A Dash of Insight

The Most Common Error in Stock Market Research

There is a very common research mistake. It is pervasive in Wall Street research, even that presented by the big-name firms. My academic friends are not immune, partly because they have their own set of incentives.

My mission in this post is fourfold:

1. Explain the problem in a way that it can be readily understood;
2. Show how you can spot it in practice;
3. Provide a clear example;
4. Suggest some other applications.

The Problem – Selecting the Right Data

If you take a course in research design, one of the first topics will be determining the right data and sources for your analysis. To help us stay open-minded, I will use one of my favorite approaches – a sports analogy.

Let us suppose that we wanted to predict the total points that would be scored in tonight's basketball game between Wisconsin and (The) Ohio State University. The game is being played as I write this, so the exercise is purely academic. Here are some possible choices for our analysis:

1. Take the entire history of college basketball and use the average as our forecast.
2. Use data only from the time since the shot clock was put in place.
3. Use data only since the three-point basket was introduced.
4. Use only data from the Big Ten, which might differ from other conferences.
5. Use data only from Ohio State and Wisconsin, who might have different team tendencies.
6. Use data only from these teams in the last few years, perhaps reflecting their current personnel.

Note that the data becomes more relevant as it gets more specific. Please also note that there is still plenty of data for our problem, since college teams play 30 or so games each year. Even a few years of data would provide 100 cases.

The Stock Market Comparison

Let us take what we learned in step one and consider how it applies to the stock market. Suppose that we wanted to forecast tomorrow's trading volume at the NYSE. Here are just a few of the major changes in stock trading (readers are invited to add more) since the 1792 agreement signed under a Buttonwood Tree.

• Stock quotes replaced a ticker tape.
• Securities regulation to provide information.
• Competitive commissions.
• The invention of computers.
• Options trading.
• Futures trading and arbitrage.
• Online trading.
• New NASDAQ rules and deep pools.
• Decimalization of stock prices.
• SOX and regulation FD.
• High frequency trading.
• Individual stock circuit breakers.

There are other elements, including the more active role of the Fed, but you get the drift. If you were interested in predicting volume, you probably would not use data that was more than a few years old. Too much has changed.

Even when it comes to more general market analysis I am not interested in what happened in the Taft Administration, the FDR era, or even the Ike years. I do not care much about the Nixon years, or even Jimmy Carter. We at least need to get to the modern era of an active Fed, active stock trading with low commissions, and broader access to data through financial television and computers.

An Example

For the purposes of this post I want to use a very innocent example from two of my favorite sources – both valuable contributors to our understanding of markets and current issues.

Let us first look at this chart from my friend Doug Short:

This is a beautiful chart. It is accurate and provides the most comprehensive history available from any source. Doug notes that the long-term, inflation-adjusted increase in stock prices is an annualized growth of 1.73% and that current values are 48% above this trend.

When I look at Doug's chart my eye does not follow his proposed regression line, mostly because I am totally uninterested in the old data. I imagine a different line, starting with the post-war period – surely more relevant. I also imagine a line beginning in 1982, where the data become even more relevant.

The starting point of 1871 is represented not because it is best, but because that was the earliest year for which Dr. Shiller could generate data. There is not a strong research reason for the choice.

While I was pondering this question and considering developing my own chart, I discovered this presentation from Scott Grannis:

Scott's chart is not inflation-adjusted, but it also does not include dividends. The conclusion is dramatically different, showing that stocks are in the middle of the long-term trend – growing at almost 7% a year plus dividends.

Neither source gives any particular reason for the choice of starting point – and that is my main focus here.

Great analysis begins with choosing the right data. Everyone has heard the expression "Garbage in, garbage out." This is where it starts.

Other Applications

If you understand this problem, you have jumped the first (and most important hurdle) in identifying strong research.

It will help you grasp the mistakes of most recession and business cycle forecasters. They simply do not have enough relevant cases to do a good job of ex-post analysis.

You can see the mistakes of those whose research identifies "bad times to invest." They also do not have enough past cases, so the inferences are unsound.

You can see the shortcomings of leading academics. They get respect for exhaustive and thorough analysis, finding data that others have missed. That is fine for their book reviews. You and I need to apply a higher (different?) standard. The popular book about why "this time is different" book has only a handful of truly relevant cases.

Investment Implication

The world wants "actionable investment advice." Fair enough. I have been acting on the principle described here for several years – with weekly articles to explain.

The basic conclusion is that many of the popular pundits, despite their apparent use of data, have developed inaccurate and over-fit models. It is better to have simple models with more relevant data. These may not seem as impressive at first glance, but prove to be more robust in practice.

More to come on this important theme…..

Business Cycle Forecasting: The First-Rate Results of Robert F. Dieli

This article is probably the most exhaustive and challenging piece I have written.  It was worth the effort because understanding the business cycle is crucial to making great investment decisions.  To get the full benefit, I urge readers to spend some time reading the background links and watching the videos.

I am going to follow up with another piece describing how I use this information for investment decisions.  For now, let us all focus on the method, understanding how and why it has worked so well throughout history.

Background

In May of 2011 I embarked on a search for the best recession forecasting methods.  I had been a long-time fan of the ECRI approach.  They were still very positive on the economy at the time, and my quest was not driven by their conclusions.  I was uncomfortable with the methodology and the lack of transparency.  I had many reader suggestions, and I reviewed them all.  The criteria were stringent -- "Jeff's Acid Test."  The easy winner of this competition was Robert F. Dieli's "Mr. Model."  (This article described the competition and the results).

The main conclusion from Bob's work was that there was no imminent recession.  This ran counter to some other well-publicized and popular forecasts.  Some readers complained in the comments that the history of the forecast included some imperfections.  Others disagreed with the methods.  The subject was too difficult for simple responses to these questions.  I promised to follow up in more detail, but I wanted to do so in a convincing fashion.

A Year Later

A year later, some key elements of my rationale should be even more convincing:

1. Bob was right -- once again, as so many times before.  And he did it in real time, not on a back-tested basis.
2. Imperfections in real-time forecasting are acceptable -- even desirable.  When I see a perfect forecast, it always means that the model has been tweaked and changed to fit all of the past data.
3. Simple is good.  Methods that over-specify the number of variables and numerical trigger points also imply excessive back-fitting and poor predictability.
4. Theory is important.  The model should make sense.

Most recession forecasting models fail because they emphasize weakness.  This is backwards.  A recession begins at a business cycle peak, something that I explain more carefully here.  A recession starts with excessive strength.  Seen any of that lately?

Dr. Dieli explains this quite clearly in this chart.

 

Your intuition about the business cycle would be better if you completely forgot the "R" word and took Bob's lead:  Substitute "business cycle peak." 

The key driver of Bob's forecast is what he calls the "Aggregate Spread."  By reviewing results over decades we can see that this method actually provides a warning of about nine months.  The image below describes the composition of the spread, using example data from August.

The most recent aggregate spread is shown below. Just as it did last year, it provides strong evidence that the US economy is not nearing a recession.

And Now -- The Show

Get some popcorn and your favorite beverage and settle back to watch the show.  I recently met with Bob Dieli to discuss economic forecasting and to create some videos.  The result is an eight-part series in which we discuss each of the recessions of the latter 20th Century.  [Thanks to Derek Miller for helping in the production of the videos and producing the key summaries.]

In this first video, Bob and I discuss National Bureau of Economic Research and why their definitions of a recession are important. The nonpartisan NBER looks at both the peaks and troughs of the business cycle to conclude when past recessions have happened, effectively making "autopsies, rather than forecasts" - as Bob says. Therefore, it is important for the Mr. Model to use the same criteria when it forecasts for recessions, providing a clearer picture than other models.

 

 

 

In part two, Bob and I take a close look at the recession of 1957. In doing so, they describe exactly how Mr. Model works. The model signals 9 months ahead that the business cycle will be heading towards a peak or trough when it crosses the 200 basis points (shown as a red line on the chart). 

 

 

 

Bob and I illustrate the ways in which policymakers can and do impact the business cycle and how this interacts with Mr. Model. In the run up to 1960, tightening by the Federal Reserve as well as fiscal cuts by the Eisenhower Administration led to an economic downturn. In 1967, when the Fed again tightened the yield curve, the model signalled a recession. Shortly thereafter the Fed eased up, thereby avoiding a recession. At the end of the day, the NBER never called a recession in '67.

 

 

 

Mr. Model had nearly spotless performance in predicting the recessions of the 1970's. Contrary to popular belief, the 1973 recession had less to do with OPEC and more to do with other government policies that laid the foundation for an economic downturn. 

 

 

 

Mr. Model shows the result of Fed Chairman Volker's monetary policy, which inverted the yield curve and brought the Fed funds rate to 20%. The result was a short 6-month recession, then a short recovery which was stifled by other policies. Interestingly enough, the recovery never took Mr. Model past 200 basis points - meaning a new peak could not have been established for the "second" recession.

 

 

 

After the "double dip" recession of the 80's, the recovery brought the business cycle to record highs. This led to the third-longest period of economic expansion into the summer of 1990. A combination of tightening monetary policy and changing policies regarding the first war in Iraq were both responsible in part for the downturn. In 2000, Mr. Model signaled a recession in an election year - something that was sure to happen regardless of who was elected. However, in both instances the model predicted short and shallow recessions unlike the seriousness of the early 80s. 

 

 

 

In the most recent recession, Mr. Model's results were decidedly different than they had been for any previous recession. The model alerted that the 200 basis point line had been crossed in 2007 but did not decline sharply. This is in part because tightening by the Fed did not effect the yield curve as they had in past events. Quick reactions by the Bush and Obama administrations also helped to prevent a dramatic decline in Mr. Model's basis points.

 

 

 

In this final video, Bob and I focus heavily on the 2007-2009 recession. The model appears to show a false positive as it crosses the 200 basis point line in 2006, but continues sideways for some time before the recession was officially called. In a sense, this suggests severe instability rather than the dramatic declines of the past. In any case, we had ample warning that a recession was coming. It did not take us by surprise.

 

 

 

Conclusion

If you have studied the evidence, you will see that recessions usually involve the Fed!

You might also have noticed that business cycle peaks do not typically come from a problem of "stall speed" but one of excess stimulation.

Market observers are completely mistaken:

• Wrong indicators;
• Wrong interpretation (weakeness versus strength);
• Wrong sources;
• Wrong point of the business cycle; and finally
• Wrong stocks.

These will be the subjects of the next installment.

A Bull Market in Bad Predictions

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

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

Recession

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

Fiscal Cliff

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

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

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

Opportunity

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

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

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

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

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

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

 

 

 

September Employment Report Preview

For many years I have written a regular monthly preview of the Employment Situation Report.  I have done extensive research on all of the methods and even visited the stat guys at the BLS to discuss their approach.

My preview gives appropriate respect to the BLS, but also to the leading alternative methods. Why is this so important?  I have created a little story which may be helpful on this front.

A Helpful Bit of Fiction

Suppose we have a contest to guess the number of coffee beans in a jar.  Here is a picture of such a contest in Bluffton, Ohio, just down the road from where I grew up.  Let us take some liberties with the contest rules.  The contest is done every week.  Every contestant gets to know how many beans were in the jar the week before, but the shop is withdrawing and adding beans each day.

Let's consider four different approaches for determining the number of beans.

1. 1)  Lift the jar to estimate the weight.  Compare the weight with what you think it was last month and adjust your guess.

1. 2)  Track the amount of coffee served during the week.  Estimate how many beans must be added to replenish the supply.

3)  Count the scoops of beans added.  Use a sampling procedure to estimate the number of beans in a scoop.

 

4)  Measure the jar.  Determine its volume.  Determine the volume of a bean.  Do the math, sort of like this contestant in a similar contest.

 There is an actual count of the beans, but that report is available only after five days.  (Fast counters are in short supply!)  The contestants want to have a winner declared each week at the barn dance.  To meet this demand, the contest administrators decide to pick one contestant approach and declare that to be the "official" result.  Since the math contestant has a good long-term record, that is the one chosen.

A few days later the actual count is known.  By then no one cares, since the prize has already been awarded.

And that is what we all do each month in trying to squeeze meaning from the employment situation report.  Even though the BLS is just a competing contestant (readers are invited to unmask the others) their estimate is anointed as official.

Background

We rely too much on the monthly employment report.  It is a natural mistake.  We all want to know whether the economy is improving and, if so, by how much. Employment is the key metric since it is fundamental for consumption, corporate profits, tax revenues, deficit reduction, and financial markets.  Whenever there is an important question, we all seize on any available information.  While we might know the limitations of the data, any concern is briefly acknowledged -- if at all -- and then swiftly put aside.

The Data

We would like to know the net addition of jobs in the month of September.

To provide an estimate of monthly job changes the BLS has a complex methodology that includes the following steps:

1. An initial report of a survey of establishments. Even if the survey sample was perfect (and we all know that it is not) and the response rate was 100% (which it is not) the sampling error alone for a 90% confidence interval is +/- 100K jobs.
2. The report is revised to reflect additional responses over the next two months.
3. There is an adjustment to account for job creation -- much maligned and misunderstood by nearly everyone.
4. The final data are benchmarked against the state employment data every year. This usually shows that the overall process was very good, but it led to major downward adjustments at the time of the recession. More recently, the BLS estimates have been too low, as revealed in the just-released report.  For the year ending in March, 2012, the BLS estimate was off by about 30K jobs per month overall, and 35k jobs per month on private employment.

Competing Estimates

The BLS report is really an initial estimate, not the ultimate answer.  The BLS is actually like one of the contestants, with the full report coming later.  The market uses this estimate as "official" and declares winners and losers on that basis.  No one pays any attention to the final data, which we do not see for eight months or so.

• ADP has actual, real-time data from firms that use their services. The firms are not completely representative of the entire universe, but it is a different and interesting source. ADP reports gains of 162K private jobs on a seasonally adjusted basis.  In general, the ADP results correlate well with the final data from the BLS, but not always the initial estimate.  It is an independent measure that deserves respect.  The revisions noted above moved the BLS closer to the ADP conclusions over the time period cited.

• TrimTabs looks at income tax withholding data. The idea is that this is the best current method for determining real job growth. TrimTabs forecasts gains of about 210,000.  TrimTabs thinks that the BLS is wrong.  They write as follows:

"(The BLS) is missing the current acceleration in job growth.  In August, the BLS reported job growth of only 96,000 new jobs, nearly half of the job growth TrimTabs reported.  TrimTabs reports that the BLS survey typically captures employment growth more effectively in government and large corporations while nearly 84% of the recent employment growth is occurring in small and medium sized businesses."

• Economic correlations. Most Wall Street economists use a method that employs data from various inputs, sometimes including ADP (which I think is cheating -- you should make an independent estimate).
  
  • Jeff Method.  I use the four-week moving average of initial claims, the ISM manufacturing index, and the University of Michigan sentiment index. I do this to embrace both job creation (running at over 2.3 million jobs per month) and job destruction (running at about 2.1 million jobs per month). In mid-2011 the sentiment index started reflecting gas prices and the debt ceiling debate rather than broader concerns. When you know there is a problem with an input variable, you need to review the model. For the moment, the Jeff model is on the sidelines.  The recent uptick in consumer confidence, despite gas prices, the fiscal cliff, and Europe, is encouraging for jobs.  It remains difficult to account for the effect of headlines about Europe and the fiscal cliff.  The model inputs are improving a bit, but I do not think we have a good grasp on job creation.
  • Street estimates generally follow my method, but few reveal much about the specific approach.  These estimates usually adjust for the ADP report, but there was little reaction to the strong estimate for this week.  Everyone cites the "poor" ADP record in matching the BLS.
• Briefing.com cites the consensus estimate as 120K, while their own forecast is for 165K.  Their private jobs forecasts are about 10K higher, since the loss of public jobs is well known.
• Gallup sees unemployment as stable  at 8.1% on a seasonally adjusted basis in mid-September, the time of the BLS data collection.  This is interesting since they have a different survey from the government, a relatively new approach to seasonal adjustment, and an extremely bearish and political approach in past commentaries.  Gallup's methods deserve respect, so I am watching closely.

Failures of Understanding

There is a list of repeated monthly mistakes by the assembled jobs punditry:

• Focus on net job creation.  This is the most important.  The big story is the teeming stew of job gains and losses.  It is never mentioned on employment Friday.  The US economy creates over 7 million jobs every quarter.
• Failure to recognize sampling error.  The payroll number has a confidence interval of +/- 105K jobs.  The household survey is +/- 450K jobs.  We take small deviations from expectations too seriously -- far too seriously.
• False emphasis on "the internals."  Pundits pontificate on various sub-categories of the report, assuming laser-like accuracy.  In fact, the sampling error (not to mention revisions and non-sampling error) in these categories is huge.
• Negative spin on the BLS methods.  There is a routine monthly question about how many payroll jobs were added by the BLS birth/death adjustment.  This is a propaganda war that seems to have ended years ago with a huge bearish spin.  For anyone who really wants to know, the BLS methods have been under-estimating new job creation.  This was demonstrated in the latest benchmark revisions, which added more jobs.

It would be a refreshing change if your top news sources featured any of these ideas, but don't hold your breath!

And most importantly, it would be helpful if anyone would realize that the BLS is just one estimate.  The bean counter example illustrates this.

Trading Implications

The rules are changing for trading the employment report.  You can still expect the aggressive bearish spinfest that usually provides a "dip to cover," but things are a bit different now.

With the Fed intentions declared, we have left the environment where good news might be bad and bad news might be good -- all because the Fed might be more aggressive.

My operating expectation is that good news is now good.  It will not stimulate the Fed to tighten.  Bad news is bad, but if it is bad enough, the Fed might add to the QE3 quantities.

I understand that most traders and pundits are in denial about this (as I explained here), but that just provides a better opportunity for the rest of us.

The sophisticated investor does not complain about government policy.  He includes likely outcomes as part of his investment plan.

Romney? 100% Chance of Recession!

In the entire history of official recession dating (beginning in the 1850's) there is a startling fact:

Every newly-elected Republican President has brought a first-term recession.  All of them.  "Always and only" as we hear from a popular data-mining pundit.

You can check out the list of GOP Presidents here.  And the official recession dating here.  I use "elected" because there was no recession in the brief term of fellow Michigan man Gerald Ford.

It is not quite "only" since Democratic Presidents avoided recessions on a 10-2 basis.  I am not surprised that there was no first-term recession for Bill Clinton or JFK, but who would have expected a clean record for FDR or Jimmy Carter?

Economic Comparisons by Party

According to this Bloomberg article, Democratic Presidents Are Better for the Economy.  The author, Richard J. Carroll is an economist at the World Bank.  Here is a summary of his findings:

The Truman legacy has truly grown over time!

Here is another study that says Democrats win on a balance of economic indicators, 11-2.  The authors conclude as follows:

"President Barack Obama does not feature in the rankings, as he has not yet completed a four-year term. But if Obama were evaluated now on all 12 of the indicators, he would fall somewhere in the middle of the pack, Deitrick says. The bottom of the pack overall is populated by Republicans: Presidents Richard Nixon, Gerald Ford, George W. Bush and Herbert Hoover."

Lessons in Inference

I trust that readers will understand my tongue-in-cheek approach to this subject.  It is silly to conclude, based on this evidence, that electing Romney will lead to a recession.

Meanwhile, many people use similar evidence to make bold claims about recessions.  Their readers consume the pseudo-scientific claptrap and blindly follow the pundit to a dubious decision.

If you agree with me that the conclusion about Romney is not valid, then maybe you need to reconsider the work of the guy who keeps describing a syndrome involving his Aunt Gertrude.  The methodology -- using many years of backfitted data -- is just the same as you see here.

Causal Modeling

Causal reasoning in economics involves many variables.  Especially when the number of cases is relatively small and the number of variables is large, the causal model can be tricky.

Try this one:  When a Republican is elected, it is often the result of Democratic economic failures.  This means that the GOP winner is saddled with a bad economy.

See how easy it is to create reasons after the fact?  Check out one of my favorite stories from "the old days."  The smarter you are, the easier it is to fool yourself.

Investment Conclusion

If you understand this article, you can win an Olympic all-around medal!

1. Separate politics from your investments;
2. Ignore bogus pseudo-science;
3. Beware of recent trends in both fear and greed;
4. Look for stocks with attractive valuations.

Each week I summarize the very best recession forecasts.  Since those with the best records are not featured in the financial media, this gives thoughtful readers an advantage.  Those scared witless by the recessionistas are selling cyclical names and tech stocks while piling into defensive sectors and dividend stocks.

The comparative valuations are becoming extreme.  I favor early-stage cyclicals like Caterpillar, Cummings, and Illinois Tool Works.  I like tech stocks including Apple, Oracle, Microsoft, and Marvel.

When I look for "dividend stocks" I am not seeking those with super-high yields, but strong balance sheets and PEG ratios, where I can also sell calls to enhance the yield.

The individual investor can find many good opportunities, but you must start with a good grasp of the business cycle.

(HT to Bob Dieli, whose whimsical comment inspired this post.  And no, the election result is not one of the factors in his excellent system, Mr. Model.)

 

 

 

 

 

Weighing the Week Ahead: Fireworks in the Forecast?

Forecasting fireworks this week should be pretty safe!

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

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

Background

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

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

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

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

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

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

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

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

Background on "Weighing the Week Ahead"

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

In contrast, I highlight a smaller group of events.  My theme is an expert guess about what we will be watching on TV and reading in the mainstream media.  It is a focus on what I think is important for my trading and client portfolios.

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

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

Last Week's Data

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

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

The Good

The most important news of the week was very good.

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

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

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

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

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

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

The Bad

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

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

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

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

Dr. Ed shows the impact on forward earnings.

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

 

The Indicator Snapshot

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

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

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

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

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon.  We are working on a modification that will make this method even more sensitive.  None of the recession methods are worrisome.  Bob also has a group of coincident indicators. Like most of the top recession forecasters, he uses these to confirm the long-term prediction. These indicators are also not close to a recession signal.

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

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

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

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

 

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions.  This week we continued as "bullish." These are 30-day forecasts.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list.  You can also write personally to me with questions or comments, and I'll do my best to answer.]

The Week Ahead

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

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

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

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

Trading Time Frame

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

Investor Time Frame

The successful investment strategy differs markedly from trading.  It is especially important to establish good, long-term positions when prices are favorable.  I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look.  You can contrast this with the many  pundits who claim miracles of market timing.

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

Final Thoughts on Fireworks

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

Here is the dilemma:

The best investment advice comes from contrarian approaches.

  Most investors pay too much attention to recent results.

This provides a challenge for investment advisors.

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

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

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

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

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

This week is a good example.

Best Investment Advice of the Week

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

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

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

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

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

 

Europe: Get Ready for a Surprise Endgame!

How do you find an edge?

I was inspired by a news story yesterday:

Europe promises speedy response to crisis

What a joke!  This really highlights divergent viewpoints.

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

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

A Flashback

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

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

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

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

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

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

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

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

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

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

The Alternative Viewpoint

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

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

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

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

Evaluating the Downside

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

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

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

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

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

The Right Approach

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

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

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

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

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.

 

 

Weighing the Week Ahead: More Excuses for Selling?

Experienced traders understand that markets rarely move in a straight line.

Staying with a long and strong trend -- either up or down -- is often the most difficult trade.

We expect stair steps and corrections since fundamentals rarely support such rapid changes.  The result is that as a move gets more extended, even traders who have played the trend are poised to react.

I have often cited Charles Kirk as the leading source for the trading perspective, and he also has many ideas for investors with a longer time horizon.  His chart show (small fee required) is part of my weekly preparation.  (I usually cannot cite his findings, since he posts the show on Sunday and I write on Saturday, but this week he advanced the schedule).  His explanation for last week was that the market was looking for excuses to sell --and found them.

That makes sense to me, since nothing in the news was that dramatic.  The question is whether the same psychology will continue.  I'll offer some thoughts on that subject in the conclusion, but first let us do our regular review of 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

There was not much to cheer about last week.

• Sentiment is still pretty negative.  I like to look at this through data describing behavior rather than responses to surveys.  Ed Yardeni looks at fund flows and concludes the following:

"Over the past 36 months through February, net inflows into bond mutual funds totaled $1.0 trillion, while net inflows into equity funds were close to zero. Unfortunately for bond investors, the equity funds enjoyed capital gains of $2.7 trillion over this period, while the bond funds had gains of only $437 billion. Now that bond yields are starting to move higher, those gains are likely to decline. That might convince individual investors to move back into equities."

• ISM manufacturing was better than expected at 53.4 versus expectations of 53.0 and a 1 point increase over last month’s 52.4. The ISM’s own research says that this value (if annualized) corresponds to GDP growth of 3.7%.  The report internals were generally good with prices paid a bit lower, customer inventories lower, and order backlog higher. New orders were down slightly, however, and inventories unchanged rather than lower. All-in-all, a very good report.
• Initial jobless claims declined, but from an upwardly-adjusted number.  I am calling this "good" but it is continuing a relatively flat range at the 350K level.  Job losses are only half of the problem.  We also need job creation.  As you can see from Doug Short's chart, a reduction of another 50K or so would signal much better economic health.

The Bad

Most of the economic news was negative.  I want to emphasize the employment situation, but I'll start with some lesser indicators.

• ISM services disappointed.  While services make up more of the economy than manufacturing, the data series is shorter.  It is very interesting, but more difficult to interpret.
• Auto sales were a bit below forecast and gas prices are higher.
• Employment gains were disappointing.  Job gains from the establishment survey were only 120K, much lower than expectations of over 200K.  This deserves more careful analysis, so I will give it a special section this week.

Interpreting the Employment Data

The monthly employment situation report was a disappointment, for all of the reasons that last month's report was encouraging:  light on payroll job gains, negative labor force revisions, bad hourly wages, and a shorter work week.  That just about covers it.

Others came out with a "flash report" but investors do not need that, especially since there was no trading on Friday.

Perspective

This chart from Calculated Risk shows the depths of the job losses and how far we are from the needed recovery.

Along the same lines, the Atlanta Fed has a helpful tool.  You can plug in a target unemployment rate and a time frame to see what the monthly job gain needs to be to meet your target.  Try it!

Sources

For several years I have championed the idea that the BLS measurement of job growth was one of several, and not always the best.  I write this in my monthly employment preview (as I did last week).  For a long period of time I opined that the official reports were too positive, so I have earned some credibility on this subject.

As I noted in the preview, other methods suggested job gains of about 200K.  When we finally know the truth -- after revisions and benchmark adjustments -- this may prove to be correct.  By that time no one will care.

The political world uses only the official data.  The media world breathlessly analyzes it.  As investors, we are free to use many different sources -- and we should.

Range of Error

 The official methods involve two different surveys.  The establishment survey gives us the official job gain, but it has a confidence interval of over 100K.  The household survey has a smaller sample and a confidence interval over 400K.  Pundits often forget that this applies to every element of the report, including all of the subgroups.

I wrote an article on this topic four years ago where I emphasized sampling error and the danger of relying on one month.  It still reads pretty well.  My fellow Kauffman blogger Ryan Avent did the job more persuasively with this interpretation:

"TODAY, the Bureau of Labour Statistics released its March employment report. There is a 90% chance that employment rose by between 20,000 and 220,000 jobs. The change in the number of unemployed from February to March was probably between (roughly) -400,000 and 150,000, and there's a good chance that the unemployment rate is between 8.1% and 8.5%. Reported changes for important subsectors are too small relative to the margin of error to be worth discussing. In all probability, the employment growth has remained close to the recent trend of a 200,000 jobs per month increase."

Please remember that this is just sampling error.  The short-term revisions relate to businesses that have been slow in responding.  The benchmark revisions have most recently revealed that job growth from new business formation has been under-estimated.

Alternative Measures

The unemployment rate might actually be moving significantly lower, according to Gallup via Bonddad.

Looking at unemployment without attention to seasonality and labor force participation is a big mistake via  Steven Hansen.

It all amounts to an unpleasant (but not earth-shaking) surprise via Felix Salmon.

My own take is in the conclusion.

The Ugly

A research project testing investment advisors found that most recommended unsuitable funds that earned them higher commissions.  This "sting" used actors to pose as clients.

There are many good investment advisors, and they all start by determining the client's needs and emphasizing the suitability of investments.

Runner up:  The President of Hungary plagiarized his doctoral dissertation.  This is bad enough, but there are apparently no consequences.  He is continuing in office as if nothing had happened.

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.

This week they add 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 bullish after three weeks in neutral. This is a close call, but ratings are improving, including the broad averages.

[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

US stocks will start the week under pressure because of Friday's employment report.  Futures trading continued for 45 minutes after the report, indicating an expected stock decline of about 1%.

I expect additional pressure from a 60 Minutes segment scheduled to run Sunday evening.  The focus will be on continuing problems in Europe, and the preview is very negative.  You can check it out here.

The most important economic data include initial claims and the PPI on Thursday and the CPI and Michigan confidence on Friday.

I am not a big fan of the small business optimism index (Tuesday) but the JOLTS report could be interesting.

With everyone parsing everything from the Fed for a hint of more QE, I will quit saying that I do not expect policy implications from these speeches.  Someone is going to draw an inference whether it is supported or not!  Fed Chair Bernanke speaks on Monday and Friday and Vice-Chair Yellen on Wednesday.  The speeches seem to cluster since there is a quiet period right before the FOMC meetings.  Speaking of the next meeting, we will also get the beige book on Wednesday.  This collection of anecdotal evidence from around the country is compiled by a different district for each meeting.  It does set the tone for the interpretation of the hard data, and it is always interesting.

We will get the official start of earnings season with Alcoa, but I do not think this will be a focus until next week.  At that point earnings will be very important.

Trading Time Frame

Our trading accounts have been 100% invested since December. Felix caught the current rally quite well, buying in on December 19th. There are more sectors in the buy range, and the overall ratings have declined. 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 illustrates the importance of watching objective indicators instead of headlines. Despite the modest overall ratings, Felix kept us fully and profitably invested for trading accounts, finding the bull market in selected sectors. We have 28 sectors in the universe, so we can be fully invested if there are three strong sectors, even if the market overall is neutral or negative.

Investor Time Frame

Long-term investors should be aware of the continuing rapid decline in the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," and is declining further. This sort of decline has been a good time to buy stocks on past occasions. Worry is still high, but has now declined to a more comfortable level.

Even though stock prices are higher than in October, the risks are much lower. I continue to increase position size for risk-adjusted accounts. I am also looking more aggressively for positions in new accounts. Until last week this has been a challenge, since the market has offered only occasional dips to buy.

The continuing reduction in volatility has helped our enhanced yield program, where we aim for 8-9% returns with low volatility. This week may provide some opportunities for new ideas.

Our Dynamic Asset Allocation model has 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 Employment -- and the Fed

Last week's employment data did not provide much fresh information.  The official stats were weaker than expected after a couple of months where the results exceeded other measures.  In my weekly article I predicted that seasonal factors could create some problems in interpreting the data.

It is important to get beyond the noisy political and market rhetoric.  The broad range of indicators show continuing modest economic growth.  Bernanke is likely to act if things get worse.  There is no sign that inflation is moving past the Fed's 2% target or that the big Fed balance sheet is turning into excessive M2 growth.

I would not call this a sweet spot (unlike this Bloomberg article), but it is also not a recession.

And Finally -- for Market Timers

I have taken time to explain how many investors are making a big mistake with inappropriate market-timing methods.

1. The Seduction of Market Timing. The secret of sales is to claim a lot, whether or not you can deliver.
2. Do You Adjust Your Price Targets? Most do not -- and this ranges from market experts to the average investor. Unless you are constantly doing a re-evaluation, you are missing out.

Last week I invited readers to consider the following small quiz:

It is popular right now to find reasons to sell, ignoring the change in market fundamentals. Here is a little quiz?

At market tops, what percentage of stocks are above their 200-day moving average?

What percentage are above that level right now?

 

Chris Puplava, using a technique from Paul Desmond, classifies stocks as above or below their 200-day moving average, and also whether that average is rising or falling.    He observes, "As a bull market approaches a top you should see a large percentage in the topping category (BR, fall) and right now only 3% of the S&P 500 members reside in this category."  Here is a helpful table.

Puplava draws the following conclusion:

"What should also be encouraging to the bulls is that the sectors most levered to the economy (cyclicals) are showing some of the strongest breadth, which is important as these sectors are usually the first to top out and enter the BR and BF categories."

March Employment Report Preview

Fasten your seat belts!

We are about to see something really new -- the release of the monthly jobs report on a day when the market is not trading.

Some think this is wrong.

Jim Cramer, with an assist from Larry Kudlow, tried to turn this into a religious crusade. Somehow the decision to release data according to the regular schedule was portrayed as an affront to those observing Good Friday. Here is the link and the video:

 

Cramer and Kudlow are completely wrong! The US government is not on vacation tomorrow. In this country there is no establishment of a religion, and therefore normal government functions are not geared to religious holidays.

Cramer loves these rants where he gets to lecture to the government officials who really make decisions. Here is the reality:

1. The employment report delivers information to the entire nation, not just the financial markets. Message to Jim: It is not all about you -- or the markets. Most people are interested in what is happening in jobs and the economy, not what markets do.
2. Why should the government adjust to the NYSE schedule? Who elected them as the arbiter of what is a holiday? This is a can of worms for the government.
3. If you had a complaint to make, why did you wait until this week? The announcement schedule has been known for months. Why criticize the government, the SEC, and the NYSE now. Look in the mirror.

Government has never paid much attention to financial markets in making announcements, and this is no exception. It is business as usual.

I'll suggest more about how to trade this in the conclusion. For now, we have extra implied volatility. Making a small adjustment from last month....

Options traders distinguish between actual volatility, recorded and measured from data, and implied volatility. The latter term comes from solving the options models using price and the various known inputs. Typically volatility is the only input term that must be estimated. High implied volatility means that traders of options are incorporating uncertainty in their estimates. With this in mind...

Get ready for maximum potential volatility in a single weekend!

The Data

We all want to know whether the economy is improving and, if so, by how much. Employment is the key metric since it is fundamental for consumption, corporate profits, tax revenues, deficit reduction, and financial markets.

We would like to know the net addition of jobs in the month of March.

To provide an estimate of monthly job changes the BLS has a complex methodology that includes the following steps:

1. An initial report of a survey of establishments. Even if the survey sample was perfect (and we all know that it is not) and the response rate was 100% (which it is not) the sampling error alone for a 90% confidence interval is +/- 100K jobs.
2. The report is revised to reflect additional responses over the next two months.
3. There is an adjustment to account for job creation -- much maligned and misunderstood by nearly everyone.
4. The final data are benchmarked against the state employment data every year. This usually shows that the overall process was very good, but it led to major downward adjustments at the time of the recession. More recently, the BLS estimates have been too low. (See my prior preview for a more detailed account of this, along with supporting data).

I think the BLS is honest and does a good job, which seems to put me in a small minority of observers. Despite this support, I question the general concept. The BLS tries to estimate total employment in one month, total employment in another, and subtract the two to determine the difference. When you are talking total payroll employment of over 130 million jobs, even small errors are in the range of 100K jobs or more. Meanwhile, smaller discrepancies from expectations are unwisely viewed as significant.

Competing Estimates

The BLS report is really an initial estimate, not the ultimate answer. What we are all looking for is information about job growth. There are several competing sources using different methods and with different answers.

• ADP has actual, real-time data from firms that use their services. The firms are not completely representative of the entire universe, but it is a different and interesting source. ADP reports gains of 209K private jobs. Steven Hansen at Global Economic Intersection endorses the ADP method over the BLS result. He has a strong analysis covering many nuances in the data. For those who really want to understand the jobs story, it is well worth reading.

• TrimTabs looks at income tax withholding data. The idea is that this is the best current method for determining real job growth. TrimTabs forecasts gains of about 187,000. They have been pretty bearish on job growth. (Their real-time estimate was for a gain of only 45,000, but they came forward and admitted a "calendar quirk" that threw off their forecast. There have been a number of changes in the tax withholding rules, so let's cut them a little slack and give credit for being honest about what happened and their methodology. They provide a useful additional method).

• Economic correlations. Most Wall Street economists use a method that employs data from various inputs, sometimes including ADP (which I think is cheating -- you should make an independent estimate). I use the four-week moving average of initial claims, the ISM manufacturing index, and the University of Michigan sentiment index. I do this to embrace both job creation (running at over 2.5 million jobs per month) and job destruction (running at about 2.3 million jobs per month). In mid-year the sentiment index started reflecting gas prices and the debt ceiling debate rather than broader concerns. When you know there is a problem with an input variable, you need to review the model. For the moment, the Jeff model is on the sidelines.
• Briefing.com cites the consensus estimate as 215K and their own forecast is for 250K.

A Special Message for Maria

In an interview today with David Malpass, Maria Bartiromo acted like monthly net job creation of 300,000 jobs was an impossible dream. I wish that I had five minutes to talk with her about employment dynamics. If we could increase job creation by 10% (without losing jobs) we would add an additional net job gain of 200-250K jobs per month. That would be a net job gain of 400K or so. No on in the mainstream media seem to understand this.

Trading Implications

What does this mean for our trading and investing?

My basic conclusion is that it is great for our enhanced yield program. A lot of implied volatility will come out of the market by Monday.

Let us suppose that (like Mr. Beeks) you knew the jobs report in advance. How would you trade it?

Investors would like to see economic strength -- a strong report.

Traders have this irrational fixation on more QE from the Fed. The current mantra, made especially obvious by this week's action, is that any perception of more QE is good.

From this perspective, a good report will be bad and a bad report good!

This is why I am not "trading" the report -- just collecting options premiums in a sideways market.