FBIAS™ Fact-Based Investment Allocation Strategy for the week ending 3/7/2014

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 26.0, up from the prior week’s 25.7, 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 71.4, up from last week’s 70.8, and still solidly in cyclical Bull territory.  For the last three years, 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) remains in positive status, ending the week at 28, up from the prior week’s 27.  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 returned to Cyclical Bull territory as of February 28th.  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:

Despite a selloff on Monday (a typical knee-jerk reaction to the news of a Russian invasion of the Crimean portion of Ukraine), most markets quickly stabilized and moved higher by week’s end.  US indices were the best major markets in the world, averaging a +1.1% gain with SmallCaps retaking their prior leadership role.  The worst major market was Germany, at -1.9%, driven down by fears of energy supply disruptions (36% of Germany’s natural gas needs come from Russian pipelines…which run through Ukraine).

Canada’s TSX gained +0.5%, while Emerging Markets continued to bring up the rear.  Emerging Markets overall were up +0.1%, but major BRIC members Brazil and China were both down for the week and Russia’s market lost  -10% on Monday alone.  Emerging Markets remain down -5% for the year to date, a continuation of their negative performance in 2013.

US Economic data continued to come in solidly in the “fair to decent” range.  Nonfarm payroll gains for February were reported at +175,000, well ahead of the +149,000 expected.   Average hourly earnings rose 0.4% and are up 2.2% year-over-year.  The US Purchasing Managers’ Index (“PMI”) beat expectations at 57.1 and is at a four year high.

Canada, by contrast, reported an unexpected payroll drop for February of -7,000 jobs vs. expectations of +15,000.  This caused the Canadian dollar (the “Loonie”) to drop sharply to 90.17.  Reacting to the lower Loonie valuation, Air Canada CEO Calin Rovinescu told Bloomberg News that Air Canada of necessity is considering new fees and price increases.  Air Canada will not be the only Canadian firm to do so in reaction to the lower value of the Loonie.

In Europe, the chasm between capitalist dynamo Germany and socialist sluggard France continues to widen.  The services PMI reading for Germany was reported as 55.9, a 32-month high, but 47.2 for France, down from 48.9 in January and in contraction territory. The French President, socialist François Hollande, has the lowest approval rating of any major European head of state.

China’s non-manufacturing PMI for February came in at 55.0, a 3-month high, up from a flattish 50.2  However, late Friday the government released very disappointing trade data, with exports in February unexpectedly falling  -18.1% from a year earlier, while imports rose +10.1%.  However, China’s newly prosperous middle and upper classes are feeling no pain: Macau’s casino revenues soared +24% year-over-year in the combined months of January and February.  In February alone, revenue hit a record $4.8 billion as an incredible 770,000 mainland Chinese traveled there just in the single week of Jan 31 to Feb 6.  Macau makes Las Vegas look like a dusty truck stop by comparison, and now dwarfs Las Vegas in every metric except for the number of Elvis impersonators.

And for those Westerners who think of Chinese women as subservient beings following meekly behind their domineering husbands, there is this report:  Chinese women took the top 3 spots, and an astonishing 19 out of 45 total spots, in a report named “The World’s Richest Self-Made Women”, published by Hurun Reports on Saturday, “International Women’s Day”.  Note the emphasis on “Self-Made” – no inherited or marital money!

(sources: Reuters, Barron’s, 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 fell to 14.5 from the prior week’s 12.5, while the average ranking of Offensive DIME sectors rose to 12 from the prior week’s 13.5.  After a five week pause, the Offensive DIME sectors have regained their 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 continues to be 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.