FBIAS™ Fact Based Investment Allocation Strategies for the week ending 10/3/2014

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 26.1, down 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 58.8, down from the prior week’s 62.0, 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 16, down 7 from the prior week’s 23, and in Negative status.  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 October for the prospects for the fourth 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 moved to Negative status on October 1st.  The quarter-by-quarter indicator gave a positive signal for the 4th quarter:  US equities were in an uptrend, while International equities were in a downtrend at the start of Q4, and either one being in an uptrend is sufficient to signal a higher likelihood of an up quarter than a down quarter.

In the markets:

Markets worldwide were negative for the week, though well off the week’s lows thanks to the jobs-inspired rally on Friday.  LargeCap US indices continued to be relatively stronger, with the S&P 500 retreating a fairly modest      -0.8%.  US MidCaps and SmallCaps continued their underperformance, giving up -1.6% and -1.3% respectively (this was the 5th consecutive negative week for US SmallCaps).  Internationally, the biggest loser was Brazil, shedding    -6.7% ahead of Presidential elections and in reaction to negative Chinese consumption news (see below for more about the Brazil-China connection).  Emerging Markets gave up -2.7% on average, while Developed Markets lost    -3.2% on average.  Emerging Markets have now joined Developed Markets in the negative YTD column, and are now down -0.5% for the year to date, while Developed Markets are down -4.3% for the year to date.  Canada’s TSX pulled back -1.6%, and like US SmallCaps this was its 5th consecutive negative week.

For the month of September, the story was the same as above: everybody lost, but US LargeCaps did best and everything else not so much.   The Dow lost just -0.3%, the LargeCap Nasdaq-100 just -0.8% in September, but it was downhill from there.  US MidCaps gave up -4.7% and US SmallCaps shed -6.2%.  Canada and Developed International retreated -4% and -3.9%.  The biggest loser for the month was the previously high-flying Emerging Markets group, which was lost a huge -7.8%.  The 3rd Quarter as a whole was qualitatively similar: US LargeCaps were up, US MidCaps and SmallCaps were down substantially, and both Developed and Emerging International groups were also down for the quarter.  Canada’s TSX fared better than most non-US indices, losing -1.2% during Q3, but retains a lead over the US for the year to date.

The International Monetary Fund (“IMF”) recently described the US as “rare bright spot” in the global economy.  And the US lived up to that billing in this week’s economic news.  Friday brought a solid jobs report for September, with nonfarm payrolls growing 248,000 and the unemployment rate falling to 5.9%, the lowest since July 2008. The figures for the prior two months were also revised upwards; from 142,000 to 180,000 in August, and 212,000 to 243,000 for July.  Among the few negatives from the jobs report was that average hourly earnings were unchanged, and remain up just 2% from a year earlier, and the labor force participation rate fell to 62.7% from 62.8%, still a long way below pre-recession levels.  The Chicago Purchasing Managers Index (“PMI”) for manufacturing in September was a solid 60.5, while the Institute for Supply Management (“ISM”) data on national manufacturing was 56.6, down from the prior month’s 58.5 but still very good.  The ISM service sector reading came in at 58.6 for last month, also very good.

Canada got two unexpected surprises in economic data this week.  First, July saw no growth in GDP, following six consecutive monthly gains, according to Statistics Canada.  Then on Friday, Statistics Canada reported a surprise trade deficit for August as exports dropped and imports rose by the largest amount in almost two years, to a new all-time high.

Europe is described by the IMF as being stuck in a “new mediocre” condition with high debt, high unemployment and low growth.  The statistics arm of the EU, Eurostat, released its data on unemployment for the euro-18 and the rate remained stuck at 11.5% in August, only down slightly from the 12.0% reading of a year ago. Germany’s jobless rate is just 4.9%, but France is at 10.5%, Italy 12.3%, Spain 24.4% and Greece 27.0%.  The youth unemployment rate remains at shocking levels, especially in the southern tier: 53.7% in Spain, 57.5% in Greece, 44.2% in Italy and 35.6% in Portugal.  Deflation is still very much a danger, with Eurostat reporting just 0.3% annualized inflation, a five-year low.  The composite PMI for the Eurozone (combining manufacturing and services) was 52.0 in September, down from August’s 52.5.  France’s 48.4 was a 3-month low, and Italy’s 49.5 was a 10-month low (above 50 is expansion, below 50 is contraction).

It is noted above that Brazil’s market has taken a beating lately.  Some other Latin American markets have also suffered.  The troubles are in part due to political uncertainties, such as the Brazilian presidential race (the leading candidates are two Socialists each trying to out-promise one another with plans for taxes and anti-business regulations).  However, another little-appreciated cause for concern is that much of Latin America has become highly leveraged to China.  So much so that, to paraphrase an old saying, when China sneezes, Latin America catches a cold.  And it appears that the current slowdown in China may have given some Latin American economies a cold!  This chart, from Bloomberg, shows how much the total trade between major Latin American countries and China now exceeds the trade done with the US (note that both Chile and Brazil now do about double the amount of trade with China compared to their trade with the US).

(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)

The ranking relationship (graph below) 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 8 from the prior week’s 9.5, while the average ranking of Offensive DIME sectors fell to 16.3 from the prior week’s 15.3.  Institutional investors remain cautious, and the Defensive SHUT group ranks higher than the Offensive DIME group ranking by the widest margin in more than a year.

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.