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What a week! Last week I expected a return to normalcy after the long debt ceiling debate. So much for that prediction.

The market seamlessly moved to a new set of worries, partly sparked by the poor ISM manufacturing report on Monday.

The result of this is a paradise for pundits. Everyone who has had a bearish market prediction any time in the last two years is claiming to have been right -- and for the right reason. This creates a difficult environment for investors, who have been invited to think the worst about everything.

Let me set the stage with the debt ceiling decision. As I predicted for many months, there would be no default. This was the key issue. The next important test was that there would not be an instant move to austerity, making the recovery more difficult. That test was also passed, since the compromise agreement had little impact on 2012 GDP.

The last test -- a distant third -- was the impact on the long-term deficit. Somehow the significance of this issue changed in a suicidal rush to emphasize immediate deficit reduction. This reaction was reflected in the S&P decision to downgrade US debt.

The single best story on this issue is from Prof. James Hamilton. He carefully explains how three different issues are involved, and provides guidance on each. Please take a minute to read this great analysis.

The S&P downgrade decision will provide a negative start to the week. Before turning to these prospects, let us do our regular review of last week's data.

Background on "Weighing the Week Ahead"

There are many good services that do a complete list of every event. 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.

Readers often disagree with my conclusions. That is fine! Join in and comment. 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

The economic news was generally weak, consistent with economic growth of 1.5 - 2%.

The Good

There were some bright spots.

  • Initial jobless claims stayed at 400K. This is still not what we need, but it is better than recent levels and much better than many were forecasting a few weeks ago. It is not a recessionary level, nor a sign of robust growth.
  • Payroll employment (and the ADP employment estimate) was stronger than expected. The gain of 117,000 jobs is not enough to absorb new job market entrants, but is not a recession level.
  • The money supply rebound continues. This is a major forward-looking indicator that is widely ignored. It is a leading indicator, giving it extra significance. I have been writing about this for several weeks, highlighting the weekly updates from Bonddad. Everyone knows that monetary policy works with a lag, but no one is paying any attention to this story. Bonddad also notes that eight of ten high frequency indicators were positive.
  • Earnings strength continues. The Bespoke Investment group notes the big divergence between the earnings beat rate and price action in the stocks.
  • Market valuation is supported by these earnings, with many noting the modest 12x multiple on expected earnings. Here is a good assessment from Dr. Ed Yardeni, including a helpful chart. The market prices reflect widespread skepticism about earnings forecasts.

The Bad

There was plenty of negative news.

  • Consumer sentiment continues to decline, especially in the wake of the debt ceiling process. The Rasmussen daily report show a sharp decline among consumers and a bigger fall among investors.
  • The ISM services report was 52.7, not as bad as manufacuring, but also a bit weaker than expected.
  • Consumer spending was slightly negative, and lower than expectations. We need consumer confidence and spending as part of an eocnomic recovery.
  • Interest rates increased in Italy and Spain, as further questions were raised about their deficit reduction programs.

The Recession Odds

The weaker economic data stimulated a rush of recession forecasts, much as we saw last year. Martin Feldstein gave odds of 50%, but without mentioning a time frame. Investors rushed out of mutual funds, lending market credence to the negative forecasts. Most economists think that the slow growth leaves the US economy more exposed to a shock, but they do not yet see a recession.

Bob Dieli's "Mr. Model" service, which I have been monitoring for a few months, has an excellent record of forecasting recessions. His principal method (real time, not a back test) has provided a nine-month lead for more than thirty years. He has also devised some secondary supporting indicators. None of these currently signal a recession.

For investors fearing a repeat of 2008, Michael Santoli has some good answers in this week's Barron's:

But it's not like '08 in several important respects. First, unlike Lehman Brothers, Greece or Italy or Spain can't be put out of business overnight by a financial-market boycott. Their debt costs can and have gone to punitive levels, but a meltdown of Lehman-like proportions among governments or even European banks is tough to envision.

Note, too, that in 2008, the U.S. stock market was already down 20% in a typical recession-prompted bear market before the systemic madness began to invoke a wholesale liquidation of risky assets. Today, even after the 11% break in the Standard & Poor's 500 in a couple of weeks, we're down less than 5% year to date, in muted recognition that GDP growth has fallen pitifully short of forecasts. Perhaps the best defense against a 2008 scenario is the very active muscle memory among investors conditioned by 2008's experience.

The Indicator Snapshot

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

As I have often noted in the past, the ECRI and the SLFSI report with a one-week lag. This means that the reported values do not include last week's market action. In my research, I take account of this lag. In my daily monitoring of the market I look at the underlying elements in the SLFSI. I cannot do this with reliability for the ECRI since the indicators are secret. The SLFSI will increase next week, but not to the level that would trigger the "risk alarm."

There will soon be at least one new indicator, and the current choices are under review. In particular, I am considering replacing the ECRI method with the equally effective and more transparent approach from Bob Dieli. Click to enlarge:

080511

The indicators show continuing modest growth at a slowing pace, with little indication of economic risk. This is in sharp contrast to market fears -- much greater than indicated from the data.

Felix is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll, now recorded on Thursday after the market close. We have a long public record for these positions.

[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 could be a lot of action this week. The futures trading suggests a knee-jerk reaction to the S&P downgrade from the stock market. This was telegraphed by skittish trading on Friday where the rally faded (perhaps on leaked info) and then rebounded when the big S&P calculation error became public. The fact of the downgrade is negative, of course, but I expect it to have little impact on the bond market. The stock market is embracing panic mode, so the initial effect will be greater there. I discuss this issue in more detail here.

The FOMC decision on Tuesday will be a focal point. Many are looking for a hint about a QE 3 program. I have not been expecting this, nor do I see it as important. Having said this, the Fed is much more sensitive to deflation than inflation right now. There could be an innovative proposal of some sort, but this would be a surprise. The Fed view of the economy is much different from that of the average market observer.

I am always interested in initial jobless claims and Michigan's consumer confidence survey. Retail sales will be watched by many, but we already have data on individual chains.

The big unknown will be Europe. There is a market focus -- some say a bulls eye painted by hedge funds -- on the debt of Spain and Italy. Many are hoping and trading based upon a failure in Europe. They are fighting the European Community and the ECB, a foreign equivalent of fighting the Fed. This is a story to follow closely. Calculated Risk is reporting some of these plans.

If the European cloud clears, there could be a rebound geared to corporate earnings. The dividend yield on the Dow is now greater than the yield on a ten-year Treasury note, and that is catching some attention.

Investment Implications

From the comments I have noted a lot of confusion regarding this "investment implication" section. I try to write something for both a trading time frame and also for the long-term investor. The trading time frame is our model-based system. The longer time frame reflects my own investment posture. Both approaches have been successful over time, but occasionally there is disagreement.

In trading accounts we we shifted into inverse ETFs early in the week, and ended with a 40% net short position. Felix has turned negative and nearly everything is in the penalty box. Felix does not respond to fundamental data, but rather to price momentum, volume, and changes. These all weakened dramatically.

For investment accounts we were cautious last week in establishing new positions. I still believe that holdings with more economic exposure will excel in the second half of the year. These include technology and cyclical stocks. As I have noted in recent weeks, the investment time frame requires looking for opportunity when traders are scrambling.

We did some gentle buying on Friday, and I plan more for later today.

Source: Weighing the Week Ahead: Paradise for Pundits