not like the President.  There have been many Presidents that I did not like, but I tried to be honest in my comments and objective in my investing.  I am also feeling a sense of personal failure because I could not explain to the intelligent and deserving potential client why she was being bamboozled.  She and her husband have earned and deserve a better retirement.

This is a story that plays out daily for me.  Nearly every investor I talk with has been bombarded with messages of fear.  It helps to explain why I am not very influenced by poll-based sentiment indicators that say everyone is bullish.  It does not square with reality.

 

Our Own Forecast

We base our "official" weekly posture on ratings from our TCA-ETF "Felix" model.  Felix has captured the big rally since last September, usually in the best sectors.  The ratings are showing more of a mixed tone.  It is a close call, but we are continuing our bullish position in the weekly Ticker Sense Blogger Sentiment Poll.   Here is what we see:

• 79% of our 56 ETF's have a positive rating, up nicely from 61% last week.
• 46% of our 56 sectors are in our "penalty box," about the same as 48% last week -- still in warning terriotry.
• Our universe has a median strength of  only +14,  but strengthening  from +7 last week, and reversing the recent decline.

The overall picture is a little stronger.  While we maintened a 100% long posture, we are watching the indicators quite carefully.

[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 data next week.  I do not expect much of a move from the Case-Shiller housing data or the government price data.  There is too much complexity and spin related to foreclosures and shadow inventory.  Nothing would be accepted as good news.

There will be the Fed announcement, but no one is expecting anything new.

The State of the Union is the most important event.  Usually I have an idea about what to anticipate, but there is a lot of mystery this time.  I will watch with interest, but I expect any surprises to be market friendly.  That seems to be the message of the recent Obama changes.

The first read on 4th quarter GDP will come out.  The perma-bears are now ratcheting up expectations in the near term and moving forward their predictions of doom to the second half of next year.  Whatever the number, the market is already looking ahead to 2011 and more earnings.

Investment Implication

Is the market priced for perfection?

The market is attractively valued on one-year forward earnings.  I have shown these to be accurate and no one has stepped up to challenge the data.

The P/E multiple is likely to increase based upon my analysis of past data.  David Tepper called the move starting in the last quarter, mostly emphasizing the asset allocation choice faced by many big players.  He repeated the story last week citing S&P 1522 in about two years (HT again to Mike C).

There can always be a correction, especially after a big move.  Most skeptics have been predicting this every week for seveal months.  The individual investor needs to focus on these three facts:

1. The market is attractively priced on a forward earnings basis (the best measure) with current interest rates in mind.
2. The economic prospects via the objective ECRI measure are very good.
3. The risk -- via the SLFSI measure -- remains very low.

 

The Little Book of Sideways Markets: A Profitable Read

I enjoyed reading Vitaliy N. Katsenelson's The Little Book of Sideways Markets, now added to our list of recommended books.  You will, too.  Most individual investors will profit greatly, and even experienced investors will pick up some valuable pointers.

The Thesis

The basic thesis for the book is that investors should expect a long period of time with the market going sideways.  Katsenelson's argument is that the recent rally in stocks has seen most companies borrow against future earnings.  He sees mean reversion behavior in profits.  He made a similar prediction a few years ago, earning widespread acclaim.  He is now repeating it.  He also sees various global economic headwinds which he describes in some detail, identifying several species of "grey swans."

The author has support from some influential voices.  John Mauldin contributes the Foreward.  While he did not know it at the time of writing, the major thesis also has the endorsement of Doug Kass.  Kass has made the unusual prediction of a flat market for 2011.  He emphasizes mean reversion in earnings, which he thinks will lead to a compression in P/E multiples.  For those who have a serious interest in making money, you should consider the entire Kass interview cited below.  (HT - Mike C.)  For those who want to focus on the question of P/E multiples, scroll ahead to the eight minute mark.

 

Here is where the fun starts!

Regular readers know that I completely disagree with this thesis.  My analysis of data shows that when market participants have an obsessive concern about a recession, the P/E multiples reflect this.  There is plenty of evidence that most people think we are still in a recession, so there is intense skepticism about earnings growth.  Even a modest level of economic growth will restore some confidence.  I already see this in many indicators that I follow each week.  I predict an expansion in the P/E multiple, and each point is about 7-8% of growth.

My conclusion is that the economy can grow modestly, earnings growth can slow, and yet ---- some confidence can be restored, increasing the multiple.  Unlike other contestants in this discussion, I actually have some data on my side.  Time will tell who is correct.

This raises a good question.  If I disagree with the major thesis, why do I like the book?

First, we all should read a very wide range of sources.  I spend much of my time each day reading viewpoints at wide variance from my own.

Second, and more important, Vitaliy's book will empower you as an investor.

Let us consider this proposition in further depth.

Investing Lessons

The book provides quite a number of investing lessons.  The basic price to cash flow analysis is described in a charming fashion -- easy to understand.  Sophisticated investors can just enjoy this as a lesson for the newbies.

In the middle chapters we can see the real analysis.  Here are the key precepts:

• Look for real value on a price-to-cash flow/ return on equity basis
• This is not "buy-and-hold."
• Sell when a stock  reaches your fair value target. Emphasizing, don't reach for a "top valuation."

These are all very good points.  My summary does not do justice to the persuasively written text in the book. 

Why You Should Read the Book

This is a book that teaches you about finding good stocks.  It does so in a well-written and colorful fashion.  You will enjoy reading the discussion and the examples, and nearly everyone will learn.   You really need to dip in and read to enjoy the colorful and persuasive descriptions.

This is an investment lesson that any intelligent reader can understand.

Attention:  Self Perceived Experts

If you think you know what is going to happen -- bullish or bearish -- Vitaliy has a chapter just for you!

You need a reality check!  Chapter 13 will deliver!  The real question is how to test yourself with alternative outcomes.

Conclusion

I would be lying if I said that I learned something about investing from this book.  Realistically, it describes what I do every day -- finding value with key metrics, avoiding buy and hold, selling when there is no longer any edge.

Even for me the provocative discussions helped to focus on the key questions.

In Chapter 17 the author expains why his approach would still be strong even if markets (to his surprise) make a big rally.  I think this is the key point.

You will enjoy and profit from this book regardless of your opinion about the market.

This book describes what many of us do in picking stocks, and it does it very, very well.  Even if you do not embrace the sideways market thesis, I strongly recommend the book.  Most readers will learn a great deal, and the lesson will be an easy one.

 

 

 

Weighing the Week Ahead: All Eyes Turn to Earnings

In the near term, the two most important market questions are the following:

1. Will corporate earnings continue the consistent strength of the last eighteen months?
2. How much of this has the market already anticipated?

To understand the importance of these quesitons it helps to look at how well companies have done in recent quarter.  Bespoke Investment Group's charts have a way of combining simplicity with a powerful message.  This chart of the "beat rate" is no different.

The BIG team notes that the historical "beat rate" is 62.5%, so we are on a six-quarter streak.  The full article shows a list of key companies and how to get additional information.  Check it out if you want to be ready for earnings season.

I have written quite a bit about earnings, noting weekly that the "dog has not been barking."  We have not had a slew of negative pre-announcements, so readers may well guess my own answers to these questions in the conclusion.  But first, let us do our regular review of 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

The economic data flow picked up last week.  The picture was mixed, with a negative lean.

The Good

Major economic indicators continue to beat expectations.

• Economic growth is improving.  The ECRI weekly leading index had a small decline last week, but  the growth index, now in positive territory for a third week, is at a 33-week high. The ECRI said several weeks ago that a near-term recession was off of the table.  Each week we have more evidence that they are correct.  Investors should think about the growth index as an acceleration term, while the WLI is a level.  The bearish punditry focused on the acceleration term when it was negative.  Please check out this interview to contrast the ECRI posture with outsiders trying to interpret their data, especially David Rosenberg.  The current ECRI verdict?  "With WLI growth rising for ten straight weeks to a 33-week high, U.S. economic growth will soon begin to revive," said Lakshman Achuthan, managing director of ECRI.
• Risk as measured by the St. Louis Fed Stress Index, edged slightly lower, remaining at a very low level.  This measure tracks a lot of market data in the eighteen inputs.  It is not a poll, nor opinions, nor a collection of anecdotes.  We should all pay attention to some real data.  The value moved to .122, down slightly from .163 last week.  For more interpretation, the St. Louis Fed published a short paper with a very nice chart that helps to interpret this index.  The chart does not reflect the recent continued decline in stress, but it identifies the dates for important recent events.  The paper also has a longer version of the chart, illustrating past stress periods.

I have run this chart for several consecutive weeks for an important reason.  I know that many people who need wealth creation, not wealth preservation, are worried about another 2008-style collapse.  I suggest this indicator as a way of sharing in stock market gains while keeping safe.  I am not planning to run this chart again, although my team is doing an analysis of this and related indicators in a "best times to invest" study.

• Portugal successfully sold some debt, which had a calming effect on the markets.
• Federal revenue growth is solid, whatever you think of tax policy or the economy.
• Hiring plans are improving.  Almost one-quarter of employers — 24% — said they plan to hire full-time, permanent workers in 2011. That compares with 20% this year, and 14% in 2009, according to CareerBuilder.com’s survey in late November of more than 2,400 hiring managers and human-resource professionals.
• The trade deficit was lower.  In the complex GDP calculation, this means that GDP will be higher.

The Bad

The bad news grabbed my attention this week.

• Initial jobless claims spiked higher, rising by 35,000.  This series needs to get well below 400K for a real jobs rally.  Regular readers know that I view this series as an important input in the analysis of employment trends.  There is a lot of skepticism about the data.  This surprises me, since it is one of the cleanest and most frequent reports.  This take on seasonality and government honesty from Edward Harrison was something I found to be especially helpful.
• Retail sales were el stinko, up only 0.5% instead of the expected 0.8%.  No weather excuses allowed...
• University of Michigan Sentiment was only 72.7 -- another good employment indicator, and a significant miss from expectations and last month.
• CPI and PPI moved higher, especially the non-core rates.  This is something to watch carefully.

The Debate Club

There are two issues in front of the Debate Club.

1. Is Sentiment a major risk?  For several weeks there has been a consistent (and losing) proposition that sentiment was too bullish.  I entered my own objection.  This week Prieur du Plessis noted something that I have also observed -- a disconnect between reports like AAII and what he was hearing in his private contacts.  He ran a poll on his site, and also at Barry's.  The official results have not been announced, but as a voter I can tell you that it is not overwhelmingly bullish.  The idea that people are "all in" already is just silly.
2. Is the economy improving?  The main consensus of economists recognizes the improving data that I have cited here for many weeks.  Various economic polls reflect the improvement.  There is a minority viewpoint suggesting that this is supposed to be bad news --- that these were all of the people who did not "forecast the crash."  This is a subject that requires a separate article, but I want to make a preliminary observation.  Most readers do not look at the long-term records of those who "forecast the crash." 

 Our Own Forecast

We base our "official" weekly posture on ratings from our TCA-ETF "Felix" model.  Felix has captured the big rally since last September, usually in the best sectors.  The ratings are showing more of a mixed tone.  It is a close call, but we are continuing our bullish position in the weekly Ticker Sense Blogger Sentiment Poll.   Here is what we see:

• 61% of our 56 ETF's have a positive rating, down from 88% last week.
• 48% of our 56 sectors are in our "penalty box," up significantly from 21% last week -- a warning.
• Our universe has a median strength of  only +7, down from +18 last week, and continuing a decline.

The overall picture is much weaker.  While we maintened a 100% long posture, we are watching the indicators quite carefully.

[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

The coming week will be shortened by a holiday and will also feature options expiration.

For me, the earnings story is paramount.  Congress will be back in session with political posturing at the forefront.

As usual, I like building permits as the most useful of the housing data.

Joe Weisenthal thinks that Thursday's data about China is "the only data point that matters."  OK.  I respect Joe's opinion, so let us keep an eye on China -- obviously important.

My own sense is that the bearish punditry has created a long list of foreign countries for a weekly check.  If it is not perfect, they predict disaster.

 

Investment Conclusion

As an investment manager I try to find the best prices for new investors, often hoping to "buy on dips."  The current market is not offering many such chances.

Turning back to the questions from the start of the article, I think the answers are pretty easy.  I have been writing for weeks about the "dog not barking"  -- the absence of negative pre-announcements.  I have also warned about people confusing their political viewpoints with a dispassionate analysis of corporate earnings.  I also wrote about the successful prediction of forward earnings by analysts.

Those following me have captured the rally in these weekly articles, but I have also done something else.

I have added a focus on risk!

I got some help on this -- feedback from regular readers (like Mike C.)  These readers may not all agree with my risk measure, but they inspired the work.  More to come on that front.  I always appreciate and learn from reader comments.

To be clear, I think that the market is significantly undervalued.  The overall market multiple will move higher as the palpable fear is reduced.  There are many great stock choices. (I am not legally allowed to advertise performance, but our contrarian portfolio has a stunning start for the year, and we are nowhere near our target values for the stocks).   For most individual investors it is a question of how to participate in the market, while controlling risk.

Most of the investment advice you read does not emphasize the right starting point:  Begin with your personal needs!  That is more important than the market.

Meanwhile, many people have missed the big rally because they did not grasp the most fundamental concept of market valuation:  Earnings.  Check out this colorful analysis from the Pragmatic Capitalist:

Markets do not care about you.  They don’t care about your family, your feelings and they particularly don’t care about your wallet.  With record deficits, QE2, 9.4% unemployment, continuing stimulus and 0% interest rates many are still baffled by a surging stock market.  What gives says the Main Street investor?  Clearly, there’s still an enormous disconnect between the market and reality.  I know, there are a lot of positive signs out there, but the fact remains – Main Street still doesn’t feel like the recovery is headed their way.  But the market isn’t the economy.  Main Street isn’t Wall Street.  And the market is a heartless beast that desires one thing and one thing only- PROFITS!

Explaining the same story in a different way is the must read weekly chart video from Charles Kirk.  He starts with some music...."I fought the law..."  For readers of a certain age, that almost tells the story.  Too many investors have gotten involved with what they think government policy should be, instead of figuring out how to accept reality and to profit.

For traders, it is a bit different.  The indicators are more mixed -- almost neutral.

Each day I wear both the trader hat and the investor hat.  It is all about time frames, and I am trying to do an honest appraisal in the weekly look ahead.

We traders will face a challenging week, with cross currents from data, sentiment, earnings, and options expiration. 

 

 

 

ETF Update: Tech Stocks Take the Lead

The early trading and earnings reports in 2011 have highlighted sector strength in technology.  Our short-term ETF models, Oscar and Felix, have helped to identify this trend.  We have a special emphasis on networking, but also hold QQQQ and VGT.

Networking stocks enjoy a top rating from our 12-month ETF model, as well as from the short-term trading systems.

There are also some good fundamental reasons to consider networking stocks, but let us first consider some basic information about our approach.

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 Networking Stocks

This week's featured sector is networking, but the ratings also show an overall trend toward technology sectors.  While my focus in this update is networking, you may wish to compare your own current choices with the other top-rated technology sectors in our list.

We trade networking stocks via PowerShares Dynamic Networking Portfolio (PXQ).   The fund includes a widely diversified portfolio of networking, software, and Internet stocks, including VMware, Juniper Networks, QUALCOMM, F5 Networks, Symantec, and others.  The top ten holdings each have a concentration of about 4-5%.  The P/E ratio is over 30, the price to cash flow is about 13, and the price-to-book is over 3, as one might expect for a growth sector.  As one might also expect, there is no meaningful dividend.

Our ETF universe was selected to reflect diversity, liquidity, and low trading expenses.  We carefully identified one sector of each type to be part of our universe of 55 ETFs.  We now also review developments in a wider group (available to subscribers on request) to consider new entrants.  A few months ago we noted the significance of networking, and added it to our featured list.

You can see the reason for our interest from this chart:

 

The group has been strong for several months, and the trend is continuing.

 

Other Opinions

We always survey commentary from other experts on the ETFs in our buy zone.  There has not been much commentary, other than to note the overall strength in the group.

• Clusterstock singles out Qualcomm, highlighting many recommendations and calling it a crowded trade.
• ETF Daily notes the strong returns.

We never mind it when few have joined us in recommending a sector.  The members of this group are part of a technology upgrade cycle including chips, software, and security protection.

This Week's Results

Felix, the more cautious approach, has fully participated in the market rally.  The sector ratings have reflected the strength, with many good choices to buy.  We hold the top five positions, so technology has been a recent emphasis.

Weekly TCA-ETF Rankings

The average rating is weaker, but we remain 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.

The Illinois Tax Increase: Why Investors Around the Country Should Care

Are you thinking about the markets, or do you have a fixation on politics?

The politics versus investing theme is familiar to readers of "A Dash."  Why do I keep beating this drum?  Because it is so important.

A Small Digression

I enjoyed Josh Brown's wonderful advice on blogging: 

If your visitor clicks a link, hits your page and is greeted with a wall of text, that visitor is gone.  No one wants to read something that looks like homework, no matter well written it is.  Your first paragraph should never be more than one or two sentences.  Each paragraph thereafter should be 3 to 4 sentences maximum.  If you're over 500 words for the whole post, you better be writing something important or brilliant, otherwise just stop.  The markets are moving and people won't even give your post a chance if it looks unconquerable.

Josh has a finger on the pulse of the market, and I am also enjoying his TV stints.  We accord him our highest office honor by taking the TV off of mute and backing up TIVO when he is on!

With respect to my blog, it is pretty obvious that I regularly fail to take his advice.  The Old Prof cannot seem to do anything in 500 words!  I also do not follow his other advice, although I agree that it is very wise.

I plan to think about this more -- perhaps by doing a few more brief pieces.  Many of my topics require more extensive analysis -- -Meanwhile

If you cannot spend two minutes reading an article, you may not be a good candidate for my material!  Put another way, if you have at least two minutes to spend, you might gain an edge over investors with ADD!

End of Digression

Illinois raised its income tax from 3% to 5% on a temprorary basis, with an eventual 3.5% rate.  There are few deductions, so this is bigger than it seems.  What does the Illinois story really mean?

The Illinois decision reflects what I expect to happen around the country, and at a national level.  I have watched the Illinois debate very closely for years.  I have many roles -- as a taxpayer, a voter, a member of the Citizens Financial Advisory Committee for a major school district, and as a former Public Finance Professor at a major university.  I have had a front-row seat.  I voted for Governors of both parties, including those who are now in prison.

The last Governor of Illinois who was loved by everyone, and who could have won the election had he run, made it clear that the deficit problems could not be solved without a tax increase.  In the context of last year's election, a tax increase was off of the table.  This was typical of national politics.

The tax increase was enacted by the lame-duck legislature.  While the Democrats will have a majority next year, it will be less powerful.  Some question the legitimacy of this decision.

Separating Investing from Politics

There is one conclusion that should be crystal clear for investors:  The Illinois decision is bullish.  Increasing taxes helps the credit rating for the state, Illinois cities, school districts, and other taxing districts.  It makes Illinois debt in all forms more attractive than it was yesterday, and it also should reduce the national concern about municipal defaults.

I expect other states to follow this approach.

I note that some observers who predicted widespread state and local defaults have now shifted gears.  They complain that Illinois should have cut spending.

This is what I mean about confusing politics and investing -- something that seems commonplace in 2011.  [I note that I am, once again, over 500 words.]

We are all familiar with the taxing versus spending debate.  No matter what the formula, a state that makes good on its obligations is doing the right thing.

Investment Implications:  Bullish for Muni Bonds, suitable for some of my clients, and a general market positive.

Ten Things that Will be "More Normal" in 2011

Getting on the right side of trends is important for successful investing.  The biggest theme for 2011 is that many things will become "more normal."

This is not an article about some "new normal" or even the "old normal."  It is not a prediction that problems will disappear.  That sort of  "light switch thinking" dominates most discussions about stocks and the economy.  It is simplistic to say, "We either have a problem, or we do not".  Those who cite the various economic worries, challenge every solution as inadequate, and they are correct.  Most problems cannot and will not be solved in a single stroke.  Improvement comes gradually.

Here are some ideas around this theme.  Each idea represents a variable or relationship that is stretched to an extreme value.  These are all things that will become more normal in 2011.

1. Profit margins.  Profits have grown rapidly through cost-cutting, slow employment growth, and a touch of revenue growth.  I join with those who see margins moving closer to normal levels, particularly as revenue increases.  This means slower earnings growth, but not a reduction in earnings.
2. Temporary versus full-time workers.  Employment has lagged the economic recovery.  Businesses have been cautious in hiring, showing a preference for temporary workers.  The mix will start to change.
3. Business investment.  Businesses have been cautious, with executives joining in the worry about the economy.  There is plenty of cash on corporate balance sheets, and 2011 will see increased investment.
4. Bank lending.  Banks have been very cautious, rebuilding capital and enjoying the yield curve spread.  There are many indications that lending is starting to expand and credit availability increasing.
5. Government revenues.  Revenues at both the federal and state level have increased, to the surprise of many.  This has happened even with the extension of the Bush-era tax cuts and the slow economic recovery.
6. Consumer confidence. Measured by any of the surveys, consumer confidence is gradually improving.  It is still far from normal levels, so expect it to get "more normal."
7. The market multiple.  Stocks have been trading at a low P/E multiple relative to forward earnings.  I expect this to improve in 2011.  I'll predict a modest gain of about one point, which would add over 7% to the S&P 500 for the year, in addition to regular earnings growth.
8. Relationship between stocks and bonds.  Stocks and bonds will move closer to a normal relationship.  Right now the world has rushed to bonds despite the poor yield.  The asset allocation models of major pension funds will continue to recognize the yield differential.
9. Financial stress.  The various sources of financial stress will continue to improve.  Government solutions in Europe, the U.S., and state government are far from perfect.  The situation will not be solved but it will be less imperfect.  My weekly monitoring of the St. Louis Financial Stress Index is intended to take this subject from the world of the anecdote to the analysis of actual data.
10. The inverse correlation between stocks and the dollar will break down.  This has already started.  The long-term relationship is positive, but traders have a short memory.  The simplistic "risk on, risk off" will gradually be replaced by opportunities to pick winning stocks and sectors.  This point may seem a little wonkish for some, but I believe that it has inhibited the normal stock reaction to earnings for at least eighteen months.

Summary

Most of the daily news flow is about market headwinds and lists of worries.  There are many.  Here is a useful exercise:  Take your personal list of major problems.  Every few months ask whether things are better or worse.  Be objective.  Use actual data.  I'll bet you will be surprised at what you learn.  It is so easy to fall into a rut of repeating the same litany, especially if it reaffirms your political/economic/market viewpoint.

My list for this article came from notes I keep about traditional relationships that seemed to be at extreme levels.  They are all becoming more normal.  In general, improvement in these relationships will be a market-friendly development.

Note also that these are not short-term trading indicators, like sentiment.  These are more closely tied to market fundamentals.  In a few months we can all see how these themes played out.

Weighing the Week Ahead: Stormy Weather?

How much attention should you pay to breaking news?  Does it matter if your time frame is measured in months, weeks, days, or minutes?

For the trading community there is an obsession about news.  The individual investor often tries to use the news to time the market.  This is a big mistake.

Here at "A Dash" I try to find some nice themes for the average investor as well as an occasional nugget for traders.  While we have a nice following on the blog and on Seeking Alpha, I do not follow the rules for gaining popularity.  Instead, my approach is to empower investors by highlighting what is really important.  While it is more profitable to peddle fear rather than knowledge, I hope each week to make some new friends who appreciate the difference.

This week's story is a complicated brew of economic data, corporate earnings, and politics.

 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

The economic data flow picked up last week.  The picture was mixed, with a negative lean.

The Good

Major economic indicators continue to beat expectations.

• Economic growth is improving...sort of.  The ECRI weekly leading index had a small decline last week, but  the growth index, now in positive territory for a third week, is at a 32-week high. The ECRI said several weeks ago that a near-term recession was off of the table.  Each week we have more evidence that they are correct.  Investors should think about the growth index as an acceleration term, while the WLI is a level.  The bearish punditry focused on the acceleration term when it was negative.  Please check out this interview to contrast the ECRI posture with outsiders trying to interpret their data, especially David Rosenberg.
• Risk as measured by the St. Louis Fed Stress Index, edged slightly higher, but remained at a very low level.  This measure tracks a lot of market data in the eighteen inputs.  It is not a poll, nor opinions, nor a collection of anecdotes.  We should all pay attention to some real data.  The value moved to .163, up slightly from .15 last week.  For more interpretation, the St. Louis Fed published a short paper with a very nice chart that helps to interpret this index.  The chart does not reflect the recent continued decline in stress, but it identifies the dates for important recent events.  The paper also has a longer version of the chart, illustrating past stress periods.

 

• Bill Daley is the new Obama Administration Chief of Staff.  I understand that there are political viewpoints about this, including those who think it shows favoritism for big banks.  When I rate the good, the bad, and the ugly, I take the perspective of the millions of people who have investments in their future.  From that perspective, the Daley appointment is market-friendly.  Most people do not understand that the Chief of Staff is usually the second most powerful position in government.  The President cannot attend to everything.  The Chief decides many issues and also determines a lot about what the President sees.  Daley's viewpoint will be more business and market-friendly.  I am not writing about politics.
• State tax revenues are moving higher.  No one seems to be noticing, but it is a good reflection on the economy.  If we held spending constant, we would have a balanced Federal budget in 5-6 years.  Check here for evidence and charts.  Personally, I expect cuts in spending and entitlement progams.
• Firms plan more hiring.  This is only one survey, but I am seeing several indications like this.  It has not really shown up yet in the official data.
• The ISM manufacturing report registered a strong reading of 57.0.  This implies a GDP growth rate of about 5%.  It is one of the better real-time indicators, and it has been over 50 for 19 months.  Most people do not realize that a reading of 42 is the breakeven point for GDP growth.

• The dog (is still) not barking.  I am not seeing many earnings pre-announcements.  Few have taken notice of this so far, and earnings season is upon us.

The Bad

The bad news seemed more important this week.

• Payroll employment gains were very weak, only about 100K.  This growth is barely enough to absorb new entrants to the labor force.  It does nothing for those who are unemployed.  The apparently decline in the unemployment rate, while helpful for news headlines, is quite deceptive.  Too many people are leaving the labor force.  The lower rate reflects this trend, rather than more people getting jobs.  Calculated Risk and Econbrowser both have great summaries of this problem.  There is also a very strong analysis from Roubini Global Economics (full disclosure -- I am a contributor), which cites many different sources:

The December payroll report indicates a labor market gradually on the mend, although the pace of improvement remains cautious at best. While the household survey painted a better picture than in November, the drop in the unemployment rate also driven by a large drop in the labor force. The return of manufacturing payrolls to positive territory, continued gains in services employment, more broad-based gains in private payrolls and a decline in part time employment for economic reasons are positive developments. However, the stall in wages and the workweek and the increase in the duration of unemployment are disappointing. On balance, while the labor market is slowly improving.

•  More Foreclosuregate.  The Massachusetts decision is bad news for the market.  If banks cannot collect on loans that were freely agreed when made, it is a problem.  If delinquent homeowners decide to quit paying and challenge paperwork, that is bad for all lenders, bad for the economy, and bad for the market.  How bad is it?  Felix Salmon thinks that it is a long tail.  Calculated Risk opines, "These issues are curable, but will be costly for the banks. As Tanta frequently argued, the upfront "cost savings" would be paid for in arrears! This does not appear to be a systemic risk."  We'll soon learn how significant this is, but the early indication is modest.

There were not as many negative stories last week, but they are more important.

The Ugly

The ugliest news of the week was the Arizona shooting story -- an attack on a Member of Congress and the death of several government officials and innocent spectators.  You might not think that this is a market story, but it soon will be.

This incident has already changed the week's agenda for Congress and has the potential to change the nature of political debate.  This will happen not out of principle, but because the most aggressive tactics are suddenly unseemly vote losers.

For the moment, let us all hope and pray for the best.  We need more responsible commentary and debate.

Our Own Forecast

We base our "official" weekly posture on ratings from our TCA-ETF "Felix" model.  Felix has captured most of the three-month market rally.  This was reflected both in higher overall ratings and  a lower penalty box number.  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, up from 82% last week.
• Only 21% of our 56 sectors are in our "penalty box," down slightly from 23% last week.
• Our universe has a median strength of +18, down from +23 last week.

The overall picture is a bit weaker, but 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

I expect this to be a confusing week with a forecast of stormy weather.  Political leaders will be reacting to a story that everyone can understand, emphasizing more security and more temperate discussions.  There is no way to interpret this news as positive, at least on a first take.  There will also be negative stories on the foreclosure developments.

Many of the big political themes with market revelvance will be "on hold."

There will be a deeper look into the negative consequences of very divisive rhetoric and those who sell it.  I expect that this examination will eventually reach the Internet "investment" sources that profit from selling fear.

Can we expect a backlash against fear?  I think so.

The actual economic data includes the following:

• Inflation (not very important in the absence of a spike)
• Factory orders and capacity utilitzation -- a "B" report, important if there is a big move.
• Sentiment, initial claims --- important for me since these are part of my employment model.

To summarize, the economic data may be less important than the politics of fear and the Obama economic team changes.  Watch closely for any earnings pre-announcements.  So far the dog has not been barking, which is a bullish sign.

My Posture

For new investors I am establishing a signficant position right away.  We see attractive current prices in many stocks. While prices have moved higher, earnings have increased even more rapidly.  We have buy targets in other names.  I recommend this combination strategy for investors who need more equity exposure.

Important Advice

In my recent articles providing my best recommendations for individual investors, I warned about scams, and I provided some tips for 2011 planning. It is important to have a plan for risk control.  If you missed these articles, I recommend taking a few minutes for a money-saving review of scams and 2011 risks.

[full disclosure -- Long JPM and GS, and buying more]