FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 6/13/2014

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 26.1, barely changed from the prior week’s 26.2 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 67.6, little changed from the prior week’s 67.8, 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 34, up from the prior week’s 33.  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 week was a modest loser for most of the world’s developed markets.  US indices fell from -0.2% to -0.9%, while Developed International retreated by -0.7% with Germany being the worst major component at -1.8%.  The Emerging Markets index, however, rose +0.1% for the week, mostly on the strength of Brazil at +3.8%.  For the first time in three months, the higher-volatility Russell 2000 SmallCap Index fell less ( -0.2%) than the lower-volatility S&P 500 (-0.7%), but the Russell 2000 remains the only US index in the red for the year at -0.1% year-to-date.  Some analysts noted that the S&P and Dow both registered a pattern called “Buying Climax” this week – a pattern created when a new 52-week high is set during the week, yet the week closes down from the prior week.  The “Buying Climax” pattern is said to indicate potential exhaustion of demand.  Canada’s TSX was buoyed by the Energy sector’s gains (due to the Iraq civil war), gaining +1.1% for the week and finishing only a half-percent beneath its all-time high set in 2008.

One of the key concerns among US economists has been the shrinking of the rate of consumer credit expansion over the last two years – reflecting credit card debt, appliances, auto purchases and the like.  Recently strong auto sales hinted at a higher rate of credit expansion, and recent Fed data now confirms a strong turnaround in credit expansion so far this year as reflected in this chart.

Other economic news in the US was notable for a couple of measurements that have regained their pre-recession highs.  The National Federation of Independent Business (“NFIB”) small business optimism index came in at 96.6, better than the 95.8 expected.  The optimism index is now at the highest level since September 2007.  Small businesses also reported great difficulty in finding skilled workers.  The government’s “Job Openings and Labor Turnover” report, known simply as the “JOLT”, reported 4.45 million job openings in April, substantially besting expectations of 4.05 million, and the most since September 2007.

Eurozone April industrial production rose by +0.8% month-over-month, better than the rise of +0.5% expected and the decline of -0.3% in March.  Italian industrial production rose by +0.7% in April, much better than the unchanged expected and the decline of -0.4% in March.  But French industrial production rose by only +0.3%, slightly lower than the increase of +0.4% expected.  UK industrial production rose by +0.4% month-over-month in April, in line with expectations and by +3.0% year-over-year, the largest increase since 2011. UK unemployment continues to decline with the unemployment rate falling to 6.6%, the lowest level in 5 years.

Chinese residential property sales are deflating from their bubble, with Standard & Poors predicting that Chinese home prices will actually decline this year, by -5%, coming at the same time that overall home sales are reported to have declined by -11% year-over-year.

No such bubble-popping in Canadian real estate yet!  Data released by the Toronto Real Estate Board this week shows there were 461 detached home sales for more than $2-million through its Multiple listing Service system in the first five months of the year, a 37% increase over the past year.  “What you are seeing is $2-million is the new $1-million,” says Drew Laszlo, a Toronto home architect.  The Royal Bank of Canada (RBC) said its affordability index deteriorated in the first quarter of this year – the third quarter of affordability declines out of the last four – with the deterioration particularly acute in the hot markets of Toronto, Calgary and Vancouver.

(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 fell sharply to 15.5 from the prior week’s 10.8, while the average ranking of Offensive DIME sectors rose to 11.3 from the prior week’s 12.3.  Perhaps in recognition of the new all-time highs in the Dow and S&P this week, Offensive DIME sectors now hold a lead over Defensive SHUT sectors.

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

Summary:

The US has led the worldwide recovery, 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.