FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 7/3/2014

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, unchanged for the third week 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 71.3, up from the prior week’s 69.7, 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 35, 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 July for the prospects for the third 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 3rd quarter:  both US and International equities were in uptrends at the start of Q3, which signals a higher likelihood of an up quarter than a down quarter. 

In the markets:

It was a positive week for most of the world’s indices.  In the US, the Dow and S&P finished at new all-time highs, with the Dow crossing 17,000 for the first time ever and the S&P less than 15 points from 2,000.  The Nasdaq led US indices with a +2% gain, while the Dow and S&P brought up the rear at +1.3% each.  Emerging International markets gained +1.9%, led by China’s +3.3% advance.  Developed International markets rose +1.3%, and Canada’s TSX gained +0.8%.

June, ending on Monday of this week, was also positive.  In the US, the SmallCap Russell 2000 index gained the most, at +5.2%, as it tried to regain some ground lost in a nasty selloff in March and April.  The average gain among US indices was a very healthy +3.1%, although the Dow lagged with a gain of only +0.7%.  Canada’s TSX gained +3.7%, while Developed International advanced +0.9% and Emerging International rose +2.4%.

The second quarter also is now in the books, and it was a good one.  Emerging International made up for its losses in the first quarter, and led major worldwide indices at +6.2%.  US indices averaged a gain of +4.1%, with the Nasdaq 100 leading at +7.1% and the Russell 2000 bringing up the rear at +1.7%.  The S&P 500 has now completed 1,000 days without a 10% market correction, the 5th longest streak in history.  Canada’s TSX handily beat its US neighbor with a rise of +5.7%.

US economic news started out the week with a strong reading from the Chicago Purchasing Managers Index (“PMI”) , 62.6 on manufacturing for June, while the Institute for Supply Management (“ISM”) manufacturing reading for the month was an equally solid 55.3, though both were slightly below expectations.  The ISM reading on the service sector for June was also strong at 61.0.  The biggest news of the week came on Thursday when the Labor Department reported that the economy created 288,000 jobs in June, completing the best five-month stretch of job creation since early 2006 (including little-noticed substantial upward revisions to May, now 224,000, and April, now 304,000, making April the best single month since January 2012).  The unemployment rate fell from 6.3% to 6.1%, the lowest since September 2008.  Much of the job growth was in lower-wage sectors, however, and actual wage growth was just +2.0% over the past year.

In the Eurozone, Mario Draghi announced that the anti-deflationary charge on bank deposits of 0.1% (intended to encourage bank lending and money circulation) will continue indefinitely at the same time that the flash estimate of Eurozone inflation came in at just +0.5% – uncomfortably close to zero and deflation.  Spain’s manufacturing PMI was 54.6, an 84-month high, but other EU countries’ PMIs were not so pleasing.  Italy’s PMI was 52.6, a 3-month low; Germany’s PMI was 52.0, an 8-month low; France came in at 48.2, a 6-month low; Greece was 49.4, a 7-month low.  Unemployment numbers, especially youth unemployment, continue to be horrific: Greece 57.7%; Spain 54.0%; Italy 43.0%; Portugal 34.8%.  On a brighter note, Ireland is emerging strongly from its self-imposed austerity measures.  Ireland’s Central Statistics Office announced that GDP rose at a +5.1% annual rate in the first quarter of 2014, and exports are once again booming at a pace reminiscent of the days of the “Celtic Tiger”.  Ireland and the UK are confounding socialists (and NY Times columnists) who insisted that austerity would ruin their economies, rather than set the stage for the strong recoveries that have actually occurred.

Though China is not commonly thought of as a gold producer, the Xinhua News Agency announced that China’s gold reserves have increased significantly over the past three years and it now has the second-largest gold reserves in the world.  China reported 8,200 ton of gold reserves, second only to South Africa’s 31,000 tons.  China was also the largest producer of gold for the seventh year running, with 430 tons mined in 2013.

As the second half of 2014 begins, this sign – intended as good advice to hikers in Colorado – imparts excellent advice to investors as well:

(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; hiking trail sign from panoramio.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 to 9.8 from the prior week’s 10.5, while the average ranking of Offensive DIME sectors fell to 15.8 from the prior week’s 14.3.  Institutional investors remain cautious, despite new all-time highs, and the Defensive SHUT group ranking is now higher than the Offensive DIME ranking by a sizeable 6 ranking positions.

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.