A Dash of Insight

Reacting to News: What to Make of Dubai?

Here at "A Dash" we try to identify the best experts on any subject.  Since we are free to position our clients in any way, we are consumers of news and analysis.  So are you.

While I manage client portfolios in real time, my writing is after hours.  I am not trying to advise people with short-term trading horizons.  Our TCA-ETF approach (still bullish) has a three-week time horizon.  Our program for long-term investors has an even longer time frame.

When I write, it is an honest assessment of my own views and an attempt to find the real authorities.  It is not trading or investment advice.  It is just something you might want to consider.

The Issue

Each night I get the daily report from Charles Kirk, a valuable service for his subscribers.  Charles (who is currently neutral on the market in all time frames) always includes a quotation with his analysis, and today's is especially apt:

"Look at market fluctuations as your
friend rather than your enemy; profit
from folly rather than participate in it."
- Warren Buffett

This is a great statement of the issue.  Is the Dubai reaction the start of something bigger, or an opportunity to "buy a dip?"

The Analytical Viewpoint

At TheStreet.com's Real Money site (subscription required)  Marc Chandler, a source for whom we have great respect, wrote as follows:

We stress again that the current troubles being seen in Dubai are a direct result of its efforts to tie its fortunes to global real estate, tourism and services, and are particularly unique to Dubai and should not have wider implications for sovereign EM risk. The property boom helped this strategy work in the good times, but the popping of the global real estate market has put severe strains on Dubai.

Developments in Dubai should thus be seen in the context of the entire country basically being geared toward real estate development and not in the context of EM sovereign risk and fundamentals. Thus, while the current period of risk-off trading could yet persist, longer-term investors should be looking for buying opportunities in EM during this correction.

We note the careful analysis of the nature of the problem, and how it might be connected to various markets.

The World Leadership Viewpoint

Other sources also provided perspective on this issue.

Banks, world leaders play down Dubai debt threat, from Reuters.  The article quotes leaders from the US, Britain, France and Japan.

The Bearish Viewpoint

Those who have been calling for a market correction see this as the start of something big.

Pimco, with a bearish viewpoint on stocks and now even seeking less risk in bonds, calls it the start of an "overdue correction."

Others, whom we will not name, see this as the first step in the decline of commercial real estate.  Or they say that we should not believe anyone who sees this as "contained" because someone or other said that subprime would be "contained."

The Trading Viewpoint

Barry Ritholtz, despite a continuing bearish tone from most articles, expected a rebound from the overnight bottom and was pretty accurate with his pre-opening call.

Our Take

There is a widespread acceptance that any warning of doom is correct, and every event is proof.  If so, the case against buying stocks is clear.  There will always be something to worry about.

Today's bears did not make a very good case.

I watched the currency trading closely.  The dollar flight to quality ended rather quickly.  The trade-weighted dollar is about where it has been for the last week.  And I am still waiting for someone to show a good link between low treasury rates and the ability to speculate on US stocks.

There were plenty of buys in individual stocks that have nothing to do with Dubai, European banks with big exposure, or even the dollar carry trade.

I don't know if Warren Buffett was buying today, but I was.

A Profitable Pattern

I have noticed a profitable pattern.  I am going to cast this from the bearish perspective, but in theory it could work either way.  I have a few other historical examples, but let us focus on the present.

Background

Investors have many time frames, and so do those managing money.  When you see someone interviewed on CNBC it could be a mutual fund manager, a hedge fund manager, or a trader.  It is natural for everyone to talk his book, but the time frame is relevant.

A mutual fund manager likes to see holding increase, get publicity, and attract new assets.  Having said this, these managers are not likely to sell into rallies.  Instead, new money in their funds gets invested at current prices in current holdings.

A hedge fund manager or trader is different.  Their disclosures warn that they may change opinions and trades in a heartbeat.  They can, and should, do so.  A five percent move in a stock is a major trading profit.

The Process

A portion of the hedge fund community takes a position.  For this example, it is a short in semiconductor stocks.  The position is supported with plenty of reasoning they deem to be rigorous and also by technical analysis.  It is especially desirable to find a situation where a sector has made a big run.  A chart of the SOX tells the story.

I haven't added any lines in this, and readers should ignore the last decline, since that is the end of the story.  The point is that analysts could have a field day with this chart -- before the decline.

Cocking the Hammer

Those establishing a bearish position wish to highlight major concerns.  In this case the "hammer" was the question of double booking of orders.  This occurs when inventories are so low that those building mother boards want to be assured of needed parts.  To do this, the theory holds, they place multiple orders for needed parts in short supply, canceling some orders when their needs are met.

It is an argument that raises a question about the validity of reported orders, and creates fear that the orders will decline.

Pulling the Trigger

One might think that actual evidence of order decline would be necessary to trigger the fear.  That assumption is incorrect.  It is easy to grasp any news as evidence that this prophecy has been fulfilled.

Yesterday the B of A/Merrill analyst downgraded the entire sector.  The resulting report, which I have read carefully, is based upon an inventory model and some assumptions about where we are in the cycle.  It does not specifically refer to any double booking, and the resulting forecasts are still above many other Street observers.  It was a big call, getting a lot of play, and knocking down the stocks by 5 percent or so, as the chart indicates.

Bearish observers incorrectly cited the double booking argument, not actually mentioned in the report.  It talks about a small "overshoot" in inventories, not mentioning any double booking.  It is based upon a theoretical model, without a lot of supporting evidence.  Since few actually read these reports, the inaccurate summaries gain credence.

The Result

Anyone with a short position can cover for a nice trade.  It was a nice setup.  Any downgrade could be cited as evidence.  When the analyst from a big firm downgrades, everyone pays respect, at least in the short term.  That is long enough for traders and hedge fund types.

The Facts

There is plenty of evidence contradicting the double-counting argument:

From iSupplyCorp we have the following:

In their earnings announcements, leading semiconductor suppliers, including Texas Instruments, STMicroelectronics and Intersil, all reported they saw no signs of double-booking during the third quarter, said Ciriello. “This should give the semiconductor industry confidence that the magnitude of the current recovery accurately reflects real demand levels.”

A balanced article at the WSJ mentions the double-booking issue:

Another analyst, FBR Capital's Craig Berger, also cited signs of weakening PC demand, though he said in a note, "We do not want to get overly bearish on the PC space given improving global demand and still-unknown holiday sell-through trends."

Berger said he remains "bullish" on the semiconductor sector. "We think fears of a first half of 2010 estimate cuts from double ordering are overblown, that global supply chain inventories are at or near all-time lows, that global demand trends will continue to recover in 2010." 

Astute tech stock observer Bob Faulkner writes as follows (see the full article for his nice inventory charts and complete analysis):

I've tracked inventory in the electronics-supply chain for years. While it’s too early in earnings season to draw any final conclusions, I think it’s very safe to say that inventory is quite tight on a relative basis.

Steve Ballmer reports that Microsoft sees "fantastic sales" for Windows 7.  If this is accurate, it should stimulate a new cycle of purchases.  More people and businesses replace computers -- especially those who avoided VISTA -- than upgrade existing machines.  The current hardware may not be adequate and is difficult to configure.

Our Take

The trading setup is a real dilemma for managers with a long-run horizon.  It was completely predictable that something -- anything -- would be seized upon as confirmation for the double-booking argument.  There was no need to wait for actual evidence.  Even knowing this, should the manager blow out all of his chip holdings, expecting a pull back of unknown size?

The real answer for those with a longer perspective is to focus on the actual time frame and ignore the bumps in the road.  The traders will make their profits, and eventually the results will tell the story.  It is an opportunity to add to positions for those who disagree with the thesis.

An Interesting Exercise

There was a similar setup -- hammer pulled back -- on car sales after the Cash for Clunkers expired.  Perhaps this is a good topic for an example where we now have more evidence -- an immediate decline, followed by a restoration in sales.

I invite other examples -- both long and short -- from readers.  Look for the setup -- what we all should watch for-- and then look for evidence.

Our position:  Long INTC, MSFT, and AAPL.

Specific Expertise: Insisting on the Best Information

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

Background

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

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

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

Meredith Whitney

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

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

Our Take

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

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

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

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

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

A More General Conclusion

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

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

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

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

Dollar Weakness and Stock Market Strength -- the Data

Anyone who is following the market on a daily basis is paying attention to the strength of the dollar versus other currencies.  It can be confusing.  While a strong dollar might seem like a good thing, there is actually an inverse market relationship with stocks -- at least in recent times.

I described the basics of the dollar debate here:  Understanding the Debate on the Dollar.  There are many opinions -- prescriptive, political, and descriptive.  The next step is to consider some data.

Dollar Strength and U.S. Equity Market Returns

In my last article I highlighted the inverse relationship between a strong dollar and the stock market.  This chart provides a dramatic illustration of the relationship for calendar 2009.

 
Sometimes a chart tells the story in a glance, but I always like to look at data as well.  I used the Fed's measure of the dollar versus a broad basket of currencies, weighted by trade.  The series started in 1995.

The correlation for this year is an almost perfect negative relationship:   -.96.

A negative relationship sometimes stands out even more if you invert one of the scales.  Here is that chart.

The data are the same, but the tight relationship is especially clear using the inverted scale.

So much for what we know.  An obvious question for investors in stocks is what would happen if the dollar gets stronger.  Perhaps we should look at more data.

A Longer Perspective

Some believe that a strong dollar is consistent with economic growth and a strong stock market.  To examine this concept, we need to consider more data.

If we look at the full data series, we see long periods where dollar strength was consistent with a rising stock market.  In fact, the correlation between the two series is a positive value:  .35.

For an objective analyst of data, the chart suggests three conclusions:

1. The relationship changes over time;
2. The last year is quite atypical;
3. There are other important variables at work.

The Carry Trade

The prevailing hypothesis about the dollar/stock relationship is the "carry trade."  Supposedly there are investors/companies/speculators who are able to borrow in dollars at a very low interest rate.  This makes the dollar the "funding currency."  Most outspoken on this subject is Nouriel Roubini, who sees disaster ahead.  [Full disclosure -- I am a contributor at Nouriel's valuable site.  I respect and appreciate his encouragement of alternative viewpoints.]

The borrowers do not then do the obvious -- lend in another currency, hedging the difference with a forex trade.  Instead they supposedly use the borrowed funds to engage in a variety of speculative trades -- emerging markets, real estate, and, of course, US stocks.

Following this logic, there is now a speculative bubble of major proportions.  This seems implausible.

My skepticism comes partly from the lack of any real data supporting this viewpoint, and partly from the daily trading.  If you really had this trade on, would you really take it off if the dollar moved by 0.4%?  The carry trade hypothesis does not explain the closely calibrated trade between the dollar and stocks, but we see this every day.

For now, let us stick to conclusions supported by data.  There is a strong inverse relationship.  If you are a trader, you had better pay attention.  If you are a long-term investor, you need to understand the long-term relationship.

Meanwhile, I invite reader comments, citations for new data, and fresh hypotheses.  I will pursue this for at least one more article, considering various causal models.

Understanding the Debate on the Dollar

A strong dollar seems patriotic.  It is also meaningful to long-term purchasing power.  Weaker dollars mean a higher cost for foreign products, and that is inflationary for the US consumer.

This natural impulse is at odds with current equity trading.  A friend asked why the market had 200+ rally in the DJIA on Monday.  My answer -- dollar weakness-- was counter-intuitive and unsatisfying, but accurate. 

Dollar's Drop Helps Dow Hit New 2009 High, explained Briefing.com.

Today the Dow declined 100 points.  Why?  Many cited dollar strength.

Investors and traders alike need to pay attention to the dollar.

The Prescriptive Viewpoint

Some commentators who choose to advise the government on preferred policy are outspoken on both the need for dollar strength and the policies required.  David Merkel calls for the Fed to raise interest rates and the Obama Administration to balance the budget.  The prescription embraces a willingness, perhaps even a necessity, for the recession to become much deeper.  The resulting unemployment and business failures are part of a needed cleansing process that will avert an inevitable deeper economic decline.  This viewpoint is based upon economic theory, not a political viewpoint.

Others seem to advocate similar views with politics in mind.  You can watch any nightly Kudlow show to get this argument about "king dollar."

A third viewpoint, represented by Bob McTeer, suggests an alternative.  McTeer is a free-market Republican, but he has a pragmatic approach.  He recognizes the need for dollar strength in the long run, but notes a short-term problem.

So, my conclusion is there is a strong argument to be made for a strong currency. It just doesn’t apply in the midst of a deep recession when the main problem is inadequate aggregate demand. Many people who don’t acknowledge that are, in my opinion, trying to avoid sounding “Keynesian.”

I’ve said this many times before. My position on a strong dollar is similar to St.Augustine’s position on chastity in his famous prayer: “Lord, make me chaste, but not just yet.” My prayer is, “Lord give us a strong dollar, but not just yet.”

His reason?  No individual country can control the currency.  All act in accord with internal political mandates.

The positive jolt to domestic GDP caused by a depreciating home currency is well known all over the world. That is why during a global slump such as we are in today we have to guard against competitive devaluations where each country tries to boost its economy through depreciation or devaluation which has the opposite effect on its trading partners. The term of art is “beggar thy neighbor” policies, sometimes called “beggar my neighbor” policies.

The Descriptive Perspective.

David Merkel and other observers are quite correct in noting the divergence between stated and actual public policy.  Investors need to understand this.

There is an inverse relationship between the dollar and equity strength.  There are several hypotheses (and little evidence) to explain the daily trading.

Investment Implication

There is more here than I can cover in a single piece, so I will take a deeper look.  We need to investigate the dollar carry trade, the alternative causal models in the relationships, and the time frames for the various arguments.  There may not be enough data for an objective answer, but I will give it a shot.

Meanwhile, investors should realize that actual policy is aimed at improving economic performance, even if the dollar declines.  If you are an investor, put aside your opinion about whether the policy is correct.

October Employment Report Preview

The monthly employment situation report is the most watched economic release.  The attention has never been greater.

• Everyone is interested in the unemployment rate, especially when it is approaching 10%.  It is a natural topic for the media.
• Partisan politics has a jobs focus.  While the Obama Administration may be claiming jobs "created or saved," this is of little interest to most.  The bottom line for most voters will be whether the net job change turns positive and the unemployment rate declines.  Few care about hypothetical results.
• Investors and traders question the economic recovery, despite improving data.  As long as unemployment remains high, people will question the economic recovery as artificial and temporary.

The massive attention is no surprise.

Lack of Timely Data

Most casual observers take the reports at face value.  Those watching closely understand the challenges in trying to do contemporaneous estimates of employment changes.  This is not like an election, where we can have a "polling place" to determine who is working and who is not.

We actually have excellent employment data, a hard count from state employment agencies.  The problem is that it takes six to nine months to get the solid results.  I wrote about this three years ago in my article, Data We Have vs Data We Need.

Real-Time Measurements

I am going to repeat a careful explanation that I suggested two months ago.  There are many sources trying to measure monthly employment changes.  Eventually the state data will show who was right.

Each of the sources we cite is attempting to measure the actual net job change.  A wise stat prof once said, "Suppose God whispered into your ear and told you the TRUTH."

The BLS is attempting to do the same thing, with dramatically different methods.  The BLS result is not TRUTH.  It is a statistical estimate.  Actual TRUTH for a specific month will not be known for many months, when the state employment data are analyzed.  The BLS tries to count all of the jobs in one month, all of the jobs in the next month, and then report the difference.  They do this very well, but it is inherently difficult.  It does not focus directly on the actual changes, as other methods attempt to do.

Meanwhile, the forecasters will all be graded by how well they predicted the BLS number -- the BLS estimate of TRUTH.

That is the wrong attitude.  The BLS number is just another estimate -- and one which will not be official until all of the revisions are in.  Despite this, the market will trade on the preliminary estimate revealed Friday morning.

Briefly put, everyone is trying to estimate monthly changes in a work force of over 130 million.  The error band is small.  The BLS -- and all of the other sources -- are doing a great job with various differing approaches.

Market participants would like to have more data, faster data, more accurate data.

It is my long-held position that too much emphasis is placed upon the BLS estimate as "official."  The BLS does excellent and honest work, but other approaches deserve attention.

Few observers understand the nature and sources of error in the BLS estimate.  Pundits routinely draw major conclusions from discrepancies of 50,000 jobs, when the sampling error alone is +/- 100,000+ jobs.  And this does not include assorted non-sampling problems, like dealing with new job creation.

The BLS versus the Critics

The BLS approach is to make an estimate of the total payroll jobs in one month, make another estimate for the next month, and subtract the two to determine the change.  They use an excellent and sophisticated survey technique to do this.  Their historical record, judged by the eventual count from the states, has been very good -- until quite recently.

Some readers have asked me why the BLS even attempts to include job creation in their estimates, using their much-maligned Birth/Death adjustment.  I will attempt the simplest possible explanation.

Any time you do a survey, there will be non-respondents.  When the question is something like "How many people favor health care with a public option?" the non-respondent problem takes a simple form.  You need only ask whether the non-respondents are similar to those who actually answered.  Most polls make this assumption.

The employment question is qualitatively different.  We are not asking the opinions of non-respondents.  We are asking whether they are even still in business.  If the BLS were to assume that non-respondents had all ceased operations, they would seriously underestimate total employment.  Historical data conclusively show that the non-respondents are split between those who did not answer and those who are out of business.  The data also show that new job creation, running at about 2 million jobs per month even in recessions, are a predictable function of dying businesses.

Because of this, the BLS employs a two-step process.  The imputation step forecasts job creation from job destruction, and includes a cyclical component..  The Birth/Death adjustment, (the only thing cited by most critics, who ignore the more important imputation step), is a residual.  For many years this residual was stable.  The most recent test against the state data indicated a significant error, showing that the BLS estimates have been wrong for nearly a year, especially starting in Q1 09.

Were the Critics Correct?

The BLS critics do not look at the ultimate scorecard, the state data.  I expect that most of them will "claim victory" in their criticisms, even though they never looked at the many years when they were wrong and the BLS was right.  We should note the following:

• There was no intentional distortion of data or results, dictated by whomever was President, as many allege.
• The method worked well for more than five years, as measured by the final data.
• The breakdown did not come at a "turning point" as many suggested it would.  That would have happened at the end of 2007.
• The breakdown did not occur because the model worked in expansion and not in recession.  The big divergence happened in the first quarter of this  year.  The big job losses right after the Lehman downfall were not that far from the truth.  Job creation seemed to stall a few months after the major credit contraction in September, 2008.

The actual breakdown in the BLS method happened one full quarter after the biggest job losses in many years.  It means that job creation was seriously impaired from January to March of this year.  At the moment, this is all we really know from hard data.

There may be some critic who predicted the timing of this breakdown, but I have not seen one -- and I follow this carefully.  Whether or not the long-term BLS relationships resume the multi-year pattern is yet to be determined.

To repeat my main theme --- there are several methods of estimating the monthly job change.  No one has a monopoly on the truth.  I invite reader comment on this point.  Any critic who actually looked at the state data, acknowledged the BLS when it was accurate, and forecast when their model would break down deserves some recognition.

Our Approach

Each month we ask the question, "What change in payroll employment would be consistent with other economic data from the same time period (the middle of the prior month)?

This is not a forecast, per se, since we do not posit any causal relationship among these variables.  They are all concomitant indicators of economic activity. 

• We use the four-week moving average of initial unemployment claims, culminating in the week of the employment survey.  This is the best direct indicator of new lob losses.  This has improved in the last two months to a loss of 532K

• We look at the University of Michigan sentiment survey, which we found more useful than the Conference Board's sentiment index.  Michigan uses a panel, where some families are carried over from month to month.  This is a good technique.    Sentiment is influenced by employment.  When people have lost jobs, or are worried about losing jobs, it shows up in sentiment.  It is a good concurrent indicator.  The Michigan index is now at 70.6, about the same as last month.

• We us the ISM manufacturing index, which showed improvement from 52.6 to 55.7  This is solid expansion in the manufacturing sector, it is quite bullish for the overall economy.  The ISM's research shows that this rating, if annualized, corresponds to a 4.5% increase in GDP, better than the preliminary report for the 3rd quarter, and occurring after the cash for clunkers and homeowner stimulus boosts.

Our long-term record has been pretty good, especially when compared to the final revised data.  This makes sense because our model was derived from the final data.  In recent months we have been too bearish.  The BLS benchmark revisions suggest that we have been much better than first thought.

This Month's Prediction

Our indicators suggest a net job loss of about 140,000, a little better than the Street estimates of -175K.

Our estimate reflects two contradictory forces.  The initial claims are still elevated, not indicating economic expansion.  The ISM data are strongly positive.  Our forecast suggests that we are still a few months away from real job growth.  We need to see lower unemployment claims before there will be net job gains.

Other Forecasts

It is always interesting to compare the job forecasts from different sources.  We follow several because of the interesting and widely varying methods they use.  A wise interpretation would be to consider all of  these disparate sources of information.

ADP has proprietary data because of its payroll management business.  ADP sees losses of 203K.

TrimTabs also uses real time data.  Their estimates are based upon tax deposits for salaried employees.  They see a net job loss of 284K.

WANTED Technologies, a relatively new entrant in this field, has a model based upon online help-wanted advertising.  This is an innovative and different approach to real-time data.  They see a net job loss of 224k.

Conclusion

While we are (for a change) less bearish than other forecasters this month, we do not see it as the basis for a change in our trading outlook.  We expect the usual full assault on the integrity and methods of the BLS, with the spinmeisters out in full force.  The short-term risk/reward still leans to the short side.

Understanding Market Volatility

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

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

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

A Natural Human Trait

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

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

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

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

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

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

Applying the Lesson to the Market

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

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

Business Week explained as follows:

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

MarketBeat had a similar take:

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

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

Briefing.com has a very different viewpoint:

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

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

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

Our Take

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

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

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

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

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

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

How I Pick Stocks

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

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

Mission and Audience

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

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

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

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

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

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

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

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

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

My Approach

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

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

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

My current themes include the following:

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

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

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

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

Specific Ideas

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

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

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

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

A Final Thought

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

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

Our Best Predictions: A Review

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

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

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

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

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

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

Our Current Take

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

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

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

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

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

Politicizing the Olympic Decision

Those of us who live in the Chicago area have paid special attention to the Olympic decision.  There are a number of theories about what happened.  There was an especially strong analysis from Dick Ebersol, NBC sports & Olympic Chairman.

Watch the video to confirm, but his key point is that the IOC has a European focus and is unhappy with the financial relationships with the USOC.  There are issues about how much of revenues come off the top, and what other countries get.  Ebersol suggests that without some changes in these fundamentals, also affecting the last bid from New York, it will be many years before we see an Olympics in the US.

His message is that this is an uphill battle -- 18 votes for the US this time, and 19 for NY the last time.  It is a problem -- and one not related to partisan politics.

The Kudlow Spin

Regular readers of "A Dash" know that we view the Kudlow show as a useful source of debate about the economy and the market.  They also know that we are disturbed by the increased injection of partisan politics, often extending to his assignments as a CNBC anchor, perhaps somewhat better since he is no longer a rumored candidate for office.

In tonight's program Kudlow portrayed the President's decision to go to Copenhagen as a big mistake, undermining US credibility.

What if the President not made the trip?  Kudlow might well have blamed the outcome on his failure to participate.  It has become routine for national leaders to make a pitch, but Obama had to trade this off with the health program debate.  Those present at the US presentation uniformly report that the involvement of the President and the First Lady were the best parts.  No one knows what would have happened if Obama had not made the trip, but the critics would have been loud.

Investment Implications?

We understand that Kudlow is competing for ratings, and working in a very conservative time-slot demographic where many are eager to criticize the President.

Briefly put, there are no investment implications from this event.  This piling on by Kudlow and his selected guests is more about partisan politics than the investment purpose of his popular program.

Our own viewpoint is that we should be focused on investments, agnostic about politics, and trying to find the best opportunities.  Our objective is to make great returns regardless of which party is in power.  We seek information that helps in this quest.  Overtly partisan messages do not fit.