A Dash of Insight

Investors: De-mystifying the Central Bank Balance Sheets

One of the many reasons that individual investors are scared witless (TM euphemism by OldProf) is a complete misunderstanding of the role of central banks and a distortion of current policies.

The critics of the Fed -- and now the ECB and other European banks -- have an easy path to page views and affirmation by readers who never took the class in Money and Banking.

This has the usual result.  Anyone who is willing to spend a little time while keeping an open mind can gain a significant investment advantage.

The Current Scare

Let us begin by summarizing the story that I hear from so many people through comments, emails, or calls.  It runs something like this:

• The Fed is printing money with reckless abandon.
• Other Central banks are now doing the same.
• Bank balance sheets are exploding and have huge leverage ratios.
• Gains in equity markets are a "sugar high."
• Central banks could be wiped out with the smallest downturn.
• Or if forced to unwind these trades, stocks would collapse.

A Typical Argument

Perhaps the most prestigious of those making such arguments is Jim Bianco.  Since he is regularly featured on CNBC, has his work published at Barry Ritholtz's blog, and has institutional clients, everyone takes his research output quite seriously.

His recent piece at The Big Picture touched all of the bases described above, and also threw in a comparison of balance sheets with aggregate stock market values.  I am going to stick to the Fed balance sheet in this analysis, but it should illustrate the point.

Here is the chart of the Fed balance sheet provided by Bianco.

This chart repeats many of the errors from the Michael Pento arguments that I refuted here.  If Bianco had read this research, his article might have been stronger.

To start with, long-term data series should be described on a log scale.  This means that a proportional change is constant over time.  Let's look at the Fed's monetary base.

This better demonstrates the recession response as well as QE II.  It also makes clear that everything else is irrelevant.

The most crucial thing to understand is that the balance sheet does not represent "printing money."  This happens when reserves are created for participating banks and they make additional loans.  This has not been happening.  Essentially, the Fed has stepped in to (temporarily) take up the slack in the money supply.  Disciples of Milton Friedman know that the long-term money supply is aligned with nominal GDP growth, so money creation is important.

To emphasize:  Printing money is necessary and appropriate -- at the right pace.

The question is whether the growth in M2 has been excessive.  Here is the key chart.  As you can see, the long-term growth looks pretty reasonable.

 

The Conference Board (and I suspect the ECRI) have dropped M2 from their indicator series since the modest result described above is apparently too bullish.

Conclusion

The Bianco analysis is another example of Wall Street Truthiness.  Since so many are primed to hate the Fed, the ECB, and the entire concept of central banking, it is popular for many to rant on this every day.

The comparison of central bank holdings with equity markets is an egregious blunder.  There is absolutely no reason to compare debt holdings with anything other than the debt market.  I have frequently analyzed the Fed purchases of debt and shown these to be a modest fraction of the trading volume in Treasuries.  Experts estimate the impact on yields to be modest.

When and if the time comes to unwind these positions, it will have little long-term effect on either bond or stock markets.  I explained this in several past articles, but the most important is here.

This is an interesting choice for investors.  Most of them cannot really grasp the money and banking aspects of money creation.   It is a pretty tricky concept.

This makes it prime fodder for those who want to fool you by calling the balance sheet "printing money" when that is not correct.

There is so much mis-information and so little time.

I am now told by an investor that the GDP increase of 2.8% proves that the ECRI recession forecast is correct.  Amazing!  It takes very little for the confirmation bias effect to kick in.

Weighing the Week Ahead: An Avalanche of Data

[Note to readers -- sorry for the delay.  As everyone knows, I always plan for the week ahead and I usually write about it.  Sometimes I have a recreational weekend, so the writing is delayed.  I did some covered writes on dividend stocks today, but that will not be a surprise for regular readers.  I suspect that there will be more opportunities this week.]

In a sharp change from recent times, this week will be all about US economic data.  With recession worries still prominent, each release will be subject to special scrutiny.  This will be especially true of Friday's employment situation report.

There will be continuing earnings news, although we have passed the peak of the season.  The Greek default story has legs.  Despite the headline potential from these sources, I see signs that there is less focus on Europe, and more attention (worry?) about the US economy.

I'll have some further thoughts in the conclusion, but first, let us do our regular review of last week's news.

Last Week's Data

In last week's report I observed that there was a change in tone.  We saw more of the same this week.  In the absence of specific bad news from Europe, the market "wants to move higher."  All of a sudden there is more attention paid to specific stock news, and a general upward trend.  I'll consider this important development further in the conclusion.

The Good

 There was some very good news this week.

• GDP was up at an annualized rate of 2.8%.  This looks really great. The best chart of this shows the components, and (no surprise) comes from Doug Short.

• Initial jobless claims were only 375K, down 25K from two weeks ago.
• The Fed ushered in a new era of transparency, revealing forecasts and promising low interest rates as far as the eye can see.  Here is why this is good news.
• Corporate earnings reports, widely thought to be too high, beat expectations at a rate of 59%.

The Bad

There was some bad economic news last week.

• GDP was up at an annualized rate of 2.8%.  This looks really great.  The problem is that it is heavily dependent on an increase in inventories, not real buying.  See my take on WSAS for one of the first discussions of this problem.  Inventories play both ways.  For a complete discussion you can't beat the analysis from Steven Hansen and Doug Short at GEI -- charts galore.

• Initial jobless claims were 375K, up 25K from last week.
• The Fed ushered in a new era of transparency, revealing forecasts and promising low interest rates as far as the eye can see.  Here is why this is bad news.
• Corporate earnings reports, widely thought to be too high, beat expectations at a rate of 59%.  Unfortunately, advance guidance is weak.  Check out the chart from Bespoke Investment Group:

The Ugly

There is always good news and bad news, but not always ugly news.  As a fan of both the Brewers (NL) and the White Sox (AL), the ugly news for me was Brewer's slugger Prince Fielder going to White Sox rival Detroit.  Drat it!

The Beautiful

We cannot always dwell on "the ugly."  Sometimes there is noteworthy work.  Let us call it "the beautiful."  There was a lot of negative anticipation about the Conference Board's change in the Leading Economic Indicators.  Some felt that the change would augur another recession.  Regular readers already know how I feel about the constant changing of indicators to provide a better back-tested performance.

I am a big fan of Dwaine van Vuuren, whose excellent statistical work is giving us better insight into a wide range of recession forecasting methods.  I am featuring the PowerStocks forecast each week, and I also want to recommend Dwaine's analysis of the new LEI method.  Here is a key quote from the article:

Composite LEI's such as the e-forecasting.com eLEI, the Conference Board US-LEI, the OECD US-LEI and the ECRI Weekly Leading Index (WLI) are generally composed of a small set (no more than 10) of well selected leading economic indicators that as a composite are subjected to rigorous statistical and out-of-sample testing. You can see a perfect example of the rigors of such statistical selection in the white paper produced by the Conference Board on the construction of their new LEI. For that reason we lean toward the use of these composites for recession forecasting purposes rather than large sets of seemingly unrelated economic leading indicators cobbled together. There is the well-known saying that if you torture large arbitrary data series enough, they will tell you any story you wish them to.

The article does not name any alternative methods, but anyone following the debate can identify the culprits from the method cited.

Here at "A Dash" we look forward to continuing sophisticated quantitative research from this source.

The Indicator Snapshot

It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

• Economic/Recession Indicators. This week continues two new measures for our table. The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread."  I'll explain the link to the C-Score next week.  The second is the Super Index. You can read more about it in this article, which is merely an introduction.   It reflects extensive research and testing, and is well worth monitoring. (The Super Index includes the ECRI approach).  I am going to do a complete review of the work very soon.  Meanwhile, I think it is important enough to watch every week.
• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions. We voted "Bullish" this week.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly 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 will be important earnings reports all week.  Eventually that is what matters.

Competing with earnings news we have the data avalanche.

Tuesday is the warm-up with housing price data (Case-Shiller), the Chicago PMI (a hint at the ISM report), and consumer confidence.

Wednesday brings the ADP private employment estimate, which has moved markets and opinions in recent weeks, as well as the ISM manufacturing survey.

Thursday we get news on auto and truck sales, as well as the best coincident read on employment, initial jobless claims.  Finally, we get a report on Q4 productivity.

Friday is the big day for employment news (payroll employment, the household survey, hours worked and hourly wages) as well as the ISM services index.

It is a quirk of the calendar that so many important reports hit in a single week.

The European story continues, of course, but the focus has been changing a bit.

 

Trading Time Frame

Our trading accounts have been 100% invested for several weeks. Felix caught the recent rally quite well, buying in on December 19th.  There are now many solid sectors in the buy range. The overall ratings have improved, helping us to stay invested while many have been in denial for the entire rally.  This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated.  Felix has been more confident than I have been on the trading time frame.  This illustrates the importance of watching objective indicators.

Investor Time Frame

Long-term investors should continue to watch the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," and is declining further.  This sort of decline has been a good time to buy stocks on past occasions.  Worry is still high, but is declining.

Even though stock prices are higher than in October, the risks are much lower.  I am increasing position size for risk-adjusted accounts.  (We cut back by about 30%).  I am also looking more aggressively for positions in new accounts.

Our Dynamic Asset Allocation model is still very conservative, featuring bonds and other defensive holdings.  It is rather like the Nouriel Roubini of our methods.  What if things go wrong?  Investors should understand that cautious, hedge-oriented positions may be slow to rebound.

To summarize, we continue a conservative posture in most of our programs, recognizing the uncertainty and volatility, but we are becoming more aggressive.  For new accounts we are establishing partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program. This program has been working very well, meeting the objectives of conservative, yield-oriented investors. It follows our key precept:

Take what the market is giving you.

Right now that continues to be dividend stocks at reasonable prices with the chance to sell call options at inflated prices.  If the stocks do nothing, you can still get almost 10% per year from dividends and call premiums.

This does not work for those selling long-dated calls.  It requires some active management, selling calls with a month or two before expiration to capture the most rapid time decay.

The Final Word

For starters, I hope some readers enjoyed my bit of whimsy in the good and the bad......

The continuing story is the disconnect between stocks and bonds.  Scott Grannis has a good take with this chart:

He offers this explanation:

In my view, this disconnect reflects a buildup of tension in the market—something is likely to break pretty soon. Bond yields have been depressed because risk-averse investors have been seeking shelter from a potential Eurozone collapse that might trigger another global recession/depression/deflation. But equity prices have been rising because in the meantime, while the world waits for the Eurozone to implode (and we've been waiting for at least 18 months now), the U.S. economy continues to improve. Bonds are the doomsday trade, while equities are more realistic about what's happening right now.

 

I agree, and that is how I am trading and investing.

 

The Fed Role in the Economy: Now Bigger. Now Better?

The Fed made history today, achieving a new level of policy-making transparency.

In my early days in the business, the results of an FOMC meeting were never announced.  Everyone waited until the day after the Fed meeting to see what open-market operations were conducted by the NY Fed.  First you needed to know what was needed to maintain the current policy rate.  Then you had to gauge whether the action was sufficient to maintain that rate.  System-wide repo's were aggressive easing and matched sales were tightening, but there was still a matter of interpretation.  Various Fed experts were quoted on the newswires to offer their interpretations.

It was like waiting for puffs of smoke from the chimney.

Now, all of the old skills are irrelevant.  It is almost like CNBC putting the stock names on the ticker along with the symbols -- amateur hour!

But that comparison is not fair.  Only the skills that have changed.

It is a new era, with a lot more information (See Global Economic Intersection for a great job on the main story and updates with each new piece of information).  During recent years -- mostly in the Bernanke era -- we have added all of the following:

• An official policy statement, carefully constructed and instantly parsed by analysts to pinpoint the nuance of each change;
• More frequent updating of official forecasts;
• More timely minutes of meetings;
• Eventual full transcripts of meetings;
• Press conferences by the Fed Chair after meetings with forecast updates; and now
• A granular look at the distribution of forecasts of the entire Board (not just voting members); and
• A statement of principles about inflation targeting and the lack of an employment target.

This is a feast for anyone with a brain and some analytical skill.  I note with amazement that some disparage this information.  Then I see that these are the same people who typically criticize the Fed regardless of what it does.

For most of the real world, having more data is valuable for planning and for setting expectations.  We all know that the Fed cannot forecast three years ahead with any certainty, and Bernanke agreed in the press conference.  These forecasts will change.

The key point is that we will now be able to see the changing long-range forecasts of the members in real time.   I am using this in my investing, and so can you if you think about it.

Today's Takeaways

There is a lot of information, so anyone offering conclusions today is only doing a first take.  Here is mine.

1. The consensus Fed forecast is for moderate, below-trend growth for the next two years.  Progress on US economic data has been offset by Europe.  Modest growth, no recession.
2. The long-term policy commitment is matched to the forecast.
3. The Fed is prepared to act more aggressively if circumstances require -- QE III.
4. The Fed has an inflation target, 2% in core PC.
5. Despite pleas from the liberal wing, employment and/or GDP targeting is secondary.

Investment Conclusion

The initial market reaction was a rally of less than 1%.   This was a knee-jerk reaction toward a weaker dollar, lower long-term rates, higher commodities, and higher stocks --  everyone's first take of the news.

This assessment is partly correct.  We all need to consider each asset class.  I think that the inflation/weak dollar conclusion is overstated.  The chance of a spike in long-term rates is a bit lower.

But here is the big story:

The Fed shows determination to fight a new recession, doing whatever it takes.  The votes are there.

This dovetails nicely with our recession series.  The method we are putting under the microscope, Bob Dieli's, accurately emphasizes Fed policy as a big factor in recessions.  More to come on that subject, but astute readers will see the drift.  We are earlier in the business cycle than most analysts think.  This is good for heavy cyclicals and cyclical tech stocks.  (Think CAT and ORCL and the XLI ETF for names I have mentioned, or write to main at newarc dot com to get our updated ETF suggestions).

This also dovetails nicely with our short-term modeling from our Felix model.

Worst Forecasts Ever

The latest Fed action suggests something interesting for market watchers.  For many years there has been a cadre of Fed critics asserting that the Fed was "out of bullets" or "in a box."  For any objective observer these statements have clearly been proven false.  The latest Fed move is something that non of these "experts" even considered a few years ago.  The same guys are now telling you the same thing about the ECB and Europe......They see no hope.

With the 2006 Fed transcripts we can now start to have some fun by looking back at bold assertions about Fed meetings and what actually happened.  So many interesting ideas and so little time.  Maybe an enthusiastic reader will take this on!

 

Weighing the Week Ahead: The State of the Union, Bernanke, Earnings

Normally the State of the Union Address would be the focal point for the week's events.  In a general sense this is still true, but our focus in this weekly series is much narrower:  What will influence markets?

This SOTU speech is unlikely to have a big market effect.  The political lines have been drawn. We can all hope for initiatives that will generate some compromise, but I am not hopeful.  I expect themes related to the major national problems - -housing and jobs.

My forecast last week was that by Thursday we would all be talking about earnings.  I expect earnings to dominate the story this week as well.

I'll take this up further in the conclusion, but first let us do our regular review of the week's news and data.

Background on "Weighing the Week Ahead"

There are many good sources for a comprehensive weekly review.  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. Do not be bashful. Join in and comment about what we should expect in the days ahead. 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 last week's report I observed that there was a change in tone.  We saw more of the same this week.  In the absence of specific bad news from Europe, the market "wants to move higher."  All of a sudden there is more attention paid to specific stock news, and a general upward trend.  I'll consider this important development further in the conclusion.

The Good

 There was some very good news this week.

• Initial jobless claim dipped back to the 350K range.  See Doug Short for the full story and multiple charts.

 

• Eurozone news was positive.  Auctions went well.  The IMF is building up firepower to the $1 trillion range.  The one-stop indicator, the Italian 10-year bond, saw yields decline to the 6.2% range from over 7% last week.  There is a nice Europe chart pack from Scott Grannis.  Here is one example:

2-yr swap spreads are an excellent indicator of financial market liquidity and systemic risk. Spreads are down meaningfully in the Eurozone, albeit still quite elevated. U.S. spreads are now back to a level that is consistent with "normal" conditions.

• Most investors have a big fear of a crash.  See Bespoke Investment Group's analysis.

 

• The Fed turned a $77 billion profit last year.  Try to find that help from bipartisan deficit negotiators.
  

The Bad

The economic data had a few negatives.

• The Baltic Dry Index is plummeting.  See Bespoke Investment Group for a great chart.  I have paid less attention to this in recent years since the supply factors from shipping outweighed demand.
• Industrial production was a bit light of expectations, although capacity utilization was firm.
• Gasoline prices continue a steady march higher.  Here is the key chart from Doug Short, also supported by AAA.  High fuel prices represent a tax on consumption, and one that is difficult to model.

 

• Building permits were virtually unchanged, month-over-month.  The year-over-year change has come entirely from multi-family constructions.  Since I am a fan of this series, the housing news bothered me more than most other observers.  See Steven Hansen's fine analysis for full details.

The Ugly -- Things Change

I started out to do the "ugly" award for the week, which I initially felt was the fake CNN email about Newt.  This was a blatant lie, leveraged through modern methods.  Apparently it did not work.  Somehow Gingrich has taken stories that would have been devastating in past eras and turned it all to his advantage.  As I write this on Saturday night, he is reported as winning the South Carolina primary.  If you had merely read the news flow, without seeing the debates, you would never have predicted the outcome.

For starters, as a former practicing political scientist at a big-time school, I see what is happening this year as a real game-changer.  The growth of Internet communications and social media is having a dramatic effect.  Just think about the differences between 2008 and now -- Facebook, Twitter, and IM versus email -- and we are just getting started.  What was innovative in 2008 is now passe'.

One factor is that Gingrich was helped by a debate format that played to his strengths -- plenty of cheering from the audience, and a group receptive to his anti-media pitch.  For perspective, I offer some relevant historical notes.

The Picture that Changed History

In 1988 Colorado Senator Gary Hart was the early leader to challenge VP George Bush.  His credentials and charisma were excellent.  There were rumors......and he challenged the media.

 

The name of the boat where this was taken was "Monkey Business" as illustrated on the T-Shirt.  In 1988 this was a big deal for voters.  Hart was crushed in the New Hampshire primary.  Dukakis went on to victory for the Dems, and put up a weak fight.

I offer no moral judgment - -just an observation that things have changed to a much higher level of tolerance for many voters.

The New Standard for Dirty Tricks

There is a long tradition of dirty tricks in politics.  Any readers who have not heard about Dick Tuck might enjoy reading about his (alleged) exploits.  There is something roguish and crafty about putting on a conductor's hat and waving a train out of the station when an opposing candidate is still speaking from the rear platform.  Hiring an elderly woman, having her put on a Nixon badge, and setting up an encounter seems clever.  The woman, the day after one of the Kennedy/Nixon debates, the first in history, embraces Nixon and comforts him in front of the cameras -- "Don't worry about last night.  You'll get him next time."

Watergate took the Dick Tuck moves to a new level.  Last week's forged CNN email propagating lies about Gingrich should be disturbing to all of us.  I am not going to repeat the lie here, but Gingrich has put out the warning.

And I say this without regard to party or candidate.

Using Political Information

Abnormal Returns  had a great post this week on how to use political information to your investment advantage (including an actionable theme).  Do not get involved with your emotions or what you think should happen.  Stick to forecasting what is likely to happen, and finding the right stocks.

That is exactly what we try to do with political commentary.  Take your own opinion to the voting booth.  Argue it vigorously with friends.  When it comes to investing, think about what will happen, not what you want to happen.

 

The Indicator Snapshot

It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

• Economic/Recession Indicators. This week continues two new measures for our table. The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread."  I'll explain the link to the C-Score next week.  The second is the Super Index. You can read more about it in this article, which is merely an introduction.   It reflects extensive research and testing, and is well worth monitoring. (The Super Index includes the ECRI approach).  I am going to do a complete review of the work very soon.  Meanwhile, I think it is important enough to watch every week.
• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions. We voted "Bullish" this week.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly 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 will be important earnings reports all week.  Eventually that is what matters.

Tuesday night we will watch the President.  In any other year the new initiatives would be worth considering.  In this election year, the proposals will all be suspect.

The FOMC announces a rate decision with a press conference by Chairman Bernanke.  Everyone already knows the rate decision.  The fresh news will be more insight into the forecasts of the various FOMC members.  Anyone following past minutes and transcripts knows that these vary significantly from staff estimates.  It could be interesting.  Everyone will view this through the prism of whether there will be another round of QE.  Market participants are more pessimistic than the Fed on the economy and have a simple heuristic about quantitative easing.  It could be interesting.

The week also includes the regular report on initial jobless claims and the initial report on Q411 GDP.   The Conference Board will give us their latest take on leading indicators, now including (yet another) change in their definitions, and a redefinition of the entire data series.  (yawn).

Oh -- Europe --- at some point we will hear about the negotiations concering Greek debt.

In the midst of all of the news, I think that earnings will be the continuing focus:

1. Margin pressure?
2. European effect?
3. Outlook?

That is what I will be watching.  For the comprehensive daily calendar of everything relevant --economic reports, earnings, speeches -- check out Mark Gongloff's helpful list.

 

Trading Time Frame

Our trading accounts have been 100% invested for several weeks. Felix caught the recent rally quite well and still has several strong sectors in the buy range. While the overall ratings are still not strong, it remains a marginally bullish forecast. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated.  Felix has been more confident than I have been on the trading time frame.  This illustrates the importance of watching objective indicators.

Investor Time Frame

Long-term investors should continue to watch the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," but it is still high, but declining. For investors desiring this risk management approach we raised cash when the trigger hit the range. We have also been cautious with new accounts.  The improvement here is pretty obvious, and we are getting close to a point where we will be more aggressive.  I would like to see a final verdict on the current Greek negotiations.  This is not some idea that it represents an "ultimate solution."  My basic thesis on Europe -- many plans, many participants, gradual progress, compromise all around -- is playing out.  Greece is the immediate issue.

Our Dynamic Asset Allocation model is also very conservative, featuring bonds and other defensive holdings.  It is rather like the Nouriel Roubini of our methods.  What if things go wrong?  Investors should understand that cautious, hedge-oriented positions may be slow to rebound.

To summarize, we continue a conservative posture in most of our programs, recognizing the uncertainty and volatility. For new accounts we are establishing partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program. This program has been working very well, meeting the objectives of conservative, yield-oriented investors. It follows our key precept:

Take what the market is giving you.

Right now that continues to be dividend stocks at reasonable prices with the chance to sell call options at inflated prices.  If the stocks do nothing, you can still get almost 10% per year from dividends and call premiums.

This does not work for those selling long-dated calls.  It requires some active management, selling calls with a month or two before expiration to capture the most rapid time decay.

The Final Word

This is an important time of decision for many investors.

Quietly -- almost without notice -- things are getting better.

The biggest example is Europe. 

Regular readers know that I am a big fan of Charles Kirk, whose work helps traders and investors alike.  I always look at his weekly chart show to get the technical picture.  I cannot always cite it in this report since I try to write it on Saturday and he posts on Sunday.  Charles has a small membership fee that basically goes to cover costs - -he doesn't need it.  Investors will recover the cost on the first decision they make.

Members get a daily update including a quote of the day.  These are always great (the one about golf was the funniest this week), but today's was especially thought-provoking:

"A market that slowly grinds higher is
a good buy. A market that soars is
usually a good sell." - Neal Weintraub

How much better could things be?  Here is an interesting contrast to the 100% recession forecasters from Ed Yardeni:

The US economy may be on the verge of a big comeback. It could experience an unusual second recovery over the next three years following the weak initial recovery of the past three years. In the past, recessions were followed by one broad-based recovery in economic activity. The Naysayers have been predicting a “double dip” recession for the US economy since it started to recover in 2009. I’m suggesting that a more likely scenario might be a double back-to-back recovery.

and finally, his conclusion....

In the past, recessions were followed by one, not two recoveries. This time, key sectors of the economy haven’t participated in the initial economic rebound, but finally may be on the verge of doing so. The second recovery could take off as the pace of hiring quickens, housing activity finally picks up, auto sales head higher, and state and local governments stop retrenching. If so, then the US would finally enjoy the benefits of a broader-based recovery.

This is an interesting concept but we need an alliterative term to equal "double dip."  For those of us who see investing as a zero sum game with a lot of misguided and misinformed players, this is something to think about.

Even noted doomster Marc Faber thinks that you should consider stocks!

Why the average investor is bamboozled by recession forecasts

I have a problem.  I cannot teach my research methods course in one short article - -not even the undergraduate version.

Since the topic is so important I want to do it right by conveying the most important features.  While readers of this article may not be able to write a critique of various research findings, you might develop a strong instinct for what is right.

Background

I have served as a referee for scholarly journals, as a methods prof at top schools, and most significantly, as a gatekeeper judging investment research.  You might be surprised to learn that much of the work at big-time firms would not pass muster by these standards.  The criteria for marketing and sales are different from peer review and actually putting your money on the line.

How to spot suspicious results

An expert can spot bogus results.  Suppose you assign a group of students to flip a coin 200 times and write down the results.  Some of them actually do it, while others fake it.  I could spot the fakes in a heartbeat, and so could you with a little practice.  Most people do not understand what random data looks like, so they do not know how to fake it.  They do not understand that "streaks" happen.  By the way, the IRS knows -- no problem for us honest folks!  Read here to learn more.

In the investment world, this is common with trading systems.  As the resident prof and gatekeeper for my trading firm in the late '80s, we got to see plenty of trading systems.  By way of background, the 1987 crash was preceded by extremely oversold conditions, a situation that many thought was right to buy.  Put premium was at unprecedented levels, and put selling was prevalent.  Even the strongest and most experienced traders sold a few puts into that fateful Friday close before the crash.  On Monday,  October 19th, 1987 there was no escape from the worst day in market history.

Very smart, very successful traders had spotted a buy signal that had been profitable for many years.  When people came around to sell trading systems, how many of them recommended a "buy" on that day?  If you are guessing "ZERO" then you are correct.  Even though the "syndrome" of successful indicators would probably resume working for another 20 years, no system developer would admit it.  It was almost as if they had a specific binary variable -- exclude any signal on a Friday in October of odd numbered years.  I am intentionally exaggerating this, of course, but it is essential.  Anyone with a computer can find something plausible that has the same effect and is more difficult to spot.  Some of the current bogus research uses this very approach -- too many variables for too few events.

Examples of Strong Research

Great research starts with a hypothesis.

My favorite professor in grad school tricked us, something that I chronicled in this article.  If you take the time to read it, you will see the error of modern "experts" who start with data instead of following the scientific method.

This same prof had a great study of innovation in public health agencies.  He discovered that agencies that had great motivation to innovate but lacked money produced little innovation.  Agencies that had plenty of bucks but a leader who was a dinosaur also did not innovate.  It took both.  He wrote a great analysis of statistical interaction.  Note the relevance of the theory, his brilliant starting point.  He did not collect some data and then define a "syndrome."

My dad solved many problems the same way --- fuel, oxygen, ignition.  It was amazing how many problems he solved this way, as I wrote in this article.  The story is amusing, but Dad had a solid lesson, which included some thoughts about respect and learning something from everyone.

Implications for Current Recession Forecasts

There is plenty of room for debate.  In my careful, months-long survey of recession forecasting I concluded that there were questions about each method.  There is a healthy discussion on this subject.  I hope that I have helped to encourage this, and I will continue to contribute.  I hope readers will understand that this is one of many important themes.  I see the concern as important but not urgent, so I am going at a careful pace.

Let us split the candidates into two groups, those that have a long-term record, and those who only started with the last recession -- or even later.

Long-term record

I still invite new nominations on this, but I think that Bob Dieli, the Leading Economic Indicators, and the ECRI are the only sources with such a record.

The LEI is a moving target.  The early roots were promising, and for years it was maintained by the government through the Commerce Department.  Some authors who wish to disparage the current findings still incorrectly refer to it as a government indicator.  A more telling criticism is that the components keep changing, with a complete repainting of the data history.  If you really want to know the record of this indicator, you need an "as reported" history.

The ECRI remains a mystery, but one that is closer to a solution every day.  A worldwide team of very bright and talented people have succeeded in reverse engineering the components of the index and also the mysterious translation to a growth index with a complex calculation.  I do not want to spoil the emerging story, but it  will not take long.  There are several key questions:

1. Is the published history based on the current index?  If not, doesn't this seem like false advertising?  If there are changes, what were they?  (I do not ask this lightly.  The team can replicate the old history almost perfectly, but not the current recession call -- the very thing we are all wondering about).
2. Does the method rely heavily upon commodity prices?  Didn't these spike in the first part of 2011 for reasons that many attribute to speculation, the Fed or other non-fundamental factors?  (Don't get me started on this!)  If so, would not a reversion to regular growth levels just be "normal" and not an indication of economic collapse?
3. Why did your story switch so dramatically?  One moment it was the idea that an era of slow growth made us more vulnerable.  In a heartbeat it switched to a 100% recession call with no effective policies for government leaders.  What happened?  Did the methods change?

Bob Dieli has done the best over many decades.  Like every model developer,  Bob is always questioning both his approach and his conclusions.  As a reviewer and critic, I am doing the same.  Unlike the ECRI, the Dieli method is open to review, and I will take this up in the next article.

Here is the key concept:  Most recession forecasters mistakenly look for weakness.  That tells you that the current economy is performing below trend, but it is not a signal of a new recession.

Bob's method looks for cycle peaks (and troughs), which is how the NBER defines recessions (and the end of recessions).  If you do not understand this, go back to the first article in this series.

The short-term candidates

There are several recession forecasters who do not have a long-term record in real time.  Essentially, they are doing research that tries to explain the past, sometimes without following a scientific method.  Since the statistical procedure and commentary are fancy, it may seem persuasive.

This is the illusion that comes from using too many variables on too few cases.  In fact, the fewer variables the better!  Especially when there are only a few cases to predict, using a long laundry list of binary indicators is a red flag!  You will overfit (over-explain) the few past cases and be forced to keep revising your indicators over time.

Hint for Careful Readers

Those who want to avoid being bamboozled can ask a simple question:

When someone tells me about a syndrome or Aunt Gertrude's symptoms, have they done the following:

1. Provided a hypothesis, stated in advance;
2. Explained the reason for the proposed statistical interaction;
3. Demonstrated a real-time record of recession forecasting; and
4. Maintained the same exact criteria over time (no fudging, changing, suggesting of Plan B or exceptions).

If not, taking up my old roles, I would not publish the article nor would I invest in the system.  It is sad that so many individual investors think that something that looks perfect is the best choice.  If only they had seen more such examples, they would have better instincts.

I hope this article will help.

Positioning for 2012: Don't forget about stocks

For the last three years I have participated in a special interview series at Seeking Alpha.  Jonathan Liss comes up with questions that suit both the times and reader interest.  I think that readers of "A Dash" may find the discussion to be interesting, and may wish to add some comments or questions of their own.

The interview was originally published here a few days ago, and the link to the series, with many fine contributions, is here.

Jeff Miller Positions For 2012: Biggest Mistake Investors Can Make Right Now Is Underweighting Stocks

Seeking Alpha (SA): Jeff, how would you generally describe your investing style/philosophy?

Jeff Miller (JM): Hi Jonathan. Thanks for inviting me to participate again this year. The Seeking Alpha year-end program brings out a nice range of expert opinion. You have sharp questions and a good format. I enjoy reading the interviews, and I am sure that many others do as well.

Our investment style emphasizes active management, a focus on risk, and attention to each client. That has been especially challenging over the past year. Many people do not want to worry about 350-point swings in the Dow. They need yield with less volatility. The Fed policy has taken away those choices, so we need to be a little more creative.

Rather than emphasizing a specific investment style, I interview each potential client and then create a blend of our five programs – something that meets the risk/reward needs of each.

With that background in mind, I would say that I am focused on data and objective indicators. I am resistant to hype and headlines. I am contrarian – finding opportunity where others see none. On a long-term basis I am optimistic about the US, the economy, and stocks. On a short-term basis I am cautious.

SA: Within equities, are there any particular sectors or themes you are currently overweight or underweight? If so, why?

JM: I am overweight technology and cyclical stocks. The economic indicators that have passed my stringent tests are more optimistic than the general sentiment. Many media commentaries still highlight people who “called 2008” no matter how early. At some point these pundits will be “one hit wonders” in the same way traders view Elaine Garzarelli and her forecast of the 1987 crash. Meanwhile, many of these sources have been dour and wrong since 2008.

Economic growth has been modest, but it has been just fine for the profitability of the major industrial firms. The trend is favorable. I like Caterpillar (CAT) and Illinois Tool Works (ITW) among others.

The technology play is excellent with economic expansion, but still works if economic growth proves to be more moderate. Many technology names are at historic low valuations on a P/E basis. Why? The story has not worked recently, and investors are like jilted lovers. Microsoft (MSFT) is an obvious example, but I also like Intel (INTC), Oracle (ORCL), and Apple (AAPL).

SA: Do you ever buy funds to gain access to asset classes or themes, or do you stick to single stocks exclusively? What are the advantages of your approach?

JM: We do not use mutual funds, but we are very active in ETFs. Two of our five programs trade via ETFs, and we have a free weekly newsletter with ETF ratings. The trading method asks the following question: What ETF will be best over the next three weeks? We have two “experts” on this subject – Oscar and Felix. You can guess their risk/reward outlook!

We also have a Dynamic Asset Allocation approach (DAA). For this model we ask: What ETF will be the best over the next year?

Please note that we do not have a holding period of three weeks in the first case nor 12 months in the second. Nonetheless, we ask these questions every day.

This gives us 20 or so trades in DAA every year and many more for Felix and Oscar.

Right now, the DAA approach is very conservative. By the nature of the method it will be slow in capturing a rebound. Essentially, it reduces volatility and gets you on the right side of big moves.

Felix and Oscar were fully invested for the year-end rally. (This could easily change by the time of publication).

To summarize, ETFs are a very important part of our trading and we have major positions for clients. It all depends on which of our programs is right for them.

SA: Speaking of ETFs, which asset classes are you overweight? Which are you underweight? Why?

JM: We have to start with the definition of an “asset class.” There is a dangerous pitch out there, reflected in current advertising. The idea is that all of the traditional asset classes – stocks, bonds, and real estate – are over-valued. The refuge first was gold. Now I see ads encouraging people to speculate in foreign exchange. Encouraging people to do active trading based upon their “market feel” is a prescription for disaster.

My scientific, model-driven approaches sometimes recommend oil and gold, but I do not have a good method to evaluate these choices on the fundamentals. The average investor should not confuse trading with investing.

SA: Can you elaborate on what you mean by “scientific, model-driven approaches” to allow readers a better understanding of what we’re talking about here exactly?

JM: Good question! I engage several model developers with different approaches. I test these carefully. You might think of it as my own version of a “stress test.”

The DAA model follows principles that have been accepted in the finance literature for decades. It is a yearly momentum model, but including some helpful tweaks. When it is applied to our universe we minimize the chance of excessive correlation. This method gets you on the right side of long-term trends. In 2008, for example, the DAA approach would have led you first to gold and bonds and later to the inverse index ETFs. This cushioned the downside, but it would have been very slow in capturing the rebound.

Felix combines momentum, a sense of the cycle, and the element of uncertainty. Felix does not call tops and bottoms, but he does get on the right side of fresh moves. If there is a big trend, Felix will participate. If the market is declining, Felix will get into the inverse ETFs --- essentially going short.

No system is perfect, and our methods do not call tops and bottoms. There is always a delay for recognition of a new trend. It depends on the time frame.

SA: Name one investment that exceeded your expectations in 2011, and one you had high hopes for that didn't pan out. Do you see any particular investment surprising investors over the next year?

JM: Our biggest winners were Apple and some of the energy and healthcare names. We are very good at forecasting economic and earnings fundamentals, but we do not try to time market sentiment.

That was the wild card. Beginning with the Japanese earthquake, then moving to the silly debate over the debt limit, and finally fixating on the European saga, there has been a continuing reason to ignore data about what is actually taking place. This meant that the most important story of the year – fantastic earnings growth – has been given short shrift.

While we had some nice winners, we expect much better next year.

The negative side included two groups:

• Anything in the financial sector was bad. Even though we were underweight and sticking to the top names, there was no correct time to buy. I still like JP Morgan (JPM), the best of the breed (U.S. major financial). The market seems to think they have European exposure, despite explanations to the contrary. It is a favorite scare ploy to use nominal derivative totals instead of net. In the case of JPM, they also do not define “net” using different institutions. It is a “pure” version of determining net exposure. It is a favorite stock for a rebound this year.
• The other negative was the medical device makers. I really got this one wrong. (Our health insurance holdings did fine). We have chosen two device stocks (ResMed (RMD) and Stryker (SYK)) that actually save money by reducing related costs. The earnings growth has been solid. Despite this, the stocks moved lower. The political uncertainty over ObamaCare has had a big impact.

SA: Some describe the current era as “The Great Deleveraging.” Do you agree/disagree, and does this macro consideration affect your investment planning process?

JM: One of the worst things that happened in 2011 was the excessive focus on debt. The argument is seductive for most. We all try to equate government problems with our personal family experience. When the economy is bad, deficits rise. There is a “debate” about this in a highly-charged political environment.

I have simple advice for the average investor:

• First, ignore the politics unless you are in the voting booth!
• Second, understand that every macro-economic model sees short-term stimulus as favorable. Put aside your ideology. It is market-friendly.
• Third, every leader of whatever party has supported stimulus when they are in office.

If we get better economic performance, deficits will be lower. There will still be a structural deficit. But it will be more manageable.

SA: 2010-11 saw a notable rush for the exits from equities and equity vehicles. Is this a cyclical, or secular shift? What would it take to bring them back?

JM: The individual investor will return to equities far too late – long after most of the obvious problems have been solved. That would be when the Dow is at 20K, possibly overvalued, and risk is high. The story has been repeated many times.

Understanding this recurring phenomenon offers both the biggest reward and the biggest challenge for the average investor. I have tried to meet this challenge by providing a blend of programs that provides participation in the upside while limiting risk. It is not easy.

SA: Do you believe gold is a genuine hedge in uncertain markets? If so, how much exposure to it or other precious metals do you have? If not, where are you turning for potential downside diversification?

JM: Gold has a strange character. There is no way to determine a fundamental value. It is a safe haven in a time of disaster (deflation, depression, riots….) and it will have value if there is hyperinflation.

Our programs have invested in gold and gold miners during the past year, and probably will do so again next year. We have been out of gold for a month or so for all accounts.

Since I expect neither disaster nor hyperinflation next year, I do not recommend gold for long-term individual investors. It has been approved as a 5% (or so) holding for many years – but not right now.

Global markets

SA: Global Macro considerations dominated the headlines in 2011. Do you see 2012 unfolding differently? If so, how?

JM: This is definitely the key question. The selection of individual sectors and stocks has been secondary for three years. I expect the European story to be resolved in a few months. Meanwhile, if the US economy improves enough, that will also change the focus.

SA: Will Eurozone contagion continue to drive the market’s direction, and how are you protecting client assets from potential fallout there?

JM: I’ll go out on a limb. I think that by mid-year in 2012 we will no longer have the Europe fixation. I have a series of articles explaining my reasoning.

I think that the market reflects a high degree of pessimism. You can protect assets by reducing position sizes, which I have done. Buying puts is too expensive. You could do some more complicated put strategies, but something like a “put diagonal” is not suitable for most investors.

SA: Do you buy into the argument that European equities are actually undervalued right now?

JM: One of my pet peeves is people who answer questions when they basically do not know. I have an honest answer. While I study the European situation carefully, I am not considering specific stocks there. There are many US companies that are undervalued because of Europe. I can get plenty of octane with much less risk buying JPM and CAT.

SA: How much exposure to emerging markets do you have both in terms of stocks and bonds? Are China, India or other major EMs better positioned to withstand a serious global economic downturn than the U.S.?

JM: Most people are surprised to learn that the US has actually fared better in recent years. It is possible to get a solid amount of foreign exposure via big US firms like CAT, MSFT, and ORCL (a recent disappointment, but still a great growth story).

SA: Let's move on to another potential event on investor minds: The Iran nuke situation and a potential Israeli, U.S. or global attack. How serious would such an event be to oil prices and subsequently, the global economy/exchanges? Is this something you're positioning for and if so, how?

JM: Great question! This is one of the big wild cards for 2012. Most people are bearish on energy because it fits the pessimistic view of the world. Many energy companies are extremely cheap on a P/E or cash flow basis. Owning some energy stocks will help if oil prices spike. I like Noble Energy (NE) among the drillers and Chevron (CVX) among the large integrated plays. There are many good choices in this sector.

U.S. Market

SA: We are coming up on an election year. Will this be good or bad for markets? Are you positioning for different potential outcomes?

JM: Elections, political events, and the impact on stocks really hit my sweet spot. As a former public policy professor at a top university, I have studied the political side for decades. Since 1987, I have been a player on the financial side. It is so tempting!

I would love to make a prediction, but it is too soon. My team is working on a generic Obama portfolio as well as a generic GOP portfolio. I will expand on this as soon as we learn more.

This is a typical area where people try to stake out positions too soon, with little information.

SA: Is the U.S. housing market still an issue, or not so much anymore? Will prices continue to fall? Do you have exposure to either REITs or residential real estate in client portfolios?

JM: I have no position at the moment, although our short-term models have been indicating good trades (three-week horizon) in these sectors. When the time comes, this will be one of our major profit sources. I am willing to miss the first part of the rebound in favor of more certainty.

Bonds/Fixed Income

SA: Where do you see Treasury yields in 12 months? Are Treasuries worth buying at current (low) yields? For clients requiring income, where have you been turning in this low yield environment?

JM: This has been a great success story, but the end is near. I have two approaches for yield.

First, for clients that only need to preserve wealth (Congratulations!), I construct bond ladders. These include only investment grade bonds with a limit of seven years on maturity. If rates rise, we’ll be able to take advantage. If you have already achieved what you need, keep risk at a minimum!

For most clients I am using enhanced yield – a good dividend stock plus the sale of a call option. I do this with Abbot Labs (ABT), Johnson and Johnson (JNJ), as well as solid tech stocks like Intel (INTC) and Microsoft (MSFT). The combination of yield plus call premium is almost 10% per year after fees. This is working because of low stock prices and high volatility. It might not work in another year, but for the moment, let us take what the market is giving us!

This is a great method as long as you pick stocks that will hold value and monitor them carefully.

SA: What is the ideal asset allocation for someone with a long-term horizon (greater than a decade) and no need to touch their investments? Can investors continue to rely on stocks after the 'lost decade' we just experienced?

JM: I appreciate your desire to quantify this, but I am struggling since it is so far from my individual approach.

Let me try it a different way.

The single biggest mistake of the individual investor – right now – is underweighting stocks. This happens for several reasons:

Fear sells – in politics, advertising, and page views.

Individual investors always react to highly-publicized events because they do not understand how to determine what is already “in the market.”

It is a mistake to be “all-in” or “all-out.” This is not poker. Most people will never attain their investment goals if they do not have a rational strategy for when and how to buy stocks.

People underestimate the upside. We have just experienced a year with tremendous earnings growth and no movement in stock prices. The price/earnings ratio is back where it was at the market lows of 2009. If and when some of the worries are relieved, stocks can move to a more normal P/E multiple.

If the European concerns are addressed, people must understand the stocks could move much, much higher.

My advice? Based upon what I see in many interviews, most people should be nudging stock exposure a bit higher. It is possible to participate in the upside potential while keeping a rein on risk.

Disclosure Statement: NewArc’s five different programs are currently invested in all of the stocks and ETFs mentioned. The specific characteristics vary according to the investor.

Here is a good illustration. New investors do not go all-in on the first day – we look for good entry points. An investor in Great Stocks would own Apple tomorrow, since I think it is massively under-valued. An investor in the enhanced yield program would never own Apple.

To summarize, every stock mentioned is right for one of our programs. The individual investor must be cautious when reviewing market commentary like this. Everyone is different!

Weighing the Week Ahead: Have big companies lost their earnings mojo?

Earnings season starts in earnest this week.  There are a number of key questions:

1. Have slowing economies in Europe introduced a big drag on profits?
2. What about the dollar strength?  Bad for profits?
3. Profit margins have been at historic highs.  Is the long-awaited mean reversion taking place?
4. What about the outlook?  Can there be any confidence about future profits in the face of so much uncertainty?

As I write this on Saturday, with a three-day weekend ahead, I know that the news from Greece will dominate on Tuesday. Whatever I write tonight could look silly, but I have been there before:)

By Thursday, we'll all be talking earnings.

I will discuss how to play this in the conclusion.  First,  let us do our regular review of last week's news.

Background on "Weighing the Week Ahead"

There are many good sources for a comprehensive weekly review. 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. Do not be bashful. Join in and comment about what we should expect in the days ahead. 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

Last week saw an interesting change in tone.  The news from Europe (at least until Friday) was better, while the US economic data was worse.  The dollar strengthened, which for many months has been the signal for lower prices on commodities and stocks.  With that in mind, stocks did pretty well.

The Good

 

• 2012 Earnings.  The best news of the week is something that you will not see mentioned by most observers.  The one-year forward earnings estimates are higher.  I view as very significant for the market.  Recently forward estimates have been drifting lower with European and recession worries.  Brian Gilmartin has been all over this story, and writes that estimates on the S&P 500 have now increased to $107.
• The Beige Book, used by the Fed Open Market Committee as part of the decision on interest rate policy, reflected improved business conditions.
• Sentiment, when measured by behavior rather than polling remains sentiment.  Mark Gongloff discusses with data and commentary from Doug Kass.
• Rail traffic ends the year with solid gains.  See Steven Hansen's complete analysis.
• University of Michigan sentiment registered a big increase to 74.  For several years this measure has been helpful as a gauge of employment prospects, but more recently has been heavily influenced by gasoline prices and the debt ceiling debate. Doug Short does a great job of illustrating the relationship between this measure, other sentiment indicators, and the economy.  There are several good charts, but this is my favorite:

The Bad

The important economic data was mostly negative.

• Initial jobless claims rebounded to 399K.  See a nice collection of employment charts at Calculated Risk.

• Job openings showed no growth.  Good charts at Calculated Risk.  An increase in the "quit rate" is one positive element of the report.
• Retail sales increased only 0.1%, well below expectations of 0.4%.  Consumer behavior in the first quarter is a big focal point.
• The trade deficit expanded to $47 billion.

 

The Ugly

Congress is not in session, so our legislative leaders dodge the "Ugly Award" this week.  Actually the Senate might be in session, but we will need the Supreme Court to decide.  At the moment they are preoccupied with determining what constitutes indecency in broadcasting.  Part of the oral argument before the court was whether the brief nudity on NYPD Blue was more graphic than the frieze in the Court itself.  Even Scalia laughed.

The ugly news is the breakdown in the negotiations over the Greek debt haircut.  While all parties want to avoid a disorderly Greek default, there is also general agreement on the need to reduce future obligations.  Some observers do not think that a compromise is possible, despite the high stakes.  This news weighed heavily on the euro and US stocks during Friday's trading. 

The Indicator Snapshot

It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

• Economic/Recession Indicators. This week continues two new measures for our table. The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread."  I'll explain the link to the C-Score next week.  The second is the Super Index. You can read more about it in this article. It reflects extensive research and testing, and is well worth monitoring. (The Super Index includes the ECRI approach).
• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions. We voted "Bullish" this week.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly 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 will be a lot of news this week, including the economy, speeches, Europe and, most important of all -- earnings.  As usual, I am highlighting the events that I see as most important.

On the economic front we'll get inflation data on Wednesday and Thursday -- PPI and then CPI.  Among the various housing reports I will focus on Thursday's building permits.

Thursday also brings the weekly report on initial claims, especially important given this week's spike.  I am not expecting much from the other economic data (industrial production, capacity utilization, and the regional Fed reports).

Thursday is the biggest day for earnings, with a long list of reports from major companies, but there will be significant reports all week.

For a consolidated list of earnings, European auctions, speeches, and economic releases, I like the weekly calendar from Mark Gongloff.

 

Trading Time Frame

Our trading accounts have been 100% invested for several weeks. Felix caught the recent rally quite well and still has several strong sectors in the buy range. While the overall ratings are not strong, it remains a marginally bullish forecast. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated.  We just closed a position in IWM (iShares Russell 2000) with a 6% gain since December 19th, initiated when things looked rather bad.  Felix has been more confident than I have been on the trading time frame.

Investor Time Frame

Long-term investors should continue to watch the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," but it is still high, but declining. For investors desiring this risk management approach we raised cash when the trigger hit the range. We have also been cautious with new accounts. We still do not have an "all clear" signal, but I am watching the decline in risk with great interest.  Depending on the news this week, we may get more aggressive.

Our Dynamic Asset Allocation model is also very conservative, featuring bonds and other defensive holdings.

To summarize, we have a very conservative posture in most of our programs, recognizing the uncertainty and volatility. For new accounts we are establishing partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program. This program has been working very well, meeting the objectives of conservative, yield-oriented investors. It follows our key precept:

Take what the market is giving you.

Right now that continues to be dividend stocks at reasonable prices with the chance to sell call options at inflated prices.  If the stocks do nothing, you can still get almost 10% per year from dividends and call premiums.

This does not work for those selling long-dated calls.  It requires some active management, selling calls with a month or two before expiration to capture the most rapid time decay.

The Final Word

This will be an important week for gauging market tone.  I expect most companies to offer cautious guidance, frequently citing European concerns and an uncertain US environment.  There is little incentive to do otherwise.  My reading of analyst reports suggests that these also reflect the same fears, helping to restrain estimates of future earnings.

The market reaction to earnings reports will provide important information.  The overall negative sentiment provides an opportunity for long-term investors as long as we continue to see progress -- not a perfect solution, but progress -- in Europe.

Best Recession Forecaster: Robert F. Dieli

Since last May I have been reviewing the record of those who forecast the business cycle.  I developed a stringent list of requirements, "Jeff's Acid Test," and I frequently invited nominations.  Here were the stated requirements:

• Openness -- with the potential for peer review
• Small number of input variables.  Most people do not understand that "small is good."  If you have a lot of variables, it is easy to do back-fitting on a few cases.  Beware.
• Real-time performance.  This means that you do not go back in history doing any data-mining.  You create an indicator and live with it through time.

I received a number of suggestions in the comments and by email.  I very much appreciate the help from readers.  One result is that I am monitoring a number of new and promising forecasting methods.  I plan a later article on the honorable mention winners.

Somewhat to my surprise, there was only one candidate who met all three criteria:

Robert F. Dieli and Mr. Model

Most people think they know about recession forecasting, but they are often responding to someone's last good call or who has the best PR team.  The Dieli method hits a winning trifecta -- it is based on sound intellectual premises, it has worked better than any other method in real time, and it is open for our review.  What more can we ask?

Background

This is Part 2 of a planned five-part series on recession forecasting (Part 1 is here).  I know that many will want to dig into the nuts and bolts of the Dieli method, and I will start that in the next segment.  There will be plenty of opportunity to for comparison and discussion of various methods.

For now, let us just think about the results in terms of the long-term track record, and learn a little more about how the model was developed.

Track Records

Let's start with a look at Mr. Model.

The key variable is the Aggregate Spread, depicted by the blue line.  It depends upon monthly data, and will be updated next week.  The trigger point is the 200 level.  Whenever the blue line crosses 200, it is a forecast of a "cycle event."  The forecast horizon is pretty close to nine months.  This means that when the line crosses 200 moving lower, it is a nine-month warning of a peak, AKA recession as defined by the NBER. When the line crosses moving higher, it provides a nine-month warning of a trough.

Doug Short does an excellent job with the two most popular candidates in his update article, The Great Leading Indicator Smackdown.  There are several excellent charts, and I recommend reading the entire article.  For our current purposes, I am selecting the one that best matches the Mr. Model forecasts.

I invite the reader to scroll from left to right, looking at the lead times for both the onset and the end of recessions.  (I understand that the ECRI uses both an acceleration term and other indicators to augment their calls, but we have to start somewhere.)

It would be nice to put all of these indicators on a single chart, but I think the strength of Mr. Model is apparent.

The Man behind the Model

As background for the record, I have known Bob Dieli only for a few months.  Since we both reside in the Chicago suburbs, it was convenient for us to meet for lunch after a joint appearance on a panel.  I appreciated his openness, honesty, and intellectual rigor.  I was even more impressed by the results of his method.  When I learned that he had not tinkered with it over the years, I really perked up.

This is a very unusual combination, helping to define someone as the "real deal."  Here is the interview I later conducted.

Q:  Bob, tell us a little bit about how and when you first conceived the ideas behind Mr. Model?

The origins go all the way back to graduate school at the University of Texas in the 1970s, when I first became interested in the business cycle.  I began to work on the model in its current form while I was doing economic research at the Continental Bank from 1978 to 1984 and at the Northern Trust from 1987 to 1994.  Both were financial institutions with major exposure to the risks associated with business cycle peaks and troughs.

Q:  You have had a number of high-profile jobs.  Did your economic research on this topic continue through all of these experiences?

Over the course of my corporate career I spent time in staff assignments in economic research and later in line assignments in credit risk management at the Continental during the crisis that led to its implosion.  In 1987 I became a fixed-income portfolio manager at the Northern, where my clients were mostly high net worth individuals.

Can you tell us a little more about how these positions helped you develop your skill as a forecaster?

The combination of those experiences gave me some important insight on the preparation and use of forecasts.  I learned that details of great interest to the forecast originator may not be very important to the forecast user.  The bottom line was that accurate and insightful forecasts, delivered in a timely and usable manner, were the most sought after by decision makers.

Q:  You feature a chart of economic performance and model signals, with an excellent real-time record.  Can you elaborate on that a bit?

My objective was to find a format that allowed the user to draw conclusions quickly.  This turned out to be charts with long historical tails that provide perspective and context at a glance.

Q:  You also write extensively on employment.  This actually represents a second approach for your economic analysis, I think.  Is it giving you a similar signal right now?

The employment figures are among the most informative statistics we have.  They are the best coincident indicators of economic conditions and, as such, give you a great place to start on figuring out where we are in the business cycle and what is likely to happen next.

Q:  How much lead time do you usually see between a signal from Mr. Model and an economic peak or trough?

The Aggregate Spread, which is the principal forecast statistic, operates with a constant nine month forward look.  Unlike other leading indicators which operate with a variable lead time, the Aggregate Spreads looks ahead nine months at all times.  Think of it in the same terms as the beam on the radar on your local weather channel.  The historical record has shown that when the Aggregate Spread gets to 200 Basis Points, from either direction, we have reason to think there will be a cycle event (either a peak or a trough) some time in the time period nine months ahead of the arrival of the Aggregate Spread at the 200 Basis Point boundary.

Q: Making those calls out nine months must lead to some interesting conversations with your clients.

Indeed they do.  For example, the signal for the peak of the 2001 recession that began in March of that year, came from model readings obtained in June of 2000.  Telling folks, in the middle of the tech boom, that the business cycle had not been repealed and that we would have a recession the following year was a tough sell.  Similarly, the indications that the recession of 2007 would end in the middle of 2009 began to emerge late in 2008 and in early 2009.  Trying to tell folks that the economy would turn up while it was in the midst of what looked like a free fall in the first quarter of 2009 was even more difficult.  But, because the model has the track record that it does, by the end of the first quarter of 2009 most of my readers were convinced that the worst of the recession was over and that a bottom would be forming.

Q: To make this clear, while you talk about markets, you are not making market predictions.  You are predicting the economy, right?

That is correct.  What I am out to do is anticipate the dates of business cycle turning points as determined by the National Bureau of Economic Research (NBER) with enough warning to allow effective planning.  The stock market, the fixed-income market, and the housing market, to name just three, all have their own cycles.  Sometimes those cycles match up closely with the NBER turning points, and other times they don’t.  But you can’t know that until you know the NBER dates.  The Aggregate Spread has an excellent record of showing, as much as a year ahead, when an NBER event is likely to take place.  Armed with that information, and the specifics of their industry, or market, informed decision makers can make appropriate plans.

Q: Could you tell us a little be about your firm and its clients?

I’d be glad to.  RDLB was started in 2002.  My clients consist of three main groups: money managers, companies that make things, and individual investors.  I send my monthly reports, which are available by subscription on my website, to all of these groups. I am available to all my subscribers for additional interpretation of the report contents. I also have a consulting practice in which I function as their economic research department.  The assignments are as varied as the firms themselves, which makes the work very interesting to me.  I also do public speaking before trade groups and gatherings arranged by and for my clients. 

Q: Why do you call your site "Nospinforecast"?

Because the forecasts and viewpoints expressed there are completely data driven.  I talk about what is on the charts.  I don’t rant and I don’t take sides.  I report the information and provide complete access to my forecasting methods.  While I do talk about possible future outcomes, I do so within the context of numbers themselves.  My objective is to provide my readers with information they can use to assess other views and forecasts as well as information they can use to effectively manage their business and financial affairs.  One of the reasons I do this is because of lessons I learned while working with the trading desks at both the Continental and the Northern.  The same piece of economic information might be reason for one desk, say short-term fixed income, to buy and another desk, say foreign exchange, to sell the instruments they traded.

Q:  Thanks, Bob, for your helpful and informative comments.

Thank you for the chance to talk about Mr. Model.

Conclusion -- Part 2

There is plenty more to discuss.  I will get into the workings of Mr. Model in Part 3.  We will revisit the comparison with the ECRI in part 4.  These are tentatively on the agenda for next week.

Meanwhile, everyone should note that a "cycle event"  -- aka recession -- is not expected for at least nine months.  Unlike those who ascribe 0% or 100% chances of events, I understand that bad things can happen.

Nevertheless, you should keep this in mind:

In the 50-year history of Mr. Model, when the indicator is at current levels, there has NEVER been a recession within nine months.  In fact, we are not even close to the nine-month signal.

Evaluating Recession Forecasts: What Every Investor Must Know

For investors who believe that stocks eventually reflect the fundamental strength of the companies, understanding the business cycle is crucial.  Since popular sentiment and stock prices are often excessively negative about economic prospects, there is great opportunity for those who can get this right.

Regular readers know that I have been conducting research on this topic since May, providing some occasional updates and background.  I am now ready to describe what I have learned.  This is going to require about five articles over the next couple of weeks.  Today's installment is the first.  Tomorrow I plan to discuss the best single method that I found.

Deceptive Dangers

Many pundits, including some of the most famous and powerful, are playing fast and loose with the "R" word.  John Hussman, a leader in keeping investors scared witless (TM OldProf eumphemism), now warns us that everyone else is looking at lagging or coincident indicators, and that we might all be blindsided by a recession.  Here is a key argument:

Let's examine the seemingly most "compelling" data point first - the fact that December payrolls grew by 200,000. Surely that sort of jobs number is inconsistent with an oncoming recession. Isn't it? Well, examining the past 10 U.S. recessions, it turns out that payroll employment growth was positive in 8 of those 10 recessions in the very month that the recession began.

Let's keep that one in mind for a moment while we consider another popular allegation.  It goes like this:

Mr. X (substitute nearly any mainstream analyst) thought that the economy was fine in December of 2007, the very month the recession was starting.

These statements are accurate, but deceptive.  Understanding why is crucial to an objective analysis of recession forecasting.

What is a Recession

For the purposes of my series, and also the basis for the deceptive arguments, we are looking at the official recession dating by the National Bureau of Economic Research (NBER).  The NBER is not a government agency.  It is a private, non-profit, non-partisan group.

I did an extensive discussion of the NBER process in April, 2008  (when the recession was still actively debated) in my article, How to Win a Recession Predicting Contest.  You can go back and see who was predicting what at that time, but the more important point is the process used by the NBER.  To summarize that description, the NBER does two things:

1. Wait until there is a significant move lower in a group of four factors, with special emphasis on personal income less transfer payments and employment.
2. Only after noting such a decline does the recession-dating committee go back to find the last cycle peak and declare that to be the start of the recession.

In the case of 2007-08, the NBER determined that the recession started in December of 2007 in December of 2008, a year later.  If the economy had rebounded during the year, or maybe if the Lehman failure had been avoided, the dating and scope would have been different.

When a recession ends, the NBER does the same two steps in the opposite direction.  The end of the recession, June 2009, was declared fifteen months later in September of 2010.

Here is a simple rule for understanding the NBER dating:

Forget the term "recession."  Think of their work as identifying peaks and troughs in the business cycle.

To avoid mistakes, the NBER waits for solid evidence before declaring a peak or trough.

This definition does not correspond to what most people think of as a recession.  Most of us just mean that the economy is growing at a rate significantly below potential, usually reflected in the long-term trend.  By this definition we never emerged from the 2008 recession.  Others like to use two quarters of negative GDP growth.  Most people have never heard of the NBER and mistakenly think that it is just another clueless government agency.

Feel free to use your own definition, but when you are reading about economic forecasting, the shaded areas you see on the charts reflect the official NBER dating.

Revisiting the Deceptive Statements

If you keep the NBER definition in mind, you will see why the deceptive statements are unfair and misleading.  Of course most recessions started when there was positive employment growth.  If you grasp that the start of a recession is defined by the NBER as an economic peak, this is almost inevitable.  If the employment growth were weak, it would not be the peak; some earlier month would be selected as the start of the recession.

Similarly, citing what someone said in December of 2007 is unfair, since no one knew for sure that it would be the peak.  It is like someone giving directions -- "If you see the school on the left, you have gone too far."

We need to find true leading indicators -- the focal point of my mission in this series.

Current Relevance

For those who are predicting that we will enter a recession next month, it could, of course, prove to be correct, but it is very unlikely.  Meanwhile, it is safe to say that the recession did not begin before December.  Why not?  None of the four major NBER factors have shown a peak so far.  Unless we have an instant and surprising decline in January, December will not be the peak either.  Check out The Bonddad Blog for a fine review of the major NBER factors and an analysis of how close we came to a recession in 2011.

Let us revisit the Hussman "leading indicators" with this quotation from Business Insider:

A few weeks ago, I noted that our recession warning composite was on the brink of a signal that has always and only occurred during or immediately prior to U.S. recessions, the last signal being the warning I reported in the November 12, 2007 weekly comment Expecting A Recession. While the set of criteria I noted then would still require a decline in the ISM Purchasing Managers Index to 54 or less to complete a recession warning, what prompts my immediate concern is that the growth rate of the ECRI Weekly Leading Index has now declined to -6.9%. The WLI growth rate has historically demonstrated a strong correlation with the ISM Purchasing Managers Index, with the correlation being highest at a lead time of 13 weeks.

Please note the "always and only" phrase.  This is what I call a leading indicator -- a really long, long leading indicator, since the article is from June of 2010!

I am also bothered by the logic implied.  An ISM index of 54 corresponds to GDP growth of about 4% according to the ISM's own analysis.  This sort of illogical data relationship smacks of back-fitting rather than scientific hypothesis testing.

The Real Tests

My interest in the recession forecasting quest is to improve  understanding of the business cycle.  As you will see in this series, my mission does not include any preconception about what is the current "correct" answer.  I started worrying about the ECRI forecast in May, when it was still quite bullish.  You will see that I do not endorse the LEI approach, which is currently quite bullish.

I laid out "Jeff's Acid Test" at the start of the project:

• Openness -- with the potential for peer review
• Small number of input variables.  Most people do not understand that "small is good."  If you have a lot of variables, it is easy to do back-fitting on a few cases.  Beware.
• Real-time performance.  This means that you do not go back in history doing any data-mining.  You create an indicator and live with it through time.  (While the ECRI predictions are a matter of record, no one knows what changes they have made in their indicators).

 In Part 2 of this series I will describe the method that best meets these criteria.

My Bespoke Roundtable Answers

For the last few years I have participated in two different "year ahead" preview articles -- one for The Bespoke Investment Group and one for Seeking Alpha.  These are both excellent resources -- each valuable because of the specific approach taken.

Last week I suggested that readers join me in checking out the ideas of the Bespoke panel.  If you have not done so, it is still an excellent and timely idea.

I know that many readers do not click through to the links.  With this in mind, I am repeating the text of my responses here at "A Dash." These reflect my current thinking on many issues covered recently in other articles, and will be the basis for continuing work.

For your convenience

Below is the full 2012 Bespoke Roundtable Q&A with Jeff Miller of A Dash of Insight.

 

1) Looking back on 2011, what were your best and worst calls?

 

Thanks again for inviting me to participate.  The questions are excellent, so I always learn something just by formulating my own answers.  You also have a great roster of participants, and I learn from their wisdom.  I know from the comments that readers of my blog also appreciate the work you do in producing this Roundtable.

 

Turning to my own results, my best calls were sticking with Apple, trading drilling stocks in a timely fashion, and accurately predicting earnings on most of my holdings.

 

My worst calls were in the medical device area, where earnings remain solid, but fear of policy changes is overwhelming.  Even though I was underweight financial stocks, the correct weighting would have been zero!

 

Overall, my worst prediction was that the market would gradually accept the evidence of better earnings and an improving economy.  I was right on the facts, but wrong on the reaction.

 

2) What surprised you the most about financial markets in 2011?

 

I was most surprised about the persistence of highly-correlated trading based on the headline of the day.  We all know that this will eventually end, and I expected that to happen last year.  The risk on, risk off, simplification underscores the irrelevance of most actual data.

 

One lesson for us was the increased emphasis on yield.  It caused us to develop a new program for yield-oriented investors.  By combining solid dividends with covered calls, we created a strong, income-oriented investment program.

 

3) The S&P 500 hit its bull market highs in April 2011.  Which will happen first?  Will we first take out the April highs or have we entered a new bear market (a decline of 20% from the highs)?

 

We almost had the decline already!  In October we were down 19.4% on an intra-day basis.  Right now it is a good question since we are about 9% off of the highs.  I expect us to take out the highs in the first half of 2012.

 

4) Depending on your answer to question 3, how long do you expect the bull or bear to last? 

 

At least through 2012.  The biggest concerns come from things that most people are not already worrying about.  Everyone is closely monitoring the economy and Europe, for example.  North Korea is a wild card.  Middle East tension and concern over nuclear weapons in Iran could generate a spike in oil prices.

 

To summarize, some shock to the economy is the biggest worry in 2012.  Barring that, a bull market will end when Fed policy sends interest rates significantly higher, probably not until 2013 at least.

 

5) How should an investor with average risk tolerance be positioned for the year ahead?

 

I appreciate the careful wording of your question.  Most investors are freaking out, over-reacting to headlines.  The big market swings induce plenty of fear.   If you think (incorrectly in my opinion) that your upside in stocks is only 8% for the year, why deal with a market that often moves 2-3% in a day.

 

Most investors are not honest with themselves about risk.  Even in a good market year it is typical to have a 15% drawdown at some point.

 

In my approach the first and most important question for the investor is not what they hope to gain, but what level of risk is appropriate.

 

With this in mind, positions should be about 30% smaller than normal because of the current risk level.  I use the St. Louis Financial Stress Index as an objective means of determining actual risk.  It is not a forecast of the stock market.  My research found that a level of 1.1 in this index was the start of a trigger range.  This level was briefly exceeded a couple of months ago.  The index has pulled back into the .8 range, but not enough to give an "all clear."

 

6) How do you see the European sovereign debt crisis playing out in 2012?

 

This is the biggest current issue and the best source for profit by getting it right.  There is an overwhelming consensus that this is an inevitable disaster.  Merely questioning this and raising alternative possibilities leads to a chorus of people questioning your sanity!

 

This is a very crowded trade: short the euro, long bonds, long puts, short US financials, 100% out of the stock market for investors, and short for many hedge funds.

 

I have a resource page linking to more detailed coverage (http://oldprof.typepad.com/a_dash_of_insight/european-debt-crisis.html), so this is just a summary of conclusions.  Check out the link to see the argument.

 

There will be a problem with European sovereign debt for a long time, a period measured in years.  Merkel has said that it is a marathon.  The market is treating it as a sprint!

 

At a dinner in October I surprised some blogging colleagues when I told them that we would no longer be worried about this issue in eight months: June or July.  Today's news reports that Mark Mobius just said something similar.

 

What is taking place is a process of negotiation and compromise that will gradually involve many different programs and participants.  The final result will be a combination of bailouts, leverage, ECB bond buying, investments from sovereign wealth funds and China, austerity, economic growth, and maybe even the departure of one or more eurozone members.

 

Not one of these things, but all of them.  Democratic governments move slowly, trying to figure out what works.  They will do more of what is working and less of what does not.  The partial moves, disparaged as "kicking the can" by the average talking head, actually provide some useful time.

 

There will be no trumpet sound ringing when it is over, just as there is no gong sounding right now.  The Europe story will gradually fade, and people will notice that it no longer dominates the news. 

 

7) How bullish or bearish are you on the following markets: The US, Europe, Developed Asia, China, Emerging Markets?

 

There are many good investments, but the US has an advantage on a risk adjusted basis.  I own many stocks with substantial global exposure.  I like China better than the general emerging market theme.

 

8) What do you believe is the contrarian call on equities right now?

 

My measure of sentiment is the P/E multiple on forward earnings, especially as compared to interest rates or inflation expectations.  This tells you what those with assets are really doing as opposed to what they are saying.

 

By that metric, sentiment is more negative than it was at the 2009 bottom.

 

9) How confident are you that US companies can live up to current consensus earnings expectations?

 

I have a contrarian take on earnings forecasts: I find them to be of some value!  No one else does.  I share the popular skepticism about "buy" and "hold" ratings, but I find the earnings forecasts to be helpful.

 

Most observers will tell you that earnings estimates are too optimistic.  The same people will tell you that the bar is too low at the time companies report.  Well you cannot have it both ways.  If these statements are both true, then at some point in time, earnings forecasts must have been reasonably accurate.  My research shows that the one year forecast period is very good, incorrect only when there is a recession.  http://oldprof.typepad.com/a_dash_of_insight/2010/10/profiting-from-forward-earnings-estimates.html.

 

I actually prefer that analysts do not try to be amateur economists and include recessions in the forecast.  I can handle that myself.

 

With this background in mind, I think that the consensus expectations for 2012 are quite reasonable.  And yes, I know that profit margins are high and will revert to the mean.  This will happen as labor markets tighten, new businesses form, and the economy improves.

 

10) Are US stocks cheap right now based on the valuation methods you rely on most?  Will multiples expand or contract in 2012?   

 

Stocks are extremely cheap based upon earnings expectations and the potential return from other investments.  This approach to valuation is only a general guide, as experienced observers understand.  Whenever there is intense skepticism about the economy, something that has been the prevalent state since the 2004 election campaign, there is a consensus that earnings estimates are too high.

 

I have frequently invited readers to lead me to any source that has done better at forecasting earnings than the consensus methods.  The most popular alternatives are backward looking methods, embraced by the bearish punditry.  Since no single stock trades on the historical earnings record (we breathlessly await each new announcement) I wonder why people think that the sum of the parts is more meaningful than the whole.

 

This leads me to the question of multiple expansion, my worst prediction from last year.  I have actually done some research on this question, discovering a curvilinear relationship between interest rates and the stock earnings rate (the inverse of the P/E multiple).  In general, the two move together: higher interest rates lead to a lower stock multiple.

 

The exception occurs when interest rates are exceedingly low, indicating fears of deflation.  In those cases no one really believes the earnings forecasts and the result is multiple compression.

 

Last year I was wrong because (like almost everyone else) I expected interest rates to rise.  Instead, the fear and skepticism intensified.  The result is like a coiled spring.  At some point interest rates will move higher.  When that happens, at least until the ten-year note gets to the 4% level or so, the stock multiples will also increase. http://oldprof.typepad.com/a_dash_of_insight/2010/12/why-the-market-multiple-will-be-higher-in-2011.html.

 

If the Europe story fades, 2012 could be a very big year for stocks.

 

11) Describe some of your favorite market indicators and what they are signaling for stocks in 2012?

 

N/A 

 

12) What are your favorite and least favorite sectors for the year ahead? 

 

Since I have confidence in an improving economy, I like cyclical stocks and technology.  I also think that energy can work well.  The health sector is in limbo due to politics, but there will be an opportunity at some point during 2012.

 

13) What is your outlook for Financials?

 

Since I expect the European concern to diminish, this is probably the area for the greatest payoff during 2012.  Having said this, financials may not be the winners in the first half of the year.  No one believes the earnings forecasts or assurances about the lack of European exposure, so this is the most hated sector.

 

14) What is in store for the US economy in 2012?

 

There is a sharp divide in the approach to recession forecasting.  The ECRI has made an aggressive forecast of an inevitable recession.  At first they provided no time frame, but now they have narrowed it to the next six months.  They went to a 100% probability without any real notice.

 

The problem is that their methods are secret.  My review of several other sources, which I started long before the ECRI call, shows that most disagree.  Many of these sources have been just as good with real-time forecasts, but less publicized.

 

None of them has a recession forecast higher than 25%.  The mainstream economic forecast is for growth higher than 2.5%.

 

To summarize, my base case is continuing modest growth, improving from 2011.

 

15) Economic indicators as a whole came in better than expected in the fourth quarter.  Do you expect this trend to continue in the first part of 2012?

 

Yes.  There was improvement early in the year.  There was an external shock from the earthquake and tsunami, as well as problems in the Middle East and higher fuel prices.  You could interpret that slowdown as the result of temporary factors, or the onset of a recession.

 

The pseudo crisis around the debt ceiling led to another economic threat.  Through all of this, the base case from many indicators that I watch has been economic growth of about 2 to 2.5%.  This is now looking a bit stronger.

 

16) What is your take on the employment picture in the US?  Will we see the unemployment rate get below 8% by Election Day?

 

If current economic trends continue, net job creation will improve quite a bit, taking unemployment below 8% by Election Day.  The controversy over labor force participation will rage on.  There is no question that some baby boomers are leaving the labor force early and also that many people are under employed.  We also will have returning soldiers.  I cover employment pretty extensively, including aspects generally missed in the mainstream coverage.  http://oldprof.typepad.com/a_dash_of_insight/2011/11/who-gets-the-jobs-story-wrong-everyone.html. 

 

17) Are Ben Bernanke and the Fed helping or hurting the recovery?

 

The Fed is an easy target for politicians and pundits.  I am interested in investments; making money no matter who is in power.

 

Bernanke is a Republican, reappointed by a Democrat.  He has done good service, unappreciated by many.  It is interesting to note that Fed critics are of two camps:

 

-Those who think they should have done less: the crash and burn group

-Those who think they should have done more: the activist wing

 

The two wings agree on one thing: The Fed is wrong!

 

18) The Fed's Zero Interest Rate Policy (ZIRP) has really hurt savers and anyone out there looking for yield.  Where should investors go to find yield right now?

 

I understand that the question talks about the effect of ZIRP rather than the reasons, but we should all be clear about that.  The Fed had a dual mandate:  inflation and employment.  They do not have a mandate to provide a guaranteed income for savers.  Those making this argument typically have an intense political agenda: one that is hazardous to your investment health.

 

I have written a series of articles on "The Quest for Yield."  It was one of the most popular series on Seeking Alpha and also on my blog.  It reflects the great interest in the topic.

 

My conclusion is that it is possible to get an excellent income stream (10% or so after fees) from a combination of buying strong yield stocks and writing call options against the positions.  It takes a lot of work, but it is worth it.

 

My idea of a strong yield stock is not just a mechanical search for the highest yield.  I would rather have a 3% yield from a company that will maintain the dividend and also the stock price over five years.  Selling calls against these positions is very profitable right now!

 

19) The housing market continues to struggle.  Are we close to making another bottom in residential real estate?  Are there specific areas of the country that you are more bullish or bearish on?

 

N/A

 

20) Will the Dollar (US Dollar Index) be up or down in 2012 and why?  Are there any other currencies that you have a strong opinion on?  How much trouble is the Euro in?

 

There is a fundamental relationship that investors should understand.  As long as the US has a negative trade balance, the dollar must move lower.

 

21) Gold has underperformed stocks in recent months.  Will this continue in 2012?  Will gold see gains in 2012?

 

I do not know how to value gold or gold stocks on a fundamental basis.  The price is a function of two wildly disparate fears: hyperinflation and worldwide economic collapse.  Both of these concepts are easy to sell to a gullible public and the profit margins are high.

 

Since I have no pressing fear of either inflation or disaster, I am not currently a gold enthusiast.  I want to emphasize that I am open-minded and have often included precious metals in my portfolios.  I just do not think that this is the time.

 

22) The ratio of platinum to gold is currently at its lowest level ever (platinum is actually cheaper than gold right now).  Is platinum a good buy relative to gold?

 

N/A

 

23) Where is the price of oil headed?  How about the spread between Brent Crude and West Texas?

 

The general trend of energy prices is higher.  In China we have 25 million drivers and a billion to go.  The headline risk is also for higher prices.  This is only a matter of time.

 

There is already arbitrage activity between Brent and WTI, so the gap will close.

 

24) What are your predictions for the 2012 election?  Which party will win the Presidency, the House and the Senate?  Who will become the GOP nominee, and what are the chances that nominee will beat President Obama?

 

As a former poli sci/public policy prof, and a student at the top school for election analysis, this is right up my alley.  Despite this background, I think it is too close to call.  My guess at the moment is that Obama will win, mostly because the economy is improving and there is no strong opponent.  My further guess is that Romney will get the nomination, beating out a weak field.  It is still very early.

 

I suspect that we face at least two more years of divided government, with the GOP keeping control of the House.

 

That is interesting.  What do you mean by weak field?

 

Many of the candidates have solid traditional credentials, but they all come with some electoral "baggage."  The GOP establishment has struggled to find their candidate.  The primary process is really not ideal for finding either the most qualified candidates or the most electable.  At the moment, no one seems to combine the themes that resonate with the right personal charisma and traditional values.

 

25) How will the elections impact the stock market in 2012 and beyond?

 

This is a really great question, but it is too soon to answer.  I can do better when the GOP candidate is known.

 

26) Will the US Supreme Court rule that ObamaCare is unconstitutional?

 

No one really knows the answer to this excellent question.  If the ruling goes with the established political lines, the answer will be "yes."  There are challenges to two justices already, suggesting that they should recuse themselves from the decision because of conflicts.  The key question, whether people can be required to buy insurance, has many analogies and is quite thorny.

 

A good question for investors would be how to find stocks that will benefit from clarification, regardless of the decision.  That is a current research topic for my team.

 

27) How do you see the US tackling its debt problems in the years ahead?

 

The Simpson/Bowles approach is sound.  There must be a sacrifice on entitlements and also an increase in tax revenue.  People get the government they vote for.  In 2010 the country voted for divided government with an aggressive minority opinion that could block most compromises.  We are now seeing the results of that decision and a general lack of leadership.

 

The most difficult problems can best be solved right after an election, a time when we can hope for a brief spurt of bipartisanship.  Unfortunately, we seem to be in a perpetual election mode.

 

28) What are the biggest threats to the global financial system right now, and are they avoidable?

 

N/A

 

29) Hedge funds as a whole underperformed the S&P 500 in 2011.  How will hedge funds perform in 2012?  What is your take on the hedge fund model in general?

 

N/A

 

30) Will the following be up or down (positive or negative) in 2012?  Where noted, what are your 2012 year-end price targets?  The price targets are meant to obtain a wisdom of crowds consensus number from all Roundtable participants.

 

-S&P 500 (up or down and year-end price target) Up, say 1450.

-Long-Term US Treasuries (up or down) Price Up, Yields Down, 3.2%

-Corporate Bonds (up or down) The yield spread with Treasuries will get tighter, but the overall yield will move higher.

-Junk Bonds (up or down) Perhaps not much change. Higher overall yield and less risk.

-Gold (up or down and year-end price target) No opinion.

-Oil (up or down and year-end price target) Up about 20%.  The underlying trend is positive and the risks are all to the upside.

-Dollar (up or down) As long as the US has a trade deficit, the dollar trend will be lower.

-Average US Home Prices (up or down) There are recent signs of bottoming.  We need to see improvement on employment for a real change here.  GDP would be better if we just stopped the decline.

-China's stock market (up or down) No opinion.

 

31) Please provide readers with any stocks that you really like right now for 2012 and beyond.

 

I look first for themes, next for sectors, and finally for stocks.  I like a number of big-cap stocks as cyclical and tech plays, including Caterpillar (CAT), Intel (INTC), and Microsoft (MSFT).  There are other similar names.  I like energy stocks including Diamond Offshore (DO) and Chevron (CVX).  I expect financial stocks to rebound so JP Morgan (JPM) is a leading candidate.

 

I think that housing and health stocks will be winners, but it may be a bit early for these names.

 

32) Where is Apple headed as both a company and a stock?  How about Google?

 

I love Apple, and I have held the stock for many years.  I do not think that the markets for their products have maxed out.  The stock is cheap on an earnings basis, especially allowing for the cash and liquid assets.  It is a stock that I buy for new clients on day one.

 

I understand that Google has had some similar growth metrics, but it has never qualified on my criteria.

 

33) Facebook is expected to IPO in 2012.  Would you be a buyer or seller of the stock at its opening price on the day it goes public?  How long would you hold it?

 

None of the recent IPOs have been attractive for the open-market buyer.  It just seems like many people need gains and are trying to hit a home run.  They are also substituting familiarity with the product for knowledge about value.

 

34) Which technologies are you currently the most bullish or bearish on?  Are any of them game changers like the PC or the Internet were?

 

N/A

 

35) What are the website, magazines, newspapers, books, apps that you use the most and would recommend others to use?

 

This is another good question.  I read many sources, including the work of my colleagues in this Roundtable.  It is difficult to answer without leaving out something important.  Most people do not have the time or opportunity to follow as many information sources.

 

I have a list of favored sources on the blog.  My weekly column, Weighing the Week Ahead, has many citations every week, highlighting the sources that I find most useful.

 

I religiously read Abnormal Returns as the principal gateway to news, Bespoke Investment Group for top notch research and charts, Charles Kirk for both links and a trader perspective, and Calculated Risk for comprehensive coverage of economic news.  But these are just my starting points. 

 

36) What are your favorite Twitter feeds?

 

This is difficult to narrow down, since I follow different feeds for different reasons.  Since I make my own market decisions, I do not rely much on those calling for short-term market moves.  I follow many political commentators, mostly as general background.  Simply put, I know which feeds to monitor for the topic of the moment.

 

 

You can see who I follow by checking out https://twitter.com/#!/dashofinsight.  For a favorite non-market feed try https://twitter.com/#!/MikePereira to get authoritative answers on NFL officiating and https://twitter.com/#!/BorowitzReport for an irreverent (but liberal) take on politics.  I am a bipartisan consumer of political humor.

 

37) Do you have any other advice that you would like to share with readers as we enter 2012?

 

 

It is important to be open-minded about your investments, especially the global macro themes.  We are in the political silly season, where many people have strong motivations behind their economic arguments.  Most of those making comments are not trying to help your investments.  I recommend that you join me in being politically agnostic, willing to make strong investment returns no matter who is in power.

 

 

I also keep an open mind.  While I think that I can make the best returns for those willing to be aggressive, my main focus is on risk.

 

 

Most investors want to be cautious.  The downside is more important to them than gains.  They want to sleep at night.  I respect this and have created enhanced income programs that will suit these investors.