Weighing the Week Ahead: The Energy Price Spike

March 12th, 2012

by Jeff Miller

While this has been a regular topic for many, the following factors combine to make inflation the focus for the coming week:

  • The continuing rise in gasoline prices
  • Increased attention to Iran and policy reactions
  • Official data on PPI and CPI
  • The FOMC meeting

I'll offer my own forecast of how this will play out -- and what it means for traders and investors -- in my conclusion. First, let's do our regular review of last week's news and economic data.

Background on "Weighing the Week Ahead"

There are many good sources for a comprehensive weekly review. I single out what will be most important in the coming week. My theme is an expert guess about what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.

Unlike my other articles at "A Dash" I am not trying to develop a focused, logical argument with supporting data on a single theme. I am sharing conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am trying to put the news in context.

Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!

Last Week's Data

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

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test.
  2. It is better than expectations.

The Good

The news was mostly good last week.

  • Employment. Friday's monthly employment situation report was solid on all fronts. Net job gains (227K) are finally increasing at a level that will reduce unemployment (more than 125K according to Macro Economic Advisors). Average hours worked remained constant while hourly wages were higher. Unemployment remained the same, but the labor force participation increased from 63.7 to 63.9%, a solid and healthy increase. Revisions to prior months added another 60K jobs. The household survey implied even larger job gains, exceeding 425,000. Summing up, even allowing for sampling error and possible seasonal vagaries, this was good news. To keep perspective, we need context. A dramatic chart from Doug Short shows the pain inflicted by this recession, and why it is not over for many.
  • The Greek debt restructuring was accomplished with a high participation rate. Credit default swaps were triggered and will be settled in an orderly fashion. This avoids many of the predicted consequences, at least for a time. From the perspective of those trying to deal with major problems, additional time is good.
  • CFO optimism is rising. The Duke Global Business Survey reports that CFO confidence in the economy has returned to pre-recession levels. It is noteworthy that respondents are more confident in their own companies than they are overall.

In the past, rising CFO optimism has been an early indicator of a strengthening economy, points out John Graham, professor of finance at Duke’s Fuqua School of Business and the director of the survey.

  • Bullish sentiment is falling. Interesting that this is happening just as the corporate managers see improvement. It is market-friendly since it is a contrarian indicator. Bespoke Investment Group shows this with one of their excellent charts, and also some thoughts on the right interpretation.

  • The Fed may not be finished. We will know more after this week's FOMC meeting, but it appears that the Fed might continue the Operation Twist concept using reverse repo's to "sterilize" the buying of long-term debt. Most sources do not even try to explain this for you, instead offering political commentary about the Fed. I recommend reading Mark Thoma's article for a first-rate description of this policy alternative. See Dr. Ed for why this is market-friendly, including a helpful chart.

The Bad

There was also some bad news last week.

  • The Keystone pipeline was blocked by the Senate, with key Democrats responding to an appeal from the President. Eleven Democrats voted with with the GOP (no defectors there) making the vote in favor of the legislation 56-42. In the modern era, nearly anything can be blocked in the Senate unless you have 60 votes in favor, so this was actually a defeat for the pipeline and a victory for Obama. (The Obama position (oversimplified here) is that more time is needed for environmental study, and a decision will be made next year). Read The Hill for a good account.
  • Insider selling is at a new high, back to last year's level according to Mark Hulbert.
  • Market technicals have become more neutral. Charles Kirk's weekly chart show (members only, but inexpensive and valuable) shows a balance of risks as well as what to watch for. As you will see below, Felix agrees.
  • Rail traffic is trending lower on a weekly basis. Railfax uses a 13-week moving average, which still shows year-over-year growth. The Bonddad Blog has been following this carefully, and passes along the chart below. Read their analysis of this subject along with other high-frequency indicators for the current week. Steven Hansen also compares rail traffic with other transportation -- very interesting as well.

The Ugly

Trading on insider information continues in many forms. While not yet proven, there are some good questions about options trading in Green Mountain Coffee Roasters (GMCR) and Starbucks (SBUX). After Thursday's market close, Starbucks announced plans for a single-cup brewing system. Since this would compete with Green Mountain's leading position in that market, it was bad news for GMCR, which traded as much as 24% lower after hours.

Heavy put trading in GMCR on Thursday has raised some eyebrows. Aggressive put buyers were opening new positions in out-of-the money options with only a week before expiration. Buying GMCR 60's with a week to go, cost $1.60 or so, and required a one-week decline of over 4 points just to break even.

Felix (our ETF model) also does stock ratings and sent GMCR to the penalty box. Experienced traders may act when seeing a stock that looks "heavy," and this exacerbates the move.

Eventually we may hear from the SEC on this one. (Reuters has a good account here).

The Indicator Snapshot

It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

This week continues two new measures for our table. The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon. (I know that I am behind schedule on this. The message remains comforting.)

The second is the SuperIndex from PowerStocks research. I am a big fan of Dwaine van Vuuren, whose excellent statistical work is giving us better insight into a wide range of recession forecasting methods. The data point that I cite each week (the four-month recession outlook) is only one aspect of a comprehensive report. The SuperIndex includes nine different methods, including the ECRI. The analysis has a very strong, practical market application which has paid off richly for subscribers over the last few months. How? Mostly by putting the ECRI recession forecast into better perspective.

Spend a few minutes at their site and you will see the following:

  • A description of the SuperIndex components and methods.
  • A collection of research reports, including how to improve the ECRI method, using the Conference Board's LEI, and deciding how much recession warning you need.
  • A sample report. This shows the richness of the weekly information, including differing time frames for recession warnings as well as an updated GDP forecast.

This is all driven by the most recent data from all of the 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. For the first time since December we have downgraded our forecast from "Bullish" to Neutral.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. For daily ETF commentary from Felix, you can sign up for Wall Street All-Stars, where I still have a few discounted memberships available. You can also write personally to me with questions or comments, and I'll do my best to answer.]

The Week Ahead

There is plenty of data on tap this week.

Because of the spike in gas prices, there will be extra attention to the PPI and CPI reports on Thursday and Friday, as well as the FOMC announcement on Tuesday.

Retail sales on Tuesday, initial claims on Thursday and the preliminary Michigan sentiment are all very important.

I have less interest in the regional Fed surveys and the small business optimism index. The JOLTS report is great for research purposes, but is not a market-moving release.

We might expect a period of calm from Europe. (Famous last words!)

Trading Time Frame

Our trading accounts have been 100% invested since December. Felix caught the current rally quite well, buying in on December 19th. There are now only a few sectors in the buy range. The overall ratings have deteriorated. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated. Felix has been more confident than I have been on the trading time frame, and has stayed invested in the face of a lot of skepticism. This illustrates the importance of watching objective indicators instead of headlines. I expect that we will reduce position size in the coming week.

Investor Time Frame

Long-term investors should be aware of the rapid decline in the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," and is declining further. This sort of decline has been a good time to buy stocks on past occasions. Worry is still high, but has now declined to a more comfortable level.

Even though stock prices are higher than in October, the risks are much lower. I am increasing position size for risk-adjusted accounts. (We cut back by about 30%). I am also looking more aggressively for positions in new accounts.

Our Dynamic Asset Allocation model is still very conservative, but starting to change into equities. For several weeks I have joked that it is rather like the Nouriel Roubini of our methods. There is nothing wrong with this! There are many successful market strategies. The risk/reward balance is a personal matter.

For several weeks I have written that buying dividend stocks and selling calls against the positions is a relatively safe way to get a solid return, what we call our Enhanced Yield program. It is what the market is giving us right now. In response to some questions about how to do this, I plan to write an article or two showing how to do this and providing a couple of recent examples.

Setting up these positions on sharp down days like we had last Tuesday is really best. More later.

The Final Word on Gas Prices

My working hypothesis on energy prices includes several conclusions. I'll list them, including a helpful article when possible.

  • The long term trend in fuel prices will be higher, mostly based upon increased demand from emerging markets.
  • In the short run, energy prices reflect risk, not just supply and demand. The risks include Iran, weather, and refinery issues. A good overview.
  • Risks are reflected by speculators. These market participants are not a cause of higher prices, but a reflection of reality. Check out Dr. Ed.
  • High energy prices are a tax with no benefit for the US. These prices represent a threat to the continuing economic recovery.
  • Behavior has changed to reflect the reality of higher prices. This is the true definition of "demand destruction" and it includes more mass transit, smaller cars, avoiding trips, and car pooling. See Joe Weisenthal.
  • There is no short-term policy that will lower gasoline prices, regardless of what politicians may say. Improved policies are needed, but all will take time. The Hill's E2 blog.
  • The current price level does not threaten another recession.

Although the prices of oil and gasoline have risen significantly from their values in October, they are still not back to the levels we saw last spring or in the summer of 2008. There is a good deal of statistical evidence (for example, [1],[2]) that an oil price increase that does no more than reverse an earlier decline has a much more limited effect on the economy than if the price of oil surges to a new all-time high. -- Prof. James Hamilton (my choice as the leading expert on this subject).

We're not seeing a decline in gasoline demand because of a recession, we're seeing a decline in gasoline demand instead of a recession. From the tour de force by New Deal Democrat at The Bonddad Blog. This is a great article, deserving a very careful read.

Investment Conclusion

We own some energy names in our long-term programs. There are many good choices. We also feature energy in our enhanced yield program. Since we see the story as playing out over time, it does not interfere with our emphasis on cyclical stocks and technology.

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