FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 5/9/2014

The very big picture:

In the “decades” timeframe, we have been 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 unchanged at 25.4, 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 62.6, down slightly from the prior week’s 63.1, 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, 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, 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 on the first day of April for the prospects for the second quarter of 2014.

Timeframe summary:

In the Secular (years to decades) timeframe (Figs. 1 & 2 above), the Secular Bear still may still be in force as the long-term valuation of the market is simply 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 2nd quarter:  both US and International equities were in uptrends at the start of Q2, which signals a higher likelihood of an up quarter than a down quarter. 

In the markets:

Most markets worldwide were negative for the week ending May 9th.  In the US, only the Dow Jones Industrials were higher for the week, at +0.4%, while all other US indices were down ranging from -0.1% for the S&P500 to     -1.9% for the Russell 2000 SmallCap index.  The Dow actually closed the week at a new all-time high, while at the same time the Russell 2000 is off about -10% from its March highs – an unhealthy divergence.  Developed International markets were down an average -0.3%, while Emerging International markets were flat on average with China notable among them at -1.2%.  Canada’s Toronto Composite Index was in the worst performers of the week group, at -1.6%.

In the US, the Institute for Supply Management (“ISM”) non-manufacturing index increased to 55.2 in April from 53.1 in March, exceeding the 54.0 economists were forecasting.  Any reading above 50 signals growth in the sector.  Two subindices were notable: the new-orders subindex jumped to 58.2 from 53.4, and the export orders subindex climbed sharply to 57.0 from 49.5.  Home purchase applications rose a modest +0.9% from the prior week as 30 year mortgage rates hit a 26 week low.  Total US exports increased +2.1% month-over-month in March, up from a -1.3% decline in February, helping the trade deficit narrow to $40.4B in March, down from $41.9B in February.

Federal Reserve Chair (“Chair” is at her request – not “Chairman”, and not “Chairwoman”) Janet Yellen made her first appearance before Congress’ Joint Economic Committee and reaffirmed that the Fed believes the economy is on the mend but that the central bank is prepared to act further if necessary.  The single sentence in her prepared remarks that got the greatest attention of investors:  “A high degree of monetary accommodation remains warranted.”

Canada’s stock market decline of -1.6% was in part due to a jobs report that greatly surprised to the downside: 28,900 jobs were lost in April vs expectations of a 12,000 job gain.  The losses were widespread, with only 3 of 10 provinces reporting job gains.  The unemployment rate was unchanged at 6.9% (13.4% for the 15-24 age bracket).  Some observers downplayed the report, however, noting that Good Friday fell in the survey week and may have distorted the reported numbers.

In Europe, economic monitoring firm Markit reported that an output measurement for the Irish economy was at a 94-month high, while for Spain it was at an 85-month high.  Germany and Italy were modestly positive, but France was moribund and continues to lag its EU counterparts.  French President Hollande’s approval rating seems likewise stuck, at just 20%.

In China, HSBC’s Purchasing Managers Index (“PMI”) for April came in at just 48.1 vs 48.0 in March, making March the fourth month in a row of contraction (below 50 is contraction).  China did receive better than expected news on the export front, up +0.9% from a year earlier in April after being down two straight months.  Imports rose +0.8% after being down -11.3% in March.  Inflation was up only +1.8% in April from a year earlier, while producer prices fell for a 26th straight month, down -2%, as manufacturers with excess capacity compete on price to keep their factories busy.

(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, wantchinatimes.com, BBC)

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 10.8 from the prior week’s 11.5, while the average ranking of Offensive DIME sectors rose to 11 from the prior week’s 11.8.  The Defensive SHUT sectors maintained their slim lead over the Offensive DIME sectors.

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

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.