A Dash of Insight

Are you really a chart expert?

When it comes to charts, everyone is an expert -- or so they think!

It can be expensive to be overconfident.  In this post and another on my agenda I will illustrate the problem.  If you get both problems right, you can have confidence in your chart-reading skill.

Tracing a Dangerous Path

One of the most common charts we see compares current circumstances to something that happened in the past.  It often comes as a warning.

My email today provided this example, suggested for consideration by one of my most astute friends.  He is also a very successful investor and market observer.

 

 

So we are tracing the same steps that we did last year, with economic disaster to follow.

But wait --- there's more!

We are following the same path as in the Summer of 2011 and the debt ceiling debate.  Oh my!

My friend did not reveal the source of the charts, but I did not need a hint.  I get similar emails every week.  The charts are all from the same source.  The perpetrators have a wonderful and profitable business model.  They have identified a market of people who want to be Scared Witless (TM euphemism, OldProf).  They love to hear about conspiracies.  They want to have their worst fears confirmed.

My own market is much smaller, but I am proud of the readership.  It consists of people who employ critical thinking when evaluating evidence.  They want to profit from their investments.

Problems with the Chart

Regular readers will have already pounced on the main problem with this chart -- the twisting of scales.  Modern computers and software have created enough charting power to overwhelm the (lack of) skill of the user.  You can now look back in history, adjust the scales from two different time periods, find a brief period that seems similar, and then show a prediction.  Bravo!

You could just as easily find a time period that showed the opposite.

When you read something like this, it is time to turn the page.  I recently awarded The Silver Bullet to Tom Brakke for exposing this kind of deception.

Problems with the Logic

Moving beyond the chart itself, let us suppose that you paused to consider the actual reasoning.  Try to forget the chart and use words instead.  Here is my best effort:

The Citi Economic Surprise Index has moved higher, just as it did last year.  It is tracking last year's move almost tick-for-tick.  We can see the collapse last year.  Ergo, we should expect a series of economic disappointments to start 2013.

It seems pretty foolish when stated that way, but it is the story they are selling.  Please note what the chart does not say:

• This is something that happens every year (not just one time);
• This is something that happens whenever there is a similar negotiation (not just one time).

There are many differences between last year and this year.  Just for starters:

• Election versus non-election year
• Debt ceiling for a temporary change versus long-term policy
• Public preamble and preparation.

But those are only starters.  The basic problem is the following: 

You cannot make valid inferences from one prior case.

Anyone cherry-picking a prior history to do this is selling snakewater.  Beware!

An Alternative Viewpoint

Let us pretend that we did not start with the original chart.

In fact, I did not.  I have often looked at the Citi Surprise Index in the past, but I have not found much predictive value.  If the economy turns positive, the expectations increase.  I have tried but cannot sync it with any meaningful prediction.

Here is one take, from Easynomics:

Keep in mind what is basically happening, as it is usually a cycle.  Expectations rise as a result of improving data, and then it becomes more likely that data will disappoint.  It doesn’t actually mean the data get worse, only that they disappoint versus expectations.  The reverse then happens in order to complete the cycle.  We hope that the downturns don’t go as deep as the upturns go high.

Dr. Ed also follows this index.

 

Conclusion

Good luck in tracking stock prices versus the surprise index.  I do not see a fit, but suggestions are welcome.

There is a lot of irony in the original presentation.  Step back from the charts and think about it.

If the Citi index showed that there were disappointments, that would be the end of the story.  The perma-bear site would simply report that the macro conditions were bad.

Since results have been beating expectations, and you are selling snakewater, there is a problem.  Solution?  If you do enough data mining you can find a time period where beating expectations was actually bearish...  Black is white.  Bad is good.

Let's see -- last year - - wonderful.  One case is enough.

If it does not fit last year, let's go back in time......

My Bespoke Roundtable Answers

For the last few years I have participated in two different "year ahead" preview articles -- one for The Bespoke Investment Group and one for Seeking Alpha.  These are both excellent resources -- each valuable because of the specific approach taken.

Last week I suggested that readers join me in checking out the ideas of the Bespoke panel.  If you have not done so, it is still an excellent and timely idea.

I know that many readers do not click through to the links.  With this in mind, I am repeating the text of my responses here at "A Dash." These reflect my current thinking on many issues covered recently in other articles, and will be the basis for continuing work.

For your convenience

Below is the full 2012 Bespoke Roundtable Q&A with Jeff Miller of A Dash of Insight.

 

1) Looking back on 2011, what were your best and worst calls?

 

Thanks again for inviting me to participate.  The questions are excellent, so I always learn something just by formulating my own answers.  You also have a great roster of participants, and I learn from their wisdom.  I know from the comments that readers of my blog also appreciate the work you do in producing this Roundtable.

 

Turning to my own results, my best calls were sticking with Apple, trading drilling stocks in a timely fashion, and accurately predicting earnings on most of my holdings.

 

My worst calls were in the medical device area, where earnings remain solid, but fear of policy changes is overwhelming.  Even though I was underweight financial stocks, the correct weighting would have been zero!

 

Overall, my worst prediction was that the market would gradually accept the evidence of better earnings and an improving economy.  I was right on the facts, but wrong on the reaction.

 

2) What surprised you the most about financial markets in 2011?

 

I was most surprised about the persistence of highly-correlated trading based on the headline of the day.  We all know that this will eventually end, and I expected that to happen last year.  The risk on, risk off, simplification underscores the irrelevance of most actual data.

 

One lesson for us was the increased emphasis on yield.  It caused us to develop a new program for yield-oriented investors.  By combining solid dividends with covered calls, we created a strong, income-oriented investment program.

 

3) The S&P 500 hit its bull market highs in April 2011.  Which will happen first?  Will we first take out the April highs or have we entered a new bear market (a decline of 20% from the highs)?

 

We almost had the decline already!  In October we were down 19.4% on an intra-day basis.  Right now it is a good question since we are about 9% off of the highs.  I expect us to take out the highs in the first half of 2012.

 

4) Depending on your answer to question 3, how long do you expect the bull or bear to last? 

 

At least through 2012.  The biggest concerns come from things that most people are not already worrying about.  Everyone is closely monitoring the economy and Europe, for example.  North Korea is a wild card.  Middle East tension and concern over nuclear weapons in Iran could generate a spike in oil prices.

 

To summarize, some shock to the economy is the biggest worry in 2012.  Barring that, a bull market will end when Fed policy sends interest rates significantly higher, probably not until 2013 at least.

 

5) How should an investor with average risk tolerance be positioned for the year ahead?

 

I appreciate the careful wording of your question.  Most investors are freaking out, over-reacting to headlines.  The big market swings induce plenty of fear.   If you think (incorrectly in my opinion) that your upside in stocks is only 8% for the year, why deal with a market that often moves 2-3% in a day.

 

Most investors are not honest with themselves about risk.  Even in a good market year it is typical to have a 15% drawdown at some point.

 

In my approach the first and most important question for the investor is not what they hope to gain, but what level of risk is appropriate.

 

With this in mind, positions should be about 30% smaller than normal because of the current risk level.  I use the St. Louis Financial Stress Index as an objective means of determining actual risk.  It is not a forecast of the stock market.  My research found that a level of 1.1 in this index was the start of a trigger range.  This level was briefly exceeded a couple of months ago.  The index has pulled back into the .8 range, but not enough to give an "all clear."

 

6) How do you see the European sovereign debt crisis playing out in 2012?

 

This is the biggest current issue and the best source for profit by getting it right.  There is an overwhelming consensus that this is an inevitable disaster.  Merely questioning this and raising alternative possibilities leads to a chorus of people questioning your sanity!

 

This is a very crowded trade: short the euro, long bonds, long puts, short US financials, 100% out of the stock market for investors, and short for many hedge funds.

 

I have a resource page linking to more detailed coverage (http://oldprof.typepad.com/a_dash_of_insight/european-debt-crisis.html), so this is just a summary of conclusions.  Check out the link to see the argument.

 

There will be a problem with European sovereign debt for a long time, a period measured in years.  Merkel has said that it is a marathon.  The market is treating it as a sprint!

 

At a dinner in October I surprised some blogging colleagues when I told them that we would no longer be worried about this issue in eight months: June or July.  Today's news reports that Mark Mobius just said something similar.

 

What is taking place is a process of negotiation and compromise that will gradually involve many different programs and participants.  The final result will be a combination of bailouts, leverage, ECB bond buying, investments from sovereign wealth funds and China, austerity, economic growth, and maybe even the departure of one or more eurozone members.

 

Not one of these things, but all of them.  Democratic governments move slowly, trying to figure out what works.  They will do more of what is working and less of what does not.  The partial moves, disparaged as "kicking the can" by the average talking head, actually provide some useful time.

 

There will be no trumpet sound ringing when it is over, just as there is no gong sounding right now.  The Europe story will gradually fade, and people will notice that it no longer dominates the news. 

 

7) How bullish or bearish are you on the following markets: The US, Europe, Developed Asia, China, Emerging Markets?

 

There are many good investments, but the US has an advantage on a risk adjusted basis.  I own many stocks with substantial global exposure.  I like China better than the general emerging market theme.

 

8) What do you believe is the contrarian call on equities right now?

 

My measure of sentiment is the P/E multiple on forward earnings, especially as compared to interest rates or inflation expectations.  This tells you what those with assets are really doing as opposed to what they are saying.

 

By that metric, sentiment is more negative than it was at the 2009 bottom.

 

9) How confident are you that US companies can live up to current consensus earnings expectations?

 

I have a contrarian take on earnings forecasts: I find them to be of some value!  No one else does.  I share the popular skepticism about "buy" and "hold" ratings, but I find the earnings forecasts to be helpful.

 

Most observers will tell you that earnings estimates are too optimistic.  The same people will tell you that the bar is too low at the time companies report.  Well you cannot have it both ways.  If these statements are both true, then at some point in time, earnings forecasts must have been reasonably accurate.  My research shows that the one year forecast period is very good, incorrect only when there is a recession.  http://oldprof.typepad.com/a_dash_of_insight/2010/10/profiting-from-forward-earnings-estimates.html.

 

I actually prefer that analysts do not try to be amateur economists and include recessions in the forecast.  I can handle that myself.

 

With this background in mind, I think that the consensus expectations for 2012 are quite reasonable.  And yes, I know that profit margins are high and will revert to the mean.  This will happen as labor markets tighten, new businesses form, and the economy improves.

 

10) Are US stocks cheap right now based on the valuation methods you rely on most?  Will multiples expand or contract in 2012?   

 

Stocks are extremely cheap based upon earnings expectations and the potential return from other investments.  This approach to valuation is only a general guide, as experienced observers understand.  Whenever there is intense skepticism about the economy, something that has been the prevalent state since the 2004 election campaign, there is a consensus that earnings estimates are too high.

 

I have frequently invited readers to lead me to any source that has done better at forecasting earnings than the consensus methods.  The most popular alternatives are backward looking methods, embraced by the bearish punditry.  Since no single stock trades on the historical earnings record (we breathlessly await each new announcement) I wonder why people think that the sum of the parts is more meaningful than the whole.

 

This leads me to the question of multiple expansion, my worst prediction from last year.  I have actually done some research on this question, discovering a curvilinear relationship between interest rates and the stock earnings rate (the inverse of the P/E multiple).  In general, the two move together: higher interest rates lead to a lower stock multiple.

 

The exception occurs when interest rates are exceedingly low, indicating fears of deflation.  In those cases no one really believes the earnings forecasts and the result is multiple compression.

 

Last year I was wrong because (like almost everyone else) I expected interest rates to rise.  Instead, the fear and skepticism intensified.  The result is like a coiled spring.  At some point interest rates will move higher.  When that happens, at least until the ten-year note gets to the 4% level or so, the stock multiples will also increase. http://oldprof.typepad.com/a_dash_of_insight/2010/12/why-the-market-multiple-will-be-higher-in-2011.html.

 

If the Europe story fades, 2012 could be a very big year for stocks.

 

11) Describe some of your favorite market indicators and what they are signaling for stocks in 2012?

 

N/A 

 

12) What are your favorite and least favorite sectors for the year ahead? 

 

Since I have confidence in an improving economy, I like cyclical stocks and technology.  I also think that energy can work well.  The health sector is in limbo due to politics, but there will be an opportunity at some point during 2012.

 

13) What is your outlook for Financials?

 

Since I expect the European concern to diminish, this is probably the area for the greatest payoff during 2012.  Having said this, financials may not be the winners in the first half of the year.  No one believes the earnings forecasts or assurances about the lack of European exposure, so this is the most hated sector.

 

14) What is in store for the US economy in 2012?

 

There is a sharp divide in the approach to recession forecasting.  The ECRI has made an aggressive forecast of an inevitable recession.  At first they provided no time frame, but now they have narrowed it to the next six months.  They went to a 100% probability without any real notice.

 

The problem is that their methods are secret.  My review of several other sources, which I started long before the ECRI call, shows that most disagree.  Many of these sources have been just as good with real-time forecasts, but less publicized.

 

None of them has a recession forecast higher than 25%.  The mainstream economic forecast is for growth higher than 2.5%.

 

To summarize, my base case is continuing modest growth, improving from 2011.

 

15) Economic indicators as a whole came in better than expected in the fourth quarter.  Do you expect this trend to continue in the first part of 2012?

 

Yes.  There was improvement early in the year.  There was an external shock from the earthquake and tsunami, as well as problems in the Middle East and higher fuel prices.  You could interpret that slowdown as the result of temporary factors, or the onset of a recession.

 

The pseudo crisis around the debt ceiling led to another economic threat.  Through all of this, the base case from many indicators that I watch has been economic growth of about 2 to 2.5%.  This is now looking a bit stronger.

 

16) What is your take on the employment picture in the US?  Will we see the unemployment rate get below 8% by Election Day?

 

If current economic trends continue, net job creation will improve quite a bit, taking unemployment below 8% by Election Day.  The controversy over labor force participation will rage on.  There is no question that some baby boomers are leaving the labor force early and also that many people are under employed.  We also will have returning soldiers.  I cover employment pretty extensively, including aspects generally missed in the mainstream coverage.  http://oldprof.typepad.com/a_dash_of_insight/2011/11/who-gets-the-jobs-story-wrong-everyone.html. 

 

17) Are Ben Bernanke and the Fed helping or hurting the recovery?

 

The Fed is an easy target for politicians and pundits.  I am interested in investments; making money no matter who is in power.

 

Bernanke is a Republican, reappointed by a Democrat.  He has done good service, unappreciated by many.  It is interesting to note that Fed critics are of two camps:

 

-Those who think they should have done less: the crash and burn group

-Those who think they should have done more: the activist wing

 

The two wings agree on one thing: The Fed is wrong!

 

18) The Fed's Zero Interest Rate Policy (ZIRP) has really hurt savers and anyone out there looking for yield.  Where should investors go to find yield right now?

 

I understand that the question talks about the effect of ZIRP rather than the reasons, but we should all be clear about that.  The Fed had a dual mandate:  inflation and employment.  They do not have a mandate to provide a guaranteed income for savers.  Those making this argument typically have an intense political agenda: one that is hazardous to your investment health.

 

I have written a series of articles on "The Quest for Yield."  It was one of the most popular series on Seeking Alpha and also on my blog.  It reflects the great interest in the topic.

 

My conclusion is that it is possible to get an excellent income stream (10% or so after fees) from a combination of buying strong yield stocks and writing call options against the positions.  It takes a lot of work, but it is worth it.

 

My idea of a strong yield stock is not just a mechanical search for the highest yield.  I would rather have a 3% yield from a company that will maintain the dividend and also the stock price over five years.  Selling calls against these positions is very profitable right now!

 

19) The housing market continues to struggle.  Are we close to making another bottom in residential real estate?  Are there specific areas of the country that you are more bullish or bearish on?

 

N/A

 

20) Will the Dollar (US Dollar Index) be up or down in 2012 and why?  Are there any other currencies that you have a strong opinion on?  How much trouble is the Euro in?

 

There is a fundamental relationship that investors should understand.  As long as the US has a negative trade balance, the dollar must move lower.

 

21) Gold has underperformed stocks in recent months.  Will this continue in 2012?  Will gold see gains in 2012?

 

I do not know how to value gold or gold stocks on a fundamental basis.  The price is a function of two wildly disparate fears: hyperinflation and worldwide economic collapse.  Both of these concepts are easy to sell to a gullible public and the profit margins are high.

 

Since I have no pressing fear of either inflation or disaster, I am not currently a gold enthusiast.  I want to emphasize that I am open-minded and have often included precious metals in my portfolios.  I just do not think that this is the time.

 

22) The ratio of platinum to gold is currently at its lowest level ever (platinum is actually cheaper than gold right now).  Is platinum a good buy relative to gold?

 

N/A

 

23) Where is the price of oil headed?  How about the spread between Brent Crude and West Texas?

 

The general trend of energy prices is higher.  In China we have 25 million drivers and a billion to go.  The headline risk is also for higher prices.  This is only a matter of time.

 

There is already arbitrage activity between Brent and WTI, so the gap will close.

 

24) What are your predictions for the 2012 election?  Which party will win the Presidency, the House and the Senate?  Who will become the GOP nominee, and what are the chances that nominee will beat President Obama?

 

As a former poli sci/public policy prof, and a student at the top school for election analysis, this is right up my alley.  Despite this background, I think it is too close to call.  My guess at the moment is that Obama will win, mostly because the economy is improving and there is no strong opponent.  My further guess is that Romney will get the nomination, beating out a weak field.  It is still very early.

 

I suspect that we face at least two more years of divided government, with the GOP keeping control of the House.

 

That is interesting.  What do you mean by weak field?

 

Many of the candidates have solid traditional credentials, but they all come with some electoral "baggage."  The GOP establishment has struggled to find their candidate.  The primary process is really not ideal for finding either the most qualified candidates or the most electable.  At the moment, no one seems to combine the themes that resonate with the right personal charisma and traditional values.

 

25) How will the elections impact the stock market in 2012 and beyond?

 

This is a really great question, but it is too soon to answer.  I can do better when the GOP candidate is known.

 

26) Will the US Supreme Court rule that ObamaCare is unconstitutional?

 

No one really knows the answer to this excellent question.  If the ruling goes with the established political lines, the answer will be "yes."  There are challenges to two justices already, suggesting that they should recuse themselves from the decision because of conflicts.  The key question, whether people can be required to buy insurance, has many analogies and is quite thorny.

 

A good question for investors would be how to find stocks that will benefit from clarification, regardless of the decision.  That is a current research topic for my team.

 

27) How do you see the US tackling its debt problems in the years ahead?

 

The Simpson/Bowles approach is sound.  There must be a sacrifice on entitlements and also an increase in tax revenue.  People get the government they vote for.  In 2010 the country voted for divided government with an aggressive minority opinion that could block most compromises.  We are now seeing the results of that decision and a general lack of leadership.

 

The most difficult problems can best be solved right after an election, a time when we can hope for a brief spurt of bipartisanship.  Unfortunately, we seem to be in a perpetual election mode.

 

28) What are the biggest threats to the global financial system right now, and are they avoidable?

 

N/A

 

29) Hedge funds as a whole underperformed the S&P 500 in 2011.  How will hedge funds perform in 2012?  What is your take on the hedge fund model in general?

 

N/A

 

30) Will the following be up or down (positive or negative) in 2012?  Where noted, what are your 2012 year-end price targets?  The price targets are meant to obtain a wisdom of crowds consensus number from all Roundtable participants.

 

-S&P 500 (up or down and year-end price target) Up, say 1450.

-Long-Term US Treasuries (up or down) Price Up, Yields Down, 3.2%

-Corporate Bonds (up or down) The yield spread with Treasuries will get tighter, but the overall yield will move higher.

-Junk Bonds (up or down) Perhaps not much change. Higher overall yield and less risk.

-Gold (up or down and year-end price target) No opinion.

-Oil (up or down and year-end price target) Up about 20%.  The underlying trend is positive and the risks are all to the upside.

-Dollar (up or down) As long as the US has a trade deficit, the dollar trend will be lower.

-Average US Home Prices (up or down) There are recent signs of bottoming.  We need to see improvement on employment for a real change here.  GDP would be better if we just stopped the decline.

-China's stock market (up or down) No opinion.

 

31) Please provide readers with any stocks that you really like right now for 2012 and beyond.

 

I look first for themes, next for sectors, and finally for stocks.  I like a number of big-cap stocks as cyclical and tech plays, including Caterpillar (CAT), Intel (INTC), and Microsoft (MSFT).  There are other similar names.  I like energy stocks including Diamond Offshore (DO) and Chevron (CVX).  I expect financial stocks to rebound so JP Morgan (JPM) is a leading candidate.

 

I think that housing and health stocks will be winners, but it may be a bit early for these names.

 

32) Where is Apple headed as both a company and a stock?  How about Google?

 

I love Apple, and I have held the stock for many years.  I do not think that the markets for their products have maxed out.  The stock is cheap on an earnings basis, especially allowing for the cash and liquid assets.  It is a stock that I buy for new clients on day one.

 

I understand that Google has had some similar growth metrics, but it has never qualified on my criteria.

 

33) Facebook is expected to IPO in 2012.  Would you be a buyer or seller of the stock at its opening price on the day it goes public?  How long would you hold it?

 

None of the recent IPOs have been attractive for the open-market buyer.  It just seems like many people need gains and are trying to hit a home run.  They are also substituting familiarity with the product for knowledge about value.

 

34) Which technologies are you currently the most bullish or bearish on?  Are any of them game changers like the PC or the Internet were?

 

N/A

 

35) What are the website, magazines, newspapers, books, apps that you use the most and would recommend others to use?

 

This is another good question.  I read many sources, including the work of my colleagues in this Roundtable.  It is difficult to answer without leaving out something important.  Most people do not have the time or opportunity to follow as many information sources.

 

I have a list of favored sources on the blog.  My weekly column, Weighing the Week Ahead, has many citations every week, highlighting the sources that I find most useful.

 

I religiously read Abnormal Returns as the principal gateway to news, Bespoke Investment Group for top notch research and charts, Charles Kirk for both links and a trader perspective, and Calculated Risk for comprehensive coverage of economic news.  But these are just my starting points. 

 

36) What are your favorite Twitter feeds?

 

This is difficult to narrow down, since I follow different feeds for different reasons.  Since I make my own market decisions, I do not rely much on those calling for short-term market moves.  I follow many political commentators, mostly as general background.  Simply put, I know which feeds to monitor for the topic of the moment.

 

 

You can see who I follow by checking out https://twitter.com/#!/dashofinsight.  For a favorite non-market feed try https://twitter.com/#!/MikePereira to get authoritative answers on NFL officiating and https://twitter.com/#!/BorowitzReport for an irreverent (but liberal) take on politics.  I am a bipartisan consumer of political humor.

 

37) Do you have any other advice that you would like to share with readers as we enter 2012?

 

 

It is important to be open-minded about your investments, especially the global macro themes.  We are in the political silly season, where many people have strong motivations behind their economic arguments.  Most of those making comments are not trying to help your investments.  I recommend that you join me in being politically agnostic, willing to make strong investment returns no matter who is in power.

 

 

I also keep an open mind.  While I think that I can make the best returns for those willing to be aggressive, my main focus is on risk.

 

 

Most investors want to be cautious.  The downside is more important to them than gains.  They want to sleep at night.  I respect this and have created enhanced income programs that will suit these investors.

Can Investors Survive the End of QE II?

As regular readers of "A Dash" know, I have been monitoring debate about Fed policy for many years. There have been many confusing sources, including some bloggers who built their entire reputation on criticising the Fed.  For 5 1/2 years I have suggested a different and profitable way of viewing the Fed:

1. Analyze what the Fed will do, not what you think they should do.
2. Don't confuse your political opinions with investing.

This approach makes it less fun to read my work, since we cannot all engage in some boo-yah comments about how dumb those guys in Washington really are.  Meanwhile, if you focus on accurate prediction of policies, you can make clear-headed decisions about your investments.

For me -- and for my clients -- this is an easy and profitable choice.

A Summary of Known Fed Policy

Here is what we know about the Fed:

• They do not accept responsibility for commodity price increases.  Various studies show that droughts, speculation, and other factors were responsible.
• They do not agree with the "man in the street" definitions of inflation.  They like core inflation because of the predictive value.  They don't care what your personal market basket shows.
• The Fed cannot control food and energy prices through interest rate policy.  They know that, and you should, too.
• The Fed is still a bit more worried about deflation than inflation, and remains committed to low interest rates and QE II.
• The Fed wants some inflation -- about 2% by their own measures.  They believe that a little inflation is good for the economy.
• The Fed does not fear a Congressional action against the dual mandate to consider employment and economic growth as well as inflation.

Current Mistakes

The mistaken emphasis on politics and economic theory -- what I call a false Fed fixation--- has caused many to miss a terrific rally in stocks.  Those who have been completely wrong are compounding the error by engaging in even more political arguments.  Enough!  It is time to move on.

There is another viewpoint that I see as even more dangerous -- the idea that stocks have rallied only because of QE II.  This is a lame excuse offered by those who have been totally wrong about the market fundamentals for many months.

There are some very simple and obvious facts:

1. Expected corporate earnings have improved dramatically during the QE II period;
2. Risk, as reflected in objective measures, has declined;
3. Economic expectations, measured by objective third parties, have improved.

Some of this comes from the second order effects of Fed policy, but it is not a direct result of Fed action.

Those who do not understand the fundamental basis of the stock market rally are doomed to miss the next leg.

An Afterthought

I know that a big Wall Street firm has a research report on QE II versus the fundamentals.  Joe Wiesenthal at Business Insider, a long-time favorite source, accurately perceived this to be a big story.  Please read Joe's article to get the complete background.  You will find it compelling, and you will wonder why I disagree.

The story is important.  The emphasis on the end of QE II is the big story for the next few months.

• Those who believe that no one will buy US treasuries after June should be held accountable.
• Those who confuse correlation with causation should be held accountable --- especially anyone with a PhD in Statistics.

We do not need to settle this right now.  I hope to review the complete report in more detail, and others will as also.  I expect an active and vibrant debate about the reasons for the six-month market rally, as well as the prospects for the next few months.

While I like to think that stock picking is important, I suspect that the focus on overall asset allocation will be even more significant.

Actionable Advice

My wonderful editor at SA always reminds me that articles are more interesting if there is actionable advice.  Fair enough

I expect good earnings news, and  appreciate the dips.  For new accounts, and for those adding funds, we were buying some strong cyclical names like CAT, growth names like AAPL, and energy producers like NE -- as well as ETFs we have mentioned in prior articles.

 

 

 

 

The Blogger Manifesto

There is widespread blogosphere agreement on this point:

Information is good.

and the corollary

More information is better.

The logic is pretty simple.  If the information is not there, no one can get it.  We hunger for data, viewpoints, and alternative methods of analysis.

It creates a problem, of course, since there is too much to read.  We must then rely upon favorite sources to highlight key pieces.  Your choice of gatekeeper can dramatically affect your investment returns, but at least  you have a choice.

A Humorous Example

I tried a little test at the Kauffman Conference of Leading Economic Bloggers.  You have to keep in mind that this group is very diverse -- academics, think tank guys, top journalists, entrepreneurs, etc.  They also cover the political spectrum from one wing to another.  They cover the economic waterfront from all shades of Keynesians to all shades of Austrians, including some of the "self taught" persuasion.  I cannot imagine a group with more diversity and savvy.

So I asked a few of them this question:

During the last year there was one topic where everyone in the economic blogosphere agreed.  No dissent!  What was it?

No one was able to answer correctly, but all remembered when I told them the correct answer:  Kartik Athreya.  In case you have also forgotten, he is the Richmond Fed economist who dared to suggest that economics is hard and that maybe you should have some knowledge before writing on the subject.  This proposition has a certain appeal, but Athreya reached a peak of snobbery that alienated everyone.  I could not find a single blogger who defended that position.

So there we have it.  Everyone is free to spout off on economic topics whether they know anything or not.  It is a case of caveat emptor.  This means that you do not need to have specific credentials or experience, nor a prestigious employment relationship. I see the principle in action scores of times each day.

Applying the Concept

The reaction against Athreya stemmed partly from our mutual feeling that someone was trying to quash dissent.  Let us keep this in mind while I raise the current issue.

Many bloggers, with an anti-Fed fixation, seem to think that less information is good.  Here are two recent examples.

1. Fed press conferences.  Some of our blogging colleagues do not like this.  Why not?  We have more information and the opportunity for questions.  Most of us think that we are smart and wise enough to make use of this information.  If you are not, don't rain on the party - -just tune out.
2. Fed papers.  The Fed encourages staff research reports on many topics.  There is plenty of disagreement and the papers are noted as not reflecting the view of the Federal Reserve System.

This healthy flow of scholarly work by Fed staff has allowed us to consider, for example, varying views about measuring inflation.  Most of us know about the Cleveland Fed and trimmed mean measures.  Dissent and discussion are good for all of us.

With this in mind I am astounded at the reaction of Cullen Roche to recent research from high-ranking staffers at the SF Fed.  The research findings are not consistent with his pre-conceived viewpoint.  That's fine.  I believe his criticisms are ill-founded, but I will return to the substance of the article on another occasion.  For those readers who do not follow him, Cullen is the top-ranked economics writer at Seeking Alpha.  He has about 70,000 followers, including me.  He often has interesting practical market advice.  His bio is a bit unclear about his expertise in statistical methods or formal economic training, but he often writes on these topics.

What disturbs me is Cullen's position that the article should not have been published.  This is simply wrong -- not consistent with intellectual freedom, the quest for knowledge, or the Blogger Manifesto.

Here at "A Dash" my readers are smart enough to discern between staff comments with a warning at the bottom and official statements from Bernanke and other FOMC members.

If Cullen's readers are not up to speed on this distinction, I respectfully suggest that he educate them.  This is better than quashing information that the rest of us might find useful.

I'll return to the substance of this article later.  For the moment readers can check out my comment on his site -- the basic lack of specific analysis on methodology and the incorrect use of the term "data mining."

Meanwhile, this constant Fed bashing is not productive.  It is causes you to take your eye off the ball -- earnings, the economy, and risk.

 

 

What You Really Need to Know about Employment Data

The widely held outlook about employment is both dismal and bearish.  The popular viewpoint is that there is almost no job creation.  That people lose their jobs and remain on unemployment forever, or until benefits run out.  That there is a small, stagnant, and unchanging pool of job openings.

While the employment situation remains poor, this consensus view, is so exaggerated that it can cloud our ability to understand and to forecast.  This leads everyone to be too pessimistic about the prospects for economic growth and personal consumption.

Here are three important and overlooked facts from recent government reports.

Job Creation

If we could increase job creation by 10%  -- just 10% -- we would make rapid progress on employment.  Payroll employment growth has been just 500K over the last four months, or about 125K per month.  This is only about what is needed to absorb new entrants to the labor force.  What if employment growth was 350K instead?  That is a level that many cite as meaningful for improvement.

An increase to a monthly gain of 350K requires only a 10% growth in job creation because the economy is already generating 2.3 million new jobs every month.  By incorrectly focusing on the net change in jobs, the impression is wrongly created that we have an impossible task.  This is a silly and common mistake, as is the persistence in basing percentage changes on the net change figure.  The monthly change is a very volatile figure and it is small compared to the labor force.  Try this comparison.  If you were talking about a move in GDP from 2% to 3% you would not say that it was a 50% increase.  This is the same thing.  Percentages based upon changes are misleading.

Source:  The  BLS QCEW Report.

Job Availability

The impression is that there are no jobs.  Wrong!  There are about 2.8 million job openings right now.  That number has been pretty constant for months.  Some pundits incorrectly infer that the constant number of openings means that the same jobs are standing empty, perhaps because skills are not matched to the job needs.

This is completely wrong.  While there may be some structural unemployment, you cannot find evidence in the Job Openings and Labor Turnover Report.  (JOLTS).  In fact, the report emphasizes the dynamic nature of changing job openings.  The mistake is that many observers look just at the total of job openings.  The real value of this report is what it shows about the underlying change.

I'll bet you did not know that more people quit their jobs than are fired or laid off.  Almost 2 million people quit last month.

Source:  The BLS JOLTS Report

Unemployment Duration

Mostly we hear stories about long-term unemployment.  To keep perspective, note that as of last month 57% of the unemployed were finding jobs within 26 weeks.  41% within 15 weeks.

These are still poor numbers by historical standards, but not as bad as the general impression.

Source:  The BLS Employment Situation Report

Conclusion

I write a monthly employment preview on the Wednesday before each month's payroll employment report.  I have been among the most bearish of the forecasters, but I try to keep a sense of reality.

My fellow analysts need to join me in looking more deeply into the various employment reports.  The jobs picture has been very poor, but not as bad as widely thought.

Most importantly -- the key takeaway:

It would only take a modest 10% increase in job creation to improve all of the data.

 

 

Does Honesty Matter?

Evidence from a court case shows that Merck, working through Elsevier, did some fancy marketing footwork.

The Scientist, a source we read daily, broke the story, Merck published fake journal.

The company paid the publisher to create a couple of issues that appeared to be a peer-reviewed scientific publication.  Instead, it was a collection of reprints with a masthead of names from the scientific advisory board.

The Scientific Misconduct Blog has more detailed coverage.

Does it Matter?

The question for investors is whether this matters at all.  In a perfect world, scientific integrity and respect for peer review would be important.

In the actual world, we doubt that investors care.  Some may even see this as astute marketing.

It is an interesting object lesson about what matters on Wall Street.

[no position]

ISM Interpretation: Watch that Decimal Point!

Today's ISM number for May came in at 49.6, slightly below the level indicating expansion in manufacturing, but a touch better than expectations.  Is the ISM report important?  We'll look first to news reports and pundits, and then provide our own take.

News Interpretations

Bloomberg gave a balanced account, noting economic forecasts as follows:

Economists forecast the index would decrease to 48.5 from 48.6 in April, according to the median of 75 projections in a Bloomberg News survey. Estimates ranged from 46 to 50.5.

and also...

ISM's gauge of new orders increased to 49.7 from 46.5, while a production measure rose to 51.2 from 49.1, ISM said.

The Wall Street Journal's Real Time Economics has the usual nice collection of economic reaction.  The title, "Economists React: ‘Severe Recession Has Been Averted’?" captures the main theme.  The economic data have been good enough to cause many to reconsider their recession predictions.  Read all of the comments for yourself, but the consensus indicates a greater chance of Q2 GDP at a rate of 1.5% or so.

Significance of the Report

At "A Dash" we always wonder how economists can make forecasts of survey results like this one or of consumer confidence.  The analysts at Briefing.com share this concern.  The following describes their concern:

This is a highly over-rated index.  It is merely a survey of purchasing managers.  It is a diffusion index, which means that it reflects the number of people saying conditions are better compared to the number saying conditions are worse.  It does not weight for size of the firm, or for the degree of better/worse.  It can therefore underestimate conditions if there is a great deal of strength in a few firms.  That may well be what is happening at present with exports booming at large firms, but not necessarily across all manufacturing sectors.  The current readings on the ISM manufacturing index are providing a more negative view of conditions than the actual industrial production data.  The data have thus not been either a good forecasting tool or a good read on current conditions during this business cycle.  It must be recognized that the index is not hard data of any kind, but simply a survey that provides broad indications of trends. 

We see the ISM data as a contemporaneous economic indicator that we analyze along with payroll employment.  We have frequently warned in the past when we expect a surprising negative result with market impact.

To summarize, this was good news, showing an economy that is growing below trend but defying the recession predictions.

An Alternative Viewpoint

Over at The Big Picture, one of our featured sites, Barry Ritholtz, the self-styled gonzo economist, had a different view about what we should see in this report.  He pounced with the "Bad Headline of the Day."  His point was that the article called the report a gain in manufacturing activity, which it was not.  He did not, however, mention that the report implied a higher GDP than was expected.

We congratulate Barry on noting the decimal point error of the headline writers, but we are left wondering about the main story.  Does he believe that this was bad news?  Also, this is a survey.  Is he considering the confidence interval and statistical significance?  Can we be confident that the null hypothesis of "Not 50" can be rejected?

Big Picture Reader Contest

The quibble over the decimal point created a mini-contest in our office.  We started arguing about data interpretation on The Big Picture.  We have recommended this site since our inception, and we read it daily, usually with great care.  We also watch Barry on TV, as do our clients.  Sometimes we dig into the archives, usually when we are trying to answer a question like "What did people think was wrong with the market in June, 2004?"  The answers are all there.

But back to the contest.  We offer a prize to the reader who can find an article on The Big Picture where Barry analyzed the data and suggested that the results were more positive for the market or the economy than the official report suggested.  The prize goes to the most recent entry.  It must be a regular report, of the sort listed on the Briefing.com calendar, where Barry's interpretation was more bullish than the report seemed to indicate at face value.

Conclusion

Each economic data point shows an economy slogging along below trend, at great cost in terms of lost potential, but not as bad as many expected.  Today's economic numbers were pretty good, but were overwhelmed by the S&P decision about future writedowns for some investment banks.

We shall look at the payroll employment report forecast later this week.  Meanwhile, our indicators respect the tape.  We are more cautious in the intermediate term.

Cherry Picking in Data Analysis

There is a type of research that is especially dangerous for individual investors.  The researcher takes current data and makes a statement like one of the following:

• If you avoided the ten worst trading days over the last five years....
• If you missed the ten best trading days over the last five years....
• If you threw out the ten strongest earnings reports....
• If you threw out the ten worst earnings reports...
• If you avoided the last five recessions....
• If you threw out the companies with the strongest stock performance...
• If you threw out the companies with the weakest stock performance...

This type of analysis is pretty easy to do for anyone with a computer and a data set.

Many trading systems do backfitting, avoiding the recessions or downturns.  It is easy to find an indicator that gave a definitive signal when looking at past data.  The problem is that such systems, lacking rigorous development of hypotheses, failing to use out-of-sample data, and willing to accept an insufficient number of cases, usually produce post-diction rather than robust predictive models.

The Current Example

Barry Ritholtz at The Big Picture highlights an interesting situation posited by Mike Panzer.  Mike reports that a small number of stocks have powered the Nasdaq higher.  Mike  concludes as follows:

Finally, 13 out of 100 stocks -- 13% -- are responsible for two-thirds of the overall advance.

While this heavy lifting by a small number of shares does not mean the index can't go higher still, history suggests rallies that lack widespread participation sometimes lack long-term staying power.

What to Conclude?

We are troubled by this facile conclusion, which was reported without comment by various pundits.   We enthusiastically endorse the more analytical questions  raised by Barry:

What might this mean?

Are Technicals Waning as a Positive Influence? I'm not exactly sure -- What I'd like to see is how past rallies have moved forward in terms of leadership.

Is it unusual to have 13 stocks in the NDX’s 100 account for 67% of the aggregate advance? Is this unusually narrow? When has this occurred, early or late in a run?

I don't know the answers to these, but I am curious . . . 

In scholarly research one would not start with a conclusion, but with a hypothesis.  It might go something like this.......

When fewer than fifteen stocks in the Nasdaq account for two-thirds of recent gains of X percentage, we define the leadership as "narrow."  Looking back on the Y number of cases fitting this description, we note that stock returns over the following Z days were as follows (table included).

Even with such a statement there are issues about how the definition of narrowness was determined, whether there were enough cases, and whether the researcher really generated the proposition and then tested or just used all of the data to identify key parameters.  This approach would at least provide some comparison.  Ideally, the relevant data would be provided to other researchers to check the selection of parameters.

In the absence of such data, one is left with questions.  The indices are weighted by capitalization.  What is the performance of the rest of the index?  What is the market cap percentage of the top stocks?  Markets often look for leadership.  Is a gain by some of the top stocks indicative of success or of failure?  If other stocks are lagging, is it possible that the market will later show strength in the laggards?

A Final Word

Like Barry, we do not pretend to know the answers to these questions.  In our effort at "A Dash" to raise the standard of Street research, we try to highlight certain problems.  Often these are conclusions that are readily embraced by those who seek support for what they already believe.

Some research is driven by conclusions, not by hypotheses.  It is not scientific.

As usual, the discriminating investor, insisting upon strong research methods,  can gain a contrarian advantage.

Mortgage Availability and Personal Consumption: The Dubious Relationship Breaks Down

What happens to Personal Consumption Expenditures when banks tighten up mortgage lending standards?  With the release of April PCE data, we can now check out a dubious, but widely publicized prediction.

Background

Two months ago the influential Doug Kass repeatedly published a chart that purported to show a near perfect correlation between lending standards as measured in a quarterly Fed survey and year-over-year PCE.  The chart was also posted and discussed at the widely read Calculated Risk blog site.

In a three-part series on "A Dash", we went to the original data sources and performed our own analysis.

Part One. We showed readers that the correlation was exaggerated, that the scale had been manipulated in a deceptive fashion, and that the causation argument did not fit the data.  The existing correlation was probably spurious, the change in each resulting from changes in prevailing economic conditions.

Part Two.  We explained the difference between a confidence interval and a correlation, helping readers to understand the difference between substantive significance and statistical significance.

Part Three.  We compared the chart to various optical illusions, showing why accurate measurement is better than the eye.

The Prediction and the Result

The original Kass chart showed an ominous tightening in lending standards, suggesting that we were on the verge of a similarly precipitous decline in personal consumption.

As one can see from the updated chart, (the new segment indicated by a red line around it) the PCE change was modestly lower.  The rate of PCE growth continues well within the range from the last two years.

The Kass prediction was incorrect.

Conclusion

As we concluded in our original analysis:

The current mortgage market is much different from that of 1990. Nearly everyone -- especially Doug Kass -- believes that recent standards have become quite loose.  Some tightening is a logical reaction.  There is nothing in the data he presents that shows that this should result in a decline in consumer spending.

Such a decline might occur, of course.  There may be other reasons to link housing and the economy.  That is beyond the scope of Doug Kass's argument and this response.  The point here is that the data in the original Kass chart do not support his conclusion.

The next Fed survey of bank officers should be reported any day, so there will be a new data point to add to the chart.

A History Lesson for Wall Street Resesarchers

Wall Street researchers are terrible at history!

The worst examples occur when they make hasty and sloppy comparisons.  A current example is finding an old chart from one time period and lining it up with current trading.  This is a blatant form of data dredging, but some find it to be compelling reading.  (Here is a typical example from The Big Picture, but please note that the inference is not endorsed by Barry Ritholtz).

The problem is that everyone who follows the markets looks at charts on a daily basis.  Even the non-technicians claim some basic skill.  Show us a chart, and we all have an opinion.

At "A Dash" we have tried to point out that the data we really need for good research is rarely available.  This forces us to reach back in time --- often way back -- to get enough data to review more than one or two market cycles.

We seriously doubt that market data from the Taft Administration has much relevance for today.  In fact, we question any information from the era before stock options and futures, and maybe before the invention of the personal computer.

There are some market characteristics that endure over time.  Sure, everyone should read and enjoy Edwin Lef́aevre's Reminiscences of a Stock Operator (on our recommended list).  The question is whether the inferred psychology from this era is equally applicable today.

It is a question that must be asked repeatedly, every time someone presents data that reaches back more than twenty-five or thirty years ago.

It helps to be fully grounded and in touch with what people really believed in the era you are using.  If one wants to use data from 1900, why not see what people were thinking then?

There is a wonderful list of predictions for the year 2000 made in 1900 by J. Effreth Watkins in The Ladies Home Journal.  It is a rather long list, but very entertaining.  Each of us will find certain favorite observations.  (Thanks to Tyler Cowen at Marginal Revolution, where we spotted this).

Our own overall conclusion is that Watkins was very good at extrapolating technology known at the time -- the rise of automobiles and improvements in medicine (including diagnosis), and the anticipation of FedEx (with a lot of pneumatic tubes).

He was less successful at quantification.  The U.S. was to have 350 to 500 million people.  We would have a life expectancy of 50 instead of 35 in those days) and everyone would be able to walk ten miles a day or be thought a "weakling."

He was predictably weak on technology that was just appearing like airplanes, which he thought would never replace the automobile for passengers and freight.

Most mysterious are the predictions that must have seemed plausible, but went terribly wrong?  Why DO we still have all of these mosquitoes?

The lesson for those doing market research:  Take care to make sure that historical comparisons are well-researched and appropriate.

The lesson for our fellow consumers of Wall Street research:  Let the warning bells go off when there is a chart or analogy including a time period from long ago.