A Dash of Insight

Weighing the Week Ahead: Fireworks in the Forecast?

Forecasting fireworks this week should be pretty safe!

I will have trouble outdoing last week's WTWA theme:  Upside Surprises.  Nearly everyone in the comments disagreed with me.  Sentiment is so negative that you can hardly get a good discussion about what might go right.

We could have more fireworks this week, and not just those on the 4th.  Friday is shaping up to be a big day, with expectations for employment gains pretty low.

Background

The current climate is a torture test for the average investor!

It invites people to act on their least-effective instincts, leading to the worst results.  I tried to explain why this happens in an article last week about those who "explain" the message of the market.  The key point is that most pundits talk about things after the fact and pretend that they predicted it.  Contrast this with last week where I was pretty much alone in suggesting that things might go right.

In sharp contrast, if you look at the markets objectively, most of the big-shot pundits have been proven wrong:

• Wrong on recession forecasts - -made as imminent and unavoidable over nine months ago;
• Wrong on earnings and profit margins -- a multi-year prediction of disaster;
• Wrong on Europe;
• And soon to be wrong on upcoming worries like the "fiscal cliff."

I love Barry Ritholtz's blast from the past.  He questions the current worries about "uncertainty" and compares it to the cold war era.  We both remember that time.  Most people thought that their lives would end from a nuclear war.  Can things possibly be worse now?  He wisely notes that markets thrive on uncertainty.

This is a nice way of describing the "wall of worry" concept that many investors have found to be a valuable idea (0nce they get it).

The fireworks this week may illuminate events and reduce uncertainty.  Only losers will wait for all of the answers.  It is not that easy!

I'll offer some more thoughts on this in the conclusion, but first let's do our regular review of the events and data from last week.

Background on "Weighing the Week Ahead"

There are many good sources for a list of upcoming events.  With foreign markets setting the tone for US trading on many days, I especially like the comprehensive calendar from Forexpros.  There is also helpful descriptive and historical information on each item.

In contrast, I highlight a smaller group of events.  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.

This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting 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:

1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
2. It is better than expectations.

The Good

The most important news of the week was very good.

• Important steps in Europe.  Last week's EU Summit significantly reduces the immediate contagion threat that has affected US stocks.  It improves prospects for European economic growth.  It demonstrates that the process of negotiation and compromise is working.  This is exactly what I have been predicting for over a year -- a process of incremental change with concessions by many parties.  The next thing to expect is more action by the ECB as well as the IMF and others.  (See here for past articles with more detail on what to expect).
• Congress passed legislation on transportation and student loans.  It was a bipartisan effort with significant margins.  Now what about that fiscal cliff?
• US household deleveraging is nearly over.  It shows a path that Europe could follow.  The result is potential for spending if confidence improves.  The entire Scott Grannis article deserves attention and you should enjoy the great charts.  Here is a key quote:

"In any event, households' aggregate debt and financial burdens are now about as low as they have been for the past three decades. That amounts to some considerable adjustments, and I would argue that these adjustments have set the stage for some big changes in the years to come. For example, if confidence in the future increases, households' risk aversion is likely to decline, and the demand for money is likely to decline as well. There are trillions of dollars in savings deposits that households could decide to spend."

• New home sales are stronger.  Bill McBride at Calculated Risk has taken the lead on forecasting this.  He is not getting carried away on the rate of the rebound.  It is the thoughtful and careful analysis that you would expect from him.  I also like Steven Hansen's discussion.  My own role is in helping investors find the best sources.  The key point to keep in mind is that just getting a bottom in housing -- not a rebound -- will help GDP by 1 to 1.5%.

...and by the way, for those who expect an avalanche of foreclosure homes on the market, Bill does not see that either.

• Rail traffic was good, if one adjusts for the coal distortion.  Todd Sullivan has an innovative chart on a topic we have reviewed on past weeks.

• US Consumers have another $250 billion to spend through reduced energy costs.  Great analysis from Prof. James Hamilton.

The Bad

Most of the economic data was a little weaker than expected.  This continues the pattern of sluggish growth we have seen for several months.

• Initial jobless claims remain at the 385K level.  This rate of job loss is inconsistent with more robust growth and solid net job gains.  (contra - Scott Grannis looks at year-over-year and sees nothing close to recession levels).
• Personal consumption is weakening.  See Steven Hansen's balanced analysis of all factors and also note the contrast with the deleveraging cited in the good news.
• Corporate profits fell last quarter for the first time since the recession -- on a seasonally adjusted basis.  (via Catherine Rampell in the NYT).
• Consumer confidence remains weak -- in spite of falling gasoline prices.  This suggests continuing weak employment, concern about poor policy decisions, or both.  There are many charts of this, but I prefer Doug Short's analysis.  It compares the principal confidence measures and also shows past recessions.  Here is the Conference Board chart:

• US Consumers are bearish on stocks via Bespoke.  This impacts spending, so it is not contrarian.

• Earnings estimates are declining.  The Q212 forecast now calls for a decline of 1.1% via Bespoke.

Dr. Ed shows the impact on forward earnings.

The estimates are a bit lower, but there are still solid growth forecasts for the year.  This bears watching.

 

The Indicator Snapshot

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

• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.
• An updated analysis of recession probability.

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 SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events.  It uses data, mostly from credit markets, to reach an objective risk assessment.  The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.

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.  We are working on a modification that will make this method even more sensitive.  None of the recession methods are worrisome.  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 also not close to a recession signal.

There is a lot of activity from the recession forecasters.  The basic summary is that those with the best records still see little chance of a recession in the next six months or so.  The people that get featured  in the press and on TV are sticking by their guns, even though the evidence is mounting against them.

We are now at the end of the nine-month forecast window that the ECRI adjusted to after their September, 2011 call (recession imminent, maybe already here, and unavoidable) seemed to prove wrong.  Since then they have been adjusting indicators and trying to extend the window, which supposedly ends right now -- mid-year 2012.  Here are some good updates:

• The Bonddad Blog notes the failure of the ECRI forecast.
• Georg Vrba asks whether the ECRI is still relevant.  Great analysis and charts.
• Doug Short has the latest economic forecasts.  (look for the charts we have come to expect).
• Doug Short has an ongoing analysis of the ECRI call, including evidence from various sources.  This is the single best source for updates, including a weekly chart of the ECRI leading index and comparison to other sources.

There are many threads on this theme, and I am overdue for a full update.  I'll try to bring them together.

 

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 continued as "bullish." These are 30-day forecasts.

[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

Last week was one of our best in identifying both the focus and the potential outcomes.  This week is very different.  For many firms the "A Team" will be on vacation.  Some will take five days off going through the mid-week holiday.  Others will take five days starting with Wednesday.  Still others will take all week!  Here at "A Dash" we'll be on duty all week:)

This may dampen trading activity.  Monday morning will  provide the ISM manufacturing index, which is an important indicator.  Then things will get quiet until Thursday.

On Thursday we will get the ECB rate decision, ADP private payrolls, and initial jobless claims.  Friday will bring the employment situation report.

To summarize, the fireworks will come on Thursday and Friday.

Trading Time Frame

Our trading positions geared up last week.  After Monday we were fully invested.  Felix is not a range trader, but is excellent at getting on the right side for big moves.  As I predicted last week, this was the week of opportunity for trading.

Investor Time Frame

The successful investment strategy differs markedly from trading.  It is especially important to establish good, long-term positions when prices are favorable.  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.  You can contrast this with the many  pundits who claim miracles of market timing.

The best strategy through the various gyrations has been buying dividend stocks and selling calls for enhanced yield.  Anyone unhappy with bonds should be doing this for a yield of 8-10% with greater safety than pure stock ownership.  Take what the market is offering!

Final Thoughts on Fireworks

This week marks an especially important time for most individual investors.  While my audience includes traders and investment advisors, it is the individual investor who is most likely to be led astray.  I often try to write as if I were speaking directly to one of my clients or friends, face-to face.  I relate to their biggest fears and try to provide some reassurance.

Here is the dilemma:

The best investment advice comes from contrarian approaches.

  Most investors pay too much attention to recent results.

This provides a challenge for investment advisors.

When I interview a new client, I have six different programs available.  They all beat their benchmarkrs on a long-term basis, but they differ widely in risk and reward.  To take two simple examples:

• If you want to make 8-9% a year with reduced risk, I have a program for that.
• If you want complete safety, we can do that also.

These are not the right moves for most people who have a longer time horizon.  Even older investors need a touch of octane in the tank!

And that is where we are right now.  Most of the people you read or see on TV are looking at the past and pretending -- bad advice.

While I do not give specific investment advice on the blog, my general assessment is that each investor should be a little more aggressive than usual (adjusted for personal circumstances).  When I speak with individuals, I find that most are scared witless (TM OldProf euphemism), and therefore not prepared to participate in the upcoming rally as problems are solved.

This week is a good example.

Best Investment Advice of the Week

For my strongest advice this week I recommend Matt Busigin's first rate article, The REAL Cult Of Equity.

This is the single best piece I saw last week, and I read hundreds of articles.  Take a few minutes.  No, take more than a few minutes and read it twice.

Matt covers the key quesitons about whether we are in a recession,  why stocks are cheap, the risk/reward for stocks, and some refutation about those "bad times to invest" guys -- although he is too polite to name them.

He is especially powerful in explaining marginal forces on asset allocation -- something totally ignored by most pundits.  Here is one example:

If the chart seems a little wonky and does not make immediate sense to you, all the more reason to read the article.  You will see why!  (It shows the powerful mean reversion of stocks and bonds -- a key concept).

 

Reading the "Message of the Market?" Be Careful!

Does the market have a message?

Whether it does or not, there are hundreds of pundits who want to explain it!

There is an interesting contradiction.

If you believe that markets are efficient -- carrying a message -- then there is no edge for most of us in the investment business.  As Mr. Buffett says, he would be on a street corner selling pencils from a tin cup if markets were efficient.

If you believe that markets are not efficient -- so that you can claim to have an investment edge -- then you cannot infer a message when you have only noise!

Why is it that no one seems to realize this?  When the market is going in the direction of their prediction, people claim that "the market has learned how to interpret these rumors from Europe," just to pick one current example.

I am astonished by the current claims that the "bond market is smart" because it recognizes fears and the stock market should be thousands of points lower.  This might be true in normal times, but the current bond market is inhabited by millions of amateurs (the fearful), not the bond vigilantes of old.  Suggesting otherwise, as I hear every day on CNBC's Santelli report from the Chicago trading pits, is completely deceptive.

A Modest Proposal

I have a working hypothesis about the market message.  It is basically the opposite of what most other people think.  This is how sophisticated and experienced managers get an edge on the market.

• On the "global macro" front, where everyone has an opinion and few bother to find the best sources, the market offers great opportunity.  This is the Warren Buffett  playground -- open to the long-term investor.  Abnormal Returns has a great post on this subject.

"Let’s first stipulate that the financial markets are going to do whatever they darn well please. There is nothing any individual can do to affect the overall direction of the markets. Therefore active management is much like trying to play tennis against a professional player. This leaves the individual investor open not only to forced errors but unforced errors as well. The financial markets have a tendency to fool as many investors it can as often as it can. Can an individual investor score some points against the market? Sure, but the odds are that the market will on average return more volleys that you can’t handle."

I plan to add to this discussion, but this is really great advice.

• On the stock and sector-specific front, especially in shorter time frames, it is important to watch the market.

This is one reason that technical analysis, at least in simple forms,  provides useful information.  Here are three current examples:

1. We monitor price, volume, and technical factors through our "Felix" model.  Felix highlighted strength in home building last week.  We share these reports on Wall Street All Stars and also with those who subscribe to our reports.
2. Felix also likes health care ETFs, an interesting move in front of the Supreme Court decision.  The market is expecting improvement in health care, which actually might happen simply from eliminating the uncertainty.
3. Felix often highlights stocks in front of earnings reports.  This week Apollo Group (APOL) rocketed to a high position in our single-stock ratings. I chose not to play this in front of the earnings announcement, but Felix was right.  The point is that the market may seem to have information in front of important announcements.  Leaks?  Some people know?

It is well-established that trend-following methods are effective.  It all depends on the time frame and the setup.

Implementing the Message

Following the market trend is a staple for commodities traders.  Felix has an awesome performance in picking the Nasdaq 100, but there are some big drawdowns.  Few should take this approach, no matter how well it works.

For the long-term investor, most of what you read is unhelpful, misleading and costly.  Pretend that you are interviewing the pundit for a job.  You can ask the same question I do:

What can you tell me that I did not already read in this morning's Wall Street Journal?

The question needs to be updated, since the FT  is moving in.  The concept is still correct.

Most of what you read and hear comes from people who want to explain the day's trading as if they had predicted it.

 

 

 

A Closer Look at Current Survey Results

There has been a spate of pretty negative reports on business and consumer confidence.  Some people are very skeptical of surveys.  As a Michigan man who spent many hours at the Survey Research Center, I have respect for surveys that include strong design and execution.  Most of the complaints you hear come, as usual, from people who never took a single course in survey research.

I understand that the value of surveys can range widely.  Since some of the recent results (Philly Fed, the new Markit flash PMI, consumer confidence) are moving the market so dramatically, it is a good idea to take a deeper look.

I have been monitoring this theme for a long time, but some recent results are of special interest.  There are two key themes, explored below.

The "Us versus Them" Disparity

Responses to surveys vary dramatically depending upon whether the respondent is discussing his/her own situation or that of others.  I have many examples, all showing the same thing.  The results below are indicative.

• McKinsey does a respected global economic survey.  There are many results that deserve your detailed consideration.  You can see the entire report if you do a free registration.  Here is the key point:

"...(E)xecutives remain optimistic about their companies’ prospects. Only 15 percent say customer demand for their companies’ products and services will decrease, and more than half expect profits to increase in the next six months. But this optimism does not extend across all regions and industries: larger shares in India and in the manufacturing sector now expect demand to decrease than did in March."

• Businesses worry about others.  Here is a nice chart from the Duke survey of CFO's.  The difference between one's own company and the overall economy is obvious.  It has become a regular part of the economic landscape.

 

• Personal spending expectations are down only slightly, despite the overall concern about others.

 

The "Future versus Now" Disparity

Responses vary dramatically depending upon whether the respondent is discussing current conditions or what he/she expects to happen in the future.  I have many examples, all showing the same thing.  The results below are indicative.

• Consumers worry about the future.

"While consumers’ expectations declined, consumers’ views on the present situation rose in June. Overall, the data suggest that there may be “little change” in the pace of near-term economic activity, Franco said."

•  Businesses also worry about the future.

Here is what they say about their own business prospects:

“The Duke-CFO survey measures plans for the next 12 months, which is in contrast to the Bureau of Labor Statistics’ assessment of the employment situation, which measured a single month: May,” said Kate O’Sullivan, editorial director at CFO Magazine. “In contrast to the BLS number, CFOs indicate a level of hiring that would reduce the national unemployment rate to near 7 percent within a year, if all else remains constant.
“More than one out of four U.S. CFOs say their employees are maxed out, so the planned increase in payrolls is long overdue,” O’Sullivan said.

 But they are still worried about future conditions. 

Conclusions from the Data

When asked about their own situations, both consumers and businesses are more positive than when asked about others.  Which response do you think reflects the more informed reply?

When asked about the future versus now, both consumers and businesses see some comfort in future conditions but are worried about the future.  Which response do you think reflects the more informed reply?

I hope the answers to these questions are as obvious to readers as they would be to an expert on surveys.

The investment community looks at the "headline numbers" without asking much about the details. Businesses and consumers, despite their own success, read the same newspapers as everyone else.  The effect of the constant drumbeat of crisis stories has an effect.

Perceptions Become Reality

One of the key problems is that mistaken perceptions can become reality -- a self-fulfilling prophecy.

There is plenty of evidence about this concern.

"Top executives are increasingly worried about potentially big changes in U.S. tax and spending policies in 2013— the so-called fiscal cliff — as well as the spillover effects of the financial crisis in Europe.

The Roundtable’s chairman, Boeing BA -0.17%  CEO Jim McNerney, said all the uncertainty is causing “paralysis” among businesses as the end of the year approaches. Some are even cutting jobs until they have a clearer idea of how the fiscal cliff and European crisis will be resolved."  (Marketwatch)

US businesses are moving funds out of European banks and taking other preparations. (Reuters).

Investment Conclusions

Two ideas leap out -- and both are important.

1. Conditions are not as bad as the headline numbers suggest.
2. The failure of leadership is creating a negative climate.  Some of this failure can be laid at the doorstep of specific leaders, but much of it is a natural fallout of the US election cycle and the ongoing negotiations in Europe.

There is a danger that the delays in the political process will make things worse.  There is also an opportunity, since any change in perceptions could stimulate economic growth.  More confidence leads to more investment and more spending.

Monitoring this will help investors make decisions about cyclical stocks, tech stocks, and financials.  Recent favorites I have mentioned include CAT, AAPL, and JPM, but these are only examples.

Weighing the Week Ahead: Time for some surprises?

When nearly everything you see or read seems to carry the same message, it is time to take a deeper look.  The mainstream thought now seems to include an obligatory nod to the "mess in Europe" featuring their clueless leaders, the fiscal cliff, the recessionary US economy, and the upcoming hard landing in China.

Wow!  It does not take much to convince the punditry that investors should all step aside until after the election.

It is reminiscent of early 2009, when everyone searched to explain relentless selling in the absence of any fresh news.  I started writing a four-part series and only finished three before things changed.

 When it is least expected, something might go right.

 

I'll offer some more thoughts on this in the conclusion, but first let's do our regular review of the events and data from last week.

Background on "Weighing the Week Ahead"

There are many good sources for a list of upcoming events.  With foreign markets setting the tone for US trading on many days, I especially like the comprehensive calendar from Forexpros.  There is also helpful descriptive and historical information on each item.

In contrast, I highlight a smaller group of events.  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.

This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting 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:

1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
2. It is better than expectations.

The Good

The US economic data last week was actually pretty good.

• The Greek election was the best possible news, opening the way for a reasonable compromise solution.  The New Athenian is a great source, covering the various possible outcomes.
• The Fed paved the way for further action.  The official policy extended Operation Twist as I (and most others) expected.  In the press conference (apparently ignored by many who heard what they wanted to hear) Bernanke was quite clear in stating that the Fed would not be stopped by politics.  The disparity between the economic forecasts and stated objectives is clear -- the subject of several questions.  Bill McBride at Calculated Risk thinks this means action at the August 1st meeting, but he notes that others see a further delay.  See also top Fed watcher Tim Duy's analysis.
• The Conference Board's leading indicators recorded a surprising gain  of 0.3.  See Steven Hansen's analysis.
• The most important housing data showed strength -- especially building permits.  (See Calculated Risk for the good charts and analysis.  Bonus!  Shadow demand is increasing).
• The G20 meetings were positive for the Europe situation.  The coverage of these meetings in the regular financial media is so bad that it is almost impossible to track the progress.  If you want to track progress, you need to have good sources.  Here is a key point from the Council on Foreign Relations:

'What were the main takeaways of the summit?

The two key takeaways are: first, the additional commitment of funds to the IMF by the large emerging markets, which indicates that they have accepted to continue a longer-term process of IMF quota reform, despite the Obama administration's inability to get Congressional approval for the 2010 agreement before the October 2012 deadline. Secondly, it is the detailed commitment of the euro area, which "will"--rather than intend, or should--"take all necessary measures to safeguard the integrity and stability of the area, improve the functioning of financial markets and break the feedback loop between sovereigns and banks."'

• Sentiment is more negative than in early 2009 (via Bespoke).

• Conditions in Europe have improved.  You would never know this unless you looked at data instead of headlines!  I read FT Alphaville to follow this news, and so should you.   Spanish bond yields are the single simplest measure of progress:

 Scott Grannis notes this as well as swap spreads, adding more good charts.  He writes as follows:

"The 10 bps decline in swap spreads in the past week or so is impressive by itself, and more so since it takes swap spreads back to the levels of late July last year, when the Eurozone crisis was just beginning to heat up. The ECB's liquidity injections have managed to restore a lot of confidence and liquidity to the Eurozone financial market, and that is an essential first step to allowing the crisis to play itself out."

The Bad

Most of the economic news reflected weaker than expected results.  This continues the pattern of sluggish growth we have seen for several months.

• Even the highway bill despite bipartisan support, seems to be stalled.
  
• Earnings estimates are falling.  The Q212 estimates for the S&P 500 have declined dramatically (via Reuters).  Dr. Ed. has a helpful chart showing  the decline for the quarterly estimates.  The overall estimate is still a healthy increase over last year, but it bears watching.

• The Philly Fed Index had an alarming decline.  For years I have expressed little confidence in this indicator -- one region, with no information on the sample, response rate, margin of error, etc.  It also is a diffusion index, so it shows direction rather than level.  We all know that the direction is lower.  The market is pretty uncritical about this.  See Steven Hansen's discussion for a comprehensive analysis and a lot more history.
• Chinese Economic Data are Suspect.  This is a repeat item from last week, but with new evidence.  At the moment the concern is that the Chinese government (not known for Freedom of Information) might be overstating growth.   Fair enough, but the motives and biases may not always be clear.   There are many reasons for understating growth.  They may simply wish to disguise motives,  perhaps acquiring assets cheaply.  Here at "A Dash" we are equal opportunity skeptics.
• Home Loans are Declining, despite lower rates.  The problem?  Potential borrowers cannot qualify (from Dr. Ed.)

The Ugly

Are the Chinese taking over Toledo?

Actually, I don't think this is bad news, but it was sent to me by one of the many active emailers who make sure that investors are able to find the worst in anything.  The story about foreign purchases of US real estate is an old one for veterans.  A highlight is the Japanese purchase of the famous Pebble Beach Golf course in 1990.

As long as the US has a trade deficit, our trading partners will make investments in US assets.

 

The Indicator Snapshot

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

• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.
• An updated analysis of recession probability.

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 SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events.  It uses data, mostly from credit markets, to reach an objective risk assessment.  The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.

Tim Duy has a nice update on financial stress, including the SLFSI and some alternatives.  He has expert analysis and helpful charts.

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.  We are working on a modification that will make this method even more sensitive.  None of the recession methods are worrisome.  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 also not close to a recession signal.

For comprehensive recession forecasting we recommend the RecessionAlert team.  They have reverse-engineered the ECRI approach and improved on the recession forecasting power.  Since they have not gotten the mainstream recognition they deserve, you can still enjoy the advantage from their methods.  You should consider subscribing for more detailed reports covering various time frames and GDP forecasting.  They have also initiated a new service -- the Shadow Weekly Leading Index.  If you like the ECRI approach, you can get an advance read before their weekly announcement.  The most recent take on the ECRI approach suggests a 37% recession probability.  If there is no improvement, there might be a warning in two or three months -- still not close to the ECRI's own prediction.

Doug Short has a complete history of the ECRI call, updates from fresh data, a list of sources, and the famous Short Charts that you would expect.

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 switched to "bullish." Last week we noted that the "neutral" call was marginal.  Remember that these predictions, although made each week, are supposed to represent expectations over the upcoming month.

[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

I was correct last week in my prediction both about the FOMC decision and the week-long focus.  This week has more possible themes, including the Supreme Court decision on health care and speculation about the European Summit.

There are three housing reports including new home sales (Monday), Case-Shiller home prices (Tuesday), and pending home sales (Wednesday).  Taken together with last week's housing data, these could be interesting.

In order of importance, we have the regular Thursday report on initial jobless claims, consumer confidence (Tuesday), personal income and spending (Friday), and durable goods (Wednesday).   There are various regional Fed reports during the week, but they will be less important unless we get a big change like last week's Philly survey.  The Chicago PMI is interesting as an early read on the national ISM number, especially when there is a weekend in between as is the case next week.

Trading Time Frame

Our trading positions were unchanged last week.  We remain 2/3 invested in long positions.  Felix is not a range trader, but is excellent at getting on the right side for big moves.  There are several highly-rated sectors in the penalty box, while the inverse ETFs are at the bottom of the chart.  I expect to add new long positions during the week.

Investor Time Frame

The successful investment strategy differs markedly from trading.  It is especially important to establish good, long-term positions when prices are favorable.  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.  You can contrast this with the many  pundits who claim miracles of market timing.

The big threat is for investors is the apparent safety of bond funds.   The consensus expectation is that rates are rising, as shown in this clever and important chart from Doug Short:

Each line represents the forecasts for a new year.  You can see that the consensus of economists expects interest rates to move much higher.  Unless you think you are smarter, you might want to pay attention.

If that happens, I outlined last week why you should be worried about holding bond funds instead of individual bonds.    It is the biggest investor threat right now.

Right now the market is giving you two things:

1. Plenty of great stocks that are as cheap as they were at the market bottom in 2009, on a price-to-earnings basis.  To pick two examples, I buy Apple (AAPL) and Caterpillar (CAT) on day one for every new client.  There are many others.
2. Good dividend stocks where you can sell short-term calls. I am doing this as a "bond substitute" providing the yield we need in a low-rate environment.  I am targeting 8-9% returns on this approach, and achieving it through an up and down market cycle.  You can, too, but it takes some work.

Investors who play these themes will do well, regardless of the headlines.

Final Thoughts on Possible Surprises

The investor quest for yield has taken sector valuations to extreme levels.  Take a look at this chart from Bespoke.

No wonder we see tech stocks as cheap.

There are several sources for a surprise in the next few weeks.

1. The Supreme Court health care decision will provide clarity.  Business leaders have complained about a lack of predictability.  If the law is struck down, many will celebrate immediately and certain health sectors will rally.  Even if it is maintained, the rules will be known.
2. Housing is showing signs of bottoming.  Many forget that the economy will be 1 to 1.5% better on GDP merely by avoiding further declines.  If the 2.25 million people under age 34 decide to move out of  the basement and into their own homes, it will be even better.
3. European Summit decisions.  Since the consensus now is that these are all meetings with no substantive progress, the stage is set for a surprise.  Most US investors might be surprised to learn that the European leaders actually have access to all of the same information they have, via newspapers printed in other languages.
4. Increased confidence from lower fuel prices.

These are just the most obvious.  Readers are invited to suggest other ideas.  Please try for something new!

 

 

The Quest for Yield (Part 7): What about Bonds?

The biggest risk for most investors is one they are not even thinking about:  Bond funds, the black swan of 2012.

Individual investors are on a mission.  The cry comes from everywhere:  Give me yield!

Scared witless by the housing bubble, the stock market decline in 2008, and the continuing headlines, the average investor makes the mistakes that come so naturally:

1. Chasing past performance -- bond funds have done well.
2. Confusing true yield with current payouts -- many "yield plays" are simply returning your capital.
3. Failing to balance risk and reward -- yield history provides a false sense of security.

These combine to create a false sense of security about investments in bond funds.  Many investors, despite the warnings in the prospectus, think that these are safe investments with assured yield.

Not so!

The Risk in Bond Prices

Whenever you buy a bond, the price is determined by current yield.  If interest rates move higher, the bond price must go lower to generate the new market yield.

Anyone who does not understand this relationship should not own a bond fund.  You can get badly burned.  One of my best friends owned bonds on the 70's when rates spiked.  He lost a fortune and explained that he would never buy bonds again.  (This was before my investment advisor days.) We can all see that it was the wrong lesson.   Bonds were a great investment just at the moment he was selling!  It is pretty much the opposite of the current market.

How to Think About Bonds

To start the process here are three questions:

1. What do you expect the inflation rate to be over the next ten years?  How about next year?
2. If inflation increases, what do you think will happen to interest rates?
3. Do you need any of your funds within ten years?

Let us suppose that you want to be super-safe, so you have joined the crowd in buying the (formerly AAA-rated) US Treasuries.  Let us take the benchmark 10-year note as our example.   If the interest rate moves from the current 1.61% to 2% you will have an immediate capital loss of about 3.5%.  If the rate moves to 2.5%, your loss is about 7.8%.

And we are just getting started.

You will not have capital losses if you do not sell the bonds, but what if you are in a bond fund?

The Rules of Bond Funds

The problem with bond funds is that you cannot control when the selling occurs.  If there are redemptions, the fund is forced to sell, even if losses are locked in.  Since we have had a multi-year run of inflows to bond funds, no one thinks about the dark side.

You will never hear about this risk from bond fund managers (think Pimco, whose employees all seem to follow the party line) or researchers that work mainly for bond guys (Bianco).  These guys have only one product to sell, so you will never hear a valid comparison of stocks and bonds on a risk/reward basis.

Objective Sources

Over the years a number of readers have commented along the lines that people like me are trying to sell stocks.  The most aggressive of these have called me a "shill" for the sell side firms.  I understand that some of these are paid trolls, and I usually only make one polite response.  It is a bit aggravating because it is so wrong.

The truth is that independent investment advisors profit only when their clients do.  We are completely aligned, attempting to find the best asset allocation.  I start with each new client by asking whether we are attempting to preserve wealth or to create wealth.  I manage six different programs including bonds, stocks, ETFs and alternative investments.  The right mix differs by client.

I have new clients -- right now -- for whom a major emphasis on bonds is correct, so that is what we do. This is completely unlike the "expert" you see on TV who makes his money exclusively by selling gold, or stocks, or annuities, or bonds.

My Chicago colleague and friend Brian Gilmartin provides similar advice on asset allocation.  He covered the topic in fine fashion in this recent article on his new blog.  It is a good illustration of how a first-rate manger tries to incorporate bonds for clients.

An Alternative Concept

I have a different approach to bond investing.  It is strong, and working well.  Here is the mantra:

Buy bonds, not bond funds!

My approach is a bond ladder.  See if you qualify.

• A strong focus on guaranteed return;
• No immediate need for the principal;
• Desire to participate as rates move higher;
• Willingness to accept a modest yield.  (If you need more, you should be in our enhanced yield program described in Part 6.  It is an individual matter.)

A bond ladder meets these objectives.  The exact specifications can vary but my rules are as follows:

• Five "rungs" with three bonds per rung;
• Everything is investment grade with no company on negative watch;
• Only one bond per company;
• Careful shopping on entry to get the best prices (which affects the yield);
• Ability to "roll" to higher yields if/when rates move higher.
• The investor has fifteen different high-grade bonds with very little risk and the ability to ratchet up yield over time.

When we get paid on a maturing bond, we reinvest at the long end.  We are not at the mercy of other investors who may not share our interest.

Why is this Special?

Why is it that every investor is not doing this?

It is a bit tricky.  Most investors are comfortable buying stocks, but they do not understand how to buy bonds.  There are some tricks and traps.  It is well worth learning, but it takes a little work.  It is a complex subject.  I have new clients building current bond ladders, and I'll provide some specific examples in future articles.

Meanwhile, I want to highlight a great educational site about bonds.  If you are interested in fixed income, you should set aside some weekend time to explore the many great ideas at LearnBonds.com (now added to our featured sources).

Conclusion

If you own bond funds or bond ETFs you should conduct an immediate review.  Taking personal control of your bond allocation requires owning bonds, not bond funds.

 

 

 

Weighing the Week Ahead: Can the Fed Meet Expectations?

In the absence of any action on fiscal policy, economic responsibility rests with monetary authorities.  Investors rightly ask:

What more can the Fed do?  Will it be enough?

In normal times, this would be the big story.  This time the week ahead will start with the Greek election and the aftermath, which I covered in a special preview.  This article focuses on what to watch after we digest the news from Greece.

Christina Romer, back at the Berkeley econ department after serving as Chair for the Council of Economic Advisers for the Obama Administration offers this assessment in the New York Times.

"...(W)e need more effective fiscal and housing policies. But neither is likely to happen, at least not before the presidential election. As a result, the Fed is the only plausible source of immediate help for the American economy. It was set up as an independent body precisely so that somebody can do what’s right when politicians can’t or won’t.

I find a related argument even more frustrating: that the Fed shouldn’t act because Congress wouldn’t like it and might retaliate. This argument exposes the important truth that the Fed is only as independent as Congress lets it be".

Cardiff Garcia at FT Alphaville has a nice FOMC preview with odds, a good flowchart from Credit Suisse, and a number of helpful links.  Conclusion:  Something, probably more twisting.

Everyone wants to politicize the Fed, making it much more difficult for investors.  We should focus on how the actual decisions will affect the economy.

I'll offer some more thoughts on this in the conclusion, but first let's do our regular review of the events and data from last week.

Background on "Weighing the Week Ahead"

There are many good sources for a list of upcoming events.  With foreign markets setting the tone for US trading on many days, I especially like the comprehensive calendar from Forexpros.  There is also helpful descriptive and historical information on each item.

In contrast, I highlight a smaller group of events.  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.

This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting 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:

1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
2. It is better than expectations.

The Good

The US economic data last week was generally weak.  There were many bright spots, but not on the most important factors.

• Home equity increase the highest in 60 years.  (via Financial Advisor and Bloomberg).  Household balance sheets are improving.
• Business inventories are improving.  Excessive inventories are a negative.  This does not get enough attention because the component parts come out in several different releases.  Steven Hansen does a very nice job of explaining how the different pieces fit and providing informative charts.
• Inflation -- both wholesale and consumer --remains benign.  Steven Hansen covers the PPI report.  Doug Short looks at each CPI component with the energy threat in the background.

• OPEC is maintaining oil supplies at current levels.  This helps with the continuing decline in gas prices.  Doug Short has an informative chart and good analysis.

• The off-season earnings beat rate has been good, including the great chart we expect from Bespoke Investment Group.   I have a sense of greater negative pre-announcements, however, but I did not see a solid report on this.

• Housing inventory -- both regular and shadow is lower (via Calculated Risk).  Any improvement in housing would be very helpful.

 

The Bad

Most of the economic news reflected weaker than expected results.  This continues the pattern of sluggish growth we have seen for several months.

•  Chinese Economic Data are Suspect.  How could we have known?  It seems that auto sales data include some channel stuffing.  Come to think of it, that might also happen in the US!
  
• Biggest US asset is student loans.  I am not sure this meets my criteria for "bad" but it does not feel right.  Here is the chart from Doug Short.

• Industrial production was slightly lower and capacity utilitzation was below expectations.  Calculated Risk has charts and analysis.  Scott Grannis is a bit more positive on the longer trends.
• Jobless claims moved higher, further from the non-recession comfort zone.  This is a special concern for me.
• Retail sales declined 0.2% which was pretty much in line, but the ex-auto decline was disappointing.  Given the recession concerns, there is special focus on consumer activity.
• Michigan sentiment declined to 74.1 from 79.3 last month.  This is especially bad with a background of falling gas prices.  In the absence of gas prices and political factors, this is a fair read on employment.  It is worrisome, as you can see from Doug Short's chart.

 

The Ugly

Making fun of those recovering from handicaps.

When you make a public mistake it is best to acknowledge it and move on.  I have had some occasions on this blog.  One of my hardest lessons was to quit trying for the academic "perfection in writing."  I soon realized that I would never get anything done.  Mistakes will happen.

President Obama decided to admit his mistake last week where he said that the private economy is fine.

The financial media expects this sort of behavior from politicians, but not from themselves.  When a leading TV program and pundit has an embarrassing and insensitive gaffe, an apology is in order.  The person involved was so out of touch with the event that she did not actually name the stroke victim who was the object of her scorn, but it is clear from the context.

The Indicator Snapshot

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

• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.
• An updated analysis of recession probability.

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 SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events.  It uses data, mostly from credit markets, to reach an objective risk assessment.  The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.

Tim Duy has a nice update on financial stress, including the SLFSI and some alternatives.  He has expert analysis and helpful charts.

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.  We are working on a modification that will make this method even more sensitive.  None of the recession methods are worrisome.  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 also not close to a recession signal.

For comprehensive recession forecasting we recommend the RecessionAlert team.  They have reverse-engineered the ECRI approach and improved on the recession forecasting power.  Since they have not gotten the mainstream recognition they deserve, you can still enjoy the advantage from their methods.  You should consider subscribing for more detailed reports covering various time frames and GDP forecasting.  They have also initiated a new service -- the Shadow Weekly Leading Index.  If you like the ECRI approach, you can get an advance read before their weekly announcement.

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 switched to "neutral" and the ratings are actually marginally bullish.  Last week we noted that the "bearish" call was marginal.  Remember that these predictions, although made each week, are supposed to represent expectations over the upcoming month.

[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

I was correct last week in my prediction that we would be focused on leadership, or maybe the lack thereof!  This week will start with the results of the Greek election and the implications both for Europe and for global economic growth.

The focal point for this week will be the FOMC announcement and the Bernanke press conference on Wednesday, the culmination of a two-day meeting.  This will include an update of economic forecasts as well as any policy announcement.

G20 leaders meet in Mexico on Monday and Tuesday.  This is the wrong group for decisive action on Europe, but there could be some interesting news.

This is a big week for housing data.  I find the building permits quite helpful (Tuesday), especially given recent weakness.  We'll also have housing starts at the same time, and existing home sales and FHFA home prices on Thursday.

Thursday is the big day for data, including initial jobless claims (important), leading indicators and the Philly Fed index.

Trading Time Frame

Our trading positions changed dramatically last week.  The "cautious short" that I described was sold early and we are now 2/3 invested in long positions.  Felix is not a range trader, but is excellent at getting on the right side for big moves.

Every week I prepare by consulting Charles Kirk's weekend chart show.  This week it is available a day early, as we all prepare to celebrate Father's day.  It is interesting that Charles is waiting for more evidence of a breakout, not unlike Felix.  (Investors and traders alike would benefit from an inexpensive membership to The Kirk Report).  Traders spend a lot of time trying to call tops and bottoms for "selling the rips and buying the dips."  There are many ways to trade successfully.

Investor Time Frame

The successful investment strategy differs markedly from trading.  It is especially important to establish good, long-term positions when prices are favorable.  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.  You can contrast this with the many  pundits who claim miracles of market timing.

The single most difficult thing for me to explain is that investors should often embrace opportunity just as traders are trying to do some fancy footwork.  Investors should not be trying to guess the next market move. Instead, take what the market is giving you.  You should not be a "buy and hold" investor, but instead engage in  active management.  Think about risk control rather than market timing.

Right now the market is giving you two things:

1. Plenty of great stocks that are as cheap as they were at the market bottom in 2009, on a price-to-earnings basis.  To pick one example, I buy Apple (AAPL) and Caterpillar (CAT) on day one for every new client.  There are many other great examples.
2. Good dividend stocks where you can sell short-term calls. I am doing this as a "bond substitute" providing the yield we need in a low-rate environment.  I am targeting 8-9% returns on this approach, and achieving it through an up and down market cycle.  You can, too, but it takes some work.

Investors who play these themes will do well, regardless of the headlines.

Final Thoughts on the Fed

Expectations for the Fed are unrealistic and wide-ranging.  This makes it easy to disappoint.

• Communications.  If the Fed reduces growth estimates and acknowledges some economic weakening, many will criticize, saying that they are frightening the markets.  If the Fed maintains that conditions are acceptable, the same people will say they are out of touch.  There is no satisfying some!

• Decision.  Whatever the Fed decides to do some will say that it is inadequate - -more was needed.  Others will decry the move as inflationary stimulus.  And of course we will see many repetitions of "pushing on a string."

Expert Fed watcher Tim Duy plays "devil's advocate" in this post:

"Bottom Line:  I think you can tell a story that the most recent data is not sufficient to move Fed forecasts, in which case it remains possible that the Fed does not implement any changes next week.  I have to admit to being a little nervous that we get a Fed "leak" over the next few days in an effort to reset expectations ahead of the meeting.  Still, given the increased downside risks to the forecast, it is hard for me to make this my baseline scenario, especially given the very dovish Yellen/Williams/Evan contingent, which is why I expect some action next week.  But much still rests on Bernanke, who has surprised by positioning himself to the hawkish side of the center.  After all, if he believed the Yellen/Williams/Evans stories, he would have eased already.  He hasn't, suggesting that he has a pretty high bar to additional easing, and we just might not have crossed that bar."

The entire article is worth a careful read.

Here is the key point that the market pundits do not get:  It is not all about you!

The Fed is responding to economic needs.  The tools all have marginal economic impact.  They often use the market response like a poll, to gauge the instant sentiment.  Who wouldn't?  But that is not the major purpose.  The "wealth effect" on the economy is modest, but the occasional Fed comments on this topic have created a sense that the Fed objective is to drive up stock prices.

Anyone maintaining this position should be able to find evidence in the detailed transcripts of past meetings.  Put up or shut up!

My vote?  I am expecting some sort of extension of Operation Twist, but the Fed is running out of short-term assets to sell.  This is a small, token move.

Greek Election Preview for Investors

Whenever there is a big "binary" event, preparation is vital.  This happens in two different ways:

1. Advance positioning.  These are specific trades to be done before the event occurs -- deciding on asset allocation, sector allocation, and possibly protection against unlikely (but possible) outcomes.
2. Tactical preparation.  The analysis must be done in advance, but the trades will occur after an initial outcome is announced.

The idea behind advance positioning is that you must not wait!  Whatever happens will move the market so much that you cannot possibly adjust.  This is often true in binary events like FDA decisions about new drugs, but it is not very true of events related to global macro.

On Wednesday night I listened (oh so briefly) with astonishment to the assembled punditry explaining why it was foolish to be "going long into the weekend" where the Greeks might exit the Euro.  The question we raised in our office was why was it not equally foolish to be short?

I guess we now have the answer, after two days of rebound.  Those who were so confident on Wednesday night have missed a big rebound.  It is not that I predicted the two-day trading move (although our Felix model caught it quite well).  What bothered me was the false, TV-inspired confidence of those "explaining"  the market on Wednesday.  As regular readers know, I believe that investors should be expecting a long-term solution in Europe.  This is a long-term prediction of a process of gradual compromise and negotiation, which you can check out here.

Tactical Positioning

If you do not think about problems in advance, you will be paralyzed at the wrong times.  My Wisconsin friends always talked about the "deer in the headlights" and the idea has caught on.

Here are some thoughts for advance planning.  This illustrates what I am doing.  You may feel free to disagree, but you had better have good reasons and be ready for some fancy footwork.

Greece is unlikely to exit the Euro

The reason is simple:  It does not really help any nation, whether inside Europe or outside.  This means that everyone will be trying to avoid this outcome.  Here is an excellent discussion from a great source, Credit Suisse’s Head of Global Research, Giles Keating.  In contrast to other pundits, please note that his background includes the analysis of politics as well as economics.

 

 

 

 

Keating believes that it would take a total breakdown for a return to the Drachma, and that much of the negative sentiment is built in.

An Eventual Solution -- regardless of the initial decision

I like the thoughtful analysis from William De Vijlder, the chief investment officer at BNP Paribas Investment Partners (via Barry Critchley and FP Street).

“I am confident that a lasting solution will be found,” said De Vijlder, who spends his time when in  Europe between Brussels and Paris, in an interview in Toronto on Wednesday. De Vijlder, who has a Ph.D. in economics, bases his confidence on three main factors:

• There is knowledge of what needs to be done.

• There is the political will; and,

• It can be done.

The full article does a nice job of explaining each point.

The Market has Underestimated the Spain Plan

The market reaction is unsurprising, since the acid test is some sort of comprehensive plan.  Few in the financial punditry see the advantage of incremental improvement.  Here are some great points from one of our favorite sources, Peter Tchir of TF Market Advisors (via Financial Post).

I do not want to quote the entire (excellent) article, so here are my favorite points.  You really should read it all.

• The plan will restore health of Spanish banks: A healthy banking system is necessary for a healthy economy, and official European investments will support investor investments in the medium- to long-term. “Over the next five years, this can pay off,” Tchir argues, and the rumored five-year moratorium on bailout repayments will give this time to happen. “I think [European lenders] will make decent investments, and investors will calm down,” adding that this could be a significant positive for Spain in the crisis.
• Subordination of debt isn’t such a big deal: Thus, the risk of investments fleeing Spanish bonds because they are now subordinated to the preferred status of European lenders “is being overly hyped right now,” Tchir argues, though qualifying that investors shouldn’t be completely ignoring it. He believes that a much of this fear is rooted in the idea that Spain will actually be out €100 billion and misconceptions about where European cash is actually being invested.
• Gives Europe time to get its act together: A reported 15-year repayment plan on loans to the FROB at just 3% interest means that Spanish banks are likely to remain afloat for a while as European leaders make more sweeping changes to the economic and political structure of the euro area.

Investment Summary

Your general takeaway should be that there will be an eventual solution, perhaps of the "muddle through" variety.

The worst case would be an election result with no clear winner and doubt about the ability to form a coalition.  The better cases would include a more probable path to a coalition.

In any case I expect plenty of skepticism and negative reaction -- the prevailing sentiment.  There will be time to react, even for investors who have been cautious before the decision.

Here is a key precept for Monday:

Do not worry about a market reaction of 1 or 2%.  The stakes are much larger. 

A satisfactory solution could spark a major rally, since there are ripple effects for the US economy and corporate earnings.

An unsatisfactory solution will also require more analysis from many experts.

Why Pundit Ignorance about Politics Costs You Money: The Dimon Hearing

Making fun of Congress is a long-standing American tradition for comedians.

Will Rogers --

A fool and his money are soon elected.

Ancient Rome declined because it had a Senate, now what's going to happen to us with both a House and a Senate?

Current comics --

"How much do you think Senators make? They now make $154,700 a year. But they say it will stimulate the economy because eventually that money will trickle down to the liquor stores, the hookers, the brothels ... then it will get back in the community." —Jay Leno, on Congress voting itself a pay raise.

Click through to the links for many more good jokes.

The Dimon Hearings

Today's financial news coverage focused on JP Morgan Chase's CEO Jamie Dimon's long-awaited testimony before the Senate Banking Committee.  Most of the coverage you saw on television or will read tomorrow is terrible.  There are two simple reasons:

1. They did not seek out the opinion of any experts on Congress.  How silly!
2. The pundits imposed their own viewpoints on what should have happened. Showing off instead of helping investors.

I'll turn to specifics below, but it is useful to do a little background.

The Job of Pundits on CNBC

CNBC does not reveal how pundits are chosen for their various programs.  In our office we usually mute, but listen to Josh, Carter, Barry, Paul, and a few others on FastMoney.  Tonight we happened to have the sound on to hear the offensive segment at the end of this post.

I'm just going to speculate that the show wants to drive ratings in a particular demographic.  Participants are encouraged to be controversial and cater to that audience.  Part of the gig is to be a smart alec and an expert on everything.

I have worked at hedge funds and with many traders.  There is a big payoff for fast decisions that you can later change in a heartbeat.  You get paid for short-term moves, being an expert on everything.  Your knowledge is an inch thick and a mile wide.

That is a job description that few could match, explaining the narrow ranks of successful hedge fund managers.

It is almost exactly the opposite of the job of legislator.  This may explain why TV trader/pundits are so poor when it comes to analyzing public policy.

The Job of Senators

The Senate reveals how members are chosen:  by election.  There are many books on Congressional behavior, none of which have been read by the pontificating pundits.

Congressional hearings are supposed to be the foundation for potential legislation.  In fact, there are many purposes.  Sometimes it is a symbolic move to show the public that a controversial topic is under scrutiny.  Often this means nothing, but sometimes it is as important as Watergate.

Hearings also provide a forum for those participating.  If the participants at FastMoney would try to think about the problem from the perspective of the Senator, they would have a better answer.

Many Senators (or Congressmen at House hearings) are doing the political equivalent of "talking their book."  No one they care about is watching live.  Instead, they might get a few seconds on the nightly news in their area, so they go for the money shot.

This is a normal reaction to the job.  In the Dimon hearings it meant that supportive Senators were looking for a friendly response.  Critics were trying to show how tough they were.  Meanwhile, there was some actual questioning related to the key issues.

Why You Should Care

This failure of the financial media -- CNBC and FastMoney, but others as well -- is expensive for the average investor.  The problem is that most people listen to these pundits every day without realizing that they are totally ignorant when it comes to public policy.

Since policy decisions are the most important factors in Europe and facing the "fiscal cliff" we should be looking for genuine experts.  Instead we have hedge fund smarties.

Karen Finerman's Gaffe

In the segment below, please scroll to Karen Finerman's comment about the Committee, starting at about 4:30.

 

Several points are obvious:

• Finerman knows nothing about  Congressional hearings, despite many past examples on CNBC.  The hearings always start with the Chair, who makes comments and asks questions before turning to the ranking Minority member and allocating time.  Always.
• Finerman was clueless about the Senate Banking Committee and Chairman Tim Johnson's rebound from a serious stroke.  (references below).  Anyone who did homework should have known about this.  It was background in every news article.  Finerman talked without research.
• Finerman mistakenly thought that it was all about her!  Get real.  The Banking Committee does not care about her opinion.  They are not addressing hedge fund managers or CNBC.  They are aimed at the general public.
• Finerman is completely insensitive.  Anyone watching the hearing could see that Sen. Johnson had a handicap.  Piling on is offensive.  How can someone on the Michael J. Fox Foundation Board be so clueless and insensitive as she was?

Anyone who wants to understand about the remarkable story of Sen. Johnson, his illness, his praise from President Bush and his colleagues, and his recent effectiveness can read about it here.

Investment Implications

Here at "A Dash" we are interested in investment results.  I postponed some other agenda items about Europe because this was breaking news and immediately relevant to the average investor, people I talk with every day.  They watch TV and read articles that are ill-informed about political leadership.  The result costs them on two fronts:

1. They underestimate the skill and ability of leaders in Europe to reach a negotiated solution.
2. They underestimate the potential for the US political process to avoid the "fiscal cliff."

Accountability

Elected leaders are expected to take responsibility for their statements and actions.  CNBC should do the same.  They give endless time to mistakes by Gov. Romney and Pres. Obama.  How about an apology from Finerman and FastMoney?

[long JPM]

Weighing the Week Ahead: A Search for Leadership

I cannot do justice to the concept of leadership in one article, but let us hit the highlights.

Leadership is what most market commentators want when they complain about "politicians."  They want leaders of democracies to ignore the demands of constituents and do what is right.  Unfortunately, the punditry has widely varying views on the best course of action!

The search for leadership is hitting center stage.

Leadership requires more than accepting and following opinion polls.  It includes finding solutions and convincing people that this is the right path.  Bringing contending parties together.  Finding compromises.  Personal charisma.  A persuasive presence.  Confidence in the face of crisis.

The need for strong leadership is readily apparent, but why the focus right now?  I see three factors:

1. The upcoming Greek election, which may well determine whether Greece leaves the Eurozone and on what terms;
2. Increased urgency among European leaders, as austerity programs fail both with voters and in economic results;
3. Intensifying US politics, with a new focus on the personal skills of the candidates.

This last point, highlighted by Obama's press conference comments, will be the big topic for the weekend talk shows and featured in financial news this week.  It is difficult to find a really neutral link for this subject, and you can easily find many on your own, but this coverage from Business Insider provides both facts and context.  It shows the actual statement and plenty of quotations from Republicans, but also some data.

I'll offer some thoughts on this in the conclusion, but first let's do our regular review of the events and data from last week.

Background on "Weighing the Week Ahead"

There are many good sources for a list of upcoming events.  With foreign markets setting the tone for US trading on many days, I especially like the comprehensive calendar from Forexpros.  There is also helpful descriptive and historical information on each item.

In contrast, I highlight a smaller group of events.  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.

This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting 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:

1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
2. It is better than expectations.

The Good

The US economic data last week was more positive than in recent weeks.

• Technical selling was averted.  This was a big fear last week.  Josh Brown did a great job of explaining why this might not happen.  I hope readers followed our link to his analysis.
• ISM Services index showed continued expansion.  Steven Hansen does a good job of analyzing the internal elements and also provides a helpful chart.
• Spain has agreed to accept outside aid for its banking system.  The $125 billion is three times the amount cited by the IMF as needed.  (New York Times).  The terms were structured with an emphasis on bank reforms rather than new austerity measures.  German officials praised Spain.  This is the sort of face-saving compromise action that investors should be watching as a sign of progress, as I suggested in my Europe surprise ending article.
• Sentiment continues to be very negative, which is positive for markets.  Steven Hansen highlights the increased bearishness in the Ticker Sense survey of bloggers (including "A Dash).  The Bespoke Investment Group shows the same picture for individual investors.

 

• US household balance sheets are $1 trillion better than in 2007.  Scott Grannis notes that this has not led to the widely-predicted economic implosion.

The Bad

There was also some bad news on the economic data front.

• France lowers the retirement age by two years, to age 60 for some workers.
• The European bank"job" continues -- good story from Floyd Norris at the NYT.
• US debt will reach 200% of GDP by 2037, according to the CBO, if Congress extends current tax policy without cutting entitlements.
• Initial jobless claims remain at unacceptably elevated levels.  I see this as the most important of the weekly data series.  The chart from Doug Short shows why:

• Big US banks face downgrades according to the WSJ. 

"Moody's Investors Service has said it is likely to reduce by the end of June credit ratings for 17 large global banks, including five of the six biggest U.S. financial firms by assets. The downgrades are expected to raise borrowing costs and crimp some lucrative trading businesses at the banks...."

• PMI reports from around the world have been weaker.  Dr. Ed Yardeni has a good discussion about the differences between the US, China, and Europe.  The US is holding up best, but there is a general weakening pattern as you can see from this chart:

The Ugly

The Greek television talk show wins this week's "ugly" award.  The  neo-Nazi politican is now on the lam after slapping and slugging a woman from the Communist party.  The New Athenian is one of our featured sources, so we recommend this video of the incident, where John Psaropoulos does the reporting.

Speculation ranges widely on what effect this might have on the upcoming election.  No guesses here!

The Indicator Snapshot

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

• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.
• An updated analysis of recession probability.

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 SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events.  It uses data, mostly from credit markets, to reach an objective risk assessment.  The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.

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.  We are working on a modification that will make this method even more sensitive.  None of the recession methods are worrisome.  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 also not close to a recession signal.

For comprehensive recession forecasting we recommend the RecessionAlert team.  They have reverse-engineered the ECRI approach and improved on the recession forecasting power.  Since they have not gotten the mainstream recognition they deserve, you can still enjoy the advantage from their methods.  You should consider subscribing for more detailed reports covering various time frames and GDP forecasting.

 

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 continued as "bearish" and were 1/3 short via DOG in trading accounts during the week.  The ratings are close to neutral.  There are sectors in the buy range which might emerge from the penalty box, so this is a very fluid situation.  It is bearish, but marginally so.

[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

I was correct last week in my prediction that the financial news would have a Fed fixation.  All of the Fed speeches, including Bernanke's testimony, passed uneventfully.  The Beige Book showed a the economic strength that the Fed sees but traders do not.  Yellen offered some QE hope, but Bernanke did not.  We are now waiting until next week's FOMC report without any further direction.

There is plenty of data this week, but little that I see as important.  I don't expect much on the inflation front and I do not care about regional surveys like the Empire State Index.

On Thursday we will see initial jobless claims, still in the survey period for the next employment report.  On Friday we get industrial production, capacity utilization, and Michigan sentiment.  Then we get pre-weekend speculation about Greece and options expiration.

I expect the first part of the week to focus on the leadership questions, with attacks on Obama as "out of touch."

Trading Time Frame

We have been partially invested in trading accounts, in a bearish position with 1/3 of our position profitably in bond ETFs and another 1/3 in an inverse (short) ETF, as I predicted last week.  Felix has now sent the bond position to the penalty box, so we have a cautious short position.

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.  You can contrast this with the many  pundits who claim miracles of market timing.

The single most difficult thing for me to explain is that investors should often embrace opportunity just as traders are trying to do some fancy footwork.  Investors should not be trying to guess the next market move. Instead, take what the market is giving you.  You should not be a "buy and hold" investor, but instead engage in  active management.  Think about risk control rather than market timing.

To highlight the continuing discrepancy between headlines and the economic fundamentals, let us look to Dr. Ed.  He compares various alternative investments to stocks, using the trailing earnings.  This chart summarized a point that was widely observed in the past week.

The earnings yield from stocks, when compared to corporate bond yields, is at a 50-year spread.  This suggests extreme skepticism about corporate earnings.  Another way to view this is that it is the greatest fear since the mid-70's.  If the two lines simply met, the S&P 500 would have to rally by 27%.  This is conservative, since you can see that the bonds usually trade at a higher yield.  If you used forward earnings or Treauries, the so-called Fed model, you would get an even larger discrepancy.

The biggest mistake that individual investors make is bad timing by following headlines.  Using data is a way to avoid that.

Long-term investors who ignore this warning can follow "Plan B."  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 over the course of a market cycle. You can, too.  With the increase in volatility, there are many good opportunities.

Final Thoughts on Leadership

I have a very good record of predicting what will happen, especially on political events.  Eventually this pays off, since earnings follow and stock prices eventually track earnings.

My concern is that sometimes perceptions create their own reality.

Suppose you are considering a major business expansion -- a new product, new plant, or new employees.  Economic uncertainty is the enemy of such plans, since you have less confidence in your forecasts.

Suppose your family is considering  a new job, a new home, or a new car.  Uncertainty can create a delay.

This is why the effect of leadership is important.  Even if all will eventually end well, people need to have some confidence.  Otherwise, why not wait until after the Greek elections, after the Europeans solve the problems, after the fiscal cliff is addressed, after the US elections......

This is why the extended US political process is so destructive, particularly when it incorrectly focuses on the personal competence of the candidates.

Here is a secret:  The things most important to investors will be fine no matter who is elected.  Both candidates are competent and will have great supporting teams.

The perceptions create an economic drag, but investors who wait for everything to be fixed will be buying at Dow 20K.

This is a challenging subject and I need more articles to explain.  Meanwhile, I try each week to highlight the most important things I am following.

 

Europe: Get Ready for a Surprise Endgame!

How do you find an edge?

I was inspired by a news story yesterday:

Europe promises speedy response to crisis

What a joke!  This really highlights divergent viewpoints.

The market  wants to know why they have not already fixed these obvious problems.  Every new move is described as smoke and mirrors, kicking the can, or something similar.

Many stories begin by telling you how stupid or ineffective the European politicians are.

A Flashback

Back in my teaching days we had simulations as class exercises.  These were wonderful teaching tools -- much better than textbooks.

I only wish that I could collect a group of hedgies, traders, and market pundits for such an exercise.  Each player would be given a role.  The success in the game would be determined by how well the national objectives were met.  For Germany, it would be preserving the Euro, which has led to great financial success, while exacting concessions from others on changes in labor rules, agreement with debt limits, etc.

For the ECB the rules would stipulate not going too far until various governments had made commitments.

For the Chinese, it would mean not committing funds until the Europeans had done their part.  Ditto for the US.  If you acted too soon, you could not get an "A" for the simulation.

For Greece, it would mean exacting debt concessions, stimulus, and whatever else you could get.  Ditto for Italy.

For Spain and France, it would be a little more nuanced.

Please note that no single party gives flying Stanley Cup hockey puck (TM OldProf euphemism) about the short-term verdict of the US stock market.

The rules of the game do not optimize the global result.  If you and I were dictators, we would have "solved" this long ago, although our ideas of the best solution might differ.

The result from students who engaged in simulations like this was amazing.  They got it right away!

Meanwhile, the investment world consists of people who never took this class and who all mistakenly think they are smarter than the top leaders in the world.  The bloggers and the commenters seem to think that being sassy and sarcastic makes them look smart.  Even some good journalists fall into this trap.

The Alternative Viewpoint

Let us start with what does not work -- being a Wall Street Parrot (a species I identified here) and repeating what you read in the newspaper.

Anything that is in the paper is "old news" so you need to look beyond the headlines.  Sure, you can get your gig on CNBC and look smart by catering to what people think they already know.  It is too bad that this is not like baseball, where they put up the career stats along with the featured pundit.  Instead, they show the assets under management.  This shows how well management does in bringing fans in to watch a bad team!

I have a long-term forecasting record on this which has been pretty accurate on general European developments.  It is dragging out longer than even I expected, but I still see the following conclusions:

• Some sort of deposit insurance for Europe, ending the bank run worries that have dominated the stories for the last several weeks.  Do you really think that European leaders have no plan for this?  This will be the first news.
• More powers for the ESM -- either direct lending to banks, or giving bank powers and leverage to the ESM.
• Expanding the war chest -- this will happen gradually.
• Concerted action by G8 powers -- quite possible, and already rumored.
• Political and fiscal integration -- probably happening since most countries will benefit.  I do not know about Greece, but I will note that an exit now is much less painful than it would have been a  year ago.  This illustrates why it is useful for leaders to buy time.

Evaluating the Downside

I have noted some pundits and commenters who make an argument like the following:

Company X has 20% of its sales in Europe.  Europe is in a recession.  This is really bad for Company X so it is obvious to sell those shares. 

 This is one of the biggest investor blunders -- something that I call "light switch thinking."  It is employed by non-economists who do not try to identify and model quantitative relationships.  I invite readers to think about this.

Suppose that the European recession is a GDP decrease of 2%.  What should be the cut in the sales and/or earnings of Company X?  Would it matter if the company sold toilet paper?  Autos?  Business software?  What is the worst case?

With all of this in mind, how much should we adjust the fair value of Company X?  Is down 20% a good number?

The Right Approach

I like the approach of Steven Einhorn (perhaps because his list is what I have been highlighting for months).  Thanks to Doug Kass and Barry Ritholtz for highlighting this useful checklist of what you should be watching in Europe.

Most people are watching for some big, comprehensive plan.  They will not see a solution until they have missed the whole move.  If you follow the items on this list, you can track progress in real time.

There are many stocks that have been excessively punished through this thinking, but you might see the best leverage from some software names like Oracle (ORCL) and cyclical stocks like Caterpillar (CAT).  Stocks like Apple Computer (AAPL) have also been dragged down because of the excessively simplistic Karate Kid view of the markets -- risk on, risk off.

If you want to do better than advice from a kid movie, my suggestions are a good start!