FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 1/31/2014

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 24.8, little changed from the prior week’s 24.9, 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 68.2, down from last week’s 72.2, 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 approached 2007’s levels.

In the intermediate picture:

The intermediate (weeks to months) indicator (see graph below) is in negative status, having dropped to 21 from the prior week’s 32.  Separately, the quarter-by-quarter indicator – based on domestic and international stock trend status at the start of each quarter – gave a positive indication on the first day of January 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 moved to negative status on January 29th.  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:

It was another down week for most markets worldwide, culminating a decisively down January.  The Dow, down 4 of the last 5 weeks, finished January down -5.3% and was the worst of the US indices (and the worst month for the Dow since May, 2012).  Developed Markets were down a similar -5.2% on average for January, but Emerging Markets fared much worse at an average -8.6% for January alone (and adding to losses from 2013).  Canada’s TSX bucked the trend, however, gaining +0.5% for the month on the back of a winning month for precious metals and miner stocks.  China reversed a string of recent weekly losses and gained 1% for the week while Brazil continued its losing ways, down almost -2% for the week.  Japan’s Nikkei had the worst week of major global indices at -3%, and is at its lowest level since November.

The world economy dodged a bullet during the week when China Credit Trust Co Ltd, a leading Chinese “shadow bank” (a private trust used to finance projects that state-run banks won’t), was bailed out through some unexplained mechanism.  Had it failed, many privately-owned Chinese companies would have been badly affected and with them, the Chinese markets and, by extension, many others.  However they did it, let’s hope it sticks.

A number of emerging-market countries have seen their currencies battered in recent weeks as investors sold them aggressively, perhaps in response to the Fed’s tapering which is thought to have knock-on negative consequences for emerging economies.  Some countries have tried to protect their currencies with interest-rate increases, while others welcome the de facto devaluations as a means to maintain or increase competitiveness.  Turkey, Argentina, Ukraine, Hungary and Poland have all shared the headlines.

In the US, mixed economic news included the early read of the January Purchasing Managers Index (“PMI”) which rose to 56.6 in January, up from 55.7 in December.  But pending home sales cratered -8.7% month over month, the biggest miss in over 3 years and worst numbers since May 2010.  Durable goods orders dropped by -4.3% vs an expected +1.8% rise, and core capital expenditures fell -1.3% vs an expected +0.3% rise.  And new home sales tumbled -7.1% month over month in December, much worse than the expected -1.9% drop.

Canadians welcomed the news on Friday that the US State Department has concluded that the Keystone XL Pipeline project will have negligible adverse consequences to the economy and the environment.  Although the battle is not quite completely won yet (Pres. Obama gets the last word), some might wonder whether the prominent advertising campaign in Washington DC’s Metro train stations had some effect.  The National Post reports that “Since at least early January, thousands of commuters in the U.S. capital have passed under massive banners showcasing idyllic scenes and touting up the Great White North as “America’s best energy partner.”

(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 sharply to 11.5 from the prior week’s 16.0, while the average ranking of Offensive DIME sectors fell to 16.5 from the prior week’s 13.8. The Defensive SHUT sectors have overtaken the Offensive DIME sectors and now lead them by 5 ranking positions.

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.