An eclectic approach to better trading and investing. Finding market inefficiency. Discussing and applying the best ideas and methods from several disciplines.
If you are reaching an important investment decision, I have a suggestion for you:
Insist on data -- accept nothing less!
Investors should monitor diverse sources of investment information to avoid confirmation bias. If you want to succeed, you still need to engage in critical thinking. Some are in complete denial about progress. There is a simple solution if you do not like the reality of strong corporate earnings:
Talk about "normalized earnings."
This has a wonderful scientific feel to it, lending an air of credibility to those who have not studied the subject. After all, don't we want our estimates to be "normal?"
If the current strong earnings reports do not fit your forecast, you can just say that you want to "normalize" earnings without offering any clue about your method or how it has worked in the past.
Background
When the recession hit, there were many observers who felt that even the finest companies would be crushed by the economic collapse. They expected that revenues would fall, expenses would increase, and profit margins would collapse.
Some of us thought that the best companies -- not all -- would learn to get "lean and mean" and would increase earnings rapidly during the rebound. We were right, and we have profited from this investment.
The increased earnings had a downside, since it often came at the expense of workforce reductions, with remaining workers asked to do more.
The Recovery
During the recovery period, the companies with enhanced productivity have blossomed -- better earnings and better cash flows. There is a clear lesson:
Profit margins went higher as pricing power and employment went lower.
I disagree with some observers (sometimes accused of being perma-bulls) who think that profit margins have achieved a permanently higher level. My own conclusions are more nuanced. I fully expect profit margins to decline, and I am interested in two questions:
When?
How far?
We should all be open-minded about the eventual profit margin level, which is a function of (primarily) new competitive entrants. When it comes to a topic like -- for example -- unemployment -- the bearish pundits are eager to embrace the idea that there have been structural changes. OK -- and what about the many companies that are protecting their profit margins?
More importantly, I agree with the general concept that profit margins will decline. At the same time this "mean reversion" occurs I expect all of the things we associate with a strong recovery: Better employment, better pricing power, and more aggressive competition from new companies.
There is nothing surprising about any of this, since it reflects a typical business cycle.
Time to call "FOUL!"
There is a group that I'll call Pundits in Denial. They engage in static analysis, expecting profit margins to decline while nothing else changes. As a result of this misguided analysis they help to scare the daylights out of the average investor by stating that if earnings were "normalized" ---what a wonderful word!! -- then the market is massively overvalued.
How to Normalize
When I am analyzing a stock with cyclical properties, I definitely consider the earnings at peaks and troughs of the business cycle. This is one of the key elements of my edge, so most people have no idea about how to do this. If you are at a business cycle trough, you must be willing to buy cyclical stocks at a high P/E multiple -- and vice versa.
To do this correctly you need to have a good theory of the business cycle and where we are right now.
You cannot just take a meat cleaver to earnings, saying that you reject the data because of profit margins.
Investment Conclusion
If you want to gain an investment edge you have to find something that most people are doing wrong. Investing in cyclical stocks combines common errors on profit margins, economic strength, and where we are in the business cycle.
I have a current emphasis on this theme, but today presents an outstanding candidate in Caterpillar (CAT). I had several stocks in mind for this article, but CAT is the most timely. I am choosing it as the worst-performing (and therefore the best opportunity) of stock fitting this theme, since the stock sold off today despite a good report. Here is the long-term earnings picture (from the excellent fastgraphs source) before today's report:
Any investor who looks at this chart for a minute or so will be far ahead of most of the people they see in TV! You can see for yourself the worst case of earnings during recessions, the general growth rate, the ability of the company to deal with recessions, and the current potential.
Nothing in today's report upset this story, so you get a chance to buy a terrific stock at a discount.
Once again, I abbreviated this story to cite the stock with the best current opportunity. Another candidate to feature in this story was Apple, but that would have been a layup! I hope readers understand that there are many, many stocks like this.
To repeat the main point -- "normalizing" profits is not as obvious as it first seems.....
A press conference where Bernanke will try to explain it all.
Most of this transparency is pretty new, and it is still controversial. One reason is obvious.
In the old days, when no one expected a policy change, there would be no reason for fixation on the Fed. There is now much more to analyze.
I'll offer my ideas on what to expect in the conclusion. First, let us do our regular review of last week's news and data.
Background on "Weighing the Week Ahead"
There are many good sources for a comprehensive weekly review. I single out what will be most important in the coming week. My theme is an expert guess about 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
Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:
The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
It is better than expectations.
The Good
The general economic data continues to be a little soft, while earnings have been very good.
Building permits show solid growth. In my experience this is the best leading indicator. Steven Hansen does a nice job on this indicator, which the ECRI should probably consider including instead of housing measures obfuscated by foreclosures.
Earnings reports are very good so far, via Bespoke Investment Group. As you look at this, please keep in mind that many claimed that earnings estimates were too high and should be moved lower.
Earnings and revenues. One of my pet peeves is a general lack of accountability on earnings expectations. Remember when the earnings rebound started? Here is Dr. Ed Yardeni's account:
"When the bull market first started in 2009, the bears growled that the rebound in earnings was all attributable to cost cutting. So it wasn’t sustainable, in their opinion. They didn’t believe, and couldn’t imagine, that revenues might actually have a normal recovery too. I track three measures of business revenues, which are all at record highs now."
Rail traffic was solid if you ignore coal. Steven Hansen at GEI has been doing a great job with this series. This table tells the story -- solid except for coal.
Too much focus on the trees -- and neglecting the forest. We should all keep in mind the overall picture coming from creativity and innovation --- via Abnormal Returns and Barry Ritholtz.
The Bad
The economic news was disappointing, with everything a touch worse than expected. If the list is not enough for you, check out a source that even sees employment growth as bad (via Todd Sullivan).
Initial jobless claims moved higher, to 387K and revisions were also higher. The times include the final week for the April employment report. While many observers opine that this will be better when the unusual seasonal factors are resolved, I continue to be concerned about the jobs numbers in two weeks.
The Philly Fed was a bit light at 8.5 versus expectations in the 10 range and 12.5 last month.
Assorted political salvos. I hardly know where to start. Each party is proposing legislation that has no chance of passage. The GOP has a choke point in the House and also preventing 60 votes (required to block a filibuster) in the Senate. The President can veto any bill and the GOP has no chance of a 2/3 vote to override. I have a long list of links from last week, but I think it is better handled as a separate article. Let us just say that political debate is descending to the lowest common denominator (see here for examples). Jeb Bush warns to expect the most negative campaign ever.
Vehicle traffic has moved lower, especially with an adjustment for population. This is an interesting and creative indicator from Doug Short.
European debt continues to be worrisome. While the scheduled auctions met sales targets, the rates are high, so I am putting this in the "bad news" category. The Spanish 10-year note was trading at the 6% level and the Italian equivalent at about 5.5%. I monitor these daily. While I still believe in a broad compromise settlement involving many parties, there is obviously an attack in the CDS market. I encourage readers to check out Cam Hui's commentary. I invite other recommendations for good sources in the comments.
The Ugly
This week's Ugly award goes to the stock-picking robot -- ready to help you find instant gains in penny stocks. The economic and investment losses have created a new level of desperation. There is a dramatic increase in both perpetrators and victims.
The robot team had a business model that profited in all of the key ways:
Selling bogus software to clients. The software developers were told that the program needed to appear to be analyzing data, but actually taking direction from the scammers.
Selling pump-and-dump services to companies. Results guaranteed.
Front-running the suckers.
This is a constant battle. I want to give credit to the SEC, but it is frustrating. I have reported a number of obvious scams. The SEC does not let you know what happened. They do not even acknowledge your contribution. Two groups that I reported were the subject of later action, but some are still at large.
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
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.
The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon. Bob also has a group of coincident indicators. Like most of the top recession forecasters, he uses these to confirm the long-term prediction. These indicators are not close to a recession signal. For his subscribers, he offers the following conclusion:
"I now find myself in statistical opposition to all those who are calling for a cycle peak in 2012. I use the “statistical” qualifier in that sentence because after doing this for more years than I care to admit, one has to be cognizant of the fact that strange things can happen. So it is possible, but highly improbable, that the conditions associated with a cycle peak could present themselves before we “turn the page” on 2012."
Bob has his usual exhaustive analysis with many charts. His analysis is erudite, comprehensive, entertaining, and witty. Here is a single chart summary, but you should understand that all show the same thing.
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. The data point that I cite each week (the four-month recession outlook) is only one aspect of a comprehensive report. The SuperIndex includes nine different methods, including the ECRI. The analysis has a very strong, practical market application which has paid off richly for subscribers over the last few months. How? Mostly by putting the ECRI recession forecast into better perspective. I am publishing the one-month delayed Leading SuperIndex estimate of recession probability in the near future -- three or four months. This is plenty of time to have value for public followers of their reports.
Two weeks ago they added another interesting recession indicator, finding states that show economic changes in advance of the nation. You will be surprised at which states are the "canaries in the coal mine."
Last week Dwaine teamed with Georg Vrba to analyze the unemployment rate as a recession indicator. It turns out that this single measure has terrific results. It currently suggests, "One can therefore reasonably conclude, based on the historic evidence of these unemployment-based indicators, that there will be no recession in the near future and that ECRI’s recession call may have been premature."
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. This week we shifted from bearish back to neutral. The last several weeks have been pretty close calls. The ratings have improved a bit. The inverse ETFs are no longer at the top of the list, so I would not be surprised to see a little buying next 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. For daily ETF commentary from Felix, you can sign up for Wall Street All-Stars, where I still have a few discounted memberships available. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
While I expect the Fed to be the main story this week, there will be plenty of other action.
Before the trading week even starts, we will have the first round of the French elections. Normally this would not be a major consideration for US stocks, but this time is different. A loss by incumbent Sarkozy could lead to dramatically changed policies for France, with other countries in line. This could affect the euro, the European economy, and also US stocks. This Washington Post summary lays it out nicely. That will be Monday's story.
I am interested in Consumer Confidence (Tuesday) and Initial jobless claims (Thursday) as important coincident reads on the economy. Q1 GDP -- the first reading -- will be reported on Friday, presumably confirming that the economy weakened a bit but was not close to a recession.
This is the big week for housing data, including Case-Shiller prices, FHFA prices, new home sales, and pending home sales. Housing is important, of course, and some see signs of improvement. I am not expecting much from these reports.
It is also a big week for earnings reports. It could well be an exciting week.
And finally -- Tuesday will give us the BLS Business Dynamics Report. This is the one that shows whether the employment estimates from 8 months ago were accurate. Everyone should be watching this, but I will probably be the only one reporting!
Trading Time Frame
We were out of the market last week in trading accounts, after a long period when Felix caught the rally pretty well.
The current market has been confusing to many top professionals, as I reported last week in this article featuring commentary from Art Cashin.
Investor Time Frame
For investment accounts I have been buying on dips in stocks that we like. I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look.
Investors should not be trying to guess the next market move. Instead, take what the market is giving you. I have been offering this advice for months, and it led to a great quarter for anyone taking heed.
If you are an investor who has been frustrated by a market that ground relentlessly higher, providing no opportunity for entry ---- well--- what are you waiting for now?
I want to emphasize that being an investor does not mean "buy-and-hold" or a "forever" portfolio. I believe in active management of investment accounts, adjusting for changed circumstances. We need to look beyond the headlines, political commentary, and those profiting from the climate of fear.
There is an important difference between short-term market timing and active management of your holdings.
I look at the following:
Recession risk -- now very low.
Earnings growth -- excellent and undervalued.
Financial stress -- high on the headlines, but modest on the data, falling rapidly.
If you are really worried, you can imitate our enhanced yield program. Buy good dividend stocks and sell short-term calls. I am targeting 8-9% returns on this approach, and achieving it no matter what the market is doing. You can, too.
Final Thoughts on the Fed
When I put on my trader hat, focusing on the attitudes of those on the front lines, I know what is important.
Traders want more of that QE!
The trading perspective is that the economy is weak and the Fed does not get it. Traders -- and therefore the "market" in the short term -- want to see the Fed doing more. At the most fundamental level there is no need for a deep explanation. The last two years show a pattern which (to a very forgiving eye) seems to show a market that rises when the Fed is active and declines when it is not.
While I disagree with this interpretation, success in trading means understanding the perspective of everyone else. The Fed policy has had much less impact than traders believe. Here is a helpful chart from Doug Short.
For investors, more twisting is not a big deal. For traders, it is.
Let me start with a proposal about politics that would get wide agreement:
The 2012 election will be significant for the economy and the financial markets.
Getting a handle on this requires understanding the nature of the American Voter -- a special breed. The long series of election studies shows that voters have strong opinions but often lack information.
The latest story on this line cited a Pew Poll asking people a simple question: Who is the Chief Justice of the US Supreme Court?
If you know the asnwer, put yourself in the top 25% of the population. I understand that most people might not know, but some responses are amazing. 8% said "Thurgood Marshall" proving that they had heard of this famous Justice and former Solicitor General. They did not seem to know that he had never been the Chief Justice nor that he died in 1993. 4% cited Harry Reid! A little confusion of the branches of government.
A few years ago I reported that 80% of the people could name two of the Seven Dwarfs, but only 30% could name two Supreme Court justices. Who do you think is the best-known Justice?
Background
As a former poli sci prof, I have studied every presidential election since Truman in 1948. As an undergrad student, I did an analysis of voting data on the Kennedy/Nixon debates in 1960. When I started in the financial markets in the late 80's I looked to the analysis of politics as something that would provide an investment edge -- and it has.
I do not engage in political advocacy at "A Dash." I am a political agnostic when it comes to investing -- seeking to profit no matter who is in power. I have opinions that I share with friends and express in the voting booth.
Here in Illinois we have our own system of term limits for politicians: One term in office and one in prison! I have voted for officials from both parties.
I am trying to put this expertise to work, but the crystal ball is still cloudy for this year.
The 2012 Election
I have not yet suggested investment conclusions for this year, but it is an active research project. It was only last week when we learned, for sure, the GOP nominee -- my prediction in my January year-ahead interviews. We can now start analyzing the actual policy differences, as opposed to the skirmishes we are already seeing this week.
Each week will provide some additional clarity, but there is a problem.
The most important issues for investors require significant knowledge and analytical skill. The most salient issues for voters are things that anyone can understand.
We can see this taking shape.
Investor issues include the following:
Economic growth -- stimulus, the Fed, and deficits.
Regulation -- more or less. Big business or small.
Health care -- how much and how to deliver.
Supreme Court Appointments -- judicial philosophy and policy dispositions.
Foreign policy -- leadership, peacemaking, diplomacy, and command skill.
and we are just getting started.
Things of interest for the electorate include the following:
Treatment of pets no matter how long ago. (LBJ caused a controversy in playing with his dogs, "Him" and "Her" by lifting one by the ears -- picture below).
What someone in the campaign said about the role of mothers and work.
How quickly we should fire misbehaving government officials.
Whether the leader ever changed his mind about something.
Notice the difference in the knowledge and skill required. The latter list of topics is something where everyone can have an opinion with little information. The opinion is based upon everyday experience. Yours is as good as mine.
Investment Conclusion
The big issues will eventually be important, but I do not see it so far. At the moment we just have a spectator sport. There is no reason to jump the gun with investment picks.
As part of my work I speak with smart people from differing backgrounds:
Individual investors -- clients and potential clients;
Business leaders -- colleagues on corporate boards;
Leading economists and journalists -- both groups well-represented at the recent Kauffman Conference;
Colleagues in the blogging world.
There is an interesting pattern. Most of them feel more confident about their personal circumstances, but they are worried about everything else. When it comes to the stock market, the fear is palpable.
Even the pros are struggling to get a handle on this market. Readers know that I love Art Cashin. A good friend gave me an autographed copy of his book. I have been reading his daily wisdom since I started in the business in 1987. He really does have the pulse of the NYSE floor. When Art says that the normal yardsticks are not working, we should all pay attention.
If Art and the NYSE traders find the market confusing, the rest of us are in good company!
Finding Clarity
There are two perspectives -- trading and investing -- with differing time frames. I explained this here, and I encourage everyone to read it as background.
The traders must deal with all of the issues Art Cashin raises. Our Felix model finds it all confusing, and has sent all of our 28 trading sectors to the penalty box. Felix realizes that traders should not press when confidence is low.
The investor perspective is more interesting. My email and comments suggest that the most helpful work I have done relates to explaining something called "the wall of worry."
When I first saw this term, I confess that it seemed rather silly. As an academic who began an investment career with some basic confidence in the efficient market hypothesis, I expected fresh information to be quickly reflected in market prices.
I soon learned that this was not true. Warren Buffett (one of my heroes, and we all wish him the best) put it well when he said, "I’d be a bum on the street with a tin cup if the markets were always efficient.”
This meant that an astute investor could beat the market, but it required better methods.
The single biggest source of investor profit relates to evaluating what many call "market fundamentals" and others call "headwinds."
A List of Worries
Here is a list of worries for your consideration:
ETF liquidation doomsday scenario
Flash crash -- and overall worries about market manipulation
Bush-era tax cut expiration
Collapse of the euro and/or European Union
The Hindenburg Omen
Increase in US budget deficits
Ominous head-and-shoulders pattern in market averages
Dow 5000
Dow 2000
Dow 1000
The collapse of the US consumer
The double-dip recession
Sell in May
Sell in October
Sell, Mortimer, Sell (OK, I sneaked that one in for those who know).
The BP spill
Fear of Obama
Obamacare
Weakness in the dollar
Strength in the dollar
Weakness in China's economy
Strength in China, leading to higher rates
Korea
Iran
Initial claims spiking to over 500K
Initial claims falling, but results skewed by seasonality
Shadow housing inventory
Foreclosure robo signing
Overstated and exaggerated corporate earnings
Fed blunders -- QE II
High frequency trading
Worldwide collapse and deflation
Worldwide hyperinflation
If some of these seem a bit outdated, you are reading carefully. The list is from December, 2010.
It is a good look back on the history of worries. Readers should note that worries and headwinds are not quantified. Anyone can deal in words and anecdotes. It requires some expertise to include data. Those of us who have been data-driven have beaten the anecdotal crew by a wide margin.
Current Worries
Let us turn from the old list to the most important issues raised by current market skeptics. Dick Green at Briefing.com examines the most important "bearish arguments to ignore."
Dick hits a number of themes that will be quite familiar to regular readers of "A Dash." Here is his list:
"The Bearish Arguments That Are Wrong
Three of the most persistent bearish arguments were highlighted in a recent article on a major financial web site.
The arguments are:
1) Market valuations as measured by Price/Earnings (P/E) multiples aren't low. 2) The 10-year Shiller P/E shows stocks overvalued. 3) Profit margins are high and using a "normal" profit margin shows stocks are overvalued."
I strongly urge readers to check out his article. He explains that these methods are backward-looking, do not reflect interest rates, and assume that margins will mean revert without any corresponding change in employment or gross revenue.
As I said -- arguments familiar to (and profitable for) readers of "A Dash."
A Final Thought
If you are an investor who is not mesmerized by fear, you will be able to join me in doing two things:
Finding stocks that have strong anticipated earnings and cash flow.
Finding stocks with strong dividend yield.
The Wall of Worry is a difficult concept to explain, and even tougher to appreciate in real time. The daily stories seem so tangible --- often augmented with TV video.
For a free education on this topic, you could dip into my archives.
For those in agreement on the economic theme and Europe, I like JP Morgan Chase (JPM), Caterpillar, Inc (CAT), Aflac (AFL), and Oracle (ORCL).
The dividend yield concept is more challenging, since I have an ever-changing roster of great dividend stocks where we sell calls to enhance the yield. Intel (INTC) and Abbot (ABT) are among the recent choices.
Game time! Earnings season -- with special significance.
It is always important.
Owners of growth stocks can be especially vulnerable to a missed quarter, since an earnings miss affects both the "E" in the P/E ratio and may also lead to a lower multiple.
Owners of cyclical stocks
Even owners of dividend stocks need enough growth to provide support for current and future yield.
This time the earnings story is even bigger. It is objective, non-government evidence of the state of the economy. Market skeptics insist that earnings estimates are too high and "must move lower." They expect that the reduced pace of economic growth and problems in Europe have put pressure on profits.
I'll offer some thoughts about the earnings season in the conclusion, but first let us take our regular look at last week's data and events.
Background on "Weighing the Week Ahead"
There are many good sources for a comprehensive weekly review. I single out what will be most important in the coming week. My theme is an expert guess about 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
Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:
The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
It is better than expectations.
The Good
Despite the stock market reaction, there were some bright spots in last week's news. These were probably less important than the bad news, but still worth noting.
The trade deficit for February was "only" $46 billion, much lower than the expected $51.7 billion. The significance is that this is a boost to Q1 GDP, as everyone will soon see. Check out the coverage and charts at Calculated Risk.
Bank lending is improving at a six-month annualized rate, a post-recession high (see the chart from Scott Grannis).
The quit rate is higher, according to the JOLTS report. People quit jobs more frequently when confident about the employment market. Churn is also good. Check out Mark Perry for a further explanation. Mark's chart shows the improvement, but also that we have a long way to go.
Sentiment indicators are bearish. Since these are all interpreted as contrarian signals, this is bullish. Pragmatic Capitalism cites the AAII survey at a seven-month low. Mark Hulbert draws a similar conclusion from his index of market timers.
Inflation reports were pretty good, whether you looked at PPI or CPI, core or headline. For the most comprehensive analysis and comparisons, see Doug Short's chart collection and commentary. There is something for everyone -- even those of the ShadowStats persuasion can see some relevant comparisons. With the current focus on energy prices, I would like to feature this informative chart:
The Bad
The most important economic news was negative.
Multiple Fed speeches did not satisfy. There was a lot of talk, but the market does not have confidence in the Fed management of the economy and craves more QE.
Rail traffic declined again.Steven Hansen's thoughtful article has plenty of helpful charts. In the past he has identified coal shipments as the main cause, but now sees a broader decline.
China's GDP growth was still above 8%, but lower than the whisper numbers (close to 9%) that helped to fuel the Wed-Thur market rally. Global Economic Intersection has a good summary article that shows both the weakness as well as some bright spots while citing varied perspectives.
Spanish debt yields pushed back to the 6% level seen by many as a trigger point for membership in the bailout club. This was a big factor in Friday's stock market weakness, since it is interpreted as a failure of the ECB's LTRO policy. Has it worn off so soon? One good indicator is the spread versus German bonds, illustrated in this great chart from Sober Look.
Initial jobless claims moved sharply higher to 380K and prior weeks were also revised upward. There is discussion of seasonality and the "early Easter" holiday affecting the timing of claims. We all watch the four-week moving average to avoid some of the noise, but the current pattern is troubling. We need more data, but I am concerned.
Michigan sentiment was a little light. Unlike market sentiment, this is important as a coincident indicator of employment and spending. It seems to have stalled in a range usually more associated with recession than with healthy economic growth.
The Ugly
North Korea had another failed rocket launch. This seems to signal that Kim Jong-un is continuing his father's policies of confrontation rather than negotiation and conciliation. Some think it is too soon to expect a change from policies that were already in motion.
It is difficult to gauge all of the consequences of a military confrontation at this flash point. It has the immediate effect of altering the perspective on defense spending. There is good coverage of this, as well as the likely political implications, in this article from The Hill.
The Silver Bullet
I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. Think of The Lone Ranger.
This week's award goes to David Merkel, a proven ally of the individual investor, who is on the warpath against penny stock promoters. This problem does not get the attention it deserves. The get-rich schemes are always tempting. Losses in stocks and real estate have made matters worse. You might think that only foolish investors could be taken in, but you would be wrong. Some very intelligent people are among the victims, including friends who would not listen......
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
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.
The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon. Bob also has a group of coincident indicators. Like most of the top recession forecasters, he uses these to confirm the long-term prediction. These indicators are not close to a recession signal.
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. The data point that I cite each week (the four-month recession outlook) is only one aspect of a comprehensive report. The SuperIndex includes nine different methods, including the ECRI. The analysis has a very strong, practical market application which has paid off richly for subscribers over the last few months. How? Mostly by putting the ECRI recession forecast into better perspective. I am publishing the one-month delayed Leading SuperIndex estimate of recession probability in the near future -- three or four months. This is plenty of time to have value for public followers of their reports.
Last week they added another interesting recession indicator, finding states that show economic changes in advance of the nation. You will be surprised at which states are the "canaries in the coal mine."
Here is the latest example, which does a great job of explaining the current ECRI changes in methods.
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. This week we shifted to bearish for the first time since last fall. Last week was a close call and so is this one. The ratings have deteriorated quite a bit. The inverse ETFs are still in the penalty box, but I would not be surprised to see one or more of the in the top three spots this week. Check here for a look at the full list of ratings as of Wednesday's close.
[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. For daily ETF commentary from Felix, you can sign up for Wall Street All-Stars, where I still have a few discounted memberships available. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
I expect earnings to be the main story of the week, although news from Europe was more important last week. Germany has bond auctions on Wednesday, while France and Spain conduct auctions on Thursday. These could be significant.
There are a number of minor reports, but I will be watching retail sales (Monday), building permits (Tuesday), initial claims (Thursday), and leading indicators (Friday). The various regional Fed reports might move the market if far from expectations.
I expect plenty of attention to company statements about global economic effects and their outlook. This is dangerous because there is little reason for management to go out on a limb.
Trading Time Frame
This week marked a dramatic change in our trading accounts. We have been 100% invested since December. Felix caught the current rally quite well, buying in on December 19th, but the picture is now very different as I showed in this article.
We are now only 33% invested and I would not be surprised to see a purchase of one or more inverse ETFs during the coming week. 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, and has stayed invested in the face of a lot of skepticism. This has now changed.
Investor Time Frame
It is always challenging to explain why time frame is important.
There are many roads to market success. Whatever approach you choose, you must test it, believe it and follow it.
If you are a trader like Felix, you will be trying to outguess the other traders, not caring about market fundamentals. If you are an investor (like Warren) you treat short term price fluctuations as an opportunity to buy or sell, dependent solely on your own valuation of your holdings.
If you are an investor who has been frustrated by a market that ground relentlessly higher, providing no opportunity for entry ---- well--- what are you waiting for now?
I want to emphasize that being an investor does not mean "buy-and-hold" or a "forever" portfolio. I believe in active management of investment accounts, adjusting for changed circumstances. We need to look beyond the headlines, political commentary, and those profiting from the climate of fear.
There is an important difference between short-term market timing and active management of your holdings.
I look at the following:
Recession risk -- now very low.
Earnings growth -- excellent and undervalued.
Financial stress -- high on the headlines, but modest on the data, falling rapidly.
I have been more aggressive in adding investment positions. For those who are more worried, I recommend a combination of dividend stocks and the sale of short-term calls for enhanced yield. You can achieve 8-9% in a sideways market.
Our Dynamic Asset Allocation model has also become much less conservative. Gone are positions in bonds and gold. DAA responds to the message of the market, cashing in on extended moves. It is rather like what some call a "lazy portfolio" but better. The DAA approach is finding some of the best sectors over the last year.
Final Thoughts on Earnings
My recommended sentiment gauge for asset allocation is the equity risk premium. It gets to a very high level when there is intense skepticism about earnings -- something we see right now.
The skeptics are elusive and often contradict themselves. They variously maintain the following:
Earnings estimates are too high and need further reduction
Earnings estimates are crashing and need to move even lower
When earnings beat expectations it was because the bar was lowered.
There is no accountability. If a pundit wants to opine on what earnings estimates should be, then how about checking the record of his past comments on earnings?
I prefer relying on facts. If estimates are too high, then we should accept stronger earnings as evidence that things are better than expected.
My personal guess, based partly on reading research reports, is that stock analysts have unwisely become amateur economists. They are incorporating their own opinions about the economy, drawn from reading the newspaper, into their earnings projections. The result is that expectations are pretty low, as you can see from previews in The FT and in Barron's.
It will be an interesting week on the earnings front.
Left Out
Left out of this week's analysis was the Romney victory in the GOP nomination. This is important, of course, but we need to figure out how and why.
This is not a blog about politics, but we do analyze the impact of politics on our investing. I have expected the Romney victory all along. As the issues are more clearly defined, I will generate some investment forecasts.
ETFs provide a great trading vehicle. One of our programs uses a 28-member universe to find the most promising sector for the next three weeks.
I have not provided the ETF updates during the last year, but some readers have subscribed to weekly updates with briefly delayed ratings (available via email to etf at newarc dot com).
The ratings are not just a recommendation of what to buy right now, although that is a very profitable approach. I use the ratings for three distinct purposes:
Overall market strength, reported in my weekly WTWA articles
Finding the best sectors
Using the top sector choices as a starting point to find individual stocks.
Our popular trading model, "Felix", provides the ratings. With this background in mind, let us take a peek at the most recent output. The advice of Felix is something that I had mind when I wrote about the difference between wise traders and wise investors.
Time to buy health care?
This week’s featured ETF is the Health Care SPDR (XLV). This is one-stop shopping for all of the big name health care stocks. The top holdings include JNJ, PFE and MRK, which make up 32% of the fund. The top ten constitute 58%, so the overall concentration is not too bad.
The trailing P/E ratio for the fund is 14 — pretty attractive. The dividend yield is 1.92%
These are metrics for investors. Traders, including Felix (our model) are more interested in the tale of the tape. Take a look at the chart:
Felix does not explain reasons, but I know from experience that a chart with apparent support, a recent high, and a modest pull back usually earns a “buy” rating. These features leap out.
Fundamental Rationale
I usually like to cite other ETF experts on what is happening with the sector, but there is not much recent commentary. From my own analysis I know that health care stocks are part of a strong growth sector, but there is a cloud because of the uncertainty surrounding ObamaCare.
Eventually, these will be good holdings — especially insurance stocks (UNH, WLP) which we hold for some accounts and devices (RMD, SYK) which we also favor. This week there was pressure on some stocks since Ohio is playing hardball on who is authorized for Medicaid.
Model Output
The results of the model as of 04/11/12 are below. For those in this trading program we decreased to only one position. This report shows ratings from our balanced universe — designed so that we do not get too many highly similar sectors in the top three.
Please keep in mind that this is a holding for an active trading program. The model rates this as the best choice for the next three weeks, but this is a question we ask every day! Felix may come up with even better choices, and we will adjust our trading accordingly.
The ratings have two parts — the strength and the penalty box. The strength rating shows how we expect the sector to perform over the next three weeks compared to the historical norm. A rating of 100 is one standard deviation better than average. The penalty box represents our confidence in the forecast. Many astute traders just step away from a confusing market. Felix does the same thing. When we have little confidence in our ratings, the sector goes into the Penalty Box. For some additional information, here is the article where I introduced the system to WSAS readers.
We have NOT been fully invested this week. The top-rated and only ETF out of the penalty box is: Health Care SPDR (XLV). Our median strength has gone negative to -14. There are only 25% of the ETFs that have a positive strength, and some of these are inverse funds. The number of ETFs in the penalty box has soared to 96%. While the model likes health care, the overall message is bearish.
Felix does not anticipate tops and bottoms. Felix has kept us profitably in the market since mid-December. There are now some signs to step back a bit. While the rally may continue, we can afford to miss a few days after such a long run.
Here are the ratings:
[long XLV, SYK, RMD, UNH, WLP in individual and institutional accounts.]
Whenever markets pull back for a few days, fear sets in. You see plenty of stories about how to protect your portfolio, what stocks will fare the best in a decline, and a parade of pundits explaining what is going wrong.
In an election year, it is even worse.
If you are in the market, what should you do? It depends.....
Are you a trader or an investor?
Barry Ritholtz has a great article on this theme, emphasizing the importance of time frame and having discipline geared to your objectives. He includes a number of specific and helpful rules.
Readers of "A Dash" know that I endorse this distinction, making it carefully in my weekly WTWA articles. Despite this, and just as Barry mentions, people wonder why my recommendations may diverge from my market commentary. Since I am managing five different investment programs, geared to different investor needs, the right move depends upon the program objective and the time frame.
As Barry notes, investors should not try to "play the squiggles" based upon their preferred concept of long-term valuation. This is consistent with my recent article showing that none of the big-time pundits is very good at market timing, if you look at actual results.
Traders versus Investors
There are sharp distinctions right now, with differing conclusions. Here are some of the key topics:
The Fed and QE 3
Steve Liesman today offered this analogy. Suppose your doctor gave you a clean bill of health. Alternatively, suppose your doctor said that you were really sick, but he had a prescription for you. Which would you prefer?
For traders, the analogy breaks down because they are all smarter than the Fed. They know that the economy is in dire shape whether the Fed realizes it or not. For them it is all about more QE, since they have become convinced that central bank money printing flows directly into stocks. It is a simple focus on Fed policy.
Investors do better to stick with traditional economic policy and forecasts.
The Natural State of the Economy
Traders seem to believe that the normal state of the economy is recession and this will occur as soon as government stimulus programs end, the "sugar high" wears off, or the "training wheels are removed."
Investors should realize that the normal state of the US economy is is trend growth of about 3%. In the absence of any policy, that is where we will eventually wind up. Specific policy actions may make it happen sooner or later. Right now there is a huge performance gap, as illustrated by Scott Grannis:
Until the gap is closed, things will seem very negative.
How to React to Selling
Traders need to game the system, anticipating how other hot money players will react and beating them to the punch. This can imply trading styles that either anticipate market tops or react quickly when they seem to occur.
Investors should see short-term selling as an opportunity to establish positions at favorable prices. This is a fundamental lesson from the Buffett school -- use your own valuation, not the current market price.
Interpreting Sentiment Indicators
Traders are intensely focused on sentiment, trying to identify "dumb money" (everyone other than them!) and take the opposite side.
Investors seeking to establish new positions hope to find periods of irrational sentiment.
Calendar Effects
Traders are in love with cycles and the calendar. They have scenarios and retracements and sometimes even astrology. If something has worked for the last year or two, it is expected to happen again unless there is evidence to the contrary.
Investors make decisions on fundamental values. The perceived seasonal effects merely provide opportunities to establish new positions or lighten up on those that require rebalancing or selling.
Mistakes
The mistakes come when traders and investors get confused about their roles.
Traders should reduce positions in recognition of the message of the current tape. I agree. In trading accounts we are not guessing exactly how deep a correction might be. Instead we watch the evidence. Some traders may get impatient to "call a bottom" in a normal market correction.
For investors it is quite different. Many have been frustrated for months by a market that moved relentlessly higher, providing no obvious points of entry. Now that there is some selling, these same investors may be unable to pull the trigger for fresh buys.
In our investment accounts we have been waiting to add to positions and we have a shopping list. There are many candidates. Since we think that the short term perspective is wrong on Europe and the economy, we have been buying positions in energy stocks, strong cyclicals like Caterpillar (CAT), leading technology like Oracle (ORCL), and US banks poised to exploit selling by European banks -- JP Morgan Chase (JPM). We also see Aflac (AFL) as a nice back door play in Europe --- good earnings, great business, good dividend, but some holdings of European bonds. This is safer than buying Europe since there is less downside, and yet plenty of upside.
Conclusion
Understanding your objectives and time frame is essential to market success. We often have completely different postures for our investment and trading programs.
If you do not distinguish between trading and investing, it is easy to get caught in a Twilight Zone where you are always doing the wrong thing!
Experienced traders understand that markets rarely move in a straight line.
Staying with a long and strong trend -- either up or down -- is often the most difficult trade.
We expect stair steps and corrections since fundamentals rarely support such rapid changes. The result is that as a move gets more extended, even traders who have played the trend are poised to react.
I have often cited Charles Kirk as the leading source for the trading perspective, and he also has many ideas for investors with a longer time horizon. His chart show (small fee required) is part of my weekly preparation. (I usually cannot cite his findings, since he posts the show on Sunday and I write on Saturday, but this week he advanced the schedule). His explanation for last week was that the market was looking for excuses to sell --and found them.
That makes sense to me, since nothing in the news was that dramatic. The question is whether the same psychology will continue. I'll offer some thoughts on that subject in the conclusion, but first let us do our regular review of last week's data and events.
Background on "Weighing the Week Ahead"
There are many good sources for a comprehensive weekly review. I single out what will be most important in the coming week. My theme is an expert guess about 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
Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:
The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
It is better than expectations.
The Good
There was not much to cheer about last week.
Sentiment is still pretty negative. I like to look at this through data describing behavior rather than responses to surveys. Ed Yardeni looks at fund flows and concludes the following:
"Over the past 36 months through February, net inflows into bond mutual funds totaled $1.0 trillion, while net inflows into equity funds were close to zero. Unfortunately for bond investors, the equity funds enjoyed capital gains of $2.7 trillion over this period, while the bond funds had gains of only $437 billion. Now that bond yields are starting to move higher, those gains are likely to decline. That might convince individual investors to move back into equities."
ISM manufacturing was better than expected at 53.4 versus expectations of 53.0 and a 1 point increase over last month’s 52.4. The ISM’s own research says that this value (if annualized) corresponds to GDP growth of 3.7%. The report internals were generally good with prices paid a bit lower, customer inventories lower, and order backlog higher. New orders were down slightly, however, and inventories unchanged rather than lower. All-in-all, a very good report.
Initial jobless claims declined, but from an upwardly-adjusted number. I am calling this "good" but it is continuing a relatively flat range at the 350K level. Job losses are only half of the problem. We also need job creation. As you can see from Doug Short's chart, a reduction of another 50K or so would signal much better economic health.
The Bad
Most of the economic news was negative. I want to emphasize the employment situation, but I'll start with some lesser indicators.
ISM services disappointed. While services make up more of the economy than manufacturing, the data series is shorter. It is very interesting, but more difficult to interpret.
Auto sales were a bit below forecast and gas prices are higher.
Employment gains were disappointing. Job gains from the establishment survey were only 120K, much lower than expectations of over 200K. This deserves more careful analysis, so I will give it a special section this week.
Interpreting the Employment Data
The monthly employment situation report was a disappointment, for all of the reasons that last month's report was encouraging: light on payroll job gains, negative labor force revisions, bad hourly wages, and a shorter work week. That just about covers it.
Others came out with a "flash report" but investors do not need that, especially since there was no trading on Friday.
Perspective
This chart from Calculated Risk shows the depths of the job losses and how far we are from the needed recovery.
Along the same lines, the Atlanta Fed has a helpful tool. You can plug in a target unemployment rate and a time frame to see what the monthly job gain needs to be to meet your target. Try it!
Sources
For several years I have championed the idea that the BLS measurement of job growth was one of several, and not always the best. I write this in my monthly employment preview (as I did last week). For a long period of time I opined that the official reports were too positive, so I have earned some credibility on this subject.
As I noted in the preview, other methods suggested job gains of about 200K. When we finally know the truth -- after revisions and benchmark adjustments -- this may prove to be correct. By that time no one will care.
The political world uses only the official data. The media world breathlessly analyzes it. As investors, we are free to use many different sources -- and we should.
Range of Error
The official methods involve two different surveys. The establishment survey gives us the official job gain, but it has a confidence interval of over 100K. The household survey has a smaller sample and a confidence interval over 400K. Pundits often forget that this applies to every element of the report, including all of the subgroups.
I wrote an article on this topic four years ago where I emphasized sampling error and the danger of relying on one month. It still reads pretty well. My fellow Kauffman blogger Ryan Avent did the job more persuasively with this interpretation:
"TODAY, the Bureau of Labour Statistics released its March employment report. There is a 90% chance that employment rose by between 20,000 and 220,000 jobs. The change in the number of unemployed from February to March was probably between (roughly) -400,000 and 150,000, and there's a good chance that the unemployment rate is between 8.1% and 8.5%. Reported changes for important subsectors are too small relative to the margin of error to be worth discussing. In all probability, the employment growth has remained close to the recent trend of a 200,000 jobs per month increase."
Please remember that this is just sampling error. The short-term revisions relate to businesses that have been slow in responding. The benchmark revisions have most recently revealed that job growth from new business formation has been under-estimated.
Alternative Measures
The unemployment rate might actually be moving significantly lower, according to Gallup via Bonddad.
Looking at unemployment without attention to seasonality and labor force participation is a big mistake via Steven Hansen.
It all amounts to an unpleasant (but not earth-shaking) surprise via Felix Salmon.
My own take is in the conclusion.
The Ugly
A research project testing investment advisors found that most recommended unsuitable funds that earned them higher commissions. This "sting" used actors to pose as clients.
There are many good investment advisors, and they all start by determining the client's needs and emphasizing the suitability of investments.
Runner up: The President of Hungary plagiarized his doctoral dissertation. This is bad enough, but there are apparently no consequences. He is continuing in office as if nothing had happened.
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
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.
The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon. Bob also has a group of coincident indicators. Like most of the top recession forecasters, he uses these to confirm the long-term prediction. These indicators are not close to a recession signal.
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. The data point that I cite each week (the four-month recession outlook) is only one aspect of a comprehensive report. The SuperIndex includes nine different methods, including the ECRI. The analysis has a very strong, practical market application which has paid off richly for subscribers over the last few months. How? Mostly by putting the ECRI recession forecast into better perspective. I am publishing the one-month delayed Leading SuperIndex estimate of recession probability in the near future -- three or four months. This is plenty of time to have value for public followers of their reports.
This week they add another interesting recession indicator, finding states that show economic changes in advance of the nation. You will be surprised at which states are the "canaries in the coal mine."
Here is the latest example, which does a great job of explaining the current ECRI changes in methods.
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. This week we shifted to bullish after three weeks in neutral. This is a close call, but ratings are improving, including the broad averages.
[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. For daily ETF commentary from Felix, you can sign up for Wall Street All-Stars, where I still have a few discounted memberships available. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
US stocks will start the week under pressure because of Friday's employment report. Futures trading continued for 45 minutes after the report, indicating an expected stock decline of about 1%.
I expect additional pressure from a 60 Minutes segment scheduled to run Sunday evening. The focus will be on continuing problems in Europe, and the preview is very negative. You can check it out here.
The most important economic data include initial claims and the PPI on Thursday and the CPI and Michigan confidence on Friday.
I am not a big fan of the small business optimism index (Tuesday) but the JOLTS report could be interesting.
With everyone parsing everything from the Fed for a hint of more QE, I will quit saying that I do not expect policy implications from these speeches. Someone is going to draw an inference whether it is supported or not! Fed Chair Bernanke speaks on Monday and Friday and Vice-Chair Yellen on Wednesday. The speeches seem to cluster since there is a quiet period right before the FOMC meetings. Speaking of the next meeting, we will also get the beige book on Wednesday. This collection of anecdotal evidence from around the country is compiled by a different district for each meeting. It does set the tone for the interpretation of the hard data, and it is always interesting.
We will get the official start of earnings season with Alcoa, but I do not think this will be a focus until next week. At that point earnings will be very important.
Trading Time Frame
Our trading accounts have been 100% invested since December. Felix caught the current rally quite well, buying in on December 19th. There are more sectors in the buy range, and the overall ratings have declined. 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, and has stayed invested in the face of a lot of skepticism. This illustrates the importance of watching objective indicators instead of headlines. Despite the modest overall ratings, Felix kept us fully and profitably invested for trading accounts, finding the bull market in selected sectors. We have 28 sectors in the universe, so we can be fully invested if there are three strong sectors, even if the market overall is neutral or negative.
Investor Time Frame
Long-term investors should be aware of the continuing rapid decline in 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 has now declined to a more comfortable level.
Even though stock prices are higher than in October, the risks are much lower. I continue to increase position size for risk-adjusted accounts. I am also looking more aggressively for positions in new accounts. Until last week this has been a challenge, since the market has offered only occasional dips to buy.
The continuing reduction in volatility has helped our enhanced yield program, where we aim for 8-9% returns with low volatility. This week may provide some opportunities for new ideas.
Our Dynamic Asset Allocation model has become much less conservative. Gone are positions in bonds and gold. DAA responds to the message of the market, cashing in on extended moves. It is rather like what some call a "lazy portfolio" but better. The DAA approach is finding some of the best sectors over the last year.
Final Thoughts on Employment -- and the Fed
Last week's employment data did not provide much fresh information. The official stats were weaker than expected after a couple of months where the results exceeded other measures. In my weekly article I predicted that seasonal factors could create some problems in interpreting the data.
It is important to get beyond the noisy political and market rhetoric. The broad range of indicators show continuing modest economic growth. Bernanke is likely to act if things get worse. There is no sign that inflation is moving past the Fed's 2% target or that the big Fed balance sheet is turning into excessive M2 growth.
I would not call this a sweet spot (unlike this Bloomberg article), but it is also not a recession.
And Finally -- for Market Timers
I have taken time to explain how many investors are making a big mistake with inappropriate market-timing methods.
Do You Adjust Your Price Targets? Most do not -- and this ranges from market experts to the average investor. Unless you are constantly doing a re-evaluation, you are missing out.
Last week I invited readers to consider the following small quiz:
It is popular right now to find reasons to sell, ignoring the change in market fundamentals. Here is a little quiz?
At market tops, what percentage of stocks are above their 200-day moving average?
What percentage are above that level right now?
Chris Puplava, using a technique from Paul Desmond, classifies stocks as above or below their 200-day moving average, and also whether that average is rising or falling. He observes, "As a bull market approaches a top you should see a large percentage in the topping category (BR, fall) and right now only 3% of the S&P 500 members reside in this category." Here is a helpful table.
Puplava draws the following conclusion:
"What should also be encouraging to the bulls is that the sectors most levered to the economy (cyclicals) are showing some of the strongest breadth, which is important as these sectors are usually the first to top out and enter the BR and BF categories."
We are about to see something really new -- the release of the monthly jobs report on a day when the market is not trading.
Some think this is wrong.
Jim Cramer, with an assist from Larry Kudlow, tried to turn this into a religious crusade. Somehow the decision to release data according to the regular schedule was portrayed as an affront to those observing Good Friday. Here is the link and the video:
Cramer and Kudlow are completely wrong! The US government is not on vacation tomorrow. In this country there is no establishment of a religion, and therefore normal government functions are not geared to religious holidays.
Cramer loves these rants where he gets to lecture to the government officials who really make decisions. Here is the reality:
The employment report delivers information to the entire nation, not just the financial markets. Message to Jim: It is not all about you -- or the markets. Most people are interested in what is happening in jobs and the economy, not what markets do.
Why should the government adjust to the NYSE schedule? Who elected them as the arbiter of what is a holiday? This is a can of worms for the government.
If you had a complaint to make, why did you wait until this week? The announcement schedule has been known for months. Why criticize the government, the SEC, and the NYSE now. Look in the mirror.
Government has never paid much attention to financial markets in making announcements, and this is no exception. It is business as usual.
I'll suggest more about how to trade this in the conclusion. For now, we have extra implied volatility. Making a small adjustment from last month....
Options traders distinguish between actual volatility, recorded and measured from data, and implied volatility. The latter term comes from solving the options models using price and the various known inputs. Typically volatility is the only input term that must be estimated. High implied volatility means that traders of options are incorporating uncertainty in their estimates. With this in mind...
Get ready for maximum potential volatility in a single weekend!
The Data
We all want to know whether the economy is improving and, if so, by how much. Employment is the key metric since it is fundamental for consumption, corporate profits, tax revenues, deficit reduction, and financial markets.
We would like to know the net addition of jobs in the month of March.
To provide an estimate of monthly job changes the BLS has a complex methodology that includes the following steps:
An initial report of a survey of establishments. Even if the survey sample was perfect (and we all know that it is not) and the response rate was 100% (which it is not) the sampling error alone for a 90% confidence interval is +/- 100K jobs.
The report is revised to reflect additional responses over the next two months.
There is an adjustment to account for job creation -- much maligned and misunderstood by nearly everyone.
The final data are benchmarked against the state employment data every year. This usually shows that the overall process was very good, but it led to major downward adjustments at the time of the recession. More recently, the BLS estimates have been too low. (See my prior preview for a more detailed account of this, along with supporting data).
I think the BLS is honest and does a good job, which seems to put me in a small minority of observers. Despite this support, I question the general concept. The BLS tries to estimate total employment in one month, total employment in another, and subtract the two to determine the difference. When you are talking total payroll employment of over 130 million jobs, even small errors are in the range of 100K jobs or more. Meanwhile, smaller discrepancies from expectations are unwisely viewed as significant.
Competing Estimates
The BLS report is really an initial estimate, not the ultimate answer. What we are all looking for is information about job growth. There are several competing sources using different methods and with different answers.
ADP has actual, real-time data from firms that use their services. The firms are not completely representative of the entire universe, but it is a different and interesting source. ADP reports gains of 209K private jobs. Steven Hansen at Global Economic Intersection endorses the ADP method over the BLS result. He has a strong analysis covering many nuances in the data. For those who really want to understand the jobs story, it is well worth reading.
TrimTabs looks at income tax withholding data. The idea is that this is the best current method for determining real job growth. TrimTabs forecasts gains of about 187,000. They have been pretty bearish on job growth. (Their real-time estimate was for a gain of only 45,000, but they came forward and admitted a "calendar quirk" that threw off their forecast. There have been a number of changes in the tax withholding rules, so let's cut them a little slack and give credit for being honest about what happened and their methodology. They provide a useful additional method).
Economic correlations. Most Wall Street economists use a method that employs data from various inputs, sometimes including ADP (which I think is cheating -- you should make an independent estimate). I use the four-week moving average of initial claims, the ISM manufacturing index, and the University of Michigan sentiment index. I do this to embrace both job creation (running at over 2.5 million jobs per month) and job destruction (running at about 2.3 million jobs per month). In mid-year the sentiment index started reflecting gas prices and the debt ceiling debate rather than broader concerns. When you know there is a problem with an input variable, you need to review the model. For the moment, the Jeff model is on the sidelines.
In an interview today with David Malpass, Maria Bartiromo acted like monthly net job creation of 300,000 jobs was an impossible dream. I wish that I had five minutes to talk with her about employment dynamics. If we could increase job creation by 10% (without losing jobs) we would add an additional net job gain of 200-250K jobs per month. That would be a net job gain of 400K or so. No on in the mainstream media seem to understand this.
Trading Implications
What does this mean for our trading and investing?
My basic conclusion is that it is great for our enhanced yield program. A lot of implied volatility will come out of the market by Monday.
Let us suppose that (like Mr. Beeks) you knew the jobs report in advance. How would you trade it?
Investors would like to see economic strength -- a strong report.
Traders have this irrational fixation on more QE from the Fed. The current mantra, made especially obvious by this week's action, is that any perception of more QE is good.
From this perspective, a good report will be bad and a bad report good!
This is why I am not "trading" the report -- just collecting options premiums in a sideways market.
This is inspired by an old game show called "Name that Tune." While the format changed a bit over the years, the idea was that you would hear a few notes and then guess the tune. In some variations contestants could say...."I'll name that tune in X notes...," the fewer the better.
The Current Pronouncement
As stocks move higher, there are more pundits seeing the advance as an opportunity to call the top. With this in mind, here is a statement taken right from the news:
"My main call is about the multiple you pay for earnings.... Why should I pay a higher multiple for earnings produced where you have massive fiscal stimulus, incredibly accomodative monetary policy, by a government whose debt to revenue is worse than Greece? Why should I pay more for those earnings?"
I have some thoughts about this observation, but first a small quiz. Who is the source of this quotation:
A leading blogger of the bearish persuasion.
A leading hedge fund manager, talking his book.
A leading sell-side firm, behind the curve.
A leading bond fund manager, explaining why stocks are still inferior to bonds.
A leading political leader, with any of several motives.
The answer is below, but first a few thoughts.
Choosing the Right Multiple
I am astonished at the wrong-headed analysis in the cited quotation.
When I pick a stock, I focus on the current and future business of the company. I look at earnings, cash flow, the balance sheet, the dividend, stock buybacks, and the earnings growth rate. I am interested in the business model and future prospects of the company.
And finally, I compare each investment choice to the available alternatives. I often find myself in complete disagreement with the top Wall Street pundits, something that has worked well for me for many years.
There are currently many stocks that are very attractive according to this method.
I accept the reality of government policy--and so should you. In democratic societies the leaders do not stand back and watch the economy fail without taking any action. Fed policy -- whether stimulating or restricting -- is just part of the economic landscape. So is fiscal policy.
I change my price targets based upon new information, as I described here.
The idea that a professional would discount earnings because he disagrees with government policy -- or thinks it might not work -- is abdicating his role as objective analyst.
And the winner is......
Any reader who guessed the "sell side" firm. The quotation is not from Tyler Durden, John Hussman, Bill Gross, John Mauldin, or even Newt! Here is the commentary from Adam Parker, Chief Equity Strategist from Morgan Stanley.
Parker and a team of fellow PhD's have taken over the forecasting at Morgan Stanley and have a price target for the S&P 500 of 1157. That is their story, and they are sticking to it!
I have no objection to PhD's; some have been known to make valuable contributions. When it comes to investment analysis I like to see representation from various disciplines. The Morgan Stanley team is overloaded with stat guys. They need more balance, including policy specialists, and most importantly, experts in research design. I see too much focus on being clever with numbers and finding correlations without good theoretical foundations.
They are not alone.
One after another, those claiming expertise in the objective analysis of data are falling into excuses laced with political rhetoric. Watch for the telltale signs from those who used to talk data. Do they now complain about "printing money?" About bailouts? Are these surprises? Things that have never happened before?
Understanding, predicting, and explaining government actions is part of making accurate market forecasts.Learn this or lose.
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