Weighing the Week Ahead: Looking Past the Debt Ceiling Issue

Did you hear about the big vote on the Education Sciences Reform Act of 2002?  I didn't think so.  Welcome to the arcane world of the US Congress!

After months of debate, the US policymakers reached a last-minute compromise solution.  As regular readers know, this is what I have been predicting -- including the  protracted nature of the process.  Many predicted an early solution and even more expected no solution.  The biggest surprise --even for me -- was the ability to take this to the very last day. The crucial vote was on a "technical amendment" to the Education Sciences Reform Act of 2002.  One of my agenda items is to explain why this was done and the significance that no one saw.

Here is the roll call tabulation, including the "aye" vote from my Representative, Judy Biggert.  Many voted against the bill while knowing that it would pass, so the "nay" votes are over-stated.  Democrats split 50-50.  Check out the background for this vote here.

The process took longer than anyone expected (including me) and the stock market lost patience in the final week, a reaction that was irrationally negative.  Observers often suggest that the bond market is more sophisticted, and trading last week illustrated the point.  The bond market has not shown any evidence of a crisis.

There was a lot happening during my "vacation" in Toronto (where construction activity is obvious, expensive hotels are jammed, and restaurants are doing well).  It is always frustrating to have many ideas worth discussing, but no time to write.  I have a full blog agenda from this topic, but for now, let's just hit the highlights, beginning with last week's data.  [I am going to include today's information in the weekly report.]

Background on "Weighing the Week Ahead"

There are many good services that do a complete list of every event.  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.

Readers often disagree with my conclusions.  That is fine!  Join in and comment.  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

The economic news may have seem mixed to most, but I think the balance is turning positive.

The Good

There was good news in a mixed week.

• No default.  I understand that extremists do not like the outcome, but that is the nature of compromise.  Reaching a deal is very good news. 
• Initial jobless claims dipped below 400K.  This is still not what we need, but it is better than recent levels and much better than many were forecasting a few weeks ago.
• Housing data.  Any improvement is welcome.  Pending home sales and Case-Shiller prices were a touch better than expected.  There are many factors involved in interpreting these series, including the rate of foreclosures and seasonality.  I am not getting excited about the uptick, but at least we are seeing some signs of a bottom.
• The money supply rebound continues.  This is a major forward-looking indicator that is widely ignored.  It is a leading indicator, giving it extra significance.  I have been writing about this for several weeks, highlighting the weekly updates from Bonddad.  Let me add the comments from Bob McTeer:

"For those of us seeking relief from the hot air in Washington and the rest of the country, it comes in a little noticed bounce in the money supply statistics. The Fed’s latest estimates for M2, in its H.6 release on July 21, shows the growth rate for the past 3 months at 8.2 percent; the past 6 months at 6.8 percent; and the past 12 months at 6.0 percent. These numbers are a welcome increase from the 5 percent level they were all stuck at throughout the recent round of quantitative easing."

The Bad

There was plenty of negative news, including some indicators that I regard as important.

• Consumer sentiment declined sharply.  The reading in the Michigan survey was 63.7, much lower than the June result of 71.5.  The Michigan survey is an important indicator of employment gains and consumer involvement in the economy.  The bullish analysts think that the number was tainted by the debt ceiling discussion.  I suppose that this is possible, but for now I just see a very weak data point.
• The GDP report.  Q211 GDP was even worse than expected, at 1.3%.  Some will dismiss this as a result of transitory events -- the Japanese earthquake and higher energy prices.  Perhaps so.
• The ISM index(actually from the current week).  The reading of 50.9 was a big disappointment for most, but I see it as bringing this metric in line with what we know from other data.  It still corresponds to a GDP increase of 2.9%, since the break-even point for manufacturing and GDP is a reading of 42.5.  I have never seen this explained by anyone in blogs or the media, so you have an edge if you understand the data.  Here is the key quote:

"A PMI in excess of 42.5 percent, over a period of time, generally indicates an expansion of the overall economy. Therefore, the PMI indicates growth for the 26th consecutive month in the overall economy, as well as expansion in the manufacturing sector for the 24th consecutive month. Holcomb stated, "The past relationship between the PMI and the overall economy indicates that the average PMI for January through July (57.6 percent) corresponds to a 5.3 percent increase in real gross domestic product (GDP). In addition, if the PMI for July (50.9 percent) is annualized, it corresponds to a 2.9 percent increase in real GDP annually."

The Irrationally Stupid

I want to state this forcefully and clearly:

Bond rating agencies are not running the government!

The credit rating agencies are on the verge of suicidal stupidity.  They have already played a crucial role in the 2008 crisis by giving AAA ratings to paper described with a four-letter word by some issuers.

These agencies are now engaging in self-important posturing by threatening a downgrade of US debt.  Let's get this straight.  These geniuses thought that Abacus was AAA and are now suggesting that the US deserves less?

What if they downgraded and no one agreed?  These guys are attempting to dictate the pace and nature of the deficit solution to the US government and it is not going to happen.  They will be ingored by Congress and the President, and they should be.  No one elected them.  They are way off base, and they are looking for a tumble.

Do they really think that China and other bond investors believe their silly reports about the exact nature of the US deficit solution?  What other bonds do they recommend instead?

Will there be a race to the bottom among the rating agencies?  Which will do the worst job on this issue?  At the moment, S&P is leading the chase to be the worst.

The Indicator Snapshot

It is important to keep the weekly news in perspective.  My weekly indicator snapshot includes important summary indicators:

• The ECRI Weekly Leading Index and the derivative Growth Index
• The St. Louis Fed Stress Index
• The key measures from our "Felix" ETF model.

There will soon be at least one new indicator, and the current choices are under review.  In particular, I am considering replacing the ECRI method with the equally effective and more transparent approach from Bob Dieli.

 

 

The indicators show continuing modest growth at a slowing pace, with little indication of economic risk.  The market fears, as is often the case, are greater than one might expect from the data.

Felix is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll, now recorded on Thursday after the market close. We have a long public record for these positions.

[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

The compromise debt limit deal will pass, so attention will turn back to corporate earnings and the economy. 

Getting past the Senate debt limit vote, which I see as automatic, the big story is the monthly employment report and corporate earnings.  I am not looking for a strong employment report, especially with the weak consumer confidence and jobless claims during the key period.  The question is whether investors will look past the expected weak data.

Earnings remain strong, and that is the fuel for stock prices.

Investment Implications

From the comments I have noted a lot of confusion regarding this "investment implication" section.  I try to write something for both a trading time frame and also for the long-term investor.  The trading time frame is our model-based system.  The longer time frame reflects my own investment posture.  Both approaches have been successful over time, but occasionally there is disagreement.

In trading accounts we were fully invested throughout the bad week.  Felix does not respond to fundamental data, but rather to price momentum, volume, and changes.  These all weakened, leading us to go to "neutral" in the overall posture.  There are still several postiive sectors, so we remain invested in a neutral market.

For investment accounts we were cautious last week in establishing new positions.  I still believe that holdings with more economic exposure will excel in the second half of the year.  These include technology and cyclical stocks.  As I have noted in recent weeks, the investment time frame requires looking for opportunity when traders are scrambling.

This week marks an important turning point.  The most imporant worries have been addressed, but stock prices remain low.  The news coverage has strayed from stories that are clearly linked to investment return into the realm of political winners and losers.  Since both liberals and tea party types hate the compromise, they have become the story.

I expect to buy more aggressively this week for long-term investors.  This represents a change in what I have said for many weeks.

Comments

[oldprof]

Angel -- I'll try to do another article on this subject, but here is something to think about. Evaluating creditworthiness over many future years based upon recession and recovery revenues is not appropriate.

Put another way, as a matter of public policy we should not allow an unelected private company to dictate fiscal policy. Trying to solve the deficit problem in such short order, in the minds of most humans and their models, simply makes things worse.

Ultimately, the interest rate paid will be decided by the market. We'll see how it plays out.

Nice to see you commenting here. Thanks for joining in.

Jeff

[Angel Martin]

Jeff. Good summary. You were absolutely right about the outcome of the debt ceiling.

However, I disagree with you on the ratings agencies and the Treasury AAA rating. I don't think any sovereign borrowing 43 cents of every dollar spent, with 100% debt to gdp, no immediate prospects of rapid revenue growth, and major unfunded liabilities for the retirement programs has an " EXTREMELY STRONG capacity to meet its financial commitments" over the long term.

I'd rather hold ADP or JNJ