6-25-18 Market Update

 

The very big picture:

 

In the “decades” timeframe, the current Secular Bull Market could turn out to be among the shorter Secular Bull markets on record.  This is because of the long-term valuation of the market which, after only eight years, has reached the upper end of its normal range.

 

The long-term valuation of the market is commonly measured by the Cyclically Adjusted Price to Earnings ratio, or “CAPE”, which smooths out shorter-term earnings swings in order to get a longer-term assessment of market valuation.  A CAPE level of 30 is considered to be the upper end of the normal range, and the level at which further PE-ratio expansion comes to a halt (meaning that increases in market prices only occur in a general response to earnings increases, instead of rising “just because”).

 

Of course, a “mania” could come along and drive prices higher – much higher, even – and for some years to come.  Manias occur when valuation no longer seems to matter, and caution is thrown completely to the wind as buyers rush in to buy first and ask questions later.  Two manias in the last century – the 1920’s “Roaring Twenties” and the 1990’s “Tech Bubble” – show that the sky is the limit when common sense is overcome by a blind desire to buy.  But, of course, the piper must be paid and the following decade or two are spent in Secular Bear Markets, giving most or all of the mania gains back.

See Fig. 1 for the 100-year view of Secular Bulls and Bears.  The CAPE is now at 32.74, down from the prior week’s 33.03, and exceeds the level reached at the pre-crash high in October, 2007.  This value is in the lower end of the “mania” range.  Since 1881, the average annual return for all ten year periods that began with a CAPE around this level have been in the 0% – 3%/yr. range.  (see Fig. 2).

 

 

 

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 71.68, down from the prior week’s 73.56.

 

 

 

 

In the intermediate and Shorter-term picture:

The Shorter-term (weeks to months) Indicator (see Fig. 4) turned positive on April 3rd.  The indicator ended the week at 26, up from the prior week’s 25.  Separately, the Intermediate-term Quarterly Trend Indicator – based on domestic and international stock trend status at the start of each quarter – was negative entering April, indicating poor prospects for equities in the second quarter of 2018.

 

 

 

Timeframe summary:

In the Secular (years to decades) timeframe (Figs. 1 & 2), the long-term valuation of the market is simply too high to sustain rip-roaring multi-year returns – but the market has entered the low end of the “mania” range, and all bets are off in a mania.  The only thing certain in a mania is that it will end badly…someday.  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 negative for Q2, and the shorter (weeks to months) timeframe (Fig. 4) is positive.  Therefore, with two indicators positive but one negative, the U.S. equity markets are rated as Neutral.

 

In the markets:

U.S. Markets:  The major U.S. benchmarks were flat to lower for the week.  The narrowly focused Dow Jones Industrial Average performed the worst, hurt by its heavier concentration of export-sensitive industrial firms and exporters.  The Dow Jones Industrial Average fell 509 points to close at 24,580, a loss of -2%.  The technology-heavy NASDAQ Composite gave up 53 points and closed at 7,692, a loss of -0.7%.  By market cap, smaller companies that are primarily domestically-focused fared the best with the small cap Russell 2000 rising 0.1%, while the large cap S&P 500 and mid cap S&P 400 declined -0.9% and -0.1%, respectively.

 

International Markets:  Canada’s TSX managed a third consecutive week of gains by gaining 0.8%.  Across the Atlantic, the United Kingdom’s FTSE 100 retraced last week’s loss by rising 0.6%.  Markets on the European mainland did considerably worse: France’s CAC 40 fell -2.1%, Germany’s DAX gave up -3.3%, and Italy’s Milan FTSE declined -1.4%.  In Asia, China’s Shanghai Composite plunged -4.4%, which was its fifth consecutive decline.  Japan’s Nikkei was also down, falling -1.5%.  As grouped by Morgan Stanley Capital International, developed markets ended the week down -1.2%, while emerging markets declined a larger -2.3%.

 

Commodities:  Precious metals had a second week of losses with gold giving up -0.6%, or $7.80, to end the week at $1270.70 an ounce.  Silver declined just -0.1%, closing at $16.46 an ounce.  Energy rebounded strongly after four consecutive down weeks.  West Texas Intermediate crude oil surged over 5.4%, ending the week at $68.58 per barrel.  Copper, seen by some analysts as a barometer of global economic health, fell for a second straight week, losing -3.7%.

 

U.S. Economic News:  The number of Americans seeking new unemployment benefits fell for the fourth week in row as layoffs remained near their lowest levels since the early 1970’s.  The Labor Department reported initial claims for unemployment declined by 3,000 to 218,000 in the week ended June 16, in line with economists’ forecasts.  The more stable monthly average of new claims dropped by 4,000 to 221,000 – just slightly above a 45-year low.  Continuing claims, which counts the number of people already receiving unemployment benefits, rose by 22,000 to 1.72 million.  That number, also near a 45-year low, is reported with a one-week delay.  Companies continue to report difficulty finding skilled workers.  Thomas Simons, senior money market economist at Jeffries stated, “There is no reason to expect that layoffs will accelerate.”

 

Homebuilders are torn, according to the latest data from their industry association.  The National Association of Home Builders’(NAHB) monthly confidence index fell 2 points to 68 this month, as seemingly limitless demand for housing was offset by input costs pushing prices higher and higher.  The cost of lumber is up 59% since the start of 2017 with some feeling the Trump administration’s decision to add a 20% tariff to Canadian lumber was largely to blame.  Still, overall confidence has averaged 70 so far in 2018—a record not accomplished even at the height of the housing bubble a decade ago.  In the details of the report, each of the sub-components of the NAHB’s index fell by one point.  The gauge of present sales conditions hit an 8-month low of 75, while the gauge of future sales fell to 76—its lowest reading since November.  The reading missed expectations by a longshot, as economists had a forecast a big jump to 78.

 

The other main housing-related trade group, realtors, also reported weakness in their latest report.  Existing-home sales were at a seasonally-adjusted 5.43 million rate in May, down -0.4% from April, according to the National Association of Realtors.  The median forecast among economists was for a 5.52 million pace.  From the same time last year, sales were off by -3%, and April’s selling pace was revised down.  At the current sales rate, there is a 4.1 months’ supply of homes available on the market, well below the 6 months generally considered a “balanced” housing market.  As supply has dwindled, prices have surged.  In May the median sales price for an existing home was $264,800, an increase of 4.9% over the past year.  By region, the Northeast was the only one to log an increase in sales, up 4.6%.  In the Midwest, sales were down 2.3%, in the South they dipped -0.4%, and in the West they were off by -0.8%.

 

The number of new homes under construction surged to an 11-year high in May, according to the Commerce Department.  Housing starts were at a seasonally-adjusted annual 1.35 million rate last month, exceeding forecasts of a 1.3 million pace.  With the latest data, housing starts saw their fastest activity since 2007.  The reading was a 5% increase over April’s, and over 20% higher than the same time last year.  One area of concern, however, was in the permits data.  Permits, which analysts use as an indicator of future building activity, came in at a 1.3 million pace—a decline of 4.6% from April.  Ian Shepherdson, chief economist for Pantheon Macroeconomics wrote in a research note, that permit issuance “usually reflects the pace of new home sales, which we think have now peaked for this cycle.   In May, most of the total drop in permits was due to an 8.8% fall in the volatile multi-family sector, but the real story is the 2.2% decline in single-family permits, to an eight-month low.  We expect further declines over the summer, as higher mortgages rates and tighter lending standards bite.”

 

In the city of Brotherly Love, manufacturing activity slowed sharply to a reading of just 19.9 in June, down from 34.4 in May.  The Philadelphia Fed’s manufacturing index had jumped 11.2 points last month but gave up all of the increase in its latest reading.  The index is now at its lowest reading since November of 2016 and well below economists’ forecasts of 28.  In the details of the report, the new-orders index plunged almost 23 points to 17.9 while the shipments index rose 2.9 points to 25.8.  Of concern for the future, the expectations for activity in the next 6 months fell for the third straight month.  Ian Shepherdson at Pantheon Macroeconomics remarked that given the current global trade tensions, “We now expect the headline index to hover around the 20 mark; solid, but it’s hard to see sustainable upside from here.”

 

Research firm IHS reported that its’ indexes that track U.S. manufacturers and service-oriented companies both tapered off slightly in June but still showed the U.S. economy is expanding at a strong pace.  The flash Purchasing Managers Index (PMI) for manufacturing index slipped to a seven-month low of 54.6, down -1.9, while its services barometer dropped to a two-month low of 56.5, a decline of -0.3.  While both readings declined, readings over 50 still signify expansion and readings above 55 are considered exceptional.  “The flash PMI surveys add to evidence that the U.S. economy is enjoying a strong second quarter. Despite growth cooling slightly in June, the latest numbers round off the best quarter for three years, and suggest economic growth has lifted markedly higher than the 2.3% rate of expansion seen in the first quarter to well over 3%,” said Chris Williamson, chief business economist at IHS Markit.

 

While a Canadian rate increase was widely expected just weeks ago, an unexpected plunge in Canada’s retail sales in April and flat inflation figures for May have cut expectations that the Bank of Canada will hike interest rates to no more than 50-50 at best.  Retail sales had their largest drop in more than two years, declining -1.2% in April, and separate data showed inflation remained at 2.2% in May making it harder for the central bank to go ahead with a rate hike at its next meeting in July.   Canada’s once-hot housing market has slowed dramatically in the wake of a series of mortgage rule changes, and consumer and business confidence has taken a hit from the escalating trade dispute with the United States.  Despite the weak data Royce Mendes, senior economist at CIBC Capital Markets reminded investors not to rule out a rate hike just yet by noting that the most important data, such as GDP and employment, have yet to come in.

 

As the rest of the world’s globalist think-tanks predicted widespread gloom-and-doom for the United Kingdom as it pursued a “Brexit” from the European Union, leading accountancy firm KPMG claims that “hope is on the horizon”.  Economists at the firm say that despite the obvious “jitters” over the UK’s future relationship with the EU, the UK is “back on course for a steady yet unremarkable growth performance over the next two years.”  Yael Selfin, chief economist at KPMG in the UK, said: “A cold wave in February and March was behind some of the weakness in the first quarter, with construction output and consumer facing activities such as retail sales, restaurants and cinemas hit by the bad weather.  The latest business surveys point to an uptick in activity in the second quarter, and while manufacturing output dropped in April, retail sales were relatively healthy in both April and May.”  The economist cites the employment rate of 75.6% in the three months to April – the highest since records began in 1971, and unemployment rate at 4.2% – the lowest since 1975, as being key stats for the years ahead.

 

On Europe’s mainland, France’s national statistics agency INSEE forecasted France’s economic growth will slow from 2.3% to 1.7% in 2018 due to a stronger euro and rising oil prices among other factors.  INSEE now expects gross domestic product to rise by 0.3% in the second quarter and 0.4% in both the third and fourth quarters for a full-year figure of 1.7%.  France’s central bank earlier this month downgraded its 12-month growth figure to 1.8%.  INSEE’s head of its Economic Outlook division Frederic Tallet said, after a “particularly sunny” year in 2017 for France and the Eurozone, “clouds have now appeared”.  Sluggish household consumption and widespread public sector strikes at home along with threats of a global trade war, rising oil prices, and political uncertainties in Europe all led to its forecast.

 

The influential newspaper Die Welt wrote this week that “Germany’s second economic miracle is over”, comparing the years of growth since the end of the financial crisis to the post World War II reconstruction period.  As Europe’s economic powerhouse, Germany is among the nations that are most sensitive to mounting trade tensions between the United States and other major economies.  Both the Berlin-based DIW and Munich’s Ifo Institute sharply lowered their growth forecasts for the second half of this year and next.  DIW cut its forecast for this year by half a percentage point to 1.9% and next year by 1.7%, while Ifo was even more drastic, slashing its forecast for 2018 to 1.8% from the 2.6% it previously predicted.  Ifo macroeconomics chief, Timo Wollmershaeuser wrote “Clouds are gathering over the German economy,” whose industrial engine “began sputtering at the start of the year.”

 

Even as the global economy picks up speed, China’s central bank said trade disputes, geopolitics, and monetary policies of major economies are the key uncertainties – and potential negatives – in its economic outlook.  The comments come as concerns have been mounting that growth in the world’s second-biggest economy is cooling faster than expected.  In addition, an intensifying clash with the United States is adding to the difficulties.  Both sides announced tariffs on $50 billion of each other’s products last week and President Trump threatened to impose another $200 billion on Chinese goods.  Official economic data for last month showed that growth in key areas like exports, investments by companies, and consumer spending all declined compared to the same month a year ago.  The numbers “suggest a broad-based slowdown is now emerging, and we expect this to continue,” said Louis Kuijs, head of Asia economics at research firm Oxford Economics.

 

Core inflation in Japan remained subdued in May highlighting the difficulty the Bank of Japan is having hitting its 2% price goal despite more than five years of massive government stimulus.  The core consumer price index, which includes energy in Japan’s version of the index but not food, rose 0.7% year-over-year last month, unchanged from April.  The data came after the Bank of Japan cut its inflation assessment, leading analysts to conclude that the central bank will be in no hurry to begin tapering its massive stimulus programs.  Japan’s economy is widely expected to rebound in the second quarter following a contraction in the first quarter that ended Japan’s longest growth streak since the bubble economy of the 1980s.

 

Finally:  As the bull market in equities enters its ninth year, investment strategist Jim Paulsen at the Leuthold Group recently released a research note in which he pointed out that the % of market cap represented by the “defensive” sectors has reached a multi-decade low, now lower even than at the peak of the dot-com bubble.  This is a sign of lop-sided investing in which speculative investments are concentrated in a few areas of the market (like the current pursuit of the FANG stocks (Facebook, Amazon, Netflix and Google)), and other areas are left for dead.

Paulsen writes “More and more of the leadership stocks have been the more aggressive, high beta stocks and a lot of the defensive names have been left for dead.  They’ve diminished as far as their size of the overall [S&P 500] index.”  His advice to those investors holding little more than the FANGs?  Pat yourself on the back and congratulate yourself for a great investment, and then “maybe buy a beat-up consumer staple or utility here or pharma stock today that no one is taking a look at, but sells at a much better value.” (Chart from cnbc.com)

 

(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)

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