FBIAS™ for the week ending 8/1/2014

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 25.5, down from the prior week’s 26.2, 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 63.6, down from the prior week’s 67.5, 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 31, down 3 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 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:

July finished with a thud, as most markets gave up their July gains on the last day of the month.  In the US, the Dow suffered its worst point loss in 5 months on July 31st, at -317.1, and the S&P 500 recorded its worst week in 2 years.  The Nasdaq 100 was the lone profitable index in the US for July, managing to record a gain for the month of +1.1%, but the Russell 2000 small-cap index continued to underperform other US indices and lost a whopping   -6.1% for July.  Canada’s TSX index gained for July, returning +1.2% and widening its year-to-date lead over the US.  Developed International lost -2.6% for July, led on the downside by European countries.  Emerging International gained +1.4%, led on the upside by China and Brazil.

For the week, notwithstanding all the attention paid to the fireworks on Wall Street, other markets did significantly worse.  Germany lost -4.9%, and went negative for the year (as did the Dow Industrials).  European markets as a whole lost -3.2%, while US indices averaged a -2.6% loss  – and for the first time in a while, the small-cap Russell 2000 was not the worst US index, outperforming both the Dow and the S&P 500.  Canada’s TSX lost a relatively modest -0.8%.

Surprisingly, US economic news for the week was mostly good.  GDP grew on a +4.0% annualized basis in the second quarter, up from -2.9% in the first quarter and well above expectations of +3.1%.  Consumer sentiment came in at 81.8, up from 81.3 and better than the 81.5 expected.  The Institute for Supply Management (“ISM”) manufacturing index came in at 57.1, up from 55.3 and better than the 56 expected.   Jobless claims were reported at 302,000, and the 4-week moving average of jobless claims fell to the lowest level since 2006.  And the big report of the week, Non-Farm Payrolls, came in above 200,000 (at 209,000) for the sixth straight month – the longest such streak since 1997.  The Q2 Employment Cost Index (“ECI”) was up +0.7%, with wages and salaries advancing +0.6% – the fastest rate of increase since Q3 2008.  The ECI is up +2.0% year-over-year.  Many economists believe that wage growth will eventually take off and will force the Federal Reserve to begin raising interest rates sooner than is currently anticipated by markets.  US auto sales for July were extremely good, with the domestic Big 3, Toyota and Nissan all reporting sizable gains. General Motors Co. said sales were up 9% from a year ago, GM’s best July sales total since 2007, despite all its issues with recalls. Ford Motor’s sales were up 10%, its best July in eight years, while Chrysler Group reported U.S. sales soared 20% from the same month year-over-year, the best July for it since 2005.  There was significant slowing in the housing market, however.  Home prices rose at their slowest pace since February 2013.  Pending home sales fell -1.1% month over month, home prices fell by -0.3% month over month vs expectations for a +0.3% gain, and mortgage bankers reported refinancing applications fell -4% in the week.

The pace of growth in the Canadian manufacturing sector picked up to its best level in eight months in July as gauges of new orders and employment improved, according to data released Friday.  The RBC Canadian Manufacturing Purchasing Managers’ index (“PMI”), rose to a seasonally adjusted 54.3 last month from 53.5 in June.

Japan has been closely watched by economists for two years as Prime Minister Shinzo Abe attempts dramatic efforts to get the moribund, deflating Japanese economy going again.  After hopeful signs last year, and a quickening of manufacturing growth earlier this year, the latest readings are a distinct disappointment.  Retail sales fell -0.6% in June, year-over-year, with second-quarter sales down a surprisingly large -7% from the first quarter.  Industrial production fell -3.3% in June over May, far worse than expected, and June wage growth was up just +0.4% vs. year ago levels, also worse than expected.  Adjusted for inflation, wages were actually down -3.8%.  This is a terrible disappointment for the Abe government, which is pinning its hopes for defeating deflation on higher wages and expanding manufacturing output.

Before the upcoming release of its Q2 earnings, Dick’s Sporting Goods, the largest retailer in the United States of TaylorMade and Callaway products, on July 22nd fired all the PGA professionals it had employed in the golf sections of its more than 560 store.  Dick’s had professed to wanting one PGA professional at every store to better differentiate the experience from online retailers that try to undercut brick-and-mortar stores.  But the economy, the downturn in participation, the decline of Tiger Woods and too many products flooding the market have cut into Dick’s bottom line so much that the company seems to be giving up on winning the golf equipment business.  On average, the golf business accounts for about 15 percent of Dick’s overall revenues.   “Every macro-indicator that we’ve been looking at for the past 20 years – rounds played, number of minorities playing, women coming into the game – all of these things that we tracked say that there are fewer people playing,” said Mark King, the former president of TaylorMade who was recently named president of Adidas North America.  “Young people entering the game after high school, 18- to 30-year-olds are down 35 percent in the last 10 years.  So I don’t like where the game looks like it is going.”

(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 was unchanged from the prior week at 13.3, while the average ranking of Offensive DIME sectors was also 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.