Effective Market Management: Art & Science

By Notes From the Rabbit Hole

saul steinberg
From Saul Steinberg’s 1954 drawing ‘The Line’

The notion that there is art involved in interpreting the economy and financial markets is probably heresy to many market participants and probably 99.9% of economists (that .1% guy being the one who’s excluded from the meetings and egghead social gatherings), whether they be right or left leaning (I always find it entertaining to hear right wing and left wing economists duke it out, as I did on NPR yesterday, coming to diametrically opposed conclusions amid the tax reform debate).

You see, economists are trained by their science to follow the data. Now, the politics get involved when they cherry pick which data to highlight and extrapolate; but the data are the data. As an example, we all know that inflation is very tame now because TIPS yields are low, the 10 year Treasury yield is still low by historical standards and despite robust employment, cost-push inflation is simply not manifesting.

So what does the conservative economist do? He extrapolates this Goldilocks scenario well into the future, just as the liberal economist did before him when it seemed convenient. It’s called playing for a punt or expecting the can to continue getting kicked down the road because after all, the data point that way. There are few signs of stress on the near horizon.

But that is the point. In placing two feet in two different disciplines (hard data and psychological freedom from it’s directives) a big part of NFTRH‘s success in illustrating and successfully navigating markets has been had.

Examples?

  • In 2012 the gold sector did not do what it was supposed to do according to the money supply data amid the coming of QE3 and legions of cheering gold bugs. HUI later went on to break a key parameter (we called it the “460 parameter”, for the key support level that was broken) and much though I was a gold bug at heart and did not know why the sector was going bearish, the combination of data interpretation and technical analysis (a black art, not a science) led to a negative view that we had to abide by, no “ifs, ands or buts” as I used to note at the time.
  • In October 2014 the Semiconductor industry had a mini meltdown because a Semi company that Wall Street analysts deemed a “canary in a coal mine” (Microchip Semi) reported a negative view for the industry. See Microchip Tech Could Be Warning of a Market Top. We resisted this herding…

…and noted the following in this December 2014 post.

We should not discount the significance of the scary test of major support [by the SOX index] in October. That, along with the associated negative hype as Microchip Semi’s weak guidance* was broadcast far and wide, could actually end up being the fuel for [an upside] blow off scenario [1].

* As you know, media hype is a source of frustration for your letter writer because he tries to be honest and hype-free in taking on the responsibility of writing about markets and the economy for you.  That is why you endure me calling the ‘Fiscal Cliff’ drama from 2012 a Kabuki Dance, calling the Eric Sprott interview (Ebola may lift gold and silver prices!) in the Gold Report a disgrace… Cyprus, Greece, Ukraine… the media (and certain lazy analysis) get a hold of these things and try to use people’s emotions to promote viewpoints.

The latest example was when supposed Semiconductor bellwether Microchip Semi released unpleasant guidance and the market freaked out [and SOX tanked].  We called it hype at the time and what do you know?  Now they are out with a brightened outlook…

Global Semiconductor Outlook Brightens, Microchip Sees Sales Rebound 

Chief Executive Steve Sanghi said the company has seen an improvement in bookings and billings since October.  “We are now even more confident that the small correction that we experienced in the September quarter is behind us,” he said.

You just cannot make this stuff up.

[1] We are not predicting a stock market/Semi sector blow off, but are open to its possibility.

So tell me Beuller, what did the Semi sector go on to do? Why, it blew up our ‘best’ upside target of SOX 930, eventually reaching 1169 just a couple of weeks ago.

Do you want to know where all the data honks and quant nerds were when Microchip issued its negative warning in 2014? They were selling into a low that would go on to form the basis of a massive upside blow off. All we had were the SEMI equipment bookings data, which below the surface were indicating all was fine, and a SOX chart that remained intact to its long-term breakout.

Dialing ahead to today and taking a more macro view, we find economic data nerds computing expected inflation by looking at TIPS yields, nominal Treasury yields and their relationships (i.e. yield spreads). And that is all good stuff because it keeps us right with the markets. I am by no means saying that you should do opposite what the signals say (that would be contrarianism gone wrong). I am saying that they can be used as a short-term guide but distortions are hard wired into the modern financial system and its markets, and that these should not be extrapolated long-term, as hard science.

Proof? Well, if you consider ever-growing trillions of dollars in national debt and a Fed balance sheet stuffed to the gills with previously unwanted products to be normal and good, then I have no proof. But if you consider that all those soon to be slowly regurgitated ‘assets’ planted into the Fed’s balance sheet through QEs 1-3 (and the market distorting* Operation Twist) to be conspicuous (at best) to a healthy situation, you may realize that the equation may not be as simple as 1+2 = 3 in, and 3-2-1 = 0 out.

There’s a lot of ‘art’ embedded in there. Proceed accordingly. While I have an operating plan that sees good potential for a significant market correction out ahead, the artful side of me is prepared for the opposite as well (unfettered asset appreciation, likely through a suddenly apparent inflation problem). Either way, it will be the product of systemic distortion, which is all the more reason to supplement data (science) with art.

* Op/Twist was the definition of a market distortion as its stated goal, in the word of the Bernanke Fed itself, was to “sanitize” inflation signals.

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