FBIAS™ Fact Based Investment Allocation Strategies for the week ending 12/26/2014

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 27.4 up from the prior week’s 27.2, 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 63.1, up from the prior week’s 62.3, 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, up 1 from the prior week’s 22.  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 are again rated as Positive.  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:

Santa came calling on Wall Street, bringing in his bag of goodies a modest rally that – if history is a guide – may continue into year-end.  For the first time in a month, the US was not the biggest worldwide gainer.  That distinction is held by China, gaining +3.5% on news of the easing of Central Bank lending restrictions.  China pulled Emerging International into the lead amongst the world’s broad indices with a gain of +1.5%.  The US indices gained +1.1% on average, with the Small Cap Russell 2000 leading the charge for the third week in a row.  Beaten-down US Small Caps have staged a late-year revival, but still are the year-to-date laggards amongst US indices.  Developed International brought up the rear with a gain of +0.9%, held back by Japan’s lackluster +0.4% gain.  Canada’s TSX rose +1.0% as many energy stocks stabilized or gained.  Both Emerging International and Developed International indices are in the red for 2014 and look unlikely to pull into the green in the remaining three trading sessions of this year.

US economic news was dominated by the “final” reading of third-quarter GDP: a whopping +5.0%.  That is the best since Q3 of 2003, 11 years ago.  The Q2+Q3 combined performance was also the best two-quarter performance since 2003, so Q3 was not just a singular fluke.  Consumer spending rose at a strong +3.2% annual pace in Q3, up from the +2.5% pace of Q2.  A CNN/ORC poll revealed that – for the first time in seven years – a 51% majority of Americans have a positive view of the economy, a sharp increase from the 38% who felt that way in October.  It is not a coincidence that the rise in economic views coincided with the collapse in oil and gasoline prices.  On the negative side, November durable goods orders were down -0.7% when an increase was expected, and November existing and new home sales were both less than forecast and down vs October, despite a record-low 30-year fixed mortgage rate of just 3.8%.

Canada’s stock market remains largely tied to the materials sector, which makes up a third of the Toronto Stock Exchange weighting.  And this year has not been good for materials producers or processors.  Everyone is aware of the plunge in energy prices, but many other materials produced in Canada have also had a rough ride in 2014.  Iron ore lost nearly half its value to reach the lowest price in more than five years.  Coal, silver, potash, copper and lead prices also weakened in the past year.  The carnage wasn’t universal, however, as nickel, uranium, aluminum and zinc managed to hold steady or gain this year.

Christmas week meant no economic news was released in Europe.  But in Japan, there was a slew of bad news.   Industrial production was down -0.6% in November vs October where a gain was expected, retail sales were down 0.3%, consumer prices ex-fresh food (their core) were up only +0.7% after stripping out the effects of April’s sales-tax increase vs the government’s +2% target, while real wages fell the most since 2009, down -4.3% last month vs a year earlier.  Japan has already had two down quarters in a row and now growth in the fourth is very much in question.  Also, for the first time since records were collected in 1955, Japan has a negative savings rate. Japan is a country that is aging rapidly and the Japanese are drawing down their savings.  Household spending is correspondingly down -2.5% as well.  This is a look into the future of many other countries, particularly those in Northern Europe.  Japan’s Cabinet on Saturday approved about 3.5 trillion yen in fresh stimulus to fight the recession.

China’s overcapacity problem is becoming critical.  Factory-gate prices, as producer prices are known in China, have fallen in year-over-year terms for 33 consecutive months.  An op-ed in the Financial Times notes that “The consequences of China’s deflation problems are ubiquitous and spilling into the rest of the world. Slower economic growth and a steady decline in the [Chinese] economy’s commodity intensity is already affecting commodity producers from Perth to Peru, with negative multiplier effects arising from lower revenues and reduced capital spending by resource companies. Moreover, as Chinese companies cut prices to clear excess supply, global competitive pressures intensify, forcing foreign manufacturers to do so too.  China’s structural deflation, along with factors such as excess debt and rapid aging, will continue to have repercussions for monetary policy in advanced economies worldwide…The U.S. Federal Reserve and other western central banks have failed to anticipate this deflation environment…and appear powerless to reverse the trend.”

As many have suggested, falling energy prices are a boon to consumers.  A surprise to some, though, is the fact that falling energy prices also are a boon to the stock market despite their obvious negative implications for the stocks of energy producers and processors.  Here is a look at 6-month forward historical performance of the S&P 500 (in blue) and the Consumer Discretionary sector (in red) following 6-month periods of rising crude prices and 6-month periods of falling crude prices (source: Strategas Partners).

(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)

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 9.5 from the prior week’s 8.5, while the average ranking of Offensive DIME sectors rose to 16.5 from the prior week’s 18.3. Institutional investors remain cautious, and the Defensive SHUT group continues to rank 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.