The Sherman SITREP

Week Ending 11/3/2017

SITREP: n. a report on the current situation; a military abbreviation; from "situation report".

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 31.57, up from last week’s 31.49, and exceeds the level reached at the pre-crash high in October, 2007.  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).

Fig. 1

Fig. 1

Fig. 2

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 78.47, up from the prior week’s 76.67.

Fig. 3

Fig. 3

In the intermediate and Shorter-term picture:

The Shorter-term (weeks to months) Indicator (see Fig. 4) turned positive on September 7th.  The indicator ended the week at 26, down from the prior week’s 28.  Separately, the Intermediate-term Quarterly Trend Indicator - based on domestic and international stock trend status at the start of each quarter – was positive entering October, indicating positive prospects for equities in the fourth quarter of 2017.

Fig. 4

Fig. 4

Timeframe summary:

In the Secular (years to decades) timeframe (Figs. 1 & 2), whether we are in a new Secular Bull or still in the Secular Bear, the long-term valuation of the market is simply too high to sustain rip-roaring multi-year returns.  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 Q4, and the shorter (weeks to months) timeframe (Fig. 4) is positive.  Therefore, with internal agreement expressed by all three indicators being positive, the U.S. equity markets are rated as Positive.

In the markets:

U.S. Markets:  The major U.S. market indexes finished the week mixed.  The large cap indexes continued to outperform, extending their number of weekly gains to eight, while small cap indexes reported a third week of losses of the last four.  The Dow Jones Industrial Average rose 105 points to close at 23,539, a gain of 0.45%.  The technology-heavy NASDAQ Composite added 63 points to end the week at 6,764, an increase of 0.94%.  By market cap the large cap S&P 500 gained 0.26%, while the mid cap S&P 400 fell -0.17% and the small cap Russell 2000 retreated -0.89%. 

International Markets:  Canada’s TSX rose 0.4%, its eighth straight week of gains.  In Europe, the United Kingdom’s FTSE rose 0.74%, while across the channel, France’s CAC 40 gained 0.4%, Germany’s DAX added almost 2%, and Italy’s Milan FTSE gained 1.5%.  In Asia, China’s Shanghai Composite reversed last week’s gain by falling -1.3%, while Japan’s Nikkei had its fifth week of solid gains, rising over 2.4%.  As grouped by Morgan Stanley Capital International, developed markets rose by 0.9% while emerging markets added 0.4%. 

Commodities:  Precious metals ended the week mixed.  Gold had its third week of declines with a modest -0.2% loss to $1,269.20 an ounce, while silver rebounded slightly from last week’s loss closing at $16.83 an ounce, a gain of 0.49%.  In energy, oil had its fourth week of gains rising 3.2% to close at $55.64 per barrel of West Texas Intermediate crude.  The industrial metal copper, used by some analysts as a barometer of worldwide economic health due to its variety of uses, retraced some of last week’s loss and finished the week up 0.45%.

October Summary:  In the U.S., the Dow Jones Industrial average was the big winner, gaining 4.3%, while the NASDAQ Composite added 3.6%, and the S&P 500 added 2.2%.  The S&P 400 midcap index was up a similar2.2%, while the small cap Russell 2000 added just 0.78%.  Internationally, Canada’s TSX rose 2.5%, the United Kingdom’s FTSE added 1.6% and France’s CAC 40 rose 3.25%.  Germany’s DAX gained 3.1%, while in Asia, China’s Shanghai Composite rose 1.3%.  The biggest mover in major world markets was Japan’s Nikkei, by a wide margin, which surged over 8.1% in October.  As grouped by Morgan Stanley Capital Markets, developed markets added 3.28% for the month, while emerging markets gained a lesser but still respectable 1.7%.  In commodities, gold declined by 1.1% for the month of October, while West Texas Intermediate oil gained 4.7%.

U.S. Economic News:  The number of Americans applying for initial unemployment benefits fell to a near 45-year low last week according to the Labor Department.  Initial jobless claims fell by 5,000 to 229,000, lower than the 235,000 estimated by economists and far below the key 300,000 threshold that analysts use to indicate a “healthy” jobs market.  The less-volatile four-week moving average of initial claims declined by 7,250 to 232,500.  That number hit its lowest level since April of 1973.  The number of people already receiving unemployment benefits, known as continuing claims, dropped by 15,000 to 1.88 million.  That’s the lowest level since December of 1973. 

According to the Bureau of Labor Statistics’ Non-Farm Payrolls (NFP) report, the U.S. added 261,000 jobs in October as employment rebounded to normal levels following the twin hurricanes Harvey and Irma.  Economists had expected an increase of 325,000 in nonfarm jobs.  The biggest gainer was in the leisure and hospitality sector, followed by professional and business services.  The unemployment rate fell from 4.2% to 4.1%, the lowest since 2000.  A broader measure of unemployment, known as the U-6 jobless rate, fell to 7.9%.  This is the first time that the U-6 rate has been below 8% since 2006.  The U-6 rate counts all the unemployed, as well as those “marginally attached to the labor force” and employed “part time for economic reasons”.  Analysts consider the U-6 rate a more representative measure of the health of the labor market than the headline number.

According to payroll processor ADP, hiring in the private sector rebounded in October with 235,000 jobs added following September’s relatively weak number.  In the details of the report, small private-sector business employment rebounded with 79,000 jobs created.  Medium-sized businesses added 66,000 jobs, while large businesses added 90,000.  Most of the gains were in the services sector, with 150,000 jobs added, while goods‑producing businesses added 85,000.  

Home prices across the country accelerated higher in August, according to the latest S&P/Case-Shiller home price indexes.  The S&P/Case-Shiller 20-city home price index rose a seasonally-adjusted 0.5% in the third quarter, and was up 5.9% from the same time last year.  That was stronger than the 5.8% annual gain in the period ending in July.  The broader national index rose 6.1% for the year in August.  The national index surpassed the high it previously set at the peak of the housing bubble last year, and is now 5.6% higher.  The 20-city index sits just 1.8% below its peak in 2006.  In the details, annual price gains in August were led by a whopping 13.2% increase in Seattle, followed by Las Vegas with an 8.6% increase.  Some in the industry warned that these types of gains can’t continue forever.  David Blitzer, chairman of the index committee at S&P Dow Jones Indices noted that “measures of affordability are beginning to slide, indicating that the pool of buyers is shrinking.”

The Commerce Department reported that spending on construction projects ticked up last month, led by public works and housing.  Construction outlays ran at a seasonally-adjusted $1.22 billion rate.  Spending increased 0.3% during the month, and stood 2% higher than the same time last year.  For the second month in a row, public works projects drove the spending increase.  Public-sector spending was 2.6% higher than in August, while private-sector spending was 0.4% lower.  Compared to the same time last year, the pace of total public construction is 1.6% lower, while overall private spending is 3.1% higher.  Residential construction remained flat on the month, but is 9.5% higher for the year.  Almost all of that spending is on single-family houses.

Confidence among the nation’s consumers climbed to a 17-year high last month, according to the Conference Board.  Consumer confidence rose to 125.9 in October - its highest level since December of 2000.  The surge in confidence comes at a time when U.S. stock prices have hit record highs, lifted by strong economic growth, robust corporate earnings, and expectations of tax reform.  Lynn Franco, Director of Economic Indicators at the Conference Board, stated that the high level of confidence suggests the economy will continue to expand “at a solid pace” for the rest of 2017.  The index takes into account Americans' views of current economic conditions and their expectations for the next six months.  The index is particularly important because consumer spending accounts for about 70 percent of U.S. economic activity.

Spending by consumers hit an eight-year high in September, due to a surge in spending following hurricanes Harvey and Irma.  The Commerce Department reported that spending rose 1%, its biggest monthly gain since 2009 shortly after the economic recovery began.  Inflation, meanwhile, appears to still be under control.  The 12-month rate of Personal Consumption Expenditures (PCE) inflation rose slightly to 1.6%, but the core rate remained near its two-year low of 1.3%.  Both are well below the Federal Reserve’s 2% inflation target.

Manufacturing in the United States remained strong last month, according to the Institute for Supply Management’s (ISM) manufacturing survey index.  ISM’s manufacturing index retreated to 58.7 in October from September’s 13-year high of 60.8.  Of the eighteen industries tracked by ISM, sixteen reported growth.  In the details of the report, both the new orders index and current production gauge fell 1.2 points, to 63.4 and 61.0, respectively.  A measure of employment fell 0.5 to 59.8.  Economists had expected the ISM gauge to fall to 59.5.  Readings above 50 indicate continued expansion, while those less than 50 suggest contraction.  In services, ISM’s non-manufacturing index hit 60.1 last month, reaching its best level since August 2005 and handily exceeding its forecasts.  October’s reading was the 99th consecutive month of growth in the overall economy, and the 94th month of growth in the services sector. 

The Federal Reserve remained optimistic that the economy would continue to perform well as it held rates steady at its latest meeting.  As was widely expected, the Fed left rates unchanged in a range of 1% to 1.25%.  Policymakers had signaled ahead of the meeting that were was virtually no chance of a rate hike this month, but December is still a possibility.  In its statement released following its two-day meeting, policy makers said economic activity has been rising at a “solid rate”, an improvement from the language in the September minutes that described growth as “moderate”. 

International Economic News:  To the north, Canadian employers added 35,300 jobs last month as a surge in full-time jobs was offset by a smaller decline in part-time positions.  According to Statistics Canada, the last time the country saw such strong gains was in March of 2000.  On an annualized basis, 396,800 full-time positions have been created, marking the country’s strongest job growth since the beginning of the century.  Bank of Montreal economist Doug Porter noted that the surge in full-time jobs came on the heels of an even larger gain in September, setting a new all-time record for any two-consecutive-month period.  Despite the gains, the national jobless rate actually rose 0.1% as more people rejoined the work force, to 6.3%.

Across the Atlantic, the United Kingdom’s FTSE 100 index reached a record high this week after solid sales across the services sector showed the economy remained resilient following the post-Brexit vote.  The new highs came as the Bank of England announced its first interest rate increase in more than 10 years.  Services firms “signaled a shift in momentum”, according to a survey of the sector.  Analysts said the survey showed that the services sector, which makes up almost 80% of UK economic activity, remained resilient despite the Brexit uncertainty.

On Europe’s mainland, the French economy expanded in the third quarter, putting the French economy on a stronger growth path than the United Kingdom.  French national statistics institute INSEE reported that gross domestic product (GDP) expanded by 0.5% in the third quarter, following 0.5% and 0.6% increases in the first and second quarters.  Over the past year, France’s economy has grown by 2.2%, its strongest showing since 2011.  Analysts were quick to point out that the 12 month growth rate is higher than in the United Kingdom where the economy is up a still-respectable 1.5%.  INSEE stated that the economic activity was driven by a pick-up in household consumption and rising investments.

In Germany, the Federal Labor Agency reported unemployment in Germany held steady at historic lows last month, suggesting Europe’s largest economy can look forward to continued good health.  The jobless rate stood at a seasonally-adjusted 5.6% in October, matching September’s reading.  However, in unadjusted terms, the rate fell to 5.4% - its lowest level since German reunification in 1990.  Low unemployment has supported economic growth in Germany by increasing domestic demand for goods.  Surveys show the public believes their prosperity will continue to grow, giving them the confidence to spend money.  However, economist Casten Brzeski at ING Diba bank noted that many of the jobs created have been low-wage positions, often in the health or social care sectors.

Chinese President Xi Jinping’s promise to clamp down on corruption will ultimately help the nation’s economy.  This surprising conclusion is contained in research led by Mariassunta Giannetti, finance professor at Stockholm School of Economics, The research found that the amount of money large companies spent on meals and gifts to attract the favor of government officials, commonly detailed in the accounting line known as “entertainment expenses”, dropped as a ratio of their sales in the two years after Xi’s campaign began.  In turn, that has led to smaller companies without deep expense accounts to compete on a more level playing field, according to the research.  “Small firms are more profitable and productive when their large peers spend less on so-called entertainment expenses in proportion to their sales, because they are able to increase their sales, invest more, and have cheaper funding,” the researchers wrote in the paper.  The crackdown, launched only days after Xi came into power in late 2012, has snared more than 1.5 million officials.

According to several private sector estimates, Japan’s economy likely achieved annualized growth of around 1.5% in the third quarter.  The gain would mark the seventh quarter of uninterrupted expansion for the Japanese economy.  These projections for real gross domestic product growth come from the average of estimates from ten private sector think tanks.  Japan’s Cabinet Office will publish its official preliminary third-quarter numbers on November 15.  The current economic growth phase began in December 2012, and is poised to become Japan’s second-longest boom in the post-war era. 

Finally:  As the stock market continues to hit new highs it might be a shock to hear how few Americans actually own stock.  According to a detailed study of stock ownership by New York University economist Edward Wolff, 84% of stocks available in the United States are owned by just the top 10% most-wealthy households.  Furthermore, more than 93% of all stock is owned by just the top 20% of households.  That means that the bottom 80% of households in the United States only own about 7% of the total stock market.  And, he notes, his research includes everything, direct ownership of stocks and indirect ownership through mutual funds, trusts, IRA’s, Keogh plans, and other retirement accounts.  Put bluntly, the policies of the Fed and the government that set the stage for the current long bull market greatly favored the rich, and they indeed got very much richer.

Fig 0.jpg

(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 dropped to 23.00 from 20.50, while the average ranking of Offensive DIME sectors fell to 12.75 from the prior week’s 12.25.  The Offensive DIME sectors expanded 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.

Fig. 5

Fig. 5