Jeff Miller | May 18, 2014 12:41AM ET
To the surprise of most, bonds have rallied while stocks have moved sideways. In a week with very little data, and many thinking about an early Memorial Day vacation, the bond/stock tradeoff proved to be a favorite topic for the punditry.
h2 Prior Theme Recap/h2Last week I expected a focus on market divergences, especially the decline of small cap stocks. While the financial media also featured news from hedge fund gurus and Fed speakers, the divergence notion was an important theme all week. It will probably continue.
Since I do not regard these divergences as an important leading indicator, the planning was helpful in doing some shopping.
Forecasting the theme is an exercise in planning and being prepared. Readers are invited to play along with the "theme forecast." I spend a lot of time on it each week. It helps to prepare your game plan for the week ahead, and it is not as easy as you might think.
Naturally we would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react.
h3 This Week's Theme/h3What should we make of the rally in bonds, a surprise to nearly everyone? Does it provide an important signal of weakness in stocks?
It is a complex topic, with many angles.
For investors trying to make stock/bond asset allocations, the explanation is important. Past speculation (Woe is us! After QE ends, no one will buy US bonds!) has been unhelpful.
Each week I break down events into good and bad. Often there is "ugly" and on rare occasions something really good. My working definition of "good" has two components:
The Good
There was little news, but it was mostly good.
The Bad
There was also plenty of bad news.
The Ugly
The drought, now affecting half of the US with 15% experiencing extreme conditions. Vox has a great article and charts, including this one:
I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. Think of The Lone Ranger. No award this week. Reader nominations are always appreciated!
h3 Quant Corner/h3Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. For more information on each source, check here .
Recent Expert Commentary on Recession Odds and Market Trends
unveiled a new system .
RecessionAlert : A variety of strong quantitative indicators for both economic and market analysis.
Doug Short : An update of the regular ECRI analysis with a good history, commentary, detailed analysis and charts. If you are still listening to the ECRI (2 ½ years after their recession call), you should be reading this carefully. He notes that the ECRI has emerged from hibernation. "Interestingly, the interview includes no reference to ECRI's recession call, instead focusing on whether the winter economic downturn was weather-related or reflective of a cyclical downturn."
With Q1 weakness in the economy, it is important to monitor Doug's Big Four indicators. There is clearly some weakness, analyzed in detail in the full post .
Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured "C Score." One of his conclusions is whether a month is "recession eligible." His analysis shows that none of the next nine months could qualify. I respect this because Bob (whose career has been with banks and private clients) has been far more accurate than the high-profile TV pundits.
One of his key charts illustrates where we are in the business cycle – crucial for the long-term investor. Here is his most recent chart:
We have a very light week for news and data.
The "A List" includes the following:
The "B List" includes the following:
There are more regional Fed surveys. I do not regard these as very important (at least not individually) and it takes a big move in one for any real market impact. It is another active week for FedSpeak, including more from Chair Yellen.
Ukraine remains a wild card. I am not expecting much excitement from European elections either (preview here ).
h3 How to Use the Weekly Data Updates/h3In 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.
h3 Insight for Traders /h3Felix has continued the bullish rating, and the choices have become more aggressive. The broad market ETFs look a little worse than last week. The iShares Russell 2000 Index (ARCA:IWM), is now negative. With fewer sectors in the penalty box, we have higher confidence in the ratings.
Those who want to follow Felix more closely can check us out at Scutify , where he makes a daily appearance to join in vigorous discussions about trading.
h3 Insight for Investors/h3I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. The current "actionable investment advice" is summarized here .
We finally had enough volatility to do some buying – two down days in a row.
Those trying out our Enhanced Yield approach should have enjoyed yet another good week in a sideways market. It is important and helpful to own value stocks that pay dividends and add some hedging via short calls. I have written several times about examples that you can try on your own. It reduces your risk. Start small and get the sense of how to do it.
Here are some key themes and the best investment posts we saw last week
David Merkel warns about risk and reward in his post, Playing for Pennies, Risking Dollars . He says the following about junk bonds:
I try to avoid investments where the upside is limited, but the downside is unlimited. That's the way I feel about junk bonds now. Have junk yields been lower before? No, we have eclipsed the time in 2013 when the junk market was in a yield frenzy, until Bernanke uttered the word "taper."
I think he is too conservative about stocks, which have similar risk to the junk bonds but much more upside, but read his entire post.
Bubble talk? Since the bubble stories get the headlines, the average investor can easily be persuaded that current stock prices are an artifact of Fed policy. In truth, a combination of stronger corporate earnings, a better economy, and reduced financial stress fully justify the market rally.
Eddy Elfenbein, one of the best allies for the individual investor, updates his helpful earnings chart .
Scott Grannis looks directly at overall corporate profits with this chart:
Chuck Carnevale, provides ten stock ideas , each from a different sector. Great work, and worth reading the entire post carefully.
Beware of the micro-cap marijuana stocks. The SEC warns of misrepresentation of facts and market manipulation in some cases. Who could have guessed?
Hedge fund manager David Tepper has turned cautious. Jason Zweig reports his "nervous time" comment. This is interesting information for investors, who should always make sure to "right size" their risk. I warn that Warren Buffett's advice that stocks are better than bonds is not appropriate for all investors. The same is true of Tepper. You are unique.
Chuck Jaffe also has a great column on analyzing your personal risk/reward balance. You must be realistic. This is where I begin with each new client.
Stocks could be undervalued. Investors are bombarded with negative stories on valuation. Here is Jeff Saut with a standard metric (and not the only one) that you hear little about. He thinks it is "too optimistic" but worth noting:
If Graham and Dodd's estimated P/E formula is anywhere near the mark (P/E = 8.5 + 2x Growth Rate), the SPX's correct P/E should be 20.3, not the 16.6 times it is currently trading for on a trailing 12-month basis. Recall Graham observed the average no-growth stock traded at 8.5 times earnings, and that P/E ratios increased by twice the rate of earnings growth, therefore 8.5 + 2(5.9%) = a P/E ratio of 20.3, or a price objective of 2781 for the SPX.
If you are obsessed about possible market declines, you have plenty of company. This is one of the problems where we can help. It is possible to get reasonable returns while controlling risk. Check out our recent recommendations in our 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 and use feedback).
h3 Final Thought/h3The cause of the bond rally? There is no single reason. Most persuasive are the arguments about fund flows from Europe and conservative decisions by pension funds (finally closer to their targets).
Those inferring economic weakness include the usual collection of "bond guys" talking their book and assorted pundits who never seem to find the "buy" button for stocks. It is great fun to criticize economic forecasts, but most of the critics do even worse themselves.
Nearly everyone is just itching to call the "end of the cycle" because it has lasted a long time. I have been accurate in my patience. This was a prolonged economic cycle, featuring a slow recovery from a sharp decline. I recommend two key points to follow:
Most market pundits are not even thinking about what could happen if the output gap is closed.
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