Weighing the Week Ahead: More Clarity from the Market Message?

Do you have an opinion about stocks or bonds or foreign exchange? If so, it is easy to find a market message that will support (or contradict) your viewpoint.

The “message” of the market has rarely been this confused. With plenty of important news and data this week, the theme will be: Can we find clarity in the market message?

Prior Theme Recap
Last week I expected a focus on housing. The short trading week would start with Prof. Shiller (that was right) and end with discussion of pending home sales (also right). In between, there was plenty of filler because nothing much seemed to be happening. I lost count of the number of stories about the driverless Google car – interesting, but not very relevant for the markets.

Forecasting the theme is an exercise in planning and being prepared. Readers are invited to play along with the “theme forecast.” I spend a lot of time on it each week. It helps to prepare your game plan for the week ahead, and it is not as easy as you might think. Feel free to suggest your own likely theme in the comments.

Naturally we would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react.

This Week’s Theme

What is the “message” of the market? Will it be clarified this week?

Here are three perspectives, from three different markets:

  1. Stocks are at new highs. Historically, stocks have been a leading indicator for the economy, reflecting expectations about future earnings.
  2. Bonds are rallying. Many view this as a sign of economic weakness. Those who are bearish on the economy like to insist that the bond market is “smarter” than that for stocks. Santelli watchers get this viewpoint every day. Cullen Roche offers some alternative concepts. I analyzed several explanations two weeks ago in this WTWA post.
  3. The VIX (the volatility index) is making fresh lows. Most pundits argue that this demonstrates unwarranted complacency. It is a warning to equity investors. (See a good argument at Free exchange. See also Cam Hui for a more nuanced interpretation).

The market message is confused and inconsistent!

As usual, I have some thoughts that I will share in the conclusion. First, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading the background information.

Last Week’s Data

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

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

The Good

There was plenty of encouraging news.

  • Consumer confidence improved. This is the Conference Board version. It usually tracks with Michigan, but not always. Doug Short has good analysis and charts.
  • Chicago PMI was very strong at 65.5. This is the best read on the national ISM manufacturing report. It gets more attention when there is a weekend before the national report. It is good news, but we’ll know a lot more on Monday.
  • Case-Shiller home prices beat expectations rising 1.2%.
  • Capital spending should improve. Even bearish economists note the importance of capital spending. Dr. Ed Yardeni explains the relationship with forward earnings, which continue to improve.

Yardeni capital spending

  • Initial jobless claims improved dramatically. This is a noisy series, but one of the best concurrent economic indicators. It helps us to understand the number of job losses, but we still need to learn about new job creation.
  • Durable goods orders were strong, up 0.8% seasonally adjusted and even stronger on non-adjusted data. Steven Hansen at GEI has complete analysis and charts, including this one:

91184213ztemp

The Bad

There was a fair share of bad news last week.

  • Sentiment is more bullish. This is a contrarian indicator. Bespoke tracks the American Association of Individual Investors series. Their typically fine chart shows the current gain, the biggest jump in more than a month. They also note that it is not yet at the average for the entire bull market – 38.4%

AAII Bullish 053014

 

  • Personal spending declined by 0.1% in April. Personal income growth was acceptable at 0.3% (Calculated Risk).
  • Michigan sentiment disappointed with a final May reading of 81.9. I view this series as important (and not just because I am a Michigan man). My own research shows it to be a good indicator of spending and employment. Doug Short does a regular update of the series which includes my favorite chart. You can find it here.
  • Pending home sales disappointed, with growth of only 0.4%. Sober Look argues that lower mortgage rates will not help. Bonddad remains bearish.
  • GDP declined 1% in the first quarter of 2014. I am scoring this as “bad news” since it was a significant downward revision and GDP is the final measure of economic performance. In fact, the market shrugged off the news. Dan Gross notes the inventory effect (accounting for the entire revision). Personal consumption increased 3.3% and durable goods increased 1.4% despite weather effects. (Hale Stewart). Prof. James Hamilton provides an even-handed take. He notes the weather and the consumption increase, but also observes that part of the spending increase was on health care. Business fixed investment and new home construction declined. “I am still expecting numbers for the rest of the year to come in much better. But there’s no getting around the fact that 2014 got off to a pretty weak start.”

    One way of view the data is in terms of real GDP per capita. This method is recommended by my Scutify jousting colleague Simon Constable in his award-winning book on economic indicators – an excellent reference. (Curiously, I act more like a consumer of data while Simon claims an advantage over the economists he covers as a journalist. Maybe we should switch jobs!) Doug Short does a regular update of GDP in these terms. His fine chart (one of many good ones) shows the sad story of continuing disappointment in the US economy. (Doug’s charts should be classroom examples for those trying to explain data – log scale when appropriate, helpful trend lines, accurate sourcing, good description, multiple variables all clearly included, and helpful callouts.)

    real GDP per capita

     

 

The Ugly

Detroit rebuilding costs. Knocking down abandoned property is an inevitable part of fighting blight in a city that has gone from a population of 1,850,000 in 1950 to 700,000 last year. The abandoned homes will never be used again. Even destroying those leaves problems of lead and asbestos abatement. The cost estimate is $850 million. Fewer than half of property owners pay taxes. 118,000 properties are on track for tax foreclosure, but who will buy them?

There are no easy solutions.

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 Paul Kasriel (via GEI), who shows the error in knee-jerk analyses of the unemployment rate. He writes that everyone has been trained to do a quick comparison of labor force participation with unemployment to see if the rate is providing a clear message. This is not enough. He writes as follows:

… (A) decline in the labor force does not always reflect an increase in so-called discouraged workers. And, in fact – well, fact may be too strong a word, but according to data contained in the April Household Employment Survey – the number of people not in the labor force in April but who did want a job changed by a big fat ZERO.

This is something to watch for on Friday.

 

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. For more information on each source, check here.

indicator snapshot 053114

Recent Expert Commentary on Recession Odds and Market Trends

Georg Vrba: Updates his unemployment rate recession indicator, confirming that there is no recession signal. Georg’s BCI index also shows no recession in sight. For those interested in hedging their large-cap exposure, Georg has unveiled a new system.

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis.

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured “C Score.” One of his conclusions is whether a month is “recession eligible.” His analysis shows that none of the next nine months could qualify. I respect this because Bob (whose career has been with banks and private clients) has been far more accurate than the high-profile TV pundits.

Doug Short: An update of the regular ECRI analysis with a good history, commentary, detailed analysis and charts. If you are still listening to the ECRI (2 ½ years after their recession call), you should be reading this carefully. Doug also has the best continuing update of the most important factors to the NBER when they analyze recessions. In general, you need to have a business cycle peak and then a significant decline. In contrast with Bob Dieli’s method, this approach shows a possible peak in some of the elements.

dshort big four

 

The Week Ahead

We have plenty of data this week including the most important reports. The WSJ focus on the big news is helpful – a useful alternative to the comprehensive list.

The “A List” includes the following:

  • Employment report (F). Rightly or wrongly, this remains the most important data for the market.
  • ISM index (M). A sensitive gauge of manufacturing trends with some leading components.
  • ECB policy decision (Th). Important not only for forex, but for stocks and bonds as well. Here is a guide about what to watch. And also here.
  • Initial jobless claims (Th). Best concurrent read on employment.

The “B List” includes the following:

  • ISM services (W). More businesses covered than manufacturing, but a shorter history for the series.
  • ADP employment (W). This measure of private employment deserves respect, and gets it from most Street economists.
  • Auto sales (T). Good read on possible consumer rebound. Watch the F150 indicator of construction activity.
  • Beige book. (W). This is the “color” provided to FOMC participants at the next meeting – anecdotal evidence from each Fed district. Will it confirm the official interpretation of data?
  • Construction spending (M). April data, but an important sector.
  • Factory orders (T). More April data.
  • Trade balance (T). April data, but relevant for Q2 GDP, which will be a subject of great interest.

There will be plenty of FedSpeak and also news from the G-7 Summit in Brussels.

 

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

My weekly insights often suggest a different course of action depending upon your objectives and time frames. They also accurately describe what I am doing in the programs I manage.

Insight for Traders

Felix is a bit more upbeat this week. There are more fresh buys in the ETF universe, including QQQ. The high penalty box level implies less than normal confidence in the ratings. We briefly cut our trading position size during the week, but finished the week fully invested in three top ETF sectors.

The overall call is very close between bullish and neutral. Even in a neutral market there are often good sectors to buy.

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. The current “actionable investment advice” is summarized here.

The market did not provide much opportunity for fresh buys. The gentle upward action is fine for long-term investors and excellent for those trying out our Enhanced Yield approach.

Here are some key themes and the best investment posts we saw last week:

Doom and gloom sells – like sex, writes Howard Gold at MarketWatch. He is keeping score at taking names! This is so much better than the TV folks who pander to viewers by trotting out these pundits without any reference to past record. He writes:

It draws viewers to TV, eyeballs to websites and buyers to books from “Crisis Investing,” published in 1980, to “Surviving the Great Depression of 1990” to “The Collapse of the Dollar and How to Profit from It” (2008).

The financial crisis and Great Recession created a bull market in doom and gloom. But nearly six years after Lehman Brothers’ collapse, the worst hasn’t happened — unless you consider a 180% advance in the S&P 500 Index a disaster. Which it was, to those who avoided U.S. stocks because they believed the doom-and-gloomers.

So, now, enough time has passed to label certain outrageous forecasts as just plain wrong and to call out the people who made them.

Here are the four worst predictions to gain traction over the past few years.

Regular readers might want to guess before reading!

Could there be a “stealth recovery” in the economy? The analysis from HighTower Advisors includes this interesting quotation from Richard Bernstein:

Bear markets are made of tight liquidity, significantly deteriorating fundamentals, and investor euphoria.  Although the Fed is starting to reverse course, there are no signs yet of a significant tightening of liquidity.  Rather, the data are beginning to suggest that private sector credit growth is starting to replace the Fed as the provider of liquidity

Sell in May did not work. (WSJ). Serial correction forecasters will insist that it is now “Sell in June” or something else. The reality, an answer to my client questions nearly every week:

  1. There will be a market correction of 15-20%. Look at a long-term chart. It is a regular event.
  2. You cannot predict when these will occur and neither can the supposed experts. If you get good evidence on their market timing records, you will see. Check out my post on the Seduction of Market Timing.
  3. Those trying to time this correction have already missed a big move. Ironically, this does not convince them of a mistake. Instead, they are even more determined to wait.
  4. A better approach is to watch the fundamental indicators (recession odds and financial stress) and quit trying to time the smaller swings.

You pay too much attention to financial news. Morgan Housel describes this so well! Here is the daily story:

NEW YORK – S&P 500 companies earned $2.71 billion of net income on Tuesday. $890 million of that will be paid out as dividends, with the remainder retained for future growth.

That’s it. The report would be the same tomorrow, the next day, and the next. Figures would be updated quarterly, but the format wouldn’t change, ever.

This would not be very good for ratings, but it would help your bottom line.

Take advantage of pessimism writes Scott Minerd of Guggenheim partners. After noting the recurring prophesies of doom, he suggests that central banks remain active on the other side. He writes as follows, providing a helpful chart as well:

U.S. and European economic data have been on an improving trend, helping to bolster the outlook for the global economy. As output accelerates in advanced economies, countries around the world should benefit from increasing demand for manufacturing inputs. With the investment cycle turning in the United States and Europe, global trade should accelerate in the near term, helping kick-start growth in some struggling emerging market economies.

Trade data via Guggenheim

 

If you are obsessed about possible market declines, you have plenty of company. This is one of the problems where we can help. It is possible to get reasonable returns while controlling risk. Check out our recent recommendations in our new investor resource page — a starting point for the long-term investor.  (Comments and suggestions welcome.  I am trying to be helpful and I love and use feedback).

Final Thought

The very concept of the market message should be troubling for active investors. If you think that markets are efficient, you are wasting time trying to gain an advantage. If you deny the efficient market hypothesis, what is the point in searching for a message?

Most cite the market message when it supports their viewpoint and ignore it otherwise.

I recommend that you reach your own conclusions based upon fundamental data. Since my indicators show an improving economy and little recession risk, I interpret the strength in bonds as a reflection of other factors – low inflation expectations, favorable comparisons to European yields, and traders caught “offside” on the bond trade. (I sympathize with that!)

To the extent that the message is inconsistent, I expect yields to rise over the remainder of the year. I do not see “complacency” in the stock market. It is better described as an uneasy balance of nervous viewpoints on both sides.

And by the way….so many treat the VIX as an indicator rather than a market. That is an error. If you really believe that the VIX signals complacency you can step right up and buy options on the underlying stocks or else the VIX itself.

Why would anyone think that the options market is less sophisticated than that for stocks or bonds?

Weighing the Week Ahead: How Should Investors Judge the Prospects for 2014?

Sometimes the calendar of news and events makes it easy to predict what will grab our attention in the week ahead. In the last few weeks leading up to the Fed tapering announcement, I highlighted the following:

I certainly don’t always get it right, but it has been a pretty good run.

The accident of the calendar, mid-week holidays for two consecutive weeks, has created an extended vacation for many market participants. There is little earnings data or important reports, but plenty of football.

The field is open for pundit prognostication!

The predictions cover a wide range, including one featured columnist who sees a 90% chance of a market crash. There is another series on how to prepare for a total collapse, including a link to a survivalist “grab-and-go” bag. I am not including it here, since I clicked on it myself and it now pops up on every page I visit! (Amazon is sold out, at the moment…. Hmm).

How should you navigate the varying forecasts?

  • Consider the track record. Anyone can improve, but sometimes it requires accepting new data. You can start with my featured “hot and not” list for last year. There are some sources that just do not understand earnings, the economy, and the Fed. It is past time to tune them out.
  • Try to find balance. Seeking Alpha is once again drawing upon a range of sources to help individual investors. I always find this to be a balanced and helpful source and I hope to contribute again this year.
  • Demand data, not examples. Do we really care how many times a big market year was followed by another, going back to the Taft Administration? These are anecdotes disguised as data.
  • Look for some reasoning based on economic fundamentals and data, not just vague opinions. In particular, ask if the analysis fits where we are in the business cycle.

To start your thinking, Andrew Thrasher suggests that we are just entering Stage 4.

Im-10-cycle

I have a little more to suggest in the conclusion. First, let us do our regular update of the last two week’s news and data.

Background on “Weighing the Week Ahead”

There are many good lists of upcoming events.  One source I regularly follow is the weekly calendar from Investing.com. For best results you need to select the date range from the calendar displayed on the site. You will be rewarded with a comprehensive list of data and events from all over the world. It takes a little practice, but it is worth it.

In contrast, I highlight a smaller group of events, including some you have not seen elsewhere.  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. Each week I consider the upcoming calendar and the current market, predicting the main theme we should expect. This step is an important part of my trading preparation and planning. It takes more hours than you can imagine.

My record is pretty good. If you review the list of titles it looks like a history of market concerns. Wrong! The thing to note is that I highlighted each topic the week before it grabbed the attention. I find it useful to reflect on the key theme for the week ahead, and I hope you will as well.

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

Most of the recent news continues to be good.

  • Q4 earnings still look good, according to earnings expert Brian Gilmartin. He has been very accurate, using both forward earnings and actual reports as part of his regular analysis. Concerning the upcoming reports, he writes as follows:

    What is fascinating is, the q4 ’13 earnings warnings seem pretty dire, as CNBC has detailed, but the expected q4 ’13 earnings growth rate for the SP 500 as a whole, is now projected to be 7.6% as of this week’s “This Week in Earnings” published weekly by Thomson Reuters, which is the HIGHEST rate of expected earnings growth to start a quarter since q1 ’12. The fact is q4 ’13 will be quite robust when companies begin reporting in 2 weeks.

    Our estimate for q3 ’13 earnings growth of 7% – 8% was right on, and we now expect the 4th quarter of 2013 to be plus 10% by the time the 4th quarter is fully reported by mid-March ’14.

  • LA port traffic shows solid growth. (Via Calculated Risk).
  • Durable goods orders surprised on the upside. (Via Steven Hansen).
  • US oil production is surging – good news on the surface. James Hamilton explains why this will not necessarily translate into lower prices. Essentially, it is offsetting prior tight supplies and there is more demand from emerging markets.

Oil_price_proj_dec_13

  • Q3 GDP was revised higher, to an annual rate of 4.1%. The biggest factor was increased consumer spending. Inventories still constitute a big component, whether by accident or design… a big question. Most analysts are now upping their estimates for Q4. (See analysis at Calculated Risk, Doug Short and Steven Hansen at GEI, and Ed Yardeni on inventories.)
  • Initial jobless claims dropped. I am registering this as “good” but it is a complex and noisy story. Doug Short’s fine analysis and charts help to clarify a complex story. See comparisons that help you navigate the seasonal adjustments and other noise. Meanwhile, here is a key chart:

Dshort Jobless Claims

The Bad

There has not been much bad news over the last two weeks. Feel free to suggest items in the comments

  • Investment sentiment remains very bullish, generally viewed as a contrarian market indicator. Bespoke analyzes the AAII series, where bulls are over 50% for the first time since January.

Aaiibull1226

  • The Budget Deal may be overrated says Stan Collender in his 5 myths story. The myths include some conclusions that I have featured here, so readers should take a look at what this former staffer and current consultant has to say. Over the last two years I have been more accurate than he has, but I always read his work with respect.
  • High frequency indicators are still positive, but softer, according to New Deal Democrat. NDD’s weekly commentary has moved to XE.com but it still includes a fine summary of important data you might otherwise miss. Some soft spots he cites this week are money supply growth (M2) which is below the desired economic trend and weakness in steel production. I always read the entire post, and so should you.
  • Dodd-Frank will be futile according to departing CFTC Commissioner Bart Chilton. He describes Wall Street’s four-pronged strategy, the D.C. Quadra-Kill. (Defeat the bill, limit funding, negotiate on regulations, and litigate). William D. Cohan at Bloomberg has a great story.
  • Personal income growth has been disappointing. Steven Hansen has a good analysis, featuring this chart:

Fredgraph

The Ugly

Holiday shopping SNAFU’s. We still do not have the final verdict on the brick-and-mortar shopping season, but we know it was affected by calendar compression and cold weather. The online experience was disappointing for many, as last-minute purchases did not arrive as promised. We still do not know the economic effect on retailers, who may have to issue some refunds. Or else! So says Sen. Richard Blumenthal.

Another disturbing retail story is the hacking of Target’s credit card data. The immediate reaction was to limit some debit card transactions right during the shopping season. Target claims that the hackers cannot break the “strong encryption” of the pin data, but many are not taking any chances. Blumenthal, former Connecticut Attorney General, is weighing in on this issue as well, offering Congressional cooperation with the FTC.

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 Paul Krugman and John Lounsbury. While most of us are enjoying the holidays, John is reading Krugman papers from six weeks ago! I know that many readers just tune out anything from Krugman, but this is poor practice for investors. One of the key stories of the year has been the austerity debate and the flawed work of Rogoff and Reinhart – still continually cited by those who think you are uninformed. A key question is whether there is a debt “trigger point” that causes a decline in economic growth. Once again, I care as an investor, not as a voter – despite the politically charge that has been applied to the issue. So here are the facts in two charts.

The first shows the relationship with Japan as an outlier.

51062179debt-interest-rates-krugman-fig.1-2013-nov

The second shows the members of the EU with a different marker.

6981316debt-interest-rates-krugman-fig.2-2013-nov

See John’s post for the full explanation about why it helps to have your own currency.

The Indicator Snapshot

It is important to keep the current news in perspective. I am always searching for the best indicators for our weekly snapshot. I make changes when the evidence warrants. At the moment, my weekly snapshot includes these important summary indicators:

  • For financial risk, the St. Louis Financial Stress Index.
  • An updated analysis of recession probability from key sources.
  • For market trends, the key measures from our “Felix” ETF model.

Financial Risk

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 recently edged a bit higher, reflecting increased market volatility. It remains at historically low levels, well 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 SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events.  It uses data, mostly from credit markets, to reach an objective risk assessment.  The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.

Recession Odds

In 2014 I will have a new format for this section. It is important, but the changes occur slowly and require more highlights. Suggestions are welcome.

I feature the C-Score, a weekly interpretation of the best recession indicator I found, Bob Dieli’s “aggregate spread.”  I have now added a series of videos, where Dr. Dieli explains the rationale for his indicator and how it applied in each recession since the 50’s.  I have organized this so that you can pick a particular recession and see the discussion for that case.  Those who are skeptics about the method should start by reviewing the video for that recession.  Anyone who spends some time with this will learn a great deal about the history of recessions from a veteran observer.

I also feature RecessionAlert, which combines a variety of different methods, including the ECRI, in developing a Super Index.  They offer a free sample report.  Anyone following them over the last year would have had useful and profitable guidance on the economy.  RecessionAlert has developed a comprehensive package of economic forecasting and market indicators. Their most recent report provides a market-timing update for those considering whether to “buy the dips.”

Georg Vrba’s four-input recession indicator is also benign. “Based on the historic patterns of the unemployment rate indicators prior to recessions one can reasonably conclude that the U.S. economy is not likely to go into recession anytime soon.” Georg has other excellent indicators for stocks, bonds, and precious metals at iMarketSignals. His most recent update revisits Albert Edwards’s year-old prediction that the Ultimate Death Cross was imminent. Georg refuted the claim at the time, and now takes a more complete look.

Unfortunately, and despite the inaccuracy of their forecast, the mainstream media features the ECRI. Doug Short has excellent continuing coverageof the ECRI recession prediction, now more than two years old.  Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting.  Doug also continues to refresh the best chart update of the major indicators used by the NBER in recession dating. The ECRI approach has been so misleading and so costly for investors, that I will soon drop it from the update. The other methods we follow have proved to be far superior.

Readers should review my Recession Resource Page, which explains many of the concepts people get wrong.

Here is our overall summary of the important indicators.

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.  Over the last three months Felix has ranged over the full spectrum – twice! The market has been moving back and forth around important technical levels, driven mostly by news. The current values are now neutral. There are still many positive sectors, but few with real strength.

Felix does not react to news events, and certainly does not anticipate effects from the headlines. This is usually a sound idea, helping the trading program to stay on the right side of major market moves. Abrupt changes in market direction will send sectors to the penalty box. The Ticker Sense poll asks for a one-month forecast. Felix has a three-week horizon, which is pretty close. We run the model daily, and adjust our outlook as needed.

The penalty box percentage has increased dramatically, meaning that we have less confidence in the overall ratings. 

[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 is a little data –some important – in the holiday-shortened week.

The “A List” includes the following:

  • ISM manufacturing (Th). Important concurrent economic indicator.
  • Initial jobless claims (Th). Best fresh data on employment.
  • Consumer confidence (T). Good read on both employment and consumer spending.
  • Auto sales (F). Growing attention as recent increases fuel economic growth.

The “B List” includes:

  • Pending home sales (M). Housing remains crucial for the 2014 economic outlook.
  • Case-Shiller home prices (T). Slightly lagging data, but widely followed.
  • Chicago PMI (T). Probably the best regional series for predicting the national number, out two days later.

The American Economic Association annual meeting will feature presentations by several Fed presidents and Chairman Bernanke. Some of these will occur on Friday and others on Saturday. There may also be advance copies available. With continuing quiet trading, some will try to squeeze out some fresh Fed news.

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

My weekly insights often suggest a different course of action depending upon your objectives and time frames. They also accurately describe what I am doing in the programs I manage.

Insight for Traders

Felix has remained in neutral, although we are still mostly invested in the top two sectors. Felix’s ratings have been in a fairly narrow range for several months. The rapid news-driven shifts are not the ideal conditions for Felix’s three-week horizon. This week we see somewhat higher ratings, and many sectors in the penalty box. There are still two attractive sectors, and we may add to positions in the week ahead.

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Each week I try to highlight something special for the long-term investor.

I try to refresh the concepts and ideas each week, emphasizing the best themes from my reading. My overall recommendations do not change as rapidly – nor should they. I am considering some format changes for next year, helping to highlight the specific new recommendations.

One of my major themes for the year has been the “great rotation” from bonds to stocks. This has three aspects:

  • Bond yields are so low;
  • Bond prices have fallen, leading to absolute losses for conservative investors;
  • Stocks have surged.

This should not have been a surprise for those paying attention. It is just getting started. As he often does, Josh Brown captures the main theme in this post about the rotation. He is quoting the chief market strategist at ConvergEx Group:

In short, the trade in 2013 has been out of munis and gold, and into the world’s stock markets.  Look a little deeper, and the headline becomes “Mutual fund buyers are finally back”.  Just 2 years ago the U.S. mutual fund investors were net sellers of financial assets, to the tune of ($27.5 billion).  The year 2012 saw them tiptoe back, with positive flows of $117.6 billion, but still redeeming stocks for bonds.  This year inflows are $164 billion with two weeks or so remaining and substantially all of that into stocks.

This rotation is just getting started. Our own themes are the same, but I will also do a “year ahead” preview pretty soon.

Here is a summary of our own current recommendations for the individual investor.

  • Headlines. The challenge for investors is to distinguish between the major trends and the short-term uncertainty. The main themes are not related to headlines news, even though sentiment may drive market fluctuations. Do not be seduced by the idea that you can time the market, calling every 10% correction. Many claim this ability, but few have a documented record to prove it. Most who claim past success are using a back-tested model. Please see The Seduction of Market Timing.
  • Risk Management. It is far better to manage your risk, specifically considering the role of bonds and the risk of bond mutual funds. As I emphasized, “You need to choose the right level of risk!” Right now, it is the most important question for investors. There is plenty of “headline risk” that may not really translate into lower stock prices. Instead of reacting to news, the long-term investor should emphasize broad themes.
  • Bond Funds are Risky. Investors have been surprised at the losses, which will continue as the long end of the interest rate curve moves higher. You need to have the right mix of stocks to benefit from a rising rate environment.
  • Stepping in gradually. If you are completely out of the market, you are not alone. Consider buying dividend stocks and selling calls against them. This strategy has been working great both for our clients and for many readers. (Thanks for the email responses!) This will work in a sideways market. You can also buy some stock in the sectors with the best P/E ratios.

And finally, we have collected some of our recent recommendations in a new investor resource page — a starting point for the long-term investor.  (Comments and suggestions welcome.  I am trying to be helpful and I love feedback).

Final Thought

It would be silly to predict the market in the final week of the year, with tax trading and window dressing in the first two days, and “new” positions in the last two.

My general sense is that many are still looking for an entry point. I was impressed (negatively) by a Barron’s columnist this week. After noting the 2-1 odds that stocks would be higher (which I have already suggested that you ignore) he emphasizes the 33% chance of a decline. OK.

Then he dredges up a list of warmed-over worries that might resurface. OK.

This is all true, and might happen. But get the final stanza:

Still, the biggest risk to the U.S. could be the gift that has topped our wish list for years: a much stronger economy, which could ignite inflation and force the Fed to hike interest rates sooner than expected. It’s getting hot out there: Sales of durable goods and new homes have been much stronger than forecast.

While the Fed’s favorite inflation gauge, the PCE deflator, remains stuck near 1%, the GDP price index rose at an annual rate of 2% during the third quarter, suggesting inflation might be running higher than policy makers expect, says Michael Shaoul, CEO of Marketfield Asset Management.

Should that prove the case, the Fed’s plan to gently reduce its bond-buying, which will start next month with a $10 billion taper, would be thrown into disarray. The pace of the taper would have to increase, and an interest-rate hike could come quickly. “Everyone wakes up, the Fed is miles behind the curve, and everything needs to be torn up,” Shaoul says. “That’s when you go through a 1994- or 1987-style adjustment.”

In other words, on the one hand there are a lot of economic risks. If these are avoided and things get better, the Fed will bring it to a swift end.

I strongly recommend that investors ignore pundits whose analysis has no provision for “buy.”

Weighing the Week Ahead: Lessons from 2013

This is a special edition of Weighing the Week Ahead.  With holidays and market closings in the middle of the next two weeks, we can expect a time of relative quiet.  It is a good time to review the lessons from 2013.  I'll have a regular WTWA next week and (soon) my regular preview of the year ahead.

Here is a pictorial review of 2013 from the perspective of the individual investor.  It is not based upon page views or ratings, but rather upon the economic, market, and public policy themes that could have helped you the most.

I managed to stay on the right side of most of these trends, and I hope you did as well.  Here are the most important trends of the year — what was hot versus not and especially profitable versus costly.

The winners next year might be different, and some who lagged this year will remain in denial.  I strongly recommend that you consider each comparison with an open mind.

Disagree?  Other nominations?  That is fine.  Join in the comments!  This is my scorecard, but I welcome dissent and discussion.  I am including a few links, but in most cases the verdict should be obvious.  I hope everyone enjoys this as much as I did in working on it!  Slide12

It was a "risk-on" year.

Slide17

Mr. B knows how to have fun!  Who's that guy he is playing against.  Here was his advice about gold, going "long on fear."

  Slide6

Doug Short's charts make the data speak to you.  There is no higher praise.  Selling short?  Not so good last year.

Slide14

Fundamentals, represented by Chuck Carnevale and his relentless theme — Earnings Determine Stock Price — triumphed over the gadgets, seasonality, waves, and omens.

  Slide8

Kelly Evans is intelligent and informed, reaching to a larger audience–the winner from Maria's departure.  Rick Santelli's message still gets the background cheers, but the audience is shrinking, perhaps because he has been so wrong.

Slide1

Centrist compromise versus the liberal wing.

Slide3

Centrist compromise versus the Tea Party wing.

Slide2

Disciplined forecasting method gaining widespread recognition.  Owning silver?  Not so good!

Slide13

Being rich and having a lot of assets under management does not assure success.  You are as good as your last trade in the big-name hedge fund business.

 

  Slide7

Understanding the business cycle is really important.  Many economists know that the ECRI has been wrong – -more than two years past the 100% forecast, and still not giving in.  I am featuring Bob Dieli since he focuses on the full business cycle and has been calling it right in real time for more than 30 years.  More here.

Slide11

We all know and use Twitter.  The Columbia Journalism Review explains about the sad decline of longform.

Slide4
Josh Brown keeps bringing it no matter how many characters he has available.  He has exceled on Twitter, blogging, and TV.  Downtown Detroit?  A sad story for the city of my roots.

Slide5

Two respected economists were bearish.  One kept his indicators and changes his opinions (See fine Ritholtz discussion).  The other kept his opinions and changed his indicators.

 

  Slide10

Professor Shiller has a Nobel prize and some new gigs as a partner in equity funds.  These new projects do not involve market timing using his famous CAPE ratio.  There is a growing realization that when something has not worked for several decades, it might be time for a review.

Slide9

Musk acclaim is well-deserved.  Johnson had good ideas for the wrong company at the wrong time.

Slide15

Stimulus triumphed over austerity.  A big surprise is that the true believers keep quoting Rogoff and Reinhart without any awareness of the errors.

Slide16

The choice of Congress for the final "not hot" award will not be controversial.  I understand that Bernanke has been a polarizing figure.  Many believe that it will all end badly.  For 2013 they were wrong, and those of us who did not fight the Fed were right.

 

Will Janet Yellen bat cleanup in this post next year?

Weighing the Week Ahead: An End to the Debt Limit Stalemate?

In chess, a stalemate is a drawn game. Chess players study endgames, where small advantages become big wins. Computers have now solved these endgames – all of them! Some require dozens of precise moves. A mistake converts a draw into a win or a loss. Humans make mistakes.

Political processes are inherently human. It is possible to estimate the outcomes, but there is plenty of room for surprises along the way. I have been analyzing public policy issues for forty years, including the study of hundreds of actual decisions as part of my dissertation – the original research required to get your "professor credentials." I do not have any exaggerated illusions about the predictive power of academic research, but at least for me, the research has helped to identify investment implications.

There are certain principles that hold up with amazing frequency in the US political process, and more generally in democratic systems:

  • If a particular outcome is clearly beneficial to nearly everyone, that result will usually be achieved.
  • The process of bargaining and compromise is always messy. It looks terrible to observers who have never personally experienced it.
  • Compromise does not yield the best possible result. Instead, it generates the best result possible. Outsider each have an idea of the perfect solution. The problem is that there are many differing and inconsistent "perfect" solutions.
  • No one really loves the result of a compromise.
  • Every political issue is subject to compromise, even those that seem to involve strict rules.

Why dwell upon this in a blog dedicated to successful investing?

For the last three weeks I have accurately highlighted the political debate as a major concern for investors. Investors who read last week's post saw that while I did not see a specific outcome in the week ahead, there were five things to watch:

  1. A temporary extension of the debt limit. This will be criticized by the punditry as "kicking the can" but it will serve the function of buying some needed time. The market will respond to the progress, not to the political wails of some pundits.
  2. Minimally, an agreement that provides some tweaking of sequestration and provides Speaker Boehner a chance to claim some credit.
  3. Maximally, a broader compromise on some entitlement and debt issues – less likely and taking longer.
  4. The agreement could be reached overnight or on a weekend, without much notice.
  5. The resulting pop in stocks (just like the fiscal cliff resolution) will leave many chasing the market, waiting for a pullback.

This proved to be a fairly accurate assessment. As I write this, the situation is changing almost by the hour. Yesterday the emphasis was on the Senate. Today it is on the most recent proposals from Republicans in the House.

The biggest element missing from the five points listed above is the political cover for Speaker Boehner. Poll results showing blame falling mostly on Republicans seem to have stiffened the resolve of Democrats. They are now asking for higher spending levels, easing the sequestration rules. The principle highlighted by the administration is not to allow the debt limit threat as the foundation for policy negotiations. The principle highlighted by Republicans is the need to use maximum leverage to achieve goals viewed as important.

An Important Distinction about Politics

Regular readers know that I strongly recommend separating your political viewpoints from your investing. You should join me in being politically agnostic—willing to invest successfully no matter who is in power.

It is fine to have an opinion about ObamaCare, about debt, about European leadership, or about the Fed. Feel free to express your viewpoints in personal discussions or in the ballot box. Stop there. Confusing what you hope will happen with what probably will happen is the fast track to investment losses!

When I discuss policy issues, I am helping you to predict what will probably happen and also the investment consequences. I have been extremely accurate on every important policy decision for many years – Europe, 2011 debt ceiling, fiscal cliff, etc. – often in disagreement with the majority of pundits. I have never expressed personal preferences, but instead emphasize how to profit from likely outcomes. I regularly cite sources covering a wide political spectrum. Discerning readers might note that I find the viewpoints of extremists of all types to be market-unfriendly. Mainstream thought, from whichever party, is better for investments, whatever your personal views.

The implication for investors is that gridlock leading to a default on U.S. debt is bad. This is an investment conclusion, not a vote on ObamaCare.

A New Theme: Earnings

In the absence of fresh economic data, the discussions will start early. The best and most recent update comes from earnings expert Brian Gilmartin. Brian explains why we should watch earnings closely, and especially monitor the forward 4-quarter estimate. He writes as follows:

In a nutshell, the reason we track the forward estimate growth rate and y/y change is that (in my opinion) it is the one metric that validates or "explains" an expansion (or contraction) in the SP 500′s p.e ratio, or what is otherwise known as P.E expansion. Although I can't prove it mathematically, it seems intuitive that if the growth rate of the forward estimate is increasing, then the SP 500′s p.e ratio can "expand" to keep pace with the presumed acceleration in "earnings expectations" or contraction as the forward growth rate slows.

Just like the bond market and the Federal Reserve are more concerned with "inflation expectations" than actual inflation that we can see in the data, I think the one component missed by strategists and the CNBC community is "earnings expectations" and the growth therein, and the one metric that quantifies this expectation is forward earnings, and yet we hear about it so very little.

I expect us all to be seriously focused on earnings by the end of this week.

I also have some thoughts on how the debt limit endgame will play out. I'll report on that in the conclusion.  First, let us do our regular update of last week's news and data.

Background on "Weighing the Week Ahead"

There are many good lists of upcoming events.  One source I regularly follow is the weekly calendar from Investing.com. For best results you need to select the date range from the calendar displayed on the site. You will be rewarded with a comprehensive list of data and events from all over the world. It takes a little practice, but it is worth it.

In contrast, I highlight a smaller group of events, including some you have not seen elsewhere.  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. Each week I consider the upcoming calendar and the current market, predicting the main theme we should expect. This step is an important part of my trading preparation and planning. It takes more hours than you can imagine.

My record is pretty good. If you review the list of titles it looks like a history of market concerns. Wrong! The thing to note is that I highlighted each topic the week before it grabbed the attention. I find it useful to reflect on the key theme for the week ahead, and I hope you will as well.

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

With the shutdown limiting issuance of fresh government data, there was much less (non-political stuff) to ponder, and very little good news.

  • Janet Yellen was nominated to be Fed Chair. This was widely expected, so it did not have much market impact. Yellen opponents should consult above for the definition of "good" as "market-friendly." Felix Salmon has some interesting ideas on how she can improve communications, an area where many of us have found Bernanke disappointing.
  • Non-government indicators show strength. Scott Grannis has a chart pack that shows some optimistic market-based indicators. This is something we should all read in addition to the headlines!
  • The market bounce was not just short-covering. This is in sharp contrast to general media reports, so it is important to note. Bespoke provides the analysis including this chart:

Decile short 1010


The Bad

Despite the data shortage, there was some bad news.

  • The IMF warned on the threats to global growth and especially from the US debt ceiling issue.

MW-BM677_imfgdp_20131007151843_MG


  • Jobless claims spiked higher. Partly this was the "California effect" as their computers caught up with recent claims. The overall level is still better than recent months, but there is more noise than ever. This will not diminish with the effects of the government shutdown.
  • Consumer sentiment, as measured by the University of Michigan, remains disappointing. There is a real chance that the political issues, even if resolved, will have an impact on confidence and the economy. Doug Short has my favorite chart for this indicator, showing the current level in the context of history and recessions:

Michigan Sentiment Doug Short


Gallup also shows a decline in confidence (via Calculated Risk).

The Ugly

More investor confusion! Mark Hulbert notes that many newsletter writers make impossible, exaggerated claims. These often exceed the results of the best investors.

Who could have known?

One method seems to involve avoiding mark-to-market. You just book the winning trades and ignore the losers. Annualize returns. Presto!

Noteworthy

This week marked the Eighth Blogiversary for Abnormal Returns. Congratulations to Tadas for these years of pioneering excellence. He has helped to define the concept of content curation. His work is indispensable for all of us who follow markets and the economy. I use it constantly. Everyone also enjoys the touch of humor and personal interest links.

Well done!


The Indicator Snapshot

It is important to keep the current news in perspective. I am always searching for the best indicators for our weekly snapshot. I make changes when the evidence warrants. At the moment, my weekly snapshot includes these important summary indicators:

  • For financial risk, the St. Louis Financial Stress Index.
  • An updated analysis of recession probability from key sources.
  • For market trends, the key measures from our "Felix" ETF model.

Financial Risk

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 recently edged a bit higher, reflecting increased market volatility. It remains at historically low levels, well 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 SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events.  It uses data, mostly from credit markets, to reach an objective risk assessment.  The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.

Recession Odds

I feature the C-Score, a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread."  I have now added a series of videos, where Dr. Dieli explains the rationale for his indicator and how it applied in each recession since the 50's.  I have organized this so that you can pick a particular recession and see the discussion for that case.  Those who are skeptics about the method should start by reviewing the video for that recession.  Anyone who spends some time with this will learn a great deal about the history of recessions from a veteran observer.

I also feature RecessionAlert, which combines a variety of different methods, including the ECRI, in developing a Super Index.  They offer a free sample report.  Anyone following them over the last year would have had useful and profitable guidance on the economy.  RecessionAlert has developed a comprehensive package of economic forecasting and market indicators, including this recent update on the world economy.

Georg Vrba's four-input recession indicator is also benign. "Based on the historic patterns of the unemployment rate indicators prior to recessions one can reasonably conclude that the U.S. economy is not likely to go into recession anytime soon." Georg has other excellent indicators for stocks, bonds, and precious metals at iMarketSignals. For those interested in gold, he has a recent update, asking when there will be a fresh buy signal.

Unfortunately, and despite the inaccuracy of their forecast, the mainstream media features the ECRI. Doug Short has excellent continuing coverage
of the ECRI recession prediction, now two years old.  Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting.  Doug also continues to refresh the best chart update of the major indicators used by the NBER in recession dating.

Readers should review my Recession Resource Page, which explains many of the concepts people get wrong. Most importantly, the concepts help you to stay invested when the "R word" is loosely used.


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.  Over the last month Felix has ranged from bearish to neutral to bullish and now back to bearish. The market has been moving back and forth around important technical levels, driven mostly by news.

Felix does not react to news events, and certainly does not anticipate effects from the headlines. This is usually a sound idea, helping the trading program to stay on the right side of major market moves. Abrupt changes in market direction will send sectors to the penalty box. The Ticker Sense poll asks for a one-month forecast. Felix has a three-week horizon, which is pretty close. We run the model daily, and adjust our outlook as needed.

The penalty box percentage moved higher this week.  A high rating means that we have less confidence in the overall ratings. 

[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

This week's schedule will be dramatically affected by the government shutdown. Private data will assume unusual significance. Even if the government reopens, it will take several days to get the data machinery going again, including the September employment report.

The "A List" includes the following:

  • Initial jobless claims (Th). Still interesting as the most responsive employment indicator, but very noisy due to California problems and the shutdown.
  • The Fed Beige Book (W). This provides anecdotal information from around the country. It is part of the evidence in front of FOMC members at the next meeting, and sometimes influences market thinking about the economy.
  • Leading economic indicators (F). Still popular with many market followers.

Bernanke is speaking on Monday. While the topic is the Mexican central bank, there are always policy questions. Bernanke speeches will now have a lower relevance factor.

Mostly we will be watching news about the debt limit negotiations.

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a "one size fits all" approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

My weekly insights often suggest a different course of action depending upon your objectives and time frames. They also accurately describe what I am doing in the programs I manage.

Insight for Traders

Felix has switched to a bearish posture. For our trading accounts we decreased positions to 2/3 long. The long positions are rather defensive. This is not a short position, but we could find ourselves buying the lightened up at mid-week, but we are once again fully invested. This happens when we find three or more attractive sectors, even in a neutral or soft market. Felix's ratings have been in a fairly narrow range for several months. The rapid news-driven shifts are not the ideal conditions for Felix's three-week horizon. The high penalty box rating continues to underscore the uncertainty.

Insight for Investors

The challenge for investors is to distinguish between the major trends and the short-term uncertainty. The main themes are not related to headlines news, even though sentiment may drive market fluctuations. Do not be seduced by the idea that you can time the market, calling every 10% correction. Many claim this ability, but few have a documented record to prove it. Most who claim past success are using a back-tested model. Please see The Seduction of Market Timing.

Last week was a perfect illustration of how difficult it can be for investors to adjust when there is breaking news. Many who choose to go "all out" because of fear have no plan for re-entering when the risk is lower. Eddy Elfenbein – as he does so often – provides excellent historical perspective. Much was made of VIX levels (the implied volatility gauge that many view as the fear index) reaching 20. Eddy writes as follows:

But viewed in proper perspective, a VIX of 20 really isn't that high. It's just that recent volatility has been so low. Last quarter, the S&P 500 had an average daily volatility of just 0.45%, which was a seven-year low. The S&P 500's close on Tuesday was 4% below the all-time high close from a few weeks ago. In 2011, the market fell nearly 20%.

(Geeky math interlude: If you're curious as to what exactly the VIX measures, it's the market's estimate for the S&P 500's volatility over the next 30 days. The number is annualized, so we can get it down to one month by dividing the VIX by the square root of 12, which is roughly 3.46. That gives us the market's one-standard-deviation estimate for the S&P 500's plus/minus range for the next month.)

Let's take a step back and remember that during the last Debt Ceiling fight two years ago, the VIX came near 50. During the height of the Financial Crisis, the VIX topped 80. Traders are nervous today over a 20 VIX. The VIX was above 20 almost continuously for five straight years during the late 1990s and early 2000s. The stock market is far calmer today.

I recently wrote about how investors can manage risk, specifically considering the role of bonds and the risk of bond mutual funds. As I emphasized, "You need to choose the right level of risk!" Right now, it is the most important question for investors. There is plenty of "headline risk" that may not really translate into lower stock prices. Instead of reacting to news, the long-term investor should emphasize broad themes.

And finally, we have collected some of our recent recommendations in a new investor resource page — a starting point for the long-term investor.  (Comments and suggestions welcome.  I am trying to be helpful and I love feedback).

Final Thought

As I have noted in recent weeks it is very difficult to trade around the Washington headlines. For long-term investment positions I use the fluctuations as opportunities to adjust positions, not as major risk factors. My current working hypotheses include the following:

  • There is a real chance that no solution will be reached by the official D-Day – Thursday. Stan Collender puts the odds at worse than 50-50. That was also the verdict on several of the Sunday morning talk shows. Senate action will be further delayed since many procedures require unanimous consent to avoid delay. Some objectors are now calling for votes on unrelated issues.
  • There will not be an actual default on Thursday. Here is a better timeline. We might still be wrapping up this issue next weekend.
  • Whenever you can see overlap in the positions of two opposing parties, the eventual resolution is just a matter of time. There is pressure on the GOP from business leaders. There is pressure on Obama because of the very real effects. There is pressure on everyone from declining approval in polls.
  • The eventual solution will combine some face-saving accomplishments for the GOP while also avoiding any precedent-setting notion of success. This is actually the trickiest point.

Daily trading will react and over-react to each piece of news, beginning with a soft opening tomorrow. This will all soon be forgotten, with a renewed focus on corporate fundamentals.

Biggest risk: The longer the issues drag on, the greater the chance that reduced consumer and business confidence has a real effect.

Understanding Risk: The Role of Bonds

What is the most important decision for the long-term investor?

This is actually an easy question, but most investors get it wrong. You need to choose the right level of risk!

Here are the key facts:

  1. Even in the best market years there is often a serious "correction" during the year.  Since 1980, the average intra-year decline has been 14.5%.  Every time there is a modest pullback you will see many warnings that this is the "big one."  That is when most investors bail out.
  2. And of course there really are a few big ones.

Here is the helpful table via JP Morgan's Guide to the Markets:

1301609671985_MI-GTM-3Q2013_NoPageNumbers-2-64


The last couple of years have had unusually low intra-year declines. This might be giving a false impression.

Most investors are far too confident of their risk tolerance. I question new clients carefully on this front.  If you are going to have a portfolio that is 100% in stocks, no matter how diversified, you must be prepared to weather a 20% decline.  I ask clients to pick a number that would be an acceptable "paper" loss – and we all hate losses, even on paper.  If our own first-rate indicators said that it was a "psychological" correction, not supported by fundamentals, what number would be tolerable.  Take that number and multiply by 5. That tells you how much you can invest in stocks.

This approach works much better than some of the questionnaires used by various firms who are just touching the bases on compliance. I am trying to learn what people really think!

Most investors over-estimate their risk tolerance, take on positions that are too large, and then wind up selling whenever there is a correction. Their poor market timing is why they trail a buy-and-hold program by 5% or more.  The major reason for a bond portfolio is to reduce the overall volatility.

It is better to have an acceptably sized risk and stay in the market than to be too big and get scared out.

Every investor should start by considering risk, not return!

You should not try to be a poker-playing genius, going "all-in" or all out based upon some index, omen, or advice from a guru on TV. You need a low-volatility anchor for your portfolio. Traditionally, this has been the role of bonds.

The problem is that bond mutual funds are now too dangerous – likely losers as interest rates move higher.

Possible Solutions

In past posts I have covered this topic in some detail. Let us focus today on three possible solutions. (I continue to explore others).

  1. A bond ladder. This allows you to get the interest rate you expect and principal on maturity. You can then roll out to the higher rates. The exit strategy is built into the program, unlike a bond mutual fund. You might only make 3% or so, but you can adjust to rising rates and it provides a conservative anchor to your portfolio, allowing you to step out with the rest.
  2. Reasonable dividend stocks. I say "reasonable" because the quest for yield has driven some dividend plays into territory that is too rich for me. I do not like utilities, but I do favor some of the established companies with great balance sheets and dividends in the 3% range.
  3. Selling calls against your dividend stocks. An actively managed portfolio, focused on selling the rapidly-decaying short term calls, can dramatically increase the return from a dividend stock portfolio. This is a good plan for those who are not seeking gangbuster market returns. It is safer and more dependable in a sideways market. It is a good blend for those who have a bond ladder and some stocks. I target 9% (after costs) but agile individual investors might match this or do better. You need a low cost broker.

There are other nominees under review. There are MLP's, but the tax issues dissuade many. There are alternative funds. There are structured products. Some of these ideas are very good and might be attractive for the average investor. The problem is the complexity and potential for a fatal mistake.

More to come on these ideas.

Conclusion and Anecdotes

The importance of right-sizing risk remains. The loss of bond funds as a solid portfolio anchor creates a new challenge.

I talk with many investors each week, both existing clients and those who might become part of our group. A recent case featured someone whose account had cratered during the 2008 decline. She now wanted to make it back in a short time, and asked me for a schedule of projected gains. This very smart person was focused on return, not on risk, despite her few remaining years until retirement. I'm not sure what the others promised, but creating false expectations is not wise.

Many others are very nervous. They read the headlines, which always sell fear (covered in this post where I explain how to quantify actual risks).

My basic solution is one that you can imitate. The Enhanced Yield approach serves as a bond substitute, reducing portfolio volatility while delivering 9% or so after commissions.  It will do this in a sideways market, and it also has a lot less risk than a stock fund in a declining market. Examples of stocks that you could use if you want to try this at home are CSCO, INTC, MSFT (old tech works well), KSS (surprising retail strength), and DE. The key is valuation, a reasonable dividend, and picking a call that is out of the money and will return 10% annualized from the sale. Do not chase if the conditions are not right.

Whatever you choose as an anchor, do not be over-confident about stocks. If you are young and willing to ignore volatility, the prospects are good. For most people, the risk/reward balance is crucial.

[Long all named stocks versus short calls]

Weighing the Week Ahead: Is this a tipping point?

Each week I consider the upcoming calendar and the current market, predicting the main theme we should expect. This step is an important part of my trading preparation and planning. It takes more hours than you can imagine. My record is pretty good, with recent topics including Fedspeak, increased volatility, and a focus on interest rates – all very accurate.

Sometimes there is no clear theme, and I try to be honest about that. In the past I have described it as a "lull before the storm" and as "waiting for evidence." This week I see an absence of major new data. At the same time the markets are at a crucial point for both technicians and traders. That is the main reason for the recent volatility. I see the following key questions?

  • Is this a potential tipping point for markets – both bonds and stocks?
  • What is the real "new normal?"

PIMCO invented and popularized "new normal" and every word by their public spokesmen gets plenty of media attention. I want to highlight an alternative "normalization" viewpoint from Brad DeLong, a Berkeley econ prof. His positions means both that he has the highest qualifications possible and that he will be ignored by most of my market colleagues because of their own biases. This is foolish. Here at "A Dash" I highlight great sources from various persuasions, ranging from the very liberal to rock-ribbed conservatives and libertarians. I do leave out extremists from the conspiracy wings.

Prof. DeLong also did a great job as organizer of the recent Kauffman Conference – helpful both to me and to many others. (More on that to come). This week he wrote an excellent post that is very important for investors. Since it is long and wonkish, it will not get read by those who need the information the most—investors! What if I said that it was the most important post I saw this week –out of the hundreds that I review each week?

My job is to summarize such information, but it is a challenge with this piece. It includes a survey of what is unusual and an analysis of paths to normalization.

So here is the summary: This is not simple! The media buzz you are getting is not just uninformative, it is wrong. The various discrepancies in labor force participation, government debt, and regulation will be resolved, but the path is not clear.

I have my own thoughts on the real "new normal" which I'll report in the conclusion.  First, let us do our regular update of last week's news and data.

Background on "Weighing the Week Ahead"

There are many good lists of upcoming events.  One source I regularly follow is the weekly calendar from Investing.com. For best results you need to select the date range from the calendar displayed on the site. You will be rewarded with a comprehensive list of data and events from all over the world. It takes a little practice, but it is worth it.
In contrast, I highlight a smaller group of events.  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

This was a mixed week for economic data, but the most important reports were positive.

  • The employment report beat expectations. Job gains did not run high enough to stimulate Fed Fear. The market celebrated the news, but those paying attention understand the shortcomings:
    • Gene Epstein, writing in Barron's, sees a recovery as at least a year away. That merely extrapolates the current growth rate without adjusting for changes in the work force.
    • The pace of net job gains is not fast enough (although a recent study suggests that anything over 80K cuts unemployment (via GEI).
    • Other employment indicators were not as strong. Regular readers know that I like to view the BLS as one of several sources. I am delighted to read Goldman Sachs economist Jan Hatzius says the same. See the helpful article from Cardiff Garcia.
    • The wage increases are lagging job gains (See Martin Hutchinson at Breakingviews).
  • Mortgage debt is down and household net worth is higher. Calculated Risk analyzes the latest Federal Reserve Flow of Funds report. We should note, however, that the gains are skewed to the upper end of the wealth and income ranges.
  • CFOs are optimistic about the U.S. economy according to the quarterly Duke survey. The Optimism Index rating of 61 is a rebound from last quarter's 55 and above the long-term average of 59. Latin American and Asian CFOs are even more positive. Despite this, spending plans are only modestly higher. There are a number of interesting findings here, so it is well worth checking out.
  • The IMF recognizes
    excessive austerity in Europe. More economic growth in Europe would help everyone.
  • Home prices show strong gains from the CoreLogic NSA series. Calculated Risk is the place to monitor the housing rebound, where Bill McBride writes as follows:

    "The year-over-year comparison has been positive for fourteen consecutive months suggesting house prices bottomed early in 2012 on a national basis (the bump in 2010 was related to the tax credit).

    This is the largest year-over-year increase since 2006."

CoreLogicYoYApr2013


  • The dollar is getting stronger on a trade-weighted basis. Dr. Ed has the story and this chart:

Real Broad Dollar Index


  • And the inverse correlation of stocks with the dollar has reversed quite sharply (via Bespoke). Here is the key chart, but check out the article for discussion and analysis. This change has been a major surprise for many, especially those who love to overuse the word, "debase."

Correlation1


The Bad

There was also plenty of bad news.

  • The Hindenburg Omen is back! Look out below, since it has been confirmed. Three years ago I explained that this indicator was the poster boy for a bad research method – widely followed by those with multi-year forecasts of recessions and "worst times" to invest. A twitter friend suggested that I should also mention that some see it as an "alert" rather than a prediction. Read the explanation and see if you find it helpful. MarketWatch's "The Tell" has the right conclusion:

    "Either way, the HO this past week showed how much attention you can garner with an ominous sounding name in times of market skittishness, and generated its share of Tweets."

  • China's flash PMI was below 50. The market seemed to shrug this off on Monday morning, but we should still watch Chinese economic growth carefully.
  • The ISM index was 49, down from 50.7 last month. The ISM sees this as consistent with GDP growth of 2.1% based upon historical data. (We are in a trend of manufacturing lagging overall growth). Many believe that their research on this relationship needs updating.
  • The sequester effects are starting to hit. The effect is probably about 0.5% in GDP (via Rick Newman at The Exchange).
  • Initial jobless claims have broken the bullish trend. I know that last week's number was a little better than expectations. I also know that a really good number dropped out of the four-week moving average. Steven Hansen at Global Economic Intersection takes a deeper look. He compares the current moving average (which is everyone's top choice to reduce the noise in the series) and compares it to the prior year. Both are seasonally adjusted. See the entire article for discussion and several good charts, but here is an important one:

Fredgraph


  • Fed speeches included discussions of how the current QE purchases might be tapered off. The "T" word has replaced the "R" word as the newest fear factor. The trader perception, parroted regularly on CNBC, now includes the idea that the Fed somehow orchestrated this mixed message to create ambiguity. Do these "experts" think that all of the meeting transcripts and minutes are faked? They have absolutely no idea about how government decisions are reached. The simple and incorrect meme about the Fed is taken far too seriously. It is obviously time for another article on this theme.  Meanwhile, get ready for some selling whenever one of the "hawks" gives a speech, whether or not he is a voting member.

The Ugly

This week's "ugly" award goes to the Illinois legislature. The session ended with no solution to the ever-expanding public pension problem – the most under-funded in the country. This is an issue that is not going away and gets worse with the passage of time. The immediate result was a downgrade of the state's debt rating. The legislature did approve turning the Elgin – O'Hare expressway (which goes neither to Elgin nor O'Hare) into a toll road.

One might expect a state where one party controls the governor's office as well as both houses of the legislature to be capable of needed actions. Illinois politics are different, with cross-cutting factions representing Chicago, the suburbs, and downstate interests as well as the two parties. One successful bill combined a downstate fertilizer plant with a new arena for DePaul's basketball team – not close to campus but near McCormick Place.

The Governor has called for a special legislative session on the pension issue, but it will take a major new ingredient to break the logjam.

This story is something to keep in mind when we revisit the debt limit and sequestration issues later this year.

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 SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events.  It uses data, mostly from credit markets, to reach an objective risk assessment.  The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread."  I have now added a series of videos, where Dr. Dieli explains the rationale for his indicator and how it applied in each recession since the 50's.  I have organized this so that you can pick a particular recession and see the discussion for that case.  Those who are skeptics about the method should start by reviewing the video for that recession.  Anyone who spends some time with this will learn a great deal about the history of recessions from a veteran observer.

I have promised another installment on how I use Bob's information to improve investing.  I hope to have that soon.  Meanwhile, anyone watching the videos will quickly learn that the aggregate spread (and the C Score) provides an early warning.  Bob also has a collection of coincident indicators and is always questioning his own methods.

I also feature RecessionAlert, which combines a variety of different methods, including the ECRI, in developing a Super Index.  They offer a free sample report.  Anyone following them over the last year would have had useful and profitable guidance on the economy.  RecessionAlert has developed a comprehensive package of economic forecasting and market indicators, well worth your consideration.

Georg Vrba's four-input recession indicator is also benign. "Based on the historic patterns of the unemployment rate indicators prior to recessions one can reasonably conclude that the U.S. economy is not likely to go into recession anytime soon." Georg has other excellent indicators for stocks, bonds, and precious metals at iMarketSignals.

Unfortunately, and despite the inaccuracy of their forecast, the mainstream media features the ECRI. Doug Short has excellent continuing coverage
of the ECRI recession prediction, now over 18 months old.  Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting.  His latest comment points out that the public data series has not been helpful or consistent with the announced ECRI posture.  Doug also continues to refresh the best chart update of the major indicators used by the NBER in recession dating.

This week there is (yet another) effort by the ECRI to suggest that there might be a recession. Doug Short notes as follows:

"Here are two significant developments since ECRI's public recession call on September 30, 2011:

  1. The S&P 500 is up about 40%.
  2. The unemployment rate has dropped from 9.0% to 7.6%."

The average investor has lost track of this long ago, and that is unfortunate.  The original ECRI claim and the supporting public data was expensive for many.  The reason that I track this weekly, emphasizing the best methods, is that it is important for corporate earnings and for stock prices.  It has been worth the effort for me, and for anyone reading each week.

Readers might also want to review my Recession Resource Page, which explains many of the concepts people get wrong.


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 switched to a neutral forecast. These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings have been weakening over the last two weeks, and dropped significantly this week.  The penalty box percentage measures our confidence in the forecast.  A high rating means that most ETFs are in the penalty box.  When that measure is elevated, we have less confidence in short-term trading.

[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

After two weeks with plenty of data, the coming week's calendar is a little light.

The "A List" includes the following:

  • Initial jobless claims (Th).   Employment will continue as the focal point in evaluating the economy, and this is the most responsive indicator.
  • Michigan Sentiment (F). Sentiment is a good coincident indicator for employment and consumer activity.
  • Retail Sales (Th). The consumer is still a big story.

The "B List" includes the following:

  • Industrial production (F). This remains a key factor in overall economic health.
  • PPI (F). This will be important at some point, but there is no sign of inflation so far. A calendar quirk means that we will not see the PPI and CPI on consecutive days, as is most often the case.

There will also be some inventory data, but the market pays little attention. The inventory story is easily spun and difficult to interpret. I only see one Fed speech on the calendar – the hawkish Bullard on Monday.


Trading Time Frame

Felix has switched to a neutral posture, now fully reflected in trading accounts. We have no position in equities. Our partial position includes a bond inverse fund and a commodity.

The overall ratings are slightly negative, so we were close to an outright bearish call. This could easily be the case by the end of next week. While it is a three-week forecast, we generate a new forecast every day.

It is fair to say that Felix is cautious about the next few weeks. Felix did well to avoid the premature correction calls that have been prevalent since the first few days of 2013, accompanied by various slogans and omens.

Investor Time Frame

Each week I think about the market from the perspective of different participants.  The right move often depends upon your time frame and risk tolerance. Too many individual investors check in only occasionally and then make dramatic decisions based upon slender evidence. That is especially wrong right now.

This is a time of danger for investors – a potential market turning point. My recent themes are still quite valid. If you have not followed the links, find a little time to give yourself a checkup. You can follow the steps below:

  • What NOT to do

Let us start with the most dangerous investments, especially those traditionally regarded as safe. Interest rates have been falling for so long that investors in fixed income are accustomed to collecting both yield and capital appreciation. An increase in interest rates will prove very costly for these investments. I highly recommend the excellent analysis by Kurt Shrout at LearnBonds. It is a careful, quantitative discussion of the factors behind the current low interest rates and what can happen when rates normalize.

  • Find a safer source of yield: Take what the market is giving you!

For the conservative investor, you can buy stocks with a reasonable yield, attractive valuation, and a strong balance sheet. You can then sell near-term calls against your position and target returns close to 10%. The risk is far lower than for a general stock portfolio. This strategy has worked well for over two years and continues to do so. (If you cannot figure it out yourself, or it is too much work, maybe we can help – scroll to the bottom).

  • Balance risk and reward

There is always risk. Investors often see a distorted balance of upside and downside, focusing too much on new events and not enough on earnings and value.

Three years ago, in the midst of a 10% correction and plenty of Dow 5000 predictions, I challenged readers to think about Dow 20K. I knew that it would take time, but investors waiting for a perfect world would miss the whole rally. In my next installment on this theme I reviewed the logic behind the prediction. It is important to realize that there is plenty of eventual upside left in the rally. To illustrate, check out Chuck Carnevale's bottoms-up analysis of the Dow components showing that the Dow "remains cheaply valued."

  • Get Started

Too many long-term investors try to go all-in or all-out, thinking they can time the market. There is no reason for these extremes. There are many attractive stocks right now – great names in sectors that have lagged the market recovery. You can imitate what I do with new clients, taking a partial position right away and then looking for opportunities.

We have collected some of our recent recommendations in a new investor resource page — a starting point for the long-term investor.  (Comments and suggestions welcome.  I am trying to be helpful and I love feedback).

Final Thought

What will be the new normal? How will the wide gap between the valuation of stocks and bonds be resolved?

My own answer has been that the two will converge. Interest rates and stock prices will both move higher. At the start of 2011 I predicted ten things that would be more normal. Some have proved accurate while others are a work in progress.

My 2010 forecast of Dow 20K is also proving out – and for the right reasons. You can check out the history, reasons, and progress toward this goal at our new investor resource page. If you are skeptical of the conclusion, you will be just like those who raised doubts three years ago. Why not check out the reasons?

Dow 150,000?

I feel like a real piker when compared with Michael Gouvalaris, who takes a long-term technical viewpoint. Here is his key chart:

Dow_best_case


Well! 2043 is outside of my regular forecasting range, but the concept is sound. Mike writes as follows:

"…(T)he markets will always favor the upside over the long term because of pure math. The downside risk is 100%, that is the worst case scenario. While your upside is unlimited. We just saw two separate cases of long term macro bull markets that produced over 2000% returns while the declines maxed out at around 55%. Do you see where I am going with this? Institutions adopt this mindset, they look at the 2000% upside over time after a historically oversold decline, as opposed to the downside risks in the short term. It's easy to blame the PPT, the Fed and a whole plethora of others for market rallies in the face of "headlines" and slow data. Ironically it is almost always the same ones that have gotten monetary policy, QE, fiscal policy etc, completely wrong from the very start."

Makes sense to me!