FBIAS™ for the week ending 9/23/2016
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 26.86, up from the prior week’s 26.56, and only a little lower than the level 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 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) is in Cyclical Bull territory at 62.85, up from the prior week’s 62.05.
In the intermediate picture:
The Intermediate (weeks to months) Indicator (see graph below) turned positive on June 29th. The indicator ended the week at 31, 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 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 positive (Fig. 3 above), 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 above) 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 slumped Friday, putting a damper on an otherwise strong week for the market. On Wednesday, the Federal Reserve elected to hold interest rates steady which seemed to be the catalyst for the week’s gains. The move (or lack thereof) was widely expected, but analysts noted that Fed Chair Janet Yellen’s tone appeared to be less “hawkish”. Markets were a sea of green for the week, with all major indexes recording gains. The Dow Jones Industrial Average added +137 points to close at 18,261, up +0.76%. The tech-heavy NASDAQ Composite managed a gain of +61 points to 5,305, a gain of +1.17%. Smaller indexes showed relative strength, as they have for much of the year to date, with the S&P 400 MidCap index rising +1.96% and the Russell 2000 SmallCap index gaining +2.44% while the LargeCap S&P 500 index added a more modest +1.19%. The Russell 2000 and NASDAQ Comp both established new highs for the year on Thursday. Both Transports and Utilities had a strong week with the Dow Jones Transports index rising +2.14% and Utilities up +3.34% as defensive sectors enjoyed a good week.
In commodities, precious metals had a strong week with Gold up $31.50 to $1341.70, a gain of +2.4% per ounce, and Silver surging +5% to $19.81 an ounce. Oil was also bid up, with a barrel of West Texas Intermediate crude oil settling at $44.48, up +1.97%. The industrial metal copper also gained, adding +1.9%.
In international markets, it was a sea of green as almost every major economy recorded gains. To the north, Canada’s TSX was up +1.7%. In Europe, the United Kingdom’s FTSE rose +2.97%. On Europe’s mainland, the major economies of Germany and France enjoyed significant gains, up +3.4% and +3.6% respectively. Italy’s Milan FTSE was also up +1.6%. To the east, China’s Shanghai Stock Exchange added +1%, along with Hong Kong’s Hang Seng which rose +1.5% and Japan’s Nikkei which was up +1.42%. Broadly speaking, both developed markets and emerging markets enjoyed strong gains with the widely-followed Developed Market ETF “EFA” ending the week up +3.08% and the Emerging Market ETF “EEM” gaining +3.07%.
In U.S. economic news, initial jobless claims fell -8,000 to 252,000 vs. an expected 260,000, the lowest level since July and signaling a continued strong labor market. Initial claims have remained below 300,000 for 81 weeks, the longest streak since 1970. The smoothed 4-week average of new claims also fell 2,250 to 258,500. Continuing claims, the number of people already receiving benefits, fell 36,000 to 2.1 million the previous week.
In housing – it’s hot out there! The National Association of Home Builders (NAHB) reported that home builder confidence surged to its highest level in 10 years. The NAHB’s index climbed +6 points to 65, the highest level since the height of the housing boom. Economists had forecast a reading of 60. The current sales conditions gauge rose +6 points to 71 and the future sales index gained +5 points also hitting 71. Buyer traffic added +4 points to 48. In its release, the NAHB noted that builder sentiment is being supported by the presence of “more serious buyers” in the market. The Commerce Department reported that multi-family construction starts declined sharply by -7.2% but that permits for single-family starts were up +3.7%. Starts and permits rose in every region of the country except the South.
Constrained by supply, sales of previously-owned homes fell for a second straight month as the inventory of homes for sale continued to shrink (now down to 4.6 months of inventory). Existing-home sales fell -0.9% to a seasonally adjusted annual rate of 5.33 million according to the National Association of Realtors. The figure is +0.8% higher than a year ago. Economists had forecasted a 5.48 million pace. The Northeast was the only region to see gains. The median sale price for a previously-owned home is now $240,000, +5.1% higher than in August 2015. First time homebuyers made up 31% of the pre-owned market in August.
On Wednesday, the Federal Reserve kept interest rates unchanged, but Chairwoman Janet Yellen said one increase would be “appropriate” this year barring any major new risks to the economy. Even though senior Fed officials are “generally pleased with how the economy is doing”, the central bank wants to see more progress in the labor market. At the press conference following the meeting, Yellen said “For the time being we are going to watch incoming evidence.” Yellen disputed the claim by Republican presidential candidate Donald Trump that the Fed is keeping rates low for political reasons. She emphatically stated that “Partisan politics plays no role in our decisions.”
The Chicago Fed National Activity index fell into negative territory at -0.55 last month, from a slightly positive reading in July. The Chicago Fed index is a weighted average of 85 different economic indicators. Only 19 of the 85 individual indicators made positive contributions in August. The index’s 3-month average ticked up to -0.07 from -0.09 in July.
The Conference Board’s Leading Economic Indicators (LEI) index fell -0.2% last month due to weakness in the manufacturing sector. The index was hurt by a decline in the average workweek of production workers as well as a decline in the new-orders component of the Institute for Supply Management’s manufacturing index. Ataman Ozyildrim, director of business cycles and growth research at the Conference Board put a positive spin on the report, stating “while the U.S. LEI declined in August, its trend still points to moderate economic growth in the months ahead.”
Also in manufacturing, Markit’s flash U.S. manufacturing Purchasing Managers Index (PMI) was the weakest in 3 months due to stagnation in new orders and a stronger U.S. dollar. The index fell -0.6 point to 51.4, the lowest level since June. Readings above 50 indicate expansion. Tim Moore, senior economist at Markit stated “softer new-order gains are the main concern in the latest PMI survey, and this could act as a drag on production growth into the final quarter.”
In Canada, economists at TD Bank say the Canadian economy is set for a “barn-burner” third quarter, but they also caution that the trend won’t last for long. TD reported that manufacturing has picked up, oilsands output has rebounded, and exports grew in July following the -1.6% contraction in the second quarter. TD estimated that growth for the July-September period is set for a +3% increase. However, TD warned that “Canadians shouldn’t be misled into thinking that this momentum will hold. Once one-off factors roll off, growth will drift back to a more modest +1.7% to +1.8% pace through 2017 and 2018.”
In the United Kingdom, the Bank of England said that the U.K. economy faces a challenging period after the Brexit vote. Policymakers stated that the vote for Brexit has created a “challenging period of uncertainty and adjustment.” In a quarterly update on the health of the financial system, the bank’s policymakers also said the United Kingdom’s withdrawal from the European Union would not be used as a way to reduce regulation on the banking sector. In its annual assessment of the help-to-buy scheme, a government program aimed to help first-time home buyers, it reported its closure would not lead to mortgage lending drying up or an increase in the size of deposits required to gain a home loan.
On Europe’s mainland, preliminary data on France’s economy contracted slightly in the second quarter. France’s statistics agency Insee said second-quarter gross domestic product in the Eurozone’s second-largest economy fell by -0.1% quarter-on-quarter, following a +0.7% rise the first quarter. Enterprise investment fell by -0.4% following a +2.1% rise the first quarter. French Finance Minister Michel Sapin said that the budget would bring the deficit down to 2.7% of economic output in 2017 from a forecast of 3.3% earlier this year.
Germany’s Finance Ministry said the German economy will lose steam in the second half of 2016 as weaker foreign demand causes industrial output to slow. In its monthly report, the Finance Ministry stated “German economic growth was robust in the first half of the year, but the latest economic data indicate a slowdown in economic momentum in the second half of the year.” Growth in industrial orders came to a halt in July and factory output and exports fell unexpectedly. The ministry blamed weak foreign demand for the low industrial activity and expected factory output would be weak the rest of the year.
China invested more money abroad last year than foreign firms invested in China for the first time ever. Overseas direct investment surged more than +18% to an all-time high of over $145 billion last year, exceeding the $135 billion of foreign direct investment according to the government’s Statistical Bulletin report. According to the report, the milestone was a result of the “enhancement of China’s comprehensive national power” by encouraging Chinese firms to “go abroad” in search of growth. Commerce Ministry representative Zhang Xiangchen told reporters “we feel companies currently are keen to go abroad and actively integrate into global innovation, manufacturing, and market networks.”
Japanese authorities stand ready to act against excessive rises in the yen, according to a top government spokesman. The warning came amidst recent yen gains that could hurt the country’s export-reliant economy. The dollar fell to a nearly 4-week low of 100.10 yen on Thursday after the U.S. Federal Reserve trimmed its long-term interest rate expectations. Chief Cabinet Secretary Yoshihide Suga told a news conference, “We’re concerned about recent extremely nervous moves in the currency market. The government hopes to keep watching currency market moves ever more carefully and if such moves persist, will be ready to take necessary action.”
Finally, Jim Paulson, chief investment strategist at Wells Capital Management, shared a simple recipe for “substantial stock market gains” during a recent interview on CNBC. The key condition, he says, is for the S&P 500 earnings growth to be greater than the 10-year treasury yield. Using data back to 1950, the strategist found that when this is the case, the S&P 500 has gained an average of +11.6% for the subsequent year. When it’s been below, the S&P has risen just +4.7%. A further benefit is during periods when earnings are above the treasury yield, there was a lower volatility of returns.
So which condition are we in now? Unfortunately, with earnings growth below the current 10-year yield, the current signal is negative for stocks as the chart below illustrates.
(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)
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 sharply to 19.3 from 22.3, while the average ranking of Offensive DIME sectors fell even more sharply to 22.5 from the prior week’s 18.3. The Defensive SHUT sectors now rank higher than the Offensive DIME sectors for the first time in seven weeks, despite the positive week. 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®, RMA®