A Dash of Insight

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.

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.

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.

Investor Opportunity: When to Look

At any point in time there is a popular thesis, widely shared by those who hold the marginal trading dollar.  For many months, that thesis seemed to recognize that the market had become excessively pessimistic.  Negative news could be shrugged off.

The prevailing thesis can change very quickly.  The daily mantra  now seems to focus on the ending of certain government programs.

• Cash for clunkers.  Sales went up and now have not sustained the gains.  There is an inclination to attribute the entire auto rebound to this program.  In fact, the idea was to stimulate the industry and attract interest.  The jury is out on the continuing effect, but it should not be dismissed out of hand.
• Home buyers' credit.  Once again, the programs have stimulated activity and firmed up pricing.  This is a good starting point for improvement.  Since the program is set to expire, some predict a relapse in home prices.  No one really knows whether that will happen, or whether Congress will extend the program.
• Stimulus spending.  People have strong opinions about the stimulus bill, but most seem to forget that the spending was spread out over three years, just to avoid the appearance of a sudden cutoff.

Whether one agrees or not, the investing and trading backdrop has changed.  For those who see it as an opportunity (like us) it is time to go shopping.  In our next installment on this theme we will discuss how and where to find ideas.  As we noted in an article last week, we were looking to buy RIMM on the decline after the earnings announcement.  We were buying yesterday and today for recent client accounts.  There are many other fine opportunities, if you have done your homework and have a price target in mind.

Time of Opportunity?

Since one of our missions is to find the best sources on any topic, here is a survey of opinion we find quite interesting.

• Abnormal Returns points out that "Sell in September" did not work, citing several sources including their own work.  Our own article on this topic got some nice circulation in Advisor Perspectives.  Tadas repeats his September conclusion:  Ignore the calendar.
• Barry Ritholtz had a nice appearance on the Kudlow show after a long absence.  He adds a nice perspective.  Tonight he clarified his market position, which grew increasingly bullish beginning in February and is now up to 75% long.  While he thinks the rally has more room to run, he is doing some end-of-quarter hedging.  This is a very balanced perspective from a someone noted as a skeptic on the economy and the market.
• RevShark at RealMoney [subscription required] attributed today's selling to a shift in the Goldman forecast of job losses from 200K to 250K.  We do not question his analysis, but we wonder what people are thinking.  This series, as we have frequently noted, has an error band of over 100K jobs  -- and that is just the sampling error.  (We did not publish our own regular forecast, since it depends upon the ISM report, announced today, and we write in the evening.  Perhaps we can figure out a method for doing an update in situations like today, when the ISM leads the employment report by a single day.)

Our Take

The economic news, as we have frequently noted, is not going to show a straight-line march upward.  This is especially true of employment.  For reasons noted by many, some corporations will be slow to re-hire, or to hire new workers.  Note well:  There is plenty of hiring going on, but it does not match the new job losses reflected in the initial claims series.  We expect continuing increases in the unemployment rate until job growth catches up.

We reject comparisons to a Great Depression situation, as we noted in yesterday's article.  Here is a follow-up to that piece, taken from an authoritative source, The Liscio Report (frequently cited by perma-bear Alan Abelson).  In a nice analysis from January, they looked at the Great Depression and current unemployment rates.  They debunked those who saw unemployment as at Great Depression levels, noting that there was no measure of unemployment at that time.  Any data series must try to reconstruct data from that time and patch the series together.  Like us, they see the BLS as doing a good job in providing unbiased information for this analysis.  Read the entire article, but here is the key chart, carefully merging data series.

Investment Take

As we enter the new earnings season, where we have seen relatively few negative pre-announcements, we expect continuing skepticism.  Since we regard employment as a lagging indicator, it is still a time of opportunity.  Investors should note that consumer spending has remained fairly strong, to the surprise of many.  The tipping point may come when corporate executives start to see more opportunity.  It remains a matter of psychology.

We plan to discuss further some specific stocks for investors to consider.

Four Things You Didn't Know about Unemployment

There is a lot of commentary about the unemployment rate.  Various pundits are determined to find the worst possible interpretation of data, and also to impugn any official reports.  Let us take a closer look.  Many of the answers come from  the following source, helpfully highlighted by Barry Ritholtz at The Big Picture:

Measuring Unemployment in the Nineties
Janet L. Norwood and Judith M. Tanur
The Public Opinion Quarterly, Vol. 58, No. 2 (Summer, 1994
http://www.jstor.org/pss/2749542

Anyone who took a few minutes to read this important article would have some real insight into the world of policy nerds -- people like us!

Since few will be willing to invest the time to do a little real homework, here are the key things you would learn.

#1. Presidents do not dictate changes in statistical procedures.

This flies in the face of the popular "rogue economist" selling his conspiracy theory.  It will also seem implausible to the "B" movies fans.  Nevertheless, it is the boring truth.  The Clinton-era changes in employment measures were the result of a long process, thoroughly examined and challenged by many groups.  The final measures adopted the recommendations of the 1979 Levitan Commission, chaired by the renowned labor economist, Sar A. Levitan.  Here is a glimpse of the process, taken from the Norwood and Tanur Article:

The Process
The leadership of the two agencies [Census and BLS, jm] began a joint effort to develop a comprehensive strategic plan to reaffirm the CPS's leadership in labor
force surveys by using state-of-the-art questionnaire design and advanced technology. A series of meetings with the senior staff of the two agencies, including the BLS commissioner and the Census director, delineated the comprehensive set of tasks that needed to be carried out. Several joint task forces were established to develop the research issues that needed to be addressed and to establish the necessary plans, budget estimates, and time tables for implementation. The work began with efforts to identify areas of the old questionnaire that might need change. First, experts from BLS and the Census, as members of the CPS Questionnaire Redesign Task Force, reviewed problem areas. Based on their experience in developing and analyzing the data, they were often able to see questions that had a high potential for response error or that failed to implement existing definitions properly. They also noted questions needing definitional changes and identified areas of labor force analysis for which more data were needed. They believed that because of the dramatic increase in labor force participation of women and the rise in part-time and temporary workers,more information was needed from the survey about these categories of workers. Bureau of Labor Statistics staff were also eager to develop a more user-friendly processing system so that these and other important analytical issues could be addressed more easily and more quickly than in the past.

Next, the task force recommended a program of preliminary research.
Respondents were brought together in focus groups to explore their understanding of the concepts underlying the questions asked. It was this technique, for example, that confirmed a discrepancy between the respondents' and the CPS's use of the term "on layoff." Another preliminary technique tapped interviewers' experience with other CPS concepts by using card sorts to explore their coding of open-ended questions about job search and other matters (Fracasso 1989).

The next step was to design two new questionnaire....

This goes on for pages.  Any objective reader of this report will immediately dismiss the conspiracy theory.  There is no way that all of these academics, bureaucrats, and observers would have maintained some conspiracy.  They have different ideology and policy preferences.  What they shared was a desire to "get it right."

#2  The changes made the employment measures worse.  Here is a key quotation:

In November 1993, government information suggested that the jobless rate, undoubtedly one of the most politically sensitive of all federal statistics, had been substantially underestimated-by about half a percentage point-for many years. And this, in spite of the fact that the Current Population Survey (CPS), the 53-year-old survey that produces the data to assess the unemployment rate and provides a great deal of other labor force information, has long been used as a model of the best in survey design both in this country and around the world. What had changed?

The biggest factor was the increase of women in the labor force.  The BLS statisticians, like all data lovers, want to see continuous series, unchanged by methodology.  When the world changes, sometimes the questions must follow.  The BLS altered the workforce definition in a way that instantly increased the most common unemployment measure --- because it was the right thing to do.

Part of the change was a clarification of what it meant to be part of the work force.  This list of questions determines what respondents were really doing --  looking for work, attending school, keeping house or going fishing.  The current measures of labor force participation resulted from this work.  In prior years, we have no idea of what the answers might have been.

#3  The Federal Government measured the impact of the changes.

The BLS and the Census Bureau did an "overlap" sample where both the old and new questions were asked of 12,000 respondents.  By comparing these answers, one can infer the impact of the changes.

It is pretty obvious that this thoughtful statistical technique is the work of scientists, trying to find the right answers.  Those who are making accusations about political motives need to explain why this extra care was taken.

#4  Current unemployment, while very bad, does not approach that of the Great Depression.

Here at "A Dash" we have a mission of helping investors to find the best information from the best sources.  Often this means a focus on the change in economic conditions.  Some sources seem determined to find the absolute worst interpretation of every economic report.  This is currently a great way to get popularity on the Internet.  Some others seem to have a bullish spin on everything, perhaps going for a niche market.

Our idea is a bit different.  We try to find the best indicators from believable sources.  We classify these indicators as leading or coincident.  We then stick with the program, unlike others who discard or change measures in a heartbeat when they no longer like the results.

The Great Depression comparisons are erroneous.  They also seem quite unhelpful in recognizing key economic trends.  Here is a source for thoughtful readers:

This Is Not Another Great Depression

In fact, there are no continuous unemployment sources showing that current results are comparable to the Great Depression.  Anyone suggesting otherwise is blowing smoke.

And that is the official answer to our Summer Quiz Question #6.  This is the last of the answers, and we will declare a winner this weekend, awarding a nice prize from Amazon.com.  In practice, anyone who did the homework and got most of these answers right enjoyed the summer rally, and ignored the "sell in September" rhetoric."

Reacting to News: The RIMM Lesson

How the market reacts to news can be very revealing.  Twenty years ago, when a stock halted trading I was often asked by our trading team where it would reopen.  The problem is understanding the framework of the analysts following the stock and the overall market environment.  The same news can have a widely differing impact based upon the market circumstances.  I have occasionally worked as an expert witness on matters relating to news.  The key is to look at comparable companies and determine the market background.

The modern era is different.  Every commentary reflects knowledge of where the stock is trading after hours.

The Research in Motion Example

Research in Motion (RIMM) announced earnings that beat the official Street expectations by 3 cents (3%).  The revenues were about $90 million light (2% or so).  Gross margins were solid at 44.1%.  New handset growth was 5% short of expectations.  The outlook was in line with expectations.

In a neutral market environment the stock might be down 3-4%, but the current market is not neutral.  In after-hours trading the stock is down 12%, and tomorrow's reports and commentary will reflect this market reaction.

The Investment Lesson

The macro view.  The market is "teed up" for a focus on revenue.  The bearish argument has been that corporations achieved good earnings last quarter through cost cutting.  Here at "A Dash" we understand and accept this behavior.  Companies cut back on costs and employment.  They will hire slowly and reluctantly.  They are lean and mean.  If the economy continues to improve, revenues will grow and earnings will grow faster.  Slow hiring, wise for an individual company, undermines the need for the economy to add employment.  It will be a mixed picture for many months.

In addition, many are looking for a reason to sell after a big rally.  Dow 10,000, while meaningless to professionals, has a psychological impact.  Technicians see S&P 1050, which will be challenged tomorrow, as a key support point.

Briefly put, the market will be unforgiving when companies miss on revenues.  It will be doubly so when the company does not provide a bullish outlook.  Few can be expected to do so in a time of economic uncertainty.  Many companies are not even providing guidance.

It is a clear choice for investors in this stock and others:

If you see a depression as "off the table" and a period of reasonable growth, revenues and great earnings will follow.

Those who hate government data and prefer specific company reports and anecdotal information (the Power Lunch economic index comes to mind) will find plenty to worry about.  We highlighted this in April in our article, Jim Abbott and the Wall of Worry.  Our viewpoint, now proven to be correct, was met with plenty of skepticism.  The worries continue.

It would be naive to expect the market to move in a straight line.  That is too easy.

The RIMM viewpoint.  We own RIMM in our own account and those of many clients.  We have been looking to add a good growth stock for more recent clients, and will add RIMM in the coming days.  Despite today's report, the prospects are very good.  Jordan Kahn at RealMoney (subscription required) sees earnings of $5 next year and a target of $100 in a year or so.  Every portfolio should have a growth component, and this is a great candidate.

Since we are aware of possible market share loss to Apple (APPL), our clients also own that stock.  We expect both companies to benefit from the growing mobile Internet market.

Final Take

We expect to see this story repeated many times during the earnings season.  There have been few negative pre-announcements, but companies use earnings as the trigger for those statements.  There will be revenue misses.

Thorny Questions

Here at "A Dash" we try to help investors find the best answers to tough questions.  Any investment manager with a long-term record of success (like us) takes plenty of contrarian positions.  By definition, the current position usually seems implausible to many investors.

Here is the irony.  The confused investor who has done the wrong thing for the last several months is still the most difficult to convince.  The popular answers seem so obvious.  The contrarian (and correct) answers are more abstract and therefore more difficult.

Here are a few examples that we are hearing.  In each case, the challenge is not so much finding the correct answer, but explaining it to someone who has already made up his mind.  In this overview article, we merely state positions, but each can be explored at length.  At the moment, it seems more important to highlight some terrible and very common mistakes.

• The market has rallied so much, there has to be a correction.  Why?  It did not really work that way on the decline.  We are still below the pre-Lehman levels, and most of those concerns have been addressed.  There seem to be many ready to buy each dip.
• The market cannot rally with unemployment so high, since this means the consumer is crippled.  Companies can bounce back with thin work forces and make plenty of money before the big-time hiring binge.  Personal consumption has not gotten as weak as expected.  Money is getting spent, as specific stock data and retail sales demonstrate.  Corporations have cut costs, and are very leveraged if revenue increases.
• The Fed is ruining everything; Bernanke missed the entire crisis.  Bernanke is a public figure who has made many statements for the record.  As is the case with any such person, it is possible to compile some statements that make him look foolish.  During his time in power, circumstances have changed dramatically, and he has naturally changed his position.  Our viewpoint is that he has done so quite wisely, and earned his reappointment from President Obama.  Blanket statements such as "he did not see the housing crisis" are inaccurate and quite unfair.
• Warren Buffett made a mistake in October, so we should not believe him now.  This is similar to the Bernanke opinion, but it is even more foolish.  Those making this statement are suggesting that we ignore a multi-decade period of unparalleled success because of Buffett's call to buy last October, a call that was 35% too soon.  The wise methods of a lifetime did not work last autumn.  They do seem to be working again now.

Conclusion

Many are thinking about problems the wrong way, trying to force a very unusual period of time into some specific historical context.  It is not so easy.  Most such efforts are post-hoc data fitting.

It is especially dangerous to reject methods that have survived the test of time--and by this we mean both economic and investment methods.

Is the Recession Over?

Fed Chair Bernanke tells us that the recession is probably over.  Business Week reports:

From a technical perspective, the recession is very likely over at this point," Bernanke said in responding to questions at the Brookings Institution. "It's still going to feel like a very weak economy for some time because many people will still find that their job security and their employment status is not what they wish it was."

The announcement marks the start of a new "silly season" where people argue about recession dating, and misconstrue statements, taking them out of context.

Here is the issue.

The public goes by the "feel" method, using plenty of anecdotal evidence.  If there are many people feeling the pain from an economy growing below trend, it feels like a recession.  We really sympathize with this practical approach.  It is important to achieve potential.  The economy has been below the potential growth path for years, and will probably not get back there, achieving full employment, for years to come.

This is the cost of the credit collapse.

The media combines anecdotes with the "two quarters" rule.  Two quarter of negative GDP signal a recession.  It is not clear what constitutes a recovery.

The economists take a very different and more complex approach.  Read carefully.  If and only if there is a big decline on various indicators, the recession has been established.  At that point, and only at that point, the NBER committee looks back and finds a peak.  That peak is then designated as the start of the recession.

There is a good reason for this approach.  Economists want to link the actual recession timing to other economic data.  They are not trying to give a real-time signal.  It is all about timing for economic research.

Interpretation

The media and the big-time blogs have a field day with the economists' definition.  They play upon the popular conception, portraying economists as clueless bozos, who cannot see a recession when it is obvious to all.  This is great fun and gets many boo-yah's from the readership.

We did a careful description of this process in April, 2008, How to Win a Recession-Predicting Contest.

In that article we successfully guessed the actual start of the recession.  We urge readers to take a look at that article.   More importantly, we wrote as follows:

It Really Does not Matter

There is no light switch that makes things terrible if the economy is in a recession and acceptable if it is not.  Economic data show that we are experiencing a period of economic weakness.  This means lost jobs and lost profits.  It is a permanent loss and painful to many.  This is true whether or not the economic weakness attains status as an "official" recession.  It is a range of results, not a black or white question.

Now for the Flip Side

We are now entering the "flip side" of this story.  If the economic rebound continues, the dating committee will go back to determine the trough.  It will probably be some time in the last few months.  We will not know the official answer for many more months.

Investment Conclusion

There are some who are very negative on the economy right now.  If it turns out that the recession actually ended last spring, it does not mean that these analysts were foolish.  Similarly, going back to 2008, those who did not predict the recession might have been right.

The key point?  The Lehman failure and the instant freeze of credit markets created the downturn that verified the recession, moving the date back to the prior peak.

It is a cheap shot to take issue with those who did not foresee Lehman and the consequences, just as it will be a cheap shot to criticize those who are not currently predicting the recession end.

Big economic events provide the trigger for a post-dated result.  For investors, it matters little.  It is wise to ignore the "silly season" and focus on the fundamentals of interest rates and expected earnings for stocks, both of which are now becoming much more positive.

A Final Thought

We have frequently cited the ECRI as a source for economic cycles in real time.  Many predicted a recession for years before it occurred.  Since there is a recession every five years or so, this is a broken clock method.  The ECRI made the call in real time.

What about now?  The ECRI leading indicators have been very strong since July.  Most pundits are skeptical, thinking that they have deeper insights.  We shall see.

Fighting the "Fundamentals"

How should one interpret the market rally?

One widely-held viewpoint is that the rally has occurred despite weak fundamentals.  This means the market is over-extended and due for a correction or even a crash.  Those taking this position cite continuing high unemployment, a continuing high rate of foreclosures, threats to commercial real estate, the "spent-up" consumer, high debt levels, and a generalized concern about government policy.

These have all been the factual backdrop for many months.  These factors have not changed.

Another Approach

An alternative viewpoint is that the US equities in March reflected a worst-case scenario, revisiting depression conditions.  If conditions -- still bad -- improved from those levels, then many individual stocks deserved higher valuations.

What has changed since March?  Two things - -both important.

Forward Earnings.  Ed Yardeni follows the forward earnings estimates quite closely (subscription required).  He writes as follows:

Earnings are turning. S&P 500 forward earnings is turning up rather nicely and consistently since it bottomed at $62.92 per share during the week of May 8. Last week, it was up 12% from the bottom to $70.49. It’s up for 17 weeks in a row to the highest level since January 23. As 2009 ends, forward earnings will converge to analysts’ consensus expected earnings for 2010. This estimate has also been moving higher from a low of $73.37 during the week of May 8 to $75.29 last week

Interest Rates.  Investors have a choice in asset allocation.  When there are extremely high corporate bond rates, this is an attractive alternative to stocks.  If one is taking a risk in buying corporate paper instead of Treasuries, the return should be compared to expected stock gains.

The Atlanta Fed does a nice job of summarizing many economic indicators.  Here is a recent look at corporate credit.

 

There is an obvious improvement in corporate yield spreads.  Lower yields make corporate paper less attractive in comparison to stocks.

 

Credit default swaps show the same picture.

Conclusion

However one defines the "fundamentals" it should not be a static concept.  The data show that stocks have less risk and more potential reward than was the case a few months ago.

Those choosing a static definition of the fundamentals -- looking at backward earnings, for example -- miss out on the changes in risk and reward.

Considering these data, one could easily make the case that stocks are just as attractive now as they were last Spring.  Prices are higher, but risk/reward is also better.

The Perils of Data-Fitting

We are delighted to see the Felix Salmon piece (highlighted by Abnormal Returns) reviewing the supposed relationship between Japan in the 90's and the current US market.  Check out the article to see the "great fit."

Here at "A Dash" we have frequently exposed such  bogus relationships, even when the loud voices took the other side.  There is a simple process for generating a misleading relationship:

1. Examine a bunch of charts.  Look for variables that are all correlated to the economy in some way.
2. Find a couple of prominent features to the charts.  It is especially good if one of them (the leader) shows a move not yet reflected in the other.
3. Adjust the scales to make the prominent features line up.  Ignore any other activity.
4. Disseminate the predicted next move as widely as possible.

We exposed this process in the "Batman" chart allegedly showing a relationship between bank lending criteria and personal consumption expenditures.  This widely publicized chart was never defended by any of the original big-time proponents.  The collapse in PCE did not occur in the predicted time frame, as we showed here.  No one was keeping score.

It was an obvious case of data-fitting, although our analysis did not get the buzz that we see for Felix Salmon's piece.  Perhaps it will do better in the book version.

What You Do Not Understand

Let us assume that everyone now sees the peril of twisting old chart data to fit a pattern.  This is a lesson that can be applied to something you do not already know.

When someone reaches into history for an analogy -- -it is the same thing.  It is back-fitting of data, using the human mind, the most powerful computer.

When someone presents a trading system -- based upon many runs of old data, it is back-fitting.  The spectacular returns are not real.

Our Take

It is a shame that people are drawn to bad charts, bad analogies, and bad systems.

Too bad for them.  For the rest of us, it is a time of opportunity.