FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 9/5/2014

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 26.6, up slightly from the prior week’s 26.5, 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 66.7, up from the prior week’s 64.9, 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) ended the week at 24, up one 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 returned to Positive status on August 25.  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:

Except for Emerging International indices, markets were little changed for the week.  Nonetheless, most US indices managed to post a 5th straight weekly gain.  Both the Dow and the S&P 500 gained a modest +0.2%, while the Nasdaq was flat and the Russell 2000 SmallCap index declined by -0.4%.  Canada’s TSX also declined by -0.4%, dragged down by declining commodities prices.  The best performers were found in the Emerging Markets category, led by China with a large +5.1% gain for the week.  Another strong winner in the Emerging category, India posted a +3% gain.  Several popular India ETFs (e.g., EPI, INDY, INDA, SMIN) are up 30% – 50% for the year to date.  Developed International indices were up +0.4% on average, with Europe leading the way in that category with a +1.8% gain.

In the US, the August nonfarm payroll report was the biggest economic headline of the week, but was disappointing with just 142,000 jobs created.  This was the first figure below 200,000 after six consecutive months above that level, and was also well below expectations of 220,000-230,000. The unemployment rate ticked down from 6.2% to 6.1%, while average hourly earnings rose just +0.2%.  July construction spending was up a strong +1.8%, July factory orders rose +10.5% (looks like a big number, but 11% was actually expected!).  The Institute for Supply Management (“ISM”) readings for August manufacturing came in at 59.0, and the services segment was reported at 59.7.  Both were very solid and the services segment reading was the best since August, 2005.  Janet Yellen’s speech at the recent Jackson Hole conclave was dissected syllable by syllable by economists and Fed-watchers; one of the peculiar findings was that her (or the Fed’s) new favorite word is “slack” – an intentionally ambiguous word with no associated metrics.  Her speech used the word an incredible 25 times.  No slacker, she!

Statistics Canada, the branch of Canadian government in charge of reporting employment numbers, caused more raised eyebrows when its August employment report showed heavy losses in private sector employment, but a nearly-equal gain in self-employment for a net job loss of 11,000.  This followed the July report which required a correction after a rather large number of workers (some 42,000) were later discovered to have been overlooked by Statistics Canada.  Scotiabank economists Derek Holt and Dov Zigler pointed out that never before in the 38-year history of the employment report had a decrease in private sector employment of this magnitude occurred    (-112,000) nor had the nearly-equal increase in self-employment ever occurred.  They called it “very fishy” and urged their clients to regard the report with some suspicion.

In Europe, Germany’s Angela Merkel and the International Monetary Fund (“IMF”) chief Christine Lagarde continued their long-running feud over stimulative government spending (Lagarde’s preferred strategy) vs austerity and reform (Merkel’s preference).  Merkel pointed out again this week that countries which chose austerity and reform seem to be recovering better than those who have done little but pay lip service to reforms or reduced expenditures.  Ireland, for example, imposed severe austerity measures three years ago, but now Ireland has the Europe’s leading composite Purchasing Manager’s Index (“PMI”) for August at 61.8, the best level since August 2000, the manufacturing PMI is 57.3, the best since 1999, and its GDP is likely to grow +3% this year.  Even Spain, previously a basket case, is beginning to benefit from its own limited brand of austerity measures, reporting a composite PMI of 56.9 for August, the best in 89 months.  But those countries that have only given lip service to reform – in particular France and Italy – continue to be stuck in flat or declining economies.

The extent and duration of the “declining” mentioned above can be readily seen in this chart.  Total Euro Area industrial production has been down from its August 2011 peak for 3 years, and is up less than a third of the gain in US industrial production over the period December 2009-July 2014.

(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, Orcam Financial Group)

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 from the prior week’s 14, while the average ranking of Offensive DIME sectors declined to 16.8 from the prior week’s 14.3.  Institutional investors remain cautious, and the Defensive SHUT group expanded 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.