A Dash of Insight

Is This a Tradable Bottom?

We have had some inquiries about our "Gong Model."  They say that no one rings a gong at the bottom, so our marketing department thought this was a cool name.  This article showed a good description of the last time the Gong sounded.

Many traders are seeking "oversold signals" and calling the bottom.

The Gong is not now signaling a bottom, and it is not close.  The Gong model has two parts.  First the hammer must be drawn back, and we are not yet at that stage, nor close to it.  Second, the mallet must come forward.  We'll provide some updates.

Can We Be Wrong?

Of course.  We can certainly be wrong.  If tomorrow's payroll number is surprisingly good, given the +/- 100K confidence interval, the market could rally by a couple of hundred Dow points on a report showing surprising strength.  Our report on The Gong, and other methods, are available to readers on request.

Our intermediate-term outlook has grown increasingly bearish over the last month or so, as documented in our participation on the TIckerSense blogger sentiment poll.  We have reported this both there, and on the weekly updates of our TCA-ETF system.

It is entirely possible that we will have a rally without The Gong.  Also, the gong model gives an entry signal, but not an exit.  We have searched hard for the ultimate bottom-calling method, but we are realistic.  It is not easy.

The Importance of Time Frames

While our system signals have been negative, we have been less convinced by the fundamentals.  In our programs, we have the system (affectionately called the "Vince Model") and the fundamentals, (called the "Jeff Model").  The time frames are different.  The "Jeff'" model is geared to the long-term investor and has a great long-term record.  It is thematic, and the themes have worked over a period of more than ten years.  It is not a trading system, although we obviously try to find the most promising stocks and sectors.  We currently believe that people have become far too negative about the economy and economically sensitive stocks.  Vince sees more pain in the near term.

Readers may be interested in our discussion of the importance of time frames.  We also have written about how a single trade can have two winners -- those who have different time frames or investment objectives. It is not just a question of the immediate stock reaction.

Conclusion

In a difficult market it is important to have one's primary objective in mind.  Traders and investors can reach different conclusions.  One theme is the reaction of the individual investor -- scared out at market bottoms.

Is this the bottom?  Probably not, but that does not mean bailing out of one's retirement account.  We have a nice list of attractive stocks with good valuations.  When the Gong sounds, we will get more aggressive.

Easy Money

Let us suppose a fantasy world in which we could sit down in a game of chance with a select group of opponents.  The other players had the following characteristics:

• They are drawn randomly from the population.  If you think you are smart, they are less smart.
• They have little education in the relevant subject.  You have an advanced degree, and they either did not take or do not remember Course 101.
• The opponents have no theoretical or conceptual model -- and probably do not understand what that means.
• The opponents are willing to make big bets on their opinions.

Please keep the scenario in mind.

Ritholtz Bets on the Masses

Over at The Big Picture Barry Ritholtz offers the rather astounding suggestion that when all of the experts in a field agree, it is time to take the other side.  Here is a key quote:

As someone who has been skeptical about the artificially low inflation and unemployment rates for quite sometime now, the public's reaction makes a whole lot of sense. If we believe the negative sentiment of the American people, then its likely that Inflation has been much more pervasive than reported by either the top line or the core.  And the same thinking likely applies to the low unemployment rate. If we judge by sentiment, perhaps its not as low as advertised. Ignoring widespread distress in the population is a recipe for major electoral changes.

Does this really make sense?  Should an investor take action based upon public perceptions of economic statistics -- throwing out the opinions of experts?

The Public in Action

To consider the wisdom of betting on the public, let us consider their track record.  We'll have more to say about this in future articles, but for now let us go to a source highlighted by Barry, Michael Shermer.  (We could cite our past articles on the blunders by individual investors, but for today, let us stick with Barry.)

In Shermer's book, Why People Believe Weird Things:  Pseudoscience, Superstition, and Other Confusions of Our Time, the author, the editor of Skeptic, (now on our list of featured readings) writes as follows:

If we are living in the Age of Science, then why do so many pseudo-scientific and non-scientific beliefs abound?...New Age ideas and nonsense of all sorts have penetrated every nook and cranny of both popular and high culture.

He goes on to cite a Gallup poll showing that 52% believe in Astrology, 46% in ESP, 19% in witches, 22% that aliens have landed on earth, 41% that humans and dinosaurs lived simultaneously, 65% belief in Noah's flood, and 67% who have had a psychic experience.  42% think they communicate with the dead.

Shall we bet with the public?

Real Life Applications

One application we know about is the world of tournament bridge, where those who have a sound theory and understand odds routinely beat those who do not.  We suppose this is the same in mind sports like chess.

Another application is poker, where the popular conception loses to the expert on a daily basis.  The expert welcomes those with little background or knowledge.

In other casino games, they send a limo for those with a "system."

Is economics different?

What about the Economy?  And the stock market?

How should we interpret economic data?  Shermer has a useful suggestion:

Science is progressive because its paradigms depend upon the cumulative knowledge gained through experimentation, corroboration, and falsification.  

The key point is that real scientists reveal their theories and data, inviting the criticism and tests of others.  Anyone not offering findings for peer review and analysis is suspect.

The pseudo-science of those criticizing economic data relies on sources that have no peer review.  It is something to think about.

Our Take

There are several easy ways of pandering to public perceptions about the economy, government actions, and stocks.

• Those who have no real economic credentials gain from disparaging those who do.

• Those who have never actually developed econometric models -- or any models -- gain from acting as if these models have no value.

• Those who have no government experience gain from simplistic interpretations (That is a model!).

• Those who start with a world view, and then criticize any inconsistent data, can find support for that perception.

The stock market offers the chance for those who can identify the real experts to make easy money.  Most often, this happens when sentiment is at a bullish or bearish extreme, not supported by reality.

One of our missions is to identify such points.  For now, there is a key question:

When experts and the general public disagree, how do you vote -- with your money?

Send the limo.  (More later -- a lot more.)

(Regular readers will note our current model-based bearish stance.  We write both about fundamentals and current prospects.  Often the sentiment diverges from our sense of opportunity. Our trading reflects the differing time frames).

Housing Bill Veto Threat

There is a threat to the housing bill that has been moving through Congress.  It is important, and attracted little market attention today.

Background

The House passed an aggressive version of housing relief, led by House Financial Services Committee Chair, Barney Frank (D MA).  The Senate went through a negotiating process, with Sen. Richard Shelby (R AL) acting as the spear carrier for the Bush Administration.  Shelby succeeded in negotiating a compromise with Sen. Banking Committee Chair, Christopher Dodd.  The compromise bill cleared the committee on a vote of 19-2.

In the normal course of events, the bill would be passed by the Senate, since it has strong bipartisan support.  Many key Republicans represent states hard hit by potential foreclosures.  The next step would be a conference committee to reconcile the differences with the House version.  The plan was to complete legislation for President Bush's signature by July 4th.

Today's Developments

Today's story, breaking from various sources, got little attention during trading.  To the surprise of most (since Shelby had already used the Bush veto to exact various compromises) the Administration announced opposition to the Senate measure.  This bill was more conservative than the Frank version from the House.

Influencing the decision was information suggesting that some key officials, including Senators, received favorable loans from Countrywide.  Some analyses of the legislation suggest that Countrywide will be unduly assisted by the legislation.  There are many articles on this subject, but we recommend the very objective reporting from CQ Politics.

Our Take

At "A Dash" we have emphasized that solutions to the housing problems will not be a single comprehensive solution.  Instead, government works in incremental fashion, addressing one aspect of the problem at a time.  Some of the increments are in place, but this bill is an important addition.

As usual, we urge readers to put aside personal opinions about the  merits of the legislation and consider the market impact.  That is our mission.

This bill would help to stabilize housing demand.  There has been a lot of attention paid to housing supply, but there is also latent demand.  Most observers believe that some buyers are waiting to see stability.  Others need some help in qualifying for loans.  For these reasons, the measure is expected by most to help the housing market in an incremental, but important fashion.

A Presidential veto would be a negative for housing, credit markets, and the stock market in general.  It is possible that a scandal involving leading Senators could either delay the Senate passage, the conference committee action, or passage of the resulting bill.  It might also provide justification for a Presidential veto, especially since the lame duck Bush Administration may not be fully aligned with the GOP election needs.

If the political turmoil derails the legislation, we view this as a serious negative for US stocks.  If the issue is not resolved soon, no action will be taken before the election.

It is a strange fact of our political system that the implications for specific individuals and companies may outweigh a general concern.  One is easy to describe and makes good election fodder.  The other involves a deeper understanding of economic effects, one that eludes the grasp of the average voter.

Comparing Data Interpretation

Explaining and displaying data combines art and science.  The information itself is objective, as are calculations of trends and changes.  Despite this, there is an element of artistry.

A professor leading a class is motivated to help students find the truth.  One of our old professors described a certain statistical technique as grabbing the data around the neck, squeezing, and insisting, "Speak to me!"

If one starts with a conclusion, however, it is often possible to find support within almost any complicated economic report.  The analyst can look at changes from one period to another, or year-over-year.  One can look at seasonally adjusted or unadjusted data.  One can reject the overall number and look to "internals".  In such a case, the key question is whether the chosen indicator provides important information.

A Case Study: Today's GDP Report

With so many forecasting a recession, or insisting that the current period of slow growth will finally be judged as a recession, many are interested in the official report on GDP.  The estimate for growth in Q1, 2008, was revised upward to an annualized real rate of 0.9%.  While this is well below economic potential, it stayed in positive territory.

Since every economic report comes with plenty of commentary, let us consider the interpretation of the GDP data from three different sources -- all respected analysts who are among our featured sources.

We have provided extensive quotations, much more so than usual, but there is a reason.  Readers should take a few minutes to look carefully at each interpretation and see what conclusions they find.

Gary D. Smith

In his excellent "Bottom Line" summary Gary analyzes the Bloomberg report of the data and draws his own conclusions, including the following:

The economy grew more than previously estimated in the first quarter as Americans shunned imports and exports climbed to another record, Bloomberg reported. Jeffrey Frankel, an economist at Harvard Univ. who is a member of the panel that dates US economic cycles, said in a Bloomberg Radio interview, “I wouldn’t rule out going into recession” later in the year. This statement implies that he doesn’t currently view the slowdown as a recession, in my opinion.

and also this:

The gain in growth last quarter would have been even greater if not for a decline in estimates for inventories. Companies cut inventories at a $14.4 billion annual rate versus an initial estimate of a $1.8 billion gain. Inventories added only .2 percentage point to growth, less than the previously estimated contribution of .8 percentage point.

and finally this:

A measure of total sales, which excludes inventories, was revised to a gain of .7% at an annual pace rather than a .2% drop that was previously estimated. I expect 2Q GDP to easily exceed economists’ estimates of a .1% gain and growth to accelerate modestly into year-end on fiscal/monetary stimuli, lower commodity prices, decelerating inflation, an end to the American Axle strike, a firmer US dollar, inventory rebuilding, an end to the credit market turmoil, strong exports, diminishing housing fears and an improving job market.

Barry Ritholtz

Those reading the Barry Ritholtz blog (and that includes nearly everyone) might get a strikingly different picture.  Barry's key bullet points were as follows:

-Weakest two quarter growth since 2001 recession;
-Private inventory investment added 0.81% to GDP growth;
-Final Sales of domestic product: (GDP growth - private inventories) 0.7% (-0.2% previously)
-Personal consumption expenditure unchanged at +1%  (slowest since Q2 2001)
-Gross private domestic investment: -6.5% (previously -4.7%);
-Residential investment "improved" to -25.5% from -26.7% (most since 1981);
-Business fixed investment: -7.8% (improved from -9.7%);
-Exports weakened to +2.8% from +5.5%;
-Imports weakened to -2.6% from +2.5% ;
-Federal Government consumption expenditure and gross investment: +4.4% (+4.6% previously);
-State and Local Govt: 0.6% (+0.5% previously)

Barry also helpfully notes that if one subtracts trade and inventories, a key indicator according to Merrill Lynch's David Rosenberg, the actual quarter-over-quarter figure was a decline of 0.1%, indicating a "fragile economy."

Briefing.com

Briefing.com provides a timely and comprehensive analysis of every economic report.  Here is their bullet-point summary:

• The revised rate of 0.9% for Q1 GDP was due to an upward revision to net exports (0.6% additional contribution from 0.2%), and nonresidential structures (0.2% higher to 0.0%), and to inventories (0.6% lower to a 0.2% contribution).  All of these were about as expected as the March data on the trade balance, construction spending, and business inventories were out after the advance GDP report and all suggested changes of about this magnitude.
• The revision set GDP trends up for close to a 2% real gain in Q2.  Inventories will add about 0.5% to GDP if there is simply no more liquidation, and net exports and real PCE enter Q2 above the first quarter average.  Any modest improvement in these components in April-June will boost GDP solidly. 
• Real PCE (personal consumption expenditures) rose at a 1.0% annual rate.  This ultimate measure of consumer spending shows that lower home prices and higher gas prices have only dampened consumer spending, not produced declines.  Real PCE is tracking for another gain the second quarter.
• Exports continue to rise sharply and provide a boost to GDP.
• Housing (residential construction) remains a disaster and will continue sharply lower in Q2.  It is now down to just 3.8% of total GDP. 
• Business investment in equipment and software has been surprisingly resilient and will continue near flat in Q2.
• Nonresidential construction has started to weaken and will be a drag on Q2 GDP.
• Inventories provided a modest boost to Q1 GDP (due to a slower rate of liquidation) after taking a slice out of Q4.  Inventories will add further to GDP in Q2 as some accumulation might occur.

Their conclusion is as follows:  The recession has been postponed. (Read the entire article for a more complete analysis).

Our Conclusion

For today, the conclusion is up to the reader.  Three of our favorite sources seem to reach three different conclusions.  What is wrong?  Can we find an inaccurate statement?  Which approach does the best job of illuminating reality -- making the data really "speak?"

The key question is "How many readers can "cut through the spaghetti?" (as a key member of our team often puts it.)

Important News on the Housing Bill

When something important happens, with potential market effects, we interrupt our normally scheduled programming for an update.

We intend to publish the answers to the economics quiz and to announce the winners.  Meanwhile, potential entrants have another day to win this prestigious contest!

The Housing Compromise

At "A Dash" we have written a series of articles on  housing problems and possible solutions.  Since the government steps have been incremental in nature, the market has not really responded.  At some point, there will be a realization that something important has happened.

Last week we pointed out that investors should be watching Sen. Richard Shelby as the indicator of a real compromise.  A Senate Banking Committee compromise was reached today.  While there are more steps in the legislative process, we see this as the real hurdle.

The Significance

We note with interest the opinion of Nouriel Roubini, an outspoken bear on the housing situation.  In two articles, Roubini discusses the merits of the proposal and responds to critics of his viewpoint.  Here is a key portion of his argument, but readers should consult both articles.

Very few reflected on the substance of this proposal and its strong economic logic that would benefit borrowers, lenders and even the government as the fiscal cost of no action (a systemic banking crisis that would trigger a costly fiscal bailout of banks given deposit insurance) is much higher than the potential modest fiscal cost of this proposal.

Conclusion

This is good news for the housing market, the economy, and the stock market.  We shall delve more deeply into the proposal and the effects in future articles.  We shall also examine the reactions of economists and prominent bloggers.

UPDATE, 5/20/08, 1 PM CDT

The editors at TheStreet.com have kindly moved my article on the Frank/Dodd legislation to the non-subscription portion of the site.  Readers of "A Dash" can check out this article for insights from Doug Kass and Jim Cramer, the description of the remaining steps before it becomes law, and the reasons I believe President Bush will sign the legislation.  The process is going to take another six weeks or so, but it will get more attention before then.

Reviewing the Media Pundits: Two Views of the Fed

One of our themes at "A Dash" is the array of challenges to the individual investor.  Interpreting market commentary is one of the most important.  While our readers understand the blogosphere, the influential print media remain far more important.

The MSM articles do not have any comments, so readers are on their own to spot any problems.  To illustrate this, we will contrast today's article by New York Times columnist Gretchen Morgenson with a recent piece by Bloomberg's John M. Berry.

Morgenson on "Trash for Treasuries"

Regional printing has made it possible for people all over the country to enjoy a hard copy of the New York Times with morning coffee.  Our Thursday and Friday editions (during our West coast trip) were printed in Seattle, and today's, delivered at our door, was printed in Chicago.  Many individual investors look to their business coverage.

One of our favorite sources is Pulitzer Prize-winning columnist Gretchen Morgenson.  Her perspective is clear from her background -- history, English, journalism, and a record with publications that make difficult topics clear for average investors.  On most occasions, she does this very well.

Her column today includes all of the hallmarks of good journalism.  She has plenty of sources -- a mortgage guy saying that the Fed is accepting questionable collateral, quotes from Fed officials on the dubious nature of securities ratings, and a pithy quote from the sassy and colorful Joan McCullough calling the Fed a "monetary bordello."  There is a source for every statement.  Every technical point of journalism is covered.

Her conclusion?  The Fed is risking taxpayer money on dubious securities and we might all be left holding the tab.

Her opinion?  "To be sure, crisis times call for creative measures. But as long as Wall Street is allowed to swap trash for Treasuries on the taxpayers’ dime, don’t try to tell me this horror show is over."

Our Analysis

We are disappointed that Morgenson missed the point so badly.  She has written an article where every piece of it is accurate, yet the conclusion is deceptive.

It is not the mission of the Fed to engage in policies with profit in mind, although the net effect of Fed actions does provide "profits" to the taxpayer each year.

The Fed mission is to address the twin goals of economic growth and price stability, while assuring stability in financial markets.

By writing a column that focuses completely on the risk to the taxpayer, without due attention to the Fed mission, she misleads her readers -- mostly average investors.  The colorful language about "trash" emphasizes this viewpoint.

An Alternative View from Berry

John M. Berry has long been recognized as an authority on the Fed, often with an inside glimpse of official thinking.

In a recent article, he makes several important points.  First, the nature of the Fed actions:

The Federal Reserve is supplying the financial system with more than $150 billion in cash, a liquidity cushion that has helped keep enough credit flowing to ensure the economy's growth.    

After another auction of term funds on May 19, the amount of cash from the Fed will probably top $175 billion. And if the system needs still more, Fed Chairman Ben S. Bernanke said in a May 13 speech, the Fed stands ready to supply it.

What has been the effect?  Berry cites some useful data, as follows:

...(T)he unprecedented amount of cash pumped into the system have helped the economy defy predictions of a recession.    

Recent data suggest the economy grew at about a 1 percent annual rate in the first quarter, slightly more than the 0.6 percent estimate released by the Bureau of Economic Analysis on April 30.    

And on May 13, Macroeconomic Advisers predicted that the tax-rebate checks now being sent to many households would spur consumer spending this quarter, boosting growth to 2.5 percent. Third-quarter growth would exceed 3 percent, the forecast said.

The specific lending effects?  More from Berry:

The Fed had no choice except to supply the liquidity that was no longer available in the market. Otherwise, even credit worthy households and businesses wouldn't have been able to borrow, and a recession would have been inevitable.    

Instead, over the 12 months ended in April, commercial and industrial loans rose 20.9 percent at banks, while home-equity loans climbed 9.9 percent and consumer loans increased 9.3 percent. Even other types of real-estate loans were up 6.7 percent over the period.

Our Take

The New York Times readership differs dramatically from that of Bloomberg.  A reader of Morgenson's piece alone may not understand the rationale for Fed actions, nor the important effects on the credit crunch and economic growth.

One of the biggest challenges for readers of opinion articles is to understand what has been left out.

The real story of the Fed initiatives was avoiding the "death spiral" of forced selling into illiquid markets.  Mainstream media have done a poor job in covering this issue.

It is so much easier to write something that will appeal to the "common man" in a way that emphasizes taxpayer risk.  Even if some loans go bad -- far from clear from the data -- the economic benefits dwarf any potential losses.

Investors who do not understand this are fighting the Fed, something we warned about in December.

             

Test Your Economics IQ

Stocks can and do stray from valuations suggested by fundamental analysis.  Despite this, it never hurts to understand the economic background.  Understanding the economy helps to gauge earnings forecasts.  This is especially important for stocks with a cyclical character.

Here are some statements about economic data and the market.  For each statement you need merely to decide "true" or "false".  We are not trying to serve up trick questions, but sometimes those citing the information do so in a tricky way.  It is up to you to see through this!

The Quiz

1. Home prices are now deflating at a 32% annual rate, versus 8% six months ago.
2. Inflation, as measured by the CPI, shows housing costs to be increasing according to the "imputed rent" formula.
3. Planned corporate layoffs rose 68% in April to a total of over 90,000.
4. As long as the largest asset on household -- and bank -- balance sheets continues to deflate, the credit and consumption hits will keep coming.
5. The US economy created about 2.5 million new non-farm payroll jobs last month.
6. The TED spread is now at 86 bp's, down from 204 in mid-March.
7. The Baltic Dry Freight Index has plummeted, showing global economic weakness.
8. The Fed has devoted about half of its balance sheet to "unusual" liquidity efforts.
9. The BLS Birth/Death adjustment has reduced past predictive performance, as measured by actual state employment counts when the data became available (months later).
10. Household liquid assets at $21.9 T and net worth at $31 T are about 1% below the all-time records as of the most recent published data.

Answers

Many wise and regular readers of "A Dash" will do well on this quiz.  We will recognize the best scores submitted by email (note the link at the top left).  Please do not show off by making your answers in the comments!

There will be ample time to discuss and disagree when we publish the answers.

Scooped by Muckdog

On our blog agenda there is a discussion of the "alternate data universe."

There is a rich and thriving discussion of economic data among economists -- that would be the "real economists".  We are talking about those who are (preferably) in the academic world or working on Wall Street.

There is another discussion.  It occurs mostly in the cottage industry of those making a business of criticizing the official government data.  As we have noted, government is an easy target.  The only representatives who speak in public are the political actors.  The hard-working, non-partisan, intelligent staffers do not have any access to the media.  That makes organizations like the BLS an easy target.  They are not paid to go on CNBC.

Attacking the non-farm payroll report, GDP, or inflation data is an inviting target for the gonzo-economists, the non-economists, and those with a paid-site business model.

We were looking for a way to describe this "alternate universe" and even had the Twilight Zone in mind, but we were scooped by Muckdog.  (Regular readers of "A Dash" sometimes ask why we recommend Muckdog, with whom we have never spoken, when his source seems to lack the official credentials we admire and is also anonymous.  The answer is simple.  We are not advocates of credentialism.  We do hold anonymous sources to higher standards of helpfulness.  We include them among featured sites when there is a real investment payoff.)  Muckdog gets to the point much better than we would:

From Barry Ritholtz:  GDP Alternate Measure. It's the whole conspiracy theory thing about understating inflation and overstating GDP.  Maybe "alternate universe?"  Sure, but those make for good Twilight Zone and Star Trek episodes, no?  And Barry's always a good read.

The Choice for Investors and Traders

It is pretty simple.  One can go into the Twilight Zone where no official report means anything -- there is always something wrong.  The prime source for this, which we will not link to, is a paid site on a mission.  The serious economists do not cite this source.  The bearish non-economists frequently do so.  The mainstream media, with a couple of exceptions, do not travel this path.  It is a trail which requires certain dubious assumptions:

• "Government" is some unitary actor, like the manager of a business, with a mission of punishing certain people -- mostly senior citizens, in an effort to cut costs and balance the budget.
• The Boskin Commission was some sort of conspiracy with this aim in mind.
• Various Administrations and the Fed have joined forces to foster this approach.

In the beginning government classes students learn that we have a pluralistic society.  Many different interests are represented, and quite effectively.  Senior citizens have a special  pull with Congress, since they represent a powerful voting block.

In fact, the Boskin reforms, discussed in a bipartisan Commission, have been reviewed by economists.  If anything, the adjustments to CPI are still inadequate.  CPI remains overstated.  As we have noted, that is what the Fed believes.

Investors have a simple choice.  They can choose to follow the alternate universe, where  everything has gotten  much worse over many years during a time when wealth increased.  This is an ideological choice, not an investment choice.

Alternatively, investors can accept the debate among real economists, those trying to generate accurate data, and those offering real public policy alternatives about economic issues.

Conclusion

Like the many economic sources available on the Internet, we are not going to engage in a debate on specific calculations.  It is too time-consuming  to fight this battle when the alternative universe has this as a single-minded mission.

A trader or investor who wants to profit is well-advised to deal with the data generally accepted in the economic and investment community.  If no one with real credentials chooses to engage in a discussion of the findings, that is meaningful and should be respected.

An Anecdotal Afterthought

Our mission at "A Dash" is helping investors and traders.  We were in some doubt about whether this was an important issue until we had a recent visit from one of our most intelligent and informed investors.  He asserted that some of these issues were "controversial."

We were surprised.  We suggested an analogy of the debate over cold fusion.  This theory, suggesting a potential for vast energy creation, was almost universally disputed by a broad spectrum of scientists.  Nonetheless, it won popular support, some grant money, and some academic followers.  This was a controversy principally among non-scientists.

There is plenty of room for debate over data and findings.  Unless you are yourself an expert, your mission should be in discovering and following the real experts.

That is what we do at "A Dash."

Developing and Evaluating Trading Systems

Improved technology, more power.  We would expect this to be good.

In fact, more power can enable us to do exactly the wrong thing.

This happens all of the time with the world's most powerful computer, the human mind.  A year ago we reviewed analysts who thought the market looked like a replay of the 1987 crash.  This type of analysis crops up all of the time, often using old charts as evidence.  With the power to search among thousands of choices, picking the time frame, and adjusting the scales, the human computer can "prove" nearly anything.

Those developing computer-based trading systems face the same problem.  The modern software makes it easy to include many variables --- too many!

Some Helpful Illustrations

Bill Rempel missed the Kentucky Derby by a few days, but his story highlighting horse race handicappers is excellent.  A group of handicappers were tested, using gradually increasing amounts of information.  The extra data increased their confidence, but not their performance!  (Read the entire discussion.)

Bill discusses Occam's Razor and points out the importance of reducing the number of independent variables:

I use this paring down or pruning technique at work as well as when examining trading strategies or opportunities. My first question, when faced with complex models, has for a long time been “I wonder how many of those variables actually do most of the work?”

This is pretty convincing to us, since Bill sounds just like our own Vince Castelli.  It is easy to develop a model using all of the available data and lots of variables.  You will generate a perfect "post-diction" but not anything useful for prediction.

The result:  Over-fitting and over-confidence, a dangerous brew!

Unfortunately, consumers of system strategies, including a few big-time "gatekeepers" we have met, have become accustomed to seeing eye-popping (and unrealistic) results.  They apply an automatic discount, regardless of the methodology employed.

The TCA Model Applied to the S&P 500

For the purposes of comparison, the chart below shows our TCA Model (Trend, Cycle, Anticipation) as applied to the S&P 500.  Without giving away the store, we can say that the model uses a relatively small number of variables -- some designed to choose between trend and cycle, and others representing indicators for each.  Much of the power comes from advanced techniques for filtering and smoothing data, thereby improving signal to noise.  The chart below is not a back-test, but the signals actually used in trading during the last year.

The overall performance shows a gain of about 6% during a time when the S&P declined by a few percent.  It accomplishes this while reducing risk by staying out of the market for significant periods.

A key point is that the model gets the investor into the market to enjoy the big moves.  The cost?  There are some losses at times of rapid changes or churning.

Finding the big moves is very important.  Some traders have trouble joining in when the market has already made a move.  They are reluctant to "chase."  It is difficult to show gains when missing the big rallies.

Anyone interested in trading systems should join us as regular readers of The Rempel Report, where he updates and reports on several interesting trading systems.  One of these is similar to our own sector rotation approach.

TCA-ETF Update

Each Thursday (a day late this week) we share with the investment community a recent report from our ETF ratings.  We have been doing this in real time for eight months.  Our purpose is partly to gain visibility for the approach (free report available on request), but also as information for other ETF traders, and most importantly to provide a laboratory for others trying to develop trading systems.  We discuss the issues surrounding system development in many of the articles in this series.

As we noted last week, we have expanded the ETF universe, and we seek more additions.  Adding more targets is helpful, as long as they can be shown to have characteristics suitable for one's model.

The current ratings show some dramatic changes from recent weeks, and include one of the new ETF's, KOL.

Investors Seeking Foreclosure Riches

One of the ingredients for "bubbles" is the quest for the home run.  Investors look to how much they wish to gain rather than to risk and reward.

What happens when this quest intersects with a major downturn in an asset class?

The Foreclosure Boom: Donald Trump

Our local papers have featured ads from Donald Trump, explaining how you can profit from the foreclosure explosion.  This article, while a few months old, is typical of what is happening.  It is from Seattle, a pretty strong housing area which we visit four times a year for board meetings.

But not to fear, capitalists, because one man's misery is another man's meat. In the same issue of the P-ITrump University"," a class where Trump promises "If you're not a millionaire by December 2008, you didn't attend my foreclosure workshop." Yes, that's right. Your struggling neighbors who are losing their homes in the subprime fiasco, are easy prey. The ad enthuses that "Foreclosures soared 94% in 2007!" What a paradise for the entrepreneur. The ad features a full-length Trump (who won't actually be at the seminar, by the way) staring you down, challenging you to become as rapacious, amoral, and loathsome as he is. If you don't have the guts to let Donald make your rich at the expense of the suckers of Pottersville, well, you're fired!

The LA Times also reports on the Trump approach:

An ad in this very newspaper showed a picture of The Donald and quoted him as saying, "Investors nationwide are making millions in foreclosures . . . and so can you!

"I'm going to give you 2 hours of access to one of my amazing instructors AND priceless information . . . all for FREE."

OK, I know what you're thinking. You're thinking there has to be a catch, such as the fact that the ad doesn't mention anywhere that the free two-hour seminar is only a "preview" of the three-day workshops that Trump offers for $1,495.

The reporters are skeptical of the Trump seminars, but we are offering no opinion.  We merely suggest this information as an interesting piece of information about identifying market bottoms and investor behavior.

Books on Foreclosures

There were a number of books on foreclosures in the last real estate bust, and now we see some new ones and also some revisions.

• Foreclosure Investing for Dummies is a year old now, so not a good bottom call.  Nonetheless, we are always interested when dummies get into the game.
• Here is one that came out in April.
• This "insider's guide" is almost a year old.
• This "complete guide" came out in January.
• If you want something that no one else knows, and only a couple of months old, this is your choice.
• And finally, here is something for "dummies" who want to fight foreclosure -- with or without help from Barney Frank and Congress!

What Does it All Mean?

We do not know!  When will the wave of foreclosure buyers intersect with the foreclosure sales?  Perhaps we need to wait for the cover of a major magazine before we have a clear contrarian signal.

While we are confident of the knowledge base of our regular readers, let us make it clear that we are neither endorsing the foreclosure course nor the books cited.  It is information for investors to consider -- that is all.