FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 7/25/2014

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, unchanged from the prior 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 67.5, down from the prior week’s 68.5, 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, 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 were mixed last week, with several US and European indices negative but many others positive.  In the US, the S&P 500 was flat and the Dow was -0.8%.  The Nasdaq 100 gained +0.6% for the week, the best US index.  SmallCaps, however, continued their losing ways (more on the bifurcation between LargeCap and SmallCap performance below).  The best performers of the week were Brazil (+1.5%) and China (+5.1%), and the Emerging International group to which they belong gained +1.4% vs Developed International’s +0.1%.  Canada gained +1.2% and padded its lead over the US for the year to date.

Even though precious metals have held their own recently (a major source of Canada’s resilience this year – Canada’s TSX finished Friday at an all-time high), other commodities – particularly agricultural commodities – have had a very tough time this year.  Corn prices, for example, are down almost -30% in just three months and down   -55% from their all-time highs in 2012.  Soybeans and wheat have also nosedived as growing conditions have proven to be nearly perfect this season.  Farmland values, which have skyrocketed in recent years, have begun to roll over and farm implement makers, such as Deere, are reporting falling sales.  Unrelated to growing conditions, commodity orange juice sales have fallen to the lowest level on record (more due to declining demand than any other factors – Americans just don’t drink as much OJ these days).

Although it is not obvious on the surface of the US stock market, there is a very large year-to-date performance gap within the market when stocks are grouped by market capitalization.  Since March, the largest capitalization stocks have continued on their merry way, while mid- and small-cap stocks have fallen by the wayside.  This has resulted in unintentionally deceptive reporting of the market’s year-to-date gains.  Most investors know that the S&P 500 is up about +7% for the year, but it is a safe bet that very few know that the lower-capitalization half of the market is actually negative year-to-date.  As the following chart shows, if you break up the total-market Russell 3000 into six groups of 500 stocks each according to their market capitalization, the top 3 groups of 500 (half of the Russell 3000) are up for the year, while the lower 3 groups of 500 (the other half of the Russell 3000) are down for the year.

A major cause of the declining fortunes of the smaller-cap stocks in the US market may be the sudden and severe reduction in analysts’ earnings expectations for the companies in the SmallCap Russell 2000 over the past few months, compared to analysts’ earnings expectations for members of the LargeCap S&P 500.  Earnings estimate revisions for Russell 2000 members are down almost -14%, whereas earnings estimate revisions for S&P 500 members are off less than -2%.

(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)

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 13.3 from the prior week’s 12.8, while the average ranking of Offensive DIME sectors was unchanged from the prior week at to 13.8.  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.