The following graph from the Congressional Budget Office shows the projected output gap between actual and potential GDP with and without stimulus spending, i.e., the American Recovery and Reinvestment Act (see full CBO presentation). The CBO presentation highlights the implementation lags of fiscal policy, and illustrates why a stimulus package that stretches over 2 or 3 years seemed justified given that the CBO expected the GDP output gap to persist for longer than one year. Projections have only 24% of the money being disbursed in fiscal year 2009, 74% disbursed by the end of FY 2010, and 91% disbursed by the end of FY 2011.

Source: Congressional Budget Office

Given the back-loading of spending, and the realization that the recovery is not taking hold as quickly as most would want (except possibly by politicians up for re-election next year and looking for an election year boost), this is creating a problem now for both the administration and Congress. On the one hand, quicker, and more front-loaded stimulus seems warranted, yet data such as that provided by the CBO has been used to justify the huge delayed spending in coming years. Therefore, if the projections are correct, then patience is in order, but something tells me that is not going to fly as unemployment nears 10 percent.

So how do you speed things up? As outlined by the CBO, you could waive environmental reviews, award contracts without competitive bidding, or simply not dole out money by jurisdictions, but instead give money to those who can most efficiently spend it (shovel-ready project). The first one is a non-starter given the environmental shift of the current administration, the second is going to be difficult given the criticism that no-bid projects received in the last administration, and the last one is simply unacceptable to anyone in Congress - given their parochialism and the fact that it actually makes some sense (and of course, you need shovel-ready projects on a rather large scale - most are probably already funded).

So on the short-term, what needs to be done? The quickest way is through changes to taxes. This could come in rebates (which are relatively quick in non-tax months, but also somewhat ineffective when people are scared and the savings rate is increasing), or through lowering withholding (currently tried with the middle class, but not having the desired effect). This leaves suspending some income taxes for a period of time, or lowering income taxes on everyone, including the wealthy and corporations. Suspension is difficult to sell given the state, or perceived state, of social security and medicare needs, not to mention the growing deficit (even though lower rates can bring in higher receipts), while reducing taxes on corporations and the wealthy is anathema to most of those currently in power.

The limited real and political choices available has now caused the discussion to come full circle - backed to considering another stimulus. I forget - what was that definition about doing the same thing again and expecting different results? If President Obama is not able to convince the American public and Congress to be patient, we may find out the answer rather quickly.

While the focus on the recent June jobs report was on the number of job losses and the unemployment rate, the average workweek and average weekly earnings data was also not very encouraging. The average workweek fell to 33 hours, down 0.1 hours, taking it to its lowest recorded level going back to 1964 (see Business Week article). While hourly earnings remained flat, the shorter workweek caused average weekly earnings to also fall from $613.34 in May to $611.49 in June. With employed full-time workers scheduled for what is looking more like part-time work, consumer spending and consumer confidence will most likely continue to suffer. This will no doubt put pressure on consumer discretionary stocks and make the prospects of a jobless recovery more likely. Given that companies tend to increase the workweeks of existing employees, and even offer overtime to such employees before taking on the expense of hiring and training new employees, it may take a long time before consumer spending once again reaches the levels required to bring the average workweek back to normal hours. As a result, it may be a while before the Friday noon traffic is caused by workers once again going out for a business lunch, and not simply going home early for the week.

According to the recent TIM (Trade Ideas Monitor) report and the TIM Sentiment Index (TSI), institutional brokers increased 4.5% from 51.70 to 54.03 (see previous post or youDevise website for additional information on the TIM report). For the five trading days ending July 9th, the number of new long ideas as a percentage of new ideas sent to investment managers increased to 74.10% from 60.84% one week earlier (see last week's post). While the intra-week trend did fall, it later rebounded. To date, longs represent 58.64% of all ideas this year.

As for individual securities in the U.S. and North America, Western Union (WU) and DryShips (DRYS) were the stocks most recommended as longs by institutional brokers, while U.S. Steel (X) and Morgan Stanley (MS) were most recommended as shorts. The information technology, materials, and consumer discretionary sectors had increased broker sentiment for the week, while health care and energy had decreased sentiment.

Hedge funds posted their first inflows in nine months (see BarclayHedge article, free registration required). Based on a survey of over 1,200 hedge funds, it is estimated that the hedge fund industry gained $1.4 billion in May, or 0.1% of total assets. Nonetheless, funds-of-funds and CTAs are still experiencing outflows. Fund-of-funds, which did not do as good a job as expected picking hedge funds in order to justify their extra layer of fees, lost $5.2 billion, or 1.0% of assets in May. This makes their twelfth straight monthly outflow. Below is the hedge fund asset flow data by strategy for May 2009 (source: BarclayHedge, see article, free registration required). Next to fund-of-funds and managed futures, event driven strategies saw the biggest outflows. Equity long-short, fixed income, and multi-strategies saw the biggest inflows.

ALPS has launched a new Equal Sector Weight ETF of ETFs (EQL) that provides an equal weight position in each of the nine Select Sector SPDR ETFs (see IndexUniverse article). The fund rebalances the sector positions every quarter. The attraction of the fund, beyond not needing to invest in nine different ETFs in order to get sector diversification, is that it is designed to avoid over-investment in “bubble” sectors that may have run-up too far, too fast. When their strategy was back-tested over the last 10 years, the EQL strategy of reducing the spread in sector returns outperformed the S&P 500 by more than 3% per year. The EQL ETF charges 0.55% in annual expenses, which includes the assumed 0.21% in expenses for the underlying nine Select Sector ETFs. The EQL ETF sounds like an interesting and useful product, although it is not entirely clear how accurate one can measure when to reduce exposure to bubble sectors going forward.

There was an interesting interview on CNBC today with Ken Chenault, CEO of American Express. While Chenault spent half of the interview discussing the AXP brand and strategy, he also spent time discussing the economy in general, and credit card legislation specifically. Instead of simply pumping the economy and his company, Chenault was more sober and direct. In particular, during the first few minutes he mentioned that while recent government actions have produced stability and are giving signs that could potentially lead to "green shoots," it is too soon to call this a recovery. Around the 7:30 min mark he also comments on the proposed credit card reform. While he believes that some type of reform is necessary, he does not agree with some of the proposals regarding risk-based pricing, which could stifle growth and limit credit for those who may need it the most. As written, he is yet not convinced that the current proposed legislation will have a positive impact on the economy.

While Chenault has a dog in the fight, and company interest in the legislation, I believe he is right to expand the argument to the broader economy. While restricting the ability the price risk would reduce an extra source of revenue for the credit card companies, the impact on retail sales will also be negative, significant, and ultimately detrimental to growth (see previous post). Beyond the lost of revenue due to lower rates and fees, the inability to effectively manage risk can not be discounted, or its effect on helping to measure, control, and regulate systemic risk (see previous post).

Source: CNBC Video

CNBC interview with Nassim Taleb from earlier today. Of interest are the following observations:

1. Why trust the employment number forecasts being made? These forecasters did not forecast the downturn.
2. When the unemployment number has essentially doubled in less than a year, why worry about one monthly number? Error must be considered.
3. The current system is complex and fragile, and will eventually break and crash.
4. Instead of deflating debt, governments are trying to stimulate and inflate assets.
5. Monetary policy is out of control.
6. We need to convert debt to equity.

Source: CNBC Video

According to the recent TIM (Trade Ideas Monitor) report and the TIM Sentiment Index (TSI), institutional brokers became more bearish over the last five trading days as the TSI decreased 5.0% from 57.32 to 54.46 (see previous post or youDevise website for additional information on the TIM report). For the five trading days ending July 1st, the number of new short ideas as a percentage of new ideas sent to investment managers increased to 30.98% from 22.07% one week earlier (see last week's post), but the intra-week short trend did fall off its high of 35.26%. To date, shorts represent 41.46% of all ideas this year.

As for individual securities in the U.S. and North America, Tyco Electronics (TEL), Intel (INTC), and Electronic Arts (ERTS) were the stocks most recommended as longs by institutional brokers, while Chemspec International (CPC), Bed Bath & Beyond (BBBY), and First Solar (FSLR) were most recommended as shorts. The energy, information, and consumer discretionary sectors had increased broker sentiment for the week, while utilities and health care had decreased sentiment.

Now for a little fun (?). Below is a video of the 3 month to 30 year U.S. Swap Spread data from Bloomberg, animated and set to music. Who said Swap Spreads were not fun? Well, maybe just about everyone. This may not change your mind, but let us give a hat tip to Nick Gogerty for putting it together anyway.

Source: YouTube

Comments on electronic program trading and market manipulation from Joe Zaluzzi of Themis Trading (HT to the Zero Hedge blog). Interesting stuff.

Source: YouTube

In what is turning out to be more than just a little bit of irony, sovereign credit default swaps may end up being more widely traded when a new basket of 15 countries is launched later this year through the Markit iTraxx SovX Western Europe Index (see WSJ article). It is widely believe by many that the corporate CDS market was to blame in part for the recent financial crisis. To help clean up the mess and unfreeze the credit markets, many European and world governments have been borrowing massive amounts of money and injecting it into their economic systems in order to add liquidity. Unfortunately, the massive spending and borrowing are putting the credit quality of many these same countries into jeopardy, producing an unusual turn of events as CDS contracts are now being used to protect against default in those very countries which had too many companies with dangerous levels of CDS exposure. Now, not only can you trade CDS contracts to protect yourself against a country defaulting, but soon you will be able to trade a more diversified basket of sovereign CDS contracts. Profitable? Maybe. Of course if there is another massive default, I am not sure who will be left to bail out this market if spending continues at current levels. There is only so long you can solve a problem caused by too much debt by taking out additional debt. But, look on the bright side. At least now you can trade it. I guess financial innovation never sleeps.

Some investors in global and emerging market funds are starting to become nervous that such markets have risen too far, too fast (see Asian Investor article). After a nice run since early March, investors in emerging market funds that are tracked by EPFR Global have seen investors pulling a net $1.87 billion out of Asia ex-Japan, Latin America, Europe, Middle East, Africa, and diversified global emerging markets equity funds as of June 24th. High-yield bond and global equity funds also saw their string of consistent inflows stop, with the funds flowing into money market and U.S. bond funds. The reversal of flows has been driven in part by investor worries as to when foreign demand for manufactured goods and commodity exports will increase. Russia and Brazil equity funds, which are commodity dependent, are also posting new outflows.

As a few examples, the yearly charts for both EEM (iShares MSCI Emerging Markets Index) and the EFA (iShares MSCI EAFE Index ETF) reflect some of this indecision in the second half of June, but the trends are not unlike what has been observed in the S&P 500 Index over the same period.

Source: Bigchart.com

This slowdown in the bullish trend comes just as the International Energy Agency cut its expectations for medium-term global oil demand (see Financial Times article), with the recession diminishing the medium-term risk of a supply crunch as the spare capacity cushion remains healthy. Natural gas storage is also up (see EIA article) and above the 5-year historical range.

Yet, not everyone appear as cautious or nervous, with many analysts and traders still bullish (see SeekingAlpha articles here and here and here). In addition, as hedge funds are near completing one of their best starts of the year since 1999, many managers expected capital to continue to flow into their funds, especially those funds that are focused on emerging markets (see The Australian article). Given that many emerging market funds are commodity driven, then next few weeks/months should be telling as data on the summer driving season, housing, and currencies markets will help signal if the commodity correction has indeed arrived (see SeekingAlpha article), and whether or not emerging markets will continue their recent strength.

ETF Securities is now providing levered 2X ETFs on four popular European indexes (see Financial Times article, Citywire article). The eight ETFs being offered include both long and short exposure on the FTSE 100, Dow Jones Euro STOXX, CAC 40, and DAX. The four 2X short ETFs will carry annual management charges (AMC) of 60 bps. The 2X leveraged long ETFs will carry charges between 40 and 50 bps. The company is offering the ETFs to allow fund managers the ability to hedge portfolios in place of borrowing stock or using derivatives.

According to the recent TIM (Trade Ideas Monitor) report and the TIM Sentiment Index (TSI), institutional brokers became more bullish over the last five trading days as the TSI increased 12.7% from 51.96 to 58.54 (see previous post or youDevise website for additional information on the TIM report). For the five trading days ending June 25, the number of new long ideas as a percentage of new ideas sent to investment managers increased to 72.55% from 70.92% one week earlier (see last week's post). The intra-week trend was positive. Longs now represent 66.50% of all ideas in June.

As for individual securities in the U.S. and North America, Ashland Inc. (ASH), Bank of America (BAC), and Black & Decker (BDK) were the stocks most recommended as longs by institutional brokers, while Boeing (BA), Century Aluminum (CENX), and Microsoft (MSFT) were recommended as shorts. The information technology, industrial, and energy sectors had increased broker sentiment for the week, while health care had decreased sentiment.

Below is a video by Peter Navarro which explains how he uses a select group of international exchange traded funds to better help him time trades in the domestic market, in particular, the S&P 500 (SPY). The three international indexes he follows include the FXI (following 25 large and liquid Chinese companies, sometimes called the Dow of China - betting that as China goes, so goes Asia), the IEV (following the S&P Europe 350 Index), and the ILF (following the S&P Latin America 40 Index).

While I have not back-tested these specific indexes for providing leading signals, the video does remind us of the benefits of looking at other data for helping one to spot trends and even forecast movements in domestic indexes. A number of years ago I was engaged in some research that was looking to see if the S&P 500 could be used to help predict trends in various international indexes. After all, the feeling was that as the U.S. goes, so goes the rest of the world - or so we assumed. As our research progressed, and we began doing correlation studies, principle component analysis, information-based data mining, and everything else we could throw at the problem, it became clear that in many instances we had it backwards. The international indexes were more predictive in helping forecast the U.S. market. While some of these correlations broke down over time, it nonetheless helped send the message that we could not assume that the U.S. markets were always driving the world markets, or that the influence was always consistent, in either size or direction. While this is more clear today, and less of a surprise, it still seems as though few traders and investors use such information. The three international ETFs mentioned above are a good place to start your own studies.

In an interview with the WSJ, Gary Gensler, Chairman of the Commodity Futures Trading Commission, said he believes the most critical change needed in the oversight of derivatives is the regulation of dealers involved in derivatives (see article). He goes on to say that "only through the dealer can we get the whole panoply" of information regarding derivative contracts. Such a move would require customized contracts traded over-the-counter (OTC) to go through a central repository, similar to an exchange clearing house.

Gensler believes that "central clearing will further lower risk," but will it? While this is probably true initially, the long-run benefits could disappear. How so? Given that dealers will need to abide by stricter capital and margin requirements, the capital requirements will no doubt continue to grow as the added liquidity risk of less actively traded contracts is accounted for. While again this seems sensible, the extra cost will force even more contracts to move on to the exchanges. This will in turn reduce the amount of OTC contracts that are likely to be offered. Once again, all good, right? Not necessarily. One of the benefits of OTC contracts is that you can develop a specialized contract that better matches the risk you are trying to hedge. Standardized contracts do not offer the same flexibility, causing a company to enter into less than perfect hedges, thereby making the company more risky over the long-run. This has the effect of causing risk management to be more expensive and less efficient for companies, just at the time when additional risk management is being encouraged.

Once again, raising capital requirements on risky assets has some obvious benefits, but hopefully the added burden is not so much as to eliminate the efficient use of the OTC market. If this happens, regulators may find themselves dealing with yet another problem. In the mean time, I guess at least the exchanges (NYX, NDAQ, CME) will be happy as the potential for increased order flow continues to rise.

That great American philosopher Mike Tyson was once asked about whether it worried him that his opponent was training hard and seem to have developed a fight plan against him. Tyson respond with something to the effect of "Everybody has a plan until they get punched in the face". So true. Once you get knocked back on your heals, everything changes, with your plans often getting scrapped in the process. Traders and investors know the feeling all too well. Even the best made trading plans and analysis can be ignored after the market throws you a curve ball and administers the equivalent of a punch to the face.

All of this came to mind today as I was watching what seemed to be a muted reaction to the Fed decision, and more importantly, a reaction that did not fit well with the plans or expectations of many of the traders I was following on Twitter. When this happens, it is easy to start improvising, but of course, this is were new traders, and even those with experience, start to get into trouble. On such days I always find it useful to remind myself of some common mistakes to avoid, three of which are nicely presented in a new wallstcheatsheet.com article based on interviews with traders Joe Donahue and Joey Fundora (see article). While most mistakes fall into the category of common sense, it is still good to remind ourselves of them from time to time. The three mistake given by Donahue and Fundora, along with some added comments, include the following:

1) Not Selling Fast When You Are Wrong: Here it is important to remember that one of the most important metrics is knowing what you can lose on a given trade or investment. Of course, having an idea what you can make is also important, along with knowing what the risk-reward of the trade or investment is, but knowing when to cut your losses will keep you in the game. The old adage of "let your winners run, but cut your losses quickly" applies here. If you let the winners run, but have tight 8-10% stops on your losses, it is possible to be right less than half the time and still make money since you have kept yourself in the game for those times when your due diligence pays off, and the market finally realizes how smart you are.

2) Using Multiple Approaches or Strategies: This ties in somewhat with the Mike Tyson quote. While it is important to have a trading/investing plan and strategy in mind, you need to remember that every once in a while the market is going to punch you in face. During these times it is important to remember why to got into the trade and try not to stray or trade aimlessly or recklessly, simply chasing. Sometimes the best contingency plan is to simply walk away from the computer and shut your engines down for the day, giving yourself time to evaluate your strategy.

3) Trading Too Large: Trading small, or even paper trading, is always good advice for new traders. Stepping back on the amount of capital at risk is also good for experienced traders who have hit the wall and are not seeing trades and investment opportunities quite as they should. Even baseball players that consistently hit over .300 will lay down a bunt just to help them get out of a slump. Trading is no different - except you often don't get paid when in a slump, making it all the more tempting to swing for the fences. Discipline is key.

A few other common mistakes worth repeating include the following (adapted from here and here):

• Mistake 4.) Committing too much capital per trade
• Mistake 5.) Not effectively using different time frames
• Mistake 6.) Not using technical analysis (using only fundamentals, especially for short-term trading)
• Mistake 7.) Not paying attention to what the market indexes are doing
• Mistake 8.) Not being selective enough, and taking the time to screen for the best opportunities
• Mistake 9.) Not paying attention to volume
• Mistake 10.) Not paying attention to sectors (and industry trends)
• Mistake 11.) Not knowing what to expect from the trade (risk versus reward)
• Mistake 12.) Being greedy and not leaving the party soon enough
• Mistake 13.) Following the crowd too long, or too late in the move (chasing the market)
• Mistake 14.) Immediately reversing the trade once it goes against you
• Mistake 15.) Trying to pick tops and bottoms
• Mistake 16.) Losing your cool and letting your emotions cloud your thinking
• Mistake 17.) Waiting too long to pull the trigger after the analysis is done
• Mistake 18.) Trading too many markets at once
• Mistake 19.) Assuming the news you just read has not already been discounted by the market
• Mistake 20.) Relying on tips or talking heads without doing your own analysis.

I am sure there are many more, some that you think don't apply, and probably even a few other mistakes not mentioned that I continue to make myself. Here is hoping that looking at the list causes you to remember why you have succeeded in the past, and why you continue to be a successful trader / investor - or at least reminds you to walk away or just bunt every now and then.

Traders who are clients of StreamBase are using software developed by the company to scan Twitter for information that can be utilized by their algorithm-based automated trading platforms (see Telegraph article). While the company is not specific about who is using the software to follow Twitter feeds, current clients of the company include the Royal Bank of Canada and hedge fund BlueCrest Capital Management. Those using the software to monitor the Twitter feeds hope their automated trading platforms can utilize breaking news that has not yet been filtered by providers such as Reuters Thomson or Bloomberg. One trader mentioned how using a broadcast tool such as Twitter would allow them to further take advantage of the ability to "buy on the rumour and sell on the facts." Given the volume and variety of the content you find on Twitter, or for the matter, any message board or social networking site, the term "rumor" is probably a little generous in many cases. For their sake, let us hope that those firms following any social networking site have a good AI system for separating the wheat from the chaff. This tasks is hard enough when all you are following are those slow "filtered" news sites.

The Institute for Financial Analysts polled its members and found that they no longer believe in efficient markets, or at least that prices reflect all information (see hedged.biz article). So, is stock investing based on fundamentals a waste of time? After all, information is more prevalent now than every before, and new information (for the most part) is suppose to be shared equally. If prices are not reflecting fundamentals, then surely, efficient market theory is lacking. As a kind of compromise, some will argue that while the markets are efficient, the participants are not, each analyzing the news, information, and data differently. It is felt that this is where some of academia has gone wrong - assuming that all participants interpret new news in the same way (although those in behavior finance might beg-to-differ).

Unfortunately, this view usually creates more confusion given that for many the participants are the market, such that as long as there are human traders, there will be fear, greed, and pricing anomalies. This is why it is often felt that being a fund manager is as much about understanding historical patterns and psychology, as it is about knowing the fundamentals. The irony is that as the flow of information has become more efficient, given the Internet and the 24-hour new cycle, one could speculate that the market may have actually become less efficient. Now freshly armed with new information, you have even more traders and investors trying to figure it all out, each with their own biases, over-reactions, and in some cases, somewhat predictable herd behavior. Such inconsistencies will no doubt keep market participants looking for alpha, all the while allowing fund managers and technical analysts to continue to thumb their noses at those in the ivory tower.

Over at the Clusterstock blog (poster John Carney), there is an interesting discussion/insight from Michael Lewis into the new regulatory reforms being introduced by the Obama Administration (see article here, original video link here, and embedded video below). A few days old, but worth a look. Interesting, and a little depressing.