FBIAS™ Fact Based Investment Allocation Strategies for the week ending 12/19/2014

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 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 62.3, up 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) is Positive and ended the week at 22, down 1 from the prior week’s 23.  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 most markets this past week, this is all one needs to know:

A rise in the price of oil and the stocks of energy companies helped, too, especially in Canada and other locales sensitive to oil prices.

Prior to Wednesday, Dec 17th, US stocks had declined six out of seven sessions.  But the Fed’s benign language and Janet Yellen’s non-threatening press conference was enough to put in another “V”-shaped bottom, and it was off to the races.  The subsequent Wed-Fri rally was the best since March, 2009.  For the week, US indices gained an average of more than +3%, with the SmallCap Russell 2000 index leading at +3.8%.  Surprisingly, despite the breathtaking rally US indices did not quite recover all of their losses from the prior week, but are nonetheless back to within spitting range of their all-time highs.  Canada’s TSX rallied the most in 5 years, gaining +5.4% on the double shot of good news from the US and from the jump in both oil prices and energy company stocks.  The Energy stocks in the TSX gained an eye-popping +13% for the week.  However, neither Developed nor Emerging International indices fared as well as did the US and Canada.  Developed International gained +1.2% for the week, and Emerging International +1.3%, but neither came lose to overcoming their prior-week losses of -6.2% and 4.7% respectively.

US economic news was benign on balance, as has been the norm for some time.   Industrial production rose +1.3% vs expectations for a +0.7% increase – the +1.3% gain was the biggest monthly increase since May 2010.  Initial jobless claims were reported at 289,000 vs expectations of 295,000.  Capacity Utilization came in above 80% for the first time since 2008.  The 80% level is often seen by economists as a level at which new capital spending must occur for the creation of additional capacity, with that very spending becoming an economic boost.  US manufacturing output rose +1.1% in November, finally surpassing its pre-recession peak.  On the negative side, November’s Purchasing Managers Index (PMI) for manufacturing was reported at 53.7, the lowest reading in more than a year, and the PMI for Services fell to 53.6, the lowest in 9 months.

The Canadian dollar fell for the fourth week in a row, to 0.862 US dollars.  November Canadian consumer prices rose 2% from the year-ago level, down from the October pace of 2.4% annualized.  The modest increase is well within the Bank of Canada’s target range, seen as giving the central bank continued leeway with interest rates.

Eurozone economic data continues to be lackluster.  The “flash” Eurozone composite PMI for December was 51.7 vs. 51.1 in November, with the manufacturing reading going from 50.1 to 50.8 and the service sector rising to 51.9 from 51.1.  Despite these rises, they remain barely in expansion territory (50 is flat).  The readings for the two biggest Eurozone economies, Germany and France, were dispiriting as well.  France saw its manufacturing PMI fall to 47.9 when an increase had been expected, while Germany’s composite PMI rose to 51.2 from 49.5, but the services PMI fell from 52.1 to 51.4.  Deflation remains a major concern as euro area inflation for November was just 0.3% annualized, vs. 0.4% in October and 0.9% a year ago.  Prices declined in Greece (-1.2%) and Spain (0.5%), while they rose just 0.4% annualized in France and 0.5% annualized in Germany.

In China, the government has declared that small particles from the smog in many Chinese cities have surpassed smoking as the primary cause of skyrocketing lung cancer diagnoses.  Lung cancer now tops the list of all cancers in China, and has been increasing at an annual clip of almost 27% in recent years according the China’s National Cancer Registration Center.  It is most likely no coincidence that the rate of lung-cancer cases in Beijing, which is plagued by some of the nation’s worst smog, went from 39.6 per 100,000 in 2002 to 63.1 in 2011, an increase in rate much higher than the national average.

Amazon has done a great – if so far unprofitable – job of becoming the dominant online retailer.  Its “Amazon Prime” service, incorporating free shipping, special discounts, and music/video streaming services, has jumped in popularity, rising from 20 million members to almost 60 million just in 2014.

Given that level of penetration, it seems inevitable that Santa would receive this letter:

(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, Business Insider)

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 rose slightly to 8.5 from the prior week’s 9.0, while the average ranking of Offensive DIME sectors fell to 18.3 from the prior week’s 17. 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.