FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 9/19/2014

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 26.4, barely changed from the prior week’s 26.3, 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 64.7, little changed from the prior week’s 64.6, 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, unchanged from the prior week.  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:

LargeCap US equities gained for the week, and pretty much everything else around the world dropped.  On the plus side, the S&P 500 gained +1.3%, and the Dow Industrials rose +1.7%.  But US MidCap and SmallCap indices lost -0.2% and -1.2% respectively for the week.  Likewise, Canada’s TSX gave up -1.7%, Developed International pulled back a slight -0.1%, and Emerging International lost -0.8%.  It is a saying among Wall Streeters that when the market is running out of steam, “large caps are the last to go.”  If the market is indeed running out of steam, the market is following this script.

In US economic news, initial jobless claims fell to 280,000, the lowest number in 7 years.  The National Association of Home Builders (“NAHB”) reported its housing market index rose to 59 from 55 a month ago, and matched its highest reading since 2005.  The Empire State Manufacturing index grew to 27.5 in September, the highest level since October, 2009.  Producer Price Index and Consumer Price Index figures stayed steady, benefiting from falling energy prices which have declined significantly over the last month.  On the negative side, housing starts were below expectation, as was industrial production which was dragged down by motor vehicle production that dropped -7.6% from the prior month.  And although it was widely anticipated that the magic phrase “considerable time” (describing how long accommodative policy would remain in place) would be removed from the Fed statement issued this week, it remained in place rendering the Fed announcement mostly a non-event.

Canada’s annual inflation rate was reported at 2.1%, the fourth month in a row that it was above the Bank of Canada’s 2.0% target.  The Bank of Canada is now in a quandary: it is on record as intending to maintain low interest rates to boost a soft economy, yet also on record as being more than willing to raise rates to keep a lid on inflation.  The central bank said earlier in September that higher inflation recently seen has been attributable to “temporary effects.”

The Organization for Economic Development (“OECD”) issued revised (and mostly lower) estimates of Eurozone GDP for 2014. The Eurozone as a whole estimate was revised down to +0.8%.  Some individual country examples are:  U.K. (+3.1%); Germany (+1.5%); France (+0.4%); Italy (-0.4%).

In China, factory output rose just +6.9% in August from a year earlier after a +9.0% rise in July, further confirmation of a slowdown.  Foreign direct investment in China, which is the lifeblood of the manufacturing sector, fell -14% last month to a four-year low, and followed a -17% decline in July.  Chinese new-home prices fell a fourth straight month in August.  Of 70 major Chinese cities surveyed, prices fell in 68 of them last month, following a decline in 64 of 70 in the previous month.

All year, globally-allocated investors have hoped that non-US assets would outperform US assets for the first time in four years.  Indeed, Emerging Markets have done better than the S&P 500 in 2014 until just a couple of weeks ago.  Since then, however, Emerging Markets have underperformed the S&P by a large -5% and in the process gave up their lead.  This chart shows the rather sudden reversal in fortunes:

(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 to 10.8 from the prior week’s 11.8, while the average ranking of Offensive DIME sectors rose to 16.3 from the prior week’s 18.3.  Institutional investors remain cautious, and the Defensive SHUT group continues to rank 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.