FBIAS™ Fact Based Investment Allocation Strategies for the week ending 11/28/2014

The very big picture:

In the “decades” timeframe, we may still be in the 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.

Even if we are in a new Secular Bull Market, market history says future returns are likely to be modest at best.   The Shiller P/E is at 27.2, up a little from the prior week’s27.1, 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 63.3, up from the prior week’s 61.1, 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 27, up from the prior week’s 25.  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), whether we are in a new Secular Bull or still in the Secular Bear, the long-term valuation of the market is simply too high to sustain rip-roaring multi-year returns.  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:

Markets that are not dependent upon commodities advanced modestly last week, while those that are commodity-dependent declined, some quite hard.  The US market indices advanced +0.7% on average, with the Nasdaq leading at +1.7% and the S&P 500 at a more modest +0.2%.  Canada’s TSX was battered by both the oil freefall and a decline in gold prices, and declined by -2.4%.  Emerging markets, many of which are commodity producers, fell by -2.2%, while Developed markets gained +0.3%.  DBC, the PowerShares Commodity Tracking ETF, fell -6.1% for the week.  DBC tracks a composite of energy, precious metals, industrial metals and agricultural commodities.

The month of November was positive for most markets worldwide.  In the US, the Dow and the S&P 500 both gained +2.5%, with only the SmallCap Russell 2000 index losing ground at -0.02%.  Despite the setback in the last week of the month, Canada’s TSX managed to gain +0.9%.  Emerging markets fell by -1.5% for November, but Developed markets eked out a slight gain of +0.1%.  As the markets enter the final month of the year, many observers are wondering if the S&P 500 index can finish the year without 4 down days in a row.  There hasn’t been a single year since 1950 without the S&P 500 experiencing at least 4 down days in a row.

US economic data included the first revision to third-quarter GDP, and it was an expectation-beating +3.9%.  Coupled with the second quarter’s +4.6% rise, this represents the biggest back-to-back advances in GDP since late 2003.  October durable goods and consumer spending came in lighter than expectations but still positive.

Canada’s economy grew an annualized 2.8 percent in the third quarter, faster than economists had forecast, as exports of crude oil grew and consumers bought more cars and big-ticket items.   However, the rout in oil and renewed decline in precious metals are playing havoc with large segments of the Canadian economy.  Oil is at a 5 year low, copper at a 5 year low, and the Bloomberg commodity index has fallen to the lowest level since May 2009. Many energy and mining company shares have fallen 10%-20% in the last three weeks.

The crash in oil prices is by far the most important global economic news.  West Texas Intermediate (WTI) oil plunged below $70.00 a barrel to finish the week at $66.15 – a decline of a whopping -14% on the week, with the price having fallen over $40 since the mid-June weekly closing highs of nearly $107.00, or off about 38% in just five months.

US imports of crude oil from OPEC nations are at the lowest levels in almost 30 years, according to a Financial Times analysis of Department of Energy data, with OPEC’s share of the imports dropping to 40%, the lowest since May 1985. At its peak in 1976, OPEC represented 88% of U.S. oil imports. 

The plunge in the price of oil is not universally good news, of course:  Deutsche Bank warned in a study “that if oil fell to $60, there could be a 30% default rate among borrowers in the energy sector, who loaded up on debt to fund their operations and acquire new acreage in states like North Dakota.”

But it is certainly being taken as good news by retailers, who stand to gain from the increased spending power of consumers who are presumably spending a lot less at the gas pump.  Another bit of good news, at least to retailers, has been the early and harsh arrival of winter in the US.  Retailers expect the sales of winter-season apparel to rise dramatically, and have greatly expanded their stocks of heavier clothing and outerwear.  Terry Lundgren, CEO of Macy’s, said “We now have much higher expectations for the fourth quarter.”

This chart shows what Macy’s and other retailers already know:  November was cold!  In fact, it was the second coldest November on record for the US, trailing only 1911.

(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, St. Louis Fed, fivethirtyeight.com)

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 7.5 from the prior week’s 6.5, while the average ranking of Offensive DIME sectors rose to 15.8 from the prior week’s 16.5. 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.