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).

Lessons from the Crash of ’87

Friday, October 19th, is the 25th anniversary of the stock market crash of 1987.  I was a mere three weeks into my new job as research director for a group of market makers at the Chicago Board Options Exchange.  It was a dramatic experience.  Mrs. OldProf was visiting both to celebrate our anniversary and to look for an apartment in the city.  We met friends, hit some shows, and dined at Al Capone's favorite restaurant.  Great fun on Friday.

On Monday things looked a lot different.  We decided to put the move from Wisconsin on hold for a little longer, not signing any leases just yet!

Fortunes were made and lost that day, sometimes the result of what seemed like very small decisions a few days earlier.  Like everyone else who lived through those days I have quite a few stories.  While those are interesting, I want to focus on the lessons that might be relevant for today's investors.

Causes of the Crash

In October of 1987 there was an explosive mixture of an over-valued stock market, rampant and ill-advised program trading, and extreme over-confidence on the part of many investors.  A growing trade deficit and falling dollar caused many to believe that higher interest rates were necessary.  The spark seemed to occur on Friday, October 16th, 1987, with the effects rippling around the world over the weekend.  Mutual funds had large sell orders on the morning of the 19th, necessary to meet redemptions.

I am sure that the paragraph above will sound to some just like a description of current conditions.  I wrote it with that in mind.  I suspect that you will see more than one article pursuing that theme.  It is true that some problems seem to persist for decades, or to re-emerge in different forms.  The exact causes of the Crash are still being debated.  The combination of my academic curiosity and personal stake inspired me to study the subject very carefully.  Here is a brief summary of my conclusions.

Valuation

The stock market was wildly overvalued, even by the most bullish methods.

To avoid getting bogged down in the question of the best valuation measure, let's pick one and use it both for 1987 and for today.  Those who are most concerned about current market valuation are very critical of using 12-month forward earnings and taking account of interest rates — variously called the "Fed Model" or the equity risk premium.  Today's forward earnings on the S&P 500 are about $108 so the earnings yield is about 7.6% compared to a ten-year Treasury note yield of 1.8% or an ERP of 5.6%.

Right before the Crash, the forward earnings were $22.45 for a forward yield of about 7.0%.  The difference is that the ten-year yield was 9.42%, so the ERP was not a premium at all, but a negative 2.42%.  Even if you aggressively believed that the earnings yield should be the same as the Treasury note, stocks were over-valued by 33%.  The decline on the day of the crash was 22%.  Inflation was running in the 4.5% range, but was moving significantly higher.

The valuation situation is not similar.  If you think the market is overvalued now, it was awesomely overvalued then!  (And please don't substitute what you think the CPI or interest rates should be.  It is better to evaluate data than opinion).

Trading and Market Rules

In 1987 many big fund managers embraced a concept called "portfolio insurance."  Simply stated, the idea was that you should hold a very aggressive allocation in stocks — more than your normal risk tolerance would suggest.  If the market started lower, you would then (and only then) sell short futures on the broad stock market.  These short futures would hedge your position.  If the market declined further, you would sell more futures.  You did not want to hedge in advance, since it would be a drag on your performance.

The result was that the instant decline in stocks triggered the sale of index futures.  The futures, which responded more quickly than the cash market, gapped lower.  Arbitrageurs attempted to buy futures and sell stocks to profit from the spread.  This pushed stocks even lower, causing another leg down in this deadly spiral.

While we still have program trading, the highly-publicized events of the last few years do not rival 1987 either in breadth or magnitude.  The portfolio insurance concept has been abandoned.  Various circuit breakers limit the possibility of a cascade of futures and stock trading.  Electronic markets have improved liquidity.  In 1987, the Nasdaq market was based on telephone calls and the market makers were not even answering!  Options traders settled up at the end of the day with "outtrades" checked in the morning.  In 1987 some traders dropped their cards on the floor and left the building.  Some, who had escalated risks to their backers during the day, simply headed for O'Hare, spawning the term "airport play."  Now the trades are electronically transmitted throughout the day, so backers and clearing firms always know what is happening.

Economic Situation

Most importantly, we should note that the 1987 crash was not associated with a recession, either before or after.  Some have suggested that rhetoric about the weakening dollar was the proximate cause.  The easiest way to evaluate this is by looking at a chart of the trade-weighted dollar.  Look at the long-term trend as well as the specific time in 1987 and now.

TWEXBMTH_Max_630_378

The 1987 crash was not an economic phenomenon.  We do not currently face similar risks.

The Real Lessons

  1. A better understanding of risk and reward.  Before the crash the individual investor was a happy seller of naked puts.  The "crash" issue of Barron's had classified ads for trading systems the showed you how to print money.  People sold puts based not on how much risk they could afford, but how much money they wanted to make.  Options clearing firms evaluated positions based upon a three-standard deviation move — a real extreme.  This was a big lesson in the fat tails of the stock return distribution.  The aftermath was the greatest opportunity in history to sell put premium, something that I pointed out to my new boss.  The rules had changed!  Even professional traders were on a short leash for put selling.
  2. The importance of margin. Those who had accounts on margin of any sort suffered the greatest cost.  Positions were ruthlessly liquidated to satisfy the margin call.  This included futures positions and option contracts that were trading far from anything resembling fair value.  Taking on excessive margin risk proved to be a big mistake.

And the Most Important?

Simply put, the crash destroyed objective analysis for years.

This most important lesson of the Crash is not commonly understood.  For the next few  years, any stock system, whether based on fundamentals, technicals, or a computer program, had an acid test:

Did it call the crash?

We saw dozens of pitches.  No one even bothered with a method that did not include a successful "crash call."  The event was so important, and had such a great impact on results, that you could not make a persuasive case for a system that did not have a "tweak" that would have predicted the crash.

Similarly, analysts who had given warnings were celebrated as heroes.  This turned out to be fifteen minutes of fame for some.

This final lesson is probably the most important, and the most difficult to understand.  Excessive emphasis on the "crash call" warped the thinking of portfolio managers and individual investors alike.  The life-changing events from 25 years ago punished some of the smartest traders and rewarded some of the, ahem, least skilled who happened to have the right position for the wrong reason.

Those who took the wrong lessons from this got to double down in lost opportunity.  They followed the wrong gurus and the wrong systems for many years thereafter.  They never recovered.

2008 is an echo of 1987.  Another generation of investors may be lost.

A Final Word

Can stocks decline from current levels?  Of course, and for various reasons.  A 2008-style decline came for reasons much different from 1987.  We now know more about those risks as well, something that I track every week.

Markets can decline, but it will not be from a scenario like that of 1987.

July Employment Report Preview

We rely too much on the monthly employment outlook report.  It is a natural mistake.  We all want to know whether the economy is improving and, if so, by how much. Employment is the key metric since it is fundamental for consumption, corporate profits, tax revenues, deficit reduction, and financial markets.

Since the subject is so important, most people place too much emphasis on the official (preliminary) report, which is really only an estimate.  In about eight months, we'll have an accurate count from state employment offices, but by then no one will care.

There are several competing methods that provide independent approaches to analyzing employment.

I will first summarize the BLS official methodology.  Next I will review alternative approaches and those forecasts.  I will conclude with some ideas about what to watch for.

The Data

We would like to know the net addition of jobs in the month of July.

To provide an estimate of monthly job changes the BLS has a complex methodology that includes the following steps:

  1. An initial report of a survey of establishments. Even if the survey sample was perfect (and we all know that it is not) and the response rate was 100% (which it is not) the sampling error alone for a 90% confidence interval is +/- 100K jobs.
  2. The report is revised to reflect additional responses over the next two months.
  3. There is an adjustment to account for job creation — much maligned and misunderstood by nearly everyone.
  4. The final data are benchmarked against the state employment data every year. This usually shows that the overall process was very good, but it led to major downward adjustments at the time of the recession. More recently, the BLS estimates have been too low. (See here for a more detailed account of this, along with supporting data).

Competing Estimates

The BLS report is really an initial estimate, not the ultimate answer. What we are all looking for is information about job growth. There are several competing sources using different methods and with different answers.

  • ADP has actual, real-time data from firms that use their services. The firms are not completely representative of the entire universe, but it is a different and interesting source. ADP reports gains of 163K private jobs on a seasonally adjusted basis.  In general, the ADP results correlate well with the final data from the BLS, but not always the initial estimate.  It is an independent measure that deserves respect.
  • Economic correlations. Most Wall Street economists use a method that employs data from various inputs, sometimes including ADP (which I think is cheating — you should make an independent estimate).
    • Jeff Method.  I use the four-week moving average of initial claims, the ISM manufacturing index, and the University of Michigan sentiment index. I do this to embrace both job creation (running at over 2.3 million jobs per month) and job destruction (running at about 2.1 million jobs per month). In mid-2011 the sentiment index started reflecting gas prices and the debt ceiling debate rather than broader concerns. When you know there is a problem with an input variable, you need to review the model. For the moment, the Jeff model is on the sidelines.  From my perspective, the decline in consumer confidence, even with lower gas prices, is disturbing.  It is difficult to account for the effect of headlines about Europe and the fiscal cliff.  The initial claims were weak during July, as was consumer confidence.
    • Street estimates generally follow my method, but few reveal much about the specific approach.  Some of these estimates are already responding to the positive ADP report.
  • Briefing.com cites the consensus estimate as 105K, while their own forecast is for 100K.
  • Gallup sees unemployment as falling  to 7.7% on a seasonally adjusted basis in mid-July, the time of the BLS data collection.  This is interesting since they have a different survey from the government, a relatively new approach to seasonal adjustment, and an extremely bearish and political approach in past commentaries.  Gallup's methods deserve respect, so I am watching closely.
The Impact of Revisions
We have been studying the revisions in the BLS reports, as well as the success of alternative methods.  We know that the BLS approach under-estimated the decline in employment in 2008.  Comparing the original estimates to the final report from the state data (the benchmark revisions) is a good way to analyze this.  Here is the picture from 2008:
Employment 2008
As you can see, the initial reporting was missing the final benchmark result significantly, with an upside bias.  Now let us consider 2011.
Employment 2011
Once again, you need to compare initial to benchmark.  The benchmark revisions after September will have more changes.  The pattern up to that point shows a consistent under-estimate in the initial report.  This helps to illustrate why I believe that we should be giving some credit to alternative approaches.
Each method of estimation should be compared to the final data.  This is an ongoing project for us.  More soon.

Temporary Workers

This month I am introducing an interesting new source, IQNtelligence.  They specialize in real-time analysis of temporary workers, drawing from worldwide inputs from major companies.  Because of the sources, I expect their data to be more accurate than that from the official report.

IQNtelligence specializes in specific trends adapted to market sectors and regions, but it is also a great source for those of us with more general macro interests.  Take a look at this chart of trends in temporary employment.

  GRPH_IQNdex_2Q12_SubPages_Master

The conventional wisdom is that temporary jobs are a good leading indicator for permanent jobs — companies taking a conservative first step.  In the current climate, we might question the old relationship for two reasons:

  1. Uncertainty over employment costs and benefits (regulations and Obamacare).
  2. Uncertainty over economic prospects.

As the uncertainty is resolved, there is great potential for permanent job creation. We will look for more insight from this source on this crucial question.

Failures of Understanding

There is a list of repeated monthly mistakes by the assembled jobs punditry:

  • Focus on net job creation.  This is the most important.  The big story is the teeming stew of job gains and losses.  It is never mentioned on employment Friday.  The US economy creates over 7 million jobs every quarter.
  • Failure to recognize sampling error.  The payroll number has a confidence interval of +/- 105K jobs.  The household survey is +/- 450K jobs.  We take small deviations from expectations too seriously — far too seriously.
  • False emphasis on "the internals."  Pundits pontificate on various sub-categories of the report, assuming laser-like accuracy.  In fact, the sampling error (not to mention revisions and non-sampling error) in these categories is huge.
  • Negative spin on the BLS methods.  There is a routine monthly question about how many payroll jobs were added by the BLS birth/death adjustment.  This is a propaganda war that seems to have ended years ago with a huge bearish spin.  For anyone who really wants to know, the BLS methods have been under-estimating new job creation.  This was demonstrated in the latest benchmark revisions, which added more jobs, as well as the most recent report from state employment offices.

It would be a refreshing change if your top news sources featured any of these ideas, but don't hold your breath!

Trading Implications

My experience with employment Fridays is that there is little benefit to being aggressively long before the report.  The spinfest usually provides shorts with a morning "dip to cover" when the number is surprisingly good.

I also expect some dampening in either direction.  A really bad number will be met with expectations for Fed action.  A strong number will get the opposite result, and maybe a stronger dollar.  Despite what some believe, the Fed did not have the employment data available for today's decision, so a weak number will be important for FOMC policies.