Weighing the Week Ahead: Have Stock Prices Lost Touch with Reality?

It is a big week for economic data and the first address to Congress from the new President. Most of the punditry is engaged in a collective head-shake about overbought conditions. Even if the data flow remains strong, pundits will be asking:

Have stock prices lost touch with reality?

 

Personal Notes

I always try to publish for Sunday morning, which is convenient for most readers. Occasionally circumstances delay me. Sorry about this weekend.

On a second front, a reader thought he spotted me at a political rally. Readers know that I emphasize political agnosticism in investing. Like most of you, I have opinions, but try to keep them separated from our decisions. With that in mind, I have an alibi for this occasion!

Last Week

Last week the economic news was mostly positive, and stocks responded.

Theme Recap

In my last WTWA I predicted a discussion about Trump policies and the business cycle. This was partially correct, but the prevailing theme – by a widespread margin – emphasized the likely delays in key economic policies. That will be a transition point for the week ahead.

The Story in One Chart

I always start my personal review of the week by looking at this great chart from Doug Short via Jill Mislinski. She notes yet another record close based on the week’s gain of 0.7%.

Doug has a special knack for pulling together all the relevant information. His charts save more than a thousand words! Read his entire post for several more charts providing long-term perspective.

The News

Each week I break down events into good and bad. Often there is an “ugly” and on rare occasion something very positive. My working definition of “good” has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!

This week’s news was mostly positive.

The Good

 

The Bad

  • Hotel occupancy softened over the last few weeks (Calculated Risk).
  • New home sales missed expectations. The prior three months were all revised lower. While sales were up 5.5% year-over-year, the comparison months were among the weakest. Calculated Risk notes that these were the first months after mortgage rates moved higher and provides analysis and this key chart.

  • European tourism interest in America is down 12% after the travel ban. (Forbes).

The Ugly

Russia may have interfered with the Brexit vote say UK officials. Jake Kanter and Adam Bienkov have the story at Business Insider.

 

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. This week’s award goes to EconompicData, for an important and careful analysis of the effect of rising interest rates on bond investors.

The problem is that the debate over the Fed and interest rates became political. To maintain consistency, many argue that higher rates will be good for bond investors. Here is Jake’s summary of the problem:

I’ve read too many posts / articles that outline why a rise in rates is good for long-term bond investors (as that would allow reinvestment at higher rates). While this can be true depending on the duration of bonds owned and/or for nominal returns over an extended period of time, it is certainly not true over shorter periods of time and absolutely not true for an investor in most real return scenarios… even over very long periods of time.

There are a range of possible assumptions and consideration of each. Here is a key illustrative chart:

To summarize a great post – which bond investors should read carefully – higher rates will be great for future bond investors, but painful for those with current holdings.

 
The Week Ahead

We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead. You can make your own predictions in the comments.

The Calendar

We have very big week for economic data, with all of the big reports except the employment situation.

The “A” List

  • ISM index (W). Important for both concurrent and leading qualities. Strength continuing?
  • Auto sales (W). More gains from a key sector or “peak auto?”
  • Consumer confidence (T). Will the great strength continue?
  • Personal income and spending (W). January data, but a very important business cycle series.
  • Fed beige book (W). With the Fed resuming a role as a key worry, there will be extra attention.
  • Initial jobless claims (Th). How long can the amazing strength continue?

The “B” List

  • ISM services index (F). Continuing strength? More important than manufacturing, but harder to interpret.
  • GDP Q4 (T). The second estimate includes more data, but little change is expected.
  • Durable goods (M). January data in a volatile series, but progress is needed.
  • Pending home sales (M). Not as important as new construction, but a good read on the market.
  • Chicago PMI (T). Best of the regional surveys is a little preview of the national ISM report the next day.
  • Construction spending (W). Big rebound expected in the important but volatile series.
  • Crude inventories (Th). Recently showing even more impact on oil prices. Rightly or wrongly, that spills over to stocks.

     

President Trump’s first Address to Congress on Tuesday night will command attention in many ways. Most importantly for our purposes will be hints about legislative priorities and the Congressional reaction. Insider tip: Watch for things that get applause from both sides of the aisle.

Next Week’s Theme

 

The punditry, locked into a mindset about valuations, Trump policies, Fed significance, and daily preoccupation with what could go wrong is engaged in a collective head shake. Isn’t it obvious that many of the Trump policies will be delayed? Won’t this derail the “Trump Rally?”

The commentary increasingly expresses amazement, wondering:

Have Stock Prices Disconnected from Reality?

On one side, those who date the rally from the day of the election infer cause and effect. Anything that damages the prospects for tax and regulatory relief also damages the bullish story.

Another group notes that the market, after an extended period of strength is “overbought.”

An increasing number of observers is questioning whether Trump policies are actually the basis for the increase in stock prices.

If these policies are crucial, Tuesday night’s Presidential Address to Congress is definitely the key moment of the week – regardless of economic data.

What does this mean for investors? As usual, I’ll have a few ideas of my own in today’s “Final Thought”.

Quant Corner

We follow some regular great sources and the best insights from each week.

Risk Analysis

Whether you are a trader or an investor, you need to understand risk. Think first about your risk. Only then should you consider possible rewards. I monitor many quantitative reports and highlight the best methods in this weekly update.

The Indicator Snapshot

 

 

The Featured Sources:

 

Bob Dieli: The “C Score” which is a weekly estimate of his Enhanced Aggregate Spread (the most accurate real-time recession forecasting method over the last few decades). His subscribers get Monthly reports including both an economic overview of the economy and employment. (see below).

Holmes: Our cautious and clever watchdog, who sniffs out opportunity like a great detective, but emphasizes guarding assets.

Doug Short: The World Markets Weekend Update (and much more).

RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature his recession analysis, Dwaine also has several interesting approaches to asset allocation. Try out his new public Twitter Feed.

Georg Vrba: The Business Cycle Indicator and much more.Check out his site for an array of interesting methods. Georg regularly analyzes Bob Dieli’s enhanced aggregate spread, considering when it might first give a recession signal. His interpretation suggests the probability creeping higher, but still after nine months.

Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies. His most recent post notes that the expected growth rate in S&P earnings is now 8.41% — the highest level since October, 2014.

The legal Marijuana business will create nearly 300,000 jobs by 2020.

 

How to Use WTWA (especially important for new readers)

In this series, I share my preparation for the coming week. I write each post as if I were speaking directly to one of my clients. Most readers can just “listen in.” If you are unhappy with your current investment approach, we will be happy to talk with you. I start with a specific assessment of your personal situation. There is no rush. Each client is different, so I have eight different programs ranging from very conservative bond ladders to very aggressive trading programs. A key question:

Are you preserving wealth, or like most of us, do you need to create more wealth?

Most of my readers are not clients. While I write as if I were speaking personally to one of them, my objective is to help everyone. I provide several free resources. Just write to info at newarc dot com for our current report package. We never share your email address with others, and send only what you seek. (Like you, we hate spam!)

 

Best Advice for the Week Ahead

The right move often depends on your time horizon. Are you a trader or an investor?

Insight for Traders

We consider both our models and the top sources we follow.

Felix and Holmes

We continue with a strongly bullish market forecast. All our models are now fully invested. The group meets weekly for a discussion they call the “Stock Exchange.” In each post I include a trading theme, ideas from each of our four technical experts, and some rebuttal from a fundamental analyst (usually me). We try to have fun, but there are always fresh ideas. Last week the focus was on sector rotation strategies, with a recent example from Oscar.

Top Trading Advice

 

Brett Steenbarger explains how knowledge is part of trading. He makes a powerful analogy between traders that can see both the macro and micro pictures and a quarterback who sees the entire field. His work always helps traders discover both what they should know, and how to learn it. While this was my favorite for the week, the daily posts should all be on the trader’s must-read list.

The early T-Wops (a negative Presidential tweet) had a negative impact on stocks. Traders learned this, of course, and the high-frequency algorithms did automated tracking. As often happens, once everyone catches on, things change. The WSJ shows that a Negative Tweet may not crush a stock

Insight for Investors

Investors have a longer time horizon. The best moves frequently involve taking advantage of trading volatility!

Best of the Week

If I had to pick a single most important source for investors to read this week it would be Warren Buffett’s annual letter to his investors. It is full of wit and humor – and plenty of great insights. You can learn about tax policy, accounting issues, stock buybacks, and Mr. Buffett’s ten-year bet where he took the overall market versus hedge funds.

Stock Ideas

 

Mr. Buffett’s dividend stocks versus the “dogs of the dow.” Jon C. Ogg crunches the numbers.

Big biotech? Battered down, but with good earnings and cash flow. Some of the companies also have a pipeline. Check out some large cap choices.

 

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. If you are a serious investor managing your own account, this is a must-read. Even the more casual long-term investor should make time for a weekly trip on Wednesday. Tadas always has first-rate links for investors in his weekly special edition. As usual, investors will find value in several of them, but my favorite is the post from Dan Danford. He explains the difference between excellent but general advice from experts and advice specific to your circumstances. Keep this in mind when reading the Warren Buffett letter. Here is a key quote:

Those experts don’t know a thing about you or your situation. They don’t know your age, health, marital status or personality quirks. They don’t know where you live or how much your house cost. They don’t know how much you spend on groceries or hobbies, or that you were forced into early retirement by an ungrateful employer. They know none of this. Nada.

 

Seeking Alpha Editor Gil Weinreich’s strong series is ostensibly aimed at financial advisors – a must-read for them. It also attracts many DIY investors. The zesty topic of the week started with an explanation from a noted writer and advisor, David Merkel, on why investors need good advice. I strongly agree with David, but I realize that some investors enjoy doing the work to maintain a successful program. (Is that you? My (free) short paper on the top investor pitfalls is a good test of whether you can successfully fly solo. Send a request to main at newarc dot com).

 

Watch out for…

 

Rising interest rates. In a riff on this week’s Silver Bullet analysis, Davidson (via Todd Sullivan) explains some key fundamentals about rates, the yield curve and the Fed. It is another myth-busting analysis.

 

Final Thoughts

 

How the punditry interprets the current market depends on how one defines base valuations and expectancy.

  • Stock values are attractive
    • Emphasis on earnings expectations and forecasts
    • Belief in relative valuations – comparing stock expected performance, with bonds, real estate, gold, etc.
    • Confidence that a recession is not imminent.
  • Stocks are over-valued
    • Emphasis on trailing earnings
    • Analysis based partially on 19th century data
    • Belief that valuation is absolute. A sector’s value is independent of the alternatives
    • Focus on headline risk – uncertainty, world events, etc.

The result?

Most people choose the over-valued path. It is the conventional wisdom in the media. Even the bullish pundits choke out a statement that stocks are “reasonably valued.” This world view requires some explanation of why the stock rally continues. The explanation has changed over time —

  • Stocks are overvalued and a crash is likely.
  • A crash might not happen, but returns over the next five, ten, twelve years will be lower.
  • Valuation is not a good method of market timing, and who knows when the “half-cycle” will end?
  • Stock strength is due to extraordinary Fed policy, providing liquidity that banks or the plunge protection team use to buy stocks. It will end with the end of QE, which probably will never happen.
  • The end of QE merely shifted focus to Europe, where the ECB has taken over the money printing.
  • The current rally is based upon Trump promises, which will never come to pass and might not even work.

Investment Conclusion

I hope most will notice that the forward valuation approach and the recession data I report weekly is a simple explanation. The current market is what we would expect. The Republican victory had increased small business confidence, but is not the main driver of stock prices.

The prevailing explanation was wrong-footed at the start and has remained so. Like bad science, it has not explained anything, so it must be continually re-invented.

It is really not complicated. There will be a time to become cautious. Meanwhile, mid to late- stage cyclical stocks, financials, homebuilders, and technology remain attractive.

The Quest for Investing Excellence and the Lesson of Dow 20K

The new movement to passive investments is a sharp break from the historical quest for excellence. Many articles claim that no one can do better than the market average. If that is true, you should just throw out your investment library and skip the popular lists of “best investment books.”

This post will suggest a short list of books that would have needed quite different titles. They also would not have become best-sellers! In the conclusion, I will provide some ideas about why this is important for your investment decisions. Here are the hypothetical titles followed by a cover shot of the real book. Suggestions for more examples are quite welcome!

 

In Search of Mediocrity

Market Sheep

The Average IQ Investor

The Little Book that Equals the Market

Common Stocks and Average Profits

Buffett: The Making of a Lucky Investor

Stay Even with Wall Street

Implications

In this series on investment expertise I have (so far) covered the following:

  • There are indeed experts. Sometimes it is obvious, and sometimes they are difficult to find. Consider the case of Phil Mickelson.
  • Forecasting is not always folly. I provide specific examples of expertise, and a checklist for finding the best modeling experts.
  • Dow 20K. The round-number milestone has finally been achieved – at least for today! There are many who are stepping up to claim some credit for their prediction on this front. Some were way too early, and others made the call as we got much closer. Each prognosticator had a method.

My own Dow 20K forecast came when the Dow was at 10,000 and many prominent pundits were calling for Dow 5000! My opinion was controversial at the time. Check out the history of the forecast to remind yourself of how bad things were (unemployment over 10%, and I was ridiculed for suggesting it might fall to 8%).

While it is nice to get some recognition (like this spot from CNBC when we got close to the milestone last month), I see it more as a validation of my methodology. I seek out the best experts. I am constantly looking for excellence. I know that I do not have all of the answers, but my background taught me how to search and to learn. Following superior methods helped to keep my readers and clients on the right side of the market through a long rally hated by most of the punditry and many traders.

There are many paths to trading and investment success. Mine was not the only way, but it was a good way. Having strong evidence and indicators is crucial for confidence.

What Now?

Most of the key factors I see as important are still in place. I summarize them each week. The list of worries has changed a lot but it is still there. The time will come to pull back – but it is not here yet.

 

Weighing the Week Ahead: Dow 20K?

The post-election market run has been accompanied by improving economic data and increasing confidence. The result has the punditry asking a question that seemed crazy in January:

Will the Dow hit 20K?

Before reading this week’s installment, “Sherman, set the WABAC machine to” mid-year, 2010. The Dow was at 10K and many famous pundits were predicting a fall to 5000. In order to appreciate the psychology of the time, please read my post and especially the comments at Seeking Alpha. You will see some very colorful criticisms of my work! You will enjoy a few good laughs. I’ll comment more on this below, but it is a great place to start.

Last Week

Once again, last week’s calendar of economic news was nearly all good, supporting the market gains.

Theme Recap

In my last WTWA (two weeks ago), I predicted a period of stronger economic news and the possibility of a more positive market reaction. This is what has happened, but most commentators still are not emphasizing the main theme. It is not all about the Fed.

The Story in One Chart

I always start my personal review of the week by looking at this great chart from Doug Short. He captures the continuing rally and the move to new highs.

Doug has a special knack for pulling together all the relevant information. His charts save more than a thousand words! Read his entire post where he adds analysis grounded in data and several more charts providing long-term perspective.

 

The News

Each week I break down events into good and bad. Often there is an “ugly” and on rare occasion something very positive. My working definition of “good” has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!

This week’s news was quite good—almost all positive. I make objective calls, which means not stretching to achieve a false balance. If I missed something for the “bad” list, please feel free to suggest it in the comments.

The Good

  • Rail traffic finally scores a slight positive. Steven Hansen provides the current data, as well as the more negative long-term perspective.
  • Senate passes stopgap funding. This is not getting a lot of attention, but it is a big shift from the past eight years, especially 2011, when the last correction came for this very reason. (The Hill).
  • OPEC reached a production limit agreement. Whether this will attract cooperation from non-OPEC countries is open to question. We might also ask whether a floor under energy prices is a positive. That said, the oil price/stock correlation has been a factor since the energy collapse. Months ago, I suggested that we were entering a sweet spot for oil pricing. The OPEC participants see a cap of about $60/barrel, which makes sense.
  • Jobless claims down ticked, and remain near all-time lows. See Calculated Risk for the story and charts.
  • Productivity rose over 3%.
  • Michigan sentiment spiked to 98 on the preliminary estimate. LPL shows why this is important.

  • Borrowers continue to move out of negative equity on their homes. 384K in Q3 (Calculated Risk).
  • ISM non-manufacturing strengthened to 57.2. Doug Short has the story and this chart:

 

The Bad

  • Gas prices rose over five cents. (GEI).

  • Interest rate components of long leading indicators are weakening. (New Deal Democrat). This is mostly a positive story, but the long-term interest effects are worth watching. NDD’s report of high frequency indicators is a regular read for me, and should be for other frequent traders.

 

The Ugly

Secret outside influence on U.S. elections. Foreign countries frequently have an interest in the most important elections. There is nothing new or unusual about that. Voters can weigh the opinions and arguments in the same way they use other information. Actions that are secret are another matter, especially when following the “dirty tricks” approach.

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. No award this week, but opportunities abound and nominations are welcome!
The Week Ahead

We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead. You can make your own predictions in the comments.

The Calendar

We have a big week for data.

The “A” List

  • FOMC rate decision (W). An increase is widely expected. The statement and Yellen’s press conference may yield hints about next year.
  • Housing starts and building permits (F). Softening pace expected in this important sector.
  • Retail sales (W). November data following a very strong October.
  • Industrial production (W). Any improvement in this economic weak spot?
  • Initial claims (Th). The best concurrent indicator for employment trends.

The “B” List

  • PPI (W). Interest in inflation measures is increasing, but prices are not.
  • CPI (Th). See PPI above. Eventually these will be important.
  • Philly Fed (Th). The first look at December data is expected to be positive.
  • Business inventories (W). Significant for Q4 GDP, but little change is expected.
  • Crude inventories (W). Recently showing even more impact on oil prices. Rightly or wrongly, that spills over to stocks.

     

With the FOMC meeting at mid-week, FedSpeak is on mute. Expect plenty more news on possible Trump policies.

Next Week’s Theme

 

The strong data continues, as does the market rise. We still do not see a reflection in forward earnings, but the earnings recession has ended. The Fed is about to raise rates, and no one cares. It is not all about the Fed, and more are learning that. As the market hits new highs, including a big round number on the DOW, the focus this week will be on DOW 20K.

In my 2010 articles I tried to emphasize the right focus for investors. Too many were paralyzed by fear from the frequent disaster predictions. Their upside risk was huge. This section was crucial:

Asking the Right Questions

The bias is inherent in the situation. The problems are known. If you write for a major publication, you are rewarded for analyzing the negativity. If you go on TV, you are expected to parrot the analysis of problems. This makes you seem smart.

By contrast, the solutions are vague and unknown. If you even talk about them, all the “hot shots” are skeptical.

That should be your clue to pay attention. Repeating the known news does not make you money. Try asking these questions:

What if unemployment falls to 8%?

What if the annual budget deficit is reduced?

What if housing prices and sales show a clear bottom?

What if mortgage rates remain low?

What if politicians negotiate a compromise on tax increases?

What if Europe stabilizes?

What if China and other emerging countries resume a solid growth path?

What if earnings for US companies continue to surge, leaving the 10-year trailing earnings in the dust?

What if the US rationalizes immigration?

If you have not thought about these possibilities, you have a fixation on negativity. My Dow 20K concept is designed to set you free — to get you thinking about the long sweep of history and the potential for success. If even a few of these things happen, what would be the market reaction?

This list of worries seems so old….

Two years later the New York Times ran a story with the analysis from a big firm. The reasoning was like mine, but missing the first 30% of the move.

Josh Brown takes note of the Barron’s cover. Since magazine covers are often viewed as contrary indicators, he adroitly includes a few others that might have been viewed as signals of a top. Great insight, and great fun.

Scott Grannis shows the wall of worry climb (but I still like my own version better!)

Eddy Elfenbein highlights the sharp contrast between now and January as well as the impact of the banking sector.

Remember how the start of 2016 was one of the worst market starts in Wall Street history? Howard Silverblatt noted this stat: At the market’s February, low, the S&P 500 was down 10.5% YTD, yet the Financials were down 17.7%. Since then, the S&P 500 has rallied 21.5%, while the Financials are up 45.6%. It’s as if the entire market were the dog being wagged by the banking sector’s tail.

None of this really answers the DOW 20K question, but the information is great. As usual, I’ll have a few ideas of my own in today’s “Final Thoughts”.

Quant Corner

We follow some regular great sources and the best insights from each week.

Risk Analysis

Whether you are a trader or an investor, you need to understand risk. Think first about your risk. Only then should you consider possible rewards. I monitor many quantitative reports and highlight the best methods in this weekly update.

The Indicator Snapshot

 

The increased yield on the ten-year note has lowered the risk premium a bit. I suspect much more to come. By this I mean that the relative attractiveness of stocks and bonds will continue to narrow.

The Featured Sources:

 

Bob Dieli: The “C Score” which is a weekly estimate of his Enhanced Aggregate Spread (the most accurate real-time recession forecasting method over the last few decades). His subscribers get Monthly reports including both an economic overview of the economy and employment.

Holmes: Our cautious and clever watchdog, who sniffs out opportunity like a great detective, but emphasizes guarding assets.

Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies.

RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature his recession analysis, Dwaine also has several interesting approaches to asset allocation. Try out his new public Twitter Feed. His most recent research update suggests some “mixed signals” from labor markets.

Doug Short: The World Markets Weekend Update (and much more).

Georg Vrba: The Business Cycle Indicator and much more. Check out his site for an array of interesting methods. Georg regularly analyzes Bob Dieli’s enhanced aggregate spread, considering when it might first give a recession signal. Georg thinks it is still a year away. It is interesting to watch this approach along with our weekly monitoring of the C-Score.

There is a Correlation Nosedive says Nick Colas (via Josh Brown). This signals an opportunity for those who can identify the best stocks and sectors. The phrase “stock-picker’s market” is oft-repeated. Now it makes some sense.

Dr. Brett analyzes the divergences and the implications.

Brian Gilmartin reports on the recent Chicago CFA luncheon where “Dan Clifton of Strategas Partners gave a great presentation on the coming fiscal stimulus and what it might look like and what it might mean for the US economy in 2017”. This means plenty of money for share buybacks and earnings increases. Brian (who has been very good on both earnings and the market) reaches this conclusion:

In year-end meetings with clients, I’m telling clients from both sides of the aisle that the SP 500 could be up 20% next year. Prior to the election and since last Spring ’16, the SP 500 was already looking at its best year of expected earnings growth in 5 years. The proposed President-elect and Congressional fiscal policy could be another level of earnings growth above what was already built into the numbers, before November 8th.

Personally, the $1 trillion repatriation estimate that Dan Clifton threw out seemed on the lighter side to me. Apple alone has $250 billion sitting on its own balance sheet, which is 1/4 of the expected total.

This is something we all should be monitoring.

 

How to Use WTWA (especially important for new readers)

In this series, I share my preparation for the coming week. I write each post as if I were speaking directly to one of my clients. Most readers can just “listen in.” If you are unhappy with your current investment approach, we will be happy to talk with you. I start with a specific assessment of your personal situation. There is no rush. Each client is different, so I have six different programs ranging from very conservative bond ladders to very aggressive trading programs. A key question:

Are you preserving wealth, or like most of us, do you need to create more wealth?

My objective is to help all readers, so I provide several free resources. Just write to info at newarc dot com. We will send whatever you request. We never share your email address with others, and send only what you seek. (Like you, we hate spam!) Free reports include the following:

  • Understanding Risk – what we all should know.
  • Income investing – better yield than the standard dividend portfolio, and less risk.
  • Holmes and friends – the top artificial intelligence techniques in action.
  • Why it is a great time to own for Value Stocks – finding cheap stocks based on long-term earnings.

You can also check out my website for Tips for Individual Investors, and a discussion of the biggest market fears. (I welcome questions on this subject. What scares you now?)

 

Best Advice for the Week Ahead

The right move often depends on your time horizon. Are you a trader or an investor?

Insight for Traders

We consider both our models and the top sources we follow.

Felix and Holmes

We continue with a strongly bullish market forecast. Felix is fully invested. Oscar is fully invested in aggressive sectors. The more cautious Holmes also remains fully invested, but with continued profit-taking and position switching. The group meets weekly for a discussion they call the “Stock Exchange.” This week we talked about maximizing gains. Last week the topic was minimizing risk. (We report exits from announced Holmes positions if you ask to be on that list. Write to holmes at newarc dot com).

Special thanks to our guest expert, Blue Harbinger, who provided first-rate fundamental analysis, providing counterpoint for our technical models.

Top Trading Advice

 

Brett Steenbarger continues to provide almost daily insights for traders. Sometimes the ideas draw upon his expertise in psychology. Sometimes they emphasize his skills in training traders. Sometimes there are specific trading themes. They all deserve reading. This week I especially liked the following, each reflecting one of the main themes:

 

Insight for Investors

Investors have a longer time horizon. The best moves frequently involve taking advantage of trading volatility!

Best of the Week

If I had to pick a single most important source for investors to read this week it would be Morgan Housel’s post on The Art and Science of Investing. I am delighted that he is keeping his promise to keep writing, leading the effort at a new, multi-contributor blog. This entry, as is the case with much of the best investing work, does not emphasize immediately “actionable” advice, designed to attract plenty of page view. The concept is great, and the post is worth a careful read. Here is the thesis:

This drives people crazy, because the more important a field is, the more scientific and predictable we want it to be. People take scientists seriously because they can count of them. Art is taken less seriously because it comes and goes.

But most fields outside academia are both science and art.

Including investing.

An example?

There is scientific data showing the best way to invest is to buy the cheapest set of companies you can find. There’s equally persuasive data showing the best way to invest is to buy the fastest-growing set of companies, which tend to be expensive. Some investors obsess over brand and intangibles. Others say ignore those and only look at fundamentals. Neither is right or wrong. You just have to appreciate that each strategy lives in its own context, and that market trends come and go. It’s an art.

I love this concept! There are many ways to profit from trading and investing. Arguments about approach may either distract or enlighten.

 

Stock Ideas

 

Brad Thomas suggests two REITs for the new Commander-in-Chief. Besides the recommendations, Brad analyzes some potential losers.

Still wondering about winners from the election? Marc Gerstein’s stock screening methods generate a great list of stocks and sectors.

Looking for safe yield? Who isn’t!! Blue Harbinger provides a first-rate analysis of Saratoga Investment Corp. (SAR). There are plenty of traps in the Business Development Company (BDC) universe. Mark’s analysis shows how carefully you must consider the data in finding sound choices. He carefully considers the implications from higher rates.

Our trading model, Holmes, has joined our other models in a weekly market discussion. Each one has a different “personality” and I get to be the human doing fundamental analysis. We have an enjoyable discussion every week, with four or five specific ideas that we are also buying. This week Holmes likes Molson Coors (TAP). Check out the post for my own reaction, and more information about the trading models.

While we cannot verify the suitability of specific stocks for everyone who is a reader, the ideas have worked well so far. My hope is that it will be a good starting point for your own research. Holmes may exit a position at any time. If you want more information about the exits, just sign up via holmes at newarc dot com. You will get an email update whenever we sell an announced position.

But Tom Armistead warns that there is too much enthusiasm about Deere.

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. If you are a serious investor managing your own account, you should join us in adding this to your daily reading. Every investor should make time for a weekly trip on Wednesday. Tadas always has first-rate links for investors in his weekly special edition. There are always several great choices worth reading. My personal favorite this week is the Bloomberg analysis of when it is right to wait before claiming Social Security benefits. While it is an individual choice and calculation, delay is good for many. (See also “Watch out for” below.)

Seeking Alpha Editor Gil Weinreich’s Financial Advisors’ Daily Digest is a must-read for financial professionals. The topics are frequently important for active individual investors. Gil is on a well-deserved vacation, but his last post is very helpful. He takes a nice look at the current risks and rewards from the market rotation away from bonds.

Watch out for…

Structured products. Larry Swedroe (ETF.com) provides a careful analysis of what the investor is really getting. Most have inflated notions about the returns and are not properly informed about risks. In many cases, a simple fixed-income security would be better. This is a complicated story, but it is worth reading carefully if you, like so many, are considering these investments.

 

Final Thoughts

 

Will we reach DOW 20K? And stay there? I expect us to touch that level soon. When the market gets close to such numbers there is a magnetic attraction. Sellers see it as inevitable, so they back away. It becomes a self-fulfilling prophecy. Whether the level holds will be a trickier question. It will, but perhaps not right away. No one really knows.

My purpose in the DOW 20K project, including buying the domain name, was to help individual investors to focus on the right problem: Missing the upside because of the paralysis of fear. Consider the following:

  • For many years, anyone forecasting more than an 8% gain in the market was tagged as super-bullish.
  • Since 2010 there have been incessant warnings of another market crash, a decline of 50% or more.
  • A market doubling in 6 ½ years represents 11% compounded growth.

It was not a prediction of rush to 20,000, but an emphasis on taking the right perspective. There are always market worries. The big negative predictions always get the attention. It is always difficult to stay the course.

Is DOW20K the end? Definitely not. The fundamentals are all better than in 2010, and the worries are different. I’ll write soon about the methods behind the original call and the current implications. For now, I’ll just say that the upside/downside risk is still attractive.

Investors need not just “buy and hold.” Recessions are the biggest risk, so I watch that closely. The right allocation among asset classes deserves a regular review.

This is a good time to ask yourself about how have you done? If you are wondering whether you might do better with a financial advisor, check out my latest paper, The Top Twelve Investor Pitfalls – and How to Avoid Them. If you regularly navigate these problems, you can fly solo! Readers of WTWA can get a free copy by sending an email to info at newarc dot com. We will not share your address with anyone.

The Evolution of the “Hussman Chart”

Hardly a week goes by without an article like this one by the influential Henry Blodget — One smart stock market analyst thinks this is where we’re headed…(gulp). Mr. Blodget writes as follows:

But anyone who’s feeling comfortable after a strong week in the markets should at least understand that: 1. The macro environment most conducive to crashes is still in place (overvaluation + increasing risk aversion) and 2. The way the market is behaving now is exactly the way it behaved before the biggest crashes in history.

So, neither Hussman, nor I, nor you should be surprised if the market keeps on dropping and doesn’t bottom until it’s down 50% or more from the peak.

As Hussman noted last week in his usual depressing note, a 50% crash would not even be the worst-case scenario. It would just be a normal correction from valuations we reached in 2015.

Featured in the valuation articles is a chart purporting to show very low expected annualized returns for a multiple-year period. The implication for stock investors is clear: Little upside combined with huge risk. It has had a big impact both with individual investors and also my investment advisor colleagues.

Background

Last week, among several other illustrations of popular investment misconceptions, I included a version of what I will call the “Hussman Chart.” I suggested that if you did not understand the chart, you shouldn’t be using it for your investment decisions. My main point was that people blindly accept conclusions from intelligent sources who use sophisticated methods. Of the are dozens of possible illustrations, I included the Hussman Chart. I know that many people sold their stocks some time ago when their investment advisors warned them, producing one of the charts I discuss below.

My worst fears were confirmed! Out of the thousands reading the post, only two or three explained anything about the chart – how it was constructed, what it implied, how to think about it. Quite a few people repeated the author’s conclusion. Wow! They understood and accepted the conclusion without any evaluation of the reasoning. Others did not want to be challenged. They wanted me to explain what I thought was wrong with the chart.

Readers promptly ignored everything else in the article. Some even concluded (amazingly) that I was stating that I personally did not understand the chart. Jesse Felder, a fellow investment advisor and blogger stated this viewpoint explicitly. His conclusion (without any explanation of the chart):

Furthermore, this negative correlation between valuations and forward returns is statistically very high (greater than -90%) and backed by 65 years worth of data. The Buffett Yardstick, as Hussman demonstrates, has been nearly as good as his own version at forecasting forward returns and is backed by roughly 90 years worth of data. Both charts, and the data and reasoning behind them, clearly demonstrate and validate the concept that, “the price you pay determines your rate of return.”

Summary

Apparently I need to elaborate on the original theme. I will do so by providing examples of “the chart” over the years. The variables, adjustments and time periods change, but the conclusions are generally the same. Each chart has a documented method and stands on its own. Together one gets a different picture. While the method is continually “improved” and the time period changed, there is never a date with destiny. We do not know whether the early versions worked or not. There is no distinction between the time period used to create the method and the “out of sample” period that follows.

Here is a summary of the charts below.

Date Independent variable Starting point Length of Forecast Adjustments
Nov, 2008 Terminal multiple 1950 7 years
Oct, 2010 Terminal yield 1944 7 years
Aug, 2010 Adjusted forward earnings 1963 10 years Reducing margins
Jan, 2011 Normalized earnings 1928 10 years “Normalizing” earnings
Dec, 2013 CAPE 1932 10 years Mean-reverting margins
Feb, 2016 Non-financial Gross Value Added 1950 12 years World effect, excludes financials

The rest of this report will show the evolution of the approach and raise some specific concerns and points that you might wish to consider.

[I have never met Dr. Hussman, but I have a generally favorable impression of him. He taught for a bit at one of my schools. (Someday I might learn if he considers himself a “Michigan man.”) He is respected as a philanthropist. His approach is intended to be in the best interest of his investors. Updating his methods and conclusions is a natural part of investment management. He reports his thinking frequently and takes on issues directly. Were this not the case, a review like this one would not be possible. He has built a very successful business and earned a strong reputation. His articles are always among the most popular, especially among investment advisors].

Analysis – the Evolution of “The Chart”

First example — How Low, How Bad, How Long? November, 2008

http://www.hussmanfunds.com/wmc/wmc081110.htm

wmc081110h

Second example — No Margin of Safety, No Room for Error October, 2010

http://www.hussmanfunds.com/wmc/wmc101011.htm

wmc101011b

Third example — Valuing the S&P 500 Using Forward Operating Earnings August, 2010

http://www.hussmanfunds.com/wmc/wmc100802.htm

This quoted explanation illustrates why some might have trouble following the methodology:

The two main failures of standard FOE analysis are that 1) analysts assume a long-term norm for the P/E ratio that properly applies to trailing net, not forward operating earnings, and; 2) analysts fail to model the variation in prospective earnings growth induced by changes in the level of profit margins, and therefore wildly over- or underestimate long-term cash flows that are relevant to proper valuation. By dealing directly with those two issues, we can obtain useful implications about market valuation.

As I have frequently noted, it is not theory, but simple algebra, that the long-term annual total return for the S&P 500 over any horizon T can be written as:

Long term total return = (1+g)(future PE / current PE)^(1/T) – 1
+ dividend yield(current PE / future PE + 1) / 2

The first term is just the annualized capital gain, while the second term reasonably approximates the average dividend yield over the holding period. For the future P/E, one can apply a variety of historically observed P/E ratios in order to obtain a range of reasonable projections, but the most likely outcome turns out to be somewhere between the historical mean and median.

You have to get two things right: the “normal” future P/E and the prospective long-term earnings growth rate g. Standard FOE analysis misses on both counts. Very simply, looking out over a 7-10 year horizon, the proper historical norm for price-to-forward operating earnings is approximately 12.7. Moreover, one cannot simply apply the long-term operating earnings growth rate of 6.3% (0.063) as an unchanging measure of g. Rather, an accurate growth rate for the model has to reflect the level of profit margins at any point in time, since the current P/E multiple may reflect either depressed or elevated earnings. For a 10-year investment horizon, the proper value of g should take into account the gradual normalization of margins. Historically, the best estimate is approximately:

g = 1.063 x (0.072 / (FOE/S&P 500 Revenues))^(1/10) – 1

[Jeff]You should at least be able to understand that the earnings are “adjusted” by a method that is deemed to be appropriate.

wmc100802a

Fourth example — Borrowing Returns from the Future January, 2011

http://www.hussmanfunds.com/wmc/wmc110117.htm

wmc110117a

Fifth example — Does the CAPE Still Work? December, 2013

http://www.hussmanfunds.com/rsi/cape.htm

CAPEh

http://www.advisorperspectives.com/commentaries/20160221-hussman-funds-speculative-half-cycles-tend-to-be-completed-badly

wmc160418c

[Jeff] If you look at this chart and the two above, you will see that the big divergence in the late 80’s has disappeared.

Comments on the multi-year growth projections

These are points that would be discussed extensively if the research had a peer review.

  • It is necessary to explain carefully both variables, especially making clear when one can evaluate the relationship
  • There should be a sharp distinction between the portion of a chart which is a back test, or an idea fitted to past data, and the “out of sample” data that follows.
  • A multi-year projection has an eventual “date with destiny.” If you are one year away, you can calculate the return that would be needed to make the forecast correct. Think of it as a runner going for a world record in the mile. If he is five seconds off the pace with 100 yards to go, you may safely conclude that he will not break the record.
  • The concept might be extended to more years. If a very negative forecast is in place and the first year or two is strong, it might take a market crash for the forecast to come true.

Research Tests

This very brief summary is a glimpse of what a solid research design should include.

Necessary

There should be a hypothesis and a test of the hypothesis.

It should be possible to disprove the conclusion.

Stated results should not consume all of the data.

Desirable

It is best to share data, especially when not proprietary. This allows others to replicate the work. (One of the top economics books of the past year included a serious spreadsheet error, discovered because data were shared. It is fairly common in academic circles. Dr. Shiller shares his data, despite the great difficult in develop the historical earnings).

It is important to provide a complete description of the methodology. This should include paths not taken and variables that were rejected.

It is helpful to show the link (ideally with an update) of past research theses as more evidence emerges.

My Own Concerns about the Conclusions

Many have asked me why I have not followed this approach in my own investment management. I do not write about it very much because of the work required. Dr. Hussman has a great research budget and team. I have a small staff who are already fully-employed on stock picking and managing our programs. Going back to replicate one of the old charts would be a fair amount of work. I will share my concerns here, but only in abbreviated form.

  • We never seem to reach the point of evaluation. How did these approaches work in the past?
  • The methodology seems to include many of the classic overfitting problems. I am certainly not the first to note this. Philosophical Economics in late 2013 wrote Valuation and Stock Market Returns: Adventures in Curve Fitting.
  • There are adjustments that are not well explained. The earnings are adjusted for expected changes in profit margins, for example. What if this assumption is not accurate? Profit margins are an intense (and separate) debate.
  • The method for adjustment keeps changing – different approaches, coefficients, etc.
  • Over the years, the time frame for the forecast keeps moving, from seven, to ten, and to 12. If you go back to the original Shiller papers, he was using five years. His disciples keep experimenting with different choices.
  • The independent variables change with each new iteration. The overall model always seems to fit. Past discrepancies disappear.
  • The attribution of “bad patches” in results to market overvaluation or undervaluation. This seems backwards. Why is the market wrong and the model right?

I am especially bothered by what I see as exaggeration and distortion. What does it add to this discussion to call valuations “obscene?” I find especially distasteful the statement, “The CAPE Ratio id doing exactly what it has always done, which is to help investors anticipate the investment returns they should expect over the next decade. Those returns will very likely be in the low, single digits”.

The CAPE ratio is not some wise old friend that has been around for centuries. It was invented only recently and has not worked very well. The claim of historical validation is also completely wrong. What if I told you that the Packers always won at home after a double-digit away loss in a dome? (I made this one up, but you get the idea). It is historically accurate, but does not have any value for predicting the future. Since Dr. Shiller and Dr. Hussman made a lot of specific choices about measuring earnings, past time frames, use of inflation information, and future time frames, their conclusions should be described as a model, not some definitive historical record. It is rather easy to create a view of history that provides a vastly different conclusion. (see The Single Greatest Predictor of Future Stock Market Returns). It includes this impressive chart.

avginv11

[Jeff] Similar approach, vastly different result. This is not the only such example.

Implications for Investors

My most important point is a plea, repeated from last week’s post: Be careful about investing your money using analysis you do not really understand!

Whether you share my concerns or not, I recommend a deeper look into these issues, with one of three conclusions:

  1. If this leads you to agree with Dr. Hussman, his fund offerings that provide the best balance. I have written that his stock picking is excellent. Investing with him is better than going “all out” on your own because of fear.
  2. If the deeper look leads you to disagree, you might consider funds or advisors who take a different approach.
  3. If you are not sure, then hedge your investment “bets.”

Weighing the Week Ahead: Is a Recession Looming?

The economic calendar is light and it is the start of the week-long Chinese New Year. This means some media time and space that must be filled. Needing an attention-getter, I expect the punditry to be asking:

Is a recession looming?

Prior Theme Recap

In my last WTWA I predicted that everyone would be talking about whether the stock market correction was over. That was one of the most frequent media topics for the week, especially at the lows on Wednesday and again on Friday. As expected, answers varied and we still don’t know for sure. The early-week strength, mid-week rebound, and Friday selling in Doug Short’s weekly chart. (With the ever-increasing effects from foreign markets, you should also add Doug’s World Markets Weekend Update to your reading list).

SPX-five-day

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

We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead. You can make your own predictions in the comments.

This Week’s Theme

Earnings season continues, but the economic calendar is light. Because of the Chinese New Year, we will not have stock or economic news from there. With plenty of recent economic data and scary forecasts to digest, pundits are pondering the worst. When that happens they ask everyone (regardless of qualifications) the same question:

Is a recession looming?

With economic data, especially in manufacturing, weaker than it was for most of 2015, many wonder what this portends. Listed below are popular bearish arguments from a variety of sources:

  • The recession has already started.
  • The stock market is clearly signaling recession.
  • Falling commodity prices have signaled a recession.
  • Declining oil prices have started a death spiral.
  • China economic weakness will drag down the rest of the world.
  • Emerging market weakness will drag down the rest of the world.
  • Energy company bankruptcies will drag down banks.
  • The Fed is out of bullets.

The bullish arguments are more concentrated in the economic community:

  • The economy shows only modest growth, but not a recession.
  • A U.S. recession has never resulted from global weakness.
  • Historically reliable indicators do not show a recession.
  • Key economic indicators followed in dating recessions have not peaked.

As always, I have my own opinion in the conclusion. But first, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading the background information.

Last Week’s Data

Each week I break down events into good and bad. Often there is “ugly” and on rare occasion something really good. My working definition of “good” has two components:

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially – no politics.
  2. It is better than expectations.

The Good

On balance the news tilted to the negative side last week, but there were a few bright spots.

  • Federal receipts (and spending) are 3% higher. This is usually a positive economic sign. (CBO via GEI).
  • The Fed may be walking back the tough talk from last month. (Tim Duy).
  • Private payrolls grew by 205K according to the ADP report. James Picerno notes that while the level is solid, the pace is declining.

adp.03feb2016

The Bad

Most of the economic data tilted negative.

  • Earnings reports have disappointed. Even growth ex-energy is only 2.1% and sales growth barely positive. Earnings expert Brian Gilmartin provides data, analysis as well as a look at forward earnings. Bespoke notes that the overall stock reaction on earnings day has been slightly positive. Take a look at their lists of the biggest winners and losers.
  • ISM manufacturing was about as expected at 48.2, but it is the fourth consecutive month below 50.
  • ISM services remained in expansion at 53.5, but that was slightly lower than expectations.
  • Initial jobless claims edged higher, but Calculated Risk notes the level is still not bad.

WeeklyClaimsFeb042016

  • Ford F150 sales were down 5% on a year-over-year basis. It is still the best-selling U.S. vehicle, and is also popular with construction companies and small businesses, which is why I watch it as an economic indicator.

F150-Sales-YTD-2016-013116

  • Employment gains disappointed, at least on the overall non-farm payroll gain. The story was actually mixed, since the unemployment rate and earnings were both higher. Everyone should remember that the “headline number” has an error band of over 100K, even after revisions. I like the WSJ summary of the report, featuring twelve charts.

The Ugly

Martin Shkreli. His smirking non-testimony before a House committee was bad enough to make the Representatives seem attractive by comparison. My concern? A rational debate on drug pricing is needed. Between this guy and the candidates, we can expect months before this will happen. Meanwhile, what about the drugs that deserve investment — right now.

 

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts.  Think of The Lone Ranger. This week’s award goes to Paul Hickey of Bespoke Investment (via Pradip Sigdyal of CNBC). Over the last few years we have frequently heard about high margin debt on the NYSE. The argument was that the degree of leverage signaled danger. The accompanying charts seemed to show coincident peaks, but people saw what they wanted to see.

 

Although declining margin levels are often cited as a bearish signal for the market, Hickey believes that it is a small concern given the indicator’s coincidental nature. On the other hand, the prospect of rising rates spooks investors much more, and holds them back from buying stocks.

“Margin debt rises when the market rises and falls when the market falls,” Hickey said. “If you look at the S&P 500’s average returns after periods when margin debt falls 10 percent from a record high, the forward returns aren’t much different than the overall returns for all periods.”

 

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. Beginning last week I made some changes in our regular table, separating three different ways of considering risk. For valuation I report the equity risk premium. This is the difference between what we expect stocks to earn in the next twelve months and the return from the ten-year Treasury note. I have found this approach to be an effective method for measuring market perception of stock risk. This is now easier to monitor because of the excellent work of Brian Gilmartin, whose analysis of the Thomson-Reuters data is our principal source for forward earnings.

Our economic risk indicators have not changed.

In our monitoring of market technical risk, I am now using our new model, “Holmes”. Holmes is a friendly watchdog in the same tradition as Oscar and Felix, but with a stronger emphasis on asset protection. We have found that the overall market indication is very helpful for those investing or trading individual stocks. The score ranges from 1 to 5, with 5 representing a high warning level. The 2-4 range is acceptable for stock trading, with various levels of caution.

The new approach improves trading results by taking some profits during good times and getting out of the market when technical risk is high. This is not market timing as we normally think of it. It is not an effort to pick tops and bottoms and it does not go short.

Interested readers can get the program description as part of our new package of free reports, including information on risk control and value investing. (Send requests to main at newarc dot com).

In my continuing effort to provide an effective investor summary of the most important economic data I have added Georg Vrba’s Business Cycle Index, which we have frequently cited in this space. In contrast to the ECRI “black box” approach, Georg provides a full description of the model and the components.

For more information on each source, check here.

Recent Expert Commentary on Recession Odds and Market Trends

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured “C Score.”

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

Doug Short: Provides an array of important economic updates including the best charts around. One of these is monitoring the ECRI’s business cycle analysis, as his associate Jill Mislinski does in this week’s update. His Big Four update is the single best visual update of the indicators used in official recession dating. You can see each element and the aggregate, along with a table of the data. The full article is loaded with charts and analysis.

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. While we feature the recession analysis, Dwaine also has a number of interesting systems. These include approaches helpful in both economic and market timing. He has been very accurate in helping people to stay on the right side of the market.

Dwaine has a new article providing a first-rate analysis of various recession indicators. It is well worth a careful read and a study of the charts. Here is his conclusion, and a chart showing his version of the “Big Four” indicators.

To summarize, despite many pockets of disconcerting co-incident indicator weakness, many brought on by the energy and commodities complex, the risk of near-term recession appears low. Although many short-leading indicators are showing recession there are not enough of them yet to warrant a confident recession call. What remains highly elusive is finding long-leading data that points to recession.

Recession odds are rising, as is commentary surrounding recession. Most of this commentary centers around “cherry picking” this or that indicator or sector to bolster an argument but rarely covers broad-based assessments.

2016-02-03_1900

Peterson Institute and Market Valuation

I regard the equity risk premium from the Indicator Snapshot table as an important measure of market perceptions about the economy and earnings. A problem with many discussions of stock valuation is that they completely ignore expected inflation and interest rates. Olivier Blanchard and Joseph E. Gagnon, both top economists with many years of relevant experience, now at the Peterson Institute for International Economics, clearly explain this point.

…(T)he deviations of the P/E from its historical average are in fact quite modest. But suppose that we see them as significant, that we believe they indicate the expected return on stocks is unusually low relative to history. Is it low with respect to the expected return on other assets? A central aspect of the crisis has been the decrease in the interest rate on bonds, short and long. According to the yield curve, interest rates are expected to remain quite low for the foreseeable future. The expected return on stocks may be lower than it used to be, but so is the expected return on bonds.

The way to make progress is to compute expected returns on stocks and bonds, and look at the equity premium, pre- and post-crisis. With this in mind, table 1 compares expected real returns on stocks, constructed in three different ways, with expected real returns on bonds, constructed in two different ways. To smooth out temporary fluctuations, the measures are based on averages of four quarterly values in each year. We compare expected returns as of 2015 with those of 2005, a time when there was little concern about overvaluation in stock prices. Our results would be similar if we had compared with any year in the mid-2000s.

You can debate how much of an adjustment to make for interest rates, but not whether some consideration is needed.

blanchardgagnon20150201-figure1-1

 

The Week Ahead

We have a relatively quiet week for economic data. While I highlight the most important items, you can get an excellent comprehensive listing at Investing.com. You can filter for country, type of report, and other factors.

The “A List” includes the following:

  • Retail sales (F). Any sign of life in this important indicator?
  • Michigan sentiment (F). Important concurrent read on employment and spending – a bit off of the peak.
  • Initial Claims (Th). The best concurrent news on employment trends, with emphasis on job losses.

The “B List” includes the following:

  • Wholesale inventories (T). Volatile December data has GDP impact.
  • Business inventories (F). See wholesale inventories.
  • Crude oil inventories (W). Attracting a lot more attention these days.

Fed Chair Yellen testifies about the economy – Wednesday the House Financial Services Committee and Thursday the Senate Banking Committee. The statement will be the same, but the questions will be different. Market observers will be searching for hints about a changed attitude since the last Fed meeting.

Tuesday’s New Hampshire primary will have a big impact on the prospects for candidates, but probably not much market impact. Things will get more interesting when the primaries move on to different regions and larger states.

Earnings reports will also remain important.

 

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have six different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

WTWA often suggests a different course of action depending upon your objectives and time frames.

Insight for Traders

We continue both the neutral market forecast, and the bearish lean. Felix increased from about 80% invested to 100%, but 2/3 is in foreign ETFs. The more cautious Holmes is about 1/3 invested. For more information, I have posted a further description — Meet Felix and Oscar. You can sign up for Felix and Oscar’s weekly ratings updates via email to etf at newarc dot com. They appear almost every day at Scutify (follow here). I am trying to figure out a method to share some additional updates from Holmes, our new portfolio watchdog.

holmes

Hedge funds are hiring poker pros. (When I started in the business it was bridge players). The analysis of risk and reward combined with speedy decision making is common to both. Garrett Baldwin has an interesting and informative article as part of a series.

Brett Steenbarger continues to deliver help to traders that they could not get anywhere else. His seven tips for getting to the next level are quite helpful. I especially like #1.

1)  My profitability has improved since I’ve focused on consistency rather than profitability.  I’ve honed in on what are good trades for me and where my profits have come from.  I just want to be consistent in trading those good trades.  If I can do that, the profitability will come.  And if I want greater profitability, I should size up the good trades, not take other, more marginal trades.

 

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Major market declines occur after business cycle peaks, sparked by severely declining earnings. Our methods are focused on limiting this risk. Start with our Tips for Individual Investors and follow the links.

We also have a page (recently updated) summarizing many of the current investor fears. If you read something scary, this is a good place to do some fact checking. Pick a topic and give it a try.

Many individual investors will also appreciate our two new free reports on Managing Risk and Value Investing. (Write to main at newarc dot com).

Other Advice

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

If I had to pick a single most important source for investors to read, it would be a short but important post. Bespoke shows what can happen to high multiple stocks, using data from this earnings season.

 

decilespe

 

This naturally raises the question of how you can avoid such disasters. I recommend using Chuck Carnevale’s F.A.S.T. Graph tool. Here is an example of what you could learn:

lnkd fastgraph

Helping you to avoid this 45% haircut:

LNKD

 

Stock and Fund Ideas

AAPL is frequently recommended as a cheap stock. Charles Sizemore goes beyond the typical arguments in concluding that “It’s ridiculous!”

MLP’s may still have plenty of downside. (Kevin Kaiser via Barron’s)

Resource prices may have bottomed says Jeremy Grantham (!) in the analysis of the positives from low oil prices.

 

Interpreting Research Results

The Psy-Fi Blog explains the weakness in most current stock research.

Here’s what ought to be a really boring idea – we need scientists in general and psychologists and economists in particular to stop hypothesising after results are known (HARKing, geddit?). Instead they need to state what they’re looking for before they conduct their experiments because otherwise they cherrypick the results they find to confirm hypotheses they never previously had.

By coincidence, I wrote a similar post on the same day. My emphasis is on how costly it is to insist on some post-hoc explanation of surprising phenomena.

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. The average investor should make time (even if not able to read every day as I do) for a weekly trip on Wednesday. Tadas always has first-rate links for investors in this special edition. There are several great posts, but I especially liked this advice unconventional advice from Allison Schrager – you might not always want to max out your 401K contribution. The article provides a good analysis of key factors in retirement planning, and the tradeoff with keeping some emergency cash.

Final Thoughts

My weekly prediction (guess?) for WTWA typically raises a theme question with a variety of possible answers. Even if it is the topic of the week, it is often not resolved. I offer my own conclusions, but sometimes do not have a strong opinion.

This week is different. My extensive research into the best methods for recession forecasting provides the basis for some confidence. The methods I highlight have worked the well, and done so for a long time.

The market is pricing in recession odds of nearly 50%. There are so many negative headlines, often misleading.

The “Oilmageddon” term coined by some Citi analysts captured the headlines. You had to read to the very end of the articles to see that this is something they suggested might happen. (CNBC interview). Their actual prediction was that it would probably be avoided by some appropriate policy adjustments. Scott Grannis notes that such problems are usually self-correcting and suggests that the best policy would be to get out of the way. Those predicting the inevitable increase of the dollar would do well to consider this chart:

Screen Shot 2016-02-02 at 12.37.09 PM

In sharp contrast, the best sources see recession odds of 10% or lower. This is the greatest opportunity left in this business cycle, since you can buy many value stocks with single-digit multiples. Great analysis from John Alberg and Michael Seckler (via Advisor Perspectives—read by advisors, but also interesting for individual investors).

 

Everyone wants to know when to expect the value rebound. I do not expect a single, mind-changing event. This is a change that will happen gradually, as evidence is reflected in higher earnings.

Weighing the Week Ahead: What are the Best Year-End Investments?

There is a lot of data to be reported in only three full trading days, but it does not rate to signal important economic changes. I expect plenty of participants to take the week off and even more will leave after the first hour on Wednesday. The punditry still has pages and air time to fill, despite the lack of fresh news. The punditry will be asking:

What are the best year-end investments?

 

Prior Theme Recap

In my last WTWA I predicted that the market story would focus on the message from falling commodity prices. This thesis lasted for one day, as the market continued the multi-week trading pattern of following crude oil prices. That was all. The rest of the week included a rally that most found inexplicable. Gains occurred in the face of terrorist actions, falling commodity prices, and a strong signal of an imminent increase in interest rates. The strong rally left most participants shaking their heads and reaching to invent explanations. To get the full story, let us look at Doug Short’s weekly chart. Doug’s full post shows the various relevant moving averages in a very negative week for stocks. (With the ever-increasing effects from foreign markets, you should also add Doug’s World Markets Weekend Update to your reading list).

SPX-five-day

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

We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead. You can make your own predictions in the comments.

This Week’s Theme

The economic calendar is normal, but all of the reports occur within three days. Friday’s session is a half-day. Many participants will be taking off and others will leave after Wednesday morning’s data. TV producers will be reaching to find subjects. It may be the toughest week of the year to guess a theme. Volume will be low and surprise news could have a big effect. It is a bit too soon for the Santa Claus rally topic, but that is also possible.

My guess is that the discussion will focus on the surprising market resilience and what it means for investments.

People will be asking:

What are the best year-end investments?

There will be a wide range of viewpoints, featuring the following:

  1. Bonds. Stocks are over-priced and dangerous.
  2. Gold. Time to hedge against geopolitical and economic threats.
  3. Safe stocks, emphasizing dividends.
  4. Bets on an improving economy.
  5. A shift to emerging markets.
  6. Popular recent leaders.

There is an argument for each approach. Expect to see some new faces on TV and new sources featured in columns. As always, I have my own ideas, reported in today’s conclusion. This week I have tried to give special emphasis to sources with specific stock ideas.

But first, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading the background information.

 

Last Week’s Data

Each week I break down events into good and bad. Often there is “ugly” and on rare occasion something really good. My working definition of “good” has two components:

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially – no politics.
  2. It is better than expectations.

The Good

There was a little good news, but most results were in line with expectations.

  • More dovish commentary from ECB head Draghi. (Institutional Investor)
  • The Philly Fed beat expectations. While the index (1.9) did not show great expansion, the results have been getting wider attention. Calculated Risk has the story and this chart showing the relationship with the more-noted ISM index.

ISMFedPreNov2015

  • Bank lending strengthens. Scott Grannis has the story and a nice chart pack on credit.
  • Building permits rose 45K, in line with expectations. This continues a trend in this forward-looking construction indicator. See Jill Mislinski at Doug Short’s site for more analysis and the expected great charts.
  • Builder confidence was reported as 62, a slight miss of expectations. Calculated Risk notes that it is still a strong reading.

NAHBNov2015

 

 

The Bad

Some of the economic data missed expectations. Feel free to add other suggestions in the comments.

  • Rail traffic is declining. Steven Hansen (GEI) gets beyond the noise of the weekly data and reveals the trend.

Rail Traffic

  • Housing starts missed forecasts. Jill Mislinski at Doug Short’s site has a nice, detailed report.
  • Industrial production missed explanations. Steven Hansen (GEI) takes a deeper look at the data, explaining that it might be a little better than the headline indicates.

The Ugly

Continuing terrorism. Just as those responsible for the Paris attacks were found, there was a new assault on a luxury hotel in Mali. As I write this, there is a threat to restaurants and cafes in Brussels.

This is, of course, a human story rather than one about markets. Many of us will be giving thanks this week for our own safety and that of friends and loved ones. Many will also support the victims and families in the way they best can.

I know that many are curious about why there was not a greater market impact. The Economist offers some explanations.

 

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts.  Think of The Lone Ranger. No award this week. Nominations are always welcome.

 

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. This week I have made some changes in our regular table, separating three different ways of considering risk. For valuation I report the equity risk premium. This is the difference between what we expect stocks to earn in the next twelve months and the return from the ten-year Treasury note. I have found this approach to be an effective method for measuring market perception of stock risk. This is now easier to monitor because of the excellent work of Brian Gilmartin, whose analysis of the Thomson-Reuters data is our principal source for forward earnings.

Our economic risk indicators have not changed.

In our monitoring of market technical risk, I am using our “new” Oscar model. I put “new” in quotes because Oscar is in the same tradition as Felix and the product of extensive testing. We have found that the overall market indication is more helpful for those investing or trading individual stocks. More about Oscar next week. The score ranges from 1 to 5, with 5 representing a high warning level. The 2-4 range is acceptable for stock trading, with various levels of caution.

I considered continuing to report the Felix updates, but I already have a distinction between long and short-term methods. I want to minimize confusion. Those who want this information can subscribe to our weekly Felix updates.

For more information on each source, check here.

Recent Expert Commentary on Recession Odds and Market Trends

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured “C Score.”

Georg Vrba: An array of interesting systems. Check out his site for the full story. We especially like his unemployment rate recession indicator, confirming that there is no recession signal. He gets a similar result from the Business Cycle Indicator, updated this week.

This week Georg dropped the indicators emphasizing the ECRI WLI, which he has concluded add nothing to the forecasting power of his other approaches. He has written on this topic several times, but perhaps he will provide a summary of the factors behind his decision.

Doug Short: Provides an array of important economic updates including the best charts around. One of these is monitoring the ECRI’s business cycle analysis, as his associate Jill Mislinski does in this week’s update. The ECRI story is becoming repetitive and even more unhelpful. It seems too related to commodity prices, and only slightly changed from their failed recession forecast. It would be refreshing to see them do a complete reset and adopt a fresh approach.

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. While we feature the recession analysis, Dwaine also has a number of interesting systems. These include approaches helpful in both economic and market timing. He has been very accurate in helping people to stay on the right side of the market.

 

The Week Ahead

There is quite a bit of economic data for a 3 ½ day week. Wednesday is the big day. While I highlight the most important items, you can get an excellent comprehensive listing at Investing.com. You can filter for country, type of report, and other factors.

The “A List” includes the following:

  • New home sales (W). Good concurrent read on an important sector for economic growth
  • Michigan sentiment (W). Good concurrent indicator of job growth and spending
  • Personal income and spending (W). Can people afford holiday spending?
  • Consumer confidence (T) Conference Board version is similar to Michigan’s, also showing recent strength.
  • Initial claims (Th). Fastest and most accurate update on job losses.

The “B List” includes the following:

  • Core PCE prices (W). The Fed’s favorite inflation indicator. Will not have much significance until there are a few hot months.
  • Existing home sales (M). Not as important as new home sales, but shows the state of the market.
  • GDP 2nd estimate (T). Backward looking, but probably revised higher.
  • Durable goods. (W). Improvement expected in this volatile series.
  • Crude oil inventories (W). Focus on oil prices keeps this report in the spotlight.

All quiet on the speaking front, but breaking news might have an exaggerated impact in the expected low-volume environment.

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

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

Insight for Traders

Oscar continues Felix’s neutral market forecast, but he is fully invested. There are often plenty of good investments, even in an expected flat market. For more information, I have posted a further description — Meet Felix and Oscar. You can sign up for Felix and Oscar’s weekly ratings updates via email to etf at newarc dot com. They appear almost every day at Scutify (follow here).

The most dramatic lesson for traders comes from a rookie who did not accurately assess his risk. He held an overnight short position in a stock that was supposedly going bankrupt. The next morning he learned that his $37,000 account was wiped out and he owed his broker over $100,000. Shawn Langlois (MarketWatch) has the story and this chart:

MW-DZ658_kbio_c_20151119151301_ZH

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Major market declines occur after business cycle peaks, sparked by severely declining earnings. Our methods are focused on limiting this risk. Start with our Tips for Individual Investors and follow the links.

We also have a page summarizing many of the current investor fears. If you read something scary, this is a good place to do some fact checking.

Other Advice

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

If I had to pick a single most important article, it would be this analysis from Rupert Hargreaves at Value Walk. He reports on advice from Michael Mauboussin, a leading expert on investor behavior. Read the entire piece and check out the great links, but here is a key segment:

 

Over the past decade, the S&P 500 has gained 7.7% per annum, but the average investors has only been able to achieve a return of 5.3% per annum. According to Michael Mauboussin, these figures are similar across most of the world’s markets and can be explained by one key factor; we often fail to keep a cool head and end up we buying high and selling low.

As Mauboussin puts it, a human phenomenon is the desire to be part of a group, which gives a sense of security but it’s not always a good thing.

 

Many investors have the skill and tools to do well, but not the emotional stability or discipline.

SL Advisors notes that this affects asset allocation as well. The “retail” funds, ETFs, and stocks have done worse than those favored by institutions.

Russ Koesterich adds data on the “enormous long-term cost” of holding cash.

Stock Ideas

Successfully bullish strategist Thomas Lee recommends a shift from consumer discretionary stocks to energy. James Picerno analyzes this call, comparing charts and data from both sectors and providing plenty of evidence via more links.

Morningstar reveals the top ten conviction buys of their “ultimate stock pickers. They also show the top ten new money purchases. Read the full article for details of both lists and some underlying rationale.

3637

Utility stocks? Eddy Elfenbein explains the risks, and it is not just a matter of rising rates.

Big bets from the Robin Hood Conference. Valeant? Oil prices to $70. There are many interesting ideas.

Warren Buffett is going against the crowd on IBM. But what does he know? (WSJ)

13 Dividend Aristocrats with yields over 4%. (Philip van Doorn, MarketWatch)

 

Watch out for….

 

Obamacare effects. UnitedHealth Group downgraded earnings expectations, blaming the ACA. The health insurance group plummeted and the selling pressure rippled to hospitals and even to biotechs. The next day the other big insurers all stated that participation, fees, and revenues were on track. This has been a popular and important market sector, so the story deserves careful monitoring.

 

Tax scams. The IRS might lose your data, but they have some advice. You are probably already doing these seven things, but it only takes a moment to check.

 

Yield plays. MLP’s, REITs, BDC’s and others. (Bloomberg)

 

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for ten year. The average investor should make time (even if not able to read every day as I do) for a weekly trip on Wednesday. Tadas always has first-rate links for investors in this special edition. There are several great links, but I especially liked this warning about non-traded REITs from Micah Hauptman, financial services counsel for the Consumer Federation of America. (WSJ)

Nontraded REITs are rife with conflicts of interest both in how they are governed and how they are sold. Often, the entities that manage and sell nontraded REITS are closely affiliated and controlled by the same top executives who divvy up the high upfront costs investors pay. Further, the brokers who recommend these products are allowed to call themselves “trusted financial advisers” while they operate like salespeople seeking to earn a commission. These conflicted structures enable a systematic wealth transfer from retail investors, who need to make every dollar count, to the financial firms that create, manage, market and sell these products.

The article provides data on the huge impact of up-front fees on eventual returns.

Josh Brown offers his typically powerful comments on the same topic – a familiar one for him.

China Outlook

Another major mining company affirms Chinese economic growth rates. (Bloomberg)

Final Thoughts

For long-term investors, the best sources of value require some confidence in economic growth. This is clearly a contrarian opinion, as you can see from the sources below.

One factor influencing stocks – especially those in the economically sensitive sectors – is the persistent belief that the economy is bad and getting worse. The results of Gallup polling show this effect, despite lower gas prices and an improved economy throughout 2015. (Josh Zumbrun, WSJ)

Gallup_2

The article provides data showing the sharp contrast between this general poll and those that ask about individual circumstances.

Barry Ritholtz joins in with a nice analysis on the factors behind the unhappiness of voters – an uneven recovery, misleading noise, and ignorance, each discussed nicely. The lesson he reaches for investors his one of my favorite themes. Be politically agnostic. Accept the reality of the policy environment and take advantage of whatever is offered. This advice will become more difficult to follow as election campaigns heat up.

By contrast, “Davidson” (via Todd Sullivan) explains as follows:

The most important knowledge of Value Investors which lets them invest when others are racing to ‘high-ground’ is in understanding that throughout human history we have always recovered from self-made disasters. Value Investors are primarily optimists and are virtually the only buyers at market recession lows. Geneticists, anthropologists, psychologists/psychiatrists and neurologists have recently been coming to similar conclusions.

He elaborates nicely, showing how this applies to housing and shelter. Here is a key chart:

Screen-Shot-2015-11-17-at-1.23.45-PM-618x420

Investment Conclusion

Key themes for a strengthening economy include financials (I especially like regional banks), technology, homebuilders, and mid to late stage cyclicals. While I cannot be sure that they are choices for the rest of 2015, the market seems to be swinging that way.

Weighing the Week Ahead: Greek Ripples or Economic Fireworks?

The elements are in place for a week of fireworks. Barring some unlikely last-minute news, we are expecting a Greek bank holiday and capital controls on Monday, followed by one of the biggest weeks of the year for economic data, all crammed into a holiday shortened week. Will it be…

Greek ripples or economic fireworks?

Prior Theme Recap

In my last WTWA I predicted that market participants would on events in Greece, and so it was. There was some other news, but the twists in turns of the Greek negotiations commanded attention and seemed to move markets, at least within a one percent range. As usual, Doug Short’s excellent five-day summary captures the story in one great chart.

dshort market week

 

Feel free to join in my exercise in thinking about the upcoming theme. We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead.

This Week’s Theme

This week promises fireworks from two very different sources. To start the week markets will deal with the apparent breakdown of the Greek bailout talks. Then we get a huge week for economic data, with optimism growing due to recent strength. And finally, by 10 AM on Thursday you can expect plenty of players to be heading for the beach and a long weekend.

I expect market observers to be asking:

Should the focus be Greek ripples or a rebounding economy?

The Viewpoints

Barring a last-minute miracle, the optimists on the Greek negotiations were wrong. I summarized the range of viewpoints last week, so check there for more detail on the recap. Briefly put, the question now is whether this is a “Lehman moment” or (as First Trust opined) more like Detroit.

We will get an answer to that by Tuesday, so the rest of the week will focus on the economy.

The familiar viewpoints include the following:

  1. Some remain worried about deflation, emphasizing Q1 GDP. (IMF)
  2. The muddle through camp, seeing a continuing threat of recession in a low-growth world. (ECRI)
  3. Overall strengthening suggesting a 3.5% pace for the remainder of 2015. (Barron’s)

 

As always, I have my own ideas in today’s conclusion. But first, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading the background information.

 

Last Week’s Data

Each week I break down events into good and bad. Often there is “ugly” and on rare occasion something really good. My working definition of “good” has two components:

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially – no politics.
  2. It is better than expectations.

The Good

There was plenty of good economic news.

  • Earnings estimates have halted the recent decline and are looking better. (Brian Gilmartin).
  • Michigan sentiment rebounded implying strong consumer spending. Doug Short has the complete story, analysis, and some great charts.
  • Consumer spending rose by 0.9%, the biggest gain in six years. And consumers are healthier, with better balance sheets and lower credit card debt. (Scott Grannis)

Credit card delinq

  • New home sales beat expectations.
  • Existing home sales hit the highest level since 2009. Calculated Risk, as usual, has complete analysis including this chart:

EHSMay2015

 

The Bad

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

  • Durable good declined by 1.8%, slightly more than expected.
  • Rail traffic is still declining. See GEI for analysis of the trends in this noisy series.
  • The Greek bailout negotiations unraveled. (Continuing strong coverage at ft.com).
  • Americans are not prepared for emergencies. A survey shows that 29% have no emergency savings at all. (Despite the improvement noted above).

The Ugly

Chinese stocks. Thursday’s trading showed a 7.4% decline in the Shanghai Composite Index, with many stocks hitting the 10% drawdown limit. Some investors are using 6x leverage on portfolios. Full meltdown approaching? (Alpha Architect)

MarketCycle has a nice section on China, including this chart:

chart-blog-16

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts.  Think of The Lone Ranger. No award this week, but nominations are always welcome.

Noteworthy

Investors often exaggerate unlikely fears. Compare that tendency to the question of which animals kill the most humans – who we should fear most.

There are plenty of snakes, and gators, and sharks. The astute readers of WTWA might well guess the top threat, but #2 might surprise. (HT MarketCycle, with answer in today’s conclusion).

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. For more information on each source, check here.

 

Indicator Snapshot 062715

Recent Expert Commentary on Recession Odds and Market Trends

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured “C Score.”

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. While we feature the recession analysis, Dwaine also has a number of interesting market indicators. He recently noted an increase in his combined measure of economic stress, although the levels are still not yet worrisome.

Georg Vrba: has developed an array of interesting systems. Check out his site for the full story. We especially like his unemployment rate recession indicator, confirming that there is no recession signal. He gets a similar result from the Business Cycle Indicator (featured below). Georg continues to develop new tools for market analysis and timing, including a combination of models to do gradual shifting to and from the S&P 500.

Doug Short: An update of the regular ECRI analysis with a good history, commentary, detailed analysis and charts. If you are still listening to the ECRI (3½ years after their recession call), you should be reading this carefully. Recently the ECRI finally admitted to the error in their forecast, but still claims the best overall record. This is simply not true. I rejected their approach in real time during 2011 and also highlighted competing methods that were stronger. Until we know what is inside the black box (I suspect excessive reliance on commodity prices and insistence on unrevised data) we will be unable to evaluate their approach. Doug is more sympathetic in his last update. While I disagree, it will require a longer post to elaborate.

In this week’s update Doug notes the ECRI claim of lower growth and more frequent recessions. The two do not necessarily coincide. Recessions do not generally begin with “stalls” but rather with business cycle peaks. Some readers have suggested that I retire this line of discussion from WTWA. I would happily do so if more media sources did a better job with the recession discussion. Until then it provides an important reminder.

The best concurrent economic pulse comes from Doug’s Big Four summary of key indicators, those watched by the NBER’s recession dating committee. There is no evidence of a business cycle peak.

The Week Ahead

This might be the biggest week of the year for economic data.

The “A List” includes the following:

  • Employment report (Th). Still the most important for markets, despite the variation and revisions. Continuing strength expected.
  • ISM Index (W). Good read on an important sector, with some leading qualities.
  • Auto sales (W). Recent strength continuing? Watch the pickup truck sales.
  • ADP employment report (W). A very good independent read on private sector employment.
  • Initial jobless claims (Th). The best concurrent news on employment trends, with emphasis on job losses.

The “B List” includes the following:

  • Pending home sales (M). More good news from housing?
  • Chicago PMI (T). The only regional index that really has market significance. Often a hint of the national ISM.
  • Construction spending (W). Crucial component if the economic rebound is to continue.
  • Crude oil inventories (W). Current interest in energy keeps this on the list of items to watch.
  • Factory orders (F). May data and very volatile, but still of some interest.

There is not much FedSpeak in the holiday-shortened week. Anything fresh about Greece will command attention.

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

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

Insight for Traders

Felix continued a neutral stance for the three-week market forecast. The confidence in the forecast remains very low with the continuing extremely high percentage of sectors in the penalty box. Despite the overall market verdict Felix has generally been fully invested in three top sectors. For more information, I have posted a further description — Meet Felix and Oscar. You can sign up for Felix’s weekly ratings updates via email to etf at newarc dot com. Felix appears almost every day at Scutify (follow him here).

In response to a recent question from a rookie trader, I recommended the many resources from Charles Kirk, some at nominal cost and some free. Even veteran traders could benefit from a refresher on these topics. I especially like this recent post on how to think like a trader. Hint: Scenarios rather than certainties.

I also mentioned the go-to source for traders trying to improve their performance, Dr. Brett. This week he has a nuanced post on how role modeling can help traders. It is worth a careful read.

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Major market declines occur after business cycle peaks, sparked by severely declining earnings. Our methods are focused on limiting this risk. Start with our Tips for Individual Investors and follow the links.

We also have a page summarizing many of the current investor fears. If you read something scary, this is a good place to do some fact checking. Please also check out part one of my new series on risk. Early reactions were good, and more comments are welcome. At least three more installments are planned.

Other Advice

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

If I had to pick a single most important post, it would be this thoughtful piece by Morgan Housel. Everyone these days seems to know about confirmation bias and the need for contrarian thinking. It is much more difficult to read various sources and consider different viewpoints. Here is a key point:

If you think stocks are like physics, you believe there must be smart people who can measure exactly where the Dow Jones Industrial Average will be in five months, just as smart people can measure exactly when the sun will rise in five months.

So investors complicate things. They trade, they fiddle, they buy this and sell that—all with the hope of achieving a higher return than can be earned sitting still and letting the market work for you.

But the evidence is overwhelming: The odds that you will achieve long-term success by actively trading or timing the market round to zero.

Stock Ideas

Barron’s has an interesting story on a top biotech fund, discussing both methods and some specific names. There is a natural tendency to sell biotech holdings after such a great run. Here is a key thought from the managers:

With biotech stocks up 30% annually in the past five years, it’s fair to ask if they are overvalued, Kolchinsky admits. But, he says, “biotech has generated amazing breakthroughs that no one, five or 10 years ago, would have thought probable. Gene therapy is now starting to work. A whole new field of oncology has emerged. For cancers that were previously thought to be incurable, what appear to be some cures are starting to emerge. There is more to come.”

Value managers at Morningstar mention some favorite names, including surprises like Amazon, where the market “misunderstands” the strategy for future profit.

Brian Gilmartin provides a great lesson in how to use cash flow to compare dividend stocks. Exxon and Chevron: From A Dividend And Free-Cash-Flow Perspective analyzes two popular stocks, provides ideas about the sector, and helps investors to learn a key element of stock picking.

An interactive chart (Capital Market Laboratories) explains why Facebook is worth more than Walmart. There are many interesting tables, including data showing $1.34 million in revenue per Facebook employee while “only” $221,000 for Walmart.

 

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. The average investor should make time (even if not able to read every day as I do) for a weekly trip on Wednesday. Tadas always has first-rate links for investors in this special edition. I especially liked this advice about risk and questionnaires. Allan Roth has a strong list of reasons for rejecting the questionnaire approach. I agree with his nuanced approach, which closely reflects my own client interviews. Everyone is different, and a few questions provide very little guidance.

Watch out…

Investors should be careful about buying diamonds. It is more complicated than gold. (Paulo Santos)

Risks in dividend stocks, REITs, and MLPs if interest rates rise. Good analysis from Martin Tillier.

Market Outlook

This week’s Morningstar conference provided excellent interviews with a wide variety of managers. Two of the top “bottoms-up” managers (an approach with which we identify) were pushed hard by interviewers. They wanted some comments on valuation, the Shiller P/E, etc. Here is the key takeaway:

Both managers are bottom-up investors, but when pressed for their market-level view neither see stocks as unreasonably expensive. Nygren says it is important to have the right starting point in thinking about valuations. If you see the market of six or seven years ago as normal, then yes, a triple from that level leaves things looking very pricey. But if you, like Nygren, think 2008, 2009 was a generational buying opportunity, then things don’t look as elevated. Nygren says that P/Es are in line with historical averages. Romick also sees stocks as relatively attractive, given the current interest-rate environment.

Neither seemed to think the Shiller P/E ratio was the right way to look at the market. Nygren says that it is unlikely to see an event as severe as the Great Recession every decade, so pricing one in to valuations is extreme; meanwhile, Romick said the measure doesn’t take the current rate environment into account.

Most years have corrections of 10% or more. You just can’t guess which ones. Ben Carlson provides this table:

Final Thought

I summarized my approach to the Greece situation last week – less optimistic than many.

With that background, here is how I am using the framework to think about this risk. My conclusions are based upon a wide variety of sources. In WTWA I do not make an argument for my own viewpoint, but I usually share it.

I rate the chance of a default as quite high. The Greek leadership, encouraged by its constituency, seems unwilling to make concessions. European leaders seem to have reached their limit. Reports from those close to the negotiations have not been encouraging.

I expect the ultimate consequences to be limited, but only after a period of uncertainty. While contagion is unlikely, markets hate uncertainty.

It is always difficult to know what is reflected in current market prices. My conclusion is based upon nearly thirty years of observation of daily trading. My sense is that the Greece effect has (so far) been pretty minor. Most market participants have been trained to expect an eleventh-hour resolution. (Dr. Brett).

The average investor should not over-react to this, going “all out” of the market for a temporary effect. A trader might try to capture the reaction. We did a little of this in our accounts.

As always, the right trade depends upon your time frame and your agility.

I am much more upbeat on the economic potential, and especially what it might mean for earnings. Beginning with Wednesday’s news, investors might find something to cheer about.

Puzzle Solution

chart-blog-15

Weighing the Week Ahead: Can Employment News Change the Fed’s Course?

This week’s economic news is mostly jobs-related. The Fed has cited employment as the most important factor in future rate decisions. There is plenty of FedSpeak on tap. Pundits love to talk about the Fed. Voila! The theme for the week will combine all of these elements:

Can the employment news change the Fed’s course?

Prior Theme Recap

In my last WTWA I predicted that attention focus on markets rather than the economic reports. In particular, I suggested several different viewpoints about expected market action. While each of these got a riff or two during the week, I was expecting the main theme to be the challenge to the top of the trading range. With the soft start to the week, the upside breakout potential got little attention.

Feel free to join in my exercise in thinking about the upcoming theme. We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead.

This Week’s Theme

This week’s economic news is mostly about employment. At week’s end we will get the monthly employment situation report, with plenty of angles and spin potential. In addition we will see the ADP private employment report, news about layoffs, initial jobless claims, and a report on service sector employment. The Fed is giving special attention to employment, watching for signs that the labor market is getting tight and wage pressures mounting. This week I expect discussion to center on employment and the aftermath of last week’s FOMC rate meeting. Fed speakers will be out all week, discussing the data and answering questions. Analysts will be asking:

Can the employment data change the Fed’s course?

The Viewpoints

Fed policy is a favorite market topic, eliciting a range of viewpoints encompassing both economic prospects and prospective rate tightening. Here are the leading candidates:

  • The economy remains very weak, so the Fed is on hold. (Numerous super-bears).
  • The economy remains sluggish, but the Fed will begin a modest rate increase program nonetheless. (Tim Duy).
  • There are already signs of inflation and the Fed will begin rate increases by September. (Scott Grannis)

CPI CPI Core 6mo

 

  • Labor markets are tighter, even though the overall economy is weak. (Eddy Elfenbein – initial claims 2nd lowest since 1973).

initial claims Eddy

  • The Fed is already hopelessly “behind the curve” and must start tightening soon. (Martin Feldstein).

As always, I have my own ideas in today’s conclusion. But first, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading the background information.

Last Week’s Data

Each week I break down events into good and bad. Often there is “ugly” and on rare occasion something really good. My working definition of “good” has two components:

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially – no politics.
  2. It is better than expectations.

The Good

There was some good news in a mixed week.

  • Consumer spending rose 1.9%, confirming the early read from New Deal Democrat that we noted last week. See his post for these results and much more.
  • Home prices showed a nice gain of 5% y-o-y according to the Case-Shiller method. (Calculated Risk).

CSYoYFeb2015

  • Initial jobless claims hit the lowest point since 2000, 262K.

The Bad

The news also included some negatives.

  • Consumer confidence missed expectations on the Conference Board survey. Doug Short has a full account, including some negative quotations from the source. The article also covers and charts the Michigan Sentiment survey, which was a little more positive.

dshort conference board confidence

  • Earnings reports tilted a bit negative in a complex story. 71% beat on earnings and only 46% on revenue. Both of these numbers are below average. When weighted by market cap, the earnings story is a bit better. The outlook stories still lean negative. See both FactSet and Brian Gilmartin for both data and analysis.
  • Student loan defaults are even worse when viewed as a fraction of those actually expected to make current payments – over 30%. (WSJ).
  • Q1 GDP was barely positive, showing a gain of only 0.2%. Conclusions about this weak report vary widely.
    • The meager gains are to be expected in a new world of recessions. (ECRI).
    • One-time factors explain much of the weakness (summarized with links by Mark Thoma).
    • Seasonal factors take this down from a more accurate read of a 2% gain (Barron’s).
    • Core GDP is a much better measure, focusing on the domestic economy and avoiding variation in exports and inventories. Bob Dieli’s reports are both witty and sophisticated. His analysis shows why the current weakness is not like the prior pre-recession bouts. He has agreed share this report with our audience. As a bonus, you will also learn Bob Uecker’s advice on how to catch a knuckleball!

 

The Ugly

Baltimore – sad in all respects.

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts.  Think of The Lone Ranger.

This week’s award goes to Barry Ritholtz for his analysis of margin debt. This is yet another measure that peaks coincident with or after new market highs. It is usually cited via an uncritical chart that does not show any leading quality, like this one modified from a more objective Doug Short analysis:

-1x-1

 

Barry concludes as follows:

Margin debt rises and falls with markets. The basis for making loans against equities naturally increases when the value of that portfolio goes up. Margin debt declines when the value of that underlying collateral goes down. No big surprise; that is how margin works.

However, it is a double-edged sword. It can help drive buying during a bull market; during a bear market it does the opposite, pushing prices lower. It gets ugly during a retreat, when falling equity prices lead to so-called margin calls and forced selling. The rules generally don’t permit margin debt to exceed 50 percent of the shares pledged as collateral.

So why don’t I consider margin debt a valid indicator? Because as markets reach new highs, so too does margin debt. As we have previously discussed, new highs are a good thing.

During a bull market, those new highs occur with regularity. As my colleague Josh Brown notes:

On a daily basis, the S&P 500 trades at an all-time high 7% of the time and trades within 5% of an all-time high 36% of the time. This means that on 43% of all days, since the S&P 500’s inception, US large cap stocks were at or close to making new records.

It should come as no surprise then that NYSE margin debt keeps rising.

 

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. For more information on each source, check here.

Recent Expert Commentary on Recession Odds and Market Trends

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured “C Score.”

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. While we feature the recession analysis, Dwaine also has a number of interesting market indicators. He recently noted an increase in his combined measure of economic stress, although the levels are still not yet worrisome. Recently Dwaine introduced a valuation model that is much more sophisticated than the popular Shiller CAPE method. It also provides a much less worrisome conclusion, 13.7% returns through the end of 2016.

Georg Vrba: has developed an array of interesting systems. Check out his site for the full story. We especially like his unemployment rate recession indicator, confirming that there is no recession signal. He gets a similar result from the Business Cycle Indicator. Georg continues to develop new tools for market analysis and timing, including a combination of models to do gradual shifting to and from the S&P 500. I am following his results and methods with great interest. You should, too.

Doug Short: An update of the regular ECRI analysis with a good history, commentary, detailed analysis and charts. If you are still listening to the ECRI (three years after their recession call), you should be reading this carefully. Doug has the latest interviews as well as discussion. Also see Doug’s important Big Four summary of key indicators, updated regularly.

“Sell in May” gets more slicing and dicing. If you pick the right time period and the right number of months, you can make the data sing. Dana Lyons says May is the worst. Or maybe not, says Force Majeure.

The Week Ahead

There are fewer reports than usual this week, but some are very important.

The “A List” includes the following:

  • The employment report (F). Despite the wide error range and many revisions, this remains the most important economic touchstone.
  • ADP private employment (W). A good alternative read on changes in private employment.
  • ISM services (T). Good concurrent read on service sector strength, with some leading components.
  • Initial jobless claims (Th). The best concurrent news on employment trends, with emphasis on job losses.

The “B List” includes the following:

  • Trade balance (T). March data will affect Q1 GDP revisions.
  • Factory orders (M). Volatile March data.
  • Crude oil inventories (W). Maintains recent interest and importance.

It is a big week for Fed speakers, including Chair Yellen. Expect also to hear more from former Chairman Bernanke.

Earnings season continues.

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

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

Insight for Traders

Felix continued a bullish stance for the three-week market forecast. The confidence in the forecast remains rather modest, reflected by the percentage of sectors in the penalty box. Our current position remains fully invested in three leading sectors. For more information, I have posted a further description — Meet Felix and Oscar. You can sign up for Felix’s weekly ratings updates via email to etf at newarc dot com. Felix appears almost every day at Scutify (follow him here).

We also have some exciting news about Oscar. Just like the revised TV show, we have updated Oscar to include a new and promising universe of trading targets. The results of this model (Felix logic but a new universe) are quite interesting. More soon.

Traders can start to plan for trading in weekly VIX options, maybe as soon as July. This will allow trades to be more closely calibrated to the timing of major data releases and Fed announcements. (Barron’s)

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Major market declines occur after business cycle peaks, sparked by severely declining earnings. Our methods are focused on limiting this risk. Start with our Tips for Individual Investors and follow the links.

We also have a page summarizing many of the current investor fears. If you read something scary, this is a good place to do some fact checking.

Other Advice

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

Featured Commentary

If I were to recommend a single source this week, it would be this discussion about Warren Buffett’s answers to questions at the Berkshire annual meeting. There is a persistent misleading theme, citing Buffett’s “favorite indicator” of stock market valuation as evidence of a high-risk market. In fact, Mr. Buffett has not mentioned this in many years. Charlie Munger refuted (via Ben Carlson) the claim. Buffett repeatedly notes that stocks are more attractive than bonds. Those on a mission to keep you scared witless (TM OldProf) repeatedly dredge up the old quote. The specific response this weekend should set the record straight. Briefly put, interest rates matter (not a surprise to my regular readers).

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. The average investor should make time for a weekly trip on Wednesday. Tadas always has first-rate links for investors in this special edition. I especially liked this article from Jonathan Clements of the WSJ: What Long Life Spans Mean for Your Money and Career. Those approaching 65 need to think about living, perhaps for another twenty years or more.

 

Stock Ideas

Biotech stocks have sold off sharply. Michael Batnick puts this into perspective by analyzing the pain and the gain. The chart below makes the biotech success stand out. Meanwhile, nearly half of the time the sector has been in a correction of more than 10%. It takes patience, as well as right-sizing your risk.

tumblr_inline_nnmkg6Zn5x1sba62w_500

 

Energy

Oil prices artificially low, eventually headed to $60? Interesting analysis from Luay Al-Khatteeb at Brookings.

Practical Advice

Don’t try to call the top. Take a look at the table from Ben Carlson and see if you can find a pattern.

Tops2

Cullen Roche explains that it is usually good enough to be right about the general direction of the market — “partly right instead of mostly wrong.”

Watch out!

…for those warning that the “easy money has already been made.” They do not understand that it is never easy, says Morgan Housel.

Barron’s, Nov. 2009: “The Easy Money’s Been Made”

Morningstar, Dec. 2010: “The Easy Money Has been Made”

MarketWatch, Nov. 2011: “The easy money has already been made”

TheStreet, May 2012: “The Easy Money Has Been Made”

Morningstar, Dec. 2013: “The Easy Money Has Been Made”

Barron’s, Oct. 2014: “The Easy Money Has Been Made”

CNBC, March 2015: “The easy Money has been made”

 

Final Thought

My forecast for the week’s theme often includes topics that I personally do not regard as important.

The Fed will see two monthly employment reports before they next meet in June. Indications are that they would like to start a gentle, prolonged, and varied tightening cycle. It might well last for more than two years before reaching normal levels in short-term rates.

If you accept this as the base case, we should expect strong employment news to encourage a rate increase in June, a little earlier than many market participants expect.

In terms of psychological impact, some will immediately invoke the “Don’t Fight the Fed” language. Those who see the increase in stocks as an artificial result of QE will pounce.

In terms of actual impact, Fed policy will remain accommodative for many months – even years – to come. Stocks have typically done well in the early stages of a tightening cycle.

Traders might choose to game the market psychology, but agility will be needed.

Investors would do better to put aside the obsession with Fed policy, at least until the ten-year note yield gets over 4% and/or the yield curve inverts. Until then, good economic news is good news for stocks, despite any knee-jerk reactions.

Weighing the Week Ahead: The Quest for New Worries

In my last WTWA (two weeks ago, since I am allegedly on vacation. I resumed work on Fed day to watch and to meet with readers and potential investors near New Orleans. Next week I’ll be back on my normal). I asked whether good news was now bad for investors. The continuing Fed focus was once again a successful theme, despite the increasing irrelevance of Fed policy.

Doug Short’s pictures are always worth a thousand words.

SPX-150320

 

Feel free to join in my exercise in thinking about the upcoming theme. We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead.

This Week’s Theme

The upcoming week has an emphasis on housing data, but that probably will not be the theme. I expect a search for new worries. These might include falling earnings estimates, the strong dollar, falling commodity prices, mistaken Fed policies, and increased volatility. Since airtime and news space must be filled with “explanations” of any market move, there is a job to be done! With the Fed decision behind us,

What should investors worry about next?

The Candidates

  • The ever-popular Fed failures remain the leading candidate. The Fed is “in a box” or “painted in a corner” so unable to take appropriate action.
    • It has been too slow to raise rates. Steven Hansen at GEI states this position quite aggressively. Gene Epstein (Barron’s) agrees. Those who attribute stock gains simply to central bank policy now prefer Europe to the US. (Bloomberg).
    • It might raise rates too quickly. Ray Dalio got a lot of buzz last week with his “1937 scenario.” (via Ben Carlson)

  • Falling earnings expectations might be serious. Factset now sees Q115 declining 4.8% year-over-year. The biggest declines are in the energy sector, but the stronger dollar has affected other stocks as well.
  • Increased volatility is the newest “wise comment” from the punditry. Even those who are relatively sanguine about the markets warn of the “wild ride” we should expect. The implication is that volatility is bad.
  • Overvalued markets will generate poor long-term returns. Since the repetitive bubble warnings have not proven prescient, investors are now urged to worry about long-term returns. Ten years is the suggested horizon. (Barron’s).

As always, I have some additional ideas in today’s conclusion. But first, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading the background information.

Last Week’s Data

Each week I break down events into good and bad. Often there is “ugly” and on rare occasion something really good. My working definition of “good” has two components:

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially – no politics.
  2. It is better than expectations.

The Good

There was some good news last week.

  • Building permits rose 3%. Calculated Risk also notes the Campbell survey which projects action from first-time buyers. I agree with his “we will see soon” conclusion.
  • Fed policy attracted market support. There are some observers who have been consistently right on analyzing the Fed. Their conclusions often disappear sharply with those of traders, assorted non-economist skeptics, and especially the most dangerous group, those “self-taught” in Austrian economics. (I have noted that some claiming that credential have recently promoted themselves to “leading experts” in Austrian economics). Here are the conclusions from two favorite sources, obviously in tune with the market.
    • Tim Duy is the leading expert on Fed policy. If you only watch TV you are missing out. He writes as follows:

      Bottom Line: Yellen does it again – she moves the Fed both closer to and further from the first rate hike of this cycle. By moving toward the markets on the path of rate hikes, the Fed acknowledges that they are eager to let this recovery run on. Moreover, they proved that they are in fact data dependent by moving policy in the direction of the data. Overall, Yellen has managed the transition away from what the Fed came to see as excessive forward guidance just about as well as could be expected.

    • Diane Swonk is the level-headed analyst from Mesirow Financial. She writes as follows:

       

      Bottom Line: The FOMC remains clearly focused on hedging downside risk; members would rather wait and raise rates too slowly, than risk stamping out growth and having to reverse course and lower rates soon after the first increase. They also want to make sure the recovery is truly self-sustaining before removing the proverbial punch bowl. Since the party has hit a lull, the Fed wants to make sure that more of us get to the punch bowl before watering down the mix; they have also paid the band and the waitstaff to work a little longer. Our forecast for a modest increase in rates in September holds. The fed funds rate is expected to end 2015 at 0.50% but only if we see a sharp reacceleration in growth in the second and third quarters.

       

  • Household debt service hits a new low. Calculated Risk has the full story and this helpful chart:

HouseholdQ42015

 

The Bad

There was also some discouraging economic news.

  • Housing starts plunged 17% and 3.3% YoY. With weather exceptionally bad – worse than normal seasonal adjustments – it is tempting for some to use that as an excuse. Calculated Risk shows the dramatic weather effect in the table below, but Bill concludes that it is still a weak report.

  • Industrial production missed expectations, rising only 0.1%. (WSJ).

     

The Ugly

IRS scams. These are back again. Beware of fake calls wanting payment by credit card. (Yahoo Finance).

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. For more information on each source, check here.

Recent Expert Commentary on Recession Odds and Market Trends

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured “C Score.”

Doug Short: An update of the regular ECRI analysis with a good history, commentary, detailed analysis and charts. If you are still listening to the ECRI (three years after their recession call), you should be reading this carefully. Doug has the latest interviews as well as discussion. Also see Doug’s Big Four summary of key indicators.

dshort big four

 

Georg Vrba: has developed an array of interesting systems. Check out his site for the full story. We especially like his unemployment rate recession indicator, confirming that there is no recession signal. He gets a similar result from the Business Cycle Indicator (chart below). Georg continues to develop new tools for market analysis and timing, including a combination of models to do gradual shifting to and from the S&P 500. I am following his results and methods with great interest. You should, too.

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. While we feature the recession analysis, Dwaine also has a number of interesting market indicators. He recently noted an increase in his combined measure of economic stress, although the levels are still not yet worrisome. This week Dwaine has a valuation model that is much more sophisticated than the popular Shiller CAPE method. It also provides a much less worrisome conclusion, 13.7% returns through the end of 2016.

2015-03-16_1650

 

 

The Week Ahead

It will be a light week for economic data.

The “A List” includes the following:

  • Initial jobless claims (Th). The best concurrent news on employment trends, with emphasis on job losses.
  • New home sales (T). Still mired in February weather.
  • Michigan sentiment (F). A good concurrent read on employment and spending, with some leading qualities.

The “B List” includes the following:

  • Existing home sales (M) Less important than new home sales, but everything about housing remains important.
  • Durable goods (W). Volatile February data, but significant.
  • CPI (T). Inflation data is of lesser significance until we see several months at higher levels.
  • Crude oil inventories (W). Maintains recent interest and importance.
  • Q4 GDP final estimate (F). Old news.

A resumption of FedSpeak.

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

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

Insight for Traders

Felix switched to bearish mode and then back to neutral for the three-week market forecast. There is high uncertainty, reflected by the percentage of sectors in the penalty box. Our current position is still fully invested in three leading sectors, mostly because there have been good opportunities in spite of the volatility. For more information, I have posted a further description — Meet Felix and Oscar. You can sign up for Felix’s weekly ratings updates via email to etf at newarc dot com.

Those who want to test their skills should check out the hedge fund manager contest at Scutify.com and compete for over $20,000 in cash and prizes. It is plenty of fun and the risk/reward is excellent!

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Major market declines occur after business cycle peaks, sparked by severely declining earnings. Our methods are focused on limiting this risk. Start with our Tips for Individual Investors and follow the links.

We also have a new page summarizing many of the current investor fears. If you read something scary, this is a good place to do some fact checking.

My bold and contrarian prediction for 2015 – that the leading sectors would lose and the laggards would win – lagged a bit last week as utilities rebounded and interest rates fell. I also see plenty of time left in this economic and stock cycle.

Other Advice

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

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. The average investor, even if busy, should join with a weekly trip on Wednesday. Tadas always has first-rate links for investors in this special edition.

Stock Ideas

Have some stocks declined more than warranted due to the rising dollar? Barron’s mentions a number of ideas including HEDJ (recently favored by Felix) and the stocks in the table below. Read Jack Hough’s full article for full explanations and more ideas.

ON-BJ358_JackWh_D_20150320202120

 

The Alibaba lockup expires Wednesday, permitting sales from some of the buyers of the IPO. It is anyone’s guess how much buying interest there is for these shares and how much of the expected selling pressure is already reflected in the market. We did not buy the IPO because the valuation seemed to rich. After the stock ran up and then receded, we bought on the decline for those in our “high octane” program. The WSJ has a nice summary and comparisons to other recent IPO’s.

MI-CI390_ALIBAB_16U_20150317142706

 

Economic Cycle

The bull market is getting old. Jim Stack, a top Newsletter writer, is cautious, cutting stocks from 80% to 76%. (MarketWatch).

The bull market is younger than you think. (MarketWatch).

Final Thought

The popular market worries are not very convincing.

Let’s start with the Fed. Most of the current critics have been consistently wrong for many years. The predictions of Fed failure have now been moved years into the future. It is all speculation, mostly from those who did not agree with policies that have (so far) been pretty successful.

The increased volatility argument ignores history. The long-term historical volatility of the S&P 500 is 15. That corresponds to a daily change of nearly 0.9%. The frequent TV emphasis on a “triple digit move in the DOW – stay with us” means a volatility of 12. And remember that volatility is not just a measure of downside moves. A market that goes down 1% every day, up 1% every day, or alternates between the two has the same volatility – about 16.

See It Market has a good short course on volatility with explanations and good charts. Here is one example:

volatility

 

While every minor twist and turn is getting the “Fed treatment,” it really makes no sense. The market rallied on news that the Fed remains patient, whether explicitly stated or not. Investors should get ready for an extended period of time with continuing low short-term rates. This means a longer than normal business cycle.

I continue to see daily effects from the “new” carry trade, the one where the dollar is not the funding currency. I mentioned this in my 2015 preview, but it may be time for a more complete discussion.

Weighing the Week Ahead: Help for the Economy from Housing?

The economic calendar includes much more housing data than we normally see in a single week. With Fed Chair Yellen’s Congressional testimony and the GDP revisions also on tap, I expect many observers to be linking these topics. They will ask:

Is it finally time for a housing rebound?

Prior Theme Recap

In last week’s WTWA I predicted that the punditry would focus on the new record in stocks, and especially on whether energy stocks would support the breakout. Those were indeed two major themes all week and they were frequently linked, so the question was accurate. Mostly the answer was rather negative. The stock rally continued, but without help from most of the energy sector.

Feel free to join in my exercise in thinking about the upcoming theme. We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead.

This Week’s Theme

The quirks of the calendar include some of the major economic reports on housing – new sales, existing sales, and pending sales – along with Case-Shiller and FHFA pricing and the mortgage index. There is a lot of fresh information.

We will see the second estimate of Q4 GDP, with many wondering about the role of a possible housing rebound. Janet Yellen will testify before two Congressional committees, elaborating on current Fed thinking. And finally, the remaining earnings reports feature some of the major companies associated with home construction.

The confluence of these factors will spark the question: Can Housing Finally Contribute to the Economic Rebound?

The Viewpoints

There is a wide range of opinion on housing:

  • Fundamental weakness. Some major opinion leaders, including Jeff Gundlach, Laurence Fink, and Sam Zell note the changing demographics and issues in supporting the mortgage market. (This article is from last year, but lays out the reasoning effectively).
  • Miscellaneous bearish factors. CNBC’s Diana Olick covers the housing beat and always seems to find a threat to the rebound. A look at her blog’s index page shows stories about the trickle down of high rents to small cities, expected weakness in Houston from falling oil prices, lack of impact from more jobs, higher mortgage rates, negative effects of a strong dollar, and similar stories.
  • The long bottom. Calculated Risk has been the leading exponent of this view. The data show that some of the new construction represents owner-built starts and homes intended for rent. Bill recommends consideration of this chart:

StartsQ42014

  • Positive developments. Jonathan Golub of RBC notes that household formation is booming:

jonathan-golub-rbc-capital-markets

As always, I have some additional ideas in today’s conclusion. But first, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading the background information.

Last Week’s Data

Each week I break down events into good and bad. Often there is “ugly” and on rare occasion something really good. My working definition of “good” has two components:

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially – no politics.
  2. It is better than expectations.

The Good

There was some good news last week.

  • Progress in Greece. After a slow start to the week, including a German spokesman calling the Greek proposal a “Trojan Horse,” there was finally a firm agreement — to delay for four months. As I noted last week, this type of negotiated solution is actually quite typical. Each side does as little as possible. There is an opportunity for face-saving. The worst crisis outcome is averted. Markets seemed less worried about Greece than three years ago, and celebrated the Friday agreement.
  • Weekly jobless claims dipped. Back below 300K. Calculated Risk analyzes and charts the significance.

WeeklyClaimsFeb192015

 

  • Port deal reached. This news broke on Saturday, so it is not reflected in Friday’s closing prices. As I have noted in recent weeks, the Longshoreman slowdown and the accompanying lockout were threatening a major economic disruption. It will still take weeks to resume normal shipping, but this is very good news.

The Bad

There was only a little bad news.

  • Ukraine cease fire breaks down. This is a continuing human tragedy and a major drag on the world economy.
  • Earnings reports have weakened a bit. There are still 75% of reporting S&P companies beating on earnings and 58% on sales. (FactSet). The blended growth rate is 3.5% as calculated there or about 7% if you take out energy. Brian Gilmartin notes that Apple contributed half of the ex-energy earnings growth and warns against arbitrarily excluding stocks and sectors. You need a good reason!
  • Housing starts and building permits disappointed slightly.

The Ugly

The Fed is worried about a rush for the exit in bond funds. Bloomberg’s Matt Boesler tweeted about a passage in the Fed minutes. (Full story from Myles Udland of BI).

…because investors are using mutual funds to invest in bonds, instead of owning the bonds, there could be a problem if investors all want to leave at the same time.

When you own a bond mutual fund, you don’t actually own a bond which will continue to pay a coupon so long as the issuer isn’t in default, you just own a share of the fund, which is comprised of lots of bonds and sometimes other things.

Also, a bond fund is only going to have so much cash on hand, so if the investors in a certain fund all want to redeem their shares of the fund at the same time, it will pose problems for the fund manager trying to meet redemption requests. Most likely, the manager will be forced to sell some bonds, potentially at a discount, as the fund needs to simply raise cash to meet redemptions.

And ace Fed watcher Tim Duy emphasizes the determination to raise rates.

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts.  Think of The Lone Ranger. No award this week, but nominations are welcome. I am seeing plenty of bad charts, but little refutation.

On a related theme, could someone explain why PBS continues to feature the guy who called for Dow 5K before 20K, instead of someone who did the opposite? Do they have an interest in the investment success of their viewers? Can anyone find any such items?

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. For more information on each source, check here.

Recent Expert Commentary on Recession Odds and Market Trends

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured “C Score.”

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. While we feature the recession analysis, Dwaine also has a number of interesting market indicators. This week he notes an increase in his combined measure of economic stress, although the levels are still not yet worrisome.

2015-02-18_10501

 

Doug Short: An update of the regular ECRI analysis with a good history, commentary, detailed analysis and charts. If you are still listening to the ECRI (three years after their recession call), you should be reading this carefully. Doug has the latest interviews as well as discussion. Also see Doug’s Big Four summary of key indicators.

Georg Vrba: has developed an array of interesting systems. Check out his site for the full story. We especially like his unemployment rate recession indicator, confirming that there is no recession signal. Georg continues to develop new tools for market analysis and timing. Some investors will be interested in his recommendations for dynamic asset allocation of Vanguard funds and TIAA-CREF asset allocation. He has added a method for Vanguard Dividend Growth Funds. I am following his results and methods with great interest. You should, too.

 

The Week Ahead

It is a normal week for economic data.

The “A List” includes the following:

  • Initial jobless claims (Th). The best concurrent news on employment trends, with emphasis on job losses.
  • New home sales (W). Time for a rebound?
  • Consumer confidence (T). Conference Board version correlates with economic spending and employment.
  • Michigan sentiment (F). Same concepts as Conference Board, but using a panel design.

The “B List” includes the following:

  • Existing home sales (M). Less important for the economy than new construction, but still significant.
  • Durable goods (Th). Continuing weakness in volatile series?
  • CPI (Th). Inflation is still not important in these ranges, but always watched closely.
  • GDP (F). The second estimate. Backward looking but still noteworthy.
  • Chicago PMI (F). Gets extra attention when occurring right before a weekend. Best regional report for predicting the ISM index.
  • Crude oil inventories (W). Maintains recent interest and importance.

There is plenty of FedSpeak, featuring Chair Yellen’s “Humphrey Hawkins” testimony before a Senate Committee on Tuesday. The House gets a chance to question her on Wednesday. There are at least four other appearances by Fed Presidents on Thursday and Friday.

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

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

Insight for Traders

Felix has continued a “bullish” posture for the three-week market forecast. The data have improved a bit, but are only slight better than the recent neutral readings. There is still plenty of uncertainty reflected by the high percentage of sectors in the penalty box. Our current position is still fully invested in three leading sectors, and we have gotten more aggressive. For more information, I have posted a further description — Meet Felix and Oscar. You can sign up for Felix’s weekly ratings updates via email to etf at newarc dot com.

As I have noted for six weeks, Felix continues to feature selected energy holdings. Felix is not just a momentum trader!

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Major market declines occur after business cycle peaks, sparked by severely declining earnings. Our methods are focused on limiting this risk. Start with our Tips for Individual Investors and follow the links.

We also have a new page summarizing many of the current investor fears. If you read something scary, this is a good place to do some fact checking.

My bold and contrarian prediction for 2015 – that the leading sectors would lose and the laggards would win – looked a lot better over the last two weeks. If I am correct, there is a very, very long way to run for the cheapest market sectors – energy, technology, cyclicals, and financials.

Other Advice

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

Personal Finance

Abnormal Returns continues to focus on personal finance in the Wednesday links. Read them all, but I especially like Morgan Housel on risk and David Merkel on why investors underperform stock averages.

Stock and Sector Ideas

Warren Buffett cuts back on big oil. Others debate his wisdom. (Barrons)

Five reasons not to expect a big rebound in oil prices. (Tim Mullaney at MarketWatch).

The place for bonds, even when rates are rising. Mark Hulbert shows how intermediate bonds can show gains even when rates are rising sharply. The basic idea is to keep the maturity short and reinvest as rates move higher. (This is the concept we follow in our bond ladder). Bonds are also essential for those who need to reduce the volatility of a pure stock portfolio.

Cam Hui suggests that it might be time to buy Greece. His article was published the day before the announcement, but is well worth reading, especially for those who like some technical support for fundamental ideas.

A longer term chart of the Athens General Index and the US Greek ETF GREK also tells a similar story. Greek stocks look washed out, especially when they don’t react negatively to bad news.

 

ATG vs GREK

Health insurance companies that support Medicare Advantage are benefiting from the influx of “younger seniors.” (Wedbush via Barrons). I enjoyed some of these names last year, but sold on a valuation basis as new highs were reached. Time to revisit the price targets?

Market Outlook

Robert Shiller may be reducing his holdings of US stocks. Media questioners always try to get him to predict an imminent crash. Market bears use his CAPE ratio as the foundation for demonstrating an over-valued market. Most people would be surprised to learn that he continues to hold over 50% stocks, an aggressive allocation given his age. He has also recently been noting risks in bonds.

Morgan Stanley sees another 1000 points in the S&P 500 as foreign investors join the party.

Final Thought
Most economic recoveries have help from the housing sector. Part of the reason for below-trend growth has been the continuing missing elements. We have had drags from government spending (especially local), business investment, weather, and housing. Gene Epstein takes note of this as follows:

The U.S. economy is in the benign grip of a virtuous circle, with key positive factors reinforcing one another, all of them lubricated by low energy prices. Employment gains are driving up wages and salaries, which are driving consumer spending, which is encouraging capital investment, which is in turn motivating business to hire.

So far, however, the housing market has been barely participating in that virtuous circle. Monthly housing starts have been running at an annual rate of only a little over a million, nothing like the 1.5 million that could be seen if household formation begins catching up with the increase in the population.

Household formation could heat up by 2016 as labor markets become tighter. Then growth of 4% could finally become a reality.

He has a good point. I expect a final surge in economic growth during this business cycle, and it might take two or more years to play out.