Weighing the Week Ahead: What should we expect from Santa?

Courtesy of Doug Short.

Market forecasts are made for many different time frames. Peter Lynch focused on the long term, famously saying that he could not tell you the direction of the next 1000 point move in the market, but he could for the next 10,000 points. Our Felix model makes a three-week forecast, although we take a fresh look and adjust positions (if needed) every day. That is long-term thinking for the day trader, and an eternity for the high frequency trading operations.

Each time period is a different battleground. Somehow everything changes at this time of year as you hear the question: Will there be a Santa Claus Rally?

Even those who would not normally make a two-week prediction enjoy playing this game. There are plenty of year-end shenanigans, window dressing, tax selling, and the like.

Felix is bullish, but with low confidence, for the year-end period. I am not convinced, as I will explain in my conclusion. First, let us take our regular look at last week’s events.

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. 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

The data from last week was mixed, but encouraging on balance. As has been the case US news was trumped by anything from Europe.

The Good

The economic story was mixed, but there is still no indication of a current recession.

• The last US troops have left Iraq.
• Initial jobless claims fell to 366K, the best level offsetting last week’s +400K result. The seasonal adjustments can be difficult at this time of year, so everyone watches the four-week moving average, which is also improving. Matt Busigin explains the significance of this improvement with four great charts. Here is the first, which he suggests shows the relationship between stocks and this economic indicator, implying higher stock prices to come. Check out the other three relationships as well.

• Exports are strong, as measured by container data from Los Angeles reported by one of our favorite sources, Scott Grannis.
• As expected, inflation as measured by the CPI remained tame. The year-over-year core rate is slightly higher than the Fed’s target.

The Bad

The negative news reflects diverse fronts.

• Chinese manufacturing growth is slowing, although not quite as much as the original “flash” indexes suggested.
• Tax withholding is lower, even after adjusting for changes in the law. This is a broader measure than the income tax data I cited last week. The Bonddad blog covers this and a mixed bag of other high-frequency data.
• CEO’s are still worried about the economy, according to the Business Roundtable. They read the same newspapers we do. This is bad news, since the economy would be helped if they would start investing some of that mountain of cash they have built up — over $2 trillion in non-financial companies. See Josh Brown’s colorful exhortation for these leaders.
• Trade is weak, as measured by container data from Los Angeles and Long Beach. In sharp contrast to the Scott Grannis take above, Steven Hansen (another favorite source) takes a deep look into both import and export data.
• Job openings declined very slightly, as did the “quit rate.” The number of openings is around 3.3 million which is 1.2 million higher than the recent low, but still behind the 4.4 million from before the recession. More people quit their jobs than are laid off or fired. In summary, we need a lot more job openings. Good discussion and a helpful chart at Calculated Risk.

The Ugly

This week’s “ugly” award goes to the MF Global story. It is tough to beat out the Washington contenders in their struggle to finish business before going on vacation, but John Corzine has done it.

The disappearance of $1.2 billion, the questionable transfers of funds, and the unconvincing Congressional testimony of Corzine himself have all helped to keep the story alive. It is especially ugly, since it raises investor concern about the safety of their money. Which accounts are really safe, carrying the proper controls and insurance?

Europe

For now I am going to monitor developments in Europe in a separate section. My general approach, which is based upon my experience in the messy process of policymaking in democracies, is that the eventual solution will include a combination of many programs and participants, some of which we do not yet know. I have been doing a separate series of articles on this theme. So far I have the following:

How Investors Should Think about Europe — an overview with a general conclusion.

How to Predict Policy Decisions — Focusing on Europe — comments on the players and motives.

In future installments I will discuss further the behavior of individual decision makers, try to define what constitutes progress and how we can measure it, and finally, venture some ideas about how and when it will all play out.

In the weekly updates I will highlight events that are important in the context of my thesis — a combination of political, institutional and policy changes that will take time. Reaching back through the much-maligned Summit of ten days ago, here are the key developments:

• Progress toward EU treaty changes and some bilateral agreements for enforcement of budget discipline. It would have been better to have unanimity, but this progress will provide some comfort for the ECB.
• The EU will provide more funds to expand the existing EFSF facility. No one thinks that the amount is enough –so far — but the point is to measure progress.
• ECB changes in bank lending terms — longer times and weaker collateral requirements. This is positive since it helps strengthen the banks, reduces the problem, and buys time.
• The Fed is not going to join in any bailouts, Bernanke explains to Republicans. I think we all knew that, but some reassurance was required. This is not market-friendly, so a negative on my scorecard. [Please note the distinction between market friendly and good public policy.]
• IMF head Lagarde warns (along with dozens of others) that there will be a disaster if nothing is done. The market sold off on this story, but we should get used to it. The IMF wants cooperation on all fronts.
• Ratings agencies are downgrading again. This time it is Belgium, but plenty of other governments are on warning. Once again, we had better get used to this.

This is a race. Merkel calls it a marathon and the market thinks it is a sprint. The impending test is the rollover of Italian debt. For the moment, our progress indicator is the yield on Italian bonds. There has been some progress, but the cost is still too high.

The Most Fun

I really enjoyed Josh Brown’s story on the ten biggest market moments of 2011. Everyone can quibble with the exact nominees, but that is part of the fun. If you missed the post, take a look.

The Silver Bullet

Last week I recognized the leadership of several sources — Barry Ritholtz, The Bonddad Blog, and Prof. James Hamilton. Each provided a careful and thoughtful analysis of some poor data analysis. This is a difficult and thankless task, but it is necessary. The blogosphere is loosely peer-reviewed, but there are no real incentives for active engagement and discussion.

When you embark on such a story, you are like the Lone Ranger. In the spirit of encouraging this type of work I hope to mention a “silver bullet” story each week. I invite readers to send suggestions. I expect that this will only be an occasional topic.

Meanwhile, this week’s Silver Bullet goes to Rex Nutting for his story, Is the government lying to us about the economy? He takes on some widespread perceptions with allusions to Shadow Stats, Rush Limbaugh, and a closer look at Richard Nixon and the BLS. He makes an interesting case concerning current data. Whether you agree with him or not (and I do), we should all encourage this kind of article.

The Indicator Snapshot

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

• An Economic/Recession Indicator. I am evaluating several candidates. None confirm the ECRI forecast of an inevitable and imminent recession. These are sources that have a similar track record, greater transparency, but less PR. I realize that I am (long) overdue for making the choice for a new indicator. It has been a careful research process, and I expect the explanation to require multiple articles. Meanwhile, if something really bad were taking place, I would make it clear in the weekly updates. From the strongest candidates, I see the recession odds over the next nine months as being less than 25%.
• The St. Louis Financial 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 has moved a lot lower, and is now 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.

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. We voted “Bullish” this week.

[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

There are many interesting economic reports this week.

We’ll get several reports on housing, starting with the NAHB index and ending with new home sales on Thursday. My personal favorite is building permits (a Tuesday release) which has actual status as a leading indicator. No one is expecting much from housing right now, especially at this time of year.

Wednesday brings the Leading Economic Indicators, which many see as an important recession gauge.

Thursday’s initial jobless claims have a special significance, for the reasons described above.

Friday’s report on personal income and spending is of special interest. Consumer spending continues apace, even as debts are reduced.

I am not expecting much impact from industrial production or the revisions in the Michigan sentiment index.

As usual, Mark Gongloff has the comprehensive data/earnings/speechifying calendar which we should all put on the bulletin board.

Trading Time Frame

Our trading accounts have not had any US equity exposure for several weeks. Felix has relegated everything to the penalty box. This suggests that a vote of “abstain” is more accurate, but the general ratings picture is quite positive. I expect new trading positions this week. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated.

Investor Time Frame

Long-term investors should continue to watch the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. Six weeks ago we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our “trigger range,” but it is still high. For investors desiring this risk management approach we raised cash when the trigger hit the range. We have also been cautious with new accounts. We still do not have an “all clear” signal, but I expect the SLFSI to decline next week.

Our Dynamic Asset Allocation model is also very conservative, featuring bonds and other defensive holdings.

To summarize, we have a very conservative posture in most of our programs, recognizing the uncertainty and volatility. For new accounts we are establishing partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program.

Take what the market is giving you.

Conclusion

We can forecast some elements for the next two weeks:

• Trading volume will be lower
• There will be less political activity and speech-making

The reduced volume sometimes exacerbates big moves, so I make no guesses about volatility.

There are indications that the stock market would move higher without the daily pressure from Europe. The best measure of sentiment is the flight to bonds, shown in this chart from Scott Grannis.

Read the entire article for more charts and a full discussion, but here is the key takeaway:

This is a highly unusual circumstance that can only have highly unusual roots. I think those roots are most likely to be found in the Eurozone. Such is the fear that the PIIGS defaults will destroy the Eurozone banking system and ultimately lead to a global depression and a financial market collapse, that investors are willing to pay exorbitant prices for Treasuries in view of their safe-haven status. The risk-free status of Treasuries seems paramount, far more important than possible concerns about inflation.

If there is a message here for investors, it’s that fear has reached extraordinary levels, artificially inflating the prices of Treasuries. And it’s not a stretch to go from that conclusion to the belief that fear is also artificially depressing the prices of equities.

Eventually this picture must change, but it will take more time than the remaining two weeks of 2011.

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