Paul is a client.  He is a very intelligent entrepreneur with a successful business.  He wisely chooses to diversify his principal business by taking profits and investing.  His question is one facing every individual investor.  When and where should he invest?

Paul is frightened.  He reads extensively.  Most of what he reads is, simply put, doom and gloom.  He visits all of the most popular investment blogs and also follows the commentary from the key mainstream sites.

We realize that Paul’s approach is not typical of the average reader of “A Dash” or readers of the big traffic blogs.  He is more skeptical and open-minded than most.  He wants real answers.  Here is the conversation.

A Dialog

Paul:  The market looked terrible.  I pulled all of my investments from other funds.  Everyone says that we are on the verge of a deep recession.  The indicators are all negative.  But I am confused.  I have questions.  Why do my favorite sources say that a 300 point rally in the Dow is “confirmation of a bear market?”

Jeff:  The analyst is looking at big moves in what is described as a bear market rally.  It is a way of looking at results and then projecting the future.

P:  Is this a strong method?

J:  We are always nervous when there are only a few cases and we try to make projections.  It is also better to use percentages in evaluating long-term data.  Barry Ritholtz astutely noted some reactions on this theme.

P:  Does it change if there are two 300+ days in a week?

J:  We do not know of any research on a double 300 week, but there is a strong update on the initial question from Bespoke Investment Group.  They noted that the conditions of bull and bear markets were somewhat subjective.  Their conclusion was that the market generally moved higher in almost any time period mentioned.  They did not address the “double 300″ situation.  Read the entire article.

P: What if there were another big day?

J:  You are kidding me.  I am trying to explain the bearish perspective for you!  At some point, everyone would recognize a new trend.

P:  OK.  What about oil?  I understood the problem when oil prices were moving higher.  This meant that there was top-line inflation.  It would hit consumers, cut spending, put the Fed in a “box” where higher inflation forced higher interest rates.  Now oil prices are coming down.  The same sources tell me that this is an indicator of “demand destruction” and shows that the global economy is failing.  What’s up?

J:  We share your confusion.  We prefer intellectual honesty in indicators.  There is something wrong when the same source tells you that rising oil prices are bad and falling oil prices are also bad.  Will these sources take note of declining headline inflation?  More consumer spending power?  In the past, such sources have used phrases like “oil prices remain elevated.”  We shall see.

P:  How about the yield curve?  Is it still inverted?  What does this suggest about a recession?

J:  The yield curve inversion theory is pretty loose.  A year ago we pointed this out, citing the “Will Rogers” of yield curves.  It is supposed to predict a recession, and it may have succeeded.  This assumes, of course, that one allows plenty of latitude on timing.  The curve now has a positive slope.  Those who used it to predict a recession have generally fallen silent on what this means for the future.

P:  Isn’t that inconsistent?

J:  Yes.  Anyone who wants to look forward on the economy would use the same indicators.  This might be one way of discovering who is starting with the conclusion and who is starting with data.

P:  These all seem like very simplistic indicators.  Earnings reports are also hard to read.  Financials are bad, energy is good.  How can one decide?

J:  As you know, our indicators shift with the times.  Over the last few months we have been bearish, neutral, and now bullish.  Looking at a wide range of information is better than a fixation on some simple heuristic.

Conclusion

There are no easy answers in forecasting economic growth, profits, or stock prices.  Sometimes the stock price already reflects a pessimistic assumption.  That is what we currently see.

It is a skill that requires knowledge and experience.  Most investors read about the economy and stop thinking.  They never ask whether stock prices reflect opportunity.

Last 5 posts by Jeffrey Miller

• A Tough Nut to Crack - October 29th, 2009
• ETF Update: Looking to the Internet - October 25th, 2009
• Healthcare Reform Becoming Less Likely - October 21st, 2009
• ETF Update: Another Look at the Banks - October 18th, 2009
• Identifying Quackery (and Other Mistakes) - October 6th, 2009