Weighing the Week Ahead:
Will the Fed Disappoint the Markets?
After weeks of buildup, culminating with Fed Chair Bernanke's Jackson Hole speech, the time for decision has arrived. While some of the economic data is better, the jobs picture remains poor. Friday's employment report has raised expectations for some aggressive action. Are these hopes justified, or will the Fed disappoint the markets?
I was very accurate last week in predicting that the story would be all about jobs. The Democratic Convention, the pundit commentary, the GOP response, the media focus, and the Thursday and Friday data all followed this theme. Given Friday's disappointing employment situation report, the question became, What now? I suggested in my employment preview that reaction would be dampened by the expectation of more aggressive Fed action. This is exactly what we saw from Friday's trading.
The general expectations have shifted, setting the bar higher. Here is the take from Jon Hilsenrath, who seems to have the pulse of the Fed:
"Officials have been leaning toward an open-ended bond-buying program in which the Fed holds open the possibility that it will continue to buy bonds after an initial allotment is purchased if the economy doesn't pick up. They also have been leaning toward purchasing mortgage backed securities."
Michael Derby at the WSJ Real Time Economics Blog notes that the expectation is now "QE3 and more."
The expectations from these sources are at odds with the investment posture of both the Street, and the public. Check out two of my favorite sources.
Barry Ritholtz has tracked the "most hated rally" so check out his article for the history. Here is the chart that shows why this is important -- the underinvestment of some big firms.
Josh Brown shows the same psychology on the part of average investors, explaining that they have left $65 billion on the table through recent decisions to bail out of stocks.
I'll offer some of my own expectations in the conclusion, but first let us do our regular review of last week's news.
Background on "Weighing the Week Ahead"
There are many good sources for a list of upcoming events. One source I especially like is the weekly post from the WSJ's Market Beat blog. Ben Fox Rubin and Steven Russolillo go beyond the formal list of economic releases by mentioning major earnings reports, speeches, and even conferences.
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:
- The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
- It is better than expectations.
There was a fair amount of good news last week.
- The ISM services index provided an upside surprise. The employment component is especially encouraging. Bespoke has a comprehensive look with the components individually listed and charted. Here is the overall history, but the full article is worth a look.
- Home prices continue to rise as measured by CoreLogic. Global Economic Intersection has an excellent discussion and charts comparing different approaches. Here is a sample:
- Productivity was up 2.2%, handily beating expectations. Productivity gains have come from corporations doing more with fewer workers. At some point they will need to add workers to meet growing demand. Meanwhile, this is good news for profits.
- Job creation was strong, according to ADP and various other analysts, as I described in my monthly employment report preview. I understand the need for some "official" result, and the BLS method is very good. Alternative approaches are also very good. In the richness of time, these estimates often prove to be more accurate.
- Auto sales are rebounding smartly (via Scott Grannis).
- The ECB delivered on promises. Unlike many of the past incremental steps in Europe, this one did not generate a "sell the news" reaction. The potential open-ended nature, the willingness to take equal status with private investment, and the assertion of power to act independently from government decisions were all factors. The one downside element was that the purchases will be "sterilized" so that the overall balance sheet does not expand. This is not the all-out money printing that some craved. The overall effect was rather amazing, stretching into the 10-year yield for Spain and Italy, even though that is not where the ECB proposed to buy. Attitudes seem to be changing, as reflected in market prices.
There was negative news, lesser in quantity but greater in importance.
- Earnings forecasts drift lower. Brian Gilmartin, an expert on earnings both for individual companies and the overall market, tracks these trends very closely. (Similarly, Dr. Ed Yardeni) He notes the recent weakness and acknowledges the debate about what is already priced into the market. On his excellent new blog he writes as follows:
"...(A)ccording to ThomsonReuters – 2nd quarter, 2012 earnings are still expected to grow at 1.3% ( ex Bank of America and the financial sector) and 3rd quarter, 2012 earnings, which we continue to think will be the bottom for this cycle in terms of the earnings slowdown, are expected to decline year-over-year at a -2.1% rate.
The forward 4-quarter estimate for the S&P 500 estimate as of late last week was $108.02, exactly where it was 1 week ago."
- Economic confidence remains weak (via Gallup). This measure is off the lows from last year, but still very weak -- a bad sign for consumer spending.
- Foreign economic indicators (Europe and China) all declined last week. I always watch these -- always. It is how I start my day, and I often comment on them in my daily diary at Wall Street All Stars. I understand that we have a global economy, and I want to put it in perspective. Offsetting some of the decline, China will do more stimulus. Analyzing the impact on US stocks is a challenge.
- The official jobs numbers reflected a weak economy, worse than expected and worse than needed. Discussing this objectively is nearly impossible for most, since the issue is so salient for voters. There was nothing good about this report. The net job gain of 96,000 is less than needed to keep up with the growth in population (perhaps 125k, although the target changes with trends in retirement and immigration). Downward revisions for the last two months subtracted another 40K jobs, half of which were in government. The household survey also showed a decline in jobs, although this series has fluctuated wildly. The decline in the unemployment rate was not statistically significant (after rounding) and mostly reflected a reduction in the labor force.
The official employment data is roughly consistent with the rest of what we see -- growth of 2% or so. Putting aside the political rhetoric, everyone realizes that more economic growth and a greater increase in net jobs is needed.
The ugly award goes to the rather surprising result of diversification into commodities. Tom Brakke always combines clear-headed analysis with great charts. He analyzes the concepts behind the chart below. Check out the full discussion, but this point describes investor behavior: "Investors have embraced these alternatives, only to find that they don't really know much about them other than they're not stocks or bonds."
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
- The St. Louis Financial Stress Index.
- The key measures from our "Felix" ETF model.
- An updated analysis of recession probability.
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."
Bob and I recently did some videos explaining the recession history. I am working on a post that will show how to use this method. As I have written for many months, there is no imminent recession concern. I recently showed the significance of by explaining the relationship to the business cycle.
The evidence against the ECRI recession forecast continues to mount. It is disappointing that those with the best forecasting records get so much less media attention. The idea that a recession has already started is losing credibility with most observers. I urge readers to check out the list of excellent updates from prior posts.
Readers might also want to review my new Recession Resource Page, which explains many of the concepts people get wrong.
The single best resource for the ECRI call and the ongoing debate is Doug Short. This week's article describes the complete history, the critics, and how it has played out. The article highlights the most important economic indicators used in identifying recessions, showing that none have rolled over. Doug updates the recession debate every week and includes a great chart of the "big four" indicators used by the NBER in recession dating.
Meanwhile, the ECRI story continues to change. The latest variation is that the data will eventually be revised lower to show that we are already in recession.
Note on the Fiscal Cliff -- A thoughtful reader asks whether our recession forecasts include the fiscal cliff, a good question. Methods derived from historical experience are not helpful on issues like the cliff, so the general answer is "no," but some of the market-based methods will capture this as the time comes closer. I treat factors like the fiscal cliff, the collapse of Europe, the collapse of China, an attack on Iran, and similar factors as relevant elements of "tail risk." There is no good way to incorporate these into standard recession forecasting methods, so no one even tries. (I am ignoring those with a semi-permanent recession forecast!)
I frequently cite and monitor these factors in the weekly commentary, especially in "the ugly" section. If you insist on waiting for a time when there are no low-probability risks, you are a spectator, not an investor.
Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions. This week we continued with our recent switch to neutral. We have been bullish since June 23rd, with a one-week move to neutral a month ago. These are one-month forecasts for the poll, but Felix has a three-week horizon. The ratings have moved lower, and the confidence has deteriorated from last week.
[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
There is plenty of data coming this week, but two events loom large:
The "A List" includes the following:
- The German Constitutional Court ruling (W, before US markets open). The feeling is that the Court will accept an increased German role -- -perhaps 80%. If not, there will be a scramble to figure out what portion of current plans may still be feasible.
- The FOMC announcement and Bernanke's press conference (Th afternoon)
- Trade balance (T) with implications for GDP.
- Initial claims (Th) which continue to provide the most up-to-date read on jobs and the economy.
The "B List" includes several reports:
- Industrial production (F).
- Michigan consumer sentiment (F) which has implications for consumer spending and employment.
- PPI (Th) and CPI (F) are sometimes important, but only if we get a few scary reports. That would create a dilemma for the Fed.
The time from the market opening on Wednesday through the FOMC announcement on Thursday will be the most crucial hours of the week.Trading Time Frame
Despite Felix's overall "neutral" posture, our trading positions continued in fully invested mode last week. Felix became more aggressive in a timely fashion, near the start of the summer rally. Since we only require three buyable sectors, the trading accounts look for the "bull market somewhere" even when the overall picture is neutral. The ratings have been getting a little weaker, but the trade continues to be profitable.
Felix does not try to call tops and bottoms, but instead keeps us on the right side of major moves, either up or down.
Investor Time Frame
Long-term investing is an objective for many of my clients, so I give it a lot of thought. Each week I try to provide an idea or two that will be useful for those sharing this perspective. Here are two new ones.
How much risk to take. The right answer is different for everyone, but too many people choose "zero." These investors do not follow the Buffett advice of buying when others are fearful. Then, when the market rallies, they are afraid that they are "too late." I wrote a new article, Stock Prices and the Fundamentals: Don't be Fooled, showing how to avoid this trap.
How to pick dividend stocks. Regular readers know that I am fussy about my choice of dividend stocks and I like to enhance yield by selling near-term calls against the position. Carla Pasternak explains why it is important to look beyond the yield, finding companies that also represent good value. This is a fine article, combining both a great approach with some specific ideas.
If you have been following our regular advice, you have done the following:
- Replaced your bond mutual funds with individual bonds;
- Sold some calls against your modest dividend stocks to enhance yield to the 10% range; and
- Added some octane with a reasonable allocation of good stocks.
There is nothing more satisfying than collecting good returns in a sideways market.If you have not done so, it is certainly not too late. We have collected some of our recent recommendations in a new investor resource page -- a starting point for the long-term investor. (Comments welcome!)
Final Thoughts on the Fed
Before this week I was not expecting an aggressive action by the Fed, but my own opinion changes with the data.
The mistake made by most is a collection of dangerous ideas -- OK for politics, but risky for trading and investing. In the absence of a better term, I'm going to call it the Fed Skeptic Syndrome.
The Fed Skeptic has the following collection of beliefs:
- QE has no positive economic effect. It has not helped employment and has boosted stocks only because the Fed bond buys act like direct purchases of stocks and commodities -- in addition to pushing conservative savers into tech stocks and soybeans. Fed action has artificially kept stock prices and the economy higher, but is ineffective. You can see this because things are worse than they were a few years ago. It is all a sugar high, and it will end badly either through deflation, or hyperinflation, or both. These forecasts are certified by an array of "chief investment strategists" whose credentials do not include economic education but do include frequent media appearances. The most popular are "self-taught in Austrian economics."
The FOMC has the opposite viewpoint:
- QE has lowered interest rates by a few bps and generated a gain of about 2 million jobs over what otherwise would have happened. There was no direct effect on commodity prices. Misguided speculators drove these prices higher. Stock price increases reflected the improved economic prospects from the program, and also created a virtuous cycle of confidence and wealth effects. The proponents are all credentialed mainstream economists of both political parties.
As a voter, feel free to take whatever perspective you want.
As an investor, it is wise to understand those who actually have power, and predict what they will do. Most of those who are missing the rally do not have sufficient respect for the determination and power of government officials.
Originally posted at Jeff's blog: A Dash of Insight