The Fastest Way to Improve Your Investment Results

Here is the key concept: Abandon that which is not helpful!

Background

One of my best friends loved “investing” in baseball. He had an opinion about every team and every game. He also had a happy bookie.

He called me after taking a course in baseball betting. He explained that you could improve your results, regardless of your system, but refusing any team that had lost the day before. The course provided the evidence, and it was right. Systems all did worse when recommending losing teams.

I could not resist. I told my friend that if he also passed on all plays involving teams that won they day before, he would have a great system!

Investment Advice

Investors flock to websites providing the least helpful information. The writers are making a fortune without ever providing a single constructive or profitable idea! They collect by preying upon your fears and providing confirmation biases for the conclusions you already have reached.

This is a brilliant business model. It is much better than mine, since I must try to explain the contrarian side, provide evidence, and highlight good ideas.

Here is a suggestion for readers hoping for better results:

Review each source you regularly follow. If you cannot find some helpful advice in the last year, cross it off your reading list. If there is not a single stock recommendation that worked, put the site on double-secret probation!

Conclusion

This brief post might be the best piece of investment advice you will ever see. Most will continue their old habits. They love horror stories and lust for confirmation of their biases. You can choose to be different.

Finding Investment Excellence

There is a lot of recent buzz about active management – basically showing that excellence is difficult to achieve. The conclusion is popular, especially among those who have no aspiration to beat average.

I cannot do this in a single post, but I must start somewhere. As I often do, let me start with something far away from financial markets as the original illustration. As the TV lawyers say when wandering off course, “Your honor, just give me a few questions and I’ll connect it all up.”

Experts Exist

Let us suppose we have a difficult situation, not unlike a complex market. In this case, you are golfing. Your ball is in the rough, and there is a danger of going over the green on your approach shot.

If you are a golfer, you will get a laugh out of Golf Digest’s 26 most difficult shots. I have experienced all of them. The “shot over water” was especially intimidating at Butler National, where I asked my caddy about the drop zone. He wisely told me, “You need a better swing thought.” That was great advice!

Here is an example of Phil Mickelson hitting a 64-degree wedge. It is not a cherry-picked result. A google search will show many other similar shots.

The commentator observes that Lefty might be the only one who could hit that shot.

Finding the Expert

I hope everyone is convinced that there are experts in golf. In fact, there are experts in any field. In most cases there is a problem of “Untangling Skill and Luck” as Michael Mauboussin astutely poses it. In the case of Mickelson’s flop shot, the skill is evident. Many important cases are more challenging. What about someone with a model that provides a 10% improvement in forecasting hurricanes? Or earthquakes? The social gain from such expertise is important, but it might be difficult to identify.

If you are an investor in search of excellence, this is the challenge. For over ten years I have taken pride not in my own expertise, but in the ability to spot the best experts in various fields. That is now more important than ever for those who want more than mediocrity.

Stock Exchange: Model Picks Teach Us to Manage Risk

Individual investors are intensely focused on the concept of risk. And why shouldn’t they be? Finding an appropriate level of downside risk is paramount. However, too few give equal weight to the potential upside risk in their decisions. Permabears and doom-and-gloomers often watch from the sidelines as the market rallies beyond the fear of the day.

We’ve been able to enjoy such a rally in the wake of the election. As the uncertainty surrounding future government policy dissipates, investors have a broad range of new opportunities.This week, our models’ picks give us an opportunity to explore both upside and downside risk.

To help us cut through the fog, we are joined by Blue Harbinger (AKA Mark Hines).

What level of risk is right for you?

The Stock Exchange provides an expert-level debate on technical and fundamental analysis. (Important background is available here). Comments, dissent, and specific stock questions are welcome!

This Week—Is Athena late to the party?

It’s an extremely common mistake for investors to chase a stock on a rally, then panic and sell at the first downturn. This buy-high, sell low strategy is an obvious loser. Athena is our answer to everyone who wants to find a trend, enjoy the ride, and hop out near the peak. Let’s see what she has on tap this week.

Athena

Athena: Drill, baby, drill! Continental Resources, Inc. (CLR) was on a roll in November – though I couldn’t say why. All I see is solid upward trend and a spike in price to cap it off.

clr_technical_chart-athena

Blue Harbinger: Continental has some competitive advantages and challenges relative to other energy exploration companies, but its price still remains highly correlated with the price of oil. For example, Continental has competitive WTI break even prices of around only $30-$35 per WTI barrel, and it was an early mover in the Bakken Shale (Williston Basin). However, it will take a long time to develop its huge acreage.

A: I hadn’t factored in time for future development, but to me that sounds like potential for future growth.

BH: Two other things I know you didn’t factor in – the incoming administration (of which you have no knowledge), and attempts by OPEC to reduce crude supply.

Regarding the incoming Administration, it seems the regulatory balance may shift slightly towards pro-business, pro-profits and pro-growth, instead of pro-environment. That may work in Continental’s favor, but the bigger factor remains oil supply/demand, something the Administration has very little control of.

Regarding the attempt of OPEC to reduce supply, would-be buyers may have already missed that boat. Oil shot up on Wednesday (11/30) as OPEC agreed to its first oil production limits in eight years. Oil, as measured by US Oil Fund (USO) was up 8.65% on Wednesday, and Continental was up 22.88%. Caution is prudent with regards to initiating any new positions, because Continental will likely be very volatile in the near-term.

A: Well that’s all very interesting, but I’m only looking to CLR for the next couple weeks. Am I wrong to see upside here?

BH: We certainly won’t see any concrete policy shifts in your time frame, but that may not matter. Sometimes the appearance of a shift to market-friendliness can move a stock just as much.

Felix

I’m not looking for anything nearly as risky as Athena. Looking out a year or two down the road, I expect broad-based gains from the biotech sector (IBB).

ibb_technical_chart-felix

We’re reaching the bottom of a year-long slip, and the market seems to be correcting its perception of what IBB has to offer.

BH: From a contrarian standpoint, biotechnology and pharmaceutical stocks are attractive. And ETF IBB is a decent way to play the space because it provides diversified exposure at a decent price (the expense ratio is 0.47%).

F: Who’s the contrarian here? It looks like the market is coming to terms with a drastic change in this sector. Could the recent election be having an impact here too?

BH: It makes sense to consider IBB with regards to the goals of the incoming Administration and Congress. Hillary Clinton caused several big drops in IBB over the last year simply by taking issue with the way drugs are priced. Now that her Presidency seems off the table (at least for the next four years), and the threat of the House and Senate being flipped has been removed, the prospects for biotechnology and drug-makers looks better. IBB did pop (up nearly 10%) the day after the election, but it has given back nearly half of those gains.

If you are a long-term contrarian investor, it may make sense to consider some of the individual stocks within the ETF because you don’t have to pay the 0.47% annual expense ratio. For example, the two largest holdings (Celgene and Biogen) have only underperformed the broader market (as measured by the S&P 500) slightly over the last year. However, the third largest holding, Gilead, has dramatically underperformed. We don’t own Gilead, but we wrote about its attractiveness at the end of May (Gilead: A Trump Stock Worth Considering), and it’s valuation has only become more attractive since then.

Oscar

Fantasy football is going to be the death of me. I liked OBJ a few weeks back, but I didn’t like the Giants next few matchups. I left him on the bench. Naturally, he started playing his best games of the season. This on-again-off again approach isn’t working for me.

BH: Did you want to talk about stocks here or what?

O: Right – you gotta stick with what you know. I’m back on airlines & airline manufacturers. I liked ’em near the end of October and I like ’em again now. Check out BA. This one looks like a winner through the end of December, at the least.

 

ba_technical_chart-oscar

BH: Industrials in general (as measured by the Industrials ETF, XLI) have performed well since the election, and Boeing has performed well too. Industrials (like Boeing) tend to be cyclical, and the market seems to like the incoming administration’s pro-growth message.

From a valuation standpoint, Boeing is not unreasonable considering its price-to-earnings ratio (both twelve-trailing-months and forward) is within its historical range.

bh-oscar-1

O: Glad to see we agree (for once). Any reason to hold onto this one for a while longer?

BH: Boeing continues to spit off a lot of free cash flow that it has been using to reward shareholders with big share repurchases and healthy dividend payments. The dividend yield sits 2.9%, which is above average compared to the S&P 500, and may be attractive to many income-focused investors, especially considering interest rates are low and rising (i.e. bonds don’t offer a lot of yield and their prices will decline as interest rates go up).

Holmes

I spy brighter days for Under Armour (UA). The recent selloff here was overdone, and some recovery is expected. Since I’m familiar with profit-taking techniques like trailing stops, some recovery is all I need.

ua_technical_chart-holmes

BH: It appears the selloff was the result of management tempering long-term growth expectations. Under Armour has been growing like wild fire since 1996, but it’s a big company now, and it’s much harder for Under Armour to keep growing at the same high rate.

H: There may be some long-term concerns, but I’m not terribly concerned with that. How does this position look in the fundamentals?

BH: From a valuation standpoint, Under Armour is cheaper than it was, but it’s still very expensive, and the market still has very high expectations for future growth. For example, check out Under Armour compared to its rival, Nike.

bh-h-1

Blue Harbinger: The market can be very fickle when it comes to brands and fashion. Under Armour enjoys a lot of brand recognition and favorability now, but that can change quickly. Plus, it already doesn’t enjoy the same profit margins as Nike.

bh-h-2

H: Be that as it may, I’ll again say I’m really only interested in the stock’s modest recovery. Talk to me again in February, and we’ll see how this one worked out.

Background on the Stock Exchange

Each week Felix and Oscar host a poker game for some of their friends. Since they are all traders they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange.” (Check it out for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am the only human present, and the only one using any fundamental analysis.

The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities. Each week features a different expert or stock.

Questions

If you want an opinion about a specific stock or sector, even those we did not mention, just ask! Put questions in the comments. Address them to a specific expert if you wish. Each has a specialty. Who is your favorite? (You can choose me, although my feelings will not be hurt very much if you prefer one of the models).

Conclusion

Our models’ picks for this week were uncharacteristically risky – but that’s not all they had in common. By and large, the gang picked big potential movers for their short-term potential. Fundamental analysis and broader market context raise questions, where technical pings see a big upside.

This is why it is important to consider your level of risk tolerance as a function of your objectives. For many long-term investors, these positions would have little to offer. For those with a trading mindset, there may be a tidy profit to make before the holidays.

What is Your Confirmation Bias Quotient?

Most thoughtful investors know and understand the concept of confirmation bias. Very briefly put, we selectively perceive and choose evidence that supports our existing beliefs. It is a powerful natural process. Everyone is susceptible.

 

Morgan Housel has a good challenge: “What’s something you strongly believe that’s likely wrong?” He has a wonderful description of the key problem:

 

And while most of us are OK being told we don’t know everything, being told we have a lazy thought process is hard to interpret as anything but an insult.

So we have the ultimate cognitive dissonance: Fully aware that we’re wrong about something but unable to admit being wrong about anything.

 

Unfortunately for the decision maker, fixing the process is the key to better results. There are various discussions about how to avoid confirmation bias, but they are pretty general and not well-linked to investment decisions. Even worse, many investment discussions descend into an argument about who is biased, instead of an intelligent discussion of the facts.

 

Since it is not easy to detect your own biases, I have devised a Confirmation Bias Quotient to help. I have scaled the test so that high is good.

 

  1. Anecdotes. If you pay a lot of attention to specific stories and examples, give yourself -3. Illustrations can add color to conclusions, but when used as the basic level of analysis if is too easy to find supporting narratives.
  2. Specific examples. Similar to #1 but probably even more common. How do you interpret information during earnings season? If you pay a lot of attention to news reports on specific companies, give yourself -3. (It does not matter whether the stories are positive or negative; -3 either way).
  3. Symbols. If you find yourself drawn to colorful or graphic symbols of events – new paradigm, stall speed, stagnation, or anything similar pointing in any political direction – give yourself -2. If you completely reject analysis of data, take an additional -2.
  4. Demonstrably biased data. Examples are things like ShadowStats, where there has been compelling and responsible refutation, without response, on several occasions. Or like the idea that over 90 million people in the U.S. are without work. There is a legitimate debate about some data, but a general rejection of this type indicates a preference for conclusions before evidence. Take -2 if you find these arguments credible.
  5. Emphasizing unimportant data. Choosing to use data rather than stories is a good step. The problem is that there are so many indicators, and most of them have little significance. If you are looking at the Markit PMI (for Europe, China, or the U.S.), or regional diffusion indexes like Empire or Dallas, give yourself -1. There are so many of these that you can find anything you want, and none of them are established as really important.
  6. Embracing biased interpretations. This happens so frequently that I can only give examples. Suppose that a source complains about seasonal adjustments one month, but not another. Or emphasizes sentiment measures only when pointing in the preferred direction. Or emphasizes some specific factor (birth/death adjustment, core measure versus headline) only when it fits their message. It is pretty easy to spot such sources if you look for them. If you find yourself in this camp, take another -1.
  7. Relying upon biased or weak sources. Mr. Buffett said that you should not ask your barber if you need a haircut. Why ask a bond guy about stocks? Or an emerging market manager about bonds? Or a hedge fund manager, who is not really there to help you, about anything? If you do not have a high level of skepticism about sources, take another -1.

 

If you are really mired in bias, you could have a score of negative 15 at this point. Let us turn to the positive factors. Each is worth a possible +5 points, for a total of +20.

 

  1. A willingness to separate your evaluation of the economy and investments from your personal political beliefs.
  2. Finding the most important economic indicators and sticking with them, even when they convey a message that feels wrong to you.
  3. Discovering sources that have demonstrated expertise and track records in the relevant subject.
  4. Being willing to read carefully the analysis of experts with differing viewpoints.

 

The Test is one of Process, not Conclusions

 

A crucial point: You may well reach a consistent bearish or bullish conclusion without significant confirmation bias. The test is about your information, method, and process — not about conclusions. Different experts can look at the same data and reach different conclusions. In my weekly WTWA column I carefully follow all four of the positive factors listed, and strive to maintain a high CB quotient. It happens that my conclusions have been correctly bullish. Some erroneously believe that this reflects bias. Not so. If the evidence changes, so will my conclusions. Why shift from a winning method for “cosmetic” reasons?

 

Scoring the Test

 

If your score is negative, your biases are costing you money. My estimate is that 70% of investors would have a negative score on this test.

If you have even a small positive score you are actively seeking objectivity – probably in the top 20% of all investors.

If your score is above +10, you are doing a very good job of seeking evidence. Your investment results probably reflect this!

 

Expensive Misconceptions

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.

 

A Bear Market Rally?

Mixed markets often lead to a debate over the primary trend.  Bearish pundits insist:

This is just a bear market rally.  It can be sharp and strong, but overall conditions are still bearish.

Bullish pundits suggest the opposite:

There is a strong bullish trend.  Some dips occur, but these are merely buying opportunities.

Both traders and investors should be asking whether this debate is even relevant.  There is no actionable difference; it is just semantics.  In a market which has both ups and downs, and that means most of them, it is pretty easy to make an argument either way by your definition of the time frame.  If you go back to the height of the Y2K days, I guess you can make the subsequent era seem bearish.  If you go back more — or less! — it seems like a bull market.

This is a pundit’s paradise.  Whatever your viewpoint, you can support it with data.  This is worse than unhelpful.  It reinforces the known cognitive biases of investor by providing apparent authoritative support for their error.

Trading and Investing Implication

The “bear market rally” debate is irrelevant. Traders should be interested in the next ten minutes, while investors should care about the next ten years.

Financial publishers always like to emphasize “actionable investment advice” and that is part of the problem.  This argument has the illusion of relevant information.

Sometimes (often?) the best investment advice is to ignore pundit pseudo stories.  The insightful investor understands how to tune out the noise.

You Do Not Get Paid for Knowing Yesterday’s News!

You do not get paid for knowing yesterday’s news… unless you work as a pundit!  In that case you just need to go on TV and repeat what you read that morning in the Wall Street Journal or the FT.  Like the “B” student in a class, you learn the conventional wisdom and repeat it.  You can sound very confident — even smug — and seem right because you are describing the past.

For traders and investors, yesterday’s news is history — already reflected in market prices.  Unlike other aspects of life, being well-informed provides you no edge. It might even be a disadvantage.  The post-hoc explanations for market moves twist theory to fit perceptions.  As humans, we crave to make sense of everything; we are very creative in finding explanations.  This may build a view of the world that is quite wrong.

Finding an investing or trading edge requires an accurate view of the future, not the past.  You can do this in several ways:

  • Better information — possession of facts not widely known;
  • Speed — getting news faster and drawing the right conclusions;
  • Interpretation of data — understanding and using an indicator or technique that is not widely followed;
  • Contrarian investing
    • Determine the conventional wisdom
    • Find important mistakes in the popular, oft-repeated viewpoints
    • Consider what sectors and stocks would benefit if there is a return to reality

Examples

If you start asking yourself the right questions, following the points listed above, you will find some fresh ideas.  Here are a few examples:

Information — There are many important facts that are not widely known.  Worldwide demand for energy has increased every year, more this year than last.  Using energy prices as a gauge for the world economy is too pessimistic.  Bank exposure to energy companies is relatively modest and reserves are much better than in 2008.

If you accept this information, you can shop economically sensitive companies and banks.  This information is hiding in plain sight.

Speed — Good luck with this approach!  You really need to have a plan in advance and jump on breaking news, beating the computer algorithms.

Indicators — The page-view payoff for pessimistic news has inflated the perceived probability of a recession.  Insider buying has been strong in several crucial sectors.  CEO’s generally express confidence about their own business, even when less optimistic about others. The relevant data is easy to find.

Contrarian Analysis — The conventional wisdom has punished biotech because of a political debate about drug prices.  Oil prices are seen as hovering at a permanently depressed level.  Banks are targets for political rhetoric and exposed to bad loans.  Apple is too big and lacks new products.  And more.

Do we really believe that an aging population will not embrace the new drug discoveries?  That China, India, and other countries will not need enough energy to close a 1% gap between supply and demand?  That banks will not escape the political noise with more profit?

Conclusion

I do not expect everyone to agree with the specific trade ideas in this post, but I hope readers will consider the basic approach.

If you want trading or investment profits, think for yourself and think ahead!  Reading the news only helps to know what others are doing.

 

 

Weighing the Week Ahead: What are the Biggest Market Worries?

The economic calendar is again light in a holiday-shortened week. There are a variety of important news items, but no dominant theme. I expect the punditry to seize the opportunity by asking:

What are the biggest market worries?

Prior Theme Recap

In my last WTWA I predicted that everyone would be talking about the high and rising worry about a recession. That was one of the most frequent media topics for the week, with some sources even choosing “looming” as part of the description. Fed Chair Yellen grabbed the spotlight for her testimony, but even that centered on economic concerns and what the Fed might do. Friday’s rebound was notable in size, but left plenty of skeptics. As Doug Short notes, the rally came in concert with yet another mystery rally in oil prices. Skeptics saw short-covering action, with issues to be revisited this week. You can see the story in Doug Short’s 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

Doug’s update also provides multi-year context. See his full post for more excellent charts and analysis.

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

Earnings season continues, but the economic calendar is light in a holiday-shortened week. In most of the world there will be news on trading on Monday, which will set the tone for U.S. markets. With continuing worldwide volatility, I am not expecting a single issue to dominate next week. Instead I expect the pundits to be asking:

What is the biggest worry for investors?

2016 began with declining stocks and plenty of concerns. New candidates surface each week. Listed below are the most-noted worries. Those getting a lot of fresh attention are listed last. I have omitted the evergreen valuation and disaster scenarios.

  • Stocks show technical weakness
    • Almost breached important technical levels
    • Lack of breadth
    • Friday saved only by short-covering
  • The stock market is clearly signaling recession
  • Earnings growth weak and outlook weaker
  • Strong dollar hurting sales, exports, and earnings of multi-national companies
  • New variants on the “R word”
    • Earnings recession
    • Growth recession
    • Manufacturing recession
    • New recession definitions (e.g., slow growth)
    • Self-fulfilling prophecy recession
  • Falling commodity prices
  • China weakness and capital flight
  • There is an emerging leadership crisis
    • Barron’s cover featuring outsider candidates, Trump and Sanders
    • Early takes on Justice Scalia’s death
  • Negative interest rates
  • Declining dollar
  • End of Fed QE policy

I did the list without even going to ZH for ideas, so there are probably more. Feel free to add anything important in the comments!

Scott Grannis reviews many of the issues in one of his helpful chart packs, accompanied by commentary. He reaches a mildly optimistic conclusion, despite the high level of fear revealed in this interesting indicator:

Walls of worry

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 “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

On balance the news was pretty good last week, despite the market reaction.

  • Initial jobless claims have turned lower. Bespoke has both analysis of the data and great charts, including this one:

021116-Initial-Claims-SA

  • Both job openings and the quit rate were strong. The WSJ reports the voluntary quit rate as the highest in nine years. This shows continuing expansion and confidence in job markets.
  • Bullish sentiment (a contrarian indicator) is back to bull-market lows. (Bespoke).

AAII-Bullish-021116

  • Retail sales were strong. Bloomberg calls it a broad-based advance, highlighting online sales and figures with (low-priced) gasoline excluded.

The Bad

As always, some of the news was negative.

  • Leadership worries. Early primary results have favored “outsider” candidates. In my 2016 preview I said that it was far too soon to draw conclusions about the Presidential election. Even though that was only a month ago, there have already been twists, turns, and surprises. That said, commentators note that markets prefer establishment candidates and stable leadership. Personally, we can and should each express our own viewpoints and vote our consciences. Our personal choices may not always be “market friendly.”
  • Michigan sentiment index declined to 90.7. This preliminary read was lower than last month’s final number of 92.0, and also missed expectations by the same amount.
  • Business sales and inventories are in contraction. Steven Hansen takes on a complex subject, showing many interesting takes on how to view the data. (Unadjusted – blue line, inflation adjusted – red line, 3 month rolling average—yellow line).

7980347ztemp

  • Earnings for Q4 remain disappointing. While the earnings “beat rate” is OK, only 49% of companies are beating on sales. Guidance is 68-17 negative. The blended revenue growth would be slightly positive without energy stocks. (FactSet).
  • Low inflation is bad (?) It is if you are the Fed, trying to raise inflation expectations. Data show an actual decline, although still above the Fed’s target. (WSJ).

BN-MO883_MICHIN_G_20160212112634

The Ugly

Cheating. This is more pervasive and important than you probably realize. We see the occasional story of a dishonest broker or insider trading. There are scandals in sports. Even my own world of top-level tournament bridge was recently rocked by revelations about several of the top professional partnerships.

In all of these cases, there are significant financial incentives. Steven Mazie reports on a scientific study that shows that winning begets cheating. Several different experiments show that winners in one game, randomly determined without their knowledge, will cheat on a subsequent game when having the power to do so unnoticed. And this happens with no financial incentive or even public acknowledgment.

But the upshot is troubling for people who care about the future of humankind. “It is difficult to overstate the importance of competition in advancing economic growth, technological progress, wealth creation, social mobility, and greater equality,” the authors write. “At the same time, however, it is vital to recognize the role of competition in eliciting censurable conduct. A greater tendency toward unethicality on the part of winners … is likely to impede social mobility and equality, exacerbating disparities in society rather than alleviating them.” There may be no way to completely remove this flaw from human nature, but “[f]inding ways to predict and overcome these tendencies” would seem to be a mission well worth pursuing.

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 always welcome!

 

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. Beginning last week I 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.

Recent Expert Commentary on Recession Odds and Market Trends

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.”

Georg Vrba: provides an array of interesting systems. Check out his site for the full story. We especially like his unemployment rate recession indicator, confirming that there is no recession signal. He gets a similar result with the twenty-week forward look from the Business Cycle Indicator, updated weekly and now part of our featured indicators.

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. His Big Four update is the single best visual update 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.

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.

Econbrowser’s Prof. Menzie Chinn updates a yield-curve based recession model. He notes that the model predicts recessions accurately about 78% of the time and non-recessions at an 85% pace. The current recession probability for the next year is about 9%.

Similarly, see Jim Picerno, who does a similar analysis and concludes as follows:

Meantime, let’s keep reminding ourselves of a salient fact: every US recession has been accompanied by a plunging stock market but not every stock-market plunge has been accompanied by an NBER-defined recession.

 

The Week Ahead

We have another quiet 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 (W). Potential for more gains?
  • FOMC minutes (W). Even when you think there is nothing more to learn……
  • Industrial production (W). A sign of improvement in this sector would be very encouraging.
  • Initial Claims (Th). A lot of attention to the recent volatility in the best concurrent news on employment trends.

The “B List” includes the following:

  • PPI (W). No sign of inflation. It would take a few “hot months” to get serious attention.
  • CPI (F). See PPI.
  • Philly Fed (Th). Gaining more attention as the first read on the prior month.
  • Crude oil inventories (W). Attracting a lot more attention these days.

There is some FedSpeak on tap, but less than usual. Presidential campaigning will be intense before next weekend’s primaries. The Chinese holiday is over, and some expect news on Monday, when U.S. and Canadian markets are not trading.

Earnings reports are still in full swing.

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, and the bearish lean. Felix is still 100% invested, but with more conservative choices than last week. The more cautious Holmes is still about 1/3 invested. For more information, 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.

When might human traders do better than computers? Rob Carver has a thoughtful comparison. As a manager employing computerized decisions in some programs, the topics reflect my own experience. The question of when a human should “override” a model decision is especially interesting. I frequently consider this when reviewing the decisions of Felix and Holmes.

Brett Steenbarger continues to suggest important and novel ideas about trading. This week he writes about having the macro wind at your back, and how to handle that happy news.

More importantly he gives some tips on how to spot the moves of big institutions.

It’s a common mistake to become tunnel visioned during times of market stress and only follow the position(s) you are trading.  That blinds us to the waxing and waning of macro themes and the influence of large market participants.  You may not trade the markets thematically yourself, but it helps to have those themes at your back–and certainly not in your face.

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 (recently updated) 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.

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 this short post from Tadas Viskanta. He speaks clearly and effectively to investor concerns about how they are doing and second-guessing decisions. He notes the weak start to the year by some famous investors, and also advises tuning out the so-called “authority figures” on financial TV. His key advice? Cut yourself some slack!

 

See also the Investment News report on some of the top fund managers, down 20-25% in spite of their long-term success records.

 

Stock and Fund Ideas

Three Warren Buffett picks are on sale. (Matthew Frankel at TMF).

Ben Carlson cites data showing the historical rebound of global stocks following a bear market. He also supplies a list of what has been working and what has not – at least so far.

Tough times for solar stocks. (ETF.com).

 

Energy Prices

Last week. (MarketWatch)

Long term. BP’s annual energy outlook is a great data source.

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Watch out for….

Guaranteed income certificates. David Merkel has a nice post on investment charlatans with a good specific example.

Non-traded REITs and BDC’s. FINRA accuses broker of bilking Native Americans for over $11 million.

Special care is required when investing in these vehicles. You had better know what you are doing, and understand the risks.

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 this advice from Carl Richards (NYT) about the need to accept uncertainty. Check out the stories about medical examples. You might also review my recent piece on the costly craving for explanations.

Final Thoughts

Investors do not understand worries, uncertainty, and scary headlines. If there were no “headwinds” then the market would be more richly valued. Most people have heard the expression, “wall of worry” but few understand it.

Almost six years ago, when the DJIA was at 10K and many were expecting it to go to 5000, I made my controversial Dow 20K call. There were many market worries, which are now mostly history. Instead, we have moved on to a new list of challenges. (Check out the story here).

The market gradually rises as fears are surmounted and earnings rise. There will be a time to become more cautious, or even bearish. That time will be indicated by data, not by fear-inducing headlines and speculation.

For many weeks I have noted that traders and others with a very short time frame should reduce risk. Investors should be seeking opportunity.

My noted neighbor to the North is Brian Wesbury. (Wheaton and Naperville once contested the location of the County Seat. Wheaton took the records and Naperville folks met at the Pre-Emption House to plan a raid. Somewhere during the night, the plans became muddled. Rumor has it that strong drink was involved).

Brian also wrote this week about whether recession was “looming” and how to interpret the market action. His conclusion (similar to mine last week):

This is a correction, not a turning point for the stock market.  Our models, with stocks driven by interest rates and corporate profits, not sentiment, suggest the market is still significantly undervalued.

It’s not often you get recession level prices when there is no recession.

Put money to work, don’t run away.

Revisiting the Stress Test

Early this summer we raised a number of questions in our Summer Quiz.  The objective was both to enlighten and to help investors make wise investment decisions over the summer.  As we hoped, anyone who took the quiz seriously has had a profitable summer.  (We'll try to wrap up the answers and award the prize, since we are now beyond Labor Day).

In Question #7 we asked:

The government stress tests for financial institutions have something
called an "adverse scenario."  The conditions from that scenario have
already been met, or nearly so.  (True or False)

At the time we posed the question, there was a universal fixation on the unemployment rate.  This was the only readily measurable input, and it seemed artificially low.  It was pretty clear that unemployment was going to lag the rest of the economic recovery.  Meanwhile, the other stress test inputs were not very visible.  On a symbolic basis, it was bad politics from the Obama Administration.

This fact was widely known to anyone paying attention.  A month before our quiz, Tom Brown wrote as follows:

But
as unhappy as I am about the stress test, I’m even more shocked by all
the commentators who dismiss the test results because they believe it
wasn’t stressful enough. Some of these people simply believe
the U.S. economy is headed into a death spiral; no how matter how
bearish a given forecast is, they’ll tell you it’s not bearish enough.
Others have lately built a nice business for themselves by being
relentlessly, flamboyantly negative. Still others simply don’t know
what they’re talking about.  Let’s look at a few of these people have
had to say lately:

Brown went on to analyze several bank critics.  These were the people celebrated as "getting it right."  Brown pointed out that the loss reserves in the test were very aggressive.  His prediction of the result?

The
likely result of all this? Just as in the last recession, the big banks
will emerge overcapitalized, over-reserved, while their shareholders
have been unnecessarily diluted.  It’s a disgrace.

Other source fixated on the employment number in the stress test, ignoring the (more important) loss reserve inputs.  Despite their analysis, several of the big banks are paying back TARP funds.

What Happened?

Since our quiz on June 15th, the big banks are up about 30-35%.  Anyone who did the homework could have participated.  Meanwhile, there has been fresh news about bank failures and additional capital requirements for regional banks.  As part of our series about what to watch, we noted that bank failures are not an important economic indicator.  Many blogs enjoy reporting a few more failures each week, adding to the impression that this is significant.  There has also been news that regional banks may need to add capital.  Maybe so, but it is not the crucial point.

As Tom Brown wrote:

In
particular, in the latest quarter, the banks’ NCOs came to 3.16% of
loans, far short of the 4.16% laid out in the stress case. And as you
can further see, chargeoffs under the stress scenario won’t peak for
another three quarters, at which point they’ll top 5%.

He produced the following chart.

090805stress


We remain very interested in when banks will be willing to do more lending!

A Crucial Question for Investors

A common theme among many pundits is to say something like "X was wrong on subject A, so why listen to any future predictions?"  Some of the more aggressive pundits extrapolate.  If an expert was wrong on "A" you should ignore him/her on "B".

That was the dubious logic for missing one of the biggest rallies in history.

A Dose of Reality

The subject really requires a more extensive article (forthcoming), but the stress test issue highlights the main theme.  Every time we cite Tom Brown we get critical comments, since he "missed it," while Meredith Whitney and others "got it right."

Predictions are not so simple.

Those who "called the crash" are not all geniuses.  The others are not all dummies.  Experts use widely varying methods.

The biggest investor mistake is chasing performance, thinking that someone has a hot hand.

We are about to see this play out in many sectors.  The stress test is a good example.

[Full disclosure — Our accounts hold GS, BAC, and held at various times, regional bank ETF's.]

Don’t be Stubborn!

Near the top of investor mistakes is the stubborn adherence to something that has been proven wrong.  The error might be a strategy, an economic viewpoint, a market opinion, or the choice of favorite pundits.  You need to step back and reevaluate when there is important new information.

Here are two key examples:

  • The failure of Lehman.  Many thought that the big investment banks were too big to fail.  It turned out not to be true.  While some still think that the government should have acted, those in power felt they lacked authority to act.  In the aftermath we all learned what would happen to the economy if there was no confidence in any financial institution.  What we call "normal and sensible lending" came to an end.  Most mainstream economists adjusted their forecasts to account for the extreme reaction of corporate leaders.
  • Massive government intervention.  Many thought that the government would be powerless or ineffective.  This turned out not to be true.  While some still think that the government actions were wrong, those in power saw a responsibility to act very aggressively.  In the aftermath we all learned what would happen when there is aggressive action and intervention by the federal government.  Most mainstream economists adjusted their forecasts to account for the extreme reaction of government leaders.

Ironically, many observers who were accurate on one of these key points missed the other.  In a further touch of irony, economists who adjusted forecasts in both cases (notably those in the mainstream) are now frequently criticized for "missing" the first move.  The implication is that their current forecasts will be wrong.

The Three Doors Problem

We anticipated this situation in June when we asked the following question:

You get the chance to be on a game show.  The host lets you pick one of
three doors for a prize.  One door has a great prize and the others
have trivial rewards.  You make your pick.  The host (who knows where
the real prize is) reveals one of the two alternatives and offers you
the chance to switch your choice.  Should you do so?

Top traders with whom we have been associated use this question as a screening test for new recruits.  Getting it right on the first pass (easy for bridge players, who are experts at probability) is excellent.  Since most people fail on the first pass, the question is how long it takes them to accept the answer.  Some of the most intelligent people in our universe could not accept the solution.  That is a bad trait for a trader!

The Solution

The problem is a simple probability question, but the answer is counter-intuitive.  The best simple explanation comes from Leonard Mlodinow, whose book, The Drunkard's Walk,  we recently recommended.  The explanation comes from an excellent quiz presented by The Numbers Guy, Carl Bialik.

Answer: Yes. When you initially chose door No. 1, you had a one
in three chance of picking the car. The other scenario, in which the
car is behind one of the other two doors and so only one of those two
doors hides a cow, has a probability of two-thirds. Let’s focus on that
scenario, and assume — since we don’t have any information to the
contrary — that the host always opens a door that reveals a cow. In
that case, the door he didn’t open and that you didn’t choose always
contains the car. So if you switch, there’s a two-thirds chance that
you’ll win the car. If you don’t, you’re stuck with a one-third chance.

Bialik goes on to note the recent featuring of this problem in the poker movie, 21, which we recently saw on Netflix.  We might have chosen a different problem, since many readers now seem "clued in" to this specific answer while missing the concept.  Readers who want more such questions should look at his original quiz, especially #3, which has a similar theme (also a layup for bridge players).

The issue of stubbornness is highlighted in the reaction to Marilyn vos Savant, who presented the question in her popular Parade Magazine column.  Many "experts" disputed her answer.

Current Relevance

We see many economists and pundits who stubbornly adhere to a viewpoint that "called the crash" or had some method of market valuation that seemed, in retrospect, to be accurate.

Forecasts must change with facts and new data.  There is no substitute for keeping current on the best indicators.  We try to balance our fundamental analysis with market indicators from our disciplined trading system.  It is a reality check.  Many of the most popular financial websites have an ongoing commitment to finding the worst possible interpretation of any reported data.  There is a need for balance.