FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 7/18/2014

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, little changed 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 68.5, down from the prior week’s 69.4, 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, down 1 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 worldwide regained some of the prior week’s losses during the week ending July 18th.  The Dow Industrials, which have been a laggard all year, led the US gains with a +0.9% advance, while the SmallCap Russell 2000 continued to lose ground with a -0.7% setback.  Janet Yellen named SmallCaps and Biotechs as having “stretched” valuations, but she is a little behind the curve since the air has already come out of SmallCaps – they are the only US index to be negative for the year to date at -0.7%.  Canada’s TSX matched the Dow with a gain of +0.9%.  Both Developed International and Emerging International rose +0.6%.  For the second consecutive week, Brazil was the best (+3.1%) and Germany the worst (+0.1%) among markets of significance.

Economic news in the US was positive on balance.  Home builder sentiment rose to +53 (back in positive territory above 50), but housing starts in June were reported at 895,000 annualized vs the 1.02 million expected – the biggest miss since January of 2008.  Home construction was reported to have plunged 30% in the South, while all other regions were positive, leading many to suspect the South report was a “rogue” number.  The New York manufacturing survey rose to 25.6, the highest level since 2010, and the Philadelphia manufacturing index rose to 23.9, well above the expected 16.  Although just 10% of companies have reported Q2 earnings so far, the rate of earnings “beats” is a healthy 64%.

Inflation in Canada continues to exhibit stubborn staying power in the face of a weak economy and even softer employment conditions.  For the second month in a row, the annual rate hit a new two-year high-water mark as it rose one-tenth of a point to 2.4% in June, and core underlying inflation edged ever closer to the Bank of Canada’s 2.0% target at 1.8%.  However, rising prices are not a sign of strength in the Canadian economy.  Stephen Poloz, Canadian central bank governor, said “Right now, we do not have a sustainable growth picture in Canada,” leading most observers to conclude that any inflation-fighting rate increases will be postponed until the economy perks up.

In contrast to Canada, Eurozone inflation was reported at the near-deflation level of +0.5% annualized for June, the same as in May, and down from +1.6% a year earlier.  Spain was unchanged, France +0.6%, Germany +1.0%, Italy +0.2%, Portugal -0.2% and Greece -1.5%.  Bond yields reacted, and in many Eurozone countries hit their lowest in recorded history. The French 10-year hit a record low 1.57%, Germany 1.15%, Austria 1.41%, Belgium 1.57%, Netherlands 1.36%, Finland 1.31%, Spain 2.59% and Italy 2.78%.  Many believe that these super-low rates will hold down US rates as well, since there is no competitive pressure for them to rise.  The US 10-year rate finished the week at 2.48%, down 0.04% for the week.

China reported Q2 GDP at +7.5%, which provoked snickers and skepticism worldwide as it was (too) conveniently the exact number that had been predicted by Premier Li Keqiang.  Residential real estate continues to deflate a bit, with China’s National Bureau of Statistics reporting new-home prices actually declined in 55 of 70 markets during June – the first time ever that such a sizeable majority of Chinese markets have declined in a single month. China also revealed that it has returned to the US bond market – and in a big way.  For the five months through May, Chinese purchases of US debt maturing in more than one year reached $107.2 billion – more than any other 5 month period since record keeping began in 1977.

(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 fell to 12.8 from the prior week’s 10.8, while the average ranking of Offensive DIME sectors slipped to 13.8 from the prior week’s 14.  Institutional investors remain cautious, despite new all-time highs, and the Defensive SHUT group ranking continues to be a little 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.