Weighing the Week Ahead: An End to the Tapering Obsession?

Over the last two weeks we have had an avalanche of economic data – mostly good news. The market reaction has been mixed, because so much of the "hot money" has a Fed fixation. For much of the last two weeks, every piece of good economic news led to lower stocks, presumably because this would lead to a reduction in QE. Finally, the good payroll news on Friday got the opposite reaction.

The question for the coming week – and maybe the next few months – is will "good news" finally be good news? Put another way,

Will the fixation on the "T word" finally come to an end?

The media, increasingly catering to their trader audience, plays into the constant focus on the Fed. This allows everyone to join in, but it has not provided much actual help for investors.

I have some further thoughts 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

Most of the recent news has been very good.

  • China's PMI of 50.8 shows expansion and represents a new recent high.
  • Congress seems to be nearing a deal on the budget. This will avoid another round of debt ceiling and shutdown crises, and it may even open the door to immigration reform. (See The Hill). It will not represent a "grand bargain" which might still be five years away. (See Stan Collender for ten reasons).
  • GDP was stronger than expected in Q3. The revision was mostly the result of inventory buildup, which invites spinning. Bob McTeer is well aware of this issue. It all depends on whether the inventories represent intentional accumulation for anticipated sales, or disappointing current performance.
  • Employment is improving. The weekly jobless claims hit a new low. The monthly employment situation report shows a nice rebound with growth in the household survey and a lower unemployment rate. We are still far from resuming trend growth, but it is an improvement and certainly belies any lingering recession worries. Scott Grannis has a nice summary, including a chart of both the major surveys. He also puts to rest the part-time employment argument, writing as follows:

    Despite what you might have heard repeated many times in the media, jobs growth in the current recovery has not been dominated by part-time jobs. As the chart above shows, there actually has been zero growth in part-time jobs since the last recession, and the ratio of part-time to total jobs has been falling steadily, much as it has in every recession in the past.

Private Nonfarm Employment

Yardeni indicators

  • Michigan sentiment was very strong. I view this as an important concurrent indicator both for employment and consumption. Doug Short's chart is my favorite and his analysis is excellent.

Dshort michigan

  • Housing still looks good – new home sales and permits. See the authoritative work from Calculated Risk.

The Bad

There was not much bad news. Feel free to add suggestions in the comments. These should be items from the current week, not the repetition of something you could have said (and probably did) six months ago!

  • Personal income disappointed, declining in real terms. See Steven Hansen's analysis.
  • The ISM Services index was positive, but below expectations.
  • Holiday sales were soft for some retailers – at least from the early reports.
  • Investor sentiment remains very bullish, a contrarian short-term indicator. Bespoke charts the AAII data:

AAII Bullish Sentiment 112913

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. Thanks to the many readers who wrote or commented suggesting that my analysis of the Morgan Stanley chart on forward earnings should be this week's winner. I cannot give myself the award, but I do urge readers who missed the article to take a look. It was like a movie that got critical acclaim but did not attract a big audience.

Ironically, the original chart I was analyzing pretty much went viral.

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. 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 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 two 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 still bullish, but only marginally so.

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 decreased dramatically, meaning that we have more 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

After the post-Thanksgiving data feast, we have a relatively thin week for new data.

The "A List" includes the following:

  • Initial jobless claims (Th). Resuming a key role as the most responsive employment measure.
  • Retail sales (Th). The consumer remains a focal point.

The "B List" includes:

  • PPI (F). Inflation data remains tame, so this is not likely to move the markets.

The speechmaking schedule is still thin. James Bullard of the St. Louis Fed will speak on Monday. Secretary of State Kerry will testify before a Congressional Committee on Tuesday. We will also get more news on the developing budget deal.

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 continues in bullish mode. In our trading accounts we have been fully invested and the positions have gradually become more aggressive. 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 lower ratings, but more sectors in the penalty box. There are still three attractive sectors, but it would not be surprising to see a move toward "neutral" in the week ahead.

Felix gets credit for identifying biotech (IBB) and riding the wave. This has been one of the top-rated choices in our free weekly email update (email address in the "Felix" section above.

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. I am covering some detailed ideas and links in this section, but also see the conclusion.

There is a continuing barrage of "bubble talk." It seems like there is a drumbeat of stories with the same bearish themes, mostly relying on the Shiller CAPE P/E method of valuation and also the argument that profit margins are elevated. These are both rather old and tired arguments, but the refutation gets little publicity. Worried investors should take a few minutes to read these two sources:

Macro Man – analyzing a number of bearish arguments. The entire article is great, but let me focus on the issue of profit margins, where he writes as follows:

[Argument] Earnings as a percentage of GDP are too high. They will revert back to the long term mean, which means substantially lower profits.

That is only true if you look at TOTAL earnings. DOMESTIC earnings are NOT excessively high as a percentage of GDP. Much of the recent earnings growth over the past decade has actually come from abroad:

Image002

Jeremy Siegel, who has been absolutely right about the market, both for the very long term and for the current year. Advisor Perspectives Editor Robert Huebscher had a fine recent interview where Prof. Siegel explains why the market is 10-15% undervalued right now, and has the potential for working significantly higher. He especially responds to arguments based upon his friend Robert Shiller's CAPE ratio, profit margins, and Fed policy.

Here is a summary of 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

We are reaching the end of a year when many scary possibilities did not occur. Since these many scenarios weighed on stocks, it was natural to see a rally driven both by an improved economy and earnings as well as a reduction in fear. Those who attribute everything to Fed policy are simply making excuses for their bad forecasting as I noted in The Fed as a Fig Leaf.

The classic wall of worry concept, which you can learn more about on my investor page, was nicely illustrated by this chart from LPL Financial (via Cullen Roche).

LPL2

If we had nothing to worry about, the Dow would already be at 20K, fulfilling my prediction. I am looking forward to a time of less emphasis on the Fed and more attention to market fundamentals.

Economic Bloggers See Modest Growth, Modest Risk

We welcome the return of the Survey of Leading Economic Bloggers. Tim Kane spearheaded the survey during his Kauffman Foundation tenure. Tim has moved to the Hudson Institute, where he has busily been writing books [with important policy implications according to this NYT review – the OldProf has this on the reading list, but is still catching up], and has now brought back the survey.

I am a long-time fan of this survey. Most investors focus on a few specific blogs. The survey helps them to put the conclusions in a better context. It also introduces them to other valuable sources. The Kauffman Foundation has continued to support the annual Conference of Economic Bloggers, which is a very valuable resource. (More on that soon). There is a change in the survey participants, but no more so than you would see in the panel for the highly-regarded University of Michigan consumer sentiment survey!

My marketing team tells me that the title of this post is a little …..Modest. I should try for something more attention-grabbing.

That is the problem! Pseudo-excitement does not lead to great investing. The consensus advice from this group is much, much better than the daily news stream. Don't believe me? Take a look at my key points from the survey two years ago. Assume that you had used this information as part of your investment planning.

Key Results

I am going to highlight some of the results I find most interesting, adding my own take. The survey has many interesting questions, including a few innovative entries. I encourage readers to look for other reports as well.

The Word Cloud

The hallmark of the survey is the word cloud. Respondents are asked to provide five adjectives to describe the current economy. This innovative, open-ended approach provides a unique insight.

Blogger Survey Word Cloud

Let us contrast this with the cloud from two years ago.

Blogger Survey 2011

Uncertainty still reigns, but the adjectives seem a little more positive.

Economic Prospects

Economic bloggers see continuing prospects for growth, albeit modest.

This question provides an interesting combination of economic and political forecasting.

10Hubbard

There is logic to this approach. Economic prospects are inextricably linked to fiscal policy.

Recession Odds

The blogging community sees only modest chance of a recession.

14Picerno

This is a little higher than my own group of forecasters who focus on the recession issue in my WTWA economic updates, but it is much more encouraging than the pundit parade you see in the media.

End of QE

What will happen if the Fed quits buying bonds? The question was stated in terms of the 30-year bond. (My own suggestion was a focus on the ten-year note, but this is OK). The expectations are pretty dramatic.

12Falkenstein

My own view is that the impact would be quite modest. The results expected by my blogging colleagues are more consistent with a complete unwind and selling of the entire Fed balance sheet. There is research on the current QE effects, which are more like 15-20 bps on the ten-year note. Clearly I need to write more on this topic!

And so much more

I have focused on the conclusions most relevant to investors. There are several questions geared to important policy issues including debt limits and ObamaCare. This group takes no prisoners when it comes to hard-headed analysis. The overall conclusions are interesting, and pretty tough.

While my own work avoids policy advocacy – great investors are political agnostics – I know that many readers will enjoy looking at the results from the entire survey.

Weighing the Week Ahead: Will the Fed Change Course?

After weeks of speculation based upon speeches, newspaper columns, and pundit pontification we will finally have some hard information. Maybe. The two-day FOMC meeting will include not only the regular announcement of the decision, but also revised economic forecasts and a press conference by Chairman Bernanke. Everyone will be watching for any hints of a change in policy.

  1. Will the Fed reduce the pace of the current QE purchasing?
  2. If not, will it provide more information about the timing of a possible change?
  3. What might be the size of any reduction?

Those expecting early action seem to focus on September. Tim Duy reviews the most recent data and concludes, "Bottom Line:  Today's data appears consistent with Fed expectations that they can begin tapering asset purchases this year.  Still a horse race between September and December, although I think the Fed is aiming for the earlier date if data allows."

Those expecting later action point to the lack of inflation. Recoveries from recession are usually stronger and faster; that usually means inflation. Rex Nutting notes that it is the lowest core inflation in history.

MW-BE051_inflat_20130613151403_MG


Bloomberg (via Josh Brown) compares inflation to past recoveries. Josh concludes that the Fed has time to jawbone rather than changing policy. Here is the key chart:

Inflation-1024x624


If the Fed does change course, what will be the result?

Most market observers expect a major reaction at the first sign of a Fed policy change. They are not waiting for an actual increase in interest rates, but getting ready to head for the exits at the first sign of a policy shift. This analysis from Barclays, cited in The Economist, is typical. It shows the "sensitivity" of various markets to changes in the Fed balance sheet. There is no attempt to show a causal mechanism.

Intone after me:

Fed prints money. Liquidity, liquidity. POMO, POMO. Asset prices move higher – all of them!

20130615_gdc777_1


I have some contrarian thoughts about what to expect from the Fed. I'll elaborate in the conclusion, but 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

On balance, this was a good week for economic data.

  • S&P revised the outlook on U.S. debt to stable from negative. Do we really care?
  • Year-over-year growth in expected earnings is stronger (via Brian Gilmartin). This comparison deserves more attention.
  • Initial jobless claims surprised and declined to 334K. There is less firing, but we still need more hiring!
  • Retail sales showed a surprising gain, even after subtracting higher gasoline sales. There is solid growth but less than expected from a normal recovery. Scott Grannis has a good analysis with a Fed related theme and many helpful charts. Here is the retail sales "control" group version:

Control group


 

The Bad

There was some bad news, but probably not as important.  Feel free to add in the comments anything you think I missed!

  • Pump and dump is back. Investors who feel like they have missed the rally are trying to catch up in the wrong way. The SEC and FINRA are warning about an increase in scams.
  • The PPI increased by 0.5%, mostly reflecting energy prices. In the long run, we care about food and energy costs, but the year-over year change was only 1.7%.
  • Another debt ceiling debate looms (via The Hill). This can put a lid on job growth.
  • Rail traffic is stagnating (via Cullen Roche). Contrary view from GEI, using different comparisons.
  • Industrial production was flat, missing expectations. James Picerno has a nice analysis, advising that the indicator bears watching but is not yet a "smoking gun." Here is one of the useful charts:

Industrial Production - Picerno


  • Chinese growth is losing some momentum, but still relatively high (via Ed Yardeni).

The Ugly

Congress is a repeat winner of the "ugly" award. It seems like there is often something new. Gallup reports that confidence in Congress has hit an all-time low of 10%, down 3% from last year. One reason for poor performance might be lack of knowledge and attention. The Hill reports that the majority of the Senate preferred to check out early for the weekend rather than to attend a classified briefing on NSA snooping.

There were some other candidates this week, so feel free to add your own ideas in the comments!

MW-BE048_congre_ME_20130613140925


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 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.

Calculated Risk joins us in concluding that there will be no recession for "some time" and also in placing a high priority on this analysis.

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.

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.  We recently switched our stance to neutral, but it is a close call. Felix might switch to a bearish posture if the overall market drifts lower. The inverse ETFs are more highly rated than positive sectors by a small margin, but remain in the penalty box. These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings seem to have stabilized at a low level. The penalty box percentage measures our confidence in the forecast.  A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings.  That measure remains elevated, so 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

This week brings little data and scheduled news, an artifact of the calendar and the holidays.

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.
  • Building permits and housing starts (T). Building permits are an excellent leading indicator for housing, and housing is what we should be watching.
  • FOMC decision and press conference (W). The key point for the week.

The "B List" includes the following:

  • CPI (T). At some point the inflation data will be more important. For now it is benign.
  • Existing home sales (Th).  This is a key element of the economic rebound, so it is important to follow.
  • Leading economic indicators (Th). This report is still widely followed and used by some in recession forecasting.

I am not very interested in the Empire State index or the Philly Fed report, but people will pay attention to extreme moves.

There will also be continuing news from President Obama's travel abroad, but I am not expecting a specific market impact.

How to Use the Weekly Data Updates

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

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

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

Insight for Traders

Felix has continued a neutral posture, now fully reflected in trading accounts which have no position in equities. Our partial position includes a bond inverse fund and a commodity. The overall ratings are slightly negative, so we are 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 update the model every day and trade accordingly. 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.

Insight for Investors

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. It has already started. Bespoke Investment Group has a great chart package showing how the rush into yield-based investments is going South in a big way! Anyone focused on yield should read this post and look at the charts. The most recent victim is the preferred stock, as you can see here:

Pff611


 

I also 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. (I freely share how we do it and you can try it yourself. Follow here, and 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. Check out the ten suggestions from Barry Ritholtz, specifically aimed at those who feel they missed out on the latest market move.

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. Ignore all of the talk about the Fed and focus on stocks. One of my favorite sources, Bill Nygren of Oakmark refused to play the game in his CNBC interview this week. He would not answer the standard questions about the short term, and carefully explained why investors should take advantage of volatility to buy cheap stocks. This is also my message, and I agree with many of his specific stock suggestions. For those who were not monitoring CNBC two hours before the opening, you might have missed this great interview.

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

What should we expect from the Fed?

It has actually been pretty easy so far. Here are the rules:

  • Pay attention to Bernanke, not speeches by others. They are free to talk in the modern era, but the message is not orchestrated.
  • Do not expect a road map when there is no specific plan. When the message is that policy is "data dependent" that is clear communication. It is silly to expect more specificity from a committee. They are all looking at the evidence.
  • Do not over-estimate the Fed impact. This is the most important lesson. Everyone who has been wrong about their forecasts – recessions, interest rates, stocks – has blamed it on the Fed.

These are the same people who told you that the Fed was "out of bullets." They argued that the Fed would not be effective. That the Dow was going to 5000. These are sources that are using the Fed as a fig leaf to cover up their own mistaken analysis.

The reality is that the Fed has had a modest impact on both interest rates and the recovery in stocks. The facile, two-variable correlations between QE and various markets are flawed. Anyone doing serious economic analysis understands that many variables are changing at the same time. Consider the Barclay's graph I cited the introduction.

Do you really think that Turkish stocks will get crushed if the Fed eases off on QE? What happened to the "correlations" that we saw with food prices and energy on the last round of QE? Notice how the comparisons change when convenient?

Fed policy has been a modest substitute for better fiscal policy. It had a modest economic effect when implemented, and will have a modest economic effect when withdrawn.

The psychological effect is another matter, and a problem for another day.

Ultimately, interest rates and stock prices will both move higher. For more explanation check out my post from the start of 2011 I predicted ten things that would be more normal. Some have proved accurate while others are a work in progress. Former Goldman Sachs Asset Management Chairman Jim O'Neill reaches a similar conclusion:

In the short term, getting back to normal probably means some fallout across equity markets, too — but this is much less likely to be lasting. Longer-term investors will want more exposure to equities, not less. Normality means a reversal in the popularity of the two main asset classes: As people fall out of love with bonds, they'll fall back in love with equities.

The Fed as a Fig Leaf

Everyone who has been wrong about the market has now joined in a familiar refrain:

The Fed is printing money. It is the only thing holding up stocks. It will all end badly.

Background

A little research on these sources shows that – as of a few months ago – their take on the Fed included the following:

  • The Fed is irrelevant
  • The Fed is pushing on a string
  • The Fed is in a box
  • The effectiveness of QE has declined with each new round.

When the various bearish predictions have not played out, the same sources come up with a NEW VERSION of the theory. In this revised story, no one could possibly have predicted the effect of the Fed's money printing and debasement of the currency. Wow!

Once again this flies in the face of facts:

  1. While the Fed's balance sheet has increased, M2 growth has been modest. Whatever "printing" is taking place seems to be stalled at the level of excess reserves.
  2. The dollar has actually strengthened. In fact, there is no real correlation to Fed policy – despite the rhetoric.

Fredgraph

But it is an easy explanation. Blaming the Fed is a fig leaf for bad analysis.

David_figleaf

The Reality – An Alternative Hypothesis

There is a simple reason for higher stock prices: Better economic conditions and higher profits. Over the last three years the most important market worries have lessened.

Most people struggle to understand the "wall of worry" concept. Briefly put, it means that, at any given time, stock prices might be lower than one expected because of headline risks. These are plentiful at all times, fueled by ratings-seeking media and blogs. Trying to explain how Europe will bargain its way to a solution is pretty boring when compared to footage of a run on banks in Cyprus!

It is very difficult to evaluate the worries in real time. To avoid this problem, let us use the Wayback machine to go back three years. In my Dow 20K series, I raised a number of "what if" questions. The commenters were most of the "Miller, you idiot" persuasion. Feel free to go back and see how nearly everyone questioned the mere possibility that any problems might be solved. Here was the favorite from the Seeking Alpha crowd:

'What if unemployment falls to 8%? What if the annual budget deficit is reduced? What if earnings for US companies continue to surge, leaving the 10-year trailing earnings in the dust?'

And what if my aunt had balls?

She'd be my uncle!

The smart-aleck who offered this viewpoint is still around — providing the same "in-depth" and inaccurate analysis.

But let us turn to what I suggested…

My List of "What if's"

This is all from the article three years ago:

Asking the Right Questions

The bias is inherent in the situation. The problems are known. If you write for a major publication, you are rewarded for analyzing the negativity. If you go on TV, you are expected to parrot the analysis of problems. This makes you seem smart.

By contrast, the solutions are vague and unknown. If you even talk about them, all of the "hot shots" are skeptical.

That should be your clue to pay attention. Repeating the known news does not make you money. Try asking these questions:

  • What if unemployment falls to 8%?
  • What if the annual budget deficit is reduced?
  • What if housing prices and sales show a clear bottom?
  • What if mortgage rates remain low?
  • What if politicians negotiate a compromise on tax increases?
  • What if Europe stabilizes?
  • What if China and other emerging countries resume a solid growth path?
  • What if earnings for US companies continue to surge, leaving the 10-year trailing earnings in the dust?
  • What if the US rationalizes immigration?

If you have not thought about these possibilities, you have a fixation on negativity. My Dow 20K concept is designed to set you free — to get you thinking about the long sweep of history and the potential for success. If even a few of these things happen, what would be the market reaction?

If you look objectively at the list from years ago, you will see that most of the items have been accomplished and there has been significant progress on the rest. What has that been worth in market value? The actual growth in S&P earnings is about the same as the increase in stocks.

Note well: This is not a story about the Fed, although Fed policy helped with economic growth and mortgages.

Choosing the Right Pundit

There is a group of market "experts" who have been completely wrong on all of the items on the list above. They have been wrong about "headwinds", recession probabilities, and the overall market. They were also wrong about the Fed – both in forecasting policy and the ultimate effect. You can see them every day on financial TV and in the media. The quoted "Street Cred" does not mention the past results of their methods.

These pundits now desperately cling to their pseudo-expertise on "global macro." They seize the "fig leaf" of the Fed. It is easier to claim that you missed the power of the central banks to "print" than to admit that you had the whole story wrong.

They are now warning that a disaster looms. Please note that the new prediction rests upon the accuracy of the old one.

Investor Lesson

Those who have been wrong about Fed policy so far, will also be wrong about the exit. Take a deep breath. I am a consumer of economic information, and so are you. We succeed if we find the best sources. Right now that means understanding that it is not all about the Fed – despite the daily media diet of news.

The complete story will require more than one post, but I did show the way with the first installment. My next post will ask what the effect would be if the Fed unwound the entire balance sheet in one year. What is your guess? Let us suppose two methods:

  1. No notice at all.
  2. Announcement of the general plan, but without daily or weekly specifics.

We all know that it could not happen in either of these alternatives, but let us consider them as a useful hypothetical starting point.

Weighing the Week Ahead: Are You Ready for Some Fedspeak?

Ready or not, we should expect a week dominated by an even greater focus on Fed policy. There are four reasons:

  1. The economic data calendar is very light;
  2. Earnings season has ended;
  3. Many will be heading for the exits early, anticipating a holiday weekend; and finally
  4. Bernanke testifies on the economy before the Congressional Joint Economic Committee. There will also be other Fed speeches and the minutes of the last FOMC meeting.

What should we expect?

Fedspeak is described by former Fed Vice-Chair Alan Blinder as "a turgid dialect of English." In the Greenspan era, the Fed Chair was intentionally ambiguous. (Blinder, who favored a more open exchange, did not last long in the Greenspan era). In the Bernanke era there is supposed to be more transparency. There certainly is more open disagreement among the FOMC participants.

Two Viewpoints

Among market participants there is widespread sentiment that current asset prices of all types, and especially stocks, are the result of worldwide QE. These observers are ready to head for the exit at the first sign of any change in Fed policy. This perspective has been the most popular approach for several years – right or wrong.

Some others regard stock prices as pretty normal, especially since a U.S. recession seems to have been avoided. It is the reduction of fear that supports the rally. The Fed has been relevant in reducing recession chances, but the market rally reflects improvement in fundamental factors – reduced risk and stronger earnings. Most readers would be startled to learn how much negative sentiment is still reflected in current stock prices. Ed Yardeni looks at forward earnings in much the same way I do. Here is a chart showing a normal mean reversion in multiples. If you adjusted for inflation and/or the potential for other investments, we would be talking a market valuation at least 30% higher.

Yardeni Valuation


My fearless forecast is that none of the news on Wednesday – either from Bernanke's testimony or the FOMC minutes – will resolve this debate! It will provide something for the parade of pundits to talk about.

I have some thoughts on what to expect from the Fed 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 another good week for the stock market, but there was only mild support from the data.

  • Retail sales were strongly positive. Last week I wrote that we would be focusing on the consumer, and this was a surprise for me. Steven Hansen has a very nice analysis at Global Economic Intersection. This analysis has charts and many comparisons, avoiding the controversies of the various adjustment processes. Take a look!
  • Energy exporting from the U.S. is promising. See the first-rate discussion at ft.com.
  • Building permits showed strong growth. Regular readers know that I favor this as a leading indicator on housing. So does Scott Grannis.

Building Permits


  • Michigan sentiment was amazingly strong. This is very good news about consumption and employment. Here is the helpful chart from Calculated Risk. You can see the improvement to a crucial level. Check out the full article for further analysis.

ConsumerSentPreMay2013


The Bad

There was plenty of bad news.

  • Gas prices are moving higher. This is a surprise, since the trend in both oil and gasoline had been lower. Automotive Fleet covers this news – up six cents last week. Illinois is near the top of the list in prices ($4.20 – 4.25 here in the Chicago burbs) partly because of refinery problems. In my annual pickup trick for my son, there was a 65-cent swing in prices if you drove an hour south. (Derek has been an occasional contributor on my blog. Please indulge me in a bit of fatherly pride at his 4.0 as he completed his Junior year at Illinois).
  • Household debt is lower – by 11.4% from the 2008 peak. Put another way, the U.S. consumer is reducing debt at the same time that overall consumption has been solid. See the details from Jeffry Bartash at MarketWatch.

MW-BC676_nyfedh_20130514093435_MD


  • Initial jobless claims spiked to 360K, about 30K higher than expectations. This is a noisy series with challenges related to seasonal adjustments, so everyone watches the four-week MA. It is still bad news, and worth special attention in the next few weeks.
  • Housing starts declined sharply. Calculated Risk has this story and also a more comprehensive interpretation. The housing starts are quite disappointing, but distorted a bit by the sharp decline in multi-family units. Here is a good chart showing both types:

StartsLongApril2013


The Neutral

Sometimes it seems like we are running in place. I always read and enjoy the high frequency indicators from The Bonddad Blog. New Deal Democrat's weekly post covers many indicators beyond those highlighted here. At the moment, his conclusion is similar to my overall picture – a period of sluggish growth.

The Ugly

The IRS is the clear winner of this week's "ugly" award. The actions of this agency managed something previously thought to be impossible – unifying Congress! If you watched or read the testimony of IRS officials – can't remember, not sure about notes, etc. – do not try that at home! IRS auditors are not likely to be very forgiving when records are missing.

If this turns out to have some reach into the upper levels of the Obama Administration, it could have some market effects.

Man Bites Dog

S&P has downgraded Berkshire Hathaway. I had to recheck the headline! The guys who were so wrong about subprime? Who downgraded US debt after the debt ceiling debate, even though an agreement was reached – just because they did not like it? No one elected these people to dictate the public policy agenda for us. There is a very nice Reuters story on this topic, which I recommend.

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.  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.

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 well over a year 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. It is time for a fresh look at his "Big Four" chart.

Doug Short's Big Four


Doug reviews the latest (umpteenth) change in the ECRI methods, showing why there is nothing magical about nominal year-over-year growth in GDP of 3.7%. Short answer: low inflation distorts the analysis.

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 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.  After a brief move to "neutral" about a month ago we switched back to a bullish position.  These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings stabilized at a low level and improved significantly over the last few weeks.  The penalty box percentage measures our confidence in the forecast.  A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings.  That measure has moved lower, so we now have more 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

This week brings little in the way of economic data.

The "A List" includes the following:

  • Initial jobless claims (Th).  This is the high-frequency indicator on employment. Interest will be especially high after last week's surprise spike.
  • New home sales (Th). Interest is greater than usual. Many are counting on strong housing data to offset the sequester, and expectations are high for the spring.
  • Existing home sales (W). See above.

The "B List" includes the following:

  • Durable goods (F). Interesting but volatile series.
  • FOMC minutes (W). From the May 1st meeting.
  • FAFA home prices (W).  These are the prices from the regular homes in the government market.

Various Fed speeches, highlighted by Bernanke's testimony on Wednesday morning, just after the market open.


Trading Time Frame

Felix has continued a bullish posture. Even with a brief move to a "neutral" overall rating, Felix continued to find at least three attractive sectors. The positions were pretty defensive until about ten days ago. Felix has picked up the shift to cyclical stocks and technology, and also the move to financials. The trading picture is attractive and broadly-based.

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.

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.

Other yield-based investments have a similar or greater risk profile. As David Kehohane of FTAlphaville notes, even junk bonds are now yielding less than 5%!

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 for over two years and continues to do so.

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 will deal with the logic behind the prediction. It is important to realize that there is plenty of upside left in the rally, as Barron's notes this week in the cover story, We Were Right!

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 should we expect from this week's Fed news?

I expect Bernanke to re-emphasize the commitment to economic growth. The markets have clearly not gotten the message. The Fed is determined to avoid deflation. There is little inflation risk, especially using the Fed's preferred measure, the PCE index. The public consensus is that stimulus will be gradually withdrawn as the economy improves. Why not accept that message? Those who have taken the Fed at its word have done much better than the perpetual skeptics.

Here is another perspective from Jim O'Neill, economist and former Chairman of Goldman Sachs Asset Management. I especially like sources who are not selling a particular product, and so should you.

"Our stock markets seem to be enjoying themselves. Many ascribe the robust performance of stocks as nothing more than the consequence of friendly monetary policies all over the world. While I am sure this is playing its part, it was just as fashionable to argue the same easy monetary policies were also fuelling the commodity rally some time ago, so perhaps it isn't that simple.

Maybe something a bit more substantive is happening. After the pleasant surprise of +0.3pc real GDP in the UK in Q1, many of us were braced for the resulting setback, which would follow the pattern of the past couple of years. But while it is early days, quite a bit of recent economic news has continued to be on the positive side.

While much of the eurozone continues to struggle, US performance remains encouraging; a housing recovery and a competitive boost from cheaper domestic energy seem to have underpinned the improvement.

And, while we don't export a great deal to Japan these days, the improving mood of the Japanese consumer to the country's monetary and fiscal boost suggests that a number of other economies will take heart. It is too soon to be singing in the streets, but the signs are looking better than they have for a while."

This really nails it. Those who have been completely wrong about the economy and the stock market have blamed Fed policy for every move in every market.

Do you remember when the price of tacos was blamed on Bernanke?

I started to explain this with my controversial article on the flaw in David Tepper's analysis. I accept Tepper's conclusion, but I object to those who take shortcuts in economic analysis. I'll have more on this theme.

Investment Implication

I understand that most of the world is programmed for a knee-jerk response to any news about the Fed. Eventually, the actual effects – both on the economy and corporate earnings – will prove to be more important. Some think that they can anticipate and "game" the reactions of others. That might be worth trying. But shouldn't we start with a better understanding of reality?

If you get the fundamentals right, you will be a successful investor.

Investors: How to Profit by Understanding the Fed

Why have so many TV “experts” been so wrong about the market?

Many blame government. This demonstrates that they fail to include the government factor in their forecasts.

The recessionistas asserted that economic decline was inevitable. Investors were assaulted with negative stories. This included multiple TV appearances by the ECRI and weekly columns from Hussman and Mauldin and assorted “100% recession” forecasts. It went on for more than a year. The puppet shows about the “Bernank” went viral. Meanwhile, this video (via Bonddad) has only a few thousand views.

Truth is harder to sell than fear.

How to Profit

This is a wonderful opportunity for the average investor!

Why not make objective forecasts about government policy and the likely effects? Be agnostic about partisan politics. Try to profit no matter who is in power.

The pundits make a series of mistakes, which you can easily avoid:

  1. Underestimating government. Many have heard that George Soros “broke the pound” in his bet against the UK. Here is a clue. You are not George Soros! Governments are large and powerful and traders are small. A determined government policy will squash you like a bug. Beware.
  2. Oversimplifying. The story is that the Fed prints money and rushes out to buy Treasury debt. The CNBC anchors ask rhetorically how much higher interest rates would be if not for the Fed. They nod wisely at each other without bothering to provide any evidence. Here are two doses of reality.
    1. The entire QE program has less than a 1% effect on the ten-year note. QE3 is only a few basis points in terms of direct effect.
    2. There is no direct link from QE investments (think POMO) to purchases of soybeans, oil, stocks, or anything else. If you can’t trace the cash, don’t risk your stash!
  3. Poor forecasts. The average pundit thinks that the Fed may change course at any moment. The market overreacts to every dissenting speech by a Fed member. Meanwhile, the main message is clear: Expect aggressively easy money until the economy gets better. The Fed is trying to change expectations. That means you! Policy will not change because of a few strong economic reports.
  4. Too much politics. The entire monetary policy debate was politicized during the election campaign. The “out party” will always attack – Dems in 2008 and GOP last year – but investors should see through this.
  5. Overemphasis on stock market effects. The Fed is interested in the stock market as a measure of their effectiveness and as a (minor) economic transmission mechanism. From the Fed perspective, the more important measures are interest rates, employment, and GDP.

I do not want to turn this list into a slogan about fighting the Fed, since the story has more nuances. It is not just the Fed, but central banks around the world. And the interpretation of Fed policy cannot be done with a simplistic “risk on, risk off” approach.

Useful Background Reading

In preparing tonight’s post I was looking for something original to say. I started by reviewing my past work on Fed policy and the individual investor. Many of the key points are analyzed in more detail on my investor resource page about Fed policy and QE. You can easily find the links for the last few years and check my record.

If I had to pick a single recent post, it would be my discussion of QE3 misconceptions and how to profit.

While the market is about 6% higher in the four months since I wrote that post, it is not too late. This story has many, many months to run.

One specific theme is to play stocks that are earlier in the business cycle, like Caterpillar (CAT). I also continue to favor technology names like Oracle (ORCL) and Apple (AAPL).