The economic calendar is heavy. In the battle of competing explanations for the market declines, the inflation story has taken center stage. With both PPI and CPI scheduled for release this week, I expect many to be asking:

Will rising inflation spark another leg down for bonds and stocks?

Last Week Recap

My last edition of WTWA will go down as a personal favorite. My objective is to help investors plan for what might be coming. Reacting is always easier if you have a plan. If you read last week’s installment, you should not have been surprised by anything that happened during the week. Many of the best investment minds were on TV or writing during the week, emphasizing the continuing sound fundamentals. They were correct, of course. I hope that readers were able to prepare in advance, understanding the unfolding events.

Now if I can only do half as well in the week ahead!

The Story in One Chart

I always start my personal review of the week by looking at a great chart. I especially like the Doug Short design with Jill Mislinski updates and commentary. You can see many important features in a single look. She includes not only the price changes, but also volume and helpful callouts. The entire post includes a great collection of charts and analytical observations.

The decline for the week featured a 9% trading range! Remember all those weeks when the range was only 1%? It was a time of abnormal behavior – a long time. A 9% move is also abnormal. The long-term average for the VIX is 19.

A key question is how long the current decline might last, and how large it could be. As a starting point, this history of drawdowns over the last ten years is quite helpful, especially given last week’s action.

Drawdowns of 5-10% are completely routine, often occurring several times a year. The last two years have been quite unusual.

A Good Question from Eddy

Eddy Elfenbein is the best at finding key points and explaining them effectively. I subscribe to his feed and follow him on Twitter. He asks, is this a good time to buy? He cites many of the comments we all hear right now. (Answer at the end of today’s post).

The News

Each week I break down events into good and bad. For our purposes, “good” has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!

The economic news remains very positive, despite the reaction of the markets this week. New Deal Democrat’s weekly comprehensive indicator update should satisfy even the nerdiest observer. I read it every week. Here is his conclusion for this week:

It is important this week to emphasize that I use this information for forecast the economy, not the stock market.  Stocks were melting up at a 48% annual rate since the beginning of September, so even the 10% correction this week, they did not make a 3 month low! Thus they remain a positive in this forecast. Aside from several long leading indicators, the only other weak spots were steel and rail carloads.

The Good

• Budget deal. The result left plenty to complain about, which is the normal result of compromise. For investors, the fact of an agreement is good news. Markets are always challenged by uncertainty, and these issues have been linked to major declines in the past.
• Sentiment is less bullish. This contrarian indicator seems to follow the market. Bespoke shows the recent history.

• ISM services reported a headline reading of 59.9 up from 59.0 last months and more than three points better than expectations.
• Initial jobless claims declined to 220K, from 230K last week. This was also better than expectations of about 236K. (Bespoke).

The Bad

• The December trade deficit increased to $53.1 Billion, worse than the prior month’s $50.5B and expectations of $52.3B.
• JOLTs was viewed as negative by those with a fixation on the slight decline in job openings. Since so many misinterpret this report, I’ll score it as a negative. When will any analysts start citing the Beveridge curve and labor market structure? The Daily Short had a more perceptive look at the data.

The Ugly

This week’s ugly award goes to the short volatility products. These were supposed to provide consistent modest growth. Investors looking at past performance would have seen no reason for alarm. Individual investors lost 80-90% in the collapse and closing of these products. Many probably did not understand what they were buying.

But we all were affected by the ripples. Hedge funds were big players and used leverage to magnify the modest gains. Robin Wigglesworth (The FT) provides a good explanation.

Investors often also use volatility as a proxy for risk, embedding it into many algorithmic trading strategies. For example, if a fund has a volatility target of 10 per cent and the stock market is twice as turbulent then they automatically hold more cash to hit their target. If markets are tranquil, they use leverage to increase their exposure. In practice, they are short volatility.

Barclays estimates that the deleveraging could lead to sales of $225 Billion in stocks – and that was the Tuesday estimate. At this point no one really has a good figure. We do know that as the trade unraveled, the required selling increased volatility even more and exacerbated the situation.

The Week Ahead

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.

The Calendar

We have a big economic calendar. Since so many believe that the threat of inflation is the major cause of the market decline, I expect extra attention to that data. We’ll also get an inkling of whether the stock market decline has affected consumer sentiment, since the preliminary Michigan interviews include the first 14 days of February. The NFIB survey is based strictly on January.

Those more interested in economic growth have important reports on retail sales, housing starts, and industrial production.

Briefing.com has a good U.S. economic calendar for the week (and many other good features which I monitor each day). Here are the main U.S. releases.

Next Week’s Theme

The big economic calendar will probably take second chair to market gyrations. The key releases will be the CPI and PPI, with the former report atypically coming first. With so much focus on the wage growth in the employment report and possible Fed policy, expect the punditry to be asking:

“Will rising inflation spark another leg down for financial markets?

As usual, there is a range of opinion. Everything I read includes blame for the decline, dodges any responsibility, and offers a solution featuring their own product. I am not going to include links, but I saw them all. There is so much claimed certainty, and so little evidence.

• Get out now! There has been a financial epiphany. People have realized the risk in current market valuations, and a crash may follow. What I have been saying for the last ten years is about to happen.
• This has nothing to do with unusual financial products or any financial engineering. Our products (including sexy names like risk parity and targets) are still quite attractive. We are experts and you are not.
• My technical analysis method shows exactly where you can expect support in the market. Sign up now for my newsletter.
• The volatility demonstrates the risk in normal markets, fiat currency, escalating debt, and the Fed. Buy gold.
• Risk too high for you? Buy my high-commission product that guarantees no losses and a share of gains (if we remain solvent).
• Market action is all about short term trading, with little implication for investors.
• Stay the course. If you own the right proportion of stocks and bonds you should ignore gyrations like this.

As usual, I’ll suggest my own interpretations in today’s Final Thought.

Quant Corner

We follow some regular featured sources and the best other quant news from the week.

Risk Analysis

I have a rule for my investment clients. Think first about your risk. Only then should you consider possible rewards. I monitor many quantitative reports and highlight the best methods in this weekly update.

The Indicator Snapshot

For the first time in months we have a touch of red on the screen. The short-term market health is now neutral, and could turn negative in a few days if there is further market deterioration. If this happens we will exit some or all trading positions. Long-term indicators remain bullish, in line with the conclusions from our fundamental analysis.

To emphasize: None of this is a forecast of future market action or an attempt to call a market top. It is a reaction to heightened risk. Being careful about risk might well reduce performance, but you can have more confidence in your ability to live and fight another day.

The Featured Sources:

Bob Dieli: Business cycle analysis via the “C Score.

RecessionAlert: Strong quantitative indicators for both economic and market analysis.

Brian Gilmartin: All things earnings, for the overall market as well as many individual companies.

Doug Short: Regular updating of an array of indicators. Great charts and analysis.

Georg Vrba: Business cycle indicator and market timing tools. None of Georg’s indicators signal recession. His business cycle index, which we use in the Indicator Snapshot, is no longer “on the peg” at 100, but does not indicate a recession. Here is the current look:

Guests:

James Picerno provides a good explanation of actual volatility and VIX, indicators that we follow each week.

“Davidson” (via Todd Sullivan) has an excellent explanation for why the TBill/Ten-year note spread is so important.

He cites this as one of the best indicators not in current use. His conclusion?

The T-Bill/10yr Treasury rate spread shifting to 1.35% is a strong indication that lending is likely to expand, the economy should accelerate, and equity markets should rise in response the next couple of years. The best estimate looking through the current ‘Fog of Volatility’, is for significantly higher equity markets 3yrs-5yrs from today. This is the long-term perspective not tomorrow’s trade.

Insight for Investors

Investors should have a long-term horizon. They can often exploit trading volatility! I remind investors of this each week, but now is the time to pay attention.

Best of the Week

If I had to pick a single most important source for investors to read this week it would be Ben Levisohn’s Barron’s article, After Correction Pain, More Market Gain? He provides a measure interpretation of recent action, which is needed by investors who are too interested in short-term moves in their accounts. It is a nice article, and this is a key element:

Still, the market needs a narrative—and so it’s latched on to whatever’s handy, in this case that the Fed is so far behind the curve that inflation will spike and bond yields will soar. As with many good stories, there’s a kernel of truth to this one. Inflation is picking up, bond yields are heading higher, and the Fed is behind the curve, says Richard Bernstein, chief investment officer at Richard Bernstein Advisors. Many had been reluctant to embrace that idea. Now they may have no choice. “The employment report destroyed the narrative that there would never be inflation again,” says Bernstein, who doesn’t foresee the correction becoming a bear market. “And that caused chaos at this point.”

Stock Ideas

Amazon (AMZN) is a mystery for some value investors. Bill Miller is not mystified. He owns a big stake and explains that the company is clearly earning money. It is just not showing up on the traditional metrics. Chuck Carnevale’s cash flow analysis helps to explain. As always, we also get a helpful lesson in using his excellent tools.

See David Brenchley (Morningstar) for another take.

Blue Harbinger (on Monday) published a list of 100 high-yield stocks and highlighted five that were worth considering.

A sports investment? Usually only billionaires can own baseball teams, but now you have a chance. You can also be an owner of the Packers if you wish, but you get no dividends and there is no market for your stock. That’s loyalty! And also, here is a sports-related investment that was a top choice in January – up 900%.

Is Allergan (AGN) cheap? Stone Fox Capital analyzes the fundamentals.

How does PepsiCo (PEP) compare to competitors? D.M. Martins Research looks at the fundamentals and recent history, including the chart below. (Take note of the risk—or reward– of buying in front of Tuesday’s earnings report.

Peter F. Way analyzes Facebook (FB), Amazon, and SPY using the expected ranges implied by market-maker action. This is a good explanation of his method, and a conclusion that might surprise you.

“Ultra-safe” utility stocks? Lee Jackson (24/7 WallSt) screens the Merrill database for five candidates.

Or you can look at “tech giant” candidates from the same source.

Russia? 40% cheaper than other emerging markets.

...

Abnormal Returns has a special Wednesday focus for individual investors. There are a variety of ideas, and nearly always something you will find useful. I especially liked this week’s citation of Ben Johnson’s (Morningstar) analysis of 3 Investing Mistakes to Avoid. Great advice.

We spend a huge amount of time trying to make smart decisions with our money. I think its possible that we could add just as much value—if not more—by avoiding dumb ones.

The most costly errors we make as investors tend to be mental ones. Being aware of our biases is an important first step in preventing these errors. But awareness alone will not suffice.

By focusing on the handful of things that we can control, keeping our eyes trained on our long-term objectives, and tuning out the noise in the market, we can boost our odds of building and sticking to a plan that will help us to meet our goals.

Watch out for

Junk bond ETFs, doing worse than the underlying issues (WSJ).

Hedging via gold or Bitcoin. Neither has worked well despite claims of those selling these products.

Final Thoughts

Last week’s financial news was an invitation for those selling fear and their own solutions. It is difficult to identify a single source of the fear, but much of it settled on inflation and the Fed. This is a light-switch change from recent worries that the Fed was not hitting its two percent inflation target. This contradictory commentary frequently came from the same sources! Whether inflation is too low or too high, their solutions are the same: bonds, annuities, gold, or a structured note.

The inflation story will require more than a few data points to establish a new trend. The Fed is far from excessive tightening. Increasing inflation and interest rates are just fine, if economic growth and corporate earnings increase as well.

This understanding may be the single most important challenge for investors. It is so easy to fall for the slogans and pop economics. “Don’t fight the Fed” is good advice when the increases are a likely precursor to recession. It is a nonsense slogan when interest rates remain low, and it is pure speculation about the magnitude of future Fed policy. This recent article from the St. Louis Fed team helps to explain why inflation has been so low.

Regardless of the initial spark, last week’s trading reflected various characteristics, some unusual and others traditional.

• Volatility led to stock declines rather than just following. The blowup of funds in the “short-volatility” trade required the sale of stocks as an offset.
• ETFs were the vehicle of choice for many sellers. Good stocks get dragged down along with the overvalued.
• Technical trading drove markets. When there is no other benchmark, traders develop one through their favorite methods. Retesting old lows, Fibonacci retracements, and favorite moving averages are all in play. The many experts on where “support” in the averages might be are in their element.
• Margin calls influenced intra-day trading, both in the morning and the afternoon. These bouts of forced selling occur faster than in days past and can continue day after day.

If there is another test of the 200-day moving average (about 2540), there could be a breakout move. Many traders and some investors have stops set slightly below this point. Others know this and may try to exploit it. Investors can watch how this plays out but should not feel compelled to take immediate or mechanical action.

Last week I asked, “Do you have a plan? If not, you are a potential victim of everyone selling fear and making their profit from gold, page views, annuities, bitcoin, or newsletter subscriptions. Bill Miller: “Why would you sell because others are selling? You should have an idea of what businesses are worth and buy when there are opportunities”.

Here was my own stated plan:

1. Stick to the fundamentals, especially recession signs and earnings news.
2. Rely on actual proven, quantitative measures, not hype.
3. Normal selling of some winners that hit price targets and trimming my largest holdings has left me with a little more cash than usual. I did not begin buying on Friday, but I expect to go shopping next week. I joined many others in taking a wait-and-see attitude about events this weekend.
4. I am perfectly willing to become less bullish, if the economy and earnings get worse.

In the event, I did not do much buying, but I expect to next week.

Investors should not think like traders. Do not try to time these market swings. Adjusting for risk is a different matter. Your existing positions should always be within both the normal ranges of variation and your own comfort zone.

I’m more worried about:

• Trade issues. While still limited in scope, retaliatory measures are showing up with two major trading partners – Canada and China.
• The escalation of partisan rhetoric over the FBI. This is difficult to quantify so far, but voices are getting louder.

I’m less worried about:

• Korea. There is some sign that the Olympics are having a positive effect.

• The overall market decline. It is a normal part of investing, illustrating the difference in time frame between traders and investors.

______________________

Eddy’s answer? He notes that it is understated, since the chart ends at the beginning of a big bull market.