FBIAS™  Fact Based Investment Allocation Strategies for the week ending 1/15/2016

The very big picture:

In the “decades” timeframe, the question of whether we are in a continuing Secular Bear Market that began in 2000 or in a new Secular Bull Market has been the subject of hot debate among economists and market watchers since 2013, when the Dow and S&P 500 exceeded their 2000 and 2007 highs.  The Bear proponents point out that the long-term PE ratio (called “CAPE”, for Cyclically-Adjusted Price to Earnings ratio), which has done a historically great job of marking tops and bottoms of Secular Bulls and Secular Bears, did not get down to the single-digit range that has marked the end of Bear Markets for a hundred years, but the Bull proponents say that significantly higher new highs are de-facto evidence of a Secular Bull, regardless of the CAPE.  Further confusing the question, the CAPE now has risen to levels that have marked the end of Bull Markets except for times of full-blown market manias.  See graph below for the 100-year view of Secular Bulls and Bears.

Even if we are in a new Secular Bull Market, market history says future returns are likely to be modest at best.   The CAPE is at 23.82, down from the prior week’s 24.4, after having earlier reached the level also reached at the pre-crash high in October, 2007.  Since 1881, the average annual returns for all ten year periods that began with a CAPE around 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 the CAPE 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 more typical of a rip-snorting 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 U.S. Bull-Bear Indicator (see graph below) turned negative this week, dropping into Cyclical Bear territory.

In the intermediate picture:

The intermediate (weeks to months) indicator (see graph below) turned negative on Friday, December 11.  The indicator ended the week at 1, down sharply from the prior week’s 10.  Separately, the quarter-by-quarter indicator – based on domestic and international stock trend status at the start of each quarter – gave a negative indication on the first day of January for the prospects for the first quarter of 2016.

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.  The Bull-Bear Indicator (months to years) is negative, indicating a new Cyclical Bear has arrived.   In the Intermediate (weeks to months) timeframe (Fig. 4 above), U.S. equity markets are rated as Negative.  The quarter-by-quarter indicator gave a negative signal for the 1st quarter:  neither U.S. equities nor ex-U.S. equities were in an uptrend at the start of Q1 2016, sufficient to signal a higher likelihood of a down quarter than an up quarter. All three major indicators – Bull-Bear, Quarterly Trend, and Intermediate are now negative, making the current market condition very negative.

In the markets:

Stocks declined for a third consecutive week after sell-offs on Wednesday and Friday overwhelmed the market’s attempt to stabilize after a difficult start to 2016.  Small cap stocks have now officially entered bear market territory as the Russell 2000 index has declined more than 20% from its recent highs.  The other major benchmarks are all in correction territory—down greater than 10% from their highs.  For the week, the Dow Jones Industrial Average lost 358 points, or -2.19%, to end the week at 15,988.  The NASDAQ composite declined 3.34%, ending the week at 4,488.  The LargeCap S&P 500 gave up -2.17%, while the MidCap S&P 400 and SmallCap Russell 2000 continue to show relative weakness, ending down -2.95% and -3.68% respectively.  The Dow Jones Utilities Average was alone in bucking the trend and gained +0.69%, as investors sought the safety of the traditionally-defensive utility sector.

In international markets, Canada’s TSX continued to decline on weakness in the oil sector, down -2.99%.  Europe had a difficult week as well.  The United Kingdom’s FTSE was down -1.83%.  On the mainland France’s CAC40 declined -2.85%, Germany’s DAX gave up -3.09%, and Italy’s Milan FTSE lost -3.39%.  In Asia, China’s Shanghai Stock Exchange plunged -8.96%.  Hong Kong’s Hang Seng lost -4.56% and Japan’s Nikkei was down -3.11%.

In commodities, the industrial metal copper declined a further -3.3% last week.  A barrel of West Texas Intermediate crude oil lost -6.69% or $2.20 to $30.68 a barrel.  Crude oil had briefly traded below $30 a barrel last week, a low not seen since 2004.  Precious metals were also negative with an ounce of gold trading down -$15.50 to $1088.60, while silver lost a penny and closed at $13.91 an ounce.

In U.S. economic news, new jobless claims rose 7,000 to 284,000 last week, according to the Labor Department.  The final number is the highest since July.  The smoothed moving average of claims rose 3,000 to 278,750, the highest in 6 months.  Continuing claims for jobless benefits rose to the highest level since September, up 29,000. 

The Labor Department reported that 2.83 million people quit their jobs in November, up from 2.78 million and the most since April 2008 according to the latest Job Openings and Labor Turnover Survey (JOLTS).  Hires were up 29,000 from October to 5.197 million in November.  Layoffs declined to 1.69 million, down from both October’s and September’s numbers.  The number of job openings rose 82,000 to 5.431 million, slightly missing forecasts and below July’s all-time high of 5.668 million.

Last week, the number of U.S. oil rigs in production fell to the lowest level since April 2010 as the price for a barrel of crude plunged to a new low.  Last week, the number of rigs in operation dropped by 20 to 516, the 7th decline in the last 8 weeks, according to Baker Hughes.  The current number of rigs in operation is a whopping 64% lower than this time last year.  According to the EIA, U.S. shale output is expected to decline by 116,000 barrels/day (bpd) in February to 4.8 million bpd.  It would be the seventh straight monthly decline in bpd, but still only 638,000 below the March 2015 bpd peak.  In addition, the EIA reported that U.S. crude and fuel stockpiles had climbed the previous week.  Crude inventories rose 234,000 barrels to 482.6 million barrels last week.  Supplies in Cushing, Oklahoma, the delivery point for West Texas Intermediate crude oil, climbed to an all-time high of 64 million barrels.

The Commerce Department reported that retail sales were down -0.1% in December, missing expectations for a flat reading.  The bigger surprise was the -0.1% decline in sales ex-autos.  Economists were hoping for a +0.3% rise in the holiday shopping season.  Lower gas prices continued to weigh on sales, but even ex-autos and gas, sales were still flat.  Seasonally adjusted sales at motor vehicle & parts dealers remained unchanged.  Non-store sales, which are retailers such as Amazon, saw their sales rise +0.3% last month, and up +7.1% versus a year earlier—the biggest gain since October 2014.  Strong gains were also reported in food service, building materials retailers, and furniture stores, but sales at general merchandise stores declined -1%.

U.S. import prices fell -1.2% last month according to the Labor Department adding increased pressure on U.S. large global product makers such as Apple, General Electric, and Caterpillar.  The price decline wasn’t as steep as expected, but it was the 6th straight monthly decline.  Year over year, import prices are down -8.2%.  Import prices for Chinese goods declined -1.7%, and -3.4% for non-petroleum goods—the strongest yearly declines since 2009.  The stronger dollar continues to get most of the blame (or credit) for falling import prices, but also gets the blame for weakening exports. 

Factory activity in the New York area continued to sink as the Empire State Manufacturing Index declined to 19.37 for January, its lowest reading since March 2009.  It was more than a 14 point plunge from December’s reading and far worse than the expectation of a -4 reading.  The contraction has been ongoing since August.  New orders collapsed to -23.54, the 8th consecutive monthly decline and the steepest decline since early 2009.  Unfilled orders, employment, and shipments were all negative, at -11, -13, and -14.39 respectively.  The 6-month outlook also declined 26 points to 9.5—the least optimistic reading since March 2009. 

St. Louis Fed President James Bullard said “Headline inflation will return to target once oil prices stabilize, but recent further declines in global oil prices are calling into question when such a stabilization may occur.”  Bullard, considered one of the more hawkish Fed officials, said policymakers usually “look through” oil price swings, but that this is “one circumstance where one may be more concerned when inflation expectations themselves begin to change due to the changes in crude oil prices.”  Bullard’s comments lead Fed watchers to believe that the Fed will be less eager to raise rates again after their last initial hike last month. 

Finally, we certainly don’t know yet whether the recent market weakness is the opening slide into a new Cyclical Bear period (as the Bull-Bear Indicator suggests), or is just a less-damaging “correction” in a longer-running Cyclical Bull.  What we can be certain of, however, is that the U.S. market is still richly valued.  Mark Hulbert, of Marketwatch.com, published the graphic below which shows that the 6 most widely-used valuation measures are still higher – even after the current market decline – than they were at 70%-90% of all prior bull-market peaks.

(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,  marketwatch.com,  wantchinatimes.com, BBC, 361capital.com, pensionpartners.com, cnbc.com)

The ranking relationship (shown in Fig. 5) 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 was unchanged at 6.8, while the average ranking of Offensive DIME sectors rose slightly to 15.5 from the prior week’s 15.8.  The Defensive SHUT sectors have maintained their lead over the Offensive DIME sectors.   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, despite the superior US performance.  Because the world 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.