Weighing the Week Ahead: Negativity Prevails

Let us suppose that there was a clear-cut, factual error in an important news item.  In the Age of the Internet, this sort of thing is corrected in a heartbeat.  Let us call it the Dan Rather principle.  Rather had a distinguished career as a broadcast journalist, but met a sad ending in 2004.  His news reports on President George W. Bush’s military service relied upon documents that were quickly challenged.  The Internet community reacted swiftly and effectively.  It was a close election, and this might have made the difference.  It certainly would not have happened in, for example, the days of Harry Truman.

With this example in mind, I am baffled that the Internet community is so poor at correcting blunders in financial reporting.  When a typographer says something about fonts, the world listens.  When an expert explains something about financial data, it is a different story.  Confirmation bias reigns.  Today’s report highlights one example, but I have several more in mind.

A Simple Lesson

Suppose you hop in your car for a short trip.  You drive to the expressway entrance and accelerate rapidly to a speed of 80 MPH.  Glancing at your speedometer, you decide this is a bit too fast, so you slow to 60.  Notice three things:

  1. You started with a period of very rapid acceleration.  Acceleration is a change in speed, known as a second derivative in calculus. Since most people did not take or do not remember calculus, this simple example is enough.
  2. You then reduced speed from 80 to 60.  This is rapid deceleration.  The second derivative turned sharply negative, even though your speed is still high.
  3. In your final “cruise” state you are still making rapid (and legal) progress toward your destination.  You certainly have not stopped completely, nor are you moving backwards.

Now try an example from the financial markets.  The Institute for Supply Management publishes an excellent monthly report on business conditions.  Their headline number has an excellent correlation with the GDP.  Let us apply the car example.

  1. The ISM headline number accelerated rapidly to 59.7 for May.  This corresponds if annualized to GDP growth of 6%.  Does that seem a bit high to you, given other data?  I agree.
  2. What if GDP growth were only about 3%?  Slowing the growth rate to that level would imply an ISM value of about 51, dramatically lower than current levels.  The deceleration rate would be breathtaking.
  3. We should expect such a decline and accept it as consistent with reasonable growth.

The Significance

If you understood these examples, you now have a major advantage over the biggest MSM sources, The Kudlow Report, and the leading bloggers.  We know this story was important, because it was the most popular click through at Abnormal Returns — the authoritative source for those following financial news.  But first, what happened last week?

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.

Last Week’s Data

In last week’s preview I did not expect much from the economic data.  This was a solid prediction, since we traded almost tick-for-tick on the strength of the Euro.  Since the European resolution is a multi-year story, we can have confidence that this correlation will change at some point.  Meanwhile, all traders see it so nothing else matters — for now.

The Good

There was a bit of good news, even in a light week for data.

  • Mortgage rates are nearing all-time lows.  I realize that some explain this as a flight to quality in US bonds, but let us be fair.  You cannot cite an indicator as important and then make continuing excuses when it does not go as you expected.  There were plenty of people predicting a spike in mortgage rates when the Fed quit buying.  They were wrong.
  • We again held the bottom of the “trading range” with more tests of the flash-crash low.  This seemed to some that I was reaching for good news in last week’s article, but I am sticking with it.  Many people pay attention to these trading ranges.  Even if you do not agree, there are too many others who do.  Feel free to disagree, but I was right in citing this as a key point last week.
  • Michigan sentiment upticked. This is good news, especially in the face of the jobs report and the stock market.  It deserved more attention.
  • China was the biggest news of the week, with a report that exports rebounded by almost 50%.  There were immediately headlines of two types  (go figure):
  • Worries that the Chinese economy was overheating
  • Worries that Chinese exports would be hit by European problems.

Perhaps most interesting is that so-called “empties” jumped in May. Empties are ships heading out from the port empty to be filled with goods from Asia and brought back to American store shelves. At the Long Beach port, empties rose 35 percent in May, but at the Port of Los Angeles, they were up 58 percent. This could signal that retailers which cut inventory drastically during the recession are now planning to stock up this summer in time for back-to-school sales.

The Bad

Even in times of economic growth the story is mixed.  So it was this week.

  • Retail sales were disappointing.  Some of the analysts who have a bullish viewpoint suggested that the details were not so bad — subtract gasoline, building materials, adjust for holidays, etc.  The analysts cited same-store sales to suggest a late-May rebound. There is always some spin factor, and I like to take data at face value, emphasizing long-term trends.
  • Trading ranges and volatility.  The wild swings continue.  Investors and managers alike react negatively to risk.  The key resistance is at 1103 or so, and most of the technical crowd remains skeptical.
  • Initial jobless claims were supposedly a positive.  I do not get it.  If we have initial claims in the range of 450K on a weekly basis we are not making much progress.  I do not regard a “beat” by 5000 claims as a positive.  Please note, this series is a good example of this week’s lesson in second derivatives.  It was following a dramatic decline, and then stabilized at a level consistent with the current economy.

The Ugly

The ugly story of the week is the trend in financial news.  There is a continuing race to the bottom.  Everyone knows that the existing online audience has a heavy skew on various dimensions.  Print media that used to be able to pay for top-flight journalists are now competing with blogs.  The online sites pick authors with popularity in mind, basically without regard to content, balance, or journalistic integrity.

So let me turn to this week’s theme:

The ECRI’s WLI report turned negative this week.

Regular readers know that we accord special respect to the ECRI analysis.  The problem is that media sources do not understand their method, nor how to interpret the conclusions.  Let me start with the hands-down worst example from an emerging blog at the Wall Street Journal.  This is Exhibit A, but I could have picked any of the other sources.

The ECRI gave a clear and strong signal for last year’s equity-market rally, rising sharply ahead of the post-crunch lows. It had bottomed at 30-year lows and soared to 30-year highs in a matter of months. It has now returned, just as quickly, to a roughly flat position. Although a significant drop below zero has been a reasonably good indicator the U.S. economy is sliding into recession, the ECRI has delivered several false alarms over the decades. So even if it continues its drop into negative territory over the coming weeks, it wouldn’t necessarily be giving a cast-iron guarantee of a double dip. Still, the recent pace and magnitude of its decline is unprecedented.

Meanwhile, in the comments there was a stern rebuke.

While we certainly appreciate the attention given to our Weekly Leading Index, I’d like to clarify a few points raised in the article. First, according to the Economist magazine, “the ECRI” has not ever given false alarms on a recession forecast. http://www.businesscycle.com/about/testimonials/

The purported false alarms from “the ECRI” mentioned in this article come from a mistaken and simplistic view that negative growth in ECRI’s Weekly Leading Index (WLI) is tantamount to a recession forecast. In fact, since 1983, cyclical downturns have taken WLI growth under the zero line a dozen times, but recessions have followed on only three of those occasions – times when ECRI actually made a recession forecast.

Since ECRI itself has never used WLI growth going negative as as a recession signal, it is important that such “false alarms” are attributed not to ECRI or even to the WLI, but to what is a mistaken interpretation of the WLI.

In fact, at the very least, ECRI itself would need to see a “pronounced, pervasive and persistent” decline in the level of the WLI (not merely negative readings in its growth rate) following a “pronounced, pervasive and persistent” decline in ECRI’s U.S. Long Leading Index (not discussed in the article), before it makes a recession call.

It is pretty obvious that the ECRI does not want anyone misinterpreting their methods to suggest a recession forecast that they do not foresee.

Meanwhile the punditry is swinging wildly.  Even though they do not know what elements make up the the ECRI index, nor do they have any concept of the second derivative, the big-time media sources are ready to give their opinions.

Here are the most popular bloggers —

Zero Hedge:

ECRI Leading Economic Index Drops To 44 Week Low, Predicts Massive Economic Contraction


ECRI Leading Indicators Dip Again; Is a Double-Dip Recession Coming?

The Pragmatic Capitalist:

ECRI Growth Plunges

And here is mainstream media —

The FT emphasizing the bearish impact.

The Kudlow Report twisting the words of ECRI representative Lakshman Achutan, who makes many appearances.  If you watch the video, the result is quite clear.  Please check it for yourself.

There are a few other examples where sources attached a bearish headline to an accurate quotation from the ECRI.  Meanwhile, I have received several emails highlighting this as a major concern.  The gang at TheStreet.com is also worried about this.


The Week Ahead

I do not expect much from the economic data in the coming week.  I am a fan of building permits, but past data on home construction and sales is not helpful.  I am looking to see when the link to the Euro will be broken, and also waiting for earnings season (which I expect to be positive).

Our Own Forecast

Our own indicators turned bearish right after our May 9th report and then flipped neutral when volatility increased.  This continues to be our vote in the weekly Ticker Sense Blogger Sentiment Poll.   As you can see from the data, and as I reported last week, the call could easily be a bearish tilt.  It is only the general volatility that suggests a neutral posture.  Here is what we see:

  • Only four of our 55 ETF’s have a positive rating and three of these are inverse ETFs.  This is about as weak as it gets.
  • The single ETF in our buy range has a rating of only 6.
  • All 55 sectors are in our “penalty box,” showing an extremely high level of uncertainty and risk.
  • Our Index Package now has a very strong negative rating.

[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.]

For short-term accountswe were mostly neutral last week.

Investment Implications

Each day I look at the world with several different time frames.  In the three-week horizon from our models, I know that it is right to respect the tape.  The models counsel caution.

My analysis on the ECRI and the second derivative is not helpful in the short run.  If nearly everyone chooses to misinterpret data, that is a simple reality.  The winning investor must wait for a date with destiny.

The sentiment among those on trading floors is very negative and it is reinforced by the inaccurate media reports.  The trading community is very intelligent and profit-driven, so eventually there will be a change.

Meanwhile, those who see great fundamentals are still waiting for a catalyst.

An Afterthought

If the Internet community is so good and so smart, why can’t we do better to correct inaccuracies.  The Internet Commentariat is completely flubbing it on financial news.  If I put up a simple explanation of something on Seeking Alpha, politely stated and with a link to an informative post, I will always get  a “thumbs down” or two.   Obviously I don’t care and I am undeterred, but many writers depend upon positive reactions to survive.

I think that everyone who agrees with this article should go back to the original pieces I have cited and make a comment.  Teach them a lesson!  Do the Dan Rather thing.  If you understand why they mis-interpreted the ECRI, then let them know.  I am quite surprised that the WSJ never replied to the polite comment from Lakshman.

If we all just sit back and watch, we can expect reporting to get even worse.

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  • Vittorio Mazzolata June 13, 2010  

    Re: “Initial jobless claims were supposedly a positive.  I do not get it.”
    The continuing claims declined from 4.717 mln claimants from the week ending May 22 to 4.462 mln for the week ending May 29.
    This is a significant drop – big positive.
    Re: “ECRI”
    Stock market performance is one of the components of ECRI. I am perplexed as to why everyone freaks out over ECRI decline during ~14% stock market correction.

  • Jeff Miller June 13, 2010  

    Vittorio — I agree that the continuing claims news seems positive, but I do not have a good historical basis for interpreting the data series. The initial claims series is overemphasized by many, but I have found it to be a useful indicator.
    As to the ECRI index makeup, they have a proprietary indicator. I have seen speculation about the elements. Are you sure that the stock market is part of it? Please post or send me a source.
    Thanks for your comment.

  • chil25 June 13, 2010  

    you got right future is coming like freight train down to a broken bridge

  • Vittorio Mazzolata June 13, 2010  

    “In summary, evidence from simple tests suggest that ECRI WLI movements coincide with or slightly trail stock market behavior, offering little trading intelligence over the short or intermediate terms.”
    From Secrets of Successful Speculation By Ulrich Peter Krach:
    “The components of the ECRI weekly leading index are money supply plus stock & bond mutual funds, the JOC-ECRI industrial materials price index, mortgage applications, bond quality spreads, stock prices, bond yields, and initial jobless insurance claims.”
    U.S. Weekly Leading Index (WLI)

  • Vittorio Mazzolata June 13, 2010  

    Re: “I agree that the continuing claims news seems positive, but I do not have a good historical basis for interpreting the data series.”
    Continuing claims is a leading indicator of the unemployment rate (see last 3 cycles of continuing claims vs. the unemployment rate — once a coincident indicator and twice a leading indicator).

  • Jeff Miller June 14, 2010  

    Thanks for the help. I have seen a number of sources of speculation, and I am interested in anything with more authority.