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 30.62, little changed from last week’s 30.60, 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 67.03, up from the prior week’s 65.63.
In the intermediate and Shorter-term picture:
The Shorter-term (weeks to months) Indicator (see Fig. 4) turned positive on September 7th. The indicator ended the week at 20, up from the prior week’s 18. 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 positive. Therefore, with internal agreement expressed by all three indicators being positive, the U.S. equity markets are rated as Positive.
In the markets:
U.S. Markets: The major U.S. market indexes finished the week mixed. The large cap benchmarks were flat to slightly higher, with both the large cap S&P 500 and the Dow Jones Industrial Average finishing modestly higher, but the technology-heavy NASDAQ Composite ending the week down. The Dow Jones Industrial Average continued to rise, adding 81 points to end the week at 22,349, an increase of 0.37%. The Nasdaq composite gave up some of last week’s gains by falling 21 points to 6,426, a decline of -0.33%. By market cap, the large cap S&P 500 was essentially flat, rising just 0.08%, while the S&P 400 midcap index rose 0.84%, and the Russell 2000 small cap index gained 1.33%.
International Markets: Canada’s TSX rose for a second consecutive week gaining 1.85%. Europe was green across the board. The United Kingdom’s FTSE offset some of last week’s losses by rising 1.32%. On Europe’s mainland, France’s CAC 40 rose 1.29%, Germany’s DAX gained 0.59%, and Italy’s Milan FTSE increased 1.36%. In Asia, China’s Shanghai Composite ticked down just -0.03%, while Japan’s Nikkei tacked on an additional 1.94% and Hong Kong’s Hang Seng gained 0.26%. As grouped by Morgan Stanley Capital International, Developed Markets rose 0.48%, while emerging markets fell by -0.46%.
Commodities: Precious metals were under pressure for the second week in a row. Gold fell by -$27.70 an ounce to end the week at $1,297.50, a decline of -2.09%. Silver, Gold’s more volatile cousin, was also off down -4.09% to close at $16.98. The price of oil rose for a third straight week gaining 1.54% to end the week at $50.66 per barrel of West Texas Intermediate crude oil. Copper, used by some analysts as a gauge of worldwide economic health, fell for a third straight week declining a slight -0.15%.
U.S. Economic News: Applications for new unemployment benefits fell sharply last week, partially offsetting the previous week’s surge. Initial claims for the week ended September 16 fell by 23,000 to 259,000, according to the Labor Department. The number of Americans seeking jobless benefits remained near a 44-year low, and far below the 300,000 threshold analysts use to indicate a “healthy” jobs market. Economists were surprised, as they had expected claims to top 300,000 due to people temporarily put out of work due to hurricanes in Florida and Texas. The less-volatile four-week moving average of claims rose by 6,000 to 268,750. Continuing claims, which counts the number of people already receiving unemployment benefits, rose by 44,000 to 1.98 million. That number is reported with a one-week delay.
Construction of new homes dipped in August, but an indicator of future building activity improved, according to the Commerce Department. Housing starts declined 0.8% to an annual rate of 1.18 million in August, matching economists’ expectations. Housing starts fell -7.9% in the South and in the Northeast which plunged -8.7%. However, in the Midwest and West, starts improved. Permits to build new homes, an indicator of future housing activity, surged 5.7% to a 1.3 million annualized rate. New single-family construction lead the way, with starts on single-family homes at an 851,000 annualized rate—up 17% from the same time last year. Meanwhile, new construction on buildings with five or more units, such as apartment complexes, fell 5.8% to a 323,000 annualized rate—down 23% over the past year.
Confidence among the nation’s builders slipped this month on concerns about the continued shortage of qualified labor and the availability of building materials. The National Association of Homebuilders (NAHB) housing market index fell 3 points to 64 in its latest reading, while August’s reading was revised down by one point. NAHB chairman Granger MacDonald said in the release, “The recent hurricanes have intensified our members’ concerns about the availability of labor and the cost of building materials.” The concern is that recent hurricanes in Florida and Texas will draw many construction workers from across the nation to more lucrative jobs in those regions for rebuilding. Overall, the index is still in optimistic territory as readings over 50 indicate “improving” conditions. The group forecasts continued growth through the end of the year. NAHB Chief Economist Robert Dietz stated, “With ongoing job creation, economic growth and rising consumer confidence, we should see the housing market continue to recover at a gradual, steady pace throughout the rest of the year.”
However the news in the existing-home sales market isn’t as rosy. Existing-home sales have fallen four out of the last five months, with sales declining 1.7% last month. The National Association of Realtors said existing-homes fell 1.7% to a seasonally-adjusted annualized rate of 5.35 million, its worst level in a year. Economists had expected an annualized rate of 5.44 million. Housing inventory at the end of last month fell 2.1% to 1.88 million existing homes available for sale. That inventory level is 6.5% less than the same time last year. The limited inventory has been a primary driver of higher home prices. The median existing-home price is $253,500. In its statement, NAR Chief Economist Lawrence Yun said, “Sales have been unable to break out because there are simply not enough homes for sale.”
In the City of Brotherly Love, the Philadelphia Fed’s manufacturing index accelerated this month to a reading of 23.8, a three-month high that exceeded economists’ expectations. Manufacturing activity increased in the mid-Atlantic region with the sub-indicators for general activity, new orders, and shipments all showing improvement. Two-thirds of the survey respondents said they planned on increasing production in the third quarter, with a higher percentage stating it was due to business conditions rather than seasonal factors. The same ratio stated they intended to boost production either by hiring more workers or adding additional hours.
The Federal Reserve’s Open Market Committee announced this week that it intends to begin reducing its $4.5 trillion balance sheet starting next month. The Fed took the controversial step in 2008 to buy trillions of dollars’ worth of bonds in a frantic effort to lower U.S. interest rates and support endangered financial institutions. Now, nine years later, Fed officials believe the economy is strong enough to stand on its own. Chairwoman Janet Yellen stated in a press conference, “The basic message here is U.S. economic performance has been good”. In addition, Fed officials reiterated their intention to raise interest rates one more time this year (most analysts believe the Fed will wait until December for that next rate hike). The Fed maintained its forecast for three rate hikes in 2018, but reduced the number of anticipated hikes in 2019 to two.
As the stock market and housing prices have continued to increase, the net worth of households across the country rose by $1.7 trillion in the second quarter. The Federal Reserve reported the net worth of households and nonprofits rose by 1.7% to $96.2 trillion. Equities were responsible for $1.1 trillion of the increase while the value of real estate rose by about $600 billion. Unfortunately, the gains weren’t distributed across the board to all households – prior to this report, the Federal Reserve released another report stating that less than half of all households in the country currently own stocks.
International Economic News: The Organization for Economic Co-operation and Development (OECD) raised its expectations for economic growth in Canada this year to 3.2%, the highest in all of the G7. This report supports the International Monetary Fund’s report released earlier that stated Canada was set to beat all of its developed economy peers this year. However, the OECD also warned that the vulnerability of Canada’s red-hot housing market could weigh on growth in the future. Rising house prices and swelling household debt levels in Canada increase the risk of a real estate market correction that would reverberate through the economy, the report warned.
Ratings service Moody’s downgraded the UK one level to “Aa2” and rated its outlook for the country as “stable”. Moody’s attributed the downgrade to Brexit pressures on the country’s economic strength along with rising debt levels. Moody’s analyst Kathrin Muehlbronner stated “Moody’s expects weaker public finances going forward, partly linked to the economic slowdown under way but also reflecting the increasing political and social pressures to raise spending after seven years of spending cuts.” The UK didn’t take the downgrade lightly. Prime Minister Theresa May delivered a speech after the downgrade stating Moody’s assessment of the Brexit impact to the economy was “outdated” and that she had an “ambitious vision for the UK’s future relationship with the EU.”
Across the Channel in France, tens of thousands of people took to the streets in Paris to protest Emmanuel Macron’s overhaul of France’s labor laws. The demonstration was organized by Jean-Luc Melenchon, the far left leader who has emerged as Macron’s main political opponent. The protests were a day after Macron signed a new law making it easier for businesses to hire and fire staff. Across the country, more than 132,000 people took part in the protests condemning the reforms. Mr. Mélenchon, whose party opposes the controversial labor reforms, is an outspoken critic of the president’s reformist economic policies and has said that the policy changes are an attack on workers’ rights.
The German finance ministry stated the economy weakened at the beginning of the third quarter following a strong first half of the year, but that its indicators suggest solid growth will continue. Europe’s biggest economy is growing on the strength of its consumers, propelled by record-high employment, rising real wages, and lower borrowing costs. The economic growth is likely to help carry Chancellor Angela Merkel to her fourth term as Chancellor in Germany’s federal elections on Sunday. The German economy grew 0.7% in the first quarter and 0.6% in the second quarter, driven by increased household and state spending as well as higher investments in buildings and machinery.
Italian Economy Minister Pier Carlo Padoan stated that growth of 1.5% is estimated for both 2018 and 2019. In his statement, he acknowledged that some people may regard the estimates as too optimistic, but he thinks they are “totally justified”. The brighter outlook may help the ruling Democratic Party ahead of the national elections if voters notice an improvement in their standard of living. The Treasury department said GDP will rise by 1.5% this year, higher than the 1.1% forecasted earlier, due to better than expected data the first half of the year and better business sentiment.
In Asia, U.S. ratings agency S&P Global Ratings downgraded China’s sovereign credit rating from “AA-“ to “A+” saying the rating reflected increased economic and financial risks in China after a “prolonged period of strong credit growth.” The Chinese government fired back stating it was a “wrong decision”, and that the ratings agency was ignorant of China’s sound economic fundamentals. The decision brings S&P’s ratings in line with Moody’s and Fitch which had downgraded China earlier this year. The Finance Ministry complained S&P ignored China’s stable economic growth and reform efforts. Official data showed the economy grew by 6.9% in the first half of the year, and government revenue rose by over 10%.
Japanese Prime Minister Shinzo Abe pledged to implement “daring policies” targeting taxes, the budget, and regulations to promote domestic investment as well as push for further corporate governance reforms. Abe offered no specifics in a speech given to investors at the New York Stock Exchange, but said he was “absolutely” confident his government could deliver changes that would offset the weaker demographic challenges facing the world’s third-largest economy. While Japan’s Nikkei stock index has reached a more than two-year high this week and its economy has expanded for six straight quarters, Japan has not achieved its price inflation targets.
Finally: As the stock market continues its seemingly relentless march higher, it’s reasonable to expect that the mood of investors would be positive. However, analysts are getting concerned that optimism is reaching levels seen before at major stock market peaks. According to the Wells Fargo/Gallup Investor and Retirement Optimism Index, the level is at its highest since September of 2000. The latest boost in optimism pushed the index almost 100 points higher over the past 18 months. The 98 point hike in that time frame is the largest increase in the 20-year history of the index (other than during sharp rebounds from sudden plunges).
(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 fell sharply to 15.75 from the prior week’s 10.75, while the average ranking of Offensive DIME sectors rose sharply to 11.75 from the prior week’s 16.75. The Offensive DIME sectors reversed higher and now lead the Defensive SHUT sectors for the first time since late July. 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®