Market Situation Report for Week Ending 10/31/2014
The SITREP for the week ending 10/31/2014
SITREP: n. a report on the current situation; a military abbreviation; from “situation report”.
The very big picture:
In the “decades” timeframe, we have been in a Secular Bear Market which began in 2000 when the P/E ratio (using Shiller’s Cyclically-Adjusted P/E, or “CAPE”) 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 below (click for larger image) for the 100-year view of this repeating process.
If history is a guide, we may not yet be done with this Secular Bear Market. The Shiller P/E is at 26.4, up from the prior week’s 25.7, and approximately at the level reached at the pre-crash high in October, 2007. Even though P/E’s are substantially lower than their crazy peak in 2000, they are nonetheless at the high end of the normal historical 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 below).
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 returns typical of a 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 below) is at 54.6, up from the prior week’s 52.6, 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.
In the intermediate picture:
The intermediate (weeks to months) indicator (see Fig. 4 below) is Positive and ended the week at 18, up sharply from the prior week’s 10. 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.
In the Secular (years to decades) timeframe (Figs. 1 & 2), the Secular Bear may still be in force as the long-term valuation of the market is simply 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. 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:
The rush back to “risk-on” continued during the week ending October 31 for most of the world’s stock market indices. US indices gained from +2.7% to +4.9%, and the SmallCap Russell 2000 regained positive territory for the year to date. The Dow and S&P 500 finished the week in record territory, after kissing “correction” territory just 2 weeks earlier. Canada’s gains were much more muted, at just +0.5% for the week for the TSX index. Earlier in the year, Canada’s market gains had far surpassed those in the US, but that lead has vanished and Canada is now trailing the US in year to date gains. Developed International and Emerging International both rose by +2.8% for the week, with Japan and Brazil leading the way with gains of +7.1% and +4.0%, respectively.
The rapidity with which fear left the market in the 2nd half of October was dramatic and record-setting. Three consecutive days of 10% declines in the VIX Volatility Index (commonly referred to as the “Fear Index”) had never been experienced before, and a total drop of 48% between the 16th and the 31st was the most rapid drop in the VIX Fear Index since March of 2009.
For the month of October, the gains in the final week of the month turned a loser into a winner for US indices and many International indices. However, Canada and Developed International still were negative for October, with Canada turning in the worst performance at -2.3%. The fact that gold finished the week at the lowest weekly level in 4-1/2 years did not help Canada, whose market is more sensitive to the price of gold than is any other developed nation’s market.
In US economic news, September durable goods (big-ticket items) fell -1.3%, worse than expected, and September consumption (consumer spending) unexpectedly declined -0.2% when an increase had been forecast. All other data points reported during the week, however, were very positive. The initial reading on third-quarter GDP came in at a better than expected +3.5% whereas economists were calling for +3.0%. The back-to-back performance of Q2 and Q3 is the best 2-quarter result since the final six months of 2003. The Case-Shiller home price index for August showed prices rose +5.6% year over year for the 20-city index, vs. July’s +6.7%. The slowdown in price appreciation, coupled with low mortgage rates, make housing more affordable. In another case of “the last shall be first”, home prices rose the most in Miami, up +10.5% year-over-year, and +10.1% in Las Vegas. Friday’s Chicago Purchasing Managers Index (“PMI”) for October was reported at 66.2, a reading that not only exceeded expectations, but was the best in 12 months. Two very important Central Bank events also occurred during the week. First, the Federal Reserve ended its massive bond buying programs (known as “QE1” thru “QE3”) – and the stock market shrugged it off. The Fed’s statement remained accommodating and left in language containing the magic phrase “considerable time” in describing how long interest rates may remain near zero. The other Central Bank gift to the market came from Japan’s Central Bank, which surprised markets with the announcement of a gigantic asset purchase plan, which will include the purchase of not only domestic Japanese but also non-Japanese equities.
Statistics Canada reported a surprise decline of -0.1% in Canadian GDP for August. Drops in oil and gas output combined with a fall in manufacturing contributed to the first shrinkage in GDP since December. On an annualized basis, GDP was +2.2% through August. The Retail Council of Canada reported record-setting sales of Halloween costumes, candy and accessories. The Retail Council maintains that Canadians now outspend the US on a per-capita basis, especially over the last three years which has seen the popularity of Halloween skyrocket in Canada.
Eurostat, the statistical arm of the European Union, reported the unemployment rate for the Euro-18 was unchanged in September at 11.8%, which is only down 0.2% from September 2013’s 12.0%, indicating basically no progress in unemployment in the past year. Some representative numbers: France 10.5%, Italy 12.6%, Spain 24.0% and Greece 26.4%. The youth unemployment rate remains extraordinarily high in Italy (41.8%), Spain (53.7%) and Greece (50.7%).
China’s manufacturing activity continued waning in October with the Chinese Manufacturing PMI hitting a five-month low of 50.8 in October, down -0.3 from September and -0.9 from the yearly peak of 51.7 hit in July. Although readings above 50 indicate expansion, there’s not much of it.
(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 below) 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 to 7.0 from the prior week’s 6.0, while the average ranking of Offensive DIME sectors rose to 18.5 from the prior week’s 19. Institutional investors remain cautious, and the Defensive SHUT group continues to rank substantially higher than the Offensive DIME group ranking.
Note: these are “ranks”, not “scores”, so smaller numbers are higher ranks and larger numbers are lower ranks.
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.