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

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.

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.

 

Weighing the Week Ahead: Time to Sell the News?

The economic calendar is moderate. Fed Heads are mostly on the bench. The Doho oil conference (combining OPEC and non-OPEC producers) will be the first major news for the week ahead. Markets have already anticipated the outcome, just as they have the trend of first- quarter earnings. It is a classic test of the theme:

Is it time to sell the news?

Prior Theme Recap

In my last WTWA I predicted special attention to corporate earnings reports and a possible break of the trading range. The first part was true throughout the week, and the second part was in play on Friday. Doug Short comments on the increased volatility and also notes the good overall week and the volume spike on options expiration. See his discussion and context as well as 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

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

The economic calendar is moderate. There are few scheduled Fed distractions. Earnings season will be in full swing. This reporting period might be the most important in recent years.

Last week gave us a preview. The talking heads at pundit central were constant asking why the market moved higher in the face of moderate or bad news on the “fundamentals.” At the start of the week –and maybe by the time you read this—the Doho outcome will be known. By week’s end we will have much more information on earnings. Both themes set up the popular question for next week:

Is it time for investors to “sell the news?”

Background

My approach to introducing this week’s theme was to discuss the Iraq War and the non-stop CNBC coverage of Iraqis pulling down a statue of Saddam Hussein, basically with no tools. (Some believe that the whole thing was staged, making it an especially good example for my purpose). Futures had popped at the opening. It took an hour or so for the statue to come down. What do you think was the result?

Mrs. OldProf advises me that this example is boring and pedantic (who, me?) She recommends instead a song that was (amazingly) written in fifteen minutes. If Cat Stevens had been on time for their date, the song might not ever have been written!

We can never know about the days to come
But we think about them anyway, yay
And I wonder if I’m really with you now
Or just chasin’ after some finer day

Anticipation, anticipation
Is makin’ me late

220px-CarlysimonAnticipationartwork

 

Viewpoints

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

  • Stocks have increased dramatically for no apparent reason. It is a classic time to sell.
  • Doho expectations make no sense. The “positive” side has been built into expectations. A likely negative outcome will hit oil prices, the recent correlate for all risk-on assets.
  • Earnings achieved the customary result – beating dramatically lowered expectations. It means nothing.
  • Economic data remain weak and international threats abound.
  • The earnings recession is upon us. Outlook updates have been poor. Expect an over-valued market to crash.
  • Strength in the face of mediocre news is a positive. Next step? Breaking the trading range.
  • The bad news has been “baked in.” Perceptions of fundamentals are pretty negative. A weaker dollar will help.

These viewpoints have all been vigorously expressed in recent days, but my sense is that short-term traders remain pessimistic about both earnings and energy prices.

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.

  • The CPI remains low and gradually rising — 0.1% on both headline and core.
  • The crude oil “glut” is narrowing. “Davidson” (via Todd Sullivan) notes the narrowing of the 1% gap between supply and demand. He cites various sources suggesting that the gap is narrowing – a massive change in perceptions from the IEA in only a few weeks. The significance?

    What this says is that most of what one hears is tied to trends in oil prices and not to fundamentals. The behavior of the majority of investors, perhaps more than 95% of investors, is to assume that price trends carry economic information and then look to determine which fundamentals they think are responsible. Herd mentality is always a strong force when individuals do not know how to read fundamental data.

  • Long leading indicators have improved, although the overall picture is still mixed. (New Deal Democrat).
  • Jobless claims down ticked to 253K, beating last week and also expectations by a solid margin. Doug Short and Jill Mislinski have analysis and one of his amazing charts that combines short term, long term, recessions, two time frames, each weekly result, and the four-week moving average.initial jobless claims

 

  • Bullish sentiment moves even lower despite recent market gains. (Bespoke).

AAII-Bullish-041416

 

The Bad

Most of the news was negative.

 

  • new-eng-weo-tableSeveral big banks fail the “living will” test. (Reuters)
  • Retail sales disappointed, dropping 0.3 % (0.4 ex-gasoline). Calculated Risk elaborates.

RetailMar2016

  • U.S. Q116 GDP downgrades continue. The NY Fed has now joined Atlanta in doing a rapid update of current GDP. Other central banks discuss business conditions, but not attempting a specific forecast. The official GDP data comes much more slowly after revisions from the underlying sources are complete and a benchmarking process followed. Do the fast techniques cut some corners? How good are these estimates? Barry Ritholtz has a skeptical take on this process, reminding us:

    The old joke seems to apply here: Do you want it fast, cheap or good? Pick two.

-1x-1

  • Industrial production fell 0.6%, slightly lower than the prior month and badly missing expectations of “unchanged.” Steven Hansen looks at the data using his customary wide array of methods.
  • Michigan sentiment of 89.7 (preliminary reading) was down 1.3 from the March final and missed expectations by 2.3 points. Doug Short associate Jill Mislinski has a comprehensive review, quoting the Survey’s economist Richard Curtin.

    None of these declines indicate an impending recession, although concerns have risen about the resilience of consumers in the months ahead. Consumers reported a slowdown in expected wage gains, weakening inflation-adjusted income expectations, and growing concerns that slowing economic growth would reduce the pace of job creation. These apprehensions should ease as the economy rebounds from its dismal start in the first quarter of 2016. Overall, the data now indicate that inflation-adjusted personal consumption expenditures will grow by 2.5% in 2016.

dshort Mich Sentiment

The Ugly

The IRS is especially vulnerable to hackers (Robert Hackett, Fortune). Few know that the IRS has about one million cyberattacks per day! One IRS employee, charged with helping those whose identity had been stolen, actually helped the hackers.

Is it time to refocus priorities? Perhaps increase appropriations? My sense is that many government computers are old and vulnerable.

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 Steven Saville who exposed the bogus, fear-inducing post at everyone’s favorite disaster site. The article about an emergency Fed meeting followed by a Yellen conference with both the President and Vice-President probably caused many individual investors to exit the market and got traders on the wrong side. The latter group may have covered quickly. They needed to.

The Fed mythology preys upon people’s greatest fears. Saville cites a Bloomberg article in November on the same theme. These are absolutely routine meetings where the Governors consider suggestions from the regional Presidents.

You need to be a real expert to know the difference between “expedited procedures” and “emergency.”

 

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 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.

Recent Expert Commentary on Recession Odds and Market Trends

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. She cites a recent speech by ECRI co-founder Lakshman Acuthan who notes 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.

Dshort big four

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.”

 

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:

  • Building permits and housing starts (T). Housing, especially new homes, remain as a crucial sector. Rebound continuing?
  • Leading indicators (Th). A solid increase is expected. Many follow this report, despite various changes in calculation methods.
  • Initial claims (Th). The best concurrent indicator for employment trends.

The “B List” includes the following:

  • Existing home sales (W). Less immediate economic impact, but still helpful as a read on an important sector. A further rebound expected.
  • Philly Fed (Th). One of two regional indexes worth watching. I remain unconvinced about the fundamental basis, but the markets react.
  • Crude oil inventories (W). Attracting a lot more attention these days.

There is not much FedSpeak. We may start with a hangover from options expiration.

There will be a continuing focus on corporate earnings!

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 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 back to 100% 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 keeps bringing it, week after week.  Do you have an R & D program?

 

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 David Foulke’s post at Alpha Architect. The new rules on fiduciary responsibilities for investment advisors are confusing to many. He provides a helpful quiz showing the hidden brokerage and insurance links obscured by several popular advertisements. This is both entertaining and extremely valuable. Here is one of many examples that confuse or obfuscate.

2016-03-16-15_30_49-Life-Insurance-Retirement-Investments-_-Prudential-Financial

 

Stock Ideas

10 mid-cap stocks from Chuck Carnevale’s screening. He demonstrates that all have plenty of upside.

Eddy Elfenbein identifies twelve stocks with sales growth over 60 straight quarters.

Barron’s has auto news on the cover (25% upside?) and feature stories on both Ford and GM. (Makes sense to me).

Strategy

It all starts with setting your goals. Ben Carlson shows that investors want to protect wealth. But they also want to increase it. It is a dual mandate that is difficult for many to navigate on their own.Screen-Shot-2016-03-30-at-8.48.32-AM

 

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 about The “Rosemary’s Baby” of Investment Products by Tony Isola. He explains well the drawbacks from indexed annuities, a popular current “product”:

So when all is said and done, fixed-index annuity investors receive the following:

Bond like returns with many unnecessary layers of complexity

Hedge fund like fees.

Steep surrender charges greatly reducing liquidity. Translation, you can’t sell this crap when you might need to.

Counter party risk that is unnecessary. Since you are transferring your risk to an insurance company, an investor is at the mercy of the insurer’s financial situation. Insurance companies can go bankrupt.

The upside is capped and often reset. This means the market can go up 15% but an investor’s maximum gain may be 5%!

And also:

There is no chance you will travel faster than the guy next to you if you are rowing against the current and he isn’t. When it comes to fixed-indexed annuities, the current is twice as strong.

High fees and the exclusion of dividends will literally sink your investment boat before the race even starts.

[Jeff] It is difficult to help people who have purchased these products. The sales agent has gotten signatures on disclosures that are densely written and difficult to interpret. This advice is important for many investors who are encouraged to think that all problems are solved with this approach. It can be fine for some investors, but they need a guide not prepared by the salesman. As Mr. Buffett notes: Don’t ask your barber if you need a haircut!

Commodities

Have we made a bottom in commodities? BHP Billiton chief executive Andrew Mackenzie has an upbeat take on commodity prices, believing the worst may be over. The Pundit-in-Chief dismisses the evidence from Billiton’s model. What do you think?

2016-ytd-from-recent-lows-all-prices-template

Watch out for….

Active bond funds with (apparently) high returns. Pimco executive Dan Ivascyn explains,
“Investors are gravitating toward income-generating high dividend ETFs which sometimes don’t have restrictions on lower credit quality.”

Larry Swedroe elaborates in discussing Unconstrained Mutual Funds, writing as follows:

Unconstrained mutual funds are permitted to own global bonds, currencies, high-yield bonds, structured bonds and even equities. Many utilize leverage, derivatives and swaps, taking short positions as well as long ones. In other words, in addition to their typically high expense ratios, unconstrained funds are often highly complex. Unfortunately, complexity often carries risks that may offset the very risk-reducing benefits bond investors seek and dilute fixed income’s role as a portfolio’s primary risk-mitigating component.

As one example of the risks involved, Morningstar data shows that as of year-end 2014, the average fund in the “unconstrained” category had 40% exposure to investments rated below investment grade (or that didn’t have ratings). This compares with less than 7% for the average intermediate-term bond fund. What’s more, there isn’t any such exposure in the Barclays U.S. Aggregate Bond Index.

[Jeff] It is difficult to judge risk/reward when the risks are difficult to determine!

 

Market Timing

You are likely to pick the wrong time to invest as well as the wrong stocks! (Morgan Housel). One stock has earned a quarter trillion dollars in profit since 2012 without much change in price. Another has earned nothing while the stock has tripled. He has several other great examples.

But disagreeing with popular sentiment is easier said than done. Few things feel better than fitting in, and having a viewpoint that goes against everyone around you is a mental battle not one person in a ten can maintain for long. Rather than identifying extremes in current sentiment, it’s easier to justify the market’s mood no matter what it is.

 

If your perspective is short-term, you need to figure out what everyone else thinks now as well as what they will think tomorrow.

Even value investors can be tricked by chasing the best returns from the prior year. (Morningstar).

 

Final Thoughts

Our top sources – Brian Gilmartin and FactSet are always mandatory reading, but especially so during earnings season.

FactSet shows the relative exposure to dollar strength. In Q1, the effect was still strong. Whether it will continue is a key question.

FactSet Earnings by Global Exposure

 

Brian Gilmartin notes the importance of the Doho conference and also maintains his position that this this quarter will mark the earnings bottom.

My Take

For traders, it is difficult to figure out either the trend or the contrarian position. Markets have moved higher for little apparent reason and many are positioned for selling. Bloomberg quotes traders as questioning whether oil could possibly move higher after the meeting.

I expect the options “hangover” but no lasting effect. We are prepared to do some buying into a soft Monday market.

For investors, I see many value stocks still trading at recession prices. For an investment portfolio you should embrace the opportunity to do some buying. We have recently trimmed stocks that hit price targets, so we are shoppers on weakness.

For our Enhanced Yield program (selling short-term calls against dividend stocks) we see many positions that will work in a flat market.

Don’t be stubborn. Take what the market is giving you!

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.

1455039323847

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.

Applying The Lessons From 2015

[This post originally appeared on Seeking Alpha last week.  I enjoy a wide following there, and I appreciate the opportunity to participate in their annual series.  As I note at the beginning of the interview, this is a very valuable resource.  I share the interview with readers of “A Dash” with the permission of Seeking Alpha.]

George Moriarty (GBM) — Thank you for once again taking the time to share your plans for the year ahead with us.

Jeff Miller (JM) — Thanks for inviting me to participate. The Seeking Alpha annual previews are extremely important for thoughtful investors. You always have interesting and diverse ideas from an impressive group of contributors. I enjoy reading the work of others, but it also helps me to focus my own ideas. I normally write about Weighing the Week Ahead, but this is Weighing the Year Ahead.

GBM — The start of this year has been pretty rough for investors. Does that affect your outlook?

JM — I don’t place any special emphasis on the first few days of the year. Most of the factors I am watching are event-driven, not the result of the calendar. The early trading this year has helped to create many attractive opportunities – mostly through excessive economic pessimism.

This year started with a decline in the Chinese stock market. I doubt that anyone could put together a cogent argument about why this was important for U.S. stocks, but the narrative caught on. For more information, check out my post here.

When we next got a rash of doomsayers and many slinging the “R” word, I wrote a post on that topic as well.

Despite this I am frequently asked about someone’s newly created recession model. The simple fact is that the debunking stories are not nearly as popular. No one cares about the plane landing safely.

GBM — What has so many investors/citizens feeling the economy is on thinner ice then? Why is this economy viewed so negatively by so many?

JM — This is something of a trick question! If we look at citizens, they have been reasonably positive. I track both the Conference Board survey and the Michigan Sentiment Index (which I prefer). People are reasonably upbeat about their personal situations, but critical of the overall leadership. Many in financial news interpret these surveys through the prism of the market, not realizing that the average person is not responding based upon a stock portfolio.

Another subject to consider: CEOs consistently predict their own business to continue growing at a healthy rate, though they tend to be negative about the state of the global economy.

Investors are negative for a variety of well-documented reasons:

  • News and headlines that drive viewers and page views. I think that Seeking Alpha and our colleagues there are something of an antidote to this, but the very popular sites are bearish. As I am responding here, I see a new headline from one of the top media sources, Woeful earnings threaten to intensify stock-market bloodbath. The author speculates about four quarter of declines, when there have only been two so far. He completely misreads the chart from his source. Then his editor gives it that headline.
  • It is in the political interest of some to make things seem terrible. Since I recommend avoiding partisanship in investing, let’s call this the “out” party. Both parties do the same. We can expect a drumbeat of bad news.
  • It is in the financial interest of many to make things seem terrible. Most people do not carefully track the background and interests of featured media “experts.”
  • People are encouraged to think that they can trade and time the market. Brokerage commercials foster the idea. Looking at stock quotes too often is hazardous to your wallet. I like the approach of our colleague, David Van Knapp.

If your retirement funding plan is based on selling assets, it puts you in the position of being a “forced” seller to obtain the cash you need. Selling into a falling market can be scary. As the value of your assets drops, you need to sell more units to get the same amount of cash. If you are early in retirement, this is doubly harmful, because it has a disproportionate impact on the amount of remaining assets that you own.

Everyone needs a specific and personal plan.

GBM — Now before we dive too far into 2016, can you reflect briefly on what you learned in 2015?

JM — This is a particularly appropriate question. Normally a market veteran would not learn much of significance in a single year. 2015 was different, and the lessons are new ones.

I call it the Dominance of Trading. There is always plenty of short-term action, but it is now bleeding into the thoughts of long-term investors. Here is how it works.

  1. High frequency trading firms seek and constantly update market relationships. There is no need and no desire to be analytical. Who cares if the relationship is causal or a spurious correlation? The firms trade instantly and aggressively on things like language in a Fed statement or a currency ratio.
  2. Human traders notice and act upon the same relationships. They cannot beat the algorithms on speed, but they still see the pattern.
  3. The punditry “explains” the stock market move. This usually means finding some logic – however distorted – to make the trading effect seem rational.
  4. Well-intentioned individual investors, those seeking to make sense out of the noise, are misled by the pundits.
  5. Long-term relationships between factors are ignored in favor of explaining each day’s move – a required part of the financial coverage of every media source. It does not matter that the daily change is usually in the percentage range of normal randomness.

This cycle of investor misunderstanding is new. As is always the case when Mr. Market gets something wrong, there is an opportunity for the thoughtful investor. To collect you need to fight your way through the daily emphasis on “explaining” the most recent market move – usually linking it to some prediction or macro theory.

GBM — Moving ahead, you and I both love politics. Given the dynamics of the early primary season, talk me through how you’re positioning for this election, which feels very different than previous years.

JM — You are absolutely right. As I recall, you are a political scientist from Fordham, a great school. And it is a very different primary season. Here are the key elements of difference:

  • No incumbent running, no “designated” successor, yet little competition in one party.
  • Extensive competition in the other party, with candidates eliminated even before the first vote is cast in any primary or caucus.
  • The serious candidacy of a woman.
  • The “Trump effect” and the emphasis on “outsiders”

It is a very interesting situation, especially for people like us. We remember that the front runners at this stage often met with surprises. Larry J. Sabato, Director of the UVA Center for Politics is my go-to source on elections. He recently produced an interesting and humorous summary of the erroneous conventional thinking in Presidential elections going back to 1960.

GBM — You thrive on taking the long view, but in managing a primary season, how do you suggest individual investors position themselves as the candidates get sorted out in each party?

JM — Most observers see investing through the prism of their own experience, without any questions about the relevance. I am going to do the opposite. My experience is that each Wall Street firm has someone with relatively modest political science credentials. They must write articles and make suggestions just as a matter of interest. They make small news into big stories. I have three admonitions for investors following the election:

  1. Do not over-estimate election effects. The President’s powers are more limited than most people think. As an example, take a look at the recent Obama executive orders and the instant opposition.
  2. Do not confuse your own opinions about the best candidate with the likely market effect. When it comes to investing, you should strive to be politically agnostic.
  3. There are some “macro” effects for extreme candidates from both parties. Moderate choices and the potential for compromise are the “market-friendly” outcomes.

With that in mind, here is what I am watching. In each case I am looking for a theme that gets some dominance in the public debate:

  • Health care/Obamacare. It will not be repealed, but funding cuts may affect insurance company profits. Drug pricing may be perceived as a big issue.
  • Energy. Coal companies, pipelines, use of the Strategic Petroleum Reserve, and tax benefits for oil companies are all relevant. This is probably the most complicated for drawing policy conclusions. For example, how is alternative energy affected?
  • Defense. Candidates differ greatly on defense policy. Some approaches imply significant buildups to deal with regional issues. Others involve cuts.
  • Free trade. Economists do not agree about many things, but they are nearly unanimous in supporting free trade initiatives.
  • Immigration. This is another theme where economists (pro-immigration) and many voters may disagree. An anti-immigration policy could have some negative economic consequences.

GBM — Back to investment topics, last year you emphasized that the business cycle has no expiration date. So where are we in the cycle now?

JM — This is the crucial question for the year ahead! Many observers note the modest economic growth and expect the U.S. economy to stall out. This would be virtually unprecedented. Cycles end with a peak in activity, higher inflation, and much higher interest rates – not the modest moves contemplated by the Fed.

None of the best recession indicators signal high risk. The business cycle is just about where it was last year. Eventually there will be a “big bang” and probably a late Fed over-reaction, but that could be years away.

Bob Dieli, who probably has the longest and best record on recession forecasting, updates the business cycle position monthly. His “where we are in the cycle” chart has not moved in the last year.

Ed Hyman reaches a similar conclusion.

My best guess is that we will be discussing this same subject next year.

GBM — Where are the upside risks today?

JM — Let’s start with why stocks didn’t do better in 2015? Earnings growth stalled, mostly because of energy. Markets have traded in line with forward earnings expectations. This partly reflects the economy and partly the lagging sectors. Leading economist Brad DeLong describes six different shocks which have occurred during the recovery period. Most people impose some simple summary on the economic narrative, but this article provides much better insight.

It includes plenty of good charts like the one below:
6a00e551f08003883401b7c7fe0e6a970b

If we can avoid some of the episodic drags of the last few years, the economy will do better. A common mistake is to believe that a free-market economy requires constant stimulation. In fact, we have unused labor and capital available right now. Skeptics love to argue about the monthly payroll report and the “birth-death” adjustment. I monitor the actual count from state employment services – the tax collectors. This information trails by eight months, but it is certainly not overstated. Who wants to pay excess taxes? It demonstrates that new business formation has been quite healthy.

This gives us an opportunity in stocks that will benefit from better growth and higher interest rates. People may also be surprised to see P/E multiples move higher (!) along with interest rates. Multiples on forward earnings currently reflect a lot of skepticism on whether the “E” will be there. If the ten-year note got to 3.5% it would reflect a healthier economy, as long as inflation remains under control. JP Morgan’s excellent Guide to the Markets is a dream come true for those who love charts and data.

GBM — What other themes are you monitoring as we proceed into 2016?

JM — My basic approach is to look at the themes that reflect the “trader confusion.” Value investors trailed the market last year despite using excellent, time-tested methods. The top twenty stocks in the S&P 500 went up over 60%, but now sport a P/E in the 90’s. (EV to EBITDA is a more respectable 17.5). Stocks with earnings but a P/E below 14 were down 13.7%. This sort of discrepancy evens out over time. While no one knows the time frame for sure, I am positioning to benefit if 2016 is the “Year of the Value Stock.” We have a special report on this topic and the opportunities presented, available to readers on request.

Here are some themes where there was over-reaction last year. These are all factors that historically have been supportive for U.S. stocks.

  • Dollar strength. Lack of support for the dollar was part of the impetus for the 1987 crash. In general, a strong dollar has been neutral-to-positive for stocks.
  • Oil prices. High oil prices were behind the market struggles in the early 70s. In general, low oil prices have been good for the U.S. economy and for stocks.
  • Interest rates. In the long run, low interest rates are a positive factor for stocks.

Investors have been confused by short-term effects on all of these fronts. Those who understand the long run relationships have a great opportunity. Note the charts below (the vertical axes for both bond yields and crude prices have been inverted to facilitate comparison).


I expect the overall market to grow in line with earnings expectations and the economy. Astute investors can do much better by emphasizing last year’s laggards – materials, energy, some tech, and financials.

GBM — Any final thoughts?

JM — We both know that forecasts should have time frames, and that is challenging right now. I expect most of my themes to play out over the next year, but we might need to wait until Q2 earnings.

And finally, most people appreciate some good examples as well as data. Here are three recent ones from CNBC (when I accidentally left the “mute” button off).

  1. One of the anchors mentioned to an interview subject that the “stock guys” seemed to see a recession coming, when none of the economists did. No kidding!
  2. One of the anchors asked a Presidential advisor what the White House might do about the low oil prices. He was amazed and explained that the benefit of lower prices was $750 per person. She asked about some jobs in Houston and an airline stock.
  3. CNBC interviewed a stock trader who attributed the big declines to a fall in oil. Then they interviewed an oil trader who said that their market was following stocks!

Investors who can get a grip on economic fundamentals have plenty of choices. I follow quite a few value investors and they all have a list of stocks they really like. One recently said that he was like a “kid in a candy shop.”

Thanks for reading! As always, please feel to share your thoughts in the comments section below.

2015 in Review: Hi-Yo, Silver!

1388287952-0For years, it’s been a staple of our Weighing the Week Ahead series to recognize analysts who go above and beyond in their coverage of the issues. We congratulate these writers with the Silver Bullet Award – named in honor of the Lone Ranger, who lived by a strict code: “…that all things change but truth, and that truth alone, lives on forever.”

In 2015, we gave out the Silver Bullet Award 21 times – the most ever in a single year. Despite the constant fearmongering from some bloggers and media personalities, more and more people are providing individual investors with the tools they need to make informed decisions. Our winners are summarized below. Readers may also want to check into our 2013 and 2014 compilations, as many of the same issues persist to this day.

Have any thoughts or predictions on what will dominate news cycles in 2016? Know of a great analyst flying below our radar? Feel free to post in the comments with any suggestions or nominations.

 

 

January 4, 2015

Our first Silver Bullet of the year went to RL at Slope of Hope for his examination of charting “techniques” in the post 2008 recovery.

RL notes:

What can we conclude from all the above? Well, first of all that making long-term trend predictions is not recommended, no-one knows what is awaiting for us in the future. Bull or Bear Market, inflation or deflation, you name it. What we can do, is to predict market trend extensions with statistical analysis, comparing past trends and current trends and that is in fact what we do with our RL models. We do not know if the market can go to 3000 in the next few years, it’s possible if all of a sudden a lot of investors, after staying on the sidelines since 2009, decide to join this 5 years long rally (how about that for a “confirmation signal”?). What we do know (based on our statistical models) is that the market is overbought right now, and it has been rising ~500 points in the last 2 years, although the strongest rise was in 2013, and in 2014 the speed of advance was a little bit slower (maybe a sign that the rally is faltering?).

In our view, this strong pace is not sustainable in the long term and some correction inevitably will come, although it does not have necessarily to be a 3-years Bear Market, it may be a 3 months correction, or a quick crash followed by a recovery, etc. What we can do is to gauge the market trend extension from a TIME and PRICE point of view with our model and this is an honest method to gauge the short and medium-term market direction

March 1, 2015

Nicholas Colas and Jessica Rabe of Convergex took on Jeff Gundlach’s assertion that equities have never risen for seven years in a row since 1871. With due respect to Mr. Gundlach, the authors primarily took issue with the dataset (courtesy of Robert Shiller) he had used to draw his conclusion. Colas and Rabe write:

“Gundlach used a well-known dataset from Robert Shiller for his findings, but it is not suitable for calculating calendar-year returns since it does not capture exact month-end levels. The S&P 500 actually rallied for eight consecutive years from 1982 to 1989 based on price returns and total returns. The index was also up for nine straight years from 1991 to 1999 using total returns. Therefore, the S&P 500 may have a few more years to run before breaking any records, but volatility will likely rise as well…Whether the stock market finishes the year in positive territory is anyone’s guess, but it wouldn’t be unprecedented.”

April 5, 2015

Barry Ritholtz dug up an old Onion article, as an analogue for what passes as analysis in the financial blogosphere. Readers may be reminded of Sidd Finch.

“Given this line’s long history of jaggedness, we really should take a wait-and-see approach,”Fortune magazine associate editor Charles Reames said. “And even if this important line continues its upward pointiness, we must remember that there are other shapes, colors, numbers, and lines to consider when judging the health of the economy.”

Reames also warned that the upward angle of the line, which most analysts agreed was approximately 80 degrees, may have been exaggerated by the way the graph was drawn.

“The stuff that’s written along the bottom of the graph is all squished together, making the line look a lot more impressive than it is,” Reames said. “Had that same stuff been spread out more, the line would have looked a lot less steep.”

April 11, 2015

Bill McBride (AKA Calculated Risk) ended 2014 by asking himself ten questions about the state of the economy. His quarterly reviews helped to measure economic progress over time, in line with his expectations. This innovative approach to interpreting data earned Bill our Silver Bullet Award.

“At the end of last year Bill made a series of ten forecasts about the economy with a full post on each. He provided a three-month update this week. While early in the year, I found it quite impressive. It is more measured than the optimistic economic predictions and much better than those always seeing the worst from any report. See for yourself, and you will understand why I emphasize this source each week. If you are interested in economic growth, housing, employment, the Fed, or oil prices there is something for you.”

April 19, 2015

Ed Dolan’s thorough deconstruction of ShadowStats is one of our favorite blog posts from 2015. From the way he picks his target, to his measurement of the data – his post reads like a step-by-step guide to winning a Silver Bullet. We found this excerpt particularly interesting:

“As mentioned above, Williams’ ShadowStats inflation series incorporates an additional 2.0 percentage point correction to reflect methodological changes that are not captured in the CPI-U-RS series. I would like to examine that number more carefully in a future post, but for the sake of discussion, we can let it stand. If so, it appears to me that, based entirely on Williams’ own data, methods, and assumptions, the adjustment for the ShadowStats inflation series should be about 2.45 percentage points below CPI-U, rather than the 7 percentage points he uses.

In my view, Williams alternative measure of inflation would be more convincing if he were to make this correction. It would also be less likely to feed the anti-government paranoia of some of his followers, who allege that the BLS is falsifies source data and manipulates reported indicators in the way that Argentina and some other countries appear to do.

It is worth noting that Williams himself makes no such claim. He is a fierce critic of BLS methodology, but he acknowledges that the agency follows its own published methods. He argues that the BLS has adopted methods that produce low inflation indicators, but not for motives of short-term partisan politics. Rather, he sees the choice of methodology as driven by a longstanding, bipartisan desire to reduce the cost of Social Security and other inflation-indexed transfer payments. It would be hard to deny that he is at least partly right about that motivation.”

April 26, 2015

The “what if?” question plagues individual investors and fantasy football fans alike. While the sports fans can afford to indulge in flights of fancy, investors probably shouldn’t. David Fabian won the Silver Bullet for writing to this effect very effectively:

Lastly, I think it’s important for investors to forget the “if/then” narrative that seems to be a psychological barrier to living in the present and investing for the future.

If the Fed had never….

If big banks had never….

If stock buybacks had never….

Stop worrying about what the world might look like if those things had never happened, because they did and we are where we are. Focus on the present and the things that you can control in order to get the most out of your investment portfolio.

June 08, 2015

We frequently warn individual investors to keep their politics and their investments separate. Morgan Housel earned himself a Silver Bullet by illustrating this with a clear, relatable example. The market has seen significant gains since 2008. If you’ve been sitting on the sidelines, you’ve missed some big opportunities.

Take these two statements:

“11 million jobs have been created since 2009. The stock market has tripled. The unemployment rate nearly cut in half.  The U.S. economy has enjoyed a strong recovery under President Obama.”

“The recovery since 2009 has been one of the weakest on record. The national debt has ballooned. Wages are stagnant. Millions of Americans have given up looking for work. The economy has been a disappointment under President Obama.

Both of these statements are true. They are both history. Which one is right?

It’s a weird question, because history is supposed to be objective. There’s only supposed to be one “right.”

But that’s almost never the case, especially when an emotional topic like your opinion of the president is included. Everyone chooses the version of history that fits what they want to believe, which tends to be a reflection of how they were raised, which is different for everybody. We do this with the economy, the stock market, politics — everything.

It can make history dangerous. What starts as an honest attempt to objectively study the past quickly becomes a field day of confirming your existing beliefs.

June 13, 2015

Regular readers know that we like to carefully scrutinize mainstream financial media. Needless to say, we got a kick out of Cullen Roche’s colorful guidelines for financial journalists. They’re all well worth reading, but our favorites are quoted below.

I.  The Stop Scaring People Rule. Scaremongering is not to be tolerated except during the middle of a financial crisis or nuclear war. Writing scary articles for the sake of conjuring emotionally driven page views is not a legitimate business model and is generally counterproductive.

III. The Crash Call Rule. That pundit who comes on TV predicting financial Armageddon every week is not a “guru” and is directly contributing to poor financial decisions. Please refrain from interviewing him regularly. Also, see Rule I.

IX. The Bubble in Bubbles Rule. If you feel the need to use the word “bubble” please reconsider. This word is only allowed to be used by a select few financial experts (Robert Shiller, Robert Shiller & Robert Shiller).  If you are not one of the names listed in the previous sentence please do not use this terminology.

June 20, 2015

Declining profit margins are a prime target for perma bears in the blogosphere. You’d think after an “expert” calls nine of the last three recessions, this one would go away – but we’ve been fighting it for years. Pierre Lapointe received the Silver Bullet for taking on the crowd.

“It can take a long time before contracting margins begin to hurt stock prices,” Lapointe and colleagues Alex Bellefleur and Francois Boutin-Dufresne wrote in a report yesterday. They cited the 1982-1987 bull market, which took place even though earnings as a percentage of GDP were among the lowest since World War II.

“It isn’t at all clear that margins will contract further from here,” they wrote. “They could stabiglize and remain near current levels for some time. This wouldn’t be a disastrous scenario for equities.”

July 04, 2015

Beyond errors in the investment world, we like to caution our readers to think carefully about all kinds of data. Math Professor Jordan Ellenberg, of the University of Wisconsin-Madison, provided a fascinating article about the misuses of numbers. We gave him the Silver Bullet based on his conclusion:

All these mistakes have one thing in common: They don’t involve any actual falsehoods. Still, despite their literal truth, they manage to mislead. It is as if you said, “Geraldo Rivera has been married twice.” Yes—but this statistic leaves out 60% of his wives.

In the era of data journalism, truth is not enough. We need people in the newsroom who can check not only a number’s value but also its meaning. Unless we can ensure that, we’re going to be reading a lot of data-driven stories that are true in every particular—but still wrong.

July 18, 2015

Zero Hedge is one of the least credible yet oft-cited websites sucking up oxygen in the financial blogosphere. Their supporters are apparently pervasive, which is why we had to give Fabius Maximus a Silver Bullet for his thorough deconstruction. The full article is of course excellent: his commentary ranges from exposing half-truths, conspiracy-mongering, selective use of data, and outright deception.

ZH is an ugly version of Wal-Mart or Amazon. It would be sad but insignificant if ZH was exceptional. But ZH is a model of successful web publishing, probably taking mindshare from mainstream providers of economic and market insights. I see websites using its methods proliferating in other fields. For example, geopolitics has become dominated by sites that provide a continuous stream of threat inflation as ludicrous as the worst of ZH.

July 26, 2015

On a lighter note, we greatly appreciated a video done by Jimmy Atkinson at Dividend Reference. His guide to useless (but entertaining) stock market indicators comes with an important lesson attached. Below is one example particularly relevant to hockey fans in the Chicago area.

August 02, 2015

Michael Batnick won a Silver Bullet this year when he abated growing fears about market tops. His careful analysis (backed up by solid data) is a huge asset for individual investors looking for edge.

Conventional wisdom goes that prior to market tops, the major averages become more reliant on just a handful of stocks to lead the rally. When stocks are making new highs, it’s important to look at breadth indicators because indices can pull a nasty trick of masking what is actually happening to the majority of stocks. For instance, the S&P 500 is up 2.3% YTD, however, the average S&P 500 stock is down 0.7%.

Observers with a mission fail to note that divergences often resolve to the upside. Here is an interesting table, showing both frequency and the range of gains.

August 22, 2015

We at “A Dash” applaud anyone willing to challenge the so-called conventional wisdom. We gave Barry Ritholtz a Silver Bullet this year for taking on the Death Cross.

…yesterday’s decline triggered the dreaded Death Cross, as the index’s 50-day moving average crossed below the 200-day moving average. The other major indexes haven’t yet succumbed to the Death Cross horror, though the S&P 500 is heading in that direction.

In a research note late yesterday, Bespoke Investment Group observed that this was the first time this has happened since Dec. 30th, 2011, or in 903 trading days. They also note the modest statistical significance of the Death Cross. Looking at the past 100 years, they wrote that “the index has tended to bounce back more often than not.” Shorter term (one to three months), however, these crosses have been followed by modest declines in the index.

How modest? The average decline is 0.17 percent during the next month and 1.52 percent the next three months. By comparison, Bespoke notes, during the past 100 years the Dow averages a 0.62 percent gain during all one-month periods and a 1.82 percent rise during all three-month periods.

In an e-mail I asked Justin Walters of Bespoke to expand on the details. He wrote: “Most of the time these crosses don’t mean much of anything. This one the forward performance numbers are a little more negative than we would expect to see over the next one and three months, but it’s basically 50/50 whether we go higher or lower.”

August 30, 2015

Our final award of the year went to Michael Batnick and Todd Sullivan (citing “Davidson) for two separate articles on the same theme. Both illustrate the danger in the way the Shiller CAPE ratio is presented to investors. Batnick notes:

When Shiller says 15-16 is where CAPE has typically been, what he really means is this is what the average has been. However, what he fails to mention is that over the past 25 years, the CAPE ratio has been above its historical average 95% of the time. Stocks have been below their historical average just 16 out of the last 309 months. Since that time, the total return on the S&P 500 is over 925%.

Sullivan shows that the profit estimates in the data are flawed because of accounting changes. He shows that large and completely implausible changes in “earnings” were actually the result of the FAS 157 rules.

Conclusion

As always, you can feel free to contact us with recommendations for future Silver Bullet prize winners at any time. Whenever someone takes interest in defending a thankless but essential cause, we hope you’ll find them here.  Have a Happy New Year and a profitable 2016.

Weighing the Week Ahead: Will Falling Earnings Sink the Stock Market?

There is special interest in 2nd quarter earnings both as a read on the economy and trends in costs and margins. Ordinarily the focus would be Fed Chair Yellen’s House testimony on Wednesday and the reprise on Thursday. She has stated her viewpoint so frequently – rate hike possible, data dependent, expecting better growth – that a surprise is unlikely.

I expect the earnings story to steal Yellen’s thunder, with pundits wondering:

Will Falling Earnings Sink the Stock Market?

 

Prior Theme Recap

In my last WTWA I predicted a lazy summer week, with plenty of time for pundits to analyze the heavy schedule of FedSpeak. If you merely looked at the overall result for the week, it might seem like this call was accurate. Wrong! The Greek story lingered with both downs and ups. China’s market collapsed and the government intervened. Computer malfunctions took down the NYSE.

As usual, Doug Short’s excellent five-day summary captures the story in one great chart. Read the full article for more charts and discussion.

SPX-five-day

I did say that guessing last week’s theme was a crapshoot. At least I was right about that!

So why bother thinking about a theme? 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 try it at home.

This Week’s Theme

Let me start with the theme competition. A focal point for this week will be Fed Chair Yellen’s semi-annual Congressional testimony. This time she starts with the House Financial Services Committee and repeats the same message the next day before the Senate Banking Committee. Six months from now the order will be reversed. Both groups get a chance to ask questions. If you know why it is done this way, it will take you far in your understanding of Congress as an institution, and American politics in general.

While we will have live coverage for most of this, do not expect anything new. You can save a lot of time by reading the latest update from Fed expert Tim Duy. This is a great economic summary combining helpful charts and understandable explanations. This summary and chart provide a small taste of the article:

The US economy is an island of mediocre tranquility in the midst of the stormy sea of the global economy. Tranquil enough to keep the Fed eyeing its first rate hike despite the surrounding storm, but sufficiently mediocre that they feel no reason to rush into that hike. As such, the Fed will remain on the sidelines until the forecast points toward sunnier skies. Uncertainty from Greece and China are likely raising the bar on the domestic conditions that would justify a rate hike.

GDP Forecasts

Despite the Fed story, I expect earnings news to steal the spotlight. There is considerable focus on year-over-year comparisons showing an expected decline in earnings. The importance of earnings is one of the few aspects of stock evaluation nearly universal agreement. Because of this significance and concern about the economy, I expect the question:

Will Falling Earnings Sink the Stock Market?

The Viewpoints

The earnings story is controversial including a range of viewpoints. We need to consider both aspects of this week’s question – the possible earnings decline and the effect on the stock market.

Earnings declines

  • A weak economy has finally taken a toll on corporate profits, especially in some sectors
  • A strong dollar hurts the exports and profit margins of many large companies
  • Profit margins are extended and overdue for a reversion to normal levels

There is excellent and objective overall coverage on these topics from FactSet, including the overall expectation of a 4.4% YoY decline in earnings. FactSet expects higher margins, but lower revenue growth until 2016.

Impact on stocks

  • Reality will finally take down the market
  • Stocks will pause while earnings “catch up”
  • Forward earnings are less worrisome, especially without energy
  • Comparisons for the rest of 2015 will be easier

There is excellent and objective commentary on forward earnings and the implications for stocks from Brian Gilmartin.

As always, I have my own ideas in today’s 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

There was some good economic news.

  • Alcoa earnings reflected economic strength. Mostly this was in the revenue figures, highlighted in interviews on CNBC. Although I have no position in Alcoa, and it has lost its “bellwether” status, it is still a good read on certain markets – autos, aircraft, and construction of certain types. Seeking Alpha’s excellent transcript reports are essential tools for those who want to monitor companies, but cannot spend hours on conference calls.
  • Job turnover is encouraging, as documented in the JOLTs report. The most important features of this report are not overall job growth (tracked better by payroll employment) but the job openings and quit rate. These show the flexibility in the market, as well as the willingness to leave a job on a voluntary basis. Doug Short has a complete analysis as well as this chart, which is a conservative take on the quit rate.

dshort JOLTs

  • ISM services were “in line” but signaling a solid expansion. Scott Grannis explains why. Both for the Eurozone and the US, the service economies remain in moderate expansion.
  • Rail traffic was a bit better this week. See the report at GEI.
  • Fed commentary was generally dovish, despite Yellen’s Friday speech. See the discussion above citing Tim Duy.

 

The Bad

There was also some negative data last week, partly on the policy front.

  • No convincing progress on Greece. We started the week with the resounding “no” vote in the Greek referendum. This seemed to give extra bargaining power to Prime Minister Tsipras. The initial market reaction to the uncertain effects of a Grexit was very negative. Later in the week, news about the umpteenth plan for a resolution seemed to stabilize markets. By the time markets open, who knows? We do not seem to be much closer to an enduring solution. Read The New Athenian and The FT for updates.
  • Negative earnings revisions outnumber the positive shifts by 4-1. (FactSet).
  • Commodity prices moved sharply lower. I am reporting this as a negative, but I am skeptical because of possible distortions from Chinese margin calls. (Stock investors forced to cash in commodity positions). That is fine as an indicator of commodity prices, but not as an economic signal. Bespoke also reports on some upward pressure. The jury is out on this indicator.
  • Initial jobless claims were worse than expected. It is a difficult time of year for seasonal adjustments, making it a good time to check in with Steven Hansen at GEI. His report takes various approaches, including non-seasonal comparisons. Here is one of the helpful charts:

11114957ztemp

The Ugly

Technology and “glitches.” The United Airlines delay was aggravating and possibly costly for passengers. The trading halt at the NYSE did not prevent people from trading at other sites, but (combined with the United problem) raised questions about a possible cyber-attack. The WSJ site went down, perhaps because of visitors checking on the NYSE story. Some may have altered their trades in the face of uncertainty and a market decline. And finally, there were calls from Congress to investigate and act if necessary.

Meanwhile, how is the government doing with technology? The Office of Personnel Management finally admitted the extent of the information breach and the slowness of the response. The FBI admitted that the background check system should have prevented the Charleston shooter from buying a gun. Congress is calling for an investigation into this tragic failure.

Technological oversight and regulation might not be the strong suit for government.

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 welcome, especially if refuting a specific chart that is both bogus and popular!

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. For more information on each source, check here.

Recent Expert Commentary on Recession Odds and Market Trends

Doug Short: An update of the regular ECRI analysis with a good history, commentary, detailed analysis and charts. If you are still listening to the ECRI (almost four years after their recession call), you should be reading this carefully. Recently the ECRI finally admitted to the error in their forecast, but still claims the best overall record. This is simply not true. I rejected their approach in real time during 2011 and also highlighted competing methods that were stronger. Until we know what is inside the black box (I suspect excessive reliance on commodity prices and insistence on unrevised data) we will be unable to evaluate their approach. Doug is more sympathetic in his last update. While I disagree, it will require a longer post to elaborate.

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.

Georg Vrba: 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 from the Business Cycle Indicator. Georg continues to develop new tools for market analysis and timing, including a combination of models to do gradual shifting to and from the S&P 500.

This week Georg has an improvement of the Shiller P/E CAPE ratio method. Unlike the widely-followed Shiller method, Georg’s approach has the advantage of actually generating some “buy” signals! (And as I have frequently noted, I am a fan of Prof. Shiller, who owns stocks and advises others to do the same). Current readings show that stocks are “not greatly overvalued, nor likely to crash anytime soon.”

PE10fig1x

 

New Deal Democrat, in addition to his must-read, high frequency indicators, has produced a midyear update on four crucial long leading indicators – those used by Prof. Geoffrey Moore, founder of ECRI. I believe that the ECRI performance would have been better had they stayed with these methods.

See the full post for charts and discussion of each, but here is the conclusion:

While not every long leading indicator is making new highs, and in particular corporate profits have stalled, the other indicators solidly suggest that this economic expansion will last at least through the 2nd quarter of 2016.

The Week Ahead

This week brings some important economic data.

The “A List” includes the following:

  • Housing starts and building permits (F). Is the rebound for real?
  • Michigan sentiment (F). Good concurrent read on employment and spending.
  • Retail sales (T). What happened to the gasoline savings?
  • Initial jobless claims (Th). The best concurrent news on employment trends, with emphasis on job losses.
  • Industrial production (W). Volatile series, but helpful in GDP estimates.

The “B List” includes the following:

  • PPI (W). Inflation data remains of little interest until and unless we see a few hot months.
  • CPI (F). See PPI.
  • Beige book (W). Anecdotal information for the next FOMC meeting.
  • Crude oil inventories (W). Current interest in energy keeps this on the list of items to watch.
  • Wholesale Inventories (F). May data relevant to GDP.

As usual, I have little interest in the regional Fed surveys. There is plenty of FedSpeak in addition to Chair Yellen’s Congressional appearances. Expect further news from Greece and China, but both are hard to game.

Options expiration may add some volatility, especially if overall trading volume remains low, or we get a big move early in the 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 five 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?

My weekly insights often suggest a different course of action depending upon your objectives and time frames. They also accurately describe what I am doing in the programs I manage.

Insight for Traders

Felix continued a neutral stance for the three-week market forecast, but it is verging on turning mildly bearish. The confidence in the forecast remains very low with the continuing extremely high percentage of sectors in the penalty box. Despite the overall market verdict Felix has been mostly invested in three top sectors. For part of the week this included a ½ size position (leaving trading accounts 67% long) in some inverse fund hedges. For more information, I have posted a further description — Meet Felix and Oscar. You can sign up for Felix’s weekly ratings updates via email to etf at newarc dot com. Felix appears almost every day at Scutify (follow him here).

Dr. Brett Steenbarger has another powerful and authoritative article helpful both to traders, and also to nearly everyone else. He shows how a simple technique – keeping a journal – can greatly improve your performance. You need to read the full article to see how and why this works. It is not enough just to write.

…journals of the least successful participants served reporting and venting functions. That is, the least successful professionals used their journals to report on events of the day or week and to express their thoughts and feelings about those events.

Conversely, the journals of the most successful money managers served learning functions. The journal entries specifically analyzed what had happened in the recent past, but then went further to frame goals for going forward.

 

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.

In Part Two of my series on risk I used the Chinese market as an example of headline risk. My main objective is to explain how to navigate the ever-threatening headlines. Along the way I share a few ideas of how you might profit from stocks with Chinese exposure.

Other Advice

Here is our collection of great investor advice for this week.

If I had to pick a single most important article, it would be Sarah Max’s cover story in Barron’s, Bye-Bye Bond Funds. The article is loaded with great advice, especially for the average investor. How do you reduce the volatility of a stock portfolio, when bonds have become risky? Here are some key points:

  • Quoting Robert Johnson, CEO of the American College of Financial Services — “If you lock in bonds at these levels, you’re locking in a purchasing-power loss.”

    Not long ago, the notion of a no-bond portfolio would have seemed crazy. But what’s really crazy, says Johnson and many of his peers, is clinging to the conventional wisdom. “What are bonds supposed to do? They’re supposed to preserve wealth, provide periodic cash flow, and hopefully some price appreciation,” he says. At the moment, however, they aren’t offering much in the way of income, and there is a real possibility that investors could lose money.

  • Investors should consider individual bonds rather than bond funds. You can choose to hold a bond to maturity. The fund manager may not, or may not have a choice in the face of redemptions.

    That exit may be already starting. In the first five months of the year, investors put more than $75 billion into taxable and municipal-bond funds, according to Lipper. But in June, the trend turned, with investors withdrawing a net $17 billion. If that presages a bigger exit, bond funds could fall sharply.

  • Asset allocation is an individual matter

    There was a time when bonds could do it all—provide stability, income, and capital appreciation. Those days are over. Now, investors need to pick their focus. And that focus should be determined by an investor’s need, rather than a hackneyed asset-allocation plan that decrees 55-year-olds dump 55% of their assets into bonds.

    But even if the conventional wisdom no longer holds true, the advice is very much the same as it ever was: Know thyself as an investor, and construct a plan that suits your timeline and temperament.

This article and the companion pieces are well worth the price of this week’s issue. We do all of this for clients, but some readers may be able to take these important steps for themselves.

Stock Ideas

Energy is ready to rebound according to the investment newsletter writers with the best records on oil prices (via Mark Hulbert). The article includes both technical and fundamental reasons and suggests several undervalued stocks in the sector.

I am a fan of Bret Jensen, following his research reports on Seeking Alpha. He takes a value approach and is willing to be a contrarian. This week he happened to write about two stocks we already hold, Gilead (GILD) which has done well and iRobot (IRBT) which has not. His rationale is quite similar to ours. Readers would benefit from following his future work.

Alpha Architect analyzes the performance of the most attractive sectors on a value basis for the first two quarters of 2015. Health care did great, while energy was the worst. The payoff from value investing does not always show up in six months.

ytdsector-1030x424

 

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 every day as I do) for a weekly trip on Wednesday. Tadas always has first-rate links for investors in this special edition. As always, there are several great links, but I especially liked this story about retirement calculators.

Value versus Momentum

There are many successful investment approaches. In the WTWA posts we usually describe momentum as a trading approach, normally as practiced by our “Felix” model. Value investing is what we do in our long-term stock program. Ben Carlson has a nice explanation of the difference, including some data. Here is an important takeaway:

As with any strategy that has been proven to work historically, there are usually two explanations given — either the strategy takes more risk and is compensated for those risks or there are behavioral factors involved that allow the premium to persist. To me, the behavioral explanation always makes more sense, because really the only way for one investor to outperform is for another investor to underperform. To do better you have to be able to take advantage of someone else’s mistakes. This is the foundation that any viable long-term investment strategy rests on.

Market Outlook

Ben Carlson, providing a little calm in a volatile week, contributed a helpful and humorous post on who would benefit from a market correction. Example: Everyone who’s been saying volatility is a “second half story.” And: That co-worker of yours who told you in 2012 that they were going to wait for a 10% correction until they put their 401(k) contributions back into the market.

Final Thought

If you are a realist, you should expect this to be a tough quarter for earnings comparisons. Most of the factors cited in the introduction were indeed headwinds.

And the market paused.

We are left with the question of whether we are at an inflection point for earnings and for stocks. While I understand the current caution, I remain optimistic for the long term for the following reasons:

  1. There is no recession on the horizon. This is the biggest threat to stocks.
  2. The Q1 economic weakness was (for various reasons) overstated on GDP.
  3. The currency issues are stabilizing, and can be mitigated with appropriate stock choices.
  4. Stock buybacks improve per-share earnings. (Unlike others, I do not mind getting a bigger piece of a smaller pie).
  5. P/E multiples improve when investors have more confidence in the future. That is coming.
  6. As usual, the estimate reductions have probably set the bar too low. Here are the past results from FactSet;

factset estimates

Stocks in the sectors I have recommended showed solid gains in a soft market in the first half of 2015. I am looking for more of the same as well as a generalized rally.

This said, it might take another quarter of earnings results to convince the naysayers.

Patience is a virtue – and often necessary for investors!

Correction

Last Week’s WTWA stated that Greek debt was equivalent to 30 hours of Walmart revenue. The source I quoted accurately described this as the debt to the IMF, the potential default, not the total national debt. I always try to be completely accurate, and I regret this misstatement.

How to Think about Risk

As the bull market marches on, everyone is itching to call the top.

  • Some see an economic collapse as the Fed changes course;
  • Average investors worry about markets “up here” with strong memories of prior declines;
  • Pundits proclaim that it is time to “take something off the table”;
  • Those who have been wrong get highlights, insisting on kicking the target down the road, i.e. half cycle? Ten year returns?
  • The market risk/reward calculation is skewed.

This is a complex but important topic. I have written about each aspect in the past, but it is timely and important to pull these threads together. I plan a series of posts (suggestions welcome):

  1. Why risk is an individual question, and why the analysis must include both upside and downside.
  2. Downside risks.
  3. Upside risks.
  4. Hedging strategies: Cheap protection?
  5. Pulling it all together: A plan for action.

This post covers the first topic, but there is more to come.

Risk is an Individual Matter

No one should tell you how much investment risk to assume. Not Warren Buffett. Not CNBC. Not Jim Cramer. And certainly not my blog posts.

Each person has a different investment goal and a different risk tolerance. Everyone would like to have a guaranteed return with almost no risk. Beware of those claims, the basis for the BM approach (think of a famous failed manager and manage a chuckle).

Any investment program starts with an analysis of your goals. Do you have what you need, and are therefore preserving wealth? Or like most of us, do you need to add to wealth to meet your goals? If you are in the latter group, how much risk is required to aim for the needed return?

There are no shortcuts or easy answers. Most of the “coupon solutions” have become a crowded trade. If you have reached for yield – apparently safe – you have assumed risk whether you know it or not. If you have too much invested in stocks, you will be frightened at the first downturn, even if it is a normal fluctuation.

It is fine for Mr. Buffett to say that he would not own bonds and prefer stocks. Most investors need some kind of balance. It is an individual matter. Beware of anyone giving universal advice of the “all in,” “all out” or 50% invested (!!) style. How could these same answers be right for everyone?

Here is a quotation from a piece that I share with investors, but have not published:

Investors have a dilemma — If stocks resume the long-term trend of 8 -10% annual growth, they want to participate. In fact, many of them must participate if they are to meet retirement goals. It is important to realize that this long-term outcome is the most likely.

If the Dow goes to 20K, we would all like to be on board, but what about the risk of another meltdown?

The challenge is how to provide the needed investor confidence in a world where most of the news and commentary is very negative. Many intelligent investors want to participate as they watch the rebound in corporate profits and stock prices. They are willing to assume reasonable, normal risks, but wonder about another economic collapse.

The Dow 20K reference started with the Dow at 10K and many predicting a 50% decline. Here is the history.

To emphasize, I have not been suggesting an “all in” approach. Asset allocation is an individual matter.

Risk Analysis is Balanced

If you think about risk in terms of a stock sell-off, you are an amateur – a deer in the headlights.

Everyone is living longer. Inflation at the rate of 3% cuts your nest egg in half in 24 years. Sitting completely in cash is a decision, and it could be a costly one.

If you want to make a balanced decision about your investments, you need to consider the following:

  • Downside risk
  • Upside risk
  • And most importantly, your own needs.

Taking this approach is stronger than any magical solutions and certainly better than getting scared witless (euphemism TM OldProf).

Conclusion

I have a varied client base – assets, income, age, and objectives. The key message of this post is that there is no universal answer. You should strongly resist anyone who suggests otherwise.

If you right-size your risk, you will be able to hold strong through the normal market fluctuations.

As always, I welcome suggestions on this new series!