A Dash of Insight

Developing and Evaluating Trading Systems

Improved technology, more power.  We would expect this to be good.

In fact, more power can enable us to do exactly the wrong thing.

This happens all of the time with the world's most powerful computer, the human mind.  A year ago we reviewed analysts who thought the market looked like a replay of the 1987 crash.  This type of analysis crops up all of the time, often using old charts as evidence.  With the power to search among thousands of choices, picking the time frame, and adjusting the scales, the human computer can "prove" nearly anything.

Those developing computer-based trading systems face the same problem.  The modern software makes it easy to include many variables --- too many!

Some Helpful Illustrations

Bill Rempel missed the Kentucky Derby by a few days, but his story highlighting horse race handicappers is excellent.  A group of handicappers were tested, using gradually increasing amounts of information.  The extra data increased their confidence, but not their performance!  (Read the entire discussion.)

Bill discusses Occam's Razor and points out the importance of reducing the number of independent variables:

I use this paring down or pruning technique at work as well as when examining trading strategies or opportunities. My first question, when faced with complex models, has for a long time been “I wonder how many of those variables actually do most of the work?”

This is pretty convincing to us, since Bill sounds just like our own Vince Castelli.  It is easy to develop a model using all of the available data and lots of variables.  You will generate a perfect "post-diction" but not anything useful for prediction.

The result:  Over-fitting and over-confidence, a dangerous brew!

Unfortunately, consumers of system strategies, including a few big-time "gatekeepers" we have met, have become accustomed to seeing eye-popping (and unrealistic) results.  They apply an automatic discount, regardless of the methodology employed.

The TCA Model Applied to the S&P 500

For the purposes of comparison, the chart below shows our TCA Model (Trend, Cycle, Anticipation) as applied to the S&P 500.  Without giving away the store, we can say that the model uses a relatively small number of variables -- some designed to choose between trend and cycle, and others representing indicators for each.  Much of the power comes from advanced techniques for filtering and smoothing data, thereby improving signal to noise.  The chart below is not a back-test, but the signals actually used in trading during the last year.

The overall performance shows a gain of about 6% during a time when the S&P declined by a few percent.  It accomplishes this while reducing risk by staying out of the market for significant periods.

A key point is that the model gets the investor into the market to enjoy the big moves.  The cost?  There are some losses at times of rapid changes or churning.

Finding the big moves is very important.  Some traders have trouble joining in when the market has already made a move.  They are reluctant to "chase."  It is difficult to show gains when missing the big rallies.

Anyone interested in trading systems should join us as regular readers of The Rempel Report, where he updates and reports on several interesting trading systems.  One of these is similar to our own sector rotation approach.

TCA-ETF Update

Each Thursday (a day late this week) we share with the investment community a recent report from our ETF ratings.  We have been doing this in real time for eight months.  Our purpose is partly to gain visibility for the approach (free report available on request), but also as information for other ETF traders, and most importantly to provide a laboratory for others trying to develop trading systems.  We discuss the issues surrounding system development in many of the articles in this series.

As we noted last week, we have expanded the ETF universe, and we seek more additions.  Adding more targets is helpful, as long as they can be shown to have characteristics suitable for one's model.

The current ratings show some dramatic changes from recent weeks, and include one of the new ETF's, KOL.

Investors Seeking Foreclosure Riches

One of the ingredients for "bubbles" is the quest for the home run.  Investors look to how much they wish to gain rather than to risk and reward.

What happens when this quest intersects with a major downturn in an asset class?

The Foreclosure Boom: Donald Trump

Our local papers have featured ads from Donald Trump, explaining how you can profit from the foreclosure explosion.  This article, while a few months old, is typical of what is happening.  It is from Seattle, a pretty strong housing area which we visit four times a year for board meetings.

But not to fear, capitalists, because one man's misery is another man's meat. In the same issue of the P-ITrump University"," a class where Trump promises "If you're not a millionaire by December 2008, you didn't attend my foreclosure workshop." Yes, that's right. Your struggling neighbors who are losing their homes in the subprime fiasco, are easy prey. The ad enthuses that "Foreclosures soared 94% in 2007!" What a paradise for the entrepreneur. The ad features a full-length Trump (who won't actually be at the seminar, by the way) staring you down, challenging you to become as rapacious, amoral, and loathsome as he is. If you don't have the guts to let Donald make your rich at the expense of the suckers of Pottersville, well, you're fired!

The LA Times also reports on the Trump approach:

An ad in this very newspaper showed a picture of The Donald and quoted him as saying, "Investors nationwide are making millions in foreclosures . . . and so can you!

"I'm going to give you 2 hours of access to one of my amazing instructors AND priceless information . . . all for FREE."

OK, I know what you're thinking. You're thinking there has to be a catch, such as the fact that the ad doesn't mention anywhere that the free two-hour seminar is only a "preview" of the three-day workshops that Trump offers for $1,495.

The reporters are skeptical of the Trump seminars, but we are offering no opinion.  We merely suggest this information as an interesting piece of information about identifying market bottoms and investor behavior.

Books on Foreclosures

There were a number of books on foreclosures in the last real estate bust, and now we see some new ones and also some revisions.

• Foreclosure Investing for Dummies is a year old now, so not a good bottom call.  Nonetheless, we are always interested when dummies get into the game.
• Here is one that came out in April.
• This "insider's guide" is almost a year old.
• This "complete guide" came out in January.
• If you want something that no one else knows, and only a couple of months old, this is your choice.
• And finally, here is something for "dummies" who want to fight foreclosure -- with or without help from Barney Frank and Congress!

What Does it All Mean?

We do not know!  When will the wave of foreclosure buyers intersect with the foreclosure sales?  Perhaps we need to wait for the cover of a major magazine before we have a clear contrarian signal.

While we are confident of the knowledge base of our regular readers, let us make it clear that we are neither endorsing the foreclosure course nor the books cited.  It is information for investors to consider -- that is all.

The Individual Investor Experience

At "A Dash" we let the big guys do the marketing research for us.  Television ads for online brokers indicate that "leading investors" are thinking for themselves instead of relying upon help from their former investment advisors.  Not wanting to be completely alone, however, investors want some help and comfort.  The online firms have "licensed representatives" available to offer help 24/7.

How is this working out?

We are interested in learning more about the experiences of individual investors who have decided to direct their own investments.  We are also interested in investment advisors whose clients direct all or a portion of their own accounts.

The information is for our book research, would be quoted only with permission, and names withheld in any references.  The names or email addresses will not be used for any commercial purpose beyond our research.  Please submit via our email address, at the top of the page on the left.

Questions

We are open to any and all observations, but the following questions might stimulate some thought.  There is no need to answer all of them.  It is just a list of ideas.  Feel free to raise or suggest any other questions.

How long have you been making your own investment decisions?

Do you stick to big issues like asset allocation, or do you pick your own mutual funds, bonds, and stocks.

Do you invest in ETF's?  Commodities?  Sell short?  Trade options?

What sources of information do you use in reaching your decisions?  In particular, do you read popular mainstream publications?  Do you watch financial TV or listen to radio programs?  Do you use stock screens?  Informational Internet sources?  Opinion and advisory sources?  What else?

How much time do you spend on your investments in an average week?

How many trades do you make in a month?

Do you follow a specific system?  What is your investment "style"?

How are you doing?  In particular, are you meeting your own expectations?  Do you check your performance records?

In a general sense -- say for the next six months or so -- do you see investment opportunity?  Are you bullish about stocks?  Bonds?  Commodities?

Why not a survey?

We have conducted professional surveys many times, both in the university setting and for consulting work.  A good survey starts with a good sample, and we are not going to get one.  There is no reason to infer a level of pseudo-science as one sees in some online polls.

We are simply interested in stimulating some opinions and comments about going it alone as an investor.  It is a reality check -- a way of finding out what works for people and what does not.

A little help from our friends

Thanks in advance to anyone helping with this project.  We will find some appropriate way to share some of the results on "A Dash" for the consideration of all.

Please do not be bashful.  We need to hear from a range of people regardless of their results.  Once again, please submit via our email address, at the top of the page on the left.

Informational Power: Interpreting the Payroll Employment Report

What is the market impact from the interpretation of data?

It is an open and free debate, but there is a problem.  The results follow from advanced statistical methods and processes.  Even the smartest hedge fund managers, columnists, and pundits cannot draw independent conclusions.  They did not take the right classes.  They never did any time series modeling or survey research.  Briefly put, they lack the necessary skills to evaluate most data.

The result:  Nearly everyone relies upon the analysis of those accepted as experts.  What choice is there?

This is a recognized principle in social science, called the two-step flow of communications.

Application to the Monthly Payroll Employment Report

When do we know that data interpretation has a market impact?  One test might be the widespread citation of a conclusion.

Our "go to guy" for those on the NYSE floor is Art Cashin.  In his daily comment (very valuable and available to UBS customers) he wrote as follows:

Payroll Numbers – Three pros, Dennis Gartman, John Mauldin and Greg Weldon each deconstructed the non-farm payroll data. Their conclusions were that the data was, actually, anything but bullish. Things are not always what they seem at first glance.

So the perception on the floor relies on these influential interpreters of data.  What are their sources?

John Mauldin

John Mauldin does a number on the number!  Even though this is an extended excerpt, readers need to check out the entire analysis.

Without that addition from the birth/death number, total private employment would have dropped by 296,000. Now, if that had been the headline number, the market would have tanked. Now, I have no doubt that the economy did create a lot of new jobs last month. But when the final revisions are in, we will see that job losses were well south of 100,000. If memory serves me correctly, the BLS had to add about 800,000 jobs that they missed during the recovery in 2003-4. (The birth/death model misses job growth during recoveries, the opposite result of the miss in slowing periods.) They did this just last year, in a major revision of the data. We will see the same type of revisions in 2010, only this time it will be downward.

And even the BLS says that the birth/death numbers have little statistical meaning. The following is from their own website (courtesy of Dennis Gartman) [emphasis obviously mine]:

“Birth/death factors are a component of the not seasonally adjusted estimate and therefore are not directly comparable to the seasonally adjusted monthly changes. Instead, the birth/death factor should be assessed in the context of its effect on the not seasonally adjusted estimate... The components are not seasonally adjusted separately because they do not have particular economic meaning in and of themselves.”

Mauldin also cites Gartman and The Liscio Report.

Barry Ritholtz

Barry Ritholtz did his regular review of the employment numbers, with, as usual, a special focus on the birth/death adjustment.  The overall conclusion is that employment growth is overstated and the BLS methods are seriously flawed.

He also quotes at length from Alan Abelson, doing his monthly bearish take on the BLS report.

David Merkel

David Merkel undertakes his typical thoughtful analysis of the problem, well worth reading in the entirety.  David looks at the addition of jobs from the B/D adjustment and compares these to the net job change over time.  He graciously notes our dissent on some of the key issues.

Importance

The significance of these analyses is demonstrated by Art Cashin's citation.  The notion that the BLS methodology is wrong has become accepted as conventional wisdom.  Nearly everyone thinks that these are "phantom jobs", added by a flawed methodology, and that "turning points" in  the market are missed.

It is not part of the job description for BLS employees to write on blogs or to appear on CNBC.  As a result, there is no spokesman for their method.  It is a one-sided debate.

All of the sources cited in this article have significant power.  Their arguments have influenced active traders to believe that economic data have been artificially inflated.

Our Approach

After many months of attempting to refute specific claims about the BLS approach, we have decided to take a different tack.  More to come....

Sell in May?

There are many Wall Street adages.  Some seem to have predictive power, including the idea that one should "sell in May and go away."

Such slogans have extra influence because of the catchy, alliterative qualities.

When Indicators Conflict

There are a number of conflicting adages at the moment.

There is the Presidential Election Cycle. We have not been big fans of this because the causal model is elusive.  This year, however, we have both the Fed eases and the stimulus package.  If ever the theory were to work, this might be the time.  We also note that the popular bearish commentators embraced the theory when it suggested market weakness, but have fallen silent during the period when it suggested strength.  This should be interesting to contrarian investors.

There are technical considerations.  Can the market break through apparent resistance?  That is the current battleground for traders.

There is the question of earnings forecasts and targets.  First quarter earnings and outlooks were not as gloomy as expected.  Financial writedowns?  Yes.  Other companies?  Not so bad.  It was an unexpected double-digit gain for non-financials.

Summing up the Prospects

Two of our favorite sources provide some insight.

Bespoke Investment Group notes as follows:

Bespoke readers might remember that Goldman got rid of bullish strategist Abby Cohen when the market was cratering in March.  Cohen had a 2008 price target of 1,675 for the S&P 500, and after replacing Cohen at the market's bottom, Goldman's new strategist (David Kostin) lowered the firm's year-end S&P 500 price target from 1,675 to 1,380.

Readers should check out the entire article.  The Goldman economics team is very bearish and that has now expanded to their strategist team.  These are often quite different within a single firm.  This is a classic case of "global strategists" versus bottoms up analysts.  It bears watching, but regular readers of "A Dash" know that we think the bottoms up guys are under-rated.  Everyone is still fighting the old war of the 2000 tech bubble when companies and analysts hyped.  When will we learn that the world is different now?

Muckdog wisely highlights some research from Sy Harding via Mark Hulbert.  The gist of the story, which you should read for the full account, is that the "sale date" might be delayed this year.

That is consistent with our current model output, and our sense of the fundamentals.  To check this out, readers might wish to revisit this article, from April 3rd.

And by the way ---

What happened to "Don't Fight the Fed"?  We highlighted this as a "top secret" investment opportunity -- early, but not wrong.

Fishing in the Right Pond

Having a good trading method is only part of the problem.  One must also find the right trading "universe."

The original Turtle Traders learned this, and so should we.

We have been getting some good questions about our TCA-ETF system and why we chose the IShares universe that we have reported each week for many months.

Our criteria were logical and not overly restrictive:

• We wanted an open-ended ETF, since we did not want to be concerned with a possible discount or premium to NAV.
• We wished to avoid ETF's that were cap-weighted in sectors where a very few stocks would dominate.
• We wanted plenty of liquidity, so that the program could be scaled up as our assets grew.
• We also wanted enough trading action so that the slippage from our moves would not be too great.
• We needed enough data so that the model could be employed effectively.

The last point has been a big restriction, since we needed about one year's worth of data before a new fund could be added.  Unless there was a simulated history, we could not effectively employ a new ETF for nearly a year.  (At one point we were devising our own sectors and avoided this problem, but the ETF's are a popular and inexpensive alternative.)

Some Additions

In response to a suggestion from one of our smartest and most knowledgeable investors, we reviewed several of the Van Eck Global Market Vector ETF's to our trading universe. 

Since some of the prime candidates did not have the requisite trading history, although all other criteria were met, we asked Vince to revisit his methodology.  Without giving away Vince's secrets, let us say that his approach does a lot of filtering to reduce the signal-to-noise ratio.  He made some adjustments to achieve greater stability.  It is non-linear filtering that involves a "pathological time series."

The happy result is that we can now include ETF's with a four-month data history.  One of the new choices is currently in the top eight, so we will be buying it on tomorrow's opening.  The new ETF's will become part of our weekly report.  The new alternatives include alternative energy, gaming, coal, agribusiness, Russia, and nuclear energy.

An Invitation to Readers

We have offered our results as a general benefit to the community, reporting with a one-day lag on a weekly basis.  We now have a weekly program for investors as well as our sector partnership which trades daily.

We are open to suggestions about new ETF's that should be part of the universe.  Our experience has been that any ETF that meets our screening tests, improves long-term performance.  Feel free to make suggestions.

Candidates and Fuel Prices

Sophisticated market observers and economists joined today in objecting to Presidential candidate positions on energy issues.

The Statements

Sen. McCain was first with a proposal for a "gas tax holiday" this summer.  Sen. Clinton joined in, leaving Sen. Obama as the only holdout for maintaining federal gasoline taxes.

Sen. Clinton has been even more aggressive about high profits for oil companies.  This afternoon, as spotted by Colin Barr, her campaign complained about the decline in ExxonMobil stock, in spite of excellent earnings. 

There is something seriously wrong with our economy when Exxon’s record $11 billion in quarterly profits are seen as a disappointment by Wall Street,” Clinton said. She went on to use the company’s latest gains to reiterate her call for a gas tax holiday — a proposal has been criticized by economists who say it won’t result in lower prices for consumers. “I believe we should impose a windfall profits tax on big oil companies and use that money to suspend the gas tax and give families relief at the pump.

The Reaction

Not surprisingly, these proposals generated near-universal dissent from the economic community.  The complaints about profits and the ExxonMobil stock decline of 3.6% created similar objections among sophisticated market observers, like the panel on Kudlow and Company.

Barry Ritholtz is ready to give a good lesson to the candidates.  Check out his article about how the candidates fail Econ 101 (a course frequently cited at The Big Picture!).

We are delighted to find ourselves in agreement with Barry, the economists, and the savvy market observers on Kudlow's excellent program.

But here is the question:  Do the candidates really not understand how economics and markets work, even at the level of Econ 101?  Or is their motive a different one?

Is This Credible?

Well -- McCain admitted that he was soft on economics and was reading Greenspan's book to bone up!!  In spite of this, we think his team has enough economic horsepower to "speak truth to power" as we say in the public policy business.

Senator Clinton's case is even more clearcut.  She turned $1000 into $100,000 in only ten months of cattle futures trading, a record that none of us can claim.  She did it by "following the market closely" and "making her own decisions".

So she understands markets.  Her campaign also knows the proper role of experts, according to the Wall Street Journal.

Clinton’s position on the gas tax runs counter to that of economists across the political spectrum who argue that a temporary tax reprieve would do little to lower gas prices this summer.

“There are times a president will take a position that a group of quote-unquote experts will agree with and there are times when a president will take a position that a group of quote-unquote experts won’t agree with it,” campaign spokesman Howard Wolfson told reporters today, “Sen. Clinton believes this is the right policy.”

An Alternative Explanation

Instead of assuming that people intelligent and successful enough to be Presidential candidates are stupid, let us instead assume that they are smart.  As time winds down in a life-or-death struggle, the candidate looks for anything that might work.

It is natural to look at the issues of the day and gauge the public reaction.  Everyone is worried about high fuel prices.  Whom do they blame?

Here are data from a 2007 poll.  We follow such polling questions constantly and the numbers do not change that much.  The data show that the average person blames big oil or government for high fuel prices.  They do not understand much about market forces.  They go for conspiracies and simple-minded answers.  It is a winning tactic, at least in the short run.

If you were a candidate, would you try to educate the 2/3 of the people who are wrong-headed, or would you "go with the flow?"

Here is the poll question:

Who do you blame the most for the recent increase in gasoline prices - oil producing countries, oil companies, President Bush, Americans who drive vehicles that use a lot of gasoline or normal supply and demand pressures.

Oil companies	43%
President Bush	20%
Supply and demand	13%
Oil countries	11%
American drivers	4%
Not sure	9%

Pandering?

Barry calls the candidate efforts "pandering" and the term seems to fit.  Let us take careful note of the circumstances:

• An issue where nearly all of the top experts -- people who have relevant credentials and have reflected carefully -- draw a conclusion different from many average  people.
• Many consumers of the information believe in conspiracies and simple, common-man explanations.
• The candidate, someone in a position of leadership, chooses to exploit the public mis-perception rather than to educate and to lead.
• The resulting pandering helps the candidate, but might well hurt the average voter -- the person consuming the candidate's message.

This all has an eerily familiar pattern.  It is something to think about.

And by the way, we do not think any of the energy proposals have a ghost of a chance of passage.

Weekly Sector Update

The apparent shift in Fed policy was partly anticipated by the markets.  As a result, the expectations concerning the dollar changed.  The TCA-ETF portfolio from last week had a number of "weak dollar" plays, foreign markets, energy, and basic materials.  The data for this week (as of Wednesday's close) show a shift in the rankings, with more emphasis on technology.  (This is evolving rapidly).

The table below shows this week's rankings.  Vince has adjusted the strength scale to aid in the interpretation.  The underlying method has not changed.  A reading of zero indicates the average expected performance of a sector over a one-month time frame, the general time horizon for the model.  A reading of 50 indicates an expected return that is one standard deviation above the average, roughly the top third of returns.  A reading of 100 indicates an expected return of two standard deviations above the average.

While we update the model daily, we have introduced a program for average investors that does weekly trades unless emergency adjustments are required.  A report on this program is available upon request.

(Click to see the chart)

The GDP Litmus Test

Unless you do your own economic forecasting, you are a consumer of economic data.  Where do you shop?

The Data

The preliminary report of first quarter GDP showed an increase of 0.6%.  Taken on its face, this is very low growth -- below potential and a cause of distress for many.  No one would like this as a permanent condition.

If however, this proved to be the low point in the current cycle, it might be something like the "soft landing" that almost everyone thought was impossible two years ago.

It makes for an interesting question.  Who offers insight on the GDP question?

The Sources

We are going to stick to sources that we feature -- all respected for various reasons -- as part of this little test.

The Realists

James Hamilton at Econbrowser is no perma-bull.  He has been pretty tough in his economic assessments and skeptical about the economy and stocks.  It has sometimes been at variance with our own viewpoint, but always worthy of respect and attention.  Readers should note Prof. Hamilton's recession probability indicator.  He wisely observes that we may experience a recession that does not have two quarters of negative growth.  (Please read the entire article, good charts, good info).

I believe there is an important benefit to having a purely objective, data-based algorithm for making these declarations. The numbers are reminding us that if, for example, the tax rebates were to keep GDP growth positive in the second quarter, we would end up characterizing the most recent experience as a period of slow growth rather than a typical economic contraction.

Dick Green at Briefing.com is an excellent observer with good economists on his staff.  He has had a very good read both on the economy and stock performance for the last several years.  For some reason, his excellent observations seem not to get much play in the blogosphere.  As long-time subscribers to the "Platinum" service, we are surprised that more people do not read the valuable free content from this source.  The following is the free summary about GDP:

The first quarter increase in real GDP at a 0.6% annual rate undermines concerns that economic trends are deteriorating rapidly and even that the economy is in recession. This is not an aberrant number. Inventories added 0.8% to the overall gain, and skeptics will be quick to point out that would have declined at a 0.2% annual rate without this swing factor. However, inventories do reflect economic activity and belong in the calculation. The other component trends reflect surprising resilience and even strength that suggests the outlook for second quarter GDP is surprisingly good.

Calculated Risk is concerned that non-residential investment has turned negative.  It is a slight downturn, but certainly something to watch.  Check out the excellent charts.

The Optimists

David Malpass, in commentary distributed to Bear Stearns customers (like us) made the following observation:

We expect an economic recovery in coming quarters in response to generally good global growth conditions (record number of people working), low real interest rates in the U.S. and many parts of Asia, low inventories, and U.S. consumer resilience. While the negative inflection point in August relating to credit markets was severe, a deep pothole, we think most of the damage has been absorbed by the economy and priced into financial markets.

Just because we classify Malpass in the optimist camp, does  not mean that he is wrong.  He correctly called a sharp downturn from the credit crunch last August.  He now sees a rebound in response to stimulus.

The spread-out sequencing of the economic problems and the Fed’s concentrated response argue that we’re nearing the end of a slowdown/recession phase that began in 2006 with higher real interest rates and weakness in housing and autos.

We have followed the Malpass analysis for seven years, reading his work every week.  We did not start with an economic viewpoint (despite a few commentors who think the Old Prof is a Bush apologist!)  We have been persuaded by his analysis.  Our clients have profited from his work.

[There have been some very unfair criticisms of Malpass on the Internet, using very biased evidence.  Anyone who wants to move beyond the ad hominem attacks and look at the evidence will see why we think it is important to read David Malpass's work.]

The Pessimists

Mark Thoma at Economist's View has long been one of our daily reads (and is now added to our list of recommended sites).  He cites an argument that is nearly the exact opposite of the Malpass position!

After pointing out that the numbers will probably be adjusted, Thoma cites an article by Dennis J. Snower, suggesting that the blows to the economy will come in slow motion, with adjustments not equal to the effects.  Thoughtful readers should review the entire article.  This bears watching.

Barry Ritholtz applies his own interpretation of inflation data to conclude that the GDP report is really negative, a clear indication of recession.  We include non-economist (or self-styled "gonzo-economist") Ritholtz among the economists cited here since his work has very powerful mass appeal.

We would find Barry's analysis more persuasive if he would do the following:

1. Accept the fact that there are many inflation indicators.  A different market basket is used for each purpose, so the results cover a wide range.  Careful economists choose an indicator that fits the purpose.
2. Offer an indicator of his own.  It is easy to appeal to the masses by pointing out prices that are rising.  It is more challenging to do something constructive.  Most of his viewpoint seems to rest upon some pre-Boskin measures of CPI.  Putting aside the question of whether the CPI is the right inflation measure for all purposes, the inflation measurement question deserves more attention.

The Litmus Test

The question for most of us -- those who are consumers of economic data and interpretation -- is the approach of the analyst.

Do they start with a consistent method and then draw conclusions?  Or do they start with a conclusion and then find an argument?

It takes knowledge, analytic skill, and a lot of time to reach this conclusion.  How many traders and investors can do this?

Stock Market Implications

Colin Barr has an interesting article on the recent performance of Legg Mason's Bill Miller.   He  is skeptical, based upon some current positions, but his article is quite fair and balanced.  He includes Miller's position, as follows:

You might assume the point is that no one should ever bring up Miller’s recent negative returns, but that’s not quite it. “For value investors, price is one thing, and value is another,” Miller explains. “When prices move against us, it usually means that the gap between price and value is growing, and our future expected rates of return are higher.”

and this:

...with most investors being fearful, I think it makes sense to allocate some capital to the greedy side of that pendulum, and that means putting cash to work in equities.

At "A Dash" we have a bit more confidence in Bill Miller.  It is based upon his method as much as his long-term performance.  It is so easy to reach erroneous conclusions by looking at short-term records.  Our own indicators, both fundamental and system-based, support Miller's outlook.

Having said this, we are fully cognizant of economic challenges, including tomorrow's ISM data and the payroll employment report, where we do not expect positive readings from these mid-April indicators.  One's trading or investment decision depends more upon future economic prospects and earnings expectations.  It is all about time frames.

Which viewpoint will the market embrace?

The Financial Commentary 'Peter Principle'

The world of financial commentary now has its own version of the Peter Principle.  There are so many outlets -- financial television, podcasts, mainstream blogs, individual blogs -- that the editorial process has been overwhelmed.

In the old days -- that would be a couple of years ago -- publication in certain trusted sources would provide some confidence about the general reliability of the sources and the content.  No more.

The hunger for content, ratings, and hit count is driving the process.

The Herb Greenberg Example

Tonight's Kudlow and Company included a typically aggressive exchange between Herb Greenberg and Don Luskin. [link apparently unavailable] Luskin's point, for which we cannot find any particular defense from Greenberg, is that he makes quite a number of "common man" general assertions without any particular evidence.  Since he is a handsome, intelligent, and articulate speaker, he probably has quite an impact with viewers.

And that is the problem.  The world of financial media has become very democratic.  In voting, this is a good thing.  In expertise, it is not so good.

Luskin praises the Herb Greenberg of old --- someone we also followed every day.

I remember a decade ago Greenberg was a razor-sharp newspaper columnist who had a well-earned reputation for blowing the whistle on companies who were playing fast and loose with financial facts. Back then if you owned a stock that Herb wrote about, you were in trouble (and so was the company you were investing in).

That is how we remember it also.  What happened?  Luskin continues:

Whenever I see him now, instead of talking in depth about subjects of his own choosing about which he has real knowledge, he is trying to improvise uninformed responses to ad hoc big-picture market or economic topics or stocks in the news -- and he's no good at it. To live up to his "brand image" as the bear, the skeptic, the curmudgeon, he just spouts contentless generalities -- he raises doubts, he adduces dark possibilities, he emphasizes the risks. But there is no value in that. Everyone has doubts. Everyone knows there are dark possibilities. Everyone knows there are risks. Value is added when you take a stand, express an opinion, synthesize the possibilities into probabilities.

Luskin does not have comments, but he reproduced an email from one Forbes Tuttle (who seems, via Google, to have made a number of astute comments in various places):

Years ago (10-15), when I wrote research -- on special situations -- Herb Greenberg used to phone me up and ask questions about certain stocks, and stories. He was a good reporter. He asked insightful questions. He wrote interesting and thought-provoking stories. Now he is asked to have opinions of the broad market and the economy of which he has no background in experience or training upon which to base such opinions. This is the mistake of television news and opinion broadcasting, where reporters and journalists interview other reporters and journalists. From a substantive perspective, it is really quite boring...

Our Take

A few months ago we noted Greenberg's own words -- his belief that economic expertise really did not matter.  He figured that his years as a journalist were just as good as training in economics.  We urge readers to review the entire article, where we explain the error in this idea.

Anyone who thinks that it is possible to draw valid economic conclusions without understanding economic methods is like the pigeon at a poker table full of pros.  In future articles, we shall provide a few examples.

A Final Thought

Ratings and popularity generate momentum.  Since so many are seeking higher hit counts and ratings, no one wants to criticize a big player (like Greenberg).  When the popularity is so high, and there is no criticism, the journalistic community pays more and more attention to the most visible bloggers.

The result is a dangerous, lowest common denominator system.  Those who cater to the impressions of investors build a readership, but do not serve their readers well.  By comparison, the best economic analysis is often a bit dull.  It requires data and expertise.  It may challenge existing beliefs.

A challenge for investors is that most of the "economic commentary" is noise, not signal.

Fear, Investors, and Marketing

The most powerful selling approaches go with the flow.

Let us compare "selling" investment opinions with the positions of politicians seeking the Presidency.  Both topics hit our sweet spot.  We have also been talking with many individual investors and also many voters.  It is interesting.

The Election

A reader who wants to understand candidate behavior should imagine that he/she was hired as an advisor.  Many voters have strongly-held beliefs, often based on scanty information.  For candidates many issues have a clear choice:  Educate voters to change opinions or go with the flow.

The astute political strategist knows the answer to this one.  It is the easy explanation for the Democratic candidates' positions on NAFTA, capital gains taxation, health policy, payroll taxes, ethanol, and social security.  There is little that a candidate can say to change the viewpoints of voters, especially in the sound-bite era.

The result:  Candidates take positions that will win the day to gain electoral success.  What they actually propose and what they deliver may be quite different.  Readers who are old enough may recall the senior Bush promise to "read my lips, no new taxes."  The reality of governing is quite different from campaigning.

If a Democratic candidate wins the election, we expect the eventual  positions to be more moderate, but that is not that market expectations.

Selling Investment Strategies

We received in our email an appeal from a very famous investment manager.  It was all about fear, the recession, and danger to stock portfolios.  The  oft-quoted manager  had the answer to this -- proven success in the last recession.

This is a message that resonates with the average investor, so it is a good campaign -- not  unlike what  political leaders are doing.

Voters and investors have opinions.  Catering to those opinions is good marketing, regardless of the underlying wisdom.

The email approach described investment returns that were pretty good, although less than we have accomplished.  The proposed strategy is also not much different from what we are doing.  His recession performance in 2000 was not as good as ours.  The sales technique is much better.  The author points to success in the 2000 era and asserts that he will do as well in the coming challenges.

There is no effort to analyze the economy, earnings expectations, or what is already "baked in."  It is just a play on fear.  He is (wisely) going with the flow.  We are (perhaps unwisely) trying to educate investors.  Hmm.

Investor Reaction

Our conversations with individual investors have revealed several significant reactions.

• Some investors bought pre-1847 gold, to be placed with retirement trustees.  They soon learned that they could not sell these positions for anything like the prices they paid.  Big commissions were already deducted.
• Some investors bought variable annuities that guaranteed a rate of return, but with a cap.  The cap was not carefully explained in the expensive and colorful brochure.  These were sold to elderly people, with a high surrender value, and included upfront commissions of 10% or so.  The valuation of the portfolio is done in a way that shows an investment account value quite different from what can actually be withdrawn.  There are assorted provisions allowing investors to withdraw funds on a schedule.  Existing clients are happy with what they see.  None of them understand the function of the cap, how the biggest years are lost in their program, or how the big years contribute to overall returns.
• Most baby-boom investors, looking to retirement, are very heavily in real estate, bonds, and cash.

The Climate of Fear

Many investors took these retirement actions based upon their Internet research.  They are consumers of a climate of fear.  These consumers, encouraged by television advertising to manage their own accounts, read about the "fundamentals" of the economy and the stock market.  They use the same skills that helped them to success in their businesses -- reading, research, and logic.

The problem is that the value of information depends upon the analytic method.

Unless one knows how to interpret data about the economy and forward earnings expectations, the raw data is useless.

A Summary Anecdote

One of our investors, perhaps the wisest man we have ever encountered, likes to make his own calls and argue about ours.  He read a news article about a stock -- something that had been widely known in the market for months -- and wanted to buy it.  When asked whether others might have this same information, and he was a bit chagrined.  He often questions our contrarian picks -- but he stays with us.

The ability to discern what is "in the market" on a specific stock is well beyond what  most investors can do.  They do not think in those terms.  Not at all.  Information alone is not enough.

And by the way -- some of the investors making bad decisions on gold and annuities got their information from big-time Internet blogs with advertising or other ties to these products.

A little knowledge -- too little knowledge -- can be a dangerous thing.