A Dash of Insight

Weighing the Week Ahead: Will Q1 Earnings Disappoint?

Game time!  Earnings season -- with special significance.

It is always important.

• Owners of growth stocks can be especially vulnerable to a missed quarter, since an earnings miss affects both the "E" in the P/E ratio and may also lead to a lower multiple.
• Owners of cyclical stocks
• Even owners of dividend stocks need enough growth to provide support for current and future yield.

This time the earnings story is even bigger.  It is objective, non-government evidence of the state of the economy.  Market skeptics insist that earnings estimates are too high and "must move lower."  They expect that the reduced pace of economic growth and problems in Europe have put pressure on profits.

I'll offer some thoughts about the earnings season in the conclusion, but first let us take our regular look at last week's data and events.

Background on "Weighing the Week Ahead"

There are many good sources for a comprehensive weekly review. I single out what will be most important in the coming week. My theme is an expert guess about what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.

Unlike my other articles at "A Dash" I am not trying to develop a focused, logical argument with supporting data on a single theme. I am sharing conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am trying to put the news in context.

Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!

Last Week's Data

Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:

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

Despite the stock market reaction, there were some bright spots in last week's news.  These were probably less important than the bad news, but still worth noting.

• The trade deficit for February was "only" $46 billion, much lower than the expected $51.7 billion.  The significance is that this is a boost to Q1 GDP, as everyone will soon see.  Check out the coverage and charts at Calculated Risk.
• Bank lending is improving at a six-month annualized rate, a post-recession high (see the chart from Scott Grannis).
• The quit rate is higher, according to the JOLTS report.  People quit jobs more frequently when confident about the employment market.  Churn is also good.  Check out Mark Perry for a further explanation.  Mark's chart shows the improvement, but also that we have a long way to go.

• Sentiment indicators are bearish.  Since these are all interpreted as contrarian signals, this is bullish.  Pragmatic Capitalism cites the AAII survey at a seven-month low.  Mark Hulbert draws a similar conclusion from his index of market timers.

• Inflation reports were pretty good, whether you looked at PPI or CPI, core or headline.  For the most comprehensive analysis and comparisons, see Doug Short's chart collection and commentary.  There is something for everyone -- even those of the ShadowStats persuasion can see some relevant comparisons.  With the current focus on energy prices, I would like to feature this informative chart:

The Bad

The most important economic news was negative.   

• Multiple Fed speeches did not satisfy.  There was a lot of talk, but the market does not have confidence in the Fed management of the economy and craves more QE. 
• Rail traffic declined again.  Steven Hansen's thoughtful article has plenty of helpful charts.  In the past he has identified coal shipments as the main cause, but now sees a broader decline.
• China's GDP growth was still above 8%, but lower than the whisper numbers (close to 9%) that helped to fuel the Wed-Thur market rally.  Global Economic Intersection has a good summary article that shows both the weakness as well as some bright spots while citing varied perspectives.
• Spanish debt yields pushed back to the 6% level seen by many as a trigger point for membership in the bailout club.  This was a big factor in Friday's stock market weakness, since it is interpreted as a failure of the ECB's LTRO policy.  Has it worn off so soon?  One good indicator is the spread versus German bonds, illustrated in this great chart from Sober Look.

• Initial jobless claims moved sharply higher to 380K and prior weeks were also revised upward.  There is discussion of seasonality and the "early Easter" holiday affecting the timing of claims.  We all watch the four-week moving average to avoid some of the noise, but the current pattern is troubling.  We need more data, but I am concerned.
• Michigan sentiment was a little light.  Unlike market sentiment, this is important as a coincident indicator of employment and spending.  It seems to have stalled in a range usually more associated with recession than with healthy economic growth.

 The Ugly

North Korea had another failed rocket launch.  This seems to signal that Kim Jong-un is continuing his father's policies of confrontation rather than negotiation and conciliation.  Some think it is too soon to expect a change from policies that were already in motion.

It is difficult to gauge all of the consequences of a military confrontation at this flash point.  It has the immediate effect of altering the perspective on defense spending.  There is good coverage of this, as well as the likely political implications, in this article from The Hill.

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts.  Think of The Lone Ranger.

This week's award goes to David Merkel, a proven ally of the individual investor, who is on the warpath against penny stock promoters.  This problem does not get the attention it deserves.  The get-rich schemes are always tempting.  Losses in stocks and real estate have made matters worse.  You might think that only foolish investors could be taken in, but you would be wrong.  Some very intelligent people are among the victims, including friends who would not listen......

The Indicator Snapshot

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

• The 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 C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon.  Bob also has a group of coincident indicators.  Like most of the top recession forecasters, he uses these to confirm the long-term prediction.  These indicators are not close to a recession signal.

I am a big fan of Dwaine van Vuuren, whose excellent statistical work is giving us better insight into a wide range of recession forecasting methods. The data point that I cite each week (the four-month recession outlook) is only one aspect of a comprehensive report. The SuperIndex includes nine different methods, including the ECRI. The analysis has a very strong, practical market application which has paid off richly for subscribers over the last few months. How? Mostly by putting the ECRI recession forecast into better perspective.  I am publishing the one-month delayed Leading SuperIndex estimate of recession probability in the near future -- three or four months. This is plenty of time to have value for public followers of their reports.

Last week they added another interesting recession indicator, finding states that show economic changes in advance of the nation.  You will be surprised at which states are the "canaries in the coal mine."

Here is the latest example, which does a great job of explaining the current ECRI changes in methods.

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions.  This week we shifted to bearish for the first time since last fall.  Last week was a close call and so is this one.  The ratings have deteriorated quite a bit.  The inverse ETFs are still in the penalty box, but I would not be surprised to see one or more of the in the top three spots this week.  Check here for a look at the full list of ratings as of Wednesday's close.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. For daily ETF commentary from Felix, you can sign up for Wall Street All-Stars, where I still have a few discounted memberships available. You can also write personally to me with questions or comments, and I'll do my best to answer.]

The Week Ahead

I expect earnings to be the main story of the week, although news from Europe was more important last week.  Germany has bond auctions on Wednesday, while France and Spain conduct auctions on Thursday.  These could be significant.

There are a number of minor reports, but I will be watching retail sales (Monday), building permits (Tuesday), initial claims (Thursday), and leading indicators (Friday).  The various regional Fed reports might move the market if far from expectations.

I expect plenty of attention to company statements about global economic effects and their outlook.  This is dangerous because there is little reason for management to go out on a limb.

Trading Time Frame

This week marked a dramatic change in our trading accounts.  We have been 100% invested since December. Felix caught the current rally quite well, buying in on December 19th, but the picture is now very different as I showed in this article.

We are now only 33% invested and I would not be surprised to see a purchase of one or more inverse ETFs during the coming week.  This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated. Felix has been more confident than I have been on the trading time frame, and has stayed invested in the face of a lot of skepticism. This has now changed.

Investor Time Frame

It is always challenging to explain why time frame is important.

There are many roads to market success.  Whatever approach you choose, you must test it, believe it and follow it.

If you are a trader like Felix, you will be trying to outguess the other traders, not caring about market fundamentals.  If you are an investor (like Warren) you treat short term price fluctuations as an opportunity to buy or sell, dependent solely on your own valuation of your holdings.

If you are an investor who has been frustrated by a market that ground relentlessly higher, providing no opportunity for entry ---- well--- what are you waiting for now?

I want to emphasize that being an investor does not mean "buy-and-hold" or a "forever" portfolio.  I believe in active management of investment accounts, adjusting for changed circumstances.  We need to look beyond the headlines, political commentary, and  those profiting from the climate of fear.

There is an important difference between short-term market timing and active management of your holdings.

I look at the following:

• Recession risk -- now very low.

• Earnings growth -- excellent and undervalued.

• Financial stress -- high on the headlines, but modest on the data, falling rapidly.

Barry Ritholtz has a great article on this distinction, which I strongly recommend.  Inspired, I wrote my own piece on this theme.  Find your role, your strategy, and stick to it!

I have been more aggressive in adding investment positions.  For those who are more worried, I recommend a combination of dividend stocks and the sale of short-term calls for enhanced yield.  You can achieve 8-9% in a sideways market.

Our Dynamic Asset Allocation model has also become much less conservative. Gone are positions in bonds and gold. DAA responds to the message of the market, cashing in on extended moves. It is rather like what some call a "lazy portfolio" but better. The DAA approach is finding some of the best sectors over the last year.

Final Thoughts on Earnings

My recommended sentiment gauge for asset allocation is the equity risk premium.  It gets to a very high level when there is intense skepticism about earnings -- something we see right now.

The skeptics are elusive and often contradict themselves.  They variously maintain the following:

• Earnings estimates are too high and need further reduction
• Earnings estimates are crashing and need to move even lower
• When earnings beat expectations it was because the bar was lowered.

There is no accountability.  If a pundit wants to opine on what earnings estimates should be, then how about checking the record of his past comments on earnings?

I prefer relying on facts.  If estimates are too high, then we should accept stronger earnings as evidence that things are better than expected.

My personal guess, based partly on reading research reports, is that stock analysts have unwisely become amateur economists.  They are incorporating their own opinions about the economy, drawn from reading the newspaper, into their earnings projections.  The result is that  expectations are pretty low, as you can see from previews in The FT and in Barron's.

The great team at Bespoke Investment Group is on the job.  Here is the story so far -- a good record, but not always rewarded with higher stock prices.

It will be an interesting week on the earnings front.

 

Left Out

Left out of this week's analysis was the Romney victory in the GOP nomination.  This is important, of course, but we need to figure out how and why.

This is not a blog about politics, but we do analyze the impact of politics on our investing.  I have expected the Romney victory all along.  As the issues are more clearly defined, I will generate some investment forecasts.

 

 

Positioning for 2012: Don't forget about stocks

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The negative side included two groups:

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

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

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

I have simple advice for the average investor:

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

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

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

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

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

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

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

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

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

Global markets

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

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

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

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

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

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

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

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

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

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

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

U.S. Market

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

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

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

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

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

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

Bonds/Fixed Income

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

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

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

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

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

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

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

Let me try it a different way.

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

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

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

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

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

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

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

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

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

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

My Bespoke Roundtable Answers

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

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

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

For your convenience

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

N/A 

 

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

 

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

 

13) What is your outlook for Financials?

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

N/A

 

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

 

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

 

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

 

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

 

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

 

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

 

N/A

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

N/A

 

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

 

N/A

 

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

 

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

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

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

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

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

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

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

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

N/A

 

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

 

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

 

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

 

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

 

36) What are your favorite Twitter feeds?

 

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

 

 

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

 

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

 

 

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

 

 

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

 

 

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

A Unique Review of 2011: The Year that Wasn't!

The "year in review" market is another crowded trade.  Either you have a special angle, or why bother?  I hope readers enjoy playing along with my idea for the year that wasn't.

My approach involves an essential analytical skill.  You need to have a basis for comparison -- often called the "counterfactual."  Regular readers know that this is a frequent theme at "A Dash."  If you want to evaluate the stimulus legislation, or the Bush-era tax cuts, or the effect of the Iraq war -- you cannot just ask where we are, but also where we would have been in the absence of that policy.

What was at the end of the road not taken?

With that in mind, I offer six events/decisions for your consideration.  In each case our question is:  What would have happened in the absence of the event in question?

I have done my own speculating, but I invite comments and other nominations.  I am focusing on US equities, but the impact on other markets and sectors might have been highly correlated.  Please note that I am not offering an opinion on whether the event or decision was good or bad.  The question is whether it was market-friendly.  (See here if you want more insight into why this is important).

Three Bullish Events

Here are three things that happened that improved market performance in 2011.

1. Fed policy. We saw QE II which everyone believed was important -- so it was, whether the effects were substantive or psychological.  We also got Operation Twist.  The Fed is on a mission, and it has increased the monetary base, although with a smaller effect on M2.
2. The Greek Leadership Debate.  The market went into a tailspin when Greece questioned the bailout terms and suggested that they might invoke -- (drum roll) ---  DEMOCRACY.  This had the potential to unravel the entire European story, but the Greek leadership change kept the incremental rescue process on course.  (runner up to Italy and Spain).
3. The NATO involvement in Libya.  In the absence of this decision, the rebels would probably have been crushed.  Oil prices might well be significantly higher.  The course of Arab Spring would have changed.  (runner up to the Osama bin Laden 'excecution').

I suggest that in the absence of any of these events, the US stock market might have declined significantly this year.  What do you think?

Three Bearish Events

Here are three things that happened that hurt market performance in 2011.

1. The Japanese earthquake/tsunami.  When this occurred the world economy seemed to be on the mend.  What started with a tragedy for the Japanese had a global effect.  There was a hit both to consumption and to production.  US companies could not build things because of supply chain problems.   Most ironic outcome?  Ford could not supply cars painted black!  What would Henry have thought?
2. The debt ceiling debate.  While the parties reached an agreement in the nick of time, no one appreciated the inside view of the sausage factory!  China expressed alarm.  The S&P downgraded the US.  Europe did not understand, so US leaders lost whatever moral authority they might have had.  Consumer confidence plummeted in a fashion that equaled the major crises of the century.  This turned out to be a really big deal, even though all of the professionals never doubted that the limit would be extended.  There is a lesson here, but no sign that it is being learned in the right places.
3. The Dominique Strauss-Kahn story.  This is my "surprise" nomination, but the logic is clear.  The WSJ now says that "dithering" turned the European problems into a global threat.  If DSK had been on the job in May, the organization and response would have been stronger.  It took many weeks to recover.  This is true regardless of the cause of the incident, but the conspiracy theories are now afoot.  So far the speculation has focused on DSK's political enemies in France.  Will the Oliver Stone movie version feature them, or a band of happy Wall Street short sellers?

I suggest that in the absence of any of these events, the US stock market might have rallied significantly this year.  What do you think?

Conclusion

Sometimes events have a temporary market effect.  If the economy or the market is already at a tipping point, the impact of stories that originally seem minor can be magnified significantly.  Especially if it is a slow news day!

Investors' Guide to the Supercommittee Failure

It is difficult to forge effective policy solutions during the political "silly season."  We would all like to see less time spent on elections and more on solving problems.

The failure of the Supercommittee, which I originally thought had a fair chance to succeed, illustrates the dangers of extreme partisanship.  Some are suggesting that people vote against all incumbents.  In fact, we have three political parties --- extreme Democrats, extreme Republicans, and those willing to compromise.

As an investor, I would like to support those in the Compromise Party, since that is the only way we can expect any solutions.

As usual, I am trying to emphasize the investment issues at hand, remaining politically agnostic.  I like candidates who favor market-friendly policies, but I urge you to exercise your own preferences.  Meanwhile, what does today's news mean for investors?

I will briefly discuss the direct consequences, the psychological effects, future prospects for deficit reduction, and whether this can be combined with effective, growth-oriented tax policy.  Finally, I'll look at some winners, losers, and investment themes.

I think I have found some excellent sources, covering the key points you need to know.

A downgrade of US debt is unlikely -- at least not soon.  The ratings agencies have all commented on the process and the result.  The automatic cuts are as large as the committee goal.  For the sequestration to be overturned would require action by both Houses of Congress and a signature from the President.  That is not going to happen.  Here is a good story from The Hill on the "downgrade watch."

The failure still mattered for financial markets.  As I noted in my weekly preview, where I gave my "Ugly" award to the Supercommittee, the important effects are mostly psychological.  Most people are not stopping to analyze the exact effects, but are reacting to the failure of leadership.  Perhaps the most prominent example was noted market strategist and now hedge fund manager Barton Biggs, who upped his recession forecast and reduced his stock position, partly for this reason.

“I'm very disappointed,” Biggs said of the U.S. deficit- cutting congressional supercommittee's failure to agree on $1.2 trillion in federal budget savings. “It's pathetic that they haven't come to a deal. It shows our political system is really dysfunctional. I've been wrong in being too optimistic about the outcome in the U.S.”

Whether you agree with him or not, it illustrates how some people are thinking.  For a variety of reasons, I think that today's selling was more about Europe, the dollar, and fallout from MF Global.  When so many things happen at the same time, it is difficult to pinpoint causation.  (For those interested in this theme, I expanded on it in my new investment diary).

There is still a chance....

Part of the reason for the failure was the evolving disregard for the sequestration consequences.  Various observers were offering opinions that failure was not so bad.  Matt Yglesias captures this sentiment.  His article is also the single best explanation of the incentives for action.  The new reality is that the Bush-era tax cuts will expire before the election without some compromise.  Matt discusses how this is interpreted by both parties, and the implications for future action.

Putting the deficit in perspective

Much of the coverage you see on financial television has a big political tinge.  Each night I set the TiVo for both Kudlow and the PBS Newshour.  Both programs include guests of various political persuasions, but the tone is quite different.  Tonight the PBS discussion was really first-rate.

 

The entire segment is worth your time, but Henry Aaron of Brookings makes a point that is frequently overlooked:

Well, I think there are three things wrong with the way in which the discussion has been proceeding so far.

The first is that we are discussing the second most important problem the nation faces, not the most important problem. The most important problem is the fact that 20 million Americans are either unemployed or out of the labor force because there are no job opportunities.

Job number one should be to stimulate the economy today. We do face a serious longer-term budget problem. And Maya is exactly right that what was under discussion is not large enough to deal with that problem. So, what I feared from this discussion and the kind of deal that was on the table here was that, even if they had reached agreement, and everybody celebrated the success of dealing with the deficit problem, just two years from now, we are going to face budget projections just as bad as those we face today, if that's all they do.

In what seems like a permanent political season, this issue is a matter of partisan politics.  As investors we should be interested in the economic recovery as well as the deficit.

Public Opinion

Congressional leaders will now head home for the Thanksgiving recess.  They will carry their message to their districts, and also listen to reactions.  Polls have consistently shown that more people hold the GOP to be responsible for the failure to reach debt reduction targets.  They also believe that some tax increases are necessary as part of a solution.  (Here is a good summary of poll results.  Here is one showing which solutions people favor, and the role of revenue increases.)

This is not a complete answer, of course.  Part of politics is trying to change public opinion.

Winners and Losers

The Hill's coverage also includes a nice summary of winners and losers.  Most of these are political, but some are stocks.  Bob Cusack cites pharma and agriculture as sector winners.  I already have been working some pharma positions in my enhanced yield program (dividends plus covered calls), and the prospects now look even better.

Predicting the Europe Outcome: What it Means for US Stocks

Let's start with my nomination for the quote of the day, the words of Jack Bouroudjian:  A blinding glimpse of the obvious.

Here is the context.  Bouroudjian, a CNBC regular, when asked about his reaction to the late-day Fitch warning about a possible rating downgrade for US banks responded as follows:

...What i call scared cash on the sidelines that seems to run for that ten-year bond every time Fitch or somebody else gives us what i call a blinding glimpse of the obvious.

I recommend the entire interview that also includes David Goldman.  The CNBC site now has a nice feature where you can look through the transcript and sync with the video.  I like it!

 

The overall market perspective is very good and worth a careful listen.

Trading Background

Regular readers know that I advise against too much interpretation of daily market swings.  Today there was a rather obvious cause, so we have something specific to think about.  There was a sharp market selloff immediately after a Fitch press release on a possible downgrade of credit ratings for US banks.  Mark Gongloff had a nice take in real time in his post, Here We Go Again.   He noted the mild nature of the Fitch comments and the extreme nature of the selling.

Today was a light-volume day during expiration week.  Veteran market observers know that it takes little to get extreme moves in these circumstances.  Whatever the reasons the prices are recorded and technical analysts will impute meaning to the selling.

A Contrary Take on Europe

I continue to hold a contrary constructive view on Europe.  My reason is pretty simple:

It is in the financial interest of the entire world to reach a solution.

Do you remember the various steps in this story?  A few weeks ago we were worried about a vote in Malta and the power of a splinter party in Slovakia.  The market sold off on every rumor about leadership in each European country. The small players eventually came around.

What now?  It is obvious that some European banks are unloading sovereign debt and there is also an attack on the Italian bond via futures selling.  It is the most convenient way to "short Europe."  There are many who would profit from a collapse of the Euro, European banks, and world-wide markets, and they are out in force.

Various pundits have predicted the fall of Europe by comparing debts to German assets, for example, as if Germany is the only resource.

This is silly!

Today's mild Fitch comment -- a mere suggestion that US bank ratings were at risk, resulted in a market cap loss in US stocks of about $300 billion -- in about thirty minutes!

The overall effect on US stocks is greater than the "bailout need" for Europe.

You can do a similar calculation on the Chinese economy.  Allowing Europe to fail is a disaster for them -- and also for the Saudi's.  It is in the national self-interest of many countries to help.  You can expect them to join in at the appropriate time.  Meanwhile, they are all exhorting European leaders to do more and do it more quickly.

When it is in the self-interest of so many countries to solve a problem, you can expect it to happen.  The process is not as fast and efficient as traders and pundits would like, but then they have never had this kind of responsibility, so their opinions lack the wisdom of genuine experience.

The Contrarian Edge

The individual investors I meet are usually very intelligent and well-informed.  They think that they have an advantage when they understand everything that they read in the daily financial news.  This is wrong -- exactly wrong.

They have an advantage only when they see the error of those writing or quoted in the daily news.  The financial stocks were unduly punished today, so that is the best shopping ground.  Regular readers know that I like JPM.  Stocks in many unrelated sectors were also punished for no reason.  How about Oracle (ORCL)?  Or Target (TGT) with great earnings and a nice response before the so-called "big news" from Fitch.

The most difficult thing to learn is disrespect for this kind of news, especially when most are embracing it.

 

Understanding Chinese Policymaking

Traders do not think like government officials.

My traders friends would enthusiastically agree.

They are smarter, faster, and even better-looking!

It is fine for us to think that we are smarter and wiser than those making government decisions.  Even if this is true, it may not help us when making predictions.

If we want to forecast the behavior of government, we need to take a different perspective.  Most market commentators think about China from a trading perspective.  Consider these two questions:

1. Why does China continue to invest in US bonds?  The interest rate is small.  It is likely to rise leading to capital losses.  The dollar, despite recent strength, is in a secular decline.
2. Why would China invest in Italian bonds?  They are risky.  It seems like there are strikes every day.  The CDS prices are rising.  The market is screaming the risk.

The Trader Perspective

The trader, putting himself in the role of the Chinese, has an easy answer to both questions.  The Chinese commitment to the US bond market is fragile and fleeting.  They could sell at any moment.  Who would then buy our bonds?  It is yet another example of the danger of  debt.

The Chinese would also be crazy to buy the bonds of Italy or any other European country.  There are much safer investments and others that provide a better return.

The Policymaking Perspective

The trader view is far too narrow.  On the first question it has been incorrect for many years.  The Chinese are more interested in economic development, creating employment, and selling products than the profits on their bond portfolio.  The US trade deficit is largely a function of the undervalued Chinese currency, an intentional policy on their part.

The Chinese also have a strong interest in worldwide economic strength and avoiding collapse in Europe.  The consequences of cascading defaults might cost them much more than possible losses on a bond investment.

Conclusion

If you want to predict what governments will do, you must think like a government official.  The trading perspective may be of little concern, a much lower priority.

The rumors of Chinese buying in Europe have been around for weeks.  I did not mention them in my weekly update yesterday, because the story was too thin.

Now that the rumor has been published,  it is worth evaluating.  The outcome is far from certain, and I make no predictions here.  The Chinese may get involved, but seek some other participants.

With this in mind, there are many parties with an interest in stabilizing Europe.  This concept has been widely neglected by pundits who choose the sexy story:  The death of the European Union and the related costs.

EU leaders may find the famous Mark Twain to be appropriate: 

The reports of my death are greatly exaggerated.

Obama on Jobs

I suspect that my take, as is often the case, will differ from that of both the financial punditry and the political commentators.

My grade for the proposals is an "A" and the speech gets an "A-".  My grade for the pundits is a C-.

My perspective is simple.  I want the US economy to improve.  I want my unemployed friends to find work.  I want businesses to succeed.  I want investors to achieve their retirement goals -- something that will not happen if we stand still.  My goals are shared by nearly every American citizen.

Since that is true, why do I feel so lonely on the Internet, where cynicism is far more popular?

The Facts

Yesterday I explained the job creation problem.  Few are paying attention, including the experts on the Obama team.  Their proposal would have been stronger if they had used the data I cited.  This would have helped to clarify the task.

We need to increase job creation by 5% and reduce job losses by 5%.  That's it.  That would be enough.

The first step is understanding that this can be done.  The second step is realizing that the issue is not the 2012 election.  Waiting for another eighteen months could be fatal.  We need action right now.

What elements should we look for in a jobs proposal?

1. Combine a macro economic effect and specific targeting.
2. Include direct incentives and tax cuts.
3. Have direct help for new businesses.
4. Help now, payment later.

The Obama proposals included these elements, so it is a good start.

The Pundit Blunder

As I watched the speech I monitored my twitter feed, a combination of liberals and conservatives.  Both groups were critics, and that is the heart of the problem.  If you are a pundit, you seem so smart when you are telling the President what he did wrong --- criticizing the plan, the speech, the presentation, or whatever.

This was mostly BS.  I have been watching Presidential addresses for over 40 years.   There is nothing wrong, for example, with including a rhetorical flourish about "pass this bill." Some pundits who know nothing about rhetoric or speech did not like it.  The President addressed both the audience in the room (mostly Republicans) and the nation.  He chose the setting.  There was a lot for most people to like, and a good challenge for Congress.

Some pundits complained that the costs of the program were delayed.  Guess what?  They should be delayed.  Every economist who does a GDP estimate says that immediate austerity reduces GDP and tax revenues, making matters worse.  When Republicans were in office they accepted the same logic (and I agreed with them then).

People should understand both the long-term deficits and also the near-term challenge.  It should not be a partisan matter.  At "A Dash" I have frequently cited centrists from both parties who understand this point.

Who Should Decide

Here is a theme that deserves more attention.  Much more!

A few weeks ago I wrote that the S&P had blundered in their downgrade of US debt.  Some readers missed the point, telling me that I was "blaming the messenger."  In fact, everyone already understood the US debt situation without the dubious help of S&P, so the messenger argument was irrelevant.

The  point I was making was completely missed:  Who should decide US policy?

We live in a pluralistic society.  We give exaggerated respect to minority viewpoints and struggle for consensus before reaching decisions.  We do not have dictators nor Parliaments with major consensus votes.

This system has worked very well for over 200 years, and most US citizens like it just fine.  Meanwhile, the investment world is embracing opinions from a variety of questionable sources, people who should not be involved in dictating US economic or foreign policy.

• A semi-anonymous Bulgarian.  Enjoy his conspiracy theories if you get off on that, but why should US policy follow his ideas?
• A French-Egyptian executive for a bond fund.  Do we want to emulate those governments?  Why should we listen to his advice about US policy?
• A ratings agency catering to European board members.  The immediate reaction from the Chinese was that we should be cutting defense spending!  Great idea!  Let's curry favor with the S&P and weaken our defenses.
• Assorted sources that are obviously cashing in when most of us lose.  Many of the fear peddlers, who bombard my inbox, are selling gold, ammunition, and dubious structured products with a lot of fine print.  They are exploiting the distress of many Americans for their own profit.

What people involved in the investment debate do not understand is that this is not just about bulls and bears, although the bearish pundits rate to make serious money from selling fear.  This is about how the United States makes decisions.  Who makes them.  Who gets respect.

It is not a partisan issue, it is an issue of patriotism.

If Congress passes some portion of the Obama proposal, it will be a good start on the jobs problem.  My initial take is that there are enough GOP tax-oriented incentives to get the job done.  I hope that there are enough centrists from both parties to make progress.

UPDATE:  I see a WSJ report where Mark Zandi, chief economist at Moody's, estimates that the plan would add 2 percentage points to real GDP growth and 1.9 million payroll jobs, while reducing the unemployment rate by a percentage point.

 

 

 

Interpreting the Market: Good Luck!

Intelligent people want to make sense of the world around them, no matter how confused it may seem.  Everything must have an explanation.  When the market rallies by more than 300 points after weeks of persistent selling, well....There must be a reason!

Reuters offers this explanation: 

Hopes for another Fed rescue drive 3 percent rally

The Wall Street Journal asserts:

Stocks Jump on Hopes for Fed Action

The New York Times had a benign headline, but offered this lede:

After weeks of uncertainty, the markets finally seemed to seize the day.

Stock indexes powered ahead on Tuesday as investors sought buying opportunities on cheap stocks as they bet that weak economic data would support the possibility of further stimulus from the Federal Reserve. It was at the Fed’s annual symposium in Jackson Hole, Wyo., last year that Ben S. Bernanke, the Fed chairman, signaled further stimulus in light of a similar slowdown of the American economy.

Kwame Holman, who gives the official summary on the PBS Newshour stated the following:

Wall Street shot back up today amid speculation that the Federal Reserve might try a new stimulus program after all.

Wow!  Four powerful opinions --- all wrong.

Reminiscing

One of my favorite books as a poli sci student was Timothy Crouse's, The Boys on the Bus.  The book covered many great themes about campaign coverage in the 70's.  Much has changed, of course, since reporters can now file stories by WiFi at any time.  In those days they often filed much of the story in advance, but then had to find the lede (called the "lead" in those days).

A crucial point was that anyone who was out of step with the consensus was open to criticism.  Everyone looked to AP's Pultizer Prize winning Walter Mears.  Crouse wrote:

"At what he does, Mears is the best in the goddam world," Said a colleague who writes very non-AP features.  "he can get out a coherent story with the right point on top in a minute and thirty seconds, left-handed.  It's like a parlor trick, but that's what we wants to do and he does it.....He watches some goddam event for a half hour and he understands the most important thing that happened --- that happened in public, I mean.

Crouse relates several amusing stories where Mears changed his lead and competitors were called on the carpet for having the "wrong lead."

The description of this is so powerful, that I remembered it after many years.

There is a powerful force, driving journalists to a consensus interpretation of events.

The Challenge for Investors

How can you know what to watch for, if your understanding of events is flawed?  Without the right analytical framework, you have no hope of interpreting the news and daily market fluctuations.

My own interpretation of today's action is quite different from what you are reading in the news.  There is an oversold condition with many looking for a chance to buy.  The news from Europe was encouraging.  Even before the opening there was a buzz about reports from China being "less bad" than expected.  Gold (a popular measure of fear) was moving lower.  European financials were moving higher.

Check out Briefing.com for a source that shares this more sophisticated interpretation.

If you were looking for an entry point, some would see signs from this news.  If you were short, you might think about covering -- at least for a few days.

The idea that weak data -- pretty much in line with expectations -- created a sudden change in expectations about Fed policy is just silly.

As I noted in my weekly update, there should be little expectation for a major change from the Fed.  I will further explain my reasons before the speech.

Investment Actions

There are many attractive financial and tech stocks.  I am still buying JP Morgan (JPM), highlighted here.  There is a lot of debate about financial stocks, and JPM is the leader.  I also am buying Oracle.  In mentioning this, I want to highlight the work of Eddy Elfenbein.  If you wanted to look at one chart to understand what is going on, this would be a great candidate.  Eddy is calm, disciplined, and has a great sense of humor.  I love his twitter feed @EddyElfenbein.

I have five different investment programs, and four of them are pretty conservative right now.  My most successful system (judged in the long term) has a portfolio of stocks like those in Eddy's chart.  There is a time to focus on specific companies.

A Final Word

I am a member of an online discussion group that engages seriously and vigorously in important topics.  The role of Twitter is a current subject, with widely varying opinions.

The discussion has caused me to wonder about something.  Today's journalists have a virtual "bus" because of Twitter.  They reach the same lede, partly because they know what everyone else is thinking.

This is safe, but is it really helpful?

 

Five Minutes to Change or Five Minutes to Midnight?

Veteran Public Television commentator Mark Shields had an interesting take on The State of the Union Address.  He noted that conservative criticism came in two different forms:  Some saw current policy as "five minutes to change" while others saw it as "five minutes to midnight."  This is a useful perspective for investors.

Shields placed President Reagan in the former, hopeful category, and Wisconsin GOP House member and new Budget Committe Chair, Paul Ryan, as part of the midnight group.

The Obama Speech

President Obama had a number of Reaganesque flourishes, including highlighting audience members and special recognition of some political opponents.  There was an effort to charm and to cross the aisle.  Even crossing the aisle had a new feeling, since the parties were not seated in separate sections, helping to create the appearance (and perhaps even the actuality) of bipartisan support for the President's remarks.

Here are the highlights most relevant for investors:

• A spending freeze. This is aimed at cutting the deficit.  It is not intended to replace the Deficit Commission recommendations, but rather to be part of the solution.
• Education investment.  The President invoked the Sputnik era to explain why the US needs to prepare 100,000 new math, science, and engineering teachers.  The definition of investment employed here is one of the sharp differences between the parties.
• Corporate taxes.  President Obama is in favor of cutting rates -- a market friendly move -- but he also wants revenue neturality by cutting loopholes.  He also came out for cuts in favorable tax treatment for energy companies.  This is a mixed bag for investors.
• Technology Goals.  Mr. Obama cited the need for clean energy sources, high-speed rail, and more high-speed wireless.  The federal government commitment to these programs was rather vague.
• Vetoing earmarks.  Mr. Obama says that he is prepared to veto bills with spending earmarks.  Many members of Congress agree with this in principle, but still have earmarked spending for their own districts.  The question is who can best allocation appropriations.
• Social Security.  The President is open to changes in Social Security, but opposed to permitting private investment programs.
• Tort Reform.  This was a big surprise.  The door for bipartisan cooperation on medical malpractice suits is now open.

GOP Response

The response to the SOTU address by someone from the party out of power is an unfair challenge.  Even placed in a setting with some trappings of power, nothing can equal the symbolism of addressing a joint session of Congress.

Paul Ryan's response was, as Shields observed, part of the five minutes to midnight variety.  There is a different viewpoint to represent -- less emphasis on government, lower taxes, dramatic spending cuts -- and Ryan made these points.  He did so strongly, in a well-written presentation.  I suspect that the reception will not give him full credit because of the setting and a rather stilted presentation.

What to Expect Next

We will now see some early tests of the potential for cooperation.  Will there be compromise on modifying health care legislation?  Can we succeed in cutting corporate tax rates?  The deficit?

Neither party is going to cave in, so it is a test for leadership.  The debt ceiling debate will be an early test.

Market Response

On balance, I thought the speech hit most of the notes that I had listed on my wish list for investors.  There were a few extra positives, and nothing that seemed discordant.  I expect the market reaction to be mildly positive.  By the end of the day we'll be back to analyzing the Fed, QE II, and corporate earnings.

My usual warning:  Don't let your strong partisan viewpoints interfere with your investment decisions!