Weighing the Week Ahead: Is the Fed behind the Curve?

6/21/14 Once again, the market focus has turned to the Fed. For many months the official Fed policy has included an inflation target, an annual rate of 2%. For many months I have written that inflation will not matter until this level is in play. Suddenly, after a single month of data approaching this range, some believe that inflation is a threat.

There is plenty of economic data next week, and there could well be a fresh theme from housing news. Despite this, I think that the economic stories will all be interpreted through the lens of last week’s news. Expect a hair-trigger sensitivity to price increases and a special focus on the PCE index release. The media and punditry will engage in their favorite sport – second-guessing the Fed!

Prior Theme Recap
Last week I expected some early news on Iraq before a mid-week shift to the Fed. That was pretty accurate. The Fed news was the major event of the week. On Friday we had the lowest volatility of the year, despite a “quadruple witching” options expiration. Doug Short has a regular feature capturing the week just past with one of his terrific charts – the whole story in one picture.

dshort market week

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. That is the purpose of considering possible themes for the week ahead.

This Week’s Theme

With plenty of economic data and little earnings news, expect anyone with a microphone to ask interview subjects if the Fed is “behind the curve.” They will all oblige with an answer. Joe Weisenthal always has the pulse of the financial community, and he sees this as the big story of the summer. He highlights Fed Chair Yellen’s answer that recent price increases were “noise” and the skepticism from the Street.

With that in mind, let us start with some factual background.

There are many different measures of inflation. The Fed prefers the Personal Consumption Expenditure Index (which will be updated this week).

  • Why? It better captures the impact on consumers than the CPI. From The Economist:

    The two indexes frequently diverge because they are constructed differently. While the weights in the CPI basket change only every few years, the PCE’s change each month, better capturing consumers’ tendency to shift from more expensive commodities and outlets to cheaper ones. The CPI’s weights are also determined by what consumers say they spend, whereas the PCE index is based on what they actually spend, or what is spent on their behalf, such as the employer’s portion of health insurance, and what the federal government spends on Medicare. As a result the CPI assigns much more weight to rent and housing and much less to health care. PCE inflation over time typically runs about 0.3% below CPI inflation, but the current divergence, at 0.7%, is the largest in more than a decade, according to Goldman Sachs.

  • Some Fed participants might not agree. (See the St. Louis Fed message).
  • The overall effect of PCE is a lower estimate of inflation. (Chart from Doug Short).

dshort pce

Is Fed policy too relaxed? Here are the key perspectives:

  • Inflation is already above the 2% target. There is less labor slack than the Fed believes. Even if recent price increases are temporary an economic rebound will rekindle the price pressure. (Martin Feldstein op-ed).
  • Inflation is just about right, given the Fed target. (Ed Yardeni).

    Where do I stand? I am in the middle, predicting that economic growth will stay moderate and that inflation will remain modest (or vice-versa). Admittedly, the core CPI inflation rate, on an annualized three-month basis, has been rising rapidly recently, from 1.4% in February to 1.8% in March to 2.2% in April to 2.8% in May.

    Looking at the various components of the CPI shows that the recent flare-up in the core inflation rate has been relatively widespread. So there may be something to the reflation story, but we aren’t convinced just yet. In any event, we are feeling more comfortable with our 2.5%-3.0% range for the 10-year Treasury yield than we did on May 28 when the yield fell to the most recent low of 2.4%.

  • Inflation concerns are overblown. (Analysis from Mark Thoma).
  • Janet Yellen is actually an inflation hawk, given the economic forecast. (Fed Expert Tim Duy).
  • The US is in line with long-term inflation trends and is certainly not like Argentina! (Scott Grannis – good charts).

Which of these viewpoints is correct? 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 some encouraging news last week.

  • Homebuilder sentiment moved higher. The reading of 49 beat expectations, but it not quite positive. (Reuters).
  • Investor sentiment has turned negative –and that is a contrarian positive. The sentiment from the AAII was in the “bad news” just last week, so it is making some quick changes. Bespoke has the story and a beautiful chart showing the big shift:

AAII Bullish 061914

  • Leading indicators were in line with expectations, but that confirmed positive news.
  • Industrial production beat expectations, growing 0.6%. (See the WSJ).
  • Commercial credit is rising. Joe Weisenthal calls it the “best economic news of the week.” Most people do not understand that a key economic issue is that the liquidity provided by the Fed is not finding its way into the money supply. Bank lending is a key, especially to small businesses. Here is the chart:

creditgrowth

  • The St. Louis Financial Stress Index registered an all-time low. I have been highlighting this indicator for years. One of my top researchers spent a summer analyzing the past data, helping to develop a method for risk control (free paper available on request). It is amazing how many investors prefer to be scared witless (TM OldProf) rather than monitor this objective measure of risk. Here is the story and chart from the St. Louis Fed.

slfsi

 

The Bad

The economic news included some negatives as well.

  • Oil and gasoline prices move higher. New Deal Democrat’s excellent weekly summary of high-frequency indicators highlights this move as the most important feature of his report. He writes as follows:

    The oil price spike due to Iraq continued this week. This will bleed through to gas at the pump in the next few weeks.  The Oil choke collar is re-engaging, and if Iraq falls apart, or if its oil exports are disrupted, there will be economic consequences here.

    There is no denying the increase in energy prices, but there are different interpretations of the effects. Michael Santoli suggests, “Yet better average gas mileage, higher wages and a dramatic decline in miles driven since 2008 means a further climb in gas prices probably wouldn’t pinch consumers noticeably unless it reached the new “pain point” of about $4.25 a gallon”.

    Prof. James Hamilton, our go-to expert on energy and the economy, reviews his research and also includes a helpful calculator showing the relationship between oil and gasoline prices. If you pick $4.25 as your “pain point” that implies about $137/barrel for Brent crude. $4.00 per gallon is about $10/barrel lower.

    Higher energy prices are like a tax on consumers with no corresponding payoff. There is also no specific trigger point. Not everyone will react in the same way of course, truly a case of YMMV.

  • Confidence in Congress hits a new low. (Some might see this as “good news” since it suggests possible change!) It is not quite that easy. People typically blame the institution of Congress while re-electing their own representative. Viewed from the other direction, making the right decision requires some support and compromise. Gridlock has not worked very well. Here is the recent chart (via Gallup).

du9t15coj02ep4ueaaztjq

 

  • The Iraq conflict is threatening refineries. This is the step that would really affect oil prices and the world economy. This Canadian story emphasizes the effects on consumers. GEI highlights a BBC video explaining ISIS, the Sunni group behind the insurgency. Do you have 90 seconds to spare?
  • Americans go further into debt to pay the basics. (MarketWatch OpEd, but compare above and note the difference in borrowers). The credit card companies can borrow at near-zero rates, which helps to reduce lending standards. While we could have paid cash for Mrs. OldProf’s new wheels, why not finance at zero percent for five years when that beats the cash incentive? These measures of debt are challenging to interpret.
  • Sea container counts are lower. It is the second consecutive month. Steven Hansen, writing at Global Economic Intersection has the complete story with excellent data comparisons and charts. We also wish to congratulate GEI on their well-deserved surge in the blog rankings. As an early contributor, friend, and occasional critic (constructive I hope), I am delighted to see the success of my friends.
  • Building permits and housing starts were weak – very weak. This happened in spite of the rebound in builder sentiment. Bespoke has a great overall summary with tables and charts. Calculated Risk, our featured source on housing matters, still believes the story will improve because of year-over-year comparisons and general growth. See Bespoke’s full story, but here is one helpful table:

061714 Table

The Ugly

Cheating. Here are three examples in recent news.

The World Cup: The New Yorker’s Cheating the Beautiful Game

Chess: How To Catch A Chess Cheater: Ken Regan Finds Moves Out Of Mind

Bridge: The Captain of the US Senior team on how they exposed the German pair of “coughing doctors” in the World Championship Final in Bali. (Appeal pending).

These are not the only examples from sports and games, of course. You could also make up a list from politics, business, and finance. In the examples I suggest, the violations are all the result of studying records after the fact.

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. No award this week. Nominations are always welcome!

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.


Recent Expert Commentary on Recession Odds and Market Trends

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.

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.

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 includes the most recent ECRI discussion, which has been consistently bearish, including the blown call on the recession.

Doug also has the best continuing update of the most important factors to the NBER when they analyze recessions. This week he updated the retail sales indicator, illustrating the recent weakness:

dshort retail sales

Where is the US economy growing? Vox has a state-by-state breakdown. Perspectives might differ accordingly.

gsp_0614

 

The Week Ahead

We have a very big week for economic news and data.

The “A List” includes the following:

  • Core PCE Prices (Th). Given the buzz over CPI and Yellen, the Fed’s favorite indicator makes the “A list.”
  • New home sales (T). May data. Housing remains a big question mark for the rebound in the US economy.
  • Initial jobless claims (Th). Best concurrent read on employment.
  • Personal income and spending (Th). Important growth component.
  • Consumer confidence (T). The Conference Board version informs about employment and spending in a concurrent fashion.
  • Michigan sentiment (F). Similar to the Conference Board in overall results, but uses a continuing panel as part of the survey.

The “B List” includes the following:

  • Existing home sales (M). A good economic read, but less significant for growth than new home sales.
  • Durable goods orders (W). A key coincident indicator.
  • Case-Shiller home prices (T). This always gets attention, despite the lagging and narrow nature of the index.
  • Q1 GDP (W). This is normally not interesting since in market terms it is ancient history. This week it will be newsworthy because of the expected revisions. Some believe that Q1 will go into the books with a 2% decline.

In the week after the FOMC meeting we can expect plenty of FedSpeak. Several appearances are on the calendar.

While the financial markets have adjusted to the current Iraq story, there is plenty of attention to any breaking 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 grew a bit more cautious last week – fewer positive sectors, lower median score, and greater uncertainty. Our three-week forecast is still bullish, but it is a closer call. This week we were fully invested in three of the top sectors for our trading accounts.

You can sign up for Felix’s weekly ratings updates via email to etf at newarc dot com.

Here is some great advice for traders from Ryan Detrick, one of our favorite sources. He lists ten things he has learned in his decade of trading experience. The list reflects my own experience and also the behavior of the best traders I know. It is difficult to pick a favorite, so you should read them all. Forced to pick one, I choose “There’s no wrong way to make money…..If you are lucky enough to find one thing you are good at, do it and perfect it.”

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 still 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:

Beware of “liquid alternative” funds. Jason Zweig’s must-read column, The Intelligent Investor, covers this story in the context of a recently failed fund. These investments might be a good fit, but be careful! Jason writes:

Liquid-alternative funds generally offer the prospect of doing well when U.S. stocks do poorly. That hope comes at a price, however: Such funds, which tend to charge high fees, typically do poorly when U.S. stocks do well. Investors who don’t understand this link will inevitably be sorry.

Tadas Viskanta, who writes Abnormal Returns (which is universally used to keep track of important events in the financial blogosphere) is taking his annual brief and well-deserved vacation. He solicits some comments on important questions, and publishes the results during his week off. These are all great reads, full of links and ideas. Here is the advice for novice investors (which has value even for those with experience). And here are great suggestions about what to read. Only Tadas could create so much content while taking time off!

Bond funds are a continuing source of risk. Is there really consideration of an “exit fee?” I rather doubt it, and also question whether it would work. The very idea of this discussion is something of a warning. (Barron’s). People expect these investments to represent the safe part of their portfolio. If we really do get the inflation that the Fed is seeking, interest rates will rise and bond prices will fall.

If you are worried 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. You can get our report package with a simple email request to main at newarc dot com. Also 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

Writing about inflation is a thankless task. Readers begin by thinking they know all of the answers. We all shop, right? It is the most popular subject for bamboozling people, since it is easy to find examples of rapidly rising prices. It is by far the most deceptive trap for those who might confuse politics with investing.

You have a simple choice:

  1. You can reinforce your beliefs and take joy in how stupid our leaders are. You and your favorite blogger, pundit, Congressional candidate, etc. have all of the answers. You are all smarter than the isolated, ivory-tower academics at the Fed. Please note that this was the trap that ensnared leading experts and wise observers like John Hussman and the ECRI – just to mention two of the most prominent examples who have had disastrous results over the last few years.
  2. You can accept the fact that the Fed has the power to set policy. It is wiser and more profitable to understand what they are doing and just go with the flow. You can grumble with your friends at the bar, vote your conscience at elections, and still profit from your investments.

I have been extremely accurate in my Fed forecasts, but I am not claiming any prizes. It has not been difficult. I simply read information carefully and understand that it is a committee at work. Here are the key takeaways. You will disagree. You will hate them all. Keep reminding yourself that even if you are right and Yellen is wrong, you will lose on your investments. The Fed has the power. Figure out how to use the knowledge to your advantage.

  1. The Fed is attempting to increase inflation. They seek 2% on the PCE index. This runs about 0.5% cooler than the CPI.
  2. The Fed does not measure inflation through commodity prices.
  3. The Fed believes that 2% is price stability. They think that traditional measures overstate inflation. They do not subscribe to ShadowStats (and neither do any of the people they respect). They also see a touch of inflation as easier to fix than deflation. They bias is toward stimulus.
  4. The Fed will tolerate as much as 2.5% inflation (on the PCE index) for a time.
  5. The Fed has a dual mandate – inflation and employment. It does not protect savers or emerging markets. Learn to live with it and ignore pundits who think this is important.
  6. The Fed sees food and energy as noisy components of inflation – wild movements that do not relate to the dual mandate. If food prices are up because of a drought or disease in hog herds, how could this be controlled by raising interest rates? Middle East geopolitics and oil? Same question. These price changes are certainly real, but they are volatile and not relevant for policy.
  7. The Fed does not shift policy based upon small monthly changes in data. Longer trends are demanded.

     

The conclusion is that Fed policy is on a relatively stable course, but data dependent. The market does not like this, since the preference is for certainty.

If you think about it, even just a little, you can see an obvious edge for investors. You need only accept the reality of the obvious course of policy and ignore the pundits. The Fed has always succeeded in creating inflation – eventually. It will happen again, but given the overall economic weakness it is taking longer. My current guess is late in 2016 or so. Meanwhile, there are some profitable investments to enjoy.

Monitor data, not pundits.

The Most Expensive Investment Research is Free

Wall Street loves slogans. Everyone knows that correlation does not necessarily imply causation. Having uttered the magic words, most proceed to sin again.

Here at "A Dash" my mission is to help investors to greater understanding and better financial results. Much of this comes from identifying the best sources – the true experts.

I am often frustrated in this quest because it is difficult to explain errors in conventional Street wisdom – what I call Wall Street Truthiness. It is so much easier and more profitable to garner page views by pandering to the preconceptions and worries of the readers.

At first glance, today's post might not seem to have "actionable investment advice." That conclusion would be a mistake, since the point I am making is at the foundation of the current debate over the role and impact of the Fed. It is going to take too long to get there for one post, so this is the start. If you stick with me you will see how sloppy thinking on this point can be very costly.

Background – Some Wise Advice

My favorite professor from my college days, Dr. M. Neil Browne, is still
inspiring both students and alums. I have mentioned him and the most
popular of his books (Asking the Right Questions) many times. I pay serious attention to his observations, including this gem from his discussion group:

I'll bet you are well aware of the difference between correlation and causation.  And yet, I'll also bet that if we followed you with a recording device, it would not be long before the warning bell I placed on the device that would clang every time you jumped from correlation to causation would soon be playing a discordant hymn to your human desire to tell make-sense stories where causation is packaged in a neat box with an orderly ribbon decorating it.  Me too.

To perhaps reduce the frequency of our doing so, take a look at the critique of popular science writing at the following location:

http://blog.chabris.com/2013/02/what-has-been-forgotten-about-jonah.html    and click on the link to "strong rebuttal" in the 3rd paragraph

This link describes how an admitted plagiarizer embellished his writings. You might want to compare the following segment to the reactions of the modern doomsday gurus:

I think one of the clearest was Seth Mnookin's analysis of Lehrer's retelling of psychologist Leon Festinger's famous original story of "cognitive dissonance," based on Festinger's experience of infiltrating a doomsday cult in 1954. Of the moments after an expected civilization-destroying cataclysm failed to start, Festinger wrote, "Midnight had passed and nothing had happened … But there was little to see in the reactions of the people in that room. There was no talking, no sound. People sat stock still, their faces seemingly frozen and expressionless." Lehrer narrated the same event as follows: "When the clock read 12:01 and there were still no aliens, the cultists began to worry. A few began to cry. The aliens had let them down." Do you see the difference? Lehrer's version is more dramatic: people worry, they cry, they feel let down. It's more human. Each one of these little errors or fabrications makes the story work a little bit better, makes it match our expectations more closely, and thus gives it greater influence on our beliefs.

When you read the recent writings of those who have been consistently wrong about the Fed, the economy, and the market, keep this in mind. These sources use symbols like training wheels, sugar high, bubbles, manipulation, and stall speed. This is not analysis. It is an effort to explain their own past errors and to deliver to their own following.

A Jarringly Different Example

It would be easy to pick (yet another) misleading statement from Zero Hedge or Santelli channeling ZH. Since that would be unproductive, let me take an example from a source I have often highlighted with great respect: Mark Hulbert. I admire Hulbert as an entrepreneur and a source of information not found in other places. He is someone who found a need for a service and created jobs by filling that need. Well done!

As much as I love Hulbert's work when he is analyzing and reporting on newsletters, I worry when he strays beyond his expertise. Here is a recent example.

Let us start with the title:

Yet another reason to be scared

Commentary: Consumer confidence index is a contrarian indicator

This is certainly an attention grabber. The rebound in consumer confidence is seen as positive by most (including me). Let us look deeper. Is this warning justified?

The article suggests the following themes:

  • Hulbert has done his own research, showing that the market does poorly after big jumps in consumer confidence;
  • He suggests that consumer confidence trails the stock market, rather than predicting it;
  • He points out that the biggest market moves upward came after confidence lows and the biggest declines after highs;
  • He cites academic research that allegedly reaches the same conclusions.

Wrong on All Counts

I have worked with consumer confidence as an indicator in my own research on many different models. It is pretty good as a coincident indicator of economic activity, but it can be distorted by things like political events (the debt ceiling debate in 2011) and gasoline prices (2008 and the rebound last year). Most of the time it is a good read on employment. It has little to do with stocks (at least directly) since few people own stocks. This simple fact is lost on most pundits.

The stock market correlation is what we call a spurious relationship. My old classroom example was a guy in civilian clothes, standing at a corner, and waving to traffic to move at various times. He coordinated his moves with the changes in a traffic signal. The correlation was perfect. Causation was non-existent. Now suppose that the traffic signal was burned out and the guy was wearing a uniform while standing in the middle of the intersection. See the difference?

The current relevance is that many indicators move with the economy (the guy in street clothes on the corner). Most of the things that the punditry sees as correlated are simply responding to changes in economic growth. This is the technical definition of a spurious relationship.

My own research makes me deeply suspicious of Hulbert's findings. Please note that those attempting to find a link to consumer confidence can do three different things:

  1. Look at levels of confidence (the approach of the academic study he cites);
  2. Look at changes in confidence (which Hulbert says he did);
  3. Look at a second derivative, the acceleration of change (often selected by those unable to prove their point with methods 1 or 2).

I might be the only one who followed the link to the study cited by Hulbert. It does not reach the conclusion that he claims, and it is not even close. This was a 2002 paper, not a citation to a peer-reviewed journal. On Hulbert's key point, the authors write as follows:

The negative relationship between consumer confidence and subsequent stock returns is useful to investors even if it is too weak for robust tactical asset allocation is useful. The

fact that low levels of consumer confidence predict high rather than low subsequent stock returns should reassure investors that consumer confidence and stock returns do not follow each other in an endless downward spiral. Indeed, when people lose confidence as consumers, they should regain it as investors.

 

Please note the "too weak" statement. They also produce a table of effects. The relationship cited has no substantive significance. This would be determined by looking at the R-squared results, showing the amount of variance explained. This is about 1%. You can get "statistical significance" with enough cases even when there is no substantive significance. This means that we can be confident that the relationship is not zero, but we may not conclude that it is important. In fact, the data show that it is probably not important, as the authors conclude.

Hulbert's errors in interpreting the academic study make me even more suspicious about his own findings. This suggests a request. As we all learned from the Rogoff and Reinhart incident, there is merit in peer review. Perhaps Hulbert will put his data and analysis online for others to consider. What can be the harm?

And Finally

And finally, it should be obvious that the biggest market drops come from times of high confidence, high economic growth, high stock prices, low financial stress — etc. The biggest gains come from the opposite conditions. This has been a constant theme in my work. You get the biggest rewards when the wall of worry is highest.

Since none of these elements – growth, confidence, employment, and other worries – is currently at an extreme, we are not seeing the signs of a market top. Increases in consumer confidence continue to show coincident evidence of improving personal consumption and employment.