The Key Market Question and Pre-Holiday Musings

Occasionally we take up a series of topics where we have a comment, but not a full-length article.  As we head into the holiday period (including some travel and lighter posting) there are some topics that deserve special mention.

The Key Market Question

Is the US economy about to enter a recession?  If so, how bad will it be?  How much is already reflected in earnings?

The market has voted, taking down financial stocks, retail stocks, and cyclical stocks.  For many, including Doug Kass (who points to plenty of current evidence) and Barry Ritholtz (who once again questions economic forecasts), the verdict has already been delivered.

To Dick Green, CEO of the highly-respected, the evidence is not so clear.  Like us, he views economists as the most expert source of recession forecasts.  Read his article to understand how he sees the data.

Regular readers know that we are more optimistic on the economy than the market suggests.  The biggest source of outsize gains comes from figuring out when the market is over-reacting.

Having said this, we follow the discipline of market signals in a portion of our trading — that governed by our TCA-ETF model, which shows zero sector buys out of 44 choices, and recommends a short on all indices.  Our positions are duly hedged.

Intelligent observers, including those who all have great track records, can look at the same evidence and disagree about the conclusions.  This is such a time.

Great Advice on Reading

Any serious investor should be willing to read.  This means not just the online news and commentary, but serious books on investing approach, style, and methods.  While we are behind on our own reading list (taking something along on our travels) we are delighted to see this helpful list of suggestions from links at Abnormal Returns.

Great Advice for Individual Investors

Barry Ritholtz describes a conversation with a familiar ring.  Someone learns that you manage money and that you have had some success.  The person really wants to hit some big score.  Most individual investors do not carefully analyze the most powerful things they can do to get started.

No one should invest without first reading Barry’s advice.

New ETF’s — Shorting China

Bill Luby at VIX and More highlights a new ETF that allows anyone to sell short the Chinese market.  Is it a coincidence that this development occurred just as our system sold our position in FXI?  Hmm.

Core Inflation

Karl Smith writes about core inflation, well before the recent Fed decisions to forecast the headline number.  We really like Karl’s work.  (We admit the reasons.  He is a very smart guy, doing what we used to do, in a good program.  His analysis is strong and balanced.)  If you want to understand what the Fed is doing, read Karl.  The Fed may be reporting headline inflation, but they expect the two series to converge.  There will come a time when core inflation is higher than the headline number.

Happy Thanksgiving to our readers and to those who cannot be with their families, especially those serving our country.

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  • Mike C November 21, 2007  

    “Regular readers know that we are more optimistic on the economy that the market suggests. The biggest source of outsize gains comes from figuring out when the market is over-reacting.
    ****Having said this, we follow the discipline of market signals in a portion of our trading — that governed by our TCA-ETF model, which shows zero sector buys out of 44 choices, and recommends a short on all indices. ****Our positions are duly hedged.”****
    Interesting comments. How do you personally weigh what your market signals are telling you which I assume is based on some combination of technical analysis and price momentum versus what your opinion on the economy and stock valuations are (which seem to be in opposition)?
    I assume you are still optimistic on the economy and believe stocks are substantially undervalued per your preferred metric of forward operatings earnings yield versus bond yields. I would think just considering that in isolation would lead to a 100% *UNHEDGED* equity position so I am assuming you use some technical factors to become more defensive regardless of positive views on the economy and stock valuations.
    Not trying to be an inquisitor, but I’ve wondered for some time how those in the “economy is strong, stocks are substantially undervalued camp” might make adjustments to portfolios if and when it looks like the probability of rolling over into a bear market has increased.
    A normal, typical bear market decline of 30% would eliminate a good chunk of the gain of the S&P 500 over this bull market which began in late 2002/early 2003. Of course, individual stock/sector pickers could fare much differently then the overall market. If you care to share, I think it would be interesting and enlightening to get more color on the details of your hedging, the why and the magnitude.
    To be clear, I have NO strong opinion one way or another as far as bull or bear market. I’ve believed fundamental valuations on the market are unattractive for awhile (looking at P/E on normalized earnings rather than forward estimates) but that it will take 7-10 years for that to manifest itself in cumulative returns (valuation doesn’t matter over a couple of years).
    Meanwhile, one (and I have) can benefit from riding the upward technical trend and good individual stock/sector-picking instead of sitting in cash (pull the trigger). According to Dow Theory, we are at a criticial juncture. The August lows have still held and the Industrials have NOT confirmed the breakdown in the Transports. It’s still a bull market, but I’m prepared to substantially increase my hedging/defense via my preferred mutual fund for that objective if those signals go bearish.

  • Tim November 21, 2007  

    I was going to ask a similar question. The market is down significantly and none of your sectors are signaling a buy? What factors would shift your model to the buy side? Did the model give sell signals before this recent sell off?
    Jeff, I admire the info you put out here, but the sell everything when the market is down mentality really baffles me.

  • Jeff Miller November 21, 2007  

    Mike –
    We manage accounts differently according to investor needs and the type of account. In long only programs we adjust with cash levels and stock choices, but performance comes from themes that play out over time.
    The sector rotation fund, where we have given a glimpse in the TCA-ETF series, can be 100% in cash or even a little short.
    We also have a fund that combines our fundamental and system approaches, uses options, and hedges with futures. That approach is net long when we see stocks as undervalued, but the actual percentage varies with the TCA signal.
    So it is a combination of everything we write about. Both the fundamental and system approaches have done well over time and through a full market cycle.
    Thanks for the question. You are correct in noting that combining various approaches requires a disciplined plan. Otherwise you are just substituting hunches for a real method.

  • Jeff Miller November 21, 2007  

    Josh –
    Thanks for passing the links along. It is certainly worth a chuckle and shows the need for LINQCRED when reading!

  • Jeff Miller November 21, 2007  

    We use the TCA model for sector trading, one of our approaches. The TCA model uses both trend and cyclical factors applied to each sector. We have described this (each Thursday) over the last few months. It did pretty well at finding good sectors and holding on to gains in a relatively short time period. Renae will post an update on Friday this week.
    We certainly do not follow a “sell at the bottom” style. Our methods based upon fundamentals currently have a long list of very attractive stocks at current prices.
    Thanks for the question.

  • Josh Stern November 21, 2007  

    I liked the description of “lollapaloozas” in this article:
    The concept also applies to the media. People often have incentives to produce punditry about stuff they don’t understand very well, so they bias the story to go where they think the crowd is headed. Anyone who wants to go against the crowd should realize that the self-reinforcing nature of this herding allows it to continue in the momentum direction for a long time – longer than one expects.

  • muckdog November 21, 2007  

    Good linkages! Although, isn’t there a rule against linking to Barry twice in the same blog entry?
    I’m bullish as all get out and my Black Box couldn’t be screaming “BUY!” any lounder.
    Not that this is stopping the bears from running roughshod over my portfolio…
    Have a Happy Thanksgiving, Dr. Jeff.

  • blackvegetable November 21, 2007  

    “I’m bullish as all get out and my Black Box couldn’t be screaming “BUY!” any lounder.
    Not that this is stopping the bears from running roughshod over my portfolio…”
    Stand on principle….
    Sure, you may lose your shirt and more, but at least you won’t be catering to those you consider fools…..

  • Mike C November 21, 2007  

    Thanks for the response as always. I was hoping for a little more specificity on the why and magnitude of the hedging, but I can understand and appreciate if that info is proprietary. I’ve read all the TCA-ETF posts and they give a glimpse, but leave alot of the specific details unknown.
    To be clear, I have my own system, analytical criteria, and discipline for deciding the extent of my hedging and defensiveness (based on my valuation models and technical criteria) so I’m not looking to take yours.
    One theme of your blog is pointing out what others in the blogosphere and various pundits say about the overall market and economy. You’ve been consistently bullish because of your preferred stock valuation model which has been correct for the last 1-2 years, although again my view is valuation is irrelevant over that time frame.
    Maybe there is an individual investor who invested a lump sum amount sometime this year in a broad index fund or ETF because he read and heard alot about the broad market being undervalued relative to bonds. What does he do at this point? Do those who have been unabashedly bullish owe that investor any follow-up directives on what to do now? Should he be instructed on hedging action to take if others have taken such action? Probably not as each investor really is responsible for his own decisions, and ALL information presented on the Internet whether bullish or bearish should be viewed from a “buyer beware” perspective.
    This may yet just be another correction in an ongoing bull market, although the evidence is beginning to mount that it is the beginning of a bear market. The broad market buy and hold investor should be mentally prepared to withstand a substantial drawdown so that he does not panic and sell at the bottom. Again, 20 to 30% market declines every 5 years or so is the historical NORM. This last 5 years has been more of a historical aberration so if it happens here it really shouldn’t be a surprise to anyone.
    On a different note, Happy Thanksgiving!

  • ron dunn November 22, 2007  

    This following link took me to 11/11/07 and I can’t tell how it says no sectors are a buy.Am I missing something? Is there more current data? Thanks.
    “we follow the discipline of market signals in a portion of our trading — that governed by our TCA-ETF model, which shows zero sector buys out of 44 choices, and recommends a short on all indices. Our positions are duly hedged.”

  • Jeff Miller November 22, 2007  

    Ron –
    We trade the model every day as one of our methods. In our series about system-building, ETF’s, and sector trading we have been doing a weekly update each Thursday night, based upon Wednesday closing data. As of last week the table showed that 7 out of 44 were still “buys” and we held five positions. This was down from all 44 in the buy range at one point.
    Renae will post our weekly update on Friday this week with actual sale dates and current ratings. As I indicated here (an advance peek at the weekly update) there are no longer any “buys.”
    I’ll try to provide an oerview of the complete cycle.
    Thanks for the question!

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