Payroll Employment Report and the Birth/Death Model

How should we interpret today’s employment report, showing a growth in non-farm payrolls of 88K, a bit less than expected?  There is also an increase in the unemployment rate and a different picture of job growth from the survey of individuals.

This is the real story, with as little technical stuff as we can manage.  If traders or investors want to understand the data — viewed by many as most important — this is as good as we can make it for those without technical background.

Background:  The BLS in Action

The most important thing for investors and traders to understand is that the reports are prepared by civil service employees using professional statistical methods.  They do not change staff or opinions with shifts in partisan control.  They are not biased in favor of a particular outcome.

Nearly all of those commenting on today’s report, and particularly the Birth/Death Model, have never worked in a government agency and never done any forecasting using statistical methods.  Do not listen to them!  Since this is a subject where we can add value for the investment community, we have written extensively on this topic.

[Digression for the record — I was "loaned" from the University of Wisconsin to the Wisconsin Department of Revenue for a couple of years a long time ago.  The DOR did these forecasts for the state.  I also taught graduate classes to mid-career government  professionals.  The courses covered public finance and research methods, among other things.  So I know how these public officials think and what they try to do.]

Imagine that you are attempting to count all of the jobs in the U.S. economy, and you must do it EVERY MONTH.  There is no way to count them.  Compare this to voting, where in the 2000 election we had trouble actually counting the votes of people who showed up at the polls.  (Remember the "hanging chad"?)  There are 130 million jobs.  The result you get is an estimate based upon surveys and statistical techniques.

The monthly job count is the result of a survey, using as your sampling frame the businesses that existed at the start of the year.  This is subject to various sources of error, as follows:

  • Sampling error.  Even when you have a large sample size, there is always sampling error.  It is small in percentage terms, but large in the aggregate.  The sampling error for the jobs report has a standard deviation of about 60k jobs.  (Check here for the best standard English description of this you will see online via my colleague Allen Russell).  That means that 2/3 of the time the reported result will be +/- 60K.  If you want a 95% confidence interval, you need to double that.  This is the result after ALL businesses in the sample send in their forms.
  • Revisions.  As we discussed in our Employment Report Preview, the source of the revision is not any tinkering by the government.  It is the result of businesses reporting late.  Did you ever take an extension in filing your tax return?  It has no meaning, unless you think there is a systemic bias to businesses that are late in filing.
  • Non-sampling error.  The original sample does not include new businesses, and it includes other businesses that have failed.  Briefly put, this is a major problem unless there is an exact offset between the two.

So what does our earnest and professional government statistician do?  The only major place to improve is the non-sampling error.  The BLS discovered that they had serious errors without making some adjustment to the original survey.  This was the reason for creating the Birth/Death model.

They state in the description of the methodology that there is a fairly constant relationship between births and deaths of businesses.

Earlier research indicated that while both the business birth and
        death portions of total employment are generally significant, the net
        contribution is relatively small and stable. To account for this net
        birth/death portion of total employment, BLS is implementing an
        estimation procedure with two components: the first component uses
        business deaths to impute employment for business births. This is
        incorporated into the sample-based link relative estimate procedure by
        simply not reflecting sample units going out of business, but imputing
        to them the same trend as the other firms in the sample. 

It seems counter-intuitive to use business deaths to predict births, but they are looking at the data and we are not.  None of the critics are either.  Perhaps the BLS needs to share more about the underlying data.

The major point is that the BLS economists are making an honest and earnest effort to capture job changes missed by the survey.

They check their results with a benchmark revision.  Eventually, they have an actual count of jobs from state data, and they update their model regularly to reflect this.  They do an annual revision for the benchmark and a quarterly revision of their ARIMA time series modeling.  (This is a standard method.  Like other forecasters, we use it frequently.  Readers should look with suspicion on the comments of anyone who does not seem to understand this method).

In short, the BLS staff is using standard professional methods to make the best possible estimate of job growth.  It could be off by 60K on the sampling error, or more if the Birth/Death model is wrong.  None of the critics offer a better method.

What the Birth/Death Model Contributes

The Birth/Death Model has improved the estimates.  In fact, despite the constant criticism from those who claim that it adds "fictional jobs" the model actually underestimated job growth in recent years.  That is why the benchmark revisions added jobs.  It was an attempt to correct the non-sampling error, and it improved the estimate.  The critics who said that the model over-estimated job growth were proven wrong by actual state data, used in the benchmark revision.  The reaction of the critics was to ignore the actual count and criticize the BLS for "finding jobs."  These critics should walk a mile in the moccasins of someone trying to provide useful data.

Please note that the Birth/Death model does not make a single jarring adjustment to the number of jobs in a particular month.  The BLS goes back and spreads the jobs growth over the year, using the ARIMA model, in proportion to the year’s data.  Critics are challenged to offer a better approach….

The BLS warns that the methods are based upon the continuation of past trends.  They do not look at any other sources of data about economic growth.


  • Those drawing inferences from revisions do not understand the process, as we explained in the  preview for this report.  Doug Kass (we like him, we respect him, we read him, and we often profit from his short-term advice) made the point both on his daily blog and on Kudlow (video here) that there was the first downward revision in many months.  This is meaningless and Doug should know better.
  • There were various mis-statements about the Birth/Death Model.  Some analysts tried to add the adjustment to the final NFP report.  The BLS explicitly states that one should not add Birth/Death adjustments to seasonally adjusted data.  Anyone doing this does not understand the method.

Q: Can I subtract the birth/death adjustment from the seasonally adjusted
over-the-month change to determine what it is adding to employment?

A: No.  Birth/death factors are a component of the not seasonally
adjusted estimate and therefore are not directly comparable to the seasonally
adjusted monthly changes.  Instead, the birth/death factor should be
assessed in the context of its effect on the not seasonally adjusted estimate.

  • Some observers tried to focus on the construction job component, especially suggesting that the Birth/Death Model added an unrealistic number of jobs in this sector.  The model does not specify the sector for job growth, so this statement is simply wrong.  Many of those looking at the "internals" of the report lose track of a simple fact:  This is a survey.  There is an error band around any reported category.  They tried to count all of 9 million jobs in construction and mining and such in one month and compare it to the count in the next month.  There is a wide error band.

Our Conclusions

While we do think that the BLS is using a professional and technically sound method, it was obviously slow in catching growth during the expansion.  We would not be surprised to see some modest downward benchmark revision when we have an actual job count for this year.  This point was made by Tony Crescenzi today in his excellent blog on’s RealMoney (a paid site, but worth it for any serious investor).  Tony uses the household employment survey to assist his analysis, since he thinks it might catch factors missed in the payroll report.  We agree.

Econobrowser, a site that we read daily on RSS, takes a different approach.  James Hamilton blends data from several report estimates to get a different projection.  While this differs dramatically from our own forecast using Michigan Consumer Confidence, initial jobless claims, and the ISM manufacturing index, it is interesting and professional. 

Meanwhile, the Fed is looking at these data in a long-term trend, in conjunction with other indicators.  Chairman Bernanke, the Open Market Committee, and the 350 Fed economists all know how to interpret employment data.  They do it much better than those on TV.

We would all like to have a monthly read on employment.  I would also like to know how the Sox will do tomorrow or the Bulls will do versus the Pistons.  It is important to realize the limitations of the data.  There is a difference between the data we want and the data we need.  It requires interpretation.


Many of the interpretive mistakes cited here will appear in Alan Abelson’s column tomorrow…..

Little Known Facts about the Payroll Employment Report

Here are a few facts that you probably do not know about the Payroll Employment Report (unless you are a regular reader of "A Dash").  You should know them, because the Fed does.

  • The Bureau of Labor Statistics (BLS) does not actually measure the change in jobs from month to month!  We know this may seem confusing.  The change in jobs is what everyone talks about, but it is not what the BLS measures.  They try to estimate the total number of jobs, using survey techniques.  They then compare the estimate from one month to the estimate from the next to calculate the change.

The result:  They can be great at estimating the total, and still have a huge error band for the change.  If you want more explanation on this point, we covered it here.

  • The original report is revised for two reasons, but not because the government is cooking the books.  The first reason is that many of the businesses in the survey do not send their reports in on time.  What a surprise!  Some businesses NEVER respond.  The BLS does two revisions, based on more complete returns, and then declares the result to be final — for a time.  The second reason for revision is that the BLS sample for the survey includes only businesses that existed at the start of the year.  The dynamic economy is gaining and losing businesses all of the time.  The BLS eventually takes actual data from state employment offices and compares it to their own count.  They adjust the methodology based upon the actual count, using something called a birth/death model.

Result #1:  Anyone who claims to see "a trend in the revisions" is being fooled by randomness.  You can tune that person out, and move on to useful work.  The revisions reflect businesses that were late.  Who knows the reason for that?

Result #2:  Critics of the birth/death model generally provide a very lame analysis.  Any such critic should step up to the plate and suggest a better method.  The BLS takes the actual state count at the end of the year.  They go back to their methods and try to improve them by building this in.  Many critics do not like the need for this revision, but they have nothing better to offer.

  • The so-called "internals" are also a survey result.  All of the data that people talk about — the job growth by sector, the hours worked, or whatever — are also survey results.  The error range for subsets is even greater than for the overall number, since the surveyed population is smaller.

Big-time commentators do not understand this.  It is a pretty cheap shot to criticize the government, claim that revisions are political, and offer one’s own view of something like a "birth/death  model".  The BLS economists do not go on CNBC to defend anything, so it is an easy way to look smart and sell research to institutions.  Do not be fooled by this!

  • We will never know the real truth–the actual change in payroll employment.  The final result, entered more than a year later into official statistics will be the outcome of two surveys.

The result:  Even if you knew the actual change (my old stat prof said "God whispers in your ear and tells you TRUTH") you could be seriously wrong.  Why?  The market is trading on the BLS survey estimate — something that has a wide error band.  This is true even though the survey is professionally designed and has a large sample.

You can test this for yourself!  My long-time friend and colleague Allen Russell has assisted us in devising the Payroll Employment Game.  Those of you reading this can get inside information, the actual figure entered as "truth" for this month — 129,000 jobs.  This is the result of our excellent regression model using the various key indicators charted at the PEG site.  If you repeatedly enter this number as your guess, you will have the best possible result.  You might even win our prize.


The information described here is useful because most of the Street does not get it, but the Fed does.  You may not be able to guess the number in advance, but you will have a better sense for the way it is viewed in the FOMC.  As we have described in detail, the Fed knows better.

Party Like 1999?

With the prospect of another round number surpassed in the venerable Dow Jones Industrial Average, Erin Burnett had her party hat on before the opening.  Mark Haines refused to wear his, but he did not have one of his "crash helmets."  The savvy Art Cashin not only explained the dynamics of the market, but picked up Erin’s hat when she dropped it.

Art is the insider’s insider on the floor.  We always listen to Art ("Art’s on!", the cry goes up, and we unmute the TV)  since he knows what those on the floor think is important.  If you are trading, you had better be listening.  Art’s daily comments (sign up with your UBS representative to get them) are a delight.  He always starts with some historical fact.  Today it was how America got named that instead of "Columbia" or something.  He then has a hilarious and knowingly lame segue to current market conditions.  Today he explained about program trading, futures, and ETF’s.  You can see John Bogle’s Business Week article for the data he reviews.  Art advises a focus on the numbers, not the conclusion.  We agree.  Finally, Art gives a few little algebra and trivia problems, just to keep you on your toes.

Party Hats?

We have two observations for those who are risking the call of a market top here.

  1. Market valuation, as measured by a comparison of earnings rates to interest rates is completely unlike that of the "bubble era."  At "A Dash" we have alerted investors to this with our Fed model series.  While many do not endorse this particular approach, it is a good starting point for individual investors worried about whether they are buying a market top.  Traders can also use this for their overall market attitude and positioning, even though their time frame is different.
  2. The individual investor is still missing in action.  Managers like us who work with these clients know this from conversations.  They have been frightened by recession warnings and the cycle of negativity.  They will start to participate more aggressively, attracted by the Dow headlines.  For those who act quickly, we believe there is still plenty of time to realize big gains.

One test of a market top is our CNBC advertising indicator.  (We should have applied for a patent on this one!)  Through the magic of TIVO we tracked the ads on Kudlow’s show tonight.  Here is the summary:

AARP can sell me some health insurance

There’s a big investment manager that will work closely with
me — them and us!

I can buy a good SUV for under 25K.

Medical problems – and the law.  I might be able to sue someone.

I need to watch Cramer to learn the key stocks to make Mad Money.

Another airline wants me to use their credit card.

A stylized cartoon guy on a treadmill is musing about retirement – a
caption suggests a guy named Chuck.

A big software company sells a product that is just right
for my small business.

Pre-packaged meals will help you lose weight – showing
before and after women (results not typical, according to the fine print).

Morgan Stanley is World Wise – they go behind the scenes to
get information.

ING has a person on a bench that attracts a cat by opening a
can of tuna when scores of others are scrambling around in futile efforts.

A clown isn’t a good substitute for a surgeon – so the CBOE
is the real deal.

A medical center tells me they are really good.

A local jeweler is the place to go for engagement rings.

A distinguished professor and a big, successful hedge fund manager explain to me how
to buy the right kind of ETF.

A brokerage firm explains how my costs from them would be
the lower on options as well as stocks.

A travel site is trying to get me to use them for hotels.

A big bank is encouraging me to take out a home equity loan.

A big firm ran some scenarios to show that a client could
retire early and did not need to relocate, as his company wanted.

A big company, noted for grain, shows how nice they are by explaining how they
help little people.

A credit card company cuts the hassle.

BrimleyWilford Brimley has advice for diabetics.

Compare to 1999

This is a case of a "dog not barking" as Sherlock would say.

We see no ads describing performance.  It is all "touchy feely."  No one cites performance.  This is mostly because fund managers do not focus on a narrow price-weighted index like the Dow, (one of the marketing coups of all time).  Even though pros do not focus on the Dow, customers do.  Meanwhile, the NASDAQ stocks make up part of anyone’s diversified portfolio, but they have seriously lagged.

There are none of the 1999-style ads.  What happened to the "tough guys who finished first", the cab driver buying an island, or the greatest of all, Stuart and Mr. P (click on the link to see the YouTube blast from the past).

This sentiment indicator is difficult to quantify (and regular readers know that we love quantification) but it should not be ignored.

Until individual investors (and maybe foreign equity investors) are once again committed to buying U.S. stocks, we have not seen the top.

International Exposure: A Challenge for Investors

The level of exposure to international stocks is an important issue for investors.  One of our featured sites,  Abnormal Returns has a thoughtful analysis of this question.  A.R. writes:

The question is whether this surge in international investment is
simply a means of catching up to the commonly recommended 20-40% equity
allocation. Or is it simply another case in the long line of individual
investors chasing hot performance? We will not know the answer to that
question until we have a notable market break, but until then there are
plenty of issues to deal with on the international investing front.

Read the entire article, a thoughtful consideration that includes evidence from several sources.  There is an interesting question for individual investors:  Can you use ETF approaches to hedge your inherent exposure to world conditions?  It is innovative and interesting.

A Reaction

Our observations are just opinions — conclusions based upon experience without our normal collection of data specific to this question.  This is the kind of topic that we have on the writing agenda for further research, but the question is so timely that we cannot resist a preliminary comment.

  1. Is this performance chasing or a thoughtful rebalancing of assets?   We vote for the former!  Chasing performance is one of the big mistakes of the individual investor, and many financial consultants wind up doing the same thing.  Financial advisors, even though they know better, are forced into taking positions like this to show they are "with it" and match performance.
  2. Is there transparency?  We say "No!"  ETF’s are opaque, not transparent.  The investor delights in not having to think about individual stocks.  Investors are encouraged to trade on "feel."  They just want to get some exposure to BRIC.
  3. Investors have no real knowledge of the countries or industries in which they are investing.  We know that more people in the U.S. can name the Three Stooges than can name the three branches of government.  They know who is leading on American Idol, but can’t name their own Senator.  Investors do not know the leaders, population, rate of economic growth, or political issues facing the countries in which they invest, much less information about the companies in the ETF.
  4. Accounting issues.  Financial accounting in the U.S. is at a different standard from that of other countries.  What do we really know about these companies?

Our strategy has been to invest in U.S. companies like Caterpillar, Inc. (CAT) where there is as much as 50% foreign exposure, and accounting that we can trust.  So far, this has not worked as well as buying the ETF’s.  Only recently has the market begun to realize the strength of the multi-nationals with foreign sales.

Thanks again to Abnormal Returns for an excellent insight on an important question.  Our reactions are more of a research agenda than a conclusion, so comments are especially welcome.

Transocean, Inc. — A Case Study of Risk and Reward

The current issue of Barron’s has a feature story by Andrew Bary, Crude Calculations, that points investors to the group of offshore drillers, two of which, Transocean, Inc.(RIG) and GlobalSantaFe Corporation (GSF), we own both for individual clients and in our funds.  Let us look first to Bary’s observations.  We will then compare that to our own risk/reward analysis.  He writes:

These and similar stocks
trade for 7-to-11 times estimated 2007 earnings, and 6-to-7 times 2008
projections, among the lowest P/Es anywhere.

The drillers carry such low valuations because Wall
Street is concerned the current profit boom won’t last as a slew of new
rigs hits the market by 2010. The industry historically has had
volatile profits, reflecting wide swings in daily rig-leasing rates, or
"day" rates. The drillers operated at around breakeven as recently as

Uh-oh!!  That must look risky to many investors.  Is this danger or opportunity?  Let us digress to consider risk and reward — and time frames!

The Objective of the Game Determines Time Frame

CNBC’s stock contest has hundreds of thousands of entrants and gets hourly publicity on the station.  Each  program has a celebrity (full disclosure — the old guy doesn’t know all of these supposed heavyweights.  I need help from Ryan and Renae) that gets on and makes picks.  It seems like anyone watching should be able to understand a few key ideas:

  1. The celebrities do not know anything about stocks.
  2. The rules of the contest require that participants beat a million other folks in a short time period.
  3. The only way to do this is to take risk — big-time risk — and get lucky.
  4. No investment manager could pass the Series 7 without understanding all of this.

Does it surprise anyone that plenty of those in the audience are trying to follow the winners?  Not us?  As participants in plenty of cocktail party conversations we have learned that everyone wants a "hot tip".  No one has ever asked me for suggestions about risk-adjusted return!

Roll the Dice

Bill Luby at VIX and More  has been doing a nice job with one of his entries.  (He is an expert on sentiment, options, and many topics that take us back to our own CBOE days.  We have been following Bill’s blog and now add it to our list of recommended sites.)  Bill would not buy RIG or GSF for the contest, since there is not enough short-term potential.

The time frame of the investment is crucial, as we discussed here, and Bill also did here.

Bill was alarmed to discover that a reader was putting his IRA money into one of his high-beta "shots."  Maybe the reader was joking, and maybe he was not.  After all, more than 30% of the people cannot name the Vice-President.  Some County Treasurer in Michigan invested in a Nigerian scam.

Risk Control

At the other end of the risk spectrum is the wonderful job being done by David Merkel on his blog.  David carefully explained how investors that managed risk had better long-run performance than those who did not.  We would add that David’s investors also sleep well — very well.  The drillers probably do not fit David’s criteria very well either.

Why We Like RIG and GSF

When analyzing stocks on the fundamentals, we look for two things — an inefficient market and a catalyst.

Inefficiency.  The market is too focused on the past and the overall cyclical nature of the business.  Few have done the requisite homework.  These stocks have a solid earnings base of locked-in contracts for two years, with plenty of upside.  Do you think that oil prices are dropping below $35/barrel?  We don’t either.  More from the Bary article:

Some investors fear a drop in oil and gas
prices will send day rates plunging; they have weakened recently for
rigs that operate in the shallow waters of the Gulf of Mexico. But
Transocean CEO Bob Long downplayed worries in a November conference
call, saying "we’re pretty comfortable that…oil prices down to $40 a
barrel and maybe even down to $35 would have little or no impact on the
deepwater market."

A Catalyst.  This is always a problem.  The consistently-excellent Kirk Report recently discussed William F. Eng’s book (which we have not yet reviewed).  Charles summarized the rules and we were struck by #46 —  yes, we read the entire list.

46.  The smarter you are the longer it takes.

Put another way, deep insight requires patience.

Here is Bary’s suggestion for a catalyst.

One way the drillers could boost their
share prices is by paying higher dividends, as Ole Slorer, an
oil-services analyst at Morgan Stanley, advocates. Slorer figures their
shares could rise 50% if they adopt a policy of paying out most of
their earnings.

Back to the Risk/Reward

There are two ways of looking at risk in the offshore drillers — absolute risk and volatility.

Absolute Risk.  Since we do not believe that oil is going back to below $35/barrel, and we like the locked-in earnings.  We see the absolute risk as very low.

Volatility.  Drilling stocks are part of various energy ETF’s.  Many hedge funds, not schooled in the Chicago futures tradition, do not use futures in their trading.  Many financial consultants also make aggressive moves in these ETF’s since the transaction costs are low.  Stocks like RIG and GSF swing around based upon the front-month oil spot price, even though this has little to do with their long-term prospects.  In fact, the oil futures forward curve, the best read on market prices, shows little backwardation.  The stocks caught up in this thrashing about show unwarranted volatility, and this exaggerates traditional risk measures like the Sharpe ratio.

Reward.  The catalyst might require market recognition of the factors we cite.  In the case of GSF, there is also buyout speculation, although we never use this as a fundamental buying rule.  Bary notes this:

Investors also could benefit from takeover
activity or leveraged buyouts in the sector. Seadrill (SDRLF.PK), a
fast-growing Norwegian driller with the highest P/E ratio in the group,
is believed to be weighing acquisitions. In a recent note, Citigroup
analyst Geoff Kieburtz identified GlobalSantaFe and Noble as the most likely targets for Seadrill.

Conclusion and Full Disclosure

These offshore drillers are among our favorite positions.  The market is wrong on risk as well as reward.  We hold them in all accounts.  We bought RIG two years ago, so we have a near-double already, but the stock has languished recently.  While we make trades in them at the margin, the overall risk/reward balance is so favorable that it would take a massive repricing for us to sell the entire position.

When Fundamentals and Perceptions Collide

What action is right when market perceptions conflict with fundamental valuation methods?

Let us put aside whether our valuation or the market perception is correct, and turn to the interesting case where there is conflict between the two.

For Warren Buffett or other Benjamin Graham followers the question is easy.  They recommend buying businesses that are undervalued.  If Mr. Market comes to them with a lowball offer, they do not care.  With Mr. Buffett’s track record, there is no need to worry about adverse fluctuations in value, even if these persist for quite a long time.

For most fund managers this answer does not work.  One has a mixture of holdings reflecting different time frames.  If properly done, the expected edge must vary with how long one must wait.

Hypothetical Example

Let us suppose that one holds "Stock X", a company that is about to announce earnings.  Your valuation methods show that the stock is very under-valued.  Recent LBO’s provide some evidence that this example is not so far-fetched, even for major companies, as Paul Hickey explored in an excellent article on TickerSense.

Let us further suppose that you have listened to past conference calls from Company X.  You know that the management does not hype earnings prospects, and frankly discusses anything of concern.  Company X has, as a part of its business, exposure to housing construction.  You fully expect that management will mention "the H word" during the conference call.

While this has no significance for your long-term projection, you might choose to take a trading position reflecting the market expectations.  In a hedge fund, for example, one might choose to use options to hedge the positions, or lighten up holdings until after the call.

For the individual investor it is much more difficult.  Psychologically, the most difficult move is to re-establish the position if the stock actually moves higher after the call.  Your hedging decision was wrong.  The manager must think in different time frames and trade accordingly.  This is more difficult for individuals.

Market Example

Let us next apply this thinking to a perspective on the overall market.  Regular readers of "A Dash" know that our long-term view on the market is quite bullish, and that we also take tactical short positions in accounts geared to trading.  Others, like Doug Kass and Barry Ritholtz, have an overall bearish view, but make astute trading calls to take long positions.  Using the time frame effectively can work if one is willing to trade against the overall outlook.  Some recent criticisms of bearish pundits strike us as unfair, since none of them trade exclusively based upon a long-term market viewpoint.  This may be difficult for their readers to follow, but those observing them carefully should be able to note their bullish counter-moves.

To get to specifics, many market participants have (among many concerns) two that stand out as major market threats.  As we often do, we look to Barry Ritholtz to identify these concerns.  Since we have occasionally (!) disagreed with Barry, let us look to two recent observations where we are in complete agreement.

  • The Fed.  Barry really nailed this story.  He analyzed the news and interpretation of the recent Fed statement and minutes in a series of posts.  We agree that the Fed is not about to cut rates, and suspect that another hike may be in the future.  This is because the Fed (correctly in our view) sees strength in the economy and is pursuing a policy of planned slowing to quash inflation expectations.  It is quite clear that the market, which has little respect for the Fed, has a fixation about the need to lower interest rates.  This poses a problem for trades or investments using a longer time frame.
  • Rhetoric — particularly about "stagflation."  In a strong post today Barry added some analysis to a great story from Caroline Baum of Bloomberg.  We have discussed the power of symbolic language, and the freely-used stagflation term catches the attention of many.  This may be particularly true of individual investors or, as Baum suggests, younger fund managers.  This is also a problem of positions in two time frames.  While we do not fear a stagflation scenario, we do expect that various (lagging–see CXO Advisory) economic indicators, like unemployment and inflation readings, may get worse before they get better.  With each report, even though the moves may be small, the stagflation scenario might seem more real.

At some point the market psychology will change.  Identifying the catalyst for this change is a thorny problem.

We will try to pursue this with the analysis of some specific stocks.

Good Games and Time Frames

A young person recently asked me for some career advice.  In my academic days I advised many students, of course, so the question was a familiar one.  This person wanted to enter the trading world.  The most important aspect of my advice was as follows:

Be sure to find a good game.

She asked, of course, "What does that mean?"

My definition of a good game is one where your theoretical edge will show up within sufficient time.  This may mean before your trading account runs out, you lose your clients, or you lose your sponsors.

In a good game you get into "the long run" fairly quickly, and use money management to make sure that risk is controlled.  We emphasize that investing (or trading) is not gambling, but the mathematics of the gambling literature is quite applicable to trading.  Casinos have a good game, since they have a known edge and can get into the long run quite quickly.  Despite this, short-term results (and earnings) are influenced by the performance of "whales", the big bettors who take big chances.

Ken Uston’s excellent book, Million Dollar Blackjack (now featured on our reading list), describes both his system and the implementation in team play.  Card-counting nerds would signal "the Big Player" who would seem to flit from table to table, cocktail in hand and a woman on both arms.  The team used the Kelly Criterion, treated extensively in William Poundstone’s book, Fortunes Formula which we discussed in this post.

As a result of this team method (no longer effective given casino counter-measures), Uston played exclusively in situations where he had an edge of about 5%.  Despite this advantage, he describes a period of time where they had a losing streak lasting more than a month!  Please note that this includes thousands of hands played.

Most gamblers, and probably many traders, make the mistake of over betting their bankroll, not realizing the devastating effect of a losing streak that should be entirely predictable.  Effective money management cannot turn a losing system into a winner.  Ineffective money management can doom even the best system.

What is a Good Game for Trading?

Dr. Brett Steenbarger’s recent post, "What We Can Learn from Trading and Poker," provides focus on this issue.  Time frame is important.

Here are the key time frames:

  • Intra-day.  Technical setups occur frequently.  If one has a good system, the long run can occur very quickly and a modest edge can yield big profits.  Many trading firms now use software that identifies small advantages and makes quick moves through automation.  This is the competition for the intra-day trader.
  • Short term.  I define this as trades lasting a period measured in days.  We employ an excellent system for short-term trading.  It is over-simplifying to call it "mean reversion" but that is the basic concept.  Vince, our modeling guru, identified key concepts and measured them in a unique fashion, drawing upon advanced mathematics.  Even with such an advantage, one must expect losing streaks that can last for weeks.
  • Intermediate term.  This is a period that is projected in weeks, often based upon technical indicators.  Vince has developed an excellent trend-following method, once again using his own special methods.  It is this model that we employ in our weekly responses to the Ticker Sense blogger sentiment poll.  For the  moment, we have made these calls public in the poll.  The  method can lead to gyrations at market turning points.  In the last few weeks it has steered us to be long, neutral, and short (currently long).  Such a system has the advantage of getting on the right side of the market for major moves and avoiding major losses.
  • Long term.  This is the realm of valuation, and macro analysis of fundamental trends. It describes much of what we write about on "A Dash."  The problem with long-term market calls is that the scenario might take a lot of time to play out.  The debate between bearish analysts and those seeing great value in the market is now in (at least) the third year, with few viewpoints changing.  The extended period of Fed rate hikes and the debate over the economy has prolonged the issue.  While we see it as a period of undue negativity (with evidence here), others continue to see an imminent recession.

Key Lessons

There are two main lessons.

First, the edge one needs must increase with the time period.  A good game requires getting into the long run.  The long run is not measured in time.  It is measured in the number of independent opportunities to make a "bet."  One should not invest or trade on a long-run call without the expectation of substantial edge.  Having made such a decision, patience is required.  One holds on until victory is achieved or the evidence changes.

Second,  it is important to choose a trading or investing strategy that is geared to the expected edge.  This means careful attention to position size.

This is a framework for analysis, and a key concept for traders and investors — or poker players!

Reality Check: Productivity

Should one look at the forest or the trees?

We are bombarded with data on every topic related to the economy.  An important one is productivity, which is subject to many influences.  It is important because economic growth — and ultimately earnings growth — can show gains through productivity increases.

The secular decline in manufacturing jobs, more than offset by an increase in service jobs, is partly a function of improved machinery.  The output for each manufacturing worker has increased, and continues to do so each year.

Last year, before my father’s death, I had the opportunity to go to Dearborn with him and tour the Ford Rouge plant.  Sometimes one just needs the sweep of a long period of time to understand that things are different.  The Rouge plant was Dad’s first assignment after the war.  It did not even resemble what he remembered.  Many street pundits seem detached from the yearly improvements in output/worker.

While this varies from year to year, partly based upon wage gains, the overall trend is quite clear.

In the service sector it is just as dramatic.  There is a tendency for us to think that service jobs are all low-paying and menial.  In fact, most of those reading this are engaged in high-paying service work.

So let’s do a reality check.  Here is a little,  homely anecdote that got me thinking about the subject.  Our bowling league changed sites.  (This happened because the land for the former site became so much more valuable that the owners finally sold out.)  I needed to know how to get to the new site for our match.  I typed in the name of the lanes and the city in Google.  A map popped up, showing the location.  I clicked on directions and my home address was available as a starting  point.  I printed this out and had an accurate answer to my problem in less than one minute.

Multiply this by the hundreds of small tasks you do each day.  We all check scores of market commentaries in a short time with RSS readers.  News is there instantly.  I checked my flight today with Google SMS, and also scouted O’Hare parking.  I downloaded quotes and ran our sophisticated models to plan tomorrow’s trades in a few minutes.  When we have a new model, backtesting it takes hours rather than weeks.

There is also video conferencing, online sharing, and many other more sophisticated applications.

Many of these developments have taken place during the last five years.  In my operation, I think that it would take a staff of at least double our size to do what we do today.  Personally, I do three times the work that I did a few years ago.  What is your experience?  (I understand that some time is not productively spent, so you can allow for that.  Some fun is allowed, and encouraged at the top firms).

It is easy to get caught up in statistics and ignore the obvious. 

Be skeptical.  When someone suggests that economic growth is not "organic", but only a function of some sort of "stimulus", it may be time to ask questions. Do you really believe that a fully-employed work force, using better tools, has not improved since the last time that "peak earnings" were achieved?

Recession Expectations: An Important Anomaly

Where does one look for economic forecasting?  At "A Dash" we take the role of the educated consumer of forecasts.  We like to find the best information from the most reliable sources.

During the last week we learned the recession expectations of distinctly different groups.


The Blue Chip Economic Indicators panel reduced the consensus forecast for U.S. economic growth for 2007 from 2.5% (last month) to 2.3%.  The 2008 forecast dropped 0.1% to a prediction of 2.9%.  These results do not provide for the analysis of individual forecasts without a subscription.

Our take:  The forecast is consistent with the planned Fed slowing of the economy to address inflationary expectations.  It is what should be expected if we are accomplishing what some call a "soft landing" and we call the Glide Path — a better term when one expects to keep flying!

The Wall Street Journal poll of economists forecasts GDP growth for the first two quarters of 2007 to be 2.2% and the remainder of the year to be 2.9%.  62% of those polled expressed confidence that the result would be within 0.5% of their estimate.

Consistent with this confidence level was the statement that the chance of a recession in the next twelve months was only 26%.  Keeping in mind that recessions occur with some regularity, one needs to understand that "normal" expectations are about a 20% chance.  Something can always go wrong.

The economists were asked what might upset their predictions.  20 of 54 respondents said slower CapEx spending and only 11 cited the housing market.

Our take:  Once again, the overall results are consistent with the Fed’s expectation for growth that is slightly below the long-term trend expectation of about 3%.  There is not much worry about recession, and the forecasters are pretty confident of their views.

Regarding the biggest worry, one must realize that the question asked them to name something!  The respondents did not attach a probability to CapEx or Housing.  They merely answered that this was what to watch.

Despite this rather obvious inference one would get from actually looking at the questions and answers, the headline of the story in the WSJ was:

Economy Enemy No.1:
Soft Capital Spending

An alternative might have been:  Economists see recession as unlikely.  What to watch?  CapEx.  A notable feature of this poll is that the highly trumpeted housing factor is the big threat for fewer than 20% of respondents.

Prominent bloggers like Barry Ritholtz at The Big Picture also highlighted the CapEx concern.

Read it here first: Slow CapEx Spending Worries Economists

This emphasis on a "forced response" does not capture the overall sense of the survey.

The People

The Bloomberg/LA Times poll asks the people what they think about economic prospects.  The Bloomberg Story had this headline:

Most Americans See Recession in the Next 12 Months

Their survey showed that 60% of respondents expected a recession, and they compared this to 64% who had similar expectations in December of 2000, "three months before the last decline."

This seems to imply some prescience on the part of the average American to anticipate recessions.  Buried in the article is another interesting result.

Sixty-four percent of those polled said their own finances
are very or fairly secure compared with 35 percent who described
them as shaky.         

“People tend to be pretty optimistic about their own
situation, but when it comes to the larger economy they’re much
more pessimistic,” said Karlyn Bowman, a polling expert at the
American Enterprise Institute in Washington. “The public’s just
in a very sour mood because Iraq continues to cast a pall over


Our take:  The public perception is not surprising given the media spin on the economy.  It is not that economic reporters are intentionally biased; potential problems are more newsworthy than bland forecasts.

We are also reminded of the ongoing poll results about how people feel about Congress (always scoring high negatives as an institution) and their own House Member (usually scoring positives).  It is an interesting irony which does not lend itself to a solution in the voting booth.


At "A Dash" we have stressed the importance of finding the real experts on any topic.  Does the average citizen have a better sense of the probability of recession than a panel of economists?

There is a general sense on Wall Street and in the blogosphere that since economists did not forecast the last recession their opinions are no good.  It is a wonderful, democratizing conclusion, allowing each pundit or writer or citizen to feel they are just as good as those who trained to do this, and spend their professional lives on the problem.

We disagree.  This is not American Idol.

This is an important theme, especially with the election season starting, so we plan to pursue it further.  Meanwhile, readers with a serious interest in recession chances could pursue our past posts on this topic.

Quantifying the Impact of Housing Problems — An Update

Recently we objected to a Doug Kass prediction that demand for new housing would fall by 50%.  Doug used an approach that identified potential foreclosures and eliminated entire classes of buyers.  He also cited secondary effects.

Our Objection

We suggested that the economy does not work this way.  A potential buyer may qualify for a lower mortgage, even if standards tighten.  New buyers emerge.  Existing loans get restructured.  Prices move lower, of course, until a market-clearing point is reached.  Briefly put, supply and demand are not absolutes, but intersecting curves that shift until the market-clearing price is reached.

Already there is substantial support for our viewpoint.  In a typically excellent summary of Dallas Fed President Fisher’s speech today, Gary D. Smith points out (among other things – read the whole post) that Fisher sees the market, the Fed, and lenders working to resolve the problem.  Fisher sees the damage as "contained."  (Here is the Bloomberg summary, and here is the entire speech.)

Meanwhile, news stories like this one (Lenders willing to help struggling homeowners) cite a rather obvious point.  Lenders prefer to work with existing owners rather than to foreclose.

Anecdotal Evidence

This weekend I heard of a young couple that waited for a price reduction on a home in Madison, Wisconsin and can now qualify for a suitable mortgage.

My home construction contacts in the Chicago suburbs continue to find new work.

My real estate contact in Minneapolis reports a brisk business in the 300K to 700K range, with prices down 5 to 10 percent from last year.

While we like to use macro-level quantification, sometimes the individual cases help to see the economy at work.


Taken together, this is all evidence that the doom-and-gloom scenario for mortgages and housing is overstated.