FBIAS™ Fact Based Investment Allocation Strategies for the week ending 11/7/2014

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 a little from the prior week’s 26.4, 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 56.7, up from the prior week’s 54.6, 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) is Positive and ended the week at 21, up 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 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 returned to Positive status on October 17th.  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:

The week saw modest gains in the US and Canada, and mostly losses in International markets.  US indices gained an average +0.4%, led by the Dow at +1.1% and with the SmallCap Russell 2000 bringing up the rear at -0.02%.  The Dow and S&P 500 finished the week at new all-time highs.  On Wednesday (11/5), the Dow, the S&P 500, the Dow Transports Index and the Dow Utilities Index all simultaneously closed at new highs – the first time since 1998 that all four had done so on the same day.  Canada’s TSX gained +0.5% on the back of strong double-digit gains in many gold and oil stocks on Friday, and ended the week at a one-month high.  Internationally, Brazil was the worst at -5.2% followed closely by Japan at -4.1%.  Developed International as a whole retreated -2.2%, and Emerging International declined -1.7%.  Europe overall gave up -1.8%.

In the US, the employment report for October notched a ninth consecutive month above 200,000 (214,000), the best such stretch since March 1995. August and September were also revised up a total of 31,000.  The unemployment rate ticked down to 5.8%, its lowest level since July 2008.  However, the labor force participation rate hasn’t likewise improved.  This chart shows clearly that labor force participation (expressed as civilian employment as % of population) has not recovered from the recession of 2008-2009.  In prior post-recession periods, labor force participation has returned to pre-recession levels promptly– but it shows few signs of doing so this time.

Statistics Canada reported that the Canadian economy added 43,100 new jobs in October, a surprise to most observers, and that the unemployment rate dropped to a nearly six-year low of 6.5%.   Analysts had expected a loss of 5,000 jobs after September’s gain of 74,100 positions.  The jobless rate, down from 6.8% in September, was the lowest since the 6.4% recorded in November 2008.  The combined September and October gains were two-thirds of all the job gains in the past year.

The European Commission reduced its growth forecast for the Eurozone to just +0.8% in 2014, down from a previous projection of +1.2%, while cutting 2015 to +1.1% from +1.7%.  The Commission also reduced its inflation forecast to 0.5% this year, 0.8% in 2015 and 1.5% in 2016, all well below the European Central Banks’s 2% target.  Marco Buti, the director general of the European Commission’s economics department, said “We see growth…coming to a stop in Germany…protracted stagnation in France and contraction in Italy.”

A good barometer of China’s economy has been the health of the gambling industry in Macau – an industry that is an amazing seven times larger than that of Las Vegas.  Macau’s casinos recorded their worst monthly revenue performance on record in October, down -23.2% from a year earlier (records go back to 2005).  Anti-corruption campaigns have no doubt dampened high-rolling excesses to some degree, but few believe it is the major cause of such a drastic decline.

(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 (shown in Fig. 5 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 fell to 7.3 from the prior week’s 7.0, while the average ranking of Offensive DIME sectors fell to 20 from the prior week’s 18.5. Institutional investors remain cautious, and the Defensive SHUT group continues to rank substantially higher than the Offensive DIME group ranking.   This caution is reflected in the fact that institutional investors are underperforming market averages this year, having been cautious and defensively positioned with lots of cash while market averages have gone on to new highs – leaving them behind.

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 globally 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.