A Dash of Insight

Stock Prices and the Fundamentals: Don't be Fooled

As stock prices made new highs this week, a frequent media theme was that this was happening --- drum roll!!!! ----   in spite of the fundamentals.

If you listened to the accompanying discussion, you eventually learned what was meant by "fundamentals."  For many observers it is some kind of unquantifiable headline risk.  As long as there is something to worry about, something to call a "headwind," then this viewpoint means that "the fundamentals are bad."  The parade of pundits warns that you should make sure that all of these risks have been resolved before investing. Don't hold your breath waiting for that!

The big reason that traders are missing the rally is that they mis-define "fundamentals."

Comparing to the 2008 Highs

I lost count of the stories saying that we were back to the 2008 highs. Danger! The idea seems to be that we all remember what happened then, so watch out!  We also have triple tops and the like.  (Whatever happened to the Death Cross and the Hindenberg Omen?)

So I did some checking.

May of 2008. Forward earnings on the S&P 500 then were 93.77, the ten-year yield was 3.9% and the odds of a recession -- according to the best method -- were nearly 100%

Now. Forward earnings are 108, the ten-year yield is 1.59% and the recession odds for the next year are below 10%.

People talk about headlines and sling around phrases like Draghi put, printing money, etc., instead of
analyzing data. The world is a much better place for investing than it was in 2008.

(This is not a political blog, and the comparison to four years ago relates to the market, not the election cycle.  I am well aware that the mileage has varied for many people.  Most folks do not have significant stock holdings.  At "A Dash" we aim to engage in successful investing no matter who is in power).

The Failure of Static Analysis

The bogus fundamentals of the "headwinds pundits" never change.  They can always complain that there is too much debt and too much government.

They are basically in denial about the power of government and central banks.  Put aside your political viewpoint.  Go ahead and cheer when Rick Santelli tells you that this is all a "sugar high" but put emotions aside when investing.

Meanwhile, Rick is not a candidate to get on the FOMC -- nor is Ron Paul.  Furthermore, if Romney is elected we will see someone who shares the Bernanke philosophy.  But that is a subject for another day.

Your assessment of the fundamentals should change with events, represented by actual data!

If you do not have your head in the sand, you are watching the events in Europe.  On Thursday, the Spanish 10-year yield is down to 6.02%, down 59 bps. This is important for the ability to refinance debt, and much lower than the touted "danger zone" of 7%.  On Friday, Italian 10-year yield now 5.02%.  Spain at 5.57%, down another 39 bps. This is not the point of the curve where the ECB proposes to buy.

This is market data, confirming what I have been telling investors for nearly a year with the decline in the St. Louis Financial Stress Index.

If you are following the data, you know that the world is a better place for investors now than it was a week ago.  It is much better than it was four years ago.

The fear premium in the market is still very high.  I know that many investors (mistakenly) think that it is too late to buy stocks since we are at the old highs.

This article is for you! 

Last year I explained how to use data to evaluate fundamentals.  Here is a brief quote covering one topic, but I invite you to read the entire article, where I cover valuation, risk, and potential:

I use the one year forward earnings from the "bottoms up" estimate from Thomson/Reuters.  Many critics take the inconsistent position that forward earnings are too optimistic, but explain the typical 70% beat rate by saying that estimates are guided down.  I have written about this at length and challenged the skeptics.  I maintain that there is a point where forward estimates by bottoms-up analysts are quite useful -- the best we can do.  That point is  approximately one year ahead.  I continue to invite any loyalist for another method -- particularly those espoused by Hussman or Shiller -- to show that they can predict earnings one year in advance with greater precision.

With this in mind, the "Jackson Hole" forward earnings yield was 8.31% and it has declined to 7.74% now.  When compared to the ten-year yield (interest rates in the table) the risk premium was a huge 5.75% last Fall and is still 4.61%.  On a long-term basis this is a juicy premium unless risk is huge.

 

Conclusion

All of the metrics are better now than they were at the prior market top.  This is why stock prices increase over time --- the fundamentals, defined correctly, get better.

If I had to pick one stock right now that reflects the changes, it would be Aflac (AFL).  The earnings and dividends are great.  The valuation is low because of excessive fear about Europe, where the company has invested insurance premiums.  Cyclical stocks like CAT are great and I still like tech stocks like ORCL.  There are many names consistent with this theme.

These stocks have bounced from the lows, but you are not "chasing."  The valuation is still solid and I buy them for new clients on day one.

 

Has CNBC Lost its Mojo?

Has CNBC lost its mojo?

I really hope not.

No one has watched more hours of CNBC over the last twenty years than I have.  I am a big fan.  Since I also represent an important part of the investment community, my viewpoint might even count for a little more.

If you and I were socializing over coffee or a drink, I could tell you some great CNBC stories, including correspondence with many of the anchors, past and present, from many years ago.

So I write this as a friend of CNBC and with the best intentions.

But I am concerned.

What Went Wrong - - the Facts

CNBC is getting killed on the ratings.  There is a death spiral as their appeal shrinks and they respond in a way that makes it worse.

CNBC Ratings Fall to 7 Year Lows

• Squawk Box (6-9 a.m.) is supposed to prime traders before the bell. The show posted its lowest rated its time block since Q4 2006.
• The Closing Bell (3-5 p.m.) is supposed to wrap up the day’s action. The slot posted its fifth-lowest rating in total viewers and second-lowest ratings in the key 25-54 demographic since 1997.
• Fast Money (5-6 p.m.) is focused almost specifically on swing trading stocks. That time slot showed the lowest rating for the 25-54 demo since 1997 — and lowest in total viewers since Fast Money launched in 2006.

This is merely a summary.  It is actually even worse.  Kudlow is losing to Lou Dobbs, etc.  It is across the board.  And this is before the boxing replacement for the Olympics.

Now we learn that they are laying off employees to institute reality programming.

What is Wrong -- the Analysis

Simply put, CNBC has little to offer to the average investor.  There is too much emphasis on day trading (in content and commercials), and far too many stories about fear.

As someone who watches the news, the blogs, and the major communication channels, I can see the pattern.  It creates a climate that actually will kill their audience.

1. There is news.
2. A widespread network of observers creates negative talking points.  The motivations may include selling gold, selling bonds, selling a political viewpoint, but none of it has much to do with investment returns for the average person.
3. These points are published on a website that embraces conspiracy and anonymity.  Somehow, many people (including those who should know better) think this adds credibility.
4. Traders avidly consume these viewpoints and send emails and tweets to the CNBC team.
5. Those reporting from the floors in NY and Chicago repeat these ideas, sometimes almost word-for-word.

The reports constitute valid information but misleading information.  They show what short-term traders are thinking, but that may not be very helpful.  The problem for investors with a longer time frame is that there is not enough context and perspective.  It scares the daylights out of people who depend upon professional journalism to provide balance.

The content of these stories has little to do with long-term investment prospects, but plenty to do with selling page views and ratings!

Examples

CNBC offers some face time to analysts with various opinions.  The skepticism is apparent for anyone who even thinks about the bright side.  A guest who forecasts a rally of 15-20% is making a "bold call" or suggesting something crazy.

Try this recent appearance of Tony Dwyer, who sees the S&P at 1575 by the end of the year.  (CNBC is having trouble with the embedded links again, so you will have to click through to watch). 

"In fact Dwyer believes his target is conservative. “15 is the lowest non-recession multiple in a sub-3% core inflation environment. The average multiple is roughly 20 times so I believe we are being overly conservative – even with our new target of 1575,” he says.Looking at the fundamentals, Dwyer sees good things for the US economy.

“We’ve had an historic drop in interest rates as well as a huge drop in energy prices.” That’s good for consumers. And he adds we also have a slow recovery in housing – again bullish."

A guest who merely poses the possibility that earnings meet current expectations and the PE multiple gets to a conservative long-term average of 15, is viewed as crazy.  This in spite of the low inflation and interest rates.

While you may not agree with the bullish analysis, it is mainstream thought for many of us, including big-time pension-fund managers.  It is not the object of scorn.  If  the S&P reached 1500 to 1575, as the analysts suggest, could we really be surprised?  After all, earnings are much higher now than when this level was reached in 2008.

Today's "Maria hour" included a story asking whether we are currently in a recession.  Hardly anyone believes this, but those who trumpet the recession story get on TV.  Those refuting this do not get the TV gigs.  I am talking about the people that I feature each week:  Doug Short, The RecessionAlert team, Bob Dieli, and The Bonddad Blog.  How about equal time for them?

Shortly thereafter we had (yet another) interview with Harry Dent about Dow 3000.  He was just on a couple of weeks ago!  Why couldn't Maria use the time to interview someone with some solid stock ideas for the average investor?  She challenged in her questions, but that is not the point.  Don't the CNBC producers understand the effect of the repetitive Dow 3000 and "End of Stocks" headlines?

Conclusion

 CNBC faced a tipping point several years ago.  They lost sight of the fact that most people are investors.  They are long the market.  That is their natural audience.  CNBC hosts do not need to be cheerleaders, but they do need to inform this audience.

Most of the active emails and tweets they get come from traders, many of whom see this as a game between bulls and bears.  The coverage reflects this.  The CNBC team started saying things like "It is a bad day for those long the market."

CNBC needs to decide whether to compete for the active trader and fear market, getting ever more negative and political, or to get back to their foundation of helping regular investors.

They are not helped by images of a car going off a cliff, or stories about Congress going on vacation.  Their viewers need to know what segments of the market are cheap.   How to succeed in the face of these threats.  How to rebuild retirement.

I really hope that they get the message in time.

 

 

 

Nature Abhors a Vacuum -- and so do Financial Journalists!

In most aspects of life, gaining information is helpful.  Smart people learn how to learn, and use the skill in everyday life.

There is a cruel twist of fate:

When it comes to investing, a little knowledge can be a very dangerous thing!

If you read the headlines, you are assured of being at least one step behind.  In the case of many headlines, it may even be a step backward.

Today is a great case in point.  Essentially, there was no fresh news except for an Italian bond auction (of short-term paper) that went very well, sending overseas markets and US stock index futures higher in pre-opening trading.  Everyone knew that the more important test would come tomorrow, when Italy auctioned off longer maturities, stretching out to ten years. 

This was the only fresh information, and I reported as much in my diary.

What Happened?

We then saw the same correlated trade that has been the staple of the past year:  Lower Euro, Higher dollar, lower commodities (oil and gold for sure), and lower stocks.  Traders love simple heuristics, so it was "risk off."

Notice that there is no explanatory power involved in this statement.  The Italian auction went well, and the initial reaction was positive for longer maturities.  Any other stories about the ECB balance sheet were "old news" since that program has been sliced and diced for a few days.

Two Competing Headlines

Tomorrow morning's papers will have many competing headlines offering explanations for today's trading.

Here are two choices, ironicalliy from the same source:

Stocks End Lower as Investors Take Dim View of ECB Lending

or this one

Year-End Caution Takes Over

The second headline is followed with this explanation:  Investors get bearish on Wednesday despite an okay debt auction in Italy as eurozone fears never fail to haunt the market.

This is refreshing honesty from reporter Chao Deng, for whom I predict great things!  She understands some key principles:

1. Not every move needs an explanation;
2. There are no delayed reactions;
3. There is a never-ending quest to explain every move;
4. Some moves are basically random and/or unexplainable.

This is consistent with her basic professionalism and her article in the Columbia Journalism Review.  (I had a minor inspirational role in this, but it is 99% hers).  Here is a brief quote:

When reading a typical stock-market story, one that says something like, “Futures Gain Ahead of Obama Jobs Plan,” did you ever think to yourself: “How do we really know the market move had anything to do with the president’s jobs plan? Says who?”

Says me.

I’m a markets reporter. It’s what I do.

Read the whole article.  She explains the problem in interpreting the news.

The Sign of the Apocalypse in Financial News

To understand this, you need to get the context of today's trading.

Let us suppose that the Dow is down a buck thirty.  There are only a few stocks fighting the market.  The "B team" is on the job at CNBC.  One of the pretty ladies has to point to each of the winners and say something.  What should she say?

One of the winning stocks was Weyerhauser (WY), fighting the "risk off" tide.  The CNBC anchor noted that Seeking Alpha featured an article explaining five reasons that Weyerhauser might move higher.

I was intrigued.  As a long-time contributor to Seeking Alpha I was delighted to see that CNBC was showing some respect.  I looked for the article and found something that was published the prior day.  It was written by an anonymous author.  I hope that CNBC continues to feature Seeking Alpha, but the process should be more disciplined.

I have no opinion on the merits of the article, but it is obvious that it had nothing to do with the stock strength today.  My point is that even the biggest media sources will reach deep to find an explanation for an unusual stock move.

And finally -- if something good happens for the company at some point, there will be a technical analyst who will tell you that today's trading signaled something big!

Investment Implications

I have been advocating the approach favored by NFL offensive coaches -- Take what the market is giving you!

For new accounts I spent today buying great dividend stocks at low prices and selling calls with inflated premiums.  There are many such examples, but don't start with a list of the highest yields.  Look for good yields, good earnings growth and reasonable payout ratios.  I recently mentioned Abbot Labs (ABT), Johnson and Johnson (JNJ), Intel (INTC), and Microsoft (MSFT) as candidates.  There were some excellent new choices today, but I am still shopping for clients.  This is a happy hunting ground for yield-oriented investors.

 [long all named stocks]

Want to make money? Take off your ideological blinders!

Suppose that your objective is to find good investments.  You start by looking at the most popular sources, and what do you find?

Most of the comments have a strong viewpoint -- either political or ideological.  This has an effect on the writers, since stimulating page views drives advertising, measures of popularity (which are confused with quality, even by experts), and face time on TV.

If you want to be a writer for any  big-time site they expect you to have a viewpoint and to be provocative.

Am I alone in seeing the irony here?  If you just take a list of the biggest "investment blogs" the ideological bias is apparent.  There are only a couple of exceptions.

Today's Example

This week provided an excellent example of how the savvy investor can profit by putting aside his/her political views.  I have in mind the ongoing Washington farce, this week emphasizing the extension of the payroll tax cuts and unemployment benefits (along with a few other elements of contention).

• As public policy, you could question whether it was appropriate to extend benefits.  Was this sending the right message to the unemployed?  Should public policy be nudging the long-term unemployed into more aggressive job searches?

• You could also question the payroll tax cut extension.  Should we  be digging a deeper hole on the entitlement balance sheet, deferring the costs until later?

• You could emphasize the political horse race -- the main theme of most stories.  This is what everyone wants to read.  Did the Democrats gain from this showdown?  Did Boehner really "cave?"  What does this mean for the election.  It is all a game to most people.

The Trading and Investment Edge

It is easy to take advantage of this political, partisan, and ideological bias.  Just ask the following question about what is happening:

Is it market-friendly?

The tax-cut/unemployment decision meets the market friendly test because it helps to stimulate the current economy.  I understand that many people believe it is wrong to spend now and pay later, but that is not the market test.

Those who wear this ideology on their sleeves and invest accordingly are losers.

Every macro-economic model used on The Street takes a different view.  Whether Keynesian policies will work in the long run is a matter for debate.  Whether Wall Street forecasts, mainstream viewpoints, and the actions of big pension funds follow this approach is not debatable.  This is what they do, and today's market underscores the point, as you will see from tomorrow's news headlines.

How to Profit

There was actually plenty of time to profit from this.  The news came out on Thursday afternoon, and there was little movement in futures.  Here is what I commented at the new Wall Street All Stars Site:

December 22, 2011 - 4:24 pm

There are reports from various sources that the House GOP will accede to the two-month payroll tax cut extension. Since the House already acted on the Senate bill, calling for a conference committee (SOP) this is going to take some fancy footwork.

jeffmiller

December 22, 2011 - 4:26 pm

Whatever one thinks of the merits of this issue, I regard this as market-friendly news.

There was plenty of time to act.  This afternoon I noted the reaction from one major firm.  I expect more to follow:

As I said yesterday afternoon, the payroll tax cut extension is market friendly. JP Morgan raised their Q1 GDP forecast from 1% to 2.5% partly on this basis. The assumption in their report is that it will be extended for the rest of the year as well. I think that is a near certainty. Here is a link to a story describing the report: http://www.businessinsider.com/jp-morgan-raises-2012-us-gdp-growth-forecast-2011-12

A Guideline that will Pay Off

Here is the rule that is working:  Anything that provides current stimulus, even if it has a later cost, is market friendly.  Expect a rally.

This goes double in Europe.  Any measure that  delays a day of reckoning and buys time for a solution will be viewed as market friendly.

Are you trying to win a debate, or would you rather get returns on your investments?

 

Understanding the Jobs Debate

Last week's terrible employment situation report has focused attention on jobs.  It is a main topic for the GOP candidates as well as tomorrow's Presidential speech to a Joint Session of Congress.

Understanding this national policy debate requires a knowledge of the facts.  Sadly, many of those engaged in making proposals do not understand the basics of labor economics and job creation.  Let me illustrate.

The General Perception

There is a general sense of malaise that includes a number of ideas, including the following:

• The economy is dead in the water with no job creation.
• People are getting laid off in large numbers; everyone who has a job is holding on to it.
• No one can find a job.
• Employers will not hire anyone because of (choose one:  health care, regulations, uncertainty, high taxes).

These misperceptions are not merely held by the public.  The same message is repeated daily in financial media and then becomes part of the public policy debate.

The Reality

The basic problem is that everyone focuses on net job changes rather than on business dynamics.  This is rather unique in public policy.  When we discuss budget deficits, we consider both taxing and spending.  When we look at a business, we consider both revenues and expenditures. [Jeff to readers -- I need a really good, graphic example of net change versus below the surface.  Suggestions welcome.]

If you want to understand what is happening, you really need to study labor market dynamics.  Here are some very relevant facts:

• The US economy creates jobs -- brand new jobs -- at a pace of 7 million per quarter.  This is a pace of over 100K new jobs on every business day.
• The US economy creates jobs from new businesses at a pace of 1.3 million per quarter.
• The US economy is losing jobs at nearly the same rate of job creation.
• Of those leaving jobs, only 43% are fired or laid off.  50% quit and the rest retire, are disabled, or die.
• About 50 million job separations take place each year.  Got that?  50 Million!
• Some businesses may respond to business-specific issues (Wall Street firms, hospitals), possibly including costs.  Other businesses (entrepreneurs, railroads), respond to general economic conditions.  Some (construction, retail) respond to both.  There is no simple answer.

Implications

Think about the numbers that are viewed as "big news."  Last week I saw pundits who gave a scale of market reaction calibrated in intervals of 50K.  If net job growth had been 50K, for example, it would have been in line with expectations.  100K would have been better.

This is silly!  In the first place, the jobs report has a confidence interval (sampling error only) of +/- more than 100K.  Secondly, these 100K changes are very small, like the tip of a wave, when compared to the massive churning underneath the surface.

Here are four key points:

1. Understanding the jobs problem means analyzing both job creation and job loss.  Both contribute.  Both are important.
2. Claiming that "no one is hiring" because of various problems is simply not true.  There may be an effect from regulation and taxes, but like most economic impacts it occurs at the margin.
3. Any plan must consider both the specifics of job creation (the popular public perception because it is easy to see) and the general economic envirnoment.
4. The public perception of distress is actually understated by the unemployment rate.  There are about 130 million payroll jobs and we know that 50 million job changes take place each year.  Very few people have "tenure" including many people who thought they did a few years ago.  Twenty million or more of these changes are involuntary.  Everyone has experienced a job loss, or knows someone who has.

Investment Implications

This is a subject where understanding what is going on may not have an immediate investment payoff.  No doubt the Obama speech will be criticized as unrealistic, ineffective, and something that will not be passed.  The expectations bar is very low.

It would be a breath of fresh air if anyone actually showed a grasp of the principles discussed here, but it is not likely.

Here is one clue.  Despite the criticism of stimulus and Keynesian policies, the market continues to react positively to any credible hint of stimulus.

A Final Thought

Here is what policymakers should really think about:

If they could improve job creation by 10% (700K jobs per quarter) we would have robust net job growth.

If they could improve job losses by 10% (700K jobs per quarter) we would have robust net job growth.

Can't we find 10% either way?  Or 5% on each?

The failure to think about policy this way contributes to the problem.  Everyone sees it as impossible when the solution actually would require a modest change.

Sources

Background at "A Dash" 

Two relevant past articles here and here.

The BLS update using actual data from state employment agencies.  No one pays taxes on phantom jobs, so we can trust this source.  It is delayed by about eight months.

The BLS also reports on job openings and turnover.  I was one of the first to popularize this report.

 

Supercommittee Profile and the Odds of Success

Regular readers know that we have been following the deficit issue and the debt ceiling debate very closely.  It is a daily topic of discussion around our office.  The work of the Supercommittee will be interesting for students of politics, since it constitutes a somewhat novel experiment.

To launch our coverage, we present this profile of the members.  While I endorse the description, the background research and writing is the work of my son, Derek, who is a poli sci student at Illinois.  I have added my own fearless forecast at the conclusion.

The Supercommittee Snapshot -- by Derek Miller

A main provision in the debt ceiling deal signed by President Obama is the creation of a 'supercommittee' to find a $1.5 trillion more in cuts to the deficit by November. Otherwise, an automatic $1.2 trillion in cuts is triggered - something neither party particularly wants.

Now that the appointment process has been completed, the committee is really starting to take shape. Citizens and investors alike should be very interested in the representatives' initial attitudes and positions.

Senators:

Senate Finance Committee Chairman Max Baucus (D-Mont.): Baucus has something of a bad reputation among many in his own party. The Washington Post notes that Baucus "was the only Democratic senator on the Simpson-Bowles commission who did not support the final product" - which was  a mix of cuts to Social Security, Medicare/Medicaid, discretionary and defense spending, as well as revenue increases via tax reform. Among his objections were the elimination of farm subsidies and deep cuts to entitlement programs; it is reasonable to expect him to defend these programs with similar enthusiasm over the coming months.

Sen. Patty Murray(D-Wash.): Murray currently serves as the chairwoman of the Democratic Senatorial Campaign Committee, therefore her appointment has been met with criticism by those across the aisle. RNC Chairman Reince Priebus was particularly outspoken about her appointment, saying "The Select Committee is no place for someone whose top priority is fundraising and politics." While she certainly has strong incentives to make Democrats look good for the 2012 elections, it is likely that she will gauge taking action to be more politically popular than gridlock.

Sen. John Kerry (D-Mass.): Kerry is seen by Republicans as a fierce partisan, given his recent anti-Tea Party statements ("I believe this is without question the Tea Party downgrade"), not to mention his status as the 2004 Democratic presidential nominee. However, he has liberals worried that he will bargain away too much. The senator's spokesperson said today that "Kerry’s got a bipartisan track record on issues big and small including building consensus on issues that had defied all consensus," which strongly suggests he will attempt to forge a conciliatory deal in the Supercommittee.

Senate Republican Whip Jon Kyl*(Ariz.): Jon Kyl is one Republican who almost certainly not break the party line in these upcoming negotiations. In a recent interview with The Arizona Republic Kyl said: "“Whatever we do, we’ve got to be careful that we don’t hurt the prospects for economic recovery and job creation. In fact, we should be doing things that support job creation, and that’s one of the reasons why we don’t want to be raising taxes.” However, he is adamant that the Supercommittee not fail completely, as the default cuts fall heavily on defense spending - and national defense is one of his major issues.

Sen. Pat Toomey*(R-Pa.): By all accounts Toomey seems genuinely dedicated to getting something done in the Supercommittee. On Fox Philadelphia this morning he remarked that "There's a real, genuine desire to get something accomplished here." It appears as though he will toe the line with Jon Kyl in stating any revenue increases  would prove counterproductive to job growth - although he has characterized the tax code as "indefensible."

Sen. Rob Portman* (R-Ohio): Portman is relatively new to the Senate, but has experience in this area as the former White House budget director for George W. Bush. He is known to be slightly more moderate than Toomey or Kyl. According to the Colombus Dispatch he may go along with opening new sources of revenue in order to cut the deficit - despite having taking the Grover Norquist Taxpayer Protection Pledge.

Congressmen:

Rep. Chris Van Hollen (D-MD): Though Van Hollen has the least experience on Capitol Hill, Politico reports that he "played a central role in the debt-limit negotiations that averted a default." He has a reputation as an eloquent speaker who is able to communicate the party message effectively. All Democratic appointees have been urged by the Blue Dogs to "develop a fair and feasible path to fixing out long-term debt." Given Van Hollen's ambition for leadership, it appears likely that he will be willing to compromise.

Vice Chairman of the House Dem Caucus Xavier Becerra (D-Cali): Becerra has experience in this area, having been a member of the Simpson-Bowles deficit commission. He has a relatively safe seat in a liberal district, and is in fact one of the most liberal Democrats in the House. According to The Hill, Beccera has lately been "the party's loudest advocate for shoring up the Social Security program without eroding any benefits." All indications are that he will remain steadfast in his defense of entitlement programs.

Rep. James Clyburn (D-SC): Clyburn, the third highest ranking House Democrat, brings 20 years of experience to the table - including several in the House Appropriations Committee, which is famous for it's tendency to produce bipartisan compromise deals. Clyburn is particularly close to Pelosi, so it is reasonable to think that he will likely try to represent her negotiating spirit. Last week Pelosi stated that her objective was  "to be as forceful as possible and as unified as possible to send a message to the American people about what the difference is here" but also not to "[draw] lines in the sand."

Republican Conference Chairman Jeb Hensarling*(R-Texas): Hensarling was a member of the President's debt commission, but opposed its final result because it contained revenue increases. According to the Miami Herald he is "one of the most avowed fiscal conservatives in Congress," a characteristic sure to stand out as he co-chairs the Supercommittee.

Ways and Means Committee Chairman Dave Camp* (R-Mich): Camp has taken a surprising opening stance towards the upcoming negotiations. According to The Hill, Camp says "Everything is on the table," suggesting that there may be some scenarios in which revenue increases could help spur economic growth. However, he has pledged not to raise taxes, and a Ways and Means Committee spokesman maintains Camp has not changed his position on new revenues. It is certain that he will be under serious pressure for Norquist's group if indeed he does agree to raise taxes.

House Energy and Commerce Committee Chairman Fred Upton (R-Mich): Upton is particularly notable because he is the only Republican representative not unilaterally opposed to revenue increases. He has been criticized often within his own party for crossing the aisle on a number of high-profile issues, notably vying for increases in discretionary stimulus spending and attempting to decrease the Bush Tax Cuts. Steve Kornacki of Salon.com notes that Upton has been under fire from Tea Partiers as of late, suggesting that the appointment to the Supercommittee may be an attempt to pressure him into more conservative positions.

*Denotes representatives who have taken the Grover Norquist Taxpayer Protection Pledge[PDF]. This pledge requires that the representative "oppose any and all efforts to increase the marginal income tax rate" and "oppose any net reduction or elimination of deductions and credits, unless matched dollar for dollar by further reducing tax rates." Simply put, these representatives have promised to oppose any and all revenue inceases proposed to cut the nation's deficit.

While most major news outlets and political commentators do not expect much from this Supercommittee, its members have serious incentives at play. Almost nobody wants the default $1.2 trillion in cuts to take effect. In combination with the potential political benefits of overcoming 'business as usual' in Washington, it is clear that many lawmakers see an advantageous end game.

Jeff's Odds on the Outcome

Derek has done a nice job of showing the diversity and biases of the Supercommittee members.  He accurately notes that most observers see a probable deadlock from this group.  They believe there is too much disagreement, and little has changed from the debt ceiling debate.

Everyone seems to be missing a key point.  There is an advantage to making sure that potential dissenters have a role in the process.  It then becomes easier to sell the final deal to the entire legislative body.  The sharp divergence in viewpoints was essential for this to have any chance of working.  By contrast, the twists and turns of the debt ceiling debate played out in a way that some important group always felt left out of the process.

While I plan to give this more thought, my early line is 2-1 that the Supercommittee will reach an agreement.  If they do, I expect it to become law.

Debunking the Myth of the QE II Rally

The single biggest market question is this one:

What happens at the end of QE II?

I have explained this on several occasions and promised more detail.  After listening to countless talking heads talk about the QE II rally, we need some clarity.

Background

There are two views of the world:

1. Gains in various markets are all the result of Fed policy and things will reverse as soon as Fed policy changes.
2. Stock market gains have resulted from improved fundamentals.

Viewpoint #1 gets most of the attention, especially when the market sells off a bit.  The second viewpoint is almost a state secret.  Too many people confuse actual market fundamentals with what they call "headwinds."

The Facts

If you really want to understand market fundamentals, you need to consider valuation, risk, and future potential.  I discuss these concepts every week in my Weighing the Week Ahead series.  Today I want to consider a longer time frame.

My approach is very simple and based on hard data.  It is easy to understand.  It is contrarian since most traders and pundits want to use words and anecdotes rather than data.  Here is the key table.

 

 Let us consider each of the three key elements.

Valuation

I use the one year forward earnings from the "bottoms up" estimate from Thomson/Reuters.  Many critics take the inconsistent position that forward earnings are too optimistic, but explain the typical 70% beat rate by saying that estimates are guided down.  I have written about this at length and challenged the skeptics.  I maintain that there is a point where forward estimates by bottoms-up analysts are quite useful -- the best we can do.  That point is  approximately one year ahead.  I continue to invite any loyalist for another method -- particularly those espoused by Hussman or Shiller -- to show that they can predict earnings one year in advance with greater precision.

With this in mind, the "Jackson Hole" forward earnings yield was 8.31% and it has declined to 7.74% now.  When compared to the ten-year yield (interest rates in the table) the risk premium was a huge 5.75% last Fall and is still 4.61%.  On a long-term basis this is a juicy premium unless risk is huge.

Risk

When considering the yield premium, you need a way to evaluate risk.  Most people do this by producing a laundry list of unquantified (and maybe unquantifiable) worries.  I choose to focus on data.  An excellent candidate is the St. Louis Fed Stress Index, which uses 18 different data series.  The methodology employed isolates the specific contribution of each factor.  These are not government measurements, but actual market data.  It is a sophisticated way of letting the market speak to you.  It was also a great method for spotting problems in 2007-08.

At the time of the Jackson Hole speech the SFLSI was at a worrisome .69 level.  (1.0 is a one standard deviation change.  I am doing reserach on the best warning level).  Right now the SFLSI is in negative territory.  Simply put, if you measure risk in objective terms, it is vastly different from last fall.

Potential

I view economic growth as the potential for future earnings.  While the market is not a GDP futures contract, it does have a good long-term relationship with economic growth.  Stocks famously have predicted ten out of the last three recessions.  There is incessant skepticism, for political, mercernary, and publicity reasons.  Let us compare then and now.

Last August

The ECRI growth index was at negative 10.  Many widely-publicized pundits insisted that this never happened without a recession.  Double dip was on everyone's lips.  Nearly everyone ignored the ECRI's own interpretation.

Now

The ECRI growth index is in positive territory and has stayed there for many months.  A realistic estimate is a continuation of modest growth, but only extremists expect a recession in the next year.  The perma-bears of last autumn have fallen silent.

Briefly put, the potential is much better.

Conclusion

For those of us looking at data, it is so easy to understand the stock market rally.  The big question is why the market has not moved even higher.  I see many specific stocks that are more attractive than ever on a P/E basis, even if the prices are higher.  (JPM, AAPL, and CAT are among current choices).

This article has emphasized the real reasons for the rally, but I still expect to write about some of the alternative explanations.

In an era where many data series have moved higher, it is easy to find strong correlations.  While most people pretend to know about the difference between correlation and causation, very few market studies demonstrate the ability to distinguish.

A Final Thought

I have tried to interest various economists in discussing the QE II effects.  Most are completely uninterested because they only see a few basis points of effect.  When I explain that traders and financial television (not to mention the conspiracy sites) are completely focused on this, they just express amazement.

One of my roles is to bridge this gap.

 

You need to have a system....

Quote of the Day

Tadas Viskanta, ...(Y)ou have to have a system that gets you in and out of the market based upon your own signals and not pay attention to what other people are saying.

I could not agree more!  The quotation is from today's screencast at Abnormal Returns, a brief video that I watch and enjoy every day.  The cited text comes at the 2:10 mark or so, but you should really watch the whole thing.  The links are also informative and fun.

[Regular readers of Abnormal Returns will notice that I have shamelessly ripped off their daily introduction to let Tadas have a turn at being the source of the "quote of the day."]

Inspiration

Like Tadas, I am not a big fan of round numbers or anniversaries, but his screencast inspired me to compare today's market with what we saw two years ago.  I have done a few pieces like this in the past, but this was an occasion to be more systematic and to spend a few hours doing additional research.

The table below shows a summary of the method that I use to "have a system" and to ignore the noise.  It combines value, future prospects, and risk.

There is room for improvement, but it helps me stay on the right side of the market.

I am going to discuss each of the categories in turn.  The result, a doubling in stock prices, is what we seek to explain.  Let me explain the other factors.

Value

There is something about discussing market valuation that generates passionate responses.  Regular readers of "A Dash" know that I have provided solid evidence that the bottoms up projections by analysts are the best predictor of next year's earnings.  I have a continuing invitation to those advocating alternative methods to provide any evidence.  [Here is the article where I discussed the misinterpretation of the widely-cited McKinsey study.]  So far I have no takers.  This is something to keep in mind the next time you read someone assert, without evidence, that analysts are "too bullish."

Everyone who picks stocks looks ahead, starting with what they expect the earnings to be.  The sum of this individual analysis of stocks is reflected in the valuation of the market. Who knows?  If Ben Graham had lived in the era of sell-side analysts he might have improved his backward-looking method of forecasting earnings.  My guess is that he would have employed the best available information, had it been available.

In the table above I have also provided data for those who (mistakenly) prefer to look at past earnings instead of looking ahead.  I have also added interest rate comparisons.

The forward P/E for the market is now 13.5 compared to 10.8 in 2009.  The trailing P/E comparison is even worse -- 15.8 instead of 10.3.

Many pundits thoughtlessly cite average P/E multiples without regard to interest rates.  Since every major pension fund manager has a daily choice between stocks and bonds, the comparison is of obvious necessity.

The table shows two interest rate comparisons -- the rate for investment-grade corporate bonds and the ten-year treasury note.  The former provides a comparison for those willing to take the risk of corporate failures and the latter an indicator of perceived risk in the system.

By this measure, stocks are 20% undervalued now and were only 12% undervalued in 2009.  Another way of looking at this is that investors in corporate bonds have also done very well in the last two years.

The valuation disparity is quite different when compared to the ten-year note.  The stock risk premium is still 100%.  This is large by historical standards, but only half of what it was in 2009.

Future Prospects

The stock market is not a futures contract on GDP.  Having said this, the prospects for the economy are the biggest single input for expected earnings.  There is a real challenge in finding forward looking economic indicators.  The Economic Cycle Research Institute has a good record and a widely followed forecast.

In 2009 their Weekly Leading Index was a meager 105.5 and the growth index a negative 23.7.  Today the WLI is at 105.5 and the Growth Index a postive 6.5.  While the ECRI does not look ahead more than six months or so, the economic prospects look good.  This is confirmed by other professional economic surveys.

The economic future looks much better than it did in 2009.

Risk

I evaluate risk using the St. Louis Fed Stress Index.  This method is objective and market-based.  If a doomsday pundit is telling you to worry, and the concern is not reflected in any of the 18 factors in the SLFSI, I recommend choosing the data over the anecdotes.

 In 2009 the SLFSI was at 3.88.  This is measured in standard deviations, so it was a true black swan.  The chance of this happening is about 0.5%.  An intersting comparison is the maximum stress from the prior 90 days, which I show in the change in the level.  The prior high was at a 3/1000 percent extreme.

The current readings are quite normal -- very close to the middle of the distribution with a mild decline from the high in the last three months.

The future also looks less risky than it did in 2009.

Investment Conclusion

The overall conclusion from this analysis is pretty clear.  This is a better time to invest than it was two years ago.  The valuation is a little lower, but the risk is much, much lower.  Risk-adjusted return is our goal.

I realize that most readers will disagree with this conclusion, but that is only because they already know what happened to an investment in 2009, and they are skeptical about the future.

Many would also have been skeptical in 2009.  This is the challenge of looking ahead.  Investors need an objective, data-based method for cutting through the noise.

You might want to consider my Value+Economy+Risk approach.  I write about this method nearly every week in my "Weighing the Week Ahead" series.  I also have a risk-adjusted program for clients, where I pay special attention to what might go wrong.  You can do the same at home by following the indicators I have outlined..

One More Thought

One more factor that I cite is the need for a list of widely publicized worries.  Most investors are big losers because they react to market "headwinds" by selling.  The gradual meeting of worries has been the story of the last two years.  We continue to have a long list of worries, highlighted every day.  When this is no longer true, it will be a warning of a market top.

As compelling evidence the Abnormal Returns article provides a link to an entertaining article on Clusterstock, reviewing the bearish punditry of the last two years.  As you read through the past predictions, you might well notice that most of those cited are offering the same advice now as they did then.  A little research will show that they are often hailed as "early" predictors of the financial crisis, which means they were bearish as early as 2005 or so....

What better evidence can there be for the quote of the day?

You need your own approach.

 

 

 

Investment Lessons from 2010 Lists: Prosaic, Profound, Predictable, Pornographic, and Provocative

Here at "A Dash" I recommend that you join me in reading widely and critically.  Most people do not have the time for this, so let me offer a few suggestions for a 2010 review.

I want to have a little fun with this, but there are some good investment insights.  These are the "Ten Best" lists from various sources.  With a couple of exceptions, I emphasize sources you probably do not already read.  I will provide the source and my own quick take, but you will have more fun if you look at the entire list, draw your own conclusion, and add your own insight in the comments.

The Prosaic

If you really want to know what investors are thinking, why not look to the most popular articles in the mainstream media?

MarketWatch fits the bill.  I think this choice represents what average people read about the economy and stocks.  If you look at the list you will see why most people are scared silly and under-invested.  The popular articles emphasize why the world is going broke, why we may have anarchy or a revolution, how banks are going under, and similar themes.  I recommend this not for the content, but so that my astute readers can keep a finger on the pulse of the public. If you ever read the comments on these articles, you get a good sense of the mood of this particular attentive public.

It is also a good antidote for the current buzz about sentiment indicators, polls of a few investors about their opinions.  This popularity index shows what people are really thinking about.

The Profound

Try out Advisor Perspectives.  This is an undiscovered gem for most investors.  Robert Huebscher is a fine editor whose sophisticated audience of investment advisors seeks a deeper look into the financial issues of the day.  This year's list of most popular articles covers topics ranging from debt and deficits, to gold, fixed income investing, and retirement planning.

The difference between the choices of average readers and those of the advisors is noteworthy.

The Predictable

What could be more predictable than our fearless leaders in Washington?  The top political quotations from 2010 included a Vice-Presidental "F-bomb," a Supreme Court Justice dissing the Pres during the State of the Union, and explanations of witchcraft.

The lesson?  Politics often involves simplifying issues to appeal to the marginal voter.  Marginal voters are the least common denominator.  If you want to be a smart investor, you need to see beyond the predictable appeals, expecting a lot of silly commentary.  (By the way, not all of the 535 members of Congress are dumb, and many of the staffers are first rate).

The Pornographic

Suppose that we focus instead on a most intelligent and high-minded group:  Scientists.  I regularly read The Scientist because it reports issues related to pharmaceutical companies, research findings, and other related news.  Their list of the ten most popular articles had an interesting winner -- a study of the effect of pornography on the incidence of sex crimes.

The lesson?  Let us move beyond the obvious conclusion that scientific readers are just as interested in porn as average people.  The investment angle:  Understanding causation and correlation.

If I were still teaching research methods, I would use this as a class example.  Everyone comes to this question with a pre-conceived notion and a reluctance to consider any real data.  It is easy to find a study showing that most sex offenders had contact with pornography.  This reasoning -- going from effect to cause -- is exactly what is wrong with most of current Wall Street research.

You have probably guessed the "surprise ending" to this story but read the article to make sure.

The Provocative

Since it is the football bowl and playoff season, let me share one of my favorite sports sites,  Awful Announcing.  Like most sports fans I fume at the constant mistakes made by announcers in their discussion of a game.  At Awful Announcing you can register specific complaints about announcer blunders and even nominate them for something called the "Pammies."  Here are this year's winners.

The lesson?  At some point I realized that my reaction was similar to what I felt watching financial television.  The sports announcers are actually better, since they generally do not shout at each other and are expected to be experts.  So many financial announcers now have opinions.  They believe that we are watching to hear what they think rather than to get news or listen to interviews with good guests.

There is a lot of air time to fill!

Conclusion

I hope you have enjoyed my somewhat whimsical look at some 2010 lists that you did not see elsewhere.  Investors can and should draw lessons from many sources.

Wall Street Myths and Truthiness

Our newest addition to the list of  pages on the side panel deals with the myths and "truthiness" commonly propagated on financial TV and in the blogosphere. The page is posted in full below:

In an effort to promote more empirical thinking in the blogosphere, one of the main themes here at A Dash is to expose Wall Street myths and “truthiness.” I laid out my major objectives when I began a series on this subject in December 2, 2008.

1. Identify a widely-held belief or conclusion where supporting evidence is sketchy;
2. Raise this topic for further discussion and analysis;
3. Consider what facts, if any, might prove the conclusion to be incorrect.

In A Search for Catalysts (December 3, 2008), I considered a number of widely held beliefs that had the potential to set the market in motion.

• The SEC report on mark-to-market accounting, due on January 2nd.  This might recommend reporting transparency, but some relief on the official asset calculation.  Or it might not.
• Housing initiatives.  The Treasury is hinting at a new plan to reduce mortgage rates.  The Fed has already acted.  We expect the market to be skeptical of both, so it may take some real evidence to change opinions.
• Corporate earnings.  No one will believe anything from Q4, so if there is positive news, we are waiting until April -- at least.
  

I have been fighting these myths on Wall Street – especially those related to the BLS and the Birth-Death Adjustment (August 6, 2009) – literally for years. This is just another illustration of how “truthiness” has its way of permeating conventional wisdom.

“As always, our motives are to make the best use of available data.  The multi-year criticism of the BLS and the methodology used has been shown to be incorrect.  Despite this, the myth prevails.  This is due partly to the lack of any mainstream media coverage of the BLS viewpoint.”

Back in April of 2009 I took issue with pundits who felt that the Financial Accounting Standards Board was caving to political pressure on its mark-to-market decision. It was a common case of bureaucracy being drastically oversimplified. As I wrote then:

“Various opponents of change claim that FASB caved in to political pressure.  This is an easy story for journalists to write and for pundits to criticize.  None of them exhibit any understanding of how the American political system works.  They are writing to a receptive audience, which shares their pre-conceptions about how government should work.”

Much of the time mainstream media is largely responsible for spreading these rumors and myths in a misleading fashion. In Popular and Critical Acclaim (June 8, 2009) I quoted an article by Barry Ritholtz in which he suggested a number of ways to improve financial television. He writes:

“Fact Check: An awful lot of things on air get stated with authority and confidence. Much of them are little more than junk or pop myths. Why is it that the more dubious a proposition is, the greater the confidence the speaker seems to muster? Consider fact checking as much of the statements that are made on air as possible, and making frequent corrections.”

At the end of the day, the independent investor simply cannot expect to be successful by following the conventional ‘wisdom.’ Turning a profit means careful analysis from empirical data.