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 30.23, little changed from last week’s 30.26, 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 70.65, up from the prior week’s 69.41.
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 26, unchanged from the prior week. Separately, the Intermediate-term Quarterly Trend Indicator – based on domestic and international stock trend status at the start of each quarter – was positive entering July, indicating positive prospects for equities in the third 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 Q3, and the shorter (weeks to months) timeframe (Fig. 4) is negative. Therefore, with two indicators positive and one negative, the U.S. equity markets are rated as Neutral.
In the markets:
U.S. Markets: In U.S. markets, it was the Dow…and then everyone else. The Dow Jones Industrial Average rose over 250 points last week closing at 21,830. The tech-heavy Nasdaq Composite fell 13 points to close at 6374, a decline of -0.2%. By market cap, large caps fared better than their smaller brethren. The S&P 500 large cap index gave up just -0.02%, while the S&P 400 mid cap index fell -0.65% and the small cap Russell 2000 retreated -0.46%.
International Markets: Canada’s TSX fell -0.36%, while across the Atlantic, markets were mixed. The United Kingdom’s FTSE retreated -1.13%, while on the mainland France’s CAC 40 rose 0.27%. Germany’s DAX fell -0.63%, and Italy’s Milan’s FTSE gained 1.08%. In Asia, China’s Shanghai Composite rose 0.47%, while Japan’s Nikkei retreated -0.7%. Hong Kong’s Hang Seng added 1%. As grouped by Morgan Stanley Capital Indexes, developed markets rose 0.36%, while emerging markets added 0.28%.
Commodities: Gold gained ground for a third straight week, rising 1.63% to close at $1,275.30. Silver had similar price action, rising 1.45% to close at $16.69. Energy had an even better week. West Texas Intermediate crude oil surged over 8.6% ending the week at $49.71 a barrel.
U.S. Economic News: The number of Americans who applied for initial unemployment benefits increased slightly last week, but remained near its lowest level in decades. The Labor Department reported initial jobless claims for the week ending July 22 increased by 10,000 to 244,000. The less-volatile four-week moving average of claims remained unchanged at 244,000. New claims have remained under the key 300,000 threshold that analysts use to indicate a healthy jobs market for 125 straight weeks—its longest run since the early 1970’s. The number of people who have already been receiving unemployment benefits, so-called continuing claims, fell by 13,000 to 1.96 million. Continuing claims have been under the 2 million level for 16 straight weeks—an event not seen since 1973.
Sales of previously-owned homes fell to the slowest pace since February as limited supplies of homes for sale continue to weigh on the housing market. Existing home sales were at a seasonally-adjusted annualized rate of 5.52 million homes last month, according to the National Association of Realtors (NAR). The reading was 0.7% higher than the same time last year, but a 1.8% decline from May’s reading. In addition, it was the second lowest reading of the year. Supply continues to be the biggest factor affecting the existing home sale market, says NAR. Total inventory was down 7.1% from the same time a year ago, and at the current sales rate there is only a 4.3 month supply of homes on the market. Zillow’s Chief Economist Svenja Gudell said, “It’s difficult to sell homes when there are so few available to buy, and the chronic inventory shortage the market has been suffering from — bordering on an inventory crisis at this point — is now more than two years old.” The supply imbalance continues to push prices higher. The median sales price was $263,800, a 6.5% increase compared with the same time last year. That sets a fresh record and marks the 64th consecutive month of yearly price gains. Of concern to economists, housing prices are growing at roughly double the pace of wage gains and thus the rate of price growth is unsustainable.
New home sales increased for a second straight month, according to the Commerce Department. New home sales for June were at a seasonally-adjusted annual rate of 610,000, an increase of 0.8% from May. June’s reading was 9.1% higher than a year ago. The median sales price of a new home was $310,800 in June, a 3.3% decline compared to the same time last year. At the current sales pace there is a 5 month supply of homes on the market. Stephen Stanley, chief economist for Amherst Pierpont Securities said in a research note, “I am not worried about flagging demand, as builders and realtors have been very clear that the demand is there.”
Overall home prices (both new and existing) remained strong but eased slightly according to the S&P/Case-Shiller 20-city home price index. The index rose 5.7% in the three-month period ended in May compared to the same period the year before. The reading was down a slight 0.1% from the previous month. Of the 20 cities surveyed, nine reported greater price increases for the 12 months ending in May than in April. Seattle, Portland, and Denver showed the strongest growth. At the other end of the scale, Chicago was the weakest. The broader national index rose 5.6% for the year in May, matching April’s reading.
Confidence among consumers rose in July to its second highest level in 16 years, according to the Conference Board. July’s consumer confidence index rose to 121.1, a gain of 3.8 points from June. July’s confidence number was exceeded only by March’s reading of 124.9 when confidence had soared due to the high expectations surrounding the new Trump administration. Although his administration has struggled to pass meaningful pro-business reforms, Americans are still the most confident they’ve been in years. A significant factor supporting the high confidence readings is the strong labor market. The unemployment rate is currently at 4.3%, its lowest level since the turn of the century.
Manufacturing output in the United States reached a four-month high this month according to IHS Markit’s flash U.S. manufacturing Purchasing Managers Index (PMI). The index rose 1.2 points this month to 53.2, as readings for output, new orders, and employment all accelerated. IHS cited improving demand conditions and reduced risk aversion among manufacturers as reasons for the gain. In the services industry, Markit’s flash services PMI remained unchanged from the previous month at 54.2. Markit said services were able to maintain its level due to an “improving economic backdrop”. Overall, the composite (manufacturing+services) PMI rose 0.3 point to 54.2. Chris Williamson, chief business economist at IHS Markit said “The July PMI surveys show an economy gaining growth momentum at the start of the third quarter, enjoying the strongest monthly improvement in business activity since January.” Readings above 50 indicate growth.
Orders for manufactured goods expected to last three years or longer (so-called “durable goods”) surged to a three-year high last month, but unfortunately the gain was almost entirely due to a large aircraft order at Boeing. The Commerce Department reported that durable goods orders rose 6.5% last month as Boeing began processing nearly 200 orders for new aircraft following the Paris Air Show. Ex-aircraft and autos, orders were up only a slight 0.2%. Auto makers actually reported a decline in orders of -0.6%. Ex-transportation, other major industrial segments reported weak demand. Core capital goods orders, which are capital goods excluding aircraft and goods produced for the Defense Department, were down 0.1% in June. However on a positive note, core orders have risen 5.6% over the past 12 months—the fastest year-over-year rise since 2012.
In the Windy City, the Chicago Federal Reserve’s national economic activity index rose to a positive 0.13 in June, an increase of 0.43 from May. The index was supported by improvements in the manufacturing and employment components. May’s reading had been the lowest since August of 2016. The three-month moving average of the Chicago Fed’s index, smoothed to iron out monthly volatility, improved to a positive 0.06. Production-related indicators increased to a positive 0.09 in June, while employment-related indicators contributed a positive 0.06. The index is a weighted average of 85 economic indicators, designed so that a reading of zero represents economic growth, while a reading below -0.7 suggests a recession has begun.
U.S. Gross Domestic Product (GDP) grew at a 2.6% annual rate in the second quarter, according to the latest data from the Bureau of Economic Analysis. Consumer spending, the main driver of the U.S. economy, led the increase with a 2.8% gain, while business investment in equipment rose 8.2%.
International Economic News: Canada’s economic growth blew past expectations, led by a surge in oil production. According to Statistics Canada, real gross domestic product jumped 0.6% in May—triple the 0.2% growth that economists had predicted. The biggest contributor was a 7.6% surge in oil and gas extraction. The sector received a large boost from Syncrude Ltd’s Mildred Lake oilsands operation in Alberta which came back online. Wildfires in March had taken much of Canada’s oil production equipment offline. Compared to the same time last year, real GDP was up 4.6%–its fastest year-over-year growth since 2000. Krishen Rangasamy, senior economist at National Bank of Canada, breathlessly summed it up in a research note, “The Canadian GDP results were simply stunning.”
Across the Atlantic, the United Kingdom’s Home Office launched an independent review of the impact of European Union migrants on the nation’s economy. The independent committee was asked specifically to look at how EU migrants affect different sectors of the U.K. economy. More than 3 million citizens of other EU countries live and work in Britain, and many areas of the economy rely on foreign workers. Home Secretary Amber Rudd said that the government needs “the most accurate picture possible of the extent to which the U.K. economy uses EU labor.” The government says it will end free movement — a key principle of the EU — and impose immigration controls after Brexit. Rudd wrote “The U.K. must remain a hub for international talent. We must keep attracting the brightest and the best migrants from around the world.”
On Europe’s mainland, France’s economy expanded for a fourth consecutive quarter giving new President Emmanuel Macron the momentum he needs to push through his reforms. GDP rose 0.5% in the second quarter matching the pace of the previous two quarters. The expansion was driven by exports and investment, with net trade making its biggest contribution in more than seven years. In addition, both consumer confidence and business confidence are at their highest levels in several years. Ludovic Subran, chief economist at Euler Hermes in Paris said, “Everyone is thrilled that France is back but it doesn’t mean it’s out in front, it has simply returned to the pack.”
In Germany, business morale hit a record high as manufacturers dismissed concerns over a stronger euro and anticipated a surge in already robust exports. The Munich-based Ifo economic institute said its business climate index, based on a survey of about 7,000 firms, reached its third record high in the last three months. The index rose 0.8 point to 116.0 in July, beating a Reuters consensus forecast of 114.9. Ifo economist Klaus Wohlrabe said manufacturers were particularly optimistic, telling reporters “Hardly anything seems to be able to hit the German economy.” Ifo chief Clemens Faust said, “Sentiment among German businesses is euphoric. Germany’s economy is powering ahead.”
The Italian economy received a modest vote of support when the International Monetary Fund upped its growth forecasts for 2017 and 2018. Italian GDP is forecast to increase by 1.3% this year, according to the IMF. For 2018, the economy is forecast to grow by 1%, a gain of 0.2% over its earlier prediction. Prime Minister Paolo Gentiloni said the upgraded forecast “brings confidence and conviction about our country’s possibilities”. The rate of economic growth in Italy has been sluggish for the last three years. Italy’s jobless rate is around 11%, well above the Eurozone’s average of 9.3%.
China’s economy continues to hum, say multiple indicators from a variety of sources. Confidence expressed in surveys of small and medium-sized Chinese businesses as well as increased construction activity indicates continued resilience in the world’s second largest economy. Standard Chartered Plc’s Small and Medium Enterprise Confidence Index broke a three-month streak of declines and rose to 56 this month. The firm conducts a monthly survey of more than 500 Chinese companies. In addition, the China Satellite Manufacturing index published by San Francisco-based SpaceKnow Inc. increased 1 point to 50.5 in July. The firm uses commercial satellite imagery to monitor activity across thousands of industrial sites. Together with recent surveys of sales managers, steel mill executives, traders, and financial experts, the consensus view is that China’s economy continues to be robust.
In Japan, labor shortages have now hit a new extreme as the unemployment rate hits 2.8%. For the first time on record, the number of permanent jobs open now outnumbers the number of potential applicants. In June, the ratio of permanent job openings to applicants reached 1.01—the first time it rose above parity since records began. This suggests to analysts that the labor shortage is spreading beyond the ranks of just casual part-time jobs into the area of regular, salaried employees. After a multi-decade trend of companies offering workers insecure contract work, they are now being forced to offer permanent jobs in order to fill open positions.
Finally: Investment bank Goldman Sachs recently released research that reveals a different take on the relationship between present stock market valuations and future returns (see “The Very Big Picture” section of this report as well). Goldman reports that after periods of valuations in the top quartile of all historical valuations, the S&P 500 index has delivered single-digit or negative returns 99% of the time. In nearly a fifth of instances (17%), returns were negative. Unfortunately, current stock market valuations are solidly in that upper quartile.
(sources: all index return data from Yahoo Finance; Reuters, Barron’s, Wall St Journal, Bloomberg.com, ft.com, guggenheimpartners.com, zerohedge.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 was unchanged from the prior week’s 15.75, while the average ranking of Offensive DIME sectors rose to 15.75 from the prior week’s 16.25. The Offensive DIME sectors and Defensive SHUT sectors are now tied in rank. 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®