Weighing the Week Ahead: It’s All about Earnings

by Jeff Miller

In last week's prediction for the week ahead my streak I guessed that the main theme would be whether we had dodged the bullet on the matter of a correction. This proved to be pretty accurate, despite news about China, the Bernanke testimony, and some big earnings numbers.

This week we have very little economic data and the Fed members are finally taking some time off from the speech circuit. It is one of the two biggest weeks of the earnings season, so I expect that earnings will be the key focus.

Here are some perspectives to consider.

• The Storytellers -- who can be of either the bullish or the bearish persuasion. The bears have emphasized the big misses in technology stocks. The bulls can point to strong reports from banks and health care companies. Anecdotal evidence is the raw material of confirmation bias, so watch out!
• The Data-driven – who analyze all of the results. The story so far is that companies continue to beat expectations on earnings while missing on revenues. This is turning into a multi-year story. As we always do during earnings season, we pay special attention to the updates from the Bespoke Investment Group.

• The Practical Forecasters. This group insists on looking beyond current revenue and earnings, emphasizing the outlook for company prospects. Nearly everyone following the earnings conference calls does this, but doing it for the market as a whole is almost a secret weapon. There is an excellent resource for looking beyond the current earnings reports, as I explain here.

I have some thoughts on the earnings season including a half-baked idea that I have never revealed before. I'll explain more 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:

1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
2. It is better than expectations.

The Good

This was a modicum of good news on the economic front.

• Moody's upgraded the U.S. debt outlook from negative to stable. Is this really good news? Please note below the impact of government spending on the economy. Who elected these guys to a position that would influence public policy decisions?
• The European story is better – more revenue, lower recession odds, and less threat to the world economy and US earnings. This is the story from Barron's. (Contrary view from Rebecca Wilder – and nice to see her writing again).
• High yield spreads are narrowing again. Bespoke provides analysis and the great charts you expect, including this one:

• Initial jobless claims moved lower, back into the recent range. This is an important indicator but difficult to interpret on a weekly basis. Seasonal adjustments are difficult for such a short time frame, especially when you get into the "retooling" season for auto companies. Scott Grannis has an alternative look that emphasizes the unadjusted data. It is easy to see the general level of improvement.

The Bad

There was a little bad news.  Feel free to add in the comments anything you think I missed!

• The CPI headline number was higher than expected. This subject is a huge source of misunderstanding on the part of the average investor. The magnitude of the difference is best understood if you realize that the Fed sees inflation as too low. Their preferred measure is currently showing a lower rate than the CPI. (See Dr. Ed for more). Explaining this is beyond the scope of my weekly article, but those who are interested in predicting Fed behavior should be paying attention. Doug Short has a nice continuing series on inflation which is also well worth reading.
• Gasoline prices are higher, influencing the CPI. The Bonddad Blog points to both higher oil and gas prices, asking "Why?" I think that it is a narrowing of the WTI/Brent spread, as noted by Bespoke (and various other sources). If this explanation is correct, we can expect gas prices to reflect fundamental changes in future months.
• Sentiment remains bullish. Bespoke notes that this contrarian indicator remains elevated after a "trivial" decline.

• GDP estimates are falling. Menzie Chinn at Econbrowser mentions the sequester and the increase in payroll taxes as causes. He also cites several other authoritative sources. Doug Short discusses the forecasts and shows the entire range of the WSJ economic panel in this chart:

• A technical signal from the High Low Logic Index is a warning of another 2007 (via Mark Hulbert). This approach is an element of and inspiration for the Hindenburg Omen, but does not seem to have so many false positive signals. On the other hand (via Mark Hulbert) none of the market timers he follows generate any edge on a long-term basis.
• Leading economic indicators were unchanged. This was below expectations so I am scoring it as "bad." Steven Hansen at Global Economic Intersection always has an interesting take, often by looking at the long term and avoiding seasonal adjustments. His analysis and charts help to put this report in perspective.
• Housing starts were very weak – much worse than expected. Calculated Risk keeps this in perspective by considering the multi-family effect and also building permits. Bill McBride is the go-to source on this subject, so I have special interest in his conclusion:   "Starts are moving up and completions are following.  Usually single family starts bounce back quickly after a recession, but not this time because of the large overhang of existing housing units." I continue to watch this very carefully. 

The Ugly

The Motor City. Matthew Dolan of the WSJ has a good story loaded with facts on the largest municipal bankruptcy. $18 billion in liabilities….

The Bond Buyer covers the implications ("ominous") for the muni market.

And what assets must be sold? Museum holdings? This car (original Mustang)?

Appreciation

My main reason for writing is pretty simple: I have an impulse to share a message that I hope some will find helpful. I did this for many years, partly as a way of communicating with clients. At some point, I started to get some inquiries from potential new clients. Many said that I was so low-key that they did not understand that I had investment services available! I have a good team, but not a special marketing departmentJ

1. I appreciate those who send an email with some kind words, or who make an encouraging comment. It lets me know that I am helping and offsets some of the "Miller, you idiot!" messages I get.
2. I appreciate those who consider our services, whether they choose us or not.
3. Thanks to Brian Gilmartin for his kind words on his excellent blog, Fundamentalis. He gives me too much credit merely for encouraging his efforts. He has a powerful, profitable message and a strong desire to share it. He is a natural writer.
4. And thanks also to Insider Monkey for including "A Dash" among the top 100 finance blogs. This is a real surprise. There is a formula for popularity and my relatively infrequent and skeptical long posts do not fit the bill. We are only at #89, but that leaves room for improvement.

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.

Financial Risk

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.

Recession Odds

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.

Meanwhile, here is the latest take from Bob's monthly take on the economy:

Bob's work is crucial to understanding why we are still early in the business cycle. Others look at elapsed time. Bob looks at data.

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. Of special interest is the Leading SuperIndex, which accurately forecast the absence of a summer swoon. Since the weekly data are still mixed, it is important to monitor the index closely. Here is the most recent update and chart:

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. These all have recent updates.

Unfortunately, and despite the inaccuracy of their forecast, the mainstream media features the ECRI. Doug Short has excellent continuing coverageof 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 briefly switched to a bearish position, but it was a close call. Two weeks ago we switched back to neutral, which was also a close call. The inverse ETFs were more highly rated than positive sectors by a small margin, but remained in the penalty box. Last week we were almost in bullish territory, an amazing change in only two weeks. Last week I wrote that we were sticking with "neutral", but the bias was to the upside. This week the ratings have improved enough to warrant a bullish forecast.

These are one-month forecasts for the poll, but Felix has a three-week horizon.  Felix's ratings have improved quite a bit. 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 remains the focal point in evaluating the economy, and this is the most responsive indicator.
• Michigan sentiment index (F). This remains a good concurrent indicator for employment and spending. This is the final reading for July, but it sometimes differs significantly from the preliminary report.
• Existing home sales (M). Housing remains as a crucial driver for the U.S. economy.

The "B List" includes the following:

• New home sales (W). Important, but less interesting than permits
• Durable goods (Th). More interesting than normal given the low GDP.

And especially – Earnings!

A quiet time on the Fed speechifying front.

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 moved to a bullish posture, now fully reflected in our trading accounts. We have maintained our long position in oil and also added two equity ETFs. 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. Felix has dodged some of the market volatility, profited from a short bond position, and made gains in oil (via USO).

Insight for Investors

This is a time of danger for investors who are stubbornly sticking to losing ideas. This was the subject of some great posts last week.

Abnormal Returns wrote about those who have missed the rally, citing several other helpful articles. Here is a key quote:

…(W)e investors have a tendency to personalize these things. The past five years has been a difficult for investors. Especially for those investors who have fought the rally all the way higher. Those who did so have often been enamored of one theory or another on why the economy (and stock market) were headed for a fall. Unfortunately the market doesn't care about your theories.

I encourage reading the entire post and all of the links cited. This is a great way for those who have missed the rally to gain a new perspective.

Meanwhile, our readers with a long-term perspective should find this approach as quite familiar. If you have followed our indicators on earnings, recession risk, and the St. Louis Financial stress index you have had a much more constructive viewpoint. If you follow Bob Dieli's business cycle work, you have a special edge.

My recent themes are still quite valid. If you have not followed the links below, please 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. Check out Georg Vrba's bond model, which continues to signal the risk. Other yield-based investments have also suffered, and it is not over. Check out the latest interest rate forecast from LearnBonds. Or the timetable to a 4% ten-year note from Goldman Sachs (via Joe Weisenthal).

• 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 have had a number of questions about this suggestion, so I recently wrote an update. That post provides background as well as concrete examples showing how you can try this strategy yourself. There is nothing quite as satisfying as watching your account grow while the market is doing nothing or trading in a range.

• 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. Recent weeks have been tough for traders. Most were surprised by the market reaction to more FedSpeak and the spike in interest rates.

For investors it was a different story. If you had your shopping list, there have been good opportunities to buy stocks. For those following our enhanced yield approach you had both the chance to set new positions and to sell calls against old ones. This week's Barron's has a nice list of inexpensive stocks. You need a subscription or to purchase a copy, but I like the list --- perhaps because we hold three of the seven stocks mentioned!

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).

Final Thought

I have no special insight in how the rest of the earnings season will play out.

Regardless of the current results, we will soon enter a period of seasonal strength. The "sell in May and buy in October" meme defies logic. Most good investment ideas disappear. When they are known, people follow them.

Here is a clue about why seasonality works. This is a quotation from Andrew Bary in this week's Barron's

"The S&P 500 trades for about 15 times projected 2013 profits and 14 times estimated 2014 earnings. Small-cap indexes have higher valuations, with the Russell 2000 index fetching about 17 times projected earnings in the coming year. The S&P 500 is up 18% this year and the Russell, 24%."

It is July, so he is citing a multiple for both 2013 and 2014. In a few months no one will talk about the 2013 multiple; they will all look ahead.

This may seem silly, but I have watched it for two decades. Earnings are reported and summarized by calendar years, and that is how they are discussed. At some point, if earnings are growing (as is usually the case) the market just seems cheaper since the multiple is for the next year. You can gain a solid advantage by always using a 12-month forward earnings approach, as I describe here. I also do this with my individual stock analysis.

I expect the market to digest the current numbers, but also to look beyond the current earnings season.

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