Weighing the Week Ahead: What is the Risk/Reward for Stocks?

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This week’s economic calendar is loaded, and packed into a holiday-shortened week. There will also be plenty of FedSpeak, encouraging the favorite game of not just reporting data, but wondering how the Fed will see it.

When it comes time to put it all together, pundits will be asking:

What is the risk/reward tradeoff for stocks?

Last Week

The news was very good, and the market responded.

Theme Recap

In my last WTWA, I predicted that the pundits would be focused on the oil price rally and what it meant for investors in stocks. That was a good call, with the theme continuing through week’s end. Several sources even cited both the recent strength and the apparent ceiling at $50/barrel. As a bonus, the strong housing data revived the “springtime for housing” theme from two weeks ago. Despite the competition from election news, these were important stories. If you prepared in advance, you were better able to handle the news.

The Story in One Chart

I always start my personal review of the week by looking at this great chart from Doug Short. He 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.

SPX-five-day

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 most important economic and market news was quite good.

The Good

  • Q1 GDP was revised higher, up 0.8% instead of 0.5. This is old news, but it does provide a slightly stronger base for the year. More importantly, the current data suggests that Q2 will be much stronger – some estimates now reaching 3 %.
  • Jobless claims declined again, to 268K. People are not losing jobs, especially when considering the higher working population. We also need job creation. Bespoke has the story, and a great chart.

     

052616-Initial-Claims-SA

  • Industrial production jumped 5.8%, the most in eighteen months. Utilities were behind much of the gain.
  • The Michigan sentiment index showed a surprising increase of 5.7 points, for the highest reading in nearly a year. Jill Mislinski provides a complete analysis and Doug Short’s chart. You can readily see that the index is back at healthy levels, topped only by the Y2K era.

Michigan-consumer-sentiment-index

 

  • Housing data showed real strength.
    • Pending home sales popped 5.1%. (Calculated Risk)
    • New homes sales had the best showing since 2008. Inventory is now down to 4.7 months. (Calculated Risk)

NHSApr2016

The Bad

  • April durable goods fell 0.8%, worse than expectations of a 0.3% decline. (BI).
  • Transportation “stunk in April” according to New Deal Democrat. It has certainly been the worst part of the economic story. Check out the full post for details. Steven Hansen at GEI has a thoughtful analysis suggesting that this was a “huge recession which never came.” Think about coal.
  • Puerto Rico debt measure is stalled in the Senate after progress in the House. This represents more than the specific issue. It is something of a litmus test for Speaker Ryan’s ability to negotiate. That is the real market significance.

     

The Ugly

The vulnerability of government technology. The multi-year pressure on government spending has had a definite effect on equipment. Upgrades that would be routine in business simply do not happen in government. It is a vicious cycle. The older the equipment and software get, the higher the maintenance costs. Barbara Kollmeyer has a good analysis of the problem, including this chart.

MW-EN838_gao226_20160526041302_NS

This problem is deeper than general obsolescence. The determined hackers are looking for vulnerable systems. There is a likely collision course, already seen in prior attacks.

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. Think of The Lone Ranger. This week’s award goes to Narayana Kocherlakota, former President of the Minneapolis Fed. Many of those who have moved on from a roles as official participants in Fed meetings are speaking out. This valuable information gives us an inside look. Sometimes the message is that we are making too many unjustified inferences. Kocherlakota writes:

Timing alone, though, hardly merits so much attention. To understand why, consider two possible scenarios. In one, the Fed starts raising rates in June and then adds another quarter percentage point at every second policy-making meeting (once every three months) for the next three years. In the other, the Fed waits until the second half of 2017 and then adds a quarter percentage point at each of the next 12 meetings. The second path represents slightly easier monetary policy, but most economic models would suggest that there would be almost no difference in the effect on employment or inflation.

It is possible that no information will be more important for investors over the next two years or so.

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 very big four-day week for economic data. (Dare I say YUGE?) I highlight the most important items, helping us all to focus.

The “A” List

  • The employment report (F). Remains the biggest news of all.
  • ISM index (W). Great read on an important sector. Concurrent with some leading qualities.
  • Personal Income and spending (T). April data, but a continuing rebound here is important for economic expansion to continue.
  • Auto sales (W). A strong indicator of economic growth. F150 sales? Many believe this is linked to construction and small business.
  • Consumer confidence (T). This is the Conference Board version. It provides information on job creation and spending plans that you will not get elsewhere.
  • ADP private employment (Th). This independent read on private employment growth, using contemporaneous data, deserves more attention.
  • Initial claims (Th). The best concurrent indicator for employment trends.

The “B” List

  • Fed Beige Book (W). The anecdotal report that will inform participants at the upcoming Fed meeting will not tell us much, but pundits will find something!
  • PCE prices (T). The Fed’s favorite inflation measure. Not much change expected.
  • Construction spending (T). Volatile April data is still relevant because of the importance of this sector.
  • ISM services (F). Not quite as important as manufacturing, but only because the data series is shorter. Will recent strength continue?
  • Trade balance (F). April data relevant for Q2 GDP calculation.
  • Crude inventories (W). Often has a significant impact on oil markets, a focal point for traders of everything.

Not much will be happening at the start of the week, with many slow to return from a long weekend. Expect volume to pick up.

There is also a full slate of Fed speakers, including Chair Yellen.

Next Week’s Theme

 

It is a big economic calendar and a holiday-shortened week. There will be a trifecta of questions:

  1. Economics. Will the recent data rebound continue?
  2. The Fed. Will strong data increase the pace and timing of rate increases?
  3. Stocks. How will stocks react? Will good news be good?

The pundits will circle around these topics. Even the pundit-in-chief seems to be shifting with the winds. They will analyze the data, emphasize how important Friday will be for the Fed, and wind up asking:

What is the risk/reward tradeoff for stocks?

 

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

 

Indicator Snapshot 052816

The Featured Sources:

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

Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies. This week he observes that more people are using forward earnings, and many are thinking about 2017.

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). Monthly reports including both an economic overview the economy and employment.

RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature the 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.

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

Noteworthy this week:

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 and no cookie-cutter approach. 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.
  • Felix and Holmes – top artificial intelligence techniques in action.
  • Why 2016 – The Year of the 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. (Please send any 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 our neutral market forecast. Felix is fully invested, and with more aggressive sectors. Most sectors remain in the penalty box. The (usually) more cautious Holmes is once again fully invested. Holmes uses a universe of nearly 1000 stocks, selected mostly by liquidity. Even when the overall market is neutral, there will often be some strong candidates. That is what we see now.

Top Trading Advice

Dr. Brett Steenbarger emphasizes emotion-free trading. He writes:

The emotionally intelligent trader can prepare for frustration, fear, greed, and other seemingly disruptive states.  By anticipating them, rehearsing our response to them, and channeling their energy constructively, we turn our experience into a powerful trading asset.

Holmes is barking enthusiastic agreement, and Felix is nodding wisely!

12 good points from Paul Tudor Jones (via New Trader U). They are all worth considering, but my favorite is #9:

“Always think of your entry point as last night’s close.”

 

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, it would be the overall market outlook from David Templeton at HORAN Capital Advisors. He covers many of the themes I regard as most important, but readers will enjoy getting the message from different sources.

In particular, he deals with the common argument about good news: The Fed will raise rates. He writes as follows:

Historically though, the initial moves in rate increases by the Fed is pursued to get rates back to a more normal level. As a result, when interest rates are increased from a level below 5% stocks tend to rise. In short, below the 5% level there is a positive correlation between interest rates and stocks.

correlation rates market

Stock Ideas

Chuck Carnevale has a terrific follow-up to his prior article on Emerson Electric (EMR). Individual investors who do their own stock picking should read this carefully. Not only does he provide great analysis and advice about entry points, it illustrates what your research should cover.

Time to buy Europe? Jason Zweig (WSJ) recounts all of the bad news, as well as the depressed stock levels. Is it time to “buy low?”

And for income investors – always consider the dividend kings. Here are eighteen companies that have increased dividends for at least 50 years. If that level of income is enough, this kind of stock may be the answer. Philip Van Doorn (MarketWatch)

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 always several great choices worth reading, but my favorite this week is from Ben Carlson for his discussion of Social Security Benefits. Here are but two points from a great post. You should read it all.

  • Social Security is a more important part of retirement than many realize, covering more than half of the needs for most people.

Screen-Shot-2016-05-09-at-9.35.14-AM

  • Waiting longer for benefits generally helps, if you are able to do it.

Screen-Shot-2016-05-20-at-4.19.39-PM

The article also has some links to good sources. Your financial advisor should be considering the Social Security contribution when figuring out your retirement needs and asset allocation.

Older investors pick their biggest mistake – not starting early enough in saving for retirement.

Value Stocks

How about AbbVie as a retirement holding? Looking at the numbers shows value, but perhaps no immediate catalyst. Where others see “value trap” I see an opportunity for enhancing good dividend yield by selling near term calls. Take what the market is giving you!

Energy Stocks

There is not a specific recommendation here, but the information is important. I am watching it, and so should you. What companies begin to profit at various levels of oil prices? (The Daily Shot)

5731ace1-a511-4e58-90cf-70fe183dad33

Watch out for….

Safety stocks. Seth Masters asks, Are “Safety Stocks” Truly Safe? Many of the relevant sectors have been part of the recent quest for yield. With investors fearful about a weak economy – or even recession – something with a dividend yield looks great. If the economy improves, it is a different story, as this chart shows:

 

w1056

Bonds. In the “man bites dog” department, even Bill Gross is going negative on bonds. Mr. Dow 5000 is still not recommending stocks.

 

Final Thoughts

 

The risk/reward debate includes many viewpoints, but the worries usually dominate.

  • These stories are more newsworthy, so they get higher ratings. Barry Ritholtz has a good article on “click bait.” One of his examples is the repeated story about George Soros buying puts. I have two different posts (here and here) showing the error of this approach, but the scary stories get the readership.

1200x-1

 

  • The negative predictions call for extreme outcomes (market 50% over-valued – various sources, we are already in a recession – Peter Schiff’s claim this week, Europe and the rest of the world will crumble, or maybe it will be China. There is just enough plausibility in the arguments that many people are “scared witless” (TM OldProf euphemism) If you think the downside is 50% and the upside only 2%, what would you do?
  • The positive arguments are generally modest and restrained. Ed Yardeni (who also accurate downplayed the recession worries in January) sees a 10% upside for stocks in the next year. The Fast Money gang acted like he was crazy. “What needs to happen for that?” was the question. Not much, he explained. A little earnings growth, no recession, and a little inflation. It was a modest claim.
  • Politicians of all stripes find it useful to highlight dissatisfaction. This political approach is effective when running for election, but it is dangerous for investors. It is easy to think about societal ills rather than improving your investments. You cannot improve public policy by making poor investment decisions and losing your money!

For a change, why don’t we ask what could go right? (The Barron’s cover story this week is on the right track, repeating some of our main themes — but perhaps not analyzed as thoroughly. It is always helpful to have more voices helping investors).

  • The economy is not headed for recession, and actually shows promise on the big-purchase items like autos and homes.
  • Employment is good and improving.
  • Earnings may have troughed with the energy crash (apparently) behind us. Meanwhile, energy prices remain relatively low.
  • Interest rates remain low – this makes companies more profitable and stocks more attractive.
  • The dollar strength seems to have leveled off, helping the earnings of multi-national companies.
  • Economic and market cycles do not die of old age. A “mature” cycle has the same survival potential as a new one, despite the appealing metaphor of the doddering old person.

The market could easily gain 10% next year, and the year after that. Picking value stocks could increase your potential, since the economic skepticism has created recession pricing.

Most do not understand this key point: We could be having the same debate two years from now! Or even three.

And stocks could be 50% higher.

Weighing the Week Ahead: How Should Investors React to the Oil Price Rally?

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This week’s economic calendar is pretty light. Market participants will be looking to an early getaway for the long weekend. While there will be plenty of entertaining FedSpeak, I expect a different topic to be at the fore. Pundits will be asking:

Should investors react to the oil price rally?

Last Week

The news was pretty good, but the stock market was not.

Theme Recap

In my last WTWA, I predicted that the punditry would be asking whether it was “springtime for housing”. That was the recurring topic as housing news was reported on several different days and garnered plenty of discussion. Competition came from the Fed Minutes, some dramatic earnings reports, and the election race.

The Story in One Chart

I always start my personal review of the week by looking at this great chart from Doug Short. He 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.

SPX-five-day

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 economic and market news, on balance, was pretty good.

The Good

  • Housing starts increased to a 1.172 annual rate, beating expectations. Calculated Risk has a complete analysis. I am especially interested in single-family building permits, a good leading indicator. Bob Dieli’s monthly economic report always updates this chart:

Dieli Building Permits

 

  • Existing home sales were up 5.45 million (SAAR), the top of the Calculated Risk range for a solid report. Bill writes:

    Note that January and February are usually the slowest months of the year and March and April are the beginning of the “selling season”.  This is a solid start to the year.

    EHSNSAApr2016

  • Jobless claims down ticked to 278K, in line with estimates and below the 300K level that some have been citing. (The four-week moving average was up slightly).
  • Industrial production rose by 0.7%. Eddy Elfenbein has a good report, noting that this interrupts the downtrend since November, 2014. He also points out the effect on the Atlanta Fed’s GDP forecast for Q2, now up to 2.8%
  • Sentiment remains very negative. Urban Carmel summarizes asset allocations and economic skepticism. Ben Eisen of the WSJ cites four stats, including the fund flows in the chart below. Schwab’s Liz Ann Sonders agrees. She notes only negative questions from both investors and advisors, “all almost bordering on Armageddon.”

w1056

The Bad

  • The Philly Fed indexremained negative and essentially unchanged, -1.8 on the diffusion index. Employment improved dramatically, but remained marginally negative. The outlook fell a bit but remained strongly positive. There was little market reaction.
  • Fed minutes showed more chance for a June rate increase. Our go-to Fed expert, Tim Duy, sees a June hike as a bit less than 50-50 but July as quite possible. The Fed remains more confident about the economy than most market participants.
  • LA port traffic declined. Calculated Risk uses a rolling twelve-month average to control for seasonality. The decline was 0.7% for inbound traffic and 0.8% for outbound. Steven Hansen opines that this raises recession concerns.
  • Rail traffic “moves deeper into contraction”. Steven Hansen looks at a variety of rolling averages, including some analysis that adjusts for the declining coal shipments.

The Ugly

State and local pension funds. Chicago provides an example. A decision of the Illinois Supreme Court struck down an “overhaul” of the system, adding $11.5 billion to the deficit, now $18.6 billion. The fund covers 70,000 workers and in the absence of any changes, will run out of money in ten years. (Crain’s Chicago Business)

Noteworthy

Try this financial literacy quiz designed by economists from Wharton and George Washington. (via Shawn Langlois) I am confident that WTWA readers will do well. Keep in mind that less than 1/3 of the population could get all three questions right!

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. Think of The Lone Ranger. This week’s award goes jointly to Gene Epstein of Barron’s and New Deal Democrat of the Bonddad Blog and xe.com. Both take on the frequent current scary articles about the “flattening” yield curve, citing the yield difference between the ten-year and two year notes. That spread is currently 0.94 percentage points. Those on a mission often cherry-pick the part of the curve to analyze, and cry alarm whenever it gets a little smaller.

Epstein points out that until the curve actually inverts (a spread of less than zero) there is not a reliable recession indicator.

2016_05_23_cmyk_NL_

NDD has a great article with plenty of charts. He calls out the “doomers” with this commentary and chart:

In the last week or so there have been a spate of articles – from the usual Doomer sources but also from some semi-respectable sites like Business Insider vans an investment adviser or two ,see here ( https://lplresearch.com/2016/05/19/is-the-yield-curve-signaling-trouble-… ) – to the effect that the yield curve is flattening and OMG RECESSION!!! Here’s a typical Doomer graph – that draws a trend line that ignores the 1970s and neglects to mention that 2 of the 4 inversions even within the time specified don’t fit:

image_686

I wish that more publications would recognize the Silver Bullet winners and writers like them. It is difficult to call out weak and biased posts. There is little reward for good and courageous analysis.

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 modest week for economic data. I highlight the most important items, helping us all to focus.

The “A” List

  • New home sales (T). Continuing strength in housing?
  • Durable goods (Th). Important April data. Continuing recent strength?
  • Initial claims (Th). The best concurrent indicator for employment trends.
  • Michigan sentiment (F). Best for job growth and prospective spending. Strength continuing?

The “B” List

  • Pending home sales (Th). Unlikely to match last month. Not as important as new sales, but a read on the market.
  • GDP second estimate for Q1 (F). This will get attention, but it is old news by now with Q2 more than half over.
  • Crude inventories (W). Often has a significant impact on oil markets, a focal point for traders of everything.

There is plenty of FedSpeak, including a Friday appearance by Chair Yellen. Things will be slowing down by Friday as some slip away early for a long weekend marking the unofficial start of summer.

Next Week’s Theme

 

It is a pretty light economic calendar. In addition to the daily dose of analysis by pseudo-experts on the Fed, I expect to see some serious discussion about energy prices. Will the oil rally continue? What does that imply for investors and traders?

Voting a tentative “No” is Dana Lyons, who cites technical resistance and concludes as follows:

Will the oil rally stop here? We have no idea – but we wouldn’t be surprised to see the rally get clogged up, at least temporarily.

tumblr_inline_o750onwm8P1sq14jh_500

Oil & Energy Insider is also cautious but more bullish, mostly citing fundamentals. Their free edition includes this analysis:

Oil prices bounced around this week, flirting with $50 per barrel but stopping short of that key threshold. The major supply outages in Nigeria (now at 900,000 barrels per day) and Canada (more than 1 million barrels per day) continue to put upward pressure on oil prices as they are erasing the supply overhang. Still, much of that will be temporary. The EIA poured a bit of cold water on the rally this week, reporting a surprise uptick in oil stocks. At the same time, U.S. production continues to slowly erode. The markets are more confident than at any point in recent weeks that prices won’t crash back into the $30s, but more movement to the upside is not a given.

Their premium edition (which requires a subscription) is headlined Fundamentals Starting to Underpin Oil Price Rally. They cover a wide range of considerations, but include key questions: When might we expect Nigerian supply to rebound? Most investors would find their analysis quite helpful:

–    The Niger Delta Avengers have attacked pipelines and platforms in Nigeria, knocking 800,000 barrels per day offline.
–    Between 2006 and 2009 Nigeria suffered a similar level of attacks and outages, and a sweeping amnesty policy helped bring an end to the violence. The new President Muhammadu Buhari has taken a tougher line, ending patronage that existed in security contracts for many militia members, a move that has contributed to the resurgence in pipeline attacks.
–    Nigeria’s cash reserves are running low as its economy slows. Reserves have plunged from $49 billion in 2013 to $27 billion recently.
–    Eni (NYSE: E) suffered the latest attack this week. Fellow oil majors Royal Dutch Shell (NYSE: RDS.A) and Chevron (NYSE: CVX) have also seen their infrastructure taken out from explosions.
–    Nigeria’s oil production is at its lowest level since the 1980s. The attacks show no sign of letting up, and as of now the Nigerian government is unwilling to back down.

 

 

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

Indicator Snapshot 052016

The Featured Sources:

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

Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies. This week he observes that more people are using forward earnings, and many are thinking about 2017.

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). Monthly reports including both an economic overview the economy and employment.

RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature the recession analysis, Dwaine also has a number of interesting approaches to asset allocation. This week Dwaine opened to the public one of his subscriber-only research reports. He notes that one of his recession indicators has moved up to 60%. He goes on to explain that he uses a group of six different methods as his preferred approach. He writes as follows:

Another way to look at the RFE is to average the current recession probability showing on each of its six model components, which is currently showing a 14.6% probability of recession. This model appears to have served well in the past, with zero false positives above readings of 0.20.

2016-04-26_1743

Georg Vrba: The Business Cycle Indicator, and much more. Check out his site for an array of interesting methods.

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

Noteworthy this week:

Hedge funds are using artificial intelligence to analyze the Fed minutes. Guess who can do it faster – you or them?

Peter F. Way reports on the hedging techniques of “big money” traders, identifying candidates with the best risk/reward balance. Apple?

501110-14632831049172328

 

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 and no cookie-cutter approach. 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.
  • Felix and Holmes – top artificial intelligence techniques in action.
  • Why 2016 – The Year of the 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. (Suggestions and questions welcome!)

 

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 our neutral market forecast. Felix is about 75% invested, and with less aggressive sectors. REITs and utilities have moved near the top of the list. The (usually) more cautious Holmes remains almost fully invested. Holmes uses a universe of nearly 1000 stocks, selected mostly by liquidity. Even when the overall market is neutral, there will often be some strong candidates.

Top Trading Advice

Dr. Brett Steenbarger has important advice about Seeing Beneath the Market Surface. He writes:

Markets move higher, markets move lower.  The question worth continually posing is, “Is the market getting stronger or weaker?”  This is a meaningful question because a market that moves higher can be getting weaker and a market that moves lower can be getting stronger.

Read the entire post as he explains how to apply this approach.

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, it would be this Forbes article by Brett Steenbarger (and not just because he has some kind words about WTWA, but thanks!) As a psychologist and trading coach he sees things missed by others and explains them very well. I share many of his themes, but often cannot communicate them as well. People need to be open to new ideas and unemotional in executing the plan.

Few can meet these tests.

Stock Ideas

Chuck Carnevale has a timely post on cyclical stocks. He shows how to use his tools to analyze valuation in this difficult sector. When can these stocks be right for dividend-oriented, conservative investors? Emerson Electric (EMR) is his illustration. If you agree with our experts that a recession is not imminent, cyclical stocks are a good place to shop.

How about Kroger? Hale Stewart makes this a good example of how to search for a good stock – find an interesting sector, a cheap stock, and a catalyst.

Retailers that might profit from the “Amazon effect.” (Philip Van Doorn) Hint: they need to change their business model.

Marc Gerstein has some interesting contrarian retail plays. Marc always uses some science in his method. Here he identifies desired characteristics, develops a screen, and looks for a catalyst. It is another article that goes beyond simply delivering stock ideas (although it does that). Stock screening meets Peter Lynch.

How about solar? If energy prices improve, solar stocks do as well. Travis Hoium has an interesting argument favoring First Solar (FSLR) over some alternatives.

Outlook

Why is it so attractive to be negative on your investments? One good answer lies in Morgan Housel’s explanation of volatility and how it can take investors off course. It is so easy to think about an account in terms of how far we are from the past high. In fact, that is the condition over 87% of the time. Each year includes a lot of big moves that seem small when you later look at the long-term stock chart. He uses 1998 as a year of major gains, but only if you were able to ride out the major swings. I like this chart showing time spend below the prior high:

sp6_large

 

 

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 this special edition. There are always several great choices worth reading, but my favorite this week is from Carl Richards at Investment News. He suggests that a good financial advisor helps clients by turning off the news spigot. (If you do not use a financial advisor, I recommend that you turn it off anyway! You might make an exception for WTWA).

There’s a valuable role for us to play as real financial advisers, that of the human curator. Do our clients really need to spend hours sorting through their feeds and trying to decode the headlines or could we be doing that for them? What should they be paying attention to?

For instance, one friend shared with me that when he turned off the financial news spigot, he calculated that he saved two to three hours every night. Do the math and it ends up being a savings of 40 or so days each year.

Value Stocks

Time to buy again? They are cheaper than the broad market and that seemed to be the story last week.

Watch out for….

Boeing (BA). Barron’s warns that demand for fuel-efficient aircraft has declined.

Bonds and fund redemptions. If the ten-year note increases one percentage point, to something like 2.8%, you will immediately lose 9% on your investment. It would take a few years to make that up, even if rates moved no higher.

Investment big-shots using a platform to talk their book. Are they really there to help you? This is an interesting summary of recommendations at the recent SALT conference, which was breathlessly covered in the media. Most of the topics would require a lot of research, but the Sherwin-Williams (SHW) recommendation (You can’t buy paint online) caught my attention. It took about five seconds to discover the error of this assertion.

13F filings. Here is one example that highlights stocks from David Einhorn. This, and nearly everything written about 13F reports is misleading. This WSJ article headlining George Soros is especially misleading. I explained this carefully (for the second time) but no one cares. We can think of it as our secret!

Final Thoughts

Knowing economics helps to understand energy pricing, but the payoff for that knowledge has been delayed. In my most popular article ever on Seeking Alpha, I noted a few basic facts about energy including the relatively small gap between supply and demand. We are now observing the closing of that gap. It could (and will) continue in one of three ways:

  1. Reductions in supply through economic forces. U.S. producers responded, but most others have not – so far at least.
  2. Increases in demand through a growing economy. This is happening with record miles driven in the U.S. and many new consumers worldwide.
  3. External shocks, through weather, disasters, or war.

The same economic effects may well push against a price increase. The reduction in rig counts, for example, seems to have paused for the first time in eight weeks. Bespoke has one of their great charts using data from the primary source on drilling activity, the Baker-Hughes weekly report.

052016-Baker-Hughes

 

Even if $50/barrel represents an intermediate high for oil prices there are important favorable consequences:

  1. The savings to the consumer, compared to recent years, remains large;
  2. The fears about failing companies and job losses, exaggerated and localized, will be less of a story.;
  3. The concern about banks failing due to oil company bankruptcies will be reduced.

Current oil prices may represent a sweet spot both for the energy sector and the overall stock market.

Government Reports from Big-Money Investors: Three Things You Need to Know (but don’t)

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Four times a year big-time money managers are required to file form 13F with the SEC.  This always sparks news stories naming the most important investors, people like George Soros and Warren Buffett, and drawing conclusions about what they are doing.  The implication is that you might benefit from looking over their shoulders.

You won’t!  The information is worse than worthless — it is misleading.  Here is why, the three things you should know:

  1. The reports are old news.  The law provides 45 days to file after the end of the quarter and there is no incentive to be early.  The process for filing has been streamlined for the modern age, but the requirements have not.  This delay is an eternity in the modern investing world.  The consumer of the information has no idea whether the positions are still valid.  Has recent news been important?  Could the firm reporting be selling into the strength generated by the report?  They have no obligation beyond the legal reporting.  They are free (and should be) to trade in the best interest of their investors as they get new information and opportunities.
  2. The reports cover only long positions.  There is no requirement to report “shorts.”  The implications of this gap invalidate the reports.  Bill Ackman, for example, is widely known for his short position in Herbalife (HLF) and his very public attacks on the company and its business model.

If you relied upon the government to inform you about Mr. Ackman’s short positions, the 13F would tell you absolutely nothing!

Ackman Longs

Here is another example.  George Soros reported long positions in Barrick Gold and a call (a bullish position) in a gold ETF.  What do we know from this?  Nothing at all.  He might actually have a neutral gold position like a pairs trade, long Barrick and short another gold stock that he believes to be weaker.  We don’t know, because shorts are not reported.

His long call position in the gold ETF might be paired with a short call.  Whether the overall position is long or short depends on which strike and expiration date was bought and sold.  Once again, we know nothing about the overall position.  I do not know from the filing whether Mr. Soros is really bullish on gold, and neither do you.

3. The report on options positions is  — can’t think of a kind word — clueless.  Since the government will not approve a method of analyzing an options position, they require something that is really stupid.  The filer reports long options only.  This means that there are no spreads, including both long and short options, even though that is the most common method of trading for big-time investors.  Worse yet, the long options are not described in terms of their actual value.  The value of each option is assigned the nominal value of the underlying stock!!  Professional traders, and the Nobel-Prize winning options modelers, know that an option has a value based upon a variety of factors, including the stock price, the strike price, the time to expiration, interest rates, expected volatility, and expected dividends.  The option has a theoretical value based upon these factors and a “delta” (the expected change in option value for each dollar move in the underlying).

I understand the government problem in assigning a “theoretical value” and assuming some level of expected volatility.  That does not excuse these blunders:

  • Ignoring short positions in the spread
  • Assigning the underlying stock value to options, even those that are far out-of-the money

Here is a great example from Mike Saltzman, my top researcher, associate portfolio manager, and a veteran options trader.

The reported SPY put position (a bearish bet) is 2.1 million.  The government filings multiply that times the value of the underlying spy, reaching a total value of $430 million or so.  Since the total number of puts is greater than last quarter, this is seized upon in the popular media.

In reality, we have no idea of the strike or the time to expiration for these puts.  The implication is that we have no idea of the value or the deltas for each put.  If far out of the money, they might be cheap protection.  More likely they represent a spread, the sort that a professional trader might buy as cheap downside protection.

Suppose, for example, that you did this spread.

Buy 1.05 million Jun’16 180P for .21

Sell 2.1 million Jun’16 175P for  .12

Buy 1.05 million Jun’16 170P for .09

This is a put butterfly, an extremely common  limited risk position. We own the same number of long and short option positions, so risk is limited. This particular butterfly would cost about $.06 in option, and $6 in commissions. It has a lot of potential. If the SPY goes down to 175 it would make  $9.94 per spread or almost  This spread has a very small short delta component.  It will only make money if the SPY were to fall  more than 10% in just a few weeks. It costs eighteen cents (or about 180K) and might make almost $10 million.

This is not really a short bet on the market.  It is downside protection purchased on a risk/reward basis.

Meanwhile, on the 13F this would show up as being long 2.1 million puts, with a value of (think short value) of $430 million — completely unrelated to the actual position value or properties.  There are many other examples of spreads that would fit the 13F filing,  including some that actually are bullish plays on SPY.

From the filing itself we cannot even conclude that Mr. Soros has a short position in SPY.  It is extremely unlikely that he simply bought 2 million puts without any offsetting short puts.  Professional traders usually work with spreads.

Conclusion

The 13F report is an unhelpful and costly exercise.  Those who take it seriously may well do the wrong thing.

I wrote about this two years ago but the media coverage has not improved.  The best investment advice is to ignore these stories.

 

Weighing the Week Ahead: Springtime for Housing?

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This week’s economic calendar includes some key data on the housing market and few other major reports. The debate about the strength of the U.S. economy continues. The housing market is an important contributor to the economy. As we enter the key season for real estate many will be asking:

Is it Springtime for housing?

Prior Theme Recap

In my last WTWA, I predicted that there would be special attention to the mixed message of economic reports, contrasting the relative strength of employment with other data. That was a major theme. Some insisted that the employment was overstated. Others said it was a lagging indicator. A few mentioned that GDP was probably understated. Friday’s relatively strong data continued the mixed message. I also suggested that the political sideshow would grab attention, but that was obvious.

Once again the early strength faded at the end of the week. Doug Short captures the story of the decline, the third straight) with his excellent weekly chart. (With the ever-increasing effects from foreign markets, you should also add Doug’s World Markets Weekend Update to your reading list).

SPX-five-day

The entire post adds more analysis on the major themes as well as a multi-year context.

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.

This Week’s Theme

The economic calendar has mostly secondary reports again this week. Friday’s stronger economic data only intensified the debate, as the market reacted negatively. This week features three important housing reports and two of lesser significance. Since springtime brings higher expectations for this sector, I expect more attention than usual. The punditry will be asking:

Is it Springtime for Housing?

Background

Attention focuses on housing with some frequency since it is important to the economy. Wells Fargo notes that residential investment rose 14.8% in the past year, contributing 0.5% to the Q1 GDP growth (which coincidentally was 0.5%). Last year the National Association of Homebuilders calculated that housing was over 15% of GDP. The impact is not just home sales, but also remodeling.

housing-share-of-GDP-1024x768

Viewpoints

The basic themes, moving from bearish to bullish on stocks are as follows:

  • The real estate market is about to crash (Ron Insana);
  • 0% down has returned. Didn’t we learn anything?
  • Increasing housing prices strain the affordability for new buyers (prices are too high);
  • Millennials do not have adequate credit;
  • Homes held in foreclosure proceedings or by speculators provide low-priced competition; (Whoops. That one changed).
  • Home sales are low because there is insufficient supply (the new version).
  • Interest rates remain at historically low levels, helping affordability;
  • We can expect increasing purchases from young people;
  • Increased home prices enable more people to sell – trading up or even sideways to take new jobs.

It is easy to find disciples for each viewpoint.

As always, I have my own opinion in the conclusion. Make your own choice, and feel free to make your case in the comments.

But first, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading the background information.

Last Week’s Data

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:

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially – no politics.
  2. It is better than expectations.

The Good

There was some good news.

  • “Framing” lumber prices are higher. One of the many reasons to follow Calculated Risk is finding data no one else mentions.
  • The “shallow industrial recession” seems to be over. New Deal Democrat provides both data and analysis.
  • Retail sales were much stronger than expected, up 1.3% versus expectations of 0.9%. The retail earnings reports varied widely, with high-end names doing poorly. Online sales were excellent and gas station sales moved higher. (Remember that gas prices have been part of the recent retail weakness). Auto sales remain strong.
  • Life expectancy is higher – and health inequality is lower. Alex Tabarrok of the Foundation For Economic Education presents the data, including the chart below. There is still a downward slope in the data, but the entire line has shifted.

Life-Expectancy-2

  • The Michigan sentiment index beat both last month and also expectations by a wide margin – 95.8 versus about 90. This survey gets timely information about job creation and spending that we do not see elsewhere. As always, I recommend looking at the best chart (and also great discussion) from Doug Short. This month I also recommend checking out the Michigan site. You can find long-term charts and a great explanation of the method. Here is the summary of the key forward-looking data:

Michigan Sentiment mid-May

  • The job market improved, as indicated by the JOLTs report. I often describe this as the most misunderstood data release. Too many people try to use it to analyze net job growth, something better done with various other sources. The ECRI has a new indicator (something about purple animals) subtracting actual hires from job openings, and somehow inferring weakness if this difference increases. They seem to be on a mission to find something negative in the data. Here is their key chart:

 

160510_JOLTS_web_W495Let’s keep this simple.

  • Job openings are good – the more the better.
  • The quit rate shows voluntary departures from jobs, a strong signal of confidence about finding an alternative.

The Atlantic has an article that is geared toward non-economists, but explains the key points. The article notes that quits are highest in low-paying jobs and lowest among financial services workers and government employees.

Doug Short illustrates the strength of the voluntary quit rate versus layoffs.

JOLTS-quits-versus-layoffs

 

The Bad

Some of the news was negative.

  • Energy bankruptcies increased, despite rising oil prices. Terry Wade at Reuters suggests that recent oil price increase might be too little, too late for many companies.
  • Rail traffic continues to worsen. Steven Hansen reports the 10.6% y-o-y decline, adding a variety of interesting comparisons.
  • Earnings season continued with mixed data. FactSet has a nice weekly analysis with interesting charts and also a focused discussion on key sectors. Here are some of the main themes:
    • The 71% earnings “beat rate” is higher than usual, but everyone knows the expectations have been lowered.
    • Earnings declined for the fourth consecutive quarter.
    • The sales beat rate was below normal.
    • Many companies cited the strong dollar as a source of weakness, so they expect better future results.
    • Autos and internet sales showed the most strength.
    • A forgiving market did not punish “misses” as much as usual – at least on average!

FactSet Revenue Growth by Sector

  • Jobless claims edged higher. 294,000 was the highest reading in more than a year. (Jeffry Bartash, MarketWatch) Employment is important and we should watch in closely – both job creation (which this does not measure) and job loss (which it does).
  • Business inventories rose more than expected. The inventory data is easy to spin and difficult to interpret accurately. Does it reflect unsold goods or business confidence in future sales? Steven Hansen (GEI) sees the bullish side.
  • Puerto Rico defaulted on a $400 million debt payment. The Council on Foreign Relations explains the significance.

The Ugly

The TSA. Airport security lines have grown much longer. People are missing planes and some airlines are even delaying flights. Baggage is sitting outside because of inspection delays. There are no immediate plans for more TSA resources, so it is a matter allocating what is available. Here is a good story in The Guardian (via a tweet from Real Clear Markets). A video of the lines at Chicago’s Midway airport now has over two million views.

The comments from Guardian readers suggest that the situation is having an impact on potential international travelers.

1800

 

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.  Think of The Lone Ranger. No award this week. Nominations are welcome. I see plenty of opportunities!

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. I recently made some changes in our regular table, separating three different ways of considering risk. For valuation I report the equity risk premium. This is the difference between what we expect stocks to earn in the next twelve months and the return from the ten-year Treasury note. I have found this approach to be an effective method for measuring market perception of stock risk. This is now easier to monitor because of the excellent work of Brian Gilmartin, whose analysis of the Thomson-Reuters data is our principal source for forward earnings.

Our economic risk indicators have not changed.

In our monitoring of market technical risk, I am now using our new model, “Holmes”. Holmes is a friendly watchdog in the same tradition as Oscar and Felix, but with a stronger emphasis on asset protection. We have found that the overall market indication is very helpful for those investing or trading individual stocks. The score ranges from 1 to 5, with 5 representing a high warning level. The 2-4 range is acceptable for stock trading, with various levels of caution.

The new approach improves trading results by taking some profits during good times and getting out of the market when technical risk is high. This is not market timing as we normally think of it. It is not an effort to pick tops and bottoms and it does not go short.

Interested readers can get the program description as part of our new package of free reports, including information on risk control and value investing. (Send requests to info at newarc dot com).

In my continuing effort to provide an effective investor summary of the most important economic data I have added Georg Vrba’s Business Cycle Index, which we have frequently cited in this space. In contrast to the ECRI “black box” approach, Georg provides a full description of the model and the components.

For more information on each source, check here.

indicator snapshot 051416

Recent Expert Commentary on Recession Odds and Market Trends

Doug Short: Provides an array of important economic updates including the best charts around. One of these is monitoring the ECRI’s business cycle analysis, as his associate Jill Mislinski does in this week’s update. She respectfully cites their most recent article. In my view it uses tortured logic to reach a negative conclusion of the JOLTs report (discussed further above). The Doug Short analysis of this report is much, much stronger. The ongoing review of the ECRI is comprehensive and provides an interesting comparison with Recession Alert, one of our featured sources. Chart lovers will love this regularly updated article.

Doug’s Big Four update is the single best visual review of the indicators used in official recession dating. You can see each element and the aggregate, along with a table of the data. Doug’s updates cover both the individual elements and a chart-packed summary helping to see what it all means.

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured “C Score.” His view of where we are in the business cycle differs sharply from that of the ECRI. His approach has been more accurate over a long period and especially in the last decade. I am overdue for an update comparing the recession methods. (So many great topics to consider, so little time).

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. While we feature the recession analysis, Dwaine also has a number of interesting systems. These include approaches helpful in both economic and market timing. He has been very accurate in helping people to stay on the right side of the market.

Georg Vrba: provides an array of interesting systems. Check out his site for the full story. We especially like his Business Cycle Indicator, updated weekly and now featured in our table. Georg also has an unemployment rate recession indicator. This has long confirmed that there is no recession signal. What would it take to change the prognosis? In this interesting post he suggests that an increase of 0.3% in unemployment would warn of a recession.

The Week Ahead

We have a modest week for economic data. While I highlight the most important items, you can get an excellent comprehensive listing at Investing.com. You can filter for country, type of report, and other factors.

The “A List” includes the following:

  • Housing starts and building permits (T). Most are looking for a rebound.
  • Existing home sales (F). Less GDP impact than new construction, but a good read on the market.
  • FOMC minutes (W). Expect pundit efforts to make something out of nothing!
  • Leading indicators (Th). A controversial but popular measure of economic trends.
  • Industrial production (T). An important but volatile series. Signs of improvement in a lagging sector?
  • Initial claims (Th). The best concurrent indicator for employment trends.

 

The “B List” includes the following:

  • Philly Fed index (Th). I have promoted this indicator in importance after an academic study of it. First May data.
  • Business inventories (F). March data, but relevant for Q1 GDP.
  • CPI (T). Inflation by any measure remains of secondary importance until we get a few hot months. Then the story will change significantly.
  • Crude inventories (W). Often has a significant impact on oil markets, a focal point for traders of everything.

     

There is a little FedSpeak. The Supreme Court will announce some decisions, perhaps including Obama actions on immigration and Puerto Rico. Political news will continue, and some are indeed attributing market weakness to the probable candidates. There are still a few important earnings reports.

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have six different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

WTWA often suggests a different course of action depending upon your objectives and time frames.

Insight for Traders

We continue our neutral market forecast. Felix is still 100% invested, but with less aggressive sectors. REITs and utilities have moved near the top of the list. The more cautious Holmes is also fully invested. Holmes uses a universe of nearly 1000 stocks, selected mostly by liquidity. Even when the overall market is neutral, there will often be some strong candidates. Holmes holds a maximum of 16 positions at one time. For more information about Felix, I have posted a further description — Meet Felix and Oscar. You can sign up for Felix and Oscar’s weekly ratings updates via email to etf at newarc dot com. They appear almost every day at Scutify (follow here). I am trying to figure out a method to share some additional updates from Holmes, our new portfolio watchdog. (You learn more about Holmes by writing to info at newarc dot com.

Dr. Brett offers innovative ideas for traders, and he does it week after week. Are you a perfectionist? Then prepare to be frustrated in your trading.

So what is our trader’s need?  It’s the need to trade, the need to make money.  If the market isn’t making sense, there’s no trade to put on and no money to be made.  If the setup isn’t there, the trade isn’t there and neither are the profits.  If a bad trade is placed, the fruits of a good trade are erased and there go profits.  That same dynamic can also make it difficult to step away from screens, even though the trader recognizes in real time the signs of frustration.  It’s not OK to miss opportunity.

Holmes is barking agreement. Felix would also agree if he were here instead of at a blackjack table in Vegas (emailing daily results). I hope Felix doesn’t get caught count counting cards like some of those other models.

Todd Sullivan provides us with another valuable insight from “Davidson.” This quotation shows what traders should really be watching, if they want to catch short-term moves:

Today’s pools of capital are seeking gains within the day-by-day trading frenzy. The least little shift is taken as the possibility of a new trend and capital shifts in anticipation.

And later…

Most of the discussion today centers on whether it is oil or the US$ which is driving the correlation. This is like a discussion of which comes first, the ‘Chicken’ or the ‘Egg’. My perception is that the main driver in changing global trade balances. Even if one could unravel all the inputs we have on global trade, the data itself is incomplete with a number of nations treating global trade figures as state secrets. Global trade balances impact prices and currencies long term to produce the correlations seen in the chart from Jan 1973.

Davidson on oil prices

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Major market declines occur after business cycle peaks, sparked by severely declining earnings. Our methods are focused on limiting this risk. Start with our Tips for Individual Investors and follow the links.

We also have a page summarizing many of the current investor fears. If you read something scary, this is a good place to do some fact checking. Pick a topic and give it a try. Feel free to suggest new topics if your own “fear” is not on the list.

Some readers expressed concern about the overall market valuation. I discussed this last week. If you are worried about all of those valuation indicators (which supposed worked for centuries, but not in the last couple of decades) I urge you to read, Is the Market Cheap? Three things you need to know about valuation, but don’t.

Many individual investors will also appreciate our two new free reports on Managing Risk and Value Investing. (Write to info at newarc dot com).

Other Advice

Here is our collection of great investor advice for this week. If I had to pick a single most important source for investors to read, it would be David Merkel’s post, You Can Get Too Pessimistic. He notes the low probability of real disaster scenarios. In the context of a thoughtful analysis, he provides the following advice:

If you give into fears like these, you can become prey to a variety of investment “experts” who counsel radical strategies that will only succeed with very low probability.  Examples:

  • Strategies that neglect investing in risk assets at all, or pursue shorting them.  (Even with hedge funds you have to be careful, we passed the limits to arbitrage back in the late ’90s, and since then aggregate returns have been poor.  A few niche hedge funds make sense, but they limit their size.)
  • Gold, odd commodities — trend following CTAs can sometimes make sense as a diversifier, but finding one with skill is tough.
  • Anything that smacks of being part of a “secret club.”  There are no secrets in investing.  THERE ARE NO SECRETS IN INVESTING!!!  If you think that con men in investing is not a problem, read On Avoiding Con Men.  I spend lots of time trying to take apart investment pitches that are bogus, and yet I feel that I am barely scraping the surface.

Stock Ideas

Chuck Carnevale has an interesting recommendation for retired investors – Cisco Systems (CSCO). As usual he does a thorough analysis, using his first-rate methods. See the whole story for illustrative charts and the key points.

Barron’s has a cover story on Regeneron (REGN), which it calls the best of the biotechs. I see many attractive names in this beaten-down sector. The article does a good job of explaining why Regeneron is special.

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 this special edition. There are several great choices worth reading, but my favorite is from Josh Brown. He explains that many investors have a “toxic combination” of reducing financial literacy and increasing confidence. It is nothing personal, but a general consequence of aging.

Outlook on China

There has been a lot of very negative commentary about China in recent weeks. Some of this comes from outspoken hedge fund managers who have significant short positions. To balance this, investors need information from those who study and invest in China. One such source is KraneShares, which provided an excellent briefing for financial advisors last week. While there were many key points, her are two worth extra emphasis:

KraneShares China Growth

And also, most observers focus on manufacturing, ignoring the planned shift to a service-driven consumer economy.

KraneShares Service economy

My conclusion is that investing in China is not a matter of if, but when and how. The financial press emphasizes data points like the “flash PMI” which have little relevance to the key issues. (Full disclosure: KraneShares offers KWEB. We own it in our aggressive program, and I am considering expanding it to more investors who need more international exposure).

Market Fairness

Some individual investors are missing opportunities because of the perceived unfairness of the system. If you are trading in modest size, high frequency trading may actually have slashed your trading costs and increased your potential gains.

 

Watch out for….

Onecoin. This cryptocurrency seems to include elements of multi-level marketing, Ponzi schemes, and a lack of liquidity. There is always a great temptation to make money fast, but recent economic conditions may have increased the appetite. Before “investing” I urge you to do some careful research. Here is an opinion from a crypto currency site and also one from a CPA who has a great quotation from the Association of Certified Fraud Examiners:

  • The investment opportunity promises “guaranteed” returns.
  • The opportunity is described as “once-in-a-lifetime,” or pressures you to buy immediately “before it is too late.”
  • The deal sounds too good to be true. Compare any promised return with the returns on well-known stock indexes.
  • The investment offer was unsolicited.
  • You are unable to find any public information about the investment opportunity. Often, this is explained away as the investment being “by invitation only” and a “secret that is best kept, lest too many people get involved.”
  • The opportunities or people touting them are located outside of the United States. This particular point gives the scam an exotic feel and includes the idea (real or implied) that profits can be squirreled away offshore and away from the taxing authorities.
  • You do not know the person who is contacting you, or they are just an acquaintance.

Check out the full post to see the comparison to the Onecoin marketing materials.

Final Thoughts

Last week I offered a strong opinion about resolving the tension between various economic data sources. I make most of WTWA a balanced summary of what is happening, with an emphasis on a current theme. It is in the conclusion where I do my editorializing. As I noted last week, when I do not have a solid answer to the weekly theme question, I am not afraid to say so. If only more observers would do the same! Readers sometimes complain that I do not give a specific answer to my own question. That misses the point. The weekly question is my prediction for the market theme – what you will see in the media. I cannot control that, and it would be dishonest to claim an answer that I do not really have.

With respect to housing, I expect growing strength. It might not show up this month, since we are still following Bill McBride’s “long bottom.” I plan to watch Calculated Risk stories this week for the best interpretation of the data. He writes this week:

Housing starts are up 13% from March 2014 to March 2016.

New home sales are up 25% over the two years.

Existing home sales are up 13%.

House prices are up 9.7% (Case-Shiller National Index February 2014 to February 2016).

Some day I’ll be bearish again on housing.  But not in 2014 – and not now.

My own reasons for longer-term optimism include the following:

  • Supply. Not that long ago many were predicting a “shadow supply” of foreclosed homes. That was gradually absorbed. Now the same sources are discussing a lack of inventory!
  • Demand. When I first wrote about “shadow demand” it generated a lot of skepticism from readers (something that I embrace). We still have plenty of people living with parents when they would prefer their own home. Many magazine feature writers try to make this into a new preference of Millennials. I doubt it. Mostly this is the result of the lag in employment growth.
  • Demographic and social trends. These are also demand factors, of course, but as people enter the labor force, we get more household formation. Immigration policy has been a negative in recent years, and it remains a wild card.
  • Improving home prices. Many homeowners were making their payments, but were underwater on their mortgages. Higher prices have resolved some of that. They are now abler to move more readily, either to follow the jobs or to upgrade.

Trading and Investment Implications

Traders must continue to work the trading range, guessing daily reaction to Fed speculation, the moves in the dollar, and the shifts in oil prices. On Friday, stronger economic data sent the market lower. For the short term the message is that “good news is bad news”.

Investors should take the opposite perspective. The worry about the economic message from oil prices and interest rates is overdone. A good investor looks for good value. There is a method for this:

Find sectors and stocks that are currently unloved.

While I have been cautious about adding to our underweight energy positions (not just unloved, but hated) I do like and own homebuilders and regional banks.

Is the Market Cheap? Three things you need to know about valuation, but don’t

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There is a general consensus that valuation indicators are not very useful for market timing. Despite this, the financial media and the blogosphere feature an avalanche of articles warning that the market is seriously overvalued. Your retirement account might drop 50% at any moment. There are countless worries in the world.

Many investors have been “scared witless” (TM OldProf) by this, missing out on a great opportunity. Is it now too late? What is the current potential for market gains?

Here are three things you do not know about valuation:

  1. The oft quoted indicators are not currently endorsed by their developers, only by those of the bearish persuasion.
    1. Warren Buffett described his “favorite valuation indicator,” the stock market cap to GDP ratio, in 2001. The current high readings are gleefully cited by many. Warren Buffett himself, while not specifically repudiating the indicator, has often noted that it does not work when interest rates are so low. He has repeatedly said that investors should prefer stocks to bonds in the current market climate. Charlie Munger has said the same thing. There have been many stories about this, but they are mostly ignored.
    2. Prof. Shiller’s CAPE ratio shows an overvalued market and is frequently cited. No one ever mentions that Prof. Shiller himself is more than fully invested in stocks for someone of his age. He cut exposure a bit last fall, but does not recommend the “all-in, all-out” approach of many who quote him. Whenever he is asked in an interview he explains that young people should certainly own and hold stocks. He never advocates using CAPE for market timing. He has endorsed CAPE for sector selection. Barclay’s seems to have pulled the page with the Shiller endorsement, although the CAPE Fund is still trading. My article explains the methodology.
    3. Tobin’s Q was invented in the 50’s by a great economist. It emphasized the replacement cost of major companies. If he were alive today, this brilliant man would be revising his methods to explain modern technology companies, as well as stocks like Amazon, Google, and Facebook. It is not fair to apply methods designed for a world with more manufacturing to one so different. No one uses this method for individual stock analysis. Only a few people profit from writing about this aged and obsolete indicator.
  2. There are many experts whose methods show that stocks are attractive. Whenever these people – Laszlo Birinyi, Brian Wesbury, Jeremy Siegel, Jim Cramer, and me, to mention a few – suggest that stocks are undervalued, someone plays the “perma-bull” card. I don’t know for sure about the others, but I am perfectly willing to shift positions as the evidence changes. No one should be embarrassed about being right. I find the name-calling unhelpful for both bullish and bearish viewpoints.
  3. There is a bias in valuation coverage. Because the bearish concept has such a grip, and predicts huge declines like 50% or so in stocks, it grabs headlines and page views. If you do not believe me, do a little personal poll or else a Google search on stock market valuation. Look at the headlines. Those who are comfortable with current stock values expect 10% gains or so. For the average investor, the risk-reward seems dangerous. The key is that the big declines are low probability, while the expected gains are pretty normal.

Conclusion

The bearish valuation theme has persisted for many years. It is usually invoked to claim that all indicators show an over-valued market. No other choices or ideas allowed! This is not a balanced analysis.

The consensus that valuation methods are not good for timing came years too late. It was only after the various bearish valuation indicators did not signal a buy in 2009. How many years will it take before investors catch up? Forget about changes in pundit opinion. They are all “locked in.”

The single greatest reason for the valuation error is the level of inflation and interest rates. And not the Fed-controlled rates, but the longer end that reflects market forces. Mr. Buffett, as usual, nailed it in his commentary, but few paid any attention. In an interview last August, he stated:

Buffett reiterated that he was a long-term investor, saying he expected prices to be “a lot higher” 10 years or 20 years from now.

He likened owning stocks to owning a home, saying that if homeowners expected prices to fall 5%, they wouldn’t sell their homes in hopes to buy it back for 5% less. They are locked in for the long haul.

He also stated, as he has on many other occasions:

What you can say now — [it’s] not very helpful – but the market against normal interest rates is on the high side of valuation. Not dangerously high, but on the high side of valuation. On the other hand, if these interest rates were to continue for 10 years, stocks would be extremely cheap now. The one thing you can say is that stocks are cheaper than bonds, very definitely. We’ve seen low interest rates now for six years or so, rates that we really wouldn’t have thought possible, particularly in Europe where they’ve gone negative. And that’s continued a long time, and of course we saw them continue for decades in Japan.

Do you think you should pay attention to What Mr. Buffett said fifteen years ago, or what he says now? Can’t he interpret his own indicator? Can you or I do better?

The same argument applies to Prof. Shiller, who is poorly served by the uber-bearish applications of his work.

My conclusion? Earnings prospects are important and remain my own principal focus for stock valuation. Stocks remain moderately attractive, despite the scary stories. Specific names are quite cheap, with low PEG ratios and great prospects. Develop a good shopping list!

Weighing the Week Ahead: Why the Surprising Strength in Employment?

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The economic calendar had most of the big news last week. Earnings season is winding down. It is a time to digest and analyze what we have learned. Many will be asking:

Why is employment growth still strong while other indicators show weakness?

Prior Theme Recap

In my last WTWA (two weeks ago), I predicted that the media buzz would focus on the challenge to the old highs in the stock market. This was indeed a popular topic as the market moved higher. After last Tuesday’s primaries, it was trumped by political news. (I have trumping on my mind (heh heh) only because many of my friends are currently competing in the Team Trials to determine the U.S. representative to the 2016 World Bridge Games).

The attempt at a new stock record missed again and the early strength last week also faded. Doug Short captures the story with his excellent weekly chart. (With the ever-increasing effects from foreign markets, you should also add Doug’s World Markets Weekend Update to your reading list).

SPX-five-day

The entire post adds more analysis on the major themes as well as a multi-year context. Since it has been two weeks since the last WTWA, I will include a second of Doug’s charts to catch up. You can see another failed rally, a triple top, a head-and-shoulders, and an upside down head-and-shoulders.

SPX-2

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.

 

This Week’s Theme

The economic calendar has mostly secondary reports this week. Friday’s employment data rekindled an ongoing debate about employment growth versus the other indicators showing economic weakness. We will have help (?) from plenty of FedSpeak, probably offering widely different conclusions. I expect attention to center on the following question:

Why is employment fairly strong while so many other indicators seem weak?

The Sideshow

My suggested theme is a bit too wonky for media sources seeking viewers and readers. I understand that many will be tempted instead to wax political, trying to infer what the election means for your investments. I wrote about the political theme two months ago, and the implications have not really changed. Just skip to the conclusion of that post. This week Barry Ritholtz does one of the better pieces on political implications for investors, reaching a conclusion similar to mine. He notes the biggest new idea, also debated by the Squawk on the Street gang: A Trump presidency might well involve refinancing debt and doing a lot of construction.

Here are some public policy differences between the leading candidates. It is a starting point for thinking about specific stocks.

Background

Pundit scrambling continues. After Monday’s modest market strength, a TV anchor glibly stated that the gains were not surprising given the start of the month and the expected news from BuffettFest. He had not suggested this on Friday, in time for your trading and the tune quickly changed on Tuesday. So typical.

Those charged with explaining each and every piece of economic news have had to deal with a mixed picture.

Question

How much time per day does the average Facebook user spend on the site? Answer at the end of today’s post.

Viewpoints

The basic themes, moving from bearish to bullish on stocks are as follows:

  • Global recession is upon us. There is something wrong with employment data. GDP is better.
  • Most recent U.S. indicators have missed expectations.
  • Leading indicators show a slower rate of expansion. Employment will soon catch up.
  • Earnings have been engineered. Just look at sales for the truth.
  • Job growth is the most reliable economic indicator, better than GDP. (NYT)
  • Wages show a consistent 2.5% year-over-year increase. Spending will follow.
  • Q1 will mark (yet another) soft spot to the start of the year. Expect a resumption of modest growth.
  • Growth is about to increase, stimulated by increased Federal deficits, policy changes in China, and low interest rates.

 

It is easy to find disciples for each viewpoint.

As always, I have my own opinion in the conclusion. Make your own choice, and feel free to make your case in the comments.

But first, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading the background information.

Last Week’s Data

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:

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially – no politics.
  2. It is better than expectations.

The Good

There was some good news.

  • Bullishness registers a major drop. Mark Hulbert explains why the market timer behavior is probably bullish for stocks.

w704 

  • ISM services increased and beat expectations. The reading of 55.7 also reflected some positive comments from respondents.
  • The lending environment has improved. Torsten Sløk of Deutsche Bank (via Barry Ritholtz) writes that banks are more willing to lend and consumers more willing to borrow. Using the Fed’s Senior Loan Officer Survey, he cites stronger consumer balance sheets and solid improvement growth as reasons for improvement from a sluggish start to the year.

lend 

  • Earnings reports were mixed. FactSet reports that the earnings beat rate is positive. The sales beat rate remains below the five-year average. A common story is a company beating on the bottom line, but missing on sales, also slightly worse than the five-year average. Outlooks are better than average. Utilities are weak. Auto companies are strong. Brian Gilmartin is a bit more optimistic (but cautious) as he cites the ex-energy numbers.
  • Employment growth remains positive. The monthly employment report is sufficiently complicated to permit spinning in any direction. I heard authoritative sources comment on the net jobs increase needed to avoid more unemployment, with a range from 85,000 to 130,000. My employment preview post explained why too much is made over small changes in a single month. The basic trend of reasonable growth continues, but without the major increase we normally see in an expansion. This economic recovery has been slower and stretched out. The question is how much further employment can improve. While everyone has an opinion, the WSJ always had a good chart pack on this subject. Here is one.

 

WSJ employment

 

A source with no horse in the race (Holmes instructed me not to use “dog in the hunt”) has an interesting take on seasonal adjustments. He believes that the adjustment background is too short and the weather recognition too limited. This is a good subject for a full post, but readers may want to consider it.

jobnumbers5616

 

The Bad

Some of the news was negative.

  • Productivity increased and beat expectations. But it remains unacceptably low. Scott Grannis calls it the “missing ingredient.”
  • ISM manufacturing dropped to 50.8 and slightly missed expectations.
  • Auto sales missed expectations by about 0.5%, but improved over the prior month.

The Ugly

Cheating on data announcements. A study by the ECB suggests the presence of “informed trading.” (This sounds like one of my euphemisms!) The results cover a wide range or reports including both public and private. This is an important topic for traders, especially those carrying positions overnight. Here is a key quote:

Abstract

We examine stock index and Treasury futures markets around releases of U.S. macroeconomic announcements. Seven out of 21 market-moving announcements

show evidence of substantial informed trading before the official release time. Prices begin to move in the “correct” direction about 30 minutes before the release time.

The pre-announcement price drift accounts on average for about half of the total price adjustment. These results imply that some traders have private information about macroeconomic fundamentals. The evidence suggests that the pre-announcement drift likely comes from a combination of information leakage and superior forecasting based on proprietary data collection and reprocessing of public information.

 

If you believe that the results are achieved from “superior forecasting” you are not a long-time reader of WTWA!

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.  Think of The Lone Ranger. This week’s award goes to Jeff Reeves who questions a Reuters column suggesting that Tesla was overvalued since its market cap represented a huge multiple of cars sold.

$620,000 for every car it delivered last year, or $63,000 for every car it hopes to produce in 2020.

By comparison, General Motors Co’s (GM.N) $48 billion market value is equivalent to about $4,800 for every vehicle it sold last year.

Reeves suggests (after the mandatory “with all due respect”) that you are an idiot if you take that approach. He provides a number of excellent examples from other companies illustrating that this is a completely irrelevant approach to valuation. Please read the article to see how Netflix, Facebook, Apple, Coke, the New York Times, and biotech might compare.

There are so many catchy headlines and so little refutation!

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. I recently made some changes in our regular table, separating three different ways of considering risk. For valuation I report the equity risk premium. This is the difference between what we expect stocks to earn in the next twelve months and the return from the ten-year Treasury note. I have found this approach to be an effective method for measuring market perception of stock risk. This is now easier to monitor because of the excellent work of Brian Gilmartin, whose analysis of the Thomson-Reuters data is our principal source for forward earnings.

Our economic risk indicators have not changed.

In our monitoring of market technical risk, I am now using our new model, “Holmes”. Holmes is a friendly watchdog in the same tradition as Oscar and Felix, but with a stronger emphasis on asset protection. We have found that the overall market indication is very helpful for those investing or trading individual stocks. The score ranges from 1 to 5, with 5 representing a high warning level. The 2-4 range is acceptable for stock trading, with various levels of caution.

The new approach improves trading results by taking some profits during good times and getting out of the market when technical risk is high. This is not market timing as we normally think of it. It is not an effort to pick tops and bottoms and it does not go short.

Interested readers can get the program description as part of our new package of free reports, including information on risk control and value investing. (Send requests to info at newarc dot com).

In my continuing effort to provide an effective investor summary of the most important economic data I have added Georg Vrba’s Business Cycle Index, which we have frequently cited in this space. In contrast to the ECRI “black box” approach, Georg provides a full description of the model and the components.

For more information on each source, check here.

Indicator Snapshot 050716

Recent Expert Commentary on Recession Odds and Market Trends

Doug Short: Provides an array of important economic updates including the best charts around. One of these is monitoring the ECRI’s business cycle analysis, as his associate Jill Mislinski does in this week’s update. She cites a recent presentation by ECRI co-founder Lakshman Acuthan suggests a period of “stagflation lite.” The review of the ECRI is comprehensive and provides an interesting comparison with Recession Alert, one of our featured sources. Chart lovers will love this regularly updated article.

Doug’s Big Four update is the single best visual review of the indicators used in official recession dating. You can see each element and the aggregate, along with a table of the data. Doug’s updates cover both the individual elements and a chart-packed summary helping to see what it all means. Here is the look after Friday’s employment report.

Big-Four-Indicators-Since-2009-Trough

 

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured “C Score.” His view of where we are in the business cycle differs sharply from that of the ECRI. His approach has been more accurate over a long period and especially in the last decade. I am overdue for an update comparing the recession methods. (So many great topics to consider, so little time).

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. While we feature the recession analysis, Dwaine also has a number of interesting systems. These include approaches helpful in both economic and market timing. He has been very accurate in helping people to stay on the right side of the market.

Georg Vrba: provides an array of interesting systems. Check out his site for the full story. We especially like his Business Cycle Indicator, updated weekly and now featured in our table. Georg also has an unemployment rate recession indicator. This has long confirmed that there is no recession signal. What would it take to change the prognosis? In this interesting post he suggests that an increase of 0.3% in unemployment would warn of a recession.

This week Georg added a new indicator, (DAGS) a variant of Bob Dieli’s Enhanced Aggregate Spread. His excellent article includes a discussion of what might cause a recession as well as an approach that historically would have improved the lead time for a recession signal. In a companion post he describes the Dieli method including similar charts for comparison. Concerning the prospects for a recession, Georg writes as follows:

Assuming that the current trajectory of the DAGS does not change, then it will reach zero in the fourth quarter of 2016, signaling the possibility of a recession start 40 weeks later, in the third quarter of 2017. However the DAGS could rise again, as it did after January 2012 when it was at a similar level to where it is now.

Under current economic conditions the DAGS would indicate a cycle peak much earlier than the EAS, and when such a signal occurs there would be ample time to consult a set of coincident indicators to make a recession call.

DAGS+-fig-1

 

 

The Week Ahead

We have a modest week for economic data. While I highlight the most important items, you can get an excellent comprehensive listing at Investing.com. You can filter for country, type of report, and other factors.

The “A List” includes the following:

  • Retail sales (F). Expectations are for a solid rebound.
  • Michigan sentiment (F). Some distrust survey data, but there is no better way to discover current spending and employment trends.
  • JOLTS Report (T). The report on job openings is still relatively new and widely misunderstood. Important indicator of structural changes in the job market.
  • Initial claims (Th). The best concurrent indicator for employment trends.

 

The “B List” includes the following:

  • Wholesale inventories (T). Volatile March data, relevant for Q1 GDP.
  • Business inventories (F). March data, but relevant for Q1 GDP.
  • PPI (F). Inflation by any measure remains of secondary importance until we get a few hot months. Then the story will change significantly.
  • Crude inventories (W). Often has a significant impact on oil markets, a focal point for traders of everything.

     

FedSpeak is back! Those thirsting to hear more from Fed Regional Presidents will have an opportunity almost every day next week.

Political news will continue, but a big market impact is unlikely – at least for now.

There are still some important earnings reports as the Q1 reporting season winds down.

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have six different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

WTWA often suggests a different course of action depending upon your objectives and time frames.

Insight for Traders

We continue our neutral market forecast. Felix is still 100% invested, but there are fewer attractive sectors. The more cautious Holmes remains close to fully invested. Holmes uses a universe of nearly 1000 stocks, selected mostly by liquidity. Even when the overall market is neutral, there will often be some strong candidates. Holmes holds a maximum of 16 positions at one time. For more information about Felix, I have posted a further description — Meet Felix and Oscar. You can sign up for Felix and Oscar’s weekly ratings updates via email to etf at newarc dot com. They appear almost every day at Scutify (follow here). I am trying to figure out a method to share some additional updates from Holmes, our new portfolio watchdog. (You learn more about Holmes by writing to info at newarc dot com.

Dr. Brett continues to find ideas that no one else has discussed. This week he explains about the “path” to a good trade. Here is a stimulating excerpt:

Let’s do a thought experiment:  I might expect a stock index to move from 2000 to 2100, a 5% move.  Let’s say the index remained nearly unchanged in value for six months before shooting higher to 2100 in the seventh month.  How many traders would have stuck with this trade?

Let’s consider a different scenario:  The index moves from 2000 to 2100 in one month, but only after having dropped to 1940 in the first week.  How many traders would have stuck with this trade?

Mike Bellafiore warns not to jump the gun, anticipating before your setups are really in place.

(The cautious Holmes is barking approval at this idea).

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Major market declines occur after business cycle peaks, sparked by severely declining earnings. Our methods are focused on limiting this risk. Start with our Tips for Individual Investors and follow the links.

We also have a page summarizing many of the current investor fears. If you read something scary, this is a good place to do some fact checking. Pick a topic and give it a try. Feel free to suggest new topics if your own “fear” is not on the list.

Many individual investors will also appreciate our two new free reports on Managing Risk and Value Investing. (Write to info at newarc dot com).

Other Advice

Here is our collection of great investor advice for this week. If I had to pick a single most important source for investors to read, it would be Morgan Housel’s post, Alternative Definitions of Risk. He explains that even significant market volatility (like 2011) does not signal real risk. He cites several types of risk that are often neglected. Here is a good example:

The risk of inadequate return

Cash is now the most desirable asset among savers age 18 to 29,  even if the money isn’t needed for 10 years, according to a survey by Bankrate.

Young investors do this to cut down on the risk of investing in stocks. But odds are they will come to see this as one of the riskiest investments they ever make. Cash for the long-term won’t fund future goals, while the market volatility they’re avoiding today posed little risk to those future goals.

 

Stock Ideas

Goldman Sachs recommends a dividend basket.

When should you sell a stock? George Athanassakos a Professor of Finance and the Ben Graham Chair in Value Investing suggests eight reasons. I like and use them all!

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 this special edition. There are several great choices worth reading. We all like apps and we also like saving money, so you will enjoy my favorite from the group, 5 Apps That Will Actually Save You Money.

Outlook

Oppenheimer Funds sees the China prospects as encouraging. This is an interesting contrarian viewpoint.

Value Stocks

Has the tide turned? Morgan Stanley notes that in 2016 value has beaten growth. So far, so good for my prediction that 2016 will be the year of the value stock. (For those interested, get a free report from main at newarc dot com).

MS-5-2-USD-value

Watch out for….

Non-traded REITs. Before deciding that this is the right investment for you, be sure to read the fine print. Here some excerpts of listed risk factors from an actual offering. As a buyer, you sign off indicating that you have read all of this stuff!

the proceeds from a sale or redemption of shares may be less than the original amount invested;

there are substantial conflicts among the interests of the REIT’s advisor, sponsor, dealer manager and respective affiliates;

may incur substantial debt, which could adversely impact the value of an investment;

obligated to pay substantial fees to its advisor;

may pay distributions from any source, and there are no limits on distributions that may be paid from sources other than cash flow from operations;

…and a general observation that payments may come from assets rather than operations. So much for your expected 7% annual return.

Final Thoughts

When I do not have a solid answer to the weekly theme question, I am not afraid to say so. If only more observers would do the same! Readers sometimes complain that I do not give a specific answer to my own question. That misses the point. The weekly question is my prediction for the market theme – what you will see in the media. I cannot control that, and it would be dishonest to claim an answer that I do not really have.

This week is different. I have confidence in the recession indicators I cite – chosen after extensive study and analysis. I also have studied labor economics and the various tracking measures. Most of those commenting on the employment versus GDP question are talking their book. The bond folks disparage employment and the stock reps cite employment data. My mission is quite different. I need to guide clients into whatever is best for their personal circumstances and the current environment.

While I have looked at many indicators, here are two that are typical of the main theme.

  1. The global economic fears are overstated. Gavyn Davies (FT) has a thoughtful article, Fading Risks of Global Recession. He cautiously notes as follows:

    The latest nowcast shows a rebound in global activity growth to 3.4 per cent, which is just below trend. Growth in the advanced economies has rebounded from a low point of 1 per cent in February to 1.4 per cent now (ie still about 0.3 per cent below trend). Growth in the emerging economies has jumped from 3 per cent in February to 5.5 per cent now, which is at trend for the first time in three years. However, the rebound in the emerging economies is driven by improvements in China and Brazil, both of which are subject to large risks of renewed setbacks in coming months.

ftblog1073

  1. Employment, measured in many different ways, shows no sign of rollover. One advantage of subscribing to Bob Dieli’s service is a monthly deep dive into the employment data, published the day of the report. Whether you are interested in labor force participation, part time workers, wages, job quality or overall trends, one of the forty pages of charts will provide an answer. I am trying to persuade Bob to offer a lower-priced version for average investors. His big theme this week was that the economy was not rolling over. The expansion phase continues. The chart below is but one example:

Dieli April 2016 Employment

Getting the most out of your investments is not just a matter of buy-and-hold. It also does not require guessing the “normal” market volatility in an effort to be a genius. It certainly does not mean going all-in or all-out.

Long-term investors profit from a focus on data, not emotion.

Answer to the Facebook question: 50 minutes per day. My reaction is Wow! What is yours?

The Employment Report: Three Things You Should Know but Don’t

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Reporting economic news is a major subject for the media. It starts with the facts, but after lingering briefly, attention turns to speculation about what this means for the boxed-in, painted-in, rock and hard place, corner-bound Fed. Take your pick of the metaphors, including plenty of mixed versions. You’ll hear them all. Probably tomorrow!

The financial world has plenty of self-proclaimed experts in “global macro.”  Many of these people never cracked an Econ textbook, and others did not even buy the Cliff notes! In an effort to improve investor understanding, I have added some of these topics to my “blog agenda.” (Suggestions for new topics are always welcome.

The employment report is universally regarded as the most important economic release. Employment is of clear importance to the Fed as a measure of economic strength. It is also a key issue in political discourse and public debate. If you consider this at all in your investing decisions, it is vital to have a good understanding of what can be learned from these data.

Here is a key starting point: The more complex the report, the more opportunity for spin.

If you want to be a good consumer of the commentary, here are three things that you need to know but probably don’t.

  1. Layoffs tell only half of the story.  Everyone watches weekly initial unemployment claims and stories about mass layoffs.  What about hiring?  We have no good reports about job creation.  Many sources have attacked the BLS Birth/Death adjustment.  It is so commonplace that it is routinely cited when it adds some jobs — used as a code phrase for fictitious jobs growth.

In fact, the long-term record of the birth death adjustment has been excellent.  Each quarter we get an update called the Business Dynamics report.  This never makes the news because it is eight months old.  That is unfortunate.  Unlike the monthly report, it is not an estimate based upon a survey sample, but a collection of data from local unemployment offices.  Companies have strong incentives not to overstate employment in these reports.

I use this report to gauge the accuracy of the various monthly estimates.  It separates job gains from new establishments from job losses from closing establishments.  The BLS monthly report begins with an assumption that “missing data” in the survey, when due to defunct companies, has been offset by new companies.  This assumption is far more important than the birth/death model, but the combination has been accurate.

In the latest period for which we have data, here are the gross and net job changes:

Table A.  Three-month private sector gross job gains and losses, 
seasonally adjusted 

Category                                 3 months ended

                                Sept.   Dec.    Mar.    June    Sept.
                                2014    2014    2015    2015    2015

                                      Levels (in thousands)
                                      
Gross job gains................ 7,235   7,658   6,947   7,554  7,292
 At expanding establishments... 5,905   6,279   5,666   6,220  5,958
 At opening establishments..... 1,330   1,379   1,281   1,334  1,334

Gross job losses............... 6,710   6,563   6,721   6,725  6,874
 At contracting establishments. 5,523   5,322   5,558   5,541  5,657
 At closing establishments..... 1,187   1,241   1,163   1,184  1,217

Net employment change(1).......   525   1,095     226     829    418

A little subtraction shows the net job gain from business births and deaths over the past year is 523K.  The b/d adjustment over the same period was 789K.  This discrepancy is minor on a monthly basis, or in comparison to the overall number of jobs.  I have tracked this for several years, and the differences are usually small and have no consistent bias.  Can we finally put this subject to rest?

2.  The BLS report is really just an estimate.  Many sources also estimate actual monthly net job growth with a variety of approaches.  Many of these (changes in state withholding, changes in private payroll reports, changes in national tax revenues) might well be better than that used by the BLS.  They basically estimate the size of an elephant each month via a survey. Then they subtract one month from the next.

The sampling error is over 120K, swiftly forgotten or completely ignored in the commentary. This error range is based on an accurate sample with 100% responses.  In fact, there are multiple revisions to the original estimate.  The margin of error applies to the final revised data, which we will not actually see for many months.

Despite the drawbacks in the BLS approach (and they are skilled statisticians doing a professional job).  It is viewed as “official”.  In my best post on this subject I explained that others doing estimates were not trying to measure “truth” but instead guess what the BLS would say!

3.  Evaluate the overall job changes, not the specific subsets.  Most commentators confuse job creation with net job growth.  They also give undue emphasis to sub-sector job changes.

Overall job creation is about 2.5 million per month!  Job destruction is only a bit lower.  Keeping this in mind helps to understand why so many feel the stress of unemployment.

The margin of error for specific subsets is much larger than people realize.  I explained this in 2010, but no one ever mentions these facts:

Sampling error means that the businesses or households chosen for the survey (even if all respond) may not accurately represent the actual population characteristic you are trying to measure.  If you learn this in a statistics class, you have a jar with a known percentage of black and white marbles from which you draw repeated samples.  As you do more samples, you come to realize that they reflect the underlying population on average, but often deviate.  There are statistical methods for estimating sampling error.  The BLS often cites a 90% confidence interval.

This is understood but usually overlooked in discussing the big headline numbers.  For the payroll report, for example, the 90% confidence interval is about 104,000 jobs.  Viewed in this way, we could infer that given our survey result actual job growth would be between -4000 and +204,000 about 90% of the time.

When the discussion turns to the various “internals” of these reports, the participants seem to forget that these are are also survey results.  Each item has its own 90% confidence interval.  Here are some selected examples:

Unemployment rate    +/- 0.16%

Size of labor force    +/- 490,000

Change in labor force MoM  +/- 400,000

Do you see why some of the glib commentary about the unemployment rate and the number dropping out of the labor force might be a bit overstated?  It is dangerous to infer too much from monthly changes, even when they seem like large numbers.  The errors are actually quite small in proportion to the entire size of the labor force.  Source:  http://www.bls.gov/opub/ee/empearn201005.pdf  (pp. 233-34).

Here are a few more examples:

Average weekly hours    +/- 1.65%

Average weekly earnings    +/-1.65%

Construction monthly change    +/- 24,000

The changes in weekly hours, viewed as such a negative this month, is well within the “noise” level.  Last month’s positive reading was only a bit outside the confidence interval.  People regularly comment on changes in various subgroup categories when the change is well within the confidence interval.  Here is the source for these and other results from the establishment survey.

Conclusion

The monthly employment report is a field day for pundits, but provides little solid information.  Understanding the economy requires a longer time period as well as alternative estimates.

  • Traders must guess the number (which they could not do even if they knew the “truth”) and also the market reaction.  Many think that a strong report will be negative because the Fed will be more likely to nudge rates higher.  Sheesh!
  • Investors once again have an advantage.  The volatility has little to do with the long-term prospects for your positions.  You may take what the market is giving you, whether trimming winners or acting on your shopping list.

The Evolution of the “Hussman Chart”

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Hardly a week goes by without an article like this one by the influential Henry Blodget — One smart stock market analyst thinks this is where we’re headed…(gulp). Mr. Blodget writes as follows:

But anyone who’s feeling comfortable after a strong week in the markets should at least understand that: 1. The macro environment most conducive to crashes is still in place (overvaluation + increasing risk aversion) and 2. The way the market is behaving now is exactly the way it behaved before the biggest crashes in history.

So, neither Hussman, nor I, nor you should be surprised if the market keeps on dropping and doesn’t bottom until it’s down 50% or more from the peak.

As Hussman noted last week in his usual depressing note, a 50% crash would not even be the worst-case scenario. It would just be a normal correction from valuations we reached in 2015.

Featured in the valuation articles is a chart purporting to show very low expected annualized returns for a multiple-year period. The implication for stock investors is clear: Little upside combined with huge risk. It has had a big impact both with individual investors and also my investment advisor colleagues.

Background

Last week, among several other illustrations of popular investment misconceptions, I included a version of what I will call the “Hussman Chart.” I suggested that if you did not understand the chart, you shouldn’t be using it for your investment decisions. My main point was that people blindly accept conclusions from intelligent sources who use sophisticated methods. Of the are dozens of possible illustrations, I included the Hussman Chart. I know that many people sold their stocks some time ago when their investment advisors warned them, producing one of the charts I discuss below.

My worst fears were confirmed! Out of the thousands reading the post, only two or three explained anything about the chart – how it was constructed, what it implied, how to think about it. Quite a few people repeated the author’s conclusion. Wow! They understood and accepted the conclusion without any evaluation of the reasoning. Others did not want to be challenged. They wanted me to explain what I thought was wrong with the chart.

Readers promptly ignored everything else in the article. Some even concluded (amazingly) that I was stating that I personally did not understand the chart. Jesse Felder, a fellow investment advisor and blogger stated this viewpoint explicitly. His conclusion (without any explanation of the chart):

Furthermore, this negative correlation between valuations and forward returns is statistically very high (greater than -90%) and backed by 65 years worth of data. The Buffett Yardstick, as Hussman demonstrates, has been nearly as good as his own version at forecasting forward returns and is backed by roughly 90 years worth of data. Both charts, and the data and reasoning behind them, clearly demonstrate and validate the concept that, “the price you pay determines your rate of return.”

Summary

Apparently I need to elaborate on the original theme. I will do so by providing examples of “the chart” over the years. The variables, adjustments and time periods change, but the conclusions are generally the same. Each chart has a documented method and stands on its own. Together one gets a different picture. While the method is continually “improved” and the time period changed, there is never a date with destiny. We do not know whether the early versions worked or not. There is no distinction between the time period used to create the method and the “out of sample” period that follows.

Here is a summary of the charts below.

Date Independent variable Starting point Length of Forecast Adjustments
Nov, 2008 Terminal multiple 1950 7 years
Oct, 2010 Terminal yield 1944 7 years
Aug, 2010 Adjusted forward earnings 1963 10 years Reducing margins
Jan, 2011 Normalized earnings 1928 10 years “Normalizing” earnings
Dec, 2013 CAPE 1932 10 years Mean-reverting margins
Feb, 2016 Non-financial Gross Value Added 1950 12 years World effect, excludes financials

The rest of this report will show the evolution of the approach and raise some specific concerns and points that you might wish to consider.

[I have never met Dr. Hussman, but I have a generally favorable impression of him. He taught for a bit at one of my schools. (Someday I might learn if he considers himself a “Michigan man.”) He is respected as a philanthropist. His approach is intended to be in the best interest of his investors. Updating his methods and conclusions is a natural part of investment management. He reports his thinking frequently and takes on issues directly. Were this not the case, a review like this one would not be possible. He has built a very successful business and earned a strong reputation. His articles are always among the most popular, especially among investment advisors].

Analysis – the Evolution of “The Chart”

First example — How Low, How Bad, How Long? November, 2008

http://www.hussmanfunds.com/wmc/wmc081110.htm

wmc081110h

Second example — No Margin of Safety, No Room for Error October, 2010

http://www.hussmanfunds.com/wmc/wmc101011.htm

wmc101011b

Third example — Valuing the S&P 500 Using Forward Operating Earnings August, 2010

http://www.hussmanfunds.com/wmc/wmc100802.htm

This quoted explanation illustrates why some might have trouble following the methodology:

The two main failures of standard FOE analysis are that 1) analysts assume a long-term norm for the P/E ratio that properly applies to trailing net, not forward operating earnings, and; 2) analysts fail to model the variation in prospective earnings growth induced by changes in the level of profit margins, and therefore wildly over- or underestimate long-term cash flows that are relevant to proper valuation. By dealing directly with those two issues, we can obtain useful implications about market valuation.

As I have frequently noted, it is not theory, but simple algebra, that the long-term annual total return for the S&P 500 over any horizon T can be written as:

Long term total return = (1+g)(future PE / current PE)^(1/T) – 1
+ dividend yield(current PE / future PE + 1) / 2

The first term is just the annualized capital gain, while the second term reasonably approximates the average dividend yield over the holding period. For the future P/E, one can apply a variety of historically observed P/E ratios in order to obtain a range of reasonable projections, but the most likely outcome turns out to be somewhere between the historical mean and median.

You have to get two things right: the “normal” future P/E and the prospective long-term earnings growth rate g. Standard FOE analysis misses on both counts. Very simply, looking out over a 7-10 year horizon, the proper historical norm for price-to-forward operating earnings is approximately 12.7. Moreover, one cannot simply apply the long-term operating earnings growth rate of 6.3% (0.063) as an unchanging measure of g. Rather, an accurate growth rate for the model has to reflect the level of profit margins at any point in time, since the current P/E multiple may reflect either depressed or elevated earnings. For a 10-year investment horizon, the proper value of g should take into account the gradual normalization of margins. Historically, the best estimate is approximately:

g = 1.063 x (0.072 / (FOE/S&P 500 Revenues))^(1/10) – 1

[Jeff]You should at least be able to understand that the earnings are “adjusted” by a method that is deemed to be appropriate.

wmc100802a

Fourth example — Borrowing Returns from the Future January, 2011

http://www.hussmanfunds.com/wmc/wmc110117.htm

wmc110117a

Fifth example — Does the CAPE Still Work? December, 2013

http://www.hussmanfunds.com/rsi/cape.htm

CAPEh

http://www.advisorperspectives.com/commentaries/20160221-hussman-funds-speculative-half-cycles-tend-to-be-completed-badly

wmc160418c

[Jeff] If you look at this chart and the two above, you will see that the big divergence in the late 80’s has disappeared.

Comments on the multi-year growth projections

These are points that would be discussed extensively if the research had a peer review.

  • It is necessary to explain carefully both variables, especially making clear when one can evaluate the relationship
  • There should be a sharp distinction between the portion of a chart which is a back test, or an idea fitted to past data, and the “out of sample” data that follows.
  • A multi-year projection has an eventual “date with destiny.” If you are one year away, you can calculate the return that would be needed to make the forecast correct. Think of it as a runner going for a world record in the mile. If he is five seconds off the pace with 100 yards to go, you may safely conclude that he will not break the record.
  • The concept might be extended to more years. If a very negative forecast is in place and the first year or two is strong, it might take a market crash for the forecast to come true.

Research Tests

This very brief summary is a glimpse of what a solid research design should include.

Necessary

There should be a hypothesis and a test of the hypothesis.

It should be possible to disprove the conclusion.

Stated results should not consume all of the data.

Desirable

It is best to share data, especially when not proprietary. This allows others to replicate the work. (One of the top economics books of the past year included a serious spreadsheet error, discovered because data were shared. It is fairly common in academic circles. Dr. Shiller shares his data, despite the great difficult in develop the historical earnings).

It is important to provide a complete description of the methodology. This should include paths not taken and variables that were rejected.

It is helpful to show the link (ideally with an update) of past research theses as more evidence emerges.

My Own Concerns about the Conclusions

Many have asked me why I have not followed this approach in my own investment management. I do not write about it very much because of the work required. Dr. Hussman has a great research budget and team. I have a small staff who are already fully-employed on stock picking and managing our programs. Going back to replicate one of the old charts would be a fair amount of work. I will share my concerns here, but only in abbreviated form.

  • We never seem to reach the point of evaluation. How did these approaches work in the past?
  • The methodology seems to include many of the classic overfitting problems. I am certainly not the first to note this. Philosophical Economics in late 2013 wrote Valuation and Stock Market Returns: Adventures in Curve Fitting.
  • There are adjustments that are not well explained. The earnings are adjusted for expected changes in profit margins, for example. What if this assumption is not accurate? Profit margins are an intense (and separate) debate.
  • The method for adjustment keeps changing – different approaches, coefficients, etc.
  • Over the years, the time frame for the forecast keeps moving, from seven, to ten, and to 12. If you go back to the original Shiller papers, he was using five years. His disciples keep experimenting with different choices.
  • The independent variables change with each new iteration. The overall model always seems to fit. Past discrepancies disappear.
  • The attribution of “bad patches” in results to market overvaluation or undervaluation. This seems backwards. Why is the market wrong and the model right?

I am especially bothered by what I see as exaggeration and distortion. What does it add to this discussion to call valuations “obscene?” I find especially distasteful the statement, “The CAPE Ratio id doing exactly what it has always done, which is to help investors anticipate the investment returns they should expect over the next decade. Those returns will very likely be in the low, single digits”.

The CAPE ratio is not some wise old friend that has been around for centuries. It was invented only recently and has not worked very well. The claim of historical validation is also completely wrong. What if I told you that the Packers always won at home after a double-digit away loss in a dome? (I made this one up, but you get the idea). It is historically accurate, but does not have any value for predicting the future. Since Dr. Shiller and Dr. Hussman made a lot of specific choices about measuring earnings, past time frames, use of inflation information, and future time frames, their conclusions should be described as a model, not some definitive historical record. It is rather easy to create a view of history that provides a vastly different conclusion. (see The Single Greatest Predictor of Future Stock Market Returns). It includes this impressive chart.

avginv11

[Jeff] Similar approach, vastly different result. This is not the only such example.

Implications for Investors

My most important point is a plea, repeated from last week’s post: Be careful about investing your money using analysis you do not really understand!

Whether you share my concerns or not, I recommend a deeper look into these issues, with one of three conclusions:

  1. If this leads you to agree with Dr. Hussman, his fund offerings that provide the best balance. I have written that his stock picking is excellent. Investing with him is better than going “all out” on your own because of fear.
  2. If the deeper look leads you to disagree, you might consider funds or advisors who take a different approach.
  3. If you are not sure, then hedge your investment “bets.”

Weighing the Week Ahead: Can Stocks (finally) Set a New Record?

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The economic calendar has more news, including a meeting of the FOMC. Earnings season is in full swing. Despite all of the substantive news, the punditry loves to discuss markets, especially when they are challenging the old highs. Many will be asking:

Will stocks (finally) set a new record high?

Prior Theme Recap

In my last WTWA I predicted that markets might already have anticipated the Doha oil conference as well as the trend of first-quarter earnings reports. Despite the lack of an agreement from the meeting, energy stocks and the overall market moved higher. Earnings reports also tilted negative, but with only modest effect. With no obvious way to explain the market action, many observers did opine that the events were already anticipated. What would have been the predictions for the week had people known about Doha and earnings in advance?

Doug Short captures the deceptively quiet week with his excellent weekly chart. (With the ever-increasing effects from foreign markets, you should also add Doug’s World Markets Weekend Update to your reading list).

SPX-five-day

The entire post adds more analysis on volatility, moving averages, volume, and long-term context. Doug’s update also provides multi-year context.

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.

Personal Note

I really enjoyed writing this edition of WTWA and I hope readers like it as well. I have a number of new sources and creative ideas. Meanwhile, I will probably not write next week, taking a little Spring holiday with Mrs. OldProf.

This Week’s Theme

The economic calendar includes plenty of news. The FOMC is meeting. While no policy change is expected, everyone will closely watch the language in any statement. It is also a big week for corporate earnings. If the week begins on a positive note, CNBC will have a countdown to a new record high. If not, there will be discussion of the “failed rally” in stocks. Either way I expect attention to center on the following question:

Will stocks finally make a new record high?

Background

Nothing really good happened last week, but the stock market reaction was modest. The “sage observers” say something like, “It just doesn’t want to go down.” Some might conclude that expectations are modest. Last week was a good illustration of how anticipation and positioning of “hot money” can affect the reaction to news. Brian Gilmartin explains how this might be relevant for a key part of the story in the week ahead – Apple earnings. It is a great overview for the earnings week ahead.

Viewpoints

The basic themes, moving from bearish to bullish, range from astonishment to modest confidence.

  • The levitation in stocks continues. The Wile E. Coyote moment is near!
  • The worldwide economy threatens to drop into recession.
  • Earnings have been engineered. Just look at sales for the truth.
  • Technical indicators show that stocks are about to move lower.
  • Technical indicators show that stocks are about to move higher.
  • Not much was expected from this earnings season. The market is looking ahead.
  • The economic data have not been great, but the recession threat has lifted.
  • This could be a trough in the economy and corporate earnings. Stocks will respond.

It is easy to find disciples for each viewpoint, including those earnestly following similar methods. Here is the challenge, from the weekly Doug Short summary. You can readily see the challenge of the old highs.

SPX-snapshot

As always, I have my own opinion in the conclusion. But first, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading the background information.

Last Week’s Data

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:

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially – no politics.
  2. It is better than expectations.

The Good

There was a little good news.

  • Hotel occupancy rates are tracking close to last year’s highs. (Calculated Risk)
  • Mortgage delinquency rates are the lowest in nine years. (Calculated Risk)

Delinquencies

  • Jobless claims dropped again to a 42 ½ year low. (HT BBRO) And contrary to many opinions, the job growth in the 25-34 age cohort is stronger.

fredgraph

  • Earnings reports were mixed. FactSet reports that the earnings beat rate is positive, but below the five-year average. A common story is a company beating on the bottom line, but missing on sales, also slightly worse than the five-year average. Outlooks are better than average and the market rewarded beats more than it punished misses.

Revenue surprises

  • Existing home sales improved. Calculated Risk is our top source on housing. Bill describes it as a good start to the year.

The Bad

Most of the news was negative.

  • Markit PMI data suggested weakness in manufacturing. James Picerno explains and provides the chart below. He also contrasts the results with the ISM manufacturing index, and various regional measures. I urge you to read the entire post. This is why I try to pick the most important indicators instead of adding to the noise by citing everything. Markit is attempting to establish a market for their data, even though the history is very short. They have to start somewhere. Unlike the ISM data, the results are very difficult to interpret.I am especially suspicious of worldwide results, where the sample sizes, margin of error, and response rate are not reported. We are always hungry for data, so we uncritically accept whatever there is.

mfg.pmi_.22apr2016

  • Rail traffic continues the decline. Steven Hansen (GEI) slices and dices the data, examining year-over-year comparisons with special attention to coal, as noted in this quote:

    Coal is over 1/3 of the total railcar count, and this week is 43.4 % lower than the production estimate in the comparable week in 2015. The middle row in the table below removes coal and grain from the changes in the railcar counts as neither of these commodities is economically intuitive.

    2016-04-23_22-01-36

  • Trucking tonnage also declined. GEI also has this story, with a comprehensive look at the data and possible future revisions.
  • The Philly Fed manufacturing index missed expectations and turned negative. More encouraging was the outlook portion of the report, which moved significantly higher. (BI)
  • Housing starts and building permits fell nearly 8%. Revisions mitigated the news a bit. (Calculated Risk)

SingleMar2016

fig2 

 

The Ugly

“Dieselgate.” VW announced a plan to buy back as many as 500,000 cars in the U.S. The cost of this program, plus fines, and lost sales imply a cost far exceeding earlier estimates (Jalopnik). Barron’s puts the overall cost at $51 billion. The FT notes that there has been no reduction in headcount nor in the expected dividend.

Daimler announced that it is doing an internal investigation at the request of the Justice Department. Mitsubishi also admitted that it had falsified test data on 600,000 vehicles.

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.  Think of The Lone Ranger. This week’s award goes to Jeffry Bartash (MarketWatch). The popular misconception is that net job creation is all about part-time or low-paying jobs. The simplistic analysis often suggests that any manufacturing job is good and any service job is like burger-flipping. This is especially humorous when the article is written by a six-figure service worker! But I digress. It is always better to focus on data.

The story is not completely upbeat. The article provides a balanced assessment of recent trends. Here is a key point:

MW-EK715_well_p_20160420103644_ZH

 

Noteworthy

People do not even understand Google search results, unable to distinguish ads. No wonder they cannot identify problems with stock charts, a topic I took up last week. If you missed the post, please check out my post about the most expensive investor misconceptions.

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. I recently made some changes in our regular table, separating three different ways of considering risk. For valuation I report the equity risk premium. This is the difference between what we expect stocks to earn in the next twelve months and the return from the ten-year Treasury note. I have found this approach to be an effective method for measuring market perception of stock risk. This is now easier to monitor because of the excellent work of Brian Gilmartin, whose analysis of the Thomson-Reuters data is our principal source for forward earnings.

Our economic risk indicators have not changed.

In our monitoring of market technical risk, I am now using our new model, “Holmes”. Holmes is a friendly watchdog in the same tradition as Oscar and Felix, but with a stronger emphasis on asset protection. We have found that the overall market indication is very helpful for those investing or trading individual stocks. The score ranges from 1 to 5, with 5 representing a high warning level. The 2-4 range is acceptable for stock trading, with various levels of caution.

The Holmes risk indicator improved from “mildly bearish” to “neutral”. We score this as 3 rather than 4 in the table.

The new approach improves trading results by taking some profits during good times and getting out of the market when technical risk is high. This is not market timing as we normally think of it. It is not an effort to pick tops and bottoms and it does not go short.

Interested readers can get the program description as part of our new package of free reports, including information on risk control and value investing. (Send requests to info at newarc dot com).

In my continuing effort to provide an effective investor summary of the most important economic data I have added Georg Vrba’s Business Cycle Index, which we have frequently cited in this space. In contrast to the ECRI “black box” approach, Georg provides a full description of the model and the components.

For more information on each source, check here.

Indicator Snapshot 042316

Recent Expert Commentary on Recession Odds and Market Trends

Doug Short: Provides an array of important economic updates including the best charts around. One of these is monitoring the ECRI’s business cycle analysis, as his associate Jill Mislinski does in this week’s update. She cites a recent interview with ECRI co-founder Lakshman Acuthan who continues his anti-Fed theme that the current business cycle is a “Grand Experiment” but with flawed assumptions. The review of the ECRI is comprehensive and provides an interesting comparison with Recession Alert, one of our featured sources. Chart lovers will love this regularly updated article.

Doug’s Big Four update is the single best visual review of the indicators used in official recession dating. You can see each element and the aggregate, along with a table of the data. The full article is loaded with charts and analysis. As you can see, the indicators show a mixed picture, but not the conditions for a recession.

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured “C Score.”

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. While we feature the recession analysis, Dwaine also has a number of interesting systems. These include approaches helpful in both economic and market timing. He has been very accurate in helping people to stay on the right side of the market. This week Dwaine has an update on the labor market which he describes as “not as strong as you think.”

Georg Vrba: provides an array of interesting systems. Check out his site for the full story. We especially like his Business Cycle Indicator, updated weekly and now featured in our table. Georg also has an unemployment rate recession indicator. This has long confirmed that there is no recession signal. What would it take to change the prognosis? In this interesting post he suggests that an increase of 0.3% in unemployment would warn of a recession.

Recession-Forecast-fig-1

Bob Dieli’s analysis is similar, but dependent on the source of the change in employment.

While on this theme, we should recall a recent post from Philosophical Economics, suggesting that the “perfect recession indicator” focused on change in the unemployment rate, not the level. This is probably similar to what Bob concluded.

 

The Week Ahead

We have an average week for economic data, with an emphasis on housing reports. While I highlight the most important items, you can get an excellent comprehensive listing at Investing.com. You can filter for country, type of report, and other factors.

The “A List” includes the following:

  • FOMC rate decision. (W). Even though there will be no press conference, no updating of forecasts, and no expectation of a change, the punditry will be watching!
  • Personal income and spending (F). A crucial component of economic expansion.
  • Michigan sentiment (F). Some distrust survey data, but there is no better way to discover current spending and employment trends.
  • Consumer confidence (T). Almost as helpful as the Michigan data.
  • New home sales (M). Housing remains important for economic expansion and new construction is the real test.
  • Initial claims (Th). The best concurrent indicator for employment trends.

The “B List” includes the following:

  • Core PCE prices (F). This is the Fed’s favorite inflation measure, so it will eventually be important. For now, inflation questions are on a back burner – something that could change quite suddenly.
  • Pending home sales. (W). Not as interesting as new homes, but still a good read on the market.
  • Durable goods (T). Volatile March data, but still an interesting read on a key economic sector.
  • Chicago PMI (F) The most significant regional index is always more important when released on a Friday.

     

Fed members will be quiet because of the FOMC meeting.

There will be a continuing focus on corporate earnings, with almost 40% of the S&P 500 reporting this week.

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have six different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

WTWA often suggests a different course of action depending upon your objectives and time frames.

Insight for Traders

We continue both the neutral market forecast, but our overall rating recently moved to “neutral” from “mildly bearish”. Felix is still 100% invested. The more cautious Holmes continues to better the market while taking a lot less risk and is now close to 100% invested, after some profit taking. Holmes uses a universe of nearly 1000 stocks, selected mostly by liquidity. Even when the overall market is neutral, there will often be some strong candidates. Holmes holds a maximum of 16 positions at one time. For more information about Felix, I have posted a further description — Meet Felix and Oscar. You can sign up for Felix and Oscar’s weekly ratings updates via email to etf at newarc dot com. They appear almost every day at Scutify (follow here). I am trying to figure out a method to share some additional updates from Holmes, our new portfolio watchdog. (You learn more about Holmes by writing to info at newarc dot com.

Victor Niederhoffer has some great advice derived from checkers expert Tom Wiswell, whom he met by chance in Central Park. The key idea is to reduce size in the face of uncertainty. While we do this routinely in our firm, most traders either sell the entire position or remain “all in.” The post led me to another page of Wiswell Proverbs. Traders and investors alike will enjoy these. It is difficult to pick a favorite, but here is a candidate;

ERRORLESS PLAY: In Chess and Checkers you can be ninety-nine percent right and still lose; one bad move can defeat ninety-nine good ones.

Which is your favorite?

Dr. Brett explains about the need to challenge your limits and learn new skills. Hint: You need to do more than stick with what worked in the past.

Pradeep Bonde has an excellent post on trading setups. This is a good checklist of conditions, helping the trader to maintain discipline. One of my favorites from the list is:

To anticipate a breakout look at stocks currently not undergoing momentum burst.

Stock should be in extremely low momentum phase for anticipation.

It can be a shallow pullback or consolidation in established momentum phase.

Holmes barked with enthusiasm when I read this to him!

 

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Major market declines occur after business cycle peaks, sparked by severely declining earnings. Our methods are focused on limiting this risk. Start with our Tips for Individual Investors and follow the links.

We also have a page summarizing many of the current investor fears. If you read something scary, this is a good place to do some fact checking. Pick a topic and give it a try. Feel free to suggest new topics if your “fear” is not on the list.

Many individual investors will also appreciate our two new free reports on Managing Risk and Value Investing. (Write to info at newarc dot com).

Other Advice

Here is our collection of great investor advice for this week. It was especially difficult to screen for WTWA since there were so many good articles. Please enjoy!

If I had to pick a single most important source for investors to read, it would be Bryan Caplan’s discussion of forty lessons in his forty years. I have met Bryan a few times at conferences and respect his approach. This is not a traditional source for investors. Good! While I would enjoy debating many of the items with him, I see many great lessons. Reading his list will expand your investment horizons. The first two are favorites:

1. Supply-and-demand solves countless mysteries of the world – everything from rent control to road congestion.

2. Almost anyone can understand supply-and-demand if they calmly listen.  Unfortunately, the inverse is also true.

Stock Ideas

Which sectors have the most promising outlook? FactSet has interesting data. We still need to figure out how much is anticipated by current prices.

Earnings Outlook by Sector

Opportunities in telecom stocks. After recently meeting the author, I have been following My Sunday Brief. Jim Patterson is the real deal, with broad expertise on telecom issues and a keen analytical sense. The question is how best to make use of this excellent information. This is not a source of specific stock tips like those commonplace in the financial press or seen on TV. That is good, because the field will not be crowded. This week Jim writes about set-top box regulations, mentioning the implications for TIVO and Comcast. I am an early adopter of TIVO with multiple devices at home and the office. When I am in a hotel, I am frustrated by the inability to “listen lightly” or multitask, and then scroll back. Loving the product does not mean that you love the stock, of course. If you had a solid sense of the specific implications of the regulatory moves, you could act quickly as news emerged. You might also choose to anticipate regulations if the risk/reward was right. There is a lot of other interesting material, including the story of the controversial Sprint ad.

Aswath Damodaran, the leading expert on valuation, writes about Valeant. Even if you are not interested in this stock, looking at his changes in valuation (from risky to attractive) is an education.

Strategy

Does it help to be contrarian? Two sources whom I regularly follow weigh in on this topic.

Adam Parker talks to clients who all think they are contrarian, even though their views are similar.

Morgan Housel identifies the risk, putting it in the context of recent market history.

This is a great topic – now on my agenda.

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 this special edition. There are several great posts, but I especially liked the advice from Richard Weaver and Anne Bucciarelli about over-concentration in your own company’s stock. I have seen many sad stories of confident executives whose companies hit an unexpected stretch of hard times. The combination of possible job loss, salary reduction, retirement income loss, and declining option values can cast a pall over a comfortable future. (We provide a special options service to executives who need diversification, but cannot sell company stock).

Many people have high concentrations in company stock from retirement plans. It is important to know. Whatever the source, this chart shows the effect of excessive concentration.

Bucciarelli_Should-I-Keep_display1_d2

Oil Prices

As has been the case for many months, you can find three kinds of oil experts:

  1. Those calling for higher prices (cuts in US production and greater investor confidence).
  2. Those who see lower prices ($20/barrel?)
  3. Those who can always explain after a move but cannot forecast accurately. (Vox summarizes some interesting academic research).

Group 3 is the largest!!

oil spot price vs expectations

Watch out for….

FANG stocks. Last year it was difficult to beat the market without a significant holding in the Fab Four – Facebook, Amazon, Netflix, and Google. Chasing last year’s winners is not a sound strategy. ETFdb asks whether Netflix is a sign of what is to come for these names. Hint: There are plenty of assumptions about growth built into current prices.

 

 

Final Thoughts

I certainly do not know whether the stock market will make a new record next week, but I expect it soon. We had a chance to buy stocks at “recession prices.” Now the market is closer to normal, but conditions are still improving.

Josh Brown notes how angry people are with the move back to Dow 18,000, something that most trader types see as unjustified. His advice (with which I agree)?

Anger at new highs or because of a correction or bear market is symptomatic of process-free investing. I know this from experience, and I’m thankful for this experience even though it felt terrible at the time. It taught me what not to do.

Regardless of what you hear from various sources most people are frightened and under-invested in stocks. The charts that most use to assert “investor confidence” are all candidates for the Silver Bullet award! Stock ownership (as a percentage of people) is the lowest in 19 years, the entire history of the Gallup survey. (Shawn Langlois)

w704

Investment Take

We have been taking profits on stocks that hit targets and replacing with new selections. There are many candidates, and we go shopping on dips. We classify stocks three ways:

  1. Aggressive upside, but plenty of risk. You need to buy a basket, not a single stock.
  2. Great companies with great prospects, currently undervalued, but with potential catalysts.
  3. Stodgy, conservative names without a lot of upside. Great candidates for enhancing dividend yield by selling near-term calls.

Thinking about opportunities in this way is a good method for the individual investor.

Expensive Misconceptions

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The investment world abounds with research reports.  Intelligent and educated people generally benefit from careful study and accrued knowledge.

While it seems unfair, the investment world is different.  A little knowledge can be a dangerous thing!

There are many examples of this.  I have been stalled on this important topic because I was trying to do a comprehensive analysis.  It is often better to just get started!  I will start  with some of the most egregious and costly temptations for consumers of financial information.  I welcome more nominations to the list.  This is a great topic for us all to share ideas.

Shifting Indicators

This happens when the “rules” for interpreting data change to fit the per-conceived conclusion.  One recent example by bears related to the divergence of small cap stocks.  When the Russell 2K stocks were leading, the market was “frothy.”  When they lagged, it was a warning divergence.

Other indicators like sentiment, the Baltic Dry Index, Hindenburg omens, etc. are cited only when they fit.

Bullish analysts do the same.  If the monthly report does not fit the story, just look at non-seasonally adjusted data. year-over-year, or something else.  Many reports are susceptible to various spins.  The only solution for this is to know the agenda of the source.  This is rarely provided.

A persuasive chart

Please consider this chart, which is offered weekly as evidence that long-term investors have little to gain in the next decade while facing a lot of risk.

wmc160418b

I have a simple question for you:  Could you step up in front of a group of people and explain this chart?  If not, why do you believe it?  A smart and influential guy presents something that you cannot really evaluate.  Why is this a sound basis for your decisions?

It is unchallenged because of the lack of peer review in the investment world.  It is challenging to explain the errors, partly because so few could appreciate the arguments.

A plausible story

So many investment arguments depend upon simple analogies that are immediately convincing.  The frog in the pot story (even though it is not true) is one example.  These are stories that enable us to imagine an outcome without any real data.

  • Stall speed for the economy.  Graphic but wrong.  Economic expansions generally do not stall out, despite the intuitive appeal.
  • The aged bull market.  This is another argument that appeals to intuition but has no supporting evidence.  Whenever there is a streak that exceeds normal history — a hitter in baseball, a basketball team winning many games in a row — there is a temptation to say that this must be ending soon.  In fact, a winning team or player is actually just as likely to continue the streak.  Bull markets and economic cycles that have longer-than-average length are no more likely to end soon. (Nice survival analysis from SF Fed).

Your intuition and the confident-sounding talking heads are both wrong.  It is plausible spin.  You can take a profitable contrarian position by betting on further economic recovery.

The insightful investor fights spin with data and analysis.