Weighing the Week Ahead: How Will Markets Digest the New Fed Message?
We have the first reaction to the FOMC announcement and the Bernanke press conference, but there is more to come. Sometimes there is a compelling story line, and the financial media will not let go. This is such a time. Every twist and turn of the market is attributed to Fed policy or interpretations by one and all.
Despite plenty of fresh news on tap, I expect another week of discussion and debate about the Fed. The stories will ask what the new Fed policy means for individual investors as well as for active traders.
There are many opinions about this week's Fed news, but I want to highlight three distinct ideas with a representative comment from each:
What is the big deal? The Fed announcement merely amplified what everyone already knew. Former Dallas Fed President Bob McTeer writes:
"Chairman Bernanke, in his last two post-FOMC press conferences, said what most people in the markets expected him to say and what the logic of the situation called for. Given the still weak economy the present degree of quantitative easing ($85 billion of security purchases per month) would be maintained, but, if the economy strengthens sufficiently, that pace of purchases would be tapered down in the next several months and, when the economy is healthy enough to be on its own, the purchases would be ended. Short-term Interest rates would remain low some time after that. While one of the medicines would be reduced and eventually withdrawn, the economy would be much stronger before it happens….
… (W)hat happened to the rule of buying on the rumor and selling on the news. That makes sense, but day after day we see markets appear to be surprised by the obvious or the telegraphed….Chairman Bernanke must be tearing his hair out. He offers to help as long as it's needed and to quit only when it's not and we respond with sell, sell, sell."
- The timing and tone was wrong. The announcement of a reduction in policy accommodation at a time when the Fed was reducing economic estimates (still widely regarded as too optimistic) seemed to limit the upside for growth. St. Louis Fed President Bullard took this theme in explaining his dissent, analyzed here by Tim Duy. Ryan Avent of The Economist elaborates the theme with three reasons which I will summarize as limiting the upside, doing too little, and accepting a pace that is too slow.
The actual Fed impact is exaggerated. Scott Grannis explains as follows:
"The most important message to be found in today's bond market action (i.e., sharply rising real and nominal yields on Treasuries) is that the Fed's purchases of Treasuries did not artificially distort the Treasury market. Yields were low because the market expected the economy to be very weak for a long time—not because the Fed's purchases made them low."
Grannis continues, "If the market thinks the economy is improving and/or inflation is rising, then no amount of Fed purchases will be able to keep yields from rising. That is what today's market action is all about."
These three approaches have very different implications for the eventual impact on financial markets. As usual, I have some thoughts to add in the conclusion. First, let us do our regular update of last week's news and data.
Background on "Weighing the Week Ahead"
There are many good lists of upcoming events. One source I regularly follow is the weekly calendar from Investing.com. For best results you need to select the date range from the calendar displayed on the site. You will be rewarded with a comprehensive list of data and events from all over the world. It takes a little practice, but it is worth it.
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. Each week I consider the upcoming calendar and the current market, predicting the main theme we should expect. This step is an important part of my trading preparation and planning. It takes more hours than you can imagine.
My record is pretty good. If you review the list of titles it looks like a history of market concerns. Wrong! The thing to note is that I highlighted each topic the week before it grabbed the attention. I find it useful to reflect on the key theme for the week ahead, and I hope you will as well.
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.
Despite the negative reaction in financial markets, there was some good news this week.
- Forward earnings edged higher. Some are focusing on changes in calendar year earnings. The forward earnings have been more accurate and useful, since these estimates can be continuously compared. Brian Gilmartin has both the data and a discussion of why earnings matter. Factset provides strong support for Brian's viewpoint with this chart:
- Household debt service ratio is the lowest in 30 years (via Calculated Risk).
- Existing home sales beat expectations with another decline in inventory. Another "solid report" according to Calculated Risk.
- Inflation remains low as measured by the CPI. See Doug Short for great charts, comparisons and analysis.
The regular economic news was mostly negative.
- China's flash PMI hit a nine-month low of 48.3 (below 50 signals contraction). Chinese growth is important to the overall world economy and especially to commodities. Barron's has a good cover story by Jonathan R. Laing covering the issues in Chinese credit markets and possible over-spending on infrastructure. Global Economic Intersection has a comprehensive look at the Chinese yield curve, comparisons to US institutions in 2008, and possible policy changes. There are good charts and links to sources.
- The immigration bill remains stalled. Contrary to popular opinion, the bill would reduce the deficit by almost $200 B over ten years, mostly through higher tax revenues from immigrants. (CBO estimate).
- Earnings pre-announcements are much more negative than usual, 93 out of 116 total. According to ThomsonReuters, it is typical for bad news to be announced early, but the long-term ratio is only 2.4.
- Leading economic indicators were up, but only by 0.1%, a slight miss. See Doug Short for charts that provide perspective.
- Initial jobless claims were up 18,000 over a (slightly revised) prior week. Several analysts noted that this included the survey week for the monthly payroll report. This is true, but my research shows that the payroll report is more closely correlated with the results for the entire month rather than a specific week. This makes sense because it is a level rather than a short-term change. The four-week change is only 2500 higher, meaningless noise in this context. The moving average has lost some "good" weeks recently.
- Housing starts and building permits were a bit lower than expectations, so I'm listing this in the "bad" category. Calculated Risk, however, called it a "fairly strong report" because the single-family starts were up and prior months were revised higher.
It was a tough week in all markets on Wednesday and Thursday. While stocks only declined about 2% on the week, for those watching very closely (perhaps too closely) it felt worse. The real damage is in the interest-sensitive assets, a theme we have warned about for several weeks. Here is what has happened to what people have regarded as "safe" assets. (SoberLook via Joe Weisenthal).
The Indicator Snapshot
It is important to keep the current news in perspective. I am always searching for the best indicators for our weekly snapshot. I make changes when the evidence warrants. At the moment, my weekly snapshot includes these important summary indicators:
- For financial risk, the St. Louis Financial Stress Index.
- An updated analysis of recession probability from key sources.
- For market trends, the key measures from our "Felix" ETF model.
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 recently edged a bit higher, reflecting increased market volatility. It remains at historically low levels, well 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.
I feature the C-Score, a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I have now added a series of videos, where Dr. Dieli explains the rationale for his indicator and how it applied in each recession since the 50's. I have organized this so that you can pick a particular recession and see the discussion for that case. Those who are skeptics about the method should start by reviewing the video for that recession. Anyone who spends some time with this will learn a great deal about the history of recessions from a veteran observer.
I have promised another installment on how I use Bob's information to improve investing. I hope to have that soon. Meanwhile, anyone watching the videos will quickly learn that the aggregate spread (and the C Score) provides an early warning. Bob also has a collection of coincident indicators and is always questioning his own methods.
I also feature RecessionAlert, which combines a variety of different methods, including the ECRI, in developing a Super Index. They offer a free sample report. Anyone following them over the last year would have had useful and profitable guidance on the economy. RecessionAlert has developed a comprehensive package of economic forecasting and market indicators, well worth your consideration.
Georg Vrba's four-input recession indicator is also benign. "Based on the historic patterns of the unemployment rate indicators prior to recessions one can reasonably conclude that the U.S. economy is not likely to go into recession anytime soon." Georg has other excellent indicators for stocks, bonds, and precious metals at iMarketSignals.
Unfortunately, and despite the inaccuracy of their forecast, the mainstream media features the ECRI. Doug Short has excellent continuing coverage
of the ECRI recession prediction, now over 18 months old. Doug updates all of the official indicators used by the NBER and also has a helpful list of articles about recession forecasting. His latest comment points out that the public data series has not been helpful or consistent with the announced ECRI posture. Doug also continues to refresh the best chart update of the major indicators used by the NBER in recession dating.
The average investor has lost track of this long ago, and that is unfortunate. The original ECRI claim and the supporting public data was expensive for many. The reason that I track this weekly, emphasizing the best methods, is that it is important for corporate earnings and for stock prices. It has been worth the effort for me, and for anyone reading each week.
Readers might also want to review my Recession Resource Page, which explains many of the concepts people get wrong.
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. A few weeks ago we switched to a neutral position, but it is a close call. Felix might switch to a bearish posture if the overall market drifts lower. The inverse ETFs are more highly rated than positive sectors by a small margin, but remain in the penalty box. These are one-month forecasts for the poll, but Felix has a three-week horizon. Felix's ratings seem to have stabilized at a low level. The penalty box percentage measures our confidence in the forecast. A high rating means that most ETFs are in the penalty box, so we have less confidence in the overall ratings. That measure remains elevated, so we have less confidence in short-term trading.
[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
This week brings little data and scheduled news, an artifact of the calendar and the holidays.
The "A List" includes the following:
- Initial jobless claims (Th). Employment will continue as the focal point in evaluating the economy, and this is the most responsive indicator.
- Personal income and consumption (Th). A key measure of the pace of the economic rebound (May data).
- Michigan sentiment index (F). This remains a good concurrent indicator for employment and spending – after removing the noise of fluctuations in gas prices as political news.
- Conference Board sentiment (T). While I prefer the Michigan approach, the Conference Board method usually has a very similar results.
The "B List" includes the following:
- Durable goods (T). Another measure of the economic recovery (May data).
- Chicago PMI (F). Important as an indicator of the national ISM index, which comes out the following week. This is the most reliable of the regional indicators.
- Case Shiller home prices (T). This indicator is a three-month average of twenty cities, but it is widely followed
- New Home sales (T). Another piece of the housing puzzle.
We will also have more speeches by Fed regional bank presidents – Fisher and Lacker, as well as Fed Governor Powell.
I continue to watch earnings pre-announcements and also a few early reports. I am not very interested in the final revisions to Q1 GDP, which is "old news."
How to Use the Weekly Data Updates
In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a "one size fits all" approach.
To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?
My weekly insights often suggest a different course of action depending upon your objectives and time frames. They also accurately describe what I am doing in the programs I manage.
Insight for Traders
Felix has continued a neutral posture, now fully reflected in trading accounts which have no positions. We sold our partial positions (a bond inverse fund and a commodity) last week. The overall ratings are slightly negative, so we are close to an outright bearish call. This could easily be the case by the end of next week. While it is a three-week forecast, we update the model every day and trade accordingly. It is fair to say that Felix is cautious about the next few weeks. Felix did well to avoid the premature correction calls that have been prevalent since the first few days of 2013, accompanied by various slogans and omens.
Insight for Investors
This is a time of danger for investors – a potential market turning point. My recent themes are still quite valid. If you have not followed the links, find a little time to give yourself a checkup. You can follow the steps below:
- What NOT to do
Let us start with the most dangerous investments, especially those traditionally regarded as safe. Interest rates have been falling for so long that investors in fixed income are accustomed to collecting both yield and capital appreciation. An increase in interest rates will prove very costly for these investments. It has already started.
- Find a safer source of yield: Take what the market is giving you!
For the conservative investor, you can buy stocks with a reasonable yield, attractive valuation, and a strong balance sheet. You can then sell near-term calls against your position and target returns close to 10%. The risk is far lower than for a general stock portfolio. This strategy has worked well for over two years and continues to do so. (I freely share how we do it and you can try it yourself. Follow here, and scroll to the bottom).
- Balance risk and reward
There is always risk. Investors often see a distorted balance of upside and downside, focusing too much on news events and not enough on earnings and value. You need to understand and accept normal market volatility, as I explain in this post: Should Investors be Scared Witless?
- Get Started
Too many long-term investors try to go all-in or all-out, thinking they can time the market. There is no reason for these extremes. There are many attractive stocks right now – great names in sectors that have lagged the market recovery. Ignore all of the talk about the Fed and focus on stocks. Here are two great sources:
- This article by Chuck Carnevale is loaded with great stock ideas backed by sound reasoning and analysis.
- Talk stocks and sectors every day with the gang at Wall Street All Stars. You can get good answers to your own stock questions and listen in on the ideas of successful professionals and individual investors. There is a small subscription fee, but I have asked for last week's investor chat to be unprotected so that my readers can get a free look.
And finally, we have collected some of our recent recommendations in a new investor resource page — a starting point for the long-term investor. (Comments and suggestions welcome. I am trying to be helpful and I love feedback).
I find it helpful to think about a likely destination for the economy and financial markets. This is helpful in avoiding excessive focus on any single variable in a world where so many things are correlated. I expect the economy to improve, interest rates to move higher (starting with the long end), PE ratios to increase (as is usually the case when rates go to 4% or so), profit margins to decrease somewhat, and the U.S. deficit to decrease. This climate will be very negative for some stocks and sectors and very positive for others. (I provide more detail here.)
A key element is to avoid the fixation on the Fed. The idea that the Fed determines long-term interest rates is rapidly being proven wrong. James Hamilton shows (It's not just the Fed) that interest rates actually increased after the announcement of both QE2 and QE3. He writes, "It's worth emphasizing that the recent rise in interest rates has been a global phenomenon, not just something seen in the United States."
I have demonstrated that Fed buying is only 1% of daily trading in the cash markets. Nearly everyone confuses net new issuance of debt, total new issuance, and the float. This is a big mistake, and it can be a costly one.
Here is some wise advice from Eddy Elfenbein's weekly update:
"I think the markets are making a few mistakes here. First, too many people assume that without the Fed's help, the stock market is toast. The Fed has obviously helped the market so far, but that started when the economy was flat on its back. That simply isn't the case now.
The other mistake is thinking the Fed is running away. Not so! Short-term rates are still going to be near 0%. The bond buying is going to continue. It will just be in progressively smaller amounts. Remember that all of this is predicated on pretty optimistic economic projections. In the policy statement, the Fed said that downside risks to the economy have diminished. Let's hope they're right."