jaudio shorts

The Economy Had a Check-up--Here's What the Doctor Found

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Market experts all around the world have been debating the recession risk game for the past few weeks. There isn't even a consensus yet, as if a consensus would even matter when some of it is largely based on prognostications from those that have not crunched the numbers.

What do the numbers say, and what does it all mean?

Well, just in the same way our doctors can check our blood pressure, pulse, and temperature, we can play doctor on the economy by checking the economic indicators. And better yet, instead of having to search far and wide for all of these numbers, they are relatively easy to find just a few clicks away from where you are now.

In his book, THE SECRETS OF ECONOMIC INDICATORS, Bernard Baumohl takes on a subject that many people find boring & complicated and turns it into a highly organized simple read that doubles as a valuable resource tool. On page 12, he lists what he considers the 10 most important economic indicators most sensitive to stocks. I took these 10 indicators, put them in a chart, and I ranked them Bull, Bear, or Flat based on their 6-12 month trend. I ranked them this way only for the sake of simplicity. The idea behind this is that if we see a pattern of indicators flashing signs of Bull or Bear, we can get a better idea where the economy is going, and in turn, where the stock market is going. Though I am a biased bear, I did not distort the rankings to reflect my view and I was surprised at the results. My sources for the data are listed at the bottom of this blog.*

Here's the data:

Bull trends:
ISM Report--Manufacturing
Retail Sales
Personal Income and Spending
GDP

Bear trends:
Employment Situation Report
Consumer Confidence/Sentiment Survey

Flat trends:
Producer Price Index
Consumer Price Index
Weekly Claims for Unemployment Insurance
Advance Report on Durable Goods

In addition, it is my view that the CPI is leaning Bear, but not enough for me to classify it as a longer term bear trend. Though some of my above rankings can be debated, the important thing to note is that the economy doesn't seem to be in trouble--yet.

What does this tell us?

If anything, the economy is only flashing a caution sign. Friday's unemployment report should be quite telling. For all of you market timers, Friday may be a scaled down version of the excitement post FED, either up or down.

Just as SLO players timed their trades to the FED decision on interest rates, we can also time our trades to the news releases of the economic indicators that affect stocks the most. Looking for a calendar listing October's releases? Just go to http://moneycentral.msn.com/investor/calendar/econ/current.asp.

For those that want a more detailed calendar, go to
http://www.dailyfx.com/calendar/briefing.

The informed investor is the successful investor.

*online sources of economic data:

bls.gov
ism.ws
ows.doleta.gov
census.gov
sca.isr.umich.edu/main.php

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The Lucas Critique and the Index of Misleading Indicators

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Sometimes a trader pays the price for not following the herd.

Case in point is my portfolio. If you are feeling blue about your portfolio returns, click on my portfolio to cheer up. I have been hammered over the past month as the market has recovered. The basics of my strategy have been to buy and hold and bet that we are at the beginning of a sustained bear market. My best case scenario is that I was a little too early in my analysis. My worst case scenario is that I am on a sinking ship with no one to bail water. However, I will not abandon ship at the first sign of trouble. After rising to number 19 in the rankings, I have plummeted way out of contention. At this point in time, ironically, the only thing that will save me is a stock market crash, something I wouldn't wish for even if it would make me a boatload of money and help me win the game.

As I look over some of the specifics of my trading strategy, the one I want to focus on is the Index of Leading Economic Indicators, also known as the LEI.* The LEI is an excellent tool, but with many flaws. The types of flaws inherent to the LEI also exist in many aspects of broad economic policy. These types of flaws have been addressed over the years, with Robert Lucas** (designer of the Lucas Critique) being just one of them.

We are all familiar with the disclaimer "Past performance does not guarantee future results" when it comes to investing. The same applies to broad economic policy, explained by the Lucas Critique.

The Lucas Critique says that basing monetary policy on historical data correlations is simple-minded because policy changes alter the rules of the game, making past data possibly misleading. An example of this is the past ideas of the negative correlation between inflation and unemployment. It was thought that as inflation went up, unemployment would go down, explained by the Phillips Curve. Stagflation of the '70's was the reality check. The Lucas Critique sought to give emphasis to modeling individual behavior and what individuals will do conditional on the change in policy. The fallacy of correlating inflation and unemployment were forewarned by economists, but to no avail. Some things never change.

In my own strategy, I have made trades based partially on the LEI, and Robert Lucas is laughing at me.

The LEI is an index that is designed to predict the economy's direction. It is published along with the Index of Coincident Indicators and the Index of Lagging Indicators. These Indexes are good answers to the questions "where are we, where have we been, and where are we going?" when referring to the economy. Just like all market predictors, it is not fool proof. The strength of the LEI is that it is based on economic numbers, not emotions. You can crunch the numbers, look at the trends, and make a decision. It almost seems too easy.

It isn't.

The weaknesses of the LEI are numerous. The most blatant is that out of the 10 numbers used to compile the Index, 3 must be estimated at the time of the release of the LEI. As a percentage of weight, 44.7% of the index is calculated with estimates, and those estimates can sometimes be wrong. A second weakness is revisions in the numbers after the Index has been released. Preliminary numbers are revised all the time, as we saw with the job loss of 4000 reported in September being revised up to an 89,000 jobs gain. A third weakness is that the LEI has a spotty track record in predicting recessions, and when it does predict a recession, it can be as close as 2 months away or as far as 20 months away. That isn't the type of thing day traders are looking for. The LEI released in September showed a decline of 9 of the 10 components, but the economy still looks strong. It isn't all bad for the LEI, though. The LEI does have a better track record at predicting economic recoveries. That isn't relevant right now, but the day will come, so keep the LEI in mind when that day arrives.

Until then, I will enjoy these sour grapes. Curses, Lucas.

*globalindicators.org/us/latestreleases
**http://nobelprize.org/nobel_prizes/economics/laureates/1995/press.html

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That's the Problem with Banks!

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The big banks have spoken. The worst is over. All is well.

I wouldn't be pulling all that cash you've stashed under the mattress and running into a bank just yet.

Back on September 28th I wrote that October 17th,18th, and 19th would be the "3 scariest days in October" due to the reality of how bad the credit crunch has hit the big banks. The moment has passed, so let the Monday morning quarterbacking begin.

First the good news:

1. The big banks have teamed up with the blessing of the Treasury Secretary Henry Paulson to create the 200 billion dollar superfund to restore liquidity in the commercial paper market. This move, along with the cut in the discount rate and the recent cut in the Federal funds rate mean that plans are in place to avert disaster.

2. J. P. Morgan Chase didn't get hammered from the credit crunch. Though it hasn't been smooth sailing, JPM has shown they can navigate through choppy waters.

3. The lower dollar means a reduced trade deficit, that is, we will be exporting more and importing less. It also means more foreign investment, another plus for the economy.

Now the bad news: All of the above.

It's a funny thing about financial news; one trader's bad news is another trader's good news. Every market dip is either a financial loss or a buying opportunity. For every home seller that has seen his property plummet in price, there is a real estate vulture circling the sky. It's all about perspectives. It's also about being on the right side of a zero sum game.

Here is the Bear's take on the above good news:

1. The big bank superfund is a sign that the bankers and Treasury Secretary are preparing for the inevitable Armageddon. No European bank has signed on to the superfund yet, so is the superfund a good idea? The FED threw the market a life preserver--make that a yacht--with the rate cuts. That is a sign that the FED knows there is big trouble on the horizon. Try to forget that this latest idea of the superfund shares its name with a plan designed to protect people by cleaning up toxic waste dumps they lived on or beside.

2. JPM made it through the choppy waters indeed, along with steady numbers from Fifth Third, but with Citigroup, Bank of America, Wachovia, Washington Mutual, and Wells Fargo checking in with dismal numbers, it's hard to feel confidence. All of those dismal numbers were rewarded with a small hit on the stock price, but don't expect buyers to be rushing in. MSN's Jon Markman lays the big bank problem out perfectly in the second half of his "Boeing bends the plane truth" article on 10/18. Put the corks back in the champagne bottles, the cops just crashed the party.

3. Let's forget the debate on whether the trade deficit even matters. A falling dollar is a good thing for foreign investment, but can that make up for the big bite American consumers will pay at the pump? Oil is priced in dollars, and as the dollar falls, oil will go up. That isn't as big an issue when the economy is expanding, but the economy is slowing down. The last thing we need is higher fuel costs priced into our consumer goods. The Dow transportation average has not recovered from the August lows. It is off over 12% from its July high and is now sitting a mere 2.5 % higher than its August low. The transports have been taking some hits with slowing freight orders lately, but the glass jaw of the transports is fuel. In a slowing economy, so go the transports, so go the market. In addition, the cheap stuff we have grown to love shipped in from China just became more expensive thanks to the falling dollar. With the powder keg in the Middle East ready to explode at a moments notice, things are a bit uneasy. The economy has been able to handle high oil before, but let's see what happens when it starts pushing $100 a barrel. Don't forget about how the $100 mark will be a milestone anxiously awaited by fear media only compounding the problem.

Last week's market slide isn't a "getting rid of the froth". Rather, it is a clear sign that there are serious problems that exist that we have been denying since August. The market in the next 2-4 weeks may recover a bit, but the longer we go, the more information we will have bringing to light the true damage of the credit meltdown. Back when the market took a dive in August, many were beating the "buying opportunity drum", and many people were able to take advantage and book some paper profits. However, going long is getting more and more risky.

How does the wannabe bear take advantage of the above situations? Several SLO players have already beat me to the punch.

The first play is SKF, the ultra short financial ETF.

SKF is up over 12% since last Monday. I increased my stake in SKF 2 weeks ago anticipating some bank earnings fallout, and I wasn't disappointed. However, I am not locking in any gains yet. There is more turmoil to come. SKF topped out at $96.50 in August, and though it went as low as $72, it still has room to run as the financial reality hits home.

The second play is SRS, the ultra short real estate ETF.

Most people think that they missed the train when it comes to making money on the downside of real estate. Not so. Though SRS clocked in at over a 10% gain last week, it is still sitting at its price in late July. It ran all the way up to $121 in the August meltdown, wildly swinging between $95 and $115 four times in a month. If you can stomach 10-15% swings in price when the market gets crazy and you think that real estate isn't out of the woods yet, SRS is one to study.

The third play is SZK, the ultra short consumer goods ETF.

If you think that buying SRS and SKF would be getting in late, then SZK is just about right. It's a little over $64 now, up from its $61.43 low. With the Dow transports down, Fedex and UPS warning about lower freight volume, lower earnings numbers across several sectors, and the continuing drag from the housing problems, consumer goods will take a hit sooner or later. Better to get on the short side sooner than later.

My bearish bets have not panned out so far in the SLO, but I am staying the course. Being early to the bear party isn't a bad thing if you can tough it out while others make money. I still have $35,000 to put down on one more buy, something I will do between now and our favorite 78th anniversary on the 29th. I believe that the bull market has run its course and the warning signs in the economy will soon translate into the market headed south. Until then, cheers.

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FED Up-- The Entrenched Bears Throw in the Towel

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The bears have a tough life.

They cry wolf non-stop through the 5 plus years of a bull market, always warning us of doom and gloom. The "I-told-you-so" moments that the bears celebrate always turn out to be buying opportunities for the smart bulls. A broken clock is right at least twice a day, but bear time never comes. When all is lost, even the most entrenched bear gives up.

Beware when the bear changes course.

While trolling through the boatloads of financial news, I ran across a few interesting articles that would make both bulls and bears do a double take. The first was an article by Brent Arends entitled "Jeremy Grantham's Losing His Growl" featured on thestreet.com. The second was by MSN's Contrarian Chronicles author, Bill Fleckenstein entitled "Tech stocks' pain proves they're vulnerable, too". The third is an article by Jack Willoughby on Barrons.com entitled "Margin Debt-- and Risk--is Growing". These three articles are examples of the dangers ahead of us, and examples of why I am staying on the bear wagon. Lines pulled from each article explain themselves:

1. "They say the time to get really nervous is when the last bear turns bullish."

2. "According to the Investors Intelligence's report . . . last week the bulls stood at 62% and bears at about 19%. For anyone who's been around the stock market for any length of time, that is a clear warning sign."

3. "Based on historical levels, margin debt makes the market look risky and subject to a sharp downtick right now. It comes to 2.4% of total adjusted-market capitalization -- 3.4 times its 62-year norm of 0.74%."

The first two articles work in tandem with each other and the last shows how everything can go south in a hurry. Jeremy Grantham, a long time bear, is "FED up" with the FED seemingly rescuing the market from certain death. Want to know how bearish Grantham has been in the past? Just google his name and read his past work. Converting this guy to a bull is like the Pope renouncing Catholicism. His patience has been tapped out, and the bulls clearly have him on the ropes. The only thing that will keep Grantham from being pummeled would be the FED holding steady on rates and the market shedding 3% in one day.

Fleckenstein has always offered an opposing view to the conventional wisdom, and his latest article doesn't disappoint. His article rips the tech stocks, but it's what's in the last paragraph that is the most interesting. He states that when everyone gets on board to ride the bull, the bull buckles under pressure. We may be reaching that point.

Willoughby's article talks about how we haven't learned from our past mistakes in the not so recent past of August. The historical dollar amount of margin debt isn't as important as the percentage of margin debt to market cap. Nearly all of the margin that was called in after the August meltdown is washing through the market once again. Previous to 2007, we haven't seen it like this since...well...the end of the dot com party. Partying like it is 1999 isn't a bad thing unless we can't make it to the door soon after the ball drops. When margin is called in, the exit door gets incredibly harder to fit through.

I have already admitted in past entries that I called the top of the market early and hence shorted the market early. However, in sticking with my strategy, my trades have been few and I will let the market determine the rest. Vad called me out in his last blog by saying the following:

Jaudio-- you can't really stay all short in the long term- inflation and the fact that your upside is effectively capped at 100% will catch up to you eventually.

It is true and I agree, Vad, that no one can stay all short in the long term, and the upside is capped at 100%. However, this game is short term, so being all short in the short term could pan out. I looked at the overall downward pressure on the bull market coupled with the fact that everyone has bet long. When everyone zigs, I zag. In a market downturn, even the best companies can get hit hard. After all, look at Berkshire Hathaway (BKR.A) at any time during 1999 and compare the stock price then to its low point in the first few months of 2000. It took BKR.A buyers that bought at the top over 4 years to recover their losses. Even the genius gets hit in the short term. My resolve has also been tested in this game . . . enduring the pain as my portfolio gets hit. The game isn't over yet; the fun is just beginning.

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