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

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 26.3, down from the prior week’s 27.3, 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 62.0, down from the prior week’s 65.5, 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 23, down 3 from the prior week’s 26.  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:

For the US and many other markets, the week ending Dec 12th was the worst week in several years.  The Dow Industrials suffered its worst loss since November 2011, -3.8%, while the S&P 500 lost -3.5%, its worst performance since May 2012, with both indices snapping seven-week winning streaks after each hit a new high the prior Friday.   The Nasdaq Composite index fell a second consecutive week, losing -2.7%.  The Russell 2000 SmallCap index was the best performing US index, at -2.5%, but fell back into the red for the year to date.  The rest of the world fared even worse.  Once again, commodity-dependent markets performed the poorest, led by Brazil at -9.3%.  Emerging Markets as a whole dropped -6.2% while Developed Markets on average retreated          -4.7%.  The Greek stock market, for political rather than commodity reasons, crashed -20%, the worst performance since 1987.  Canada’s TSX index declined by -5.1%, and has given up almost all of its gains for the year.

Even in the midst of the stock market gloom, there were good US economic reports away from the news-dominating price of oil.  US retail sales rose +0.6% month over month, better than expected.  Consumer confidence came in at 93.88, which was much better than expectations.  The National Federation of Independent Business (NFIB) small business optimism index was reported at 98.1, the highest in almost 8 years.  Initial jobless claims were 294,000, down 3,000 from last week and a bit lower than expected.  The Mortgage Bankers Association reported that home-refinance applications rose +13.2% week-over-week.  And, of course, oil fell          -12.6% just this week and is off more than -40% from its 2014 highs.

The Canadian dollar (the “Loonie”) fell to a 5 1/2 year low of 86.42 cents US.  The Loonie has tumbled almost a full US cent just this week as oil prices continued to plummet.  Partially offsetting the negative Loonie news was a government forecast of stronger non-petroleum exports on the back of new competitiveness from the lower Loonie.

In Europe, poor economic reports for the Eurozone continued.  Eurozone industrial production for the month of October was released, up just +0.1% month over month (and up a scant +0.7% year over year).  German industrial production for October was also up a less-than-expected +0.2% from September.  The New York Times reported on a French poll revealing an astonishing 90% public disapproval of French President Hollande’s economic policies. 

China’s national statistics bureau released a number of reports this week, none of which were particularly good.  November exports rose +4.7% year over year, far less than expected, while imports fell -6.7%.  Exports to the US rose +2.6% year over year, but this was far less than October’s +10.9% pace.  Another key barometer of economic activity, electricity output, rose only +0.6% in November vs last year.  Producer prices (called “Factory Gate” prices in China) fell an amazing 33rd consecutive month, down -2.7%.  This is outright industrial deflation, brought about by severe overcapacity, lower commodity prices, and no pricing power.  Nonetheless, the Shanghai stock exchange index is up +39% for the year to date after having lain dormant for the prior several years.  Unlike most other investor populations around the world, the majority of domestic Chinese individual investors are…women.  Middle-aged women, in particular, called “dama”.  The Beijing Economic Information Daily publication identifies these “dama” investors as the main factor behind the Chinese market’s recent bullish behavior.

Although this past week was a bust for the markets worldwide, it also is the only week in December which is historically negative.  The remainder of December has historically straightened up and sailed profitably through the end of the year, as this chart from SentimentTrader.com illustrates:

(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, Barclays)

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 slipped to 9.0 from the prior week’s 6.5, while the average ranking of Offensive DIME sectors fell to 17 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 for 2014, 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.