A Dash of Insight

A Bull Market in Bad Predictions

Why does this happen whenever I try to take a few days off?  The market for dubious predictions has geared up in earnest!

While on vacation I was watching the market (but without my customary TIVO), events developed exactly as I predicted.  I warned about signal and noise, the challenge to traders, and the opportunity for long-term investors.

I have also been reading Nate Silver's book, The Signal and the Noise, which includes a lot of wisdom on these topics.  I plan a full review when I finish.

One of Silver's points concerns predictions without any confidence interval.  Many themes will be familiar to readers of "A Dash" since I highlight pundits who claim expertise outside of their "happy zone."  Let us highlight the three worst items from the past week.

• The fiction --  the ECRI claims that we are now in a recession.  This is ECRI 4.0 after their 2011 forecast failed, their revised 2012 forecast failed, and their complaint about seasonal adjustments being wrong has not proven out.  They are now playing out the last straw, that they are the only ones who can forecast recessions in advance and that no one else knows until after it is over.  This will obviously require a deeper look.  Let me cite the most obvious incorrect statement in their claims: The business cycle has peaked and they are the only ones who know this.

The reality.  No one knows whether the current period will eventually be defined as a recession.  A recession requires a significant decline (which you do not know until you have seen it).  At that point the NBER goes back to the last peak.   The ECRI presentation last week "assumed facts not in evidence."  They are ignoring the reduction in business spending before the election and the fiscal cliff.  They are exploiting the Super storm Sandy effects.  We can expect them to pound the drum even more during the next month, since the weak patch will take a couple of months to sort out.

I have a personal sadness about this, since I like and admire the ECRI principals.  I am going to write another piece about how and why their methods failed.  I wish that they had just been willing to accept the changing evidence -- and maybe open the kimono a little bit.

• The fiction --- the decline to zero growth.  GMO's Jeremy Grantham opines that the US economy is on a zero growth path until 2050.  He focuses on the two best drivers of growth -- population and productivity.  In this CNBC segment Maria Baritromo breathlessly praises Grantham:

"...He gets paid to make predictions, steve. that's what he's doing. by the way, his former predictions have been right. let's give him that."

The reality.  No one knows what will happen in 2050.  Grantham has ignored a decline in immigration (something that has helped US GDP in the past) to support his perma-bear position.  Pretending to this kind of knowledge gets headlines, but should be a warning signal to investors.  The media commentary points out that he manages a gazillion dollars or so.  Maybe a few of those investors should look to managers who are more grounded in facts.

And by the way, maybe Maria should cite Granthams track record -- 47% -- before claiming that he has made so many great calls.  Anyone who takes this silly prediction seriously should look back forty years for a comparison.

• The fiction.  The latest new and greatest recession indicator.  This is from Lance Roberts (who without apology highlighted the bogus 100% recession indicator).  He is now back with a new entry, endorsed by John Hussman.  Roberts takes some existing economic forecasting indicators that do not initially give the result he hopes for.  He then does some arithmetic and creates something that has a lame correlation to past recessions.  Hussman (who does similar things) embraces this approach.

The Reality.  The St. Louis Fed creates about 60,000 data series.  If you do some math transformations as Roberts did, you can turn this into a million or so possibilities.  If you then set a "trigger"  at an arbitrary level based upon a handful of past cases (the way Hussman does)  you can multiply this into the hundreds of millions range.

It is bad research, bad methodology, and a seriously misleading result.  It is impossible to prove, since the bad guys used all of the data.  There is nothing left to prove them wrong.

Conclusion

So much bogus commentary, and so little time.  Can't a guy take a few days off?

I will follow up on all of these themes.  Here are the main ideas:

Recession

The ECRI errors will require a more careful review -- it is on my agenda.  Meanwhile you can get the basic concept of their mistake by reviewing my recession forecasting page.

Fiscal Cliff

This theme continues with silly trading in the absence of information.

Listen up!!  We have no new information since the election.

We will not know anything new for a few weeks.  Trade at your peril.

Opportunity

It almost seems too obvious.  So many have much at stake in scaring investors.  They have clearly won the battle, with aggressive money flowing into anything with a high yield and conservative money going to farmland and ammunition.  My conversations with investors show that many are scared witless (TM OldProf).

Since the big rewards go to the contrarian investor, there are some great opportunities.

I like CAT as the proxy stock for an economic rebound, although it is (incorrectly) China-centric.

I also like some health care insurers and defense stocks -- UNH and LMT as examples -- as winners in the fiscal cliff compromise.

AFL is a good play if there is no disaster in Europe.

These are complex questions, so I plan to write more on each issue.

 

 

 

Debunking the 100% Recession Chart

Note to readers -- It was either this topic or the fiscal cliff.  Since I have explained for many weeks that we will not be doing any cliff diving, I am choosing to take up the recession chart.  So much misleading commentary, and so little time!

This chart is making the rounds, confirmation bias for those who are convinced that below-trend growth equals a recession.

There are several leading sources pointing to the chart and suggesting that it implies a 100% chance of a recession.  There are so many things wrong with this that I hardly no where to begin.  Here is the commentary from non-economist talk-show guy Lance Roberts:

"As stated above, each time this indicator has signaled the probability of a recession at 20%, or higher, the economy has either been in, or was about to be in, a recession. However, while the indicator is currently at a level that is indicative of a recession, along with a host of other economic indicators confirming the same (LEI Coincident to Lagging Ratio, ADS, GDI, Final Sales, STA Economic Composite, etc.), the NBER will wait to date the recession until the data revisions are in. Historically, as shown in the table below, the amount of time between the recession probability indicator hitting 20% and the NBER confirming the start of the recession has been on average about eight months. However, since the turn of the century that lag has moved to roughly 11.5 months."

Try this.  Suppose that your favorite football team has not lost a game in the last three years in which it has scored 24 points or more.  Then they lose 27-24.   You simply revise the proposition to say that they have never lost when scoring 27 or more points.  This is what many amateurs do in interpreting data like the chart above.

Look at the chart above and pretend that we were going back to the future in 2005.   You could have drawn the line at 15% and said everything that Lance says now.  You would have been completely wrong!

This "never before" style commentary keeps coming up.  It has no solid basis in research methods, but it seems convincing to anyone who has not studied research methods.

A Novel Idea -- Read the Research!  D'oh

Here is a novel idea for the economic bloggers -- count to 10!  Maybe you should actually read the research and consult with the authors before rushing to publish.

If you actually read the cited paper you would see the following points:

1. The authors were trying to improve slightly on the NBER  recession dating process -- getting closer to real time.
2. The authors recommended waiting until a reading of 80% was reached for three consecutive months to avoid excessive false positives.  (P. 9 of the paper).

At a minimum, if you are going to use your bully pulpit on the Internet to scare the daylights out of people, wouldn't it be a good idea to confirm with the authors first?   This is the downside of a world where no confirmation is required before publishing.

Why the Average Investor is Getting Bamboozled -- Again!!

This is interesting research.  My strong recommendation is that interpreting a complex economic paper should involve the opinion of the authors.  I strongly doubt that any of the pundits writing about this could speak coherently for thirty seconds about Markov models.  So why should we listen to them?

I called Prof. Piger this afternoon (voicemail), and I'll try again.  Meanwhile, I am accepting his work at face value.  It is a tiny and preliminary recession warning.  I will be quite surprised if he agrees with the Lance interpretation of his work.

About eighteen months ago I initiated a challenge to the ECRI as the top recession forecaster.  At the time, they were not forecasting a recession, but I was concerned about the methodology.  I invited nominations from everyone, and regularly highlight those with the best records.  (Anyone who has followed my approach has done well in the market over the last eighteen months).

My highly visible search has helped me to discover an expert community  in recession forecasting.  We have regular discussions.  I frequently highlight the excellent articles by these colleagues.

I want to preserve the privacy of these emails, while still giving credit.  To this end let me say that Dwaine Van Vuuren of RecessionAlert, one of my regular featured sources, suggested to me that the published chart does not reflect original data.

That got me thinking, so I checked out Prof. Chauvet's site.  Sure enough, the data from last year shows a spike which apparently was later revised away if you believe Prof Piger's site.

Note the serious discrepancy with Piger.

Here is the supporting data:

Dwaine tells me that this is common with Markov models and revisions.  I hope that he will write on this topic, and that he will gain the wide visibility he deserves.

Investment Conclusion

Today's market was a combination of the following:

1. Investors confusing their politics with their investing;
2. Excessive fear about the fiscal cliff;
3. Excessive fear about Europe; and
4. Those mesmerized by "the chart" discussed here.

When there is excessive fear, it is an opportunity for long-term investors.  If you disagree with the recession forecast, the key choices are cyclical companies and technology -- all on sale via your favorite broker.  Regular readers know that I like CAT, AAPL, and ORCL, and I am buying them all.

I'll try to cover the fiscal cliff issues soon, but you already know my conclusion.

UPDATE -- 11/8/2012 10:30 CST

Both authors of the cited paper have confirmed (via email) the interpretation I explained in this post.  With permission of Prof. Chauvet, I am quoting her email to me:

"Real time probabilities are very noisy, and a little bump of 15%, 20% or even 30% does not mean much in terms of signaling recessions.

Please check the graph on real time probabilities of recession on my site:

https://sites.google.com/site/crefcus/probabilities-of-recession/real-time-probabilities-of-recession

These are the probabilities we get on a month-to-month basis, without data revisions, and without smoothing. As you can see, the probabilities can even be above 50% and a recession does not follow. This is why in my paper with Jeremy we set the rule that the probability would have to be above 80% and for a couple of months before one could call a recession."

Please also read a fine article on this topic by Dwaine Van Vuuren.

 

Information you need.......and do not get!

Consumers of investment information are getting short shrift.

I see three problems:

1. Producers of the big news shows are looking for the dramatic;
2. Journalists (with a few exceptions) have lost the ability to ask the important questions -- the ones that would help investors;
3. All media sources have been unduly influenced by email and tweets.  These come overwhelmingly from the trading community -- and these sources have dogs in this hunt.

A Deeper Look

Here is the problem.  There is a standard group of experts who seem to have the right connections.  This might include any of the following:

• Being famous for being famous.  I am reminded of Paul Lynde, famous for being on Hollywood Squares.  At least you knew you were getting entertainment.   I am open to suggestions for comparisons, but how about Marc Faber?  He is widely known for his doomster reputation, but what has he done for us lately?  He makes a regular appearance on CNBC where he gets respectful, softball interrogation.

Suggested questions?  What is the time frame for your current prediction of a 100% change of global collapse?  When did this prediction start?  Is it true that there is no way to avoid this disaster?

 

 

• Working for a big firm.  It is interesting that big-time media love to criticize the big firm's analysts, but also feature them.  This week there is a lot of buzz because one firm thinks that there is a big chance that the "fiscal cliff" will create a market collapse.  The firm notes the discrepancy between their outlook and their clients.  The lead member of the team is an undergrad math major with a background in real estate.  No one points this out. People seem to think that since he was hired to be the major portfolio guy at a big firm he must know what he is doing.  The same people would join in criticizing a "whale" trader or an analyst.

Suggested questions:  Since you are basing a big market call on a prediction about the American political process, do you have any political scientists on the team?  Did you consult anyone with a real track record on this subject?

• Ability to regurgitate the latest Wall Street truthiness.  My favorite current example is the intonation --- "Earnings estimates are too high.  They must move lower."  This has been repeated so often that I wonder if anyone is really analyzing the data.  I report the change in earnings estimates nearly every week.  It is not difficult to track this, and a smart consumer of information can find the best sources.

Suggested questions:  How much do you think that earnings estimates should be reduced?  What would the P/E ratio be at that level?  Do you have a personal track record in making earnings estimates, or are you a critic of the work of others?  If you are analyzing others, what is your record in finding the best sources?

• Making dramatic calls.  We all know that excitement sells and fear sells even better.  Current examples include two distinct groups
  
  • Those predicting a recession based on back-fitting hundreds of variables with a sliding scale on each.  This creates hundreds of degrees of freedom and invalidates the entire process.  I understand that only 1% of readers will grasp this, and that is the point.  Many are mesmerized by credentials and unable to evaluate the analysis.  Anyone can come up with a perfect "Auntie Mame" system after the fact.  If it didn't work, you would not hear about it.
  • Those predicting hyperinflation, generally based upon the loose assertion that the Fed is "printing money."  Since this fits the preconceptions of the audience, it is an easy sale.
  If someone is making a bold call, isn't it reasonable to ask a few basic questions?  When did you first make this prediction?  Has it ever changed?  Do you have any real-time record of success?  Does it include more than one instance?  (This is crucial since many pundits hang their hats on a single big call.  Readers might compare the current trader reaction to, say, Elaine Garzarelli and Abby Joseph Cohen, who are reviled, to the current crop of doomsters, who are celebrated).
• Something else -- a mystery component.  There is one frequent guest on CNBC is has been wrong forever, who has been completely inaccurate on the facts of money supply, who insults and interrupts everyone, who has shifted to multiple firms in a short time ---- and yet --- is a frequent guest on CNBC.  They must love this approach, but consumers should tune out his story.

Conclusion

I understand that this post is mostly critical of bearish analysts and the lightweight questions asked of them.  Obviously, I would also like to see tough questions to those who are bullish -- especially the perma-bull types.

As someone who offers a wide variety of investment programs -- not just long stocks -- I carefully study informational bias.  I am open to any approach, and I profit only if my clients do.  I highlight exaggerated fear because that is the current bias.

The Fiscal Cliff: What Now and What to Expect

Concern about the Fiscal Cliff has sharpened in recent weeks -- perhaps as other issues have receded a bit.  Since whatever we should be worried about gets driven to Page One, there is a constant emphasis on current issues.

Anyone who wants to look smart in print or on TV had better know how to repeat the front page.  Here at "A Dash" our mission is to improve on your MSM sources.

Background

In multiple prior articles in my Weighing the Week Ahead series I have noted the lack of progress on all of the issues related to the Fiscal Cliff.  Yesterday I invited readers to consider the concept in the context of the election, looking to the highly partisan speeches at the conventions.

What is needed is compromise.  Sadly, that is not on the agenda for either party.

The conclusion is quite clear.  We should not expect any progress on the fiscal cliff issues before the election.

Consequences of Inaction

Concern about the Fiscal Cliff has become the #1 issue for market strategists and economists surveyed by CNBC.  Here is an interesting question from the most recent survey (which is worth a closer look):

As you can see, the Fiscal Cliff is the biggest concern, by far.  There are other reports that Europeans are more concerned about this than they are about the Eurozone issues!

Another question in the survey asks about the current impact of the Fiscal Cliff.   Survey says ----  74% say that concern over the fiscal cliff is already having an effect on the economy.

This concept is supported by reports from surveys from Manpower Group.  Here at "A Dash" we always like confirmation from multiple sources.

Summary of the Current Situation

Concern about political bungling related to the resolution of  impending issues is a major factor in the minds of asset managers.  There is intense skepticism with the following consequences:

• Recession estimates -- 26% in the next 12 months according to CNBC.  This reflects the chance that politicians do nothing.
• Current economic forecasts -- seriously depressed by business indecision.

As investors review data on the economy, on recession chances, and on earnings forecasts they need to understand the following:

Everyone is building in concern about the fiscal cliff.

Looking Ahead

I try to focus on imminent concerns, while staying attentive to investors with differing time frames.  Since I manage six different programs, I wear a different hat for each perspective.  When wearing my trading hat, I do not expect any policy improvement before the election.

When wearing my investment hat, I see a different picture.  I expect a resolution of these issues in the lame-duck session of Congress.  The outcome will vary depending upon the election results, and I am not going to speculate very deeply right now.  Something significant will get done.  I am gaming the various secenios and the differences are not that great for most names I follow.

Here is an example of the progress that I see.  Most market observers are not watching signs like this, or they do not know how to interpret them.

Investment Conclusion

The Fiscal Cliff problem is similar to other market worries.  The severe negative consequences are well-known and therefore reflected in current stock and bond prices.  It is a simple test of risk and reward.

It would be possible to write thirty pages on the Fiscal Cliff while hardly getting started.  I expect to do more as the situation develops.  My current conclusions are threefold:

1. Immediate concerns exaggerate the negative outcomes, mostly because traders and pundits are excessively negative about government, politicians, and political processes;
2. The worst case is well-known, and well-publicized;
3. There is no immediate upside catalyst.

Those who seek a great, long-term entry position in stocks have it right now (as I explained here).  It is possible that prices will become even more attractive (e.g. move lower) if the economic concerns escalate.

I am pretty aggressive for new accounts right now, at current prices.  I see many attractively-priced stocks, but it is a continuing story.  We do not need to know the complete answer right now to find good investments.

Those who wait for a complete resolution to the Fiscal Cliff will have higher prices, less risk, and less reward.

My advice is to ignore the MSM cacophony of fear about the fiscal cliff.  We can re-evalute after the election

Investors who agree with this concept will be on board with deep cyclical names like Caterpillar (CAT) and also tech stocks like Oracle (ORCL) and Intel (INTC).

Four Common Mistakes about the Fed

The Fed is a favorite target for the financial punditry.  Anyone can and does join in, offering ideas that are completely without evidentiary support.  Meanwhile, there is plenty of factual information about the Fed, but it is widely ignored.

Here are four common mistakes that you frequently see in the commentary from the  pseudo-experts.  These blunders are so widespread that it is pointless to cite a specific source.

The Fed is Sidelined by the Upcoming Election

This one is a persistent theme among those who have absolutely no special knowledge or experience.  Many pundits analyze government organizations by pretending that the policymakers are a small group with a strong common motive and the ability to act in secret.  They basically take their own limited experience about how the world works and assume that they can explain government actions that way.

One reporter from the floor recently reported the latest convoluted notion:  The FOMC would not act at next week's meeting, but would instead delay so that the positive effect of its policy action would not occur before the election.

That is really deep!  Some of the same sources show a chart that quite liberally changes the dates of Fed policy to correspond to market moves.  In some cases the move occurs at the first hint of a policy change.  This is completely inconsistent.

The Fed Acts Based Upon the Stock Market

One commentator recently opined that the Fed would not act right now because the stock market was not really threatened.  The Fed would wait until there was a serious selloff to use its few remaining bullets -- maybe 1100 in the S&P.

In fact, there is absolutely no evidence that the Fed acts to prop up the stock market.  The Fed behaves in line with a dual mandate for stable prices and low unemployment.  With prices not a threat, the emphasis is on economic growth.

There is a source of confusion -- the Fed embraces the stock market as one source of how well they are doing on the economy.  While the objective is not directly to support stock prices, a successful economic policy would have that result.  The occasional reference to higher asset prices is pounced upon by conspiracy buffs.

How can we tell the difference?

1. We could listen to Bernanke's testimony, where he has repeatedly stated the economic objectives -- and also that the political circumstances are not a factor.
2. We could go to the official transcripts of the meetings, now available for many years and extending up to 2006.   These are full transcripts.  If someone wants to assert political or stock motivations, let him find the evidence in the actual record.  Put up or shut up!
3. Forget the stupid conspiracy notion.  The FOMC meetings have many participants, some of whom would be happy to report any secret moves.

 

The Fed is Out of Ammunition

A popular theme is that the Fed can do little more because short rates are already at near-zero levels and the perception is that the effect of asset purchases has been reduced.

It is difficult to discuss an erroneous viewpoint without specifying a source, and I do not want to create a straw man.  With this in mind, the Fed critics -- who have been on the job for years -- did not imagine any of the current actions either.  The "out of bullets" meme is many years old.  Why should we believe them now?

Instead, you could look at commentary from an actual authority, a former Vice-Chair of the Fed.  Alan Blinder, writing in the WSJ, offers five different ideas that the Fed could use.  Any of these surprises could catch traders leaning the wrong way.

The Fed Knows the Employment Data

This is a bonus item.  I predict that whatever the Fed does next week, the talking heads will speculate that it is based on an early read from the employment report.

This idea is completely false, and contravenes official regulations.  The President gets an early look on Thursday afternoon (via the Council of Economic Advisors) and the Fed gets a few data points to help with their Wednesday release on Industrial Production.

That is all!

This was a specific question in a BLS webinar that I attended two years ago.  Here was the answer:

11:01

Angie Clinton (BLS-CES):  Submitted via e-mail from Paul: Question QUESTION: What are the rules or law governing the confidentiality of the monthly jobs reports? When is the report/information released to the media (even though it may be embargoed for a few hours). Are DOL officials or other Executive Branch officials permitted to publicly discuss any information about those reports before they are released to the media and public? Thank you. ANSWER: Thanks for your question Paul. The Office of Management and Budget directs Federal agencies on the compilation and release of principal economic indicators. Statistical Policy Directive Number 3 designates statistical series that provide timely measures of economic activity as Principal Economic Indicators and requires prompt release of these indicators. The intent of the directive is to preserve the time value of such information, strike a balance between timeliness and accuracy, prevent early access to information that may affect financial and commodity markets, and preserve the distinction between the policy-neutral release of data by statistical agencies and their interpretation by policy officials. According to the guidelines set forth in this directive, the BLS provides prerelease information to the President, through the Chairman of the Council of Economic Advisers, the afternoon before release of the Employment Situation. Statistical Policy Directive Number 3 is available on http://www.whitehouse.gov/omb/assets/omb/inforeg/statpolicy/dir_3_fr_09251985.pdf . The directive contains the following language regarding public comment: “Except for members of the staff of the agency issuing the principal economic indicator who have been designated by the agency head to provide technical explanations of the data, employees of the Executive Branch shall not comment publicly on the data until at least one hour after the official release time.” CES and CPS data are embargoed until the scheduled release date and time. The Federal Reserve has a memorandum of understanding with BLS to obtain specific employment and hours series for manufacturing, mining, utilities, and publishing for purposes of producing estimates of industrial production on Wednesday at 8:00 AM prior to the release. The Council of Economic Advisors receives the news release on Thursday afternoon, the day prior to the release. The Chief Economist at the Department of Commerce and the Secretary of Labor receive the news release at 8:00 on the morning of the release. Members of the press and the staff of the Joint Economic Committee of Congress (if there is a JEC hearing) receive the news release under strict lockup conditions at 8:00 AM on the morning of the release. Friday June 4, 2010 11:01 Angie Clinton (BLS-CES)

This is quite authoritative, and you will definitely not see it anywhere else.  My fearless forecast is that the conspiracy buffs will be in action on this next week!

Investment Conclusion

The basic conclusion for investors is a familiar one for readers of "A Dash."  There is no substitute for finding actual experts and sources.  Accept no substitutes!

Bernanke will act if additional economic weakness indicates the need.  He will not have advance info on the employment report, so Fed action might not occur at the upcoming meeting.  While it may be fun to speculate on conspiracies and politics, this is not the path to a profitable investment.

Fighting central banks is a losing proposition for investors.

 

Progress, Technology, and Economic Fundamentals

There is a popular idea that economic growth only comes from stimulus.  Wrong!

This mistaken view of economics can be costly to the average investor.  The US economy, and others that follow a free market approach, grow through population increases and productivity gains.  Normal trend growth in the US, allowing for inflation, is a bit over 3%.  Even in the absence of any stimulus, we would eventually get there as various factors reverted to mean levels.

This is difficult to explain without a full course in economics, so today I will offer an alternative approach.  Any reasonable person can see the changes in societal well being, but it is easy to forget.but there is a thriving industry claiming that traditional economic statistics overstate the economy.

Let us consider a simple example that we can easily understand as a starting point.

A Simple Example

I was already thinking about this subject last week because of a promotional item that I received in the mail.  It reminded me of an interesting theme of progress -- the calculator.

When I was a college student, we used slide rules for calculation.  I was a student engineer at Union Carbide.  They had a few mechanical calculators that did rudimentary functions (with a lot of noise).  The calculators were perched between two desks, shared by the engineers on either side to save on costs.

A few years later I was a quant guy in the Michigan PhD program, hoping for my own calculator.  They now had electronic versions, and some could perform the basic math functions and even store a value in memory.  That was my minimum spec, and I wanted one for less than $100.  That would be the equivalent of over $500 today.  The price point was finally met with a device about the size of a paperback book, requiring a few C batteries to power it.

Both of these devices were major improvements, increasing user productivity tremendously.  Before that, we wrote down columns of figures and did the math by hand.

The same engineer could do much more work because of the improvement in technology - - a simple concept.

My alert readers have already guessed the conclusion of this little story.  The promotional item in the mail was a featherweight calculator, superior in function to the model depicted above.  It has a small battery that will last forever.  Best of all, it was free.

And this theme does not even explore the added value of the spreadsheet or computer programs that combined the required calculations.

And Now .... Add the Internet

Thanks to Al Gore (!!) we now have a new dimension of productivity.  I am astounded to discover that there are more iPhones sold each day than babies born, and I don't suppose that the 15 minutes of porn watching adds to productivity, but those are just the sidelights.

I can do work in minutes that would have taken days in a library a few years ago.  Take a look at these interesting facts from MBAOnline.com and I'll provide an investment idea in the conclusion.

 

Created by: MBAOnline.com

All of this would have been unthinkable a few years ago -- an explosion in communications and information access.

Investment Themes

There are several important ideas to think about.

• Economic growth is fueled by technological progress.

• Every major corporation has improved business with improved robotics, communication, planning, customer acquisition and service, logistics, supply chain, and I'm just getting started.

• These elements are part of the explanation for high profit margins, and also for the recent success of some companies in bringing jobs back from offshore.

• While it is easy to forget, the quality of life is better through progress -- better in agriculture, motor vehicles, clothing, health care.

Those with offbeat theories of economics need to explain this progress.  The rest of us can enjoy investing in companies that participate in economic growth and the technology companies that help to create it.

My current tech favorites are Apple (AAPL), Oracle (ORCL), and Microsoft (MSFT), but I also like innovative companies in medical devices.

I invite readers to weigh in with their own favorites!

 

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.

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.