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 29.909, up from last week’s 29.66, 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 63.69, down from the prior week’s 64.30.
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 13, down from the prior week’s 15. 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 internal disagreement expressed by two indicators positive and one negative, the U.S. equity markets are rated as Neutral.
In the markets:
U.S. Markets: U.S. markets rose this week as all major indexes recorded gains. The Dow Jones Industrial Average added 139 points to end the week at 21,813, a gain of 0.64%. The tech-heavy Nasdaq Composite had its first positive week in five by rebounding 49 points to 6,265, an increase of 0.79%. By market cap, the beaten-up smaller capitalization indexes bounced back harder than large caps with the small cap Russell 2000 and mid cap S&P 400 indexes rising, 1.45% and 0.99% respectively, while the large cap S&P 500 index gained 0.72%.
International Markets: Canada’s TSX rose 0.69%, partially retracing last week’s decline. Major European markets were mixed: the United Kingdom’s FTSE rose 1.06%, France’s CAC 40 retreated -0.19%, Italy’s Milan FTSE fell ‑0.31%, and Germany’s DAX was essentially flat rising just 0.02%. In Asia, China’s Shanghai Stock Exchange rose 1.9%, while Japan’s Nikkei fell -0.09%. Hong Kong’s Hang Seng was the best of the major International indexes, surging almost 3%. As grouped by Morgan Stanley Capital International, developed markets rose 0.85% while emerging markets gained an outsized 2.89%.
Commodities: Oil fell -$0.79 to $47.87 a barrel for West Texas Intermediate crude oil, a decline of -1.6%. Precious metals continued their uptrend after a pause last week. Gold gained $6.30 an ounce, closing at $1297.90 – an increase of 0.49%. Silver gained $0.05, ending the week at $17.05 an ounce. Copper, seen as an indicator of world economic health due to its variety of uses, surged 3.2% in its seventh consecutive week of gains.
U.S. Economic News: The number of people who applied for new unemployment benefits ticked up by 2,000 to 234,000 last week, according to the Labor Department. Last week’s reading was the lowest level in six months and the second lowest reading of the current economic expansion that began in 2009. The last time claims were as low was in the early 1970’s. So far this year, initial claims have remained in a relatively stable range around 245,000. Continuing claims, the number of people already receiving benefits, remained unchanged at 1.95 million the prior week. That number is reported with a one-week delay.
New home sales fell to a 7-month low last month, according to the Commerce Department. In July, sales of newly-constructed homes fell to a seasonally-adjusted annual rate of 571,000, an almost 10% retreat from June’s reading. Compared to the same time last year, sales were down 8.9% year-over-year. Economists had expected an annualized pace of 608,000. July’s median sales price was $313,700, 6.3% higher than a year ago. At the current sales rate, there is 5.7 months of supply available on the market. So far this year, sales are 9.2% higher than the same time last year, signaling a steady rate of growth. Analysts were quick to point out that the Commerce Department’s data is based on small sample sizes and the data is often heavily revised. Ian Shepherdson, chief economist for Pantheon Macro, called the report “disappointing” in a research note, but also stated he expected improvement in August based on mortgage application data.
Sales of existing (i.e., previously-owned) homes fell to their lowest level of the year in July, according to the National Association of Realtors (NAR). Existing home sales in July were at a seasonally-adjusted annual rate of 5.44 million – a decline of -1.3% from June’s pace. Still, compared to the same time last year, sales were actually 2.1% higher. In its release, NAR Chief Economist Lawrence Yun said that the strong demand meant listings were under contract within 30 days and that the median sales price in July was $258,300, an increase of 6.2% compared to a year ago. At the current sales rate, there is a 4.2 month supply of existing homes currently on the market. By region, sales in the South rose 2.2%, while in the West sales were up 5%. However, in the Midwest, sales fell -5.3%, and in the Northeast sales plunged 14.5%.
Orders for goods intended to last longer than three years, so-called “durable goods”, fell 6.8% in July, according to the Commerce Department. The drop effectively reversed June’s 6.4% rise. The decline was led by a sharp drop in aircraft orders, a typically volatile sector. Ex-transportation (which really means “without Boeing”), durable goods orders were actually up 0.5% in its third straight monthly gain. Orders for core capital goods orders, used by analysts as a proxy for business investment, were up 0.4% in July. Economists at NatWest released a note to clients stating, “As this rebound in capital spending appears sustained, we are forecasting another mid- single digit advance in business investment in the third quarter.”
Market research firm HIS Markit reported that its “flash” manufacturing purchasing managers index (PMI) fell -0.8 point to a two-month low of 52.5 last month. In contrast, IHS Markit’s PMI for the services sector rose 2.2 points to 56.9—its highest level in more than two years. IHS’s flash readings are an early look at the survey data, before the final numbers are released. The flash readings are based on roughly 85-90% of the total PMI survey responses.
At the Federal Reserve’s summer retreat in Jackson Hole, Fed Chairwoman Janet Yellen gave a speech defending the post-crisis bank rules put into effect following the financial crisis. Chairwoman Yellen said that the Dodd-Frank law and additional regulations have made the financial system “substantially safer”. “Because of the reforms that strengthened our financial system, and with support from monetary and other policies, credit is available on good terms, and lending has advanced broadly in line with economic activity in recent years, contributing to today’s strong economy,” Yellen said. Yellen steered clear of any questions related to current interest-rate policy. A majority of analysts now expect the central bank to announce a decision to begin shrinking its massive balance sheet at its next meeting in mid-September, and to put off considering another interest-rate hike until it’s meeting in December.
International Economic News: U.S. President Donald Trump’s threat to terminate the North American Free Trade Agreement (NAFTA) less than a week into its renegotiation hasn’t generated much response from either Canada or Mexico, which are both downplaying his remarks. Adam Austen, spokesman for Canada’s Foreign Affairs Minister Chrystia Freeland said, “Trade negotiations often have moments of heated rhetoric. Our priorities remain the same and we will continue to work hard to modernize NAFTA. Canada’s economic ties with the United States are key to middle-class jobs and growth on both sides of the border. Nine million American jobs depend on trade and investment with Canada.”
The U.K.’s Office for National Statistics reported the U.K. economy grew at an annualized rate of 1.7% in the second quarter, in line with analyst expectations. However, the slight 0.1% increase in economic growth in the first quarter means that the United Kingdom is likely to have recorded the slowest second quarter growth among all the G7 group of nations. Of particular concern is the fact that growth in the second quarter was driven predominantly by government spending—not from businesses or consumers. Business spending showed no growth at all, and consumer spending was weak. Economists had expected the Brexit vote in Britain to withdraw from the European Union to have a large immediate negative effect. That didn’t happen, but it now appears that the negative effects will be felt over a longer period of time.
On Europe’s mainland, French Prime Minister Emmanuel Macron was rebuked by Polish Prime Minister Beata Szydlo after stating that Poland’s right-wing government was isolating itself within the European Union by going “against European interests.” His remarks followed Poland’s objections to changing a controversial EU rule that lets firms send temporary workers from low-wage EU countries to rich economies without paying the usual local social charges. Szydlo responded, “I advise the president that he should focus on the affairs of his own country, perhaps he may be able to achieve the same economic results and the same level of security for (French) citizens as those guaranteed by Poland.”
In Germany, the economy achieved a record surplus for the first half of the year of 18.3 billion euro, according to the latest figures from Destatis, the German Federal Statistical Office. The surplus was driven predominantly by an improving jobs market and export-driven growth. In addition, economists note the German economy remains on a path of growth supported by consumerism and increasing company investments. Research firm IHS Markit stated it would probably lift its full-year forecasts for German GDP growth after receiving positive responses to its survey of German corporations.
Chinese first-time home buyers are having a difficult time getting good mortgage rates as the country tightens its credit controls, intended to curb property speculation. In the east China city of Suzhou, the Agricultural Bank of China announced that rates on new housing loans for first-time home buyers would be 10% higher than the benchmark set by the central bank. Commercial banks have been raising mortgage rates in China’s major cities following the stringent housing purchase restrictions that have cooled house prices. Rong360, a financial data provider, reported the average mortgage rate for first-time home buyers rose 12.38% from July of last year to 4.99%.
Japanese core consumer prices rose for a seventh straight month, rising 0.5% in July from a year earlier. The increase is a sign the economy is making modest progress towards meeting the central bank’s 2% inflation target. The increase was driven predominantly by higher fuel costs, however, making them potentially transient. The economy expanded at its fastest pace in more than two years in the second quarter as both consumer and business spending picked up. However, both price and wage growth remains weak with companies still hesitant to pass more of their profits on to employees. Nonetheless, the Bank of Japan now expects inflation to hit its 2% target in the fiscal year ending in March of 2020.
Finally: The price-to-earnings (“P/E”) ratio remains one of the most widely-accepted valuation metrics in the financial markets today. However, it is not without its flaws. For a price-to-earnings ratio to exist, a company must have positive earnings. Therefore, companies that are losing money have no earnings and a nonsensical “infinite” P/E ratio. Major financial firms that produce market indexes, like FTSE, Russell and iShares, exclude these firms when calculating their index price-to-earnings ratios. However, this could have significant consequences in indexes that have a large number of companies with no earnings, by making the overall index P/E look artificially low. Take, for example, the small cap Russell 2000 index. Almost a third of companies in the small cap index are losing money (i.e., have no earnings). Global financial firms FTSE and iShares are both reporting the Russell 2000’s P/E currently at around 20. However, as head of global macro strategy at INTL FCStone’s Vincent Deluard points out, taking into account the companies that are losing money, the actual P/E of the Russell 2000 is more like 78.7. This new calculation puts the small cap Russell 2000’s P/E far higher than the same measurements at either the top of the internet bubble, or the bull market peak in 2007, as shown below in Deluard’s chart.
(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 rose to 9.00 from the prior week’s 9.25, while the average ranking of Offensive DIME sectors rose to 16.50 from the prior week’s 17.00. The Defensive SHUT maintained their lead over the Offensive DIME 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®