FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 8/15/2014

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 25.9, up from the prior week’s 25.5, 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 61.5, up from the prior week’s 61.2, 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) is in Negative status, ending the week at 18, down 5 from the prior week’s 23.  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:

Markets continued recovering this week, picking up where they left off the previous Friday when they shook off a scare from the Ukraine.  All major markets were higher for the week, with Emerging International Markets leading the way with an average gain of +1.8% and Developed International Markets at the end of the line with a still-respectable +1.3% average gain.  Germany was once again the laggard among major developed-market indices, gaining +0.5%.  US indices gained +1.4% on average, led by the Nasdaq 100 at +2.6%, while the Dow gained the least at +0.7%.  The S&P 500, now less than 2% beneath its all-time closing high, gained +1.2%, and Canada’s TSX gained +0.7%.

In the US, July retail sales were disappointing, unchanged, and up just +3.7% the past 12 months.  Stagnant consumer incomes are begetting stagnant retail sales.  Wal-Mart matched the overall retail report with flat U.S. same-store sales for its recent quarter, and lowered forward guidance again.  July industrial production rose +0.4%, which although small was slightly better than expected.  Small businesses continue to express optimism, as reflected in the National Federation of Independent Businesses optimism index rose to 95.7, up from 95.  In the housing sector, the Mortgage Bankers Association reported a -3.7% fall in mortgage applications from the prior week, continuing a very soft trend.  Home sales plunged in Southern California in the month of July, down -12.4% from a year earlier, according to research firm CoreLogic DataQuick.  Sales in this critical six-county region have declined since October as would-be buyers are discouraged by sky-high prices, with three of the most-expensive five US metro areas contained in Southern California, as shown in this list of median home prices:

San Jose $899,500
San Francisco $769,600
Anaheim-Santa Ana $691,900
Honolulu $678,500
San Diego $504,200

In Canada, the government number-crunchers at the (previously) highly-respected Statistics Canada made an embarrassing admission:  they had lost track of a large chunk of workers, and didn’t include almost 42,000 newly-created jobs in their July report released a week ago.  The discovery of these lost jobs changed the tone of the July jobs report dramatically, to say the least.  Nonetheless, the corrected figures were still negative, showing there were 18,000 full-time jobs lost in July – though a far cry from the 60,000 losses reported originally.   The addition of these lost jobs turned the report from calamitous to merely poor – still bad, but a lot better than first thought!

There were further signs this week of major weakness in the Eurozone. The flash GDP for the euro-18 was flat vs. the first quarter, when it had risen just +0.2%.  Annualized, the rate of growth in the Eurozone is just +0.7%, down from the prior quarter’s paltry +0.9% pace. Germany saw growth decline -0.2% in Q2 over Q1, and is now up just +1.3% on an annualized basis, while an index of investor confidence hit a 2-year low.  Germany represents over one quarter of all output in the Eurozone.  France reported its second consecutive quarter of flat economic activity (up +0.1% annualized), and its full-year growth projection was lowered to +0.5%.  Despite assurances to the contrary given to the European Commission in 2011, France now says it will exceed its deficit target of 4% of GDP.   Spain reported solid growth of +0.6% in the quarter and is now running at +1.2% for the 12 months, but inflation fell -0.4% in July, raising the specter of disinflation again.  The same for Portugal, where consumer prices fell -0.7% in July, year over year.  Greece reported its 24th straight quarter of GDP contraction for Q2, although it was the smallest contraction since Q3 of 2008.  Greek retail sales were down -8.5% in June, and industrial production was down -6.7% in July, but tourists have returned as tourism was up +16.5% year over year.  The UK continues to purr, reporting that the unemployment rate for the three months to June fell to 6.4% (the lowest since 2008), though average wages were down -0.2% year over year.  European bond rates continued to fall to record low levels.  The German 10-year bund closed the week at an amazingly low 0.95%. France’s 10-year set a record at 1.34%. The Netherlands’ was at 1.13%, Spain a record low 2.39%, and Italy a record low 2.58%.

It has been a tough year for stock pickers, even the world’s best.  Here is a table from Bespoke Investment Group detailing the performance of the top 15 holdings of Warren Buffet’s Berkshire Hathaway.  For both the year-to-date (through August 4) and the trailing year, his top-15 holdings have substantially underperformed the S&P 500.

(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, bespokeinvest.com, CoreLogic)

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 rose to 12.3 from the prior week’s 13.0, while the average ranking of Offensive DIME sectors declined to 13.8, down from the prior week’s 13.5.  Institutional investors remain cautious, and the Defensive SHUT group added to its lead over 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.