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 27.94, up from the prior week’s 27.10, and now exceeding 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 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 59.49, up from the prior week’s 57.57.
In the intermediate picture:
The Intermediate (weeks to months) Indicator (see Fig. 4) turned positive on November 10th. The indicator ended the week at 29, unchanged from the prior week. Separately, the Quarterly Trend Indicator – based on domestic and international stock trend status at the start of each quarter – was positive entering October, indicating positive prospects for equities in the fourth 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 Q4, 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:
The post-election rally continued for a fifth straight week, bringing all the major indexes to a series of record highs. The Dow Jones Industrial Average rallied over +500 points to 19,756, up +3.06%. Similarly, the tech-heavy NASDAQ Composite gained over +180 points to close at 5,444.50, up +3.59%. Small- and Mid- cap indexes edged LargeCaps again as the MidCap S&P 400 index and SmallCap Russell 2000 surged +4.2% and +5.6% respectively, while the LargeCap S&P 500 gained +3.08%. Some analysts, invoking the “Dow Theory”, speculated that the strong returns were due at least in part to the new high set by the Dow Transports. The venerable “Dow Theory” (http://www.investopedia.com/terms/d/dowtheory.asp) suggests that a new high in the Dow Industrials – confirmed by the Transports also setting a new high – signifies that a Bull market is in effect and the trend should continue.
Markets were green around the world as well. Canada’s TSX reached a new high for the year gaining +1.7%. In Europe, the United Kingdom’s FTSE rallied +3.3%, but even substantial moves were on the mainland. France’s CAC 40 and Germany’s DAX surged +5.19% and +6.57%, respectively. Italy’s Milan FTSE shrugged off predictions of economic doom following its controversial vote last Sunday and catapulted an amazing +7.1%. Asian markets were less unanimous: China’s Shanghai Composite ended slightly down, -0.34%, while Japan’s Nikkei tacked on a 5th week of gains, rising +3.1%. As a group, emerging markets (as measured by the MSCI Emerging Markets Index) rose +2.99%, while developed markets (as measured by the MSCI Developed Markets Index) gained +3.54%.
In commodities, precious metals were mixed this week. Gold lost -$15.90 an ounce to end the week at $1161.90, down another -1.35%, while Silver rose +0.8% to close at $16.97 an ounce. The industrial metal copper, seen as an indicator of global economic health, consolidated recent gains while rising +0.86%. Oil continued to trade in a narrow range, losing -$0.18 to end the week at $51.50 per barrel of West Texas Intermediate.
In U.S. economic news, the number of Americans who applied for new unemployment benefits fell by -10,000 to 258,000 last week, according to the Labor Department. The pace of layoffs has remained near its lowest level in more than 40 years and well below the key 300,000 threshold analysts use to indicate a healthy jobs market. The less-volatile 4-week moving average of claims, seen as a more accurate measure of labor-market trends, rose by +1,000 to 252,000. Continuing claims, those people already receiving unemployment benefits, declined by ‑79,000 to 2.01 million the previous week. Job Openings – another important labor market indicator – also remained strong. The Labor Department reported there were 5.5 million openings in October, down -2% from the previous month, but near the highest levels in over 14 years.
America’s service industries grew last month at the fastest pace since the fall of last year, putting the nation’s biggest economic sector on a strong footing. The Institute for Supply Management’s (ISM) non-manufacturing index jumped to 57.2 in November, a gain of +2.4 points. The reading exceeded all analysts’ forecasts, where the median forecast called for 55.5. Anthony Nieves, Chairman of the ISM non-manufacturing survey reported “This last quarter is having the year finish up pretty strong…I don’t project that December is going to be much different.” The latest reading puts the ISM services gauge higher than the year-to-date average of 54.5.
In U.S. manufacturing, the Commerce Department reported factory orders jumped +2.7% in October. It was the fourth consecutive monthly gain and the largest rise since the beginning of last year. Of note, the annualized 12-month rate of change is now back in positive territory after being negative the last two years. However, most of the increase was due to a spike in the civilian aircraft sector (i.e., “Boeing”). Orders of non-defense capital goods, ex-aircraft, were up only +0.2%.
Consumer borrowing continued to grow in October, but at the slowest rate since June. Total consumer credit rose +$16 billion in October to a seasonally-adjusted $3.7 trillion, according to the Federal Reserve. That brings the annual growth rate to 5.1%. Though strong, the increase was below economists’ estimates for a +$19.3 billion rise in consumer credit. Consumer spending slowed in October, from a +0.7% gain the previous month to +0.3%. The main source of credit growth was non-revolving credit, which covers loans such as education and vehicles. Revolving credit, made up of mostly credit card loans, slowed to a +2.9% annual growth rate, down from a +5% rate of change in September.
Confidence among Americans soared following the election, according to the University of Michigan’s Consumer Sentiment survey. The index surged +4.5 points to 98.0, just 0.1 point away from the recovery cycle high last touched in 2015, and before that 2004. The enthusiasm of consumers surveyed surprised economist. Consumer views of the current state of the economy gained +4.5 points, and their views of the economic outlook rose +4.3 points. Survey director Richard Curtin wrote, “When asked what news they had heard of recent economic developments, more consumers spontaneously mentioned the expected positive impact of new economic policies than ever before recorded in the long history of the surveys.”
The U.S. trade deficit widened to a four-month high in October as American companies imported more equipment and consumer goods and overseas sales weakened. The Commerce Department reported the gap rose by over $10 billion to $42.6 billion from the prior month. The increase of +17.8% from September was the largest since the spring of 2015. Stronger demand for imported merchandise indicates that trade will add less to U.S. growth readings after 3rd quarter net exports contributed the most since the end of 2013. In addition, the latest rally in the U.S. dollar could also weigh on exports of American-made goods as they become more expensive overseas.
In international economic news, the Bank of Canada held rates steady at 0.5% citing a “significant” amount of slack in the Canadian economy. The central bank said that while the global economy has strengthened, it still faces “undiminished” uncertainty, especially among its major trading partners. The bank noted Canada’s healthy rebound in the third quarter and predicted that the nation would see “more-moderate growth” over the final three months of 2016. The decision to hold the rate steady was widely anticipated by market watchers.
Despite a turbulent year politically and dire warnings from mainstream economists on its Brexit decision, the United Kingdom will finish the year as the fastest-growing economy in all of the G7 group of major economies. According to the Purchasing Managers’ Index (PMI), the UK’s November services sector reading was 55.2, the highest since January and up +0.8 point from October. Experts say that Britain’s economy is on course to grow +0.5% in the final quarter of the year, which would put Britain in the forefront of the world’s leading economies. Chris Williamson of IHS Markit, which compiled the PMI survey, said “The further upturn in the vast services sector shows that the pace of UK economic growth remains resiliently robust in the fourth quarter, despite ongoing uncertainty.”
On Europe’s mainland, French President Francois Hollande became the first French President since 1958 to not seek re-election. Polls show that he is very unpopular. His exit clears the way for Prime Minister Manuel Valls to run as an economic reformer within the Socialist party. The center-right Republicans have chosen Francois Fillon as their candidate and the far-right National Front has chosen Marine Le Pen. Other potential contenders according to the polls include centrists Emmanuel Macron and Francois Bayrou. French voters will go to the polls for their presidential election on April 23, 2017.
The German central bank (the Bundesbank) raised its economic forecasts for Germany for this year and next. German households continue to take advantage of the strong labor market and rising incomes. Germany’s economy is now expected to grow by +1.8% this year and next according to the bank – an upward revision of +0.2% from June’s forecast. The optimistic near-term outlook for Europe’s biggest economy came after the ECB surprised markets by saying it would slow the pace of its asset purchases aimed at supporting weaker Eurozone economies.
In Italy, the International Monetary Fund called on the country to continue to make economic reforms despite Sunday’s failure of a government-backed referendum. The remarks followed an announcement from Moody’s ratings service that it was downgrading its outlook for Italy’s sovereign debt from stable to negative due to Italy’s “No” vote on proposals to modify the constitution. Italian voters rejected measures to expedite economic reforms sought by Prime Minister Matteo Renzi, who has since announced his resignation.
In Asia, the U.S. has decided it won’t grant China the highly sought after official “market economy status” that Beijing thinks it deserves. In a move that’s sure to raise tensions between the two powers, a senior U.S. administration official stated China’s failure to allow a market-driven economy have fueled trade tensions. “If China wants to benefit from treatment as a market-economy country, it must change its own practices to let the market play a decisive role in the economy,” the official said. Market economy status would benefit China by requiring global trade regulators to compare the price of Chinese exports to its domestic market (instead of higher-priced third countries) in anti-dumping cases, thus limiting their ability to impose tariffs on Chinese goods.
The Japanese economy grew by +$175 billion overnight (an amount equivalent to New Zealand’s economy), as the government adopted a new accounting standard known as the System of National Accounts 2008 (SNA). Using the new standard, research and development expenses will be included in the sum of all goods and services produced in the nation. Other nations including the U.S., the U.K., and Canada have already adopted SNA. However, unlike the U.K. which uses estimates of illicit drug use and prostitution in its economic number, Japan won’t be including illegal activities in its measurements.
Finally, Yale economist Robert Shiller appeared on CNBC this past week with a warning that his key measure of market valuation is at levels that have preceded most of the major crashes of the last 100 years. Shiller’s “cyclically-adjusted P/E” or CAPE ratio, now stands at 27.94, a level that has been exceeded only in the 1929 mania and the 2000 dot.com rally. Being extra-cautious with his wording, Dr. Shiller said “It’s not a good time, but I’m not saying to panic”. This commentary tracks the level of the CAPE ratio every week in “The Very Big Picture” section above. The chart below shows graphically that the CAPE is in territory only seen twice in more than a century.
(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 slightly to 22.50 from 22.75, while the average ranking of Offensive DIME sectors rose slightly to 10.00 from 10.25. The Offensive DIME sectors continue to strongly lead 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®