Weighing the Week Ahead: Evaluating Risks
There is a story about a personal financial advisor who saved a client several thousand dollars in expenses during his first year of service. The client, quite satisfied with the result, asked how the savings had been accomplished. The advisor replied that he had not paid any insurance premiums for the prior year.
Since nothing untoward happened, the client had saved money.
We all see the shortcoming in this apocryphal story, but can we really apply the lesson to our investing?
Most investors cannot since they look only at past results. This tells them little, since we all know what worked in the past. We did not need to buy insurance because our house did not burn down.
The better question relates to risk-adjusted returns. Even better, the question should be what return should be expected for someone with your own specific appetite and tolerance for risk. Briefly put: Are you emphasizing wealth preservation or wealth creation?
If you learn to ask both about risk and reward, you can expect investment results that better match your needs.
I will explore the topic more deeply, but let us first review last week’s data.
Background on “Weighing the Week Ahead”
There are many good services that do a complete list of every event for the upcoming week, so that is not my mission. Instead, I try to single out what will be most important in the coming week. If I am correct, my theme for the week is 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.
In most of my articles I build a careful case for each point. My purpose here is different. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. Others will disagree. That is what makes a market!
Last Week’s Data
There was little significant data last week, but is supported the continuing encouraging story. Let’s take a closer look.
Economic news continues to beat expectations.
- Initial jobless claims moved slightly lower to 421K. This is still not a good “recovery” level, but it is getting extra attention after the poor employment situation report for November. The jobless claims data is much better than the recession level. Since some pundits were attributing the recent improvement to seasonal adjustments, it is encouraging to see even a slight improvement.
- The ECRI growth index is at a 29-week high and the growth index is at a 27-week high., but at the best levels since mid-May. The ECRI said five weeks ago that a near-term recession was off of the table. Each week we have more evidence that they are correct. It is also apparent that those who made dubious interpretations of the ECRI indicator were wrong. I tried to demonstrate their error back when readers could still profit from the knowledge.
- The U of M sentiment survey beat expectations, coming in at 74.2 I regard this as a good concurrent indicator, helping us to understand employment and income. Here is a chart from Briefing.com that will show how much we have improved from the bottom — and how much farther we have to go.
As you can see, we are back to 2007 levels and the trend looks good.
- The trade data showed a nice improvement in exports. This is good news for the economy and the official GDP data. (Export growth helps).
There was also a bit of discouraging news.
- Political posturing prevented a resolution on extending the Bush-era tax cuts. I am listing this in the “bad” category, but it is not really surprising. Before any final votes are taken, the various procedural votes give politicians the chance to take a position. Astute observers know that these positions are symbolic, but that does not make them less important. I still expect compromise legislation to pass soon, despite opposition from some in both parties.
- Mortgage rates moved higher. This is an expected result of higher interest rates — a trend that most expect to continue and may challenge the appetite for buying homes. In the absence of overall price movements, affordability will be lower.
Last week I highlighted two themes that are part of my prepraration for my 2011 preview. The risk for stocks is much better than it was in May of 2009, but the P/E multiple is even more attractive. I also think that these P/E multiples are poised to move higher.
I expected that many would disagree, mostly because there is so much bearish sentiment. I was surprised at some comments (from thoughtful readers) suggesting that risks were higher now than in May of 2009. Quite frankly, I am amazed that anyone would think that. (Feel free to check the comments for the arguments posed.)
While I find those arguments completely unpersuasive, I recognize that I need to add some risk commentary to my weekly review. I always read Bill Luby, who started Vix and More and then expanded to discuss many measures of risk. Here is Bill’s discussion of the St. Louis Fed’s Stress Index.
There are several firms trying to cash in on the “risk business.” Colin Barr does a typically fine job in this survey of a new entry in the “fear” landscape.
I have always monitored a number of risk measures, but I am now going to add risk assessment as a formal part of this weekly review. I am going to use the St. Louis Fed’s Stress measure. It is objective, includes a wide range of factors (broader than VIX), not subject to manipulation, and updated weekly.
Last week shows a small uptick, but the overall risk level has declined dramatically.
It is very important to have some objective measure of risk. If you operate from anecdotes, there is no way of telling whether things are bad or good. A surprising number of comments on my articles refer to vague things like “more shoes to drop.”
When you look at an index that includes eighteen different weekly series, selected through a careful research process, it provides more confidence in objectivity.
To summarize, risk is much lower than it was in 2009, but is still at a somewhat elevated level on a historic basis.
Our Own Forecast
We base our “official” weekly posture on ratings from our TCA-ETF “Felix” model. Felix caught most of the recent rally, moved to neutral (but with several trading positions) and has turned postive again this week. The number of sectors in the penalty box, a sign of near-term risk, remains high. We are continuing our bullish position in the weekly Ticker Sense Blogger Sentiment Poll. Here is what we see:
- 84% of our 55 ETF’s have a positive rating, up strongl;y from 64% last week.
- 84% of our 55 sectors are in our “penalty box,” down slightly from 89% last week.
- Our universe has a median strength of +27, up nicely from +9 last week.
The overall picture was positive during the week, and we maintened a 100% long posture.
[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 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 a lot of economic data next week, but most is not really important. The inflation data will not be relevant unless widely outside of expectations. I do not expect the FOMC decision to suprise. I am always interested in building permits.
The key will be in Washington. Decisions about tax policy and “pseudo-stimulus” will be more important than data.
Investing decisions reflect several dimensions. Most important are the risk/reward tradeoff and the investement time frame.
So many pundits give an answer as if one size fits all. In my weekly review I try to provide a more nuanced approach.
With this in mind, it does seem like a good time to invest for a wide group of candidates. If risk went to the “below zero” range of the St. Louis Fed chart, we might well be at Dow 20K.