Stock Exchange: How to Use Backtests Effectively


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

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

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


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

Let’s turn to this week’s ideas.

This Week— *crickets*

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

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

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

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

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

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

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

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

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

V:  If only it were that easy.

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

V: I see it all of the time.

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

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

J:  How would you answer?

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

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

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

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

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

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

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

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

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

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

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

V: Any time!


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

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

Background on the Stock Exchange

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

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


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

Getting Updates

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

2016 in Review: Best of the Silver Bullet Awards Part One

Since the earliest days of A Dash of Insight, Jeff has brought attention to journalists and bloggers who dispel myths in financial media. We congratulate these writers with the Silver Bullet Award – named in honor of the Lone Ranger, who lived by a strict code: “…that all things change but truth, and that truth alone, lives on forever.”

In a year rife with misinformation and disinformation, it is fitting that we gave out a record 23 Silver Bullet Awards in 2016. For that reason, we’ll be doing this year in two parts; our winners for the first half of the year are summarized below. Readers may also want to check into our 20132014, and 2015 compilations, as many of the same issues persist to this day.

Have any thoughts or predictions on what will dominate news cycles in 2017? Know of a great analyst flying below our radar? Feel free to post in the comments with any suggestions or nominations.


It didn’t take long to find our first Silver Bullet winner of 2016. Matt Busigin took on US Recession Callers ahead of the ISM data release:

Through a combination of quackery, charlatanism, and inadequate utilisation of mathematics, callers for US recession in 2016 are embarrassing themselves. Again.

The most prominent reason for recession calling may well be the Institute of Supply Management’s Manufacturing Purchasing Manager Index. The problem with this recession forecasting methodology is that it doesn’t work.

As we now know, the US economy did not slip into a recession in 2016 – lending further credence to Busigin’s critique of these methods.


Paul Hickey of Bespoke Investment earned the second Silver Bullet award of 2016. While others were content to see doom and gloom in the level of margin debt on the NYSE, Hickey dismissed this as a minor concern.

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.”


The causation-correlation fallacy is a favorite of ours on A Dash. Robert Novy-Marx distinguished himself with an excellent paper titled “Predicting anomaly performance with politics, the weather, global warming, sunspots, and the stars.”

“This paper shows that several interesting variables appear to have power predicting the performance of some of the best known anomalies. Standard predictive regressions fail to reject the hypothesis that the party of the US President, the weather in Manhattan, global warming, El Niño, sunspots, or the conjunctions of the planets are significantly related to anomaly performance. These results are striking and surprising. In fact, some readers might be inclined to reject some of this paper’s conclusions solely on the grounds of plausibility.”

We often note how bloggers and media search back to find tedious explanations and tie a day together. For more reading, we recommend our old post “The Costly Craving for Explanations.”


“Davidson,” by way of Todd Sullivan, was recognized for writing on the confusion of nominal and real data on Retain and Food Service Sales. His key takeaway:

Retail and Food Service Sales are at the highest levels ever measured and trending higher. Would you believe that today’s pace is more than 35% higher than our last recovery. Comments in the media would lead you to believe otherwise. Perhaps you have heard a number of recession forecasts. I have heard at least a dozen well known investors say a recession will occur before this year is out. My view differs considerably and remains very positive.


Jacob Wolinsky found it suspicious that Harry Dent was predicting the next big crash – and happened to have just the product to help investors cope. This “Rounded Top” chart had started to make its way across the panicky world of financial media:

The whole of Wolinsky’s article is still worth a read (especially given its twist ending).


The economic impact of lower oil prices in early 2016 was surprising to many observers. We recognized Professor Tim Duy for his research on the economic impact of lower oil prices.

This problem, however, just scratches the surface. Look at either of the first two charts above and two red flags should leap off the screen. The first is the different scales, often used to overemphasize the strength of a correlation. The second is the short time span, often used to disguise the lack of any real long term relationship (I hope I remember these two points the next time I am inclined to post such a chart).

Consider a time span that encompassed the entirety of the 5-year, 5-year forward inflation expectations:


If we spent a little time looking for the newest conspiracy theory about the Federal Reserve, we could probably give out the Silver Bullet every week. Ethan Harris of Bank of America Merril Lynch (via Business Insider) got this week’s award for shutting down a new “theory” about central banks and the dollar.

“There is a much simpler explanation for all of this. Central banks have turned more dovish because they are being hurt by common shocks: slower global growth and a risk-off trade in global capital markets,” he argued.

“Hence it is in the individual interest of the ECB to stimulate credit and bank lending, the BOJ to push interest rates into negative territory and the Fed to move more cautiously in hiking rates,” he continued.

Some may also point out that there’s a gap between Yellen’s recent messages and some of the recent speeches from FOMC members.

But Harris has thoughts on this, too:

  1. Yellen has consistently leaned more dovish than others.
  2. Most of those more hawkish speeches were from nonvoting members.


The mythology surrounding the Fed bled over into the next week as well. We gave Steven Saville a Silver Bullet award for targeting ZeroHedge with this very thorough rebuttal:

A post at ZeroHedge (ZH) on 8th April discusses an 11th April Fed meeting as if it were an important and unusual event. According to the ZH post:

With everyone’s focus sharply attuned on anything to do with the Fed’s rate hike policy, many will probably wonder why yesterday the Fed announced that this coming Monday, April 11, the Fed will hold a closed meeting “under expedited procedures” during which the Board of Governors will review and determine advance and discount rates charged by the Fed banks.

As a reminder, the last time the Fed held such a meeting was on November 21, less than a month before it launched its first rate hike in years.

As explained at the TSI Blog last November in response to a similar ZH post, these “expedited, closed” Fed meetings happen with monotonous regularity. For example, there were 5 in March, 4 in February and 5 in January. Furthermore, ZH’s statement that 21 November was the last time the Fed held such a meeting to “review and determine advance and discount rates charged by the Fed banks” is an outright falsehood. The fact is that a meeting for this purpose happens at least once per month. For example, there were 2 such meetings in March and 1 in February.


During the economic recovery following the Great Recession, critics often argued that net job creation emphasized part-time and low-paying jobs. Jeffry Bartash of MarketWatch thought to look at the data, and concluded the US economy is still creating well-paid jobs. The key takeaway is in the following chart:


Breaking down mean averages can produce some strange results, and you can never be sure how financial bloggers might spin that data. We gave a Silver Bullet award to Jeff Reeves for breaking down this baffling valuation of Tesla.

$620,000 for every car it delivered last year, or $63,000 for every car it hopes to produce in 2020.

By comparison, General Motors Co’s (GM.N) $48 billion market value is equivalent to about $4,800 for every vehicle it sold last year.

Reeves’ full article, still available on MarketWatch, is still very smart and very readable.


The “flattening” yield curve had become the newest scare issue by late May. Barron’s Gene Epstein and Bonddad’s New Deal Democrat both took this to task, with satisfying results. In particular, the latter’s article had a solid mix of compelling charts with snappy writing:

In the last week or so there have been a spate of articles – from the usual Doomer sources but also from some semi-respectable sites like Business Insider vans an investment adviser or two ,see here (… ) – to the effect that the yield curve is flattening and OMG RECESSION!!! Here’s a typical Doomer graph – that draws a trend line that ignores the 1970s and neglects to mention that 2 of the 4 inversions even within the time specified don’t fit:


We gave this week’s award to the former President of the Minneapolis Fed, Narayana Kocherlakota. As conspiracy theories persisted, he explained the nature of Fed meetings and their timing:

Timing alone, though, hardly merits so much attention. To understand why, consider two possible scenarios. In one, the Fed starts raising rates in June and then adds another quarter percentage point at every second policy-making meeting (once every three months) for the next three years. In the other, the Fed waits until the second half of 2017 and then adds a quarter percentage point at each of the next 12 meetings. The second path represents slightly easier monetary policy, but most economic models would suggest that there would be almost no difference in the effect on employment or inflation.


New Deal Democrat earned a second Silver Bullet award for his work debunking a notoriously deceptive chart:

“The problem with this graph is that includes two slightly to significantly lagging indicators.  Your employer doesn’t start paying withholding taxes until after you are hired.  State tax receipts aren’t paid until a month or a quarter after the spending or other taxable event has occurred.  Worse, since both have seasonality, both have to be measured on a YoY basis, which means the turn in the data will come after the actual turn in the economy.”

Conclusion – Part One

As always, you can feel free to contact us with recommendations for future Silver Bullet prize winners at any time. Whenever someone takes interest in defending a thankless but essential cause, we hope you’ll find them here. Expect to see Part Two of our Silver Bullet review later on in the week. Happy New Year!

Applying The Lessons From 2015

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Everyone needs a specific and personal plan.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Ed Hyman reaches a similar conclusion.

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

GBM — Where are the upside risks today?

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

It includes plenty of good charts like the one below:

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

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

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

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

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

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

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

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

GBM — Any final thoughts?

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

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

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

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

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

US Stocks Decline: Time to Sell?

Whenever markets pull back for a few days, fear sets in. You see plenty of stories about how to protect your portfolio, what stocks will fare the best in a decline, and a parade of pundits explaining what is going wrong.

In an election year, it is even worse.

If you are in the market, what should you do? It depends…..

Are you a trader or an investor?

Barry Ritholtz has a great article on this theme, emphasizing the importance of time frame and having discipline geared to your objectives. He includes a number of specific and helpful rules.

Readers of "A Dash" know that I endorse this distinction, making it carefully in my weekly WTWA articles. Despite this, and just as Barry mentions, people wonder why my recommendations may diverge from my market commentary. Since I am managing five different investment programs, geared to different investor needs, the right move depends upon the program objective and the time frame.

As Barry notes, investors should not try to "play the squiggles" based upon their preferred concept of long-term valuation. This is consistent with my recent article showing that none of the big-time pundits is very good at market timing, if you look at actual results.

Traders versus Investors

There are sharp distinctions right now, with differing conclusions. Here are some of the key topics:

The Fed and QE 3

Steve Liesman today offered this analogy. Suppose your doctor gave you a clean bill of health. Alternatively, suppose your doctor said that you were really sick, but he had a prescription for you. Which would you prefer?

For traders, the analogy breaks down because they are all smarter than the Fed. They know that the economy is in dire shape whether the Fed realizes it or not. For them it is all about more QE, since they have become convinced that central bank money printing flows directly into stocks. It is a simple focus on Fed policy.

Investors do better to stick with traditional economic policy and forecasts.

The Natural State of the Economy

Traders seem to believe that the normal state of the economy is recession and this will occur as soon as government stimulus programs end, the "sugar high" wears off, or the "training wheels are removed."

Investors should realize that the normal state of the US economy is is trend growth of about 3%. In the absence of any policy, that is where we will eventually wind up. Specific policy actions may make it happen sooner or later. Right now there is a huge performance gap, as illustrated by Scott Grannis:

Real GDP vs 3% trend

Until the gap is closed, things will seem very negative.

How to React to Selling

Traders need to game the system, anticipating how other hot money players will react and beating them to the punch. This can imply trading styles that either anticipate market tops or react quickly when they seem to occur.

Investors should see short-term selling as an opportunity to establish positions at favorable prices. This is a fundamental lesson from the Buffett school — use your own valuation, not the current market price.

Interpreting Sentiment Indicators

Traders are intensely focused on sentiment, trying to identify "dumb money" (everyone other than them!) and take the opposite side.

Investors seeking to establish new positions hope to find periods of irrational sentiment.

Calendar Effects

Traders are in love with cycles and the calendar. They have scenarios and retracements and sometimes even astrology. If something has worked for the last year or two, it is expected to happen again unless there is evidence to the contrary.

Investors make decisions on fundamental values. The perceived seasonal effects merely provide opportunities to establish new positions or lighten up on those that require rebalancing or selling.


The mistakes come when traders and investors get confused about their roles.

Traders should reduce positions in recognition of the message of the current tape. I agree. In trading accounts we are not guessing exactly how deep a correction might be. Instead we watch the evidence. Some traders may get impatient to "call a bottom" in a normal market correction.

For investors it is quite different. Many have been frustrated for months by a market that moved relentlessly higher, providing no obvious points of entry. Now that there is some selling, these same investors may be unable to pull the trigger for fresh buys.

In our investment accounts we have been waiting to add to positions and we have a shopping list. There are many candidates. Since we think that the short term perspective is wrong on Europe and the economy, we have been buying positions in energy stocks, strong cyclicals like Caterpillar (CAT), leading technology like Oracle (ORCL), and US banks poised to exploit selling by European banks — JP Morgan Chase (JPM). We also see Aflac (AFL) as a nice back door play in Europe — good earnings, great business, good dividend, but some holdings of European bonds. This is safer than buying Europe since there is less downside, and yet plenty of upside.


Understanding your objectives and time frame is essential to market success. We often have completely different postures for our investment and trading programs.

If you do not distinguish between trading and investing, it is easy to get caught in a Twilight Zone where you are always doing the wrong thing!


Big Market Worries: Profit Margins

Often there is a persuasive argument, apparently supported by data, that can be misleading for the long-term investor.  Sometimes this relates simply to facts, but it can also involve analysis.  Such is the case with what you see about profit margins.

The basic thesis is that profit margins are mean reverting.  If any company gets an excessive margin, competition will arise and bring the profits to a more normal level.    This is a persuasive argument, consistent with how we expect capitalistic economies to work.

Let us suppose that we agree that profit margins will return to long-term norms.  (Good here!)

What are the implications?

The Bearish Viewpoint

Those with a bearish perspective take current revenues and do what they refer to as "normalizing" to chop the earnings down to lower levels.  If you reduce S&P 500 earnings by 30% or so, you can easily conclude that most stocks (and the market as a whole) is richly valued.

I do not want to give this viewpoint short shrift, but it gets a lot of visibility, and the basic contention is simple.

The Bullish Viewpoint

First Trust's Brian Wesbury raises a sharply contrasting argument:

Yes, the Fed is loose and is holding interest rates down artificially. But even if we assume more normal interest rates and stable profits (with implies declining margins), stocks are very cheap. Cheap enough in our view to take us to 14,500 on the Dow and 1475 on the S&P 500 by year end 2012.

Using a capitalized-profits approach, we divide corporate profits by the current 10-year Treasury yield of 2% and then compare the current level of this index from each quarter for the past 60 years. Hold on to your hats…this method estimates a fair-value for the Dow at 46,000. But, this extremely bullish result is largely due to artificially low interest rates. Current levels on inflation are above the 10-year Treasury yield and we believe that once the Fed normalizes its policy stance interest rates will climb to much higher levels.

If we use a more realistic discount rate of 5% for the 10-year Treasury, we get a fair value of 18,800 on the Dow and 1,975 for the S&P 500.

Another potential problem is that profits have been an unusually large share of GDP – currently almost 13%.   If profits revert to a historical norm of about 9.5% of GDP at the same time the 10-year Treasury yield is 5%, fair value would be 13,900 for the Dow and 1460 for the S&P 500. Just to be clear, that would be in a world where profits fall roughly 25% and interest rates more than double from their current levels. In other words, this doesn’t look like a dead cat bounce to us.

Our Conclusion

Let's face it.  The argument about mean reversion in profits is several years old.  Profits keep rising and margins have held up pretty well, mostly because companies have been slow to bring back employees. The P/E multiple declines, partly because the world is full of skeptics about future profits.

The leading advocate of profit mean reversion is Vitaliy N. Katsenelson.  I did a favorable review of his excellent book, which has excellent advice on stock picking.  A  book about a sideways market is a coup on many fronts, and I enjoyed reading it.

Unfortunately, many investors are convinced from these arguments that profits are about to decline.  This conclusion is not supported by the data.

High profit margins came when companies held down costs and new hiring.  If the margins fall, it implies that new workers have been added.  That is the basis for additional costs.  This means that employment, GDP, and tax revenue are all moving higher.

Briefly put –  Those who look at mean reversion in profits alone, without any attention to changes in employment, are guilty of an inconsistent forecast.

I have a simple challenge for those forecasting a mean reversion in profits:  Do you really expect the overall S&P earnings forecast to move lower?

If not, why should we care about profit margins?

Positioning for 2012: Don’t forget about stocks

For the last three years I have participated in a special interview series at Seeking Alpha.  Jonathan Liss comes up with questions that suit both the times and reader interest.  I think that readers of "A Dash" may find the discussion to be interesting, and may wish to add some comments or questions of their own.

The interview was originally published here a few days ago, and the link to the series, with many fine contributions, is here.

Jeff Miller Positions For 2012: Biggest Mistake Investors Can Make Right Now Is Underweighting Stocks

Seeking Alpha (SA): Jeff, how would you generally describe your investing style/philosophy?

Jeff Miller (JM): Hi Jonathan. Thanks for inviting me to participate again this year. The Seeking Alpha year-end program brings out a nice range of expert opinion. You have sharp questions and a good format. I enjoy reading the interviews, and I am sure that many others do as well.

Our investment style emphasizes active management, a focus on risk, and attention to each client. That has been especially challenging over the past year. Many people do not want to worry about 350-point swings in the Dow. They need yield with less volatility. The Fed policy has taken away those choices, so we need to be a little more creative.

Rather than emphasizing a specific investment style, I interview each potential client and then create a blend of our five programs – something that meets the risk/reward needs of each.

With that background in mind, I would say that I am focused on data and objective indicators. I am resistant to hype and headlines. I am contrarian – finding opportunity where others see none. On a long-term basis I am optimistic about the US, the economy, and stocks. On a short-term basis I am cautious.

SA: Within equities, are there any particular sectors or themes you are currently overweight or underweight? If so, why?

JM: I am overweight technology and cyclical stocks. The economic indicators that have passed my stringent tests are more optimistic than the general sentiment. Many media commentaries still highlight people who “called 2008” no matter how early. At some point these pundits will be “one hit wonders” in the same way traders view Elaine Garzarelli and her forecast of the 1987 crash. Meanwhile, many of these sources have been dour and wrong since 2008.

Economic growth has been modest, but it has been just fine for the profitability of the major industrial firms. The trend is favorable. I like Caterpillar (CAT) and Illinois Tool Works (ITW) among others.

The technology play is excellent with economic expansion, but still works if economic growth proves to be more moderate. Many technology names are at historic low valuations on a P/E basis. Why? The story has not worked recently, and investors are like jilted lovers. Microsoft (MSFT) is an obvious example, but I also like Intel (INTC), Oracle (ORCL), and Apple (AAPL).

SA: Do you ever buy funds to gain access to asset classes or themes, or do you stick to single stocks exclusively? What are the advantages of your approach?

JM: We do not use mutual funds, but we are very active in ETFs. Two of our five programs trade via ETFs, and we have a free weekly newsletter with ETF ratings. The trading method asks the following question: What ETF will be best over the next three weeks? We have two “experts” on this subject – Oscar and Felix. You can guess their risk/reward outlook!

We also have a Dynamic Asset Allocation approach (DAA). For this model we ask: What ETF will be the best over the next year?

Please note that we do not have a holding period of three weeks in the first case nor 12 months in the second. Nonetheless, we ask these questions every day.

This gives us 20 or so trades in DAA every year and many more for Felix and Oscar.

Right now, the DAA approach is very conservative. By the nature of the method it will be slow in capturing a rebound. Essentially, it reduces volatility and gets you on the right side of big moves.

Felix and Oscar were fully invested for the year-end rally. (This could easily change by the time of publication).

To summarize, ETFs are a very important part of our trading and we have major positions for clients. It all depends on which of our programs is right for them.

SA: Speaking of ETFs, which asset classes are you overweight? Which are you underweight? Why?

JM: We have to start with the definition of an “asset class.” There is a dangerous pitch out there, reflected in current advertising. The idea is that all of the traditional asset classes – stocks, bonds, and real estate – are over-valued. The refuge first was gold. Now I see ads encouraging people to speculate in foreign exchange. Encouraging people to do active trading based upon their “market feel” is a prescription for disaster.

My scientific, model-driven approaches sometimes recommend oil and gold, but I do not have a good method to evaluate these choices on the fundamentals. The average investor should not confuse trading with investing.

SA: Can you elaborate on what you mean by “scientific, model-driven approaches” to allow readers a better understanding of what we’re talking about here exactly?

JM: Good question! I engage several model developers with different approaches. I test these carefully. You might think of it as my own version of a “stress test.”

The DAA model follows principles that have been accepted in the finance literature for decades. It is a yearly momentum model, but including some helpful tweaks. When it is applied to our universe we minimize the chance of excessive correlation. This method gets you on the right side of long-term trends. In 2008, for example, the DAA approach would have led you first to gold and bonds and later to the inverse index ETFs. This cushioned the downside, but it would have been very slow in capturing the rebound.

Felix combines momentum, a sense of the cycle, and the element of uncertainty. Felix does not call tops and bottoms, but he does get on the right side of fresh moves. If there is a big trend, Felix will participate. If the market is declining, Felix will get into the inverse ETFs — essentially going short.

No system is perfect, and our methods do not call tops and bottoms. There is always a delay for recognition of a new trend. It depends on the time frame.

SA: Name one investment that exceeded your expectations in 2011, and one you had high hopes for that didn't pan out. Do you see any particular investment surprising investors over the next year?

JM: Our biggest winners were Apple and some of the energy and healthcare names. We are very good at forecasting economic and earnings fundamentals, but we do not try to time market sentiment.

That was the wild card. Beginning with the Japanese earthquake, then moving to the silly debate over the debt limit, and finally fixating on the European saga, there has been a continuing reason to ignore data about what is actually taking place. This meant that the most important story of the year – fantastic earnings growth – has been given short shrift.

While we had some nice winners, we expect much better next year.

The negative side included two groups:

  • Anything in the financial sector was bad. Even though we were underweight and sticking to the top names, there was no correct time to buy. I still like JP Morgan (JPM), the best of the breed (U.S. major financial). The market seems to think they have European exposure, despite explanations to the contrary. It is a favorite scare ploy to use nominal derivative totals instead of net. In the case of JPM, they also do not define “net” using different institutions. It is a “pure” version of determining net exposure. It is a favorite stock for a rebound this year.
  • The other negative was the medical device makers. I really got this one wrong. (Our health insurance holdings did fine). We have chosen two device stocks (ResMed (RMD) and Stryker (SYK)) that actually save money by reducing related costs. The earnings growth has been solid. Despite this, the stocks moved lower. The political uncertainty over ObamaCare has had a big impact.

SA: Some describe the current era as “The Great Deleveraging.” Do you agree/disagree, and does this macro consideration affect your investment planning process?

JM: One of the worst things that happened in 2011 was the excessive focus on debt. The argument is seductive for most. We all try to equate government problems with our personal family experience. When the economy is bad, deficits rise. There is a “debate” about this in a highly-charged political environment.

I have simple advice for the average investor:

  • First, ignore the politics unless you are in the voting booth!
  • Second, understand that every macro-economic model sees short-term stimulus as favorable. Put aside your ideology. It is market-friendly.
  • Third, every leader of whatever party has supported stimulus when they are in office.

If we get better economic performance, deficits will be lower. There will still be a structural deficit. But it will be more manageable.

SA: 2010-11 saw a notable rush for the exits from equities and equity vehicles. Is this a cyclical, or secular shift? What would it take to bring them back?

JM: The individual investor will return to equities far too late – long after most of the obvious problems have been solved. That would be when the Dow is at 20K, possibly overvalued, and risk is high. The story has been repeated many times.

Understanding this recurring phenomenon offers both the biggest reward and the biggest challenge for the average investor. I have tried to meet this challenge by providing a blend of programs that provides participation in the upside while limiting risk. It is not easy.

SA: Do you believe gold is a genuine hedge in uncertain markets? If so, how much exposure to it or other precious metals do you have? If not, where are you turning for potential downside diversification?

JM: Gold has a strange character. There is no way to determine a fundamental value. It is a safe haven in a time of disaster (deflation, depression, riots….) and it will have value if there is hyperinflation.

Our programs have invested in gold and gold miners during the past year, and probably will do so again next year. We have been out of gold for a month or so for all accounts.

Since I expect neither disaster nor hyperinflation next year, I do not recommend gold for long-term individual investors. It has been approved as a 5% (or so) holding for many years – but not right now.

Global markets

SA: Global Macro considerations dominated the headlines in 2011. Do you see 2012 unfolding differently? If so, how?

JM: This is definitely the key question. The selection of individual sectors and stocks has been secondary for three years. I expect the European story to be resolved in a few months. Meanwhile, if the US economy improves enough, that will also change the focus.

SA: Will Eurozone contagion continue to drive the market’s direction, and how are you protecting client assets from potential fallout there?

JM: I’ll go out on a limb. I think that by mid-year in 2012 we will no longer have the Europe fixation. I have a series of articles explaining my reasoning.

I think that the market reflects a high degree of pessimism. You can protect assets by reducing position sizes, which I have done. Buying puts is too expensive. You could do some more complicated put strategies, but something like a “put diagonal” is not suitable for most investors.

SA: Do you buy into the argument that European equities are actually undervalued right now?

JM: One of my pet peeves is people who answer questions when they basically do not know. I have an honest answer. While I study the European situation carefully, I am not considering specific stocks there. There are many US companies that are undervalued because of Europe. I can get plenty of octane with much less risk buying JPM and CAT.

SA: How much exposure to emerging markets do you have both in terms of stocks and bonds? Are China, India or other major EMs better positioned to withstand a serious global economic downturn than the U.S.?

JM: Most people are surprised to learn that the US has actually fared better in recent years. It is possible to get a solid amount of foreign exposure via big US firms like CAT, MSFT, and ORCL (a recent disappointment, but still a great growth story).

SA: Let's move on to another potential event on investor minds: The Iran nuke situation and a potential Israeli, U.S. or global attack. How serious would such an event be to oil prices and subsequently, the global economy/exchanges? Is this something you're positioning for and if so, how?

JM: Great question! This is one of the big wild cards for 2012. Most people are bearish on energy because it fits the pessimistic view of the world. Many energy companies are extremely cheap on a P/E or cash flow basis. Owning some energy stocks will help if oil prices spike. I like Noble Energy (NE) among the drillers and Chevron (CVX) among the large integrated plays. There are many good choices in this sector.

U.S. Market

SA: We are coming up on an election year. Will this be good or bad for markets? Are you positioning for different potential outcomes?

JM: Elections, political events, and the impact on stocks really hit my sweet spot. As a former public policy professor at a top university, I have studied the political side for decades. Since 1987, I have been a player on the financial side. It is so tempting!

I would love to make a prediction, but it is too soon. My team is working on a generic Obama portfolio as well as a generic GOP portfolio. I will expand on this as soon as we learn more.

This is a typical area where people try to stake out positions too soon, with little information.

SA: Is the U.S. housing market still an issue, or not so much anymore? Will prices continue to fall? Do you have exposure to either REITs or residential real estate in client portfolios?

JM: I have no position at the moment, although our short-term models have been indicating good trades (three-week horizon) in these sectors. When the time comes, this will be one of our major profit sources. I am willing to miss the first part of the rebound in favor of more certainty.

Bonds/Fixed Income

SA: Where do you see Treasury yields in 12 months? Are Treasuries worth buying at current (low) yields? For clients requiring income, where have you been turning in this low yield environment?

JM: This has been a great success story, but the end is near. I have two approaches for yield.

First, for clients that only need to preserve wealth (Congratulations!), I construct bond ladders. These include only investment grade bonds with a limit of seven years on maturity. If rates rise, we’ll be able to take advantage. If you have already achieved what you need, keep risk at a minimum!

For most clients I am using enhanced yield – a good dividend stock plus the sale of a call option. I do this with Abbot Labs (ABT), Johnson and Johnson (JNJ), as well as solid tech stocks like Intel (INTC) and Microsoft (MSFT). The combination of yield plus call premium is almost 10% per year after fees. This is working because of low stock prices and high volatility. It might not work in another year, but for the moment, let us take what the market is giving us!

This is a great method as long as you pick stocks that will hold value and monitor them carefully.

SA: What is the ideal asset allocation for someone with a long-term horizon (greater than a decade) and no need to touch their investments? Can investors continue to rely on stocks after the 'lost decade' we just experienced?

JM: I appreciate your desire to quantify this, but I am struggling since it is so far from my individual approach.

Let me try it a different way.

The single biggest mistake of the individual investor – right now – is underweighting stocks. This happens for several reasons:

Fear sells – in politics, advertising, and page views.

Individual investors always react to highly-publicized events because they do not understand how to determine what is already “in the market.”

It is a mistake to be “all-in” or “all-out.” This is not poker. Most people will never attain their investment goals if they do not have a rational strategy for when and how to buy stocks.

People underestimate the upside. We have just experienced a year with tremendous earnings growth and no movement in stock prices. The price/earnings ratio is back where it was at the market lows of 2009. If and when some of the worries are relieved, stocks can move to a more normal P/E multiple.

If the European concerns are addressed, people must understand the stocks could move much, much higher.

My advice? Based upon what I see in many interviews, most people should be nudging stock exposure a bit higher. It is possible to participate in the upside potential while keeping a rein on risk.

Disclosure Statement: NewArc’s five different programs are currently invested in all of the stocks and ETFs mentioned. The specific characteristics vary according to the investor.

Here is a good illustration. New investors do not go all-in on the first day – we look for good entry points. An investor in Great Stocks would own Apple tomorrow, since I think it is massively under-valued. An investor in the enhanced yield program would never own Apple.

To summarize, every stock mentioned is right for one of our programs. The individual investor must be cautious when reviewing market commentary like this. Everyone is different!

Weighing the Week Ahead: A Respite from European Concerns?

In the absence of fresh bad news from Europe, stocks managed some solid gains last week.  Our trading model, Felix, reflected greater confidence than most traders and investors (including me).

As noted last week I plan to focus on year-end matters, as well as enjoying time with family and friends.  This is a somewhat abbreviated version of the regular weekly update.  I want to provide continuity on the indicator updates, as well as capture important events in real time.

There was plenty of news, but I will highlight only a few items.

Background on “Weighing the Week Ahead”

There are many good sources for a comprehensive weekly review.  My mission is different. I single out what will be most important in the coming week.  My theme for the week is what we will be watching on TV and reading in the mainstream media.  It is a focus on what I think is important for my trading and client portfolios.

Unlike my other articles at “A Dash” I am not trying to develop a focused, logical argument with supporting data on a single theme.  I am sharing conclusions.  Sometimes these are topics that I have already written about, and others are on my agenda.  I am trying to put the news in context.

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

Last Week’s Data

The economic data was mixed, but the most important were positive. Initial jobless claims continued the downward trend, covering the period that will be part of the monthly employment survey.  GDP was revised lower, but the third quarter now seems like ancient history.  Personal income and spending were weaker than the recent trend.

There was great coverage of these stories from my favorite sources, and I’ll get back to highlighting that in two weeks.


Europe remains the big story, dominating everything else.  This is the single most important thing to understand, for both traders and investors.  It might start to be a case of the “dog not barking” for those who know their Sherlock Holmes.  In the absence of fresh bad news, the market seems to have an upward tilt.

There was a developing story this week that is still given short shrift by many observers: the recognition that the European “solution” will be incremental in nature.  Regular readers know that I have been a lonely advocate for this position for many months (as noted in this new summary of articles).  I forecast that there will be no magic bullet and no single meeting with a comprehensive plan.  I anticipate that we will observe a gradual process of compromise and negotiation. Eventually this will include many programs and participants.  The result will be messy and will not please everyone.  My time frame for general recognition that this is “working” is mid-2o12.  I put “working” in quotes because the underlying problems will linger for years after the situation is no longer viewed as a crisis.

This type of policymaking is viewed disparagingly by the current market punditry.  It is actually a classic and respected approach, dating back to Charles Lindblom‘s 1959 article, The Science of Muddling Through.

This week there were several new members in what I am going to call the “Lindblom Club.”

  • Mark Mobius says that the Euro crisis could be over by June and that it is easier because the UK will not be involved.  There were widely publicized articles quoting Mobius as predicting a disaster from derivatives.  Joe Kernen does a nice job, going right to the heart of the story with his questions.  The entire video is worth watching.


Despite the anxiety in the markets and the downside risk to the world’s economic growth entwined in the European debt crisis, I remain of the view that a credible plan to stem the debt crisis in Europe has just begun and that European and global leaders and central bankers will all come to their senses and intervene in a massive way.

 I expect more members in the Lindblom Club as the weeks go by.  There may never be a magic moment, but the story will gradually shift.

The Indicator Snapshot

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

  • An Economic/Recession Indicator.  I am evaluating several candidates.  None confirm the ECRI forecast of an inevitable and imminent recession.  These are sources that have a similar track record, greater transparency, but less PR.  I realize that I am (long) overdue for making the choice for a new indicator.  It has been a careful research process, and I expect the explanation to require multiple articles.  Meanwhile, if something really bad were taking place, I would make it clear in the weekly updates.  From the strongest candidates, I see the recession odds over the next nine months as being less than 25%.
  • The St. Louis Financial Stress Index.
  • The key measures from our “Felix” ETF model.

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

Indicator Snapshot 12-23-11

Our “Felix” model is the basis for our “official” vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions.  We voted “Bullish” this week.

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

The Week Ahead

There are few important reports this week.  I am mostly interested in initial jobless claims and the Chicago purchasing managers index (as a hint about the ISM report).  For anyone who is interested in real-time commentary on these reports you can check out my new “investment diary” at the Wall Street All-Stars site.  Some readers informed me that there was some kind of hacker attack leading to a virus warning.  The team there has cleaned up the problem, so please check it out again.

Trading Time Frame

Our trading accounts were fully invested last week, starting with a partial position on Monday afternoon. Before that Felix had high ratings, but also high uncertainty which relegated everything to the penalty box.  As I predicted in last week’s update, this led to new trading positions and we were fully invested by Wednesday.  This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated.

Investor Time Frame

Long-term investors should continue to watch the SLFSI.  Even for those of us who see many attractive stocks, it is important to pay attention to risk.  In early October we reduced position sizes because of the elevated SLFSI.  The index has now pulled back out of our “trigger range,” but it is still high.  For investors desiring this risk management approach we raised cash when the trigger  hit the range.  We have also been cautious with new accounts.  We still do not have an “all clear” signal, but I expect the SLFSI to decline next week.

Our Dynamic Asset Allocation model maintains a very conservative posture, featuring bonds and other defensive holdings.

To summarize, we have a very conservative approach in most of our programs, recognizing the uncertainty and volatility.  For new accounts we are establishing partial positions, using volatility to buy favored names and selling calls for those in our Enhanced Yield program.

Take what the market is giving you.

[Interested readers can get information which you can use for your own investing and/or consider us for some help — our approach to limiting risk, coaxing out more yield, and exploiting the current opportunities.  This includes a description of how to do a  year-end tuneup.  Write to main at newarc dot com — no charge, no obligation, and respect for your email privacy.]


Repeating my prediction from last week:

  • Trading volume will be lower
  • There will be less political activity and speech-making

The reduced volume sometimes exacerbates big moves, so I make no guesses about volatility.

A Final Investment Thought

When I talk with individual investors, most of them are struggling with headline risk.  They also are bombarded with stories about how the market is overvalued, earnings estimates are wrong, and the world is in a permanent state of disarray, led by poor leadership everywhere.

As someone who lived through Nixon, Vietnam, a cold war where nuclear destruction was a daily possibility, interest rates in the high double-digits, and many other challenges, I am shaking my head in disbelief.

By my standards, the world is a better and safer place.  Opportunities are greater in both work and entertainment.  The potential for personal productivity is huge.  The comical Washington scene is no worse than it has ever been.  Hasn’t anyone ever heard of Will Rogers?

 “A fool and his money are soon elected.”

….and too many others to count.  This is nothing new.

What has changed is the way we observe and parse news, and the link between that and our investment decisions.  If you want to read one thing during the holidays, check out this article by Chuck Carnevale, who shares my relentless focus on fundamentals.  While the article provides a nice uplifting message, it also includes a shopping list of 100 cheap stocks — a nice Christmas gift from Chuck.

Here are the first ten (alphabetical) stocks on the list, just to illustrate the valuable information in the table.


I own two of these names for different programs (ABT and AFL) and many others from the rest of the list.


Investment Themes: The first step in finding a great stock.

Some stock pickers start with a screen.  I start with a concept:  Look for the hated!

I search for investment themes that are decidely contrarian.  That means that few like the concept, the sector or the stock.  The themes must meet several important critera:

  • Negative sentiment and/or polling
  • Analyst skepticism
  • Modest valuations

and most importantly — hatred.

I am going to list some themes and you probably will not like them.  That is the point.

My mission here is to provide some specific ideas as well as suggestions about how the individual investor can search for and find profitable investments.

Contrarian Concepts

One problem is determining what most people believe.  That is the only way to find the contrarian (and possibly undervalued) side of the trade.  I want to encourage a free-wheeling discussion that will be helpful to all, but let me suggest two rules:

  1. Nothing political.  I understand that you may think that Europe is in a socialist decline or be offended by Romney, but that is not the point.  This is about investments, not political philosophy.  We can predict political outcomes, but the purpose is to find investments.
  2. The time frame must be reasonable.  I personally screen using three to six months.

Theme Ideas

Here are a number of themes that  I nominate for consideration.

The Economy

This is an easy choice.  Even the most optimistic economic forecasters only look for growth of 2.5% or so.  There are many recession callers including many/most pundits (especially non-economists) and the ECRI.  The recession forecasters have influenced earnings forecasts, now showing little growth in 2012, and stock prices.

Time frame:  uncertain.  The recessionistas started making their forecasts last Spring at the time of the Japanese earthquake.  Q3 economic growth did not support the theory.  Perhaps another strong quarter will move attitudes.

Stocks:  Cyclicals and Tech.  Caterpillar (CAT) and Oracle (ORCL) are contenders, but the nominations are open.

Europe Crisis

This is open to some debate.  The credit market has not shown any recognition of improved prospects.  Some think that stocks have recently been "euphoric" but it could also be a reaction to the good earnings season.

Time frame:  week to week, but some specific tests within two months.  I think the verdict (for US investors) will be in within eight months, although the social issues may linger.

Investments:  Greek bonds, Italian bonds, credit default swaps, European banks, the dollar/euro spread, US banks, US stock market — listed in order of declining risk and reward.  My own play is lightly long US banks via JP Morgan (JPM).  Those taking either side should declare a time frame and also what would make them change opinions.

Value Trap Stocks

There are many stocks that nearly everyone agrees are cheap on a P/E basis.  The stocks remain "cheap" because of a general consensus that they will not appreciate no matter what happens.  The popular descriptive but unhelpful term is a "value trap."  It is supposedly a silly mistake to be invested in these names.

Time frame:  this quarter or next.  Many names in this category have continued to improve in value.  At some point this will be recognized.  Catalysts might be technical breakouts above key moving averages, changes in leadership, or an exceptional earnings quarter.

Investments:  Cisco (CSCO) and Microsoft (MSFT) come to mind.  Nominations welcome!

Obama Re-election

This seems like a toss-up, mostly because the Republicans are floundering in the search for an opponent.  Key factors in the race will be the economy and employment, reductions in troop commitment, and the qualifications of the GOP candidate.

Time frame:  the stock effect could occur well before the election, depending upon changes in the factors listed.

Investments:  Health care stocks lead this list, since every Republican is committed to unwinding ObamaCare.  There are many candidates, including insurance companies like United Health Care (UNH) and Wellpoint (WLP) and ETFs like XLV.  Many other drug stocks and device makers are also worth consideration.

The Supercommittee

This is my favorite current theme.  There is a lot of skepticism about progress and ultimate success.  The uncertainty has cast a pall over the sectors destined for cuts in the absence of a successful outcome — mostly health care and defense stocks.

Time Frame:  the committee action is due  by November 23rd and an extension seems unlikely.  Congress and the President will need to approve, but the first hurdle is imminent.  Check out my preview from August.

Investments:  The health stocks are good candidates here as well, but so are defense names.  United Technologies (UTX), and Boeing (BA) are leading choices.

Please Join In

Do you like this approach?  The ideas here are a work in progress.  New themes and stock ideas are encouraged in the comments.

In addition, you can participate in a real-time discussion.  I have recently joined a group of investment experts at Wall Street All-Stars.  I am writing about investment ideas and responding to questions in a daily investment diary.  I invite readers to check this out and also to consider the free trial (just email our office:  main at newarc dot com).   There is also free content and other diaries on various subjects.  It is worth checking out.

Improving your trading/investment skill: Make a two-sided market!

Attention:  Your opinion is your biggest mistake!

When I started in the investment business I knew a lot about the economy, politics, and quantitative analysis.  That is why I was hired by a firm that had an all-star cast of traders.

My first lesson was about what I did not know.

The owner of the company, and the leader of many traders of exceptional skill, is a real genius in options trading.  He understood complex relationships in the options market before the computers provided a guideline of "theoretical values."

The computers caught up with the edge we had in the old days, but there is still an important lesson.

Make a two-sided market!

This means that you must think about both sides of a trade.  When a rookie trader expressed an opinion about a stock, our leader would immediately challenge with the other side.  What would make you sell?  Where would you buy?

He was teaching a key skill.  I learned it, but it is difficult to grasp.   Most people do not understand, and probably never will.  If they like a company and the stock, the price does not matter.

The Football Analogy

I enjoyed this article about the comparison between trading and NFL gambling (HT Abnormal Returns).  Investing is not like gambling, but there are important comparisons.  Investors enjoy a significant long-term advantage. Gamblers have negative edge, whether they realize it or not.

With this background in mind, please join me in taking a closer look at the lesson.

Tonight's football game is a great contest between a strong San Diego team and an aspiring Kansas City team that got off to a slow start.  KC is a tough place to play.  My newspaper reports that SD is a three-point favorite.

Most "investors" in the football market form an opinion about who will win.  Their analysis ends there.

Suppose you like the SD chances.  Back in the day, as a member of our trading group, our leader would challenge you.  How many points would you lay?  6?  7?  7 1/2?  Eventually the trader would realize that there was a limit to his opinion.  You can imagine the opposite for the KC loyalists.

The question was what bet you would make within the group.

The Conclusion

The football lesson is obvious.  At some point spread you should take KC.  At another you should take SD.  At the time I am writing this, the game is still in doubt.  I do not know what will happen, and I have no opinion.

It is a nice illustration for the market.

Whether you are a trader or an investor you should have a buy and sell price for everything in your portfolio.


 If you do not have a two-sided market, you need to reconsider your approach.  I have a price target on every stock in my portfolio — and you should, too.



Good Ideas and Possible Trades: Europe and More

There are promising investment themes.  Some of these ideas are in a nascent stage.  That is fine.  It is riskier for me to discuss these, but more interesting for readers to consider.


I am often asked about the process of stock picking.  There is a simple starting premise:

I do not believe in the efficient market hypothesis.

Warren Buffett has said that he would be on a corner selling pencils out of a tin cup if this were true.  Ben Graham used the allegory of "Mr. Market" to describe the sometimes silly prices he was offered for his stocks.

In this tradition, I join the many investment managers who are looking for contrarian themes.  The biggest edge comes when stock mis-pricing is the greatest.

Ideas Worth Watching

Here are a number of themes worth watching.  If I had more time, I might write an entire article on each subject.

  • Europe.  The key announcement has now been delayed until Wednesday.  As I noted in my weekly preview there is near-unanimity in the predictions:  Failure now or failure later.  The issues are the haircut on Greek debt, the size and leverage of the EFSF, and added capital to European banks.  I was going to write on this subject tonight, but it is all redundant.  Everyone is expecting disappointment on one or all of the various criteria.  The expected trade is to "sell the news" since the market has rebounded on hopes of a solution.

The Contrarian Trade?  Use the expected selling as an opportunity to buy.  The European solution is not a single bold plan, but a patchwork of negotiations and bargains.  I thought that I was the only market observer with this viewpoint, but I now see that David Goldman has a similar idea, writing as follows:

There’s no crisis, just a negotiation over 1) how much governments will kick in, 2) how badly senior bondholders will be dinged (forget holders of common equity), 3) the price at which foreign investors (Wilbur Ross, sovereign wealth funds, China) will put new equity into European banks, and so forth. Because the European banking system is hard-wired into political patronage, the negotiation requires a great deal of theater. But this is theater. This IS a drill. This is NOT the real thing.

  •  Apple.  I have written about Apple many times, mostly because it illustrates the difficulty of market timing.  We have a great growth stock, with plenty of cushion in the PEG ratio if you back out cash (as you should).  Most people trade the stock on words, not numbers.  Any dip is an opportunity, since the rebounds come in chunks.  If you sell, you are left behind, wondering whether or not to chase.

The Contrarian Trade?  This is one to buy and hold, at least until it gets closer to fair value on a fundamental basis.  If you were chased out, suck it up and get back in.  I am buying this stock for new accounts tomorrow.

  • Dr. Copper.  There have been a lot of big market calls based upon plummetting copper prices.  In a single day the copper market made up weeks of decline.

The Contrarian Trade?  Probably it is to fade (play opposite) the copper followers.  There were a lot of bogus spikes and correlations in the QE II era.  Without revisiting why this happened, let us just say that many commodities reached prices that did not reflect true economic prospects.  A return to normalcy does not imply a recession.    The contrarian play is to buy some deep cyclicals, starting with CAT.

  • Netflix.  This is an illustration of danger.  When you have a high P/E growth stock there are many ways to lose.  With Netflix I can predict neither earnings nor the growth rate.  This means that I have no basis for my intrinsic valuation.

The Contrarian Trade?  I do not have one, since I cannot get a handle on valuation.  You need to know when you should not play.

  •  Value Trap Stocks.  There is an entire group of stocks that everyone agrees are cheap and everyone hates.  There is a trader consensus that these stocks will never move higher.  The result is that earnings to up, the price remains stagnant, and the P/E multiples move lower each year.  To those with a trading mentality, it seems silly even to look at these stocks.  Someday this will end.

The Contratrian Trade?  Look for the former growth names that have fallen out of favor with traders.  Check to see if the 50-day and 200-day moving averages are threatened.  Consider whether there is any change in the business model that might lead to higher prices.  Ideas include CSCO and MSFT.  There are many other candidates breaking out on your charts.

  • CDS Spreads.  These credit default swap (CDS) spreads have become misleading, one-sided markets.  It is like what happened to put-selling after the crash of 1987.  There were dramatic restrictions on who could sell puts and the haircut and margin requirements.  Something similar has happened now.  Too many have embraced this indicator since it was relevant in 2008.  In those days you had AIG and others taking one side of the market while putting up no collateral.  Today we have the opposite.  It is a relatively thin market with few sellers.  Someone needs to study how much capital it takes to run up these spreads, call Bob Pisani or Rick Santelli, and profit from a position on the underlying bonds.

The Contrarian Trade?  The actual policy authorities are not responding to these prices.  There are even proposals to limit or end the trade.  Aggressive traders could dip into European banks.  I think there is plenty of edge with more conservative plays like JPM.


I hope readers appreciate the theme of this article.  The ideas may not be right for everyone.  I own AAPL, MSFT,  CSCO, CAT, JPM and similar stocks in client portfolios, depending on suitability.  I welcome suggestions about new contrarian themes and new stocks that fit the stated themes.