A Dash of Insight

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.

Weighing the Week Ahead: Are Earnings Expectations Too High?

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

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

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

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

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

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

Background on "Weighing the Week Ahead"

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

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

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

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

Last Week's Data

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

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

The Good

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

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

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

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

The Bad

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

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

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

 

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

The Neutral

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

We need businesses to start hiring more aggressively.

The Ugly

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

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

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

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

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

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

The Indicator Snapshot

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

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

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

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

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

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

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

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

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

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

 

The Week Ahead

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

The "A List" includes the following:

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

The "B List" includes the following:

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

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

Most important is the start of earnings season.

Trading Time Frame

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

Investor Time Frame

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

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

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

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

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

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

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

Final Thought

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

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

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

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

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

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

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

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

Weighing the Week Ahead: Decision Time?

Decision time has arrived!

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

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

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

Some Helpful Distinctions

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

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

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

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

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

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

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

Background on "Weighing the Week Ahead"

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

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

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

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

Last Week's Data

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

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

The Good

The economic news last week was mostly good.

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

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

The Bad

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

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

 

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

The Ugly

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

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

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

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts.  Think of The Lone Ranger.

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

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

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

The Indicator Snapshot

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Week Ahead

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

The "A List" includes the following:

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

The "B" List" includes these entries:

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

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

Trading Time Frame

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

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

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

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

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

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

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

Investor Time Frame

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

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

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

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

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

 

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

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

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

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

Final Thoughts on the Cliff

Why is compromise such a challenge?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Final Thought

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

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

Note to Readers

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

Are you really a chart expert?

When it comes to charts, everyone is an expert -- or so they think!

It can be expensive to be overconfident.  In this post and another on my agenda I will illustrate the problem.  If you get both problems right, you can have confidence in your chart-reading skill.

Tracing a Dangerous Path

One of the most common charts we see compares current circumstances to something that happened in the past.  It often comes as a warning.

My email today provided this example, suggested for consideration by one of my most astute friends.  He is also a very successful investor and market observer.

 

 

So we are tracing the same steps that we did last year, with economic disaster to follow.

But wait --- there's more!

We are following the same path as in the Summer of 2011 and the debt ceiling debate.  Oh my!

My friend did not reveal the source of the charts, but I did not need a hint.  I get similar emails every week.  The charts are all from the same source.  The perpetrators have a wonderful and profitable business model.  They have identified a market of people who want to be Scared Witless (TM euphemism, OldProf).  They love to hear about conspiracies.  They want to have their worst fears confirmed.

My own market is much smaller, but I am proud of the readership.  It consists of people who employ critical thinking when evaluating evidence.  They want to profit from their investments.

Problems with the Chart

Regular readers will have already pounced on the main problem with this chart -- the twisting of scales.  Modern computers and software have created enough charting power to overwhelm the (lack of) skill of the user.  You can now look back in history, adjust the scales from two different time periods, find a brief period that seems similar, and then show a prediction.  Bravo!

You could just as easily find a time period that showed the opposite.

When you read something like this, it is time to turn the page.  I recently awarded The Silver Bullet to Tom Brakke for exposing this kind of deception.

Problems with the Logic

Moving beyond the chart itself, let us suppose that you paused to consider the actual reasoning.  Try to forget the chart and use words instead.  Here is my best effort:

The Citi Economic Surprise Index has moved higher, just as it did last year.  It is tracking last year's move almost tick-for-tick.  We can see the collapse last year.  Ergo, we should expect a series of economic disappointments to start 2013.

It seems pretty foolish when stated that way, but it is the story they are selling.  Please note what the chart does not say:

• This is something that happens every year (not just one time);
• This is something that happens whenever there is a similar negotiation (not just one time).

There are many differences between last year and this year.  Just for starters:

• Election versus non-election year
• Debt ceiling for a temporary change versus long-term policy
• Public preamble and preparation.

But those are only starters.  The basic problem is the following: 

You cannot make valid inferences from one prior case.

Anyone cherry-picking a prior history to do this is selling snakewater.  Beware!

An Alternative Viewpoint

Let us pretend that we did not start with the original chart.

In fact, I did not.  I have often looked at the Citi Surprise Index in the past, but I have not found much predictive value.  If the economy turns positive, the expectations increase.  I have tried but cannot sync it with any meaningful prediction.

Here is one take, from Easynomics:

Keep in mind what is basically happening, as it is usually a cycle.  Expectations rise as a result of improving data, and then it becomes more likely that data will disappoint.  It doesn’t actually mean the data get worse, only that they disappoint versus expectations.  The reverse then happens in order to complete the cycle.  We hope that the downturns don’t go as deep as the upturns go high.

Dr. Ed also follows this index.

 

Conclusion

Good luck in tracking stock prices versus the surprise index.  I do not see a fit, but suggestions are welcome.

There is a lot of irony in the original presentation.  Step back from the charts and think about it.

If the Citi index showed that there were disappointments, that would be the end of the story.  The perma-bear site would simply report that the macro conditions were bad.

Since results have been beating expectations, and you are selling snakewater, there is a problem.  Solution?  If you do enough data mining you can find a time period where beating expectations was actually bearish...  Black is white.  Bad is good.

Let's see -- last year - - wonderful.  One case is enough.

If it does not fit last year, let's go back in time......

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

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

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

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

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

Content

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

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

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

Timing

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

There are four possible deadlines to consider:

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

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

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

Background on "Weighing the Week Ahead"

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

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

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

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

Last Week's Data

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

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

The Good

The economic news last week was mostly good.

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

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

 

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

The Bad

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

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

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

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

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

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

The Ugly

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

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts.  Think of The Lone Ranger.  (I was uncomfortable in even mentioning a bullet this week, but that is going too far.  The Lone Ranger and his trappings are symbols of a better time and place -- one that we do not need to lose).

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

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

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

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

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

The Indicator Snapshot

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Week Ahead

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

The "A List" includes the following:

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

The "B" List" includes these entries:

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

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

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

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

Trading Time Frame

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

Investor Time Frame

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

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

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

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

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

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

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

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

Final Thoughts on the Cliff

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

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

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

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

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

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

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

Investing Implication

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

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

 

November 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.  Two months ago I explained this with 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.

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.
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.

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 118K 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. The idea is that this is the best current method for determining real job growth.  I regularly feature the TrimTabs forecast, but at the time of writing this post they have not yet issued a release.  Their site is here, and perhaps those commenting can help if there is an update.  [Update 12/6:  202K]

• 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, but there was little reaction this week.
• Briefing.com cites the consensus estimate as 90K, while their own forecast is for 80K.  Their private jobs forecast is much  are about 10K higher, since the loss of public jobs is well known.
• Gallup sees unemployment as increasing dramatically  to 7.9% on a 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.  Here is their chart:

Despite this result, Gallup sees net job creation -- yet another illustration of why employment is so difficult to understand.

Failures of Understanding

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

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

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

And most importantly, it would be helpful if anyone would realize that the BLS is just one estimate among others -- and perhaps not the best.  The bean counter example illustrates this.

Trading Implications

This week's employment situation report involves major risk factors:

• There will be effects from Sandy, but these will be difficult to quantify.  The shift in the reporting date will magnify the distortion.
• Post-election skepticism will dominate the analysis.  Any weakness will be seized upon as evidence that the last two reports were artificially inflated.
• Those claiming that a new recession has begun will pounce on any weakness.
• Traders no longer see the Fed as a viable source of support.  We have a new era of good news is good, and bad news is bad.

Conclusion

I expect some temporary weakness from business anticipation of the fiscal cliff and the effects from Sandy.  There is a real danger that the +/- 100K confidence interval could result in a very bad number -- possibly even a negative print.

Despite the various adjustment factors cited here, there would be a huge reaction to a bad number.  When the report comes out, no one will take note of the wide confidence interval, or the fact that the BLS methods have understated job growth in the last year.

As usual, even if the report is surprisingly strong we can expect a spin-induced opportunity to buy.

For traders, it is wise to be cautious and short-leaning.

For investors, there may be a chance to buy at irrational prices.

 

A Bull Market in Bad Predictions

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

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

Recession

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

Fiscal Cliff

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

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

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

Opportunity

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

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

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

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

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

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

 

 

 

Debunking the 100% Recession Chart

Note to readers -- It was either this topic or the fiscal cliff.  Since I have explained for many weeks that we will not be doing any cliff diving, I am choosing to take up the recession chart.  So much misleading commentary, and so little time!

This chart is making the rounds, confirmation bias for those who are convinced that below-trend growth equals a recession.

There are several leading sources pointing to the chart and suggesting that it implies a 100% chance of a recession.  There are so many things wrong with this that I hardly no where to begin.  Here is the commentary from non-economist talk-show guy Lance Roberts:

"As stated above, each time this indicator has signaled the probability of a recession at 20%, or higher, the economy has either been in, or was about to be in, a recession. However, while the indicator is currently at a level that is indicative of a recession, along with a host of other economic indicators confirming the same (LEI Coincident to Lagging Ratio, ADS, GDI, Final Sales, STA Economic Composite, etc.), the NBER will wait to date the recession until the data revisions are in. Historically, as shown in the table below, the amount of time between the recession probability indicator hitting 20% and the NBER confirming the start of the recession has been on average about eight months. However, since the turn of the century that lag has moved to roughly 11.5 months."

Try this.  Suppose that your favorite football team has not lost a game in the last three years in which it has scored 24 points or more.  Then they lose 27-24.   You simply revise the proposition to say that they have never lost when scoring 27 or more points.  This is what many amateurs do in interpreting data like the chart above.

Look at the chart above and pretend that we were going back to the future in 2005.   You could have drawn the line at 15% and said everything that Lance says now.  You would have been completely wrong!

This "never before" style commentary keeps coming up.  It has no solid basis in research methods, but it seems convincing to anyone who has not studied research methods.

A Novel Idea -- Read the Research!  D'oh

Here is a novel idea for the economic bloggers -- count to 10!  Maybe you should actually read the research and consult with the authors before rushing to publish.

If you actually read the cited paper you would see the following points:

1. The authors were trying to improve slightly on the NBER  recession dating process -- getting closer to real time.
2. The authors recommended waiting until a reading of 80% was reached for three consecutive months to avoid excessive false positives.  (P. 9 of the paper).

At a minimum, if you are going to use your bully pulpit on the Internet to scare the daylights out of people, wouldn't it be a good idea to confirm with the authors first?   This is the downside of a world where no confirmation is required before publishing.

Why the Average Investor is Getting Bamboozled -- Again!!

This is interesting research.  My strong recommendation is that interpreting a complex economic paper should involve the opinion of the authors.  I strongly doubt that any of the pundits writing about this could speak coherently for thirty seconds about Markov models.  So why should we listen to them?

I called Prof. Piger this afternoon (voicemail), and I'll try again.  Meanwhile, I am accepting his work at face value.  It is a tiny and preliminary recession warning.  I will be quite surprised if he agrees with the Lance interpretation of his work.

About eighteen months ago I initiated a challenge to the ECRI as the top recession forecaster.  At the time, they were not forecasting a recession, but I was concerned about the methodology.  I invited nominations from everyone, and regularly highlight those with the best records.  (Anyone who has followed my approach has done well in the market over the last eighteen months).

My highly visible search has helped me to discover an expert community  in recession forecasting.  We have regular discussions.  I frequently highlight the excellent articles by these colleagues.

I want to preserve the privacy of these emails, while still giving credit.  To this end let me say that Dwaine Van Vuuren of RecessionAlert, one of my regular featured sources, suggested to me that the published chart does not reflect original data.

That got me thinking, so I checked out Prof. Chauvet's site.  Sure enough, the data from last year shows a spike which apparently was later revised away if you believe Prof Piger's site.

Note the serious discrepancy with Piger.

Here is the supporting data:

Dwaine tells me that this is common with Markov models and revisions.  I hope that he will write on this topic, and that he will gain the wide visibility he deserves.

Investment Conclusion

Today's market was a combination of the following:

1. Investors confusing their politics with their investing;
2. Excessive fear about the fiscal cliff;
3. Excessive fear about Europe; and
4. Those mesmerized by "the chart" discussed here.

When there is excessive fear, it is an opportunity for long-term investors.  If you disagree with the recession forecast, the key choices are cyclical companies and technology -- all on sale via your favorite broker.  Regular readers know that I like CAT, AAPL, and ORCL, and I am buying them all.

I'll try to cover the fiscal cliff issues soon, but you already know my conclusion.

UPDATE -- 11/8/2012 10:30 CST

Both authors of the cited paper have confirmed (via email) the interpretation I explained in this post.  With permission of Prof. Chauvet, I am quoting her email to me:

"Real time probabilities are very noisy, and a little bump of 15%, 20% or even 30% does not mean much in terms of signaling recessions.

Please check the graph on real time probabilities of recession on my site:

https://sites.google.com/site/crefcus/probabilities-of-recession/real-time-probabilities-of-recession

These are the probabilities we get on a month-to-month basis, without data revisions, and without smoothing. As you can see, the probabilities can even be above 50% and a recession does not follow. This is why in my paper with Jeremy we set the rule that the probability would have to be above 80% and for a couple of months before one could call a recession."

Please also read a fine article on this topic by Dwaine Van Vuuren.

 

October 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.  Last month I explained this with 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 predict what the BLS will report.

Please read last month's preview both for a laugh and a deeper look.

Background

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

The Data

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

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

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

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.  This month 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.  News coverage of this has been terrible.  One prominent CNBC anchor suggested that the changes should lead to a closer correlation with tomorrow's unrevised first estimate.  Another suggested that it is a poor time to for them to revise methods, since there are so many conspiracy theorists.  Indeed!  What does it mean when a private company, attempting to provide strong economic information to consumers like us, should pay attention to conspiracy buffs?  This is a change that has been in the works for months.  Should it be delayed?  It is an independent measure that deserves respect.  The revisions noted above moved the BLS closer to the ADP conclusions over the time period cited.  Here is a chart of their data -- mediocre gains, but positive.

• TrimTabs looks at income tax withholding data. The idea is that this is the best current method for determining real job growth. TrimTabs forecasts gains of about 140,000.  TrimTabs thinks that the BLS missed both a spike and employment and a current slowing.  They write as follows:

“We believe the BLS’ survey methodology missed the job-growth pop in August and September,” said Madeline Schnapp, Director of Macroeconomic Research at TrimTabs.  “Worse still, the BLS’ October estimate will likely miss the current slowdown in economic growth.”

• 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 generally follow my method, but few reveal much about the specific approach.  These estimates usually adjust for the ADP report, but there was little reaction this week.
• Briefing.com cites the consensus estimate as 125K, while their own forecast is for 135K.  Their private jobs forecasts are about 10K higher, since the loss of public jobs is well known.
• Gallup sees unemployment as declining dramatically  at only 7.0% on an unadjusted basis and 7.4% on a 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.  Here is their chart:

Failures of Understanding

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

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

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

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

Trading Implications

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

Much of the spinning will center on the unemployment rate.  This has so many moving parts -- discouraged workers, part time workers, demographic changes, overall labor force participation, household versus employer surveys -- that you can make a case for nearly anything if you look at only a single month.

It is pretty clear that employment is improving, but the rate is disappointing.  With the Fed intentions declared, we have left the environment where good news might be bad and bad news might be good -- all because the Fed might be more aggressive.

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

I understand that most traders and pundits are in denial about this (as I explained here), but that just provides a better opportunity for the rest of us.  Meanwhile, I am mildly short in trading accounts, and not very worried about that.

The election is more important than the jobs report, but the two are intertwined right now.  I am quite sure that a strong number will be viewed as negative for Romney and therefore negative for the market.

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

Weighing the Week Ahead: A Three-Day Homestretch

Hurricane Sandy has been uppermost in everyone's concerns.  We have the greatest sympathy for those who have lost loved ones, homes, and businesses.  The effects of weather are often devastating in any setting.  Here in the midwest, it is often a tornado that strikes with little warning.  When a hurricane hits highly-populated areas, the effects are even greater.

One mission of the investment manager is to think about the financial effects and prospects no matter what else is going on.  We now have more clarity about this week's schedule, so I will do my regular preview of the upcoming abbreviated week.

I see this as a three-day homestretch leading to an important inflection point -- next week's theme.  The key elements are the following:

1. Continuing corporate earnings reports, where a mixed story continues;
2. The looming concerns over the fiscal cliff, with increasing prominence and visibility;
3. The election, with potential for significant change.

I'll offer my own take on these themes in the conclusion, but first let us do our regular review of last week's news.

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 earnings reports.  Their schedule for this week has been thrown off, of course, but it is still valuable.

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

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

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

Last Week's Data

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

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

The Good

The economic news last week was mostly positive, including these highlights.

• Obama's Hint.  During the last debate, President Obama basically dismissed the idea that the sequestration of defense funds would be allowed to happen.  This was read in different ways by different observers.  I think the outlines of a compromise are in place no matter who wins.  Here is a good account.
• Forward earnings estimates are still strong.  Brian Gilmartin follows this trend, and also notes that we lack forward revenue estimates -- the latest metric for the skeptic.  Brian is very objective in his reports, and he presents important data and ideas that you do not see elsewhere.
• Economic growth measured by GDP beat expectations.  The 2% increase is certainly not consistent with the gloom of the recessionistas.  Some immediately noted the spike in defense spending (as if the Commander in Chief could orchestrate a big spending push).  Meanwhile, the drought subtracted about 0.4% from the GDP growth.  The defense spending may be uneven, but housing and more normal weather will help.  Scott Grannis notes that there is improvement, but that we are still well below trend.

The Bad

The actual data last week was pretty good, but the stock result was bad.  This happens, and it can be meaningful.  Let us take a closer look.

• The revenue "beat rate" is terrible.   Earnings beats have been mostly in line with expectations, taking advantaged of reduced expectations, as usual.  Those who think that profit margins and cost savings are unsustainable have focused on revenues.  Bespoke's fine chart tells the story:

 

• Pending home sales were disappointing.  I am scoring this as "bad" because that was the market reaction and the general commentary.  Calculated Risk is not as convinced by this particular data point.  Regular readers know that I favor building permits.  Interpreting housing data is a challenge on many levels, partly because of the continuing distressed sales.
• Real income less transfer payments declined.  Doug Short points out that this is more important than the nominal change in real income.  Here is his crucial "big four" chart where he monitors the indicators followed by the NBER in dating recessions.

• GDP growth was disappointing.  (Yes, the opposite of the entry in "the good."  This is the viewpoint of Prof. Hamilton, who is not prone to spinning data to fit an agenda.  Here is his take and a key chart:

The Ugly

Sandy.  Enough said.

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."

Bob and I recently did some videos explaining the recession history.  I am working on a post that will show how to use this method.  Bob and I are meeting again this week to facilitate this.  As I have written for many months, there is no imminent recession concern.  I recently showed the significance of by explaining the relationship to the business cycle.

The ECRI recession call is now over a year old.  Many have forgotten that at the time of the original prediction, the ECRI claimed that the recession was already underway by September of 2011.  See New Deal Democrat's carefully documented discussion, including the original video, at the Bonddad Blog.

RecessionAlert offers a free sample report.  Anyone following them over the last year would have had useful and profitable guidance on the economy.

The most recent news from the ECRI states that they are "Assessing the Current Optimism."  This is apparently available only to paid subscribers, the ones who had early access to the 2011 forecast.

The public will await this report with some interest. Meanwhile, their WLI has turned higher, which everyone following their data sees as good news.  Maybe it is time for them to "predict" that the recession will end within the next few months!

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.  This week we shifted to a bearish position, but it was a pretty close call. These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings have continued to drift lower.  The penalty box percentage measures our confidence in the forecast.  That indicator has moved to the top of the range, indicating little confidence in the current bearish rating.  It has been a close call over the last few weeks.

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

The Week Ahead

This week brings a little economic data.

The "A List" includes the following:

• The employment situation report (F).  This is the big news of the week, especially given the brouhaha over last month's decline in unemployment.  It has now been confirmed that despite Sandy, the report will be released on schedule.
• Initial jobless claims (Th).  Continuing strong interest after the results from the last three weeks.
• The ISM index (F).  An important economic read for most observers.

The "B" List" includes these entries:

• Personal income and spending (M).  Reported on Monday despite Sandy.  Better than expected on spending.
• ADP private sector jobs (Th).  I respect this as an alternative employment methodology.
• Consumer Confidence (Th)).  The Conference Board moved the release because of Sandy.
• Case-Shiller home prices (T).  Released on schedule, and showing improvement.

Most important will be many more earnings reports from a wider variety of sectors.  Some of these reports were delayed from the Monday-Tuesday time frame.  We also will have the Chicago PMI, auto sales data, and some Fed speeches.

Trading Time Frame

Felix has shifted to a bearish posture. It has been a close call for several weeks, but it is now turning more negative.  Felix has done very well this year, becoming more aggressive in a timely fashion, near the start of the summer rally.  Since we only require three buyable sectors, the trading accounts look for the "bull market somewhere" even when the overall picture is neutral.  The ratings have moved lower again this week.  While inverse ETFs have higher ratings than the broad market, everything is in the penalty box.  This means that we continue with no position.  Felix can go short (via the inverse ETFs) if a downtrend continues.

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.  Individual investors too frequently try to imitate traders, guessing whether to be "all in" or "all out."

The traders (including Felix) are getting more cautious for a variety of reasons.  Some are trying to lock in profits to earn their bonuses.  Investors face a completely different problem.

Most people are not very agile in "chasing" a big move.  They instead engage in a sort of wishful thinking that leads to bad decisions.  If a stock declines they wish they had sold.  Instead of treating each day as a new beginning, they watch to see if the stock regains the old price.  Then they sell!  On a logical basis, selling when a company has generated success is probably wrong, but that is psychology at work.  This is part of the reason for not trying to time the market at these inflection points, especially with your entire account.

I'll go into this more deeply next week.

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.  We have a good discussion going on bonds versus funds, and I plan a separate article that will provide a further forum.)

Final Thoughts on the Homestretch

In the last few weeks I have noted that we were entering the season of fear.  There has been a change in tone, with little response to good news.  Stocks have done poorly despite improved economic data.

When the overall earnings story is mixed, we can expect many executives to present a downbeat outlook.  There is little reason to make bold predictions.  Executives can be cautious, citing problems in Europe, China, and Washington.

I see continuing evidence that businesses are cautious while waiting for a resolution to the "fiscal cliff."

In a few days, there will be a lot less uncertainty.  Markets hate uncertainty -- and so do businesses.