Weighing the Week Ahead: Euro Weakness Increases Risk and Opportunity

For most of us in the investment business travel takes you away from home base, but not away from the market.  I always hope to write a piece or two, but it is difficult.

Issues related to Europe dominated last week's trading, and promise to do the same this week.  There is a bull market in superficial analysis and distortion.  My objective is to give readers a good start on sorting it all out.

Here was the story that moved markets on Friday.  It raises many questions about news media and sources.

Paul Vocker, Former Fed Chair and current Chair of the President's Economic Recovery Advisory Board gave a speech in London on Friday.  He noted the potential disintegration of the euro, the need for discipline in economic and fiscal policy, and further European political integration.  He also noted that Europe had been well-served by the euro and that current problems would be bigger without it.

After the speech he declined to elaborate on what European governments should do.  Bloomberg quoted him as follows:

That is up to European governments.  The nature of the problem does not lend itself to one-word sound bites.

This is exactly what I predicted (on May 4th) would happen in The Battle of the Sound Bite.  The problem lends itself to simplistic analysis and slogans. Yves Smith notes that Bloomberg cherry-picked the quotation for their main thesis and cites other alarmist headlines as follows (read her entire piece for her analysis of what Europe needs to do):

Volcker Sees Euro ‘Disintegration’ Risk From Greece [Bloomberg]

Volcker worries about future of the euro

^_[Reuters]

Volcker: The Euro Is On The Brink Of Extinction

[Business Insider]

As these headlines crossed the tape traders engaged in a natural reaction -- trading!  This sort of information does not lend itself to a nuanced interpretation.  Joe Weisenthal explains that this as a key reason in :

STOCKS HAMMERED AGAIN: Here's What You Need To Know

A little more perspective is needed.  I'll return to this theme below.

Background on "Weighing the Week Ahead"

There are many good services that do a complete list of every event for the upcoming week, so that is not my mission.  Instead, I try to single out what will be most important in the coming week.  If I am correct, my theme for the week is what  we will be watching on TV and reading in the mainstream media.  It is a focus on what I think is important for my trading and client portfolios.

Last Week's Data

The actual data from last week were encouraging.  If you had just been reading the news flow from the US, you would have expected a nice market week.  It was a nice week, up over 2%, but not the way you would expect.

The Good

The economic news last week was generally quite positive.

• Retail sales were up 0.4%, beating expectations.
• Mortgage rates declined again.  (so much for worries about the end of Fed buying)
• Industrial production moved higher.
• Small business optimism had an uptick -- finally.
• Earnings season ends with 70% of companies beating expectations.

Initial jobless claims are still stuck in a range. 

The Bad and the Ugly

The Ugly award certainly goes to the market reaction to the European situation.  Monday's trading saw huge gains, reflecting the size and scope of the proposed plan.  The rest of the week was all downhill.  Half of the Monday gains were lost, but the wild swings made it seem even worse.

A Simple Explanation

Any new government proposal generates an immediate reaction from the financial punditry.  Mostly the articles describe perceived shortcomings of the plan.  Critics expect a plan that has the following characteristics:

• Specific identification of causes,
• Specific and detailed programs that address each cause, and
• General agreement and endorsement of everyone involved.

In addition, each pundit wants the plan to agree with his/her own notion of the causes and solutions.  These are usually different and inconsistent.

I have been studying this for some time.  There are very few market participants with backgrounds in political science, public policy, organization theory or related fields.  Most people think about how they make their own decisions and assume that governments follow the same rules.

In practice, governments rarely act in this fashion.  It is much more common to have a general agreement about a problem with absolutely no agreement about causes.  It is easier to agree on policy than about theory.

Governments adopt general approaches, testing what is working.  They do more of what works and less of what doesn't.  Readers might want to compare this to the early criticism of the US response to the crisis.  The pundits said similar things about Fed programs and TARP.  Not all of the programs worked as planned, but in the end, that did not matter.

Here is a simple analogy.  Let us suppose that you were a football coach creating a game plan.  Instead of playing the game, the fans voted on whether you won or lost based upon your plan.  You did not get to make any "halftime adjustments."

Or suppose that you had to lay out, in advance, all of your proposed trades for the next month -- at the market!

No coach and no trader would do this.  Meanwhile, people expect government policy to specify causes and plans in detail, even though the problems are far more complicated than football or trading.

No one in financial punditry understands this.  They do not grasp how large organizations behave.  If you do, you have an edge.

Investment Implication

Eventually the breathless headlines will cease and the market will stabilize.  I regularly compare coverage from mainstream traditional sources like the New York Times and the Washington Post with financial media.  There is much less concern about Europe in non-financial sources.  It will be up to CNBC to give us "breaking news" on the euro trading down another fraction of a percent.  The real world is moving on.  Eventually the markets will catch up.

Our Trading Forecast

Our own indicators have turned neutral, and that was our vote in the weekly Ticker Sense Blogger Sentiment Poll. Here is what we see:

• Only 31% (down dramatically from 80% last week) of our ETF's have positive ratings.  This is moderately weak.
• The median strength is only -5 (down from +10 last week). This is a slight negative.
• 98%  (up from 60%) of the sectors are in the "penalty box," showing an extremely high level of uncertainty and risk.
• Our Index Package now has a very small negative rating.

[For more on the penalty box see this article.  For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly email list.  You can also write personally to me with questions or comments, and I'll do my best to answer.]

For short-term accounts we are almost completely out of the market.

For long-term investors it is the familiar problem.  The times of opportunity present a challenge involving both recognition and fortitude.  Can you really act when others are spreading fear?

For those who have this ability you might start with stocks that reported great earnings, but have recently been pulled down in price.  Here is a list from The Bespoke Investment Group, one of our favorite sources.

Comments

[jdb]

I feel exactly the same way. The negative bombardment is massive. It can create so much fear that you can't invest. Jeff, I would like to hear your thoughts about Europe, however, because it does seem like a macro event.

[Roman]

Really love your writing Jeff. You are truly a voice of reason in a world of insanity. Every day, I go on the internet and get bombarded with information, 99% of which is either a lie, wrong, or presented in a misleading way.

You make the process of extracting the 1% of information that is actually valuable that much easier. Thank you.