Weighing the Week Ahead: A Time of Tension

World tensions continue to mount.  Economic data were soft, yet the market rallied.  How can this be?

There are many skeptics of the most hated rally in history.  Conspiracy theories abound.  Anyone who is not a regular, loyal, and convinced reader has missed this rally.  If they remained on board (judging from emails and calls) they bailed out at the wrong time last week.

Why have so many been so wrong for so long?  How can the market rally in the face of so many worries?

My own answer is a simple one:  Stocks are attractively priced relative to other assets.  On a risk/reward basis the value is better than it was at the market bottom.  The general pressure from the really big money is to the upside.  In the last few months I published two articles showing this -- one from a big-time private wealth fund manager and another from the most successful hedge fund manager.

Some newbie hedge fund types are in denial, looking for political or economic conspiracies to explain their poor analysis.  This pop econ approach has grown like Facebook, but it does not mean that the information and analysis is reliable.  Last week I demonstrated that the bond pundits were dangerous for investors.  The list of misinformation and disinformation is so long that it is hard to fight.  The widely cited Bill Gross commentary about funding the US debt did not even mention the daily trading ($550 billion) in Treasury securities.  And this does not include the deep and liquid futures market.  It is a big and self-serving scare, as I pointed out.

How does this relate to stocks?

Here is the explanation from Bill Miller of Legg Mason (same name as my dad, but no relation):

 

 

Regular readers of "A Dash" may remember that I offered the same analysis early last December.  You could have made 7% in a few months from that article, pointing out that the risk/reward was better than the market bottom.  The analysis is still correct.  While the market has rallied, so have earnings.

Most observers foolishly focus on absolute prices instead of a dynamic system of earnings, interest rates, economic prospects, and risk.

The Bespoke Investment Group analyzed Bill Miller's performance.  Check out their chart.

Let's turn to our regular weekly review, but I shall return to the investment prospects in my conclusion.

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.

In most of my articles I build a careful case for each point.  My purpose here is different.  This weekly piece emphasizes my opinions about what is really important and how to put the news in context.  I have had great success with my approach, but some will disagree.  That is what makes a market!

Last Week's Data

I wrote last week that the upcoming data were less important than world events.  The economic news was rather poor overall, but let's look at the full picture.

The Good

To keep perspective, we should note that most major economic indicators remain in positive territory.  There is growing recognition that the economic rally now has a self-sustaining character.

• Initial jobless claims remained lower, at 382K, consistent with the gradual trend.
• Gallup's job creation poll looks better, but don't get carried away.  83% still see this as a poor time to look for a quality job.
• Q410 GDP was revised upward and relied less on inventory building.
• Stocks showed a good tone, shrugging off the many worries.

The Bad

The bad news centered on housing and Japan.

• Economic growth forecasts weakened.  The ECRI Weekly Leading Index fell slightly, to 129.3.  The growth index pulled back from the peak, 7.1% to 6.5%.  These are still good readings, but everyone is watching the indicator closely.
• Risk as measured by the St. Louis Fed Stress Index, remains very low.  This measure tracks a lot of market data in the eighteen inputs.  It is not a poll, nor opinions, nor a collection of anecdotes.  We should all pay attention to some real data.  The value moved to +.155, a bit higher than  last week's +.006.  I am putting this in the "bad" category since it has moved higher, but these are completely normal readings for a scale measured in standard deviations from the norm.  For more interpretation, the St. Louis Fed published a short paper with a very nice chart that helps to interpret this index.  The chart does not reflect the recent continued decline in stress, but it identifies the dates for important recent events.  The paper also has a longer version of the chart, illustrating past stress periods.  I am not going to run the chart each week, but I strongly recommend that readers look at the paper.  In the 2008 decline there was plenty of warning from this index -- no sign right now.  The scale is in standard deviations, so anything short of 1.0 or so is neutral territory.  I am doing more extensive research on this indicator. 
• Various other economic reports.  Check out some sources that I follow every week.  Steve Hansen has a detailed analysis of each release and other news as well.  Even New Deal Democrat was downbeat on last week's data.

NB:  The ECRI and SLFSI are actually readings from week-old data.

The Ugly

• New Home Sales plunged to a seasonally adjusted annual rate of 250K.  New homes cannot compete on the market against distressed properties.
• The OldProf's NCAA Brackets.  Gone, all gone.  Worst year in a decade.  Too many black swans.

The Continuing Uncertainty

I think I was on target with last week's comment on this front:

There is a tension in US foreign policy as it relates to revolts against dictators.  On the one hand, we applaud the outbreak of democracy around the world.  On the other, we note that this movement has the potential to topple both friends and foes.  While I have my own opinions about foreign policy, my mission at "A Dash" is to discern the investment implications.

I see an ad hoc policy, lacking a consistent guiding principle.  How else can one explain intervention in Libya and a sideline stance in Bahrain?

The turmoil has created a premium in oil prices of $15/barrel or so.  Depending upon events in the region, that premium might move either way, but the bias seems higher.

There was a little less uncertainty last week on the Japan front.  The human toll is mounting; the economic cost is better defined.  Some production is coming back online.  Companies are finding alternatives to supply chain issues.  We still will not know the full economic consequences for weeks or months.

The Middle East North Africa story continues, with a new threat mentioned each week. 

Our Own Forecast

We base our "official" weekly posture on ratings from our TCA-ETF "Felix" model.  After a mostly bullish posture for several months, Felix has turned much more cautious.  We are continuing our neutral posture in the weekly Ticker Sense Blogger Sentiment Poll, now recorded on Thursday after the market close.  This is based on the near-zero ratings for the various index ETFs, which do not at this time suggest selling short.  Here is what we see:

• Only 29% of our 56 ETF's have a positive rating, down from 45% last week, a continuing trend.
• 95% of our 56 sectors are in our "penalty box," up from 86% last week.  This is an indication of very high short-term risk.
• Our universe has a median strength of -23, down from -11 last week, also a negative trend.

The overall picture continued to deteriorate last week.  We reduced positions in trading accounts to 20%, holding only the single strongest sector.

[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 ETF email list.  You can also write personally to me with questions or comments, and I'll do my best to answer.]

The Week Ahead

Events around the world will have continuing major significance.

On the data front, it is employment week.  We'll get Challenger layoff data at mid-week.  Did you know that more people quit their jobs than are laid off?  Did you know that the economy creates over 2 million new jobs every month?  If not, maybe you missed my piece on employment data.

Non-farm payrolls and unemployment will come out Friday.  I usually do a preview on Wednesday, but one of my three inputs is the ISM manufacturing index.  Sometimes I estimate from the Chicago Index, but even that is not out until Thursday.  I will be attending the Kauffman Economic Bloggers Conference, so I might not post on Thursday or Friday.

I'll merely say that I am still not excited about net jobs gain for this week, although I expect to see a major rebound in the months ahead.

On the political front we have a continuing issue about a government shutdown.  I have been following this closely --both the polls and the political maneuvering.  Leaders of both parties understand that the American people expect government operations to continue and would blame both sides equally.  This provides a strong incentive to negotiate, and I expect the bargaining to avoid a shutdown.  Were a shutdown to occur, it would be another huge element of uncertainty, an end to necessary payments and services, a drop in confidence, a loss of economic activity, and a major market negative.

Investment Implications

My current market viewpoint is sharply divided, depending upon the time frame.

In short-term timing I look both to my own models and also to the weekly chart show from Charles Kirk.  The modest membership fee (which either defrays costs or is donated to charity) entitles you to the chart show, a wonderful organized linkfest, and access to various stock screening approaches.  This week Charles discusses his current bearish stance and, as always, precisely what it would take to change his view.  If only everyone did the same!

While we are not short, we are under-invested in trading accounts, and not enthusiastic about next week's data.

In long-term timing I adhere strictly to the fundamentals of year-ahead forward earnings, interest rates, economic growth prospects, and measurable risk.  Concerning that last element of measurable risk, I don't mean laundry lists of worries that everyone knows about.  If there is risk, it shows up in some market metrics, especially credit markets.  That is why I follow the SLFSI.

I understand that many others seem to believe that the market has been rising strictly due to Fed intervention.  I disagree with this conclusion, so it is on my agenda for further discussion.  Meanwhile, I respect and recommend alternative viewpoints, so listen to what Charles Kirk (recently returned from complete immersion with hedge fund types) has to say as well.

Comments

[Jason]

Watch the commodity markets.

[Risk-conscious Investor]

Bill Miller gets a lot of publicity. He knows that everything he says can be summoned up and quoted. Over a long time period you can find something to criticize in the record of anyone who takes a public position.

This is true. That said, there are mistakes and then there are ***MISTAKES***. I would argue that EVERYONE makes mistakes, but that some MISTAKES reveal that that individual is operating from a completely incorrect theoretical model on how the economic/financial world operates (Greenspan basically admitted this is in front of Congress that his model was flawed). Bill Miller once said that "he knew he was wrong on a stock when he couldn't get a quote anymore". That philosophy underscores an intellectual arrogance and total disdain for any sort of risk control and it shows up in his long-term track record as he is behind the S&P 500 long-term. His arrogance destroyed many years of good returns. This is an unforgiving business/endeavor and as Buffett says the downcycle will reveal those who are swimming naked during the upcycle.

I have seized that advantage by looking beyond questions of valuation to embrace a weekly monitoring of risk. This approach was actually stimulated by a discussion with your good friend Mike C. Regardless of what the market valuation was in 2008, it was not relevant in the face of extreme financial stress, reflected in the St. Louis Fed Stress Index.

This point is highly problematic because I think the market valuation was highly relevant to the *magnitude* of the decline. If we cannot agree that valuations were excessive in 2007/2008 prior to a 60% market decline, then essentially we should just disregard the entire concept of valuation as an analytical tool.

Assume hypothetically that sometime in 2013, 2014, 2015 we have another market decline comparable to 2000-2002 or 2007-2009 starting from a high Shiller P/E. Let's assume the trigger event is some exogenous factor like a sovereign debt crisis. Then we are right back at point A with one person saying the magnitude of the decline was due to high valuations while the other persons says it was due to event A happening and if A didn't happen valuations were just fine. It is sort of arguing how many angels are dancing on the head of a pin. Pretty much all 40-50% or greater market declines occurred from high Shiller P/E starting points (1929, 1937, 1972, 2000, 2007). Does it really matter what specific event triggered the 50%+ decline? There was always some reason, some trigger event. In 29 the crash, 37 pulling in stimulus too soon, 72 oil and geopolitical issues, etc. The point is when stocks are demonstrably cheap, it doesn't matter what event happens because bad conditions are already priced in. In 1990-1991, and 2002-2003 the stock market basically yawned at the beginning of wars (Iraq 1 and 2) because the stock market was already cheap at that point.

Now the interesting thing about the Shiller P/E which some recent studies have highlighted is that it is ABSOLUTELY WORTHLESS as a model for the subsequent 1 or 2 year returns. The market could just as easily go up 30% as down 30% so it is absolutely correct to note it has no utility over a 1-year time horizon.

It is ONLY when stocks are expensive, that trigger events can lead to massive declines. If the S&P had been at 800-900 when Lehman occurred, I highly doubt it would have dropped 60% to 300. It would have been a normal bear market of 20 t0 25%. I really think this point is critical. The notion that stock market risk levels are very low now in terms of potential magnitude of decline is to make the exact same mistake as 2007. That is the mistake in Miller's process. To compare earnings now to 2009 is to completely ignore that earnings are cyclical and 2009 was a trough in earnings. It is comparing apples to oranges. Are we at or near the peak? I have no idea. Maybe we do $150 in 2012. But there will be a peak someday eventually that will lead to cyclical downturn and I can pretty much guarantee that stocks will look cheap at the peak relative to other assets.

I notice that you did not comment on Miller's process, which was the point of my old article on him. What part of it don't you like? What metrics do you think he is missing now, making him "right for the wrong reasons?"

Sort of addressed this already above, but one more thing here. I've been reading the Great Reflation by Tony Boeckh who I'm sure you know is a big name in this business with decades of experience at BCA. He has a model for market analysis rank ordered by importance. Factor 1 is Monetary Policy, Liquidity, and Credit. Factor 2 is Valuation. He goes out of his way to stress that 1 is more important then 2. Again, that isn't my position...that is his position with decades of market experience. I'm trying to learn from his book on how to build a better mental model for market analysis. But clearly, looking at that last several months and the initiation of QE2 and overlaying Boeckh's model, it should be clear it is Factor 1 driving this move, not Factor 2. Is it sheer coincidence this monster move started exactly with QE2 in late August (and that QE1 put in the bottom in March 2009 and reversed the downtrend). David Tepper basically said exactly this on CNBC in his call to buy stocks. That is what I mean by being "right for the wrong reasons". It is correct to be bullish but probably incorrect to attribute it to attractive valuations instead of Fed policy. The real lesson here is one you have emphasized before which is "Do not Fight the Fed".

Anyways, we are all trying to accomplish the same objective which is to try and ascertain when it makes sense to have stock market exposure or have it at maximum targets, and when it is time to dial back stock market exposure and play defense and/or hedge. The simple fact of the matter is that the decline from Oct 2007 through March 2009 and the subsequent rebound from March 2009-present indicate that many people were operating from flawed models. In the case of those who missed the last 2-years, I think it is almost obvious to state they did not properly account for government fiscal and central bank monetary policy in their market analysis as the Boeck factor #1 would stress.

[oldprof]

Risk-conscious Investor --- Bill Miller gets a lot of publicity. He knows that everything he says can be summoned up and quoted. Over a long time period you can find something to criticize in the record of anyone who takes a public position. That is the reason that I combined the CNBC piece with the Bespoke Investment Group chart on his record. There are few who can match it. I also don't think it has anything to do with metrics or inflection points.

Those of us who manage individual accounts have an advantage over managers of a fund. When you buy a fund, most people are doing their own asset allocation. They expect the manager to be invested.

I have seized that advantage by looking beyond questions of valuation to embrace a weekly monitoring of risk. This approach was actually stimulated by a discussion with your good friend Mike C. Regardless of what the market valuation was in 2008, it was not relevant in the face of extreme financial stress, reflected in the St. Louis Fed Stress Index.

Everyone should measure position size in terms of acceptable risk. When objective measures of risk (and I don't mean the typical list of headwinds you read everywhere) get larger, your positions should get smaller.

I notice that you did not comment on Miller's process, which was the point of my old article on him. What part of it don't you like? What metrics do you think he is missing now, making him "right for the wrong reasons?"

That comment could more aptly be applied to many of those who "called the crash" starting in 2005 and are still calling it today!

Even though I disagree with your take, it is a fair question, and one worthy of discussion.

Jeff

[oldprof]

DE -- Thanks for taking the time to look so closely through my work. I hope you found some helpful nuggets.

You are correct in noting that, unlike most others who write about investments, I publish a specific weekly market viewpoint and it changes with the circumstances.

You are also correct that a valuation approach is not particularly helpful in forecasting a market crash related to the breakdown of financial institutions. My valuation methods have been quite bearish in past times, but that was when my investment writings went only to clients, predating my blog.

The question of how the long-term investor can protect himself is of major interest. I have been offering a paper I wrote on controlling risk, where I discuss this in some detail.

For now, let me just say that the very first thing I do with a prospective client is to determine what risk is appropriate, using the client's needs and attitudes. Too many people "had it made" before 2008 and should not have been taking any risk at all.

In preparing a program, I combine the long-term horizon with other approaches. The biggest cost of 2008 for most people is that they are now constantly afraid, causing them to miss out. I am going to elaborate a bit more in my reply to risk-conscious investor, so please check there as well.

Thanks for a very good question. I am probably overdue for a couple of articles about how I and others have altered some methods since 2008.

Jeff

[Risk-conscious Investor]

http://oldprof.typepad.com/a_dash_of_insight/2007/10/new-market-high.html

http://oldprof.typepad.com/a_dash_of_insight/2007/10/process-versus-.html

At the start of this year, Miller gave his opinion about the markets:  The stock market is still cheap.

At this point, how much credibility does Bill Miller have? Go back to his spring 2006 letter where he was adamant about Citigroup over commodities on a multi-year basis. How's that one working out?

DE, most people count on the fact that few will go back and check who said what when, and if a particular line of reasoning led to the wrong conclusion before, should it be utilized now?

We are in a bull trend no doubt, but many are RIGHT now for the wrong reasons. They will miss the inflection point when the trend turns bearish because they are looking at the wrong metrics.

[DE]

Jeff, I am fairly new to the site and have been working through past articles. I am trying to determine if you were ever bearish during the 07-early 09 span from a long term timing perspective. I do not find any evidence of this, which is not surprising given your focus on relative valuation. However, have you written an article about where you may have been wrong in your thinking in hindsight? Or was there no way to miss some of the downside given your long term approach? Note that I understand you have short term trading strategies that were likely defensively position during this period, I am referencing the longer term outlook of your articles during this time period.