FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 8/22/2014

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 belowfor 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 26.3, up from the prior week’s 25.9, 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 63.1, up from the prior week’s 61.5, 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) is in Negative status, ending the week at 21, up 3 from the prior week’s 18.  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:

Despite world turmoil seemingly in every corner of the globe, markets forged higher this past week.  The US led the charge, with average gains of +1.8% among the major indices.  The Dow and MidCaps gained more than +2%, while the S&P 500, SmallCaps and the Nasdaq gained +1.7%.  The SmallCap Russell 2000 index remains slightly negative for the year-to-date, while the Nasdaq 100 is up a substantial +12.8%.  Canada’s TSX forged ahead by +1.5%, and now is +16% year-to-date.  Both Developed and Emerging International indices gained a less-robust +0.5% for the week, with Brazil leading at +2% and China lagging at -0.4%.

The economic world waited impatiently for Janet Yellen’s major speech at the annual Jackson Hole, WY, conclave hosted by the Kansas City Fed.  There was nothing new in the speech, in which she reiterated the consensus view of Fed governors that although the Fed could lift interest rates sooner than currently anticipated, there is no rush to do anything.  Among various Fed officials who spoke, a variety of views emerged about the current state of the US labor market which was taken to mean that more “wait and see” is in order.  In particular, there seems to be disagreement about what “full employment” means in this new era. 

Good news for US homebuilding came from several fronts.  July housing starts were up +15.7% to their best level in 8 months.  July existing home sales also came in better than expected at +2.4%, the biggest increase in almost a year. Housing permits for new multi-unit construction climbed +8.1%, while permits for single-family homes climbed +0.9%, the highest level since December.  However, mortgage applications fell -0.4% from the prior week to a new 6-month low, despite extremely low mortgage rates.

The July US consumer price index was tame, up just +0.1%, and up a similar amount ex-food and energy.  For the trailing 12 months, the CPI is up +2.0% (+1.9% ex-food and energy).  This tame inflation reading is no doubt another reason why the Fed continues to feel there is little pressure to raise the funds rate in the near future.

In Canada, consumers bolstered the economy in June with retail sales rising for the sixth straight month, by a stronger-than-expected +1.1%.  A new retail sales record was set, according to Statistics Canada.  The median forecast in a Reuters survey of analysts had been for only a +0.3% rise, so it was a welcome “beat”.

In the Eurozone, the early “flash” report on manufacturing and services for August was released.  The composite reading came in at 52.8 vs. 53.8 in July, but the manufacturing portion was just 50.8 – too near the dividing line between growth and contraction for comfort.  Germany’s flash composite was 56.4 vs. 56.7 in July, with manufacturing ticking down to 52.0, but France’s manufacturing number, just 45.4, was little improved over the prior month’s 45.2 and remains in contraction territory.

The Chinese real estate slowdown continues.  Home prices fell in 64 of 70 surveyed cities in July compared to June, according to the China National Bureau of Statistics.

A survey of individual investors conducted in June and July by the Gallup organization, in conjunction with Wells Fargo, revealed that only 7% of investors are aware that the US market gained roughly 30% in 2013.  Fully 57% believe that the market gained 10% or less in 2013, including 9% who think the market actually declined!  Astonishingly, 2/3 of the very same respondents rated themselves as “Somewhat” to “Highly” knowledgeable about investing and markets.  The survey participants were all investors with at least $10,000 invested in stocks, bonds, mutual funds, or in a self-directed IRA or 401(k).  The survey summary can be found at http://www.gallup.com/poll/174746/investors-seem-unaware-bull-market-strong-gains.aspx.

(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, gallup.com)

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 slipped to 13 from the prior week’s 12.3, while the average ranking of Offensive DIME sectors rose slightly to 13.5 from the prior week’s 13.8.  Institutional investors remain cautious, and the Defensive SHUT group retains a slight 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.