FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 9/12/2014

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 26.3, down from the prior week’s 26.6, 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 64.6, down from the prior week’s 66.7, and continues 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 25, up one from the prior week’s 24.  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:

All major markets gave up ground last week.  Emerging markets reversed their prior week role as leader, and became the laggard, by quite a margin.  US and Canadian markets escaped the worst of it, only falling -0.3% and     -1.1%, respectively.  Developed International markets retreated -1.5%, but the worst results came from Emerging Markets with an average loss of -4.5%.  Brazil, recently red-hot, gave up a whopping -10.1% while China fell -3.7%.

Emerging Markets had been outperforming the US in recent months, but gave up their year-to-date edge over the US and returned global ex-US investors to the all-too-familiar role of running behind the US, a role they have played for the last 4 years.

Two major fears gripped the markets.  The first fear, continued European stagnation at recessionary levels, received most of the coverage.  However, the major US story was largely absent from the headlines.  That story is the sudden, severe rise in US interest rates (more on that subject below).  Interest-rate sensitive sectors in the US took a pounding for the week: the Dow Jones US Real Estate index of REITS dropped by a huge -5.0%, and the Dow Jones Utilities Index fell -3.1%.

US economic news was generally positive.  Job openings were reported at the highest levels since 2001.  Retail sales gained +0.6% month-over-month, and July was revised upward to +0.3%. Consumer confidence rose to 84.6, up from 82.5 and above the 83.3 expected.  Consumer credit in July rose by the largest amount in 13 years, and the National Federation of Independent Business (“NFIB”) small business index rose to 96.1, half a point from the highest readings since 2007.  About the only sour note was that mortgage applications fell -2.6% from the prior week to the lowest level since February.

Despite some recent cooling, The Economist magazine just rated Canada’s housing market as among the most overvalued in the world and “bears an unhappy resemblance” to what the US housing picture looked like before the financial crisis.  When comparing the relationship between the costs of buying and renting, it cited Canada, Hong Kong and New Zealand as “the most glaring examples” of overheated markets.  The Economist magazine is not alone, as the Organization for Economic Cooperation and Development (“OECD”) has said Canada’s market is overvalued by as much as 30 per cent when measured by the price-to-income ratio and by 60 per cent based on the price-to-rent ratio.

In Europe, all eyes are on the Scottish vote on independence from Great Britain.  Several major financial institutions have stated their intention to move operations from Scotland should the vote be in favor of independence, including the Royal Bank of Scotland (would it then be the Royal Ex-Bank of Scotland?).  In France, which is firmly in recession and making little progress – or effort – to get out of it, President Francois Hollande suffers from an incredible approval rate of just 13%.  Even a quarter of his Socialist supporters, who swept him to power, want to see him resign, while 62% of the entire electorate likewise wants him to go.

More about US interest rates.  As shown on the chart below, rates have sharply risen on the widely-watched benchmark 10-year Treasury Note, moving up for 9 of the last 11 days.  The US dollar rose for the 9th consecutive week, its longest rally in 17 years, on continued weakness in the Euro and in recognition of the interest rate rise – and no doubt in anticipation of more to come.

It seems to have been concluded by many major investors that the US economy has finally reached the point of robustness that will force the Fed to commence their long-delayed but inevitable rate raising.  Many observers expect that the statement at the end of this coming week’s Fed meeting will strongly hint that the rate hikes will be sooner rather than later.

Two of the most important data points that the Fed is certain to consider are shown here – the Institute for Supply Management (“ISM”) separate readings for the Manufacturing and Services portions of the US economy.  Both have recently broken out to multi-year highs and are running on the “hot” side, leaving little room for the Fed to continue to use their frequently-employed word “slack” to describe the US economy.

(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, scottgranis.blogspot.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 rose slightly to 11.8 from the prior week’s 12, while the average ranking of Offensive DIME sectors declined to 18.3 from the prior week’s 16.8.  Institutional investors remain cautious, and the Defensive SHUT group again 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.