A Dash of Insight

Why Smart Investors Struggle to Beat the Market: Past Performance

The individual investor does not beat the market, but actually trails by a significant margin. It is not a matter of intelligence.

The habits and skills that help smart people succeed in their jobs and recreational life actually mislead them when it comes to investing!

Preface

I am writing some posts subjects that have great current significance. These are issues where the average investor has a lot of money at stake. There is currently a lot of buzz about 2016 performance. This morning I heard a pundit explain that hedge fund managers had to go into "catch up" mode since so many of them trailed the market. As we enter the last quarter of the year, there is already focus on that annual grade card. Should you care?

Everyone has heard, of course, that past performance does not assure future results. Still, it must provide some kind of indication about the future? Doesn't it?

Let us investigate further.

As I elaborate, please keep in mind this story about Ken Uston, one of the greatest blackjack players of all time. In his excellent book, Million Dollar Blackjack he describes both his system and the implementation in team play.  Card-counting nerds would signal "the Big Player" who would seem to flit from table to table, cocktail in hand and a woman on both arms.  The Big Player would make large bets, but only when the odds were in his favor. As a result of this team method (no longer effective given casino counter-measures), Uston played exclusively in situations where he had an edge of about 5%. 

The Relevance of Past Performance

Suppose that you adopted a system where you took all of your money each day and bought the stocks that did the best the day before. That would be past performance on a one-day time frame. I suspect that most readers will think that is silly.

Suppose that you looked at the stocks and sectors which did best in the past year. Buy them! That may seem reasonable, but it is also a regular loser.

How about choosing the managers that did the best over the past year? Or the ETFs that were strongest? That is simply a closet method for following last year's top picks. The top investors and managers for last year owned the popular FANG stocks, utilities, and consumer dividend payers. We know that it worked last year, but will it continue?

Warren Buffett, on a monthly basis, beats the market only 51% of the time. He has had multiple losing streaks. None of this has stopped him from being a great investor.

Evaluating performance requires relevant, long-run data.

What is the long run?

 

The average investor thinks of the long run in terms of time. This is a big mistake. The long run relates to the number of decisions, not time. Here are some illustrative examples:

• High frequency trading firms rarely have a single losing day! This is because they make tens of thousands of trades each day. They reach the "long run" in an hour or two.
• Single-theme managers may lose for many years. The heroes who called the housing market collapse and were memorialized in The Big Short, endured years of losses and many angry investors –often locked in by contract. The past performance of multiple years was certainly no indication of what was to come.
• Thematic managers (like me) might have 5 or 6 themes. Even a strong strategy does not get into the long run in a given year. When the theme hits it is a huge winner.

The "long run" should be measured in the number of decisions, not the calendar time. If you try to cut it into arbitrary times, it either fails, or creates the wrong incentives for managers.

Is Performance Even the Correct Test?

Some investments are chosen without the "beating the market" concept in mind. If you make such a decision, it is wrong to revisit the results with a specific market benchmark. Here are some examples:

• Suppose you choose an income program. If the income meets the target, that should be the test.
• Suppose you fear a particular threat. One of my concerns is a cyber-attack. I suspect that the frequency is under-reported and bigger cases loom. If it happens, it would be helpful to hold a leading company in the field. I have chosen Palo Alto Networks (PANW) because it is a good company with a strong client base and real earnings. The stock was crushed today because of cautious comments in their outlook. The earnings and revenues were fine. We bought more. Should I be concerned that this hurt my performance? Should my clients? If they are worried, they have the wrong manager. Nothing fundamentally changed. If there is a big cyber event, we'll win big. We are not trying to beat the market each month or year with this stock.
• Suppose you want downside protection. If you go with a manager like John Hussman who buys puts to hedge your position, that was your choice. Even if the puts expire worthless, he did his job. You should expect reduced performance when the market does not decline significantly.
• Suppose you select a portfolio with a large cash or bond component. This is often exactly what you should do. Do not second guess yourself by wondering if you should have taken more risk.
• Suppose you invest in a "value" program. Buying cheap stocks (on an earnings basis) has been out of favor for the last few years. Should you expect this to continue, or for the pendulum to swing? My approach is to buy regional banks (STI is a favorite), technology, and homebuilders. This will work, but maybe not in the next few months. You should not worry about that.

Conclusion

 

Revisiting Mr. Uston -- despite the big percentage advantage, he describes a period of time where they had a losing streak lasting more than a month!  Please note that this includes thousands of hands played. They started questioning error rate, methods, the skill of their counters, theft, etc. I like the example since it is possible to compute a valid benchmark result for what they were doing. Eventually the winnings returned. It shows that you must have confidence in your system, and stick with it through some improbable losing times.

In similar fashion, value investing is a fundamental part of my approach. It may be difficult, even for the smartest investors, to see this. It is a good problem to analyze.

Anthony Fogler (via ValueWalk) explains why value has been treated unkindly, and why sentiment is likely to change. Here is an illustrative chart:

The chart provides some idea of what time frame you should consider to reach the "long run" in value investing. Not one or two years, but more like five.

There are many other traps for the really smart investor. The most intriguing is that most of our reading in our professional life is designed to educate and help us. In the investment world, many are trying to sell us or scare us or both. But that is a subject for another day.

 

 

Weighing the Week Ahead: Will the Fed Get the Signal to Hike Rates?

This week's calendar is loaded with important data. Now that the Jackson Hole Fed Conference is over, can we expect a policy change soon? Every data report this week will get special scrutiny. Will the Fed get the signal to hike rates?

Last Week

The important economic news was pretty good, but interest focused on Chair Yellen.

Theme Recap

In my last WTWA, I predicted a weeklong focus on the Fed conclave at Jackson Hole and the implications of Chair Yellen's speech. This was the story from CNBC's opening on Monday through the Fast Money group on Thursday after the close. There was an interlude for the "squatty potty" story, but even CNBC cannot talk about the Fed all of the time. Jane Wells is a good sport about such assignments and seems to enjoy "suiting up" for the occasion. I congratulate her on her new status as "special correspondent."

The Story in One Chart Short

I always start my personal review of the week by looking at this great chart from Doug Short. The overall range is very narrow, with stocks remaining near record highs. It shows the effect from the Yellen speech, the Fischer comments, and the final verdict. It was all pretty muted. Doug has a special knack for pulling together all of the relevant information. His charts save more than a thousand words! Read his entire post where he adds analysis and several other charts providing long-term perspective.

 

The News

Each week I break down events into good and bad. Often there is an "ugly" and on rare occasion something really good. My working definition of "good" has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!

The Good

• Initial jobless claims fell 1000 to 261K. The four-week moving average also edged lower. This is a continuing strong signal about labor market conditions.
• Chemical activity continues higher. GEI has the story. "Davidson" (via Todd Sullivan) shows why this is important.

 

• Durable goods orders rose 4.4% snapping the recent losing streak.
• New home sales beat expectations by a mile – SAAR of 654K versus expectations of 580. The NYT (finally) joins Calculated Risk in noting the rebound in the housing market.

The Bad

• Q2 GDP rose only 1.1% according to the revised calculations.
• Existing home sales declined 3.2%. Calculated Risk has the story.

The Ugly

Budget projections. Left unchanged, the U.S. federal budget will increase in relation to total economic output for the first time since 2009. Econintersect.com does a great job of highlighting key reports from a wide variety of sources. This analysis from the non-partisan Congressional Budget Office includes a revealing chart of what is in prospect.

 

Perhaps one of the Presidential candidates will reach agreement with Congress to address this.

On a personal note, I used to teach a public finance course with a unit on budgeting. One of my favorite lectures included the progression of projections. What started out as "balanced" on a five-year projection always turned into a deficit when "year zero" was reached. I taught those classes a long time ago, but nothing has changed.

 

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. No award this week. Nominations always welcome! For ideas, go to your favorite conspiracy site and look for people doing data mining and/or poets writing about economics.

The Week Ahead

We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead. You can make your own predictions in the comments.

The Calendar

We have a huge week for economic data. While personally I watch everything on the calendar, you do not need to! I highlight only the most important items in WTWA. Focus is essential.

The "A" List

• Employment situation (F). Another strong report? Will this tip Fed policy into a rate increase?
• ISM index (Th). Great concurrent read on the overall economy with some leading aspects.
• Personal income and spending (M). You have to earn it before you can spend it! July data, but both are important.
• Consumer confidence (T). The Conference Board version helps to assess both job creation and spending plans.
• Auto sales (Th). One of the best non-government reads on the economy.
• Core PCE prices (M). This – not CPI – is the measure the Fed uses to evaluate the 2% inflation target.
• Initial claims (Th). The best concurrent indicator for employment trends, but less attention during "employment week."

The "B" List

• ADP employment change (W). A good independent indicator of private employment growth. Deserves more respect.
• Pending home sales (W). Everything about the housing market is important, but pending sales are a bit less significant than other measures.
• Chicago PMI (W). The most important of the regional measures.
• Construction spending (Th). Volatile July data is important for the long-term trend.
• Trade balance (F). July data, widely misunderstood, but important for Q2 GDP.
• Crude inventories (W). Often has a significant impact on oil markets, a focal point for traders of everything.

 

The big news is the employment situation reports, especially coming right before Labor Day.

Next Week's Theme

This week brought us another week of quiet trading, but the Fed conference may have teed up a policy shift. While the speeches were short on the specifics craved by traders and the punditry, the basic message was a bit more hawkish. The Fed expects an improving economy and tighter labor markets. This week's data – and especially the employment report – will get special attention. Everyone will be asking: Will the Fed get the signal for a rate hike?

After Jackson Hole, there are three basic positions:

1. Negative rates. While discussed, both Yellen and Fischer made it clear that this was not a serious option – at least not right now.
2. Steady as she goes. Look for more economic strength before raising rates. Then move cautiously and slowly.
3. Adopt a higher inflation target. Some believe that the long end of the curve will increase only when inflation expectations move higher. This means that the Fed must commit to stimulative policy even if inflation moves above the current 2% target. (Mark Thoma has an excellent description).

Regardless of the chosen position, there was general agreement that monetary policy was being asked to do too much. The neutral sounding calls for help with fiscal policy really means a call for Keynesian stimulus.

Opinion was clearly divided in the Jackson Hole showdown as well as the ensuing discussion. Feel free to add your own thoughts in the comments, including anything I have missed.

As always, I'll have a few ideas of my own in the conclusion.

Quant Corner

We follow some regular great sources and also the best insights from each week.

Risk Analysis

Whether you are a trader or an investor, you need to understand risk. Risk first, rewards second. I monitor many quantitative reports and highlight the best methods in this weekly update.

The Indicator Snapshot

 

The Featured Sources:

Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies. This week he expresses more confidence about growth in earnings.

Bob Dieli: The "C Score" which is a weekly estimate of his Enhanced Aggregate Spread (the most accurate real-time recession forecasting method over the last few decades). His subscribers get Monthly reports including both an economic overview of the economy and employment.

The recession odds (in nine months) have nudged closer to 10%.

Holmes: Our cautious and clever watchdog, who sniffs out opportunity like a great detective, but emphasizes guarding assets.

Georg Vrba: The Business Cycle Indicator, and much more. Check out his site for an array of interesting methods. Georg regularly analyzes Bob Dieli's enhanced aggregate spread, considering when it might first give a recession signal. Georg thinks it is still a year away. It is interesting to watch this approach along with our weekly monitoring of the C-Score.

RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature his recession analysis, Dwaine also has a number of interesting approaches to asset allocation.

Doug Short: The Big Four Update, the World Markets Weekend Update (and much more).

The ECRI has been dropped from our weekly update. It was not so much because of the bad call in 2011, but the stubborn adherence to this position despite plenty of evidence to the contrary. Those interested can still follow them via Doug Short and Jill Mislinski. The ECRI commentary remains relentlessly bearish despite the upturn in their own index. Here is Doug's latest update (including the recent retail sales data) of the Big Four indicators followed by the non-partisan, non-governmental NBER in dating recessions.

 

How to Use WTWA

In this series I share my preparation for the coming week. I write each post as if I were speaking directly to one of my clients. For most readers, they can just "listen in." If you are unhappy with your current investment approach, we will be happy to talk with you. I start with a specific assessment of your personal situation. There is no rush. Each client is different, so I have six different programs ranging from very conservative bond ladders to very aggressive trading programs. A key question:

Are you preserving wealth, or like most of us, do you need to create more wealth?

My objective is to help all readers, so I provide a number of free resources. Just write to info at newarc dot com. We will send whatever you request. We never share your email address with others, and send only what you seek. (Like you, we hate spam!) Free reports include the following:

• Understanding Risk – what we all should know.
• Income investing – better yield than the standard dividend portfolio, and also less risk.
• Holmes – the top artificial intelligence techniques in action.
• Why 2016 could be the Year for Value Stocks – finding cheap stocks based on long-term earnings.

You can also check out my website for Tips for Individual Investors, and a discussion of the biggest market fears. (I welcome questions or suggestions for new topics.)

Best Advice for the Week Ahead

The right move often depends on your time horizon. Are you a trader or an investor?

Insight for Traders

We consider both our models and also the best advice from sources we follow.

Felix and Holmes

We continue with a strongly bullish market forecast. Felix is fully invested, including several aggressive sectors. The more cautious Holmes also remains fully invested.

Top Trading Advice

What are the distinguishing characteristics of top traders? Brett Steenbarger identifies five. How many describe you? My favorite is this one:

*  Successful traders know when to not trade - They wait for opportunities; they pull back their risk taking when they're not perceiving opportunity.  It's not that successful traders are always successful.  It's that their success springs from knowing how to not lose when they're not seeing the ball well.

 

Insight for Investors

Investors have a longer time horizon. The best moves frequently involve taking advantage of trading volatility!

Best of the Week

If I had to pick a single most important source for investors to read this week it would be Bill Kort's Apocalypse Now. He notes the media penchant for finding disaster lurking behind every corner. This may well be the single most costly mistake for investors. He does a nice job of linking it to this week's issue:

Sure, there are apocalyptic events in the stock market, but the media makes them sound almost routine even though they are few and far between. Market attention via the media has been wrapped around another Fed fund rate increase as a catalyst for such an event. It is very doubtful that a quarter-point increase in the rate would be a disaster. In fact, worry over a Fed rate increase at this point is "much ado about nothing".

Stock Ideas

Chuck Carnevale continues his helpful sector-by-sector review of dividend growth stocks. His articles are always a great source of ideas. I review them all, and you should, too.

Barron's identifies the "ten best dividend stocks" noting valuation as well as yield. I like the list, because most of the names are those we often hold in our enhanced yield program. (We write near-term calls to get even greater yield from strong stocks). These are all interesting choices.

Holmes will begin contributing an idea each week, a stock we bought for clients a few days ago. I will mention it here and Holmes will also post it each Friday at Scutify.com. While we cannot verify the suitability of specific stocks for everyone who is a reader, the ideas may be a starting point for your own research. Holmes may exit a position at any time, and I am not going to do a special post on each occasion. If you want this information, just sign up via holmes at newarc dot com and you will get email updates about exits. This week's Holmes pick is Level 3 Communications (LVLT).

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. The average investor should make time (even if not able to read AR every day as I do) for a weekly trip on Wednesday. Tadas always has first-rate links for investors in his weekly special edition. There are several great choices worth reading, but my favorite is this advice from Morningstar's Christine Benz, Retirement-Planning Assumptions: Yes, You Can Be Too Conservative: The risks of oversaving and underspending are real, too.

However, I think there's a risk--albeit an under discussed one--that well-meaning retirees and retirement-savers can take caution too far. For example, I've run into 75-year-old retirees who, in the interest of playing it safe, are spending just 2% of their portfolios annually; at that pace, they're very likely to leave a very large kitty behind. That may be what they want, but it may not be. In a similar vein, I've met 40-year-old accumulators who tell me that they're certain Social Security won't be there for them, or that they're assuming their portfolios will return just 2% in their 25-year runway to retirement.

I see this so frequently. Many retirees are in a solid position to enjoy life, and they should do so!

Bond Funds and Bond Ladders

If interest rates rise, there is plenty of risk in both bond funds and stocks (utilities and classic dividend stocks) that are bond proxies. A bond ladder provides more control. Larry Swedroe, director of research for The BAM Alliance, explains the many advantages. I especially like the discussion of avoiding the impact of hot fund flows.

There's another little-discussed benefit of owning individual securities. With a mutual fund (or ETF), after a period of falling interest rates, "hot money" chasing recent performance will typically buy into the fund. The fund, therefore, must buy more bonds in a low-rate environment, thus lowering the average rate for all investors. Then, if rates begin to rise, the hot money will often leave, forcing the fund (and long-term investors in it) to suffer trading costs and capital losses that can't be "waited out."

On the other hand, an investor who holds individual bonds and is satisfied with the yield to maturity when the bond was purchased, is not subject to the same problem (that is, other investors cannot force him to sell at depressed prices).

I strongly agree with this approach. For clients who are preserving wealth, we recommend bond ladders as a foundation.

 

Watch out for….

Target date funds. John Authers (FT) explains that if you do not adjust allocations for relative valuations, you can get seriously off course. If you have a financial advisor, this is a basic task. If not, you should verify that the TDF is doing what you want.

Over-reliance on the Shiller CAPE ratio. Acclaimed valuation guru Aswath Damodaran explains why this approach is potentially dangerous, often leading investors astray.

Refinery stocks. Names that may seem cheap on a long-term basis may be under pressure from other factors. Paulo Santos explains the current risks. Few understand this market. We did well when oil prices crashed since many ETFs just lump refiners in with the general oil sector. Quite wrong.

Volatility derivatives. Trading volume has exploded in these products. Traders who are "scared witless" [TM OldProf Euphemism] read a blog post explaining that this is a great way to hedge. Hardly any realize how much the odds are stacked against them. Mark Melin's article at ValueWalk does a great job of explaining these issues. The chart below summarizes the key point – contango in the futures contracts. If you do not understand the significance of this, you need to do a lot more study before trading these products!

 

Final Thoughts

The biggest story, now joined by major media sources, is the failure of the Fed efforts at more transparency. Everyone seems to agree that more information has not improved clarity about policy. I have sometimes joined those questioning the communication methods, but always emphasizing a key point:

Transparency ≠ Clarity

If the Fed is data dependent, and the data paint a mixed picture, the immediate policy implications cannot be clear.

Each day I see commentary suggesting that economic data are very weak, but the Fed should be raising rates. Some even suggest that higher rates are needed so the Fed can lower them to fight the next recession. They disagree with the Fed mission to avoid or delay the next recession.

The likely outcome from this is the analysis from Merrill Lynch's Chief Strategist, Michael Hartnett. His conclusions got a lot of attention this week, including Sara Sjolin (MarketWatch) with the chart below, and also the FT. The latter discusses the Keynesian Put, a concept you will soon be hearing more about.

The bear steepening occurs when a stronger economy raises rates on the long end of the curve. It is bearish for bonds and bond proxies, but very bullish for economically sensitive stocks and banks. We saw some hints of this shift on Friday. Strong economic data, especially tighter labor markets, may (finally) move interest rates higher.

Weighing the Week Ahead: Showdown at Jackson Hole?

This week's calendar features yet another light week for data, a lot of politics, and slow summer trading. Something has to fill all of that air time! This week the punditry gets their favorite topic – the Fed. Chair Yellen's speech on Friday may set the tone for post-election monetary policy. Sometimes there is also a presentation from a non-Fed economist that challenges current policy. Will there be a showdown at Jackson Hole?

Last Week

The important economic news was positive. Despite the impending options expiration, the big story was the lack of action. There has not been a daily 1% move since early July. This is much lower than the normal August volatility. (LPL)

Theme Recap

In my last WTWA, I predicted discussion about whether the oil price/stock price relationship was at an end. My claim is that there was never a solid basis for the correlation, despite the intense focus by traders. It was a good guess about a topic in a quiet week. (A typical example). Both TV and print journalists kept citing oil prices as influences on daily trading. The real story was the lack of volatility. Last week the dead air was filled with a sandwich promotion. This week the news was about a reported theft from athletes at the Olympics. I understand why this story is important for athletics, the host country, the Olympic rules, endorsements and other angles. It has little importance for financial markets. The attention it got highlights the lack of other news.

The Story in One Chart Short

I always start my personal review of the week by looking at this great chart from Doug Short. The overall range is very narrow, with stocks remaining near record highs. Doug has a special knack for pulling together all of the relevant information. His charts save more than a thousand words! Read his entire post where he adds analysis and several other charts providing long-term perspective.

 

The News

Each week I break down events into good and bad. Often there is an "ugly" and on rare occasion something really good. My working definition of "good" has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!

The Good

• Homebuilder sentiment was strong again at 60, an increase over 58 in July.

• Initial jobless claims fell 4000 to 262K. Claims have now been below 300K for 76 weeks. (Jeffry Bartash, MarketWatch).
• The first post-Brexit news is positive, as UK employment is stronger than expected (FT).
• Leading Economic Indicators rose 0.4 percent. This signals continuing slow growth for the next six months. Steven Hansen provides analysis and this chart:

• Industrial production continued the recent rebound, up 0.7% in July. Calculated Risk has the story.
• July housing starts – another "solid report" via (Calculated Risk).

 

The Bad

• Oil bankruptcies increased. Rupert Hargreaves provides the relevant data, including this chart.

• Fed Facebook page. Undaunted by the prior efforts at transparency, the Fed has launched a Facebook page. This will not end well.

 

The Ugly

Serious consequences from bad information. Here are two quite different examples.

• The government believes you to be dead and your benefits are ended. What next?
• Airline passengers, conditioned by recent events, hear something perceived as a shot. An incredible stampede at JFK results.

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. No award this week. Nominations always welcome! For ideas, go to your favorite conspiracy site and look for people doing data mining and/or poets writing about economics.

The Week Ahead

We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead. You can make your own predictions in the comments.

The Calendar

We have another rather slow week for economic data, but plenty of impending big news. While personally I watch everything on the calendar, I highlight only the most important items in WTWA. Focus is essential.

The "A" List

• New Home Sales (T). A good read on an important sector.
• Michigan Sentiment (F). The only concurrent data on job creation and spending.
• Durable Goods Orders (Th). Volatile July data is relevant to confirm the industrial rebound.
• Initial claims (Th). The best concurrent indicator for employment trends.

The "B" List

• Existing home sales (W). Not as important as new homes, but a solid indicator for the overall market.
• GDP – 2^nd estimate for Q2 (F). Old news, but it will be the base for evaluating the rest of the year.
• Crude inventories (W). Often has a significant impact on oil markets, a focal point for traders of everything.

 

The big news will be the Yellen presentation at Jackson Hole. Markets will get a hint when the specific topics are announced on Thursday.

Next Week's Theme

This week's quiet trading might end with a bang. The Kansas City Fed's annual Jackson Hole conference attracts economists and central bankers from around the world. There may be exploration of new policy ideas or hints at new policy directions. This is especially true when the Fed Chair is speaking. It is not a single, unified message. Some presentations may well feature dissenting viewpoints. While it provides food for the punditry, many market participants would prefer a clear policy statement from a single voice. Instead, everyone will be wondering: Will there be a showdown at Jackson Hole?

Several viewpoints have already emerged.

1. The conference generally has little market impact, even when the Fed Chair speaks.
2. Too many voices mean there will be no clear message.
3. The presentations will be too theoretical to be meaningful.
4. Sometimes the Conference highlights the start of new plans – Bernanke's hints about Quantitative Easing come to mind.
5. A spirited discussion will sharpen opinions on all sides.
6. The odds on near-term rate increases will be better understood.

There are many proponents for each. Feel free to add your own thoughts in the comments, including anything I have missed.

As always, I'll have a few ideas of my own in the conclusion.

Quant Corner

We follow some regular great sources and also the best insights from each week.

Risk Analysis

Whether you are a trader or an investor, you need to understand risk. Risk first, rewards second. I monitor many quantitative reports and highlight the best methods in this weekly update.

The Indicator Snapshot

 

The Featured Sources:

Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies. This week he expresses more confidence about growth in earnings.

Bob Dieli: The "C Score" which is a weekly estimate of his Enhanced Aggregate Spread (the most accurate real-time recession forecasting method over the last few decades). His subscribers get Monthly reports including both an economic overview of the economy and employment.

The recession odds (in nine months) have nudged closer to 10%.

Holmes: Our cautious and clever watchdog, who sniffs out opportunity like a great detective, but emphasizes guarding assets.

Doug Short: The Big Four Update, the World Markets Weekend Update (and much more).

The ECRI has been dropped from our weekly update. It was not so much because of the bad call in 2011, but the stubborn adherence to this position despite plenty of evidence to the contrary. Those interested can still follow them via Doug Short and Jill Mislinski. The ECRI commentary remains relentlessly bearish despite the upturn in their own index.

Georg Vrba: The Business Cycle Indicator, and much more. Check out his site for an array of interesting methods. Georg regularly analyzes Bob Dieli's enhanced aggregate spread, considering when it might first give a recession signal. Georg thinks it is still a year away. It is interesting to watch this approach along with our weekly monitoring of the C-Score.

RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature his recession analysis, Dwaine also has a number of interesting approaches to asset allocation.

In addition to my first-rate collection of recession watchers – selected as the best in my 2011 analysis – I always monitor other ideas. Here are some key viewpoints:

• The St. Louis Fed (via GEI, which does a great job of highlighting relevant Fed sources) has a balanced analysis, taking note of the recent weakness in GDP. Examining and rejecting the possibility of a current business cycle peak (the official start of a recession), they conclude: "…(T)he available evidence suggests that the economy, though exhibiting stubbornly weak real GDP growth, continued to expand heading into the second half of 2016."
• Menzie Chinn updates his version of the Big Four indicators used by the NBER for recession dating. He notes the improvement in industrial production, and the impact on the overall assessment.

• Bill McBride, who has had an excellent record through the financial crisis and recovery, still sees no recession through the next half of 2017, in line with our own experts.

How to Use WTWA

In this series I share my preparation for the coming week. I write each post as if I were speaking directly to one of my clients. For most readers, they can just "listen in." If you are unhappy with your current investment approach, we will be happy to talk with you. I start with a specific assessment of your personal situation. There is no rush. Each client is different, so I have six different programs ranging from very conservative bond ladders to very aggressive trading programs. A key question:

Are you preserving wealth, or like most of us, do you need to create more wealth?

My objective is to help all readers, so I provide a number of free resources. Just write to info at newarc dot com. We will send whatever you request. We never share your email address with others, and send only what you seek. (Like you, we hate spam!) Free reports include the following:

• Understanding Risk – what we all should know.
• Income investing – better yield than the standard dividend portfolio, and also less risk.
• Holmes – the top artificial intelligence techniques in action.
• Why 2016 could be the Year for Value Stocks – finding cheap stocks based on long-term earnings.

You can also check out my website for Tips for Individual Investors, and a discussion of the biggest market fears. (I welcome questions or suggestions for new topics.)

Best Advice for the Week Ahead

The right move often depends on your time horizon. Are you a trader or an investor?

Insight for Traders

We consider both our models and also the best advice from sources we follow.

Felix and Holmes

We have moved to a strongly bullish market forecast. Felix is fully invested, including several aggressive sectors. The more cautious Holmes is now also fully invested.

Top Trading Advice

Should aspiring traders start with "paper trades." Tadas Viskanta explains why it is better to have some money on the line – even if it is a small amount.

You can appreciate such an experience by watching Adam H. Grimes and the "reality show" involving a beginning trader.

Have traditional market signals lost their value? (Conor Sen)

Dr. Brett Steenbarger had a great week of posts. They are all worth reading and all have ideas you are unlikely to see elsewhere. Two of my favorites:

• Do you have talent for trading? Here is how to awaken it?
• Do you understand emotionally intelligent trading?

 

Insight for Investors

Investors have a longer time horizon. The best moves frequently involve taking advantage of trading volatility!

Best of the Week

If I had to pick a single most important source for investors to read this week it would be Ben Carlson's advice about How to Survive a Melt Up. He observes that most investors are focused on the risks, giving little thought to the possible upside.

But there's another risk in the markets that most investors don't spend too much time worrying about — a melt-up in prices.

It would seem to me that all of the ingredients are in place for a potential U.S. equity bubble. Interest rates are extremely low, central banks around the globe are almost accommodative across the board, there is a substantial need for returns from pensions and retirees and a general lack of alternatives elsewhere to invest. That doesn't mean it has to happen, but the pieces are in place for upside volatility, something very few investors believe could occur these days.

In fact, if you look back historically at how stock markets have generally performed, they are much more likely to rise substantially than fall substantially in a given year.

Take a look at the odds.

 

Stock Ideas

Chuck Carnevale notes the problem with finding good dividend stocks: Very high valuations. He nurses out an interesting candidate, Kroger, while teaching how to be selective.

The biotech stock rebound might be just getting started (See It Market).

Holmes will begin contributing an idea each week, a stock we bought for clients a few days ago. I will mention it here and Holmes will also post it each Friday at Scutify.com. While we cannot verify the suitability of specific stocks for everyone who is a reader, the ideas may be a starting point for your own research. Holmes may exit a position at any time, and I am not going to do a special post on each occasion. If you want this information, just sign up via holmes at newarc dot com and you will get email updates about exits. This week's Holmes pick is Hartford Financial Services (HIG).

 

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. The average investor should make time (even if not able to read AR every day as I do) for a weekly trip on Wednesday. Tadas always has first-rate links for investors in his weekly special edition. There are several great choices worth reading, but my favorite is Carl Richards' take on a Freaknomics theory. People are too cautious about making big changes in their lives. Is it enough to flip a mental coin?

Value Stocks

This approach, successful in the long run, has been out of favor for the last few years. Ben Fischer (Allianz) describes the factors suggesting a change in the recent trend. He also includes this chart in the mean-reverting series:

If you missed my special post on this topic, addressing the "value trap" question, please take a look.

Watch out for….

Tax scams. There is no such thing as a "student tax" and your kids will not be kicked out of school if you do not pay it. The IRS does not seek money or charge card numbers for telephone payments. And they certainly do not take iTunes gift certificates! Sheesh! While my audience at WTWA would not fall for any of these scams, you might be able to help a friend.

And definitely do not fall for bogus citations from Warren Buffett! David Merkel explains.

Emotional decision making is costly. Eric Crittenden Cio writes as follows and provides a supporting chart:

Investors have an addiction. Many of us feel like we can't help it: we buy high and sell low even though it's more logical to do the exact opposite. This addictive behavior is dooming us to a rocky investment experience and underperforming portfolios.

Final Thoughts

The continuing laments about the Fed seem concentrated among those who have done a poor job of predicting both the policy and the effects. The most recent variant is the complaint that there is not a unified message, and Fed members are not elected.

If the Fed had (even more) political accountability, rates would never increase! Politicians love low rates. The Committee currently includes a group of appointed officials with Congressional ratification, just as we have for the FDA, SEC, FCC, and other regulatory agencies. It is the nature of committees that the members will disagree, discuss, and compromise.

Instead of complaining about a very normal process of the U.S. style of government, it is more profitable to pay attention and to accept the diversity.

If the underlying data do not do not send a clear message, why should we expect the Fed to declare an unwavering policy? I expect interest rate increases sooner than the market currently believes, and that it will reflect economic improvement.

Weighing the Week Ahead: Have Oil Prices Lost Their Impact on Stocks?

This week's calendar features another relatively light week for data, a lot of politics, slow summer trading, and options expiration. Something has to fill all of that air time! Expect more Olympic coverage, political commentary, and light features. There will be the usual Fed chatter. To the extent that there is real market discussion, I am looking for a new topic: Have Oil Prices Lost Their Impact on Stocks?

Last Week

The important economic news was mixed as was the market reaction.

Theme Recap

In my last WTWA (two weeks ago), I predicted discussion about whether the earnings recession might end in Q3. I suggested we would need to fasten our seatbelts for a showdown on the economy and earnings, probably in quarter three. That might prove out, but we certainly did not need seatbelts last week! We had quiet summer trading with light news and plenty of people on vacation. CNBC interspersed Olympic coverage and even found time to have multiple segments featuring a sandwich on Friday.

Politics, global events, and competition intersected.

There was some support for my earnings thesis from our two key sources:

FactSet noted the distribution of earnings results by sector and the continuing overall beat rate.

Brian Gilmartin analyzed the forward curve for earnings, including some important implications.

The Story in One Chart Short

I always start my personal review of the week by looking at this great chart from Doug Short. The overall range is very narrow, with little overall change. Doug has a special knack for pulling together all of the relevant information. His charts save more than a thousand words! Read his entire post where he adds analysis and several other charts providing long-term perspective.

The News

Each week I break down events into good and bad. Often there is an "ugly" and on rare occasion something really good. My working definition of "good" has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!

The Good

• Gasoline prices are expected to move lower, perhaps as low as $1.92 by year's end. (EIA forecast via Calculated Risk).
• Initial jobless claims remain low and even declined by 1000. (See Doug Short for charts and analysis).
• Mortgage rates are back at the lows, 3.375 for "flawless scenarios." (Calculated Risk).
• The JOLTs report showed improved labor market conditions. Most sources are not covering this accurately. It is not an alternative method for estimating net job growth. It does show the trend in job openings, the structure of the labor market, and the voluntary quit rate. Nearly 3 million people each month are voluntarily leaving their jobs, double the number in 2009.
• Producer prices fell more than expected, 0.4%. Some are citing this as bad news. The bad news will come when stimulus overshoots.
• Michigan sentiment remained strong, slightly beating expectations. Doug Short does the best analysis and has the most informative chart:

The Bad

• Railroad growth remains slow. Zacks explains that this has translated into lower earnings, partly because of the energy sector.
• Productivity fell 0.5%. Gains in productivity are essential for economic growth.
• Retail sales disappointed, with no growth month-over-month. It was also a significant miss of the 0.4% expected gain. Doug Short analyzes this disappointing report. As always, he provides helpful historical perspective, including the chart below. It seems to show a return to the pre-recession pace of growth, but without every closing the gap to the prior trend line.

The Ugly

Public retirement commitments. Robert Pozen, in a Brookings op-ed, highlights these costs, and the main reasons:

The unfunded liabilities for retiree healthcare for the 30 largest US cities exceeds $100bn, according to the Pew Charitable Trusts, a Philadelphia-based non-profit organisation. The unfunded liabilities for the 50 US states exceeds $500bn, according to Standard & Poor's, the rating agency.

Retiree healthcare plans are uniquely American. They exist because the US has never offered universal healthcare before Medicare, the national social insurance programme, at age 65.

Many employees of cities and states retire between 50 and 55, so local governments usually provide them with highly subsidised healthcare between retirement and Medicare, and sometimes beyond.

For a more general analysis of the threat from retirement costs, see Mohamed A. El-Erian's article on the "titanic risks."

Noteworthy

There is a lot of current discussion about the "typical" American community. FiveThirtyEight provides some interesting data on both cities and states. You will find the results interesting. Much to my surprise, I am living in the state with demographics closest to the country overall.

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. This week's award goes to Justin Fox, writing at BloombergView. He takes on a popular myth that just won't die – the manipulation of government statistics. Like Fox, I have some personal experience in working with the career civil servants who analyze data. The notion that they do whatever a (temporary) political leader instructs is very costly to investors who believe it. The article takes up various accusations and stories, with plenty of good discussion. Here is one key argument:

First, because I know a little bit about the people who put together our nation's economic statistics. The Bureau of Labor Statistics, Bureau of Economic Analysis and Census Bureau are run on a day-to-day basis by career employees, not political appointees. Even the appointees are often career staffers who get promoted, and many have served under multiple administrations. When top statistics-agency officials do leave government, it's often for jobs in academia. Credibility with peers is generally of far more value (economic and otherwise) to these people than anything a politician could do for them.

I would add that any shenanigans would be the basis for articles and books by those leaving the agencies.

The Week Ahead

We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead. You can make your own predictions in the comments.

The Calendar

We have another moderate week for economic data and the end of earnings season is near. While personally I watch everything, I highlight only the most important items in WTWA. It is important to focus.

The "A" List

• Building permits and housing starts (T). Permits are a good leading indicator.
• FOMC minutes (W). No one really expects any fresh news, but the punditry will find something.
• Leading indicators (Th). Still highly regarded by many, despite the various redefinitions. Continuing strength expected.
• Initial claims (Th). The best concurrent indicator for employment trends.

The "B" List

• Industrial production (T). Improvement expected in this lagging series, important to GDP.
• CPI (T). Inflation data remains a secondary indicator. It will take a few hot months to bring it to the fore.
• Philly Fed (Th). A rebound expected. This result has earned growing respect.
• Crude inventories (W). Often has a significant impact on oil markets, a focal point for traders of everything.

There is plenty of FedSpeak for those who have been missing that. Options expiration on Friday may delay the exodus to the beach for some.

Next Week's Theme

Quiet calendars and slow trading offer time for collective introspection. There will be plenty of political discussion, tempting investors to draw unwarranted conclusions about their money. I have noted a new theme in the discussions of the Pundit in Chief and the Senior Stock Trader: Some head-shaking over the daily divergences between oil and stock prices. I might be a little early with this expectation, but it is worth thinking about. Expect the pundits to be wondering:

Has the Correlation between Oil and Stock Prices Broken Down?

Eddy Elfenbein noted the breakdown. I am always encouraged when he reports observations consistent with my own. Here is his chart:

This week's problem has two parts:

1. What will happen to oil prices?
2. Will stocks follow?

For now, let's stick to the first question, where there are plenty of opinions:

• Oil supply and demand is now in rough balance. ("Davidson" and some other experts).
• Oil is going lower – back below $30. There is still a glut and higher prices reflect a short squeeze.
• Oil is going much higher. The oil glut is smaller than expected leading to a target of $80. Current trading reflects only momentum, not fundamentals.

….and many similar opinions on all sides.

As always, I'll have a few ideas to add in the conclusion.

Quant Corner

We follow some regular great sources and also the best insights from each week.

Risk Analysis

Whether you are a trader or an investor, you need to understand risk. Risk first, rewards second. I monitor many quantitative reports and highlight the best methods in this weekly update.

The Indicator Snapshot

The Featured Sources:

Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies. This week he expresses more confidence about growth in earnings.

Bob Dieli: The "C Score" which is a weekly estimate of his Enhanced Aggregate Spread (the most accurate real-time recession forecasting method over the last few decades). His subscribers get Monthly reports including both an economic overview of the economy and employment.

The recession odds (in nine months) have nudged closer to 10%.

Holmes: Our cautious and clever watchdog, who sniffs out opportunity like a great detective, but emphasizes guarding assets.

Doug Short: The Big Four Update, the World Markets Weekend Update (and much more).

The ECRI has been dropped from our weekly update. It was not so much because of the bad call in 2011, but the stubborn adherence to this position despite plenty of evidence to the contrary. Those interested can still follow them via Doug Short and Jill Mislinski. The ECRI commentary remains relentlessly bearish despite the upturn in their own index.

It is time for another update of Doug Short's Big Four. The start of another recession would be marked by a peak and significant decline in these indicators. Most investors should take a frequent look at this chart instead of the headlines in the financial press!

Georg Vrba: The Business Cycle Indicator, and much more. Check out his site for an array of interesting methods. Georg regularly analyzes Bob Dieli's enhanced aggregate spread, considering when it might first give a recession signal. Georg thinks it is still a year away. It is interesting to watch this approach along with our weekly monitoring of the C-Score.

RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature his recession analysis, Dwaine also has a number of interesting approaches to asset allocation. This week Dwaine has his own interpretation of the "Big Four" indicators – a recent narrow miss. Despite this, he concludes:

To conclude, looking at the individual co-incident monthly data used by the NBER shows a far more pessimistic view currently than when looking at a syndrome of conditions. But the co-incident data in this particular indicator and the recession probabilities we are registering are not as bullish as the employment data would have you think. In fact, taking our proprietary implementation of the Big-4 index, and comparing it to the last 8 expansions, shows just how meek this recovery has been:

How to Use WTWA

In this series I share my preparation for the coming week. I write each post as if I were speaking directly to one of my clients. For most readers, they can just "listen in." If you are unhappy with your current investment approach, we will be happy to talk with you. I start with a specific assessment of your personal situation. There is no rush. Each client is different, so I have six different programs ranging from very conservative bond ladders to very aggressive trading programs. A key question:

Are you preserving wealth, or like most of us, do you need to create more wealth?

My objective is to help all readers, so I provide a number of free resources. Just write to info at newarc dot com. We will send whatever you request. We never share your email address with others, and send only what you seek. (Like you, we hate spam!) Free reports include the following:

• Understanding Risk – what we all should know.
• Income investing – better yield than the standard dividend portfolio, and also less risk.
• Holmes – the top artificial intelligence techniques in action.
• Why 2016 could be the Year for Value Stocks – finding cheap stocks based on long-term earnings.

You can also check out my website for Tips for Individual Investors, and a discussion of the biggest market fears. (I welcome questions or suggestions for new topics.)

Best Advice for the Week Ahead

The right move often depends on your time horizon. Are you a trader or an investor?

Insight for Traders

We consider both our models and also the best advice from sources we follow.

Felix and Holmes

We are continuing with a bullish market forecast. Felix is fully invested, including several aggressive sectors. The more cautious Holmes is now also fully invested.

Top Trading Advice

Traders are worried about the next two months, notes Steven M. Sears (Barron's). Trading desk chatter about Chair Yellen's upcoming Jackson Hole speech, a possible rate hike, and mean-reverting behavior in volatility. This has them buying call options on the VIX, popularly known as the fear index. Should you join this trade? I am not making a recommendation, but merely raising an idea for consideration. I do not share the concern about the impact of a rate hike. I also note that several of those quoted are selling derivatives.

Dr. Brett asks, Can Successful Trading Be Taught? He answers "yes" and explains how.

In another great post he explains how to "train your brain."

We should all seek information from people with the right expertise and the right experience. What could be better than a clinical psychologist, a teacher, a coach of traders, and decades of personal trading experience? Every trader I know would benefit from Brett's books as well as his blog.

Insight for Investors

Investors have a longer time horizon. The best moves frequently involve taking advantage of trading volatility!

Best of the Week

If I had to pick a single most important source for investors to read this week it would be some ideas that "keep on giving." This contradicts the page view theory of posting: Look for "actionable investment advice."

How to Read Financial News: Tips from Portfolio Managers is worth reading and re-reading. Robert J. Martorana is an insightful author and organizer. He was the editor (I called it 'ringmaster") when I wrote for TheStreet.com's Real Money site. He has organized regular conference calls among advisors, bloggers, and investment managers who all have great ideas and strong credentials. Recently he took some of the calls and turned them into a first-rate educational piece about reading financial news. I am delighted to be included. I hope others find the ideas as useful as I do. If it is popular, perhaps Rob will do more of these.

Another good post on this theme is from Morgan Housel, who describes things that he is "pretty sure about." It is a great list. My favorites are the following:

Recessions and bear markets are very easy to predict, except for the timing, cause, magnitude, duration, location, and policy response.

Look at today's five largest companies in the world. Fifteen years ago, one of them didn't exist, one was a tiny start-up, one was a belittled relic of the dot-com bust, another was fighting to stay relevant after flirting with bankruptcy a few years before. I suspect the next 15 years will be even more extreme.

If you tell people what they want to hear, you can be wrong indefinitely without penalty. This explains the careers of many pundits.

Stock Ideas

Oil exploration stocks? Peter Way has an interesting approach to analyzing the upside/downside risk of this sector.

It is not too late to buy dividend stocks. Philip Van Doorn explains how to sort through the risks.

David Van Knapp has a "periodic table" of dividend champions. You need to read the entire post to appreciate this. Here is part of it:

Holmes will begin contributing an idea each week, a stock we bought for clients a few days ago. I will mention it here and Holmes will also post it each Friday at Scutify.com. While we cannot verify the suitability of specific stocks for everyone who is a reader, the ideas may be a starting point for your own research. Holmes may exit a position at any time, and I am not going to do a special post on each occasion. If you want this information, just sign up via holmes at newarc dot com and you will get email updates about exits. This week's Holmes pick is Eastman Chemical (EMN).

Market Overview and Outlook

The consensus market forecast is now Dow 20,000 (sort of). Victor Reklaitis explains at MarketWatch.

Should you hedge against a crash? Marc Faber is (once again) predicting a 50% market crash. Some are outbidding him by calling for 80%! Barry Ritholtz takes up this topic providing a list of his past predictions and this chart:

Should you hedge against Zika? Josh Brown, expressing realistic concern about the virus, emphasizes the need to separate such events from your investment decisions.

Michael Harris suggests, "The frequency of articles in the financial media and blogosphere with calls for a stock market collapse is often a good indicator of a bullish market". Read the full post for discussion and a chart of events this year.

Should you sell the market high? HORAN Capital Advisors does a complete analysis.

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. The average investor should make time (even if not able to read AR every day as I do) for a weekly trip on Wednesday. Tadas always has first-rate links for investors in his weekly special edition. There are several great choices worth reading, but my favorite is the NYT article from Ron Lieber, explaining how to maintain your 401(k) – ignore it! You can do better if you follow the risk indicators on WTWA, but most people who closely follow their statements buy and sell at exactly the wrong times.

Election Effects

Expect many more articles on the impact of the election and what stocks you should own. I am sticking with my year-long viewpoint: This is all overdone. The new president, whoever is elected, will face a struggle in passing an innovative agenda. No such analysis can be complete without considering the likely makeup of Congress – and that is just for starters. Barron's has a cover story featuring a likely Clinton election and analyzing the policies. The NYT analyzes the difference in tax policies.

Value Stocks

If you missed my special post on this topic, addressing the "value trap" question, please take a look.

Watch out for….

Surprises in ETF trading costs. Chris Dieterich (Barron's) notes that the explosive growth in choices has led to many niche funds without liquidity. He cites some examples where the bid-ask spread imposes a higher cost than the management fee!

Utility stocks. James Picerno wonders whether the "wobbly rally" signals a bubble.

Fancy ideas now aimed at the "little guy." Some of the big guys are cutting allocations.

Final Thoughts

The correlation between oil prices and stocks never made any sense. Some traders prefer commodity prices as an economic indicator. They are skeptical of the official data. The fact that oil prices represented a supply story rather than weak demand did not stop many from hitting the recession panic button. HFT algo's picked up something that was working, and a lot of hot money started following this trade. If you were a trader, you had to take notice. On some days CNBC would view oil traders who said they were watching stocks, as well as stock traders who were watching oil. When a trade is working, you should not go too deeply into the reasons.

Investors got the chance to buy some great stocks at lower prices.

Fundamentally, lower gas prices are good. Past price surges were frequently described as a consumer tax with no corresponding benefit. Whether people spent or saved the extra cash, it had a positive effect. Since all transportation costs were lower, everyone was helped, not just drivers, although the effects are difficult to calculate.

When the market responded negatively to lower prices many started reaching for explanations. Attention turned to those living and working in oil production areas, as well as banks making loans to them. This was true enough and easier to see than the larger, but diverse effect on consumers.

A New Chapter?

With the rebound in oil prices, will the punditry cite this as a reason for higher stock prices? I am not counting on that, but two months ago I highlighted the idea that oil prices might have hit a "sweet spot." Energy company earnings will be better. The potential for higher production places a brake on price spikes. It provides a healthy environment for the economy and the stock market.

The oil/stock relationship may be fading, but count on the trading world to find something new!

Explaining small daily moves in the market averages is like analyzing why a snowflake fell on you rather than the person walking next to you. The many words and hours spent doing this are worse than worthless. The process creates a false sense of logic and order which may well cause mistakes in future decisions.

Weighing the Week Ahead: Has the Earnings Recession Reached a Turning Point?

This week's calendar includes a little data, a lot of politics, slow summer trading, and the last of the earnings reports. I expect financial media to focus on an earnings season post-mortem by asking: Has the Earnings Recession Reached a Turning Point?

Last Week

The important economic news was excellent, and the market reaction was positive.

Theme Recap

In my last WTWA (two weeks ago), I predicted a focus on what the U.S. elections might mean for stocks. With major conventions in both parties and saturation coverage of anything said, that was a pretty easy forecast. My own final thoughts included the idea that there were not yet any clear implications. Since the major averages are about where they were in my prior post, the market seems to agree.

The business of figuring out what a President will do is pretty tricky. Morgan Housel uses historical data to rank past presidents on various criteria – stock market, profit growth, GDP, and inflation. Even knowing your history, the results will surprise you. The "best" presidents on these measure often started at a time when things were pretty bad.

The politics digested, the market turned to the biggest data of the last two weeks, the monthly employment report. The news relieved some continuing concern about the economy.

The Story in One Chart

I always start my personal review of the week by looking at this great chart from Doug Short. While the range is pretty narrow, you can clearly see the early weakness and Friday's rally to a new all-time high. Doug has a special knack for pulling together all of the relevant information. His charts save more than a thousand words! Read his entire post where he adds analysis and several other charts providing long-term perspective.

 

The News

Each week I break down events into good and bad. Often there is an "ugly" and on rare occasion something really good. My working definition of "good" has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!

The Good

• Initial jobless claims remain low. There was a slight miss of expectations this week, but Calculated Risk provides the overall perspective.

• Chemical activity hits a new high. Scott Grannis continues to follow solid indicators that most others miss. This one has a good record and "points to stronger growth than is widely perceived to be the case."

• Vehicle sales beat expectations, but some complained that higher incentives were required.
• Employment increased solidly and more significantly than expected with a net gain of 255K payroll jobs and even more strength in the individual survey. While some are, as usual, seeking nits to pick, these data were an encouraging signal about economic strength. Expect the dialog to shift back to Fed policy. Bloomberg has good coverage.

The Bad

• Rail traffic declined again. Steven Hansen covers the story including non-seasonally adjusted data in several time frames.
• ISM services Index dropped slightly to 55.5, a little below estimates.
• GDP growth was only 1.2% in Q2, significantly lower than expectations. Prof. James Hamilton has an objective analysis of what is going on. Hint: Inventories are crucial, and difficult to gauge. See also Bloomberg on the inventory story.
• ISM Index dipped slightly but remained in expansion territory. Calculated Risk has the analysis and this chart:

The Ugly

Printed firearms on airplanes? The TSA caught this example, but there is a technology war going on. If you read the TSA Blog, you will see how many loaded weapons discovered at checkpoints.

 

 

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. No award this week. Nominations are always welcome. There is plenty of misinformation to refute!

 

The Week Ahead

We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead. You can make your own predictions in the comments.

The Calendar

We have a moderate week for economic data, as earnings season winds down. While I watch everything, I highlight only the most important items in WTWA. It is important to focus.

The "A" List

• Michigan sentiment (F). Good read on jobs and spending.
• Retail sales (F). Consumer spending remains as a key factor for economic growth.
• Initial claims (Th). The best concurrent indicator for employment trends.

The "B" List

• Wholesale inventories (T). Volatile June data, but an important part of gauging GDP.
• Business inventories (F). More June data with implications for GDP adjustments.
• JOLTS report (W). Important to understand labor market structure – not job growth.
• PPI (F). This will become important after a few hot months – but not yet.
• Crude inventories (W). Often has a significant impact on oil markets, a focal point for traders of everything.

 

The big story will still be corporate earnings. We have a little FedSpeak. Expect questions to focus on whether a policy change is more likely after the employment report. Don't expect much new information before Yellen's Jackson Hole speech. More politics, of course, but without a clear implication for markets.

Next Week's Theme

Markets seem to have digested the Brexit story, and surprisingly shrugged off the terrorist violence. The economic data have quieted recession worries, and even turned positive. In the slow summer trading I expect more attention to analyzing earnings. Everyone will be asking:

Has the Earnings Recession Reached a Turning Point?

• Brian Gilmartin continues his strong analysis on this topic with a review of recent reports and emphasis on outlook and future earnings. He is also a "nervous energy bull."
• FactSet reports a generally positive earnings season, with an interesting revenue spread across sectors.

• The bearish side will emphasize multiple points;
  • The streak of losses continues
  • Profit margins remain high, and (theoretically) vulnerable
  • Earnings results reflect stock buybacks and other financial engineering
  • And other points about how earnings are calculated.

In many ways, this debate will hinge upon forward expectations for the economy, business investment, and future profits.

As always, I'll have a few ideas to add in the conclusion.

Quant Corner

We follow some regular great sources and also the best insights from each week.

Risk Analysis

Whether you are a trader or an investor, you need to understand risk. Risk first, rewards second. I monitor many quantitative reports and highlight the best methods in this weekly update.

The Indicator Snapshot

 

The Featured Sources:

Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies. This week he expresses more confidence about growth in earnings.

Bob Dieli: The "C Score" which is a weekly estimate of his Enhanced Aggregate Spread (the most accurate real-time recession forecasting method over the last few decades). His subscribers get Monthly reports including both an economic overview of the economy and employment.

The recession odds (in nine months) have nudged closer to 10%. This does not completely reflect Brexit effects, so we may get a further revision.

Holmes: Our cautious and clever watchdog, who sniffs out opportunity like a great detective, but emphasizes guarding assets.

Doug Short: The Big Four Update, the World Markets Weekend Update (and much more).

The ECRI has been dropped from our weekly update. It was not so much because of the bad call in 2011, but the stubborn adherence to this position despite plenty of evidence to the contrary. Those interested can still follow them via Doug Short and Jill Mislinski. The ECRI commentary remains relentlessly bearish despite the upturn in their own index.

RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature his recession analysis, Dwaine also has a number of interesting approaches to asset allocation.

Georg Vrba: The Business Cycle Indicator, and much more. Check out his site for an array of interesting methods. Georg regularly analyzes Bob Dieli's enhanced aggregate spread, considering when it might first give a recession signal. Georg thinks it is still a year away. It is interesting to watch this approach along with our weekly monitoring of the C-Score.

How to Use WTWA

In this series I share my preparation for the coming week. I write each post as if I were speaking directly to one of my clients. For most readers, they can just "listen in." If you are unhappy with your current investment approach, we will be happy to talk with you. I start with a specific assessment of your personal situation. There is no rush. Each client is different, so I have six different programs ranging from very conservative bond ladders to very aggressive trading programs. A key question:

Are you preserving wealth, or like most of us, do you need to create more wealth?

My objective is to help all readers, so I provide a number of free resources. Just write to info at newarc dot com. We will send whatever you request. We never share your email address with others, and send only what you seek. (Like you, we hate spam!) Free reports include the following:

• Understanding Risk – what we all should know.
• Income investing – better yield than the standard dividend portfolio, and also less risk.
• Holmes – the top artificial intelligence techniques in action.
• Why 2016 could be the Year for Value Stocks – finding cheap stocks based on long-term earnings.

You can also check out my website for Tips for Individual Investors, and a discussion of the biggest market fears. (I welcome questions or suggestions for new topics.)

 

Best Advice for the Week Ahead

The right move often depends on your time horizon. Are you a trader or an investor?

Insight for Traders

We consider both our models and also the best advice from sources we follow.

Felix and Holmes

We have moved to a bullish market forecast. Felix is fully invested, including some more aggressive sectors. The more cautious Holmes is still about 80% invested. The recent strength has moved Holmes into the bullish camp, and we expect an increase in the number of candidates.

Top Trading Advice

Are you worried about "missing" a trade? Do you switch your system a lot? Do you make "boredom trades?" If your answer to any of these is "yes" you should read this post from Adam H. Grimes.

Is your trading affected by high-frequency models? Do you need to change your methods? Josh Brown has some answers and what you should be thinking about.

Brett Steenbarger distinguishes between successful discretionary traders and successful quantitative traders. Which are you?

Successful discretionary traders I've known and worked with have been distinguished by their level of market understanding.  Successful quantitative traders I've encountered have excelled at analysis and prediction.  Sometimes the successful discretionary trader makes use of predictive models as inputs to decisions; the successful quantitative trader will ground models in sound market understanding.  At the end of the day, however, quants trade their predictions and discretionary participants trade their understanding.  One trades universal patterns; another trades insights specific to what is observed here and now in a particular market.

 

Insight for Investors

Investors have a longer time horizon. The best moves frequently involve taking advantage of trading volatility! Mixing insurance and investments is a terrific way to kill two birds with one stone.

Best of the Week

If I had to pick a single most important source for investors to read this week it would be Tony Isola's discussion of widely believed lies. He includes a great list. I like so many entries that it is tough to pick a favorite. I'll go with "Mixing insurance and investments is a terrific way to kill two birds with one stone". What is yours?

Stock Ideas

The Zika virus is prominent in the news. While we all sympathize with the victims, we can also invest in companies working on a cure. Angus Nicholson of IG has some interesting suggestions for biotechs set to win big.

Chuck Carnevale turns his focus to dividend growth stocks in healthcare. This is an attractive sector, and he provides nine timely ideas in Part 1 of 3. This entry was excellent and we look forward to the future installments.

Holmes will begin contributing an idea each week, a stock we bought for clients a few days ago. I will mention it here and Holmes will also post it each Friday in a Scuttle at Scutify.com. While we cannot verify the suitability of specific stocks for everyone who is a reader, the ideas may be a starting point for your own research. Holmes may exit a position at any time, and I am not going to do a special post on each occasion. If you want this information, just sign up via holmes at newarc dot com and you will get email updates about exits. This week's Holmes pick is Enbridge (ENB).

 

Market Overview and Outlook

Josh Brown explains (Rules-based tactical vs wizardry and witchcraft) why you should not attempt to imitate big-firm pronouncements by following their calls.

Eddy Elfenbein also weighs in on market timing, reporting the dramatic difference in a Fidelity study.

Avondale's weekly Company Notes Digest is especially useful during earnings season. You do not have time to listen to all of the conference calls and you certainly cannot count on the media coverage. This is a good way to find important themes. (terrorism more important than Brexit). Also why Aetna is leaving the health insurance exchanges. And much more.

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. The average investor should make time (even if not able to read AR every day as I do) for a weekly trip on Wednesday. Tadas always has first-rate links for investors in his weekly special edition. There are several great choices worth reading, but my favorite is Jason Zweig's important warning about the risks of too much stock in your 401-K account. He writes:

Since June, four dozen companies whose stock fell by at least half in 2015 have filed disclosure forms to the Securities and Exchange Commission on their 401(k) and other savings plans. By my estimate, workers at these companies lost $1 billion in 2015 by over-investing in the stock of their own employer.

This is very important. I frequently see such risks in the accounts of potential clients. It is one of the first things we fix.

Value Stocks

Since value stocks have lagged, many strong voices have suggested that the market message is that the economic cycle is over. I covered this subject last week. If you missed it, please take a look. I provide discussion of several stocks recently dissed in the media.

Watch out for….

For those at or nearing retirement, here are eleven common Medicare mistakes.

Final Thoughts

Over the past several weeks we have gotten quite a bit of new evidence to guide our investing. I see four major themes:

1. Most investors seem to be looking beyond concerns about uncertainty and matters without quantifiable market impacts – Brexit, the election, terrorism.
2. The economic data looks better than it did in the second quarter.
3. Earnings expectations seem to have made a trough.
4. Some sectors are much more promising than others both because of potential earnings growth and current valuation.

The biggest concerns relate to improving earnings, the need for more business confidence, and a resulting increase in corporate investment.

We are entering a period where we can expect a showdown on the economy and earnings – probably in Q3, despite the upcoming election. Fasten your seatbelts!

Value Traps?

Wall Street loves to name things. The unofficial definition of a "value trap" is a cheap stock that is stuck around the current price.

Those who focus on what happened in the past have a big advantage. They can cite facts, past performance, and explanations that make them seem to be really smart. They are helping you to understand what has recently happened, and also sharing the current conventional wisdom. How can anyone disagree? The story would get an "A" in a journalism class.

Explanation of what has already happened is fine for a journalist, as long as readers are cautious about extrapolating the results. Piling into crowded trades might work for a while, but eventually leads to big losses. The very best journalists do not become great investment managers.

As an example, I once read an article in a print magazine about the worst current stocks to hold. The author had some sort of earnings screen which cranked out stocks with low earnings. I owned four of the ten! What the author did not understand was that my stocks were all asset plays, valued on the basis of things like real estate holdings and other hard assets. I used his list to explore other possible ideas.

Michael Santoli and Value Traps

Michael Santoli, who has broad experience in market commentary, recently became a Senior Markets Commentator at CBNC. I have followed his work for many years and turn off the "mute" if his topic seems interesting. That means I regard him as interesting and pretty good. He recently presented on the theme of this blog post: Is 2016 the Year of the Value Trap? He accurately observed that cyclical stocks trade at low PE's at times of economic tops and high PE's when the market is low. This widely-known observation (Peter Lynch from 30 years ago, for example) is certainly accurate. Santoli listed several current value trap stocks. He informed us that the market was suggesting the top of the economic cycle.

Since I have a value approach, driven by a sophisticated analysis of economics, I looked at his list with interest. Several of my holdings were on his list (Ford, Gilead, Gamestop), and I added another today! (Delta)

Santoli's Error

Santoli's work is an accurate representation of current thinking, and therefore solid journalism. The problem is that he is attempting to explain what already happened. He does this very authoritatively. His real message is that traders have a fixation on yesterday's news. Here are the problems:

• If the market has all of the answers, investors, traders, and CNBC watchers cannot gain any edge. Warren Buffett says that he would be on a street corner selling pencils if markets were efficient. Does Santoli really believe that he or his viewers can make money from an authoritative explanation of yesterday's news?
• He is ignoring the important investing concept of being contrarian. That is where you can make real gains.
• He is ignoring the strong mean-reversion tendencies of relationships – like that between growth and value stocks.

My Alternative Approach

I have seen this argument many times before. Past "value trap" candidates were MSFT, INTC, and CSCO, to pick a few prominent examples. Putting a label on something is not analysis.

In sharp contrast, my approach is that 2016 is the year of the value stock. (write to main at newarc dot com for the report). It is better to profit from finding market errors than a slavish devotion to what worked last month or last year. The current market is punishing cyclical stocks with recession valuations, with no recession in sight. We have two great ways to play this theme:

1. If there is a near-term catalyst, we just buy the stock in our long-only program.
2. If we expect time before the catalyst, we sell near-term calls with a target of 9% return. If the stocks are safe, the return is safe.

When others see a value trap, I see an income opportunity. Take what the market is giving you!

Not Convinced?

The flip side of the Santoli reasoning – the market is right – is that we should all be buying anything with a dividend, even if we are paying a multiple of 26 for 6% growth.

Few articles and TV programs provide real help, since being contrarian – by definition – goes against the grain. You cannot look smart like Mr. Santoli. We will not have the final verdict for months. It would be refreshing if we had some journalists who were willing to go against the grain.

focused on the "value trap."