FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 5/16/2014

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 little changed at 25.3, 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 62.0, down slightly from the prior week’s 62.6, and still solidly in cyclical Bull territory.  The current Cyclical Bull has taken the US to new all-time highs, but many of the world’s major indices have yet to top 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.  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:

The US and Canada were exceptions in returning flat to down results for the week ending May 16th.  Most other markets worldwide were positive, with Emerging Markets leading the way at +3.2% (driven by China and India, up +4.2% and +8.2% for the week, respectively).  Developed Markets were mixed but positive at +0.4%.

In the US, all indices were contained in a tight range of -0.6% to +0.5%, with the Nasdaq Comp best at +0.5%, the Dow Jones Industrials worst at -0.6%, and the S&P 500 right between them at -0.03%.  Canada’s TSX was likewise flat for the week, at -0.1%.  For the first time in 6 weeks, the Russell 2000 Small Cap Index was not the worst of the US indices.  The Russell 2000 has fallen 10% from its early March highs, and many observers have asserted that the divergence of the Russell 2000 and the Dow / S&P – which each set new all-time highs this week – can only portend bad things for the market.  However, a study from the Leuthold Group points out that the Russell 2000 experiences double-digit declines sometime during practically every year – even during otherwise very good years for the overall market – and that divergence between the Russell 2000 and the Dow / S&P are common and not necessarily indicative of coming calamity.  This illustration is from that Leuthold Group report:

In US economic news, the April retail sales figure was very poor, up just +0.1% when a rise of +0.4% was expected, and was unchanged ex-autos.   April industrial production was down -0.6% vs a forecasted slight gain.  But on Friday, the figure on April housing starts was better than expected, up +13% to a 1.07 million annualized rate.  However,  the lion’s share of the increase was due to construction starts on multifamily projects such as condominiums and apartment complexes, while single-family construction was up just +0.8%.  Single-family home sales via mortgage loans have been sinking rapidly, and RealtyTrac noted that because of tougher lending standards (coupled with rising prices and supply/demand issues), 43% of recent sales nationwide have been all cash.

Canada, a major wheat exporter, saw its agricultural sector jolted by a swift -9.4% decline in wheat futures prices that were down 8 days in a row.  Weather forecasts for good growing conditions in both the US and Western Canada, coupled with a large order from Egypt going to Ukraine instead of North American growers both pressured the market with fears of oversupply.

In Europe, Eurostat, the official statistical arm of the European Union, released GDP figures for the first quarter and the euro area grew a tiny +0.2% over the previous quarter (up just +0.9% year over year).  But if you took out Germany, up a better than expected +0.8% (+2.3% year over year), the rest of the euro-18 actually contracted!  France’s GDP was unchanged, with consumer spending down -0.5% for the quarter; Italy’s GDP was unexpectedly negative, down -0.1%; the Netherlands’ GDP was down a whopping -1.4% for the quarter and even though Spain’s rose +0.4%, it’s still up just +0.6% vs. year ago levels.  Mario Draghi is being pressured to act at the ECB’s early June meeting to both goose GDP and stave off the specter of deflation.  Deflation has already arrived in many weaker EU countries: prices fell in Greece, Cyprus, Portugal, Slovakia, Hungary and Bulgaria.

India’s pro-business opposition leader Narendra Modi is the new prime minister after the ruling Congress party conceded defeat in the Indian general election.  Modi’s Hindu nationalist Bharatiya Janata party (BJP) is expected to win an outright majority, perhaps 300 seats, which is a large victory – the first such victory for a single party in three decades.  The Indian stock market hit new highs as business leaders threw their weight behind Modi’s candidacy.

(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 Leuthold Group)

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 was unchanged at 10.8 for the week, while the average ranking of Offensive DIME sectors slipped to 10.8 from the prior week’s 11.0.  The Defensive SHUT sectors and the Offensive DIME sectors are equally ranked as indecision has taken hold.

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.