A Dash of Insight

Debunking the Myth of the QE II Rally

The single biggest market question is this one:

What happens at the end of QE II?

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

Background

There are two views of the world:

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

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

The Facts

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

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

 

 Let us consider each of the three key elements.

Valuation

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

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

Risk

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

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

Potential

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

Last August

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

Now

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

Briefly put, the potential is much better.

Conclusion

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

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

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

A Final Thought

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

One of my roles is to bridge this gap.

 

You need to have a system....

Quote of the Day

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

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

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

Inspiration

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

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

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

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

Value

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

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

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

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

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

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

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

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

Future Prospects

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

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

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

Risk

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

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

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

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

Investment Conclusion

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

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

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

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

One More Thought

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

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

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

You need your own approach.

 

 

 

Want to see a secret message to investment advisors?

I want to share something that most investors will never see -- a pitch directed to the investment manager.

If you read this carefully, and think about it, you will see why it is so popular to sell fear.

This is part of an email that I received today, with identifiers removed....The email was obviously directed to investment advisors, teaching us how to increase revenues.

I am impressed by the marketing touches about beating others to the punch and getting my "piece of the pie."  That is not at all how I think about investment advice, but perhaps I am in the minority.  I note that the gold broker also reaches for legitimacy with the 60 Minutes segment.  Most of the world has already rejected and moved on from the extreme Meredith Whitney assertions (check discussion and more links here), but the pop culture validation will play large for a few more months.

Message below:

DAY OF RECKONING IS HERE! Are you still selling only paper (Stocks, Bonds, Mutual Funds, Annuities) to your clients? Click here to view the CBS 60 Minutes segment explaining the looming risk=> click for 60 Minutes segment Tangible - Something that's "REAL"! Tangible - ABLE TO BE TOUCHED! Tangible - GOLD and SILVER! Start providing tangible GOLD to your clients, as part of your clients portfolio. Help your clients Hedge against dollar devaluation and inflation! Stay tangible to provide the stability and liquidity that your clients need and deserve! Sell GOLD to your clients before someone else does! Call us today to learn how you get started! We offer individualized training! Call us today to get your piece of the pie! This offer is available to all insurance agents or registered financial advisors Sell GOLD to your clients before someone else does! Call us today to learn how you get started! We offer individualized training! Check out our website to learn and or sign up as an agent today! It also shows the many tools available to help our agents. We have many point of sale videos that help both you and your clients understand today's financial crisis, and understand how precious metals may play an important part in providing stability and liquidity in their portfolio.

When is the Best Time to Invest?

Here at "A Dash" I often try to stimulate objective thought by taking the reader outside of the normal market discussion.  Sometimes when you see the point in a context where you do not already have an opinion, it is easier to bring the conclusion back to your investing.

Are you ready for some football?

On Sunday afternoon there was a great AFC matchup of the Jets and the Steelers.  The Jets returned the opening kickoff for a touchdown, a surprising and exciting start.  At 11:03 of the 1st Quarter, CBS displayed a graphic informing us that the Jets were 9-0 when scoring a TD.  Quite remarkable.  Scoring a TD is certainly good to do, but it is far from a guarantee of victory.  Apparently the Jets were 1-3 in games where they did not score a TD.  That is much easier to understand!

At the end of the 1st Quarter the score was Jets 7, Steelers 0.  But wait, Steeler fans!  CBS sent another message, informing us that Pittsburgh was 6-1 when the opponents scored first.  Doing a little subtraction in the standings shows the Steelers were 4-2 when they scored first, a smaller percentage.  Does this mean that it would be good strategy for Steeler Coach Mike Tomlin to allow an early score by the Jets?  Maybe he should try to allow only a field goal, or take an intentional safety, since we know that the Jets always win when they score a touchdown.  Hmm!

Even if you are not a football fan, you should be able to see the lack of logic in these arguments.

What is Wrong

The problem is that the CBS analysts are now able to look at hundreds of different variables, looking for something interesting to report.  The logic, or lack thereof, makes no difference.  My colleague Allen Russell lectured his college methods classes on the topic of statistical signficance in a very innovative fashion.  On a monitor in the corner of the classroom he was tracking results from a computer program.  The program generated a random data set with a few hundred variables.  It then looked for "statistically significant" relationships between each pair of variables.  When one was found, the monitor would flash, Significant! Significant!  (Allen was a great and innovative teacher, and I continue to benefit from his thoughtful comments and research).

(This story is from the era of slow computers.  Nowadays the monitor would be continuously flashing).

Back to the Investment World

The same type of analysis occurs all of the time in the investment world.  I am particularly disturbed by this approach from a powerful and influential voice.  First, the list of independent variables:

1) S&P 500 more than 8% above its 52 week (exponential) average 
2) S&P 500 more than 50% above its 4-year low 
3) Shiller P/E greater than 18 
4) 10-year Treasury yield higher than 6 months earlier 
5) Advisory bullishness > 47%, with bearishness < 27%

You should note that we actually have many more than five variables.  The statements include multiple conditions, each one of which can be massaged to a specific level.  Why not 10% above a simple moving average?  Why not 30% above a 2-year low?  Why not bullishness > 53%.  Etc.

This is a well known statistical problem.  There are too many degrees of freedom in the independent variables compared to the number of cases to be explained.  The resulting list of ten "bad times to invest" shows adverse effects within either a few weeks or within 21 months.  How long must we wait to know the answer?  Meanwhile, we are warned that right now is one of those bad times.

The Missing Variable

The missing variable is this one:

A 50% market decline within the prior three years.  Or how about: Negative Quarterly S&P earnings within the last three years.

Viewed in the context of the Great Recession, where stock prices declined to Depression levels and have only recently rebounded to where they were before the fall of Lehman in 2008, the factors are easier to understand.  A 50% rebound is still far from the highs.  As long as the economy is improving, the S&P is going to be above its moving average, and that might continue for a long time.  The Shiller P/E is going to be saddled with 2008 earnings for as long as this backward-looking method keeps it in the calculation.  The 10-year yield, which collapsed to levels reflecting expected deflation, has rebounded somewhat, but is still near historic lows.

If you actually think about the variables, nothing is a real surprise.  There is also no historical precedent, so there is no good basis for prediction.

An Alternative Approach

Last week I noted that a widely circulated email provided analysis that demonstrated the important difference between current conditions and the other nine cases on the "bad times" list.  I am delighted to report that Georg Vrba has now published those results.  I urge you to read his article.

Rather than trying to explain certain situations -- incorrectly beginning with the dependent variable -- Vrba uses a number of indicators that can be applied to any time period.  In fact, his own published work was completely independent of the list of "bad times" to invest.  He is taking a method and applying it to someone else's suggestion of timing.  This adds to the interest.

Two Final Notes

1. I hope that readers will understand that this is a debate on the merits.  The Vrba article is written with care and respect and I have tried to follow his lead.  In the academic world disagreements about methods and conclusion are commonplace and vigorous.  Somehow we are having trouble translating this honest engagement into the 21st century blogosphere.  Maybe we can all try harder to explain our intentions in 2011.  At the moment the discussion has been conducted in the pages of Advisor Perspectives.  This influential publication (while available to the public) is read mainly by my colleagues in the advisory business.  The articles and commentaries reflect this more sophisticated audience.
2. This topic is important.  I have limited time to write, and I choose my topics with relevance and importance in mind.  I currently have more than 50 items on my "blog agenda."  I selected today's subject because something like a "list of bad times" is seductively dangerous for investors.  I disagree strongly with the conclusion that this is a bad time to invest.  I think quite the opposite.  It is my responsibility to state that position, and to explain my reasoning.

 

 

 

Why the Market Multiple Will be Higher in 2011

Market relationships differ depending upon the time frame.  Right now, higher bond yields are bullish for stocks.  This article explains why.

The most important question for equity investors relates to rising interest rates and the implications for stocks.  Nearly everyone (including us) agrees that long-term rates are moving higher.  That has been the recent move and it implies significant capital losses for those holding long bonds.  Here is a nice analysis of the risk by John Lounsbury.

Several pundits have weighed in on the effect of an interest rate increase.  Let us take a closer look.

Background

On a theoretical basis, lower interest rates are bullish for stocks.  Companies can borrow more cheaply.  The choice for those doing asset allocation tilts toward equities.  The data support the  traditional stock/bond relationship --- usually.

But these are not typical times.  Higher interest rates may be consistent with higher stock multiples.  Abnormal Returns covers the topic and also highlights other sites on bond yields.  I want to go beyond the generalized arguments and look to some strong supporting data.

Exceptional Periods

There are circumstances where the relationship is reversed, when higher bond yields are actually correlated with higher stock prices.  Several commentators have suggested that this might be such a time, but I always like to look at the data.

We have seen this before....

We had a similar situation in 2004.  A top analyst from a major firm, drawing upon the help of his entire team, developed a regression model relating bond and stock prices.  The research team facilitated their analysis by throwing out data that did not fit their thesis.  As usual, it was a mistake to begin the research with a pre-destined conclusion in mind.

This research was actually one of the things that inspired me to start blogging.  I figured that if the proprietary research by big firms has such major flaws, there had to be room for people who had strong and discplined methods.  You can check out my old article (one of my favorites) by looking for the initial reader challenge here (no one solved the problem then, and you won't now) or the full exposure of the big firm's blunder here. 

If you want to see the entire logic -- and you should -- check out the full article.  It required more hours of research than any other piece I have ever done.  Meanwhile, here is the key finding:

The relationship between stocks and bonds is curvilinear.  In the "normal" range of interest rates, stocks and bonds trade as expected.  When interest rates fall to a an extremely low level, the relationship breaks down.  Why?  The very low interest rates reflect deflation concerns and extreme skepticism about earnings from stocks.

Here is the relationship:

The historical data show the relationship between stocks and bonds.  The chart highlights two distinct anamolous periods.  Please note that I am not just throwing out data.  Analysts (and readers) are free to draw whatever conclusions seem appropriate.  The chart facilitates your analysis rather than forcing you into a conclusion.  If you read the entire article you will see five different views of the same data.  It shows the difficulty of the task.

My Conclusion

The evidence shows a long-term relationship between the forward earnings yield and bond yields.  This is what we would expect.

When bond yields get very low, the relationship breaks down.  This also makes sense.  Yields have been very low twice in the last decade, both times when there were extreme deflation fears.  Under those circumstances there is intense skepticism about future earnings forecasts, so the multiple is low.

Investment Conclusion

We are currently at the unusual tipping point in the relationship.  The emerging consensus about improving economic prospects is having two effects:  higher long-term bond yields and more confidence in earnings.

The implication is that stocks will get a higher multiple in 2011 as confidence improves.  This is not merely speculation, but a conclusion based upon the data cited.

If the market were to embrace this traditional relationship, the forward earnings multiple would be in the 20's.  This suggests an S&P 500 value that is 50% higher (or more) than current levels.

I am not making this as a prediction, since the climate of fear has cast a negative spell upon earnings.  Who knows how long this will last?  I have often suggested that low market multiples are the best single gauge of investor sentiment.  I do predict that the path of least resistance is higher, and it could be much higher.

The summary:

Higher bond yields imply more economic confidence and a higher stock multiple.

You heard it here first, including when I highlighted the topic in the gloomy days of August.

 

Revisiting 2009: Preserving Wealth and Creating Wealth

Investors have very different needs and concerns.  Broadly speaking, I classify people between those more interested in preserving wealth and those trying to build wealth.  There are other considerations, but that is a good place to start.

Many investors of both stripes now wish they had bought the market in the Spring of 2009.  As stocks rallied, there were three distinct choices:

1. You could decide that you had "missed the bottom."  This meant that you would sit on the sidelines, perhaps forever, because you could not get over your initial mistake.
2. You could accept the fact that you were not a big-time risk taker.  You wanted to see evidence that there would not be a great depression.  At some point you decided to climb aboard.
3. You are still trying to decide.

Those taking Path 2 did great on a total return basis, making 32% plus dividends, but it required buying at a point of near-maximum risk.  It iss OK to be cautious, especially if you are preserving wealth.  The Path 3 investor has an opportunity that equals that of 2009 on a risk-adjusted basis.

Let us look at the data.

Getting a Second Chance

Usually we do not get a "do-over" in life.  Because of the pervasive negative sentiment about politics and the fear trade, the opportunity to buy traditional investments at good prices is still there.

T0 understand this, you must ignore absolute prices and forget about the fact that you did not  buy the market in 2009.  That is all history.  Where are we now?

	5/8/2009	12/8/2010
S&P 500	929.23	1228.00
Forward 4q eps	60.47	91.98
Forward P/E	15.37	13.35
Inverse of Forward P/E	6.5%	7.5%
L-T eps growth rate	7.0%	7.0%
10-year Treasury yld	3.2%	3.2%
Difference	3.3%	4.3%

Stock prices have rallied, but earnings estimates have done even better.  When you compare the market to the bond alternative, the yield differential is striking.  Regular readers know that I have produced unrefuted evidence that one-year forward earnings estimates are excellent.

Briefly put, if you have waited for a favorable risk/return to buy stocks, the time has come.

 

Investment Conclusion

Buying stocks today has more upside than at the bottom in the Spring of 2009.  Since many of the major issues are off of the table, there is even less risk.  Since many issues remain, stocks are still cheap.

The table shows the S&P 500 averages.  Successful investment advisors who have beaten these averages over a long time period may do even better.

There is an extra kicker.  The political dynamic has changed for the better.  As I noted in my weekly review, the tax and unemployment benefit compromises have dramatically improved the prospects for economic growth.  This will immediately help corporate earnings and eventually help the deficit projections.  Some market sectors will benefit more than others.

 

 

Market Outlook: Fundamentals versus the QE II Distraction

There have been many recent reports about those waiting for a market pull back.  After all, we have seen two strong months and some investment and hedge fund managers may feel under-invested as year end approaches.  Those of us with new accounts have been looking for a good chance to buy, and feeling some frustration.  Is now the time?

Individual investors have mostly been paralyzed with fear.  The Age of the Internet has not served them well. The best stories, whether from mainstream media or blogs, are always about problems.

Today I would like to highlight two distinctly different approaches to thinking about your investments.  One of these looks to stock fundamentals and earnings.  The other focuses on headlines.

The Fundamentals

If you want to spend a very profitable five minutes, watch today's screencast from Abnormal Returns.

 

I especially like host Tadas Viskanta explaining that this is a contrarian story.  Tadas, who constructs his daily guide to the investment world after reading hundreds of articles, has a better take than anyone on the general tenor of commentary.  I strongly recommend that readers check out the links in the story.  I especially like the cited work of two of our featured sources --- why fundamentals make lousy TV and fourteen reasons that things are better than you think.

This is an especially good article because of the timing.  It is easy to write something "explaining" the day's market action and attempting to appear brilliant.  These stories comprise much of the guest list on financial TV.  It takes more courage and adds more value to go against the grain.

The Distraction

The ongoing "big story" features the Fed and QE II.  The story has all of the ingredients needed for feature treatment.

• Simplistic reasoning.  Since ordinary people do not understand central banking, fractional reserves, or money creation, it is easy to be a demagogue.  The phrase, "The Fed is printing money" is powerful and defies refutation.  For the average person, it signifies everything that is wrong.
• Political posturing.  It is easy to assemble a list of people who disagree with the Fed, including those from both extremes.  This is often a sign that policymakers are doing something right, but in this case people are just piling on.
• International intrigue.  Foreign countries are criticizing us.  President Obama has supposedly been weakened.

This has gotten so bad that the cartoon discussion on youtube has a million hits.  Amazing.  I wonder how many viewers are investors....  The good news?

Anyone who can read and think can get an investment edge.

What more could we ask?

The Key Point:  Separating what will happen from what should happen

I do not know whether QE II will "work."  I am much more confident about what the Fed will do.  Here are three fearless forecasts:

1. The Fed will be completely unmoved by foreign criticism.  This should be obvious.
2. The Fed will not react to partisan criticism.  This is also obvious.  I suppose there will be some great theater in the next two years.  Those who do not think we should have a central bank will make a big fuss in Congressional hearings.
3. Those choosing to "fight the Fed" with their investments will be big losers.

So much for what will happen.  For investment decisions, that is the most important part.  But we all like to understand what is going on.

Turning to what should happen, I understand that many readers are curious about the reasoning behind QE II.  I also know that the readership of "A Dash" is pretty sophisticated, including experienced investors and colleagues in the advisory business.  If you really want to understand what is going on, here are three excellent articles from leading sources:

Paul Kasriel, economist with Northern Trust.

Every student who took Econ 101 and stayed awake during the lectures learned that the Federal Reserve has the power to create credit figuratively “out of thin air.” The A-students also learned that the commercial banking system, not individual banks, under the fractional-reserve system that we and every other developed economy has also has the power to figuratively create credit out of thin air if the Federal Reserve first provides the “seed” money to do so. This is not unique to the Federal Reserve and the U.S. commercial banking system. This holds wherever there are central banks and fractional-reserve commercial banking systems.

Mark Thoma, University of Oregon economist, and the leading source of economic "pointers."  Read the entire article for a nice explanation of the policy options, with graphs.

Presently, the Fed cannot operate at the short end of the yield curve because the short-term rate the Fed generally targets –- the overnight federal funds rate — is at or very near zero. Operating at the short-end of the yield curve doesn’t do much good since those rates can’t come down any further. However, the Fed can still bring down rates at the long-end:

 

And finally, former Dallas Fed President Bob McTeer.  Of all the commentators, McTeer provides the most consistently accurate and pragmatic view.

I don’t quite get the logic of the “won’t-work-but-it-will-be- inflationary” point of view. If it won’t work to stimulate the economy, that presumably means it won’t stimulate spending. If that is so, how is it inflationary? If more bank reserve sit idle as excess reserves and aren’t used for lending, investing, and money creation, how is it supposed to tank the dollar? New (printed, if you insist) money must be spent on goods and services to drive their prices up; it must be spent on foreign exchange to drive the dollar down. If it isn’t spent, it doesn’t do good, or harm.

Say it won’t work. Or, say it will be inflationary. But don’t say both without explaining how that is supposed to work.

Conclusion

On the one hand, you can get your investment advice from cartoons and fight the Fed.

Or you can -- and should --  focus on fundamentals.

Blogging Economists are Wimps!

There is a new survey of economic bloggers covering many key issues about the economy and the markets.  The overall results are pretty negative about our future.  Let us take a closer look.

Background

The Ewing Kauffman Foundation is an important source of research about innovation and entrepreneurial activity.  The Foundation has embraced the concept of economic blogging as part of this mission.  This is an important step, helping to provide visibility and a sense of gravitas for those of us who might otherwise be ignored.

The Foundation sponsors a quarterly survey of opinon and an annual conference of leading economic bloggers.  This process of aggregating opinion and bringing bloggers together for extended face-to-face discussions is an important contribution to economic analysis.  I have been invited to participate in the poll for several quarters, and to attend the last conference.  I found the conference to be quite interesting and educational.

Two Groups of Bloggers

There is an important difference between two groups that I will call "economic bloggers" and "blogging economists".  (Yes, I know that these do not seem to be exclusive subsets, but just understand that the first group lacks professional economic credentials and live with the terminology).

The blogging economists, with a few notable exceptions who get regular mainstream media attention, are factual, disciplined, careful in drawing conclusions, and use the tools of their trade in their analysis.

The economic bloggers often start with popular misconceptions about economic issues.  While they cite many facts and often have appealing charts, the arguments lack a rigorous analytical method.  The resulting stories and conclusions often play to pre-existing sentiment.  The narrative is also much more aggressive, sassy, possibly profane, and always irreverent.  The economic blogger group tries to drag down those who have accomplished something in order to imply their own equality.

Is it a surprise that the economic bloggers are more popular than the blogging economists?  Briefly put, people do not want to learn, nor do they want to believe that the study of economics has anything to offer.  It is more satisfying to read articles that cater to what they already believe.

Group Interaction

There was an extreme dispartiy in respect accorded by the two groups.  The economic bloggers had a natural orientation toward respect because there is a certain civility in the professional and academic world.  There is also a "blogger effect."  The economic bloggers were popular.  They had high rankings and many page views.  In a conference of bloggers, this sort of popularity is important.

Briefly put, the professional economists are too courteous, too deferential, and act like a bunch of blogging wannabees.  They are wimps, unwilling to call out obvious blunders by the non-professional bloggers.

The Survey

Let us  apply this to the survey.  I am taking one key question as an example, but there are many other good ones.  The table below shows the question suggested by Mark Thoma, one of our featured sources.

I looked at a number of news stories about this question.  They felt the lead was that the bloggers thought there was an effect!  To quote Homer (no not that one):  D'oh!

Anyone who thinks that the ARRA had no effect or a negative effect is a clueless bozo, without even the most rudimentary knowledge of economics.  Even those who hate the stimulus bill and the particular programs chosen, should realize that it is impossible to spend that much money without having some employment effect.

Despite the popular reports, the key story here is not that most of those in the survey thought that the stimulus had a positive impact.  The real story is that over a third felt it had a zero or negative impact.  What were they thinking??  See Econbrowser for analysis.  And why are the real economists not calling out the imposters on this question?

The Lesson

Like most readers and investors, I am a consumer of economic information and forecasts.  I am not a card-carrying economist, but I am good enough to recognize the real thing and to sort out the imposters.  I am often asked by readers how to find the best sources of information.

My working hypothesis on economic blogging is that there are three general categories of sources:

1. Blogging economists who analyze data.  This is the best source, but I give less credence to those with obvious political motives.
2. Economic bloggers who dismiss the need for formal economic training.  Theses sources may dazzle you with charts, but they are simply telling you what you already know and want to hear.
3. Economic journalists.  This is a swing group.  Some journalists, notably Steve Liesman, make a strong effort to explain what is happening.  Other journalists, perhaps under page-view pressure, go for the sensational conclusion.

You can gain an investment edge by looking for quality rather than popularity.

A Small Challenge

Most surveys provide not only a tabulation of results to each question, but some cross-tabs of opinion by demographic group.  When you read opinions about health policy, for example, you usually see a breakdown between Republicans and Democrats or between likely voters and those less likely to vote.

I have questioned Kauffman on this issue.  Why is the tabulation so superficial?

My hypothesis is that if you broke down the answers by professional background you would see statistically significant differences between the groups on several questions, including overall outlook, stimulus effect, and the accruacy of government statistics.

It would help Kauffman in fulfilling their mission if they provided a deeper analysis of the data.  The incremental cost would be very small.

 

 

 

 

The Investor Sentiment Cycle: An Interesting Survey from Charles Kirk

Charles Kirk has many innovative ideas that help us all think about the market in new and constructive ways.  This week he conducted a private poll including 100 top professionals.

To get the maximum benefit from this exercise, I encourage readers to make their own answer the following question:  Where do you think we are in the investor sentiment cycle and why?  Choose a specific answer from the figure below.

No cheating!  Answer first, and write down your reason in three sentences.  You will learn much more by doing it that way.

The Survey Results

While Charles makes no pretense of science in determining his original sample, his work attracts a widespread following.  People with varying market "ideologies" regularly read and use his recommended links and watch his new weekly chart videos (small membership fee required, and well worth it).  Personally, I was quite curious about what the results would be.  Here is the basic summary:

Of those who dared to offer take the poll and go on record (most I asked never responded), 63% thought the cycle had already bottomed out while 37% see further downside to go in this cycle.

Check out the article for the full distribution of results as well as many excellent comments from participants.

My Vote

Regular readers of "A Dash" could probably guess my vote.  I was in the "depression" camp.  As usual, I am willing to go on the record.  We were asked for a three-sentence comment, and I wrote as follows:

“Sentiment reflects reality, so we hit bottom post-Lehman. The depression and capitulation came in March, 2009. The slow and halting economic recovery will be accompanied by improved sentiment — a process including feedback.” – Jeff Miller, Dash Of Insight

If I had written a bit more, I would have elaborated on the feedback point.  One problem in the economic recovery is the pervasive lack of confidence.  Nearly every poll shows that people do not believe that any policies are working.  Most think that the recession never ended.  This is true across a wide swath of demographic groups, including bankers and CEO's who control investment and lending.

A successful president could lead and inspire the country: "We have nothing to fear but fear itself."  Instead, we have a skeptical public asking, "Where's the beef?"

My vote reflects my confidence in the recovery (a reflection of our country and our people as much as policy), but an acknowledgment that it is a difficult and slow process.  The economic rebound could have been faster and more robust.

Investment Conclusion

My oft-stated conclusion for long-term investors is that we are at a point of substantially above-average opportunity for stocks.  There are many companies that record great earnings with little change in the stock price.  That means that P/E multiples have moved lower.

Improving sentiment means that multiples will move higher.  This means that stocks will do even better than the earnings growth rate, but it is going to take time.

Meanwhile, I really liked the survey idea.  It was useful to think about my own answer and to read those of others.  It is a tool that I might consider using as well.

The IMF Suggests A Trade

Remember the sovereign debt issue from a few months ago?

It was supposed to be like cockroaches.  Greece was to be like Bear Stearns.  The dominoes would start falling.  The facile analogies came day after day.

There were plenty of pundits who predicted disaster.  The IMF was on the other side.  It has been several months since this issue surfaced, with many predictions of disaster.  It is time to review what has happened and what might lie ahead.

Predictions of a Crash

Rick Santelli (who seems unable to separate his politics from his market analysis) thought that the European debt restructuring plan would fail and the Euro would go to parity with the dollar.  Many agreed with him.  It was so scary that Art Cashin warned about how the market could crash if the dollar gained strength against the Euro, reducing earnings of US companies.

Here at "A Dash" we love Art Cashin.  He is an accurate reporter of what floor traders think.  In this case, many were expecting a collapse in the Euro and a crashing stock market.  That was his report.  Guess what?

They were wrong!  All of the floor pundits on TV.

Accountability

 There is little accountability for these predictions.  Examples of draconian predictions can be found here and here and here.  Let us look at the chart to see how it played out.

 

FXE Stock Chart by YCharts

The IMF Viewpoint

The IMF has done some research on the topic.  In a strong article Colin Barr covers the story.  Here is a key quotation:

Considering data on sovereign bond spreads over the past decades, markets sounded false alarms in the vast majority of episodes," writes a group of IMF researchers led by the group's fiscal affairs director, Carlo Cottarelli. "In our view, the risk of debt restructuring is currently significantly overestimated.

His nicely balanced article observed the high level of debt to be restructured, while noting some key history:

...(T)here have been 40 instances over the past three decades, a third of them in advanced economies, in which a country has improved its structural primary budget balance by 7 percentage points or more.

"Judging from past experience, such a major adjustment will no doubt be difficult, but is possible," the IMF said.

Investment Implications

This is a pretty simple choice.  You can cast your lot with the IMF, a multi-national version of "don't fight the Fed" or you can bet your money on people whose politics cloud their  investment decisions.  (Here at "A Dash" we like to make money no matter who is in power.  You should too!)

US stocks have traded in line with the dollar for many months.  The Euro question is a special case.  There are two considerations, general and specific:

• On the general front, markets have traded for many months in a strong correlation with the dollar.  If the Euro is not so weak, this is bullish for stocks in general.
• On the specific front, stocks that do European business may have been unfairly punished in recent months.  That would be consistent with the IMF findings on excessive CDS premiums.  I continue to like US stocks with foreign exposure, including CAT and technology names like AAPL, MSFT, and ORCL.

You could also trade foreign CDS's or currencies directly of course, but most investors do not have that access.

[Full Disclosure -- Long stocks in long-term accounts, neutral in trading accounts, long CAT, AAPL, MSFT, and ORCL.]