FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 8/8/2014

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, 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 61.2, down from the prior week’s 63.6, 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) changed to negative status during the week, ending the week at 23, down 8 from the prior week’s 31.  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 changed to negative status on August 5.  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 down week for most markets around the world…until mid-day Friday in the US (after other markets had closed for the week).  A report ascribed to NATO said that Russia was pulling back from the Ukraine border, and that was all the US markets needed to rally sharply – pushing all US indices into the green for the week.  The Dow gained +0.4% for the week, and the hard-pressed Russell  2000 Small Cap index finished the week with a best-in-US gain of +1.5%.  The rest of the world was not so lucky.  Canada rallied, too, but finished at -0.1% for the week.  Europe came in at -1.5%, Developed Markets as a whole declined -1.3% and Emerging Markets pulled back -0.8%.  Germany is now down -10% from its recent highs.  Both China and Brazil, recent leaders in the Emerging Markets category, were negative for the week.  Japan was the worst among major worldwide markets at -2.1%.

US economic news was fairly light, and there are no new Fed pronouncements expected until their annual Jackson Hole conclave at the end of August.  Initial jobless claims came in at 289,000 vs 304,000 expected, and the 4-week moving average fell to the lowest levels since 2006.  The Institute for Supply Management (“ISM”) service index was reported at 58.7, up from 56 in July and better than the 56.5 expectations and the best since December 2005.  ISM service index readings at or above the upper 50’s are generally considered to be robust.  Factory orders were better than expected, having grown +1.1% month-over-month vs +0.6% expectations.  Yields on US Treasury notes continued to defy expectations, dropping back to end the week at just 2.42% for the 10-year note.  German bond yields (a tiny 1.05% for the 10-year Bund) hit new lows during the week, and are competitively holding down US rates as they are seen as being of equivalent safety.

Standard & Poor’s said on Friday it had revised its outlook on Canadian banks to “negative,” joining Moody’s which had issued a “negative” rating a month earlier.  Both ratings agencies said that Canadian banks were at a higher risk of failure given the Canadian government’s plans to implement a “bail-in” regime to handle future bank failures with minimal taxpayer funding.  It may be coincidental…but probably not: CEOs at four of the top five Canadian banks have all retired within the last year.  None were infirm or beyond retirement age.  It is widely viewed that they were simply getting out while the getting is good.

In Europe, European Central Bank (“ECB”) president Mario Draghi blamed euro-area governments for failing to boost reforms, especially in Italy, which fell back into recession in the second quarter.  Draghi also rebuffed France’s Francoise Hollande’s call for more ECB actions in France, with Draghi saying further ECB actions will do little to help France unless Hollande’s government tackles structural economic flaws.  Portugal’s Banco Espirito Santo collapsed, with the Portuguese government pledging a bailout that will result in the bank’s equity and bond holders being wiped out.  Germany reported an unexpectedly large plunge in factory orders for the month of June, down -3.2% from May, as sanctions on Russia were beginning to take effect.  German exports fell -4.1% in June over May, and exports to the euro area were down -10.4%.  There are whispers that the German economy may actually have contracted in the second quarter.  At the other end of the spectrum, The UK July Purchasing Managers Index (“PMI”) services index leapt to 59.1 from 57.5 in June.  Industrial production was up +0.3% in June from May, and new home prices in the UK rose to a record in July, up +9.9% year-over-year.

The Wall St. Journal reported that one reason for the dramatic and sudden underperformance of US Small Cap stocks this year (the worst underperformance in 16 years) may be the large dependence of Small Caps on the housing sector.  Small Caps get about 19% of their earnings from the housing market, while only 10% of Large Cap earnings are dependent on that sector, according to a Merrill Lynch analyst quoted by the Journal.  Housing stocks have taken a real beating recently, and most are substantially below their 200 day moving averages.  The US Department of Commerce recently released updated Home Ownership data, which may not give reason for optimism about the housing sector: the US home ownership rate is back to where it was 40 years ago, in the mid-1970’s, and has fallen steeply since peaking in 2005.  The many government programs to expand home ownership to a larger and larger percent of Americans have seemingly had no net effect beyond perhaps creating a bubble whose bursting hurt the very people the programs were intended to help.

(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 13.0 from the prior week’s 13.3, while the average ranking of Offensive DIME sectors declined to 13.5, down from the prior week’s 13.8.  Institutional investors remain cautious, 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.