FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 6/20/2014

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 26.3, up slightly from the prior week’s 26.1 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 68.8, up from the prior week’s 67.6, 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 35, up from the prior week’s 34.  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 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:

Save for some emerging markets, the week was positive for stock indexes worldwide.  US markets closed on another new high for the Dow and S&P 500, gaining an average +1.4% across all US indices and led by the SmallCap Russell 2000 at +2.2%.  US market action recently has been marked by a total lack of volatility, with Friday marking the 45th straight day the S&P closed up or down less than 1% – the longest such stretch since 1995.  Canada’s TSX gained +0.7% and finished the week at a new high, besting its previous high set in June of 2008.  Developed markets gained an average +1.2%, but Brazil and China both declined on the week, dragging down the Emerging Markets index, which lost a modest -0.1%.

In the US, inflation fears regained center stage for the first time in a long time, with a 2% inflation rate reported by the government.  Fed chair Yellen, however, downplayed any threat saying that inflation appeared to be contained at or below their acceptable target.  But lots of evidence says otherwise.  The New York Post recently ran a piece subtitled “Barbecue-Season Bummer” containing these US Department of Labor stats: the cost of ground beef has gone up 11 percent, pork has increased 9.4 percent and fish has spiked 4.2 percent just since last spring.  One official at Associated Supermarket in Manhattan, who has worked in the grocery business for 30 years, said “I’ve never seen increases like this – where they jump as much as this.” He reported costs for beef, tilapia and pork chops all rising between 30 and 40 cents per pound since last year.   And then there’s oil…

Canada, which has long enjoyed a reputation as a model of immigrant assimilation, has just enacted very restrictive rules on the use of immigrant labor at the low end of the wage scale.  The period of time that an immigrant laborer can keep one of the entry-level jobs is now restricted to just two years and the percentage of employees that can be comprised of immigrants is also capped.  Restaurants and other service industry groups are very unhappy and are predicting closures, shortened hours, and higher prices as a result.

The UK, currently enjoying the strongest economy in the European Union, has also been home to the strongest rise in home prices in the EU.  A serious bubble has formed in some areas, particularly the toniest neighborhoods of London.  The UK Office of National Statistics said London home prices were up a whopping +18.7% in April from a year earlier, up 9.9% across all the U.K., but another survey revealed London prices were actually down -0.5% in June over May – so the top may be in.

China, too, is experiencing a reversal in fortunes in the housing arena.  Prices fell in 35 of the 70 cities monitored by China’s National Bureau of Statistics, down a composite -0.3% from April and down -11% from May 2013.  Developers are reported to be cutting prices for the first time in memory.  The real estate industry accounts for about a fifth of China’s GDP and JPMorgan Chase & Co. is among those warning of a potential crisis with developers that have had trouble obtaining financing, and from “property trusts” that lend money to smaller builders and face record repayments next year, just as the market is cooling.

Also from China comes this disturbing piece from the South China Morning Post: “Large colonies of micro-organisms – some capable of causing serious disease – have been discovered inside pipelines carrying drinking water to homes in most major mainland Chinese cities.  Most Chinese people habitually boil water before drinking, killing off the organisms and reducing the risk of outbreaks.  But many foreign visitors are completely unaware of the issue and often drink water straight from the tap.”  You have been warned – don’t breathe the air or drink the water!

(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, S China Morning Post, NY Post)

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 13 from the prior week’s 15.5, while the average ranking of Offensive DIME sectors fell to 13 from the prior week’s 11.3.  Institutional investors renewed their caution, despite new highs, and the Defensive SHUT group ranking is now exactly equal to the Offensive DIME ranking.

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.