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 29.86, down from last week’s 30.29, 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 68.19, down from the prior week’s 71.96.
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 17, down from the prior week’s 22. 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: Growing concerns over a conflict on the Korean peninsula and some disappointing earnings reports from a few major U.S. companies weighed on the major U.S. equity benchmarks this week. The Dow Jones Industrial Average’s streak of nine consecutive record-setting closes ended this week with the loss of 234 points, to close at 21,858, a loss of -1.1%. The tech-heavy Nasdaq Composite suffered a worse fate, falling -1.5% to close at 6,256. By market cap, large caps outperformed their smaller cap brethren. The large cap S&P 500 index retreated -1.4%, while the mid cap S&P 400 index fell -2.3% and the small cap Russell 2000 fared the worst by declining -2.7%.
International Markets: Major international markets were red across the board. Canada’s TSX fell -1.5%, while in Europe, the United Kingdom’s FTSE declined -2.7%, France’s CAC 40 was off -2.7%, Germany’s DAX fell -2.3%, and Italy’s Milan FTSE retreated -2.7%. In Asia, China’s Shanghai Composite ended down -1.6%, while Japan’s Nikkei slumped -1.1%. As grouped by Morgan Stanley Capital Indexes, emerging markets were off -2.3%, while developed markets fell -2.2%.
Commodities: Precious metals, seen by many as a safe haven in volatile markets, rose this week on the global weakness. Gold rose $29.40 to close at $1,294 an ounce, a gain of 2.3%. Silver sympathetically surged over 5% to close at $17 an ounce. Energy, though, ended down on the week: West Texas Intermediate crude oil closed at $48.82 per barrel, a decline of -1.5%.
U.S. Economic News: Initial claims for U.S. unemployment benefits rose slightly to 244,000 last week, but still remained well below the key 300,000 threshold that analysts use to indicate a healthy jobs market. The Labor Department reported the number of people applying for new unemployment benefits rose by 3,000 in the week ended August 5. The four-week moving average of claims, used to smooth out the volatility of the data, fell by 1,000 to 241,000. Adjusted for population growth, claims are at their lowest level ever, according to Ian Sherpherdson, chief economist at Pantheon Macroeconomics. Continuing claims, which counts the number of people already receiving unemployment benefits, fell by 16,000 to 1.95 million. That number is reported with a one-week delay.
The number of job openings reached a new record high in June, according the Labor Department. Job openings surged by almost half a million to 6.16 million from 5.7 million in May. Solid gains came in the professional and business services, health care, social assistance, and construction sectors. Companies continued to report having difficulty finding employees with enough skills. Minneapolis Fed President Neel Kashkari’s solution for business leaders was to raise pay aggressively if that is the case. “Are you really struggling to find workers? If so, the proof for me is you are raising wages. If you are not raising wages, then it just sounds like whining,” he said. He seemed annoyed because average hourly pay has been growing at only a roughly 2.5% annual pace, badly lags the 3-4% annual wage growth typically seen during expansions.
American consumers borrowed less in June but growth remained “solid” according to the Federal Reserve. In June, total consumer credit increased $12.4 billion to a seasonally-adjusted $3.86 trillion, posting an annual growth rate of 3.9%. While positive, this was down significantly from May’s $18.3 billion gain, which was the strongest in six months. Overall, consumer borrowing slowed in the second quarter, continuing a trend that began last fall. Non-revolving credit, which covers loans for things like education and cars, rose at an annual rate of 4.9% in June—down from 8.2% in May. Revolving credit, made up of predominantly of credit-card loans, increased at an annual rate of 3.9% in June, down from 5.7% in May. Economists had expected consumer borrowing in June to increase by $16 billion.
Sentiment among small-business owners rebounded in July as customer demand improved, according to the National Federation of Independent Business (NFI B). The NFIB’s sentiment index rose 1.6 points last month to 105.2, breaking a five-month streak of negative or unchanged readings. The jump in the survey was predominantly due to better views of the labor market, where owners reported having more open positions now as well as plans to hire more employees, and stronger sales expectations. The NFIB’s sentiment index soared following the election of Donald Trump who promised to repeal the health-care law and cut government regulations but so far has yet to deliver. In a research note, Joshua Shapiro (chief U.S. economist at economics firm MFR) wrote, “If Mr. Trump and Congressional Republicans deliver on much of what has been promised, small businesses have signaled that they will respond with actions that should boost economic growth.”
Productivity of U.S. workers improved in the second quarter, though it continued to lag below the historical average. Defined as the measure of how many goods or services workers produce per hour, productivity rose at an annual rate of 0.9% in the second quarter compared to the first quarter, according to the Labor Department. It was a significant improvement from the tiny 0.1% increase in the first quarter. Productivity, on an annualized basis, has increased by 1.2% for two consecutive quarters. It’s a significant improvement over the past few years, but it is well below the post-World War 2 average of 2.1%. Analysts are concerned because without a surge in productivity, the ability of the economy to accelerate will remain limited.
Inflation at the consumer level remained steady at a 1.7% annual rate, according to the latest data from the Labor Department. Consumer prices remained soft for the fifth consecutive month in July, rising a mere seasonally-adjusted 0.1% in July. In the details, food prices rose 0.2%, while energy prices were up 0.1%. Ex-the volatile food and energy components, the so-called core CPI also rose 0.1%. Consumer prices are up an unadjusted 1.7% over the past 12 months, a 0.1% improvement from June. On a core basis, which is watched more closely by Fed officials, consumer prices remained at a 1.7% annual rate—the same as in May and June. St. Louis Fed President James Bullard said Wednesday that Fed officials have been surprised by the low inflation readings this year. He and a growing minority of Fed officials want the Fed to hold off on further rate hikes until inflation moves higher.
At the wholesale level, prices actually declined last month for the first time in almost a year. The Labor Department reported the producer-price index fell 0.1% in July, its first drop since August of last year. The core rate, which in this case excludes food, energy, and trade, was flat for the month. Wholesale prices were subdued across the board. The price of goods fell 0.1% last month, while energy prices retreated 0.3% and food prices remained unchanged. Josh Shapiro, chief U.S. economist at MFR Inc. wrote in a note, “With major moves in prices at the producer level necessary to spark significant shifts in prices at the consumer level, we do not believe there is any cause for concern whatsoever, in either direction, from recent PPI data.” Over the past year overall producer prices decelerated to a 1.9% annual rate, falling steadily from a high of 2.5% in April. The July annual rate is the lowest since January.
International Economic News: It’s official – Canada’s economy is now ranked number two on many measures among the top seven largest economies of the world. Canada’s economy has been known for being more stable and consistent than others, but the first eight months of this year have been outstanding. The GDP growth rate is 2.5% and nearly 300,000 jobs have been added. According to a recent report from Toronto-Dominion Bank, “Whatever happens over the remainder of the year, 2017 will go down as a very good year for the Canadian economy.” James Maple, TD senior economist and report’s author writes, “We are looking at the best GDP growth and job growth Canada has seen in almost a decade.” And that will hold true even if Canada gets zero growth in the second half of the year.
Across the Atlantic, the UK economy’s performance weakened in July due to declines in car manufacturing, construction, and exports. A year after Britain voted for Brexit, there remains little sign that exporters have capitalized on the fall in the value of the pound. The Bank of England has made statements that it is counting on the recovery in exports to help lift growth in the economy. HSBC economist Elizabeth Martins said in a note, “This is a disappointing set of data for a country that has recently seen an 18 percent fall in the currency.” Forecasters at Britain’s National Institute of Economic and Social Research (NIESR) estimated that the data showed GDP growth in the three months to July slowed to 0.2%.
In France, job growth in the private sector last quarter grew at its fastest pace in at least six years according to the French national statistics agency INSEE. The increase of 91,700 jobs was a 0.5% increase over the previous quarter bringing the overall total to 19.21 million. The April-June period marked the 11th straight quarter of net new job creation in the private sector. The pickup in jobs has given new President Emmanuel Macron support as his government attempts to push reforms through France’s complicated labor regulations. Philippe Waechter, director of economic research at Natixis Asset Management, said that while the jobs figures marked another good set of data both for France and the broader euro zone, French labor reforms remained necessary.
In Germany, Chancellor Angela Merkel kicked off her re-election campaign by criticizing German auto executives urging them to innovate to secure jobs and to win back trust following last year’s diesel emissions scandal. The auto industry is Germany’s biggest exporter and provider of roughly 800,000 jobs. Her conservative Christian Democratic Union (CDU) party has campaigned on a platform of economic stability. Merkel told a rally organized by her Christian Democratic Union party in the western city of Dortmund that unemployment has dropped to a post-reunification low since she first was elected chancellor in 2005. Merkel and the conservatives are expected to win another term, although an opinion poll published on Thursday suggested her popularity had dropped 10 percentage points to 59 percent.
In Italy, while most of the euro zone economies are thriving, its third largest economy remains in the doldrums. Italy is noted by many analysts as the biggest threat to the stability of the euro zone economy, even though recent data has come in a bit more positive. Marco Wagner, senior economist at Commerzbank in Germany wrote, “Italy’s GDP (gross domestic product) year-on-year percentage change is only half of the euro zone average. This shall remain so for the time being.” The European Commission is forecasting only a 0.9% rise this year, and a 1.1% rise in 2018. Overall, the euro zone grew at a 2.1% pace year-over-year in the second quarter. The reason for the concern about Italy is the enormous amount of non-performing loans on the books of major Italian banks—356 billion euros, or 18% of all loans, as of the end of June of last year.
In Asia, China’s President Xi Jinping urged Donald Trump and North Korea to avoid “words and actions” that worsen tensions. President Trump and North Korea have been exchanging a “war of words” with the U.S. President threatening to rain “fire and fury” on the North. But China, one of North Korea’s only allies, has been urging restraint. Long-standing tensions between the United States and North Korea worsened when it tested two intercontinental ballistic missiles last month. According to Chinese state media, Mr. Xi told President Trump in a phone call that “all relevant parties” should stop “words and deeds” that would exacerbate the situation. Mr. Xi also stressed China and the US shared “common interests” over denuclearization and maintaining peace on the Korean peninsula. Mr. Xi has also reportedly told North Korea that if it should strike the first blow in a conflict with the US, it is on its own and China would remain neutral.
In Japan, Economy Minister Toshimitsu Motegi said he would do all he could to help the government achieve its fiscal discipline target of returning to a primary surplus in the fiscal year 2020. Motegi announced he intends to achieve that goal while simultaneously lowering the ratio of outstanding debt to gross domestic product. Earlier this year, the government made a policy change that many economists saw as a step toward abandoning the objective of a primary budget surplus. Some advisors close to Prime Minister Shinzo Abe have called for the government to abandon pursuing a budget surplus because it would require big cuts in spending. Motegi said he placed equal priority on fiscal discipline and economic growth.
Finally: Researchers at Boston College’s Center for Retirement Research analyzed the current status of State and Local government defined-benefit (i.e., “traditional”) pension plans across the nation. What they found was a bit disturbing. Despite an assuming that the plans would earn an average return of 7.6% per year, the 170 plans reviewed by analysts actually had an average return of just 0.6% in 2016. This has dropped the average plan funding percentage to just 67.9%. Given the underperformance with regard to investments, there remain only two viable options—increasing contributions (from governments, their workers, and/or taxpayers), or reducing pension benefits, or both. Most observers believe that, in the end, it is taxpayers who will once again get the bill – and the shaft.
(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 11.00 from the prior week’s 14.00, while the average ranking of Offensive DIME sectors rose to 16.25 from the prior week’s 17.25. The Defensive SHUT sectors expanded 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®