NOTE: Areas with blue text show the most recent market updates since the July Capital Highlights email.
“To know values is to know the meaning of the market”
- Charles Dow
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 is 23.5, up slightly from the prior week’s 23.3 (see Fig. 2 – a snapshot of www.multpl.com). 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 twenty year periods that began with a P/E at this level have ranged from -2%/yr to +7%/yr with an average of just 3%/yr.
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 US Bull-Bear Indicator (see Fig. 3) is at 80.0, up again from last week’s 78.7, and still solidly in cyclical Bull territory although currently at an extreme level that usually precedes a pullback. Early in the year, the US Bull-Bear Indicator pushed further into Bull territory than other global asset classes, reflecting the higher strength of the US relative to the rest of the world. The current Cyclical Bull has taken the US back to levels last seen in 2007, or higher, but many of the world’s major indices have yet to best 2011’s highs, let alone approach 2007’s levels.
In the intermediate picture:
The intermediate (weeks to months) indicator (see Fig. 4) has been positive since November 19, and finished the week at 34, unchanged from the prior week. The expected upward move to at least 30 has come to pass. Separately, the quarter-by-quarter indicator – based on domestic and international stock trend status at the start of each quarter – gave a positive indication for the first quarter of 2013.
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 markets have extended their march upward and virtually all sectors of the market are experiencing demand – an unbalanced condition that is usually “corrected” by a pullback. Finally, the quarter-by-quarter indicator has given a positive signal for the 2nd quarter: both US and International equities are in uptrends at the start of Q2, which signals a higher likelihood of an up quarter than a down quarter.
In the markets:
US markets closed the month and quarter on a record-setting note: the S&P 500 joined the Dow Jones Industrials in exceeding their highs from 5+ years ago. The month of March and the first quarter of the year were both strongly positive for the US. MidCaps and SmallCaps led the way for both the month and quarter, and all but the Nasdaq finished the quarter with gains of 10% or more. This is doubtless an unsustainable pace, but certainly started the year off positively.
International equity markets were seemingly operating on a different planet than the US, however. Developed markets were up about +3.7% for the quarter, but Emerging markets were down about the same amount, netting a gain of essentially nothing for the quarter. Non-US markets have mostly not even retaken their highs of 2011, let alone the highs of 2007.
Economic news was, qualitatively, more of the same: mostly good news from the US, mostly bad news from Europe, and mostly mixed news from China. Observers worldwide are pondering the question: can this divergence continue? And, if not, will the rest of the world pull the US down, or can the US pull the rest of the world up?
In the US: The Organization for Economic Cooperation & Development (OECD) sees the U.S. growing by 3.5% in the first quarter and 2% in the second quarter – both excellent numbers. February durable goods (big ticket items) were better than expected, up 5.7%, although actually down 0.5% after removing transportation orders. The two-month period of January and February was reported as the best new home sales pace since August/September 2008, though February pending home sales were beneath forecast. The S&P/Case-Shiller index of property values in 20 major metropolitan areas was up 8.1% for January over year ago levels, the best 12-month performance since June 2006. Phoenix saw the largest increase, January over January, up 23.4%. All 20 cities registered gains. But on Thursday, the March Chicago Purchasing Managers Index (PMI) came in less than expected at 52.4, yet still above the 50 dividing line between growth and contraction. On Friday, it was reported that consumer spending climbed 0.7% in February, better than expected and the best in five months, while personal income, up 1.1%, also beat estimates. The University of Michigan consumer sentiment reading, released on Friday, was substantially better than estimates. (Wall St. Journal)
In Europe: The battle between the austerity hawks and doves continues unabated, with Germany continuing its hawkish stance, but French President Hollande saying “More austerity would condemn Europe to recession. It would make it explode.” The Bank of Spain announced that Spain’s economy would shrink 1.5% this year, worse than the government is forecasting, and unemployment will rise above 27%. In Germany, February retail sales rose 0.4% over January, but were down 2.2% from year ago levels, while the seasonally adjusted unemployment rate in March remained unchanged at 6.9%. The OECD expects Germany to expand 2.3% in the first quarter, 2.6% in the second, but expects France to contract -0.6% in the first quarter before growing 0.5% in the second. Italy, the third largest Eurozone economy, is expected to shrink in both quarters by -1.6% and -1%, respectively. (Financial Times)
(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, NY Post; Figs 3-5 source W E Sherman & Co, LLC; hiking trail sign from panoramio.com)
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 9.8 from the prior week’s 10.5 while the average ranking of Offensive DIME sectors fell to 15.8 from the prior week’s 14.3. Institutional investors remain cautious, despite new all-time highs, and the Defensive SHUT group ranking is now higher than the Offensive DIME ranking by a sizeable 6 ranking positions.
Note: these are “ranks”, not “scores”, so smaller numbers are higher and larger numbers are lower.
The US led the recovery from 2011’s travails, and is the strongest among all global markets. However, the over-arching Secular Bear Market remains in place even as prior all-time highs are reached.
Because we are still 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.