FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 1/10/2014

The very big picture:

In the “decades” timeframe, we are in a Secular Bear Market which began in 2000 when the P/E ratio (using Shiller’s Cyclically-Adjusted P/E, or “CAPE”) peaked at about 44.  The job of Secular Bear markets is to burn off outrageously high P/E ratios over one or two decades, until finally the P/E ratio arrives back at a single-digit level, from which another Secular Bull Market can emerge.  See graph below for the 100-year view of this repeating process.

If history is a guide, we may not yet be done with this Secular Bear Market.  The Shiller P/E finished the week at 25.5, down from the prior week’s 26.2, and is now approximately at the level reached at the pre-crash high in October, 2007.  Even though P/E’s are substantially lower than their crazy peak in 2000, they are nonetheless at the high end of the normal historical range and leave little if any room for expansion.  This means that the stock market is unlikely to make gains greater than corporate profit growth percentage, if that.  (note: all P/E references are to the Shiller P/E values, sometimes called PE10 or CAPE, which are calculated so as to remove shorter-term fluctuations; see robertshiller.com for details).

In fact, since 1881, the average annual returns for all ten year periods that began with a CAPE at this level have been just 3%/yr (see graph below).

This further means that above-average returns will be much more likely to come from the active management of portfolios than from passive buy-and-hold.  Although a mania could come along and cause P/E’s to shoot upward from current levels (such as happened in the late 1920’s and the late 1990’s), in the absence of such a mania, buy-and-hold investors will likely have a long wait until the arrival of returns typical of a Secular Bull Market.

In the big picture:

The “big picture” is the months-to-years timeframe – the timeframe in which Cyclical Bulls and Bears operate.  The US Bull-Bear Indicator (see graph below) is at 76.3, up from last week’s 75.8, and still solidly in cyclical Bull territory.  For more than a year, the US Bull-Bear Indicator has pushed further into Bull territory than other global asset classes, reflecting the higher strength of the US relative to the rest of the world.  The current Cyclical Bull has taken the US to new all-time highs, exceeding the highs of 2007, but most of the world’s major indices have barely matched 2011’s highs, let alone approach 2007’s levels.

In the intermediate picture:

The intermediate (weeks to months) indicator (see graph below) is in positive status and stayed at 35, unchanged from the prior week.   Separately, the quarter-by-quarter indicator – based on domestic and international stock trend status at the start of each quarter – gave a positive indication for the prospects for the first quarter of 2014.

Timeframe summary:

In the Secular (years to decades) timeframe (Figs. 1 & 2 above), the Secular Bear still is in force as the long-term valuation of the market is too high to sustain a new rip-roaring Secular Bull.  In the Cyclical (months to years) timeframe (Fig. 3 above), all major equity markets are in Cyclical Bull territory, with the US being far stronger than any other major market.  The Bond market is in Cyclical Bear territory as of June 7th.  In the Intermediate (weeks to months) timeframe (Fig. 4 above), US equity markets remain in positive status.  The quarter-by-quarter indicator gave a positive signal for the 1st quarter:  both US and International equities were in uptrends at the start of Q1, which signals a higher likelihood of an up quarter than a down quarter. 

In the markets:

Save for the Dow Jones Industrials, US indices were positive for the week, averaging a +0.7% gain.   Canada’s TSX was more positive, at +1.5%.  International indices were split, with most developed markets gaining an average +1.2% while emerging markets averaging +0.4% although several big components, like China and Brazil, were negative.

The big news of the week was the December US jobs report, which shocked everyone at only +74,000, a third of the average prediction.  Markets everywhere were affected, with the currency and bond markets being affected most.  The 10-year yield fell by the most in several months.  In a seeming non-sequitur, the unemployment rate fell sharply, to 6.7%, the lowest since October 2008.  The data revealed, however, that the decline was for the worst of reasons: 347,000 workers dropping out of the workforce, reducing the number of the officially “unemployed” (since those who have given up looking for work are no longer counted as unemployed).

In Canada, the news was actually worse, as Statistics Canada reported a loss of 45,900 jobs in December.  The monthly loss means Canada’s economy only added 102,000 jobs for all of 2013.  Ontario lost 39,000 jobs during the month and even resources-rich Alberta, a source of recent strength, shed 12,000 jobs.  The Loonie, Canada’s dollar, proceeded to touch a four-year low.  Several important retailers reported negative year-over-year comparisons for the holiday season, a major disappointment.  Women’s apparel retailer Reitmans said holiday sales fell -5.3% per cent, Target said poor holiday sales at its Canadian stores will have a big impact on fourth-quarter results, and Sears Canada reported a  –4.4% holiday drop.

In the European Union, employment was also headline news this week.  Eurostats (the EU’s statistical arm), reported the overall unemployment rate in the eurozone at +12.1%, the same as in April.  Germany is at just 5.2%, but France is at 10.8%, Italy 12.7% (vs. 11.3% a year ago), Cyprus 17.3%, Greece 27.4%, and Spain 26.7%. Even the Netherlands has risen the past 12 months, from 5.6% to 6.9%.  Ireland wins the prize for “most improved”, with its unemployment rate down to 12.3% from the year-ago 14.3%.  Youth unemployment remains shockingly high for the peripheral countries, however:  Greece has a youth jobless rate of 54.8%, Spain 57.7%, Portugal 36.8%, Italy 41.6%.  A generation of working-age citizens is maturing with no work experience.

China’s HSBC manufacturing Purchasing Managers’ Index (“PMI”) showed a slowing pace of expansion in December at 50.5.  HSBC’s companion figure for the service sector for December came in at 50.9 vs. 52.5 in November, a six-month low, while producer prices fell a 22nd straight month.  December exports rose a disappointing 4.3% last month, compared to a much higher 12.7% increase in November.  Overall, a picture of stalled to tepid growth.

(sources: Barrons, Wall St Journal, Bloomberg.com, ft.com, guggenheimpartners.com, ritholtz.com, markit.com, financialpost.com, Eurostat, Statistics Canada, Yahoo! Finance, stocksandnews.com)

The ranking relationship (shown in Fig. 5) between the defensive SHUT sectors (“S”=Staples [a.k.a. consumer non-cyclical], “H”=Healthcare, “U”=Utilities and “T”=Telecom) and the offensive DIME sectors (“D”=Discretionary [a.k.a. Consumer Cyclical], “I”=Industrial, “M”=Materials, “E”=Energy), is one way to gauge institutional investor sentiment in the market.

The average ranking of Defensive SHUT sectors rose to 18.3 from the prior week’s 19.8, while the average ranking of Offensive DIME sectors fell slightly to 7.8 from the prior week’s 7.5.  The Offensive DIME sectors kept their substantial lead over the Defensive SHUT sectors.

Note: these are “ranks”, not “scores”, so smaller numbers are higher and larger numbers are lower.

Summary:

The US led the recovery from 2011’s travails, and is the strongest among all global markets.  However, the over-arching Secular Bear Market may remain in place even as new highs are reached in the US.

Because we may still be in a Secular Bear, we have no expectations of runs of multiple double-digit consecutive years, and we expect poor market conditions to be a frequent occurrence.  Nonetheless, we remain completely open to any eventuality that the market brings, and our strategies, tactics and tools will help us to successfully navigate whatever happens.