Weighing the Week Ahead: Earnings Recession Ending Next Quarter?

This week’s calendar includes a little data, a lot of politics, slow summer trading, and the last of the earnings reports. I expect financial media to focus on an earnings season post-mortem by asking: Has the Earnings Recession Reached a Turning Point?

Last Week

The important economic news was excellent, and the market reaction was positive.

Theme Recap

In my last WTWA (two weeks ago), I predicted a focus on what the U.S. elections might mean for stocks. With major conventions in both parties and saturation coverage of anything said, that was a pretty easy forecast. My own final thoughts included the idea that there were not yet any clear implications. Since the major averages are about where they were in my prior post, the market seems to agree.

The business of figuring out what a President will do is pretty tricky. Morgan Housel uses historical data to rank past presidents on various criteria – stock market, profit growth, GDP, and inflation. Even knowing your history, the results will surprise you. The “best” presidents on these measure often started at a time when things were pretty bad.

The politics digested, the market turned to the biggest data of the last two weeks, the monthly employment report. The news relieved some continuing concern about the economy.

The Story in One Chart

I always start my personal review of the week by looking at this great chart from Doug Short. While the range is pretty narrow, you can clearly see the early weakness and Friday’s rally to a new all-time high. Doug has a special knack for pulling together all of the relevant information. His charts save more than a thousand words! Read his entire post where he adds analysis and several other 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 really good. 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!

The Good

  • Initial jobless claims remain low. There was a slight miss of expectations this week, but Calculated Risk provides the overall perspective.

  • Chemical activity hits a new high. Scott Grannis continues to follow solid indicators that most others miss. This one has a good record and “points to stronger growth than is widely perceived to be the case.”

  • Vehicle sales beat expectations, but some complained that higher incentives were required.
  • Employment increased solidly and more significantly than expected with a net gain of 255K payroll jobs and even more strength in the individual survey. While some are, as usual, seeking nits to pick, these data were an encouraging signal about economic strength. Expect the dialog to shift back to Fed policy. Bloomberg has good coverage.

The Bad

  • Rail traffic declined again. Steven Hansen covers the story including non-seasonally adjusted data in several time frames.
  • ISM services Index dropped slightly to 55.5, a little below estimates.
  • GDP growth was only 1.2% in Q2, significantly lower than expectations. Prof. James Hamilton has an objective analysis of what is going on. Hint: Inventories are crucial, and difficult to gauge. See also Bloomberg on the inventory story.
  • ISM Index dipped slightly but remained in expansion territory. Calculated Risk has the analysis and this chart:

The Ugly

Printed firearms on airplanes? The TSA caught this example, but there is a technology war going on. If you read the TSA Blog, you will see how many loaded weapons discovered at checkpoints.

 

 

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. Nominations are always welcome. There is plenty of misinformation to refute!

 

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 moderate week for economic data, as earnings season winds down. While I watch everything, I highlight only the most important items in WTWA. It is important to focus.

The “A” List

  • Michigan sentiment (F). Good read on jobs and spending.
  • Retail sales (F). Consumer spending remains as a key factor for economic growth.
  • Initial claims (Th). The best concurrent indicator for employment trends.

The “B” List

  • Wholesale inventories (T). Volatile June data, but an important part of gauging GDP.
  • Business inventories (F). More June data with implications for GDP adjustments.
  • JOLTS report (W). Important to understand labor market structure – not job growth.
  • PPI (F). This will become important after a few hot months – but not yet.
  • Crude inventories (W). Often has a significant impact on oil markets, a focal point for traders of everything.

 

The big story will still be corporate earnings. We have a little FedSpeak. Expect questions to focus on whether a policy change is more likely after the employment report. Don’t expect much new information before Yellen’s Jackson Hole speech. More politics, of course, but without a clear implication for markets.

Next Week’s Theme

Markets seem to have digested the Brexit story, and surprisingly shrugged off the terrorist violence. The economic data have quieted recession worries, and even turned positive. In the slow summer trading I expect more attention to analyzing earnings. Everyone will be asking:

Has the Earnings Recession Reached a Turning Point?

  • The bearish side will emphasize multiple points;
    • The streak of losses continues
    • Profit margins remain high, and (theoretically) vulnerable
    • Earnings results reflect stock buybacks and other financial engineering
    • And other points about how earnings are calculated.

In many ways, this debate will hinge upon forward expectations for the economy, business investment, and future profits.

As always, I’ll have a few ideas to add in the conclusion.

Quant Corner

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

Risk Analysis

Whether you are a trader or an investor, you need to understand risk. Risk first, rewards second. I monitor many quantitative reports and highlight the best methods in this weekly update.

The Indicator Snapshot

 

The Featured Sources:

Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies. This week he expresses more confidence about growth in earnings.

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.

The recession odds (in nine months) have nudged closer to 10%. This does not completely reflect Brexit effects, so we may get a further revision.

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

Doug Short: The Big Four Update, the World Markets Weekend Update (and much more).

The ECRI has been dropped from our weekly update. It was not so much because of the bad call in 2011, but the stubborn adherence to this position despite plenty of evidence to the contrary. Those interested can still follow them via Doug Short and Jill Mislinski. The ECRI commentary remains relentlessly bearish despite the upturn in their own index.

RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature his recession analysis, Dwaine also has a number of interesting approaches to asset allocation.

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.

How to Use WTWA

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. For most readers, they 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 a number of 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 also less risk.
  • Holmes – the top artificial intelligence techniques in action.
  • Why 2016 could be the Year 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 or suggestions for new topics.)

 

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 also the best advice from sources we follow.

Felix and Holmes

We have moved to a bullish market forecast. Felix is fully invested, including some more aggressive sectors. The more cautious Holmes is still about 80% invested. The recent strength has moved Holmes into the bullish camp, and we expect an increase in the number of candidates.

Top Trading Advice

Are you worried about “missing” a trade? Do you switch your system a lot? Do you make “boredom trades?” If your answer to any of these is “yes” you should read this post from Adam H. Grimes.

Is your trading affected by high-frequency models? Do you need to change your methods? Josh Brown has some answers and what you should be thinking about.

Brett Steenbarger distinguishes between successful discretionary traders and successful quantitative traders. Which are you?

Successful discretionary traders I’ve known and worked with have been distinguished by their level of market understanding.  Successful quantitative traders I’ve encountered have excelled at analysis and prediction.  Sometimes the successful discretionary trader makes use of predictive models as inputs to decisions; the successful quantitative trader will ground models in sound market understanding.  At the end of the day, however, quants trade their predictions and discretionary participants trade their understanding.  One trades universal patterns; another trades insights specific to what is observed here and now in a particular market.

 

Insight for Investors

Investors have a longer time horizon. The best moves frequently involve taking advantage of trading volatility! Mixing insurance and investments is a terrific way to kill two birds with one stone.

Best of the Week

If I had to pick a single most important source for investors to read this week it would be Tony Isola’s discussion of widely believed lies. He includes a great list. I like so many entries that it is tough to pick a favorite. I’ll go with “Mixing insurance and investments is a terrific way to kill two birds with one stone”. What is yours?

Stock Ideas

The Zika virus is prominent in the news. While we all sympathize with the victims, we can also invest in companies working on a cure. Angus Nicholson of IG has some interesting suggestions for biotechs set to win big.

Chuck Carnevale turns his focus to dividend growth stocks in healthcare. This is an attractive sector, and he provides nine timely ideas in Part 1 of 3. This entry was excellent and we look forward to the future installments.

Holmes will begin contributing an idea each week, a stock we bought for clients a few days ago. I will mention it here and Holmes will also post it each Friday in a Scuttle at Scutify.com. While we cannot verify the suitability of specific stocks for everyone who is a reader, the ideas may be a starting point for your own research. Holmes may exit a position at any time, and I am not going to do a special post on each occasion. If you want this information, just sign up via holmes at newarc dot com and you will get email updates about exits. This week’s Holmes pick is Enbridge (ENB).

 

Market Overview and Outlook

Josh Brown explains (Rules-based tactical vs wizardry and witchcraft) why you should not attempt to imitate big-firm pronouncements by following their calls.

Eddy Elfenbein also weighs in on market timing, reporting the dramatic difference in a Fidelity study.

Avondale’s weekly Company Notes Digest is especially useful during earnings season. You do not have time to listen to all of the conference calls and you certainly cannot count on the media coverage. This is a good way to find important themes. (terrorism more important than Brexit). Also why Aetna is leaving the health insurance exchanges. And much more.

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 AR every day as I do) for a weekly trip on Wednesday. Tadas always has first-rate links for investors in his weekly special edition. There are several great choices worth reading, but my favorite is Jason Zweig’s important warning about the risks of too much stock in your 401-K account. He writes:

Since June, four dozen companies whose stock fell by at least half in 2015 have filed disclosure forms to the Securities and Exchange Commission on their 401(k) and other savings plans. By my estimate, workers at these companies lost $1 billion in 2015 by over-investing in the stock of their own employer.

This is very important. I frequently see such risks in the accounts of potential clients. It is one of the first things we fix.

Value Stocks

Since value stocks have lagged, many strong voices have suggested that the market message is that the economic cycle is over. I covered this subject last week. If you missed it, please take a look. I provide discussion of several stocks recently dissed in the media.

Watch out for….

For those at or nearing retirement, here are eleven common Medicare mistakes.

Final Thoughts

Over the past several weeks we have gotten quite a bit of new evidence to guide our investing. I see four major themes:

  1. Most investors seem to be looking beyond concerns about uncertainty and matters without quantifiable market impacts – Brexit, the election, terrorism.
  2. The economic data looks better than it did in the second quarter.
  3. Earnings expectations seem to have made a trough.
  4. Some sectors are much more promising than others both because of potential earnings growth and current valuation.

The biggest concerns relate to improving earnings, the need for more business confidence, and a resulting increase in corporate investment.

We are entering a period where we can expect a showdown on the economy and earnings – probably in Q3, despite the upcoming election. Fasten your seatbelts!

Is 2016 the Year of the Value Trap?

Wall Street loves to name things. The unofficial definition of a “value trap” is a cheap stock that is stuck around the current price.

Those who focus on what happened in the past have a big advantage. They can cite facts, past performance, and explanations that make them seem to be really smart. They are helping you to understand what has recently happened, and also sharing the current conventional wisdom. How can anyone disagree? The story would get an “A” in a journalism class.

Explanation of what has already happened is fine for a journalist, as long as readers are cautious about extrapolating the results. Piling into crowded trades might work for a while, but eventually leads to big losses. The very best journalists do not become great investment managers.

As an example, I once read an article in a print magazine about the worst current stocks to hold. The author had some sort of earnings screen which cranked out stocks with low earnings. I owned four of the ten! What the author did not understand was that my stocks were all asset plays, valued on the basis of things like real estate holdings and other hard assets. I used his list to explore other possible ideas.

Michael Santoli and Value Traps

Michael Santoli, who has broad experience in market commentary, recently became a Senior Markets Commentator at CBNC. I have followed his work for many years and turn off the “mute” if his topic seems interesting. That means I regard him as interesting and pretty good. He recently presented on the theme of this blog post: Is 2016 the Year of the Value Trap? He accurately observed that cyclical stocks trade at low PE’s at times of economic tops and high PE’s when the market is low. This widely-known observation (Peter Lynch from 30 years ago, for example) is certainly accurate. Santoli listed several current value trap stocks. He informed us that the market was suggesting the top of the economic cycle.

Since I have a value approach, driven by a sophisticated analysis of economics, I looked at his list with interest. Several of my holdings were on his list (Ford, Gilead, Gamestop), and I added another today! (Delta)

Santoli’s Error

Santoli’s work is an accurate representation of current thinking, and therefore solid journalism. The problem is that he is attempting to explain what already happened. He does this very authoritatively. His real message is that traders have a fixation on yesterday’s news. Here are the problems:

  • If the market has all of the answers, investors, traders, and CNBC watchers cannot gain any edge. Warren Buffett says that he would be on a street corner selling pencils if markets were efficient. Does Santoli really believe that he or his viewers can make money from an authoritative explanation of yesterday’s news?
  • He is ignoring the important investing concept of being contrarian. That is where you can make real gains.
  • He is ignoring the strong mean-reversion tendencies of relationships – like that between growth and value stocks.

My Alternative Approach

I have seen this argument many times before. Past “value trap” candidates were MSFT, INTC, and CSCO, to pick a few prominent examples. Putting a label on something is not analysis.

In sharp contrast, my approach is that 2016 is the year of the value stock. (write to main at newarc dot com for the report). It is better to profit from finding market errors than a slavish devotion to what worked last month or last year. The current market is punishing cyclical stocks with recession valuations, with no recession in sight. We have two great ways to play this theme:

  1. If there is a near-term catalyst, we just buy the stock in our long-only program.
  2. If we expect time before the catalyst, we sell near-term calls with a target of 9% return. If the stocks are safe, the return is safe.

When others see a value trap, I see an income opportunity. Take what the market is giving you!

Not Convinced?

The flip side of the Santoli reasoning – the market is right – is that we should all be buying anything with a dividend, even if we are paying a multiple of 26 for 6% growth.

Few articles and TV programs provide real help, since being contrarian – by definition – goes against the grain. You cannot look smart like Mr. Santoli. We will not have the final verdict for months. It would be refreshing if we had some journalists who were willing to go against the grain.

(long GILD, long F, GME, and DAL versus short calls)

Weighing the Week Ahead: Will Earnings Expectations Sustain the Rally in Stocks?

This week’s calendar includes a pretty normal schedule, but not the most important economic reports. There will be an abundance of FedSpeak, with questions about last Friday’s employment data. Despite this, the real story will be the start of earnings season. Expectations are pretty low. Statements about the outlook are always important, but that is especially true right now. The financial media will be asking: Can the profit outlook sustain the rally in stocks?

Last Week

The economic news was pretty good, and the market reaction was even stronger. The continuing market rebound has caught many off base. This week’s review emphasizes Friday’s employment report, since that was the biggest news.

Theme Recap

In my last WTWA, I predicted that the post-Brexit rally might continue if the economic news was good. This could lead to discussion of a possible “summer rally.” After a poor start to the week, the economic data finally turned the trick. From my “final thought” from last week:

Rightly or wrongly, much will depend on the employment report. The economy is the key to future earnings. Recession odds are low, earnings are improving, the oil issue has stabilized, and the Fed is on hold.

In addition to summer rally discussions, there was continuing skepticism – sucker’s rally, bull trap, and similar terms were bandied about. Sometimes I am right about the theme, but incorrect in my expectations. Last week both were on target.

The Story in One Chart

I always start my personal review of the week by looking at the great chart from Doug Short that summarizes the week. Since that post has not yet been updated this week, here is the picture from CNN Money. It was a pretty quiet week until the big Friday rally.

cnn weekly

 

The News

Each week I break down events into good and bad. Often there is an “ugly” and on rare occasion something really good. 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!

The Good

  • Rail traffic is showing improvement, but the story reflects some mismatch in holiday timing and weaker comparisons. (Steven Hansen).
  • Las Vegas real estate sales are improving, up 7.1% year-over-year. Calculated Risk notes:

    This is a key distressed market to follow since Las Vegas has seen the largest price decline of any of the Case-Shiller composite 20 cities.

  • Energy prices are lower, with gasoline down 50 cents from last year. The Oil and Energy Insider has plenty of good data. The charts show the forward curve of prices – not just the current spot. U.S. Production continues to decline.

d577d024-1c19-4bb4-b105-28f47c541823

  • Spenders coming back from the mortgage crisis? Victoria Stilwell at Bloomberg makes the case, noting that time has “healed the wounds” allowing more credit for those who had foreclosures.
  • Long-leading indicators have improved. New Deal Democrat has a mid-year summary of ten indicators with demonstrated lead times. This is well worth a look. One nugget among the many good ideas:

    The yield curve remains as positive even now, with the same slope as it had in the middle of the 1970s, 80s, and 90s expansions.  The 5-year spread is even wider than it was during most of the 1960s.

  • ISM services handily beat expectations (56.5 versus 53.3 expected and 52.9 last month). Scott Grannis analyzes the components and has a good chart comparing the U.S. to the Eurozone. He suggests that worries may be over-stated.

US vs Eurozone Serv

  • Employment news was good. We should follow multiple sources on employment, especially because of the volatility and revisions in the “official” data. This week the news was all good, but perhaps not as good as the initial market reaction would suggest.
    • The ADP reported a gain of 172K private jobs, beating expectations of 152K. This is an important independent source.
    • Initial jobless claims hit a new low at 254K, beating expectations by 14,000.
    • Non-farm payrolls recorded a stunning net gain of 287K, exactly the opposite of last month’s result of 11K after revisions. This was good news, but not as good as it seemed. It requires a deeper look.
      • Commentary varied widely. For details, check out the summaries at Bloomberg and The Wall Street Journal. The bearish pundits either denied the strength, said that the market was not prepared for a rate increase, or both. Bullish commentators saw Santa in July, a reassuring number that would not cause the Fed to react.
      • Many fine sources showed balance. This report was not as good as it seemed, nor was last month’s so bad.
      • The charts are always interesting. Here are some of the most important from The WSJ and Bob Dieli’s monthly employment report (subscription required). To summarize from the WSJ, the change in earnings growth is still disappointing; most net job creation is full-time, the number of those wanting but not getting full-time jobs has declined significantly. From Dr. Dieli, the overall path of growth is the main theme. The duration of unemployment is an important and often-neglected story. Both sources have many more helpful charts and plenty of analysis.

2016-07-09_19-16-59

 

2016-07-09_19-19-18

2016-07-09_19-17-53

dieli employment

dieli duration of unemployment

 

The Bad

  • China rollover risk. Tom Orlik at Bloomberg Intelligence analyzes the current situation and the need to roll over $24 trillion in debt.

    The amounts involved, the maturity mismatch between assets and liabilities, and the fragile state of final borrowers all increase the chances of a misstep — and the severity of an impact should one occur. That underlines the importance for the government to maintain buoyant nominal growth, ample liquidity and low interest rates.

  • Manufacturing orders declined by 1%. Steven Hansen (GEI) has the full story with multiple takes on this data series. He sees more of a mixed picture.
  • The worldwide yield curve is flattening. Ed Yardeni discusses this story, concluding that while not recessionary, it bears watching.

FIG1

The Ugly

Three days of violence. Like everyone else, I was sickened and saddened by events. Leaders of all stripes had comments. My own favorite professor, Neil Browne, always emphasized the need for Asking the Right Questions. Although he has allegedly retired, his mission continues. He posted a thoughtful and insightful perspective.

 

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. Nominations are always welcome. There is plenty of misinformation to refute!

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 fairly normal week for economic data. In my calendar I highlight only the most important items, helping us all to focus.

The “A” List

  • Retail Sales (F). Will this reflect improved sentiment and employment?
  • Industrial production (F). A volatile data series–closely watched given the recent manufacturing weakness.
  • Michigan Sentiment (F). Good read on employment and spending.
  • Initial claims (Th). The best concurrent indicator for employment trends.

The “B” List

  • China Q2 GDP (F). It is amazing how quickly this number is generated….
  • CPI (F). May start to get some attention if the expected increase occurs.
  • PPI (Th). See CPI.
  • Fed Beige Book (W). Descriptive reports from various Fed districts, prepared for next FOMC meeting.
  • Business inventories (F). May data, but relevant for GDP.
  • Wholesale inventories (T). Volatile May data – a factor in GDP calculation.
  • Crude inventories (W). Often has a significant impact on oil markets, a focal point for traders of everything.

 

The big story will be corporate earnings. Fed fans can enjoy appearances from at least six of the regional Presidents. Expect each to be asked if Friday’s employment data changes the likely timing and number of rate increases.

Next Week’s Theme

Markets seem to have digested the Brexit story. The economic data have quieted recession worries. We can expect plenty of post-holiday FedSpeak, but little real news from those sources. It is the start of the Q2 earnings season. There are questions about both the top and bottom lines, but expectations are pretty low. The real question is about the future.

Everyone will be asking:

Can the profit outlook sustain the rally in stocks?

Feel free to join the discussion in the comments, but I see three key questions:

  1. Will the outlook for earnings be stronger?
    1. Optimists note that the dollar has stabilized, as has the decline in energy. Earnings expert Brian Gilmartin has emphasized these themes, while still noting the sequential declines in revenues and earnings.
    2. Pessimists emphasize the “earnings recession” and the sluggish second-quarter economy.
  2. Will stocks respond if the earnings outlook is good?
    1. Optimists note ultra-low valuations in many economically sensitive sectors. These stocks have room to run skepticism wanes.
    2. Pessimists point to lagging sectors that seem to lack upside. And of course, the familiar themes about overall market valuation.
  3. Will fundamental improvement be supported by the technical analysis followers?
    1. Optimists see a potential breakout from the long-run trading range.
    2. Pessimists see an overbought market.

 

Quant Corner

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

Risk Analysis

Whether you are a trader or an investor, you need to understand risk. Risk first, rewards second. I monitor many quantitative reports and highlight the best methods in this weekly update.

The Indicator Snapshot

indicator snapshot 070816

 

The Featured Sources:

Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies. This week he expresses more confidence about growth in earnings.

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.

This week the recession odds (in nine months) have nudged closer to 10%. This does not completely reflect Brexit effects, so we may get a further revision.

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

Doug Short: The Big Four Update, the World Markets Weekend Update (and much more).

The ECRI has been dropped from our weekly update. It was not so much because of the bad call in 2011, but the stubborn adherence to this position despite plenty of evidence to the contrary. Those interested can still follow them via Doug Short and Jill Mislinski. The ECRI commentary remains relentlessly bearish despite the upturn in their own index.

Georg Vrba: The Business Cycle Indicator, and much more. Check out his site for an array of interesting methods. His latest update describes the elements of the indicator we cite every week.

RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature his recession analysis, Dwaine also has a number of interesting approaches to asset allocation.

As we review the weekly indicators it is important to maintain perspective. A 20% chance of a recession would be average. It is not a reason for fear, since it says that a recession is very unlikely. There will be a time to exercise more caution, but we are not yet close to that point. There are many very questionable recession stories right now.

How to Use WTWA

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. For most readers, they 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 a number of 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 also less risk.
  • Holmes – the top artificial intelligence techniques in action.
  • Why 2016 could be the Year 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 or suggestions for new topics.)

 

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 also the best advice from sources we follow.

Felix and Holmes

We continue our neutral market forecast. Felix remains almost fully invested, including some of the currently-popular fixed income sectors. That is working well. The more cautious Holmes is still fully invested, in a diverse group of 16 stocks from a universe of nearly 1000, selected mostly by liquidity. That group is also responding well. Even when the overall market is neutral, there will often be some strong candidates. That is what we see now. It is not a resounding endorsement of the overall market, but a vote for opportunistic trading.

Top Trading Advice

Worried about the Bloodbath of 2016 and post-Brexit fallout? The Trading Goddess has your back with ten suggestions. My favorite is the pocket chain saw.

Wondering when to sell? Adam H. Grimes helps with the question of when to take profits.

Brett Steenbarger shows the preparation needed for trading. (Start at 3 AM? Hmm). He does describe the need to have a balance including some quality time away from the market.

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 (HT Abnormal Returns), it would be Phil Huber’s Fun With Strikethroughs: Wall Street Maxim Edition. He takes on the common misperception that good investing can be accomplished through a few simple rules, and he does so adroitly with humor. You will enjoy the entire list, but here is my favorite:

As goes January, so goes the year nothing.

Stock Ideas

Chuck Carnevale is cautious, even including the dividend aristocrats. He carefully describes his valuation concerns while highlighting the best candidates.

Philip Van Doorn (MarketWatch) has more stocks that were hammered by Brexit yet still favored by analysts. Those shopping for laggards may wish to take a look.

Market Overview

Shawn Langlois’ excellent “Need to Know” column features a variety of interesting market perspectives. This week’s “the call” segment featured Joe Fahmy’s four reasons for the Dow to hit 20K this year. (Check out www.dow20k.com for a prediction on this subject made in 2010 – when the Dow was at 10K).

Laszlo Birinyi publishes an excellent monthly newsletter (subscription required). He covers many analytic methods, but he features a collection of past media stories on the market. It is a helpful way to keep perspective. Take this one for example:

[Jeff] This might sound like something from last month, but it was actually written in 2010.

[Jeff] Maintaining the right long-term perspective is one of the biggest challenges for investors. I cite this striking example not to highlight the error of a single analyst. It was mainstream — a prevailing opinion published in a leading source.

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 AR every day as I do) for a weekly trip on Wednesday. Tadas always has first-rate links for investors. This week, during his well-deserved vacation, he invited suggestions for good posts that had not gotten much attention at the time of original publication. This produced a number of high-quality ideas that he featured throughout the week. I am not surprised. My sense of something that is really good does not always resonate with readers. Other bloggers share this experience.

I am featuring one of these posts as this week’s best. In addition, please check out Wednesday’s article on Portfolio Management, and have a look at my suggestion. Cullen Roche’s piece on fear and negativity also has a timeless quality.

Watch out for….

The so-called “safe” stocks. These stocks are so overbought that it was a prevalent theme in this week’s investment advice.

Ian Bezek warns about utility yield chasing.

Ellie Ismailidou and Anora Mahmudova (MarketWatch) have a similar warning.

Corporate bond yields are also threatened (Barron’s).

Barron’s questions the fundamentals of the utility business – slowing growing demand vs. supply.

Final Thoughts

 

Stocks will eventually respond to an improving economy. We might have to wait for third-quarter earnings reports, another three months. An improved outlook will speed up this process, since stocks have tracked forward earnings. Improving the outlook will improve those projections.

Jeremy Siegel explains how stabilizing energy stocks, low interest rates, and improved earnings could lead to a 15% increase in stocks.

Years ago we could expect conference calls to “talk up” both current news and future prospects. A skeptical attitude was a healthy approach! More recently, CEO’s seem more interested in keeping expectations low. The financial community will pounce on negative statements and extrapolate to similar companies. It should be a great story.

The rotation from yield stocks to cyclical names and financials is the best opportunity for long-term investors.

But even more patience might be required.

 

Weighing the Week Ahead: The Start of Something Big?

The big market decline has the attention of everyone, even those who do not closely follow the markets. The week will start with the punditry will be asking:

Is the market decline the start of something big?

 

Prior Theme Recap

In my pre-vacation WTWA I predicted a rather wonkish theme, wondering whether economic data would confirm the negative message from the commodity markets. The guess about the topic was accurate and the answer was “no.” Economic data have continued to show modest growth. This made no difference, since actual economic data remains in disfavor. (Check here for my further thoughts on this theme).

As he does each week, Doug Short’s recap explains the story and his great weekly snapshot lets you see it at a glance. With the ever-increasing effects from foreign markets, you might add Doug’s World Markets Weekend Update to your reading list. The decline in the last 2 ½ trading days wiped out the year’s gains in stocks.

SPX-five-day

 

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 try it at home.

This Week’s Theme

This week will start with a general debate about whether we saw a selling climax or whether there is more in store.

Observers will be asking (quite differently from the hopeful message of the old Steve Allen theme song):

Is this the start of something big?

…and for some… Will the Fed send a message at Jackson Hole?

Investing.com comic 8.20 - China _ Fed Reserve

The Viewpoints

The conclusions about the current market message include a wide spectrum

  • This is the start of the big one. Everything you have been warned about valuation, omens, and world news has finally come true. I even saw a “Dow 5000” piece.
  • This is a normal and expected correction in stock prices – perhaps overdue. This article from Charles Schwab (also presented on PBS Friday night) reflects solid mainstream advice.
  • Expect a rebound. Investors are scared and that is a condition for a bottom. (Jeff Saut via William Watts at MarketWatch).

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 economic news. During my vacation there was some mostly good news – solid on employment, strong on auto sales, and very strong on housing. The divergence between economic fundamentals and the market has increased.

  • The Philly Fed beat expectations. I am giving the report more attention based upon the recognition accorded it in recent academic research. Let us start with a long-term perspective from Doug Short and Jill Mislinski.

dshort philly fed

  • Inflation remains benign, with the CPI showing an increase of only 0.1%.
  • Housing starts were strong and beat expectations. Scott Grannis includes the data as part of a general economic update along with the expected charts.

Housing Starts

  • Fed minutes got a dovish interpretation. This seemed to have only a small and transitory market effect. Has the market appetite for a rate increase shifted? Fed expert Tim Duy has his typically strong analysis of the evidence with the honest conclusion that a rate move is probably a coin toss.

The Bad

There was also some negative data last week.

  • Leading economic indicators turned negative. The Conference Board still expects moderate economic growth through the rest of the year. Steven Hansen of GEI is skeptical, citing some other sources.
  • Building permits plummeted. Some of the decline may reflect the end of certain stimulative concessions in New York which had a pull-forward effect last month.
  • The preliminary flash China PMI was 47.1, down from 47.8. This sparked trillions of dollars’ worth of selling. As far as I can tell, this has become the only piece of data from China that the market accepts as accurate! Isabella Kaminska of the FT has a nice article on interpreting Chinese economic data. This topic needs much more analysis. I have a lot of material on China, but it is too much for the weekly update.
  • Corporate revenue growth has stalled. Dr. Ed has the story, summarized by this chart:

S&P Revenue

 

The Ugly

The ugly award must go to the stock market, with massive selling in all sectors. Bespoke shows the widespread nature of the rout with this chart of ETF results:

ETF-Matrix-082115

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 the Death Cross, which happens when the 50-day moving average moves below the 200-day moving average. Drawing upon strong sources and running down the details, Barry continues his excellent series of posts on deceptive indicators. In this case, the results show a slight positive return after this event, but too small to use as a foundation for decisions.

Noteworthy

Sometimes a chart is best in helping to keep perspective. This one shows the size of the various world stock markets. (B of A via BI).

screen shot 2015-08-20 at 1.11.49 pm

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.” Here is his recent chart of where we are in the business cycle. He has an excellent new report on “long” economic cycles. I will try to get permission for our readers to get some excerpts.

Dieli Business Cycle -- August 2015

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. 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: Provides an array of important economic updates including the best charts around. One of these is monitoring the ECRI’s business cycle analysis. Jill Mislinski has joined Doug’s team and provides this week’s update.

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 special feature analyzing the elements of Fed Chair Yellen’s “labor dashboard.” His conclusion is that the time to move is upon us. Check out the analysis accompanying this chart:

2015-08-12_2024

 

The Week Ahead

It is another big week for economic data. This news has receded in recent importance, but eventually our study will pay off.

The “A List” includes the following:

  • New home sales (T). Important sign for construction and the economy.
  • PCE prices (F). The Fed’s favorite inflation indicator.
  • Consumer confidence (T). Conference Board version gives coincident information on jobs and some leading info on spending.
  • Michigan sentiment (F). Does the same as the Conference Board survey but includes an ongoing panel as part of the sample.
  • Personal income and spending (F). July data, but covering a key economic segment.
  • 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 (Th). A read on the housing sector, but without the direct significance of new home sales.
  • Durable goods orders (W). Important in the long run, but July data in this volatile series is a bit stale.
  • GDP revision for Q2 (Th). This is “old news” by now, but it still provides a baseline for interpreting growth. Higher numbers are expected and there will be discussion about Q3 as well.
  • Crude oil inventories (W). Current interest in energy keeps this on the list of items to watch.

The Fed Jackson Hole conference will be in the news by week’s end. The key speech will come from Vice Chairman Stanley Fischer, but that is not scheduled until Saturday. Chair Yellen will not attend. It will be in time for the next installment of WTWA, but not for trading.

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 in “neutral.” The confidence in this three-week forecast remains very low with the continuing extremely high percentage of sectors in the penalty box. Felix has (unfortunately) remained fully invested, including some foreign exposure, because there are still several attractive sectors. The inverse funds, bonds, and gold recently moved up the rankings, but never hit the top three, the point where we would trade them. 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).

There are some provocative trading ideas this week from two of my favorite sources.

Dr. Brett notes that he successfully deviated from his current trading playbook on Friday? Why? He has a “meta model” that helps to identify when things might have changed. Read the entire article. Then read it again. This is difficult to do properly.

Charles Kirk (another favorite source requiring a small and easily-recovered subscription price) always has a flexible game plan. Last week he noted that the normal options expiration week rally pattern was breaking down. This left a lot of “hot money” on the wrong side of the trade.

I commented on Scutify that this action brings many options back to life when pros have already written them off. It is the opposite of a short-covering rally. Many traders were short puts. Rapid declines added dramatically to the “gamma” of these options, forcing traders to cover.

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 brief piece by Mark Dow. He takes the central problem of the current market and analyzes it in simple terms. He notes that many smart analysts get too confident and use their intelligence to “explain” things in their own terms. It is more challenging (but more rewarding) to find the best sources, realizing that you do not have the answer to everything.

In today’s environment, the anchor themes are two.

1.       Disaster Myopia. We are still living in the long shadow of the global financial crisis. Six years have passed, but we still return to ‘that place’ far too quickly. Worst case scenario, daily. This ease of recall induces us to over forecast tail events—even if Macroggeddon is 0 for 500 by now. Erring on the side of optimism is still the money trade.

2.       Longest, shallowest cycle ever. The world continues its deleveraging. The US appears to be leading the rest of the world in the process.  But the extrapolation of growth optimism on which all cycles end is just not there in the US—or anywhere else for that matter. And it doesn’t seem imminent, either. This implies two things: (1) the odds of a new recession in the US are low (you can’t commit suicide jumping out of the basement window), and (2) since bear markets typically come when economic cycles turn, a bear market in US equities is unlikely until the economy gets jacked up on excessive investment and hiring.

The “basement window” comment fits our featured analysis from Bob Dieli quite well!

Stock Ideas

Energy or Utilities? While those are not the only two choices, Eddy Elfenbein notes that they seem to define the risk-on, risk-off mentality of recent trading. Here is his full matrix:

image14731

U.S. Steellooks like a steal” according to Barron’s. (Sandra Ward). There are a number of interesting ideas in this week’s issue, but “Steel” (X) as traders call it is a great example of the current market chaos. The stock fell in the wake of the yuan devaluation without much careful thought by investors. There is a lot of knee-jerk reaction to events and trading of ETFs without analysis of individual stocks. Algorithms are based on historical market reactions, not fundamentals. The market is littered with such opportunities right now.

 

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. As always, there are several great links, but I especially liked this message from David Merkel about the need for a financial buffer. Many get discouraged at the recommendation for six months of savings. As with so many things, just getting started is important. Great advice!

Economic Outlook

As usual, Josh Brown has a colorful and entertaining style as he explains the current market worries. Read it all, but here is my favorite point:

I bring you terrible news.

Oil prices have plunged to the point where it hasn’t been this cheap to fill up your gas tank in over a decade. Businesses that count energy as an input cost will be forced to figure out what to do with the excess capital they’re not spending on fuel.

Speaking of excess capital, American corporations are struggling under the burden of enormous piles of cash they don’t have a use for. Each day they must choose between shrinking their floats or handing money back to shareholders in the form of record dividends.

Meanwhile, corporate profit margins are at risk now that companies are being pressured to pay the U.S. workforce a higher wage. These improved wages may result in greater consumption and demand for products and services, not to mention the spectre of revenue growth. Executives are horrified.

Look out Andy Borowitz!

 

Final Thought

No one likes to see significant losses in their portfolio. It creates an emotional climate that leads most to do exactly the wrong thing. Investors are “stampeding out of stocks.” If you are only now asking the “start of something big” question, you do not have a plan.

That is why I did my recession project in 2011 and also added the St. Louis Financial Stress Indicator. These tools have reliably provided a multi-month warning of the major declines (40-50%) that come with recessions. If I knew of a successful method for predicting the 10-20% moves I would embrace it. I have investigated many such claims, but none of them stood up to our testing. Nominations are always welcome.

I discussed these themes in more detail in this week’s post on Rebuilding the Wall of Worry, a concept that few really understand.

The indicators tell us that we do not see the signs normally associated with a large market decline. Instead we see a parade of pundits saying “China, oil prices, and the Fed” because their job is to “explain” every market move. Here is a little test. If oil prices are signaling an incipient recession, how much do you think oil consumption has declined in the last year?

If you sense a trap, you are right. Last year marked the biggest rate of increase in five years. The IEA has a nice interactive chart, depicted below. The price decline comes from increases in supply and the fact that none of the suppliers is backing off. Also noteworthy is that the gap is only about 1%. The oil price data are reflecting almost nothing about the world economy, despite the daily drumbeat in the news.

8-22-2015 3-22-44 PM

Investment Conclusion

I do not have any idea whether Friday’s selling marked capitulation and a near-term market bottom. (Neither does anyone else). I can imagine some panicked retail investors selling on Monday’s opening. Art Cashin says that China was the cause of 70% of the selling (!!) and we all need to see whether the People’s Bank of China does something on Sunday. Sheesh! If this is really what the NYSE trading floor is thinking about, the chasm between markets and the economy has reached a new level.

I was patient during last week’s declines, but we did some buying for all of our programs on Friday. Individual investors might consider whether the price decline means that an increased stock allocation is appropriate. There are plenty of good opportunities.

I especially like the stocks that have absolutely nothing to do with China or energy, yet were caught up in the general selling. Noah Blackstein, a very sharp and successful fund manager is one of the few who get our highest office honor (turn off the mute and scroll back on TIVO to watch). In an interview he observed that everything was getting thrown out with the bath water in a market that just “wanted to go down.” He says that it became a self-fulfilling prophecy, and specifically mentioned homebuilders. Here is the link to his excellent interview.

Evaluating the Risk from the Chinese Stock Bubble

The single most important question for investors is right-sizing risk. In Part One of this series I emphasized that risk was an individual matter. You cannot depend upon wise investors, no matter how good they are, to tell you what your asset allocation should be. It is fine for Warren Buffett to go “all in” on stocks versus bonds, but he can afford to be wrong!

With that background in mind, let us turn to evaluating downside risks. With China at the forefront of attention (for a moment at least until the pundits turn back to Greece or the Fed or deflation) we’ll take that as the focus.

Headline Risk

The most common discussion of risk – by far – is “headline risk.” This is the result of the media reward system that attracts attention to anything that is going wrong and draws facile cause and effect relationships. No matter how hard you try to be rational, the media pounding is too powerful. Experiments in behavioral psychology invite listeners to pick a random number. Later answers are anchored to the number. Who cares whether the plane landed safely? It is powerful psychology, but you get paid if you can take a deeper look.

In my “young prof” days I took the bus home from the university and got off a block from my apartment – a nice neighborhood. It was twilight. I was dressed in a coat and tie. As I walked toward my place I noticed that the woman walking thirty yards in front of me was accelerating and looking back over her shoulder. Naturally I slowed my pace, but I have always remembered her reaction – a teed up suspicion from too many TV shows.

And so it is with today’s investors. So many sources get paid to frighten you, making sure that you are scared witless (TM OldProf Euphemism).

Today’s headline is China. The story line goes something like this:

  1. Chinese stocks were dramatically overvalued – a classic bubble.
  2. These stocks are crashing, reflecting either bad policy or a return to reality – take your pick.
  3. Since China is a big, important country, with economic implications for others, we should expect contagion.
  4. The 1 or 2 percent decline in US stocks validates the China concern.
  5. The Chinese stock decline implies significant weakening in the underlying economy.
  6. Crashing commodity prices validate the “weak economy” inference.
  7. This means pressure on Europe and US earnings.

The story is seductive and easy to write. And so many have!

Analyzing the Downside Risk — and the Opportunity

Taking the perspective of an investor with a free choice of asset allocation, the biggest challenge is to get beyond the headlines and insist upon data.

The first two points in the mainstream narrative above are clear enough, reflected in traditional metrics like P/E ratios. Trading the Chinese market could be profitable for traders, but you needed to be agile. Felix played here, but it was not attractive for long-term investors.

When analyzing risk, we need to get beyond the headlines and focus on data. It often helps to consider the various possible investments.

Direct investment in China

This has been very dangerous. Now it is becoming more attractive. Goldman Sachs’ Timothy Moe opined that a bottom was getting closer. I liked his breakdown of stocks into offshore China (cheap at 9.6x forward earnings and also good on book value, yield) Hong Kong (OK on all metrics) Shanghai (still a bit expensive) and small caps (the highest valuation). We are considering the mainstream stocks for our “high octane” accounts and we already own BABA.

Contagion Concerns

An important question is whether a popping of the bubble has any implications for the Chinese economy. Because of the general lack of economic data and suspicion about the reports, the Chinese economy is a fertile ground for pundits of all stripes. Sorting out reality is challenging. My own assessment is as follows:

  1. The Chinese stock market, especially the “A Shares” does not reflect the economy. So many observed that the bubble in stocks was detached from economic reality. Now, as the bubble is pricked, why should we believe that the Chinese market has somehow become a great read on the economy? A little consistency is needed.
  2. Commodity price shifts do not reflect the Chinese economy. Chinese investors often must sell commodities to meet margin calls in stocks. Commodities have also played a role as collateral. These effects are significant, which means that commodity prices are a poor and noisy indicator.
  3. The earnings effects from the stock market collapse should be minimal. We’ll have more evidence on this soon. Some stocks have a high exposure to Chinese consumers. If they cut back on purchases because of stock market losses, there is a direct effect. Here are the most-exposed stocks.

Investment Implications

  • False economic read. The single most important takeaway is that the Chinese headlines have little to do with the global economy or the attractiveness of US stocks.
  • Opportunities are focused in material stocks and cyclical names. (I like FCX and some oil stocks). Here are some other ideas.
  • Aggressive investors can start a shopping list – almost there – in some mainland Chinese stocks. (FXI? BABA?)

Conclusion

Analyzing risk is tricky, especially when headlines and pundits oversimplify the story. A successful investor knows how to take a deeper look. In particular….

Beware of “headline risk” — already known and reflected in market prices.

Weighing the Week Ahead: A Message from the Bond Market?

Last week’s wild trading defied any simple explanation. That always sets the table for pundit pontification!

We are still a week away from earnings season. Bond, stock and commodity prices are moving in different directions. I expect this divergence to be a focus of attention, with many asking: Is the Bond Market Sending a Message about the Economy?

Prior Theme Recap

In last week’s WTWA I predicted that there would be a focus on alleged January effects. That was very accurate, especially after the first two days of the week included a major decline. As always, Doug Short’s weekly snapshot tells the story at a glance. If you snoozed through the week, you missed it!

SPX-150109

 

Here were the competing theories:

  1. As goes January, so goes the year. Most of these stories included January as part of year, so the result was biased.
  2. As goes the first X days of January, so goes January. Once again the analysts often included these days in the month’s result, biasing the outcome. They also argued over whether January 2nd should count, since it was part of the holiday week. One top authority said that the theory worked for the first two days, but not the first five. Another expert, a regular on CNBC’s Fast Money, chained the days and the month together, calling the evidence irrefutable.

I hope that my readers will be skeptical about two days of trading predicting the next 250. There is certainly no reason to pick two days rather than five. These are the stories attracting big ratings, despite making little sense.

What you should do, of course, is look at the independent and dependent variable separately, using January to predict the next eleven months. You might also ask whether the same effect is seen in any other months. CXO Advisory reported this research last year. January explains only about 5% of the variance for the rest of the year, with the rest left to randomness or other factors. January is no better than other months. Etc. This kind of research deserves more publicity. This chart (one of many good ones in the article) shows that whatever the very modest effect, it ended over 30 years ago.

SP500-month-vs-next11months-return-correlations-subperiods

Will we hear the same story next year? Probably. These stories never seem to die.

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

While there is plenty of news on tap this week, we still have a week before the start of earnings season. It is a time that defies easy explanation, with wild gyrations in stocks and divergent moves in bonds and commodities.

I expect a focus on bonds, with the question:

Is the Bond Market Sending a Message about the Economy?

There are two basic viewpoints:

  1. Bonds are flashing a recession warning. Peter Eavis of the NYT’s DealB%k has a post on the perspective of the bond guys.
  2. Low bond yields reflect other unusual factors. Menzie Chinn at Econbrowser describes some of these.
  3. Bonds not cheap, but no bubble. (Prof. Shiller via Money).

As always, I have some ideas about last week’s trading as well as next week’s question. More on that 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 a normal news week, with a positive tilt.

  • Auto sales remained strong at a 16.8 million annual rate. But growth might be slowing. (Reuters).
  • Consumer confidence via the Conference Board hits a new high. The Gallup weekly poll also shows strength.
  • Dividends rose 10% in Q4. (Eddy Elfenbein).
  • Initial jobless claims hold below 300K. This was a slight miss on stated expectations, but the small deviation is not the key story. Calculated Risk puts it in perspective, including this chart:

WeeklyClaimsJan82015

  • Employment net gains beat expectations. As usual this complex report had a mixed story.
    • Net job gains continue to grow at a strong pace. It was the strongest year of job growth in the last 15, but economists still give the news a “B.” WSJ covers and see the “Bad” news below.
    • ADP private employment confirms the story
    • It hits the Fed’s sweet spot for improvement. (Jon Hilsenrath).
    • Unemployment falls

The WSJ (Nick Timiraos and Josh Zumbrun) has a great summary of the report in ten charts. Here is one that highlights some of the most controversial features, change in overall earnings:

BN-GJ021_jobswa_G_20150109085248

Even better, you can see the labor market via Janet Yellen’s Dashboard, an interactive feature at MarketWatch.

The Bad

The bad news was pretty minor.

  • ISM non-manufacturing missed expectations with a reading of 56.2 (Steven Hansen at GEI has a balanced look at the trend).
  • Factory orders declined 0.7%, a little more than expected.
  • Consumer companies lower earnings guidance despite falling oil prices (FactSet).
  • Government returns as top concern. Economic matters are a close second. (Gallup)
  • Employment news disappointed in several respects
    • Hourly earnings fell 0.2%. Stronger wage gains would be most welcome. New Deal Democrat explains further. Doug Short notes that it is the biggest decline in eight years, supplying analysis and charts.
    • Labor force participation declined again to 62.7%. Changing demographics accounts for part of the story, but this is the lowest level in decades.

The Ugly

Extremist terrorism. Again. The market seemed to have little reaction to the news from France, but it increases worldwide concern.

Noteworthy

Google is moving into the auto insurance business. Isn’t the company also pushing a driverless car? Coincidence no doubt!

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.

Fans of the Silver Bullet can check out our annual review of award winners, just in case you missed one. Most investors have been bamboozled by one or more of these stories, so an annual review can be helpful.

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.

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’s BCI index also shows no recession in sight. 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. Georg has a new method for 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. This week Georg showed why the Fed might well pause before increasing interest rates.

EffectFedFundRate

Dow 20K in 2015? Just based on long-term data the odds are about 40%. Check out this analysis of the odds on the Jeremy Siegel forecast, and maybe also my own effort from years ago, when the Dow was at 10K — http://dashofinsight.com/dow-20k-and-the-wall-of-worry/

 

The Week Ahead

It is a week with a normal news flow and plenty of FedSpeak.

The “A List” includes the following:

  • Retail sales (W). Special interest in the December data. Gas price effects?
  • Initial jobless claims (Th). The best concurrent news on employment trends, with emphasis on job losses.
  • Michigan sentiment (F). Concurrent read on spending and employment.
  • Crude oil inventories (W). Attracting a lot more attention these days.

The “B List” includes the following:

  • JOLTS reports (T). Gaining attention for the right reason – an indicator of labor market slack. This affects the Fed decisions.
  • Industrial production (F). Volatile series but important for GDP.
  • Beige book (W). Anecdotal evidence to supplement the data at the next FOMC meeting.
  • PPI (Th). Eventually this will matter.
  • CPI (F). See PPI.
  • Business inventories (W). Part of the GDP calculation. Only reason for interest in this November data.

I do not care about the regional Fed surveys, which seem to provide little help nor market impact. At least I am consistent. Some sources seem to disparage these volatile reports on some occasions and embrace them on others.

The calendar for Fed speechmaking is active, with at least four policy-related appearances.

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 held a bullish stance throughout the week, despite the early turbulence. There is still plenty of uncertainty reflected by the extremely high percentage of sectors in the penalty box. There has also been some rapid changes in the top sectors, even in a relatively quiet market. Our current position is 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.

As I noted last week, Felix continues to feature selected energy holdings.

Also – Ten reasons traders lose money — -and some hints for a successful approach.

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. We have recently updated our current ideas for investors.

We aim for a light-hearted approach in our “Hot and Not” review of the past year, but there is still a lot of investment truth. If you missed it, please take a look.

Other Advice

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

Annual Reviews and Previews

I hope that readers will enjoy my annual Seeking Alpha preview interview. I have some ideas about market trends, the best sectors, and also some specific stocks. There is also a surprise ending. I recommend the entire Seeking Alpha “Positioning for 2015” series, which has many strong ideas and diverse viewpoints.

Roger Nussbaum highlighted the winning formula, and the warning for the future, in his interesting preview piece about Grandma.

Barry Ritholtz says to take them all with more than a grain of salt, doing a review of the highlights from 2014. Crash in bonds? Dow 5000?

 

Planning for the New Year

If readers were to follow one link this week, I recommend this collection of posts curated by Abnormal Returns. This is one-stop shopping for an individual investor doing planning for the year ahead. As I have frequently noted, I rely upon Abnormal Returns to keep up with great articles that I might not otherwise see. It is part of my research for WTWA. This particular article is attractive for a wide audience of investors.

Sectors and ETFs

The popular ETF might not be suitable for an individual investor. Barron’s notes that some “bespoke” ETFs are designed for big institutions. Despite large assets, the volume is light and the trading spreads are wide. I always watch for these factors. You should, too.

Ed Yardeni notes the positive impact of lower oil prices on earnings expectations for transportation stocks.

Yardeni Transports

 

Stock Ideas

Goldman’s 40 cheapest stocks.

Market Prospects

Barron’s was probably not stealing the notes from my annual preview piece, but they certainly reached a similar conclusion: The Bulls Long Run is Not Over. Here is a good explanatory table:

ON-BH876_BeatCh_G_20150109190627

But long-term investors should be prepared for a 20% correction. Josh Brown notes that this goes with the territory, occurring every three years or so, even in bull markets.

Wealth of Common Sense provides some long-term data on bonds, an interesting comparison to the stock table. Ben recommends looking at the current yield as the starting point.

LT-Bonds1

Investor Psychology

Morgan Housel warns about thinking, I Knew it All Along. The entire article is well worth your time, but here is a key quote:

“Thank Fracking For Falling Gas Prices,” wrote The Daily Caller.

They’re probably right. It seems so obvious that the U.S. oil boom is pushing down gas prices that few feel much need to explain it any further.

But there’s something funny here.

We’ve known about the U.S. energy boom for years, long before oil prices started falling. And it wasn’t long ago that most people argued our oil boom would not lower gas prices.

“‘Drill, Baby, Drill’ Fails: Why Gasoline Prices Remain High Despite Oil Boom,” stated one article in 2013.

“Why More U.S. Oil May Not Mean Cheaper U.S. Gas,” argued another.

Before June, it was widely reasoned that since oil was traded on global markets, and demand from growing economies like China was ramping up, the U.S. oil boom wouldn’t lead to lower gas prices.

These arguments made sense, and were reasonable at the time.

But today we’re making the exact opposite argument. And just as confidently as before.

Kid Dynamite reminds us to take responsibility, not blaming the Kardashians (or the Fed) for our own mistakes. Great post and great list.

Buttonwood reminds us of easy it is to confuse skill and luck. Try your hand at this quiz (which 80% get wrong) as well as the key takeaway:

Jack is looking at Anne but Anne is looking at George. Jack is married, but George is not. Is a married person looking at an unmarried person? A) Yes, B) No or C) cannot be determined.

And this one…

Investors focus on the wrong measures. Studies find that earnings per share is the most popular measure of corporate performance and is often used for executive pay. They also find that “the majority of companies are willing to sacrifice long-run economic value to deliver short-run earnings” doubtless because of those executive incentives. But the correlation between eps growth in one three-year period and the next is actually negative; you can prop up the measure for a while but eventually growth reverts to the mean.

And how this all applies to the seduction of market timing – and why you cannot do it. (Brooklyn Investor).

Result: Many individual investors lost out – data via Stephen Gandel at Fortune. I trust that our readers did better!

Final Thought

Last week I wrote that I am not a big fan of seasonal effects unless there is a logical underlying reason. This week’s trading demonstrated why. For part of the week, daily trading was linked to oil prices and the simple heuristic followed by some computerized methods. This is a correlation analysis from months past, when a better economy lifted both oil prices and stocks, something that statisticians call a spurious correlation. It means that both factors are caused by something else.

By mid-week the executives at pension funds had returned from vacation and held their first investment committee meetings. Wednesday and Thursday reflected that. By Friday we were back to relatively normal daily news effects, including the mixed message from the jobs report.

My annual preview takes on the question of the bond market message. There are many reasons for some to own bonds, but the extremely low interest rates suggest something beyond that. I suggest a leveraged arbitrage with Europe and Japan. Please note: This is basically the opposite of the 1998 carry trade. Please read the entire article and feel free to comment!

I am comforted that the best real-time recession forecaster for the last 30+ years, Bob Dieli, is not alarmed by the bond market moves. He and I follow the key spreads carefully and these are also factors in my weekly updates for the SLFSI. These are long-term, objective indicator. No hype to sell page views. Sometimes the less dramatic story is the right one.

2013 Investment Preview

[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.

To read other pieces from Seeking Alpha's Positioning for 2013 series, click here.]

 

Jonathan Liss (JL): Jeff, it's great to have you
closing things out again this year. For those readers less familiar with
your work, how would you describe your investing style/philosophy?

Jeff Miller (JM):
Hi Jonathan. Thanks for inviting me to participate again this year. I
am a big fan of your annual “portfolio positioning” series. You have a
good range of opinions and sharp questions. It brings out my best, as it
does for others.

Our investment style emphasizes active
management, a focus on risk, and attention to each client. I have no
specific program that locks me into a pre-conceived viewpoint on the
market. Like other fixed-fee managers, my financial interests are
completely aligned with investors.

I interview each potential
client and then create a blend of our six programs – something that
meets the risk/reward needs for each. Readers who follow my weekly
review/preview series know that I am focused on data and objective
indicators. I am resistant to hype and to headlines.

Most
investors are too ebullient when everything looks great, as we saw in
2000. They are also easily frightened, especially in the wake of 2008.

My
most popular investment program targets an annualized absolute return
of 8-9% via selected dividend stocks and selling near-term calls to
enhance yield. This is working very well right now, and is a good fit as
part of many programs.

JL: As 2013 gets underway, are you generally more bullish or bearish?

JM:
This year represents a special opportunity for long-term investors.
Nearly everyone should be nudging stock allocations higher. Those who
are recently retired need to think about inflation. A reasonable stock
allocation is the best inflation fighter.

I have many reasons to
be bullish, but the most important is the number and quality of current
opportunities. Some of my themes are similar to last year, and I invite
readers to check out that article.

I
was very accurate on the macro concerns about Europe as well as the
highlighted stocks. (The featured collection averaged +25%). Anyone who
followed me during the year also benefited from my weekly update on
recession forecasting, risk (via the St. Louis Financial Stress Index),
and the Fiscal Cliff, where my prediction of the outcome was almost
perfect.

Last year’s developments are important for your 2013 question. Despite the favorable developments, many stocks have lagged.

JL: What are the major catalysts for global markets in 2013?

JM:
This is a great question! We have a unique situation where the answer
is already known, but it is mostly ignored. Many of the popularly cited
economic headwinds will become less important.

Let me be quite specific about two types of catalysts:

1.
The slow catalyst. This is the one we already know. The fiscal
cliff decision is the final piece of the puzzle. All of the following
factors will help the economy, and they are all very important:

a.
Uncertainty for business — gone! Businesses were deferring big
decisions until after the election and the fiscal cliff. Any remaining
issues will be clarified soon.

b. Uncertainty for consumers –
gone! They were doing fine until the media blitz telling them that they
should be scared witless. This concern has been resolved with the
fiscal cliff decision.

c. Housing. Clearly bottoming and
improving. Even the slowest-moving indicators are showing a bottom in
place. There has been a lot of focus on pent-up supply. Meanwhile, we
have a million households of pent-up demand.

d. Auto sales. Booming, with another great year expected.

e. Employment. Improving, especially as the drag from government job losses has slowed.

f. Energy. Good news both on natural gas and new jobs in drilling.

g. Central banks. Aggressive stimulus is now true of the U.S. and Europe. Expect China to join in.

2.
The fast catalyst. This one will happen soon, but the time is a bit
uncertain. The Fed is on a stated mission to create inflation,
targeting 2% and tolerating 2.5% on their favorite measure (core PCE),
which runs lower than the CPI.

a. Preamble – The individual
investor has been reaching for yield, unwisely using past performance as
a guide to future success, and therefore believing that bonds are the
best investment for 2013.

b. Dénouement – Investors in bond
mutual funds will learn, perhaps for the first time, that these funds
can experience absolute losses! I do not know the exact time when this
will happen, but when it does, we will have an accelerated chemical
reaction.

JL: Which asset classes are you overweight? Which are you underweight? Why?

JM:
Asset allocation for my investors is based mostly upon their individual
circumstances. With this in mind, the current market offers a better
risk/reward profile for stocks over bonds. There are improving real
estate opportunities, but these relate dramatically to locality.

JL: To which index or fund do you benchmark your performance?

JM:
Each of our programs has a different standard. In our bond ladder, for
example, we inform investors about the returns we are currently able to
get while staying shorter than seven years and using only investment
grade bonds. In our enhanced yield program we target an absolute return
of 8-9%. In our trading program we might only equal the market return,
but do so with less risk. (We are sometimes out of the market or using
inverse ETFs). Our “Great Stocks” program is benchmarked to the S&P
500 since we gain our edge via active management and thematic investing
in known names.

JL: There’s a lot of confusion
out there regarding the proper use of inverse and leveraged ETFs. As a
seasoned portfolio manager, it would be very interesting to know how you
use these funds. What are the buy and sell triggers? What sort of
holding period is typical? What position size is necessary to offer true
downside protection without the risk of significant drag on overall
performance?

JM: We use the inverse ETFs as part
of our most active trading programs, named “Oscar” and “Felix” to
reflect the basic approach of each model. Our use is not designed as a
hedge, but as a way to profit in a down market. The holding period
varies based upon the market trend. If we were to hit a 2008-type
situation, for example, Felix would first go to bonds and gold and
eventually to the inverse ETFs. We do not use any leveraged ETFs.

Individual
investors need considerable trading skill to use these ETFs
successfully. The leveraged versions track the market in short time
intervals, but the relationship breaks down with time. If you wanted to
emphasize your stock-picking in a neutral market, you could add some
portion of the inverse ETFs to your portfolio. You could also use them
as a hedge if you had an increase in an objective indicator of risk
(like the SLFSI).

Long-term ownership is just like reducing your position size, so it is a drag on performance most of the time.

JL: As we are now a week into 2013, what is your highest conviction pick for the remainder of 2013?

JM:
My basic thesis is that the improving economy will clarify where we are
in the business cycle – an extended, gradual move from a sharp decline.
The market looks very different once you realize that we are only in
the third or fourth inning of this recovery. Let me offer a few specific
stocks that fit the themes of where we are in the business cycle, as
well as other macro influences. I like to move from a general theme, to a
sector, and then to specific stock selection.

Caterpillar (CAT)
– A great early-cycle stock and one that will benefit from the
improvement in China. Costs have been kept under control. If it traded
at the PE multiple common for the last decade, it would trade at 130 or
so.

AFLAC (AFL)
– A conservative way to play the rebound in Europe. It is unloved by
many on the Street, leading to an attractive valuation. It has a
single-digit multiple with earnings growth of over 14%.

JPMorgan Chase (JPM)
– Stumbled this year after the “whale trading” incident. If you think
this incident represents an overall failure of control, you might not
like the company or the stock. If you are a contrarian, value-oriented
investor, your best picks are often flawed in the eyes of many. One
aspect of upside: European banks will be disgorging distressed assets
under Basel III. Banks with great balance sheets will be able to take
advantage. This stock could easily be 65-70 in 2013.

Technology – both PC stocks and Apple (AAPL).
Apple will benefit from the expected rebound in consumer confidence.
Current prices reflect a multiple in single digits of forward earnings,
once you adjust for cash holdings. The PC is not dead. As corporate
investment resumes, there will (finally) be the upgrade cycle to Windows
8.

Some of these themes are second-half plays. The challenge
will be the first-quarter earnings reports, which will still show weak
growth.

Best short ideas include the over-owned sectors:

Bonds – Bond mutual funds are dangerous. Shorting iShares Barclays 20+ Year Treasury Bond ETF (TLT) is a possibility.

Utility
stocks are popular as dividend plays. People are buying yield without
looking at value. These stocks will trade like 100-year bonds when rates
start to rise.

JL: Any consideration of shorting an ETF like the Utilities Select Sector SPDR ETF (XLU) – or is this just a sector you’re avoiding for the time being?

JM:
Good question, and thanks for helping me to respond clearly. I think
TLT and XLU are over-valued and dangerous holdings, so they are good
short ideas. None of our current programs involves shorting stocks or
ETFs except via the inverse ETFs, so it is not something that I can
implement.

JL: Where have you been having retirees turn for income in this record low rate environment?

JM:
We provide income to retirees through our Enhanced Yield program. This
combines conservative dividend stocks with yield enhancement via selling
short-term calls. The call sales capture the rapid part of the time
decay curve and also provide some cushion against market volatility. The
program has less risk than merely owning dividend stocks, and works
well even in a sideways market.

The most highly touted sources of
yield all represent crowded trades. The valuations of many dividend
stocks are stretched. Other investments return principal in the guise of
income – a trap for the unwary!

JL: Are there any parts of the fixed income space currently offering the prospects of decent ‘total return’ to investors?

JM:
I strongly endorse the total return concept. That is the point of
“enhancing” yield. Every time I take a deep look at a high-yield
investment, I find either a disguised return of principal or hidden
risks. You can achieve good total returns by including some stocks in
your portfolio – a little octane in the tank, as I often say.

JL:
Turning to younger investors, 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 for
the bulk of their capital appreciation?

JM:
There is a special challenge for young people – and a corresponding
opportunity. Starting early in saving and investing is crucial. Stocks
provide the chance to be a business owner as well as a worker. Those
focused on the last ten years have a negative outlook. I suggest that
any young person look at a long-term chart of U.S. stock prices. Right
now, actual risk is lower, stock prices are more attractive and economic
growth is improving.

JL: How bad is the current
gridlock in Washington and the uncertainty it breeds for investors? How
closely do you watch political developments when formulating an overall
investing thesis/asset allocation mix?

JM:
Given my background as a former college professor specializing in public
policy formation, I embrace these controversies. The recent political
issues in Europe and the U.S. are a special opportunity. Most of the
coverage of these issues drifts rapidly into opinion instead of
analysis. There is little real understanding of how multi-party
bargaining works in practice.

Take the term “gridlock.” In the
end, for the issues most important to the market there was not really
gridlock. A final compromise was reached. It happened at the last
minute. It was messy and unloved by all. This was all very predictable
and quite typical.

It is a great opportunity for me, and profitable both on Europe issues and the fiscal cliff. But let us look to the future.

The
fiscal cliff story was great for the financial media. They want to keep
the momentum going. Already there is a new campaign to characterize the
deficit negotiations as a “crisis.” You cannot make good headlines by
simply reporting the facts: Leaders are posturing before the bargaining
even starts. We will not know much for at least another six weeks.

Here
is a specific example. I do not believe that defense spending will be
slashed through the budget sequestration. However in the next two months
you will hear many claims to the contrary. The result is that a number
of these stocks are quite attractively priced, including Northrop Grumman (NOC), Lockheed Martin (LMT), and Raytheon (RTN). It is possible that prices will go lower before moving higher, but the time frame is about two months.

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

JM:
Gold rallies with fears of hyperinflation or deflation from systemic
collapse. Since I do not see near-term prospects for either, I am not
enthusiastic about gold.

The only really good method for hedging
tail risk is to buy puts or perhaps do a more complex put spread. This
is not easy for most investors. I prefer to control for risk by
downsizing positions when necessary. Recession forecasting indicators
and measures of financial stress are very good for this purpose. I
report on these each week in my WTWA series.

JL: Finally, what advice would you give to a ‘do-it-yourself’ investor in the present investing environment?

JM:

  • Don’t expect too much. It is not as easy as brokerage commercials make it seem.
  • Decide
    upon a systematic approach that you know will work. If you do not do
    this, you will bail out the first time something seems to go wrong.
  • Control your risk. Do not determine size by what you want to make, but with what you can afford to lose.
  • Expect
    to spend a lot of time on research. If you think you can achieve good
    results in a couple of hours a week, you will be disappointed.
  • Do
    not get caught up in unquantifiable headline risk and political
    arguments. Focus on what you expect to happen, not what you think should
    happen.
  • Exploit free
    resources (like Seeking Alpha) for ideas and information like conference
    call transcripts, but make your own decisions.
  • Be
    willing to pay for some information. I don’t mean stock tips or those
    who claim to time the market. I mean data that is well organized and
    easy to use – something that will save you time and let you work
    efficiently. For fundamental investors, Chuck Carnevale’s FAST Graphs product is essential. It saves me hours of work.

JL: Is there anything else that an individual investor should be thinking about?

JM:
The biggest mistake for most investors is inaction. They may suspect
that they should be adjusting their portfolio, but they do not know how
to proceed. They might be disorganized, with many different accounts.
These investors should make a New Year’s resolution for action. If you
are doing nothing, it is cheaper to get some help than to stick in bad
investments. Investment managers are used to creating order from chaos!

Thanks
again for inviting me to participate. In reviewing my answers I realize
that I am taking a contrary viewpoint on many issues. When you are
looking for significant investment edge, this is often the result.


Four Actionable Investment Themes

This is a challenging time for individual investors.  I get emails from many who wonder what they should be doing.

While I offer weekly updates in my  Weighing the Week Ahead series, the advice is general.  I am going to share several specific themes that flow from my regular analysis.  While I am very careful in offering specific advice to clients, the themes that I am mentioning are worth consideration by everyone.

Worry about Bond Funds

Investors have rushed into bond funds — mostly because of the perception of safety.

In this article I explained why  bond funds are risky, and why those needing fixed income should instead purchase specific bonds.

Doug Kass has a record of some great calls on tops and bottoms, including stocks in early 2009.  He now is calling a major top in bonds. (from Business Insider and Barron's)

"Finally, my favorite short of the next decade is the U.S. bond market, for those that possess deep enough pockets, have the fortitude and the patience. I am long ProShares UltraShort 20+ Year Treasury [TBT], which is the inverse, double-short bond ETF. Over the past 2½ years, bonds have achieved a near 60% total return. A remarkable feature is the consistency of positive returns and the absence of many drawdown years of consequence. Nevertheless, they should be viewed as a return-free asset class that is very risky. The 10-year yields under 1.5%, less than half the yield during the recessions in 2001 and 2008. That means I am paying over 65 times earnings for a 10-year-bond, a rich price even by Amazon's or LinkedIn's standards"

Whether or not you join Doug in trying to profit from a rise in interest rates, you should be wary about absolute losses in your bond fund.

Find a Growth Stock

Everyone can afford to own a growth stock.  Google (GOOG) is fine.  If you chose Facebook (FB), you were too early, but your time might come.  My favorite is Apple (AAPL).

Oppenheimer's Carter Worth, who has also been getting some well-deserved attention on CNBC's Fast Money program, had a helpful note on Apple last week. (See your OPCO rep for access).  He cited a very obscure fact — the number of times that Apple has declined 4% or more in a single day.  (answer to follow.

I have frequently noted the difficulty in trying to do short-term trading in Apple.  Those who sell have a problem finding a re-entry point.  The stock trades on news and psychology, with frequent gaps.  Those who choose to sell find themselves faced with "chasing" a rebound or perhaps missing a major rally.

If you subtract the $115 billion cash hoard and look at the P/E ratio on the rest of the stock price, you see a low single-digit multiple on a 20+ growth rate.  My own price target is $750, but it keeps moving higher.

(Carter Worth's answer:  92 times in 10 years).  I guess these were buying opportunities, as was last week's selling.  

It is notoriously difficult to time your entry in Apple.

  Find a Cyclical Stock

The current market prices cyclicals as if we were at the peak of the business cycle.  This means that the P/E multiple is at a low point, ignoring the strength in earnings.  Contrarian investors may choose to reject this notion, respecting the earnings strength of some of the leading companies.

My favorite candidate is Caterpillar (CAT).  The company announced great earnings, but like most others, refused to puff up future guidance.
I really like this choice.  Partly it is company specific, but I also think that we are in the early innings of an extended economic recovery — slower and longer than past examples.  The market has excessive fear of recession and too much emphasis on the "average" length of recoveries, even though there are only a few relevant examples.
The Fed has pedal to the metal for years to come, so this recovery will be slower and longer.
Find Some Enhanced Yield
For several weeks I have been citing the combination of buying dividend stocks and selling near-term calls as the best deal the market is offering.  You should be able to pocket 9% or so without any change in stock prices.  Readers have asked what sort of trades I am doing.  I have a method that is fussy about entry points, but many alternative approaches would work well.  Here is an example trade that I made for clients today.
In BlackRock Inc. (BLK), we bought the stock at 171 and sold the September 180 call for $2.00.  The stock is trading at a multiple of 13 or so with earnings growth over 20.  The dividend yield is (recently confirmed) at 3.5%.
If the stock does nothing in the next two months you will pocket the call premium of $2 and a dividend of $1.50, for a gain of over 2%.  If the stock rallies enough to get called away, you will make 9 points plus the call premium, for a gain of over 6% in two months.  If the stock declines, you will have a cushion from the call premium and the dividend.
The system requires finding good dividend stocks.  Many advisors suggest that this is enough, even without selling calls, so our "enhanced" method is a big improvement.
Summary
When I interview new clients I find methods that are just right for them.  Each person is different.
Despite this, nearly every investor can profitably include the ideas suggested here.

The Quest for Yield (Part 6): Enhancing the Yield from Your Dividend Stocks

Since October I have been urging yield-oriented investors to combine the selection of good dividend stocks with covered calls. This system has been working very well, and readers have asked for more information about how to make these trades.

At the risk of giving away some information about our specific methods, I have decided to go into more detail.  I hope that readers find it helpful in meeting their risk/reward objectives.

Background

The combination of dividends and call premium will yield 10% returns +/- whatever happens to the stock.  If your time frame is a few years, and your stock picks are reasonable, you need only break even on the stocks to get a return that will solidly beat bonds and inflation.  On a total return basis you can aim to double your portfolio in eight years or so, without getting unduly aggressive.

This is a sweet spot for many investors.  You can do it, but it will take a little work.  I have already covered several key topics in prior articles in this series.  You will do best if you check out the past articles as well as this one.  If you want this to work, don't cut corners!

Picking Dividend Stocks

A great dividend stock must first be a great stock!

Too many investors just screen for high yield.  Many of these stocks trade as a function of the yield.  It is like buying a 100-year bond.  If you think that bond yields are going higher, these stock prices will go lower.  Here is the chart I ran in my original dividend article:

 

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If the only idea you got from this article (November, 2010) was buying Caterpillar (CAT), you were in at 80.

Other stocks at the top of a pure yield screen might include companies about to cut the dividend since their payout ratio cannot be sustained by the earnings.

When I am picking stocks I get ideas from many sources.  With ideas in mind, my most important screen is earnings-based, since that will eventually determine price.  I am a big fan of Chuck Carnevale's service, where you can get a long-term earnings history as well as many important metrics for stock valuation.  I do not take any long-term investment position without "talking to Chuck" via his site.  Even if you are not a subscriber (and you should be), Chuck graciously shares many of his best ideas and screens with a complete suite of charts.

So we now have a list of stocks with reasonable, well-supported dividends.

Covered Calls

In my original article on selling options against your stock positions, I did not focus on dividend stocks.  I did a careful description of stocks that fit the profile.  Some stocks that I liked but were not suitable for covered writes (Apple, then trading around 318, was not suitable because we did not want to cap our upside.  Other names were just fine, including my example of Noble Energy (NE) although I said the Microsoft was also a good candidate.

The article goes into some detail about sources and how to find the right call to sell.

Putting the Concepts Together

Last October I wrote about why investors should combine these two concepts to create a true total return, income portfolio.  The basic idea is that you should not fixate on stock price movement.  If you pick good stocks, collect dividends, and collect call premiums, you will achieve your target.  Do not get too frisky on your stock selection!

I had an interesting section in this article, which I called, "Do You Qualify?"

Here is the qualification test — hardly anyone can pass it!

You cannot look at your brokerage statement, the daily mark-to-market, the monthly mark-to-market, or anything else for ten years.

This is what you would do with a bond portfolio.  You buy expecting to collect the coupon and the principal at maturity.  It is a simple test, yet a difficult one.  The bond investor does not worry about daily marks.

Psychologically, people cannot do this with stocks.

You should simply look at your statement and see if the combined flow from dividends and call sales are meeting the objective.

Implementation — A Look Under the Hood

I am going to share some "secrets" about how we are implementing this program, including some recent actual trades.

Here are a few specific ideas that were not part of the prior articles.  I am fussy about setting new positions.  I do not mind holding cash for a bit while looking for the right opportunity.  A good pick includes the following:

  • A stock that meets the dividend requirements described above.
  • A near-term option sale that would generate nearly 1% per month if the stock had no move.
  • A reasonable bid-ask spread on the option.  I have the advantage of being able to split the market in many cases, but you can try the same thing if your broker permits spread orders.
  • An option sale that will compensate you fully if the stock is called away at expiration.  This normally means that you get  an immediate payoff of 2% or so plus the call premium if the stock rallies.  You need a broker that does not soak you for an assignment on your short call.

I do not worry about losing stock positions in the current environment.  There are plenty of candidates.

Examples

To illustrate, here are some trades that we actually did last week for this program.

Bought Abbot on March 6th  (ABT) for 56.57 and sold the April 57.50 call for 57 cents.  If the stock had done nothing, we would have collected  a nice call premium as well as waiting for a dividend.  Given  the rally, we might just ring the cash register with a gain of 97 cents on the stock and 57 cents on the call premium — almost 3% in about six weeks.

Bought Conoco on March 5th (COP) for 77.41 and sold the April 80 call for 94 cents.  If the stock does nothing we again get a good premium.  If it is called away on April expiration we make $2.59 on the stock and $0.94 on the call, for a total of $3.53  — 5% in less than two months.

There are other similar trades.

This shows why we can afford to wait for good opportunities.  I go shopping on days where the market declines sharply, offering good stock prices and high call premiums.  My target is eight positions, but we sometimes have a smaller number when the market is not cooperating.

Conclusion

You can do this on your own if you have the right resources, the right broker, and watch the market closely.  You must also be patient.

When options expiration comes, you may have some new decisions about whether to "roll" your short calls or look for new opportunities.  I'll discuss this more in the next installment.

 [I still own the mentioned stocks — AAPL, NE, and CAT — as well as the specific option positions.

What the Cordray Appointment Means for Stocks

President Obama surprised many with an arcane political maneuver called a "recess appointment."  There is a political imbroglio over this decision, which helps to maintain full employment for pundits!

Here at "A Dash" we wonder whether this has any implications for stocks.  At the Wall Street All-Stars site where I have been contributing, one of our readers suggested that the Cordray appointment was good news for big banks.  The hypothesis is that there might be a global settlement that would lift a cloud from the banks and allow them to trade on their strong fundamentals.

Veteran investors know that this approach has been important in asbestos, financial reporting, and tobacco.  It is worth consideration.  Meanwhile, there was a competing alternative — the rumor of a secret Obama plan.

This is a great topic, but I did not have time to do the research and write it up (although I might have made a trade).  Fortunately, the University of Illinois is on break, so I am able to call upon the talents of one of their Poli Sci students — one who has helped us before.

Here is Derek Miller's  analysis, with a few comments from Dad in the conclusion.

Political Background

President Obama’s appointment of Richard Cordray to the top job at the Consumer Financial protection bureau has sparked significant controversy in Washington. While Republicans claim their pro-forma sessions technically keep the Senate ‘in session,’ White House lawyers (under President Bush) have determined that this does not prevent the president from making recess appointments. Based on this interpretation, it is likely that Richard Cordray will remain as the CFPB Director. Therefore, his history as Attorney General of Ohio and his probable agenda in the near future are of intense interest.

The Agenda

Cordray takes the helm of the CFPB with an aggressive agenda, seeking to target “nonbank” financial companies like money transfer agencies, credit bureaus and private mortgage lenders. In a January 5 article of the New York Times, Cordray was quoted to have said:

“Many subprime loans during the housing bubble were made by nonbank mortgage brokers. Since most of these businesses are not used to any federal oversight, our new supervision program may be a challenge for them.  But we must establish clear standards of conduct so that all financial providers play by the rules.

Clearly, mortgage companies are sure to be a target of intense focus for the CFPB under Richard Cordray. Indeed, the CFPB was explicitly designed by the Dodd-Frank legislation to “monitor mortgage originators and servicers, which were instrumental in the financial crisis by providing subprime mortgages to individuals and families who were not able to afford them.”

In a recent Residential Mortgage Litigation & Regulatory Enforcement Conference, Indiana Attorney General Greg Zoeller commended Richard Cordray as “an excellent person to run the CFPB.” In fact, thirty-seven attorneys general sent a letter to the Senate in October of 2011 to urge them to confirm Cordray. This suggests an environment conducive to a global settlement, as there is widespread demand for clear regulatory guidelines on a federal level.

Global Settlement Potential

As a matter of fact, when Cordray was first selected to run the CFPB by the Obama Administration, it was speculated that the bureau would “have a role in getting to a final settlement and particularly in enforcing the mortgage servicers, over which it has primary oversight.”

CNBC real estate reporter Diana Olick elaborates on this theme by citing Edward Mills, a policy analyst from FBR, who notes the advantage Cordray could have as a former Attorney General. “As a former AG, he could use that to his advantage in the ongoing negotiations with the AGs…Beyond a settlement, what we would be looking for are updated disclosure documents that are easier for consumers to understand and a definition of what is a ‘qualified mortgage’ – which sets in place new consumer protections on all mortgages.”

In the video below, Larry Kudlow speculates that the appointment of Cordray is the Obama Administration's first step towards an election year bailout of the mortgage market.

Regardless of what you make of Kudlow's prediction, it is clear that Cordray’s background as an Attorney General – in particular given his statements on the mortgage crisis and the manner in which he has gone about prosecuting cases – highly suggest that his appointment as the Director of the CFPB is a step closer to a global settlement to the mortgage crisis.

Investment Conclusion

[Thanks, Derek — back to Jeff]

I saw an interview on CNBC this afternoon where the interviewers started with the political angle and the opposition of the big banks.  When Cordray swatted away those challenges, citing recent conversations with Jamie Dimon and others, the questions quickly shifted to whether he was favoring big banks.

The exact causal path and reasons are still open to investigation, but the big mortgage-lending banks have shown relative strength this week.

Obvious candidates for this thesis include JP Morgan Chase (JPM), Bank of America (BAC), and Wells Fargo (WFC) for starters.

We have been very cautious, underweighting financials, but we own JPM.