More on Our Gold Model
Posted by Eddy Elfenbein on November 1st, 2010 at 8:41 am

Michael Stokes at MarketSci has a great post where he takes a closer look at our Gold Model. He found that using 2.4% as the break-even point produces a slightly better fit. (Here’s my original post.)

Michaels sums it up with three points; the good, the bad and the geeky:

The GOOD: there’s clearly something good about the CWS model. The analysis is made a little difficult by the fact that we have so little data to look at (the price of gold didn’t float prior to the late-1960’s), but the model definitely makes sense conceptually and fits the macro trends in gold over the last 40+ years.

The BAD: during both of those periods (in grey) when the model and gold diverged, long-term real rates were behaving very different than short-term real rates (and better matched the changes in gold). I’m wondering if the model could be improved by incorporating both short and long-term rates. Food for thought for future analysis.

The GEEKY: the model “works” by trying to predict month-to-month changes in gold, but has only done well modeling the absolute price level of gold. That’s awkward. A model that predicts monthly changes, but is only effective in terms of absolute price, is especially prone to curve-fitting because each monthly prediction impacts all future data points. Just something to roll around in the noggin’.

Expect a Pullback this Week
Posted by Eddy Elfenbein on November 1st, 2010 at 8:23 am

Last Thursday, I noted that the S&P 500 has barely budged over the past few trading days. Well, we can add Friday’s market to the list as well. The S&P 500 lost 0.52 points on Friday, or 0.04%.

This week, however, I think it’s very likely that we’ll see a sell-off following the Fed’s QE2 announcement. Don’t worry: I don’t think it will be a major sell-off. Bear in mind that with the recent rally that began on August 30th, the market has rallied on 27 sessions and fallen on just 16. The largest pullback based on closing numbers is 1.6%.

The catalyst for any sell-off will most likely be that the Fed’s QE2 total won’t be as much as Wall Street expects. The number that’s most frequently tossed around is $500 billion in Treasury purchases over the next six months. That’s been estimated to be equivalent to a 0.50% rate cut.

I’m still expecting a number closer to $250 billion, but no one from the Fed has contacted me for my views. In any event, we’ll know more on Wednesday. Also, the ECB and Bank of England meet on Thursday, so it’s a big week for central bankers.

The good news that no one wants to hear is that this has been an excellent earnings season. It’s odd how there’s always someone to attack any good news that comes along. According to the last figures, 71% of companies have beaten earnings expectations so far. That’s very, very high.

I will add with false modesty that all the stocks on our Buy List have beaten earnings this season. We’re not done just yet. There are three more earnings report for the Buy List this week; Moog (MOG-A), Wright Express (WXS) and Becton Dickinson (BDX).

We’re also heading into what has historically been the best six-month stretch of the year for the market. Bespoke notes that since 1960, the S&P 500 has averaged a 6.4% gain for the November through April period. For May through October, the market has only averaged 0.8%. I should add that the market has also done well for the last three “third years” of a presidential term.

I’ll be very curious what the ISM Index will say for October. I don’t expect much of a change, but even a little movement should put the Double Dip nonsense to rest. It won’t, of course, but it should.

Finally, we’ll get the October jobs report on Friday and it will not be pretty.

Morning News: November 1, 2010
Posted by Eddy Elfenbein on November 1st, 2010 at 7:01 am

U.S. Stock-Index Futures Climb as Chinese Manufacturing Expands

U.K. Manufacturing Growth Unexpectedly Accelerates as Exports Strengthen

Wall St. Futures Point to Higher Open; Data Eyed

Oil Rises as Dollar Weakens on Speculation of Fed Credit-Easing Measures

China Manufacturing Posts Biggest Gain in Six Months

Awaiting Fed’s Plans, Markets Are in Limbo

U.S. Economy Grew 2% as Consumer Spending Rises

Humana Tops Estimates, Lifts Guidance

Pontiac, 84, Dies of Indifference

Oracle Seeks $2.3 Billion in SAP Download `Humiliation’ Trial

A Very Big Week Ahead

The Joys of the Edge and Dangers of Ignoring the FAT Middle

Buy List Update
Posted by Eddy Elfenbein on October 31st, 2010 at 9:58 pm

Now that October is on the books, let’s take a look at the YTD performance of the Buy List.

Through October, the Buy List is up 10.25% compared with 6.11% for the S&P 500 (dividends not included).

Here’s a look at the chart for 2010:

You STILL Haven’t Sign up for CWS Review!
Posted by Eddy Elfenbein on October 29th, 2010 at 3:01 pm

Well, what are you waiting for? It’s free!

“Yes you did. You invaded Poland.”
Posted by Eddy Elfenbein on October 29th, 2010 at 2:42 pm

That’s enough market talk for one week. Have a great weekend everyone, and enjoy this classic John Cleese (who turned 71 this week) clip as Basil Fawlty:

Time to Raise Rates?
Posted by Eddy Elfenbein on October 29th, 2010 at 2:05 pm

Last week, Josh Brown brought up the issue of the Federal Reserve raising interest rates. With QE2 around the corner, it doesn’t look like the Fed will, but I think Josh has a good case.

Here’s a look at the Fed Funds rate against trailing four-quarter nominal GDP:

The two lines tack each other well. The hotly debated point is the middle of last decade when nominal GDP indicted that rates were too low. Other commentators said this as well, and more sophisticated measures like the Taylor Rule agreed.

Lately, however, nominal GDP growth has climbed to over 4% while interest rates are still stuck at 0%. Should this be discounted since it’s only making up for the slack caused by negative growth? Or is the Fed again behind the curve?

The Double Dip Is Dead
Posted by Eddy Elfenbein on October 29th, 2010 at 12:50 pm

Continuing with what I said before, the Economic Cycle Research Institute also calls the end of the Double Dip:

The good news is that the much-feared double-dip recession is not going to happen.

That is the message from leading business cycle indicators, which are unmistakably veering away from the recession track, following the patterns seen in post-World War II slowdowns that didn’t lead to recession.

For 25 years, we’ve personally spent every working day studying recessions and recoveries. Based on our work and that of our colleagues at ECRI, we’ve called the last three recessions and recoveries without any false alarms, including an accurate forecast of the end of the most recent recession in the summer of 2009.

After completing an exhaustive review of key drivers of the business cycle, ranging from credit to inventories and measures of labor market conditions, we can forecast with confidence that the economy will avoid a double dip.

But the bad news is that a revival in economic growth is not yet in sight. The slowing of economic growth that began in mid-2010 will continue through early 2011. Thus, private sector job growth, which is already easing, will slow further, keeping the double-dip debate alive.

Of course, it is the renewed job market weakness, combined with deflation fears, that is behind the Fed’s promise to implement a second round of quantitative easing, or QE2.

QE2 Will Spur Demand for More Risk
Posted by Eddy Elfenbein on October 29th, 2010 at 10:19 am

Next week, the Federal Reserve is expected to announce another round of Quantitative Easing, or as the cool kids are calling it, QE2. All investors need to understand that QE2 will have a major impact on their investments. The most important aspect is that Quantitative Easing will help fuel a demand for riskier asset classes.

More specifically, Quantitative Easing will aid a shift toward growth stocks at the expense of bonds and value stocks. QE2 won’t affect the direction of stock market—that will remain strong—as much as it will alter the market’s internal leadership.

Now let me back up and explain this in more detail. Over the last several weeks, the Federal Reserve has made its QE intentions crystal clear. I’m surprised that they haven’t taken out a full-page ad in the Wall Street Journal.

The Fed’s main problem is that the economy is still grinding its wheels, as today’s GDP report shows, and interest rates are already at 0%. As a result, the central bank now plans to inject money into the economy by buying enormous amounts of U.S. Treasuries.

The only question now is “how much?” The general consensus on the Street is that QE2 will clock in around $500 billion, although some say it could be as much as $1 trillion. We’re really in unchartered territory here.

Personally, I think the plan will be less than the Street expects. Remember, the C in FOMC is for “committee” and that means compromises. We can expect uber-hawk Thomas Hoenig, the president of the Kansas City Fed, to be a “nay” vote, and he may be joined by one or two others. I expect an announcement of around $250 billion give or take, which may even cause a near-term pullback. Much like a pampered Hollywood starlet, Wall Street just loves to be disappointed when it receives favors.

So where will Bernanke and his buddies get all this cash? That’s easy. They have a magical super power where they can write checks out of thin air. Or, at least, they can create currency out of thin air. The U.S. dollar has already gotten smacked around in the currency pits lately, although it’s not nearly as bad as the dollar’s haters make it sound.

My thesis that the Fed’s purchasing of debt will lead an exodus out of Treasuries and into riskier assets may sound counterintuitive. The important point is that the market is already heavily tilted toward low-risk assets. Currently, there’s a lot of money—too much money—sitting on the sidelines. Moody’s Investors Service reports that U.S. companies are sitting on $943 billion in cash. Three companies; Cisco (CSCO), Microsoft (MSFT) and Google (GOOG) account for the largest portion. Hey, who needs the Fed? They could do a QE all by themselves!

The simple fact is, to paraphrase Jimmy McMillan, bonds are too damn high. In fact, the move out of bonds has already started. Yesterday, the yield on the 30-year Treasury closed at its highest level in nearly three months and it’s now over 50 basis points from its low point in late August. Not by coincidence, that was right when the stock market bottomed. In short, the stock rally has been at the expense of bonds.

What this means is that at long last, investors are finally choosing sanity over liquidity. Let’s look at some numbers: Since August 31, the S&P 500 is up 12.8%. That’s a nice run, but the growth side of the index as measured by the S&P 500 Growth Stock Index is up 19.3%. That’s nearly double the 10.4% gain for the S&P Value Index.

Here’s the key to understanding QE2’s impact: Don’t think of it as a stock movement. Instead, think of it as a risk movement with a seal of approval from the Federal Reserve.

Third-Quarter GDP Grew By 2%
Posted by Eddy Elfenbein on October 29th, 2010 at 8:31 am

The official numbers are in and the third-quarter GDP grew by just 2%.

That estimate matched the consensus forecasts for the gross domestic product, and is a slight uptick from the second quarter.

Though the recovery officially began in June 2009, growth since then has been tepid, at best. The economy expanded at a 1.7 percent pace in the second quarter, down sharply from a 3.7 percent rate in the first.

In recent weeks, the economy has presented two faces, which is reflected in the latest G.D.P. numbers. There have been fledgling signs of growth: home sales and chain store sales are up bit, a swelling stock market has raised consumer confidence a few notches, and jobless claims fell noticeably last week, albeit to a still quite high and painful level. At the same time, the steroidal effect of the stimulus spending is fading. City and state governments have shed tens of thousands of employees, and states face a sea of red ink as they look at next year’s budgets.

Sigh. This is yet another quarter of subpar growth. For the economy to truly recover, we need to see several quarters of GDP growth over 3%. Over 4% would be even better.

This report is the government’s first attempt at an estimate. The report will be revised two more times, at the end of November and at the end of December, and it will probably be revised a few more times after that.

The trouble is that the government tries to estimate the trade numbers for the last month of the quarter. They give it a good effort, but we never know exactly. For the third quarter, it turns out that trade knocked off 2% from the final number. Excluding trade, the economy grew by 4%.

Here are the GDP numbers for the past few quarters:

The good news, if there is any, is that the economy is no longer decelerating, meaning the rate of growth isn’t slowing.

That’s basically what all the Double Dip hype amounted to: it was all in the second derivative. We never dipped. We grew, but the rate of growth dipped. This report has shown a very, very slight acceleration. Very, very, very slight.

Over the last 10 years, real GDP has grown by 17.68% which is just 1.64% on an annualized basis. The economy has grown at a slower pace over the last 10 years than over the three-year period of 1963, 1964 and 1965.