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 29.66, little changed from last week’s 29.86, 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 64.30, down from the prior week’s 68.19.
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 15, down from the prior week’s 17. 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: Stocks finished the week on a down note as volatility returned to the market, with both domestic and global conflicts contributing. On Monday, the S&P 500 index recorded its biggest one-day gain in almost four months, but gave it all back on Thursday when it fell the most in three months. The Dow Jones Industrial Average registered its second down week, falling -183 points to close at 21,674, a decline of -0.8%. The tech-heavy Nasdaq Composite recorded its fourth consecutive week of losses, losing another 40 points to end the week at 6,216, a loss of -0.6%. By market cap, smaller cap indexes again fared worse than large cap. The large cap S&P 500 index fell -0.65%, while the mid cap S&P 400 and small cap Russell 2000 indexes lost -1.1% and -1.2%, respectively.
International Markets: Canada’s TSX fell the third week of the last four, losing -0.5%. Across the Atlantic, however, major European markets ended the week in the green. The United Kingdom’s FTSE rose 0.19%, while on Europe’s mainland France’s CAC 40 added 1.05%, Germany’s DAX rose 1.26%, and Italy’s Milan FTSE surged 2.16%. In Asia, major markets were mixed. China’s Shanghai Composite rose 1.88%, but Japan’s Nikkei fell -1.3%. As grouped by Morgan Stanley Capital International, developed markets gained 0.36%, while emerging markets rose 1.75%.
Commodities: Precious metals, which generally benefit from stock market weakness, nonetheless ended the week modestly down. Gold fell -$2.40 to $1291.60 an ounce, a decline of -0.19%. Silver likewise fell -0.4% to $17 an ounce. The industrial metal copper, seen by some as a barometer or global economic health, rose 0.94%. Crude oil ended the week down, losing -0.33%, to close at $48.66 for West Texas Intermediate.
U.S. Economic News: The number of Americans who applied for new unemployment benefits in the middle of August fell to its lowest level in six months, further evidence of the nation’s strongest labor market in almost twenty years. According to the Labor Department, initial jobless claims for the week ending August 12 declined by 12,000 to 232,000. That is the lowest level since February and the second lowest reading since the current economic expansion began in 2009. The U.S. has added roughly 16 million jobs over the last 7 ½ years, driving the unemployment rate down to 4.3%.
Sentiment among the nation’s home builders rose this month after falling to an 8-month low last month, according to the National Association of Home Builders (NAHB). The NAHB’s builder sentiment index jumped four points to a reading of 68, exceeding economists’ forecasts by three points. Every component of the index rose in August. Current conditions gained four points to 74, conditions expected over the coming six months rose five points to 78, and the index of buyer traffic added a point to 49. Builder sentiment had surged following the U.S. Presidential election in which then-candidate Donald Trump promised to roll back regulations and lower builder costs, but the index has lost some ground since then. In the latest release, the NAHB attributed the increase to “ongoing job and economic growth, attractive mortgage rates, and growing confidence.” Builders continued to be concerned with lot and labor shortages and the risings costs of building materials.
The number of new homes being built rose in June, but the rate at which builders broke ground slowed. Housing starts ran at a 1.16 million seasonally-adjusted annual rate in July, according to the Commerce Department. That’s a drop of 4.8% from June’s pace and 5.6% lower than the same time last year. Economists’ had expected a 1.23 million rate. Housing permits, a gauge of future building activity also fell, sliding 4.1% compared to June’s pace. Analysts were quick to point out that the government’s new-home data is volatile and often heavily revised in later months. In the details of the report, one sign of a stabilizing housing market was the number of single-family starts. That number was at a 856,000 rate, similar to June’s reading. One year ago they were at a 772,000 annual rate. The increased emphasis on single-family homes, rather than apartments, is a sign that builders believe the economy can support more homeownership—not just rentals.
Sales at U.S. retailers surged to the highest level of the year last month, lifted by demand for new vehicles and a very successful Amazon Prime Day. According to the Commerce Department, sales at retailers rose 0.6% last month, exceeding economists’ forecasts by 0.2%. In addition, June’s retail sales were revised up half a percent to a gain of 0.3% instead of the -0.2% drop originally reported. The latest report shows that American households still had plenty of buying power going into the third quarter, and that bodes well for the economy as a whole. Chief economist at Regions Financial Richard Moody said, “The inherent volatility in the monthly retail sales reports notwithstanding, consumers will remain the key driver of growth in the U.S. economy.” Ex-auto and gasoline, retail sales still rose at a robust 0.5%. Retail sales are up 4.2% over the past 12 months, close to its five-year average. Even if Amazon is crushing many retailers, at least the total $ spent by consumers continued to rise.
American consumers were more optimistic about the economy earlier this month, according to the University of Michigan’s consumer sentiment index. The index climbed 4.2 points to 97.6, nearing the 13-year high seen in January. In the details, while Republicans and most independents continue to be the most optimistic about the economy, more Democrats are reporting that they are not as pessimistic as they had been. Of note, the survey found a sizeable increase in the number of people who said their own financial well-being had improved.
For the first time in three months, the cost of imported goods rose. The U.S. import price index rose 0.1% last month, predominantly due to the increase in the price of crude oil. Excluding fuel, import prices actually fell 0.1%. Despite the long-running economic expansion and tight labor market, inflation still doesn’t appear to be a threat just yet. The 12-month rate of import inflation remained flat at 1.5% last month, and down sharply from the five-year high of 4.7% set in February. That corresponds with the readings from other measures of inflation. The subdued inflation data has spurred debate within the Federal Reserve about whether and how soon the central bank needs to raise interest rates again. A growing number of Fed officials appear to be having second thoughts despite data earlier in the year that suggested the bank would boost rates at least once more in 2017.
U.S. industrial production rose last month, according to the Federal Reserve. Production was led by a 1.6% surge in output among the nation’s utilities, presumably to cool U.S. homes during the summer heat. Overall, output was up 0.2%, not quite meeting expectations of a 0.3% rise. Mining was also strong, rising for a fourth consecutive month, up 0.5%. Separating out manufacturing output, however, showed a slip of 0.1%, led by lower production among auto makers. It was manufacturing’s third decline out of the last five months.
In the New York-region, manufacturing jumped to its highest levels in almost three years, according to the New York Federal Reserve’s Empire State manufacturing index. The index surged 15 points to 25.2. Economists had expected an essentially unchanged reading. In the details, the shipments gauge rose 1.9 points to 12.4, while two employment readings – number of employees and average workweek – also rose. The new orders gauge, seen by economists as a proxy for future business activity, surged 7.3 points to 20.6, indicating probable stronger business conditions in the future. New York firms also remained optimistic about the future—the gauge of future business conditions spiked 10 points.
Minutes from last month’s Federal Reserve meeting showed that Fed officials debated about the path of U.S. inflation after a series of unexpectedly low readings, and questions were raised about whether the bank should raise interest rates again this year. The Fed’s policy-setting group appeared more unified on another subject: a plan to announce the beginning of a long-awaited drawdown in the Fed’s massive $4.5 trillion asset portfolio, accumulated to prop-up the major banks during the 2007-2009 financial crisis. The Fed plans to shrink its holdings of Treasuries and mortgage-backed securities over a period of several years, a move that would gradually increase the cost of borrowing.
International Economic News: The U.S. kicked off the renegotiation of the North American Free Trade Agreement (NAFTA), with some harsh words. At the opening news conference, officials from the U.S. lectured Canada and Mexico on the failures of the current agreement, while behind closed doors negotiators began seeking significant concessions from the two countries. Robert Lighthizer, trade representative from the United States stated, “We feel that NAFTA has fundamentally failed many, many Americans and needs major improvement.” While trade with Canada has been more balanced in recent years, over time the United States has run a significant trade deficit. President Trump has made it clear that he regards trade deficits as a primary measure of the economy’s health. Chrystia Freeland, Canada’s minister of foreign affairs responded, “Canada doesn’t view trade surpluses or deficits as a primary measure of whether trade works.”
In the United Kingdom, consumer spending is weakening, according to a pair of separate reports. This is particularly ominous because the U.K. economy, like that of the U.S., relies on consumer spending for a dominant portion of GDP. According to the reports, annual growth in retail sales in the second quarter dropped to 1.8%, the weakest reading in almost four years. The weakness is believed to be due to a higher level of inflation following a decline in the value of the British pound. The British pound has been under pressure since Britain’s vote to leave the European Union. Because of the declining value of the pound, prices are now rising faster than average worker wages, with real incomes falling 0.5% in the second quarter. Andrew Sentence, economic adviser at PwC stated, “Consumers are watching and waiting for inflation to subside and for the post-Brexit situation to become clearer.”
The French economy, according to UBS Wealth Management, will grow at its fastest rate since the Eurozone crisis over the next two years. The wealth management arm of the Swiss bank said buoyant consumer confidence and increased investment will boost economic activity from 1.4% in 2018 to 1.6-1.7% in 2019. UBS asserted that high levels of consumer and business confidence will translate into higher investment and consumption. Dean Turner, economist at UBS, stated, “In our view, growth in France is likely to remain robust for the remainder of the year and into next. It is the only large Eurozone country where we do not see the pace of growth easing next year.” Of concern, however, is President Macron’s upcoming labor reforms which could “trigger economically disruptive union strikes”, in UBS’ words.
Germany’s strong household spending, more investment by German companies, and higher state spending kept Germany in the driver’s seat of the Eurozone economy in the second quarter. Seasonally and calendar-adjusted GDP rose 0.6% last quarter, according to the Federal Statistics Office. That was slightly weaker than the 0.7% economists had forecast. Bankhaus Lampe economist Alexander Krueger said, “The German economy is proving its staying power, and the upswing continues.” The Statistics Office said that growth in the April-June period was mainly driven by domestic demand as households and state authorities increased their spending and companies boosted investment in buildings and equipment. However, overall growth was weighed by a decline in net foreign trade as exports rose less strongly than imports.
Italy’s statistics agency Istat reported the country’s strongest economic growth in six years. Gross domestic product was reported as rising 0.4% in the second quarter and up 1.5% from the same time last year. The 1.5% annualized growth rate is the highest reading recorded since the beginning of 2011. The increase was driven by strength in the industrial and services sectors and domestic demand. Although still lagging behind other Eurozone countries, the Italian economic recovery looked more convincing this year, with industrial output expanding at a seasonally adjusted 1.1% in the second quarter and a rise in exports of Italian goods over the same period.
In Asia, China’s economy showed further signs slowing down in the second half of the year, with factory production, investment, and consumer spending all coming in below forecast in the midst of a national drive to tackle rising debt. Yao Wei, chief China economist at Societe Generale stated, “Deleveraging and lowering risk in the financial system are now clearly among the top medium-term objectives of the Xi administration.” According to the National Bureau of Statistics, China’s industrial output expanded at an annualized 6.4% last month, down from 7.6% in June as mining and manufacturing slowed. The main engine of growth, fixed-asset investment, grew by 8.3% in the first seven months of the year, down 0.3% from the first half.
The value of Japanese exports rose an eighth consecutive month in July on heavier shipments to the United States and a weaker yen. The data supports the Bank of Japan’s view that the world’s third largest economy is showing increasing signs of strength as private consumption adds to the momentum from exports. Imports also rose for the seventh straight month on solid demand for computers and digital cameras from China. Takeshi Minami, chief economist at Norinchukin Research Institute said, “Domestic demand is gaining momentum and will likely drive Japan’s economic recovery.”
Finally: Legendary stock market technician Tom McClellan released a note this week on the subject of the historical relationship between the stock price of General Electric and the U.S. equity markets as a whole, and the news wasn’t good. Historically, the price of General Electric and a broader U.S. benchmark such as the Dow Jones Industrial Average have moved in lock-step with each other as shown in the graphic below. Up until this spring, the two had followed that general historical relationship. Since then, however, GE has underperformed quite significantly.
Why is this concerning? Because according to McClellan, “The basic idea is that when the DJIA and such a major component as GE disagree, it is usually GE that ends up being right about where both are headed.”
The chart below, from FactSet and Marketwatch.com, shows the dramatic divergence.
(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 9.25 from the prior week’s 11.00, while the average ranking of Offensive DIME sectors fell to 17.00 from the prior week’s 16.25. The Defensive SHUT sectors again 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®