A Dash of Insight

Weighing the Week Ahead: Hope for a Budget Compromise?

Sometimes the week ahead, despite our relentless focus on markets, brings policy issues to the fore. Such was the case during the fiscal cliff countdown, and it is happening again.

Here at "A Dash" I have strongly advised that investors remain agnostic about politics. It is more profitable to accept the reality of current policy. Figure out what investment is best for the times. For this reason I rarely opine about policy. I often identify what is most likely to happen, and which outcomes are market-friendly.

In this spirit I suggest that investors should be monitoring the slow and laborious process toward a compromise that will avoid the impending spending sequestration. Until now I have refrained from writing about this issue. Why this week? Two things.

1. It will be a light week for other economic data, leaving plenty of media space and time to fill. My mission in the WTWA series is to forecast what will be on the agenda.
2. The State of the Union speech might offer some real hints -- if you know what to look for.

Background on the Sequestration Issue

Sequestration was adopted originally as part of the resolution to the 2011 debt ceiling impasse. The Budget Control Act of 2011 (Congress is great at misleading names for bills!) created a Congressional Joint Committee on Deficit Reduction. This "SuperCommittee" was evenly balanced, and failed to reach a bipartisan agreement within the time limit. Congress has acted to delay the implementation of these cuts, most recently as part of the so-called "fiscal cliff" resolution. D-Day is now March 1^st, but the effects are already being felt in many ways.

While some now seem willing to allow sequestration provisions to take effect, no one really believes that the meat-axe approach is the preferred solution to U.S. budget problems. In fact, the original intent was exactly the opposite.

The issue is important. The automatic cuts will reduce expected economic growth by 0.7% according to the Congressional Budget Office. This will have a related effect on expected corporate earnings.

The timing is important, since Congress is about to go on an extended "President's Day Recess" starting Friday.

Background on the State of the Union

President Obama's second inaugural address was widely perceived as aggressive and partisan. The tradition for the State of the Union Address is different. While it lays out an agenda, it often strikes some bi-partisan and patriotic themes. It will and should be closely watched as a hint for the future. There are some preliminary leaks about the text, but even these may be trial balloons.

I have some thoughts on what to watch for in the SOTU speech which I'll report in the conclusion.  First, let us do our regular update of last week's news and data.

Background on "Weighing the Week Ahead"

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

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

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

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

Last Week's Data

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

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

The Good

This was a generally positive week, both for data and for earnings. 

• The outlook for profit margins is promising in the eyes of most analysts. Sam Ro of Business Insider show the consensus take and highlights the dissent from Goldman Sachs. Even that viewpoint is better than the common bearish assumptions of rapid mean reversion. Here is the key chart:

• Nouriel Roubini is "optimistic" on stocks. (via John Sullivan at AdvisorOne). We always admire those who use facts, changing forecasts as indicated. For those who will call this a contrary indicator, you need a reality check. That interpretation guarantees that you will never change your mind.
• The trade deficit improved – a lot! This certainly flips the sign on the preliminary Q412 GDP report, and may represent an increase of as much as 0.7% Contrary opinion from Steven Hansen. Here is a helpful chart from Calculated Risk:

• Home prices are up 8.3% year-over-year. The CoreLogic data is reported by everyone's go-to source on housing, Calculated Risk.

• The earnings beat rate is still strong. Revenues, too. Despite the twist you might have seen from your favorite conspiracy site, Bespoke has the real story, with the expected great charts:

  So far this earnings season, 64% of US companies that have reported earnings have beaten earnings estimates, while 63% of companies have beaten revenue estimates.  As we highlighted last Friday, both of these readings are strong compared to past quarters over the last few years.

The Bad

There was some bad news, but not so much on economic data.  Feel free to add in the comments anything you think I missed!

• Insiders are selling – big time! Mark Hulbert says that the pace is the fastest in several years. Cam Hui emphasizes the warning, pointing out that potential tax selling is no longer an excuse. Guy Ortmann of Scarsdale Equities also hit this theme in his excellent daily commentary. "…(T)he sentiment indicators are flashing very red warning lights as follows. The Rydex Ratio (contrary indicator) is now at a 10 year high of 48.8 showing the leveraged ETF traders as more bullish than at any point in the last decade. We would note that at the market lows in mid-November they were at a bearish extreme not seen since February 2009. Sell low, buy high??
• Gas prices are up. It is the biggest share of pre-tax income in decades, about 4%. (via The Hill's Energy Blog). Sober Look sees a possible effect on consumer sentiment and spending and provides this chart of the front-month futures:

• Factory orders were a little light.
• Productivity is lower, implying slower growth. (Via Scott Grannis). Alternate view from Steven Hansen of GEI.
• Initial jobless claims moved higher. So much for the 300K range. Bespoke has a good chart with helpful notes:

The Ugly

The Wall Street Journal reporters have been urged to do shorter and funnier articles. I know the feeling! Mrs. OldProf, looking up from her book, just asked me about the length and humor quotient of today's piece. I admitted that it was long and laden with lessons about Ben Franklin, compromise, and what really will matter to our investments.

She recommended that I find something to spice it up a bit. The big-time bloggers all write about cars and music and such. Good advice! We all know that on Wall Street if you want a friend you should get a dog. Here is her suggestion for your next dog. It brought a smile to my face.

Recommended Reading

Abnormal Returns points to the Credit Suisse Global Investment Returns Yearbook. Tadas starts with an intriguing chart. The Yearbook explains that one and more. This is worth some time to study.

The Indicator Snapshot

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

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

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

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

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

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

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

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

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

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

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions.  About a month ago we switched to a bullish position.  These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings stabilized at a low level and improved significantly over the last few weeks.  The penalty box percentage measures our confidence in the forecast.  The low current rating means that few ETFs are in the penalty box, so we have more confidence in the overall ratings. 

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

The Week Ahead

This week is extremely light on economic data.

The "A List" includes the following:

• Michigan Consumer Sentiment (F). More important than usual because of the recent dip, fuel prices, and the payroll tax increase.
• Initial jobless claims (Th).   Employment will continue as the focal point in evaluating the economy, and this is the most responsive indicator.

The "B List" includes the following:

• Retail Sales (W). Holiday season is significant. Confirmation of same-store sales?
• JOLTs Report (T). No one seems to do a really good job with this, since they try to infer overall employment. It is more about structure.
• Industrial Production (F). This is an element of GDP, so it will be watched closely.

The State of the Union on Tuesday night will be the big story of the week.

There will be Fed speeches almost every day. These are not really relevant given the Fed guidance, but that will not stop the pundits.

Earnings stories are winding down, but still noteworthy.

Trading Time Frame

Felix has continued a bullish posture. Felix did pretty well last year, becoming more aggressive in a timely fashion, near the start of the summer rally, and getting out a couple of months ago.  Since we only require three buyable sectors, the trading accounts look for the "bull market somewhere" even when the overall picture is neutral.  Felix has been cautious, but still has caught most of the rally, and done so with less risk. Felix has been bullish in 2013, but the ratings have been declining a little.

Investor Time Frame

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

The current investment climate offers a dearth of choices!

Prof. James Hamilton has a great post explaining your choices: "The question is maybe not what is a good investment right now, but instead what is the least bad investment." He writes further as follows:

But what else are you going to do? Low as the dividend yield is on stocks at the moment (2.04%) , it's still better than what you can get on a 10-year U.S. Treasury bond. Moreover, any inflation in the prices of the goods and services that firms sell, as well as any profit gains associated with a larger market, should boost those dividends over time, whereas inflation would continue to erode what you make on the Treasury. Or you might look at a Treasury Inflation Protected Security, whose coupon will rise with the headline CPI. That's currently yielding a hefty -0.57%. Anybody want to sign up for that 10-year plan?

High-yield bonds are dangerous, partly because of the stampede for yield. (Formerly referred to in my series merely as the Quest for Yield). David Schawel (in an article highlighted for us all by Abnormal Returns), writes as follows:

Greater price risk now exists: The devil is always in the details, and price is an important risk that most corporate bond investors, in my opinion, are overlooking.

Gold is currently on a "sell signal" according to Georg Vrba, whose technical model follows the Coppock indicator.

The last sell signal was at the end of November 2012 and no new buy signal has so far appeared. What is needed now for an early buy signal is a sustained upward move of the gold price to over $1,700 during the next few weeks, something which is certainly not outside the bounds of probability.

Meanwhile, we have continuing "headline risk." Buying stocks in times of fear is easy to say, but so difficult to implement.  The big-shot experts on TV are calling you the dumb money, even when you have been right! (in case you missed it, see this discussion).

Almost everyone I talk with wants to out-guess the market.  The problem?  Value is more readily determined than price! Individual investors too frequently try to imitate traders, guessing whether to be "all in" or "all out."

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

Final Thought

Is there realistic hope for a budget compromise?

Most of the pundits you see or read have little understanding of history, Congress, or the policy-making process. For them the answers are easy and obvious. Anyone who does not agree is a fool.

I am currently spending my leisure time reading Walter Isaacson's wonderful biography of Ben Franklin. As I read the final chapters on the Constitutional Convention I am struck by two themes related to compromise:

1. The U.S. Constitution required serious compromise of strongly-held principles by all parties. Franklin was not a great orator, but his final speech to the convention is widely acclaimed as stimulating the needed support for this new government.
2. The resulting government implemented checks and balances that would make compromise the order of the day for progress.

If you do not understand this, you will never be able to see how government decisions affect your investments.

Senate Democrats are vague but hopeful in their comments. Obama has earlier stated that the sequestration cuts would not occur. I will be closely watching Tuesday's speech for signs of flexibility and bi-partisanship.

Investment Conclusion

I anticipate plenty of SOTU discussion on Wednesday. The challenge will be to sift through the partisan commentary.

Avoiding sequestration would be bullish for the overall market. My guess – and that is all that anyone can do right now – is that observers see this as a 50-50 proposition or worse.

Specific sectors that would be helped relate primarily to defense stocks, a group that I'll be watching closely. (NOC, LMT, and RTN, are candidates).

[Currently long hedged positions in NOC and RTN for some accounts.]

Weighing the Week Ahead: Are Earnings Expectations Too High?

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

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

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

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

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

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

Background on "Weighing the Week Ahead"

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

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

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

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

Last Week's Data

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

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

The Good

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

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

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

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

The Bad

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

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

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

 

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

The Neutral

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

We need businesses to start hiring more aggressively.

The Ugly

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

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

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

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

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

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

The Indicator Snapshot

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

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

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

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

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread."

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

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

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

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions.  A month ago we switched to a bullish position.  These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings stabilized at a low level and improved a bit over the last few weeks.  The penalty box percentage measures our confidence in the forecast.  A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings.  That measure is moving higher, so we are becoming less confident in short-term trading.

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

 

The Week Ahead

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

The "A List" includes the following:

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

The "B List" includes the following:

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

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

Most important is the start of earnings season.

Trading Time Frame

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

Investor Time Frame

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

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

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

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

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

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

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

Final Thought

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

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

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

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

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

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

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

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

Weighing the Week Ahead: What lies over the cliff?

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

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

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

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

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

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

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

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

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

Background on "Weighing the Week Ahead"

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

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

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

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

Last Week's Data

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

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

The Good

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

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

The Bad

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

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

 

The Ugly

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

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

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

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

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

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

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

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

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

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

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

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

The Indicator Snapshot

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

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

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

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

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread."

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

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

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

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

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

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

The Week Ahead

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

The "A List" includes the following:

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

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

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

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

Final Thought

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

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

Bullish Outcome

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

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

Bearish Outcome

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

My Guess?

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

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

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

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

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

Summary

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

We'll soon know....

Fiscal Cliff Notes: Interpreting the deadline news

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

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

Here are a number of rhetorical questions:

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

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

The Reality

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

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

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

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

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

The Nature of Compromise

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

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

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

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

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

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

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

Trading and Investing

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

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

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

Weighing the Week Ahead: Decision Time?

Decision time has arrived!

After many months of debate, sparring, and posturing, the deadline has arrived for U.S. policymakers to resolve the various matters that are popularly described as the "fiscal cliff."  This is a handy simplification.  In the finest American tradition it allows everyone to have an opinion whether or not they have any information!

The average person knows only that something really bad is about to happen, and it will send taxes higher. Observers in other parts of the world see the U.S. as unable to address major problems while still offering plenty of advice to every other country.  Many of the media sources are unable to distinguish between political commentary and analysis of developments

The oversimplification adopted by a leading financial TV network is that leaders should "rise above" politics and simply do what is right.  An obvious problem with this approach is that no one elected the network to tell the rest of us what is right.

Some Helpful Distinctions

There are two major mistakes that account for most of the bogus analysis.

Emphasis on politics.  During elections issues are sharply framed.  Appeals are directed at the most extreme and partisan elements.  Television ads are negative.  In the time between elections the U.S. has historically enjoyed periods of bipartisan cooperation, especially when there was a widely recognized problem or a common enemy.

Those who have followed the hard-hitting elections of the last decade often lose perspective.  They cannot imagine a person they voted against behaving in a cooperative fashion.

Blaming participants rather than the process.  It is entirely possible for everyone involved to be intelligent, well-intentioned, and hard-working -- and yet we still have a terrible outcome.  The U.S. has a very conservative political process;  it is easy to block change.  Here's why a policy desired by the majority can often be easily blocked:

• Either House of Congress or the President can stop a proposal.  All must agree to any changes.
• The Senate requires a 60% super majority on most legislation, since a minority can delay indefinitely through the filibuster.  Ending a filibuster requires a cloture motion, and 60 of the 100 votes.  (It used to take 67!)
• The House Speaker can block proposals from reaching the floor for a vote.  This is true even when a majority would support the proposal if a vote were to be taken.  The Republicans follow something called the "Hastert Rule" (named after former Speaker Dennis Hastert).   This custom (not a legal procedure) says that the Speaker should only allow a vote on legislation supported by a majority of Republicans -- a majority of the majority.  Since the GOP has a slim majority in the House, it means that 27% could block the wishes of the entire House.  (There are some arcane methods for avoiding this, but not effective in the current case).

Despite these obstacles, the process has worked well enough for over 200 years. Has something gone wrong?  Are things somehow different?

Yes, there have been changes, and not for the good.  I'll offer my own take on what to expect on the fiscal cliff in the conclusion. Let us first do our regular review of last week's news and data.

Background on "Weighing the Week Ahead"

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

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

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

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

Last Week's Data

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

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

The Good

The economic news last week was mostly good.

• Initial jobless claims were back to the pre-Sandy range at 361K.  We continue to follow the work of New Deal Democrat from The Bonddad Blog, who is trying to work through the distortions in this important data series.
• Building permits increased, but the gain was mostly for multi-family.
• Personal income and spending were quite strong.
• Rail traffic showed a surprising increase versus seasonal expectations.  We need more data, but Todd Sullivan suggests that we pay close attention.

• The Chicago Fed economic activity index is improving.  See Steven Hansen at GEI for a full analysis.

The Bad

There was some bad news last week, but not very much.

• Leading economic indicators from the Conference Board were a big disappointment.  The six-month gain has evaporated (via Doug Short).

 

• Michigan sentiment was even lower than the depressed expectations.  The fiscal cliff is hitting confidence (and possibly holiday spending) even before our leaders have decided.  People have underestimated the continuing economic effects of these issues, pretending that the end-of-year deadline is adequate for a decision.
• Inaction on the fiscal cliff was the big item.

The Ugly

I propose that we take a break from "the ugly" this week.  There is plenty to worry about, and I have a long list of candidates.  We have had enough ugliness in the last few weeks, and we'll get back to worrying about everything in the next installment.

Meanwhile, Scott Grannis strikes an interesting note.  He has a paragraph on worries, but then goes to a collection of ten comforting charts.  My favorite is the one on building permits, up 27% in the last year.  Scott and I agree that this is a good leading indicator.

Read the article for the other nine charts and the list of worries.

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 Warren Buffett.  The political content on CNBC has increased, but at least some of the material is labeled as an editorial.  It should still be accurate.  Gary Kaminsky attacked Buffett and Berkshire Hathaway for a stock buyback that he called "hypocritical." He characterized it as an attempt to help an early investor avoid a possible increase in capital gains taxes.  It was a thinly-veiled attack on Buffett's political viewpoint.  Kaja Whitehouse's NY Post story provides the background as well as the Buffett response -- a sharp lesson for Kaminsky both in tax law and also the stated Berkshire policies on buybacks.

I understand that Mr. Buffett would rather beat me at bridge than win the Silver Bullet award.  He is also defending his own position, unlike prior award recipients.  We should still take note of his action, partly because it forced CNBC to acknowledge the error.  They never do this when I send them corrections!

Meanwhile, CNBC continues to lose ratings ground.  Instead of helping the individual investor, they are trying to "outFox" the competition.

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."

Despite the recent media blitz from the ECRI, there is no evidence of an imminent recession.  Bob Dieli's most recent report to his clients includes the following:

"From what we know now, a cycle peak does not appear to be immediately in prospect. And if the number of cars in the parking lots of the malls I drive by every day are any indicator, it does not look like consumers are being reticent in their spending. At a recent client briefing, I referred to this expansion as “the recovery with no friends.“ It has been fashionable in both the political and the business communities to bad mouth the performance of the economy. I cannot recall another instance where we have had an expansion last the better part of four years without some sector taking the lead and one of the political parties acting as cheerleader."

This is an important observation for those of us who want to invest effectively via a contrarian approach!  (Write to us at main at newarc dot com if you are interested in a free sample report from Bob).

Doug Short has excellent continuing coverage of the ECRI recession prediction, now well over a year old.  Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting.  He remains open-minded about the upcoming evidence.  In the latest article he writes as follows:

"In my opinion the economic data does not support a recession call. If we have reasonably good holiday sales, recession risk declines further. Of course, our politicians could torpedo the economy by mishandling the Fiscal Cliff budget issues."

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

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

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

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions.  Three weeks ago we switched to a bullish position, and the outlook has become even more positive. These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings stabilized at a low level and improved significantly over the last few weeks.  The penalty box percentage measures our confidence in the forecast.  A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings.  That measure has recently moved lower, so we are becoming more aggressive.

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

The Week Ahead

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

The "A List" includes the following:

• Initial jobless claims (Th).   Employment will continue as the focal point in evaluating the economy, and this is the most responsive indicator.
• Consumer confidence (Th).  The confidence news is becoming more important as a concurrent indicator of response to the fiscal cliff debate.

The "B" List" includes these entries:

• Chicago PMI (F).  Important mostly as the best early read on the national ISM index.
• New home sales (Th).  Housing coming to the fore.
• Pending home sales (F).

The decision on the fiscal cliff issues will be most important.  While nothing official will happen before Thursday, we might expect some hints on Wednesday.

Trading Time Frame

Felix has moved to a more bullish posture, now fully reflected in trading accounts. It has been a close call for several weeks.  Felix has done very well this year, becoming more aggressive in a timely fashion, near the start of the summer rally, and getting out a couple of months ago.  Since we only require three buyable sectors, the trading accounts look for the "bull market somewhere" even when the overall picture is neutral.  The ratings have moved much higher in the last three weeks.  Felix does not follow the fiscal cliff news, responding only to the message from the market.

For a fine illustration of the trader versus investor question, see Josh Brown's post (from reading his book I know that he does not do "articles") on investment maxims.  I love this one:

"And to cap off this talk (and it was a good talk, thanks for coming) I'd like to share two quotes from two of the most successful market participants of the last century:

"The only sound reason for my buying a stock is that it is rising in price." -- Nicholas Darvas

"The dumbest reason in the world to buy a stock is because it's going up." -- Warren Buffett

If that doesn't sum up the value investor / momentum investor in a nutshell, I don't know what does."

As someone who is both a trader and an investor, I understand completely!

Investor Time Frame

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

This week I want to highlight Barry Ritholtz's Washington Post article, also published on his blog, Why Don't Bad Ideas Ever Die?

Barry has a great, thought-provoking list.  You may not agree with every entry (I did not), but that is part of the point.  You should take up the challenge and do some self-examination.  I strongly recommend reading the entire article, but let me cite my favorite from the list:

"8 Gurus, shamans and prognosticators: Wall Street produces market wizards at a prodigious pace. It may be NYC’s single-biggest export. We love experts to tell us what is going to happen in the future. Never mind that their track record is awful, we prefer the mysticism of the television guru to actual thought.

The data about these experts should give us pause: The more confident an expert sounds, the more likely he is to be believed by TV viewers. Unfortunately, the more self-confident an expert appears, the worse his/her track record is likely to be. And forecasters who get one single big outlier correct are more likely to underperform the rest of the time."

 

Right now, most of the highly-publicized experts are telling you what you already know, since that is how they can seem smart.

Buying in times of fear is easy to say, but so difficult to implement.  Almost everyone I talk with wants to out-guess the market.  The problem?  Value is more readily determined than price! Individual investors too frequently try to imitate traders, guessing whether to be "all in" or "all out."  This usually leads to mistakes in market timing.  There are plenty of stocks at attractive values right now.  Here is what to think about:

1. Risk.  If you are like the average investor you have it all wrong.  You have been piling into bonds, gold, and dividend funds.   All of these categories are now over-valued, the result of this stampede.  Some of the risk is showing up right now, and you will see more in the next few weeks.
2. A portfolio anchor.  You need stability.  If you are trying to do it with bond funds, you need to understand the risks.  I prefer owning specific bonds.
3. Stretching yield.  My approach is to find some reasonable dividend stocks and sell near-term calls against the positions.  If you did this skillfully, you could hit double-digit annual returns with significantly less risk than simply owning dividend stocks.  The range-bound market of the last few weeks has been ideal for this approach.
4. A little octane.  Many investors do not think carefully about asset allocation.  There is always volatility, so the key is to "right-size" your position.  Instead of trying to time the market, try to be a player in the right sectors, the right stocks, and the right size.  There are plenty of stocks selling cheaply in terms of their historic P/E multiples.

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

Final Thoughts on the Cliff

Why is compromise such a challenge?

It used to be that the party leaders had real power.  There was party discipline, with members punished when they did not play ball.  The rule was, to get along, go along.  Rookies were not supposed to create problems.

Speaker Boehner is trying to follow this tradition, but it does not seem to be working.  Why not?

In the "old days" (and that would be only a few years ago) a member from a safe seat was free to exercise some discretion.  Every ten years there is a census and states get to redraw the boundaries for Congressional districts.  How this is done depends upon which party is in power in that state.  In the past, this has lubricated the wheels of compromise -- senior members of Congress who had some freedom to vote their consciences.

The safe seats are now safe in the general election, but open to primary challenge.  This means that Tea Party (or liberal) extremists can threaten a challenge.  This has captured the attention of relatively new GOP members who are therefore not tempted to "rise above."

Let's just say that if Maria or one of her colleagues (or you or me) were a member from one of these districts, she would not be acting like Mr. Smith.  Can you say "former Congressman?"  It is much easier to be a media pundit and critic than to assume actual responsibility.  A legislator must balance personal conclusions with the feedback from constituents.

This trend has been exacerbated by changes in rules on campaign funding.  Serious challenges are easier to finance.

Result:  Members from safe seats are less willing to compromise than they were in the past.

This does not imply an impossible dilemma, but it does represent a new era.  I continue to see leaders as trying to compromise while dealing with the new electoral reality.

The single most important thing to understand is that your electoral enemies/icons are now playing a different role from that you saw during the campaign.

• If you did not notice any movement in the Obama position, you have a political fixation and will miss the deal when it comes.
• If you did not notice any movement in the Boehner position., you have a political fixation and will miss the deal when it comes.

What we learned last week was that there will be 30-45 defections from any proposal that can be characterized as a tax increase.  This was information that Speaker Boehner did not have before.

It is now obvious that any deal will require support from both parties.  This is completely consistent with history, but a new concept for the recent GOP majority.

This week we will learn whether the current combination of leaders can achieve a compromise.  I am sticking with my forecast from last week:

"My forecast calls for a resolution of the tax issues before any real economic impact occurs.  Republican constituents are most dramatically affected by the AMT and the doc fix.  Every poll shows that the GOP will be held accountable.  Over 80% of Congressional insiders expect higher taxes on the rich in 2013.  It is only a matter of when and how the tax policy will be changed.  The publicized sticking point of rates for those with incomes over $250,000 is subject to compromise on the level of income, the exact rate, and adding some limits on deductions.  Both sides can claim victory in a compromise."

Final Thought

I follow a number of inside sources on Washington and Congress.  Some raise the concern that Boehner is worrying about his re-election as Speaker and therefore completely beholden to the Tea party extremists.  On the first day of the new Congress he needs an absolute majority of those voting.  Normally this means that the majority party picks a candidate in their own caucus and then votes unanimously for that candidate.  There are several stories suggesting that seventeen or more votes might defect from Boehner in a surprise coup.   This could lead to repeated votes, until the GOP came up with a new candidate.   There is already some opposition to Boehner because of his use of committee assignments to maintain loyalty.

What if a few Democrats voted for Boehner?  The Dems might figure that a Tea Party- approved candidate would be worse.  This would be a totally novel move.....

Note to Readers

I am working through the holidays, but emphasizing the 2013 outlook.  I will do updates on my Cliff Notes series as needed, but will probably not do a WTWA segment next week.

Fiscal Cliff Notes - Plan B Edition

Tonight's House vote on "Plan B" was not surprising nor was it very important to the final outcome of the fiscal cliff debate.  As usual, I recommend a strict investor focus.  What would constitute a market-friendly outcome?

Investors who do not have an intense partisan stake want to see the following:

• Avoiding the economic consequences of an immediate end to Bush-era tax cuts.
• Avoiding dramatic increases in capital gains and dividend taxes.
• Taking care of the AMT and the doc fix  issues.
• Avoiding the immediate impact from ending unemployment insurance and the payroll tax cuts.
• Avoiding the immediate effect of the sequestration plan, seeking instead a more gradual series of cuts.
• Avoiding a replay of the debt ceiling debate from 2011.

The House "Plan B" vote accomplished only some of these objectives, but mostly would have boosted bargaining power for the GOP.  Since the Senate was not going to take it up and Obama had promised to veto it, there was never much question of it becoming law.

Overnight stock futures are down over 1.5%.  So why is the market reaction so negative?

Commentary on twitter and TV is almost universally critical -- and also very shallow.  The Plan B vote does not represent the actual solution.  That is something that will (eventually) emerge from the non-public bargaining.

Tonight's vote is just another step in a process that was always destined for an eleventh-hour resolution.  Plan B was hated by nearly every Democrat and also some Republicans.

A plan that can actually pass in Congress will include moderates from both parties -- as it should.  Such a plan would tick off every bullet point from my list above.  Tonight's vote moves us closer to this solution.  It makes it clear that a single-party solution is not the answer.

We need compromise.

This does not mark the end of negotiations.  While it changes the relative bargaining strength of some participants, the discussions will continue.

Weighing the Week Ahead: Clarity Coming on Key Market Challenges?

After several weeks of noise -- from both data and politicians -- it may finally be time for some clarity.  I have predicted this with my theme for the last few weeks, and we are starting to see the results:

• The Fed -- aggressive policy, clearly stated, but still not well understood (more below).
• US economic data -- the Sandy weakness is proving temporary.
• China -- signs of an end to the slow slide, and not a hard landing.
• Housing -- several signs of a bottom and some for a real bounce.
• Europe -- none of the really bad things happening, but further delays in a final solution.
• The fiscal cliff -- the biggest unresolved issue.

The problem with this list is that the fiscal cliff issues are so important that we really need some answers -- and soon!  As I wrote in my first installment of "Cliff Notes," there has been little real information so far.  I refuse to join in the daily discussion of non-events, but it will now start to get interesting.  I will write more installments of Cliff Notes as circumstances warrant.

For the purpose of our weekly review, I will simplify this in two dimensions -- content and timing.

Content

Many issues have been lumped together as part of the Fiscal Cliff discussion, just as last year's debt ceiling debate turned a routine matter into a threat to US credibility.  I am putting all of the issues into two categories

1. Tax matters -- Bush-era rates, AMT, doc fix, inheritance, capital gains, and dividends.
2. Long-term deficit issues -- Sequestration, entitlements, payroll tax "holiday," higher retirement age, higher Medicare age, and the like.

There are also issues concerning the renewal of long-term unemployment benefits and whether the debt ceiling will be a regular pinata for Congress.  These might be taken up in either group.  The first group is most important to the economy since it would have an immediate effect.

Timing

I have predicted that this issue would go to the last possible moment. How is that defined?  I am reminded of my college days when I lived in Indiana.  The State legislature was Constitutionally required to pass a budget by a certain date.  Each year the legislative session ended, with no further options possible.  They regularly missed the deadline, although they were always close.  The Sergeant-at-Arms would go to the back of the chamber and stop the grandfather clock, halting it a little before midnight.  Time stood still!  Eventually the budget was passed, meeting the official deadline.

There are four possible deadlines to consider:

1. This week, allowing a Christmas break.
2. Before the end of the year.
3. In the first few days of the new Congressional session.
4. Weeks or months later.

The timing track for tax matters is more urgent than for deficit matters. 

I'll offer my own take on what to expect on the fiscal cliff in the conclusion. Let us first do our regular review of last week's news and data.

Background on "Weighing the Week Ahead"

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

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

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

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

Last Week's Data

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

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

The Good

The economic news last week was mostly good.

• Initial jobless claims dropped to 343K range.  This was not quite as good as forecast by New Deal Democrat from The Bonddad Blog, whom we cited last week.  He caught a mistake in his initial work and posted a very honorable correction.  (It would be a better world if more bloggers caught their own mistakes and corrected them).  As I noted last week, this is a very noisy series with many adjustments.  It is great information, and I watch it closely.
• The world will not be ending on Friday.  The Mayans predicted 12/21/12 as the day.  NASA says "no." From The Telegraph:  In America Ron Hubbard, a manufacturer of hi-tech underground survival shelters, has seen his business explode.  "We've gone from one a month to one a day," he said. "I don't have an opinion on the Mayan calendar but, when astrophysicists come to me, buy my shelters and tell me to be prepared for solar flares, radiation, EMPs (electromagnetic pulses) ... I'm going underground on the 19th and coming out on the 23rd. It's just in case anybody's right."

• The Fed gets more aggressive, with pedal to the metal for a long time.  Despite the ho-hum market reaction, this is market-friendly news.  It is going to require more than I can do in the weekly summary, so here are two hints:
  • This will increase the money supply, monitored weekly at The Bonddad Blog.  Their weekly indicators are mostly positive, but those who are monetarists should be encouraged by the resumption of growth in real M2, now 5.6% year-over-year.  This works with a lag on the economy, so we have not seen it yet.  Read the full story to see the other high frequency indicators.
  • Josh Brown jumps fast on the instant analysis of the punditry.  Below is his chart, but you need to read the entire post (The Dumbest Thing You'll Hear...) to understand the message.

 

• Industrial production bounced 1.1% in post-Sandy data.  See Calculated Risk for details.
• China's flash PMI moved nicely higher.  See GEI for complete details and charts.
• German investor confidence is "materially better" (via the Big Picture).
• Inflation data of all types was benign.
• The JOLTS report shows more job openings (good analysis from Steven Hansen). 

The Bad

There was some bad news last week, but not very much.

• Retail sales rebounded to a gain of 0.3%, a bit short of expectations.
• Wholesale inventories increased 0.6%, a bit more than expectations.  Inventories are a "fudge factor" for everyone.  Increased inventory is great if it augurs a perceived future need.  Inventory is not so good if unplanned.
• Q4 earnings growth is still positive, but declining each week (via Bespoke).

• The cliff diving odds increased to 75% according to one good source.
• The small business optimism index plummets.  This was planned as my highlight for the worst news of the week.  Here (via Macroblog) is the key chart:

When you read the entire article, you understand that the story is mixed.  The "young firms" are actually optimistic.  A loyal reader also pointed me to this story, suggesting that the survey results might reflect partisanship more than business plans.

Regular readers know by now that I am trying to find evidence that will help us all in making the right news.  I try to evaluate each piece of news.  Small business is important for job growth.  It is an interesting question.  David Beckworth looks for the answer, leaning to the absence of demand rather than regulation, based mostly on this chart:

This is a great article, but you need to see the other charts to get a full understanding.

The Ugly

All of the other nominees for "ugly" were pushed aside by what happened to our kids in Connecticut.  We parents understand instantly, but we are not alone.  Events like this always focus attention on what to do. It is too soon to think about that.

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.  (I was uncomfortable in even mentioning a bullet this week, but that is going too far.  The Lone Ranger and his trappings are symbols of a better time and place -- one that we do not need to lose).

This week's award goes to Tom Brakke.  He highlights a problem that I see every week.  Someone sends me a chart which has been manipulated to fit a specific scale and time period.  It looks compelling and powerful.  It is dangerous.  Here is Tom's candidate of the week, two ways of looking at Apple.

The full article is recommended, but here is the key quote:

"I have written before about the ease with which the producers of charts (including me) can deceive, even if not trying to do so.  Some of the most common ways include picking a starting point for a chart that maximizes a particular point of view, using price instead of total return for longer periods, and putting lines together on a chart without comparing them on a percentage basis.  Today’s topic is an example of the latter.

In a given day, you probably see lots of charts with multiple axes.  Most all of them give you a distorted view of the world.  You might get an idea that something is going up when something else is going up — and down when it is going down.  That can be of interest, but multiple-axes charts, which are popular with investment professionals and bloggers, give false indications."

 This is very strong work, mostly because the misleading techniques are so common.  Whenever you see a chart like this you should be asking what it looks like in different time frames and scales.

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."

Despite the recent media blitz from the ECRI, there is no evidence of an imminent recession concern.

Joining the discussion this week is University of Oregon economist and veteran Fed-watcher Tim Duy.  Prof. Duy takes up all of the indicators and does a slam-dunk refutation of the ECRI.

"I think that even a cursory glance of all the data the NBER cites as elements in recession dating, even ignoring the important issue of first identifying broad-based indicators, would lead one to be very skeptical about a July recession call on the basis of "eyeball econometrics" alone."

Doug Short has excellent continuing coverage of the ECRI recession prediction, now well over a year old.  Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting.  He remains open-minded about the upcoming evidence.  In the latest article, ECRI Weekly Update: Walking the Recession Plank he notes that the ECRI seems to have gone too far, "ECRI, however, has "walked the plank" with the company's recession call. And and at this point there's no "Peter Pan" recession to save them from a sea of crocodiles."

For the current time period to be viewed as the start of a recession, we would need to have a significant decline in the economy.  Then the NBER goes back and dates the start of the recession at the last peak.  As yet we have only small declines, and only in some indicators. None of the best methods I follow shows anything like this.

RecessionAlert uses a variety of different methods, including the ECRI, in developing a Super Index.  They also offer a free sample report.  Anyone following them over the last year would have had useful and profitable guidance on the economy.  Dwaine Van Vuuren notes that the effects of Sandy have pushed industrial production into recession territory, sending the current chance of a recession over 11% according to one of his indicators.  His latest article emphasizes his short-term indicators.  He is not identifying a recession in any of the various covered time frames.

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

Readers might also want to review my new Recession Resource Page, which explains many of the concepts people get wrong.  Newly added to the list of errors this week was the popular but bogus 100% recession chart.  Amazingly, this is still getting buzz.  Confirmation bias in action!

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.  Two weeks ago we switched to a bullish position, and the outlook has become even more positive. These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings stabilized at a low level and improved significantly over the last few weeks.  The penalty box percentage measures our confidence in the forecast.  A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings.  That measure has recently moved lower, so we are becoming more aggressive.

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

The Week Ahead

This week brings a lot of economic data, but not the most important reports.

The "A List" includes the following:

• Initial jobless claims (Th).   Employment will continue as the focal point in evaluating the economy, and this is the most responsive indicator.  We will look for confirmation that the Sandy effects are over and seasonal adjustments have been reasonable.
• Building Permits (W).  This is the best leading indicator on housing.
• Personal income and spending (F).  I am promoting this to "A" status because of the bogus claims that a recession started in July.  This is a factor to monitor.

The "B" List" includes these entries:

• Housing starts (W).  Lags permits, but still important.
• Durable goods (F).  A good post-Sandy read.
• Michigan confidence (F).  The preliminary reading was really bad.

We get the various regional Fed surveys which mean little for me.  They are not important unless deviating dramatically from expectations.  I also do not care about the final GDP revisions for a quarter in the rear-view mirror.

There will also be assorted Fed speeches, including one by Fisher (a leading hawk).

And most importantly -- Congress's decision on whether they want to take vacation for a week.

Trading Time Frame

Felix has moved to a more bullish posture, now fully reflected in trading accounts. It has been a close call for several weeks.  Felix has done very well this year, becoming more aggressive in a timely fashion, near the start of the summer rally, and getting out a couple of months ago.  Since we only require three buyable sectors, the trading accounts look for the "bull market somewhere" even when the overall picture is neutral.  The ratings have moved much higher in the last two weeks.  We noted last week that we expected more buying, and that was what happened.

Investor Time Frame

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

This week I want to highlight Cullen Roche's article, The Bull Market in Fear.  He captures the key point nicely in this comment:

"One thing I’ve really battled with in this industry (and in life) over the years is overcoming emotions.  In particular, overcoming fear.  If you have a portfolio you’re probably worried about something (to some degree).  It’s natural.  You’ve accumulated all this savings and you’re worried it might just disappear on a computer screen because of a few bad decisions."

This really captures the problem facing so many.  Cullen goes on to illustrate the high levels of current fear, loosely correlated with past results.  Even that has broken down.

Buying in times of fear is easy to say, but so difficult to implement.  Almost everyone I talk with wants to out-guess the market.  The problem?  Value is more readily determined than price!

Individual investors too frequently try to imitate traders, guessing whether to be "all in" or "all out."  This usually leads to mistakes in market timing.  There are plenty of stocks at attractive values right now.  Here is what to think about:

1. Risk.  If you are like the average investor you have it all wrong.  You have been piling into bonds, gold, and dividend funds.   All of these categories are now over-valued, the result of this stampede.  Some of the risk is showing up right now, and you will see more in the next few weeks.
2. A portfolio anchor.  You need stability.  If you are trying to do it with bond funds, you need to understand the risks.  I prefer owning specific bonds.
3. Stretching yield.  My approach is to find some reasonable dividend stocks and sell near-term calls against the positions.  If you did this skillfully, you could hit double-digit annual returns with significantly less risk than simply owning dividend stocks.  The range-bound market of the last few weeks has been ideal for this approach.
4. A little octane.  Many investors do not think carefully about asset allocation.  There is always volatility, so the key is to "right-size" your position.  Instead of trying to time the market, try to be a player in the right sectors, the right stocks, and the right size.  There are plenty of stocks selling cheaply in terms of their historic P/E multiples.

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

Final Thoughts on the Cliff

After weeks of no movement, this might now become a fast-breaking story. I'll do more Cliff Notes summaries as indicated.

So far the story has developed as I expected.  Some are changing their odds since nothing has happened.  This is fine for those following all of the commentary, but silly if you did not expect any action in the first place!

There has not been much polling of members or advance work --- "whipping" in Congressional parlance.  This means little since positions are pretty well known on these issues.

My forecast calls for a resolution of the tax issues before any real economic impact occurs.  Republican constituents are most dramatically affected by the AMT and the doc fix.  Every poll shows that the GOP will be held accountable.  Over 80% of Congressional insiders expect higher taxes on the rich in 2013.  It is only a matter of when and how the tax policy will be changed.  The publicized sticking point of rates for those with incomes over $250,000 is subject to compromise on the level of income, the exact rate, and adding some limits on deductions.  Both sides can claim victory in a compromise.

If the GOP can bargain this for an attractive commitment on spending cuts, we could see something major before Friday.  This would not include the "details" that everyone is foolishly discussing.  Any agreement will involve guidelines with various Congressional committees to work out the implementation.  For those who never took a class about Congress, think of it this way.  Management is making some kind of across-the-board spending cut and looking to departments for specific proposals.  This is a rough approximation for Congress. It could be stated more strongly since in this case the departments consist of various fiefdoms, all jealously protecting long-held power.

If there is nothing before Friday, we will see Congress in session for a final week of the year.  No one wants this.  The GOP might even vote "present" in the House to get the tax matters passed.

If the GOP cannot get an attractive deal on the deficit issues, those will be taken up next year with the debt ceiling as the key leverage point.

Investing Implication

Since opinion is widely divided on the fiscal cliff issues, the market should move significantly when we know the outcome.  Much will depend on whether a two-part agreement (tax matters now, deficit matters soon) is effectively communicated.

It is also options expiration week, so things could get interesting.

 

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.

QE3 Misconceptions and How to Profit

The analysis of current Fed policy has included the usual parade of mistaken pundits.

There is a legitimate debate about QE3, but it has been obscured by those with an agenda based upon their politics or their business models.

The result is an exceptional opportunity for the long-term investor.

Mistakes

Here are the four biggest mistakes:

1. It's all about me!  This is how the investment community views both the policy and every communication from the Fed.  What a blunder!  They look only at the effect on stocks.  The Fed mentions stock market effects, but only as one of several indicators.  They see the market as a confirmation that their moves either have helped the economy or are expected to do so.
2. I don't understand the mechanism, so it must be wrong.  The typical pundit asks questions like the following:
   • Suppose a home-buyer does not qualify for a loan.  How will this change that?
   • Mr. Gundlach (or Gross or some other bond guy), How will this change your behavior?
   • How can this create jobs?  I don't see how to connect the dots.
3. This is just printing money and monetizing the debt since the Fed is buying X% of new mortgages, etc.
4. There is no exit strategy.  When the time comes to reverse course, we will have a disaster.

Reality

And here are the correct answers, pretty obvious to anyone with any training in economics:

1. The basic objective is to change behavior on the part of borrowers and lenders.  The stock market is only one method for evaluating the impact and the "wealth" effect is only a minor transmission mechanism.
2. The key to understanding QE3 is to think about marginal effects, not the all-or-nothing, "light-switch" thinking of those without economic education.  If you lower the price of something, it has a marginal effect.  Lower interest rates encourage more borrowers, qualify more borrowers, and increase the size of qualified loans.  The price changes affect (marginally) the interest rates on all related bonds.  The increased Fed balance sheet creates more excess reserves for banks and nudges them toward more lending.  Lower rates make business investments slightly more attractive.  This all takes place at the margin.  This is the incentive for risk that Bernanke talks about.  None of it has anything to do with pushing the average investor into risk assets, the popular pundit theme.
3. The Fed is not monetizing debt if the purchases of securities are temporary.  The concept of "printing money" should relate to an increase in the money supply -- M2 or MZM.  These increases have been modest -- too low in fact.  The hyper-inflationistas have been wrong for a decade or so, but that does not stop their chorus.
4. Reversing course depends upon the demand for US debt, both Treasuries and Agency securities.  Readers should note that those who have questioned this theme in the past, asking who will buy our debt at the end of prior QE's have been completely wrong.  I do not understand why Bill Gross could be so mistaken, but he was.  He does not seem to distinguish between the total volume of US Treasury trading and the net issuance.  Or maybe he has his own agenda.  Meanwhile, the average investor does not understand the total volume of Treasury trading.  (See this piece for an illustration).

Quantifying the Effects

There are some solid econometric efforts to quantify the QE3 effects.  Here is a Bloomberg article that is helpful by sharing some results:

"In a model-driven assessment based on the past impact of QE1 and QE2, Deutsche Bank Securities chief economist Peter Hooper says this is what the Federal Reserve printing another $800 billion — slightly less than the gross domestic product of Australia — will do:

1. Reduce the 10-year Treasury yield by 51 bps

2. Raise the level of real GDP by 0.64%

3. Lower the unemployment rate by 0.32 percentage points

4. Increase house prices by 1.82%

5. Boost the S&P 500 by 3.06%, and

6. Raise inflation expectations by 0.25%"

 

I am disappointed that the writer diminished his helpfulness by skewing in such a skeptical direction about these findings, falling into the basic current trap of catering to his audience.

The Deutsche Bank conclusion is correct.  The general direction and order of magnitude of these effects makes sense given past QE policies.

A Deeper Look

In fact, I expect the current QE round to be more effective than the past versions.  Why?  The focus on changing expectations.

In the past, any good economic news was greeted with the notion that the Fed would step back.  The current policy changes this.  The Fed is committed to economic stimulation, even if it pushes inflation somewhat above the 2% target level.

For those who don't like the the Fed inflation measurement methods, you can just multiply by ten or apply whatever other silly adjustment you think is right.  Meanwhile -- learn to live with it!  This is the new policy.

Investment Implications

The basic conclusion is that the business cycle is going to be extended significantly.  We are in the third inning or so.  It is a good time for tech stocks and deep cyclicals.  (I like and own CAT, ITW, AAPL, ORCL, and INTC).

Financial stocks will enjoy a nice yield spread.  Europe will be helped.  (Think GS, JPM, AFL).

The timing is a bit different from past QE's.  Since everyone is busy misinterpreting the policy, bashing the Fed, and politicizing the decision, the immediate market impact has been muted.

This time the real test will come via the actual economy, not the speculative commodity buying of the those with a simplistic view of Fed policy.  The upside catalyst will come when we see some stronger economic reports, as we did with yesterday's ISM numbers.

 

 

A One Word Solution for the Fiscal Cliff

Moody's warns that the US credit rating could go down a notch (joining the S&P downgrade from last year) if the US fails to take appropriate medium-term action.  They write as follows (via Politico):

“If those negotiations lead to specific policies that produce a stabilization and then downward trend in the ratio of federal debt to GDP over the medium term, the rating will likely be affirmed and the outlook returned to stable,” Moody’s said in a statement. “If those negotiations fail to produce such policies, however, Moody’s would expect to lower the rating, probably to Aa1.”

In many ways this is not very helpful.  One of the key disputes over budget policy is what will do most to help in various time frames.  Some want immediate austerity while others prefer short-term growth to assist a medium term solution.  Moody's provides a warning to "get busy" but no one knows how they will evaluate various alternatives.

And who elected them, anyway?  It is not as if the ratings agencies have a stellar record on such matters.

With this background in mind, there is a pretty easy, one-word solution to the Fiscal Cliff.  Let us start with one of the helpful interactive tools from The New York Times.

The page shows the count of words spoken by each party at the conventions.  These simple quantitative measure are often deceptive, but the tool provides key speeches and also something quite clever:

You can insert your own word and discover the count!

I invite readers to try their own words and share the results with us, but you have a tall order if you want to match my suggested word:   Compromise.

The mentions were 2-1, and I mean actual count, not a ratio.  The notion of progress through compromise is missing in action right now.

And that is the one-word solution.  How long must we wait?