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Are you still invested in the market, but with one foot out the door?

Viewed another way, how can you join in the rally while keeping a close eye on risk?

There is a popular sense that the market is overdue for a correction. Many others feel that a collection of "headwinds" means that stock investors face an inflection point. This is a story that has been told for two years, with poor results. I maintain that you need some objective, data-based indicators to stay on the right side of the market. I wrote about the importance of system last week. (Upon request, we will also send my recent investor report on how I limit portfolio risk).

My weekly review of the market will look at some differing perspectives on this theme, but let us first do our regular review of last week's news.

Background on "Weighing the Week Ahead"

There are many good services that do a complete list of every event for the upcoming week, so that is not my mission. Instead, I try to single out what will be most important in the coming week. If I am correct, 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.

In most of my articles I build a careful case for each point. My purpose here is different. 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 some will disagree. That is what makes a market!

Last Week's Data

Last week the economic news was pretty good. This week we saw the opposite. The non-economic stories were even worse.

The Good

To keep perspective, we should note that most major economic indicators remain in positive territory. There is growing recognition that the economic rally now has a self-sustaining character.

  • Economic growth is still improving. The ECRI Weekly Leading Index moved higher, to 130.8. The growth index reached another fresh peak, 6.7%. Both figures were the highest since May, 2010.
  • Risk as measured by the St. Louis Fed Stress Index, remains very low. This measure tracks a lot of market data in the eighteen inputs. It is not a poll, nor opinions, nor a collection of anecdotes. We should all pay attention to some real data. The value moved to +.004, about the same as +.03 from last week. For more interpretation, the St. Louis Fed published a short paper with a very nice chart that helps to interpret this index. The chart does not reflect the recent continued decline in stress, but it identifies the dates for important recent events. The paper also has a longer version of the chart, illustrating past stress periods. I am not going to run the chart each week, but I strongly recommend that readers look at the paper. In the 2008 decline there was plenty of warning from this index -- no sign right now. The scale is in standard deviations, so anything short of 1.0 or so is neutral territory. I am doing more extensive research on this indicator.
  • Federal Budget Compromise. There is still no federal spending agreement, and all signs are that there will be another extension. I realize that most people interpret this as "Congress is not doing its job." The problem comes in criticizing an institution, rather than the participants. Depending upon your viewpoint, you might think that either Democrats or Republicans should be caving in. If you really want to understand something about this aspect of policymaking, check out my article on "strategic postponement" and thanks to aerospace engineer reader "KK" for the terminology suggestion.
  • Energy prices, still high with threats intact, moved a touch lower on the week.
  • Investor sentiment (a contrarian indicator) is lower. The Bespoke Investment Group reports, "At a current level of 35.98%, bullish sentiment based on AAII's poll is at its lowest level since September 2nd, which was more than 200 S&P 500 points ago!" Check out the great chart that we all expect from the BIG team. This is a short-term indicator, but it got a lot of play from the bearish punditry a few weeks ago. My guess is that none of these sources will mention the decline. I don't find this measure of sentiment to be very important. It is much less significant than the attitude of pension fund managers, and it does not take much to get a big change.

These are all interesting indicators, but the ECRI and SLFSI are actually readings from week-old data. There was plenty of bad news last week.

The Bad

The bad news seemed to come every day and from all fronts.

  • Initial jobless claims. The weekly number barely kept the "three handle" but this noisy series is still not where we need to see it for net job growth.
  • University of Michigan Sentiment was bad -- very bad. I regard this as an important indicator, since it helps to capture job creation. I have a feeling that the poor numbers were a reflection of the spike in fuel prices. I need to consider a fuel price component for my employment model, I guess. In the absence of further information, I see a fall in Michigan sentiment as negative for employment and for the economy. I like Doug Short's analysis of this indicator, so check out his fine charts.
  • European debt downgrades. A downgrade of Spain is more worrisome than Greece.
  • CoreLogic reported that 23.1% of mortgages had negative equity and home prices were falling.
  • The trade deficit spiked higher by $ 6.1 billion to $46.3 billion. This series is a challenge for most to interpret. Dean Baker, in an excellent interview with Talking Biz News, states the following:

My personal favorite is the identity that net national savings is equal to the current account surplus. This means that a country, like the United States, that is running large trade deficits MUST have negative net national savings. In other words, as long as we have a large trade deficit, we must have either very low private savings, a large budget deficit, or some combination. There is no way around this fact.

Economists can dispute the direction of causation (i.e. does the trade deficit lead to low savings or do low savings lead to the trade deficit), but the relationship is not in dispute. Nor is the mechanism in adjustment. In a system of floating exchange rates, like the one we have, the adjustment for eliminating a trade deficit is through a lower value of the currency (i.e. the dollar).

While no serious economist could dispute this point, my guess is that less than 1 percent of the listeners to NPR or the readers of the New York Times understand this. That speaks to an incredible failure of economic reporting.

The interview has plenty of similar wisdom. If you want to understand why most of the standard news you read is misleading, this is an article for you.

The Ugly

The earthquake and the tsunami, with the most important effects on Japan, were the dominant news for the week. The loss of life is most important, but there is also significant damage to infrastructure and property. Some are citing the stringent Japanese building codes as the reason that damage was not even worse.

While we all share a heartfealt reaction for the Japanese people, when you go back to work you realize that the picture for stocks is more mixed. Some are already looking for stocks to buy. Investors have learned that many natural disasters have led to the need for rebuilding. How bad is the news?

My concern is the continuing nuclear threat. As I write this (on Saturday night) there is news of a partial meltdown in one of the reactors affected by the quake. If this story is seen as a negative for nuclear power, there could be additional pressure on energy prices from fossil fuels. I do not want to put too fine a point on this, since the reactor is an old one and the circumstances very unusual, but dramatic events change political opinion.

This bears careful watching.

In most other weeks the events in Libya would win the "ugly" award and we would be carefully watching the rest of the Middle East. There is plenty to worry about. In Libya we must combine the human and the economic issues.

I have consistently recommended watching Prof. James Hamilton's analyis of oil prices and the economy. This week he notes that we should not expect the Saudi's to step in with more production.

An increase of a million barrels per day in Saudi production relative to reported November levels, some of which may have in fact already been implemented, would put them back up to where they were in July of 2008. If all of Libyan production gets knocked out, we'd need 1.8 mb/d to replace it. If the Saudis weren't able or willing to go above those production levels in 2008 when oil was selling for over $140 a barrel, why would you expect them to do so now with West Texas only at $106?

It is becoming clear that we must adjust to a higher base level of energy prices, with the corresponding impact on stocks and the economy. Read the entire article to get a full analysis with helpful charts.

Our Own Forecast

We base our "official" weekly posture on ratings from our TCA-ETF "Felix" model. After a mostly bullish posture for several months, Felix has turned more cautious. Several weeks ago we said it was a close call, and switched to neutral. Five weeks ago it was still close, but we shifted back to bullish in the weekly Ticker Sense Blogger Sentiment Poll, now recorded on Thursday after the market close. We remained bullish this week, but there was some debate among the staff. The indicators are just mildly positive. Here is what we see:

  • 70% of our 56 ETF's have a positive rating, down from 79% last week, a continuing trend.
  • 43% of our 56 sectors are in our "penalty box," about the same as last week (45%). This is still an indication of significant short-term risk.
  • Our universe has a median strength of only +9, down from +14 last week, also a negative trend.

The overall picture remains slightly bullish. We are fully invested in trading accounts since there are several strong sectors, but we are watching the indicators quite carefully. This has been a very close call for several weeks.

[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 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 a number of minor reports this week, but here is what I will be watching.

  • Energy prices! Like everyone else. We are now all students of the politics of the Middle East.
  • Japan -- for many reasons.
  • Initial jobless claims. Let us see where things stabilize.
  • The FOMC decision will not suprise, nor do I expect anything from the language.
  • Housing data will include building permits, which I find interesting. Unless the Philly Fed is another big surprise, it will have little impact, and I do not care about the "leading" economic indicators.
  • College basketball -- especially the resurgent young Wolverines. This is the month when TV's on trading floors switch from (the muted) CNBC feed.

Investment Implications

The ongoing theme is how investors should deal with worries. In general, there is a tendency to overreact. World events are difficult to quantify. Translating worry about Europe into the effect on, for example, tech company earnings, is quite a challenge. Many people react to the story without stopping to gauge the specific effects. Here are some helpful ideas.

  • Quantifying worries. Cullen Roche has an interesting "wall of worry" measure which uses several major sentiment indicators. He notes that there is still an ample supply of well-known worries. This is the fuel for the market.
  • Reacting to short-term news is "gambling, not investing" according to Josh Brown. I was also interviewed for this article by Nancy Miller (no relation) who took the refreshing approach of questioning like an intelligent but open-minded investor. She was well aware of current fears, but interested in getting to the right answers. The result of her professional approach is a nice article citing several prominent colleagues who are cool heads in a time of turmoil. I mentioned several areas where we are currently buying.
  • The technical aspects are the topic for Charles Kirk's weekly chart show. Charles is neutral on the market, and describes carefully what might lead to a breakout in either direction. He sees support at various levels in a correction. Most interestingly, he does not see anything really negative in the individual charts of many companies that he follows. I was reminded of our own market inferences drawn from the analysis of many sectors. Watch the show for yourself to get the entire benefit.

With so many important news stories, the issues and opportunities can change quickly. For the moment, we are marginally bullish for trading accounts and cautiously shopping in several sectors where we see great value.

Source: Weighing the Week Ahead: Time to Head for the Exits?