The Sherman SITREP

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 33.25, up from the prior week’s 33.06, and still 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 77.65, down from the prior week’s 78.53.

In the intermediate and Shorter-term picture:

The Shorter-term (weeks to months) Indicator (see Fig. 4) turned positive on February 15th.  The indicator ended the week at 16, up from the prior week’s 10.  Separately, the Intermediate-term Quarterly Trend Indicator - based on domestic and international stock trend status at the start of each quarter – was positive entering January, indicating positive prospects for equities in the first 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 positive for Q1, and the shorter (weeks to months) timeframe (Fig. 4) is positive.  Therefore, with internal unanimity expressed by all three indicators being positive, the U.S. equity markets are rated as Positive.

In the markets:

U.S. Markets:  The majority of major U.S. stock indexes ended the holiday-shortened week positive for the week (thanks to a burst higher on Friday), with the technology-heavy NASDAQ Composite index performing the best.  However, the modest gains for the week masked the volatility that occurred throughout with the Dow swinging almost 500 points on Wednesday alone.  The Dow Jones Industrial Average rose for a second week, adding 0.36% to close at 25309.99.  The NASDAQ Composite rose 1.35% to close at 7,337.  By market cap, large caps outperformed smaller caps with the S&P 500 large cap index rising 0.55%, while the S&P 400 mid cap and Russell 2000 small cap indexes added 0.16% and 0.37%, respectively.

International Markets:  Canada’s TSX also rebounded for a second week, rising 1.2%.  Across the Atlantic, the United Kingdom’s FTSE slipped -0.69%, while on Europe’s mainland major markets were mixed.  France’s CAC 40 rose 0.68%, Germany’s DAX gained 0.26%, while Italy’s Milan FTSE slipped -0.55%.  In Asia, China’s Shanghai Composite rebounded sharply for the second week, jumping 2.8%, while Japan’s Nikkei added 0.8% and Hong Kong’s Hang Seng rose 0.5%.  As grouped by Morgan Stanley Capital International, developed markets slipped ‑0.1% while emerging markets rose 0.4%.

Commodities:  Energy rose for a second week with West Texas Intermediate crude oil rising 3.25% to close at $63.55 per barrel.  Precious metals gave back much of last week’s gains with Gold falling -$25.90 to close at $1330.30 an ounce, a loss of -1.9% and Silver giving up -1.4% to close at $16.48.  Copper, viewed by some analysts as an indicator of global economic health due to its variety of uses, also gave back some of last week’s gain by falling ‑1.1%.

U.S. Economic News:  New claims for unemployment benefits dropped by 7,000 to 222,000, reclaiming their 45-year low last week.  This reading marked the second lowest level since the end of the 2007-2009 recession.  Economists had forecast 230,000 new claims.  The less-volatile four-week average of new claims declined by 2,250 to 226,000.  Claims are now down to their lowest levels since the early 1970’s.  Most firms continue to report shortages of qualified workers, and the unemployment rate is at a 17-year low.  Continuing claims, which counts the number of people already collecting unemployment benefits, dropped by 73,000 to 1.88 million.

Sales of existing homes plunged at their fastest rate in over 3 years as the available supply of homes continues to shrink.  Existing-home sales were at a seasonally-adjusted annual pace of 5.38 million in January, according to the National Association of Realtors (NAR).  Sales slipped 3.2% last month, for their second consecutive monthly decline and are down 4.8% from the same time last year - the steepest annual decline since 2015.  Economists had forecast sales at a 5.59 million pace.  The NAR notes that available supply is still the major factor weighing on the housing market – there’s no shortage of demand.  At the current sales pace, there’s just 3.4 months of inventory available, which is especially lean compared to traditional averages.  Inventory was 9.5% lower than a year ago, and marked its 32nd consecutive month of year-over-year inventory declines.  As expected, the dwindling inventory pushed up home prices.  The median price jumped 5.8% to $240,500.

Manufacturing activity in the United States surged to a nearly 3 ½ year high this month, while activity in the services sector hit a six-month peak, according to data from market research firm IHS Markit.  Markit’s Purchasing Managers Index (PMI) reading for manufacturing rose 0.4 point to 55.9, while the services barometer rose 2.6 points to 55.9.  Numbers over 50 signify expansion, and results over 55 are considered exceptional.  The only negative within the report was that the costs of raw and partly finished materials rose to its highest level in 5 years, suggesting a sign of rising inflation.  Chris Williamson, chief business economist at IHS Markit stated, “Business activity growth accelerated markedly in February, suggesting the economy is growing at its fastest pace in over two years.”

The Conference Board’s index of Leading Economic Indicators (LEI) jumped 1% last month, its fourth straight monthly gain and its biggest rise in three months.  The Conference Board reported 8 of its 10 indicators were positive, with the building permits and financial subcomponents the main drivers of the strong gain.  Ataman Ozyildirim, director of business cycles and growth research, stated “The leading indicators reflect an economy with widespread strengths coming from financial conditions, manufacturing, residential construction, and labor markets.”  Ozyildirim noted that the recent stock market volatility, coming after the data collection for the LEI report had ended, “shouldn’t have a big impact.”

Minutes released this week from the Federal Reserve’s Federal Open Market Committee meeting at the end of January showed officials saw a stronger economy at the end of last year and that more rate hikes were anticipated for 2018.  According to the minutes, the strengthening “increased the likelihood that a gradual upward trajectory of the federal funds rate would be appropriate”.  Economists have been concerned that President Trump’s tax cuts would push wages up, leading to a surge in inflation.  The minutes also showed that while several officials expected inflation to move higher this year, only “a couple” were worried that the economy may overheat.  At the meeting, Fed officials agreed to hold rates steady at 1.25-1.5%.

International Economic News:  Major Canadian bank Scotiabank said every year that proposed major oil pipelines are delayed costs Canada’s economy $15.6 billion.  Delayed oil pipeline construction is causing a steep discount for Canadian crude prices that equates to roughly 0.75% of GDP.  The shortage is expected to ease to $10.7 billion this year as more rail capacity becomes available to ship oil.  The costs come as delays continue for all three major proposed oil pipelines to export oil from Western Canada—Kinder Morgan’s Trans Mountain expansion, Enbridge’s Line 3 replacement, and TransCanada’s Keystone XL.  Scotiabank said the delay of new pipeline approvals have imposed “clear, demonstrable, and substantial economic costs on the economy.”

Britain’s economy grew less than originally reported in the fourth quarter of last year, according to the Office for National Statistics (ONS).  Britain’s economy grew 0.4% in the final quarter of last year, a 0.1% decrease from the original estimate of 0.5%.  The ONS explained that “A number of very small revisions to mining, energy generation, and services were enough to see a slight downward revision.”  Services continued to be the dominant sector of the UK economy accounting for roughly 80% of economic output. Darren Morgan, the ONS’ head of GDP said “Services continued to drive growth at the end of 2017, but with a number of consumer-facing industries slowing, price rises led to household budgets being squeezed.”  For the year, Britain grew 1.4% making it the slowest growing major economy behind both Italy and Japan.  

On Europe’s mainland, French employers have a surprising problem in a nation with a 9% unemployment rate: finding skilled workers.  Despite the stubbornly high unemployment rate that has not dropped below 9% for six years, employers lament the lack of skilled workers—particularly in the construction, engineering, and IT industries.  More than a third of French manufacturers are operating at full capacity, its highest since early 1990, and 40% report difficulties recruiting workers, according to French statistics agency INSEE.  In a sign of surging demand for labor, permanent contract hirings rose 6.4% to 48% in the final quarter of last year, levels last seen right before the onset of the global financial crisis.

Confidence among Germany’s business owners fell more than expected this month, but remained near a high level according to the Munich-based Ifo Economic Institute.  Ifo stated its business climate index, based on a monthly survey of 7,000 firms, fell to a 5-month low of 115.4, down 2.2 points from January.  February’s reading missed expectations by 1.6 points.  The decline was attributed to exporters concerned about the stronger euro exchange rate which makes German products more expensive to customers outside the bloc.  Ifo economist Klaus Wohlrabe stated, “The export euphoria is flattening out a bit.  I would not yet speak of a change in the underlying trend, the German economy is still doing very well, but some of the steam has been let off.”

In a concerning development in China, the China Insurance Regulatory Commission (CIRC) said that it will take control of the Anbang Insurance Group for a year and that the company’s former chairman has been prosecuted for “economic crimes”.  The move is aimed at protecting consumer interests as the company’s practices may have endangered Anbang’s solvency.  The regulator reported it will maintain the company as a private enterprise and that Anbang’s debts and obligations will not be impacted.  Anbang is best known in the West for its purchase of New York’s landmark Waldorf Astoria hotel in 2015.  However this is not the first time Anbang has run into trouble with the CIRC.  Last spring, the CIRC suspended the insurer from issuing new products for three months as it stated that one of the insurer’s product designs “deviates from the fundamentals of insurance”.

The Japanese government, in its latest monthly economic report, reasserted its assessment that the economy is “gradually recovering”.  The economy has grown for eight consecutive quarters, its longest continuous expansion since a 12-quarter stretch between 1986 and 1989 during Japan’s infamous economic bubble.  Continued steady growth may finally defeat the deflation that Japan has been mired in for decades.  An end to deflation would be a huge victory for Prime Minister Shinzo Abe’s aggressive monetary policies intended to reflate the economy.  Over the past few years, Abe’s labor reforms, corporate tax breaks and changes to other regulations have spurred economic growth.  Stock prices are close to their highest levels in 26 years, corporate profits are near an all-time high, exports are growing and business investment continues to increase.  To most, that sounds like more than “gradually” recovering, but the government is known to understate for purposes of expectation management.

Finally:  Analyst and long-time market commentator Mark Hulbert noted this week that despite this past month’s price action, bonds are still a hedge against stock market losses.  Hulbert pointed out that this month’s steep market decline also saw bond prices fall as well, spreading worry that in the “new normal” bonds may not serve as the protection for the stock market as well as they have traditionally.  Hulbert believes that worry is unjustified, noting that while rare, the phenomenon of both stocks and bonds dropping in tandem is not unprecedented.  Since 1926, both the S&P 500 and intermediate-term U.S. Treasury bonds have fallen together 12.4% of the months, or an average of once every eight months.  Investors, he says, are being unrealistic if they “expect bonds—or any hedge, for that matter—to work every time, all the time.”

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(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 rose to 21.75 from the prior week’s 21.00, while the average ranking of Offensive DIME sectors fell slightly to 11.00 from the prior week’s 10.00.  The Offensive DIME sectors basically maintained their lead over the Defensive SHUT sectors.  Note: these are “ranks”, not “scores”, so smaller numbers are higher ranks and larger numbers are lower ranks.

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