Weighing the Week Ahead: An Economic Turning Point?

[Note to readers — Whenever I actually enjoy some time off on a weekend, there is a challenge in posting the regular WTWA article. I could always do a simple indicator update, and I monitor many sources in real time. I also have a plan for my own trading for the week ahead. Finding the six hours or so to write it all down is sometimes a challenge. When I travel or take some time off I can either be late, be incomplete, skip the week, or do some combination of the above. This week I am choosing to provide some continuity on the series, while posting a little late.]

This is an especially important week for financial markets, so I am doing my weekly update, even though it is late, and more focused on the future than last week.

Going into this week, the recent economic reports have all been a bit disappointing — nothing terrible, but a little worse than expectations.

The timing of the weaker data coincides with seasonal patterns from the last two years and the anticipated end of the current Fed "Operation Twist." It raises the question: Have we reached an economic turning point?

Friday's employment report will be the most important evidence, but the rest of the week includes many of the most important economic reports. I will offer my guess about what to expect in the conclusion, but 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 comprehensive weekly review. 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.

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

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 a little soft, while earnings have been very good.

  • 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. One analyst from my geographical region has a convoluted explanation about why earnings are not as good as they seem. This is the same guy who has been saying that the chance of recession is 50-50 and warning that earnings could plummet by more than 50%. He gets big time exposure both from Barry Ritholtz and CNBC, but has no published record of forecasting either earnings or recessions. Can we ask for some accountability?
  • The ISM report was great — 54.8 — reaching levels from early last year. The underlying components were also very good. The ISM's research suggests that this index level (if annualized) is consistent with GDP growth of 4.1%. See the detailed analysis and charts from Steven Hansen.
  • Reported GDP growth understates economic strength. It is all about the inventory changes. Inventories have moved lower, which hurts GDP. When inventories go up, bearish pundits say that the number is overstated and bullish pundits argue that businesses expect the need for more goods. It is confusing, but Bob McTeer shows that the data are actually pretty good. He explains why the first quarter report of 2.2% is actually stronger than Q411's 3.0%.
  • The Fed acted as expected, and Bernanke's explanation (We'll be there if needed.) was understood.

 

The Bad

The economic news last week was disappointing, with everything a touch worse than expected.

  • Initial jobless claims continued at a high level. We are getting outside the time frame where pundits can blame an early Easter. Those of us who rely on data and watch the four-week moving average are concerned about the higher level of initial claims.
  • GDP Growth was weak. Taking a somewhat different perspective from McTeer, Calculated Risk considers a number of factors, including weather.
  • Social Security and Medicare are running out of money sooner than expected. Who could have known?
  • Various lesser economic reports are all slightly worse than expectations. It is becoming a trend — and one worth watching.
  • The Conference Board Consumer Confidence index is still at recessionary levels (via Doug Short).

Conference-Board-consumer-confidence-index

The Ugly

Florida State is eliminating its Computer Science Department to save less than $2 million while increasing the athletic budget by a larger amount. I understand that football generates direct revenue and the nerds and geeks do not — but still…….Something is wrong here.

 

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.

I am a big fan of Dwaine van Vuuren, whose excellent statistical work is giving us better insight into a wide range of recession forecasting methods. The data point that I cite each week (the four-month recession outlook) is only one aspect of a comprehensive report. The SuperIndex includes nine different methods, including the ECRI. The analysis has a very strong, practical market application which has paid off richly for subscribers over the last few months. How? Mostly by putting the ECRI recession forecast into better perspective. I am publishing the one-month delayed Leading SuperIndex estimate of recession probability in the near future — three or four months. This is plenty of time to have value for public followers of their reports.

Dwaine seems to produce another interesting report every week. At at time when there is worldwide economic pressure, many want to know whether the US economy can escape. Here is a great chart:

OECDMay2012

To understand the continuing relative strength of the US economy, you should read the complete article, which reaches the following conclusion:

"The next few months behavior of this index will be interesting to watch but we can make one observation about the current levels and that is it is not indicative of a pending stock market correction or peak. If anything, if the index starts pointing upwards, this will signal continued U.S stock market gains."

 

Indicator snapshot 042812

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. Two weeks ago we shifted from bearish back to neutral. The last several weeks have been pretty close calls. The ratings have improved a bit. The inverse ETFs are no longer at the top of the list, so I would not be surprised to see a little buying next 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. 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

The big story this week will be Friday's employment report, but the calendar has created another deluge of data.

I am very interested in the ISM reports on manufacturing and services, since these give great insight into employment.

The ADP private employment report (Wed) is also significant, since it provides an interesting and credible alternative to the regular BLS approach. Initial claims (Thurs) are also significant, even though the data are out of the survey range for Friday's report.

There are other reports, but the big story will be about jobs.

Trading Time Frame

We mostly out of the market last week in trading accounts, after a long period when Felix caught the rally pretty well. We have a small bond position — a further indication of caution.

The current market has been confusing to many top professionals, as I reported in this article featuring commentary from Art Cashin. Many wannabe traders look at big market moves and think that this means they should be doing something.

This is wrong!

Traders must act only when they have edge. Wild volatility may look like opportunity, but it only works if you are calling the turns. The most important decision is to act only when you have edge.

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.

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.

Final Thoughts on the Turning Point

When it comes to the economy I am watchful and wary, but I do not yet see a turning point. Many investment managers sharpened up their tools after 2008. Regular readers can join me in monitoring both systemic risk and recession risk.

Both remain much lower than headline risk!

The market makes new highs in spite of the headline risk that sells newspapers, but it is no surprise to those who follow data on corporate earnings, recession risk, or the declining chances of a financial meltdown.

Meanwhile, those who emphasize slogans have downplayed "upside risk." Here are two developments to consider:

  1. Could housing be improving? I have been stodgily bearish, but I am seeing construction in my area. Calculated Risk sees signs of a bottom. Our Felix model likes home builders, although the sector is still in the penalty box. Most people do not realize that the housing decline has been subtracting 1 to 1.5% from GDP growth. Even a flat housing market is an improvement.
  2. Can there by stimulus from energy? I wonder if most people even noticed this interesting op-ed piece in the FT by Philip K Verleger Jr., former Director of the Office of Energy Policy at the US Treasury. He points out that US economic growth has consistently exceeded expectations, and makes a bold prediction for the next decade:

"Ten years from today, the CEA and Federal Reserve chairman will again celebrate a decade of unexpected strong growth. This time the credit will go to countrywide gains from the very low energy prices found only in the US. Low-cost energy will have spawned an export surge in all sorts of goods, from chemicals to tyres.'

Readers should check out the entire article, if only to provide an alternate perspective about economic growth prospects.

 

Don’t like the real data? Just pretend!

If you are reaching an important investment decision, I have a suggestion for you:

Insist on data — accept nothing less!

Investors should monitor diverse sources of investment information to avoid confirmation bias.  If you want to succeed, you still need to engage in critical thinking.  Some are in complete denial about progress.  There is a simple solution if you do not like the reality of strong corporate earnings:

Talk about "normalized earnings."

This has a wonderful scientific feel to it, lending an air of credibility to those who have not studied the subject.  After all, don't we want our estimates to be "normal?"

If the current strong earnings reports do not fit your forecast, you can just say that you want to "normalize" earnings without offering any clue about your method or how it has worked in the past.

Background

When the recession hit, there were many observers who felt that even the finest companies would be crushed by the economic collapse.  They expected that revenues would fall, expenses would increase, and profit margins would collapse.

Some of us thought that the best companies — not all — would learn to get "lean and mean" and would increase earnings rapidly during the rebound.  We were right, and we have profited from this investment.

The increased earnings had a downside, since it often came at the expense of workforce reductions, with remaining workers asked to do more.

The Recovery

During the recovery period, the companies with enhanced productivity have blossomed — better earnings and better cash flows.  There is a clear lesson:

Profit margins went higher as pricing power and employment went lower.

I disagree with some observers (sometimes accused of being perma-bulls) who think that profit margins have achieved a permanently higher level.  My own conclusions are more nuanced.  I fully expect profit margins to decline, and I am interested in two questions:

  1. When?
  2. How far?

We should all be open-minded about the eventual profit margin level, which is a function of (primarily) new competitive entrants. When it comes to a topic like — for example — unemployment — the bearish pundits are eager to embrace the idea that there have been structural changes.  OK — and what about the many companies that are protecting their profit margins?

More importantly, I agree with the general concept that profit margins will decline.  At the same time this "mean reversion" occurs I expect  all of the things we associate with a strong recovery:   Better employment, better pricing power, and more aggressive competition from new companies.

There is nothing surprising about any of this, since it reflects a typical business cycle.

Time to call "FOUL!"

There is a group that I'll call Pundits in Denial.  They engage in static analysis, expecting profit margins to decline while nothing else changes.  As a result of this misguided analysis they help to scare the daylights out of the average investor by stating that if earnings were "normalized"  —what a wonderful word!!  — then the market is massively overvalued.

How to Normalize

When I am analyzing a stock with cyclical properties, I definitely consider the earnings at peaks and troughs of the business cycle.  This is one of the key elements of my edge, so most people have no idea about how to do this.  If you are at a business cycle trough, you must be willing to buy cyclical stocks at a high P/E multiple  — and vice versa.

To do this correctly you need to have a good theory of the business cycle and where we are right now.

You cannot just take a meat cleaver to earnings, saying that you reject the data because of profit margins.

Investment Conclusion

If you want to gain an investment edge you have to find something that most people are doing wrong.  Investing in cyclical stocks combines common errors on profit margins, economic strength, and where we are in the business cycle.

I have a current emphasis on this theme, but today presents an outstanding candidate in Caterpillar (CAT). I had several stocks in mind for this article, but CAT is the most timely.  I am choosing it as the worst-performing (and therefore the best opportunity) of stock fitting this theme, since the stock sold off today despite a good report.  Here is the long-term earnings picture (from the excellent fastgraphs source) before today's report:

CAT

Any investor who looks at this chart for a minute or so will be far ahead of most of the people they see in TV!  You can see for yourself the worst case of earnings during recessions, the general growth rate, the ability of the company to deal with recessions, and the current potential.

Nothing in today's report upset this story, so you get a chance to buy a terrific stock at a discount.

Once again, I abbreviated this story to cite the stock with the best current opportunity.  Another candidate to feature in this story was Apple, but that would have been a layup!  I hope readers understand that there are many, many stocks like this.

To repeat the main point — "normalizing" profits is not as obvious as it first seems…..

More to come.

Weighing the Week Ahead: Will the Fed Disappoint the Markets?

Get ready for a week of renewed focus on the Fed. No one expects a policy change, but there is plenty of room for disappointment.

In the new era of Fed communications there will be plenty to analyze, including the following:

  1. The FOMC statement, which can be carefully parsed for small wording changes and evidence of disagreement or dissent;
  2. The updated economic outlook;
  3. Updated projections from each FOMC member, with a report showing ranges and central tendencies;
  4. A press conference where Bernanke will try to explain it all.

Most of this transparency is pretty new, and it is still controversial. One reason is obvious.

In the old days, when no one expected a policy change, there would be no reason for fixation on the Fed. There is now much more to analyze.

I'll offer my ideas on what to expect in the conclusion. 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 comprehensive weekly review. 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.

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

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 a little soft, while earnings have been very good.

  • Building permits show solid growth. In my experience this is the best leading indicator. Steven Hansen does a nice job on this indicator, which the ECRI should probably consider including instead of housing measures obfuscated by foreclosures.
  • Earnings reports are very good so far, via Bespoke Investment Group. As you look at this, please keep in mind that many claimed that earnings estimates were too high and should be moved lower.

Beatrate420

  • Earnings and revenues. One of my pet peeves is a general lack of accountability on earnings expectations. Remember when the earnings rebound started? Here is Dr. Ed Yardeni's account:

"When the bull market first started in 2009, the bears growled that the rebound in earnings was all attributable to cost cutting. So it wasn’t sustainable, in their opinion. They didn’t believe, and couldn’t imagine, that revenues might actually have a normal recovery too. I track three measures of business revenues, which are all at record highs now."

FIGURE114

  • Rail traffic was solid if you ignore coal. Steven Hansen at GEI has been doing a great job with this series. This table tells the story — solid except for coal.

Z-rail23

 

  • Too much focus on the trees — and neglecting the forest. We should all keep in mind the overall picture coming from creativity and innovation — via Abnormal Returns and Barry Ritholtz.

 

The Bad

The economic news was disappointing, with everything a touch worse than expected. If the list is not enough for you, check out a source that even sees employment growth as bad (via Todd Sullivan).

  • Initial jobless claims moved higher, to 387K and revisions were also higher. The times include the final week for the April employment report. While many observers opine that this will be better when the unusual seasonal factors are resolved, I continue to be concerned about the jobs numbers in two weeks.
  • The Philly Fed was a bit light at 8.5 versus expectations in the 10 range and 12.5 last month.
  • Assorted political salvos. I hardly know where to start. Each party is proposing legislation that has no chance of passage. The GOP has a choke point in the House and also preventing 60 votes (required to block a filibuster) in the Senate. The President can veto any bill and the GOP has no chance of a 2/3 vote to override. I have a long list of links from last week, but I think it is better handled as a separate article. Let us just say that political debate is descending to the lowest common denominator (see here for examples). Jeb Bush warns to expect the most negative campaign ever.
  • Vehicle traffic has moved lower, especially with an adjustment for population. This is an interesting and creative indicator from Doug Short.

Miles-driven-POPTHM-adjusted

  • European debt continues to be worrisome. While the scheduled auctions met sales targets, the rates are high, so I am putting this in the "bad news" category. The Spanish 10-year note was trading at the 6% level and the Italian equivalent at about 5.5%. I monitor these daily. While I still believe in a broad compromise settlement involving many parties, there is obviously an attack in the CDS market. I encourage readers to check out Cam Hui's commentary. I invite other recommendations for good sources in the comments.

The Ugly

This week's Ugly award goes to the stock-picking robot — ready to help you find instant gains in penny stocks. The economic and investment losses have created a new level of desperation. There is a dramatic increase in both perpetrators and victims.

The robot team had a business model that profited in all of the key ways:

  1. Selling bogus software to clients. The software developers were told that the program needed to appear to be analyzing data, but actually taking direction from the scammers.
  2. Selling pump-and-dump services to companies. Results guaranteed.
  3. Front-running the suckers.

This is a constant battle. I want to give credit to the SEC, but it is frustrating. I have reported a number of obvious scams. The SEC does not let you know what happened. They do not even acknowledge your contribution. Two groups that I reported were the subject of later action, but some are still at large.

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. For his subscribers, he offers the following conclusion:

"I now find myself in statistical opposition to all those who are calling for a cycle peak in 2012. I use the “statistical” qualifier in that sentence because after doing this for more years than I care to admit, one has to be cognizant of the fact that strange things can happen. So it is possible, but highly improbable, that the conditions associated with a cycle peak could present themselves before we “turn the page” on 2012."

Bob has his usual exhaustive analysis with many charts. His analysis is erudite, comprehensive, entertaining, and witty. Here is a single chart summary, but you should understand that all show the same thing.

DAGS

I am a big fan of Dwaine van Vuuren, whose excellent statistical work is giving us better insight into a wide range of recession forecasting methods. The data point that I cite each week (the four-month recession outlook) is only one aspect of a comprehensive report. The SuperIndex includes nine different methods, including the ECRI. The analysis has a very strong, practical market application which has paid off richly for subscribers over the last few months. How? Mostly by putting the ECRI recession forecast into better perspective. I am publishing the one-month delayed Leading SuperIndex estimate of recession probability in the near future — three or four months. This is plenty of time to have value for public followers of their reports.

Two weeks ago they added another interesting recession indicator, finding states that show economic changes in advance of the nation. You will be surprised at which states are the "canaries in the coal mine."

Last week Dwaine teamed with Georg Vrba to analyze the unemployment rate as a recession indicator. It turns out that this single measure has terrific results. It currently suggests, "One can therefore reasonably conclude, based on the historic evidence of these unemployment-based indicators, that there will be no recession in the near future and that ECRI’s recession call may have been premature."

 

Indicator snapshot 042012

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. This week we shifted from bearish back to neutral. The last several weeks have been pretty close calls. The ratings have improved a bit. The inverse ETFs are no longer at the top of the list, so I would not be surprised to see a little buying next 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. 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

While I expect the Fed to be the main story this week, there will be plenty of other action.

Before the trading week even starts, we will have the first round of the French elections. Normally this would not be a major consideration for US stocks, but this time is different. A loss by incumbent Sarkozy could lead to dramatically changed policies for France, with other countries in line. This could affect the euro, the European economy, and also US stocks. This Washington Post summary lays it out nicely. That will be Monday's story.

I am interested in Consumer Confidence (Tuesday) and Initial jobless claims (Thursday) as important coincident reads on the economy. Q1 GDP — the first reading — will be reported on Friday, presumably confirming that the economy weakened a bit but was not close to a recession.

This is the big week for housing data, including Case-Shiller prices, FHFA prices, new home sales, and pending home sales. Housing is important, of course, and some see signs of improvement. I am not expecting much from these reports.

It is also a big week for earnings reports. It could well be an exciting week.

And finally — Tuesday will give us the BLS Business Dynamics Report. This is the one that shows whether the employment estimates from 8 months ago were accurate. Everyone should be watching this, but I will probably be the only one reporting!

Trading Time Frame

We were out of the market last week in trading accounts, after a long period when Felix caught the rally pretty well.

The current market has been confusing to many top professionals, as I reported last week in this article featuring commentary from Art Cashin.

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.

If you are an investor who has been frustrated by a market that ground relentlessly higher, providing no opportunity for entry —- well— what are you waiting for now?

I want to emphasize that being an investor does not mean "buy-and-hold" or a "forever" portfolio. I believe in active management of investment accounts, adjusting for changed circumstances. We need to look beyond the headlines, political commentary, and those profiting from the climate of fear.

There is an important difference between short-term market timing and active management of your holdings.

I look at the following:

  • Recession risk — now very low.
  • Earnings growth — excellent and undervalued.
  • Financial stress — high on the headlines, but modest on the data, falling rapidly.

Barry Ritholtz has a great article on this distinction, which I strongly recommend. Inspired, I wrote my own piece on this theme. Find your role, your strategy, and stick to it!

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.

Final Thoughts on the Fed

When I put on my trader hat, focusing on the attitudes of those on the front lines, I know what is important.

Traders want more of that QE!

The trading perspective is that the economy is weak and the Fed does not get it. Traders — and therefore the "market" in the short term — want to see the Fed doing more. At the most fundamental level there is no need for a deep explanation. The last two years show a pattern which (to a very forgiving eye) seems to show a market that rises when the Fed is active and declines when it is not.

While I disagree with this interpretation, success in trading means understanding the perspective of everyone else. The Fed policy has had much less impact than traders believe. Here is a helpful chart from Doug Short.

Operation-Twist

For investors, more twisting is not a big deal. For traders, it is.