A Dash of Insight

"Sticky Sentiment": Part Two

Market sentiment is an important variable both for traders and investors.  Simply put, if nearly everyone is bullish, who is left to buy?  If there is a high level of bearish sentiment, asset allocations can shift to stocks both rapidly and dramatically.

Readers of "A Dash" know that we use different measures of sentiment for different time frames.  We see sentiment as "sticky" or slow to change since those who have formed opinions are reluctant to accept the significance of new information.  We described the entire process using the real-time trading of a sports event, attempting to help readers to escape the normal trading biases.

Application to Stocks

Gary D. Smith, who has an excellent multi-year record of finding profits, is quite willing to adjust his daily positions to reflect events.  He graciously shares many of these viewpoints, and a lot of important market data, for anyone wise enough to follow his work.  We repeat our strong recommendation to do so.

Gary reports on the most recent data from the American Association of Individual Investors as follows:

The AAII percentage of bulls fell to 30.4% this week from 45.8% the prior week. This reading is still at a depressed level. The AAII percentage of bears rose to 48.7% this week from 37.3% the prior week. This reading is still at an elevated level.

There is plenty of additional detail, including the 10-week averages that show the "sticky" behavior of this sentiment.  The entire article is worth reading.

Gary adds additional information about other indicators.  Here is the more comprehensive story:

Individual and professional investor pessimism towards US stocks remains deep-seated and historical in nature. It is also noteworthy that short interest continues to soar to new record highs, corporate insiders continue to display downright giddy behavior, domestic mutual funds continue to see significant outflows, hedge funds remain net short, the equity put/call 20-day moving average recently hit an extreme, a massive mountain of money market cash on the sidelines continues to grow and according to Google Trends the use of the word “depression” in the news media has recently spiked over the last year. [check the useful links in the original article.] This is just some of the evidence of the current “US negativity bubble."

A Typical Opposing View

Writing in his weekly column for Barron's Alan Abelson states a typical opposing viewpoint:

No arguing that the various and sundry surveys of how investors feel about the market show they've been uniformly and emphatically negative. But our own sense is that the bearishness is a mile wide and an inch deep. That to judge by how they act rather than what they say, the investing multitudes have been champing at the bit to take the plunge...

Rejecting the traditional indicators, Abelson cites anecdotal evidence from the attendance at presentations by a bearish economist.  A novel approach indeed!

Others making similar long reaches for an argument ask, "How can the market have bearish sentiment, when it is reaching new highs?"  Market averages can and do fight sentiment -- all the way up (or down).  This was the point of our out-of-the box illustration from sports.

Our Take

Investors should let evidence lead them to a conclusion, changing opinions when indicated.  When one instead begins with the conclusion, it is always possible to find some new indicator that seems to confirm one's viewpoint.

Understanding the difference is crucial to investment and trading success.  We agree both with Gary's evidence and his conclusion, "I still expect US stocks to rise sharply from current levels later this year..."

Sentiment is Slow to Change: a Basketball Lesson, Part One

At "A Dash" we realize how difficult it can be to understand investment principles.  It is important to have good examples.  It is even more powerful to step outside the normal investment world, where the reader already has a strong opinion.

In our classroom days we would frequently set up a different and unfamiliar problem.  Students would examine and discuss the case with enthusiasm.  Then we would reveal the analogy that was the point of the lesson.  Some in the class would object, of course, but that was fine.  Discussing whether or not an analogy is apt is part of the process of education.

We have tried this a few times in the past.  The normal result is that Seeking Alpha does not run the story and many of our normal (and abnormal!) gatekeeper friends do not see it as relevant to the markets.  We respect their judgment about the interest of their readers.  Meanwhile, we are trying to write a book.  Getting people to think in an open-minded way is crucial.  Undaunted, we present an analysis of sentiment that uses a subject of current interest.

A Basketball Example

One way to analyze cognitive biases is to take an example completely outside one's own experience.  We have found  TradeSports.com to be a useful laboratory for this analysis.

Background.  TradeSports, the sister site of (Intrade.com where there are various political, economic, and event markets)  has real-time trading in futures contracts on the outcome of sporting events.  There is a lot of volume and those participating in the market are watching the game in question.  This adds a new dimension to the concept of interactive television.  There is even trading pit chatter, featuring the viewpoints of a number of arrogant, opinionated participants.   Their language is even more colorful than that found on the sites of stock market bloggers.

At "A Dash" we are obviously not advocating participation in this market, deemed illegal for US residents.  It is just another interesting piece of information to follow when watching the game.

The Case.  Saturday's semi-final contest between North Carolina and Kansas is a great example of market sentiment.  We have observed trading on many sporting events, so we urge you to take our word for the general interpretation.  Readers should note that we are not offering an opinion about the respective teams.  If the game were to be played 100 times, there would be many different outcomes.  The general result would be much closer than what actually occurred.

The market began with a bias about which team was better.  That opinion persisted, in defiance of the apparent results.  Sentiment changes very reluctantly.

The initial condition was that North Carolina, the overall #1 seed in the tournament, was favored by 3 1/2 points, 60% to win on a straight-up basis.  The TradeSports futures contract for a team settles at 100 for a win and zero for a loss.  The chart can therefore be interpreted as the percentage chance of victory at any point in time.

Let us start by looking at the chart.

Kansas had a very hot start to the game.  Since we are analyzing sentiment, not basketball, we shall just note that with ten minutes played, Kansas had a twenty-point lead.
At this point, the futures contract still showed a 20% chance for a North Carolina victory.  Let us think about this.  At the start of a game, a team that is a twenty-point favorite in the point spread is over 97% to win the game.  There was a clear disconnect between trading and reality, with North Carolina over-valued by the market.

A few minutes later, the lead grew to 28 points.  North Carolina futures still held a minimum bid of 5, reflecting 19-1 odds.  Market sentiment still held that UNC had a chance.

Now one might expect a team with such a lead to change strategy, but it is difficult to do so in practice.  Bill Self later stated that his team went "brain dead" for about thirteen minutes, allowing the margin to be narrowed at the end of the first half and for the first ten minutes of the second half.  Anyone who watched Gene Hackman in Hoosiers understands the difficulty in getting players to follow the coach's strategy!

Did this mean that the UNC investors were correct?  The television analysts opined that the game was over.  Despite this, with ten minutes to go, the lead was narrowed to five points.  The futures contract got as high as 50, reflecting a continuation of UNC momentum.

The best trade of the contest was to buy North Carolina at 5.5 and sell at 48 or so, a nine-bagger in less than fifteen minutes of playing time.  This profit could have been accomplished by investing in a team that ultimately lost by a wide margin, and never got the lead!  One does not need to predict the result to make money, only to predict the market reaction.

In fact, this was a highly improbable result.  That it actually happened seems to confirm the sentiment.

When Kansas slowed things down a bit and worked the ball inside, their lead grew once again.

As the clock ran down, the inevitability of the result became clear.  It was only at this point that sentiment switched.

Conclusion

The lesson here is that market sentiment is very "sticky."  Those investing in UNC futures were not just fans.  Most were regular players of many sporting events, seeking a profit on this one.  They began with an opinion, and the opinion was slow to shift.

The value of looking at an example like this is that the entire picture of sentiment and reality can be captured in the space of a few hours.

In the stock market, a similar process may take many months or even years.  We shall explore this further.

Bear Stearns Bailout Implications

Everyone needs some time away, but those of us in the investment world never really get it.  Managing money carries with it the responsibility of monitoring information and staying in touch, no matter how talented the team on the front line.

We are talking with a lot of individual investors.  The doom and gloom is palpable.  It is no surprise that the viewpoints reflect the themes of the popular press and websites.  We plan to return to the broad themes, but let us take today's news as a case in point.

CPI Data

For a few minutes this morning the market celebrated the news that February CPI (seasonally adjusted) was unchanged.  The data critics were warming up.  How could gasoline prices be down?  (Answer:  Look at a chart.  This is February data, compared with January.  People are already thinking March).

There is a reason why those who are not economists and have never actually collected or analyzed data are so critical.  If no one believes the official data, they are free to propagate any argument based upon anecdotal evidence.  With the cost of living,  it is easy to point to items that have increased in price, ignoring any serious methodology or balance.

Bear Stearns

The story, as we now know it, seems to be that Bear suddenly and unexpectedly experienced a broad scale loss of accounts.  Since financial institutions do not and cannot keep enough cash around to meet all redemptions, this "run on the bank" carried a systemic risk.  Counter-parties of Bear might also fail.  Forced selling (yet another round) of illiquid assets would partly meet obligations, but might force another round of write-offs by other institutions.  In a couple of weeks, Bear would have been able to use the new Fed TLAF facility for this collateral, but could not do so yet.  Bear turned to its banker, J.P Morgan and described the situation.  JP Morgan could borrow from the Fed's discount window, but did not want to have the traditional "stigma" that comes with such actions.  The Fed agreed to backstop their action, leaving JP Morgan with no exposure.

What to Conclude

Explained in this way it seems like a success story.  Something that was completely unexpected created a major threat.  The parties involved acted swiftly and effectively.  While stock market traders aggressively sold financial issues, the major system threats were averted.

To realize this, ask what would have happened if Bear indicated insolvency with no support from the Fed.....

Some Comments from the Punditry

Bear lied. [How do we know this?  The "later" story was that rumors became a self-fulfilling prophecy.]

Bear caused the problem when the CEO went on CNBC to explain that "all was well."  Multiple pundits and traders today explained that this was alarming and caused the problem.  [A key feature of a successful CNBC interview is to show how smart you were about something that already happened.  Let's hear from those who caught this contemporaneously.]

The Fed has lost all credibility, according to a featured trader on CNBC.  This is because of  "what they said about interest rates."  [These trader comments are amazing.  The Fed acted much more rapidly than past Feds in similar historical situations.  They adjusted policy rapidly with new data.  We wonder if traders would prefer a situation where the Fed did not respond to data?]

Everyone in power is an idiot.  [Our view is that the Fed has been aggressive and creative.  Bernanke has acted more swiftly than past Fed chairs, and has also used creative means.  The TAF facility was disparaged by pundits at the launch, but was actually quite successful.]

We cannot trust anyone.  [This is the ultimate argument for pundits.  If the average investor cannot trust statements by the Fed, by any CEO, or by the government, then it is open season for those promulgating fear.  Fear sells.]

Conclusion

A top financial analyst came up to me today and stated that no one was bullish.  Everyone he talked to shared the view that all of the government officials were stupid, the data were manipulated, the recession would be severe, technical support had been violated, and the market might crash.  Everyone.

The dilemma.  So many are saying that the market has given a verdict.  If one thinks that the market is always right, in the short term, than there is no edge for the investor or the fund manager.

The Fed, the Economy, and Stocks

Sometimes a concept is so simple and compelling that one would expect it to be universally embraced.  When important government agencies demonstrate a commitment to addressing a problem, investors and traders alike would be wise to take notice.

Instead, stocks have declined dramatically, actually beginning at the time the Fed engaged in cutting rates and initiating the successful TAF facility.  A key point is that Wall Street guru's and pundits all seem to believe that they are better and smarter than those in government.

At "A Dash" we try to find the real experts.  There may be other blogs written by people who have extensive experience in the three relevant arenas - academia, government, and financial management -- but we have not seen any.  (Readers please correct us ASAP).

The choice for the investor is easy.    On the one hand, you can accept the arguments of the market pundits who think that government officials are too stupid and academics are too smart, and both are  therefore out of touch.  Alternatively, you might consider the possibility that some very bright and capable people choose different career paths.  They are all good at what they do.

Outsmarting the TV and Internet Experts

The unending hunger for content makes everyone an expert.  Today the CNBC noontime anchors were swept away by a prediction of an inter-meeting rate cut by the Fed, a prediction made by a young woman who is a strategist for a firm trading fixed income instruments.

She might be correct in her call, but many of the bearish pundits have made two big mistakes:

1. They predicted that the Fed was "in a box" and would not ease aggressively.  Strike one.
2. They next opined that the Fed must stop cutting rates because of a declining dollar and rising commodity prices, something that they accept as a better measure of "inflation."   They were wrong again.  Strike two.

These pundits now think that the Fed is "Pushing on a string."  We hear this prediction from very few actual economists.  This is pretty strange.  We believe that it will be "Strike three."

At "A Dash" our view is that there are plenty of experts on different subjects.  When we are looking for trading insight and stock-specific information, we read and consider carefully the views of Doug Kass (full disclosure -- he is a colleague on TheStreet.com).  His ideas are plentiful, profitable, and worth the price of admission.  He endorses the "string" theory.

When it comes to economics, we prefer the viewpoint of David Malpass, who has had a multi-year record at reading the economic twists and turns with great accuracy.  Last week he weighed in on this topic in a report for Bear Stearns investors, Massive Fed Power--How it Works.

Fed Not Pushing on a String
We think there’s a general underestimate of the power of central banks to stimulate their economies in the short term.
• U.S. recessions have occurred when the Fed tried to stop inflation with high interest rates (1974, 1980, 1982, 1990), a situation the Fed may put off until 2009 or 2010. In contrast, when the Fed has held interest rates down to the inflation rate or below, the result has been strong growth, as in 1977 and 2003.

Malpass goes on to explain how the effects are amplified by the Hong Kong Monetary authority, how circumstances have improved since the August credit problems, and why the economy is likely to expand.  He does not believe that it will "end badly."

The compelling argument is that the Fed is determined to avoid a deflationary spiral.  If you are an investor, that is something to keep in mind.

Will this result in some future inflation?  It depends upon the reaction of the economy and the pace of the Fed in reversing the rate cuts.  While  no one knows for sure how this will play out, it is not a firm basis for investors and traders looking to the remainder of 2008.  That story is one of economic expansion, including both the Fed and fiscal stimulus.

Some Analysis of Rate Cutting

Michael Zhuang at The Investment Scientist has a nice table summarizing stock returns after periods of Fed rate-cutting.  His familiar conclusion is the quote from Marty Zweig, "Don't Fight the Fed."  Readers should check out his article for the full story.

We believe that the analysis actually understates the case.  The current environment is even more bullish since we are starting from such a high level of negativity.  Actual corporate earnings outside of financials remain strong.  The financial stock earnings include write-downs that emphasize current FAS 157 accounting, marking to illiquid markets, rather than looking at future  potential.  It is something to consider.

Conclusion

Market averages are heavily influenced by technical trading, forced liquidations, and sentiment.  As we indicated, there is a sense that January lows must survive a re-test.  We are not anticipating a good employment number on Friday, a subject for tomorrow.

We do not indulge in short-term market calls.  On somewhat longer basis, the averages are still trading at the level when our Gong Model (report available upon request) indicated a good risk/reward for those with a multi-month horizon.

We are also very confident that a solution for monoline insurer problems will be forthcoming.  The market skepticism on this subject has been vastly overdone.  This is an important development for financial stocks, particularly Merrill Lynch (MER).

Full Disclosure:  We are long MER.

Sentiment and Reality

At "A Dash" we do not indulge in the very short-term market calls.  It is a popular thing to do, and someone has always made a spectacular prediction.

Our problem with these methods is that they are not testable.  Someone is always right, but how should one evaluate the overall record?

Friday's Trading

On Friday we saw a steep decline in the market averages that was the virtual flip-side of the pre-weekend trading seven days ago.  What was the difference?  The hot-money traders learn quickly.  A single data point is enough!

Charlie Gasparino's prediction last week of a "bailout" for the bond insurers did not pan out.  End of story.

Actually, the Gasparino coverage was quite strong.  He revealed some of the actual discussions, showing that there was a dialog among the insurance commissioners, the potential investors, and the ratings agencies.

To anyone with some understanding of how agreements are formed, this should be good news.  The rating agencies are not rolling over and accepting anything.  The investors are listening and crafting a package.  There will be time allowed to do it right.

Meanwhile, investors are acting like spoiled children.  We want a solution, and we want it now!  There is little understanding that problems which develop over years might take a few weeks to solve.

The Bearish Victory

The disparity between expectations and data continues.  Those with a bearish bent argue that there is already a recession, it will be terrible, it is not priced into the market, earnings estimates must move much lower, and there will be a general calamity on the scale of the 70's stagflation or even the Great Depression. Wow!

When stocks move lower, it seems to prove the point.  This is most interesting and worth some thought.

Anyone who claims to provide a market edge, almost by definition, must find occasions when the market is wrong and the analyst has a superior viewpoint.  The most bearish economic pundits now get to claim victory -- even if the economy never enters a recession!

It is not necessary to be right on the facts to be right on the market.  As the market moves lower, there is a building sentiment that it "must test the January lows."  This advice is usually offered in a deep and stern voice.  If enough people believe it, it happens.  It is seen as proof of the economic forecasts.

We are now a few points away from those lows in the S&P 500 and even closer in the Nasdaq.

Data, Anyone?

Meanwhile, there is a different picture available to those willing to look at data.

• Today's ISM number was widely publicized as showing contraction in manufacturing.  The actual data are consistent with GDP growth of 2.0 - 2.5%.  This is much better than most think.
• All of the consumer data shows record spending.  David Malpass writes "Many U.S. indicators are at new all-time records, including the February 29th data on consumption in real terms ($8.351 trillion annual rate in January) and both income and consumption in nominal terms ($11.93T and $10.02T respectively).
• Earnings results outside of financials have been excellent.  Financial earnings have been hit by write-downs enforced by marking to market in extreme conditions.  The jury is out about next year, but many see the artificial markdowns as contributing a bounce. 

Markets can, should, and will look ahead...

Media types and bloggers have a fixation with scare tactics like "stagflation."  The cooler heads, like Bob McTeer, try to make careful and reasonable comparisons.  Take a look at his latest thoughts.

Meanwhile, the markets have underestimated the impact of Fed rate cuts and the stimulus package.  These will start to show up very soon -- perhaps in a month or so.

A Final Observation

There are other policy actions in the works.  It is popular to point at the list of potential housing foreclosures.  In fact, it is open season for those working to avoid disaster.

So many are so busy at the job of criticizing government officials.  In this environment it is easy for the investor to forget a key point.

Those who chose to work in government did so because they wanted power rather than salary.  When we tally up the results, whom do you think will be proven correct:  The critics, or those who actually have the power?

Our bet is with the Fed and the Treasury.

The Winning Trade is the Tough Trade

One of our favorite daily reads is The Kirk Report.  Charles Kirk shares his success, listens to his readers, and provides long lists of links that find articles often missed by others.  For the full benefit, readers should make the requested donation and become members.  You'll probably recover your cost on the first trade.

In an article today Charles provides a lot of great advice from legendary trader William Eckhardt.  We recommend reading all of the great quotes, but wish to highlight two particularly relevant insights (emphasis added):

"If a betting game among a certain number of participants is played long enough, eventually one player will have all the money. If there is any skill involved, it will accelerate the process of concentrating all the stakes in a few hands. Something like this happens in the market. There is a persistent overall tendency for equity to flow from the many to the few. In the long run, the majority loses. The implication for the trader is that to win you have to act like the minority. If you bring normal human habits and tendencies to trading, you'll gravitate toward the majority and inevitably lose." - William Eckhardt

"One common adage on this subject that is completely wrongheaded is: you can't go broke taking profits. That's precisely how many traders do go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits. The problem in a nutshell is that human nature does not operate to maximize gain but rather to maximize the chance of gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance." - William Eckhardt

The Tough Trade

The toughest concept right now is dealing with the incessant emphasis on recession prospects.  Our viewpoint is that the market prices have already built in the recession and some are even looking at early cyclicals for a rebound.  We have the interesting prospect that the market may discount a recession and follow the playbook for emerging from one -- whether or not the recession actually occurs!

It all depends upon earnings.  Turley Muller does an excellent job of describing the difference between forecasted earnings and the current market attitude.  His conclusion, like many others, is that earnings forecasts will move lower to match the  market.  This is the prevailing viewpoint of "top-down" strategists as noted in a good New York Times article.

A good question is whether the top-down analysts, whose methods are not very well described, are actually better than those following the companies.  It would be nice to have more  hard data.  Our own reading of many analyst reports is that many are already building in a downbeat economy, as are the companies.  We wonder whether the market has too much fixation on the 2000 era, when analysts and companies alike really hyped their prospects.

Some Facts

Current earnings ex-financials are about about 14% year-over year.  Generally, we do not like throwing out a particular sector, but it provides food for thought in this case.  Financial companies have been forced by accounting rules to mark down illiquid positions which might (or might not) do better than the marks.  They have expanded balance sheets rather than selling assets into an illiquid market.  The Fed is helping with the TAF facility.  The market is expecting more losses from financials, at least in the first  half of the  year.  The second-half comparisons will be much better.

Is there a Contrarian Play?  Does it have good risk/reward?

Everyone knows that interest rate cuts work with a lag.  Some of the impact comes right away, or even in anticipatory fashion.  Much of the impact comes later.

Despite this knowledge, market participants are fixated on the recession question.  Partly this is due to the financial media's preoccupation with asking anyone, regardless of forecasting ability, their opinion on the subject.  There are some important consequences, as follows:

• Individual investors bail out. Mutual fund outflows show it happening.  Some great stocks get sold along the way.
• Since the stock market is seen as a leading indicator, traders view stock prices as confirming economic consequences.
• CEO's read the news.  Even when their current business conditions are solid, many are cautious in offering guidance.  The market punishes any company that does not offer solid guidance, so there is a self-fulfilling prophecy at work.  Notable exceptions today included TEX and RIMM -- both worth attention.

Some Cool Heads at Work

Let us consider the thoughts from some quite disparate sources.

David Malpass.  Regular readers of "A Dash" know that we admire Malpass' work, mostly because he has a multi-year record of excellent predictions  about the economy.  His most recent writing, The Punchbowl is Back,  shows a major shift in his thinking.  He now places recession chances at about  10% and expects a rebound in corporate earnings.  His work on the consumer, the wealth effect, and misleading savings data deserves more attention.  A key point is that consumers doing smart things, like taking cheap loans for good assets, are summarized as piling up debt.  In fact, their assets have grown significantly, even allowing for housing declines.  Only the debt shows up in government stats.  See your Bear Stearns rep to read more of Malpass, or watch for his frequent WSJ articles.

Dick Green at Briefing.com is another of our favorite sources.  His overall read and market assessment have been strong for several years.  His most recent commentary includes the following:

Monetary and fiscal stimulus has been much more aggressive this business cycle than in the previous two recessions. A comparison with 1991 and 2001 suggests that the market is vastly underestimating the economic impact for 2008 from lower rates and tax rebates.

Last, but surely not least, is the level-headed Muckdog.  One reason that we feature his thoughts is that he has an uncanny feel for parsing a lot of disparate information and seeing a winning course.  He writes as follows:

Bottom line is that I think the Fed rate cuts will work.  The tax rebates will help.  And folks who are doing their 2007 taxes may also receive refunds, and that'll help.

Conclusion

Investors succeed by taking contrary positions, realizing when stocks are wildly overvalued, as they were in 2000, and when they are on sale.  Right now, this means understanding the negative market psychology and finding the right opportunities.

One needs to anticipate where the economy, earnings, and stocks will be in a few months.  Understanding the impact of policies -- measures already taken by the Fed and the Congress -- is part of that process.

Technical indicators, like our Gong Model (still showing that a good risk/reward bottom is in place) and our TCA-ETF method (showing numerous attractive sectors) can  help provide the needed discipline and confidence.

Those who are under-invested in equities might well consider beginning with a partial position, something that we accurately recommended at other times of stress.

TCA-ETF Update

As usual on Thursday, we show the latest output from Vince Castelli's successful model for sector investing.  Despite a tough market environment, the system, which includes trends, cycles, and anticipation, has identified a number of successful sectors.  It also shows that there can be a bull market in some sectors, even in a time of market stress.

We show this mainly to help other ETF traders and to illustrate how a system can help.  Some readers have expressed interest in a full performance report, which is available upon request.

Investors Look at the Wrong Information! Why?

It is difficult to beat the market.  Individual investors who try to do so have, on average, results that are decidedly inferior.  And not just by a little.  It is more like half of the market return.  They try to time the market using all of the wrong methods.  They are afraid when they should be active.  They are "all-in" when they should be cautious.

We are developing some general themes -- common mistakes -- but our effort is one of building the case a step at a time.

An Example

Before departing on a long weekend of pure relaxation, we tried to leave investors with an insight that we felt was particularly valuable.  Our experience shows why getting perspective is important.

Earth to OldProf:  They do not get it! We posted an article on why accounting rules may be misleading investors.  We know that this is important for several reasons:

1. It affects all of the financial stocks, an important key to the  market;
2. General understanding of the issues is poor and reflected in the prices of many stocks:
3. The financial write-downs get plenty of daily play, with each new story changing analyst estimates.
4. The crucial element of understanding requires knowledge of accounting rules, the immediate effect, and the longer-term implications.
5. The big mainstream media sources report each fact, but often do not provide an analytic framework.

With this in mind, we wrote about how the rules affected a key company, AIG, and the market impact.  Quite frankly, we hoped and expected that this would generate some interest and comment. Wrong! What were we thinking?

We checked this with our own small focus group and got a big yawn.  No one wants to think about FAS 157.  It is over the barrier of complexity.  If things get too technical, everyone tunes out, no matter how important the topic.

The focus group was correct.  We pay little attention to daily traffic at "A Dash" since we are not doing advertising, but we do periodic checks to see what resonates.  FAS 157 causes eyes to glaze over.  No one cares.

This myopia is empowering for those who take each issue to the lowest common denominator.  FAS 157 was a big story when the bearish bloggers saw last November 15th as a doomsday date like Y2K.  When it did not happen, the powerful writers in mainstream media did not point this out.  There is no accountability.  It is easy to make big predictions of write-downs.  And it is newsworthy, picked up by all of the popular media sources and financial television.

Conclusion

There is always a way to appeal to an audience without providing understanding.  Realizing this is the biggest challenge and the biggest opportunity for investors.

The credit market issues are difficult to understand.  Investors and traders are not really capable of making independent decisions.  Even if they work to get the facts, it also requires a solid analytical framework.

We shall pursue this with some other examples.  Meanwhile, we need to work on article titles!  Maybe if we had called the article DOW 15000 and included the Sports Illustrated swimsuit indicator, with a picture or two, it would have gotten more attention.

Understanding why FAS 157 is important is both more important and more challenging.

Another Round of Panic

Trading and investing are quite different things, a matter of time frames.

Today's trading was sparked by the ISM services report, something that has not attracted much attention in recent years.  The Market has focused more on the traditional ISM manufacturing survey, partly because it has a longer history, and a clear link to GDP.  For those who have forgotten that report, released two trading days ago, it suggested GDP growth of 3% as of mid-January, the time of the survey.

The ISM service release was surrounded by some controversy because of a change in the method of calculation and the early release of the data.  The ISM, in circumstances nicely reported by Kelly Evans of the WSJ,  admitted in a conference call that information might have leaked, so they announced the result before the opening.  We are always amazed to see that people do not realize that big traders can always find a way to play information when regular stock markets are closed.  Globex futures trading, anyone?

Significance of the Report

Most market participants realize that the service economy has assumed greater importance in recent years.  The large move in the index played into the recession fears of many.  As the market declined, this seemed to be confirmation of increasing recession odds.

The market and media reaction was that if many react to a piece of data, it must be right.   Let us look a bit deeper into this information.  When so many stampede, there may be a contrarian opportunity.

We have tested the ISM service series against employment changes and other economic data, and we find it to be pretty good.  When comparing it to the ISM manufacturing index we discovered that it did not add much information.  We now have a single data point where there is a significant divergence.  This would be nice to test, but there are not many other divergences to use.

Our review of today's news did not find anyone else who highlighted this statistical fact, or wondered about the meaning.  This provides an edge for our readers.

Other Interpretations and Advice

We realize that those with a predisposition to seize upon any evidence of incipient recession are touting today's number, even if they never mentioned it before.  Readers might want to compare the current interpretations from these sources with those from past months when the services figure was stronger than manufacturing.  There is a lot of selective perception at work.  Pick your favorite source and do a search to find out whether this number was ever highlighted when it was strong.

Briefing.com, an unbiased interpreter of information, reports as follows:

The data seem inconsistent with the harder figures on spending and investment and world trade which really provide the trends for domestic growth.  We also believe that the intent of this ISM index -- to reflect on growth for the entire economy outside of manufacturing -- is a mighty grand objective given the simplicity of the survey questions. 

For each component (e.g.  activity, employment, orders), the question to the survey respondents is simply, "Are conditions stronger, unchanged or weaker than the prior month?"

Gary D. Smith, who has a strong multi-year record of market forecasting, provides excellent daily commentary on his blog.  Unlike some other providers of links,  Gary cites information from every possible source.  He tells the "whole truth" without any cherry-picking of information.  Here is his take:

I continue to see the US Fed as now “ahead of the curve” and the odds of an intermeeting rate cut are rising meaningfully. The VIX is rising 8.0% today to a high 28.0. The ISE Sentiment Index hit a below average 102.0 and the total put/call is hitting an above average 1.12. Finally, the NYSE Arms has been running very high again all day at 2.47, which is also a positive. I still view the odds of a full retest or new lows in the market as unlikely and further weakness providing good entry points in favorite longs for investors.

Read the entire article to get the full context.

The Earnings Mythology

The recession hypothesis is getting an additional boost from commentators who claim that forward earnings are in decline.  Briefing.com has some great information on this:

According to Thomson Financial, fourth quarter 2007 earnings are expected to decline by 20.7%.  The main reason for the decline is the financial sector's whopping 105% decrease in earnings.  If the sector was removed, earnings would grow by 11.0%.  Homebuilders are also a drag.  For example, the consumer discretionary sector's earnings would grow by 7%, instead of declining by 15%, if homebuilders were removed from the calculation.

In general, we do not like throwing out the worst or best sectors from the overall S&P 500 earnings.  This might be an exception.  The last quarter is a bit unusual because of the forced write downs of mortgage securities.  Some believe that there are many more write downs to come.  We think that the FAS 157 losses might actually overstate the impact on these firms.  They voluntarily chose to keep securities on the balance sheet, probably because the expected performance to exceed current value in an illiquid market.  The jury is out on that question.

Meanwhile, the rest of the market sectors are not showing mean reversion, recession, or any other sort of earnings decline.  For example, Colin Barr's nice review of the Disney report highlights a good past quarter, and good future prospects.  This is a company that one would expect to be hit by consumer distress, if it were already an important factor.

Forward earnings will depend greatly upon how financial stocks rebound from current conditions.

Conclusion

Markets look forward.  Even in recessionary times, a fact not yet in evidence, forward earnings look through the recession, setting the stage for rebounds in stocks prices.

The Stress Test

As we write this, foreign markets have plunged over the weekend.  Stocks will open lower -- much lower -- at a frightening level.  Individual investors may well panic.  Some traders will see this as the indicator they have been seeking - a dramatically lower opening that provides a buying signal.

We reported our own short-term indicators (negative) and our intermediate-term indicators (waiting for the washout).  We will be buyers on the opening.

The Problem:  A Crisis of Confidence

There has quite obviously been a leadership crisis.  Any appearance by a government official -- Bernanke, Paulson, Bush -- seems to lead to another decline of 200 or so in the Dow.

What should we make of this?

During the weekend we have not only read the typical Internet sources, but talked with various fund managers and astute observers.  There are two common themes:

1. No one has any confidence in the various fiscal stimulus plans or in Fed Chair Bernanke.  No one.
2. The conclusions seem to be based upon market reaction, not actual economic data.

When there is such a unanimous viewpoint, it suggests opportunity.

Staying Calm

The best opportunities for trading and investing come when others react on emotion rather than facts.  Let us take a look.

Market commentary has dismissed anything positive, and has done so for at least a month.  Economic data suggesting economic growth of about 1.5% -- jobless claims, ISM report, Michigan consumer confidence -- is ignored.  None of these readings is close to normal recession levels, but the market sees a recession as a fait accompli.

Fiscal stimulus has been dismissed, largely because the President's package lacked specifics.  This commentary comes from those who have no particular expertise in public policy development.

Almost no one in the blogosphere provides public policy insight, especially when combined with a knowledge of economics, politics, and hands-on investment experience.  Our individual accounts under management have beaten the S&P 500 by about 6 points per year for ten years.  How?  The biggest gains come when we find a solid contrarian theme.

The Plan for Fiscal Stimulus

The Bush plan has been criticized for a lack of specificity.  We are amazed at this reaction!

Anyone who understands politics knows that the key to policymaking is compromise.  Markets should give more credit to the President's advisors, who urged him to take a moderate course.  Anyone really interested in understanding this should read the Pulitzer Prize winning work of Robert Caro, Master of the Senate:  The Years of Lyndon Johnson.

Politics is the art of compromise.  Republicans and Democrats alike have a motive to stimulate the economy during this election year.  They will probably get it done, with a combination of individual and business incentives.

They will be joined by additional Fed rate cuts.  Monetary and Fiscal policy will both be in force.  If a recession is imminent (something that has yet to be determined, despite the widespread commentary) these actions will mitigate the effects.  Meanwhile, stocks are already reflecting a severe reaction.

Bond Insurers

We are aware of the continuing speculation about bond insurers.  The worst-case speculation is a series of falling dominoes as credit market counter-parties cannot pay up.

This is exactly the sort of case where government acts swiftly and decisively.  The historical precedents include, among others,  Long Term Capital Management, Mexican Debt, Brady Bonds, and the Resolution Trust action after the Savings and Loan issues.

The key point to understand is that when private errors start to have major impacts on the general public, government gets in gear.  This will not be immediately apparent to the talking heads on CNBC or the Internet punditry, since they are not public policy experts.

When reading these discussions, one should compare the projected losses to the overall stock market losses -- those hitting average investors and pension funds.  That is the comparison that government officials will make.  Our own estimate is that tomorrow's opening losses alone -- one day -- will dwarf the entire cost of backing up the bond insurers.

Government officials look at cost/benefit analyses.

Our Conclusion

A crisis in confidence always provides a stress test.  Government may seem very slow to react.  A few weeks is really fast!  In "trader time" the reactions take an eternity.  In terms of actual economic impact, the delays are modest.

Despite the widespread speculation, no one really knows the extent of the slowing in economic growth.  Policy actions will have an effect, either to prevent or to mitigate a recession.

Meanwhile, equity investors seem to be selling without reason.  Short-term traders may look for indicators like our Gong Model.  Average investors should take a longer view.

Market Response to Recessions

Each day the market gets "new information" about a slowing rate of economic growth.  If the rate of economic growth slows enough, it can and will be interpreted as a recession, when the NBER does a retrospective analysis of the data.  What does this mean for investors?

An Interesting Table

Let us take a good look at some data from the Wall Street Journal, and highlighted by The Big Picture.

An objective look at this table suggests a major disparity between events of the 70's -- Watergate, Arab Oil Boycott, double-digit inflation and unemployment, double-digit interest rates -- and the more recent history of the last forty years.  The only significant decline associated with a recession happened from the over-valued market of the Internet bubble.  Current market PE ratios are vividly different from that era.

A second question relates to recession dating.  For almost a year, starting with the low GDP reports in Q1 '07 and especially now, many pundits have suggested that we are already in a recession.

The "official" recession dating takes place after a major decline has been observed.  At that point, the NBER dates the recession, the points used in these charts, as the prior peak in output.

Our Take

The most important question for investors and traders is how much of the slowing economy is already reflected in forecasts, earnings projections, and stock prices.  Careful readers of bearish pundits should be asking the question raised by the table:

If the recession really is underway, hasn't the market already reflected reduced earning potential?

Regular readers of "A Dash" know that we believe that forward earnings have reflected recession expectations for many months, driving forward earnings yields to low levels when compared to other asset classes.

Each day brings new and redundant information, completely consistent with slowing  GDP growth.  The market responds, each time, as if this is fresh information.  Slowing growth implies a mixed picture from companies.  We cannot expect them to make wildly bullish comments on prospects.

Those who wait for this optimistic look from companies will have waited too long.