My Bespoke Roundtable Answers

For the last few years I have participated in two different "year ahead" preview articles — one for The Bespoke Investment Group and one for Seeking Alpha.  These are both excellent resources — each valuable because of the specific approach taken.

Last week I suggested that readers join me in checking out the ideas of the Bespoke panel.  If you have not done so, it is still an excellent and timely idea.

I know that many readers do not click through to the links.  With this in mind, I am repeating the text of my responses here at "A Dash." These reflect my current thinking on many issues covered recently in other articles, and will be the basis for continuing work.

For your convenience

Below is the full 2012 Bespoke Roundtable Q&A with Jeff Miller of A Dash of Insight.

 

1) Looking back on 2011, what were your best and worst calls?

 

Thanks again for inviting me to participate.  The questions are excellent, so I always learn something just by formulating my own answers.  You also have a great roster of participants, and I learn from their wisdom.  I know from the comments that readers of my blog also appreciate the work you do in producing this Roundtable.

 

Turning to my own results, my best calls were sticking with Apple, trading drilling stocks in a timely fashion, and accurately predicting earnings on most of my holdings.

 

My worst calls were in the medical device area, where earnings remain solid, but fear of policy changes is overwhelming.  Even though I was underweight financial stocks, the correct weighting would have been zero!

 

Overall, my worst prediction was that the market would gradually accept the evidence of better earnings and an improving economy.  I was right on the facts, but wrong on the reaction.

 

2) What surprised you the most about financial markets in 2011?

 

I was most surprised about the persistence of highly-correlated trading based on the headline of the day.  We all know that this will eventually end, and I expected that to happen last year.  The risk on, risk off, simplification underscores the irrelevance of most actual data.

 

One lesson for us was the increased emphasis on yield.  It caused us to develop a new program for yield-oriented investors.  By combining solid dividends with covered calls, we created a strong, income-oriented investment program.

 

3) The S&P 500 hit its bull market highs in April 2011.  Which will happen first?  Will we first take out the April highs or have we entered a new bear market (a decline of 20% from the highs)?

 

We almost had the decline already!  In October we were down 19.4% on an intra-day basis.  Right now it is a good question since we are about 9% off of the highs.  I expect us to take out the highs in the first half of 2012.

 

4) Depending on your answer to question 3, how long do you expect the bull or bear to last? 

 

At least through 2012.  The biggest concerns come from things that most people are not already worrying about.  Everyone is closely monitoring the economy and Europe, for example.  North Korea is a wild card.  Middle East tension and concern over nuclear weapons in Iran could generate a spike in oil prices.

 

To summarize, some shock to the economy is the biggest worry in 2012.  Barring that, a bull market will end when Fed policy sends interest rates significantly higher, probably not until 2013 at least.

 

5) How should an investor with average risk tolerance be positioned for the year ahead?

 

I appreciate the careful wording of your question.  Most investors are freaking out, over-reacting to headlines.  The big market swings induce plenty of fear.   If you think (incorrectly in my opinion) that your upside in stocks is only 8% for the year, why deal with a market that often moves 2-3% in a day.

 

Most investors are not honest with themselves about risk.  Even in a good market year it is typical to have a 15% drawdown at some point.

 

In my approach the first and most important question for the investor is not what they hope to gain, but what level of risk is appropriate.

 

With this in mind, positions should be about 30% smaller than normal because of the current risk level.  I use the St. Louis Financial Stress Index as an objective means of determining actual risk.  It is not a forecast of the stock market.  My research found that a level of 1.1 in this index was the start of a trigger range.  This level was briefly exceeded a couple of months ago.  The index has pulled back into the .8 range, but not enough to give an "all clear."

 

6) How do you see the European sovereign debt crisis playing out in 2012?

 

This is the biggest current issue and the best source for profit by getting it right.  There is an overwhelming consensus that this is an inevitable disaster.  Merely questioning this and raising alternative possibilities leads to a chorus of people questioning your sanity!

 

This is a very crowded trade: short the euro, long bonds, long puts, short US financials, 100% out of the stock market for investors, and short for many hedge funds.

 

I have a resource page linking to more detailed coverage (http://oldprof.typepad.com/a_dash_of_insight/european-debt-crisis.html), so this is just a summary of conclusions.  Check out the link to see the argument.

 

There will be a problem with European sovereign debt for a long time, a period measured in years.  Merkel has said that it is a marathon.  The market is treating it as a sprint!

 

At a dinner in October I surprised some blogging colleagues when I told them that we would no longer be worried about this issue in eight months: June or July.  Today's news reports that Mark Mobius just said something similar.

 

What is taking place is a process of negotiation and compromise that will gradually involve many different programs and participants.  The final result will be a combination of bailouts, leverage, ECB bond buying, investments from sovereign wealth funds and China, austerity, economic growth, and maybe even the departure of one or more eurozone members.

 

Not one of these things, but all of them.  Democratic governments move slowly, trying to figure out what works.  They will do more of what is working and less of what does not.  The partial moves, disparaged as "kicking the can" by the average talking head, actually provide some useful time.

 

There will be no trumpet sound ringing when it is over, just as there is no gong sounding right now.  The Europe story will gradually fade, and people will notice that it no longer dominates the news. 

 

7) How bullish or bearish are you on the following markets: The US, Europe, Developed Asia, China, Emerging Markets?

 

There are many good investments, but the US has an advantage on a risk adjusted basis.  I own many stocks with substantial global exposure.  I like China better than the general emerging market theme.

 

8) What do you believe is the contrarian call on equities right now?

 

My measure of sentiment is the P/E multiple on forward earnings, especially as compared to interest rates or inflation expectations.  This tells you what those with assets are really doing as opposed to what they are saying.

 

By that metric, sentiment is more negative than it was at the 2009 bottom.

 

9) How confident are you that US companies can live up to current consensus earnings expectations?

 

I have a contrarian take on earnings forecasts: I find them to be of some value!  No one else does.  I share the popular skepticism about "buy" and "hold" ratings, but I find the earnings forecasts to be helpful.

 

Most observers will tell you that earnings estimates are too optimistic.  The same people will tell you that the bar is too low at the time companies report.  Well you cannot have it both ways.  If these statements are both true, then at some point in time, earnings forecasts must have been reasonably accurate.  My research shows that the one year forecast period is very good, incorrect only when there is a recession.  http://oldprof.typepad.com/a_dash_of_insight/2010/10/profiting-from-forward-earnings-estimates.html.

 

I actually prefer that analysts do not try to be amateur economists and include recessions in the forecast.  I can handle that myself.

 

With this background in mind, I think that the consensus expectations for 2012 are quite reasonable.  And yes, I know that profit margins are high and will revert to the mean.  This will happen as labor markets tighten, new businesses form, and the economy improves.

 

10) Are US stocks cheap right now based on the valuation methods you rely on most?  Will multiples expand or contract in 2012?   

 

Stocks are extremely cheap based upon earnings expectations and the potential return from other investments.  This approach to valuation is only a general guide, as experienced observers understand.  Whenever there is intense skepticism about the economy, something that has been the prevalent state since the 2004 election campaign, there is a consensus that earnings estimates are too high.

 

I have frequently invited readers to lead me to any source that has done better at forecasting earnings than the consensus methods.  The most popular alternatives are backward looking methods, embraced by the bearish punditry.  Since no single stock trades on the historical earnings record (we breathlessly await each new announcement) I wonder why people think that the sum of the parts is more meaningful than the whole.

 

This leads me to the question of multiple expansion, my worst prediction from last year.  I have actually done some research on this question, discovering a curvilinear relationship between interest rates and the stock earnings rate (the inverse of the P/E multiple).  In general, the two move together: higher interest rates lead to a lower stock multiple.

 

The exception occurs when interest rates are exceedingly low, indicating fears of deflation.  In those cases no one really believes the earnings forecasts and the result is multiple compression.

 

Last year I was wrong because (like almost everyone else) I expected interest rates to rise.  Instead, the fear and skepticism intensified.  The result is like a coiled spring.  At some point interest rates will move higher.  When that happens, at least until the ten-year note gets to the 4% level or so, the stock multiples will also increase. http://oldprof.typepad.com/a_dash_of_insight/2010/12/why-the-market-multiple-will-be-higher-in-2011.html.

 

If the Europe story fades, 2012 could be a very big year for stocks.

 

11) Describe some of your favorite market indicators and what they are signaling for stocks in 2012?

 

N/A 

 

12) What are your favorite and least favorite sectors for the year ahead? 

 

Since I have confidence in an improving economy, I like cyclical stocks and technology.  I also think that energy can work well.  The health sector is in limbo due to politics, but there will be an opportunity at some point during 2012.

 

13) What is your outlook for Financials?

 

Since I expect the European concern to diminish, this is probably the area for the greatest payoff during 2012.  Having said this, financials may not be the winners in the first half of the year.  No one believes the earnings forecasts or assurances about the lack of European exposure, so this is the most hated sector.

 

14) What is in store for the US economy in 2012?

 

There is a sharp divide in the approach to recession forecasting.  The ECRI has made an aggressive forecast of an inevitable recession.  At first they provided no time frame, but now they have narrowed it to the next six months.  They went to a 100% probability without any real notice.

 

The problem is that their methods are secret.  My review of several other sources, which I started long before the ECRI call, shows that most disagree.  Many of these sources have been just as good with real-time forecasts, but less publicized.

 

None of them has a recession forecast higher than 25%.  The mainstream economic forecast is for growth higher than 2.5%.

 

To summarize, my base case is continuing modest growth, improving from 2011.

 

15) Economic indicators as a whole came in better than expected in the fourth quarter.  Do you expect this trend to continue in the first part of 2012?

 

Yes.  There was improvement early in the year.  There was an external shock from the earthquake and tsunami, as well as problems in the Middle East and higher fuel prices.  You could interpret that slowdown as the result of temporary factors, or the onset of a recession.

 

The pseudo crisis around the debt ceiling led to another economic threat.  Through all of this, the base case from many indicators that I watch has been economic growth of about 2 to 2.5%.  This is now looking a bit stronger.

 

16) What is your take on the employment picture in the US?  Will we see the unemployment rate get below 8% by Election Day?

 

If current economic trends continue, net job creation will improve quite a bit, taking unemployment below 8% by Election Day.  The controversy over labor force participation will rage on.  There is no question that some baby boomers are leaving the labor force early and also that many people are under employed.  We also will have returning soldiers.  I cover employment pretty extensively, including aspects generally missed in the mainstream coverage.  http://oldprof.typepad.com/a_dash_of_insight/2011/11/who-gets-the-jobs-story-wrong-everyone.html. 

 

17) Are Ben Bernanke and the Fed helping or hurting the recovery?

 

The Fed is an easy target for politicians and pundits.  I am interested in investments; making money no matter who is in power.

 

Bernanke is a Republican, reappointed by a Democrat.  He has done good service, unappreciated by many.  It is interesting to note that Fed critics are of two camps:

 

-Those who think they should have done less: the crash and burn group

-Those who think they should have done more: the activist wing

 

The two wings agree on one thing: The Fed is wrong!

 

18) The Fed's Zero Interest Rate Policy (ZIRP) has really hurt savers and anyone out there looking for yield.  Where should investors go to find yield right now?

 

I understand that the question talks about the effect of ZIRP rather than the reasons, but we should all be clear about that.  The Fed had a dual mandate:  inflation and employment.  They do not have a mandate to provide a guaranteed income for savers.  Those making this argument typically have an intense political agenda: one that is hazardous to your investment health.

 

I have written a series of articles on "The Quest for Yield."  It was one of the most popular series on Seeking Alpha and also on my blog.  It reflects the great interest in the topic.

 

My conclusion is that it is possible to get an excellent income stream (10% or so after fees) from a combination of buying strong yield stocks and writing call options against the positions.  It takes a lot of work, but it is worth it.

 

My idea of a strong yield stock is not just a mechanical search for the highest yield.  I would rather have a 3% yield from a company that will maintain the dividend and also the stock price over five years.  Selling calls against these positions is very profitable right now!

 

19) The housing market continues to struggle.  Are we close to making another bottom in residential real estate?  Are there specific areas of the country that you are more bullish or bearish on?

 

N/A

 

20) Will the Dollar (US Dollar Index) be up or down in 2012 and why?  Are there any other currencies that you have a strong opinion on?  How much trouble is the Euro in?

 

There is a fundamental relationship that investors should understand.  As long as the US has a negative trade balance, the dollar must move lower.

 

21) Gold has underperformed stocks in recent months.  Will this continue in 2012?  Will gold see gains in 2012?

 

I do not know how to value gold or gold stocks on a fundamental basis.  The price is a function of two wildly disparate fears: hyperinflation and worldwide economic collapse.  Both of these concepts are easy to sell to a gullible public and the profit margins are high.

 

Since I have no pressing fear of either inflation or disaster, I am not currently a gold enthusiast.  I want to emphasize that I am open-minded and have often included precious metals in my portfolios.  I just do not think that this is the time.

 

22) The ratio of platinum to gold is currently at its lowest level ever (platinum is actually cheaper than gold right now).  Is platinum a good buy relative to gold?

 

N/A

 

23) Where is the price of oil headed?  How about the spread between Brent Crude and West Texas?

 

The general trend of energy prices is higher.  In China we have 25 million drivers and a billion to go.  The headline risk is also for higher prices.  This is only a matter of time.

 

There is already arbitrage activity between Brent and WTI, so the gap will close.

 

24) What are your predictions for the 2012 election?  Which party will win the Presidency, the House and the Senate?  Who will become the GOP nominee, and what are the chances that nominee will beat President Obama?

 

As a former poli sci/public policy prof, and a student at the top school for election analysis, this is right up my alley.  Despite this background, I think it is too close to call.  My guess at the moment is that Obama will win, mostly because the economy is improving and there is no strong opponent.  My further guess is that Romney will get the nomination, beating out a weak field.  It is still very early.

 

I suspect that we face at least two more years of divided government, with the GOP keeping control of the House.

 

That is interesting.  What do you mean by weak field?

 

Many of the candidates have solid traditional credentials, but they all come with some electoral "baggage."  The GOP establishment has struggled to find their candidate.  The primary process is really not ideal for finding either the most qualified candidates or the most electable.  At the moment, no one seems to combine the themes that resonate with the right personal charisma and traditional values.

 

25) How will the elections impact the stock market in 2012 and beyond?

 

This is a really great question, but it is too soon to answer.  I can do better when the GOP candidate is known.

 

26) Will the US Supreme Court rule that ObamaCare is unconstitutional?

 

No one really knows the answer to this excellent question.  If the ruling goes with the established political lines, the answer will be "yes."  There are challenges to two justices already, suggesting that they should recuse themselves from the decision because of conflicts.  The key question, whether people can be required to buy insurance, has many analogies and is quite thorny.

 

A good question for investors would be how to find stocks that will benefit from clarification, regardless of the decision.  That is a current research topic for my team.

 

27) How do you see the US tackling its debt problems in the years ahead?

 

The Simpson/Bowles approach is sound.  There must be a sacrifice on entitlements and also an increase in tax revenue.  People get the government they vote for.  In 2010 the country voted for divided government with an aggressive minority opinion that could block most compromises.  We are now seeing the results of that decision and a general lack of leadership.

 

The most difficult problems can best be solved right after an election, a time when we can hope for a brief spurt of bipartisanship.  Unfortunately, we seem to be in a perpetual election mode.

 

28) What are the biggest threats to the global financial system right now, and are they avoidable?

 

N/A

 

29) Hedge funds as a whole underperformed the S&P 500 in 2011.  How will hedge funds perform in 2012?  What is your take on the hedge fund model in general?

 

N/A

 

30) Will the following be up or down (positive or negative) in 2012?  Where noted, what are your 2012 year-end price targets?  The price targets are meant to obtain a wisdom of crowds consensus number from all Roundtable participants.

 

-S&P 500 (up or down and year-end price target) Up, say 1450.

-Long-Term US Treasuries (up or down) Price Up, Yields Down, 3.2%

-Corporate Bonds (up or down) The yield spread with Treasuries will get tighter, but the overall yield will move higher.

-Junk Bonds (up or down) Perhaps not much change. Higher overall yield and less risk.

-Gold (up or down and year-end price target) No opinion.

-Oil (up or down and year-end price target) Up about 20%.  The underlying trend is positive and the risks are all to the upside.

-Dollar (up or down) As long as the US has a trade deficit, the dollar trend will be lower.

-Average US Home Prices (up or down) There are recent signs of bottoming.  We need to see improvement on employment for a real change here.  GDP would be better if we just stopped the decline.

-China's stock market (up or down) No opinion.

 

31) Please provide readers with any stocks that you really like right now for 2012 and beyond.

 

I look first for themes, next for sectors, and finally for stocks.  I like a number of big-cap stocks as cyclical and tech plays, including Caterpillar (CAT), Intel (INTC), and Microsoft (MSFT).  There are other similar names.  I like energy stocks including Diamond Offshore (DO) and Chevron (CVX).  I expect financial stocks to rebound so JP Morgan (JPM) is a leading candidate.

 

I think that housing and health stocks will be winners, but it may be a bit early for these names.

 

32) Where is Apple headed as both a company and a stock?  How about Google?

 

I love Apple, and I have held the stock for many years.  I do not think that the markets for their products have maxed out.  The stock is cheap on an earnings basis, especially allowing for the cash and liquid assets.  It is a stock that I buy for new clients on day one.

 

I understand that Google has had some similar growth metrics, but it has never qualified on my criteria.

 

33) Facebook is expected to IPO in 2012.  Would you be a buyer or seller of the stock at its opening price on the day it goes public?  How long would you hold it?

 

None of the recent IPOs have been attractive for the open-market buyer.  It just seems like many people need gains and are trying to hit a home run.  They are also substituting familiarity with the product for knowledge about value.

 

34) Which technologies are you currently the most bullish or bearish on?  Are any of them game changers like the PC or the Internet were?

 

N/A

 

35) What are the website, magazines, newspapers, books, apps that you use the most and would recommend others to use?

 

This is another good question.  I read many sources, including the work of my colleagues in this Roundtable.  It is difficult to answer without leaving out something important.  Most people do not have the time or opportunity to follow as many information sources.

 

I have a list of favored sources on the blog.  My weekly column, Weighing the Week Ahead, has many citations every week, highlighting the sources that I find most useful.

 

I religiously read Abnormal Returns as the principal gateway to news, Bespoke Investment Group for top notch research and charts, Charles Kirk for both links and a trader perspective, and Calculated Risk for comprehensive coverage of economic news.  But these are just my starting points. 

 

36) What are your favorite Twitter feeds?

 

This is difficult to narrow down, since I follow different feeds for different reasons.  Since I make my own market decisions, I do not rely much on those calling for short-term market moves.  I follow many political commentators, mostly as general background.  Simply put, I know which feeds to monitor for the topic of the moment.

 

 

You can see who I follow by checking out https://twitter.com/#!/dashofinsight.  For a favorite non-market feed try https://twitter.com/#!/MikePereira to get authoritative answers on NFL officiating and https://twitter.com/#!/BorowitzReport for an irreverent (but liberal) take on politics.  I am a bipartisan consumer of political humor.

 

37) Do you have any other advice that you would like to share with readers as we enter 2012?

 

 

It is important to be open-minded about your investments, especially the global macro themes.  We are in the political silly season, where many people have strong motivations behind their economic arguments.  Most of those making comments are not trying to help your investments.  I recommend that you join me in being politically agnostic, willing to make strong investment returns no matter who is in power.

 

 

I also keep an open mind.  While I think that I can make the best returns for those willing to be aggressive, my main focus is on risk.

 

 

Most investors want to be cautious.  The downside is more important to them than gains.  They want to sleep at night.  I respect this and have created enhanced income programs that will suit these investors.

Weighing the Week Ahead: New Year, New Tone?

The theme has been the same for many weeks: Reasonable US data, bad news from Europe.

We start each trading day looking at the latest headline and how the Euro is trading. While the US economy has shown improvement, the European story is a huge overhang. This is mostly because no one knows how to quantify the possible impacts. The story plays in three different ways:

  1. Systemic risk;
  2. A second-order recession effect;
  3. A direct effect on corporate earnings.

Can the tone change?

For most of last week, the answer was “no,” but Friday’s trading was a bit different. The CNBC subtitle kept running as “Dow lower after employment report.” This is true, but very uninformative. If all we knew about Friday was that the Euro was trading lower, dollar higher, and Italian ten-year yields were over 7%, where would we expect the US market to be trading? The tone was a little better.

Another indication of the tone change was the nature of the commentary. Olilver Even the most bearish of pundits shifted from saying that the economic data is terrible, to saying that it is not good enough. I think we can all agree with that.

Can we have more, please?

Felix remains bullish for the near-term. While I have been more skeptical I am gradually coming around.

Can we really make headway in a week dominated by Fedspeak?

I’ll explain further in the conclusion, but first, a review of last week’s news.

 

Background on “Weighing the Week Ahead”

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

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

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

Last Week’s Data

The US economic data was pretty solid, continuing the mult-month pattern of modest economic growth.

The Good

As I noted in last week’s preview, this was a week to focus on jobs.

  • The employment report was solid. The net job gain of 200K is good, but not yet what we need. The unemployment rate of 8.5% shows continuing improvement. Hours worked increased by 0.1 of an hour. This may seem small, but it is equal to 35oK to 400K jobs. The hourly wage was higher. Gains were spread across many sectors. The only real reason to complain was to ask for “more please.”
  • The ISM report was very good at 53.9. This corresponds to an annualized GDP growth rate of 4%. The internals of the report were even stronger, since the weaknesses were in prices paid and the strength in employment and new orders.
  • Initial jobless claims of 372K were better than expected and continued the trend lower. This was outside the sample period for the employment report, so it constitutes fresh data.

The Bad

The negative news was less significant, with more emphasis on the future.

  • The ISM services report was a little lower than expectations, but still expanding.
  • There are continuing questions about seasonality in employment data. This chart from Doug Short (based on the initial claims series) shows the extreme nature of employment seasonality.

Weekly-unemployment-claims-NSA

It is obvious that seasonal adjustment is necessary, but what is the best method. The question this December relates to the number of people hired as couriers, thought to be larger because of online purchases. Is this really greater than the regular seasonal adjustment? Is there an offsetting loss of retail clerks? We’ll know more next month.

  • Investor sentiment (measured by the AAII) is at the highest level since February. Check out The Bespoke Investment Group for their interpretation of this helpful chart:

AAII Bullish Sentiment010512

  • Labor force participation still lags. Regular readers know that I regard the Y2K era as a high that will never be reached again — lots of demand pulled forward for replacement computers and COBOL programmers dragged out of retirement. I also believe that demographics mean earlier retirement for many. Even with this in mind, the employment to population ratio would be higher in a really healthy economy. Here is the picture from Doug Short.

Unemployment-population-ratio

The Ugly

Falling corporate earnings estimates have not yet reached our normal standards of ugliness, but it is a trend worth watching. The story is getting a lot of play.

Brian Gilmartin, tracking this at Wall Street All-Stars, writes as follows:

We’ve written about this before but i continue to be puzzled by the degree of “p/e compression” occurring in today’s market. Although we start to hear q4 ’11 results next week with Alcoa, the fact is S&P 500 earnings rose 14% – 15% in 2011, and yet the index finished flat on the year. Mathematically, if the denominator rises 15%, and your numerator remains flat, you get p/e compression, which is the same thing that happened in 2010. (Earnings up 30%, S&P 500 up 15%, etc.)

Dr. Ed Yardeni has a nice chart illustrating this story.

FIGURE4

This is a key story, which reflects the high level of skepticism about the sustainability of current earnings. I think this will be resolved to the upside, but I expected the same thing last year. Instead, we got another year of extreme macro worries and recession predictions.

The Political

I have not said much about the 2012 election, mostly because the investment implications are not very clear. As the field narrows, the issues may become sharper. My team has been working on a generic Republican policy to compare to Obama’s. As an indication of this type of analysis can be helpful, I suggest you take a look at this example:

What the Cordray Appointment Means for Stocks

And for an early start on your own voting, here is a test that is both educational and fun. You get to decide the importance of a number of key issues, figure out your own policy position, and then learn which candidate best matches your own views. The shadowy candidates rise in the background as you make each choice. You may be surprised at what you learn…..

Candidate Match Game

Have fun!

Europe

For now I am going to monitor developments in Europe in a separate section. My general approach, which is based upon my experience in the messy process of policymaking in democracies, is that the eventual solution will include a combination of many programs and participants, some of which we do not yet know. I have been doing a separate series of articles on this theme. So far I have the following:

How Investors Should Think about Europe — an overview with a general conclusion.

How to Predict Policy Decisions — Focusing on Europe — comments on the players and motives.

The single best market measure is the Italian 10-year bond. That was bad news, since the ending yield was over 7%, a level widely thought to signal trouble. UniCredit, the largest Italian bank conducted a rights offering to raise additional capital from current investors. Despite the steep discount (65% or so) the participation was lower than hoped. The stock cratered all week, raising concerns for other banks needing capital.

Despite this news, there were a number of auctions during the week, most importantly that of the EFSF. The story’s next big turn will be the report of Monday’s meeting between Merkel and Sarkozy. The market expectations for results of meetings is now pretty low. For a change, perhaps no one is expecting a magical solution.

The Indicator Snapshot

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

  • Economic/Recession Indicators. This week marks the introduction of two new measures for our table. The C-Score is a weekly interpretation of the only indicator I found that met the stringent tests outlined when I started the search. I will explain more about the search and the decision, but it is going to take a four-article series. I’ll have the first installment this week. The Super Index does not itself meet all of these tests, but some of the nine members do. You can read more about it in this article. It reflects extensive research and testing, and is well worth monitoring. (The Super Index includes the ECRI approach).
  • The St. Louis Financial Stress Index.
  • The key measures from our “Felix” ETF model.

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

Indicator Snapshot 01-06-12

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

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

The Week Ahead

There will be a lot of news this week. As usual, I am highlighting the events that I see as most important.

  • We start the week with a report of the Merkel/Sarkozy meeting. There will be additional commentary, auctions, downgrades by credit agencies, and assorted newspaper “scoops.”
  • The Fed will release the Beige Book, showing the anecdotal information that the FOMC will use at the next meeting. Since we are outside the Fed quiet period, there will be speeches nearly every day.
  • The most important economic data comes on Thursday (retail sales and initial claims) and Friday (trade data and Michigan sentiment).
  • Earnings season starts, with Alcoa on Monday and JP Morgan on Friday.

As usual, Mark Gongloff has the comprehensive data/earnings/speechifying calendar which we should all put on the bulletin board.

Trading Time Frame

Our trading accounts have been 100% invested for several weeks. Felix caught the recent rally quite well and still has several strong sectors in the buy range. While the overall ratings are not strong, it remains a marginally bullish forecast. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated.

Investor Time Frame

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

Our Dynamic Asset Allocation model is also very conservative, featuring bonds and other defensive holdings.

To summarize, we have a very conservative posture in most of our programs, recognizing the uncertainty and volatility. For new accounts we are establishing partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program. This program has been meeting the objectives of conservative, yield-oriented investors. It follows our key precept:

Take what the market is giving you.

The Final Word

The market does not move in line with calendar years. Many of the best themes may require a little more evidence for most to be convinced. It is fine to be cautious, but we should still monitor the actual data. Avoid emotion when doing your own year-end tune up (email main at newarc dot com for a free report on how we do it and some other investing ideas).

You can also get a lot of good advice by checking out the forecasts from The Bespoke Investment Group Roundtable, which I described last week.

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.