Four Common Mistakes about the Fed

The Fed is a favorite target for the financial punditry.  Anyone can and does join in, offering ideas that are completely without evidentiary support.  Meanwhile, there is plenty of factual information about the Fed, but it is widely ignored.

Here are four common mistakes that you frequently see in the commentary from the  pseudo-experts.  These blunders are so widespread that it is pointless to cite a specific source.

The Fed is Sidelined by the Upcoming Election

This one is a persistent theme among those who have absolutely no special knowledge or experience.  Many pundits analyze government organizations by pretending that the policymakers are a small group with a strong common motive and the ability to act in secret.  They basically take their own limited experience about how the world works and assume that they can explain government actions that way.

One reporter from the floor recently reported the latest convoluted notion:  The FOMC would not act at next week's meeting, but would instead delay so that the positive effect of its policy action would not occur before the election.

That is really deep!  Some of the same sources show a chart that quite liberally changes the dates of Fed policy to correspond to market moves.  In some cases the move occurs at the first hint of a policy change.  This is completely inconsistent.

The Fed Acts Based Upon the Stock Market

One commentator recently opined that the Fed would not act right now because the stock market was not really threatened.  The Fed would wait until there was a serious selloff to use its few remaining bullets — maybe 1100 in the S&P.

In fact, there is absolutely no evidence that the Fed acts to prop up the stock market.  The Fed behaves in line with a dual mandate for stable prices and low unemployment.  With prices not a threat, the emphasis is on economic growth.

There is a source of confusion — the Fed embraces the stock market as one source of how well they are doing on the economy.  While the objective is not directly to support stock prices, a successful economic policy would have that result.  The occasional reference to higher asset prices is pounced upon by conspiracy buffs.

How can we tell the difference?

  1. We could listen to Bernanke's testimony, where he has repeatedly stated the economic objectives — and also that the political circumstances are not a factor.
  2. We could go to the official transcripts of the meetings, now available for many years and extending up to 2006.   These are full transcripts.  If someone wants to assert political or stock motivations, let him find the evidence in the actual record.  Put up or shut up!
  3. Forget the stupid conspiracy notion.  The FOMC meetings have many participants, some of whom would be happy to report any secret moves.

Day-in-the-life-of-the-fomc_img01

 

The Fed is Out of Ammunition

A popular theme is that the Fed can do little more because short rates are already at near-zero levels and the perception is that the effect of asset purchases has been reduced.

It is difficult to discuss an erroneous viewpoint without specifying a source, and I do not want to create a straw man.  With this in mind, the Fed critics — who have been on the job for years — did not imagine any of the current actions either.  The "out of bullets" meme is many years old.  Why should we believe them now?

Instead, you could look at commentary from an actual authority, a former Vice-Chair of the Fed.  Alan Blinder, writing in the WSJ, offers five different ideas that the Fed could use.  Any of these surprises could catch traders leaning the wrong way.

The Fed Knows the Employment Data

This is a bonus item.  I predict that whatever the Fed does next week, the talking heads will speculate that it is based on an early read from the employment report.

This idea is completely false, and contravenes official regulations.  The President gets an early look on Thursday afternoon (via the Council of Economic Advisors) and the Fed gets a few data points to help with their Wednesday release on Industrial Production.

That is all!

This was a specific question in a BLS webinar that I attended two years ago.  Here was the answer:

11:01

Angie Clinton (BLS-CES): 

Submitted via e-mail from Paul: Question
QUESTION: What are the rules or law governing the confidentiality of the monthly jobs reports? When is the report/information released to the media (even though it may be embargoed for a few hours). Are DOL officials or other Executive Branch officials permitted to publicly discuss any information about those reports before they are released to the media and public? Thank you.
ANSWER: Thanks for your question Paul. The Office of Management and Budget directs Federal agencies on the compilation and release of principal economic indicators. Statistical Policy Directive Number 3 designates statistical series that provide timely measures of economic activity as Principal Economic Indicators and requires prompt release of these indicators. The intent of the directive is to preserve the time value of such information, strike a balance between timeliness and accuracy, prevent early access to information that may affect financial and commodity markets, and preserve the distinction between the policy-neutral release of data by statistical agencies and their interpretation by policy officials.
According to the guidelines set forth in this directive, the BLS provides prerelease information to the President, through the Chairman of the Council of Economic Advisers, the afternoon before release of the Employment Situation. Statistical Policy Directive Number 3 is available on
http://www.whitehouse.gov/omb/assets/omb/inforeg/statpolicy/dir_3_fr_09251985.pdf .
The directive contains the following language regarding public comment: “Except for members of the staff of the agency issuing the principal economic indicator who have been designated by the agency head to provide technical explanations of the data, employees of the Executive Branch shall not comment publicly on the data until at least one hour after the official release time.”
CES and CPS data are embargoed until the scheduled release date and time. The Federal Reserve has a memorandum of understanding with BLS to obtain specific employment and hours series for manufacturing, mining, utilities, and publishing for purposes of producing estimates of industrial production on Wednesday at 8:00 AM prior to the release. The Council of Economic Advisors receives the news release on Thursday afternoon, the day prior to the release. The Chief Economist at the Department of Commerce and the Secretary of Labor receive the news release at 8:00 on the morning of the release. Members of the press and the staff of the Joint Economic Committee of Congress (if there is a JEC hearing) receive the news release under strict lockup conditions at 8:00 AM on the morning of the release.

Friday June 4, 2010 11:01 Angie Clinton (BLS-CES)

This is quite authoritative, and you will definitely not see it anywhere else.  My fearless forecast is that the conspiracy buffs will be in action on this next week!

Investment Conclusion

The basic conclusion for investors is a familiar one for readers of "A Dash."  There is no substitute for finding actual experts and sources.  Accept no substitutes!

Bernanke will act if additional economic weakness indicates the need.  He will not have advance info on the employment report, so Fed action might not occur at the upcoming meeting.  While it may be fun to speculate on conspiracies and politics, this is not the path to a profitable investment.

Fighting central banks is a losing proposition for investors.

 

Weighing the Week Ahead: How Big is the Economic Slowdown?

After the volatility of last week's "three-ring circus," I expect a quieter trading week.  Based upon evidence from somewhat weaker economic reports and lower corporate revenues, the key question is:  How big is the economic slowdown?

It has taken only a slowing in the rate of growth — not a decline — to convince many that a new recession is upon us.  This is a key question, and we'll have more evidence this week.

I'll offer my own expectations in the conclusion, but first let us do our regular review of last week's news.

Background on "Weighing the Week Ahead"

There are many good sources for a list of upcoming events.  With foreign markets setting the tone for US trading on many days, I especially like the comprehensive calendar from Forexpros.  There is also helpful descriptive and historical information on each item.

In contrast, I highlight a smaller group of events.  My theme is an expert guess about what we will be watching on TV and reading in the mainstream media.  It is a focus on what I think is important for my trading and client portfolios.

This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting the news in context.

Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!

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

It was, as expected, a busy week for news and data.

House-price-changes-distribution-by-county-NY-Fed-2912-July-17-400px

  • Bullish sentiment "falls off a cliff" according to Bespoke.  This is a short-term market positive.

AAII Bullish Sentiment 071912

  • Corporate earnings have been beating (lowered) expectations, much as we have expected.  Some major companies (especially GE) have given relatively positive outlooks, despite the expectation that most would be conservative.
  • Rail and sea traffic are positive.  See Steven Hansen's articles (Rail, Sea).  Ports of LA and Long Beach are building at a "furious pace."  (Calculated Risk).

The Bad

 There was plenty of negative news from our three-ring circus last week.

  • Bernanke's testimony showed no immediate inclination for more stimulus.  Since traders are more skeptical about the economy than is the Fed, this caused instant, but temporary, selling.
  • Corporate revenues (contrast with earnings above) are worse than expected.  My colleague Scott Rothbort at Wall Street All Stars writes an excellent daily column.  He notes that the weaker dollar helps costs and hurts revenue for many companies.  This seems to have escaped the notice of less discerning analysts.
  • Earnings expectations for 2012 are still declining.  Brian Gilmartin tracks this carefully at his new blog — highly recommended.
  • Conference Board Leading Economic Indicators moved lower.  Their interpretation is that the economy has a steady but soft pace while sailing through "strong headwinds."  Doug Short has a good analysis and an interesting chart showing the rate of change in this index and past recessions.

CB-LEI-ROC

  • Initial jobless claims spiked higher, back to the 180K  380K range,  reflecting the auto company seasonality.  This suggests that last week's improvement was a one-time effect.
  • Fiscal cliff rhetoric is bad.  No sign of progress before the election.

The Ugly

There was a lot of ugly stuff happening last week, but I want to stick to the world of investments.  The most dangerous thing for the individual investor right now is the apparent safety in the quest for yield.  I warned a month ago that investors should build a ladder from individual bonds rather than owning funds.  Many will be surprised by actual losses from their bond funds, despite the past performance.

I was delighted to read Barry Ritholtz's fine article in the Washington Post, also recommending a bond ladder approach and warning about some alternatives.  This is important and deserves the visibility before it is too late.

In "Con Job," Tom Brakke shows how apparent high-yielding funds are really giving investors their own money back in the guise of yield.  Check out the great chart.

 

The Indicator Snapshot

It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

The SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events.  It uses data, mostly from credit markets, to reach an objective risk assessment.  The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon.  We are working on a modification that will make this method even more sensitive.  None of the recession methods are worrisome.  Bob also has a group of coincident indicators. Like most of the top recession forecasters, he uses these to confirm the long-term prediction. These indicators are also not close to a recession signal.

There is a lot of activity from the recession forecasters.  The basic summary is that those with the best records still see little chance of a recession in the next six months or so.  The people that get featured  in the press and on TV are sticking by their guns, even though the evidence is mounting against them.

We are now at the end of the nine-month forecast window that the ECRI adjusted to after their September, 2011 call (recession imminent, maybe already here, and unavoidable) seemed to prove wrong.  Since then they have been adjusting indicators and trying to extend the window, which supposedly ends right now — mid-year 2012.  Instead of agreeing to this, the ECRI has now raised the notion that there is already a recession, but it has not yet been recognized.  For the last two weeks there have been numerous refutations of this claim.  Meanwhile, I recommend this article where I did a rather comprehensive list leading up to last week and also my new Recession Resource Page, which explains many of the concepts people get wrong.

I'll have more on the most recent work in this week's conclusion.

The single best resource for the  ECRI call and the ongoing debate is Doug Short, who has a complete and balanced story with frequent updates.

  Indicator snapshot 072112

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions.  This week we continued as "bullish," although it is a pretty close call.  These are 30-day forecasts.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list.  You can also write personally to me with questions or comments, and I'll do my best to answer.]

The Week Ahead

There are a number of minor releases this week, including some regional Fed surveys.  The biggest items are the following:

  • New home sales on Wednesday, since there is plenty of interest in potential housing growth.
  • Initial claims (Thursday) especially given the recent wild fluctuations.
  • Durable goods orders (Thursday).
  • Advance GDP estimates for Q2 (Thursday).  This is important even though it is backward looking and will be subject to significant revisions.

Trading Time Frame

Our trading positions continued in fully invested mode last week.  Felix is not a range trader, but is excellent at getting on the right side for big moves.

Investor Time Frame

The successful investment strategy differs markedly from trading.  It is especially important to establish good, long-term positions when prices are favorable. Most individual investors seriously underperform long-term results by selling low and buying high.  Most successful professionals, of course, do the opposite.

This is easier said than done.  With everyone on TV explaining with great confidence what just happened (please check out my article on the "message of the markets") it is easy for the average person to think he is out of step.

There is no magic moment.  Resolving market worries is a process, not an event.

I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look.  You can contrast this with the many  pundits who claim miracles of market timing.

The market action last week, once again illustrated market moves based on little change in the underlying information, especially after Bernanke's testimony.

The best strategy through the various gyrations has been buying dividend stocks and selling calls for enhanced yield.  Anyone unhappy with bonds should be doing this for a yield of 8-10% with greater safety than pure stock ownership.  Take what the market is offering!

Those who had calls expiring worthless last Friday can now do a new round of sales.

Final Thoughts on the Slowdown

The recession forecasts have a lot of traction, despite the lack of supporting data.  I was reminded of the attraction of intuition by the continuing comments of golf analyst Curtis Strange, talking about the "heavy air" at the British Open.  This seems plausible to most, but is actually wrong.  Humid air is less dense than dry air, and in the absence of other variables, humidity adds slightly to distance.

You cannot get a bet down on that error, but you can act on the misleading recession forecasts.

Many people confuse continuing below-trend growth with a recession.  As investors, we are interested in the effect on corporate earnings and stock prices, both of which have done well despite the sluggish recovery.  A recession starts at a business cycle peak.  A slowing rate of growth does not signal a peak.  This is completely counterintuitive, so it makes the average person vulnerable.

It is in the interest of many to promote the recession talk:

  • The "out" party (and Dems would and did do the same thing when they were out);
  • The media (selling page views and ratings);
  • Those who have made a big reputational play (like the ECRI); and
  • Those selling fear and gold.

There was even more excellent work this week on the recession front, all featuring solid quantitative work.

The Bonddad Blog looked at initial jobless claims before past recessions and found little evidence that current circumstances are similar.

Dwaine van Vuuren looks specifically at the four main indicators used by the NBER in determining the start of recessions.  This is different from the recession forecasting model he has developed, since it is more of an analysis of current conditions, what he calls a "confirmation of last resort."  Most will need to read the article carefully, but the verdict should be pretty clear.

Doug Short also looks at the big four indicators.  As usual, he has many helpful charts showing quite clearly the difference between current conditions and past recessions.  The entire article is great, and recessionistas should study the charts carefully.  Here is one that summarizes the key elements:

Big-Four-Indicator-Average-Since-1959

Here is Doug's answer to his own question of whether the Big Four are rolling over:

"As of the latest data, no, they are not collectively rolling over. Here is the big picture since 1959, the same chart as the one above, but showing the average of the four rather than the individual indicators. This chart clearly shows the savagery of the last recession. It was much deeper than the closest contender in this timeframe, the 1973-1975 Oil Embargo recession. While we've yet to set new highs, the trend has collectively been ever upward."

Investment Conclusion

Most investors spend too much energy trying to form their own conclusions about the economy.  I am surprised by the strong feelings I see in comments, emails, and private conversations.

Unless you have your own macroeconomic model and plenty of experience, you have no basis for your personal opinion about recessions.

Unless you have significant experience in evaluating quantitative models, you have no basis for choosing among the various expert forecasts.

I do not have a macro model, but I try each week to help people find the best experts in various fields.  There will eventually be another recession, of course, but the evidence is not there yet.



June Employment Report Preview

We rely too much on the monthly employment outlook report.  It is a natural mistake.  We all want to know whether the economy is improving and, if so, by how much. Employment is the key metric since it is fundamental for consumption, corporate profits, tax revenues, deficit reduction, and financial markets.

Since the subject is so important, most people place too much emphasis on the official (preliminary) report, which is really only an estimate.  In about eight months, we'll have an accurate count from state employment offices, but by then no one will care.

There are several competing methods that provide independent approaches to analyzing employment.

I will first summarize the BLS official methodology.  Next I will review alternative approaches and those forecasts.  I will conclude with some ideas about what to watch for.

The Data

We would like to know the net addition of jobs in the month of May.

To provide an estimate of monthly job changes the BLS has a complex methodology that includes the following steps:

  1. An initial report of a survey of establishments. Even if the survey sample was perfect (and we all know that it is not) and the response rate was 100% (which it is not) the sampling error alone for a 90% confidence interval is +/- 100K jobs.
  2. The report is revised to reflect additional responses over the next two months.
  3. There is an adjustment to account for job creation — much maligned and misunderstood by nearly everyone.
  4. The final data are benchmarked against the state employment data every year. This usually shows that the overall process was very good, but it led to major downward adjustments at the time of the recession. More recently, the BLS estimates have been too low. (See here for a more detailed account of this, along with supporting data).

Competing Estimates

The BLS report is really an initial estimate, not the ultimate answer. What we are all looking for is information about job growth. There are several competing sources using different methods and with different answers.

  • ADP has actual, real-time data from firms that use their services. The firms are not completely representative of the entire universe, but it is a different and interesting source. ADP reports gains of 176K private jobs on a seasonally adjusted basis.  In general, the ADP results correlate well with the final data from the BLS, but not always the initial estimate.
  • Economic correlations. Most Wall Street economists use a method that employs data from various inputs, sometimes including ADP (which I think is cheating — you should make an independent estimate).
    • Jeff Method.  I use the four-week moving average of initial claims, the ISM manufacturing index, and the University of Michigan sentiment index. I do this to embrace both job creation (running at over 2.3 million jobs per month) and job destruction (running at about 2.1 million jobs per month). In mid-2011 the sentiment index started reflecting gas prices and the debt ceiling debate rather than broader concerns. When you know there is a problem with an input variable, you need to review the model. For the moment, the Jeff model is on the sidelines.  From my perspective, the decline in consumer confidence, even with lower gas prices, is disturbing.  It is difficult to account for the effect of headlines about Europe and the fiscal cliff.
    • Street estimates generally follow my method, but few reveal much about the specific approach.  Have a little fun by looking at the specific forecasts from many firms, along with a picture of the spokesperson!  Thanks to Business Insider.  Joe Weisenthal, in a good story about Goldman,  notes that some of these estimates are already responding to the ADP report.
  • Briefing.com cites the consensus estimate as 100K, the same as their own forecast.
  • Gallup sees unemployment as falling on a seasonally adjusted basis (but flat if unadjusted).  This is interesting since they have a different survey from the government, a relatively new approach to seasonal adjustment, and an extremely bearish and political approach in past commentaries.  Gallup's methods deserve respect, so I am watching closely.

Partial Indicators 

A problem with forecasting net employment changes is that you need to look at all of the following:

  1. Both hiring and firing;
  2. Companies of all sizes; and
  3. Failing companies and new businesses.

There are many interesting pieces to the puzzle, but it is easy to over-react without the context listed above.  The respected Challenger survey reports fewer layoffs.  Excellent!  But does that mean hiring?  Initial jobless claims move higher.  That tells us about job losses at certain types of firms, but nothing about job creation.

An interesting idea comes from Michael Mandel, who astutely notes the disparity in help-wanted ads according to the occupation.  Harkening back to The Graduate, Michael (one of my favorite acquaintances from my Kauffman meetings), writes as follows:

"If you have a college student in your family who is looking for a job, remember this one word: 'Data.'"

For Dustin Hoffman it was "plastics."  Michael says to watch this, so I am and you should, too.

Men on a Mission

(And women too, of course, but I could not resist the alliteration.  Biased female economists should feel free to accept equal blame!)

Here at "A Dash" we have great respect for those who make objective, independent forecasts.  We know that methods may lead to different conclusions, and that debate is healthy.

With this in mind, here are two examples:

  1. TrimTabs confidently asserts that the BLS data will be wrong!  Amazing, without knowing the content of the report or the revisions.  They assert that we are in a "depression" and are confident about the direction of later revisions.  While I have been sympathetic to their own mistakes, and agree about revisions, they do not seem to realize that the BLS has been understating growth for a couple of years.  Why the agenda?
  2. David Rosenberg is out with a list of reasons why the jobs report will "stink."  He cites a number of interesting indicators.  A serious economist would do research with a time series on each, discarding those that reflected multi-collinearity.  That is what my team did.  He cherry picks reports and plays the same tune, always finding new data.  He has an audience, and one much bigger than mine!  [Will someone please remind me of who first said that the crowd expects Neil Diamond to sing Sweet Caroline?  I want to give credit where it is due.]

Failures of Understanding

There is a list of repeated monthly mistakes by the assembled jobs punditry:

  • Focus on net job creation.  This is the most important.  The big story is the teeming stew of job gains and losses.  It is never mentioned on employment Friday.  The US economy creates over 7 million jobs every quarter.
  • Failure to recognize sampling error.  The payroll number has a confidence interval of +/- 105K jobs.  The household survey is +/- 450K jobs.  We take small deviations from expectations too seriously — far too seriously.
  • False emphasis on "the internals."  Pundits pontificate on various sub-categories of the report, assuming laser-like accuracy.  In fact, the sampling error (not to mention revisions and non-sampling error) in these categories is huge.
  • Negative spin on the BLS methods.  There is a routine monthly question about how many payroll jobs were added by the BLS birth/death adjustment.  This is a propaganda war that seems to have ended years ago with a huge bearish spin.  For anyone who really wants to know, the BLS methods have been under-estimating new job creation.  This was demonstrated in the latest benchmark revisions, which added more jobs, as well as the most recent report from state employment offices.

It would be a refreshing change if your top news sources featured any of these ideas, but don't hold your breath!

Trading Implications

My experience with employment Fridays is that there is little benefit to being aggressively long before the report.  The spinfest usually provides shorts with a morning "dip to cover" when the number is surprisingly good.

I also expect some dampening in either direction.  A really bad number will be met with expectations for Fed action.  A strong number will get the opposite result, and maybe a stronger dollar.

Unless there is a massive discrepancy from expectations, my guess is that we will move on to earnings season and option volatility will be reduced.

And most important…..investors should not let this become political, even though the pundits will.