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 Fig. 1 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 26.50, up from the prior week’s 26.17, after having earlier reached the level also reached at the pre-crash high in October, 2007. Since 1881, the average annual return for all ten year periods that began with a CAPE around this level have been just 3%/yr (see Fig. 2).
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 Fig. 3) turned positive on July 8th, and now is in Cyclical Bull territory at 55.60, up from the prior week’s 53.66 and above the Bull level of 55.
In the intermediate picture:
The Intermediate (weeks to months) Indicator (see Fig. 4) turned positive on June 29th. The indicator ended the week at 21, up from the prior week’s 20. Separately, the Quarterly Trend Indicator – based on domestic and international stock trend status at the start of each quarter – gave a positive indication on the first day of July for the prospects for the third quarter of 2016.
In the Secular (years to decades) timeframe (Figs. 1 & 2), 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 positive (Fig. 3), indicating a potential uptrend in the longer timeframe. The Quarterly Trend Indicator (months to quarters) is positive for Q3, and the Intermediate (weeks to months) timeframe (Fig. 4) is positive. Therefore, with all three indicators positive, the U.S. equity markets are rated as Very Positive.
In the markets:
U.S. stocks ended the holiday-shortened week on an up note, thanks to a very strong rally on Friday. Indices were negative for the week going into Friday, but ripped higher on the stronger-than-expected jobs report (more on that below). The benchmark S&P 500 LargeCap index ended the week at 2,129.90, within one point of its all-time closing high, up +1.28%. The Dow Jones Industrial Average gained almost 200 points ending the week at 18,146, up +1.1%. MidCaps and SmallCaps rose a bit better than LargeCaps, up +1.35% and +1.78% respectively. For the first time in 6 months, the Nasdaq Composite is again closing in on the 5,000-level with a gain of +94 points, ending the week at 4,956 (+1.94%). Even the defensive Utilities sector squeaked out a gain at +0.2%.
In international markets, Canada’s TSX rose almost 200 points to 14,259, up +1.39%. Markets were mixed in Europe where the United Kingdom’s FTSE rose +0.19%, but other major markets were down. Germany’s DAX fell -‑1.5%, France’s CAC 40 declined -1.95%, and Italy’s Milan FTSE slipped -1.4%. Markets were also mixed In Asia, where Japan’s Nikkei plunged almost -3.7%, but China’s Shanghai Composite gained 1.9%. Developed International markets as a group fell -1.02% (EFA) and Emerging Markets as a group slipped -0.55% (EEM).
In commodities, precious metals continued to shine as Gold rose for a 6th straight week to $1367.40 an ounce, up 1.67%. Silver also was bid up aggressively, adding an additional +2.49% to $20.35 an ounce. But crude oil plunged ‑$4.16 a barrel to $45.12, down a sharp -8.44%.
In U.S. economic news, ADP reported on Wednesday that private-sector employment increased by 172,000 for June—May’s number was revised down slightly to 168,000 from 173,000. Analysts had expected 160,000. ADP’s number is often looked at as an indication of the Labor Department’s employment report that covers both private sector and government employment. According to ADP, small private-sector businesses added 95,000 jobs last month, medium businesses added 52,000 and large added 25,000. However, all of the gains in the ADP report came in the service sector, while manufacturing lost 36,000 jobs.
Confirmation (with an exclamation point!) of the stronger U.S. labor market came with the government’s release of the Non-Farm Payrolls (NFP) report on Friday (sparking a big stock market rally). The NFP report showed jobs surging back last month, with a gain of +287,000 new jobs. The report seemed to put to rest worries that the labor market and broader economy had taken a turn for the worse. The sharp rebound in hiring fits with other labor market reports that indicate the labor market remains the healthiest it’s been in years. Economists had not expected such a robust report, predicting only 170,000 new jobs.
The U.S. unemployment rate rose +0.2% to 4.9% last month as more people entered the labor force in search of work. As a result, the labor force participation rate rose slightly as well, to 62.7%.
In manufacturing, the news was not quite so good. U.S. factory orders fell -1% in May following a +1.8% surge the previous month. Analyst expectations had been for a -0.8% decline. Total orders declined at an annualized -1.9% rate, and ex-transportation annual orders were down -3.4%. Orders in the energy sector improved following a sharp decline the previous month, although durable goods orders overall were still down -2.3%.
The most important sector of the U.S. economy – services – was stronger in June as Markit’s final June Purchasing Managers Index (PMI) services-sector data was revised marginally higher to 51.4, up +0.1 point. The U.S. service sector is home to most of America’s jobs and it has been offsetting a much weaker (but smaller) manufacturing sector. While service providers have continued to report growth, the rate of expansion has been slowing in part due to uncertainty over the economy and the upcoming elections. According to Markit, survey respondents reported the fastest pace of new business since the start of the year, but also subdued business confidence.
The Institute of Supply Management’s (ISM) non-manufacturing index soared to 56.5, a 7-month high that widely exceeded analyst forecasts. Readings above 50 indicate expansion. The details of the report were strong—new orders, which give an indication of future activity, came in strong, up 5.7 points to 59.9. The production sub-index rose to 59.5. Only 3 industries reported contraction in June, while 15 reported growth. ISM said the results show a “strong rebound.”
Minutes released from the Federal Reserve’s Open Market Committee meeting in June revealed unease over the risks of financial shocks to the economy. Overall, a majority was still expecting to raise interest rates in the short-term, but they were wary of potential financial shocks which could derail the process—such as the United Kingdom’s “Brexit” referendum. The minutes gave no indication of whether officials were considering a rate hike in July, September, or later in the year. Most members still expected inflation to rise gradually to their 2% target and that transitory factors that had kept inflation down had receded.
In Canada, the trade deficit was worse than expected in May at C$3.28 billion. Analysts had expected a narrowing to C$2.6 billion. The April deficit was also revised sharply higher making the April and May trade deficits the highest on record. Overall exports fell -0.7% to C$41.1 billion with an accompanying -2.3% decrease in volumes. Overall exports declined in 7 of the 11 categories, with actual shipments lower across most industrial sectors.
In the United Kingdom, worries increased about the outlook for UK commercial property prices. Several of the largest UK commercial real estate funds halted trading amid concerns that there would not be enough liquidity to honor increasing demands for redemptions. Most of the funds invest directly in UK real estate and in order to satisfy investor redemptions property assets must be physically sold off to provide liquidity.
German Chancellor Angela Merkel stated that Britain’s vote last month to leave the European Union will lead to only “limited” economic uncertainty in Germany. She said that the remaining 27 EU member states should ensure that their economic bloc remains competitive, creates jobs and fosters growth.
In Italy, over 17% of bank loans are non-performing, according to the Wall Street Journal. That figure works out to 360 billion euros or $401 billion of bad debt and is more than triple the percentage of bad loans in the U.S. at the height of the financial crisis. Bank of Italy Governor Ignazio Visco said that public money should be used to help Italy’s troubled banks. Italy’s banking system is considered to be perhaps the most vulnerable in the Eurozone with its portfolio of non-performing loans.
Economists believe China’s economic growth likely moderated slightly in the second quarter. The median forecast of 15 economists polled was that the economy likely expanded +6.6% from a year earlier, down ‑0.1% from the previous quarter. China’s policymakers are facing a serious set of issues including reducing industrial capacity to deal with defaults on debt, rising risks from capital outflows, and a weakening currency, according to economists at Mizuho Securities Asia.
In Japan, the world’s largest pension fund, Japan’s Government Pension Investment Fund (GPIF), is estimated to have lost a staggering -$43 billion (4.4 trillion yen) in the quarter ended June 30, 2016, according to calculations by Morgan Stanley MUFG Securities. The losses came following a -5 trillion yen loss for the fiscal year ended March 31, 2016. It was the worst performance for the fund since 2009. The GPIF, known in Japan as “the whale” for its immense size, is being criticized for increasing its Japanese equity exposure in 2014. In addition to losses in its own market, the yen’s strength is also hurting the returns of its investments outside of Japan.
Finally, many market observers have commented on the unusual mix of recently-rallying assets. Defying common wisdom, defensive assets (e.g., utilities, gold, and bonds) have rallied right alongside the more usual offensive sectors. Much debate about what this means has ensued – is the bond market predicting deflation? But wait, is gold predicting inflation? Are stocks giving an all-clear? If so, why have utilities gone up, too?
It may well be that the common wisdom is simply inapplicable now, as we are in a condition never before seen: widespread negative interest rates around the world (which also tend to hold down interest rates in the U.S.). In this environment, all the old relationships and expectations may have to be scrapped as we work our way through this unprecedented circumstance. Here is a table from Pension Partners illustrating how widespread across both countries and maturities that negative interest rates have become. Note that the U.S. is the odd man out among the countries shown, having no negative interest rates at any maturity – yet.
(sources: all index return data from Yahoo Finance; 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, FactSet; Figs 1-5 source W E Sherman & Co, LLC)
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 rose to 5.8, up from the prior week’s 9.3, while the average ranking of Offensive DIME sectors fell to 15.5 from the prior week’s 12.5. The Defensive SHUT sectors extended their lead over Offensive DIME sectors, despite the positive week experienced in the US market. Note: these are “ranks”, not “scores”, so smaller numbers are higher ranks and larger numbers are lower ranks.
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Dave Anthony, CFP®