Weighing the Week Ahead: Escape From the Trading Range?

October 16, 2011

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For several months US stocks have traded within a range of 1120 – 1220, give or take a few points. Active traders who have played this range have done very well so far. It has been a big challenge for two reasons:

Whenever the market is at the bottom of the range, it looks to many that a crash is imminent.

Whenever we hit the top of the range, it seems like euphoria — an excessive reaction to events.

Here is a nice chart of the range from the team at The Bespoke Investment Group. Also check out their article on the improving market breadth.

Will the range hold? Long-term investors do best when they have a strong sense of what stocks are worth. I will return to this theme in my conclusion, but first — our regular review of last week’s news and data.

Background on “Weighing the Week Ahead”

There are many good sources for a comprehensive weekly review. My mission is different. I single out what will be most important in the coming week. 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.

Unlike my other articles at “A Dash” I am not trying to develop a focused, logical argument with supporting data on a single theme. I am sharing conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am trying to put the news in context.

Readers often disagree with my conclusions. (A commenter recently suggested that was proof that I was wrong — an amazing interpretation!) Do not be bashful. Join in and comment about what we should expect. 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

This week’s news was very positive and the market responded.

The Good

Good news (which for our purposes means “market-friendly”) came from several sources.

Progress in Europe. This has been the biggest issue over the past few months. There is more clarity each week, but most pundits and hedge fund managers remain skeptical. They want a comprehensive plan, delivered on command, the way they would make a decision in their own business. Traders basically do not embrace democracy. The process is easy to portray as confusion, but it actually provides a great opportunity for investors. In specific terms:

The ESEF proposal has now been passed by all 17 governments, after some special attention to Malta and Slovakia. Keep in mind that many skeptics did not expect this to happen.

There is an increased commitment from Germany and France.

Greece is now expected to get the next round of assistance. The nature of a possible Greek default is looking more like a negotiated settlement and less like a domino-tipping disaster.

Labor dynamics are better. Understanding the jobs situation starts with getting past the “net monthly change” and considering the underlying factors. The JOLTS report helps with this picture. Here is a typical fact that you did not know before: Voluntary separations have increased significantly in the past year. In August of 2010, separations via quits or layoffs were equally likely. Now the quit rate is 51% and the layoff rate is 42%. This is an important but little-known fact.

Rail traffic was better, breaking a downtrend. Steven Hansen has been watching this and other useful recession indicators. His work deserves careful attention.

Retail sales were up 1.1% in September and August was revised higher. Consumers continue to spend despite the negative surveys and the income data. Some of this probably is from the underground economy. Whatever the source, the oft-predicted death of the consumer has not come to pass.

The Bad

There were also some negative events, although fewer than in recent weeks.

More credit ratings cuts. As I noted last week, there are so many of these on tap that it will eventually get boring. That seemed to happen last week, with reduced interest in the credit rating agencies.

M2 growth has stalled, although it is still up big on a year-over-year basis. This stimulus in the pipeline should not be ignored. This factor may not be a part of the (now highly negative) ECRI model. We shall see.

Initial jobless claims are still stuck around 400K. This is a slow-growth, treading water result. There is actually a lot of hiring going on, but we need a reduction in layoffs.

Housing prospects are still weak. Despite the low mortgage rates, potential buyers feel no sense of urgency and some do not qualify for loans.

The Ugly

Confidence — especially in political leadership remains very low. The Michigan sentiment gauge (a favorite of mine) remains at recession levels. (See Doug Short’s helpful chart). Research shows that lack of confidence in government is the key factor, with sentiment at an all-time low. Respondents disagree, of course, about what government should do!

Action is needed and pending on jobs and the deficit SuperCommittee. The expiration of the unemployment benefit extension got attention last week, with the Wall Street Journal highlighting the loss of benefits for over 2.1 million people. While there are some who take advantage of this program, the overwhelming majority are simply victims of economic circumstances. Research has shown that these programs have only a slight effect on increased unemployment, partly from keeping people in the labor force as they do mandatory searches for new jobs.

The lack of leadership and compromise is the biggest challenge, both in the US and in Europe.

The Indicator Snapshot

It is important to keep the weekly news in perspective. My weekly indicator snapshot includes important summary indicators:

The ECRI Weekly Leading Index (and the derivative Growth Index) has been dropped because it does not provide meaningful independent data. Past articles in this series have highlighted our concern over the last several months. See especially this discussion. A few comments have suggested that I dumped this index because I did not like the result. As regular readers know, I have had this measure under review since May, when it was still firmly positive. There are alternatives with equal or better track records and more transparency.

The St. Louis Fed Stress Index

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 continues to edge higher, now in the trigger range of my pre-determined risk alarm. This is partly the result of the VIX. Another rising element is LIBOR. The SLFSI is still not signalling the major calamity that many deem a foregone conclusion, but it is moving higher. This is an excellent tool for managing risk objectively, so we must respect the verdict — a slight reduction in the long-term portfolio size. More caution is warranted.

There will soon be at least one new indicator, and the current choices are under review.

Our “Felix” model is the basis for our “official” vote in the weekly Ticker Sense Blogger Sentiment Poll, now recorded on Thursday after the market close. We have a long public record for these positions.

We voted “Bullish” this week, but “abstain” would be more accurate with everything in the penalty box.

[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

It is a big week for economic data, although most reports are of secondary importance.

The regional economic surveys have garnered some recent attention because of the extreme readings. I am not looking for anything significant from the Empire State index of the Philly Fed.

Inflation data (Tuesday and Wednesday) could be a negative surprise, but will probably be unimportant. That is not the current concern.

Industrial production (Monday) is important for some.

Housing data on prices (Tuesday) and new home starts (Wednesday) are less interesting to me than building permits — a forward indicator.

Initial jobless claims (Thursday) remain important.

The Fed’s beige book (Thursday) will provide a look at the anecdotal evidence that the FOMC will consider as part of the next meeting’s action.

Friday is options expiration.

More important than any of these factors will be the ongoing earnings story, and any fresh news on the European situation.

Trading Time Frame

In trading accounts we were out of the market all week. We have shifted to a bullish vote on the market with a three-week time horizon. Nearly all of our ETF positions are in the Penalty Box, meaning that confidence in forecasts is low for us. I expect some buy signals this week.

Investor Time Frame

In our ETF-based Dynamic Asset Allocation program, the portfolio remains very conservative. This cautionary posture includes bonds, gold ETFs, and utilities. It is conservative, but has no short positions at this time.

Long-term investors should take note of the increased risk indicated by the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk.

I this article, I offered some suggestions on how the long term investor can take advantage of volatility. Investors seeking income can find stocks with reasonable yield (not too high, since you do not want a bond-equivalent) and good fundamentals. You can enhance yield by selling some calls — great extra income with the high VIX levels.

Market Sentiment and the Trading Range

There are many pundits who are befuddled by the recent rally. Some allege that a conspiracy must be afoot — that recent stock gains were not justified by news events. This presumes, of course, that prior selling was completely warranted.

The most useful sentiment gauge is the forward P/E ratio.

When this ratio is low, it suggests that there is intense skepticism about expected earnings. Despite the recent rally, stock prices reflect continuing concern about Europe and recession potential. This interesting chart from Ed Yardeni makes the point quite clearly.

If the market were to return to the level of skepticism from last Spring — still higher than average — the S&P could trade to 1400.

This initial target, still only thirteen times earnings for the next twelve months, is possible if we break out of the current trading range. This will be an especially interesting week.