NOTE: Areas with blue text show the most recent market updates since the September Capital Highlights email.
Seize the Day
The very big picture:
In the “decades” timeframe, we are in a Secular Bear Market which began in 2000 when the P/E ratio (using Shiller’s Cyclically-Adjusted P/E) peaked at about 44. The job of Secular Bear markets is to burn off outrageously high P/E ratios over one or two decades, until finally the P/E ratio arrives back at a single-digit level, from which another Secular Bull Market can emerge. See Fig. 1 for the 100-year view.
If history is a guide, we are not yet near the end of this Secular Bear Market. The Shiller P/E at 24.7, down from the prior week’s 25.0, and approximately at the level reached at the pre-crash high in October, 2007. Even though P/E’s are now half what they were at their crazy peak in 2000, they are nonetheless at the high end of the normal range and leave little if any room for expansion. This means that the stock market is unlikely to make gains greater than corporate profit growth percentage, if that. (note: all P/E references are to the Shiller P/E values, sometimes called PE10 or CAPE, which are calculated so as to remove shorter-term fluctuations; see RobertShiller.com for details).
In fact, since 1881, the average annual returns for all ten year periods that began with a CAPE at 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 P/E’s 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 the next 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 US Bull-Bear Indicator (see Fig. 3) is at 51.4, down from the prior week’s 55.1 and continues in cyclical Bull territory. The current Cyclical Bull has taken the US and some of Europe to new all-time highs, but many of the world’s major indices have yet to top 2007’s levels. The most widely followed international indexes, the Morgan Stanley EAFE Developed International index and the Morgan Stanley Emerging Markets Index, are both still below their 2007 peaks.
Research provided by WE Sherman & Co LLC
In the intermediate picture:
The intermediate (weeks to months) indicator (see Fig. 4) ended the week at 3, down from the prior week’s 7, but up from the low of 2 – enough to switch the indicator back to Positive status. Separately, the quarter-by-quarter indicator – based on domestic and international stock trend status at the start of each quarter – gave a positive indication on the first day of October for the prospects for the fourth quarter of 2014.
Research provided by WE Sherman & Co LLC
Canada’s manufacturing output dropped for the first time this year, -3.3%, reversing July’s rise to record levels. A Thomson-Reuters survey of economists had expected a much smaller drop of -1.6%. Manufacturing output had been trending higher all year, but August’s sharp drop has essentially wiped out the gains of June and July.
Eurostats, the statistical arm of the European Union, released its inflation data for September and for the 18 Eurozone nations it was up just +0.3% on an annual basis. By contrast, in September 2013 the inflation rate was +1.3%, a value the European Central Bank can only dream about today. Prices are dangerously falling in some Eurozone countries. Prices were down -1.1% in Greece, down -0.3% in Spain (after being down -0.5% in August and -0.4% in July), down -0.4% in Sweden and down -0.1% in Italy. Deflation fears are well founded, it appears. Eurozone industrial production was also released for August, down -1.8% over July and down -1.9% year-over-year. The U.K. had some positive news, reporting an unemployment rate of just 6.0%, a six-year low, for the three months thru August.
In China, September exports were reported to have risen a better than expected +15.3%, with imports also exceeding expectations, up +7%, but the exports number was strong enough to arouse suspicions of fake invoices among some observers, despite the government’s assurances that such past chicanery is now under control. Credit Suisse’s “Global Wealth Report 2014” places China as the fourth wealthiest region in the world and said that the country’s middle class, which has doubled since 2000, now makes up an amazing one third of the world’s total middle class population.
Economists and statisticians routinely deal with correlated data points. A constant – and critically important – question to ask when pondering a correlation is “does this correlation arise from coincidence or causation?” Here’s one that only the bravest would take on – two Emory University economists have discovered that there is a very high correlation between total wedding expenses and the subsequent likelihood of divorce. Is it Coincidence or Causation?
In the Secular (years to decades) timeframe (Figs. 1 & 2), the Secular Bear still is in force as the long-term valuation of the market is too high to sustain a new rip-roaring Secular Bull. In the Cyclical (months to years) timeframe (Fig. 3), all major equity markets are in Cyclical Bull territory, with the US being far stronger than any other major market. The Bond market returned to Cyclical Bull territory as of February 28th.
In the Intermediate (weeks to months) timeframe (Fig. 4), US equity markets returned to Positive status on October 17th. The quarter-by-quarter indicator gave a positive signal for the 4th quarter: US equities were in an uptrend, while International equities were in a downtrend at the start of Q4, and either one being in an uptrend is sufficient to signal a higher likelihood of an up quarter than a down quarter.
In the markets:
A roller-coaster week was experienced in worldwide markets. You know it is a wild one when investors breathe a sigh a relief that the Dow was only down -173 on Wednesday – since it had been down more than -450 earlier in the day! Thanks to a strong positive showing on Friday, though, with markets around the globe rallying +1% to +3%, some indices actually finished higher on the week. The week nonetheless saw many markets enter “correction” territory (a 10% decline from prior highs) and still others enter “bear” territory (a 20% decline from prior highs) before Friday’s bounce. Among markets reaching “correction” territory are Canada, UK, Spain, S Korea, Australia, China, Japan, US SmallCap and US MidCap. Among markets that hit “bear” territory are Germany, Italy and Brazil, as well as a number of sectors such as Homebuilders, Precious Metals Miners, and Semiconductors.
In the US, the indices that had been hardest-hit in recent weeks performed the best this week. SmallCaps gained +2.8%, thereby avoiding what would have been a record 7th losing week in a row. MidCaps also did well, rising +1.3%, but the rest of US indices lost ground, with the Dow and S&P 500 both retreating -1%. Like the US SmallCaps, Canada’s TSX avoided a 7th consecutive losing week, but only barely, finishing essentially unchanged on the week. Both Developed and Emerging International groups gained on the week, at +0.4% and +0.5% respectively, even though European stocks had declined eight consecutive days through Thursday – their longest losing streak since 2003. China led the Emerging International group (+1.4%) while Germany paced the Developed International group (+1.7%).
Although earnings news dominated the headlines (with some notable “misses” – Google and Netflix among them – but also some big “hits” from industrial giants GE and Honeywell), US economic news was neutral to positive on balance. Initial jobless claims came in at 264,000, the lowest number since 2000. Gasoline prices have fallen significantly, and are the lowest in three years, effectively giving every driver a bonus. The University of Michigan consumer confidence survey was reported at 86.4, the highest since before the “great recession”. The Philadelphia Fed index of manufacturing activity was reported at 20.7, remaining in the good growth range. Spurred by mortgage rates back to 4% and lower, refinance applications rose +10.6% week-over-week to the highest level in 4 months. On the negative side, retail sales were down -0.3%, the National Association of Home Builder’s housing market index fell to 54, down from 59 last month and unchanged year-over-year, and the National Federation of Independent Business small business optimism index fell to a 3-month low.
(sources: Reuters, Barron’s, Wall St Journal, Bloomberg.com, ft.com, guggenheimpartners.com, ritholtz.com, markit.com, financialpost.com, Eurostat, Statistics Canada, Yahoo! Finance, stocksandnews.com, wantchinatimes.com, BBC, 361capital.com, S China Morning Post; Figs 3-5 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 declined to 6.5 from the prior week’s 5.8, while the average ranking of Offensive DIME sectors fell to 120.3 from the prior week’s 17.3. Institutional investors remain cautious, and the Defensive SHUT group ranks higher than the Offensive DIME group ranking by the widest margin in more than a year.
Note: these are “ranks”, not “scores”, so smaller numbers are higher and larger numbers are lower.
The US has led the worldwide recovery, and continues to be among the strongest of global markets. However, the over-arching Secular Bear Market may remain in place even as new highs are reached in the US.
Because we may still be in a Secular Bear, we have no expectations of runs of multiple double-digit consecutive years, and we expect poor market conditions to be a frequent occurrence. Nonetheless, we remain completely open to any eventuality that the market brings, and our strategies, tactics and tools will help us to successfully navigate whatever happens.