Why Not to Panic about Europe

I feel no panic about Europe.

This is a typical test.  Every long-term investor considers the question of risk tolerance and understands that markets will fluctuate for mysterious reasons.  So far, so good.

Then, when the event actually happens, it is accompanied by a cacophony of fear mongers — all claiming that this is "the big one."

How can the average person tell the difference?

Knowing What to Ask

The first step in critical thinking about a problem is asking the right questions.  How about these?

  1. Is there systemic risk?  By this I am asking whether we have another "Lehman event" where there is a lot of unknown counter-party risk and the credit system freezing up.
  2. How big is the problem?  Let us suppose that Greece defaults on debt.  Or leaves the Eurozone.  What is the worst case?
  3. How do political events affect the prognosis?  We have election results where leaders and parties less willing to accept austerity have done well.  What does this mean?
  4. If some countries back off from "extreme austerity," what will be the response?  Will other institutions step up?  Can there be a new bargain?
  5. If everything goes wrong — absolutely no mitigation from the ECB, the IMF, or other participants –what will be the effect on the European economy?
  6. If the European economy falls into a deeper recession, what are the implications for the US economy?
  7. If the US economy is weaker, what does it mean for corporate earnings?

The Superficial Answers

Most of the commentary we see has three steps:

  1. Some problem in Europe
  2. Cockroach/contagion/domino
  3. Disaster for the world

This type of  commentary ignores any policy reaction, and also often insults the leadership of European nations, the IMF, and the ECB.

This approach is popular and gets a lot of page views since there is an active response network making these the most popular  media sites — whether blogs, online MSM, or TV.  It is an easy story, playing to preconceptions and simple analogies.

The Danger for Investors — and What to Watch

As is always the case, fanning the flames on these stories is what drives ratings and page views.  When the market dips, it seems to provide a confirmation of accuracy, even though the evidence is skimpy.

It is challenging to refute.  You must write an article about what is not happening!

It is doubly challenging since some of the best sources are the big-time private research firms.  Their business models are based upon fees, not page views.  This means that most investors — including readers of "A Dash" — do not have direct access to this information.

I suggest that investors read very critically when a story suggests causal relationships that lack specificity or quantification.  Be even more suspicious when the story ignores policy responses.  And finally, how about some quantification concerning Europe's impact on the US economy?

My own conclusion — familiar to regular readers — is that the European story is an ongoing process of bargaining and compromise.  US observers are far too ready to impose their own value judgments on other countries and cultures.  The exact trade off of austerity, bank recapitalization, central bank intervention, and rescue funds is a work in progress.  The exact nature will change and I still expect new entrants.

The long-term impact on the US is exaggerated by these fears.  The short-term impact reflects currency trading and (perhaps) the need for some European institutions to repatriate funds.

A Final Thought

For the average investor, a subscription to the prestigious BCA Research reports is not practical.  If you have an advisor with access, you would at least have indirect knowledge of their most recent macro commentary, including the following as part of "Apocalypse (Not) Now":

  • Euroskepticism in Europe: Overstated and understudied, mainly since the media does not do its homework.
  • Firewalls sufficient to protect Spain.
  • The expected fiscal drag from pending policy decisions is limited, manageable, and subject to improvement if risks increase.

These conclusions mirror my own.  I will try to elaborate further on each theme, but I want to emphasize the most important point:

Policymakers have been responsive and flexible.  Skeptics have consistently underestimated the willingness and resourcefulness of the relevant institutions.

The dumbest commentary is from those who use the phrase "out of bullets."  This is exactly what people said about the Fed before the alphabet avalanche.  Whether you liked those programs or not, they were unexpected and powerful.

The current result is that economically sensitive stocks are on sale, including those (like CAT) which have little European exposure.  US financials that will benefit from European asset sales (JPM) are also moving lower for no good reason.  The over-simplified "Risk-off" mentality confers an advantage on those who do stock picking.

 

Weighing the Week Ahead: Here Come the Candidates!

In a light week for economic data, we can expect more attention to elections both in Europe and the US.

Political activity provides both an opportunity and a trap for most investors.  It is so easy to use our own electoral preferences in forming conclusions about economic and investment prospects.

Just as Democrats did when President Bush was in office, Republicans now want to make the economy seem as bad as possible — and hopeless unless Obama is defeated.  This means super-spinning of every story.  This week's employment report is a good example.  Read Derek Thompson's fine article, The Official Guide to Spinning the April Jobs Report, to get your inoculation against the upcoming silly season.

Now that the Republican candidate is known this will get much worse.  The Hill notes that for Obama, the gloves are coming off.

In the conclusion, I'll offer some thoughts on how investors  can take advantage of the political noise.  First, let us do our regular review of last week's news and data.

Background on "Weighing the Week Ahead"

There are many good sources for a list of upcoming events. In contrast, I single out what will be most important in the coming week.  My theme is an expert guess about what we will be watching on TV and reading in the mainstream media.  It is a focus on what I think is important for my trading and client portfolios.

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

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

Last Week's Data

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

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

The Good

The general economic data continues to be soft, while earnings have been very good.

  • The debt ceiling issue will not be revisited until after the election (via The Hill).  This is one of those worries that people keep bringing up, but is then ignored when it proves not to be true.  There is still a lot of heavy lifting scheduled for after the election, of course, but that is a very different problem.
  • Corporate earnings have been stronger than expected and so have revenues. Some observers continually write that earnings estimates are too optimistic. When the beat rate is excellent, they then say that the bar was set too low.  Which is it?  Here is a good chart from Dr. Ed:

Figure120

  • ISM Manufacturing rebounded to 54.8.  The "internals" in this report were all good.
  • Gasoline pump prices may move lower, a boost for the consumer.  The Bespoke Investment Group observes, "No matter how you look at it, current prices for gasoline are high, but if the recent trend of lower prices continues, it could provide a strong boost to the consumer."  Here is one chart, but check out the article for further analysis.

Gasoline 050212

  • Initial jobless claims (not part of the employment survey period) moved back to the prior range.  Here is the nice chart from Doug Short (but see the full article for much more):

Weekly-unemployment-claims

The Bad

The most important economic news of the week was the jobs story — a big disappointment. There was some other bad news as well.  I warned in my regular employment preview last week that we could have a disappointing number with big revisions.  The BLS method for estimating new job creation has been missing on the low side, according to the most recent actual data.

  • The earnings beat rate is declining since the start of the season (via Bespoke).

Beat

  • The ISM services index dropped sharply and missed expectations.  Steven Hansen notes the decline, but focuses on the overall trend.  See his complete report.
  • Employment growth for April was poor.  The payroll jobs gain was not enough to reduce unemployment.  The reduction in the unemployment rate came from a reduced labor force, not more jobs.  We did not see improvement on hours worked or the hourly wage.  The household survey showed a decline in jobs.  Steven Hansen at GEI includes some ideas and charts you probably did not see elsewhere, concluding that it is not pretty, but there is continuing  modest economic expansion.

Steven is consistent in his analysis, unlike others who, for example, only talk about the household survey when it declines.  It has actually been showing much greater increases than the payroll approach.  Eventually the two come into line.

This was the big report of the week.  It turned out to be an anti-Goldilocks number:  Not strong enough to reassure about growth, nor weak enough to suggest more QE from the Fed.

The Ugly

This week's "ugly" award has to go to the stock market, where the reaction was disproportionate to the employment data.  There were clearly many itchy fingers looking for confirmation of the "sell in May" meme.  Charles Kirk provides the evidence:

  Viz

Part of the decline was a reaction to stories about Apple suppliers.  Jay Somaney, in his trading diary at Wall Street All Stars) pointed to the real story — a change in the needed parts — bad for suppliers but not for Apple.

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 Silver Oz, writing at The Bonddad Blog, for his article, Once Again Zero Hedge is Completely Clueless.  One of the Tyler Durdens at ZH managed to mis-represent both the seasonal adjustment process and the birth/death adjustment in making the jobs report seem even worse.  Silver Oz points out the errors and concludes as follows:  

"Chalk this up as yet another reason to NEVER, EVER listen to Zero Hedge when it comes to interpretations of statistical reports."

Trying to correct these errors is a really thankless task.  Many of the ZH arguments have just enough data and apparent plausibility that effective refutation is very time consuming and provides little payoff.  This is why so much bogus analysis lead the Internet hit parade.

The Indicator Snapshot

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

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

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon. Bob also has a group of coincident indicators. Like most of the top recession forecasters, he uses these to confirm the long-term prediction. These indicators are not close to a recession signal. Bob has graciously offered the most recent report as a free sample for our readers.

The big news on the recession forecasting front this week came from The Bonddad Blog's continuing coverage of John Hussman's recession prediction.  (Since the Hussman recession forecasting started relatively recently and relied on tweaking and backfitting, I have not included it in the group that we analyze at "A Dash.")  This sort of "modeling" should not be expected to provide solid forecasts and it is not doing so in real time.  Check out John Hussman's recession index just blew up for the full story.

"The icing on the cake is that the "all clear" signal that Hussman said he would recognize — the ECRI WLI growth index turning positive — has also come into existence for the last 3 weeks. I really don't see any wiggle room left. Under the terms he himself set, Hussman's recession index says we are in expansion."

 

Indicator snapshot 050512

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions. Three weeks ago we shifted from bearish back to neutral. The last several weeks have been pretty close calls. The ratings have improved a bit.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. For daily ETF commentary from Felix, you can sign up for Wall Street All-Stars, where I still have a few discounted memberships available. You can also write personally to me with questions or comments, and I'll do my best to answer.]

The Week Ahead

This is a light week for economic data.  We will start the week with news from the French elections, where Sarkozy is expected to lose.  This is widely projected to be negative for Europe and therefore for US stocks, but it should be reflected in markets by now.  The story will get continuing buzz, especially on Monday.  We will also have election results from Greece, where no majority winner is expected.

There are a number of minor reports early in the week, but I am interested in trade data, jobless claims, and Bernanke's speech on Thursday.  On Friday we'll have the Michigan sentiment index and PPI.  We could see a surprise from either.

We will also have some news from Omaha and the Facebook IPO where Cody Willard sees $100 B as an important dividing line.

Trading Time Frame

We mostly out of the market until late in the week for trading accounts.  Felix likes the current dip, so we are back in the market. The Felix forecast is for a three-week horizon, so it is best not to judge too quickly.  We have long experience with this program, which does not try to call market tops and bottoms.

If Felix is wrong, it will be back to the penalty box.  For now, we are looking for rebounds in several sectors.

Investor Time Frame

For investment accounts I have been buying on dips in stocks that we like. I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look.

Investors should not be trying to guess the next market move. Instead, take what the market is giving you. I have been offering this advice for months, and it led to a great quarter for anyone taking heed.  We seem to have another buying opportunity — especially in tech and cyclical stocks.

If you are really worried, you can imitate our enhanced yield program. Buy good dividend stocks and sell short-term calls. I am targeting 8-9% returns on this approach, and achieving it no matter what the market is doing. You can, too. This has been meeting objectives in spite of the market twists and turns.

Thursday and Friday were excellent days for finding new positions for this system.

Final Thoughts on Politics, Headlines, and Fear

In principle, investors know that the right time to buy is when others are fearful.  In practice, they join in the fear.

Bill Luby, in a nice guest column for Barron's, Be Greedy While Others Are Fearful, writes as follows:

"Fear is good business on Wall Street. For starters, fear helps to encourage impulsive and emotional decisions on the part of retail and institutional investors alike. It is contagious, capable of spreading extremely quickly and can sometimes appear to be unbounded. 

Fear also has been responsible for the development of a wide range of structured products tailored for institutional investors who wish to protect principal, minimize volatility and take other steps to counteract potential risks. The ugly side of fear is that it impels many people to sell at the bottom and wait to get long until markets are near a top. 

These are all good reasons to want to sell fear, but not why I choose to do so.  No, I am short fear because fear is almost always overpriced – and by a large margin."

Successful investing is not reckless, but it is fearless.  To achieve this requires a system and confidence in that system.  I recommend the following:

  • Ignore the political noise and spinning.
  • Note the low level of financial stress — the European systemic failure is off the table.
  • Note the low recession odds from the best sources.
  • Observe the continuing growth in corporate earnings, and the low forward multiple.

These are all encouraging conditions for long-term investment.  Even conservative investors can own some dividend stocks and sell calls against them.

This is what the market is giving us, and we should take it.

[long AAPL]

April Employment Report Preview

Employment is crucial.  Everyone wants to know whether the economy is improving and, if so, by how much. Employment is the key metric since it is fundamental for consumption, corporate profits, tax revenues, deficit reduction, and financial markets.

We have an accurate count on employment gains from state unemployment insurance offices, but there is a significant delay in compiling and reporting the data.  We just got the numbers for Q311.  We would all like to have this information sooner.

Let us call the actual data what it is:  The Ultimate Truth.

The truth for the April report is something that we will not know for about eight months.  There are various methods for estimating what the Ultimate Truth will be.  The BLS has one method, but there are other approaches.

To get the sense of this let us revisit the most recent actual data, from Q311.  We now know that total employment increased by 750K jobs during that quarter.

The difference between the number of gross job gains and gross job
losses yielded a net employment change of 753,000 jobs in the private
sector during the third quarter of 2011. This is the largest net job
gain since the first quarter of 2006.

So what were we really thinking at the time?

The total of the initial BLS reports was 220K, including a scary "0" for the month of August.  The initial ADP estimates (private employment only) totaled 296K.  If you look at a BLS data series now it shows the reports for that quarter to total 383K, including the "benchmark revision" from last March.  The final series will be revised even higher when we get the new benchmark revisions next March, since the BLS estimates seem to be running lower than reality.

How Wrong this Is

One of the talking heads on CNBC today was saying that ADP "missed" the BLS number by an average of 48K per month.  This is complete silliness, since the scorecard used was based on the initial BLS estimate.  It is like asking a forecaster to predict someone else's erroneous estimate instead of the truth.

The investing world should belatedly accept a proposition that I have been offering for years:

The BLS method is one of several approaches for estimating the truth.  Those seeking truth should consider each sound alternative method, and draw conclusions from the composite.

This previous article in the series summarized the various blunders the experts make each month.

I will have more on the investment perspective in the conclusion, but first, what are we looking for tomorrow?

The Data

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

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

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

I think the BLS is honest and does a good job, which seems to put me in a small minority of observers.

In particular, I want to highlight the many know-nothing pundits who roll their eyes about the birth/death adjustment whenever it helps their spin.  Two points:

  1. The  birth/death adjustment is one of two methods for estimating new job creation, and it is far less important than the imputation step.  This is where the BLS assumes that companies dropping out of the sample are replaced by new companies with similar job characteristics.  Don't hold your breath waiting for someone on CNBC to describe this, since they never have — despite the importance.
  2. The birth/death adjustment has been very accurate.  Here the data from the latest update showing a total error of only 12K jobs in a year.  Amazing!

  Birth-death 2011

Why doesn't anyone ever explain how the birth/death adjustment works, the imputation step, or how accurate it has been.  Instead, the media endorses the wrong-headed and pervasive skepticism about job creation.

Competing Estimates

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

  • ADP has actual, real-time data from firms that use their services. The firms are not completely representative of the entire universe, but it is a different and interesting source. ADP reports gains of only 119K private jobs. Steven Hansen at Global Economic Intersection endorses the ADP method over the BLS result. He has a strong analysis covering many nuances in the data. For those who really want to understand the jobs story, it is well worth reading.
  • TrimTabs looks at income tax withholding data. The idea is that this is the best current method for determining real job growth. TrimTabs forecasts gains of about 116,000. They have been pretty bearish on job growth, but their approach is worth serious consideration.
  • Economic correlations. Most Wall Street economists use a method that employs data from various inputs, sometimes including ADP (which I think is cheating — you should make an independent estimate). I use the four-week moving average of initial claims, the ISM manufacturing index, and the University of Michigan sentiment index. I do this to embrace both job creation (running at over 2.3 million jobs per month) and job destruction (running at about 2.1 million jobs per month). In mid-2011 the sentiment index started reflecting gas prices and the debt ceiling debate rather than broader concerns. When you know there is a problem with an input variable, you need to review the model. For the moment, the Jeff model is on the sidelines.
  • Briefing.com cites the consensus estimate as 167K and their own forecast is for 145K.

Trading Implications

What does this mean for our trading and investing?  Caution.

I am concerned about a big miss this month.  There is too much focus on the initial number.  Take a look at this assessment of revisions from Scott Murray at The Stock Sleuth (now added to our featured sites).

2011              Initial Release            Revision           Net Change

August                           0                            104,000            +104,000

September           103,000                       210,000            +107,000

October                  80,000                       120,000              +40,000

November          120,000                       157,000               +37,000

December           200,000                       223,000               +23,000

January               243,000                       275,000               +32,000

February            227,000                       240,000                +13,000 

March                 120,000                                  ????

In the past I have suggested that revisions were not predictable.  The first two come mostly from additional responses to the survey.  More recently we have the effects of "concurrent seasonal adjustments" as well as the benchmark revisions.   I have a concern that the seasonal adjustment method does not work as well at market turning points, helping to explain why the initial reports have been too low.

While the evidence all suggests continuing economic growth in the 2- 2.5% range, this report could easily be a disappointment.  While I am seeking buying opportunities  and new positions for long-term accounts, it  usually pays to be cautious before the employment report.  That may be especially true this month.