A Dash of Insight

Weighing the Week Ahead: Will the Fed Disappoint the Markets?

Get ready for a week of renewed focus on the Fed. No one expects a policy change, but there is plenty of room for disappointment.

In the new era of Fed communications there will be plenty to analyze, including the following:

1. The FOMC statement, which can be carefully parsed for small wording changes and evidence of disagreement or dissent;
2. The updated economic outlook;
3. Updated projections from each FOMC member, with a report showing ranges and central tendencies;
4. A press conference where Bernanke will try to explain it all.

Most of this transparency is pretty new, and it is still controversial. One reason is obvious.

In the old days, when no one expected a policy change, there would be no reason for fixation on the Fed. There is now much more to analyze.

I'll offer my ideas on what to expect in the conclusion. First, let us do our regular review of last week's news and data.

Background on "Weighing the Week Ahead"

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

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

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

Last Week's Data

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

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 general economic data continues to be a little soft, while earnings have been very good.

• Building permits show solid growth. In my experience this is the best leading indicator. Steven Hansen does a nice job on this indicator, which the ECRI should probably consider including instead of housing measures obfuscated by foreclosures.
• Earnings reports are very good so far, via Bespoke Investment Group. As you look at this, please keep in mind that many claimed that earnings estimates were too high and should be moved lower.

• Earnings and revenues. One of my pet peeves is a general lack of accountability on earnings expectations. Remember when the earnings rebound started? Here is Dr. Ed Yardeni's account:

"When the bull market first started in 2009, the bears growled that the rebound in earnings was all attributable to cost cutting. So it wasn’t sustainable, in their opinion. They didn’t believe, and couldn’t imagine, that revenues might actually have a normal recovery too. I track three measures of business revenues, which are all at record highs now."

• Rail traffic was solid if you ignore coal. Steven Hansen at GEI has been doing a great job with this series. This table tells the story -- solid except for coal.

 

• Too much focus on the trees -- and neglecting the forest. We should all keep in mind the overall picture coming from creativity and innovation --- via Abnormal Returns and Barry Ritholtz.

 

The Bad

The economic news was disappointing, with everything a touch worse than expected. If the list is not enough for you, check out a source that even sees employment growth as bad (via Todd Sullivan).

• Initial jobless claims moved higher, to 387K and revisions were also higher. The times include the final week for the April employment report. While many observers opine that this will be better when the unusual seasonal factors are resolved, I continue to be concerned about the jobs numbers in two weeks.
• The Philly Fed was a bit light at 8.5 versus expectations in the 10 range and 12.5 last month.
• Assorted political salvos. I hardly know where to start. Each party is proposing legislation that has no chance of passage. The GOP has a choke point in the House and also preventing 60 votes (required to block a filibuster) in the Senate. The President can veto any bill and the GOP has no chance of a 2/3 vote to override. I have a long list of links from last week, but I think it is better handled as a separate article. Let us just say that political debate is descending to the lowest common denominator (see here for examples). Jeb Bush warns to expect the most negative campaign ever.
• Vehicle traffic has moved lower, especially with an adjustment for population. This is an interesting and creative indicator from Doug Short.

• European debt continues to be worrisome. While the scheduled auctions met sales targets, the rates are high, so I am putting this in the "bad news" category. The Spanish 10-year note was trading at the 6% level and the Italian equivalent at about 5.5%. I monitor these daily. While I still believe in a broad compromise settlement involving many parties, there is obviously an attack in the CDS market. I encourage readers to check out Cam Hui's commentary. I invite other recommendations for good sources in the comments.

The Ugly

This week's Ugly award goes to the stock-picking robot -- ready to help you find instant gains in penny stocks. The economic and investment losses have created a new level of desperation. There is a dramatic increase in both perpetrators and victims.

The robot team had a business model that profited in all of the key ways:

1. Selling bogus software to clients. The software developers were told that the program needed to appear to be analyzing data, but actually taking direction from the scammers.
2. Selling pump-and-dump services to companies. Results guaranteed.
3. Front-running the suckers.

This is a constant battle. I want to give credit to the SEC, but it is frustrating. I have reported a number of obvious scams. The SEC does not let you know what happened. They do not even acknowledge your contribution. Two groups that I reported were the subject of later action, but some are still at large.

The Indicator Snapshot

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

• The 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. For his subscribers, he offers the following conclusion:

"I now find myself in statistical opposition to all those who are calling for a cycle peak in 2012. I use the “statistical” qualifier in that sentence because after doing this for more years than I care to admit, one has to be cognizant of the fact that strange things can happen. So it is possible, but highly improbable, that the conditions associated with a cycle peak could present themselves before we “turn the page” on 2012."

Bob has his usual exhaustive analysis with many charts. His analysis is erudite, comprehensive, entertaining, and witty. Here is a single chart summary, but you should understand that all show the same thing.

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

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

Last week Dwaine teamed with Georg Vrba to analyze the unemployment rate as a recession indicator. It turns out that this single measure has terrific results. It currently suggests, "One can therefore reasonably conclude, based on the historic evidence of these unemployment-based indicators, that there will be no recession in the near future and that ECRI’s recession call may have been premature."

 

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions. This week we shifted from bearish back to neutral. The last several weeks have been pretty close calls. The ratings have improved a bit. The inverse ETFs are no longer at the top of the list, so I would not be surprised to see a little buying next week.

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

The Week Ahead

While I expect the Fed to be the main story this week, there will be plenty of other action.

Before the trading week even starts, we will have the first round of the French elections. Normally this would not be a major consideration for US stocks, but this time is different. A loss by incumbent Sarkozy could lead to dramatically changed policies for France, with other countries in line. This could affect the euro, the European economy, and also US stocks. This Washington Post summary lays it out nicely. That will be Monday's story.

I am interested in Consumer Confidence (Tuesday) and Initial jobless claims (Thursday) as important coincident reads on the economy. Q1 GDP -- the first reading -- will be reported on Friday, presumably confirming that the economy weakened a bit but was not close to a recession.

This is the big week for housing data, including Case-Shiller prices, FHFA prices, new home sales, and pending home sales. Housing is important, of course, and some see signs of improvement. I am not expecting much from these reports.

It is also a big week for earnings reports. It could well be an exciting week.

And finally -- Tuesday will give us the BLS Business Dynamics Report. This is the one that shows whether the employment estimates from 8 months ago were accurate. Everyone should be watching this, but I will probably be the only one reporting!

Trading Time Frame

We were out of the market last week in trading accounts, after a long period when Felix caught the rally pretty well.

The current market has been confusing to many top professionals, as I reported last week in this article featuring commentary from Art Cashin.

Investor Time Frame

For investment accounts I have been buying on dips in stocks that we like. I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look.

Investors should not be trying to guess the next market move. Instead, take what the market is giving you. I have been offering this advice for months, and it led to a great quarter for anyone taking heed.

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

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

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

I look at the following:

• Recession risk -- now very low.

• Earnings growth -- excellent and undervalued.

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

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!

If you are really worried, you can imitate our enhanced yield program. Buy good dividend stocks and sell short-term calls. I am targeting 8-9% returns on this approach, and achieving it no matter what the market is doing. You can, too.

Final Thoughts on the Fed

When I put on my trader hat, focusing on the attitudes of those on the front lines, I know what is important.

Traders want more of that QE!

The trading perspective is that the economy is weak and the Fed does not get it. Traders -- and therefore the "market" in the short term -- want to see the Fed doing more. At the most fundamental level there is no need for a deep explanation. The last two years show a pattern which (to a very forgiving eye) seems to show a market that rises when the Fed is active and declines when it is not.

While I disagree with this interpretation, success in trading means understanding the perspective of everyone else. The Fed policy has had much less impact than traders believe. Here is a helpful chart from Doug Short.

For investors, more twisting is not a big deal. For traders, it is.

Bernanke to Savers: We don't owe you a living

While we wait for tomorrow's employment report, there was another big story today --- the Fed treatment of savers. 

Fed Chair Bernanke testified before the House Budget Committee, responding to some illuminating questions from Committee Chair Paul Ryan (R. WI).  Joe Weisenthal, who is usually on the track of the biggest story, anticipated this one yesterday:

DEAR SAVERS AND RETIREES: Stop Whining About Those Lousy Rates You're Getting From The Bank

Here is Joe's conclusion:

And while we sympathize with people not getting returns on their money, the fact of the matter is that the big problem we have right now is that people have too much debt, not an abundance of cash that's just sitting there not returning anything.

The bottom line is this: Yes, it sucks that pensioners and garden-variety savers aren't getting returns, but it also sucks for everyone in the U.S. right now, because the economic outlook seems to be so mediocre. Welcome to the club!

Until growth and inflation return to anything that looks robust, savers will have to be stuck with the same garbage returns boat the rest of us are in.

The confirmation came in Congressional testimony by Fed Chair Ben Bernanke and the ensuing questions.

There is a lot of buzz about the role of the Fed and also the leadership of Bernanke.  The leading Republican candidates all want to fire Bernanke, and some of them even want to abolish the Fed.  Some of the GOP House Budget Committee members have joined the criticism.

Here at "A Dash" I focus on investments, not politics.  Years ago some readers called me a "Bush apologist" and a blatant "supply sider."  I have tried to explain that I do not have a partisan perspective, but an investment perspective.  I want to find the best investments no matter who is in power.  My perspective changes with the evidence.

With that in mind, let me suggest a few propositions for your consideration.  If these are not obvious, I recommend more research.

• Bernanke is a Republican, with a conservative background.  This is typical for Fed Chairs.
• If President Bush had been re-elected, the current GOP fiscal argument would be different.  There would be support for stimulus, including both tax cuts or spending.  If you do not believe this, look back in history to the end of the Bush administration.
• If President Bush had been re-elected, the GOP monetary story would be different.  They would be screaming for easy money, as both parties have always done, including past GOP administrations, and including Bush senior.
• Paul Ryan is an ambitious and aspiring VP candidate who has a theme that resonates --- balancing the budget.  It is an effective political argument -- for the party out of power.

Meanwhile, the Fed is doing a good job of ignoring politics and focusing on the economy.

Investment Conclusion

I continue my plea:  Look beyond politics.  Most recently, look beyond the popular ploy of making a villain out of the Fed.

The Fed has a dual mandate including both price stability and employment.  Here is the official statement:

The Congress established two key objectives for monetary policy--maximum employment and stable prices--in the Federal Reserve Act. These objectives are sometimes referred to as the Federal Reserve's dual mandate.

There are many who have criticized the US approach suggesting that there should be only a single mandate - price stability.

So let us all be clear about this -- very clear.

The Fed has no Third Mandate.  There is no interest rate guarantee for savers!

It is difficult enough to balance economic growth and price stability.  The idea that the Fed should be judged by a third criterion -- maintaining interest rates for savers -- is misguided, politically biased, displaying favoritism for one group, and basically wrong.

More importantly, it is not going to happen.  Our investment decisions should be based upon reality, not the wishful thinking of those with a partisan agenda.

I understand the plight of savers and senior citizens.  I work with such investors every day, helping them find a combination of a bond ladder, dividend stocks, and enhanced yield.  Those who do not have a job at all face a more difficult problem.  Until we have a stronger economic recovery, we are all in this together.

 

Investors: De-mystifying the Central Bank Balance Sheets

One of the many reasons that individual investors are scared witless (TM euphemism by OldProf) is a complete misunderstanding of the role of central banks and a distortion of current policies.

The critics of the Fed -- and now the ECB and other European banks -- have an easy path to page views and affirmation by readers who never took the class in Money and Banking.

This has the usual result.  Anyone who is willing to spend a little time while keeping an open mind can gain a significant investment advantage.

The Current Scare

Let us begin by summarizing the story that I hear from so many people through comments, emails, or calls.  It runs something like this:

• The Fed is printing money with reckless abandon.
• Other Central banks are now doing the same.
• Bank balance sheets are exploding and have huge leverage ratios.
• Gains in equity markets are a "sugar high."
• Central banks could be wiped out with the smallest downturn.
• Or if forced to unwind these trades, stocks would collapse.

A Typical Argument

Perhaps the most prestigious of those making such arguments is Jim Bianco.  Since he is regularly featured on CNBC, has his work published at Barry Ritholtz's blog, and has institutional clients, everyone takes his research output quite seriously.

His recent piece at The Big Picture touched all of the bases described above, and also threw in a comparison of balance sheets with aggregate stock market values.  I am going to stick to the Fed balance sheet in this analysis, but it should illustrate the point.

Here is the chart of the Fed balance sheet provided by Bianco.

This chart repeats many of the errors from the Michael Pento arguments that I refuted here.  If Bianco had read this research, his article might have been stronger.

To start with, long-term data series should be described on a log scale.  This means that a proportional change is constant over time.  Let's look at the Fed's monetary base.

This better demonstrates the recession response as well as QE II.  It also makes clear that everything else is irrelevant.

The most crucial thing to understand is that the balance sheet does not represent "printing money."  This happens when reserves are created for participating banks and they make additional loans.  This has not been happening.  Essentially, the Fed has stepped in to (temporarily) take up the slack in the money supply.  Disciples of Milton Friedman know that the long-term money supply is aligned with nominal GDP growth, so money creation is important.

To emphasize:  Printing money is necessary and appropriate -- at the right pace.

The question is whether the growth in M2 has been excessive.  Here is the key chart.  As you can see, the long-term growth looks pretty reasonable.

 

The Conference Board (and I suspect the ECRI) have dropped M2 from their indicator series since the modest result described above is apparently too bullish.

Conclusion

The Bianco analysis is another example of Wall Street Truthiness.  Since so many are primed to hate the Fed, the ECB, and the entire concept of central banking, it is popular for many to rant on this every day.

The comparison of central bank holdings with equity markets is an egregious blunder.  There is absolutely no reason to compare debt holdings with anything other than the debt market.  I have frequently analyzed the Fed purchases of debt and shown these to be a modest fraction of the trading volume in Treasuries.  Experts estimate the impact on yields to be modest.

When and if the time comes to unwind these positions, it will have little long-term effect on either bond or stock markets.  I explained this in several past articles, but the most important is here.

This is an interesting choice for investors.  Most of them cannot really grasp the money and banking aspects of money creation.   It is a pretty tricky concept.

This makes it prime fodder for those who want to fool you by calling the balance sheet "printing money" when that is not correct.

There is so much mis-information and so little time.

I am now told by an investor that the GDP increase of 2.8% proves that the ECRI recession forecast is correct.  Amazing!  It takes very little for the confirmation bias effect to kick in.

The Fed Role in the Economy: Now Bigger. Now Better?

The Fed made history today, achieving a new level of policy-making transparency.

In my early days in the business, the results of an FOMC meeting were never announced.  Everyone waited until the day after the Fed meeting to see what open-market operations were conducted by the NY Fed.  First you needed to know what was needed to maintain the current policy rate.  Then you had to gauge whether the action was sufficient to maintain that rate.  System-wide repo's were aggressive easing and matched sales were tightening, but there was still a matter of interpretation.  Various Fed experts were quoted on the newswires to offer their interpretations.

It was like waiting for puffs of smoke from the chimney.

Now, all of the old skills are irrelevant.  It is almost like CNBC putting the stock names on the ticker along with the symbols -- amateur hour!

But that comparison is not fair.  Only the skills that have changed.

It is a new era, with a lot more information (See Global Economic Intersection for a great job on the main story and updates with each new piece of information).  During recent years -- mostly in the Bernanke era -- we have added all of the following:

• An official policy statement, carefully constructed and instantly parsed by analysts to pinpoint the nuance of each change;
• More frequent updating of official forecasts;
• More timely minutes of meetings;
• Eventual full transcripts of meetings;
• Press conferences by the Fed Chair after meetings with forecast updates; and now
• A granular look at the distribution of forecasts of the entire Board (not just voting members); and
• A statement of principles about inflation targeting and the lack of an employment target.

This is a feast for anyone with a brain and some analytical skill.  I note with amazement that some disparage this information.  Then I see that these are the same people who typically criticize the Fed regardless of what it does.

For most of the real world, having more data is valuable for planning and for setting expectations.  We all know that the Fed cannot forecast three years ahead with any certainty, and Bernanke agreed in the press conference.  These forecasts will change.

The key point is that we will now be able to see the changing long-range forecasts of the members in real time.   I am using this in my investing, and so can you if you think about it.

Today's Takeaways

There is a lot of information, so anyone offering conclusions today is only doing a first take.  Here is mine.

1. The consensus Fed forecast is for moderate, below-trend growth for the next two years.  Progress on US economic data has been offset by Europe.  Modest growth, no recession.
2. The long-term policy commitment is matched to the forecast.
3. The Fed is prepared to act more aggressively if circumstances require -- QE III.
4. The Fed has an inflation target, 2% in core PC.
5. Despite pleas from the liberal wing, employment and/or GDP targeting is secondary.

Investment Conclusion

The initial market reaction was a rally of less than 1%.   This was a knee-jerk reaction toward a weaker dollar, lower long-term rates, higher commodities, and higher stocks --  everyone's first take of the news.

This assessment is partly correct.  We all need to consider each asset class.  I think that the inflation/weak dollar conclusion is overstated.  The chance of a spike in long-term rates is a bit lower.

But here is the big story:

The Fed shows determination to fight a new recession, doing whatever it takes.  The votes are there.

This dovetails nicely with our recession series.  The method we are putting under the microscope, Bob Dieli's, accurately emphasizes Fed policy as a big factor in recessions.  More to come on that subject, but astute readers will see the drift.  We are earlier in the business cycle than most analysts think.  This is good for heavy cyclicals and cyclical tech stocks.  (Think CAT and ORCL and the XLI ETF for names I have mentioned, or write to main at newarc dot com to get our updated ETF suggestions).

This also dovetails nicely with our short-term modeling from our Felix model.

Worst Forecasts Ever

The latest Fed action suggests something interesting for market watchers.  For many years there has been a cadre of Fed critics asserting that the Fed was "out of bullets" or "in a box."  For any objective observer these statements have clearly been proven false.  The latest Fed move is something that non of these "experts" even considered a few years ago.  The same guys are now telling you the same thing about the ECB and Europe......They see no hope.

With the 2006 Fed transcripts we can now start to have some fun by looking back at bold assertions about Fed meetings and what actually happened.  So many interesting ideas and so little time.  Maybe an enthusiastic reader will take this on!

 

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!

More Causal Confusion: The FOMC Decision and the Market Reaction

Making sound investment decisions requires an understanding of what is going on.  Unless you are using a mechanical model, you need an intellectual framework for interpreting news events.

Many sources offer help.  There are scores of interpreters of the daily market action, but most of them are on a mission.  Whether the objective is political, gaining ratings, or demonstrating wisdom, my experience is that 90% of it is completely wrong.

Today is a good example.  The market sold off sharply, the biggest loss in many weeks.  The selling came shortly after the FOMC decision was announced.  Post hoc, ergo propter hoc.  There is an overwhelming temptation to link these two events.

As a preface, here is an interesting comparison.  Each night I record via TIVO and later watch Kudlow and the PBS NewsHour.  This prepares my investing decisions and sometimes provides the basis for these reports.  The perspectives from these two programs, as you might expect, are quite different!  PBS leads with Palestine and the UN.  The Fed is not mentioned in the first twenty minutes of the show.  My guess is that a few months from now we will all agree with the PBS emphasis.

With this background in mind, let us return to the obsessive market coverage.

Possible Explanations

Readers of "A Dash" have been challenged with some past problems concerning causal inference, and they have done very well!  Today's little test should be easy.  Here are the candidates:

1. The Fed consists of a group of clueless bozos (TM pending -- OldProf) who will inevitably do whatever is wrong.  Everyone else is smarter, better-informed, and has superior analytical skills.  This especially includes journalists, hedge fund managers, anyone who is interviewed on TV, and anyone with a blog.
2. The Fed policy, Operating Twist, disappointed the markets leading to the selling.
3. The Fed frightened markets by stating that economic conditions had weakened since the last meeting.
4. The three dissenters.  This shows that (choose one):  The Fed is adrift, there is impending stagflation, Bernanke will lose his consensus.
5. There was other news that bothered market participants -- the Moody's downgrade of some banks or news from early corporate earnings reports.  Those wishing to sell on this news waited until after the Fed announcement, just in case there was a surprise of some sort.
6. Short sellers had covered positions last week in front of the Fed meeting.  Traders have a fixation on the potential of QE-style moves, so they wanted to be flat until they knew what would happen.
7. When selling started in the final hour, some piled on and bids dried up.  The precise cause did not matter.  The short-term trend was clear.

There are plenty of options!  Make your own choice before reading on -------

My Take

As a background for this section I want to point out that my preview for the week said that nothing magical would come from the Fed.  Our trading posture was bearish for the week.  I manage several programs with different time frames.  In the long-term programs I do not believe that investors should be jumping in and out of stocks, trying to time the market.  There is a different mind set for the long-term investor.  You have to believe that the market will often be irrational, offering you good opportunities.

This explains why I was concerned about this week, while still believing that the market is over-reacting to the downside.

Let me review the candidates.

1. The Fed bashing is the single biggest threat to the individual investor.  The critics do not understand the issues and would look foolish if they had to make a presentation in an actual Fed meeting.  They seem OK on TV or their blogs because they have no opposition.  There is a concerted effort to make people feel that our country has no effective leadership.  As I have frequently made clear, I am happy to have a strong leader from either party.  We should all hope for economic improvement before the next election, and expect our elected leaders to cooperate.  I also note that Bernanke is a Republican, and would be pursuing the same policies if the 2008 election had been different.  Do not allow people with an overt political agenda to distort your investment decisions!
2. The actual Fed policy decision was widely anticipated.  If anything, it was a bit more market-friendly than expected since it did more in the 20-30 year range and also addressed housing.  It is difficult to see how the actual decision could be a market disappointment, although that will be the deceptive headline story in your morning paper.
3. The Fed scared the markets?  Really?  This argument is advanced mostly by the same people who sell fear on a daily basis.  Let us try for some objectivity.  The FOMC adjusts the outlook every six weeks.  In between these meetings we see the Beige Book.  Everyone paying attention knows that economic data has gotten a touch weaker.  In the business, this is what we quaintly call "old news."  Some will seize upon this for the familiar "Fed is behind the curve" refrain, but the update is actually timely.
4. The Fed dissenters disagree both on inflation concerns and on the underlying economic strength.  At least one of the three has stated support for more aggressive measures if the economy weakens.  Put another way, the interpretation of dissent differs sharply from what most pundits are saying.
5. I give some credence to the effect of the Moody's story.  The effect on financial stocks, both those downgraded and others, was clear throughout the day.
6. Short sellers waiting for the news.  Now we're talking!  The trading and short-selling community harbors an exaggerated fear about the QE policies.  Last week's rally seemed strange and had a short-covering flavor.  It is not surprising that those choosing to take short positions would wait until after the FOMC decision to act.
7. This also makes sense to me.  When the story is complicated, most average investors will have no clue about how to react.  Bids dry up.  Programs take hold.

Investment Conclusion

At some point we will look back on today's trading as an especially interesting example of the climate of fear that defines 2011.  There was nothing really surprising or important from the Fed.  The market reaction should not be attributed to the Fed.

I especially like the careful interpretation from TheStreet.com's market reporter Chao Deng.  Her market interpretations are better than those of the pack and well worth reading.

Although the central bank refrained from additional quantitative easing and launched a "twist" as expected, investors were surprised by the Fed's wording that the economic outlook faced "significant downside risks," a slight change from its last statement that said that "downside risks" had increased. Some analysts say that the tweak in language was in part behind today's disappointing reaction

I also like the story highlighted by Barry Ritholtz, one of our favorite and featured sources. You need to read the whole story, which refutes a widespread notion that bank profitability is reduced by this move.  Quite the opposite!

I also urge readers to watch this video from Dick Bove.  Instead of just shooting from the hip, he cites solid numbers relating to bank stocks.  He discusses cash on hand, risk, European risk, capital ratios, and other key metrics.  This is much, much better than what you usually see about amorphous risks.  Bove especially addresses the Moody's opinion that the US is less likely to support major US banks.  If you listen to him with an open mind, and then read the Moody's report, you will be better prepared to make a solid investment decision in banks.  As regular readers know I like the best-of-breed JP Morgan Chase (JPM) despite recent declines in price.

 

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?

 

The Fed Decision and the Market Reaction

The morning papers will tell you that the Fed made a decision and the market rallied by 4%.  Causation will be implied, even when not explicitly stated.

For most of the punditry the interpretation of these stories is seen through the prism of their opinions.  Forget the data!

The initial reaction to the Fed decision -- for a heartbeat -- was a rally based upon the apparent promise to hold rates low until 2013.  Then the critical commentary hit.  I watch a good group of sources via Twitter as well as the MSM commentary.  The Twitterati had an immediate negative reaction.  It is a tough audience that usually hates Bernanke and the Fed.  As the market sold off, the comments became more strident.  There was criticism of Doug Kass, who turned out to be the star of the day.  He explicitly stated that the Fed decision was favorable for risk assets.  No one agreed.  Financial TV started raising questions, like whether or not the 2013 date was a firm promise.

Kass called the rally in real time, and most everyone disagreed.

When the market rallied, suddenly things changed.  New explanations were needed.  Even tonight's Kudlow show involved as many interpretations as there were guests.

Too Many Explanations, Too Little Knowledge

Anyone experienced in analyzing causal relationships knows the difficulty when you have multiple variables and few events.  You cannot invoke the right statistical controls.

A pundit test would be great fun.  The "expert" is given a set of facts and must then predict the market reaction without knowing the real outcome.  (Please note the relevance to last week's trading).  Let us consider yesterday's huge decline, widely attributed to the S&P debt downgrade.  There were a number of possible sources of selling:

• The debt downgrade.  One would expect to see this reflected in higher interest rates, but rates moved lower.
• The European crisis.  The ECB  bought bonds and the interest rates of Italy and Spain moved much lower.  Even those who did not see this as a complete solution had to be impressed by the result.
• Margin calls on various market participants.  We do not have precise information on this, but I think it was important.
• Momentum trading.  One of our programs is a momentum model, and it did very well -- even signaling an exit late in the day.  While our technology is very good, others do similar things.

My own explanation includes all of the above, not a single cause.  The apparent anomaly on the downgrade requires a deeper look.  Between the Tea Party and the S&P, the market believes that the US must now focus on immediate deficit reduction.  I disagree -- a story for another day -- but that is the market perception.  I commented to my team that this idea would turn up somewhere, and sure enough, I see that David Rosenberg has that viewpoint.  It is one of the few good explanations of why bonds rallied on the downgrade while stocks tanked.

The Fed Decision

Let us now turn to today's action.  Let me start with my interpretation of the Fed move.  I am not going to do a detailed analysis, assuming that readers of "A Dash" have a basic understanding from primary sources.

• The 2013 date is a promise, but not a contract.  The language is not definitive, but is open to interpretation.  I think that this is intentional.  The specified date is stronger than the "extended period" language, which implied two or three Fed meetings.  If the economy improves a lot, this is going to change.  Having said this, it will be difficult to revoke the promise without a major change in conditions.  Eventually market participants will come to this viewpoint.
• The economic outlook was downgraded realisitically.  This was not the meeting to report a formal change in estimates, but obviously the change is there.  The Fed explicitly acknowledged the weaker data, even worse than the Japan/soft patch thesis would suggest.
• The door is ajar on balance sheet management.  "The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate."  This is better than announcing a QE3 program.  Most market participants still do not understand QE2, including the fact that it has not ended.
• The three dissents.  While this is still a 7-3 vote, it is far from the typical unanimity.  The dissenters seem to have a more bullish view on the economy, with less need for long-term action.  The bearish segment of the punditry will see the dissenters as fearing inflation without growth, so this is more fuel for the fire.
• An air of mystery.  Other options were considered.  Who knows?  Pundits are already speculating about a QE3, with the Jackson Hole annual speech only weeks away.

The decision gives plenty of room for interpretation, helping to explain the market confusion.

Market Interpretation

Here are several other interpretations for the market rally:

• Realizing that interest rates will be low for years to come, the comparison to dividend and earnings yields in stocks (the widest risk spread in history according to some) suggests the need to reconsider asset allocation.
• The "attack on the yield curve" stimulated short covering in Treasuries, as well as stocks.
• The market was oversold and ready for a rally unless the Fed decision was something horrible.
• Many were caught leaning the wrong way, so there was massive short-covering.

No wonder my twitter friends were so far off base.  Since the actual decision was not that dramatic, I favor a combination of the above causes.

Investment Implications

It is a mistake for the average investor to attempt to time these moves in a volatile market.  Having a price target for individual stocks that you want to own makes much more sense.

 

Bernanke Disappoints

Let me put this bluntly:  Bernanke did not communicate effectively.  His message and presentation were both poor.

I do not mean that he is substantively wrong, just that he did not effectively communicate his message.  As regular readers of "A Dash" know, I have been one of his biggest supporters.  What went wrong?

Style and Leadership.  I would be among the last to criticize an academic style -- in most settings.  When it comes to the Fed, many regular people are looking for wisdom and leadership.  There is a large market audience that he could not persuade no matter what he said, but he still has a mission.  It is possible to acknowledge some uncertainty and still communicate effectively.

As I have demonstrated in as series of recent articles (start here), the main effect from QE II was a sense of confidence that the Fed would not allow deflation.  That remains an important mission.

The presentation required some energy and a sense of leadership and confidence.  The market observers are about 4-1 Fed enemies, so they are prepared to apply a haircut to anything said.  It is not good enough to come out "flat."

Economic Forecasts.  The Fed Chair laid out the forecast without much explanation and with plenty of waffling.  Most market types do not understand economics or long-term trends.  They all engage in "pop econ."    It has been so long since we have had a solid economy, and there is so much carping, that many believe the long-term economic trend is negative.  Unless there is stimulus, they expect things to get worse.  This is wrong -- so, so wrong, and the Fed Chair is Educator-in-Chief.  He keeps talking about returning to trend, but does not explain what that means.  Most do not get it.

Stimulus.  This was the biggest blunder.  He did actually say that by maintaining the balance sheet they were continuing stimulus.  No one noticed, since it was not presented effectively.  In fact, the market confuses the end of QE II purchases with the end of stimulus.  Anyone who read a newspaper before this event knew that the market was clamoring for more stimulus to rescue the economy.  They are all wrong, of course, but that is their perception.  Then there are those who think that the QE's created inflation all over the world.  They are also wrong, of course, but that is their perception.

The Fed Chair had an opportunity to clarify either or both points, but squandered the chance.  He needed to emphasize that by maintaining the current, all-time record balance sheet the Fed has the pedal on the floor - more that at any time in history. 

The QE II program is extraordinary stimulus that has not yet hit the economy.  Almost no one seems to understand this, and those who do are not given much "air time."

The Agenda.  Bernanke does not understand the press conference format.  If he has a message, he must get it into his statement.  Once he has completed that he is at the mercy of the questions.  His statement was the typical wooden, committee-drafted presentation.

Control of the agenda virtually controls the outcome.  Surrendering control is a big mistake, one that is well-understood by political scientists.

The New Fed Transparency

If the Fed wants to use press conferences to achieve a new level of transparency, it must be done correctly.

In April I expressed the concern that the press conference innovation demanded too much from the Fed Chair.  We are already asking for a wide range of very special skills.  Effective communication in front of a sharp questioning audience is yet another dimension.

Bernanke did OK in the first press conference, but this time he came out flat.  While watching, I was remembering my April post on the subject, but I give full marks to Doug Kass who tweeeted that Bernanke needed a press secretary.  Effectively, this means that the format does not work.

Where does this leave us?

Eventually, the economy, earnings, and the market will all find the right level.  At the moment, the general state of misunderstanding continues -- negative sentiment, good opportunity.  Short-term negative, long-term positive.

[housekeeping note -- sorry to email readers who did not get the embedded video last night.  I am new to doing these videos, and if you want to hear my voice explaining the QE effects, I think you can find it here.]

Analyzing the Effect of QE II

The Fed's plan for quantitative easing was innovative and therefore unprecedented.  No one could know for sure what to expect, so there was abundant speculation.

That speculation has created an atmosphere of confusion and misinformation.

Background

Even after months of the program there is little clarity about the effects.  The problem is that many things are changing at the same time.  What caused what?  There was an economic soft patch last year related to European issues.  That coincided with the end of QE I.  The launch of QE II came just as other things were also happening, including significant improvement in economic data.  Most observers dismissed a double-dip recession and corporate earnings were strong.  Despite this background, some insisted on a Fed-based explanation for the market rally.

I have provided comprehensive QE II analysis, which you can easily review.  Understanding the Fed has certainly helped my investment decisions over the last year, and I hope some readers also found the stories useful.

Measuring the Effect of QE II

A precise measurement is impossible, since we do not know what would have happened in the absence of QE II.  Many pundits take advantage of this uncertainty by attributing anything that happened since Labor Day to QE II.  I showed why this was wrong by explaining the Super Powers of Ben Bernanke.

In fact, the effects of QE II are quite modest.  To demonstrate this I really need a chalkboard.  Failing that, I am trying an experiment by producing a little video.  It shows how what you learned in school can actually be applied to your investment advantage.

 

Video Credit: "Basic Supply and Demand" from the Wolfram Demonstrations Project http://demonstrations.wolfram.com/BasicSupplyAndDemand/ Contributed by: Mark Gillis

I hope you don't mind the little refresher.

Supporting Data

Those who need volume data on the bond market can download and review data, as I did.  It is important not to confuse the daily volume, which is most relevant for price determination, with data about the eventual holders of the securities, the size of the daily Fed auction, or the banks participating.  None of these factors is relevant to the market price which is determined by -- drumroll -- the market!

Conclusions

Once you understand that the direct interest rate effects of QE II are on the order of 20 bps, you are better prepared to deal with outlandish claims.

• The idea that "no one will buy our bonds" is silly.  A small change in interest rates will attract many buyers.  Who will this be?  Out of the $500 billion in trades it would basically be the last marginal buyer.

• QE II was not (directly) responsible for speculation in either commodities or stocks.  The 20 bps effect might nudge a few players into a different asset, but it could not be the source of the monster rally in commodities.  The Fed explanations of quantitative easing discussed the concept of making other asset classes more attractive.  Some observers seized upon this directional language and inferred effects far beyond what could have been expected from small interest rate moves.

• QE II did not cause the decline in the dollar.  The interest rate effects were too small.  The dollar is responding to the trade deficit, along with many other factors.

• The buying in QE II has ended, but the effects will continue until there is a reduction in the balance sheet.

• The alleged and mistaken "end" of QE II will have little immediate effect.  It will not take long for this to be recognized.

The Quandary

If QE II did not directly cause big moves in asset prices, and if the correlation analysis is bogus, what is the real explanation for what has happened?

The best analysis I have seen comes from Mike Konczai's interview of Joe Gagnon, a visiting director at the Fed and now working at a prestigious think tank.

MK: So did QE2 work? And if so, how can you tell?

JG: It did work. I think QE2 had two elements. One element was of moderate importance, one element was of minor importance. The moderate one is that QE2 convinced markets that the Federal Reserve would not allow deflation or a double dip recession to happen. This is good because it inspired confidence and kept inflation expectations from falling any further. That was the most important step, because it convinced financial markets that the United States wouldn’t turn into Japan, which they were worried about. The element of minor importance was that it lowered long-term bond rates a little bit. It takes a lot of purchases to move these interest rates even a little bit, and QE2 wasn’t big enough to move them dramatically. It’s not nothing, but it is small in the scheme of things.

There is plenty more analysis in the interview, including speculation about what an (unlikely) QE III would include.

As I wrote yesterday, the biggest effects are psychological, not a direct policy consequence.