An eclectic approach to better trading and investing. Finding market inefficiency. Discussing and applying the best ideas and methods from several disciplines.
They are not thinking about the right stock to buy. They are scammed by online gold sites (see this official FINRA warning.) They are scared witless [TM OldProf euphemism] by sensational predictions of the end of the world.
The Most Important Issue: Asset Allocation
Here is a clue: There are very few investors for whom the right stock allocation is zero!
Sometimes the most important issues for the individual investor are too complicated for a single neat article ending with "actionable investment advice." I regularly complain that journalists and bloggers alike play for page views by their choice of story. I do not want to do the same.
To illustrate my point I am devoting some time this week to basic investor education. These may not be the most popular articles, but I am encouraged by the emails from those who are playing along -- people who are doing some critical thinking about the typical claims they see every day and trying to analyze probability questions.
I'll return to the "doctor question" tomorrow when everyone has had a chance to play.
Meanwhile, let's turn to cheating in investment forecasting models.
The Illusion from Cheating
As the first step, I encourage readers to consider the online poker scandal of 2007. Some players had information about the software, so they could see everyone's hand. Even the worst poker player can win when he knows the hands. The story was reported on 60 Minutes and recently featured on CNBC. Here is a brief video that provides the essence of the cheating story.
From our perspective the lesson is simple: If you know the hand, you can win even if you are a terrible poker player.
The 2012 Election
One of my political science colleagues in the professoriat has a new book and a prediction for the 2012 elections. He is challenged by a young upstart lacking the formal poli-sci credentials. Some readers think I place too much emphasis on formal training and credentials, so you might be surprised at my reaction.
I am a big fan of Nate Silver and a regular reader of his work. He commands respect with his use of data. He is not writing about investments, which caters to this week's theme of taking lessons from other disciplines. He caught my attention with this tweet:
Anyone who, at this point in time, claims that Obama is certain to win or certain to lose doesn't understand forecasting, full stop.
In a full article on the topic he reviews the methods. He carefully discusses the various "keys" used by the author and then does a statistical analysis of past elections with an error margin for the key differential. It is excellent, and worth reading as we look to the election.
Here is his conclusion:
By the way — many of these concerns also apply to models that use solely objective data, like economic variables. These models tell you something, but they are not nearly as accurate as claimed when held up to scrutiny. While you can’t manipulate economic variables — you can’t say that G.D.P. growth was 5 percent when the government said it was 2 percent, at least if anyone is paying attention — you can choose from among from dozens of dozens of economic variables until you happen to find the ones that pick the lock.
These types of problems, which are technically known as overfitting and data dredging, are among the most important things you ought to learn about in a well-taught econometrics class — but many published economists and political scientists seem to ignore them when it comes to elections forecasting.
In short, be suspicious of results that seem too good to be true. I’m probably in the minority here, but if two interns applied to FiveThirtyEight, and one of them claimed to have a formula that predicted 33 of the last 38 elections correctly, and the other one said they’d gotten all 38 right, I’d hire the first one without giving it a second thought — it’s far more likely that she understood the limitations of empirical and statistical analysis.
Applying this to Investing
What Nate Silver is saying about this type of analysis is that they have cheated -- perhaps inadvertently.
You can easily find predictions from big time economists and fund managers who think that the odds of a recession are now 100%. (Let us assume that they stipulate a time frame of a year or so). Silver's rule tells you to say NO! to this. The apparent certainty of these methods comes from the omniscience of "knowing all of the hands."
Your first reaction should be the same as Silver's when he saw the 100% Obama forecast. How can anyone be 100% sure of a recession? One of the perpetrators of the investment mythology had a 100% recession forecast last year. It didn't work, but he is back with another one this year featuring new variables! Doesn't anyone monitor this stuff? This guy is on financial TV with fawning anchors explaining how he has been "right."
To emphasize, if you take hundreds of variables, selectively choose the ones that fit your thesis, throw out those that do not, and then adjust the levels to fit the forecast -- well-- you can prove anything.
An Honest Approach
Honest analysis is more difficult and it does not sell as well. Even those of us who have a long-term record of significant edge over the market averages experience plenty of fluctuation. About five years ago I wrote this true story about the importance of honest research methods. I encourage you to read it and enjoy a chuckle at my expense.
Meanwhile, you will appreciate the need to start with the hypothesis and then test. Those who start by looking at all of the hands and then tell you that the data proves they are right did not take the right classes, even if they did get a PhD.
If so, you are also smarter than a major fund manager.
Once again investors are confronted with a LIST OF WARNINGS!!!
The basic idea is that the end of the world is near. The evidence is a laundry list of events occuring in close proximity with former occasions of the end of the world.
The reasoning offered is seductively persuasive. The background story is great -- sort of like the Hindenburg Omen or the Death Cross.
Your BS detector should be on red alert when you see this stuff, but can you really see the error? It seems so persuasive.....
The Doctors' Problem
As I have often suggested, investors benefit from stepping outside of their normal world. Try to think clearly about the following problem:
1% of women at age forty who participate in routine screening have breast cancer. 80% of women with breast cancer will get positive mammographies. 9.6% of women without breast cancer will also get positive mammographies. A woman in this age group had a positive mammography in a routine screening. What is the probability that she actually has breast cancer?
Only 15% of doctors answered the question accurately.
Give it a try yourself. If you grasp the concept, the answer will be easy.
If you can solve this problem, you will have a great feel for the error in the list of warnings. Please do not post exact answers in the comments, except to say that you have solved it. Email the answers to jmiller at newarc dot com and I'll hand out the awards! Some of my readers will nail this one.
I know that readers like things wrapped into a a nice one-article package, but I am not going to do that today. There are several important lessons here and you won't get them if I put it in a single piece:
Hardly anyone can do probability problems accurately. You need to see how seductively wrong this is.
Even the smartest market participants make many errors on causation and inference -- the includes some high-profile managers and high-priced analysts.
If you can figure out problems like this, you have a real advantage.
References
I created and used a lot of problems like this in my teaching, but I saw a really good source with a more modern example. I'll catch up on giving credit with the solution.
No fair searching to help your answer! Do your own work!
Here at "A Dash" my main mission is finding the best sources and accepting a wide variety of viewpoints. I write a weekly update giving a perspective in various time frames. My recorded positions vary over time, but I always use the same indicators. If there is a change, it is a gradual process --carefully explained and reviewed. This does not happen often.
I try to set an example for an objective approach.
A Disturbing Trend in Honesty
In recent weeks the stock market has declined. Journalists and pundits have rushed to look smart by retroactively explaining the market move, or by reminding readers that they were "early" on the housing crisis (i.e. permabears).
This grab for the headlines, eagerly embraced by many journalists, has led to a disturbing outcome:
There is a bull market in torturing data!
Every day there is another parrot who dismisses actual data in favor of anecdotes and explanations of why this time is different.
There is a simple reason for this. The parrot lives in a world of slogans and so do you. You do not understand economics or causal modeling, so you have a bulls eye on your chest. Repetition is crucial. Interpreting data is hard. Headlines are easy. You are a target.
Here are some crucial examples:
The yield curve -- long history, many historical periods including lots of Fed control. Never a recession at current levels. But this time is supposedly different.
Jobless claims -- emphasized by bearish pundits when it had a five-handle but ignored now. Never a recession at this level. But this time is supposedly different.
Money Supply -- perhaps the longest and strongest relationship. Go read Milton Friedman to see the correlation with nominal GDP. We can argue whether the result will be real growth or inflation, but something is happening. Meanwhile --- this time is supposedly different.
My Viewpoint as a Methods Prof
I offer this as a professional in research methods -- student, model developer, teacher, and consumer of models for 40 years. Most of the people you see on TV or read about have not taken a single class in research methods. They have NEVER developed or tested a model. Their prominence in the media reflects marketing rather than skill. It is a sad commentary about who is featured on TV. When I see someone I do not recognize I look at the bio. Often it says something like "frequently quoted." Sheesh!
It is intellectually dishonest to start with a conclusion and keep changing your methods until the data fit. There should be a most wanted list of people doing this right now, including some of the most frequently cited sources. You can spot them if you look.
A Journalistic Challenge
Here is an idea. What if journalists looked for the cheats who change their methods and then wrote hard-hitting articles that highlighted the shifts. That would be tougher than trolling for quotes, but more helpful to readers. Maybe someone could give a prize for journalism that actually went against the grain.
Just a thought....ivory tower, no doubt.
Investment Implication
For many weeks I have highlighted the growing discrepancy between fundamental indicators of earnings, valuation, risk, and specific opportunities, including two winners highlighted here and here.
I know from conversations and email that many investors are paralyzed with fear, unsure of how to get started.
I recommend that you formulate a plan that has the right size for you -- one that can accept the expected volatility. The next step is to find some stocks to buy.
Doing Nothing?
Do you expect inflation? I do. What rate are you getting on cash? Most investors (and I say this only in general terms, since everyone is different) would benefit from a few great stocks with good dividends and good balance sheets.
For new clients I am still buying the stocks referenced -- JP Morgan Chase (JPM) and Apple Computers, Inc (AAPL). Despite my forecast last weekend, Felix let the gold miners (GDX) out of the penalty box, so we added to positions there.
On a strict valuation basis, even with a reduction in earnings expectations, I have not seen so many great opportunities since the bottom in 2009.
Last week was all about headlines and the Fed's Jackson Hole speechmaking. This week will be quite different. There is a data deluge, culminating in Friday's employment situation report.
Everyone has low expectations for this week's economic news. So do I. An already sluggish economic recovery was thrown off course by the earthquake and tsunami in Japan. Just as that effect was declining, we had the highly-publicized debt ceiling debate. The political process undermined confidence on the part of consumers, businesses, and one misguided ratings agency.
There are now two distinct interpretations --- a worldwide economy that is spiraling into recession or an extension of the "soft patch."
The coming week's data will not resolve the debate, since everyone expects more weakness in the numbers. I'll offer my own forecast in the conclusion, but first let us do our regular review of the week's events.
Background on "Weighing the Week Ahead"
There are many good sources for a comprehensive weekly review. I always check out the articles from Steven Hansen at Global Economic Intersection and Calculated Risk. My mission is different. I single out what will be most important in the coming week. 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.
Unlike my other articles at "A Dash" I am not trying to develop a focused, logical argument with supporting data on a single theme. I am sharing conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am trying to put the news in context.
Readers often disagree with my conclusions. (A commenter recently suggested that was proof that I was wrong -- an amazing interpretation!) Do not be bashful. Join in and comment about what we should expect. 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 feel free to disagree. That is what makes a market!
Last Week's Data
In a light week for data, the sluggish growth story still reflects the totality of the evidence.
The Good
There were a few bright spots.
Durable goods orders were up 4%, much better than expected. This was a July number, and it did reflect some rebound in auto production.
Initial jobless claims clocked in a bit higher, but still in the 400K range when you take the Verizon strike into account. This is still not what we need, but it is better than recent levels and much better than many were forecasting a few weeks ago. It is not a recessionary level, nor a sign of robust growth.
The money supply rebound continues. This is a major forward-looking indicator that is widely ignored. It is a leading indicator, giving it extra significance. I have been writing about this for several weeks. It is ignored in the trading community. If you understand this point you will realize that the QE II effects are just starting. This interview featuring Bob McTeer, one of our favorite sources, explains the point in a way that anyone can understand.
More hints of compromise on the Supercommittee. No one is paying much attention to this, nor are they expecting much. It is a source of edge for savvy investors. There are encouraging background reports on committee progress. No one expects much from the debt limit compromise. My contrarian estimate for success is 2-1. We now have one GOP member who does not want to cut entitlements. This is going to be a big story over the next three months, so read this article to prepare yourself for breaking news.
The Bad
There was some important negative news.
The Michigan sentiment index is at recession levels. Check out Doug Short for his great historical chart. We already knew this would be terrible based on the preliminary reading. The question is whether it is a reflection of the Washington politics from the debt ceiling or something with a lasting effect.
The ECRI growth index dropped further into negative territory. The ECRI warns against over-reacting without a persistent change in this indicator, but we are watching with interest.
Further European Confusion. There was mysterious selling on Thursday, at first linked to various rumors about European stocks. The rumors of a downgrade of German debt or French debt were both denied. Rumors about a change in the European short-selling ban were denied. The only remaining rumor was the ongoing debate about Finland's demand for collateral on Greek debt. US investors had better get used to this rumor-driven trading, since the European story is more than a year away from a resolution.
The Neutral
By the end of the week, few were expecting any big announcements from Jackson Hole. I suspect that many still anticipate some new "QE" before the year ends. As we noted on two occasions last week, the emphasis and expectations for action were overstated.
The Sad
Everyone in the business community has respect for Steve Jobs. Here at "A Dash" we acknowledge the challenge of his competing demands -- his failing health and his continuing desire for excellence. He has been an inspirational leader and created value for customers, employees, and shareholders. Few seem to understand that a great company does all of the above.
Our team hopes that Mr. Jobs finds satisfaction from every day. He deserves it.
The Indicator Snapshot
It is important to keep the weekly news in perspective. My weekly indicator snapshot includes important summary indicators:
As I have often noted in the past, the ECRI and the SLFSI report with a one-week lag. This means that the reported values do not include last week's market action. In my research, I take account of this lag. In my daily monitoring of the market I look at the underlying elements in the SLFSI. I cannot do this with reliability for the ECRI since the indicators are secret. The SLFSI will increase next week, but not to the level that would trigger the "risk alarm."
There will soon be at least one new indicator, and the current choices are under review. In particular, I am considering replacing the ECRI method with the equally effective and more transparent approach from Bob Dieli. The ECRI has a "long leading" series that is available only to subscribers, which they refer to in media appearances.
The indicators show continuing modest economic growth, but the rate of growth is getting weaker. Two weeks ago there was an increase in the SLFSI, generated by a slight increase in LIBOR rates and a big jump in the VIX. The SLFSI declined slightly this week. I have been doing extensive research on this indicator. It was not designed to predict the stock market. It is a reflection of actual risk. I believe that it will prove valuable as a tool for investors who prefer data to story telling. This article helps to explain how to interpret the values and also provides historical context.
Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll, now recorded on Thursday after the market close. We have a long public record for these positions.
A more accurate vote for this week would be "abstain" rather than neutral. Felix sees too much confusion for accurate forecasting, which is why everything is in the Penalty Box.
[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 ETF 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 are a number of big reports this week featuring the employment situation report on Friday, just before Labor Day. President Obama will follow the news with a major address on jobs and the economy.
This week may well prove to be a turning point for data. It will reflect the worst of the "soft patch" if that is a solid explanation.
We can look forward to personal income data, Case-Shiller housing data, Conference Board consumer confidence and Fed minutes. And that is all before Wednesday!
On Wednesday the focus will turn to jobs with the ADP private employment report and Thursday's initial jobless claims. Thursday will also mark the ISM manufacturing report, which everyone expects to be below 50. There is a lot of emphasis that a below-50 reading signals contraction, which it does for manufacturing. Because manufacturing is in a secular decline in the US, the break-even level for GDP is actually 42.5. No one seems to note this. GDP growth of 1.5% to 2% is consistent with an ISM reading below 50.
Friday is the big day. Forecasts are for net job growth of 67,000 or so. Our model implies even less, but the consumer confidence input has been unduly influenced by non-employment factors.
Trading Time Frame
In trading accounts we were out of the market all week, after a well-timed close of short positions three weeks ago. Our Felix model is not calling a market bottom, but is reacting to volatility. When sectors go into our Penalty Box it indicates reduced confidence in short-term predictions.
While our official vote this week is "bearish," it would be more accurate to say that we are abstaining. The power ratings are actually quite solid, so we will be buying aggressively as sectors emerge from the Penalty Box. I do not see any short-term buying this week, but we are getting close to the chance for aggressie trading.
Investor Time Frame
In our ETF-based Dynamic Asset Allocation program, the portfolio is also very conservative. This cautionary posture includes bonds, gold ETFs, and utilities. The DAA now also includes one inverse ETF, and might add more if adverse conditions persist.
For long-term investors little has changed. The market is pricing in a high level of systemic risk and recession potential, even though these outcomes are not suggested by quantitative indicators.
The base case is for continued sluggish growth, an environment that has worked well for corporate earnings and created strong balance sheets. Meanwhile, stock prices reflect expectations for a major decline in earnings, something that has not even started.
While there is always some guesswork in timing entry points, there are some promising signs. Many of our favorite names, including Apple (which we highlighted once again last week -- see our history on this stock), are trading at very attractive prices.
Last month, individual investors fled equity funds in a massive move toward the flight-to-safety trade. In July, over $25 billion was redeemed. A week ago, over $20 billion was pulled. Surprisingly, assets were taken out of every mutual fund asset class (equities, taxable and nontaxable bond funds) and went into money market funds. I estimate that individual investors will pull out at least $35 billion in August, representing the second-highest liquidation on record since the series of data began to be accumulated in 1979. It is almost a certainty that 2011 will represent the fifth consecutive year of liquidations -- something that has never happened in mutual fund history.
This is a big contrarian indicator.
As usual, we are not making a recommendation for new investors to go "all in." It is also not a time to be all out! Most long-term investors need a solid plan that right-sizes their holdings in strong equities, balancing yield and growth.
Owning any stock involves risk. Sometimes it is the risk of specific events. Apple Computer, Inc. (AAPL) is a good example.
The loss of Steve Jobs as CEO is obviously a negative for the stock. He has been a visionary leader, and that has been recognized by the market.
Precisely what does his loss mean, and how should investors react?
Background
I have been very accurate about Apple, a big, multi-year winner for me. I have written about it fairly often, most recently in July when I explained why people would probably miss big gains if they tried to trade around the 200-day moving average, then about 335. I have about twenty other articles, mostly illustrating why it is better to own this stock on valuation rather than try to time the market. Here is one from 2006, when the stock was trading about 60.
Apple is a good illustration of why earnings-based fundamental analysis pays off in the long run. That is why I have written about it so often.
Two Perspectives
There are two different ways to think about Apple -- the story and the data.
The Story
Many people focus on the drama, the product introductions and the human story. This happens for many reasons, but here are the most important:
You can write many articles about products, reviews, and innovations.
Everyone is a (self-described) expert on these topics, so all can join in.
The stock is volatile, providing a lot of opportunity to draw charts and offer technical opinions.
The ever-present threat of losing Steve Jobs was itself a source of rumors and trading opportunities.
The Data
You could also focus on the data, the greatest growth story of our time. Most people did not know how to analyze the stock correctly. Here are three incorrect methods, all frequently cited by many pundits:
Take a PE ratio without adjusting for the cash on the books.
Do some Shiller-style ten-year, backward-looking method -- guaranteed to make the company look expensive until it is too late to buy.
Try to apply Tobin's Q. What do you suppose is the "replacement value" for Apple?
The Conclusion for Apple
Regular readers know that I endorse data over the "story," but let's try to pay attention to both. Investors should have expected this. I did my own research a year ago, verifying that the new product stream was not dependent upon Jobs. As an investor, I knew that there would someday be bad news, but it was something to be expected. There was no way to time this. If you worried about the eventual bad news, you would have missed (at least) the last 100 points in the stock.
From James Altucher we have the data. "The stock trades for 12 times forward earnings, has 80 billion in cash, and 100% earnings growth. Meanwhile, the platform is all there. They are going to continue to sell iPads. They are going to continue to sell iPhones..."
From Jon Fortt we have a good take on the story. He does a very nice job of describing the special qualities of Jobs -- in negotiating costs, making new deals, and getting the most from his team. While he is important for innovation, that is not the whole story. Fortt also notes that Tim Cook has some of these same qualities.
While there will be many stories tomorrow morning, this video captures the key elements to consider.
Investment and Market Implications
If you have been waiting for an entry point in Apple, you now have it. There will also be market implications since AAPL is the largest stock in the S&P and the QQQ's.
The issue of "headline risk" is one that we must deal with every day.
Reading the headlines is guaranteed to send you to the sidelines. Does that fit with your future?
Intelligent people want to make sense of the world around them, no matter how confused it may seem. Everything must have an explanation. When the market rallies by more than 300 points after weeks of persistent selling, well....There must be a reason!
After weeks of uncertainty, the markets finally seemed to seize the day.
Stock indexes powered ahead on Tuesday as investors sought buying opportunities on cheap stocks as they bet that weak economic data would support the possibility of further stimulus from the Federal Reserve. It was at the Fed’s annual symposium in Jackson Hole, Wyo., last year that Ben S. Bernanke, the Fed chairman, signaled further stimulus in light of a similar slowdown of the American economy.
Kwame Holman, who gives the official summary on the PBS Newshour stated the following:
Wall Street shot back up today amid speculation that the Federal Reserve might try a new stimulus program after all.
Wow! Four powerful opinions --- all wrong.
Reminiscing
One of my favorite books as a poli sci student was Timothy Crouse's, The Boys on the Bus. The book covered many great themes about campaign coverage in the 70's. Much has changed, of course, since reporters can now file stories by WiFi at any time. In those days they often filed much of the story in advance, but then had to find the lede (called the "lead" in those days).
A crucial point was that anyone who was out of step with the consensus was open to criticism. Everyone looked to AP's Pultizer Prize winning Walter Mears. Crouse wrote:
"At what he does, Mears is the best in the goddam world," Said a colleague who writes very non-AP features. "he can get out a coherent story with the right point on top in a minute and thirty seconds, left-handed. It's like a parlor trick, but that's what we wants to do and he does it.....He watches some goddam event for a half hour and he understands the most important thing that happened --- that happened in public, I mean.
Crouse relates several amusing stories where Mears changed his lead and competitors were called on the carpet for having the "wrong lead."
The description of this is so powerful, that I remembered it after many years.
There is a powerful force, driving journalists to a consensus interpretation of events.
The Challenge for Investors
How can you know what to watch for, if your understanding of events is flawed? Without the right analytical framework, you have no hope of interpreting the news and daily market fluctuations.
My own interpretation of today's action is quite different from what you are reading in the news. There is an oversold condition with many looking for a chance to buy. The news from Europe was encouraging. Even before the opening there was a buzz about reports from China being "less bad" than expected. Gold (a popular measure of fear) was moving lower. European financials were moving higher.
Check out Briefing.com for a source that shares this more sophisticated interpretation.
If you were looking for an entry point, some would see signs from this news. If you were short, you might think about covering -- at least for a few days.
The idea that weak data -- pretty much in line with expectations -- created a sudden change in expectations about Fed policy is just silly.
As I noted in my weekly update, there should be little expectation for a major change from the Fed. I will further explain my reasons before the speech.
Investment Actions
There are many attractive financial and tech stocks. I am still buying JP Morgan (JPM), highlighted here. There is a lot of debate about financial stocks, and JPM is the leader. I also am buying Oracle. In mentioning this, I want to highlight the work of Eddy Elfenbein. If you wanted to look at one chart to understand what is going on, this would be a great candidate. Eddy is calm, disciplined, and has a great sense of humor. I love his twitter feed @EddyElfenbein.
I have five different investment programs, and four of them are pretty conservative right now. My most successful system (judged in the long term) has a portfolio of stocks like those in Eddy's chart. There is a time to focus on specific companies.
A Final Word
I am a member of an online discussion group that engages seriously and vigorously in important topics. The role of Twitter is a current subject, with widely varying opinions.
The discussion has caused me to wonder about something. Today's journalists have a virtual "bus" because of Twitter. They reach the same lede, partly because they know what everyone else is thinking.
Many have high hopes for this Friday's speech from Fed Chair Ben Bernanke. Everyone remembers the market reaction after last year's Jackson Hole speech. Some believe that we are about to see a replay. In CNBC's monthly survey of "market pros" there is now an expectation of QE 3. There are many other interesting findings on recession odds, the S&P downgrade, and Europe, but the QE 3 summary is as follows:
QE3 may be coming after all.
In a dramatic turnabout, market participants now believe the Federal Reserve is more likely than not to resume purchasing assets during the next year in a third round of quantitative easing the August CNBC Fed Survey shows.
Mark Gongloff nicely captures the reality in his WSJ article, Jackson Hole Might Be a Big Disappointment Sandwich For Market. He supports this theme with some well-chosen quotations from prominent Street economists. Collectively the sources believe that a higher rate of core inflation and uncertainty about fiscal policy make action less likely.
I'll provide my own forecast below. FIrst, let us do our regular review of the past week.
Background on "Weighing the Week Ahead"
There are many good services that do a complete list of every event. 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.
Readers often disagree with my conclusions. That is fine! Join in and comment. 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
In general, the news is consistent with continuing sluggish economic growth.
The Good
There were some bright spots.
Initial jobless claims continued around 400K. This is still not what we need, but it is better than recent levels and much better than many were forecasting a few weeks ago. It is not a recessionary level, nor a sign of robust growth.
The money supply rebound continues. This is a major forward-looking indicator that is widely ignored. It is a leading indicator, giving it extra significance. I have been writing about this for several weeks, highlighting the weekly updates from Bonddad. Last week I observed that everyone knows that monetary policy works with a lag, but no one is paying any attention to this story. That has now changed. We are seeing the first spinning of this important data source, with the allegation that it means that "people are going to cash." These are the same sources that are happy to point to M2 as meaningful and inflationary when it suits their purpose. Beware!
Earnings strength continues. The earnings beat rate is better than last quarter. More companies have raised guidance rather than lowered it. Both rates are weaker than the trend from the last two years, but still positive. See the story and chart at Bespoke Investment Group.
Leading indicators moved higher. How can this be? Steven Hansen doubts the data. I generally believe in taking data at face value, but I am not a fan of this indicator.
First hint of compromise on the Supercommittee. No one expects much from the debt limit compromise. My contrarian estimate for success is 2-1. We now have one GOP member who does not want to cut entitlements. This is going to be a big story over the next three months, so read this article to prepare yourself for breaking news.
The Philly Fed Index cratered to -30. Regular readers know that I have little respect for this series, but I acknowledge that it is important when it makes a major move. Since the reading is back to March of 2009 levels, I guess that qualifies! This is a survey of businesses and a diffusion index. It is volatile and poorly correlated with indicators like the ISM or GDP, but this was a very, very bad report.
The Fed is worried about European banks. Or maybe not. There were two stories. The first said that the Fed was doing some checking to make sure that European effects would not spill over to the US, and quoted anonymous officials as expressing concern. The second included an official denial of the first, and said that European banks were treated just like those in the US. Guess which one the market believed.
The ECRI growth index dropped slightly into negative territory. The ECRI warns against over-reacting without a persistent change in this indicator. Get perspective from Doug Short and one of his great charts.
Building permits declined. I see this as more important than current home sales since it has a leading quality. The news was bad, as is the continuing story for the housing front.
The Ugly
The stock market reaction, especially Thursday, gets the nod for this week's "ugly" award. The market news may become a cause as well as an effect, influencing consumer confidence, business confidence, spending, and economic growth.
Reduced growth increases the vulnerability to a recession if there is some additional shock, so those odds are now higher 30% according to some surveys.
Bonddad looks at the NBER indicators and sees no evidence for a current recession. Bob Dieli's successful methods agree, although he acknowledges distortions from unusual current policies.
The Indicator Snapshot
It is important to keep the weekly news in perspective. My weekly indicator snapshot includes important summary indicators:
As I have often noted in the past, the ECRI and the SLFSI report with a one-week lag. This means that the reported values do not include last week's market action. In my research, I take account of this lag. In my daily monitoring of the market I look at the underlying elements in the SLFSI. I cannot do this with reliability for the ECRI since the indicators are secret. The SLFSI will increase next week, but not to the level that would trigger the "risk alarm."
There will soon be at least one new indicator, and the current choices are under review. In particular, I am considering replacing the ECRI method with the equally effective and more transparent approach from Bob Dieli. The ECRI has a "long leading" series that is available only to subscribers, which they refer to in media appearances.
The indicators show continuing modest growth at a slowing pace. This week there was an increase in the SLFSI, generated by a slight increase in LIBOR rates and a big jump in the VIX. I have been doing extensive research on this indicator. It was not designed to predict the stock market. It is a reflection of actual risk. I believe that it will prove valuable as a tool for investors who prefer data to story telling. This article helps to explain how to interpret the values and also provides historical context.
Felix is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll, now recorded on Thursday after the market close. We have a long public record for these positions.
[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 ETF 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 are a number of minor reports this week, but the big story will be the Jackson Hole speech on Friday.
News from Europe is a continuing backdrop. Thursday's initial claims data will be important only if there is a major change. It is still vacation time for many, but that has not led to quiet markets this summer.
Trading Time Frame
In trading accounts we were out of the market all week, after a well-timed close of short positions. Our Felix model is not calling a market bottom, but is reacting to volatility. When sectors go into our Penalty Box it indicates reduced confidence in short-term predictions.
While our official vote this week is "bearish," it would be more accurate to say that we are abstaining. The power ratings are actually quite solid, so we will be buying aggressively as sectors emerge from the Penalty Box. That may not happen this week, but it might.
Investor Time Frame
In our ETF-based Dynamic Asset Allocation program, the portfolio is also very conservative. This cautionary posture includes bonds, gold ETFs, and utilities. The DAA will eventually include inverse ETFs if adverse conditions persist.
For long-term investors little has changed. As I noted last week, my contrarian view is that holdings with more economic exposure will excel in the second half of the year. These include technology and cyclical stocks. As I have noted in recent weeks, the investment time frame requires looking for opportunity when traders are scrambling. The market is pricing in a high level of systemic risk and recession potential, even though these outcomes are not supported by quantitative indicators.
Let me add some comments from a source that I have found valuable over the years, Liz Ann Sonders and her Schwab team. There is a mistaken viewpoint about motivations for various pundits. I often see this in comments, especially from those who seek reinforcement of their ideas.
Here is a brief guide: Guys from bond funds are selling bonds. Those pitching gold are usually selling fear. Mutual fund managers are selling their funds. Sources like Schwab profit from the success of their investors. This is also true of Registered Investment Advisors like myself. Our success depends upon how well clients do. This does not require that they be invested in stocks.
Many readers will not normally see the excellent source, Advisor Perspectives. Those of us seeking a wide range of information read it religiously. Speaking of Schwab, I want to share this week's commentary.
Also lending credence to the "panic is not a strategy" argument, although consumer confidence remains low at 59.5, the contrarian nature of the market is illustrated by the Dow Jones Industrial Average gaining an average of 14.4% annually when confidence is less than 66, more than double the average gain when the reading is above that number. Of course, past performance is no guarantee of future results.
What now? We don't pretend to know what's coming for the markets in the next couple of days or weeks, as heightened sensitivity could result in continued volatility—in both directions. We continue to believe we'll avoid a recession due to continued positive leading economic indicators, an improving jobs picture, solid corporate balance sheets and a still-steep yield curve.
We're encouraged that we're seeing some nascent signs of confidence on the corporate side as demand for loans has increased and stock buybacks are at their highest level since October 2008, according to Birinyi Associates. We continue to urge investors to keep their long-term goals in mind, match their portfolios to their risk tolerance, and remind them that trying to time the market, in our experience, tends to be a losing game.
Good advice!
Timing and Jackson Hole
When looking forward to a major event, it makes sense to be cautious. This is especially true when you are not optimistic about the result. Bernanke's speech will include a combination of policy, promise, and leadership. I am not expecting much on any of these fronts.
The Fed does not share the typical trader viewpoint --- not on the effects of QE 2, not on the current economic prospects, and not on the need for QE 3. The Fed, especially the dissenters, are more sanguine about the economy. They understand that the large Fed balance sheet from QE 2 is still working to increase the money supply.
Bernanke is not going to adopt a policy just because it is what the market wants. There might be a hint of flexibility and new ideas. I am not expecting any inspirational leadership.
German Chancellor Merkel has a similar choice. Here is her reaction:
“Politicians can’t and won’t simply run after the markets,” Merkel said in the chancellery interview, her first since returning from a three-week summer break. “The markets want to force us to do certain things. That we won’t do. Politicians have to make sure that we’re unassailable, that we can make policy for the people.”
The juxtaposition of decision makers and markets is the key investment question for the coming year.
What questions are crucial for the individual investor?
My own nominations would emphasize long-term family needs, risk tolerance, and current asset allocation. These questions have a common theme -- people know the answers from their own experience and they can answer intelligently.
Kudlow's Question
Tonight I looked forward to a great Kudlow interview with one of my favorite sources, Laurence Meyer (former Fed Governor and author of one of our favorite recommended books).
I was swiftly disappointed when Kudlow asked the following question:
What one or two things should the average investor be focused on to make the recession call for themselves?
This is a loaded question for the guest who responded as follows:
Economists always should and usually do resist telling people there is one thing they should look at.....We are looking at things like a further flare-up in Europe... not just data.
Kudlow inquires about telltale signs -- including more leading questions about weak data-- and he seems to get an affirmative answer. Then Meyer surprises him. He explains the need for a counterfactual in analyzing the effect of policy and asserts that QE 1 and QE2 were very successful -- creating three million jobs.
When asked for his own recession forecast, Meyer is pretty much in the mainstream.
It is a close call...The economy will rebound in the last half of the year, but grow very slowly.....below trend, not sufficient to reduce the unemployment rate. That is a grim forecast already, and there is a serious risk, maybe one in three, that we'll slip into a recession.
Is there an inflation problem?
Core inflation is up 2.5% over the first half of the year, taking room away from the Fed. It has reduced the potential for another QE.
The Meyer answers were honest -- check out the whole interview -- but the overall impression is misleading, especially for the average investor.
Conclusion
Regular readers know that I like the Kudlow show and I really like Larry Meyer. What went wrong?
The worst single question is the following:
What is the chance of a recession?
Here is why this is a bad question:
The difference between "official" recession forecasts and the general perception is a "ratings question." Everyone already knows that average people think we are in a recession or never came out of one. Economists have a strict definition to assist reserach analysis. Asking everyone their odds on recession, whether they know anything or not, just fans the flames. Everyone knows that the economy has never recovered "trend growth" and that it feels bad for most. The average respondent enjoys saying that professors are stupid.
None of the recession forecasts (including this one) have a time frame.
The "perceived" idea of a recession invokes 2008 -- not the typical setback, but an extreme case.
Recessions are not properly linked to the equity market in terms of expectations. There is evidence that stock prices already incorporate some very pessimistic assumptions about earnings.
Recession forecasts are only loosely linked to future earnings -- nothing data-based.
Summary
Larry Kudlow had a great guest, who can help all of us understand the Fed and the likely path of the economy. Asking Meyer to provide an individual guide to recessions is a waste of a good expert.
One reason for pointing this out is that we see it over and over. Interviewers have a chance to elicit relevant new information, but instead ask tired and unhelpful questions.
While corporate earnings are the ultimate story, there are other important questions:
Is there systemic risk?
Does the current selling presage a 2008-style economic collapse?
I have encouraged the use of objective, quantitative indicators to answer these questions. In sharp contrast, many others make simple analogies and rely upon anecdotal evidence.
To underscore the difficulty, here is the opinion of Jeffrey Gundlach, one of the very top fixed income managers:
...the time is ripe [for another AIG or Lehman-level collapse] based upon the growing lack of confidence in the growing debt of Spain, Italy, Greece, Portugal, Ireland and ultimately of France.
Adding to the danger is the fact that European financial institutions—particularly French banks own these toxic assets. The result will be a “restructured default”—unless the Germans are “going to pay the debts of everybody in Europe,” something Gundlach says is extremely unlikely.
Meanwhile, Larry Kudlow assembled a nice panel of experts addressing the specific question of how European sovereign debt affected European banks and the US banks. I watch and read many sources, highlighting only the most important for readers. This video segment is worth watching.
None of the experts (David Malpass, William Rhodes and Bill Isaacs) see US systemic risk.
Malpass explains how interest rate differentials have caused foreign banks to reduce holdings at the Fed.
The entire panel points to strong balance sheets and other differences from 2008.
No wonder it is so easy to be confused!
A Data-Based Approach
In an effort to help investors avoid a 2008 scenario, our team has been doing research on various indicators of systemic risk. A leading candidate was the St. Louis Fed Stress Index, since it was developed with this particular question in mind. I have been enthusiastic about the methodology used, and the general value of this measure.
As background, here is a helpful short paperon the development of the index, and a chart illustrating the SLFSI level at various important times in history.
The level announced today, reflecting data as of last Friday, is 0.73. This is significantly below all of the listed events in the financial crisis of 2007-08.
What Level is Important?
A focus for our research has been to identify objectively-defined risk. Since everyone would like to predict future market moves, we hoped that objective identification of risk would also be an early warning for potential market declines.
We have promising results which we can eventually publish. The recent market decline has encouraged me to reveal some findings a bit early -- before we can do the polishing for a final presentation. Let me just say that the results I am citing are accurate, but the terminology and presentation is still a little "nerdy."
The Findings
Let me start with our research objective:
Discover reality-based predictors of market drawdowns.
There are many methods of forecasting the market with technical criteria, including several employed by our team. This question is a bit different. We are looking to fundamental, not technical indicators.
One of our approaches involved using the SLFSI. Out of many different analyses, I am choosing one result that I believe best reflects our research.
This chart reflects the use of the SLFSI to predict the maximum drawdown in the S&P 500 over the upcoming three months. The orange points represent predicted values and the yellow points the actual values. In general, the prediction is pretty good.
To interpret the scales, you can see that SLFSI scores of below 1 are usually not very important. (The predictions here reflect the score, and the short-term change in the score). The vertical scale is the amount of the maximum drawdown over the upcoming three months. (e.g., -.2 means a 20% drawd0wn).
Preliminary Conclusions
There are several interesting conclusions, a lot of room for discussion, and the need for more research.
Increased stress implies stock market danger, as reflected by future drawdowns.
Drawdowns frequently occur even when not "justified" by actual increases in stress, including some of the very largest. It is incorrect to conclude that a declining market accurately reflects actual systemic risk.
The current stress levels are much lower than the events of the 2007-08 crisis.
The SLFSI did not provide an "early warning" signal for the current market decline.
Briefly put, there is a difference between predicting financial stress and forecasting market reaction. The SLFSI does the former. Sometimes it also helps with the latter, but we do not see that so far in 2011.
We continue to monitor the the SLFSI with a "trigger" in the 1.1 - 1.5 area. We also monitor the underlying 18 components (insofar as is possible) on a real time basis to avoid the four-day lag in the published results. Put another way, our research reflects the lag (as it should) but as traders we seek an additional edge.
A Final Thought
It is always helpful to have sophisticated measures of economic and market indicators. Sometimes the investor is left wondering how to interpret the information. It is not the job of the St. Louis Fed to predict the stock market. Those of us interested in fundamental analysis of risk can use their data to gain additional insight into actual systemic risk.
This work may help us distinguish between the anecdotal risk that we hear about every day and something that can actually be measured.
There are many dangerous species of animals. For investors, the most dangerous is the omni-present Wall Street Parrot (parietis vicus psittacidae). This predator is especially dangerous because of his (or her) appearance -- attractive, well-dressed, and fluent in the language of Wall Street truthiness.
Here are some key characteristics:
Fully conversant in the headlines of the day.
Specializing in telling you what you already (think) you know.
Carefully avoiding any data. Citations vague, with no ability to test or verify.
Extreme and aggressive statements.
You can see the Parrot on most financial TV programs. Ratings are good when readers are reinforced in what they already believe.
Current Examples
This species is definitely not on the endangered list. The parrots are out there in force pretending that they know exactly what will happen in Europe and basically selling fear. A careful look at the background shows that they are selling something: gold, bond, and "structured products." [Full disclosure: I am long GDX and bond ETFs in client accounts.]
Let's try this out. Since I have not implemented audio, you will have to use your own parrot voice.
Earnings must come down. Earnings must come down.
The Fed is printing money. The Fed is printing money.
[I invite reader suggestions for more parrot comments. Maybe we should also have a parrot Hall of Fame.]
A Knowledge Test
If there were a simple knowledge test, the parrot would know nothing more than a bird. None of these guys who talk about money printing could explain what happens in a fractional reserve banking system. They also could not show what happened with the proceeds of the Fed purchases under QE II. They could not name the members of the European Union, although they can talk fluently about the PIIGS. Basically, they do not know anything relevant, but they sound smart. Since they are saying something that resonates with viewers and readers, they get a lot of attention.
Similarly, those who confidently say that "earnings must come down" use a simple heuristic. There have been some soft economic data points. We all "know" that analysts are too optimistic despite strong evidence to the contrary. Conclusion: Bombs away for the market.
The Hidden Assumptions
Josh Brown has a nice piece where he highlights this as the big question. I make it as one of three big questions (Europe and the false hope of QE 3 are the other two), but Josh is on the right track.
Here are the key points:
The parrots have been wrong for several quarters -- some of them for years. There should be a statute of limitations on credibility.
Since past GDP was revised down, we now know that great earnings growth was accomplished in spite of modest economic growth. Forecasts are for better, yet modest, growth. Why must earnings be lower? It seems like things are getting better from this low base.
But wait! Many of the parrots are building a recession into their forecasts. Since a recession is unlikely, their forecasts will probably be wrong.
There is a lot of room for slack. 2012 earnings on the S&P 500 are estimated in the $100-110 range. One of the parrots said today that he is "in the mid-70's." No justification or analysis, just his opinion. What if the actual number is $92? We are still looking at a cheap market.
What is "baked in?" The low PE on forward earnings reflects intense skepticism about the future. While it is difficult to prove, the data suggest a high level of current skepticism.
Conclusion
People seem to love to argue about market valuation. Much of the commentary features methods that never give a buy signal -- not too useful in practice.
Since the basis for these arguments are earnings, let us talk dividends instead. Many of the current articles demonstrating that we have a cheap market are using the attractive dividend yield compared to the 10-year Treasury Note, formerly viewed as risk free.
Here is a good parrot challenge question: Do you expect the Dow Stocks to be cutting dividends? If so, which ones?
Resources
In my weekly summary article, I highlighted a piece that everyone should read, The Fat Pitch. Here are some other great resources.
Bonddad -- look at the great dividends AT&T 6.28% Verizon 5.94% Merck 5.10% Pfizer 5.04% Intel 4.37% General Electric 4.24% Johnson & Johnson 3.87% Procter & Gamble 3.74% Dupont 3.66% Home Depot 3.65% Kraft Foods 3.54% Chevron 3.51% Wal Mart 3.36% McDonalds 3.15% Coca-Cola 3.03% Microsoft 3.02% Boeing 3.00%
I urge readers to check out these sources. None of us has a guarantee that markets will move higher in the next few weeks, but at least we have reason and data on our side.
[disclosure -- in addition to stocks previous mentioned, we own Intel, Microsoft and Boeing in various accounts. We are actively looking at other stocks on the dividend list.]
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