The 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 32.24, down slightly from the prior week’s 32.42, 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 67.49, up from the prior week’s 66.94.

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 16, up from the prior week’s 11.  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 and one negative, the U.S. equity markets are rated as Neutral.

In the markets:

U.S. Markets:  The major U.S. equity market indexes finished the week mixed amid generally subdued trading volumes.  The Dow Jones Industrial Average shed 116 points or -0.5% to close at 24,715.  The technology-heavy NASDAQ Composite, similarly, retreated -0.7% ending the week at 7,354.  By market cap, small caps outperformed their large cap brethren.  The mid cap S&P 400 and small cap Russell 2000 rose 0.2% and 1.2%, respectively, while the large cap S&P 500 fell -0.5%.  The Russell 2000 even regained its prior all-time high, the first of the major averages to do so.

International Markets:  In international markets, Canada’s TSX followed last week’s gain with an additional 1.1% rise.  The United Kingdom’s FTSE also continued its rally, finishing up 0.7%.  On Europe’s mainland, major markets were mixed.  France’s CAC 40 rose 1.3%, along with Germany’s DAX which added 0.6%.  However, Italy’s Milan FTSE fell almost 3%.  In Asia, China’s Shanghai Composite followed last week’s gain with a 1% increase and Japan’s Nikkei finished the week up 0.8%.  Emerging markets, as a group, have suffered from the dollar’s recent strengthening.  As grouped by Morgan Stanley Capital International, developed markets retreated -0.6% while emerging markets fell over -2.8%.

Commodities:  Precious metals also suffered from a rising dollar this week, with gold losing -2.2% and silver retreating -1.8%.  The industrial metal copper, viewed by analysts as a gauge of worldwide economic health due to its variety of uses, reversed last week’s gain and fell -1.5%.  Energy continued its strong run, rising 5 out of the last 6 weeks and adding another 1% this week.  West Texas Intermediate crude oil ended the week at $71.37 per barrel.

U.S. Economic News:  The number of people seeking initial jobless benefits rose last week to its highest level in a month but nonetheless remained near their lowest levels in almost fifty years.  The Labor Department reported initial jobless claims rose by 11,000 to 222.000 last week, exceeding economists’ forecasts of a 215,000 reading.  The less-volatile monthly average of new claims fell by 2,750 to 213,250.  Job openings remain at a record high, unemployment remains below 4% and most companies are continuing to hire nine years after the current economic recovery began.  Continuing claims, which counts the number of people already receiving unemployment benefits, fell by 87,000 to 1.71 million.  That reading is at its lowest level since 1973.

Confidence among the nation’s home builders rose in May according to the National Association of Home Builders (NAHB).  The NAHB/Wells Fargo housing market index rose two points to a level of 70, beating economists’ forecasts for a reading of 69.  Readings over 50 indicate that more builders view conditions as positive.  In the details of the report, the current sales conditions index rose while those for buyer traffic and expectations in the next six months remained unchanged.  Overall, with low unemployment and a shortage of housing inventory builders remain confident.  Rising lumber and labor prices remain a concern, however. 

The number of new houses under construction dropped 3.7% last month, but remained near its 11-year high.  On an annualized basis, the rate of new homes declined to 1.29 million in April, down from the 1.34 million pace set in March that had been the strongest since mid-2007.  The reading matched economists’ expectations.  The number of permits for new construction, viewed as an indicator of future building activity, slipped a smaller 1.8% to a 1.35 million annual rate.  Most of the decline in home construction occurred in the multi-dwelling category, which includes condos, townhouses, and apartment buildings.  The more closely-watched single-family starts were little changed.  Analysts remain optimistic about the housing market for the remainder of the year.  David Berson, chief economist at Nationwide noted, “Despite rising mortgage rates and higher prices reducing affordability, solid job gains and improving demographics should push both new home sales and housing starts up in 2018 to the highest levels of the expansion.”

Sales at the nation’s retailers recorded their second straight month of gains, supporting views that the economy has accelerated following a slow start to the year.  Retail sales climbed 0.3% in April, following an upwardly revised gain in March, the Commerce Department reported.  Clothing stores posted the biggest increases in sales, followed by home-furnishings stores, internet retailers, and home and garden centers.  Americans also spent more at the gas pump with sales at gas stations rising 0.8%.  Economists’ note Americans’ have increased their spending in the past two months helped out by the recent tax cuts, annual tax refunds, and the best labor market in at least two decades.  Andrew Grantham of CIBC Economics stated, “These are solid figures, particularly given the upward revision to March, which supports our forecast that consumer spending is accelerating again in the second quarter after a sluggish first quarter.” 

Manufacturing activity in the New York-region rose this month, according to the New York Federal Reserve.  The New York Fed’s Empire State Manufacturing index rose 4.3 points to 20.1, beating economists’ forecasts of a 15.5 reading.  In the details, the new orders index gained 7 points to 16, the shipments index rose 1.6 points to 19.1, while the prices paid index rose to its highest level in several years.  In a positive development for the intermediate-term future, the six-month outlook sub-index rebounded to 31.1 after plunging to 18.3 in April. 

In the city of Brotherly Love, manufacturing activity rose this month to its strongest level in a year.  The Philadelphia Fed’s manufacturing index rose to 34.4 this month, up 11.1 points from April.  The reading was well above economists’ forecasts of 21.  Of note, the reading for new orders surged in May to 40.6 from 18.4, hitting its highest level since March of 1973.  The shipments index ticked up almost two points to 25.8, while the price indexes suggested continued inflation pressures.  The prices received index jumped 7 points to a reading of 35.4—its highest level since February of 1989. 

Industrial production, which measures real output of manufacturing, mining, and electric, and gas utilities, rose 0.7% in April, according to the Federal Reserve.  The reading was a tick above Wall St. expectations of a 0.6% increase.  Capacity utilization, which measures the percent of total industrial capacity available, rose to a three-year high of 78% last month.  In the details, manufacturing output rose 0.5%, mining output, which includes oil and gas production, rose 1.1%, while utility output was up 1.9%.  Last month’s increase was supported by increases in every major market group.  Gregory Daco, chief U.S. economist at Oxford Economics released a note stating, “Industrial production was up a healthy 3.5% year-on-year in April and we look for it to build further momentum over the course of 2018. A positive backdrop that includes firm domestic and external demand, tax cuts, a less restrictive regulatory environment, higher energy prices and a still weak US dollar are expected to underpin average annual industrial production growth of 4.2% in 2018, much stronger than the 1.6% gain recorded last year.”

International Economic News:  In a recent report, the Conference Board of Canada predicts that due to the nation’s small population and aging workforce, eliminating immigration would have a negative impact on the Canadian economy by 2040.  Kareem El-Assal, senior research associate with the Conference Board writes, “Immigration contributes to the economy in several ways.  They are going to contribute to our labour force, but they’re also going to contribute in terms of economic activity.”  According to Statistics Canada, immigrants make up approximately 22% of Canada’s population.  The report goes further, predicting that Canada’s population growth will be driven entirely by immigrants by the year 2040, compared to the 71% of population growth currently.

The prospect of an interest rate hike by the Bank of England has grown more likely after the latest official figures showed strong jobs growth had pushed the United Kingdom’s employment rate to a new record high in the first quarter of the year.  The Office for National Statistics said there were 32.34 million people in the work force in the first quarter, an increase of 197,000 from the previous quarter, and up by 396,000 from the same time last year.  The UK’s employment rate rose by 0.4% to 75.6%, its highest level since modern records began in 1971.  In addition, a majority of the jobs created were full-time positions.  James Smith, an economist at ING Bank, said the strong labor market data made an August interest rate hike from the Bank of England more likely.  “At 2.9%, earnings growth excluding bonuses is now running at the fastest rate since mid-2015 and will make the Bank of England more confident that their optimistic stance on wage growth is bearing fruit.”

In a positive development for French President Emmanuel Macron, the national statistics office INSEE reported France’s economy grew 2.2% last year, revised up from the 2% reported earlier.  The data comes at a good time for Macron as he continues to pursue ambitious reforms designed to make the country more competitive internationally.  The Eurozone’s second biggest economy, France added 57,900 private sector jobs in the first quarter, an increase of 0.3% and 270,200 jobs over the past year.  Business-friendly Macron has spent his first year in office pushing for deep reforms in France’s strict labor code, passing controversial changes intended to make it easier to hire and fire people – but not without fierce resistance from unions and left-wing politicians.

Europe’s largest economy slowed sharply in the first quarter, although analysts were quick to point out that temporary factors such as weather, a flu outbreak, and a series of strikes in the metals and engineering sectors were likely to blame.  Germany’s Federal Statistics Office reported economic growth slowed to 0.3%, its weakest performance in more than a year.  Economists had predicted a slightly brisker 0.4%.  The statistics office reported that while investment in construction and equipment rose, government spending was lower and both exports and imports declined.  Despite the weaker reading, it was the 15th consecutive quarter of growth, making this the longest economic upswing in Germany since 1991. 

Chinese and American officials made progress this week toward an agreement that could help avert a trade war.  China pledged to increase its purchase of American goods by at least $200 billion by 2020.  To reach that goal, China would reduce tariffs and other nontariff barriers that currently hinder the flow of American goods and services into China.  Right now, China imposes tariffs on a range of American products, including autos, agricultural goods and energy, and has other stiff barriers to entering its market, such as requiring American companies to enter into joint ventures with Chinese firms to gain entry and additional hurdles to shipping goods into the country.  While administration officials were quick to call the deal a victory, hard-liners within the Trump administration cautioned that China has a long history of making promises to overhaul its trade practices only to walk back or delay them later. 

Japan’s economy contracted in the first quarter of the year, ending the nation’s longest growth streak in 28 years.  The economy shrank by 0.6% on an annualized basis, much worse than the 0.2% economists had estimated.  The data marked the end to eight consecutive quarters of economic expansion.  Economists say the contraction will be temporary, but there is a risk that trade friction with the United States will hurt export demand, meaning a strong recovery is not assured.  Details of the report showed a mediocre quarter but little evidence of an impending recession.  The primary cause of the unexpectedly weak reading was a subtraction of 0.6 percentage points caused by companies running down inventories following an inventory build-up in previous quarters.

Finally:  Observant stock market investors are taking note of a development in the bond market, and its implications could be cause for concern.  In a warning sign for the stock market, the spread between 2-year and 10-year bond yields is down to just 43 basis points, its lowest level since 2007.  A flat or inverted yield curve, in which yields on bonds with a shorter duration are equal to or higher than yields on bonds with a higher duration, generally means that investors are losing confidence in the strength of the economy.  When there is little difference in the yields of short- and long-duration bonds, pressures mount on the financial sector where the business mantra “Borrow Short and Lend Long” spells trouble when there is little, no, or even negative difference between “Short” and “Long”.  The Treasury yield curve inverted before the recessions of 2000, 1991, and 1981.  In addition, the yield curve also presaged the 2008 financial crisis by two years.

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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 was unchanged from the prior week at 24.50, while the average ranking of Offensive DIME sectors rose to 11.00 from the prior week’s 12.00.  The Offensive DIME sectors again 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.

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