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 27.08, little changed from the prior week’s 27.06, 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) is in Cyclical Bull territory at 67.41, up from the prior week’s 65.11.
In the intermediate picture:
The Intermediate (weeks to months) Indicator (see Fig. 4) turned positive on June 29th. The indicator ended the week at 35, unchanged from the prior week. 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 also positive. Therefore, with all three indicators positive, the U.S. equity markets are rated as Very Positive.
In the markets:
U.S. stocks were mixed and little changed last week as the Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite all posted new all-time highs during the week, but MidCap and SmallCap indexes were slightly lower. For the week, the Dow Jones Industrial Average added a modest +32 points to end the week at 18,576. The LargeCap S&P 500 also finished with a very slight gain of +0.05%. The NASDAQ Composite rose +11 points to 5,232, up +0.23%. MidCaps and SmallCaps, which have been the biggest gainers year-to-date, finished slightly in the red. The S&P 400 MidCap index gave up -0.31% and the SmallCap Russell 2000 finished down a slight -0.12%.
International markets had a strong week compared to the U.S., as almost all major indexes finished in the green. Canada’s TSX rose +0.67%. In Europe, the United Kingdom’s FTSE rallied another +1.8%. The UK’s FTSE has risen 7 out of the past 8 weeks and is once again nearing all-time highs. Proving once again that predictions are futile, economists from major institutions and think tanks worldwide had predicted that the “Brexit” vote would plunge the United Kingdom into economic chaos and a certain depression. On Europe’s mainland, Germany’s DAX rallied +3.34%, France’s CAC 40 was up +2.03%, and Italy’s Milan FTSE added +2.23%. In Asia, China’s Shanghai Stock Exchange added +2.49%, ending 3 weeks of losses. Japan’s Nikkei was the big winner, up over +4% last week, and Hong Kong’s Hang Seng Index rose 2.8%. As a group, Developed International markets rose +1.8% (EFA), and Emerging Markets rose +2.4% (EEM).
In commodities, precious metals had a second down week with Gold giving up -$1.20 to close at $1,343.20 an ounce. Silver, almost always more volatile, was also down a second week, giving up -0.58% to end the week at $19.70 an ounce. The industrial metal copper was also negative, losing -0.65%. Energy had a strong week, adding to gains from the prior week as West Texas Intermediate crude oil rallied over +6.4% to $44.49 a barrel.
In U.S. economic news, the Labor Department’s Job Openings and Labor Turnover Survey (known by the amusing acronym “JOLTS”) indicated the job market remains resilient. Job openings and hiring increased as the JOLTS report showed there were 5.62 million job openings in June, up from 5.51 million in May. In addition, there were 5.13 million people hired during the month, up 80,000 from May. In the Labor Department’s Weekly Jobless Claims report, the number of people filing for unemployment benefits declined by -1,000 to a seasonally adjusted 266,000 for the first week of August. Initial claims have held below the key 300,000 threshold for 75 weeks in a row, the longest streak since 1970. Economists had forecasted a decline of- 2,000. The smoothed 4 week average of claims rose slightly to 262,750. Continuing claims, those people already receiving benefits rose by 14,000 to 2.16 million.
Sentiment among small-business owners managed a slight gain according to the National Federation of Independent Business (NFIB). However, the NFIB confidence index still remains below its long-term average, despite rising for the fourth straight month. The NFIB optimism index rose +0.1 point to 94.6, beating analyst expectations of a flat reading. Last month, 4 of the 10 NFIB indexes rose, while 4 declined, and 2 were unchanged. In its statement, the NFIB stated that, “small businesses continue to be in maintenance mode– meaning owners won’t increase spending.”
Retail sales in the U.S. paused in July after three straight months of gains the Commerce Department reported. Sales were essentially flat after a gain of +0.8% in June. Economists had expected growth of +0.4% for July. Auto sales were up +1.1% in July, the strongest since April. However, removing auto sales, retail sales were actually down ‑0.3% – the weakest reading since January. Retail sales are a key element of consumer spending, which is the backbone of the U.S. economy. On an annualized basis, retail sales are up +2.3% over the past 12 months. Ian Shepherdson, Chief Economist at Pantheon Macroeconomics stated “retail sales were disappointing, but not disastrous”. Amazon and other Internet-only retailers saw a gain of +1.3%, while Macy’s announced the closing of 100 stores.
Productivity declined for the third straight quarter, according to data released by the Labor Department. In the second quarter, productivity fell -0.5%, well below expectations. Economists had forecast a +0.3% gain. Annualized, productivity is down -0.4% for the trailing year, the first year-over-year decline since mid-2013. Productivity measures how much an employee produces per hour of work. Higher productivity is linked to a rising standard of living for workers because it tends to lead to higher wages and larger profits for companies. The long-term rate of productivity increase has traditionally been +2.2% per year.
The Labor Department reported that the price of imports to the U.S. rose for a fifth straight month, up +0.1% in July. Higher costs of imported goods theoretically should support a rise in inflation, which has remained below the Federal Reserve’s targeted level for years. Even with July’s rise, however, the cost of imports is still -3.7% lower than a year ago. Export prices increased +0.2% last month, the fourth consecutive rise, but remain ‑3% lower than this time last year.
In Canada, a CIBC economist warned that intervention into two of Canada’s hottest housing markets could interfere with economic growth. Canada’s economy is facing difficult headwinds, but two bright spots remain the Vancouver and Toronto housing markets. In a research note, CIBC Chief Economist Avery Shenfeld said cracking down on the sector, which accounts for the largest portion of domestic GDP, could smother the little economic growth there is. “Interest rate hikes or much tougher mortgage policies could put a damper on house prices, but at the expense of economic growth,” he stated.
In the United Kingdom, fears of the consequences of the UK leaving the European Union appear to have been hugely overblown, as retail spending rebounded +1.9% in July. The increase was the biggest rise in 6 months and up sharply from the +0.2% increase in June.
In Germany, economic growth flattened in the second quarter of the year, sparking fears that Europe’s largest economy may be running out of steam. GDP grew by just +0.4% in the 2nd quarter, down sharply from the 1st quarter’s +0.7% gain. Investment in construction and machinery was particularly weak. The headline reading was supported by higher exports and strong state spending.
The latest Italian GDP readings show that the economy is also stagnant, with 0% growth in the 2nd quarter following a +0.3% rise in the 1st. Italian Prime Minister Mario Renzi is battling to reduce bad debt in Italy’s banking sector, which is currently carrying approximately 360 billion euro worth of bad loans. Alberto Bagnai, economic policy professor at the University of Chieti-Pescara said, “There is no way to solve the banking problem without economic growth. If the whole nation doesn’t start earning more it simply can’t pay back its debts—public or private.”
Fresh Chinese economic data added to a multitude of other metrics that suggests the world’s second largest economy is weakening. Both industrial output and retail sales fell short of expectations for the month of July. A spokesman for China’s National Statistics Bureau said that the country’s economy was still in a period of adjustment and is facing downward pressure.
Finally, the folklore of the markets has always been that complacency in the markets is bad news, as it is thought to precede substantial declines. One way to measure complacency is by measuring fear, on the theory that fear is the opposite of complacency. A widely followed “fear gauge” is the Chicago Board Options Exchange Volatility Index, known as “VIX”, which measures the activity of “put” and “call” option buying/selling. Nervous and fearful investors buy lots of puts for downside protection, which results in the VIX going higher – thus the moniker “fear gauge”.
As many of the market’s indexes hit new highs last week the VIX dropped to an extremely low 11.18, suggesting investors are very complacent. Many investors have become alarmed at the low VIX readings, believing that the absence of fear is a very bad sign. However, researchers at the National Bureau of Economic Research (reported by Mark Hulbert at marketwatch.com) decided to dig deeper into historical data to see if that interpretation was correct. What they found was that the stock market’s performance following low “complacent” VIX readings is no worse, on average, than it is after higher readings. Perhaps another piece of Wall Street folklore can be consigned to the crowded category of “sounds good, but isn’t true!”
(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 fell sharply to 19.8, down from the prior week’s 14.8, while the average ranking of Offensive DIME sectors rose to 17.3 from the prior week’s 18.3. The Offensive DIME sectors are now higher in rank than the Defensive SHUT sectors. 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®