A Dash of Insight

March Employment Report Preview

Once again the monthly payroll report has a special significance. I am cautious for several reasons:

1. The market rally is generally perceived as extended – many are looking for a reason to sell;
2. The recent economic data has shown signs of weakness, possibly affecting consumption and business formation;
3. There is a ceiling on strength, due to incorrect assumptions about the Fed.

I will elaborate on each point in the conclusion, but let us first review the expectations for Friday's report.

Background

This preview is different! There are many concepts and facts that you will not see anywhere else. I also try to provide an angle both for traders and investors. There is an element of truth (what will eventually become clear) and an element of buzz (what will draw exaggerated attention Friday morning).

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.  My best analogy was to a bean-counting contest.  The winner was NOT the contestant who was closest to the correct answer.  Instead, the winner had to predict the guess of a fellow contestant.

This is what we do every month.  We want to know the truth about the economy.  Instead of recognizing that there are several good estimates, everyone tries to guess what the BLS will report.

Please read this former preview both for a laugh and a deeper look.

Recently I did something extra, reviewing the most recent period for which we have actual data and showing who had the best estimate. There were three conclusions:

• All of the estimates were too low.
• The much-maligned ADP was the best, and that missed by more than 100K jobs.
• The BLS methods were the worst.

We rely far too much on the first pass, BLS version, and officially certified 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 March.

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

1. An initial report of a survey of establishments. Even if the survey sample was perfect (and we all know that it is not) and the response rate was 100% (which it is not) the sampling error alone for a 90% confidence interval is +/- 100K jobs.
2. The report is revised to reflect additional responses over the next two months. 
   
3. There is an adjustment to account for job creation -- much maligned and misunderstood by nearly everyone. Everyone focuses on the birth/death adjustment. This actually accounts for less than 20% of the BLS attempt to estimate job creation.
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 most recent 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. The January report adjusted for these benchmark revisions.

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 158K 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.  In recent months ADP is using an improved methodology with a stronger sample.  The objective is to improve the correlation with the final print of the employment data. 
• TrimTabs looks at income tax withholding data. Their idea is that this is the best current method for determining real job growth.  TrimTabs forecasts a gain of 156K. We are moving past the year-end uncertainty about tax law from the fiscal cliff debate, so one would think that the TrimTabs estimate would now be more accurate.
• 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. This is on the summer research agenda – a time when I typically have help from smart people looking for great experience. While the Jeff model is still officially on the sidelines, it suggests significantly lower job gains than the other approaches. Put another way, on a long-term historical basis we would not expect gains of more than 100K given the other economic data. Is job growth really leading the recovery? I do not think we have a good grasp on job creation.  The BLS tries hard, but their approach lags on this front. Street estimates are generally similar to my method, but few reveal much about the specific approach.  These estimates usually adjust for the ADP report.
• Briefing.com cites the consensus estimate as 192K, while their own forecast is for 185K.  Their private jobs forecast is about 15-25K higher, since the loss of public jobs is a continuing drag.
• Gallup does not seem to have an update to their unemployment series. I have tried to give this source respect and equal time despite a rather overt bearish and political approach in past commentaries.  Why no update on seasonally adjusted unemployment?

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, which was demonstrated in the addition of 350K additional jobs in the benchmark year.

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 among others -- and perhaps not the best.  The bean counter example illustrates this.

Trading Implications

In my experience it has usually been safe to be conservative in front of this report. The story is so complex that it is pretty easy to generate a negative spin. Your favorite perma-bear/conspiracy site does a good job of preparing. It is poised to comment on seasonal adjustment, birth/death adjustment, labor force participation, hours worked, and discrepancies between the payroll and household surveys.

Here are some fearless forecasts from the Old Prof:

• Based upon my indicators, I am especially worried about this month's report.
• Much will be made of seasonal adjustments - - mostly by those who have never produced a dataset that included any seasonal adjusting!
• No one will recognize that the BLS estimate is just that --- an estimate. We already know most of the answer, and it is pretty good.
• Any extreme result will get an exaggerated interpretation. If the job growth were to be 50K, we will have claims that recession is upon us. If the BLS estimate is 300K, we will hear that the Fed is about to tighten rates!
• Watch the "hours worked." This could be an early indicator of employment weakness.

As usual, the number is less important than everyone thinks. So here is the most important point:

The Fed will not change policy based upon the March employment report—no matter what the outcome. Everything that I have written here is completely understood by the FOMC. It will take a long series of results to influence Fed policy. Since traders and pundits do not seem to grasp this, the wise investor may get (yet another) opportunity.

Weighing the Week Ahead: More Opinions, Less Data

Sometimes the weekly calendar does not provide much fresh data. This has no effect on the need for content on the part of financial media. Blank pages and air time must be filled.

The result? A bull market in opinion --- data not required.

The economic data have been pretty consistent – low inflation, consistent but weak growth, and some bright spots, especially in housing.

The policy implications have also been clear – a Fed determined to emphasize the employment side of the dual mandate.

None of this provides much zest, especially since there is little change in the story. The way to spice it up is to find some extreme opinions and get an argument going. My prediction is that this week will see a more varied media lineup, with riffs on the following themes:

1. New market top. Has the move been too fast, too far? Is it justified?
2. Stagflation. I resisted putting this in the title. I notice that it is popular with readers, so the topic is a Twinkie-style sugar high. The story comes in two parts:
   1. Some will emphasize the "Stag" with another recession salvo from the gang at the ECRI. While the measures keep changing, they seem to command media attention. Too bad that the recession truth squad does not get equal time.
   2. Some will emphasize the "flation" by claiming that government data are wrong.
3. Fed Manipulation. Yet another group will explain that this is a "training wheels" rally based upon a "sugar high" and warning that it will all end badly.

And that is my prediction – a week of opinion fluff instead of real information.

As usual, I have some thoughts about how to navigate these waters, 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 pretty good week for the economic data and market news.

• Sentiment indicators have declined. This is bullish on a contrary basis. See Bespoke for a discussion of this chart – only a sample of their popular daily product.

• Household net worth hit a new high. I am scoring this as "good" but it was not a market moving event. (See the Doug Short take below).
• Employment growth is good, especially in the wake of the "fiscal cliff." Remember the worry on this story? There were many effects at year-end, so it will take some sorting out. Dr. Ed Yardeni thinks that there was plenty of negativity built in at the end of the year. Despite the end of the payroll tax reduction, the overall impact is positive. So far he seems to be right. The market had a modest positive reaction to the news. (Some dissent in 'the bad' below).

• Obama meets GOP rank and file – away from the White House. Hey! It can't hurt. Even Leader Boehner seemed on board with the initiative. The President's poll ratings have been plunging, so that may provide some incentive to compromise.
• Gas Prices moved lower – but there is still a long way to go.
• The ISM Services Index hit a 12-month high. See Steven Hansen's story at GEI for the details. Take a look at the full table of sub-components and the comparison with the ISM manufacturing index.

The Bad

The data for this week seemed pretty good on the surface, but there were issues if you took a deeper look.

• Progress is inadequate, even as wealth rebounds. This is probably the single most important observation about the US economy. Doug Short's first-rate analysis of the net worth data, including all of the charts you would expect, shows why we still lag what is needed for solid economic improvement. There are many great charts, but this is my personal favorite. The growth has resumed, but we still lag the overall trend.

• The Fed's biggest asset (surprise!) is student loans. Without going into many complex policy details, I suspect that most share my sense: This has a bad feeling to it. Doug Short has the data and a great chart.

• The unemployment rate. The headline stated that unemployment was down by 0.2% percent. Most analysts know better. This headline number is a combination of the number employed and the size of the labor force. Even when employment is better, the labor force shrinkage has been a major factor in the employment rate calculation. Calculated Risk has a fine post discussing this topic, and including excellent charts. Here is an example:

Bob Dieli's monthly employment report for his clients points out that the only true improvement in the unemployment rate over the last several months came last September. Other examples reflect changes in the labor force. (Check with Bob and mention us for a free sample).

• Assorted Europe stories, mostly repeating the known economic weakness. I am taking note of this, but none of the market indicators suggest that this is really fresh news.
• PE Ratios Edge Higher (via Bespoke). Most people will see this as a valuation negative, so that is where I have placed it. See the article for a helpful chart. Regular readers know that I expect the multiple to increase along with better confidence about the economy, so the interpretation is open to debate. See also Brian Gilmartin's tracking of forward earnings and the equity risk premium: "Assuming a 5% 10-year Treasury yield, the SP 500 would still need to increase 48% from its current level ($112.39 divided by 5%) to bring the SP 500 into parity."

The Ugly

The state of knowledge – for both traders and investors. Most market participants do not want to be confronted with reality, but you can do this in private. Here are two quizzes on important topics. Both involve the interpretation of data. I had a very low score on one of them and a very high score on the other. Feel free to report your own scores and observations in the comments.

1. The ZH Test (via Cassandra at Ritholtz.com). I cannot improve on the introduction to the test, which everyone should take, if only for a laugh:

"Being permanently bearish on equities definitely pays.

Just ask Zero-Hedge. Unfortunately, for wool-dyed pessimists and the other overly-skeptical black sheep of the thundering herd, it pays apocalyptic newsletter writers' paychecks, and Zero-Hedge/Tyler Durden's Manhattan bar tabs rather than those who permanently position against market priapism. And it's worse than zero-sum because those who are optimistically-challenged often pay for the bad advice – whether directly in subscriptions, inflated margins on retail bullion products, or indirectly via page-views and click-throughs AND then they get hosed by the market.

The first step to improving behaviour toxic to one's own self interest is admit one has a problem. As an aid to help those who have difficulty in distinguishing "a bearish trade" from "the lead boots of anger and pessimism", I've devised a little something I call the Zero-Hedge Test to determine more precisely whether readers objective realities are sufficiently  paranoid, pessimistic, anti-social and rantingly angry to warrant more serious help."

1. The labor force participation test. The WSJ's Real Time Economics Blog does a great job with this. They take a topic of great importance, cited by everyone, and illustrate why the basic understanding is rather poor. In a perfect world every pontificating pundit—everyone discussing labor force participation -- would have his score on this test reported along with his opinion. I invite readers to suggest their own disagreements with the BLS definitions – which seem fairly reasonable once you grasp the principles.

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.  Dwaine Van Vuuren also has an excellent data update, demonstrating how the coincident data have reduced recession prospects. Dwaine also notes that recession has struck in many countries around the world—monitoring many of the OECD countries here. Take a look!

Georg Vrba is a great "quant guy" with great credentials a variety of useful tools, some available via a free subscription. His take on a possible recession? Based upon unemployment data, the ECRI is wrong.

New Deal Democrat, writing at The Bonddad Blog, does an in-depth analysis of the latest ECRI story. The metrics change in a way that "cherry-picks" old data. Read the elusive story for yourself.

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 notes that the original ECRI call was basically a "bet against the Fed." At the time they claimed that there was nothing that anyone could do. Has their story changed? You really need to read Doug's article to get the full scope of the disparity in forecasts. Doug also continues to refresh the best chart update of the major indicators used by the NBER in recession dating.

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.  Recently we switched to a neutral position.  These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings have stabilized and improved significantly this week.  The penalty box percentage measures our confidence in the forecast.  A high rating means that most ETFs are in the penalty box, so we continue to have less 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 rather light on important data.

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.
• Michigan Consumer Confidence (F). I treat this as more important than do others, mostly because our team's research shows it to be important. I see it mostly as a good confirming coincident indicator, important for consumer behavior and also for a read on employment.

The "B List" includes the following:

• Retail Sales (W). The data provide an important read on the consumer (somewhat redundant with private same store sales reports), especially given the end of the payroll tax relief and higher fuel prices.
• PPI (Th). Expectations are benign, making this report less interesting.
• CPI (F). See PPI.
• Industrial production (F). An important factor in the GDP/recession calculation.
• JOLTs Report (T). This report shows job turnover and actually provides a lot of data unknown to most. It does not get much attention, and when it does, the interpretation is soft. A good topic for a future story.
• Business inventories (W). Relevant for GDP revisions.

I am little interested in further revisions on elements of Q4 GDP, and the market will not be either. There are some retail earnings that might attract notice, but it is generally a quiet week. I also care little about regional Fed surveys.

Trading Time Frame

Felix has switched to a marginally bullish posture. It has made a slight difference in trading accounts. It has been a close call for several weeks.  When the model turned to neutral, we dropped to 1/3 long. Since the sector was consumer staples, it was still a conservative call. We increased exposure this week in a second conservative sector. Felix has turned bullish, but it is like dipping a toe in the water.

Last week it looked like Felix might switch into an inverse ETF, but that now seems unlikely. Unlike human traders, Felix responds to data, not headlines. Felix also does not anticipate – requiring actual evidence for action.

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.

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."

Warren Buffett spent a few hours on CNBC's Squawk Box last week. As regular readers know I use TIVO and mute to find the best stories from this source. CNBC helped with some highlights – only nine well-spent minutes and you can see the best of the Buffett advice.

I was struck by this comment. Mr. Buffett said that the market offered you a quote on your holdings every day. This should be an advantage, but most people made poor use of it by trading at the wrong times. They would be better off to check on their portfolio every five years or so! It explains why most people make big mistakes in trying to time the market.

So do most "experts." I exposed the false claims of many pundits. You can check out the overall issue and also pundit ranks by reading The Seduction of Market Timing.

While there are no miracles available from market timing, you can definitely improve your risk/reward balance.

I strongly believe that active management can help investors. My concepts emphasize limiting risk and finding the right themes, not trying to time the markets via watching headlines. I really tried to pull this together in my 2013 preview for Seeking Alpha.  This covers some key investor catalysts, as well as some specific stock and sector ideas.  My recommendations did well last year, and we are off to another good start.  You need to be comfortable in taking the other side of one of the most hated rallies in history.

But please beware!  General ideas are not for everyone.  Each person needs unique treatment.  We have several different approaches, including one that emphasizes dividend stocks with enhanced yield from writing near-term call options.

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

Whether you are a trader or an investor, you have done best to remain open-minded over the last four years. The warnings have not changed, but the facts have.

If you have not been reading and watching Downtown Josh Brown, you are missing out on some very frank and objective analysis.

Here is his take on the four-year anniversary of the market rally:

"Today, in case you've lost track, is the fourth anniversary of the March 9th "Generational Bottom" for the stock market. We are now headed into the fifth year of what many of us have been calling "The Impossible Rally" and I thought this would be a good time to recap and reflect.

Today, four years ago, the Dow Jones industrial average lost 80 points, or 1.2%, to end at 6,547.05, its lowest point since April 15, 1997. The S&P 500 index lost nearly 7 points or 1%, to end at 676.53, its lowest point since Sept. 12, 1996. The Nasdaq composite lost 25 points or 2%, to end at 1,268.64, its lowest point since Oct. 9, 2002.

That day, Merck had announced a $41 billion acquisition of its rival drug maker Schering-Plough and the market didn't even blink. It had been going down so hard and for so long at that point that no one believed it would ever go up again.

That morning Roubini and Faber were out doing their typical Gloom and Doom show, scaring the wits out of anyone who would listen.  One was talking about an intensifying recession with no way out, the other predicted the S&P would be dropping below 500 by year's end. The opposite ended up happening, of course."

This is now in the past, of course, but the principle remains the same.

The Capital Observer notes that there are plenty of lagging stocks – mostly in cyclical and technology names. That is where I am buying as well.

February Employment Report Preview

This month's report is especially important. I am cautious for several reasons:

1. The market rally is generally perceived as extended – many are looking for a reason to sell;
2. The story is complex, with many spinning angles;
3. There is a ceiling on strength, due to incorrect assumptions about the Fed.

I will elaborate in the conclusion, but let us first review the expectations for Friday's report.

Background

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.  My best analogy was to a bean-counting contest.  The winner was NOT the contestant who was closest to the correct answer.  Instead, the winner had to predict the guess of a fellow contestant.

This is what we do every month.  We want to know the truth about the economy.  Instead of recognizing that there are several good estimates, everyone tries to guess what the BLS will report.

Please read the September preview both for a laugh and a deeper look.

Last month I did something extra, reviewing the most recent period for which we have actual data and showing who had the best estimate. There were three conclusions:

• All of the estimates were too low.
• The much-maligned ADP was the best, and that missed by more than 100K jobs.
• The BLS methods were the worst.

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 February.

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.  This is especially important this month since the official survey response date has been moved forward by a week.  This is a routine adjustment for the Thanksgiving holiday, but it increases the potential for error and later revision.
3. There is an adjustment to account for job creation -- much maligned and misunderstood by nearly everyone. Everyone focuses on the birth/death adjustment. This actually accounts for less than 20% of the BLS attempt to estimate job creation.
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 most recent 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. The January report adjusted for these benchmark revisions.

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 198K 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.  In recent months ADP is using an improved methodology with a stronger sample.  The objective is to improve the correlation with the final print of the employment data. 
• TrimTabs looks at income tax withholding data. Their idea is that this is the best current method for determining real job growth.  TrimTabs forecasts a gain of 100K. There was a lot of year-end uncertainty about tax law from the fiscal cliff debate. TrimTabs has wisely taken note of this and is trying to adjust for the changes in tax withholding.
• 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, but it is a high priority summer project.  It remains difficult to account for the effect of headlines about politics, the sequestration debate, and the end of the payroll tax relief. None of these factors relates to employment, so there is more noise than signal right now. Layoffs catch the headlines, because these are big visible chunks of jobs.  I do not think we have a good grasp on job creation.  The BLS tries hard, but their approach lags on this front. Street estimates are generally similar to my method, but few reveal much about the specific approach.  These estimates usually adjust for the ADP report.
• Briefing.com cites the consensus estimate as 178K, while their own forecast is for 180K.  Their private jobs forecast is about 15-20K higher, since the loss of public jobs is a continuing drag.
• Gallup does not seem to have an update to their unemployment series. I have tried to give this source respect and equal time despite a rather overt bearish and political approach in past commentaries.  Why no update on seasonally adjusted unemployment?

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 will be reflected in the January report, which will show over 350K additional jobs in the benchmark year.

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 among others -- and perhaps not the best.  The bean counter example illustrates this.

Trading Implications

In my experience it has usually been safe to be conservative in front of this report. The story is so complex that it is pretty easy to generate a negative spin. Your favorite perma-bear/conspiracy site does a good job of preparing. It is poised to comment on seasonal adjustment, birth/death adjustment, labor force participation, hours worked, and discrepancies between the payroll and household surveys.

Here is an experiment. Check out what they say right after the number is reported and also note Rick Santelli's initial reaction on CNBC. Then follow Santelli for the next 30 minutes. He will get the message and report it.

Some might think of it as the "Santelli call" which would be the opposite of the "Bernanke put." It might only work for a few minutes, but that is long enough for shorts to cover.

I am also concerned about the ISM reports. While these have been very strong, the employment components have been weaker.

Here are some fearless forecasts from the Old Prof:

• Much will be made of seasonal adjustments - - mostly by those who have never produced a dataset that included any seasonal adjusting!
• No one will recognize that the BLS estimate is just that --- an estimate. We already know most of the answer, and it is pretty good.
• Any extreme result will get an exaggerated interpretation. If the job growth were to be 50K, we will have claims that recession is upon us. If the BLS estimate is 300K, we will hear that the Fed is about to tighten rates!
• Watch the "hours worked." This could be an early indicator of employment weakness.

As usual, the number is less important than everyone thinks. So here is the most important point:

The Fed will not change policy based upon the February employment report—no matter the outcome. Everything that I have written here is completely understood by the FOMC. It will take a long series of results to influence Fed policy. Since traders and pundits do not seem to grasp this, the wise investor may get (yet another) opportunity.

The Biggest Lesson from Earnings Season

Here is a fresh take on earnings season. No matter how many sources you followed, you have not seen this before.

Let me start with what we did not hear.

1. This stock is a poor investment because it has a bad Tobin's Q ratio. Readers are invited to correct me if someone is offering an opinion that Google has a poor replacement value. How do you even think in these terms? This method is an outdated approach in search of a modern critic.
2. This stock is over-valued based upon the Shiller CAPE method. Readers are invited to correct me with examples of specific stocks where people think that the P/E ratio should be based on the earnings over the last decade, adjusted for inflation and divided by 10 (or some close variant). Has anyone ever made any money using this method?
3. The earnings of the company should be ignored because it is happening in the midst of a counter-trend rally in the midst of a cyclical bear market. Readers are invited to correct me with examples of analysts on specific stocks who thought this was relevant.
4. The current value of the company should be compared to its earnings in 1870. In 1910. In 1935. In 1950. In 1970….and so forth. Readers are invited to submit examples of recent earnings analyses where anyone thought this past history was relevant to the current stock price.

Stocks react dramatically to earnings reports. None of the price changes had anything to do with the factors above. None. No one ever makes a dime from applying these methods in real time.

What did we actually hear?

1. Did earnings meet the Street expectations? How about earnings quality?
2. Did revenues meet expectations?
3. What is the outlook for the upcoming year – with special emphasis on macro concerns like Europe, recession chances, and China.
4. Are there special factors affecting the outlook?

Every major stock move is explained in these terms, or a variant thereof. The ability to understand and answer these questions is the key to investment success.

The Overall Investment Implication

Anyone who thinks objectively about these questions is driven to a rather obvious conclusion about market valuation:

How can a method advertised as a good measure for the overall market fail to explain any of the components?

As corporate earnings move higher and expectations improve, most analysts conclude that the stocks in question are worth more. The market seems to agree.

There is another group of pundits who embrace Tobin's Q, CAPE, and cycles extending farther back than the dead-ball era in baseball. The enthusiasm of their followers approaches cult status. For these analysts the market seems to be in a permanent state of over-valuation. The followers are not investors, but merely spectators. They never get a "buy" signal.

A Better Method

Is there any better method? What if we could somehow create a network of sources that monitored all of the major companies? The sources would have to be professionals whose entire work would be devoted to studying specific companies. None would have to work with more than a few similar companies. These workers would question companies at a level impossible for most of us, challenging the assumptions and outlook, using detailed earnings models.

The sum of their conclusions would represent a comprehensive look at current earnings, revenue, challenges, and the outlook for the next year. Briefly put, it would aggregate all of the things that constitute the focus for each earnings season.

Ben Graham was brilliant. If such information been available to him, he would have found a way to use it. If only there was some way -- somehow – that modern investors could find and use such a source.

Some would probably ignore the information, finding an excuse to validate their predisposition, whether supported by data or not. Those of us who embrace the best data and evaluate everything objectively would have an advantage.

If only we could hire such a work force? How much would it cost?

Where can we find such information? Any ideas? The answer might require some real contrarian thinking.

Weighing the Week Ahead: Market Correction Coming?

Whenever there is a big market move – in either direction – the question arises: Is it too much, too soon? I predicted that this week's focus would be on whether it was time for the individual investor to return to stocks. That was a good forecast ---for about two days!

The media tilt ensued very quickly. Since consumers of financial media are looking for actionable advice, the sources have a tilt toward trading. We all know that markets do not move in a straight line, so any significant move brings out those planning to "sell the rips and buy the dips."

Here are three interesting perspectives:

Correction Ahead

Some of the calls for a correction even emphasize the recent shift in fund flows, reflecting the change in attitude by some individual investors. Here is an example from BofA Merrill Lynch strategist Michael Hartnett, reported by Matthew Boesler of Business Insider.

For Hartnett, this implies a possible correction of 5% over a month or so. The article cites similar forecasts from other Street analysts.

Probable New Highs

Charles Kirk has, as usual, a balanced viewpoint in his weekly chart show. While noting the potential for a correction, Charles expects a test of the old highs first, possibly followed by a completion of the current bullish chart setup. My brief summary is but a shadow of what you get from the weekly chart show. (The Kirk Report requires a small membership charge, and is well worth it).

A Longer View

Taking a longer view, Josh Brown has an excellent post, Ray Dalio Schools You on the Great Rotation Debate. This must-read article explains why the current inflows to stock funds are not merely from bonds and not just from individual investors. Josh has taken the key points from a Dalio interview, helping his readers to see what is really important.

Naturally, I have my own thoughts on this topic and I'll cover those 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 another good week, both for data and for earnings. The most important reports were positive. 

• Year-over-year growth in forward earnings – confirming the trough in Q3 of 2012. Even CNBC got on this theme last week, belatedly following the on-target commentary from Brian Gilmartin. Brian notes that the estimates are still declining a bit, but reflect an increase of nearly 6% over last year. Read the full report for plenty of detail and interpretation that you will not see elsewhere.
• Q4 earnings reports continue to beat on both the top and bottom lines. Bespoke has their typically fine charts, including this one on revenue:

• China is looking better. Or is it? We have been following the dueling PMI indicators for months, with Markit's version usually more pessimistic than the "official" version. Now this has reversed. I am scoring this in favor of Markit, but there is a great analysis by Kate Mackenzie at FT Alphaville and also good commentary at GEI.
• Employment continues to improve, especially when you consider the final revised data. See Phil Izzo's excellent summary of economic opinion. In my monthly preview I explained why you need to look at the final results from state employment data, not just the preliminary estimates. We all know that employment gains trail what is needed for a robust recovery, but there is progress.
• The ISM index notched a significant upside surprise, with solid contributions from the various subcategories. The 53.1 reading is consistent with real GDP growth of 3.4%, according to their research.
• Housing data showed another week of improvement including both construction and Case-Shiller home prices. See Calculated Risk for both themes. The Case-Shiller approach has a three-month average that is not seasonally adjusted. The Calculated Risk chart makes it easier to see the current trend.

The Bad

There was plenty of data, and some of it was negative.

• Initial jobless claims rebounded to 368K after two weeks of dramatic improvement. It is a challenging time for seasonal adjustments.
• Conference Board consumer confidence disappointed at 58.6, down from 66.7 last month. This corresponded to the mid-month decline in the Michigan index. Payroll tax effects?
• The spike in personal income was deceptive according to Dwaine Van Vuuren's analysis. He expects January to decline, reflecting the pulling forward of income because of fiscal cliff fears. Dwaine pays special attention to this indicator since it is part of his NBER recession model (details here).
• Gasoline prices moved higher, continuing the recent trend (via GEI).

• Europe's problems continue. FT.com notes the increase in European business confidence. The Bonddad Blog says that Europe is "Still a Mess" and provides a chart as evidence:

• Employees were surprised by the payroll tax increase. Anecdotal evidence from Tim Duy.
• Q4 GDP had a negative print of -0.1% in the advance estimate. Doug Short and Steven Hansen of Global Economic Intersection call this a "nasty surprise" and provide plenty of charts and data to show some historical perspective. Many felt that the data included a convergence of "one-off" effects and the market shrugged off the news. See (MarketWatch for a summary of points and Econbrowser for Prof. Hamilton's take and more links). Scott Grannis shows why the current economic growth is not enough.

The Ugly

The government threatens our personal rights according to a majority polled by Pew Research. This is a dramatic increase from a decade ago. Most people do not realize how important this is. The U.S. government depends upon confidence and trust, typically most evident among the best educated and most successful citizens. What has happened, and what will be the consequences?

Global Economic Intersection has a good account. Here is one of the charts:

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. Nothing I follow suggests an imminent recession.

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 recently published 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.

New Deal Democrat at the Bonddad Blog has been a bulldog on tracking the ECRI forecast, including the many changing claims.  His latest post refutes the most recent ECRI "telltale charts."  The ECRI seems to have responded, but only to their subscribers.  Eventually we might learn what they said.

The average investor has lost track of this long ago, and that is unfortunate.  The original ECRI claim (and the supporting public data) was 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.  A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings.  That measure remains elevated, so we have less confidence 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 is rather light on data, after last week's deluge. The calendar quirks can do this.

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. Seasonal adjustments have made the results difficult to interpret.
• Trade balance (F). Especially after the GDP report we are interested in both exports and imports, as well as the balance. This report is growing in significance.

The "B List" includes the following:

• Factory orders (M). Too much of a backward look to be a top indicator, but still relevant.
• ISM Services (T). Services are bigger than manufacturing, but this series does not have the history of the more famous index.

It is still the heart of earnings season. These reports will be more important than ever in the absence of major economic news.

Since the FOMC meeting is over (with little excitement), we will have another round of speeches from various Fed participants. I am not expecting much, but traders will be alert for any hints of dissent.

Trading Time Frame

Felix has continued a bullish posture, fully reflected in trading accounts. 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. Felix got back into the market in a timely fashion.  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 rallies, and done so with less risk.

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."

The year is starting much as I predicted in my 2013 preview for Seeking Alpha.  This article covers key investor catalysts, as well as some specific stock and sector ideas.  My recommendations did well last year, and we are off to another good start.  You need to be comfortable in taking the other side of one of the most hated rallies in history.

But please beware!  General ideas are not for everyone.  Each person needs unique treatment.  We have several different approaches, including one that emphasizes dividend stocks with enhanced yield from writing near-term call options.

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

Is there a looming correction? I have four very different thoughts.

1. People are always trying to predict the next short-term market move. While someone is always right, the allegedly great records are either back-tested or focus on a few highlighted calls. Before falling for this I urge readers to check out my post, The Seduction of Market Timing.
2. The fund flow shift has merely started! Those claiming that the individual investor is buying the market top need to look more carefully at the data. We have had nearly $400 billion in outflows from stock funds during the current bull market. The reverse shift so far is less than $20 billion. It is too soon to call this "dumb money."
3. Felix is still positive. It is true that our Felix model does not try to predict corrections, but he is not far behind when things change. Markets that are theoretically overbought can stay that way for some time. There are a few pundits and managers who have been predicting a correction constantly for several years.
4. The facts have changed. It was only a month ago that many (most?) thought we would go over the fiscal cliff, leading to a recession and a crash in corporate earnings. They also thought that the U.S. might default on debt. These things did not happen, nor did we enter a year-end recession. Isn't that worth six percent or so in market value?

Those who set their 2013 price targets before the year-end news need to take a fresh look at the evidence!

And finally, I am sure that there will be a correction during 2013, since there nearly always is – even during the best years. This is part of my message to every new client. For your long-term investments it is important to "right size" your position. If you are "too big," you will get nervous and bail out when the inevitable and normal correction comes.

January 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.  My best analogy was to a bean-counting contest.  The winner was NOT the contestant who was closest to the correct answer.  Instead, the winner had to predict the guess of a fellow contestant.

This is what we do every month.  We want to know the truth about the economy.  Instead of recognizing that there are several good estimates, everyone tries to guess what the BLS will report.

Please read the September preview both for a laugh and a deeper look.

This month I will also do something special. In addition to tips on what to watch for, I will look back at the most recent period for which we have actual data and see who had the best estimate!

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 November.

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.  This is especially important this month since the official survey response date has been moved forward by a week.  This is a routine adjustment for the Thanksgiving holiday, but it increases the potential for error and later revision.
3. There is an adjustment to account for job creation -- much maligned and misunderstood by nearly everyone. Everyone focuses on the birth/death adjustment. This actually accounts for less than 20% of the BLS attempt to estimate job creation.
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 most recent 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. The January report will incorporate these benchmark revisions.

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 192K 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.  In recent months ADP is using an improved methodology with a stronger sample.  The objective is to improve the correlation with the final print of the employment data. 
• TrimTabs looks at income tax withholding data. Their idea is that this is the best current method for determining real job growth.  TrimTabs is forecasting a range of 135- 155K. There was a lot of year-end uncertainty about tax law from the fiscal cliff debate. TrimTabs has wisely taken note of this and reflected the potential effect.
• 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 have improved a lot.  The layoffs catch the headlines, because these are big visible chunks of jobs.  I do not think we have a good grasp on job creation.  The BLS tries hard, but their approach lags on this front. Street estimates are generally similar to my method, but few reveal much about the specific approach.  These estimates usually adjust for the ADP report.
• Briefing.com cites the consensus estimate as 180K, while their own forecast is for 195K.  Their private jobs forecast is about 15-20K higher, since the loss of public jobs is a continuing drag.
• Gallup sees unemployment as essentially unchanged at 7.8% on a non-seasonally adjusted basis.  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.  On a seasonally adjusted basis, their unemployment rate is only 7.3%!

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 will be reflected in the January report, which will show over 350K additional jobs in the benchmark year.

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 among others -- and perhaps not the best.  The bean counter example illustrates this.

Keeping Score and Taking Names

The authoritative scorekeeper is the Business Dynamics Series. This reflects data from state employment offices, so it is an actual count, not a statistical estimate. For the breathless market observers this comes far too late, since it takes about eight months to get the data.

Fair enough. We can still use the information to figure out who made the best predictions at that time. Here we go!

We know from the business dynamics report that in Q212 there were 1.26 million jobs created at new businesses. The reason you do not know that is because it is not reported in the financial media. They focus on the estimates of net job creation, not the actual count of new job creation. It makes a difference.

We also know that the net new private job creation was 582K. How did our contestants do? Here is a summary of the quarterly forecast from each:

	Original Employment Estimates - Q2 2012
	ADP	TrimTabs	Briefing.com	BLS
Apr-12	170000	116000	215000	115000
May-12	133000	124000	150000	69000
Jun-12	176000	75000	100000	80000
Total	479000	315000	465000	264000

Key takeaways?

• All of the estimates were too low.

 

• The much-maligned ADP was the best, and that missed by more than 100K jobs.
• The BLS methods were the worst.

Trading Implications

This week's employment situation report involves special risk. The results are being teed up for a failure.

Since the preliminary Q4 GDP report had a negative print, there is a quest for confirmation. Maria Bartiromo's script seems to require the word "disaster" whenever she mentions the Q4 GDP report. If tomorrow's payroll number is weak, we can expect the recessionistas to be out in force!

Here are some fearless forecasts from the Old Prof:

• Multiple pundits will jump on the benchmark revisions and ask how the BLS "found" another 350K jobs. If you look back at the history of their punditry, these will be the same people who claimed that the BLS was over-stating job growth. They do no review of their own claims.
• Much will be made of seasonal adjustments - - mostly by those who have never produced a dataset that included any seasonal adjusting!
• No one will recognize that the BLS estimate is just that --- an estimate. We already know most of the answer, and it is pretty good.
• Any extreme result will get an exaggerated interpretation. If the job growth were to be 50K, we will have claims that recession is upon us. If the BLS estimate is 300K, we will hear that the Fed is about to tighten rates!

As usual, the number is less important than everyone thinks. So here is the most important point:

The Fed is not doing anything differently based upon the January employment report. Everything that I have written here is completely understood by the FOMC. It will take a series of results to influence Fed policy.

 

The Most Common Error in Stock Market Research

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

My mission in this post is fourfold:

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

The Problem – Selecting the Right Data

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

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

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

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

The Stock Market Comparison

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

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

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

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

An Example

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

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

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

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

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

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

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

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

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

Other Applications

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

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

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

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

Investment Implication

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

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

More to come on this important theme…..

Weighing the Week Ahead: Signs of a New Bull Market?

Have we embarked on a new secular bull market?

Jeff Saut, has been pondering this theme for a few months, specifically watching the Dow Jones Transport Index.  In today's issue of Barron's Jacqueline Doherty picks up the question with this intriguing quotation:

"There's a 25% possibility we're in a new secular bull market, and no one believes it," says Jeffrey Saut, chief investment strategist at Raymond James. Supporting his case: On Dec. 31 and Jan. 2, 90% of stocks traded higher. Such broad-based strength is usually followed by more strength. After two 90%-up days, the market has climbed an additional 6.8% one month later 83% of the time and 12.8% three months later 100% of the time, says Saut.

Doug Short does a monthly update on the trend question, including this comprehensive historical chart:

With the market at a new five-year high, I expect this to attract a lot of attention in the holiday-shortened week.  The earnings stories continue, and (as I noted last week) will help to clarify the prospects for stocks.

I have some thoughts on the bull market question 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 very good week, both for data and for earnings.  The big complaint from some will be that some of the good news was "pulled forward" by the prospects for higher taxes.  The emphasis this week is on the positive, but that is what actually happened.  Over several years I have always sought balance, but I will not distort news to give a false impression.  Things are getting better, and that is something you should know.

• A little optimism on the Congressional negotiations.  Sen. Minority Leader McConnell might reprise his key role from the fiscal cliff compromise.  The GOP also seems to be shifting more to a focus on the budget rather than the debt ceiling.  The deficit issues need attention, of course, but avoiding the brinksmanship of the debt ceiling debate is market friendly.
• Rail traffic has rebounded.  Todd Sullivan provides this chart, along with answers to the key questions you might ask about the decline and the rebound.  (GEI also provides an interesting and detailed analysis).

• Initial jobless claims were much better than expected at 335K.  The Bonddad Blog notes that this is the first time in the range we would see in a normal expansion since the Great Recession.  Most of those commenting are cautious because the seasonal adjustments may be imperfect at this time of year.
• The housing data  -- especially housing starts -- continue to impress.  This could be the big story of 2013.  Calculated Risk was early in spotting the bottoming and the trend change.  Here is the link to the full chart page.  Any serious investor should be following this regularly.
• Retail sales and industrial production were both upside surprises.  See Doug Short's discussion of these indicators and the great charts we have come to expect from him.
• Earnings reports are encouraging.  It is early, but the revenue beat rate (shown below from Bespoke) is off to a good start.  For several quarters the skeptics have maintained that earnings could not be sustained without more revenue, so this meets a specific challenge.  Some of the corporate outlook statements (GE in particular) highlighted improved global conditions.

• The inflation data -- both PPI and CPI -- remained tame, as expected. Many are in a permanent state of denial about inflation data.  Even though the complaints have been proven wrong over the years, the arguments continue.  Cullen Roche, who is himself something of a skeptic about official methods, has a nice survey of alternative approaches with a chart for each.  For full enjoyment, read the comments, especially from the die-hard Shadow Stats adherents.  See also the comprehensive Doug Short version, where this is but one chart.

 

The Bad

The thin data week included a little bad news.  Feel free to add in the comments anything you think I missed!

• The Fed in 2007.  The transcripts from this crucial year have now been released.  Most of the takes relate to the degree of cluelessness of the various FOMC members.  What fun!  Eddy Elfenbein highlights the most interesting meeting from August, along with the famous Cramer video.  Eddy's astute comparison hits the key point.  Cramer had a conclusion based on some information which the Fed was apparently not considering.  Unfortunately, the Cramer rant was not very informative.  Most analysts, including the Fed, were using data on the size of the sub-prime market.  What they did not know was that the banks, apparently including Cramer's contacts, had made bets of many times the size of the market via synthetic CDO's.
• China data is suspect.  Quelle surprise!!  This has been a recurrent theme here, and with other skeptics.  The latest news is from Caterpillar which will need to take a one-time, non-cash charge as a result.  The China GDP news this week was positive, but the CAT story emphasizes why many of us are suspicious about the data.
• Michigan Sentiment declined again.  I take this more seriously than most.  I know and understand the excellent methods.  I have used the series in my own research.  It tells us something about employment and current spending that we might not learn anywhere else.  Doug Short's chart is the best:

The Ugly

Algeria -- on both a human and an economic front.  As I write this there is breaking news that the imminent crisis is over -- very good news.  The events highlight the continuing risks in a world that has grown smaller, with many interconnections.

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) provide 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 this week, 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.

New Deal Democrat at the Bonddad Blog has been a bulldog on tracking the ECRI forecast, including the many changing claims.  His latest post refutes the most recent ECRI "telltale charts."  The ECRI seems to have responded, but only to their subscribers.  Eventually we might learn what they said.

The average investor has lost track of this long ago, and that is unfortunate.  The original ECRI claim and the supporting public data was 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 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.  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.  A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings.  That measure remains elevated, so we have less confidence 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.
• Leading economic indicators (Th).  This is still a favorite for some.

The "B List" includes the following:

• Existing home sales (T).  This is a key element of the economic rebound, so it is important to follow.
• FAFA home prices (W).  These are the prices from the regular homes in the government market.
• New Home sales (F).  Another piece of the housing puzzle.  Will the improvement continue?

Earnings stories will be big, especially the technology announcements -- including Google and Apple.

Trading Time Frame

Felix has continued a bullish posture, now fully reflected in trading accounts. It was a close call for several weeks.  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.

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."

If you are thinking of going it alone, you might want to follow my series of book reviews for individual investors.  If you are not willing to invest the time in reading these books, you should not be making your own decisions!  Here are the first and second installments.

Rather than do a weekly update for investors, let me refer readers to my 2013 preview for Seeking Alpha.  This covers some key investor catalysts, as well as some specific stock and sector ideas.  My recommendations did well last year, and we are off to another good start.  You need to be comfortable in taking the other side of one of the most hated rallies in history.

But please beware!  General ideas are not for everyone.  Each person needs unique treatment.  We have several different approaches, including one that emphasizes dividend stocks with enhanced yield from writing near-term call options.

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

Are we really in a new bull market?

My answer is another question:  Does it matter?

I am a big fan of Doug Short, who accurately notes that the jury is still out on whether this is a new secular bull.  This is rather like how the NBER does recession analysis.  By the time you know, it is too late to be actionable investment advice.

When Obama took office there was immediate market skepticism and instant selling.  His first speeches were greeted with a running DJIA ticker.  His appointments were criticized -- especially Tim Geithner, now seen as especially effective.

Meanwhile, Paul Vigna notes the 72% market gain in Obama's first term.  Those who focused on political pre-dispositions and ideology either lost money, or left plenty of gains on the table.

It is better to be flexible.  Pick the right time frame for your investments.  My current conclusion, subject to change with the data, is as follows:

The next year looks pretty good.  It does not matter whether it is labeled as a new secular bull or a bear market rally.

2013 Investment Preview

[This post originally appeared on Seeking Alpha last week.  I enjoy a wide following there, and I appreciate the opportunity to participate in their annual series.  As I note at the beginning of the interview, this is a very valuable resource.  I share the interview with readers of "A Dash" with the permission of Seeking Alpha.

To read other pieces from Seeking Alpha's Positioning for 2013 series, click here.]

 

Jonathan Liss (JL): Jeff, it's great to have you closing things out again this year. For those readers less familiar with your work, how would you describe your investing style/philosophy?

Jeff Miller (JM): Hi Jonathan. Thanks for inviting me to participate again this year. I am a big fan of your annual “portfolio positioning” series. You have a good range of opinions and sharp questions. It brings out my best, as it does for others.

Our investment style emphasizes active management, a focus on risk, and attention to each client. I have no specific program that locks me into a pre-conceived viewpoint on the market. Like other fixed-fee managers, my financial interests are completely aligned with investors.

I interview each potential client and then create a blend of our six programs – something that meets the risk/reward needs for each. Readers who follow my weekly review/preview series know that I am focused on data and objective indicators. I am resistant to hype and to headlines.

Most investors are too ebullient when everything looks great, as we saw in 2000. They are also easily frightened, especially in the wake of 2008.

My most popular investment program targets an annualized absolute return of 8-9% via selected dividend stocks and selling near-term calls to enhance yield. This is working very well right now, and is a good fit as part of many programs.

JL: As 2013 gets underway, are you generally more bullish or bearish?

JM: This year represents a special opportunity for long-term investors. Nearly everyone should be nudging stock allocations higher. Those who are recently retired need to think about inflation. A reasonable stock allocation is the best inflation fighter.

I have many reasons to be bullish, but the most important is the number and quality of current opportunities. Some of my themes are similar to last year, and I invite readers to check out that article.

I was very accurate on the macro concerns about Europe as well as the highlighted stocks. (The featured collection averaged +25%). Anyone who followed me during the year also benefited from my weekly update on recession forecasting, risk (via the St. Louis Financial Stress Index), and the Fiscal Cliff, where my prediction of the outcome was almost perfect.

Last year’s developments are important for your 2013 question. Despite the favorable developments, many stocks have lagged.

JL: What are the major catalysts for global markets in 2013?

JM: This is a great question! We have a unique situation where the answer is already known, but it is mostly ignored. Many of the popularly cited economic headwinds will become less important.

Let me be quite specific about two types of catalysts:

1. The slow catalyst. This is the one we already know. The fiscal cliff decision is the final piece of the puzzle. All of the following factors will help the economy, and they are all very important:

a. Uncertainty for business --- gone! Businesses were deferring big decisions until after the election and the fiscal cliff. Any remaining issues will be clarified soon.

b. Uncertainty for consumers – gone! They were doing fine until the media blitz telling them that they should be scared witless. This concern has been resolved with the fiscal cliff decision.

c. Housing. Clearly bottoming and improving. Even the slowest-moving indicators are showing a bottom in place. There has been a lot of focus on pent-up supply. Meanwhile, we have a million households of pent-up demand.

d. Auto sales. Booming, with another great year expected.

e. Employment. Improving, especially as the drag from government job losses has slowed.

f. Energy. Good news both on natural gas and new jobs in drilling.

g. Central banks. Aggressive stimulus is now true of the U.S. and Europe. Expect China to join in.

2. The fast catalyst. This one will happen soon, but the time is a bit uncertain. The Fed is on a stated mission to create inflation, targeting 2% and tolerating 2.5% on their favorite measure (core PCE), which runs lower than the CPI.

a. Preamble – The individual investor has been reaching for yield, unwisely using past performance as a guide to future success, and therefore believing that bonds are the best investment for 2013.

b. Dénouement – Investors in bond mutual funds will learn, perhaps for the first time, that these funds can experience absolute losses! I do not know the exact time when this will happen, but when it does, we will have an accelerated chemical reaction.

JL: Which asset classes are you overweight? Which are you underweight? Why?

JM: Asset allocation for my investors is based mostly upon their individual circumstances. With this in mind, the current market offers a better risk/reward profile for stocks over bonds. There are improving real estate opportunities, but these relate dramatically to locality.

JL: To which index or fund do you benchmark your performance?

JM: Each of our programs has a different standard. In our bond ladder, for example, we inform investors about the returns we are currently able to get while staying shorter than seven years and using only investment grade bonds. In our enhanced yield program we target an absolute return of 8-9%. In our trading program we might only equal the market return, but do so with less risk. (We are sometimes out of the market or using inverse ETFs). Our “Great Stocks” program is benchmarked to the S&P 500 since we gain our edge via active management and thematic investing in known names.

JL: There’s a lot of confusion out there regarding the proper use of inverse and leveraged ETFs. As a seasoned portfolio manager, it would be very interesting to know how you use these funds. What are the buy and sell triggers? What sort of holding period is typical? What position size is necessary to offer true downside protection without the risk of significant drag on overall performance?

JM: We use the inverse ETFs as part of our most active trading programs, named “Oscar” and “Felix” to reflect the basic approach of each model. Our use is not designed as a hedge, but as a way to profit in a down market. The holding period varies based upon the market trend. If we were to hit a 2008-type situation, for example, Felix would first go to bonds and gold and eventually to the inverse ETFs. We do not use any leveraged ETFs.

Individual investors need considerable trading skill to use these ETFs successfully. The leveraged versions track the market in short time intervals, but the relationship breaks down with time. If you wanted to emphasize your stock-picking in a neutral market, you could add some portion of the inverse ETFs to your portfolio. You could also use them as a hedge if you had an increase in an objective indicator of risk (like the SLFSI).

Long-term ownership is just like reducing your position size, so it is a drag on performance most of the time.

JL: As we are now a week into 2013, what is your highest conviction pick for the remainder of 2013?

JM: My basic thesis is that the improving economy will clarify where we are in the business cycle – an extended, gradual move from a sharp decline. The market looks very different once you realize that we are only in the third or fourth inning of this recovery. Let me offer a few specific stocks that fit the themes of where we are in the business cycle, as well as other macro influences. I like to move from a general theme, to a sector, and then to specific stock selection.

Caterpillar (CAT) – A great early-cycle stock and one that will benefit from the improvement in China. Costs have been kept under control. If it traded at the PE multiple common for the last decade, it would trade at 130 or so.

AFLAC (AFL) – A conservative way to play the rebound in Europe. It is unloved by many on the Street, leading to an attractive valuation. It has a single-digit multiple with earnings growth of over 14%.

JPMorgan Chase (JPM) – Stumbled this year after the “whale trading” incident. If you think this incident represents an overall failure of control, you might not like the company or the stock. If you are a contrarian, value-oriented investor, your best picks are often flawed in the eyes of many. One aspect of upside: European banks will be disgorging distressed assets under Basel III. Banks with great balance sheets will be able to take advantage. This stock could easily be 65-70 in 2013.

Technology – both PC stocks and Apple (AAPL). Apple will benefit from the expected rebound in consumer confidence. Current prices reflect a multiple in single digits of forward earnings, once you adjust for cash holdings. The PC is not dead. As corporate investment resumes, there will (finally) be the upgrade cycle to Windows 8.

Some of these themes are second-half plays. The challenge will be the first-quarter earnings reports, which will still show weak growth.

Best short ideas include the over-owned sectors:

Bonds – Bond mutual funds are dangerous. Shorting iShares Barclays 20+ Year Treasury Bond ETF (TLT) is a possibility.

Utility stocks are popular as dividend plays. People are buying yield without looking at value. These stocks will trade like 100-year bonds when rates start to rise.

JL: Any consideration of shorting an ETF like the Utilities Select Sector SPDR ETF (XLU) – or is this just a sector you’re avoiding for the time being?

JM: Good question, and thanks for helping me to respond clearly. I think TLT and XLU are over-valued and dangerous holdings, so they are good short ideas. None of our current programs involves shorting stocks or ETFs except via the inverse ETFs, so it is not something that I can implement.

JL: Where have you been having retirees turn for income in this record low rate environment?

JM: We provide income to retirees through our Enhanced Yield program. This combines conservative dividend stocks with yield enhancement via selling short-term calls. The call sales capture the rapid part of the time decay curve and also provide some cushion against market volatility. The program has less risk than merely owning dividend stocks, and works well even in a sideways market.

The most highly touted sources of yield all represent crowded trades. The valuations of many dividend stocks are stretched. Other investments return principal in the guise of income – a trap for the unwary!

JL: Are there any parts of the fixed income space currently offering the prospects of decent ‘total return’ to investors?

JM: I strongly endorse the total return concept. That is the point of “enhancing” yield. Every time I take a deep look at a high-yield investment, I find either a disguised return of principal or hidden risks. You can achieve good total returns by including some stocks in your portfolio – a little octane in the tank, as I often say.

JL: Turning to younger investors, what is the ideal asset allocation for someone with a long-term horizon (greater than a decade) and no need to touch their investments? Can investors continue to rely on stocks for the bulk of their capital appreciation?

JM: There is a special challenge for young people – and a corresponding opportunity. Starting early in saving and investing is crucial. Stocks provide the chance to be a business owner as well as a worker. Those focused on the last ten years have a negative outlook. I suggest that any young person look at a long-term chart of U.S. stock prices. Right now, actual risk is lower, stock prices are more attractive and economic growth is improving.

JL: How bad is the current gridlock in Washington and the uncertainty it breeds for investors? How closely do you watch political developments when formulating an overall investing thesis/asset allocation mix?

JM: Given my background as a former college professor specializing in public policy formation, I embrace these controversies. The recent political issues in Europe and the U.S. are a special opportunity. Most of the coverage of these issues drifts rapidly into opinion instead of analysis. There is little real understanding of how multi-party bargaining works in practice.

Take the term “gridlock.” In the end, for the issues most important to the market there was not really gridlock. A final compromise was reached. It happened at the last minute. It was messy and unloved by all. This was all very predictable and quite typical.

It is a great opportunity for me, and profitable both on Europe issues and the fiscal cliff. But let us look to the future.

The fiscal cliff story was great for the financial media. They want to keep the momentum going. Already there is a new campaign to characterize the deficit negotiations as a “crisis.” You cannot make good headlines by simply reporting the facts: Leaders are posturing before the bargaining even starts. We will not know much for at least another six weeks.

Here is a specific example. I do not believe that defense spending will be slashed through the budget sequestration. However in the next two months you will hear many claims to the contrary. The result is that a number of these stocks are quite attractively priced, including Northrop Grumman (NOC), Lockheed Martin (LMT), and Raytheon (RTN). It is possible that prices will go lower before moving higher, but the time frame is about two months.

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

JM: Gold rallies with fears of hyperinflation or deflation from systemic collapse. Since I do not see near-term prospects for either, I am not enthusiastic about gold.

The only really good method for hedging tail risk is to buy puts or perhaps do a more complex put spread. This is not easy for most investors. I prefer to control for risk by downsizing positions when necessary. Recession forecasting indicators and measures of financial stress are very good for this purpose. I report on these each week in my WTWA series.

JL: Finally, what advice would you give to a ‘do-it-yourself’ investor in the present investing environment?

JM:

• Don’t expect too much. It is not as easy as brokerage commercials make it seem.
• Decide upon a systematic approach that you know will work. If you do not do this, you will bail out the first time something seems to go wrong.
• Control your risk. Do not determine size by what you want to make, but with what you can afford to lose.
• Expect to spend a lot of time on research. If you think you can achieve good results in a couple of hours a week, you will be disappointed.
• Do not get caught up in unquantifiable headline risk and political arguments. Focus on what you expect to happen, not what you think should happen.
• Exploit free resources (like Seeking Alpha) for ideas and information like conference call transcripts, but make your own decisions.
• Be willing to pay for some information. I don’t mean stock tips or those who claim to time the market. I mean data that is well organized and easy to use – something that will save you time and let you work efficiently. For fundamental investors, Chuck Carnevale’s FAST Graphs product is essential. It saves me hours of work.

JL: Is there anything else that an individual investor should be thinking about?

JM: The biggest mistake for most investors is inaction. They may suspect that they should be adjusting their portfolio, but they do not know how to proceed. They might be disorganized, with many different accounts. These investors should make a New Year’s resolution for action. If you are doing nothing, it is cheaper to get some help than to stick in bad investments. Investment managers are used to creating order from chaos!

Thanks again for inviting me to participate. In reviewing my answers I realize that I am taking a contrary viewpoint on many issues. When you are looking for significant investment edge, this is often the result.

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

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

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

Background

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

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

A Year Later

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

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

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

Dr. Dieli explains this quite clearly in this chart.

 

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

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

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

And Now -- The Show

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

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

Conclusion

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

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

Market observers are completely mistaken:

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

These will be the subjects of the next installment.