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 28.88, down from the prior week’s 29.30, and now exceeds 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 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 69.81 down from the prior week’s 73.17.
In the intermediate and Shorter-term picture:
The Shorter-term (weeks to months) Indicator (see Fig. 4) turned negative on March 24th. The indicator ended the week at 25, down from the prior week’s 28. Separately, the Intermediate-term Quarterly Trend Indicator – based on domestic and international stock trend status at the start of each quarter – was positive entering January, indicating positive prospects for equities in the first quarter of 2017.
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. In the intermediate timeframe, the Quarterly Trend Indicator (months to quarters) is positive for Q1, and the shorter (weeks to months) timeframe (Fig. 4) is negative. Therefore, with two of three indicators positive, the U.S. equity markets are rated as Neutral.
In the markets:
U.S. markets: Tuesday marked the first time in 109 days that the S&P 500 index closed down 1% or more. Markets were weighed down by a multitude of concerns, including the attempted passage of a new healthcare law, the pace of central bank rate increases, rising inflation, and North Korea’s nuclear saber rattling. For the week, the Dow Jones Industrial Average tumbled 317 points to close at 20,596, a loss of -1.5%. The tech-heavy Nasdaq Composite fell -1.2% to close at 5,828. By market cap, the large cap S&P 500 index retreated -1.4%, while the S&P 400 mid cap index and small cap Russell 2000 index fell -2.1% and -2.6%, respectively.
International markets: Canada’s TSX fell a third of a percent, its third consecutive weekly loss. In Europe, major markets were red across the board, but with relatively minor declines. The United Kingdom’s FTSE retreated ‑1.2%, while on Europe’s mainland France’s CAC 40 fell -0.17% and Germany’s DAX lost a quarter of a percent. In Asia, major markets were mixed. China’s Shanghai Composite Index rose almost 1% while Japan’s Nikkei slumped ‑1.3%. Hong Kong’s Hang Seng rose a slight 0.2%. As grouped by Morgan Stanley Capital International, developed markets were essentially flat falling a modest -0.14%, while emerging markets rose 0.8%.
Commodities: Precious metals continued to be bid higher. Gold rose for a second consecutive week, gaining 1.5%, to $1,248.50 an ounce. Similarly, Silver tacked on 1.9% ending the week at $17.75 an ounce. Oil gave up last week’s tepid gain falling a steep -2.7% to $47.97 a barrel for West Texas Intermediate crude. Finally, copper, viewed by some as an indicator of global economic health, retreated -2.25%.
U.S. Economic news: The number of Americans who applied for new unemployment benefits last week rose by 15,000 to 258,000. The number exceeded analyst expectations for a slight decline to 240,000. The four-week average of initial claims, smoothed to reduce the weekly volatility, rose by 1,000 to 240,000. New claims have remained below the key 300,000-level that analysts use to signify a healthy labor market for 80 straight weeks.
Sales of newly constructed homes surged to a seven month high last month as robust demand overcame lean supply, higher prices, and slightly higher mortgage rates. The Commerce Department reported new-home sales ran at a seasonally-adjusted 592,000 annual rate, up 6.1% from January and an increase of 12.8% over last February’s rate. The median sales price was $296,200, a decline of 3.9% from January, and a fall of 4.9% from the same time last year. Lower prices are likely helping to boost sales. At the current sales pace, there is a 5.4 month supply of homes available on the market.
Sales of previously owned homes fell last month as home inventory remained tight. The National Association of Realtors (NAR) reported last month’s sales were down 3.7% from January’s pace to a 5.48 million seasonally-adjusted annual rate. Economists had forecast a 5.45 million annualized pace. Still, sales were 5.4% higher than the same time last year. The median home price rose 7.7% from a year ago to $228,400. At the current sales rate, it would take only 3.8 months to deplete the available supply of homes. By region, sales rose in only one region, the South, where they were up 1.3%. Declines were the steepest in the Northeast where they dropped a sharp 13.8%. In the west, sales fell 3.1%, while in the Midwest sales were down 7.0%. According to NAR Chief Economist Lawrence Yun, properties were on the market a median 45 days, down from 59 days a year ago.
The Chicago Fed’s national activity index rose 0.36 point to 0.34 in February, beating expectations of only a 0.05 point rise. In the report, employment-related indicators led the way contributing 0.21 to the overall gain. The number of people reported as employed increased sharply last month. Production-related indicators added 0.09 point supported by a second consecutive 0.5% increase in manufacturing production. Overall, a surge of 444,000 employed people in the February household employment report was responsible for most of the indicator’s gain.
New orders for manufactured goods expected to last longer than 3 years, known as durable goods, climbed for the second consecutive month in February, according to the Commerce Department. Durable goods orders rose 1.7%, while the increase in January was revised upward to a gain of 2.3%. The increase in orders was led by a 48% jump in commercial aircraft orders. That outweighed an almost 1% drop in orders for new cars and trucks. Stripping away the volatile transportation sector, capital goods were up a lesser 0.4%. A key measure of business investment known as core capital-goods orders fell 0.1%. It was its first decline in five months. Despite the drop, core orders have risen 2.7% over the past year—its second biggest annual gain in over 3 years. Andrew Hunter, U.S. economist at Capital Economics stated, “There has been a remarkable turnaround in both shipments and production of business equipment over the past 12 months.”
International economic news: Canada’s central bank released a report that the Canadian economy was progressing but “risks remain”. Lawrence Schembri, deputy governor of the Bank of Canada said that the Canadian economy has made good progress since the plunge in oil prices in 2014, but slack and risks remain. In a prepared text to the Greater Vancouver Board of Trade, Mr. Schembri said, “uncertainty remains elevated because of prospective policies that put at risk the progress made in recent decades to liberalize trade and foster economic integration.” Schembri said that Canada has so far resisted the protectionist “tilt” that the new U.S. administration is intent on, noting the recent free trade agreement with Europe. The Bank of Canada’s key interest rate has been fixed at 0.5% since July 2015 and there is no expectation that it will be hiked anytime soon.
Across the Atlantic, Britain’s decision to leave the European Union may have unintended consequences that could impact the entire United Kingdom. The Scottish National Party (SNP) is now pushing for Scottish independence from the UK to ensure their prosperity and avoid any damage that may be caused by the Kingdom leaving the EU. Niall Mclean, who sits on the advisory board of Business for Scotland, a pro-independence group, stated, “Independence gives us a route where the EU market is still open to us and there is a way forward for trade. Brexit is the opposite.” Scotland’s First Minister and SNP leader Nicola Sturgeon says Brexit has dissolved the certainty that the United Kingdom once offered. Faced with being taken out of the EU against the will of the (Scottish) majority, Scots must have a new choice, she argued. “Independence offers them an opportunity to stay in the (EU) bloc, or at least its single market, after Britain exits”, she stated.
In France, the Presidential election has become a battle between two very different economic visions that will have profound implications for all of Europe. The leading candidates are Marine Le Pen of the far-right National Front party, and Emmanuel Macron of the progressive social liberal En Marche! Party. Le Pen wants France to quit the Euro in favor of a “nouveau franc” and protect French jobs. Macron favors open borders and more European integration. Le Pen argued that French companies should be given priority when bidding on public contracts. “The state must give priority to French companies and not foreign companies,” she said. “I’m not here to create jobs for our neighbors.” France’s presidential election will be held on April 23, 2017. Should no candidate win a majority, a run-off election will be held May 7.
The Germany economy is on a roll. Businesses in Europe’s largest economy have achieved their highest rate of growth in over 6 years, according to research firm IHS Markit. This month marked another month of robust growth in Markit’s purchasing manager’s survey for Germany where the index accelerated from 56.1 to 57 (readings above 50 mark growth). The German economy has been notably strong over the last 12 months, driven by falling unemployment, low inflation, and record monetary stimulus from the European Central Bank. Of concern, however, is the level of German inflation which has also been climbing since the start of the year. Inflation hit 2.1% last month, a four-year high, that is expected to weigh on consumer spending going forward.
In Asia, one of China’s most widely used interbank borrowing rates surged to its highest level in over 2 years last week, spreading fears that the country could experience a shortage of short-term credit, a condition known as a “credit crunch”. China’s seven-day repurchase rate (known as a “repo rate”) vaulted almost 2% to 5.5% earlier this week before settling at 5% on Wednesday. Analysts state the sudden jump is not necessarily unexpected given that China’s parliament recently concluded that they would make addressing the nation’s rising debt a priority. In addition, the country’s central bank has embarked on a tightening cycle, raising its short-term policy rates for the third time in three months last week.
The Japanese manufacturing sector continued to expand at a slow but steady pace this month, according to research firm Markit’s Japan Flash Manufacturing Purchasing Managers Index (PMI). Japan’s PMI came in at 52.6 this month, slightly below the estimate of 53.5, but remaining in growth mode above 50. March was the seventh consecutive month of manufacturing activity expansion. Amy Brownbill, economist at IHS Markit said “Although signaling a slower rate of expansion during March, the latest PMI data again point to a Japanese manufacturing economy expanding at a decent clip.” Output, new orders, and new export orders all increased but at a slower rate. The Bank of Japan expects fiscal 2017 growth to be 1.5%.
Finally: As the market experienced its worst week of the year, participants have begun to wonder if the so-called “Trump Trade” could be over. A number of analysts are particularly concerned because they’ve noted that small cap stocks have not kept pace with their larger brethren in the first quarter, after strongly outperforming in 2016.
According to a well-known market adage, a market is deemed healthy if the troops (small caps) are rising in tandem with the generals (large caps) – and is unhealthy if there is a significant divergence between them. Market researcher Mark Hulbert decided to put the adage to the test and his results were surprising.
As shown on the following chart, it turns out that the S&P 500 actually has had (on average) the best future 3-month performance when large caps have outperformed small caps by more than 5% in the trailing 3-months. So, that old generals and soldiers analogy does not hold up to at least this one statistical test.
(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 10.25 from the prior week’s 12.50, while the average ranking of Offensive DIME sectors rose to 16.25 from the prior week’s 17.25. The Defensive SHUT sectors widened their lead over the Offensive DIME sectors for the fourth consecutive 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®