A Dash of Insight

Bias in Bernanke Coverage: Does it Matter?

There is a lot of biased news coverage these days.  Some of it its intentional, and some of it is not.

Today's example is the coverage of the Bernanke reappointment hearings.

The Reality

From the perspective of those whose opinion matters, this is a foregone conclusion.  Chairman Bernanke showed real leadership when it was most required.  Under his guidance, the Fed took many creative steps to avoid an economic collapse.

If one looks to objective sources from both parties, the conclusion seems obvious.  Bernanke was appointed by President Bush and reappointed by President Obama.  His support is broad-based and extensive among professional economists.  He will be confirmed.

As is often the case these days Bob McTeer has the strongest analysis. He provides a good case for the Bernanke reappointment.  Anyone wanting a reality check should watch the video here and read the article here.   Since I know that many readers will not click through to the links (although they should) the following captures the gist:

What I don’t understand is why politicians think their deviant behavior is so appealing back home. They apparently don’t have a very high regard for the home folks, especially those in Kentucky and Vermont. My guess is that those folks are better than their Senators give them credit for. Surely blue grass and autumn leaves have some calming effect.

To my way of thinking, Chairman Bernanke (and Secretary Paulson) deserve the highest praise for saving our financial system and avoiding another great depression. I’ve defended Bernanke in blogs, speeches and TV appearances (see previous post). So have wise people like Warren Buffett. But our way of thinking, apparently, is not making any headway.

I heard yesterday that a major poll showed a majority against Bernanke’s reappointment. I guess that shows the power of financial TV and its guests who compete with each other in outrageousness hoping to be invited back.

We got to watch Congress in action.  Hearings provide a platform for those with eccentric views to spout off and get publicity.  Even the most lightweight of Senators gets to have his moment in the sun.

The practical result?  Some Senators have made an issue of the reappointment, placing a "hold" on it.  This means that there will be a real vote, not approval by voice vote.  It is quite possible that the vote for approval will be lower than in past instances, as noted in this WSJ article.

The Fiction

Internet readers got a totally different picture.  At Seeking Alpha, where I am a contributor, the big story was the "Bruising of Bernanke."  (I want to make it clear that Seeking Alpha tries to present a balanced view of stories.  Most likely the articles showing some balance did not come through in time to provide this balance. Mea culpa -- I could have written about this yesterday, but other duties impinged. The editors react to the flow of stories.  Perhaps they will square it up a bit in the future.)

But let us look at the result of the Bernanke bashers, including the writers of the featured stories and a few others.

When you get criticism of an appointment, it is news, but we need to look at the sources and the biases.  For investors, I recommend looking  beyond the salacious stories and focusing on what is really going to happen.  The attack stories get headlines, similar to the media frenzy about Tiger Woods.  It is good for page views, but not really helpful in understanding the reality.  The critics include the following:

Those running for office.  Some commentators have a clear political agenda.  They think that it would have been a wonderful cleansing experience if the Fed were not to have fought the onset of a depression.  It will be interesting to see how this platform plays in front of the electorate.

Those who have a book to push.  Some pundits lay all of our troubles on past Fed mistakes.  Everything they write is colored by support for this viewpoint.  While their followers accept the premise, the verdict of history will be rendered by those with a more objective stance.

Those who have a blog based upon attacking the Fed.  Most of these arguments include rather simplistic and often inaccurate accounts of the Greenspan Fed, now extending to the Bernanke Fed.  There is little effort to distinguish between the actual tools available, and what was needed when confronted with the collapse of Lehman.

Those citing public opinion.  This is very interesting.  The public can name the Three Stooges, but not the three branches of government.  Any time an issue is technical, we expect true leaders to look beyond polls.  Many of those citing public opinion take the other side of the argument when politicians react to polls.  They call it "pandering."  In fact, most officials make some careful distinctions.

The amateur political scientists.  This includes the commentator who has no known experience in actually making public policy decisions who declared Bernanke to be "politically naive."  He is swinging out of his "happy zone" as the Splendid Splinter called it.

And others with a hobby horse.  This includes the "live blogging" on Bernanke at TheStreet.com's Real Money site (usually helpful when focusing on stocks) where some commentators thought that their own personal viewpoints about public policy should be accepted by all.  The assertion that Bernanke was telling lies was particularly offensive.  One should never substitute personal opinion for fact.  The Bernanke testimony is available to all -- subject to objective analysis.

A Credibility Test

When I read those commenting on economics, I employ a simple test which I recommend for readers.  I call it the "Chalk Test."  Economic analysis can be controversial.  The "big minds" can and do differ, but they share certain basic skills.  If you gave them a piece of chalk and asked them to do a simple problem -- a supply and demand curve, and analyze the effect of an excise tax -- they could all do it.  Most of the popular blog writers cannot pass this test.  They write about economics, but they do not know the basic skills.  Their real skill is in dishing out pop concepts to a group of readers who already agree with their conclusions.

This is dangerous for the average investor -- very dangerous. 

Investment Conclusion

The bashers of the Fed have been wrong for a long time.  Essentially, they argued that the Fed was in a box, and would be ineffective in staving off a depression.  They were wrong.

Instead of recognizing the error, they now want to vote out the leadership and change policy to suit their own viewpoint.  They are wrong again, since this will not happen in the case of Bernanke.

Since the Internet audience is not a representative sample (think about the Dewey defeats Truman headline, where the polls had an unrepresentative sample), the flow of stories, augmented by thumbs up, thumbs down, conveys a false impression to the average investor/reader.

Most of the same sources now suggest that the Fed will soon make many other mistakes (beyond my current scope, but more later).

Repeating an important recurring theme at "A Dash", I suggest that investors should be politically agnostic.  It is better to make money regardless of who is in power, than to lose money, or miss opportunity, while complaining about politics.

Employment Report Preview

The market has the regular monthly focus on the employment situation report.  An hour before Friday's opening the data will be announced.  It will be sliced and diced by various experts.  Assorted pundits will be poised to offer comments via email to those in the MSM blogs or anchors on CNBC.

The report has so many different aspects that it is the happy hunting ground for spinners.  For many months it has proved right to be cautious, if only because the bearish spinners seem to get the attention.  We have traded the report from that perspective.  Even when the number was better than expected, it is usually possible to trade out with a modest loss.

Job Creation

One reason for the loss of confidence is the breakdown in the Bureau of Labor Statistics (BLS) model for the birth/death adjustment.  We described this in some detail last month.  Since then we have actual data from state employment reports.

Here is the information from the latest Business Dynamics Report.

 

There are two key things to note:

1. There is still plenty of job creation.  This always occurs, even in a recession, but it is usually ignored by analysts.  Gross job gains were 4.6 million in Q109 at existing establishments and over 1.1 million at new establishments.
2. The difference in job creation and job losses weakened in the post-Lehman era and plummeted in Q109.

This dramatic decline was the cause of the breakdown in the birth/death adjustment.  Readers should note that the BLS estimate still needed to add job creation.  This is in dramatic contrast to the many critics who remain skeptical than any new jobs are formed, despite the actual data count.

The problem is that estimation methods that had worked well for many years, including the turning point at the start if the recession, broke down early this year.  The credit crunch had an effect on new business formation, something greater than in the last recession, as the chart shows.

Employment Report Background

We have urged that market observers should view the BLS report as one of several measures of changes in employment, not as the "official" result.  The BLS method attempts to count every job in the economy in one month, count it again in the next month, and report the difference.  Using this method, the BLS has no choice but to make an estimate about job creation.  Later, they benchmark against known data.

We explained this carefully last month, but it bears repeating:

Each of the sources we cite is attempting to measure the actual net job change.  A wise stat prof once said, "Suppose God whispered into your ear and told you the TRUTH."

The BLS is attempting to do the same thing, with dramatically different methods.  The BLS result is not TRUTH.  It is a statistical estimate.  Actual TRUTH for a specific month will not be known for many months, when the state employment data are analyzed.  The BLS tries to count all of the jobs in one month, all of the jobs in the next month, and then report the difference.  They do this very well, but it is inherently difficult.  It does not focus direclty on the actual changes, as other methods attempt to do.

Meanwhile, the forecasters will all be graded by how well they predicted the BLS number -- the BLS estimate of TRUTH.

That is the wrong attitude.  The BLS number is just another estimate -- and one which will not be official until all of the revisions are in.  Despite this, the market will trade on the preliminary estimate revealed Friday morning.

Our Approach

Each month we ask the question, "What change in payroll employment would be consistent with other economic data from the same time period (the middle of the prior month)?

This is not a forecast, per se, since we do not posit any causal relationship among these variables.  They are all concomitant indicators of economic activity. 

• We use the four-week moving average of initial unemployment claims, culminating in the week of the employment survey.  This is the best direct indicator of new lob losses.  This has improved in the last three months to a loss of 513K.  Note that the most recent dramatic decline to 466K is not within the survey period.

• We look at the University of Michigan sentiment survey, which we found more useful than the Conference Board's sentiment index.  Michigan uses a panel, where some families are carried over from month to month.  This is a good technique.    Sentiment is influenced by employment.  When people have lost jobs, or are worried about losing jobs, it shows up in sentiment.  It is a good concurrent indicator.  The Michigan index is now at 67.4, down significantly from the last two months.

• We us the ISM manufacturing index, which declined to 53.6 from 55.7  This is still quite bullish for the overall economy, but the downtick is bothersome.

Our long-term record has been pretty good, especially when compared to the final revised data.  This makes sense because our model was derived from the final data.  In recent months we have been too bearish.  The BLS benchmark revisions suggest that we have been much better than first thought.

Our estimate is for a net job loss of 175,000.

Other Forecasts

It is always interesting to compare the job forecasts from different sources.  We follow several because of the interesting and widely varying methods they use.  A wise interpretation would be to consider all of  these disparate sources of information.

ADP has proprietary data because of its payroll management business.  ADP sees losses of 169K.

TrimTabs also uses real time data.  Their estimates are based upon tax deposits for salaried employees.  They see a net job loss of 255K.

WANTED Technologies, a relatively new entrant in this field, has a model based upon online help-wanted advertising.  This is an innovative and different approach to real-time data.  They see a net job loss of 155k.

Briefing.com cites the consensus as a loss of 125K and their own forecast is a loss of 150K.

All of these sources are valuable.  The 90% confidence interval on the BLS estimate, something that no mainstream media sources report, is +/- 100K or so.  And that is after revisions and benchmarking.  It is a survey -- a good one -- but it has an error band.

Investment Conclusion

Businesses reduced employment dramatically and swiftly last autumn.  Job creation has lagged.  Employment is an important indicator for politics and for the average citizen.  It continues to be a lagging indicator for investors.

Reacting to News: What to Make of Dubai?

Here at "A Dash" we try to identify the best experts on any subject.  Since we are free to position our clients in any way, we are consumers of news and analysis.  So are you.

While I manage client portfolios in real time, my writing is after hours.  I am not trying to advise people with short-term trading horizons.  Our TCA-ETF approach (still bullish) has a three-week time horizon.  Our program for long-term investors has an even longer time frame.

When I write, it is an honest assessment of my own views and an attempt to find the real authorities.  It is not trading or investment advice.  It is just something you might want to consider.

The Issue

Each night I get the daily report from Charles Kirk, a valuable service for his subscribers.  Charles (who is currently neutral on the market in all time frames) always includes a quotation with his analysis, and today's is especially apt:

"Look at market fluctuations as your
friend rather than your enemy; profit
from folly rather than participate in it."
- Warren Buffett

This is a great statement of the issue.  Is the Dubai reaction the start of something bigger, or an opportunity to "buy a dip?"

The Analytical Viewpoint

At TheStreet.com's Real Money site (subscription required)  Marc Chandler, a source for whom we have great respect, wrote as follows:

We stress again that the current troubles being seen in Dubai are a direct result of its efforts to tie its fortunes to global real estate, tourism and services, and are particularly unique to Dubai and should not have wider implications for sovereign EM risk. The property boom helped this strategy work in the good times, but the popping of the global real estate market has put severe strains on Dubai.

Developments in Dubai should thus be seen in the context of the entire country basically being geared toward real estate development and not in the context of EM sovereign risk and fundamentals. Thus, while the current period of risk-off trading could yet persist, longer-term investors should be looking for buying opportunities in EM during this correction.

We note the careful analysis of the nature of the problem, and how it might be connected to various markets.

The World Leadership Viewpoint

Other sources also provided perspective on this issue.

Banks, world leaders play down Dubai debt threat, from Reuters.  The article quotes leaders from the US, Britain, France and Japan.

The Bearish Viewpoint

Those who have been calling for a market correction see this as the start of something big.

Pimco, with a bearish viewpoint on stocks and now even seeking less risk in bonds, calls it the start of an "overdue correction."

Others, whom we will not name, see this as the first step in the decline of commercial real estate.  Or they say that we should not believe anyone who sees this as "contained" because someone or other said that subprime would be "contained."

The Trading Viewpoint

Barry Ritholtz, despite a continuing bearish tone from most articles, expected a rebound from the overnight bottom and was pretty accurate with his pre-opening call.

Our Take

There is a widespread acceptance that any warning of doom is correct, and every event is proof.  If so, the case against buying stocks is clear.  There will always be something to worry about.

Today's bears did not make a very good case.

I watched the currency trading closely.  The dollar flight to quality ended rather quickly.  The trade-weighted dollar is about where it has been for the last week.  And I am still waiting for someone to show a good link between low treasury rates and the ability to speculate on US stocks.

There were plenty of buys in individual stocks that have nothing to do with Dubai, European banks with big exposure, or even the dollar carry trade.

I don't know if Warren Buffett was buying today, but I was.

A Profitable Pattern

I have noticed a profitable pattern.  I am going to cast this from the bearish perspective, but in theory it could work either way.  I have a few other historical examples, but let us focus on the present.

Background

Investors have many time frames, and so do those managing money.  When you see someone interviewed on CNBC it could be a mutual fund manager, a hedge fund manager, or a trader.  It is natural for everyone to talk his book, but the time frame is relevant.

A mutual fund manager likes to see holding increase, get publicity, and attract new assets.  Having said this, these managers are not likely to sell into rallies.  Instead, new money in their funds gets invested at current prices in current holdings.

A hedge fund manager or trader is different.  Their disclosures warn that they may change opinions and trades in a heartbeat.  They can, and should, do so.  A five percent move in a stock is a major trading profit.

The Process

A portion of the hedge fund community takes a position.  For this example, it is a short in semiconductor stocks.  The position is supported with plenty of reasoning they deem to be rigorous and also by technical analysis.  It is especially desirable to find a situation where a sector has made a big run.  A chart of the SOX tells the story.

I haven't added any lines in this, and readers should ignore the last decline, since that is the end of the story.  The point is that analysts could have a field day with this chart -- before the decline.

Cocking the Hammer

Those establishing a bearish position wish to highlight major concerns.  In this case the "hammer" was the question of double booking of orders.  This occurs when inventories are so low that those building mother boards want to be assured of needed parts.  To do this, the theory holds, they place multiple orders for needed parts in short supply, canceling some orders when their needs are met.

It is an argument that raises a question about the validity of reported orders, and creates fear that the orders will decline.

Pulling the Trigger

One might think that actual evidence of order decline would be necessary to trigger the fear.  That assumption is incorrect.  It is easy to grasp any news as evidence that this prophecy has been fulfilled.

Yesterday the B of A/Merrill analyst downgraded the entire sector.  The resulting report, which I have read carefully, is based upon an inventory model and some assumptions about where we are in the cycle.  It does not specifically refer to any double booking, and the resulting forecasts are still above many other Street observers.  It was a big call, getting a lot of play, and knocking down the stocks by 5 percent or so, as the chart indicates.

Bearish observers incorrectly cited the double booking argument, not actually mentioned in the report.  It talks about a small "overshoot" in inventories, not mentioning any double booking.  It is based upon a theoretical model, without a lot of supporting evidence.  Since few actually read these reports, the inaccurate summaries gain credence.

The Result

Anyone with a short position can cover for a nice trade.  It was a nice setup.  Any downgrade could be cited as evidence.  When the analyst from a big firm downgrades, everyone pays respect, at least in the short term.  That is long enough for traders and hedge fund types.

The Facts

There is plenty of evidence contradicting the double-counting argument:

From iSupplyCorp we have the following:

In their earnings announcements, leading semiconductor suppliers, including Texas Instruments, STMicroelectronics and Intersil, all reported they saw no signs of double-booking during the third quarter, said Ciriello. “This should give the semiconductor industry confidence that the magnitude of the current recovery accurately reflects real demand levels.”

A balanced article at the WSJ mentions the double-booking issue:

Another analyst, FBR Capital's Craig Berger, also cited signs of weakening PC demand, though he said in a note, "We do not want to get overly bearish on the PC space given improving global demand and still-unknown holiday sell-through trends."

Berger said he remains "bullish" on the semiconductor sector. "We think fears of a first half of 2010 estimate cuts from double ordering are overblown, that global supply chain inventories are at or near all-time lows, that global demand trends will continue to recover in 2010." 

Astute tech stock observer Bob Faulkner writes as follows (see the full article for his nice inventory charts and complete analysis):

I've tracked inventory in the electronics-supply chain for years. While it’s too early in earnings season to draw any final conclusions, I think it’s very safe to say that inventory is quite tight on a relative basis.

Steve Ballmer reports that Microsoft sees "fantastic sales" for Windows 7.  If this is accurate, it should stimulate a new cycle of purchases.  More people and businesses replace computers -- especially those who avoided VISTA -- than upgrade existing machines.  The current hardware may not be adequate and is difficult to configure.

Our Take

The trading setup is a real dilemma for managers with a long-run horizon.  It was completely predictable that something -- anything -- would be seized upon as confirmation for the double-booking argument.  There was no need to wait for actual evidence.  Even knowing this, should the manager blow out all of his chip holdings, expecting a pull back of unknown size?

The real answer for those with a longer perspective is to focus on the actual time frame and ignore the bumps in the road.  The traders will make their profits, and eventually the results will tell the story.  It is an opportunity to add to positions for those who disagree with the thesis.

An Interesting Exercise

There was a similar setup -- hammer pulled back -- on car sales after the Cash for Clunkers expired.  Perhaps this is a good topic for an example where we now have more evidence -- an immediate decline, followed by a restoration in sales.

I invite other examples -- both long and short -- from readers.  Look for the setup -- what we all should watch for-- and then look for evidence.

Our position:  Long INTC, MSFT, and AAPL.

Specific Expertise: Insisting on the Best Information

Here at "A Dash" we have emphasized that we are all consumers.  We are consumers of data, of analysis, and of opinion.  Our principal mission is helping readers understand their role as consumers and figure out what sources and information to follow.

Background

Here are two widely-accepted findings to consider.  Both have strong support from empirical evidence on market returns.

1. Stock analyst ratings often lag, so the wise contrarian investor fades the consensus opinion.
2. Chasing performance is a major source of losses.  Those who "called the last move" are often the mean-reverting cases.  One needs to look at long-term performance.

These precepts are widely accepted in the investing community.  (I will add that both are part of my own approach to stock-picking, with a nice long-term return.)

Meredith Whitney

Yesterday afternoon CNBC indicated that Meredith Whitney would be featured on Maria Bartiromo's program.  Regular readers know that we are big fans of Maria.  We think that she asks the right questions and draws out interesting answers from high-profile guests.  Many market participants guessed at the nature of the interview and sold the market before and during her interview.

You can check out the key points of the Whitney interview here.

Our Take

Meredith Whitney, in her prior role as bank analyst with Oppenheimer, did one thing well --- very well.  She accurately predicted that banks would need to write down assets.  She accurately predicted that there would be no FAS 157 relief on mark-to-market accounting, so there would be a death spiral of bank value declines.  Those following her predictions made significant profits and/or avoided losses.

Since starting her own firm, Whitney has expanded her universe of predictions.  She is now making forecasts about the economy, the housing market, and consumer behavior.  (I regularly read her work via my helpful Oppenheimer rep when she worked there, but now I get the information along with everyone else).

It is quite fair to question Whitney's skill at economic forecasting.  Her success related to analyzing bank holdings, not forecasting the economy.  Personally, I prefer a different approach to economic forecasting, and so should you.

Her current bearishness is grounded in valuation -- financial stocks should return to tangible book value.  When asked what would make her bullish, she responded in valuation terms, giving the example of BAC at 3.  She does not believe that banks have sound core earnings, despite an attractive yield curve.

Others have commented on Whitney's bearishness, with varying conclusions.  Quite frankly, most of them use the wrong criterion.  They talk about how well she has predicted the market -- either last year, or this year, or both.  This is a very small universe for inference, dependent on a couple of key conclusions in each case.  The circumstance this year, including marking assets to market, are quite different from last year.  Whether or not one agrees with government policy, the various arms of our Federal government are all on a concerted mission.

A More General Conclusion

We are all bombarded each day with fresh opinions about our investments.  These are now taking the form of the CEO interview.  I modestly suggest the following guidelines:

• CEO's are great at discussing their current business;
• CEO's are sometimes helpful in discussing what is in their pipeline (analyze this skeptically and carefully);
• CEO's have no added advantage when offering opinions about the future of the economy, beyond what they see in their own business.  They are reading and analyzing the same news that we are.

Readers might enjoy revisiting our Ted Williams strike zone article --- emphasizing the importance of staying in your "happy zone."

[I am long GS in personal and client accounts and hold a small BAC position as well.  I am slightly long in trading accounts and remain fully invested in long-term accounts.]

Dollar Weakness and Stock Market Strength -- the Data

Anyone who is following the market on a daily basis is paying attention to the strength of the dollar versus other currencies.  It can be confusing.  While a strong dollar might seem like a good thing, there is actually an inverse market relationship with stocks -- at least in recent times.

I described the basics of the dollar debate here:  Understanding the Debate on the Dollar.  There are many opinions -- prescriptive, political, and descriptive.  The next step is to consider some data.

Dollar Strength and U.S. Equity Market Returns

In my last article I highlighted the inverse relationship between a strong dollar and the stock market.  This chart provides a dramatic illustration of the relationship for calendar 2009.

 
Sometimes a chart tells the story in a glance, but I always like to look at data as well.  I used the Fed's measure of the dollar versus a broad basket of currencies, weighted by trade.  The series started in 1995.

The correlation for this year is an almost perfect negative relationship:   -.96.

A negative relationship sometimes stands out even more if you invert one of the scales.  Here is that chart.

The data are the same, but the tight relationship is especially clear using the inverted scale.

So much for what we know.  An obvious question for investors in stocks is what would happen if the dollar gets stronger.  Perhaps we should look at more data.

A Longer Perspective

Some believe that a strong dollar is consistent with economic growth and a strong stock market.  To examine this concept, we need to consider more data.

If we look at the full data series, we see long periods where dollar strength was consistent with a rising stock market.  In fact, the correlation between the two series is a positive value:  .35.

For an objective analyst of data, the chart suggests three conclusions:

1. The relationship changes over time;
2. The last year is quite atypical;
3. There are other important variables at work.

The Carry Trade

The prevailing hypothesis about the dollar/stock relationship is the "carry trade."  Supposedly there are investors/companies/speculators who are able to borrow in dollars at a very low interest rate.  This makes the dollar the "funding currency."  Most outspoken on this subject is Nouriel Roubini, who sees disaster ahead.  [Full disclosure -- I am a contributor at Nouriel's valuable site.  I respect and appreciate his encouragement of alternative viewpoints.]

The borrowers do not then do the obvious -- lend in another currency, hedging the difference with a forex trade.  Instead they supposedly use the borrowed funds to engage in a variety of speculative trades -- emerging markets, real estate, and, of course, US stocks.

Following this logic, there is now a speculative bubble of major proportions.  This seems implausible.

My skepticism comes partly from the lack of any real data supporting this viewpoint, and partly from the daily trading.  If you really had this trade on, would you really take it off if the dollar moved by 0.4%?  The carry trade hypothesis does not explain the closely calibrated trade between the dollar and stocks, but we see this every day.

For now, let us stick to conclusions supported by data.  There is a strong inverse relationship.  If you are a trader, you had better pay attention.  If you are a long-term investor, you need to understand the long-term relationship.

Meanwhile, I invite reader comments, citations for new data, and fresh hypotheses.  I will pursue this for at least one more article, considering various causal models.

Understanding the Debate on the Dollar

A strong dollar seems patriotic.  It is also meaningful to long-term purchasing power.  Weaker dollars mean a higher cost for foreign products, and that is inflationary for the US consumer.

This natural impulse is at odds with current equity trading.  A friend asked why the market had 200+ rally in the DJIA on Monday.  My answer -- dollar weakness-- was counter-intuitive and unsatisfying, but accurate. 

Dollar's Drop Helps Dow Hit New 2009 High, explained Briefing.com.

Today the Dow declined 100 points.  Why?  Many cited dollar strength.

Investors and traders alike need to pay attention to the dollar.

The Prescriptive Viewpoint

Some commentators who choose to advise the government on preferred policy are outspoken on both the need for dollar strength and the policies required.  David Merkel calls for the Fed to raise interest rates and the Obama Administration to balance the budget.  The prescription embraces a willingness, perhaps even a necessity, for the recession to become much deeper.  The resulting unemployment and business failures are part of a needed cleansing process that will avert an inevitable deeper economic decline.  This viewpoint is based upon economic theory, not a political viewpoint.

Others seem to advocate similar views with politics in mind.  You can watch any nightly Kudlow show to get this argument about "king dollar."

A third viewpoint, represented by Bob McTeer, suggests an alternative.  McTeer is a free-market Republican, but he has a pragmatic approach.  He recognizes the need for dollar strength in the long run, but notes a short-term problem.

So, my conclusion is there is a strong argument to be made for a strong currency. It just doesn’t apply in the midst of a deep recession when the main problem is inadequate aggregate demand. Many people who don’t acknowledge that are, in my opinion, trying to avoid sounding “Keynesian.”

I’ve said this many times before. My position on a strong dollar is similar to St.Augustine’s position on chastity in his famous prayer: “Lord, make me chaste, but not just yet.” My prayer is, “Lord give us a strong dollar, but not just yet.”

His reason?  No individual country can control the currency.  All act in accord with internal political mandates.

The positive jolt to domestic GDP caused by a depreciating home currency is well known all over the world. That is why during a global slump such as we are in today we have to guard against competitive devaluations where each country tries to boost its economy through depreciation or devaluation which has the opposite effect on its trading partners. The term of art is “beggar thy neighbor” policies, sometimes called “beggar my neighbor” policies.

The Descriptive Perspective.

David Merkel and other observers are quite correct in noting the divergence between stated and actual public policy.  Investors need to understand this.

There is an inverse relationship between the dollar and equity strength.  There are several hypotheses (and little evidence) to explain the daily trading.

Investment Implication

There is more here than I can cover in a single piece, so I will take a deeper look.  We need to investigate the dollar carry trade, the alternative causal models in the relationships, and the time frames for the various arguments.  There may not be enough data for an objective answer, but I will give it a shot.

Meanwhile, investors should realize that actual policy is aimed at improving economic performance, even if the dollar declines.  If you are an investor, put aside your opinion about whether the policy is correct.

October Employment Report Preview

The monthly employment situation report is the most watched economic release.  The attention has never been greater.

• Everyone is interested in the unemployment rate, especially when it is approaching 10%.  It is a natural topic for the media.
• Partisan politics has a jobs focus.  While the Obama Administration may be claiming jobs "created or saved," this is of little interest to most.  The bottom line for most voters will be whether the net job change turns positive and the unemployment rate declines.  Few care about hypothetical results.
• Investors and traders question the economic recovery, despite improving data.  As long as unemployment remains high, people will question the economic recovery as artificial and temporary.

The massive attention is no surprise.

Lack of Timely Data

Most casual observers take the reports at face value.  Those watching closely understand the challenges in trying to do contemporaneous estimates of employment changes.  This is not like an election, where we can have a "polling place" to determine who is working and who is not.

We actually have excellent employment data, a hard count from state employment agencies.  The problem is that it takes six to nine months to get the solid results.  I wrote about this three years ago in my article, Data We Have vs Data We Need.

Real-Time Measurements

I am going to repeat a careful explanation that I suggested two months ago.  There are many sources trying to measure monthly employment changes.  Eventually the state data will show who was right.

Each of the sources we cite is attempting to measure the actual net job change.  A wise stat prof once said, "Suppose God whispered into your ear and told you the TRUTH."

The BLS is attempting to do the same thing, with dramatically different methods.  The BLS result is not TRUTH.  It is a statistical estimate.  Actual TRUTH for a specific month will not be known for many months, when the state employment data are analyzed.  The BLS tries to count all of the jobs in one month, all of the jobs in the next month, and then report the difference.  They do this very well, but it is inherently difficult.  It does not focus directly on the actual changes, as other methods attempt to do.

Meanwhile, the forecasters will all be graded by how well they predicted the BLS number -- the BLS estimate of TRUTH.

That is the wrong attitude.  The BLS number is just another estimate -- and one which will not be official until all of the revisions are in.  Despite this, the market will trade on the preliminary estimate revealed Friday morning.

Briefly put, everyone is trying to estimate monthly changes in a work force of over 130 million.  The error band is small.  The BLS -- and all of the other sources -- are doing a great job with various differing approaches.

Market participants would like to have more data, faster data, more accurate data.

It is my long-held position that too much emphasis is placed upon the BLS estimate as "official."  The BLS does excellent and honest work, but other approaches deserve attention.

Few observers understand the nature and sources of error in the BLS estimate.  Pundits routinely draw major conclusions from discrepancies of 50,000 jobs, when the sampling error alone is +/- 100,000+ jobs.  And this does not include assorted non-sampling problems, like dealing with new job creation.

The BLS versus the Critics

The BLS approach is to make an estimate of the total payroll jobs in one month, make another estimate for the next month, and subtract the two to determine the change.  They use an excellent and sophisticated survey technique to do this.  Their historical record, judged by the eventual count from the states, has been very good -- until quite recently.

Some readers have asked me why the BLS even attempts to include job creation in their estimates, using their much-maligned Birth/Death adjustment.  I will attempt the simplest possible explanation.

Any time you do a survey, there will be non-respondents.  When the question is something like "How many people favor health care with a public option?" the non-respondent problem takes a simple form.  You need only ask whether the non-respondents are similar to those who actually answered.  Most polls make this assumption.

The employment question is qualitatively different.  We are not asking the opinions of non-respondents.  We are asking whether they are even still in business.  If the BLS were to assume that non-respondents had all ceased operations, they would seriously underestimate total employment.  Historical data conclusively show that the non-respondents are split between those who did not answer and those who are out of business.  The data also show that new job creation, running at about 2 million jobs per month even in recessions, are a predictable function of dying businesses.

Because of this, the BLS employs a two-step process.  The imputation step forecasts job creation from job destruction, and includes a cyclical component..  The Birth/Death adjustment, (the only thing cited by most critics, who ignore the more important imputation step), is a residual.  For many years this residual was stable.  The most recent test against the state data indicated a significant error, showing that the BLS estimates have been wrong for nearly a year, especially starting in Q1 09.

Were the Critics Correct?

The BLS critics do not look at the ultimate scorecard, the state data.  I expect that most of them will "claim victory" in their criticisms, even though they never looked at the many years when they were wrong and the BLS was right.  We should note the following:

• There was no intentional distortion of data or results, dictated by whomever was President, as many allege.
• The method worked well for more than five years, as measured by the final data.
• The breakdown did not come at a "turning point" as many suggested it would.  That would have happened at the end of 2007.
• The breakdown did not occur because the model worked in expansion and not in recession.  The big divergence happened in the first quarter of this  year.  The big job losses right after the Lehman downfall were not that far from the truth.  Job creation seemed to stall a few months after the major credit contraction in September, 2008.

The actual breakdown in the BLS method happened one full quarter after the biggest job losses in many years.  It means that job creation was seriously impaired from January to March of this year.  At the moment, this is all we really know from hard data.

There may be some critic who predicted the timing of this breakdown, but I have not seen one -- and I follow this carefully.  Whether or not the long-term BLS relationships resume the multi-year pattern is yet to be determined.

To repeat my main theme --- there are several methods of estimating the monthly job change.  No one has a monopoly on the truth.  I invite reader comment on this point.  Any critic who actually looked at the state data, acknowledged the BLS when it was accurate, and forecast when their model would break down deserves some recognition.

Our Approach

Each month we ask the question, "What change in payroll employment would be consistent with other economic data from the same time period (the middle of the prior month)?

This is not a forecast, per se, since we do not posit any causal relationship among these variables.  They are all concomitant indicators of economic activity. 

• We use the four-week moving average of initial unemployment claims, culminating in the week of the employment survey.  This is the best direct indicator of new lob losses.  This has improved in the last two months to a loss of 532K

• We look at the University of Michigan sentiment survey, which we found more useful than the Conference Board's sentiment index.  Michigan uses a panel, where some families are carried over from month to month.  This is a good technique.    Sentiment is influenced by employment.  When people have lost jobs, or are worried about losing jobs, it shows up in sentiment.  It is a good concurrent indicator.  The Michigan index is now at 70.6, about the same as last month.

• We us the ISM manufacturing index, which showed improvement from 52.6 to 55.7  This is solid expansion in the manufacturing sector, it is quite bullish for the overall economy.  The ISM's research shows that this rating, if annualized, corresponds to a 4.5% increase in GDP, better than the preliminary report for the 3rd quarter, and occurring after the cash for clunkers and homeowner stimulus boosts.

Our long-term record has been pretty good, especially when compared to the final revised data.  This makes sense because our model was derived from the final data.  In recent months we have been too bearish.  The BLS benchmark revisions suggest that we have been much better than first thought.

This Month's Prediction

Our indicators suggest a net job loss of about 140,000, a little better than the Street estimates of -175K.

Our estimate reflects two contradictory forces.  The initial claims are still elevated, not indicating economic expansion.  The ISM data are strongly positive.  Our forecast suggests that we are still a few months away from real job growth.  We need to see lower unemployment claims before there will be net job gains.

Other Forecasts

It is always interesting to compare the job forecasts from different sources.  We follow several because of the interesting and widely varying methods they use.  A wise interpretation would be to consider all of  these disparate sources of information.

ADP has proprietary data because of its payroll management business.  ADP sees losses of 203K.

TrimTabs also uses real time data.  Their estimates are based upon tax deposits for salaried employees.  They see a net job loss of 284K.

WANTED Technologies, a relatively new entrant in this field, has a model based upon online help-wanted advertising.  This is an innovative and different approach to real-time data.  They see a net job loss of 224k.

Conclusion

While we are (for a change) less bearish than other forecasters this month, we do not see it as the basis for a change in our trading outlook.  We expect the usual full assault on the integrity and methods of the BLS, with the spinmeisters out in full force.  The short-term risk/reward still leans to the short side.

Has the Market Already Made the High for the Year?

Market followers love to make timing predictions.  They come in all time frames and flavors:

• The market has made the high for the day, and will now trade down.  Or the opposite.
• This is the bottom.  Or the top.
• We have seen the highs (or lows) for the year.
• Or when the Dow was at 9500, would we see 10000 before 9000?

Bold Predictions

Doug Kass, on August 26th, called the high.  He was off by a few weeks and a few percentage points, but he has continued to argue for this viewpoint in columns at TheStreet.com and in appearances on CNBC.

His colleague Jim Cramer has now agreed, and recommends reducing portfolios.

James Altucher sees explosive potential, after reviewing a list of inaccurate bearish predictions, writes as follows:

The economy is recovering nicely, says Altucher, and 2010 is going to be a huge year.  Companies that stopped making things and fired thousands of employees last winter out of fear of a second Great Depression will restock their shelves and start hiring like mad. The federal stimulus, which has barely kicked in yet, will really get cranking. Consumers will find jobs much easier to get, and the resulting optimism (and income) will prompt them to start spending again.

And the market?

It's going to the moon, says Altucher.

Ken Fisher is looking for a 20-25% gain "by January" which is not quite the end of the year.  Fisher earns one of the highest ratings from CXO Advisory, one of our featured sites.

Less Bold Predictions

Barry Ritholtz on October 27th predicted a possible 5% to 15% correction, after leaning bullish for much of the year.

Our own official predictions, recorded weekly, were correctly bullish through September, but shifted to neutral two weeks ago.  We use a three-week time horizon for this forecast.

What Does it All Mean?

It all depends upon one's time frame.  Are you trying to trade the market intra-day?  Are you using a one-month time horizon?  Do you have the long run in mind?

Each investor is different -- different in risk tolerance, time to retirement, time to a need for college funds, mix of asset allocation.  It is not all about market timing.

In my conversations I find that most investors are missing the big picture.  Peter Lynch (with the Dow at 4000 or so) famously noted that he could not predict the next 1000 point move, but he was confident of the next 10,000 points.

I agree, and here is the main problem:

Most investors are still responding to fear.

The current fear dates from last year, causing most to miss the market rebound.  Now many feel that they have "missed the move" and what they read reinforces the fear.

Here are some thoughts that I am sharing with my own clients:

• My initial target for this year was the pre-Lehman level from last fall.  We have not yet reached this target, but we will.  We have averted the Great Depression that the market was forecasting at that time.
• There are many attractive stocks.  I am selling some holdings only because there are others that offer even better chances.  Try to focus on specific company chances instead of general market commentary.
• The analysis of economic prospects is polluted by political punditry.  Many commentators have a vested interest in a certain political outcome.  Others are trying to sell books or high commission products.  It is a minefield for the general and inexperienced reader.
• Economic data continues to improve, despite a well-orchestrated chorus of critics.
• The stimulus efforts have worked, and there is plenty more in the pipeline.  Most of the pop economists have the viewpoint that the stimulus will stop and the economy will fail.

Reactions on the Economy

Stimulus efforts may jump start a real move.  Check out today's auto sales data, after the cash for clunkers initiative, and you will see a real improvement -- small, but a start, not a bubble.

1. Most of the stimulus funds are still in the pipeline.
2. The Obama Administration is committed to keeping this going until it works, including things like the incentives for home buyers.
3. The major complaints -- deficit spending -- are in a different time frame.
4. Watch Warren Buffett, who made the deal of his lifetime buying a railroad today.

It is a time to separate one's political viewpoint from one's investment viewpoint.  Those who are fighting the Fed, fighting Obama, and fighting Congress are spitting into the wind.

Understanding Market Volatility

Investors and traders alike need to understand market volatility.  Many market observers use volatility as a euphemism for price declines.  This is completely wrong.

The astute options analyst Adam Warner (one of our featured sources), does a great job with this concept.  Writing about the Market Vectors Gold Miners (GDX), he makes this important point:

Volatility is about fear of the unknown, and so long as gold and currencies get out of range a bit, there's apparently a bit of fear around of either missing another leg up or missing an about face down. (emphasis added)

A Natural Human Trait

Accepted lore is that markets hate uncertainty.  It is a normal human trait, one that is manifested in collective behavior as well.  Here is a simple example.

Airline passengers are quite sensitive to the unusual.  I was thinking about this on my trip this week to the West Coast.  (I always expect to post an article or two on these business trips, but usually fail.  Sorry!)  My seatmates on both flights had a lot to say about the pilots who somehow missed their destination, flying 150 miles past the airport and losing contact with air traffic control for more than an hour.  Everyone I talked to was confident that the pilots dozed off, and dismissed other explanations.

I fly on United and enjoy the flight deck feed on Channel 9, the conversation with ATC and the towers.  The Wall Street Journal cited the calming effect of this feature:

Many passengers take comfort in the back and forth between pilots and air-traffic control. Mr. Ohnstad, a technology project manager in the banking industry, says he sometimes worries about noises and jolts while in flight. "But I hear the pilot's calm voice telling ATC that 'We're experiencing continuous light chop,' and I can relax more," he said. "It's fear of the unknown that causes apprehension. Pilots can't update you every 30 seconds."

Personally, I have often enjoyed specific benefits from the flight deck commentary--often warning that choppy skies are ahead.  The funniest case was when we were parked at O'Hare waiting for a gate and the pilot asked for a small move to a new parking spot.  His passengers were getting restless!  I was one of the few to know the secret.

Anyone who flies often will enjoy the excellent blog from Captain Dave, who provides inside information from the perspective of the pilot, including an insightful treatment of the recent incident.

Applying the Lesson to the Market

When following the market, an explanation of each day's trading can be a calming influence, just like communication from the pilot.

The problem?  The explanations are all different and generally lack any evidence.  Here are today's candidates.

Business Week explained as follows:

U.S. stocks closed sharply and broadly lower Friday, led by financial issues, as disappointing reports on personal spending and consumer confidence stoked investors' concerns about the economy. Treasuries jumped as stocks skidded.

MarketBeat had a similar take:

For months, investors have worried that the recovery of both the economy and the stock market had more to do with heavy government stimulus than with fundamental economic improvement. Now those fears are raising their heads again.

The concerns sent stocks down sharply back on Wednesday, but seemed to dissipate Thursday, as a stronger-than-expected government estimate of third-quarter economic growth helped stocks erase the week’s losses in a single day. Today, weak reports on consumer spending and consumer sentiment have put the bears in the driver’s seat again.

Briefing.com has a very different viewpoint:

There wasn't any immediate cause for this session's decline, though some market watchers point out that stocks have had an increasingly difficult time of climbing higher since making their strong runs in recent months. Others have pointed out that there may be some month-end portfolio rebalancing and window dressing accounting for the recent whipsaw trade.

Nonetheless, the concerted selling effort brought about a spike in volatility. That sent the Volatility Index, often dubbed the Fear Gauge, up 24%, which marks its sharpest single-session spike by percent this year. Moreover, the VIX now stands at its highest level since July. Complementing the spike in the VIX is an elevated put-to-call ratio of 1.2, which is indicative of positioning for downside protection.

Art Cashin, a great reporter of floor sentiment, emphasizes the relationship between stocks and the dollar.  He notes that there is a high correlation -- weak dollar, stronger stocks.  He believes there is great risk in a dollar spike.  The CNBC interviewer pushes him hard on the nature of this relationship, suggesting that both the dollar and stocks are reacting to a change in appetite for risk.  Watch the video, beginning at 3:21.

Our Take

The question to Cashin was a good one.  It is what is called a "spurious" relationship.  Two variables are highly correlated.  Observers, in this case the NYSE floor traders, infer causation.

Here is an example I used in class.  You have a person in the middle of a traffic intersection with a stoplight.  When the light turns green in a given direction, he waves the traffic to go through.  The actions of the guy doing the waving are perfectly correlated with the traffic movement, but there is no causation.

Now let us suppose that the traffic light is out, and the person in the middle is wearing a police uniform.  The inference of causation is quite different.

Proving causation requires more than showing a correlation.  It requires solid evidence of timing, one variable leading another, and also a strong hypothesis about the logic of causation.  It is also useful to have statistical controls.  Art Cashin is on target when it comes to the floor trader attitudes, but they might all be fooled by a spurious relationship.

Meanwhile, there is plenty of evidence that the market is currently trading on perceptions of economic strength.  It is quite possible that we could see a stronger economy, a stronger dollar, and stronger stocks.  Or the opposite.

This explanation may not be comforting to investors, but at least it suggests what to watch.  That remains our focus.