FBIAS™ for the week ending 7/11/2014

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, little changed from the prior week’s 26.3, 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 69.4, down from the prior week’s 71.3, 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:

Markets retreated worldwide for the week ending July 11th.  In the US, the best performing index was the Nasdaq 100, home of many large established tech companies, which fell just -0.5%.  The worst, by far, was the SmallCap Russell 2000 index, which was clobbered for a -4% loss.  In recent weeks, SmallCaps had regained much of the ground they lost since March, but gave it up last week and now are alone among US indices in negative territory for the year to date.  The Dow and S&P 500 lost a modest -0.7% and -0.9% respectively.  Canada’s TSX fared better, only giving up -0.5% for the week.  The worst performers in non-US markets were in Europe, with Germany at -3.6% and Europe as a whole giving up -3.2%.  Developed International overall was down -2.5%, while  Emerging International only retreated -0.6%, with Brazil breaking from the red ink and scoring a +2.0% gain.

US economic news was sparse during the week, allowing US markets to be pushed up and (mostly) down by international news instead.  Fed minutes reveal that the last of the bond purchasing taper will take place in October with a final $15 billion reduction.  That did not seem to faze the bond or equity markets – in fact, the 10-year note yield actually declined by 12 basis points over the course of the week.  The Job Opening and Labor Turnover Survey (“JOLTS”) for May showed a total 4.63 million jobs available, the highest since June 2007.  On the negative side, the National Federation of Independent Businesses reported a drop in their business optimism index, to 95 from 96.6, and student loan debt reached another record high in May.

Statistics Canada reported on Friday that Canada surprisingly shed 9,400 jobs in June, that the Canadian unemployment rate inched up to 7.1%, and that the annual gain in jobs, at just 72,300, was the lowest in 4-1/2 years.  Analysts had expected a gain of 20,000 for June, so the miss was a surprise.  Inflation in May hit +2.3%, above the Bank of Canada’s 2% target, putting central planners in a quandary: raise rates to stifle budding inflation, or keep them low to spur employment growth?  Canada’s stock market preferred to be buoyed by gold’s highest weekly close since March, and limited its weekly loss to just -0.5%.

European economic news was dominated by a sudden banking crisis in Portugal, and continued poor manufacturing numbers from the majority of EU countries.  Here is a chart from Markit illustrating the bad – and mostly worsening – manufacturing conditions in a sampling of EU countries (PMI = Purchasing Managers Index):

Japan has long been a powerhouse manufacturer of machine tools and machinery, so a decline of -19.5% in machinery orders for the month of May compared to April (vs a forecasted slight gain) has gotten attention worldwide.  Whether it is a one-off outlier or the start of something bad is unknown at this point.

(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;  PMI chart from markit.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 to 10.8 from the prior week’s 9.8, while the average ranking of Offensive DIME sectors rose to 14 from the prior week’s 15.8.  Institutional investors remain cautious, despite new all-time highs, and the Defensive SHUT group ranking continues to be higher than the Offensive DIME group 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.