FBIAS™Fact-Based Investment Allocation Strategies for the week ending 1/24/2014

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 24.9, down from the prior week’s 25.6, and 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 72.2, down from last week’s 76.1, 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 dropped to 32 from the prior week’s 35.  A further drop to 28 would turn this indicator to negative status.   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:

Markets worldwide retreated sharply this past week.  In the US, indexes lost an average -2.3%, with the Dow leading the way lower at -3.5%.  SmallCaps and the Nasdaq did the best, at -2.1% and -1.7% respectively.  Canada’s TSX fared considerably better at -1.2%, buoyed by the commodity, precious metals and tech sectors.  Gold and gold miners did considerably better, with gold scoring a +1.1% gain on the week, and commodities as a whole +1.8%.  International markets continue to perform worse than the US, with the Emerging Markets down an average -3.9%, and Developed Markets down an average -2.9%.  Once again, China and Brazil brought up the rear of the major markets, down -4.4% and -5.3% respectively.  Brazil is now at a 5-year low.

Two major economic data points are blamed for the worldwide rout.  First, the early read of the Markit/HSBC Purchasing Manager’s Index (“PMI”) for China came in at 49.6.  Anything below 50 represents a contraction, and the reaction was very negative.  The second data point was a collective fall in emerging market currencies, headed up by Argentina (whose peso had its worst day in 12 years).  Whispers worldwide about rapid withdrawals from Emerging economies by global investors fed the declines.

Since all eyes were on China and other emerging economies, here are some additional data points from China to round out the view: China’s fourth quarter GDP grew 7.7% year-over-year, ticking down from 7.8% the previous quarter, Chinese industrial production slowed in December, declining from 10.0% year-over-year to 9.7%, and retail sales in China inched down to 13.6% year-over-year from 13.7% in November.  None of these data points are particularly serious, but all add to the overall negative-to-neutral view.  And the smog news continues to be horrible.  The density of the two worst air pollutants shot up in China by 55.7% and 30.1% respectively in December, as reported by China’s Ministry of Environmental Protection on Friday.  The 74 major cities monitored nationwide had on average more than 70% of days in December failing to meet ministry air quality standards, with many cities coming in at 90% or more of all days below minimum standards.

(sources: Reuters, 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 slightly to 16.0 from the prior week’s 16.5, while the average ranking of Offensive DIME sectors fell to 13.8 from the prior week’s 12.  The Offensive DIME sectors continue to lose the edge they had over Defensive SHUT sectors, now outranking the Defensive SHUT sectors by a slim 2.2.

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.