A Dash of Insight

Specific Expertise: Insisting on the Best Information

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

Background

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

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

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

Meredith Whitney

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

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

Our Take

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

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

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

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

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

A More General Conclusion

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

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

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

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

Interpreting Conflicting Information

A wise and valued friend called my attention to an article on municipal bonds, Short Seller:  Dump Munis.

James Chanos, noted for highlighting collapses including Enron, sees bad days ahead for municipalities.  State and local governments already have fiscal pressure.  They have defined benefit pension programs and "platinum" health care plans.  He also raises the specter of the loss of the federal tax exemption if there is a bailout.

To balance this perspective, author Tom Sullivan also cites Gary Pollack, head of fixed-income trading at Deutsche Bank Private Wealth Management.  Pollack sees "headline  and downgrade risk" but notes the power of these governments to raise taxes.

Even if one hates the idea of tax increases, this is an article about the creditworthiness of bonds, not one about politics.  It is easy and tempting to confuse the two.

Our Take

So often these questions are posed in black and white.  Either one should buy municipal bonds -- or not.

The answer might be quite different.  Suppose that both Chanos and Pollack are correct.  Frankly, that is my vote!  We should expect a higher than normal rate of failures by municipalities.  There will probably also be tax increases.

The real investment question is not which of these experts is correct.  It is the following:

Do current municipal bond prices reflect the acknowledged current risks?

The article invites us to choose one side or the other.  The market presents a more nuanced challenge.  Municipal bonds are not right for everyone.  Tax considerations are an important issues.  Having said this, there are two possibilities:

1. An investor who has confidence in a given jurisdiction may find an attractive opportunity; and
2. An investor who thinks the overall market is too pessimistic may find an attractive muni fund, avoiding the locality-specific risk.

A Further Conclusion

Too many market questions are posed in the form of one side being right and the other wrong.  In fact, the market prices usually reflect the debate.  You are only looking for an edge.

Understanding Market Volatility

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

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

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

A Natural Human Trait

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

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

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

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

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

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

Applying the Lesson to the Market

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

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

Business Week explained as follows:

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

MarketBeat had a similar take:

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

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

Briefing.com has a very different viewpoint:

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

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

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

Our Take

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

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

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

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

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

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

Finding Stock Ideas

When there has been a nice market rebound, we should expect to hear the familiar refrain:  It is a stock picker's market.

This wise-sounding expression means that it is no longer good enough to "buy the market" whether through index funds or market stocks.  It is time for some actual analysis.

There is some truth to the claim.  Last autumn nearly everything went down.  Even the hedge funds with inside information, with managers going to jail, lost on their long positions!  At times this year, everything has gone up, no matter how weak the company.

This is not the "new normal" and it is certainly not the old normal.

The ability to find outstanding stocks is important.

The New Weekly Series

As I noted in yesterday's piece about my blog agenda, I am going to write something each week about how the individual investor can find attractive stocks.  This is not directed to traders, although they may find a few interesting ideas.  Each article will be a building block for my work in progress, a book for people who are not currently reading investment blogs.  Since I have investment advisors and individual investors in my readership, I am hoping for plenty of suggestions and comments to keep me on the right track.

Each week I plan to do an article that considers one part of the stock-picking process.  I hope that it keeps up with reality, generates ideas and selections, and helps us all make money.  I might be too slow in the writing, but you can all join in the criticism.

Passive Approaches

There are many sources of stock ideas, but passive approaches are not the focus of this article,  Maybe I will revisit this topic, but there is a big hurdle for most investors.  I spend many hours each week reading opinions, analysis, and data about stocks.  The individual investor cannot match this.

Those favoring this approach might consider the following:

• Jim Cramer's work, both on his website TheStreet.com and his CNBC program is a source of stock opinion and investor education.  I like it better as education, since the many recommendations may be difficult to track.  Anyone regularly watching Cramer should have learned the need to do homework -- an hour a week on each stock position.  This is the minimum.

• Seeking Alpha "investment ideas" is another fine source.  Check it out.

There are many other sources of ideas from reading -- the subject for another article.  Here is the most important piece of advice about passive approaches:

Beware of Stock Tips

The problem is twofold.  The tipster is almost always swinging for the fences -- high reward, but high risk.  More importantly, you will not know when to exit.  Buying on a tip puts you at the mercy of the continued advice of the tipster.

This is a big mistake of the individual investor, and a common one.

Active Approaches

Stock screening is a great way to find new ideas, if you have a sound approach.  The emergence of various screening tools have put dangerous instruments into the hands of the inexperienced.

Let us suppose, for example, that you are worried about the market and decide that a great dividend yield will provide protection.  If you screen for the highest-yielding stocks, you might simply generate a list of companies that are about to cut their dividends!  It is not so easy.

If you want to explore stock screening you can do no better than paying the modest membership fee and joining The Kirk Report.  Charles Kirk is an expert at this technique and he highlights screens that have a proven record. This is a continuing source of great ideas.

Thematic screening is another approach, the basis of my own Great Stocks program.  In my first article in this series, I suggested some interesting current themes.  If you have not read that article, I suggest that you review it before proceeding.

Pursuing a Theme

I start with the assumption of a theme.  For the purpose of this example, the theme is a continuing economic rebound.  I realize that many reject this assumption, and that is fine.  It actually helps in finding good opportunities.

I am looking for companies that could have explosive earnings growth potential if the economy continues to improve.  That is the first screen.  I then try to analyze the company in more detail. Most importantly, how much downside might there be if the thesis does not play out?

The point of this article is to find candidates.  In future articles I will examine how the investor should be skeptical and challenge the potential stock price increase.

One of the very best sources for this type of screening come from the companies themselves.  What is the business model?  How are they developing a strong position?  And most importantly, can there be explosive stock price appreciation.

Today's key concept is earnings leverage.  A company that has costs under control and a business model prepared to deliver should be talking about earnings leverage.

The key resource is the Seeking Alpha transcripts of conference calls.  The Seeking Alpha team covers many calls and it is a searchable database.  If you search the transcripts for "earnings leverage" you get 128 hits, and you can sort by date.  This means that you can look at companies that claimed leverage earlier this year and see how they are doing.

This is a powerful and valuable resource.  A couple of years ago conference calls were a high-priced subscription service, available only to the pros.  It is now free, available to us all, if you only know how to use it.

Finding a Case Study

The first step from a screen is putting the stock on your "watch list."  You follow the company news, the chart, and the economic backdrop to see if the story is playing out.  We are not trying to pick bottoms.  It is completely acceptable to buy a stock at a higher price when the reward/risk ratio has improved.

Here are some ideas from the search.  I invite reader nominations for our more detailed analysis.

Zebra Technologies Corp. (ZBRA)

Lennox International, Inc. (LII)

Manhattan Associates, Inc. (MANH)

Zep, Inc. (ZEP)

Applied Materials, Inc. (AMAT)

Varian Semiconductor Equipment Associates, Inc. (VSEA)

Teradyne, Inc. (TER)

Other suggestions are most welcome.  To be continued.

[No current positions in mentioned stocks, but I am watching.]

How I Pick Stocks

Valued commenter Mike C. asks for a change of pace from my regular topics and a focus on more specific stock picking.  He notes that I have said several times that there are plenty of opportunities.  So what are they?

This is a thoughtful question, so let me start down the path to a complete answer.  I cannot get there in one article, but this will be a start.

Mission and Audience

Anyone who is a regular reader knows that I have not catered to the existing Internet audience.  If you follow blog statistics, it is pretty obvious how you should get a big audience, and I do not do it!  Here is a list of things that I am doing wrong in a marketing campaign:

• I do not think the world is coming to an end;
• I do not  see the immediate application of Austrian economics (but I watch the debate carefully);
• I do not hate Obama (nor did I hate George Bush);
• I do not hate the Fed, nor do I see them as responsible for everything that has gone wrong;
• I do not see a conspiracy around every corner;
• I do not think that government is a unilateral force organized to lie to us, manipulating data.

Putting this into a positive statement, I think that government leaders, whatever their party, are attempting to avert a deeper recession and to create employment.  Presidents Bush and Obama both did their best, given the circumstances, the existing law, their teams, and their ideology.

The government is on a mission.  You may not like the policies, but as an investor, you fight it at your peril.

This is an unpopular viewpoint in the Internet audience.  This audience has had an undue influence on mainstream media, where writers are under pressure to get readers, comments, and page views.

It reminds me of the Truman versus Dewey polls, where newspapers all predicted the Dewey victory based upon their letters to the editor.  People need to realize that Internet blog ratings, Seeking Alpha popularity, and CNBC viewer polls, are all culled from a special audience.  If I were to take this seriously, I would quit writing!

My real audience consists of people who are not even following the Internet debates.  My ideal client is an expert in what she does in her work and is looking for an expert to help with her investments.  I use the feminine gender advisedly, since guys (including me) do not like to ask for directions.  People who want to read a few Internet articles, ask about last year's performance, and think they have a "feel for the market" are not my best potential clients.

Briefly put, I am writing a book for people who are not currently reading my blog, but who need help.  Having said this, I am delighted that some current readers find my material useful, and I value their comments and contributions.  I know from my email that many readers are other investment advisors who share the challenges I face.

Also, I write at night, after my day's work is done.  My list of blog agenda items grows more rapidly than I can work.  It is a labor of love, and one that I will never complete.

My Approach

The approach that I use is not a secret.  Anyone writing to me gets a nice description and a performance update.  I am not allowed to advertise this (so say my lawyers), but the excellent results are available upon request.  I talk to every potential investor.  If someone wants overall advice on asset allocation, I provide that.  If they want a good long-only approach as part of the portfolio, I screen them for risk tolerance and suitability.  That is part of being a Registered Investment Advisor.

With this "disclaimer" in mind, here is an overview of my stock-picking approach.

Find a Theme.  I look for themes where there is excessive skepticism.  I use my extensive background in economics (where I have real training, used to follow actual data and opinions), in politics (where I have built a sister site to track everything relevant), and in valuation (where I relate forward stock potential to alternative investments).  I use daily analysis of data to challenge and review these viewpoints.

My current themes include the following:

• Recognition that public policy initiatives, from all government sources, are focused upon economic growth and recession concerns.  You can worry about inflation and excessive government, but the concern is too early for practical investment purposes.  There is plenty of stimulus in the pipeline, and more is about to be enacted.
• Health care companies.  The uncertainty about the final shape of a bill, and whether something will be passed, have cast a pall over the entire sector.  It will not end badly for all of these stocks, despite the day-to-day market reaction.
• Growth stocks.  There are always growth opportunities, if one looks at data and trends.  I always have some growth in the portfolio.
• Energy stocks.  When economic growth was more promising, we were near a tipping point in energy prices.  There are many forces providing a bottom in these sectors, and the upside is significant.

There are other themes, but let us stick with those for the moment.  I am always adding or adjusting themes.

Find a stock.  I look for stocks with the themes in mind.  At the moment, here are some considerations I have in mind:

• International exposure.  Many US companies have a  balance between US and foreign sales.  They are less exposed to a weaker dollar, and may even benefit.
• Cost cutting.  Companies that have reduced costs are well-placed to enjoy a revenue rebound and extra earnings.
• Analyst disfavor.  I like stocks that are unloved by the analyst community.  Unlike others, I think that analysts do a reasonable job on earnings forecasts.  They are too slow in changing official ratings.  I often buy when the consensus ratings are low, and sell when they are high.
• Resistance to risk.  Some companies have a business model that can dodge the apparent pitfalls.
• Stocks that have lagged the market in the rebound from the pre-Lehman levels, a point that I am using as an initial target.

Specific Ideas

I have revealed and recommended some of our holdings in past articles, especially in my 2009 preview piece.  I still like Transocean Energy (RIG), Apple Computers, Inc.  (AAPL), ResMed (RMD), and Caterpillar, (CAT), for reasons that should be obvious from the above analysis --- energy, growth, health (with resistance to skepticism) and global economic growth.  I also own Intel (INTC) which I may not have mentioned before.

While the stocks have all rallied, they are all still buyable right now.  I own them for myself and for clients.

I take a fresh look each day.  Is this a stock that I want to own for the next month, next six months, or the next year?

I recently recommended Research in Motion (RIMM) as a good post-earnings candidate, when the stock sold off sharply.  The thesis is growth in the mobile Internet space, but I like holding it along with Apple to avoid changes in market share.

A Final Thought

I mention these stocks as examples.  Obviously, my actual analysis involves much more detail.  In a future article, I will take a single example and show how it fits the criteria.

Thanks again to Mike C. for the suggestion.  Tomorrow night I have a fine birthday celebration planned in Chicago for my wife and my son (birthdays two days apart).  That means no article tomorrow.  While I love to write about stocks, it is not something I can do every day.

Our Best Predictions: A Review

Last March, at the market bottom, we wrote a three-part series on why a bottom would not be recognized by most investors.

Investors would be misled on valuation.  The debate is playing out just as we forecast.

• David Rosenberg, the economist hero of the bears, continues to see the market as overvalued.  We have all been suckers.
• Eddy Elfenbein sees things as more balanced.

We predicted the wide disparity in methods, suggesting that backward-looking methods would fail.  The forward-looking methods continue to catch criticism. 

Investors would be misled on politics.  We suggested that the failure to deal with "troubled assets" would provide scope for criticism.  This was correct.

Investors would be misled on economics.  We accurately noted the consensus forecasts, much better than most thought at the time, and now proved to be accurate.

Our Current Take

Anyone who is a serious investor or trader should click through to read the old articles, but most will not.  Most people start with a viewpoint about market valuation, politics, and economics and stubbornly adhere to this viewpoint even when the evidence changes.

In the face of improving economic data, many focus on their political viewpoints rather than finding investments, a theme that we cover regularly.  It is an unfortunate fact that most people highlighting investment articles do not realize that this is an important theme.

In April, we described how this was a classic Wall of Worry.  This is also a good read, and one met with skepticism when we wrote it.

Many investors now worry that they have "missed the rally."  Here is something to consider.  The market is still 10% below the pre-Lehman levels.  This was a time when the market was expecting a recession, and some saw a deep one.

The situation is now different.  There is a massive stimulus effort, with more to come.  There are many problems, as we suggested.  It is no longer a question of  just "buying the market" but the story is not over.  There is still plenty of opportunity for those analyzing specific stocks and sectors.

Reacting to News: The RIMM Lesson

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

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

The Research in Motion Example

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

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

The Investment Lesson

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

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

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

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

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

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

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

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

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

Final Take

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

The Perils of Data-Fitting

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

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

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

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

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

What You Do Not Understand

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

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

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

Our Take

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

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

Fun with Seasonality

There are many data series that vary in a regular seasonal pattern.  That is why all of the best sources do seasonal adjustments.

Here at "A Dash" one of our missions is to find methods that help the average investor to beat the "experts."  Sometimes we are surprised at how easy this might be.

The cottage industry engaged in disparaging government data includes the seasonal adjustment.  Many sources  play upon the inherent suspicion of government.  Even when sources engage in statistical methods that are routine -- absolutely standard practice for experts -- some pundits call them into question.

Let us take a closer look.

Why Consider Seasonality?

To begin our consideration, here is the take from Wikipedia, a neutral source:

One famous example is the rate of unemployment which is also presented by a time series. Particularly this rate depends on seasonal influences. This is why it is important to free the unemployment rate of its seasonal component. As soon as the seasonal influence is removed from this time series the real trend of the unemployment rate is visible. Seasonal adjustment is mostly used in the official statistics implemented by statistical software.

When seasonal adjustment is not done with monthly data, year-on-year changes are utilised in a naive attempt to avoid contamination with seasonality. However, each year-on-year change is the sum of twelve monthly changes. This moving window (with a width of 12) is often a poor way to understand a series. As an example, Bhattacharya, Patnaik and Shah find that by using point-on-point changes of seasonally adjusted data, the analyst is able to better obtain early warnings in the inflation time-series.

Briefly put, looking at year-over-year changes complicates your task.  You are not going to spot a significant change in real time.  You wind up making many adjustments in your head.  Did this month's YOY change look better than last month's?

A Compelling Example

Let us consider the recent report on Mass Layoffs from the Bureau of Labor Statistics (BLS).  These are layoffs involving 50 or more employees.  We have taken the entire data series, using the unadjusted raw data, and presented it in a form that will clarify the pattern.  Our team (Thanks, Feray) took the data and presented each year separately.

 

The seasonal pattern is quite apparent.  The big diversion is in September, 2005, the time of Katrina.  The move in July, 2009 is consistent with the regular seasonal pattern.

A Misleading Analysis

Taking a very different approach, one of the authors writing as "Tyler Durden" sees the July move as a spike!  In an article entitled "Mass Layoff Events Spike" the author suggests this chart as evidence.

By using data without seasonal adjustment, the chart presents a misleading view of the mass layoff pattern, showing a deceptive "spike."  In fact, the BLS seasonally adjusted data showed the opposite conclusion.  "The number of mass layoff events in July decreased by 606 from the prior month, and the number of associated initial claims decreased by 72,440."

Our Take

There are many popular sources that present data with a consistently bearish spin, completely ignoring seasonality.  Other sources -- particularly those covering housing -- frequently cite the seasonality in the data, but make no seasonal adjustment.

Market followers who are looking for important concurrent changes in data should look to seasonally adjusted results as the best source.  The alternative is to do a complex calculation about how the year-over-year data are moving.  The seasonal adjustment software does what you want to do.  It does it better and more accurately.

We acknowledge that there can be some unusual factors affecting the seasonal results.  Concerning employment, some have noted that layoffs in the auto industry occurred sooner this year, so that the July seasonality is somewhat overstated.

Readers should note that seasonal adjustments balance out with raw numbers over the course of the year.  Those emphasizing one side of this question always highlight unusual factors when the result serves their viewpoint, ignoring it when it does not.  The data must eventually balance.

Meanwhile, the seasonally-adjusted approach provides a better starting point for those seeking good information on economic changes.

Picking the Right Pundit

High on the list of investor mistakes is chasing performance.  Even though the top market pundits are aware of this fact, they make the same mistake -- time after time.

Buying what worked last year is the easiest way to pick stocks, sectors, or managers.  It is also the worst.  Despite this, it is the key question that every new investor asks.  It is natural.  It seems relevant.  For most investors it is the most obvious part of "due diligence."

When we are having a good year in stock picking, as we are now, it is easy to go with the flow.  But it is not really what we recommend.  Our long-term record -- and that of others -- should be the real question.

The False Litmus Test

We are in an era where CNBC introduces every bearish pundit with "He was one of the first to see the problems in the [housing, credit, CDS, derivative] market.  There are no track records on those who missed some big gains by making very bearish predictions many years before the collapse.  Taking the other side, people like Warren Buffett were well aware of the risks, maintained cash, but bought back into the market "too early."

We now have a bunch of rookies who think that Warren Buffett has "lost it."  They also think that some perma-bear is a genius.

One of the big news stories of the day was the SEC filing from hedge fund manager John Paulson, noted for making big money by shorting financial stocks last year.  When a major bear on a sector switches positions, that is news.

Today on RealMoney Jim Cramer observed "Buffett got this period wrong and we bid up anything he buys. Paulson got it right and we are supposed to ignore him." 

Cramer repeatedly highlighted Regions Financial (RF) and also mentioned it in his regular "Stop Trading" spot on CNBC.  The stock rallied after his early comments and popped eight cents again on high volume during the CNBC appearance.

Everyone noted that Paulson had a large position in Bank of America (BAC).  Cramer felt that RF was the stronger play.

Our feeling is that both Paulson and Buffett deserve respect.  There are many different methods that generate above market returns in different time frames.  The facile emphasis on last year's pundits has already been a losing move for many investors.  And please note that Cramer was not disparaging Buffett, but emphasizing Paulson.

Meanwhile, Felix Salmon (one of our featured sources) was highlighting a bearish Bloomberg article by Jonathan Weil, suggesting that the footnotes showed that Regions Financial was insolvent!

We can imagine investors selling the stock based upon Weil or Salmon, buying it based on Cramer, or being very confused after reading both.

Another Example

Tonight's Kudlow program had a segment with Elaine Garzarelli.  The assembled punditry scoffs whenever she appears.  Her great call on the '87 crash is an ancient memory, and most now dismiss her bottoms up method of evaluating stocks and sectors.  We disagree.

Most pundits do not really consider her methods, which are actually quite good.  She has a viewpoint that may well prove to be correct, flying in the face of the conventional wisdom of traders.  Here were a few key points:

• Her 2010 S&P earnings estimates are $73 and she is looking for a multiple of 17.5.  That corresponds to the pre-Lehman market of 1250 in the S&P 500.
• She sees the biggest threat to this valuation as an increase in risk spreads.  Corporate bonds are an alternative to stocks.
• She also replied to Kudlow that more FASB efforts to impose unrealistic marks on existing holdings would be a big negative.
• She sees the downside for stocks as 4 to 7 percent, mostly based on normal fluctuations.

Our Take

The Garzarelli earnings estimates and multiple are actually quite reasonable given current interest rates and growth projections.  The S&P at 1250 gets back to pre-Lehman levels.  It is not "bubble land."  That was at a time when the market expected a recession, but not a depression.  It represents a good initial target for stocks.  It is not an extreme target.

The declining risk spreads have increased the valuation for stocks.  She is correct in noting that any increase in bond yields is the biggest risk for stock valuation.

Making a major investment in equities implies a significant reward/risk picture.  This ratio of 5 or 6 to 1 is pretty attractive.  The exact timing (September selling?) is a bit of a guess.

Full disclosure -- We have a small position in BAC, a larger position in regional banks, and we are taking a serious look at RF.