A Dash of Insight

The Biggest Lesson from Earnings Season

Here is a fresh take on earnings season. No matter how many sources you followed, you have not seen this before.

Let me start with what we did not hear.

1. This stock is a poor investment because it has a bad Tobin's Q ratio. Readers are invited to correct me if someone is offering an opinion that Google has a poor replacement value. How do you even think in these terms? This method is an outdated approach in search of a modern critic.
2. This stock is over-valued based upon the Shiller CAPE method. Readers are invited to correct me with examples of specific stocks where people think that the P/E ratio should be based on the earnings over the last decade, adjusted for inflation and divided by 10 (or some close variant). Has anyone ever made any money using this method?
3. The earnings of the company should be ignored because it is happening in the midst of a counter-trend rally in the midst of a cyclical bear market. Readers are invited to correct me with examples of analysts on specific stocks who thought this was relevant.
4. The current value of the company should be compared to its earnings in 1870. In 1910. In 1935. In 1950. In 1970….and so forth. Readers are invited to submit examples of recent earnings analyses where anyone thought this past history was relevant to the current stock price.

Stocks react dramatically to earnings reports. None of the price changes had anything to do with the factors above. None. No one ever makes a dime from applying these methods in real time.

What did we actually hear?

1. Did earnings meet the Street expectations? How about earnings quality?
2. Did revenues meet expectations?
3. What is the outlook for the upcoming year – with special emphasis on macro concerns like Europe, recession chances, and China.
4. Are there special factors affecting the outlook?

Every major stock move is explained in these terms, or a variant thereof. The ability to understand and answer these questions is the key to investment success.

The Overall Investment Implication

Anyone who thinks objectively about these questions is driven to a rather obvious conclusion about market valuation:

How can a method advertised as a good measure for the overall market fail to explain any of the components?

As corporate earnings move higher and expectations improve, most analysts conclude that the stocks in question are worth more. The market seems to agree.

There is another group of pundits who embrace Tobin's Q, CAPE, and cycles extending farther back than the dead-ball era in baseball. The enthusiasm of their followers approaches cult status. For these analysts the market seems to be in a permanent state of over-valuation. The followers are not investors, but merely spectators. They never get a "buy" signal.

A Better Method

Is there any better method? What if we could somehow create a network of sources that monitored all of the major companies? The sources would have to be professionals whose entire work would be devoted to studying specific companies. None would have to work with more than a few similar companies. These workers would question companies at a level impossible for most of us, challenging the assumptions and outlook, using detailed earnings models.

The sum of their conclusions would represent a comprehensive look at current earnings, revenue, challenges, and the outlook for the next year. Briefly put, it would aggregate all of the things that constitute the focus for each earnings season.

Ben Graham was brilliant. If such information been available to him, he would have found a way to use it. If only there was some way -- somehow – that modern investors could find and use such a source.

Some would probably ignore the information, finding an excuse to validate their predisposition, whether supported by data or not. Those of us who embrace the best data and evaluate everything objectively would have an advantage.

If only we could hire such a work force? How much would it cost?

Where can we find such information? Any ideas? The answer might require some real contrarian thinking.

Weighing the Week Ahead: Is There a Stop Sign at the Old Market Top?

There is a psychological barrier at market tops. Think about this conundrum:

1. By definition, a former top failed. That is how it got to be a top!
2. A new high is the most bullish thing a market can do. Also by definition, since going higher means reaching and taking out old tops.

As market averages approach old highs it becomes a great story for financial media. It can be played either way – A or B. It is such a natural that I expect it to be a dominant theme next week, despite the important employment news.

For story "A" feel free to do a Google search for "lofty levels" or the like, perhaps including the name of a popular pundit. Alternatively, you can search for "double top" or "triple top."

For story 'B" we find those whose business success is firmly aligned with the success of their investors – independent financial advisors. Josh Brown is a leading advocate for this group and he does a nice job analyzing a complex story. Ned Davis Research looks at past occasions when the market revisits prior highs. Mark Hulbert reports the story. Hulbert gets featured on CNBC. Everyone involved acknowledges that there are only 13 prior cases, so we should not make much of this.

And then we do.

Josh has exactly the right touch, navigating between data analysis and a few anecdotes. He is not wildly bullish, but he understands that a little data can be a helpful antidote to misleading headlines. Here are the past occasions from Ned Davis:

Even allowing for the small number of cases, the result is encouraging.

I have some further thoughts about the new high which I'll report in the conclusion.  First, let us do our regular update of last week's news and data.

Background on "Weighing the Week Ahead"

There are many good lists of upcoming events.  One source I especially like is the weekly post from the WSJ's Market Beat blog.  There is a nice combination of data, speeches, and other events.

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

This was a pretty good week for economic data. There was bad news, but mostly with a political angle.

• The State Department report on the Keystone Pipeline found few problems. Advancing the pipeline is a market-friendly event.
• Homeowners are getting above water. Zillow reports that underwater borrowers have declined by two million in the last year. The CoreLogic numbers are a little lower.
• Business investment is stronger. This is a crucial factor, given the strong corporate balance sheets and the pre-election jitters. Dr. Ed writes as follows:

  I was certainly pleased by the underlying strength of January's durable goods orders excluding the volatile transportation index. It suggests that companies did curtail their capital spending plans late last year as a result of fiscal cliff fears. I argued that too many investors were focusing on the downside of going over the cliff and ignoring the upside if the cliff was averted, as we expected.

• US oil production hits a new high. Ultimately this will be a positive for the trade balance, GDP, and fuel prices, but it is a work in progress. Here is the dramatic chart from Mark Perry:

• Michigan sentiment was even higher than the preliminary estimate. Doug Short has good analysis and a fine chart.
• The ISM index beat expectations. The results are consistent with GDP growth of about 3.7%, although recent readings have seemed to over-state the relationship from the ISM historical data. Most of the underlying components were also solid.
• Bernanke's Congressional testimony clarifies and emphasizes the Fed commitment to monetary stimulus. Markets rallied, but many pundits are more interested in arguing their personal viewpoints about the Fed instead of accepting and profiting from the reality. (Here's how).

The Bad

It was a tough week for the world's leading democracies and their leaders. There was also some soft data.

• Personal income dropped dramatically. See Steven Hansen at GEI for a full analysis and some interesting charts.
• The Italian election. The immediate market reaction was very negative. The hot money follows simple rules. This looked like the return of an old story – one which had major effects in the past. After the recent stock market advances, many were looking for a reason to sell. The story deserves deeper analysis. My own current conclusion is that it is yet another installment in the ongoing negotiations. It is a process of democracy, which Mark Mazower calls a "political meltdown." Those of us who are more comfortable with democracy might see this as a healthy push back against austerity. The Economist offers this take:

  "Italy's political convulsions underline the need for Mrs Merkel to adapt her prescription. So far it has been a lot of austerity and some reform; it should be the other way round."

  Whatever your political viewpoint, this is not a signal of imminent Eurozone collapse, dominoes, cockroaches or whatever, or an instant impact on US stocks. I am watching the yield on Italian and Spanish bonds, which moved higher and then pulled back – not at a danger level.

• Spanish GDP is looking ugly (via Bonddad).

• Sequestration began with far-reaching implications if an agreement is not reached soon. Most often trumpeted is the overall macro effect of a reduction of GDP in the range of 0.5 to 1%. One important illustration is the effect on domestic energy production. Here is the report from the Oil & Energy Insider, which also has several other timely and helpful stories.

  "Outgoing Interior Secretary Ken Salazar told industry leaders on 26 February that "the potentially devastating impact of budget reductions under sequestration could slow our economy and hurt energy sector workers and businesses."
  
  For fossil fuels, it doesn't look good, either: The immediate effect will be a delay in the development of oil and gas projects on federal lands due to program cuts at the Department of the Interior. According to Salazar, we're talking about 300 fewer onshore oil and gas leases issued in western states, and delays for some of the 550 offshore oil and gas projects in the Gulf of Mexico."

• Gas prices were up six cents a gallon last week. But there is hope. The EIA expects prices to fall later this year. And the Senate is going to investigate the "unreasonable increase" in gasoline prices during the past year. Thank goodness for that!

The Ugly

Prospects for compromise on deficit reduction. These headlines from The Hill tell the story:

Boehner says no new taxes after sequester meeting in White House

 

Pelosi: No budget deal without new revenues

 

'I am not a dictator,' Obama says

Unlike past political "deadline events," I did not forecast an eleventh-hour solution for this one. The immediate consequences are important, but not catastrophic. The long-term consequences of a deal are important. All parties have a current incentive geared to these interests rather than a fast solution.

So we should not expect a fast answer. I think that we will get one in a month or two – a good subject for a full-length analysis. Unlike some others, I avoid speculation in the absence of solid information. We'll know more soon.

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 have now added a series of videos, where Dr. Dieli explains the rationale for his indicator and how it applied in each recession since the 50's.  I have organized this so that you can pick a particular recession and see the discussion for that case.  Those who are skeptics about the method should start by reviewing the video for that recession.  Anyone who spends some time with this will learn a great deal about the history of recessions from a veteran observer.

I have promised another installment on how I use Bob's information to improve investing.  I hope to have that soon.  Anyone watching the videos will quickly learn that the aggregate spread (and the C Score) provides an early warning.  Bob also has a collection of coincident indicators and is always questioning his own methods.

I also feature RecessionAlert, which combines a variety of different methods, including the ECRI, in developing a Super Index.  They offer a free sample report.  Anyone following them over the last year would have had useful and profitable guidance on the economy.  RecessionAlert has developed a comprehensive package of economic forecasting and market indicators.  I will try to do a more complete review soon.  Dwaine Van Vuuren also has an excellent data update, demonstrating how the coincident data have reduced recession prospects.

Doug Short has excellent continuing coverage of the ECRI recession prediction, now well over a year old.  Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting.  His latest comment points out that the public data series has not been helpful or consistent with the announced ECRI posture.  Doug also continues to refresh the best chart update of the major indicators used by the NBER in recession dating.

The year-end effect of the fiscal cliff debate on real income is apparent, as is the resumption of the payroll tax.

The average investor has lost track of this long ago, and that is unfortunate.  The original ECRI claim and the supporting public data were expensive for many.  The reason that I track this weekly is that it is important for corporate earnings and for stock prices.  It has been worth the effort for me, and for anyone reading each week.

Readers might also want to review my Recession Resource Page, which explains many of the concepts people get wrong.

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.  About a month ago we switched to a bullish position.  These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings stabilized at a low level and improved significantly over the last few weeks.  The penalty box percentage measures our confidence in the forecast.  A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings.  That measure remains elevated, so we have less confidence in short-term trading.

[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

This week brings little data and scheduled news, an artifact of the calendar and the holidays.

The "A List" includes the following:

• Employment situation report (F). This is always the most important data for markets.
• Initial jobless claims (Th).   Employment will continue as the focal point in evaluating the economy, and this is the most responsive indicator.
• ADP private employment (W). This has been as good as the "official" numbers.

The "B List" includes the following:

• ISM service index (T). Especially watch the employment component.
• The Beige Book (W). Anecdotal evidence that provides color for the next FOMC meeting.
• Trade balance (Th). Worth watching for overall trends (especially in energy) and also the GDP effect.
• Factory orders (W). Older data, but still a significant factor.

There will be continuing news about the Italians efforts to form a new government. While all of the major news organizations are giving the story great attention, I especially like the Italian election coverage from Ft.com. I understand the modern mantra that "information wants to be free." If you want the best content, you sometimes need to support the publisher financially. I purchase a subscription from The FT and the WSJ (among others that I often mention) for this reason.

Trading Time Frame

Felix was marginally bullish last week. [I missed my regular weekly posting. For those who want a complete history, please check here.] We actually reduced trading positions to 2/3. This week's further decline in the ratings has moved Felix's forecast to neutral and we are only 1/3 invested for trading accounts. This could change very quickly. At the moment, it is more likely to shift to bearish than back to positive.

One of the things that Felix does best is controlling risk. Even when Felix delivers only normal market returns, the result is accomplished with less risk.

Investor Time Frame

Each week I think about the market from the perspective of different participants.  The right move often depends upon your time frame and risk tolerance.

Buying in times of fear is easy to say, but so difficult to implement.  Almost everyone I talk with wants to out-guess the market.  The problem?  Value is more readily determined than price! Individual investors too frequently try to imitate traders, guessing whether to be "all in" or "all out."

This week's Barron's has a cover story describing how the big-time wealth managers are recommending a shift from bonds to stocks.

"The world hasn't collapsed, and there's a beginning of a normalization in the way we look at the markets," says Chris Wolfe, chief investment officer at Merrill Lynch Wealth Management.

Go ahead and read the Barron's story. Please compare this to my 2013 preview for Seeking Alpha.  This covers the same theme along with some other key catalysts. There are also some specific stock and sector ideas.  My recommendations did well last year, and we are off to another good start.  You need to be comfortable in taking the other side of one of the most hated rallies in history.

But please beware!  General ideas are not for everyone.  Each person needs unique treatment.  We have several different approaches, including one that emphasizes dividend stocks with enhanced yield from writing near-term call options.

We have collected some of our recent recommendations in a new investor resource page -- a starting point for the long-term investor.  (Comments and suggestions welcome.  I am trying to be helpful and I love feedback).

Final Thought

Should we be worried about the new market top?

I recently suggested that investors are too easily victimized by the media focus on fear. Many have missed a nice market move (so far) by following those who offered headlines without data. There is an infinite supply of headlines!

It is a sad irony that our intelligence and reading – skills that work so well on most fronts – fail us so badly when it comes to investment decisions. The intelligent investor will always find persuasive things to worry about.

Abnormal Returns, everyone's choice for the leading curator of financial stories, noted that I was not alone on this theme. Tadas has an excellent story, with great quotations from Barry Ritholtz, Josh Brown, and Seth Godin. Pulling together these stories is both rare and helpful, so please take a look. It is also one of many important themes from his book (recommended here).

We are all suggesting, in slightly different ways, that the best investment choices require more than simply following the list of worries from financial media.

 

Dumb Money?

Are you part of the "dumb money?"

Here is a helpful guide:

Amateur vs. smart money

What the experts are seeing is that retail investors are slamming money into mutual funds, which then buy stocks, of course, but then there are signs that the smarties — institutional investors — are getting more cautious and looking to increase cash holdings.

That said, the outflows to cash are not all that big right now but it has to be said this dumb (or amateur money) in versus smart money out trend happened last year ahead of a stock sell-off in April. And those bad times for stocks lasted until October.

CNBC says corporate insiders are also heading out of shares. Jeff Cox pointed out that "they've dumped $4.2 billion in stock this month, about double January's level and — here's that warning sign again — the most since … last year's rally fizzled, according to TrimTabs".

And here is more from Jeff Cox of CNBC via the online transcript with errors included. You can figure it out. And check the link for Bob Pisani's rebuttal. (video here):

…(L)ook at the money coming into the market now. it's late money. the big selling point for this real has been this fun flows metric. i did szott some tracing back. i went back to 2007. in fact, 2008 was the only year, the only january that we have not seen a big in flow into funds so you can't tell a whole lot about that. you look at what the insiders are doing. that's what i'm doing right now. the corporations have stopped buying. the unsiders are selling, so this is telling you that this rally is getting very tired, and i do believe this dash for trash that i call it, the big stocks, the big metrix doing well, stocks with a lot of short interest and zero dividend payers. they have led the rally. sorry to use the word dumb money but it doesn't look smart to me right now. a dumb idea to put money to work in this market? the corporate insiders, they are sellers.

The two statements from Cox are quite similar. The only change is that the second does not refer to institutional investors but to corporations. That would be easy to miss.

Now think about this:

The market changes, but the Jeff Cox story does not. He seems to be a designated hitter for a bearish viewpoint.

The first statement was from February of 2012, one year and almost eleven percent ago. Cox's story has changed in one respect. The new statement does not cite the big money investors, because their attitude is much more bullish. He is not calling them "dumb money." CNBC's own Davos series and the Barron's roundtable have highlighted that many big-name, high-profile investors see great upside for stocks. One example, also from CNBC, is Ron Baron who provides the logic for Dow 30K.

In a further explanation of his investment philosophy, Baron said, "Over the long term, I think the stock market is going to grow 7 percent a year," about the same rate as the overall economy, not adjusting for inflation. He said that this has been the norm for generations and he doesn't see that changing.

"So people are saying … '[Dow] 14,000, is it too late?' It's not too late; 14,000, I'm thinking in 10 years, it's going to be 30,000. In 20 years, it's going to be 50,000 or 60,000."

It makes the OldProf feel like a piker. Back in May of 2010, when the Dow was at 10,000 and there were predictions of 5000, I wrote the following:

Someone needs to say this:

Dow 20K.

The fear mongers abound in the financial media.  TV and online ratings seem to go to those helping to peddle fear and sell gold or structured annuities (with high commissions attached).   Every individual investor I meet is scared silly.  They do not realize what is at stake.

For the mainstream media, it is all about ratings.  They have all learned that fear sells.  Attacking Obama, attacking Bernanke, attacking European leaders, explaining government policy as if it were the family budget ---  it all works.  The big-time media have garnered page views and sold papers.

Even when they attempt to show "balance" they have someone warning about Dow 5000 and the "bull" saying that stocks will go up 8% this year!  Is it any surprise that watchers are scared witless?

Investors need to understand that they are missing more than an 8% move.  Stocks will double.  When will they get on board?  Do they have a plan?

I hope that everyone has noticed how the words from nearly three years ago still resound today. The same peddlers of fear and gold. The same Obama/Bernanke/family budget stuff.

Those who stayed on the sidelines have missed the first 40%. Some assert that the market is now "giddy" and stocks are "toppy."

Just think about that reasoning. A rising market makes new highs. If you are going to define every new high as "toppy" you will never buy stocks. As I asked three years ago, "What is the plan?"

Objective Analysis

The best way to invest is through data-driven, objective measures. When I analyze a stock, I look at the future expected earnings and cash flow, adjusted for business circumstances and risk. I look at the business cycle. I do the same thing for the overall market – as a background for specific investments.

Since everyone is citing the prior Dow 14,000 as the key point (I don't agree about the significance, but let us join the discussion) let us compare the 2007 decline from that point to the current rally (data from Friday).

	10/12/2007	2/1/2013
S&P 500	1561.8	1513.17
Forward Earnings	94.88	113.16
Forward Yield	6.08%	7.48%
Interest Rates	4.70%	2.04%
Risk Premium	1.38%	5.44%
Risk - SLFSI	-0.186	-0.536
Dieli Indicator	91	841
Dieli Recession Odds Interpretation	Recession Watch 100%	9-month Recession Probability < 5%
Sources: Thomson/Reuters, St. Louis Fed, No Spin Forecast
Analysis by NewArc Investments, Inc.

Even a cursory examination of the data shows that the market is much, much more attractive than it was in 2007 – even though that story had but one flaw.

Earnings expectations are much better. You are invited to look at my last comparison of this type, where I explain why this method is better than the alternatives.

The interest rate alternative investment is pretty lame. Those whose methods ignore the asset allocation alternatives as a method are now screaming that it is all unfair.

The financial risk is very low, the objective indicator for Europe. Any investor following this indicator would have known to ignore the headline risk about Europe.

And most importantly – the recession odds. This was the key problem in 2007. Bob Dieli's indicator had all of his clients on warning. (I wish I had been one of them!) The current story is much different.

Investment Conclusion

Individual investors are fearful at the bottom, slow to spot new trends, and called stupid whenever they climb aboard. There is no objective plan for market timing, and they have all been told that "buy and hold" is wrong.

This is why I recommend the following:

• Use data to adjust your viewpoint – not just absolute price.
• Actively manage your portfolio, looking for the best stocks and themes.
• Revise price targets regularly.

Ignore those who have been completely wrong, and who now call successful investors "dumb money."

Do You Understand Ceteris Paribus?

Since no one seems to take Latin any more, you probably cannot translate "ceteris paribus."

Real economists frequently cite the need to explicitly state the assumption that "all other things are equal."

In the blogging world, the biggest voices on economics are not economists. This should not surprise us. The pop economists are playing to our vision of reality:

1. State what the reader already believes;
2. Provide data that appears to support the belief; and
3. Add some bogus conclusion.

It happens every day.

Background

I am going to reveal something personal and unprofessorial. I like Jack Reacher – the character, the strength, the simplicity of needs, the moral compass, and of course, the ability to "connect."

Like many others, I was interested in the upcoming movie. How could Tom Cruise portray this giant? In reading about the story I discovered something interesting about investments. Lee Child is a pseudonym and the Brit who is actually writing is a guy named "Jim Grant." No, not that one!

In a great story by Brian Curtis at Grantland the author reveals why his work is so persuasive and sells so well:

Although he'd never lived in the U.S., Grant had visited frequently, had lapped up American TV, and had even married an American woman. "It was really a question of mimicking," he says. "If you're familiar with the rhythms and the word choices of the country and you can put them down on paper, it actually becomes their nationality." British drollery metamorphosed into a kind of hypnotic, Eastwoodian growl. Killing Floor, the first Reacher book, opens like this:

I was arrested in Eno's diner. At twelve o'clock. I was eating eggs and drinking coffee. A late breakfast, not lunch. I was wet and tired after a long walk in heavy rain. All the way from the highway to the edge of town.

Grant's wife, Jane, read his drafts and clipped out Britishisms. She called herself the Committee on Un-American Activities.

The Americanness of Lee Child's novels did not come from granular detail, from a novelistic sense of place. "You know you're in Nebraska because he says, 'We're in Nebraska,'" notes Otto Penzler, the owner of New York's Mysterious Bookshop. "You don't smell the cornfields."

No, Child aims to deliver a different American vision. When Reacher goes to Nebraska, as he did in Worth Dying For, Child borrows images from movies and TV shows — it's a "Nebraska" of our collective imagination. As Child puts it, "If you stick to that mental image, everybody says, 'That's a well-researched book.' If you actually supply the reality, people say, 'The guy's never been there.'" It's as if Child is feeding back to us the images America once beamed to England.

Investment Implications

Bringing this back to the world of investments there is a clear conclusion:

The great novelist of thrillers reveals the technique of the great fiction writers of economics!

They are telling you what you think you already know – not trying to inform.

Spotting These Imposters

The biggest tipoff to the pop economist is when he/she does not say, "ceteris paribus." This means that the author is trying to change only a single variable in a multivariate world – an amateur approach.

Here are two current examples:

1. Profit margins. We have all heard ad nauseam that profit margins are mean-reverting. The blunder of this one-variable approach is a failure to consider why profit margins are so high. Corporations have squeezed employment and costs. Think lean and mean. Those taking this viewpoint have been wrong and the multivariate approach which I endorsed two years ago and again last year has been correct. Profit margins will decline if and only if there is a massive increase in revenue and gross earnings. There is still time for investors to grasp this concept, since the wrong-headed bearish viewpoint prevails.
2. Interest rates. Suppose interest rates were to move higher, forcing greater government expenditures and offering a more attractive alternative to stocks. The Fed might go broke! I need to write more on this theme, but the concept is the same. The Fed is actively trying to increase inflation expectations. They want to encourage investment. That is the plan, little understood by traders. So there is no "ceteris paribus." When interest rates rise, the move will be accompanied by a vigorous economic rebound, including business and consumer investment.

Only the pop economists isolate on one variable and project the worst case.

Weighing the Week Ahead: Are Earnings Expectations Too High?

The quirks of the calendar have delivered a week that has little fresh economic data.  Some will use the quiet period to continue the discussion of politics and the debt ceiling.  Others will focus on predictions for the coming year.

Most are tired of "the cliff" and will be happy to turn to a new subject:  It's time for earnings!

This earnings season will be especially important.  Here are two key reasons:

1. Forward earnings estimates are at an all-time high.  The oft-repeated pundit opinion is that analyst estimates are excessive and must be reduced.
2. The January earnings season often includes full-year guidance.  This is always interesting, but perhaps even more so right now.

Both of these intriguing ideas come from my Chicago-based friend Brian Gilmartin, who is among the very best sources on corporate earnings.  He sees the forest, since he has tracked the ThomsonReuters estimates for over a decade.  He notes trends in these estimates as well as revisions by sector, most recently with this report at his blog.  He also covers many individual stocks through his posts on Seeking Alpha.  (see his Alcoa preview).

I have some thoughts on this earnings season, which I'll report in the conclusion.  First, let us do our regular update of last week's news and data.

Background on "Weighing the Week Ahead"

There are many good lists of upcoming events.  One source I especially like is the weekly post from the WSJ's Market Beat blog.  There is a nice combination of data, speeches, and other events.

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 holiday-shortened week still had a lot of significant news, and it was mostly positive.

• The Fiscal Cliff decision.  Those who object to this being scored as "good" should re-read the criteria, e.g., market friendly.  They also need to separate their political opinions from economic reality.  The decision avoided an immediate economic drag from the expiration of tax cuts and the sequester.  This was good for the economy and good for stocks.  Those who are complaining the loudest about the outcome are the same people who were completely mistaken in their forecasts.  I recommend that real investors ignore these sources and read my review of the outcome.  There are obviously important remaining issues.  I'll get around to those when it is more timely --- which is not right now!
• The ISM index is back above 50.  Bespoke has a good discussion of the trends in the sub components, including this chart:

• The ISM services index was even better.  See Steven Hansen's comprehensive discussion, including the various components.
• Shadow home inventory is down 12% according to CoreLogic (via Calculated Risk).
• Commercial lending is higher, along with many other growth indicators.  Scott Grannis is not happy with the election result or current tax policy, but he is open-minded in looking at indicators.  See the full article for all ten of his charts.  Here is one example:

• The technical picture is better with an upside-down head and shoulders playing out, among other patterns.  The analysis is not that simple, and difficult to summarize.  Charles Kirk's success reflects his willingness to change with the data.  His site has a small charge which goes to charity after offsetting expenses, and it is well worth it.  He provides this week's update while fighting the flu.  Get well soon, Charles!
• Europe continues to improve.  Remember the threat of rates over 7%  Dominoes falling?  You can either listen to the words of those singing the same song, or you can look at data.  Dr. Ed notes that the mission is being accomplished even without actual sovereign debt buying by the ECB.

The Bad

There was not much bad news last week.  I invite readers to nominate items that I overlooked, but make sure that they are fresh -- not just stale and recycled opinions.

• The FOMC minutes.  These are usually not controversial, but the new era of transparency from the Fed seems to be backfiring.  Despite the meeting decision to increase the QE program, to some the minutes seemed to suggest that a policy change might be imminent.  This is a good topic for more work, so it is high on my agenda.  Meanwhile, I recommend the comprehensive discussion from Cardiff Garcia at FT Alphaville -- a careful look at various perspectives.  I also like the account from Paul Vigna at MarketBeat.

"Investors aren’t looking at the fundamentals through their own eyes, but through what they think the Fed thinks, and trying to gauge when the Fed will send a signal to everybody else that it’s going to change course. Because if you’re really playing this game, you’re trying to catch that signal from the Fed before every other trader, speculator and investor does."

 

• Manufacturing new orders disappointed.  See Steven Hansen's report for all details.

The Neutral

Employment.  I do not do a neutral category very often.  I want to mention the employment report, but I cannot bring myself to call it "good" in the current market context.  It was certainly not "bad."  The job growth is consistent with recent months, which means that it is positive, but far less than what is needed.  The report avoided the customary complaints about seasonality, labor force participation, and manipulation of data.

We need businesses to start hiring more aggressively.

The Ugly

This week's ugly award goes to the "sold out bull."   I tried to explain why those who missed the "fiscal cliff rally" should simply understand that it was not all about price --- it is a matter of risk and reward.  If you choose to avoid the high-risk situation (and what turned out to be the best price), there is no shame in buying after the risk is lower.  It can be quite smart, and more consistent with your objectives.  Very few understand this concept.

Josh Brown is more expressive and colorful, and I recommend the full piece.  As usual he absolutely nails the market psychology of those who have been left behind.  We can all learn from this:

No, the sold-out bull is pure evil - ferociously outspoken or slyly suggestive, he is all the time engaged in a singular mission:  Scaring others out of the investments that he would like to buy back himself at lower prices.

The sold-out bull is a sickly creature, a thrashing fish on the deck of a ship, out of its element and sucking at the air for one more breath. Every trick will be employed, from fiery sermons of impending doom to sarcastic asides about the dopiness of those who are still in.

The sold-out bull is desperate and his mind is twisted, every thought and expenditure of energy is employed toward the creation of a lower entry back into the markets. Only a cheaper buy-in will vindicate the earlier decision to sell that haunts him so.

Steer clear of the sold-out bull, for the ferocity of his bearishness comes from somewhere very dark and extremely cold. He will hurt you if he can, climb over your body to get back in.

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."

Doug Short has excellent continuing coverage of the ECRI recession prediction, now well over a year old.  Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting.  His latest verdict is that the ECRI has flunked Recession 101! I have been expecting the ECRI to declare that their forecasted recession is over.  The secret long-leading indicators have been identified by some, and they have improved since the original forecast.

RecessionAlert uses a variety of different methods, including the ECRI, in developing a Super Index.  They also offer a free sample report.  Anyone following them over the last year would have had useful and profitable guidance on the economy.

Readers might also want to review my new Recession Resource Page, which explains many of the concepts people get wrong.

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.  A month ago we switched to a bullish position.  These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings stabilized at a low level and improved a bit over the last few weeks.  The penalty box percentage measures our confidence in the forecast.  A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings.  That measure is moving higher, so we are becoming less confident in short-term trading.

[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

This week brings little data and scheduled news, an artifact of the calendar and the holidays.

The "A List" includes the following:

• Initial jobless claims (Th).   Employment will continue as the focal point in evaluating the economy, and this is the most responsive indicator.

The "B List" includes the following:

•  Trade balance (F).  Continuing implications for the GDP.
• The JOLTS report (Th).  Mostly helps on the issues of structural unemployment and letting people see the gross job changes.  Not much movement in recent months.

There are a number of Fed speeches on tap.  Given last week's news, this may be more confusing than enlightening.

Most important is the start of earnings season.

Trading Time Frame

Felix has moved to a bullish posture, now fully reflected in trading accounts. It has been a close call for several weeks.  Felix has done very well this year, becoming more aggressive in a timely fashion, near the start of the summer rally, and getting out a couple of months ago.  Since we only require three buyable sectors, the trading accounts look for the "bull market somewhere" even when the overall picture is neutral.  Our current trading holdings have a foreign tilt.

Investor Time Frame

Each week I think about the market from the perspective of different participants.  The right move often depends upon your time frame and risk tolerance.

Buying in times of fear is easy to say, but so difficult to implement.  Almost everyone I talk with wants to out-guess the market.  The problem?  Value is more readily determined than price! Individual investors too frequently try to imitate traders, guessing whether to be "all in" or "all out."

Even the pros get it wrong.  Any of us who are constantly commenting on markets will have some bad calls, but last year was worse than usual.  Bloomberg's Michael Patterson & Lu Wang write, Almost All of Wall Street Got 2012 Market Calls Wrong.  Citing some of the most prominent forecasts, they write as follows:

All of them proved wrong last year and investors would have done better listening to Goldman Sachs Group Inc. (GS) Chief Executive Officer Lloyd C. Blankfein, who said the real risk was being too pessimistic.

The ill-timed advice shows that even the largest banks and most-successful investors failed to anticipate how government actions would influence markets. Unprecedented central bank stimulus in the U.S. and Europe sparked a 16 percent gain in the S&P 500 including dividends, led to a 23 percent drop in the Chicago Board Options Exchange Volatility Index, paid investors in Greek debt 78 percent and gave Treasuries a 2.2 percent return even after Warren Buffett called bonds “dangerous.”

“They paid too much attention to the fear du jour,” Jeffrey Saut, who helps oversee about $350 billion as the chief investment strategist at Raymond James & Associates in St. Petersburg, Florida, said by phone on Jan. 2. “They were worrying about a dysfunctional government in the U.S. They were worried about the euro quake and the implosion of Greece and Portugal. Instead of looking at what’s going on around them, they were letting these macro events cause fear to creep into the equation.”

We have collected some of our recent recommendations in a new investor resource page -- a starting point for the long-term investor.  (Comments and suggestions welcome.  I am trying to be helpful and I love feedback).

Final Thought

How can you go wrong by under-estimating Congress and other political leaders?  Amazing!

But that is what happened.  Even modest expectations for results was enough to keep you on the right side of the market.

For the upcoming earnings season I remain open-minded and I will be very attentive.  Last quarter was a minefield for corporations.  If the complete story -- earnings, revenue, outlook -- was not perfect, the stock price moved lower.  I avoided earnings dates in our most aggressive trading programs, and I was nearly always right.

So what now?  We all know that the economy remained sluggish in Q4, so earnings will not be great.  Much of the uncertainty has been lifted.  We know the election result and also tax policy for the near future.  Will companies provide a little more guidance?  What will it be?

I have more respect for the analyst updates than I do for the pontificating pundits with opinions but absolutely no record.  I understand that analysts are too bullish in their multi-year forecasts -- basically following trends with no allowance for bad news.  I also understand that by the time earnings are actually reported, the bar has been lowered so that more than 60% of companies beat expectations.

Most experts share these views, but I seem to be alone in drawing the logical conclusion:

If estimates are too bullish in the long run and too bearish at the time of the report, there must have been a "crossover date" when the forecasts were pretty good.  My research shows that this occurs at about one year in advance.

To summarize:  This earnings season will be important for estimate revisions as well as the current "beat rate."

Analyzing the Fiscal Cliff Outcome

With some amusement, our office gang watched the parade of pundits today.

In general the media focus was on everything that was wrong with the deal, mostly based on the idea that  spending was not slashed.  Those interviewed included nearly everyone who was wrong in predicting the actual outcome.

Astonishing!

Imagine that ESPN interviewed all of those who called the Cowboys over the Redskins last weekend.  "What is your next great call?"

Few of the analysts seemed to grasp the nature of compromise:  Hated by all!

This is something that we have highlighted for months.  Perhaps the problem is that so few people got it right, so the producers could not find good subjects for interviews.  [Hint:  Check here or here or here.]

The attention has smoothly shifted to the next challenge.  For many mistaken investors, this makes them feel like they were right, even though the facts show otherwise.

The Investment Reality

Today's market rally was a minor rebound, when viewed in terms of the post-election levels.  Put aside any notion of "chasing" and simply think about the fundamentals.

A few months ago there was a major challenge, something that might throw the economy into recession.  It did not happen.  Consider two possibilities:

1. If you understood the political probabilities, you are already in the plus column.
2. If you have been on the sidelines, you missed the bottom.  So what?  You need to have an open mind.  Each day is a new opportunity.  Forget that you did not buy the bottom.  Even if your favorite stock is up a couple of points, it might still be a "buy."

Risk and Reward

Most investors consider price and only price.  If they missed the bottom, they are paralyzed.

Wrong!

You had a chance to buy CAT at 89 or so on Monday or in the low 80's last week.  That was with the fiscal cliff issue in front of us.  Those who (incorrectly) thought this was a big risk were worried about CAT.

With that issue behind us, the risk/reward profile is different.  The CAT upside is still in the 130 range based upon the long-term P/E multiple, but the downside is much more limited.

Even though CAT is now trading at 93.50, it is at least as attractive as it was last week, and maybe more so.  It is one of the stocks that I am buying on Day One for new accounts.

Summary

The value of any investment includes both risk and reward.  Despite today's rally in stocks, there is much less risk than there was a week ago.

When market worries change, you should adjust your risk/reward profile.  Since you cannot go back and revisit last week's prices, it is better to analyze current values!

 

 

 

Weighing the Week Ahead: What lies over the cliff?

For the first time in recent memory, the monthly payroll employment report will not be the big news.

The financial media are like one of those dedicated radio stations --- All Cliff, All the Time!

Last week I noted that I might skip this week's WTWA column, focusing on "Cliff notes."  I am focused on my "year ahead" article for Seeking Alpha, a stimulating annual challenge.

Meanwhile, I recommend that my readers follow the contributions of my colleagues in the Positioning for 2013 series.  I certainly am.

I also highly recommend the "Gut Feeling" series from Scott Rothbort, my colleague at the Wall Street All Stars site.  Scott does an excellent review of his 2012 predictions.

As to the coming week, there are a few things worth noting.

No one can say much with certainty before the legislative process plays out (although that is not stopping most from offering an opinion).

The outcome that I have long predicted as most likely -- a resolution of the main tax issues and deferral of spending cuts -- is still a live possibility.

I'll update the possibilities in the conclusion, but let us first hit some highlights from last week.

Background on "Weighing the Week Ahead"

There are many good lists of upcoming events.  One source I especially like is the weekly post from the WSJ's Market Beat blog.  There is a nice combination of data, speeches, and other events.

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 economic news last week was mostly positive.  The single most important report was initial jobless claims, which are now hitting a pre-recession low.  Here is a good chart from Bespoke:

More reading:  Check out The Bonddad Blog for a summary of the year-end strength in the high-frequency indicators.

The Bad

There was some bad news last week, but not very much.  The worst news was consumer confidence as measured by the Conference Board.  The worst part of the report was future expectations, suggesting the Fiscal Cliff story is at fault.

Doug Short has excellent coverage of this report, placing the most recent news in historical context and comparing the data with the survey from the University of Michigan.  Here is one particular chart that really captures the story:

 

The Ugly

The ugly award for the week goes to those trying to stimulate ratings or page views by scaring their audience about the fiscal cliff.  There are real concerns and consequences, so no exaggeration is required!

After the close on Friday, CNBC's Kudlow Report (with Michele Caruso-Cabrera subbing for Larry) began the show with a diatribe about the lack of progress from the meeting of Congressional leaders with the President.  As I have frequently noted, this entire approach is incorrect, displaying a lack of knowledge about how the policy-making process works.

And by the way, the same program noted that the longshoreman strike went to the eleventh hour before an extension.  The NHL is still out.  There is nothing unusual about difficult negotiations going until the last minute and requiring a deadline to achieve a result.  There is also nothing unusual about needing an extension of the deadline, as the longshoreman are getting.

Regular readers know that I am long-time viewer of Kudlow, so I am saddened by the continuing efforts to outflank Fox on the right.  The former method of inviting great guests and giving them a chance to speak worked well for me.

So why is this "the ugly?"  Caruso-Cabrera's opening monologue emphasized that the market hated Obama's announcement of the meeting results and that the futures trading implied a down 300+ opening on Monday.

This interpretation is completely incorrect--- a blunder!  CNBC should be ashamed and should make a correction, just as they did when Warren Buffett called them out.  I cannot find the video on their website, but I have it on TIVO and I was not the only one to notice.

Here is a brief explanation.  Stocks stop trading at 4 PM Eastern and 3 PM Central.  Futures trade for another fifteen minutes.  If there is breaking news, the future can trade lower (or higher) than the final marks on stocks.

Since the White House meeting story was breaking late in the day (including a lot of poor reporting) the market was selling off into the close.  The actual settlement price for futures is a little complicated, but it basically is an average of the high and low price during the last thirty seconds of trading.  If there is no trade during that time, it is the last trade in the prior interval.  This is all designed to avoid any manipulation of the market, since the settlement prices are the basis for many OTC derivatives.

The "fair value" of the S&P 500 (or the Nasdaq or the Dow) is a simple arbitrage calculation.  The owner of the futures contract saves the cost of buying the underlying stocks but loses the dividends from those stocks.  Fair value can be a touch higher or lower than the cash price depending on short-term rates and dividends.  Apparently, no one at CNBC understands this -- thus the blunder.

Here is a better analysis of the late futures trading -- less than 1% lower.   Even that reflects a knee-jerk reaction to complex events.  The last trade was a rebound from the settlement price -- up 50 or so in the Dow.  My major point? None of this is really meaningful and the messengers do not understand what they are telling you.

Such is the state of investor information.  My main concern is for investors reading over the weekend.  In the 1987 crash people formed an opinion and called their mutual funds with sell orders.  This started the selling process on that fateful day.

Putting out incorrect information has consequences both for the investors who (unwisely) act on it, and also for everyone else.

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."

Doug Short has excellent continuing coverage of the ECRI recession prediction, now well over a year old.  Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting.  His latest verdict is that the ECRI has flunked Recession 101!

RecessionAlert uses a variety of different methods, including the ECRI, in developing a Super Index.  They also offer a free sample report.  Anyone following them over the last year would have had useful and profitable guidance on the economy.

Georg Vrba explicitly and carefully refutes the ECRI approach.  I encourage a thorough reading of Georg's work -- a few minutes well spent.

Readers might also want to review my new Recession Resource Page, which explains many of the concepts people get wrong.

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.  Three weeks ago we switched to a bullish position, and the outlook has become even more positive. These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings stabilized at a low level and improved significantly over the last few weeks.  This week reflects a notable decline. The penalty box percentage measures our confidence in the forecast.  A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings.  That measure is moving higher, so we are becoming less confident in short-term trading.

[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

The holiday-shortened week brings little data and scheduled news.

The "A List" includes the following:

• Employment report (F).  Normally big, and maybe it still will be.
  Initial jobless claims (Th).   Employment will continue as the focal point in evaluating the economy, and this is the most responsive indicator.
• The ISM index (W).  A good coincident indicator.

The "B" List" does not interest me this week.

The decision on the fiscal cliff issues will be most important.  This will interfere with New Year's Eve parties.  If there is no decision, we will have continuing speculation about the "bungee jump" over the cliff, where the new Congress can try to save the day by "cutting taxes."

If and when we get past this, there are plenty of Fed speeches to entertain us later in the week.

Final Thought

There are many possible outcomes as I write this on Saturday night.  Anything suggested now could seem foolish by New Year's Eve.

Since I have been very accurate so far, I'll venture to speculate a bit more.

Bullish Outcome

The most encouraging result will be a resolution of the tax matters -- anything that affects individual or business planning for 2013.  This has been my long-term base prediction.  See here for the most recent summary.

This would resolve most of the issues that threaten economic growth.  The major tax reform, spending cuts, and debt ceiling would be deferred for 60 or 90 days.

Bearish Outcome

The worst result would be a complete lack of agreement.  This would require instant reaction by the new Congress -- the so-called "bungee jump" over the cliff.  It would provide a fig leaf for those who would rather vote for tax cuts after allowing the old policies to expire.

My Guess?

As I write this, the insider reports say that there is little progress in the negotiations.  Here is what to watch for:

• Senators Reid and McConnell may come up with a compromise that have hated provisions for both sides -- tax rate increases for those earning more than $400K, a capital gains rate of 20%, dividend taxes of no more than 20%, a compromise on inheritance taxes at nearly the current exemption and rate.
• The agreement must satisfy the most conservative Senate elements to avoid a filibuster and procedural objections.
• The House would have to consider the result with little time for amendment.  Boehner would be under intense pressure to allow a vote on something with widespread GOP support, despite the Tea Party objections.
• If a vote were to be allowed, my guess is that it would pass in the House with strong Democratic support and possibly a majority of Republicans.
• The key is that the legislation would have passed muster on Sunday with both GOP and Democratic caucuses in the Senate -- before any voting.

If this does not pass muster in the House, the bare-bones Democratic proposal to extend Bush-era cuts for those earning less than $250K will be the agenda.

President Obama will be on Meet the Press Sunday morning.  The market did not give him sufficient credit on Friday.  Instead of profering his own "solution" he held back his own "Plan B" while giving the key parties one last chance to come together. 

If Boehner will not allow a vote on either of these proposals, the GOP will hear from doctors and middle-income folks who will be retroactively subjected to the AMT, as well as businesses who want some certainty.

Summary

There are many ways that an agreement can be derailed.  It has all been coming down to this for many, many months.  All of the public statements have been posturing. 

We'll soon know....

Fiscal Cliff Notes: Interpreting the deadline news

Here is an all-time first:  Market rallies on news that Congress will be in session!

That was today's story.  The market gyrations lacked a grounding in reality.  Joe Weisenthal charts the day, with my comments to follow.

Here are a number of rhetorical questions:

• After weeks of public posturing on both sides, would we really expect Reid, McConnell or Boehner to make a conciliatory speech from the floor?
• Did we think that Obama would come back early from vacation without even a rumor of a new plan?
• With 100 Senators and 435 Congressmen, do we think that they will all remain silent as negotiations proceed?
• Perhaps we should expect that many will be claiming a few minutes of fame without any new information at all!

If you were making trades by accepting this "information" you were on the wrong side today!

The Reality

While the market is following the public news sources, including anyone who will go on TV, none of this information is very helpful.

There have been continuing back-channel discussions at the staff level.  There is also escalating pressure, especially on Republicans, to reach some kind of deal.  The doctors, those affected by the AMT, and the business executives stymied by uncertainty are mostly from the GOP.

If they had a chance to vote on a compromise proposal, many GOP legislators would support a compromise.  The compromise would be close to the most recent Obama/Boehner discussion, with perhaps a little more concession from the President on spending.  While there is support for such a plan, there is a key problem of who goes first, both in terms of party and also which House.  Revenue bills are supposed to originate in the House.  This partly explains why the Senate-passed bill on the Obama plan has never formally gone to the House.

This is only going to work if the Senate finds a compromise, without a filibuster, that Boehner is also willing to accept for a House vote.  There is still some possibility of this, and we may well know the verdict tomorrow.  The path to a compromise would start with the Senate considering such a proposal.  The House would take it up on Sunday.

The other alternative is the "bungee jump."  I have noted that legislators are creative when it comes to deadlines.  They might extend their deadline by going "over the cliff" while sending a message that there will be an early vote by the new Congress.

The Nature of Compromise

I enjoyed reading the description of compromise from Alan Grayson, a Democratic Congressman-elect from Florida.  To appreciate the key point, don't think about his particular perspective, but instead focus on the process he is describing:

"Here are what I modestly and humbly refer to as "Grayson's Laws of Legislating":

1) Vote for what you're in favor of.

2) Vote for what you can live with, if you must do that to get what you need.

What we've been seeing in the House of Representatives lately has been a series of massive and pervasive violations of Grayson's Laws of Legislating. Instead of "I'll vote for X because it's right," or "You don't like X and I don't like Y, but I'll vote for X and Y if you vote for X and Y," it's "If I don't get Z, I ain't votin' on nothin'." And that's the problem."

He provides a colorful example of where nearly everyone in Congress agrees on most of the fiscal cliff issues.   On the remaining 10% he provides a colorful example of trading help for the unemployed for more defense spending.  It is a good description of how Congress has worked for decades.

The key question is whether we can see this sort of horse trading within the next few days.

Trading and Investing

The volatility is a natural opportunity for traders.  You need only to fade the statements of whatever politician spoke most recently.

Investors should look a month or so ahead.  If you are willing to conclude that there will eventually be a solution, you can go shopping for bargains whenever there is apparent bad news.

These were today's opportunities, and we might well see the same thing tomorrow.

Are you really a chart expert?

When it comes to charts, everyone is an expert -- or so they think!

It can be expensive to be overconfident.  In this post and another on my agenda I will illustrate the problem.  If you get both problems right, you can have confidence in your chart-reading skill.

Tracing a Dangerous Path

One of the most common charts we see compares current circumstances to something that happened in the past.  It often comes as a warning.

My email today provided this example, suggested for consideration by one of my most astute friends.  He is also a very successful investor and market observer.

 

 

So we are tracing the same steps that we did last year, with economic disaster to follow.

But wait --- there's more!

We are following the same path as in the Summer of 2011 and the debt ceiling debate.  Oh my!

My friend did not reveal the source of the charts, but I did not need a hint.  I get similar emails every week.  The charts are all from the same source.  The perpetrators have a wonderful and profitable business model.  They have identified a market of people who want to be Scared Witless (TM euphemism, OldProf).  They love to hear about conspiracies.  They want to have their worst fears confirmed.

My own market is much smaller, but I am proud of the readership.  It consists of people who employ critical thinking when evaluating evidence.  They want to profit from their investments.

Problems with the Chart

Regular readers will have already pounced on the main problem with this chart -- the twisting of scales.  Modern computers and software have created enough charting power to overwhelm the (lack of) skill of the user.  You can now look back in history, adjust the scales from two different time periods, find a brief period that seems similar, and then show a prediction.  Bravo!

You could just as easily find a time period that showed the opposite.

When you read something like this, it is time to turn the page.  I recently awarded The Silver Bullet to Tom Brakke for exposing this kind of deception.

Problems with the Logic

Moving beyond the chart itself, let us suppose that you paused to consider the actual reasoning.  Try to forget the chart and use words instead.  Here is my best effort:

The Citi Economic Surprise Index has moved higher, just as it did last year.  It is tracking last year's move almost tick-for-tick.  We can see the collapse last year.  Ergo, we should expect a series of economic disappointments to start 2013.

It seems pretty foolish when stated that way, but it is the story they are selling.  Please note what the chart does not say:

• This is something that happens every year (not just one time);
• This is something that happens whenever there is a similar negotiation (not just one time).

There are many differences between last year and this year.  Just for starters:

• Election versus non-election year
• Debt ceiling for a temporary change versus long-term policy
• Public preamble and preparation.

But those are only starters.  The basic problem is the following: 

You cannot make valid inferences from one prior case.

Anyone cherry-picking a prior history to do this is selling snakewater.  Beware!

An Alternative Viewpoint

Let us pretend that we did not start with the original chart.

In fact, I did not.  I have often looked at the Citi Surprise Index in the past, but I have not found much predictive value.  If the economy turns positive, the expectations increase.  I have tried but cannot sync it with any meaningful prediction.

Here is one take, from Easynomics:

Keep in mind what is basically happening, as it is usually a cycle.  Expectations rise as a result of improving data, and then it becomes more likely that data will disappoint.  It doesn’t actually mean the data get worse, only that they disappoint versus expectations.  The reverse then happens in order to complete the cycle.  We hope that the downturns don’t go as deep as the upturns go high.

Dr. Ed also follows this index.

 

Conclusion

Good luck in tracking stock prices versus the surprise index.  I do not see a fit, but suggestions are welcome.

There is a lot of irony in the original presentation.  Step back from the charts and think about it.

If the Citi index showed that there were disappointments, that would be the end of the story.  The perma-bear site would simply report that the macro conditions were bad.

Since results have been beating expectations, and you are selling snakewater, there is a problem.  Solution?  If you do enough data mining you can find a time period where beating expectations was actually bearish...  Black is white.  Bad is good.

Let's see -- last year - - wonderful.  One case is enough.

If it does not fit last year, let's go back in time......

Cliff Notes, Fiscal Style -- 12/12/12

Anyone who made it through college remembers "Cliff Notes."  As a professor, one of my jobs was to identify students who had read the real work.  Who were the imposters?

Now I am on the dark side!

Investors can join me with our Fiscal Cliff Notes.  There are so many pretenders, and so little real information.

I have repeatedly warned that the entire discussion is a costly distraction for most investors.  Here are the leading characters in the noise game:

1. The TV Anchors.  Sports fans see this constantly.  If you are a sportscaster or "color man" you need to keep talking, no matter what is happening.  It is a demanding job, leading to a lot of stupid commentary.  One of my favorite sports websites is Awful Announcing, where viewers and readers send in their favorite nominations for the blooper of the week.  With the massive and excessive coverage of the Fiscal Cliff, it is easy to find the blooper of the hour.  (Examples below).
2. The Pseudo-Experts.  Someone who knows absolutely nothing about what is happening makes a statement.   If the prediction is dramatic, it gets attention.
3. The Former Star player.  Someone who used to have power, and wants to maintain the image. 
4. The Wannabee.  Often someone without any special knowledge or credentials who wants to seem important.

Bad Commentary

Here are some typical examples of poor commentary.  I could give (multiple) citations for each, but that is not the point.  If you are a journalist or TV anchor, you have a need for content.  Standards decline.  Readers are invited to offer more in the comments.

• Breathlessly reporting every public statement.  This is silly.  The real negotiations are not happening in public and the statements are not really news.
• Calling the participants "kindergartners" (or worse).  This sort of opinionated commentary simply shows a complete lack of understanding of the process.  It has become a staple at CNBC, where they are on 24/7 cliff watch.  No doubt they will claim credit when it is all over.
• Most of the public affairs news shows.  Normally the Sunday morning shows are helpful.  I record and watch several of them every week.  This week we got to see a posturing Newt Gingrich, who made dramatic statements.  It was obvious that he was not in touch with what was really happening.  The group on ABC included a lecture from Paul Krugman and a responding attack on Krugman's motives from George Will.  There was a disappointing lack of substance, mostly because the panel had no real information.
• The claim that the market expects a resolution, and has priced it in.  With more than half of the public expecting us to go over the cliff, a parade of TV pundits saying the same thing, and the anchors themselves emphasizing this conclusion -- it should be obvious.  The issue is in doubt.  Whenever this is the case, the market will move one way or the other on the outcome.

The message should be clear:  You cannot infer progress, lack of progress, or substance from any of these public statements.  What a delight!  You can ignore the news and just read the Cliff notes.

Real Information

If you want real information about progress, you need to look at unsourced reports from behind the scenes.  These paint a very different picture:

• There is actual movement toward a compromise.  On the key tax issue, President Obama will relax the rate on the rich by a bit and the GOP will allow some rate increase on high-income taxpayers.  The key threshold might move from $250,000 to $500,000.
• There will be a solution on the tax issues before year's end.  There is tremendous pressure for this on Republicans.  No one wants an ambiguous tax code going into the new year, and the main impacts are on GOP constituents.
• Participants are trying for a pre-Christmas solution, but there are no guarantees.  It might drift for another week.

Explanations

Any fair-minded people who use their business experience and general intelligence can understand the dynamics of the political process, even if they did not take my course in Poli Sci 101.  (One of my best teaching experiences was the standing "O" I got at the end of this class in my first semester.  It was a real inspiration for a young new Asst. Prof).

• Deadlines.  Going down to the wire is typical in business.  It happens in labor negotiations, corporate buyouts, and new product introductions.  It is not the stuff of kindergarten, but rather what happens in the real world.
• Significance.  These decisions will set the national course for many years to come.  They will be difficult to change.  It is important to get it right.
• Publicity.  While the election is over, public support is still relevant to negotiating at the margins.  This is reality, and it occurs in labor/management issues as well.
• Opportunity.  The most popular government programs cut taxes or increase benefits. The most difficult decisions do the opposite.  A lame-duck session of Congress is as far removed from politics as we can get.  There are retiring members and those with safe seats.  There is no better opportunity for making big changes and grand bargains.

Conclusion

My objective is to help investors understand what is going on without the need to absorb and interpret the avalanche of information.  Most of it can safely be ignored, but I'll follow up when there is relevant news.

Here is a final tip for traders:  If you see a news flash about a joint announcement (Obama and a GOP rep) that is bullish.  You will need to be watching and to buy quickly.

When should you sell?  Perhaps as the participants go to the podium.  Maybe sooner!

This year's Fiscal Cliff resolution will not be celebrated by all.  More in the next "Fiscal Cliff Notes."