A Dash of Insight

"Sticky Sentiment": Part Two

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

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

Application to Stocks

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

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

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

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

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

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

A Typical Opposing View

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

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

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

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

Our Take

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

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

Doug Kass on Housing Predictions: An Update

At "A Dash" we have frequently cited the work of Doug Kass, a colleague at TheStreet.com.  Even before we contributed to RealMoney, we were paying customers to get Doug's work.   We found it to be a source of trading profits, as long as you understood the perspective.

We were therefore a bit surprised when Doug, writing on RealMoney Silver (where we can make no reply), took issue with our conclusions in an article about a survey.  Discussing reasoning and conclusions is fine, of course, but his comment was completely lacking in substance -- nothing about the article in question!

Instead, Doug engaged in an ad hominem attack.  Here is a key quote:

You (and many others) have been dead wrong on the magnitude of the drop in housing while the housing Cassandras have been dead right. (Just go back to your site and reference your reaction to my housing "hyperbole" several years ago.)

Those are the facts. They are not debatable.

We are delighted to see this statement of the issue.  Since we have no ability to reply where Doug wrote, we will have to write here.  As we have often done in the past, we invite Doug Kass to write something in response.  We promise to publish it without any edits.

Let us examine the quantification question.  But first, a bit of background on the housing issue.

Our Position on Housing

In the days before we were writing on this blog, we sent a quarterly newsletter to our investors.  Here is a quotation from the issue of June, 2005:

Housing

Is there a bubble? We see some disturbing facts, all signs of market tops.
People who were formerly day-traders in stocks or had good jobs in software development are now going into real estate.

If you tried to look at housing like a stock, using a PE ratio (rent/price), the number is about 35, 75% above the historic norm and double that of the major stock market averages.

Average folks with absolutely no real estate experience are buying properties with interest-only mortgages expecting to make their profits on appreciation.

We can smell some toast burning here.

We advised our clients against over-investment in real estate and those who followed our program for individual investors did quite nicely in stocks.  Doug Kass was not the only one seeing a problem in housing; he was just too early -- way too early -- in predicting the impacts.  (Check out Doug's timing here).

The "Batman" Chart

Since the issue is quantification, not direction, a great example to consider is Doug's prediction about personal consumption from a year ago.  He had this impressive chart with a distinctive pattern that we called "Batman" around our office.  The time period and the scales had been adjusted to give a false illusion of a strong correlation.  Here is the original chart.

Doug highlighted this chart in his column multiple times and took it on CNBC calling it a .9 correlation.  Charts of this sort are very dangerous for investors.  They do not understand statistics and causal modeling.  They are especially susceptible to visual evidence.

We reconstructed the data and did the calculations.  In one of the best articles we have ever written, we showed the problem in this analysis from a causal modeling perspective.  We expect this article to have a prominent place in our forthcoming book in the "Misleading Charts" chapter.

The obvious implication was that PCE would rapidly decline to below the 2% growth rate.  We analyzed the intermediate results in this article where we showed that the prediction had failed.  We think that Doug was a victim on this entire story.  Someone sent him this chart -- someone with dubious quantitative skill -- and convinced him to go with it.  He should have renounced it at some point.

Current Chart Update

The most recent evidence, one year after the original article, is even more dramatic.  As one might expect, the lending restrictions of banks have increased dramatically.  The changes are actually off of the scale.  The Fed altered the question to split out lending on qualifying mortgages versus subprime and Alt-A.  Bending over backwards, we have used the prime mortgage series in the chart.

Conclusion

As one can readily see from the chart, the precipitous change in lending standards (Doug used an inverted scale so that tighter standards would match lower PCE) did not result in a similar decline in Personal Consumption.  The direction was correct.  As we stated in the original article this is called a "spurious relationship" by those who do causal modeling.  A weakening economy causes all sorts of effects that do not have a causal relationship.

Doug Kass never cited this chart again, nor did any of the other blogs who picked it up.  The conclusion from this chart is inescapable:

Kass grossly overestimated the impact on Personal Consumption in March, 2007.  As he says, "Those are the facts.  They are not debatable."

 

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

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

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

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

A Basketball Example

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

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

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

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

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

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

Let us start by looking at the chart.

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

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

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

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

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

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

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

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

Conclusion

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

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

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

The Winning Trade is the Tough Trade

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

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

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

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

The Tough Trade

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

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

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

Some Facts

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

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

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

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

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

Some Cool Heads at Work

Let us consider the thoughts from some quite disparate sources.

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

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

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

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

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

Conclusion

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

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

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

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

TCA-ETF Update

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

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

Investors Look at the Wrong Information! Why?

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

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

An Example

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

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

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

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

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

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

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

Conclusion

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

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

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

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

Another Round of Panic

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

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

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

Significance of the Report

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

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

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

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

Other Interpretations and Advice

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

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

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

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

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

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

Read the entire article to get the full context.

The Earnings Mythology

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

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

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

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

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

Conclusion

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

The Hunger for Content and the Effect

Financial media outlets of all types hunger for content.  They are driven to find an audience, since their business models depend upon it.  Any financial program needs guests.  Prominent journalists need to write stories that will attract readers.  Bloggers who depend upon advertising or promotion need to find and satisfy an audience.  What effect does this have?

Quantity versus Quality

The rise of the blogosphere has generated diversity in content.  Anyone with a point of view can start a blog and offer opinions.  A few months ago we noted that some outside surveys questioned the credibility of financial blogs.  The definition of a financial blog was open to question, since it included mainstream media efforts to reach out to a new audience.

Competition and expansion of financial television has had the same effect.  Every program needs guest spots and the focus is on the issue of the day.

No one seems to ask whether the guest, or columnist, or blogger really has the right qualifications to be offering advice on the topic at hand.  The omnipresent question is the prospect for a recession.  Financial television asks the recession question daily to anyone and everyone.  Most people getting a TV opportunity, are not bashful about answering the question.

The Consumer

For all but a few, we are consumers of economic forecasts.  We have no independent ability to make projections, so our role is instead one of deciding who knows, and who does not.  At "A Dash" we believe that the democratization of the  media -- emphasizing the Internet -- has made the task of the consumer more difficult.  Appearing on television or having a big-time blog confers a sense of legitimacy that may be completely unfounded.

Most people do not realize this.  In particular, individual investors do not make this distinction.

It is an expensive mistake.

Are Bloggers too Negative?

There is a New York-centric debate going on among several prominent commentators (all professed pals), highlighted in the New York Times, about whether bloggers are too negative.  None of the participants dares to question the qualifications of any of the others, so the debate is rather lame.  Paul Kedrosky (at one of our featured sites) raised the question.  He did so assuming facts not in evidence about the existence of a recession, and on the eve of a significant rebound in stocks (which we predicted the following evening).   Barry Ritholtz (at another site we recommend to our readers) offers a response.  Herb Greenberg also weighs in.

We are especially intrigued by the following comment in the Greenberg article:

I don’t make market calls or offer investment advice. But via the media world, I’ve also morphed, for better or for worse (depending on your perspective), into somewhat of a financial commentator. I figure my opinions, based on more than 30 years of writing about this stuff, is as valid as others who were formally schooled in economics and the stock market. (And who, by the way, seem to get it wrong as much as they get it right.)

Readers should note that Greenberg concludes that any formal training in economics is irrelevant.  It is enough to be an observer of the scene.  Does this really make sense?  This is an important subject, to which we shall return in future articles.  Most real economists are too polite to point out the errors when on a program with non-economists.  The guests all speak in generalities.

Our Take

Let us apply a little common sense to this situation.  On the one hand we have people, very intelligent people just as smart as Herb Greenberg, who spend many years acquiring training and experience in certain methods.  These people then apply the methods in specific situations and make forecasts, some right, some wrong.  It is easy to disparage their work by picking out those who were wrong and focusing on the mistakes.

On the other hand we have someone who does not acquire the training and knowledge, but concludes that it is irrelevant.  That is what the consumer of information should consider.   Anyone who does not realize the value of expertise is in for a big surprise.

Current Market Mistakes

Because of the various challenges -- the general economy, the housing market, the credit market, the risk in CDO's -- there is--right now-- an especially important interface between economics and government.  It would be wise for investors to seek out genuine experts in both subjects.

Most current commentators have expertise in neither.

Current issues include the following:

Fed policy, where those who maintained that the "Fed was in a box" have been proven wrong.  Have any of them admitted this?  Have they simply switched arguments to some future problem?

Inter-bank lending, where many predicted incorrectly that LIBOR rates would not fall.  They underestimated the effect of the Fed's innovative TAF approach, something we highlighted.

Bond insurer issues, where people with absolutely no experience with government policy making -- none whatsoever -- make daily arguments about why any effort will fail.  The key argument is that the Treasury SIV approach failed, so a bond insurer effort will also fail.  We think that this idea is both shallow and erroneous.

As far as we know, we are the only Internet source that takes a genuine public policy perspective to identifying experts and trying to predict government actions through knowledge.  If one is looking for an investment edge based upon true expertise, this is the place.  Most of the Internet gatekeepers, even the very best, just cite the stories from popular blogs and rely upon the  caveat emptor principle.

This puts the burden upon the reader.  The gatekeepers are quite honest about this, but how many readers have the critical skills and insight to analyze what they see?

We shall return to the bond insurer versus the SIV question, but we hope that readers will first consider the challenge we posed.  It is essential in understanding the conclusion.

Market Response to Recessions

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

An Interesting Table

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

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

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

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

Our Take

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

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

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

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

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

Economic Indicators and the Employment Report

Today's market decline came after the Institute for Supply Management monthly index was reported. The ISM reading for December was 47.7, the lowest level since a couple of months in the Spring of 2003.  Since economists had expected a reading above 50  the report was worse than expectations.  (We wonder how anyone forecasts this series.)

This is a diffusion index, so readings below 50 indicate contraction in manufacturing.  If the 47.7 value were annualized, it would imply GDP growth of 1.8%, according to the ISM's own research.  Despite some media efforts to explain the index, many traders still do not realize that the break point for an economic decline is a reading below 42.  There was a knee-jerk reaction since the report was below the symbolic "50" and that fits the prevailing gloomy recession forecasts.

For an excellent and complete analysis, check out Between the Hedges.

Later in the day, crude oil futures traded briefly above $100/barrel.  This also had a symbolic value, calling attention to inflationary pressures.  The scare stories hit the tape.

Economic Facts versus Sentiment

As we look back on 2007, the biggest surprise for us has been the persistence of what we call "misguided gloom" and the astute Gary D. Smith calls a "negativity bubble."  The Fed set out to make sure that inflation expectations were firmly anchored.  Since then, the chorus of negativity from market commentators has been overwhelming.  No one believes that the Fed can help in achieving a "soft landing."  The most expensive investment research of 2006 (we have not yet made our 2007 award) was costly for anyone who followed the advice.  This has not changed in 2007.

The problem is that no one seems to understand what a soft landing looks like!  Did people really expect GDP to descend gracefully to an annualized rate of 3% and then stop?   Amazingly, that is pretty close to the growth achieved in 2007.   It has occurred in spite of spiking oil prices, declining home prices, and a crisis in credit markets.

We are confident about our methods in the long-term.  They have worked for the ten-year history of our business.  We also had a great year for individual investors in 2007, but the last three weeks surprised us.  Predicting short-term market reaction is always a challenge.   In this case, the reaction to the Fed decision three weeks ago seems especially overdone.  An observer opined today on CNBC that had the Fed explained the TAF plan before announcing the interest rate decision, the market would not have declined.

Amazing.  That was 1000 Dow points ago.    There has been time to get the message.  As we noted yesterday, there is plenty of distortion about Fed policy.  Even astute observers are misrepresenting Fed goals and policy results.

Friday's Employment Report:  Background

The monthly employment report is a subject where we have done significant research and writing.  There are two reasons for this.  First, the market--quite wrongly--places such great emphasis on the data.  Second, it hits all of the elements of our expertise -- understanding research methods, surveys, and government.

Before each payroll employment report we look at a group of indicators which are all collected at about the same time as the report data, the middle of the preceding month.  While the regression model "predicts" monthly employment changes from the other variables, the correct interpretation is that they are simultaneous but slightly different reads on the economy.

The model has a nice fit to the jobs data that is eventually written as history, duly revised and benchmarked.  We invite readers to try our Payroll Employment Game, updated monthly.  The main point of this site is to demonstrate the wide variation in possible results from the monthly survey.  It also has a comprehensive analysis of BLS methods that complements the articles at "A Dash."

Our Own Forecast: A Very Weak Number

Economic growth of less than 2% is certainly below capacity and costly in many ways, including employment.  Last month's data suggest an employment gain of only 7000.  While most reporters fail to mention it, the 90% confidence interval on the monthly change is +/- 100,000.   That is just the sampling error on the survey.  It does not include any non-sampling issues such as the adjustment for new job creation. Since the market is looking for a gain of 70,000 jobs (according to Briefing.com --some are using 50K after today's report), the potential for a negative surprise is larger than usual.  Slow growth is not enough to absorb all of the new workers, so unemployment is likely to move higher.

A No-Win Scenario?

Some suggest that there is no "good" number this week.  A strong report will not be believed.  Expect the regular chorus of pundits complaining about the birth/death adjustment.  A weak number will create the expectation for an inter-meeting move by the Fed, something that we see as quite unlikely.

Briefly put, the negative sentiment may have longer to run.  For investors and funds looking to get more market exposure, this week may provide a good opportunity.

Interpreting Comments

Bond and equity markets both reacted negatively to comments from Countrywide CEO Angelo Mozilo.  In a CNBC interview he spoke about the problems in housing and predicted a recession would result.

Should investors heed this warning?

Background

At "A Dash" we have tried to emphasize two themes that can have a great payoff for longer-term investors.  The themes may also benefit traders, although the timing is trickier.

• Identifying the expertise of the source.  The Countrywide CEO obviously has great information and insight concerning his own business.  He is providing additional information about something of current concern, and that is useful.  He is not an expert at predicting recessions.  There is no evidence that he has experience or added value in considering how the housing situation will affect individual or business spending, countervailing factors, or a quantitative forecast of the effects.  He knows about housing.

Try this comparison.  Suppose a CEO was making an extremely bullish forecast about his own company.  We might view this with some skepticism.  Applying the same attitude, one might conclude that the CEO of a business that was struggling would want to make the problem seem as great as possible.  Compare the Countrywide comment with the Bear Stearns CFO who responded to questions by saying it was the worst credit market he had seen in his 22-year career.  He was trying to explain what happened to some leveraged hedge funds, among other things.  These sources are experts at what happened in their own companies, but might be seen as biased when projecting impacts on the overall economy.

• What has already been "priced in" to the current market?  The sources cited have absolutely no expertise on the stock prices of other companies, normalizing earnings, or other factors that investors should consider.

Where to Look

Investors should look to those who are experts at taking all economic factors, viewing the impacts with quantitative impacts, and making forecasts that are tested by prior results.  In particular, it is important to understand that recession forecasters are predicting something that typically is an unlikely event.  They have few past cases to work from, particularly in the modern era.  Any economist recognizes the impact of the housing problem in GDP forecasts.  They differ in the size of the impact.  At "A Dash" we have tried to highlight sources that have avoided "false positives" in the past, including the ECRI.  Many recession forecasters place no time frame on their predictions, moving the date forward each year as they are proven wrong.  Sidelined investors have missed an opportunity by listening to these predictions.

One should also consider how much earnings forecasts have already been reduced to reflect recession chances.  This is the only method to figure out what is "baked in."

Where Not to Look

We suggest avoiding pundits who cite each statement from a housing source as important fresh information.  Many of these pundits seem to think that they are the only ones with any vision.  They repeatedly claim that others "do not get it."

In fact, everyone "gets it" in that they are aware of some GDP loss.  The difference is that some forecasters attempt to quantify the effect, while others (mostly non-economists) cite each statement as proof without sound analysis on quantifying the effect.

It is a curious fact that pundits who are not economists strongly believe that they have greater insight than those who studied for many years to learn theory, data analysis, and forecasting.  They operate from a stereotype of homeowners that reflects only a small segment of the population.

Summary

The many market pundits who take a bearish view of the economy can find plenty of specific statements and data to support the housing effect.  The difference between the real experts and the pretenders is the ability to quantify those effects.

Having arrived at an economic forecast, the investor must still ask how much the market already reflects a negative perspective.  There is an advantage to buying when fear has been priced into the market.

We rarely have the opportunity to gain a contrarian trading advantage -- buying fear -- by relying upon the real experts.  Now is such a time.