The Week Ahead: Volatility Rising?

by Jeff Miller

Eureka! Markets can move in both directions – even in a single day!

The relentless market rally since the fiscal cliff was averted has left everyone expecting a correction, looking for an entry point – or both. This came to a sudden end last week. We can see this readily from Doug Short's graphic summary of the week's trading (see the full article for more charts and helpful discussion).

Click on chart for larger image.

Follow up:

As the chart shows, my prediction for last week's featured theme -- Fedspeak – was on the money. This week I expect continuing volatility. The unresolved Fed issues will be augmented by some important data in a holiday-shortened week.

The Key Viewpoints

How one views the prospects for various financial markets is linked strongly to one's viewpoint about the role of the Fed.

• The popular view is that the economy is fundamentally weak. Financial markets will falter as soon as the Fed ends the current round of quantitative easing.
• The Fed's own view is that the economy is improving, albeit sluggishly. Expert Fed watcher Tim Duy cites and interprets New York Fed President William Dudley:

  Dudley adds something that I think is important:

  "The important thing to recognize about the U.S. economy is that things are actually improving underneath the surface," Dudley said in the interview. "We don't really see that so much in the activity data yet because of the large amount of fiscal drag."

  Translation: Fiscal drag will weigh down the GDP numbers. Look underneath those numbers to building momentum in the economy. I think this means there will be extra weight on the jobs data rather than the GDP data as an indicator of the impact of fiscal policy.

Whichever viewpoint you share, get ready for action! This debate will not end soon, and markets are reacting (over-reacting?) to each statement and every nuance.

The discovery need not send you running naked through the streets as Archimedes did, but it can serve to enlighten your trading and investing.

We should expect an increase in volatility? If so, what is the best reaction?

I have some thoughts on volatility and investing which I'll report 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.
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

As expected, this was a light week for economic data. There was some significant good news.

• New home sales are strong, especially considering revisions to prior months. Calculated Risk calls it a "solid report" providing an array of charts and supporting evidence. Here is a key example showing inventory back at pre-recession levels:

• Initial jobless claims dropped to 340K, beating expectations and moving back to the lower end of the recent range.
• Industrial production beat expectations, and was even better than the headlines (via Steven Hansen at GEI).

The Bad

The thin data week included a little bad news. Feel free to add in the comments anything you think I missed!

• The world economy shows continuing weakness. RecessionAlert tracks both the GDP results (noting percentage of countries in one- or two-quarter recessions), and also composite measures of world economic activity. This is a compilation of data not found from other sources – well worth a look. Here is an interesting sample:

• The Gang of Eight Immigration Bill is stalled in the Senate. Many do not understand the issue, but immigration reform is generally viewed as positive by economists of all stripes. See The Hill for news on the setbacks for this bipartisan effort.
• Chinese manufacturing is contracting, according to the HSBC Flash Index, which registered 49.6 versus consensus estimates. The "official" estimates usually run better, but who knows for sure?
• Investors turned more bullish according to the AAII poll (viewed as a contrarian indicator), reported with a typically great chart from Bespoke:

The Ugly

Utilities. There is a growing awareness of the risk from the multi-year chasing of yield. See Tomi Kilgore's nice WSJ analysis of the break in trend and the latest measures of technical risk.

Expect other yield-based investments to join this trend soon.

The Indicator Snapshot

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

• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.
• An updated analysis of recession probability.

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.

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.

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I have now added a series of videos, where he 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.

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.

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 well over a year 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 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. About a month ago we were "neutral for two weeks." (These are one-month forecasts for the poll, but Felix has a three-week horizon). Felix's ratings stabilized at a low level and improved significantly over the last few weeks. The penalty box percentage measures our confidence in the forecast. When there is a high rating, it means that most ETFs are in the penalty box, so we would have less confidence in the overall ratings. That measure is relatively low at the moment, so we have greater 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 some important data and news in a holiday-shortened week.

The "A List" includes the following:

• Initial jobless claims (Th). Employment will continue as the focal point in evaluating the economy, and this is the most responsive indicator.
• Personal income and Spending (F). The consumer is still important, so income and spending are both crucial.

The "B List" includes the following:

• Consumer Confidence (T). The Conference Board measure is a good concurrent indicator of the mixed effects of increased taxes, gas prices, political concerns, housing, and most of all – employment.
• Michigan Sentiment (F). Just as important as the Conference board, but we already have a preliminary reading. The final versions have surprised recently.
• Case-Shiller home prices (T). One of the regulars on CNBC said this was the most important data point for the week. I think that is silly, since it is the slowest of the housing price indicators. It is worth watching.
• Chicago Purchasing Managers' Index (F). This is more important than usual since the nationals ISM index will not be out until next week. The Chicago Index is the best estimate.

I am not very interested in pending home sales or the revision to first quarter GDP.

We will also have more speeches by FOMC participants.

Trading Time Frame

Felix has continued a bullish posture. The trading positions have become more aggressive – financials and technology – rather than consumer staples and utilities. It is popular to predict a correction, but that has been true all year. Several readers questioned Felix's bullish stance a few weeks ago. I understand, since we humans all know that markets do not move in straight lines. Felix is especially good at sticking with a trend until there is clear evidence that it has broken. The method is excellent in helping to stay on the right side of big moves.

There will come a time when Felix is wrong, giving back some gains in a correction. It goes with the territory. There are many ways to trade and invest successfully, and many trading time frames. Felix is making a three-week forecast, but we monitor it daily.

Investor Time Frame

This is a time of danger for investors – a potential market turning point. I review this investor section carefully every week, although the general advice does not change as rapidly as it does for the trading time frame. The recent themes are still quite valid. If you have not followed the links, find a little time to give yourself a checkup. You can follow the steps below:

1. 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. I highly recommend the excellent analysis by Kurt Shrout at LearnBonds. It is a careful, quantitative discussion of the factors behind the current low interest rates and what can happen when rates normalize.

Other yield-based investments have a similar or greater risk profile. As David Kehohane of FTAlphaville notes, even junk bonds are now yielding less than 5%!

1. 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 for over two years and continues to do so. (If you cannot figure it out yourself, or it is too much work, maybe we can help).

1. Balance risk and reward

There is always risk. Investors often see a distorted balance of upside and downside, focusing too much on new events and not enough on earnings and value.

Three years ago, in the midst of a 10% correction and plenty of Dow 5000 predictions, I challenged readers to think about Dow 20K. I knew that it would take time, but investors waiting for a perfect world would miss the whole rally. In my next installment on this theme I reviewed the logic behind the prediction. It is important to realize that there is plenty of eventual upside left in the rally. To illustrate, check out Chuck Carnevale's bottoms-up analysis of the Dow components showing that the Dow "remains cheaply valued."

1. 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. There are many attractive stocks right now – great names in sectors that have lagged the market recovery. You can imitate what I do with new clients, taking a partial position right away and then looking for opportunities.

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

What are the implications of the debate over Fed policy and the resulting volatility?

I like to consider problems like this from three different angles.

• The reality of the current policy is that the Fed is getting too much credit or blame for current asset prices. In my Fed as a Fig Leaf post I explain this in more detail. The basic idea is that objective analysis of fundamental economic and policy changes easily explains the change in market values over the last three years.
• The most probable economic and policy outcomes. This is not what I or others would prefer to happen, but a realistic assessment of what is likely to happen. There will be a gradual reduction in Fed stimulus – a tapering of new purchases, the end of new purchases, and finally an increase in short-term interest rates. The stimulus will not really end until this process is complete. It might take years. Whether the end is timely will depend not upon the extreme voices on the Fed, but those at the center. See Prof. Mark Thoma's current analysis of Bernanke and the center to appreciate the significance.
• The popular perception – which will be the short-term driver of stock prices. Despite increased communication and transparency, the Fed has failed to explain the rationale for QE and to convince the average market observer of the actual economic effects. This creates a climate of uncertainty.

Investment fundamentals will eventual prove out, so the first two points are most important. Meanwhile, perceptions drive markets as we have seen quite often in the last few years. I warn clients to expect a 15% market decline at some point, even in good years and even when not justified by economic fundamentals.

I do not see an imminent change in Fed policy, so there is still some time. For the moment, market volatility provides opportunity to establish new positions, as I was doing last week.

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