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 27.92, little changed from the prior week’s 27.94, 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 60.94, up from the prior week’s 59.49.
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 major U.S. indexes ended mixed for the week as the Dow Jones Industrial Average inched closer to the 20,000 level. Large caps were roughly flat while smaller-cap indexes, which have outperformed large caps this year, fell back. The Dow Jones Industrial Average gained +86 points to end the week at 19,843, up +0.44%. The NASDAQ Composite was essentially flat, down -7 points (-0.13%) to 5,437. The LargeCap S&P 500 retreated just -1 point to 2,258, while the MidCap S&P 400 fell -1.49% and the Russell 2000 SmallCap index tumbled -1.7%. Transports and Utilities diverged, with Transports falling -2.5% and Utilities tacked on a second week of gains rising +1.8%.
In international markets, Canada’s TSX retreated -0.4% from last week’s big gain. In Europe, the United Kingdom’s FTSE tacked on a second week of gains, rising +0.8%. Across the Channel, France’s CAC 40 rose +1.45%, Germany’s DAX tacked on 1.79%, and Italy’s Milan FTSE was up a fourth straight week, surging +3.95%. In Asia, China’s Shanghai Composite plunged -3.4% erasing all of its gains for the year. In contrast, Japan’s Nikkei had its sixth straight week of gains rising -2.1%. Hong Kong’s Hang Seng also had a difficult week, falling -3.25%. As a group, developed markets (as measured by the MSCI Developed Markets Index) were down -1%, while emerging markets (as measured by the MSCI Emerging Markets Index) posted a steeper -2.8% loss.
In commodities, the Commodity Research Bureau’s CRB Index fell a second straight week down -0.29%. Gold fell for a 6th straight week, losing -$24.50 to close at $1,137.40 an ounce, down another -2.1%. As expected, Silver was weak as well, losing -4.4% to $16.22 an ounce. Oil attempted to break out of the relatively narrow trading range it has been in since May, rising +2.8% to $52.95 per barrel of West Texas Intermediate crude oil.
In U.S. economic news, the number of Americans who applied for new unemployment benefits fell by -4,000 to 254,000 last week, indicating the extremely low level of layoffs taking place in the economy. In addition, the number remains below the key 300,000 threshold that economists view as a healthy job market. Initial claims fell under 300,000 early last year and have remained below that level for 93 straight weeks, the longest streak since 1970. Continuing jobless claims, those already receiving benefits, rose 11,000 to 2.02 million in the week ended Dec. 3.
Sentiment among homebuilders soared to its highest level in 11 years as construction firms anticipated a less regulatory environment under the new Republican president. The National Association of Home Builders (NAHB) sentiment index surged to a reading of 70, the highest level since July 2005 and beating expectations by 7 points. NAHB attributed the gain to a “post-election bounce” in its statement. “Builders are hopeful that President-elect Trump will follow through on his pledge to cut burdensome regulations that are harming small businesses and housing affordability.” All three of the index’s sub-gauges showed improvement in December. Current conditions jumped +7 points to 76, while expectations for the upcoming 6 months rose +9 points to 78. Both of these measures were the highest since 2005. Prospective buyer traffic rose +6 points to 53, the first time that index has risen above 50 in more than 10 years. All readings over 50 indicate improvement.
Housing starts tumbled -18% in November, pulling away from the 9-year high set in October. Following the +25.5% surge in October, homebuilding activity fell more than expected in November due to broad weakness in construction activity. Groundbreaking on new housing projects dropped to a seasonally adjusted annual rate of 1.09 million units, according to the Commerce Department. Last month’s decline was the largest in almost 2 years as all four regions declined. Analysts had noted that the number of permits had been lagging starts, so the drop in starts was widely anticipated. However, following last month’s drop in groundbreaking activity, building permits are now leading starts, which is a positive sign for the housing market.
Retail sales growth remained positive in November, but had its smallest gain in 3 months. Sales were up just +0.1%, predominantly due to weakness in auto sales. Across the board, most retailers reported improved results last month. Home furnishings, groceries, gasoline, and restaurants were all notably strong, with restaurant sales posting their strongest numbers since February. Yet auto dealers have been forced to offer deeper discounts as demand appears to be leveling off after years of surging sales. Showroom revenue fell -0.5% last month. Auto sales account for about 20% of total retail sales, and without autos, sales rose +0.2% last month. Economists had forecast a gain of +0.3%.
Higher gas prices, more expensive rent, and an increase in medical bills all contributed to a higher level of inflation last month, according to the Bureau of Labor Statistics. The Consumer Price Index (CPI), rose +0.2% last month, matching forecasts. Inflation has been rising steadily since July, which is one of the reasons the Federal Reserve increased interest rates this week. Annualized, the CPI advanced +1.7% to its highest level in more than two years. The rate of inflation has almost doubled since this summer. Higher gas prices at the pump were responsible for most of the increase. On a positive note, prices for food have remained relatively low. The cost of food for November was flat for the fifth straight month.
Inflation at the wholesale level is also beginning to pick up according to the Labor Department’s Producer Price Index (PPI). The PPI recorded its biggest gain in five months, jumping +0.4% in November. The rise was largely due to a +0.5% increase in the cost of services, responsible for more than 80% of the move. Year-over-year the PPI rose +1.3%, the biggest gain since November of 2014. A rebound in the price of oil also contributed to the increase. Core PPI, a measure that strips out the often-volatile food, energy, and trade-margin components rose a lesser +0.2%. Core PPI is up +1.8% over the past year, the largest rise since mid-2014.
Industrial output in the U.S. fell last month, primarily due to a decline in electricity usage amid unseasonably warm weather. Industrial production, which measures everything made by factories, mines, and utilities, fell ‑0.4% from the previous month according to the Federal Reserve. It was the third decline out of the last four months, and in line with economists’ expectations. Industrial output had back-to-back gains in June and July, but has struggled since. Stephen Stanley, chief economist at Amherst Securities stated in a note, “The sector is still just treading water.” In addition, capacity utilization fell -0.4% to 75%–the lowest rate since March.
The Commerce Department reported that business inventories fell -0.2% in October, the biggest decline in a year, as companies continue to reduce stockpiles. This is viewed as a positive by analysts because investment in inventory to replenish shelves should contribute to fourth-quarter economic growth. Inventory investment in the third quarter added half a percentage point to the U.S. economy’s 3.2% annualized GDP growth rate. Economists had forecasted a drop of -0.1%.
On Wednesday, the Federal Reserve raised its key U.S. interest rate for the first time in a year, and signaled that they would adopt a more aggressive stance in 2017. In a move that was widely expected, the central bank raised its key short-term interest rate a quarter point to a range of 0.5%-0.75%. The vote was unanimous. In addition, the Fed’s so-called “dot plot” indicated the central bank plans three additional rate hikes next year instead of the prior forecast’s two. Myles Clouston, senior director of NASDAQ Advisory Services stated, “What they did was highly anticipated. There was a slight surprise in next year, looking at an additional rate hike. Overall, the Fed remains pretty steady overall, looking at gradual raises in interest rates in the long run.”
Two measures of manufacturing activity, in the Fed’s Philadelphia and New York regions, climbed this week in another indication of the optimism among corporations following the election of Donald Trump to President. The Philadelphia Fed’s manufacturing index jumped almost +14 points to 21.5—the highest in 2 years. The New York Fed’s Empire State index rose over +7 points to 9. In both gauges, readings over 0 indicate improving conditions. In both cases, measures of future business conditions also saw significant improvement. The Empire State’s future business conditions surged +20 points to 50.2, the highest level in almost 5 years. The Philadelphia Fed’s future general activity measure also rocketed up over +23 points to 52.6, its highest level since January of last year.
In international economic news, the Bank of Canada warned that rising household debt and the growing proportion of highly indebted households threaten the Canadian economy. The central bank is expecting new mortgage rules to help ease the continued rise in household indebtedness that exposes the country to economic shock. Bank of Canada governor Stephen Poloz told reporters that debt levels are a risk to the economy that could be dangerous in an economic crisis. He likened the situation to a “large tree that has a crack in it. The situation may improve or worsen over time, but there’s no immediate crisis until the wrong kind of storm comes along.”
Across the Atlantic, in the United Kingdom the Bank of England left base borrowing costs unchanged at record lows of 0.25% but warned that higher inflation and slower wage growth may weigh on consumers’ budgets next year. The Bank’s 9-member committee voted unanimously to keep rates on hold and maintain the current program of quantitative easing in place. In minutes of its final meeting of the year, the Monetary Policy Committee said it would continue to trade the effects of the weaker pound raising inflation against the prospects of slower economic growth and employment. For now, they saw little need to change policy as little had appeared to have changed since last month’s report.
On Europe’s mainland, France’s national statistics agency Insee reported a steady uptick in French economic growth at the end of the year and the start of next year could be weighed down by political uncertainties. The French economy is set to gather momentum after a weak summer, Insee said – just as the country braces for an unpredictable French presidential election, the effects of the UK’s “Brexit” decision, and the impact of Donald Trump’s election as U.S. President. Insee said economic growth will rebound to +0.4% quarter-on-quarter at the end of this year, and forecasts growth of +0.3% for the first quarter of 2017.
In Germany, the economy is ending the year on a strong footing with a key index indicating growth accelerated in the final quarter. IHS Markit said its composite Purchasing Managers Index (PMI) was 54.8 this month, capping the economy’s strongest three-month stretch since the second quarter of 2014. While the services PMI declined slightly, it still remained well above the key 50 level that indicates expansion. The manufacturing PMI rose to 55.5, the highest in almost 3 years. Markit economist Philip Leake stated the PMI “signaled a strong end to the year for German private-sector firms.”
In Italy, the world’s oldest bank is in trouble amid Italy’s political crisis. Banca Monte dei Paschi di Siena (MPS) has put forward a $5.3 billion recapitalization plan that was approved by shareholders but received skeptically by investors. The bank has asked the European Central Bank for a third extension until January 20, 2017 to raise more capital. The European Central Bank had rejected the request earlier this year, but extended it to the end of the year. MPS is Italy’s 3rd largest bank and the oldest surviving bank in the world, established in 1472. The centuries-old bank has outlived many dynasties and kingdoms and is now in trouble after more than 500 years of existence. When the European Banking Authority published the results of its EU-wide stress test of 51 banks in the bloc, MPS was rated the weakest lender.
In Asia, the U.S. Federal Reserve may have rudely interrupted the Chinese Communist Party’s annual economic planning meeting for the second year in a row. During last year’s Central Economic Work Conference, the Fed raised interest rates for the first time in a decade. This week, the U.S. central bank raised rates again, and hinted at three more increases next year. Over the past 10 years, high interest rates in China compared with rock-bottom yields in the United States drew foreign capital into China. This fueled China’s renminbi decade-long currency appreciation versus the U.S. dollar. But those money flows are now moving in reverse as the interest rate spread narrows between the two. The move puts Beijing in a difficult position as Chinese officials attempt to stop the fall of the renminbi against the dollar without negatively impacting growth or raising Chinese companies’ already high debt burdens.
The Bank of Japan (BOJ) is likely to give a more optimistic view of the economy at next week’s rate review, sources say. A pickup in emerging Asian demand along with positive signs in private consumption improves the odds for a solid, export-driven recovery. An upgrade from the BOJ would reinforce market expectations that the central bank will hold off on further stimulus measures in the near future. “Global economic conditions are improving, and consumption appears to be picking up,” said one of the sources. “All in all, we’re seeing more bright signs for the economy.” The BOJ’s nine-member board will reach a final decision after scrutinizing its closely-watched “Tankan” quarterly business sentiment survey.
Finally, as the Dow closes in on the 20,000 milestone, Mark DeCambre at MarketWatch (www.marketwatch.com) penned an article that asks the question, is reaching 20,000 really that significant? After all, the Dow Jones Industrial Average represents only 30 stocks out of the thousands that make up the broader market. Outsized moves in any of the 30 components can have a very big effect in the overall index. As an example, the latest surge in Goldman Sachs has contributed about a third of the Dow’s recent 1,000 point move. In addition, 1000-point moves aren’t as meaningful as they used to be. When the Dow moved from 1,000 to 2,000 it was a 100% move, and the move from 4,000 to 5,000 was a 25% move. But a 1,000 point move from 19,000 to 20,000 represents just a 5.3% advance.
Whether Dow 20,000 will be a ceiling or another milestone remains to be seen. But in any event, this 1,000 point marker is less of a Herculean feat than ever before, as the following chart 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, 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 22.25 from 22.50, while the average ranking of Offensive DIME sectors dropped to 11.25 from 10.00. 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®