FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 6/6/2014

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 is at 26.2, up from the prior week’s 25.9 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 67.8, up from the prior week’s 65.7, and still solidly in cyclical Bull territory.  The current Cyclical Bull has taken the US and some of Europe to new all-time highs, but many of the world’s major indices have yet to top 2007’s levels.  The most widely followed international indexes, the Morgan Stanley EAFE Developed International index and the Morgan Stanley Emerging Markets Index, are both still below their 2007 peaks.

In the intermediate picture:

The intermediate (weeks to months) indicator (see graph below) remains in positive status, ending the week at 33, up four from the prior week’s 29.  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:

Gains were achieved in markets around the world for the week ending June 6th.  For the first time in twelve weeks, the Russell 2000 SmallCap index led the US indices with a +2.7% rise, followed by MidCaps at +2.4%.  The Russell 2000 SmallCap index has now joined other US indices in the green (barely) for the year to date. The S&P 500 gained +1.3% and is now +5.5% year to date.  Canada’s TSX gained +1.6%, and now stands just shy of +9% for the year to date.  Emerging International Markets picked up the pace again after several weeks of sluggish performance, led by Brazil at +2.9%, while Developed International Markets rose +1.2%.

The major economic news in the US was the highly anticipated non-farm payrolls number for May, released on Friday.  US companies added a net 217,000 workers to their payrolls in May, in line with expectations and the fourth month in a row above 200,000. The US unemployment rate held steady at 6.3%, the lowest since September 2008. A psychological milestone was also reached: all the jobs lost in the recent recession have been regained (though, of course, the workforce is now larger).  The Institute for Supply Management (“ISM”) services index for May rose 1.1 points to 56.3, the best level since last August.  The ISM manufacturing index rose to 55.4 from 54.9 in April.  US auto sales were reported to have risen 11% in May to a seasonally adjusted annualized selling rate of 16.77 million cars and light trucks, according to Autodata Corp., confirming the rebound from the harsh winter.  Except for Ford, these are impressive numbers: Ford +3%, GM +13%, Chrysler +17%, Toyota +17%, Honda +9%, Nissan +19%, BMW +17%, VW +15%.  And even Ford’s numbers represented the best May sales since 2004.  The overall industry is heading for its best year since 2006.

Canada’s unemployment report, while positive, continued to show a very sluggish economy.  Statistics Canada announced the country added 25,800 new jobs in May, which, besides being all part-time, still didn’t in numerical terms make up for the 29,000 lost the previous month.  Over the past 12 months, Canada’s economy has added 86,000 new jobs, for a 0.5% per cent increase, while the US has proportionally far outperformed, adding 2.4 million, for a 1.7% per cent increase.  Canada can still point out that all of the Canadian jobs lost in the recession were regained by early 2011, while the US only achieved that milestone last week.

For the first time ever in a major economy, a Central Bank is trying out an anti-deflation theory: negative interest rates on bank deposits with the Central Bank.  That’s what Mario Draghi and the European Central Bank (“ECB”) did on Thursday, while also reducing its lending rate to 0.15%.  A high level of confidence that Draghi will continue to do “whatever it takes” persists in Europe.  For example, 10-year Spanish bond rates are selling at an incredibly tiny 4 bps premium over the US 10-year note.

For the last several years, whenever the ECB has asked member countries to impose austerity on their economies in order to hasten recovery, the International Monetary Fund (“IMF”), particularly the Managing Director Christine Lagarde, has lashed out, decrying austerity as an unjustifiable, unnecessarily punitive path – promoting more government deficit spending and stimulus instead.  Many governments hid behind her skirts in order to avoid the hardships of austerity – particularly France, Madame Lagarde’s home country.  The UK, on the other hand, moved ahead with austerity reforms, and drew the contemptuous ire of the IMF.   The IMF’s chief economist, Oliver Blanchard, said UK budget cutting risked “playing with fire”, and predicted dire consequences for the UK economy.  The prominent American economist and New York Times columnist Paul Krugman was equally condemning, predicting that austerity would not work anywhere.  However, instead of descending into chaos, the UK has sprung smartly from recession and now leads the recovery among all EU countries by a wide margin.  Madame Lagarde was forced to admit to a BBC interviewer last week that “We got it wrong…clearly the confidence building that has resulted from the economic policies adopted by the government has surprised many of us.”  Pressed by the interviewer whether she owed an apology to the Chancellor of the Exchequer George Osborne, whom she had particularly castigated when austerity was being debated, Madame Lagarde replied huffily “Do I have to get on my knees?”  We should not hold our breath waiting for a similar acknowledgement from Paul Krugman who has, to his knowledge, never been wrong.

(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, 361capital.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 10.8 from the prior week’s 11.0, while the average ranking of Offensive DIME sectors was unchanged for the third week at 12.3.  Despite the market’s new highs in many indices, the Defensive SHUT sectors retained a slight lead over the Offensive DIME sectors as institutional investors continue to express some fear and doubt.

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 among the strongest of 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.