April 2016: Equities Continued Their Strong Rally

"Life is a series of natural and spontaneous changes. Don't resist them; that only creates sorrow. Let reality be reality. Let things flow naturally forward in whatever way they like."
~ Lao Tzu

NOTE: Areas with blue text show the most recent market updates since the March Capital Highlights email.

The very big picture:
In the "decades" timeframe, the question of whether we are in a continuing Secular Bear Market that began in 2000 or in a new Secular Bull Market has been the subject of hot debate among economists and market watchers since 2013, when the Dow and S&P 500 exceeded their 2000 and 2007 highs. The Bear proponents point out that the long-term PE ratio (called “CAPE”, for Cyclically-Adjusted Price to Earnings ratio), which has done a historically great job of marking tops and bottoms of Secular Bulls and Secular Bears, did not get down to the single-digit range that has marked the end of Bear Markets for a hundred years, but the Bull proponents say that significantly higher new highs are de-facto evidence of a Secular Bull, regardless of the CAPE. Further confusing the question, the CAPE now has risen to levels that have marked the end of Bull Markets except for times of full-blown market manias. See Fig. 1 for the 100-year view of Secular Bulls and Bears.



Even if we are in a new Secular Bull Market, market history says future returns are likely to be modest at best. The CAPE is at 26.8, up from the prior week's 25.71 after having earlier reached the level also reached at the pre-crash high in October, 2007. Since 1881, the average annual returns for all ten year periods that began with a CAPE around this level have been just 3%/yr (see Fig. 2).

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 the CAPE 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 more typical of a rip-snorting 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 Fig. 3) turned negative on January 15^th, and remains in Cyclical Bear territory at 51.21, up from the prior week’s 49.03.



In the intermediate picture:
The intermediate (weeks to months) indicator (see Fig. 4) turned positive on January 26th. The indicator ended the week at 36 (the maximum value possible), unchanged from the prior week. 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 April for the prospects for the second quarter of 2016.



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 negative (Fig. 3), indicating a new Cyclical Bear has arrived. The Quarterly Trend Indicator (months to quarters) is positive for Q2, and the Intermediate (weeks to months) timeframe (Fig. 4) is positive. Therefore, with two of the three indicators positive, the U.S. equity markets are rated as Mostly Positive.

In the markets:
Equities continued their strong rally from the February lows, fueled by hopes of continued help from central banks around the world in the form of low – or even negative - interest rates. The S&P 500 LargeCap index is now back into positive territory for 2016, along with the Dow Jones Industrial Average and the S&P 400 MidCap index, while the SmallCap Russell 2000 and NASDAQ Composite indexes still are negative for the year. For the week, the S&P 500 gained +36 points closing at 2,072, up +1.8%. The Dow Jones Industrial Average added +277 points, ending the week at 17,792 (+1.58%). The S&P 400 MidCap index and SmallCap Russell 2000 made up some lost ground on their larger brethren, gaining +2.67% and +3.53% respectively. The NASDAQ Composite index is once again nearing the 5000-level at 4,914, up a strong +2.95%. Much of the market’s gains came on Tuesday following a speech by Federal Reserve Chair Janet Yellen to the Economic Club of New York. Investors were enthused by Yellen’s cautious tone regarding hiking interest rates further and her acknowledgement of slowing growth overseas.

In international markets Canada’s Toronto Stock Exchange gained +0.62% despite continued weakness in oil. In Europe, the United Kingdom’s FTSE rose +0.65%, while on Europe’s mainland Germany’s DAX and France’s CAC 40 both ended down, -0.58% and -0.17% respectively. The worst-performer on the continent was Italy’s Milan FTSE, which declined -2.14% for the week. In Asia, markets were mixed as China’s Shanghai Stock Exchange rose +1.01%, while Japan’s Nikkei dropped a steep -4.9%.

In commodities, global growth and particularly China weighed on markets. The industrial metal copper retreated over -3% while a barrel of West Texas Intermediate crude oil tumbled -7.48% to $36.63. Oil prices fell sharply on Friday after a member of the Saudi royal family stated that the country will be unwilling to cap production unless an agreement can be reached with Iran and other major producers. Precious metals ended mixed with Gold rising +0.53% to $1,223.20 an ounce retracing some of last week’s drop, while silver ended down -1% at $15.05.

March Summary: The month of March came in like a Lion…and pretty much stayed that way. It was a strongly positive month for nearly all equity indexes worldwide, including the U.S. The strongest gain was logged by those indices hurt the most during the earlier correction: the Russell 2000 SmallCap and the S&P 400 MidCap indices. They notched gains of +7.8% and +8.3% respectively for March (though even that gain was not quite enough to pull the Russell 2000 into the green for the year). The LargeCap S&P 500 and Dow Jones Industrial indices didn’t do too shabbily, either, notching gains of +6.6% and +7.1% respectively. It must be noted though, that as strong as the gains were, they were pretty much recovering ground lost in the earlier declines of January and early February. Developed and Emerging International market averages both did well, too, rising +6.58% (EFA) and +12.96% (EEM) respectively.

First Quarter Summary: For the first quarter of 2016, the net results masked the wild ups and downs within the quarter. Well known market maven Art Cashin of UBS appropriately describes this kind of market as "…like commuting by roller coaster. Lots of chills and spills, but you ended up pretty much where you started." The Dow Jones Industrial Average and the S&P 500 posted gains with a rise of +1.49% and +0.77%, respectively – both accomplished in the very last days of the quarter. The NASDAQ composite had its worst quarter since 2009, down -2.75%, and the SmallCap Russell 2000 also declined in the first quarter, down -1.92%. Developed International markets slipped in the quarter, down ‑2.66% on average (EFA), while Emerging Markets rose a strong +6.40% (EEM). Emerging Markets were in part propelled by a monster +27.18% gain in Brazil (EWZ). The Zika virus, floundering Olympics preparations and poor ticket sales, political scandals in the Presidential office with threats of impeachment – none of these could stop the Brazil market’s rebound from the thorough pounding it took in 2015, when it lost -42%. Now that’s a rollercoaster for sure!

In U.S. economic news, 215,000 jobs were added last month, matching expectations. The jobless rate ticked up to 5%, however, as jobseekers flooded into the labor force at the fastest pace since 2007. The jobless rate rose due to a steady flow of jobseekers that entered or reentered the labor force, pushing the participation rate up to 63% - a two-year high. The roughly 2.4 million people that joined or re-joined the labor force over the past year where the most since the beginning of 2007. Retail led the way with a gain of +47,700 jobs, but leisure and hospitality, construction, and health care all showed strong job growth as well. Manufacturing continued to shed jobs, however.

Private-sector employers continue to hire at a steady rate this month, adding 200,000 jobs, According to the ADP National Employment Report. Services firms accounted for +191,000 new hires, accounting for nearly all of the gains. Small firms were responsible for +85,700 jobs, while large employers added +38,800.

Research firm Challenger, Gray & Christmas announced that corporations plan to lay off 48,200 workers in March. The 12 month layoff total has reached 643,000, the highest since early 2012. On a positive note, layoffs have receded the past two months after peaking at 75,000 in January. John Challenger, the outplacement firm’s chief executive stated “it is not just the energy sector that is seeing heavier job cuts. Layoff announcements have increased significantly in the retail and computer sectors as well.”

Private wage and salary income fell an annualized $12.9 billion in February, or 0.2%, the Commerce Department reported as income gains continue to decelerate. Overall, personal income rose +$23 billion, or +0.2%, but the gains came in areas that won’t benefit consumers that much. Rental income, government social benefits, and employer contributions to employee pensions and insurance were the main factors responsible for the gain. Softening in income growth has historically coincided with a slowdown in consumption. Personal consumption expenditures rose a mere +0.1% in February, for an annualized growth rate of +2.1%. In the same timeframe, the annualized gain in private wage income has slowed to +3.6% from +5.6%.

In housing, the S&P/Case-Shiller home price index for January showed the 20-city benchmark index rose +5.7% over the past year. Portland, Oregon saw the greatest appreciation, up +11.8% in the 12-month period while Chicago saw the least, up just +2.1%.

Consumer confidence rose to 96.2, up two points from February and above the high range of economists’ estimates, according to the Conference Board. The report isn’t exceptional, but it is moving in a positive direction. Of the survey respondents, 24.9% expressed the belief that current business conditions are “good”, down -0.6% from last month. Those saying that business conditions are “bad” retreated slightly to 18.8% from 19%.

US manufacturing moved back into expansion, according to a key factory index. The Institute for Supply Management’s (ISM) manufacturing index rose to 51.8 last month, crossing the neutral 50 level into expansion territory for the first time since last August. Economists had expected a reading of 50.5. New orders and production gauges were both solidly positive, despite weakness in the employment gauge which dropped -0.4 point to 48.1. More output with less employment is good for productivity, at least.

As mentioned above, this week, Fed Chair Janet Yellen gave a speech to the Economic Club of New York, stating that it was appropriate for U.S. central bankers to “proceed cautiously” in raising interest rates because the global economy presents heightened risks. Fed officials left their benchmark lending rate target unchanged this month at 0.25% to 0.5% while revising down their estimate for the number of rate increases this year to two hikes instead of the four projected in December.

In the Eurozone, Markit released its latest manufacturing Purchasing Managers Index (PMI) data for the Eurozone at 51.6 last month, up +0.4 point. Germany remained in expansion at 50.7, up +0.2 point, however France slipped to 49.6—its lowest reading in 7 months and slightly back in contraction territory. France also reported that consumer prices remained in deflation last month, falling -0.1%. Markit’s chief economist labeled France as the “weakest link” in Europe right now.

In China, the ratings agency Standard & Poor’s has cut its outlook on China’s government credit to “negative” from “stable” as it believes rebalancing of the world’s second largest economy would take place more slowly than had been expected. China’s credit rating stands at AA- with a negative outlook.

In Japan, business sentiment among Japan’s big manufacturers deteriorated to the lowest in nearly three years, and is expected to worsen, according to a closely watched central bank survey. Big firms also plan to cut capital expenditures in the current fiscal year. Mari Iwashita, chief market economist at SMBC Friend Securities remarked, “There’s no sign of corporate sentiment bottoming in coming months.”

Finally, this past summer it was widely noted that U.S. corporate earnings growth had stagnated. The equity markets subsequently also stagnated – along with a lot of volatility, including the worst start to a year in the stock market ever. Unfortunately, the earnings picture hasn’t improved much since then, and the longer-term outlook seems to be deteriorating.

Last Friday, the government’s Bureau of Economic Analysis released data showing the corporate profits declined -11.5% in 2015. Excluding adjustments for inventory valuation and capital consumption, the decline was still -7.6% as shown on the chart below from the St. Louis Fed.

FactSet’s John Butters observed: “For Q1 2016, the estimated earnings decline is -8.7%. If the corporate profits index reports a decline in earnings for Q1, it will mark the first time the index has seen four consecutive quarters of year-over-year declines in earnings since Q4 2008 through Q3 2009.”




(sources: all index return data from Yahoo Finance; 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, 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 remained unchanged from the prior week at 12.3, while the average ranking of Offensive DIME sectors fell to 10.3 from the prior week’s 9.8. The Offensive DIME sectors retained 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.

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 8.0 from the prior week’s 8.8, while the average ranking of Offensive DIME sectors rose to 10.8 from the prior week’s 11.8. The Defensive SHUT sectors have maintained their lead over the Offensive DIME sectors. Note: these are “ranks”, not “scores”, so smaller numbers are higher ranks and larger numbers are lower ranks.