Stock Exchange: Sizzling Summer Picks in Discretionary Spending

The Stock Exchange is all about trading. Each week we do the following:

  • Discuss an important issue for traders;
  • Highlight several technical trading methods – including current ideas;
  • Feature advice from top traders and writers; and,
  • Provide a few (minority) reactions from fundamental analysts.

We also have some fun. We welcome comments, links, and ideas to help us improve this resource for traders. If you have some earnings season ideas, please join in!

Review

Our last Stock Exchange took a deep dive into the earnings season. If you missed it, a glance at your news will show that the key points remain relevant.

 

This Week — Consumer Discretionary Spending Heats Up

Our experts are picking up on this week’s theme in a big way. From luxurious cruises to hip new threads, our technical indicators suggest there’s something driving levels on consumer discretionary spending. Derek Benedet of seeitmarket.com had an interesting take. Let’s review some traditional causes behind increased spending:

While these points are accurate, Benedet goes on to note that the patterns of spending are very different. Traditional retailers may find difficulty attracting discretionary spending in a way that Tesla or Urban Outfitters may not. Let’s ask the experts:

Expert Picks from the Models

We’re joined again by one of our favorite guest experts on the stock exchange: Blue Harbinger (also known as Mark Hines). Blue Harbinger specializes in independent investment research, and we’re glad to have his thoughts this week. Let’s get down to it.

This week’s picks happen to center around luxury goods and discretionary spending.

Oscar

Oscar: This week, I bought into my custom Leisure, Lodge, and Cruise sector. PEJ is a close approximation. Stocks in the sector have been hanging around the same level since December, but there’s been enough volatility that I can see an upside. Check the 200-day moving average on the chart below.

Despite the up and down movement, the 200-day moving average has continued the steady rise past the compensation for November’s pop. Beyond the trend, a popup near the $43 mark in the next two to four weeks would provide a solid exit point for me.

Blue Harbinger: Unless you are aware of some short-term exploitable market-mispricing anomaly, I do NOT like this ETF. The PowerShares Dynamic Leisure & Entertainment ETF (PEJ) charges a fairly high fee, it has a high turnover ratio, its price can trade at unpredictable premiums and discounts to its net asset value.

O: A grim assessment, but I’ve got my own stocks in the same sector. Is that inherently wrong?

BH: Well this is based on a goofy, undiversified and concentrated index that seems to have been developed as a marketing ploy to get retail investors to invest in something that lines the pockets of the PowerShares people.

For starters, it only holds 30 stocks, and they’re concentrated in the Consumer Discretionary sector (79%) with the remaining holdings (21%) in Industrials. According to the PowerShares website, the index is described as follows.

The Intellidex Index is designed to provide capital appreciation by thoroughly evaluating companies based on a variety of investment merit criteria, including: price momentum, earnings momentum, quality, management action, and value. The Underlying Intellidex Index is comprised of common stocks of 30 US leisure and entertainment companies. These are companies that are principally engaged in the design, production or distribution of goods or services in the leisure and entertainment industries.

In my assessment, this index is likely based on some rickety quantitative screen, that is heavy on sounding good to the marketing people, and light on empirical evidence.

O: Understood. I can’t spill too many secrets – all I can say is I’m confident that I’ve managed to strike a better balance on my own.

Athena

Athena: I’ve got a hot one today: Tesla (TSLA). As many people know, I like to buy stocks when they’re in the midst of an upswing. Usually they’re lesser-known names, although I’m happy to make an exception in this case. Let’s check the chart:

This stock is prone to significant upswings, and is currently recovering from a correction earlier this month. Considering the rapid pace at which this went up to $375, I have no qualms at all about buying in at $328.

Blue Harbinger: Athena, I love Tesla’s vehicles. They’re high quality, attractive-looking, very efficient, and they’re environmentally friendly. I also like what Elon Musk is doing with batteries and solar power. However, as an investment opportunity, Tesla is not attractive. Aside from no net income, Tesla trades at a price to sales valuation multiple that is far above other automakers, as shown in the following chart.

Tesla’s high price to sales multiple is a reflection of the market’s very high expectations for the company. However, any slip-up (for example production delays) could send Tesla’s price much lower. Also, competition in the electric vehicle space continues to grow as Tesla’s peers continue to work on new electric vehicles as well as new batteries too.

A: What do I care about price to sales multiples? The market loves the cars as much as you do. Is it so inconceivable that a bit of good news might lead to exuberance?

BH: I don’t know if the market is heading in that direction. It’s worth noting that Tesla’s short-interest is very high, as shown in the following chart.

For a company with a relatively small amount of sales, negative net income, and growing competition, its $55 billion market capitalization is simply too rich and too risky.

A: That all sounds very compelling, but I just don’t invest on that basis. I’m sticking with this one for another two weeks, and looking for another 10% pop.

Holmes

Holmes: I’m getting into Coscto (COST) this week. What a deal! This stock has been trading below $155 this month, but it’s spent the vast majority of the past year well above that same mark. See for yourself:

That 50 day moving average – despite its strong resemblance to a roller coaster – tells me this stock is undervalued. The stretch from January to June alone should be enough to convince anyone of the same.

Blue Harbinger: Costco isn’t a horrible investment, but its best days of growth are in the past, and the company will be challenged to keep customers as excited as they have historically been. Costco’s physical locations as well as its shopping club concept are not new, and they will face challenges going forward. For example, the recently announced interest by Amazon to purchase of Whole Foods drove Costco’s price lower last month, and it may actually mark the beginning of an industry shift where shoppers (and investors) are no longer as excited about Costco as they once were.

H: Well, that would explain the recent drop. Anything else I should know about?

BH: Yes. Costco’s already significant market penetration will make it challenging for new Costco locations to open because the most attractive demographic locations have already been targeted, and new locations could lead to some attrition at existing locations.

For some perspective, according to data from StockRover, the per annum EPS growth rate estimate for Costco over the next 5-year is 5.6%. Not an extremely high rate, but one that will likely be challenging to achieve. Further still, even after the recent price decline, Costco’s price-to-earnings ratio isn’t all that attractive relative to its historical valuation, as shown in the following chart.

I’m not suggesting Costco is at risk of an imminent collapse, but it’s certainly not the great growth opportunity it once was.

H: That makes a lot of sense for long term investors. Regular readers know my timeframe is much shorter. Hey, maybe the market will decide this Amazon deal wasn’t the death knell for all other retailers after all.

Felix

Felix: Urban Outfitters (URBN) looks extremely uncool right now, and to me that’s the coolest thing about it. The month and a half long lull is signalling a bottom to me. As a longer-term investor, that’s a very important factor. Have a look at this chart of the past 12 months:

I’ll admit this does not read as a success story, though I still think it provides a useful entry point. I could easily see some recovery back up to the $22 mark, especially with my extended timeframe.

Blue Harbinger: Urban Outfitters is a well-run business with very limited growth opportunities and no competitive advantage. The company’s premium brands (Urban Outfitters, Anthropologie, BHLDN, Terrain and Vetri) will face challenges in staying relevant, and this is a stock I’m are not interested in owning.

At first glance, the stock might appear attractive because of all the share buybacks, zero long-term debt, and very low price-to-earnings ratio.

However, the average five-year EPS growth estimate according to StockRover is negative 1.6%, and management expects the number of stores and square footage to grow very little.

F: You’ve been pretty rough on all our picks this week. Maybe we should start calling you the Harbinger of Doom.

BH: Alright, alright. Here’s something positive. The company does expect to grow through its direct-to-consumer channel and wholesale (Free People) business, but these currently make up a small portion of sales, and their viability depends, to a large extent, on the brand’s ability to stay relevant.

I don’t believe the brands will become irrelevant overnight, and because the business is well-run, I don’t expect Urban Outfitters to completely disappear anytime soon. However, I do believe margins will continue to be pressured, the brand value will erode over time, and despite the recent price declines and low valuation multiples, this is not a stock I am interested in owning.

F: Okay, that’s fair. I can’t say much other than I like current prices as an entry point, and that I would be looking for a long-term holding. If the mullet can make a comeback, then surely we could see new growth out of Urban Outfitters…

Conclusion

Favorable conditions for discretionary spending are bringing consumers around to household names that have been en vogue as of late. In fact, this may be the first week where our models have gravitated to these kinds of trendy companies.

Thankfully, we have Blue Harbinger here to talk us down from the hype. Each of these selections might give the human investor pause. It’s the model’s job to follow its technical indicators carefully, and to remain consistentStock Exchange Character Guide

 

Character Universe Style Average Holding Period Exit Method Risk Control
Felix NewArc Stocks Momentum 66 weeks Price target Macro and stops
Oscar “Empirical” Sectors Momentum Six weeks Rotation Stops
Athena NewArc Stocks Momentum One month Price target Stops
Holmes NewArc Stocks Dip-buying Mean reversion Six weeks Price target Macro and stops
RoadRunner NewArc Stocks Stocks at bottom of rising range Four weeks Time Time
Jeff Everything Value Long term Risk signals Recession risk, financial stress, Macro

Background on the Stock Exchange

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

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

Getting Updates

We have a (free) service for subscribers of our Felix/Oscar update list. You can suggest three favorite stocks and sectors. Sign up with email to “etf at newarc dot com”. We keep a running list of all securities our readers recommend. The “favorite fifteen” are top ranking positions according to each respective model. Within that list, green is a “buy,” yellow a “hold,” and red a “sell.” Suggestions and comments are welcome. Please remember that these are responses to reader requests, not necessarily stocks and sectors that we own. Sign up now to vote your favorite stock or sector onto the list!

Identifying “Hard” Data

During recent weeks, much of the punditry has suggested a sharp difference between “hard” and “soft” data.  The former seems to show sluggish economic growth while the latter paints a more optimistic picture.  The general distinction seems to be that surveys are “soft” and other data are “hard.”   Results are rather arbitrarily placed in one group or the other.

Test Your Hard Data IQ?

Since reliance on surveys seems to be the acid test, let’s try a little quiz.  Which of the following reports use surveys, and which do not?

  • Payroll jobs
  • ISM manufacturing index
  • Wholesale inventories
  • Retail sales
  • Unemployment rate
  • Labor participation rate
  • PPI
  • ISM non-manufacturing index
  • Consumer confidence or sentiment
  • Business optimism
  • Durable goods orders
  • New home sales
  • CPI
  • Building permits
  • Personal income and spending
  • The decennial census of U.S. population
  • Existing home sales
  • JOLTS report
  • Business inventories
  • Housing starts
  • Regional Fed indexes – Chicago, Empire State, Philly Fed, Dallas, etc.

Before going on, please make sure that you have indicated “survey” or “non-survey” for each of the reports above.

Criticism of Survey Data

Most of the survey critics dismiss such data as “soft” and undependable.  This is often an assertion that surveys always involve speculation about future behavior.  Without exception, the survey critics do not include anyone who has actually designed or administered a survey.  A real expert would know that most of the complaints are treated on day one of the methods class.

Please consider this obvious example.  Suppose we ask someone, a month before an election, for whom they intend to vote.  Now suppose we ask in an exit poll.  The respondent might still give an inaccurate answer in the latter, but logic suggests it will be more accurate than the first.  Logic is confirmed by results.

Try this example.  We ask a purchasing manager if he/she is ordering more this month than last.  Or if prices paid were higher?  It does not involve speculation – just an honest report of facts.  Suppose we ask a Chinese purchasing manager the same question.  Are we just as confident of the answer?

Many questions are carefully worded to make it easy to give an honest answer.  It is a technique taught in the classes.  Most of the critics have never looked at the actual underlying surveys or considered the issues.

Quiz Answer

All the reports listed above involve the use of surveys.  All of them.

Many pundits pick and choose data to support their viewpoints.  The “hard versus soft” meme is the latest such effort.  Here is a test.  The choice of classification has been very loose and arbitrary.  Despite this, it has been taken seriously by nearly everyone.

We have seen many new fans of the Atlanta GDP Now tracking.  It showed weak growth in the first quarter.  During the second quarter the early returns are 3.5% to 4%.  Many sources will react by finding a new favorite indicator.

Investment Conclusion

The economy has a better footing than most sources allege.

Your decisions will be better if you rely upon sources that are intellectually honest in the consistent use of data.

Stock Exchange: How to Use Backtests Effectively

 

Everyone interested in managing their own money ought to keep an old idiom in mind: if it seems too good to be true, it probably is. Unfortunately, greed is a powerful motivator. It’s tempting to see a new model with an incredible backtest and think this could be the answer.

Experienced investors know that there’s often a drastic change between a model’s backtest and its first live run. You can usually find that point by checking for where the 45-degree angle increase in value drops off into sideways movement (and generally underperforms the market).

This week, we’ll take a deeper dive into how you can minimize these problems using professional techniques.

Review

Our last Stock Exchange revisited a common theme: making stock picks according to a set time frame. Our models suggested finance and software stocks in the short-term, and energy for the long-term.

Let’s turn to this week’s ideas.

This Week— *crickets*

We usually arrive to find the gang happily enjoying their weekly poker night. Instead, all we’ve got are Felix and Oscar’s weekly rankings with a “gone fishin’” note on the counter. Strange behavior.

We decided to give Vince Castelli a call to investigate. Vince is our modeling guru, a brilliant scientist who spent the bulk of his career as a civilian employee for the U.S. Navy. During his time there, he’s had hands-on experience with modeling techniques vital to national security – not something you can find in the classroom. He knows these models better than anyone; after all, he designed them.

Jeff: Vince! What is this about giving everyone the week off?

V: I didn’t give them the week off. There were new no new fresh signals.

J: Is there something wrong with the gang? They encompass five different methods. How can there be no fresh ideas?

V: A key feature of all models is recognizing the best times to trade. When volatility increases trades become less predictable.

J: What do you mean? The VIX is lower this week. Volatility is down.

V: That measure is for amateurs. Trading volatility includes both upside and downside. That bogus fear gauge emphasizes only the downside. Predictions are affected by extreme movements in either direction.

J: Since we do not have current picks to feature, maybe we could discuss how you developed these models.  There was an excellent recent article from Ben Carlson about what you cannot learn from a backtest. It reminded me of the TV ads suggesting that anyone can discover a system and trade their way to a fortune.

V:  If only it were that easy.

J:  Ben’s description made me think of some suburbanites wandering into the woods with massive chain saws.  The power of the tools far exceeds their skill in using them.

V: I see it all of the time.

J:  I would like to take up a few of Ben’s points and get your reaction.  How about this:  How many bad backtests came before the good ones?

V:  This is a great question.  Most people do not know the right questions to ask the model developer.  That one is crucial.

J:  How would you answer?

V:  Our method preserves multiple out-of-sample periods.   We develop models on our development data, saving pristine time periods for the test.  We verify that the strength of results continues.  You cannot just look at backtest results; you must know the developer’s method.

J:  Here is another good point — Data availability at the time.   Isn’t it easy to “peek ahead” or to exclude data from failing company?

V:  It certainly is.  You need to have data that includes the failed and merged companies.  The average person at home will not pay up to get this.  It introduces a deceptive, positive bias.

J: Ben also raises an interesting point about friction.  He writes:

It’s almost impossible in a backtest to completely account for costs and frictions such as taxes, commissions, market impact from trading, market liquidity, etc. Sure, you can estimate these frictions, but you never truly understand how these things will affect your bottom line until you actually have to execute buy and sell orders.

V:  This is the first point where I really disagree with him.  Why is it almost impossible?  You should definitely include commissions and a slippage factor.  If your trades are a small percentage of the market volume, the impact from trading is negligible.  Taxes vary by the type of account and the investor.

J:  Interesting point!  “Almost impossible” is strong language.  For someone who knows the ropes, this kind of test might represent real edge.

V:  That is what I do with each of my creations!

J:  Some of Ben’s other points relate to psychological factors.  The trader bailing out of the system in the face of losses.  Or concern about real money.

V:  That is strictly a matter of confidence in the system.  If it has been developed properly, you should not do a lot of fretting.

J: Thanks for joining us, Vince. I’m sure your comments will help readers make more sense of our series.

V: Any time!

Conclusion

One important point was not mentioned in Ben’s article – simplicity.  The temptation for the untrained modeler is to introduce as many variables as possible, hoping to find correlations that others have missed.  What they find is misleading. Computers are powerful enough to discover apparent links between variables when there is actually no relationship. A great model uses as few variables as possible.  The backtest may not seem as good, but the real-time trading will be much better.

Quantitative modeling is an extraordinarily complicated field. In some ways, the way to find success here is similar to finding success in the investment world as a whole. Find the right experts, learn their methods, and try to make sense of the data for yourself. Backtesting can be effective or dangerous – it depends on the skill of the developer.

Background on the Stock Exchange

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

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

Questions

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

Getting Updates

We have a new (free) service to subscribers to our Felix/Oscar update list. You can suggest three favorite stocks and sectors. Sign up with email to “etf at newarc dot com”. We keep a running list of all securities our readers recommend. The “favorite fifteen” are top ranking positions according to each respective model. Within that list, green is a “buy,” yellow a “hold,” and red a “sell.”  Suggestions and comments are welcome. Please remember that these are responses to reader requests, not necessarily stocks and sectors that we own. Sign up now to vote your favorite stock or sector onto the list!