JULY 2017: Gridlock in Washington Continues to Weigh on Economic Expectations

"Happiness is not in the mere possession of money. 
It lies in the choice of achievement and the thrill of creative effort."
~ Franklin Roosevelt

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

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 30.10, up from the prior week’s 29.68, and now 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 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 U.S. Bull-Bear Indicator (see Fig. 3) is in Cyclical Bull territory at 67.48, up from the prior week’s 65.72.

In the intermediate and Shorter-term picture:

The Shorter-term (weeks to months) Indicator (see Fig. 4) turned negative on March 24th. The indicator ended the week at 25, up from the prior week’s 24. Separately, the Intermediate-term Quarterly Trend Indicator - based on domestic and international stock trend status at the start of each quarter – was positive entering July, indicating positive prospects for equities in the third quarter of 2017.

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. The Quarterly Trend Indicator (months to quarters) is positive for Q1, and the Intermediate (weeks to months) timeframe (Fig. 4) is negative. Therefore, with two of three indicators positive, the U.S. equity markets are rated as Neutral.

In the markets:

U.S. Markets: U.S. stocks rose for the week, lifting the large cap indexes to new all-time highs. The Dow Jones Industrial Average and the S&P 500 both touched new intraday highs; however it was the technology-heavy Nasdaq Composite that performed the best of the major indexes. The Dow Jones Industrial Average added over 223 points to close at 21,637, a gain of 1.04%. The Nasdaq Composite gained over 159 points to close at 6,312, a rise of 2.59%. By market cap, large caps edged smaller cap indexes as the large cap S&P 500 index rose 1.4%, while the mid cap S&P 400 index added 1.03% and the small cap Russell 2000 gained 0.92%.

International Markets: Canada’s TSX rebounded from last week’s decline, rising 0.98%. The United Kingdom’s FTSE managed a second week of gains rising 0.37%. On Europe’s mainland, France’s CAC 40 rose a second week, up 1.75%, while Germany’s DAX added 1.96% and Italy’s Milan FTSE rose 2.27%. In Asia, China’s Shanghai Composite rose 0.14%, while Japan’s Nikkei gained 0.95%. Hong Kong’s Hang Seng surged over 4.1%. As grouped by Morgan Stanley Capital Indexes, developed markets were up 2.28%, while emerging markets vaulted 5.57%.

Commodities: Precious metals regained some of their luster after falling for five consecutive weeks. Gold managed to rebound 1.47%, or $17.80, to close at $1,227.50 an ounce. Silver gained 3.29% to close at $15.93 an ounce. Oil managed to retrace last week’s decline, rising 5.22%, or $2.31, to close at $46.54 per barrel of West Texas Intermediate crude oil. The industrial metal copper, used by some analysts as an indicator of global economic health due its variety of uses, rose 1.66%.

U.S. Economic News: The number of Americans who applied for initial unemployment benefits retreated slightly in June, a further indication of the extremely low level of layoffs as the economic recovery stretches into its ninth year. The Labor Department reported initial jobless claims in the week ending July 8^th dropped by 3,000 to a seasonally-adjusted 247,000. Initial claims count the number of people who apply for benefits after losing their jobs. New applications for benefits have remained under the 300,000 threshold that analysts use to indicate a “healthy” jobs market for 123 consecutive weeks—its longest run since the early 1970’s. The less-volatile four-week moving average of claims, which gives a more stable picture of layoff trends, rose 2,250 to 245,750. Layoffs have been near their lowest level in almost 50 years and show no signs of rising. Continuing claims, the number of people already receiving benefits, came in at 1.95 million. Continuing claims have been under 2 million for 14 straight weeks, an event last seen in 1973.

The number of job openings in the United States fell by over 300,000 in May to 5.66 million—one month after reaching its second highest level ever. According to the government’s Job Openings and Labor Turnover Survey, known as the JOLTS report, the reduction appears to have been due to a big surge of 429,000 people hired in May—its biggest increase since March 2004. The JOLTS survey is a broader look at labor-market trends that uses a different set of criteria to assess the jobs market than the monthly employment report. The “quits” rate, which measures the number of people leaving their jobs by choice (presumably for a better job), rose a tick to its post-recession high of 2.2%. The higher number is interpreted by analysts as workers being confident enough about the economy to more readily change jobs. Overall, the report points to a strong labor market in which companies are hiring, layoffs remain near decade lows, and most people who want a job are able to find one.

Sentiment among small business owners continued to decline as the gridlock in Washington continued to weigh on economic expectations. The National Federation of Independent Business (NFIB) reported their monthly sentiment tracker ticked down 0.9 points to 103.6—its fifth-straight month of negative or unchanged readings. The index is now halfway between its pre-election reading of 98.4 and its high of 105.8 following the Trump election surge. In its release, the NFIB stated that sentiment has “sustained” the post-election surge, but warned that small business owners are losing patience with policymakers’ inability to pass health care and tax reform legislation. The NFIB noted that “Gridlock is driving down small business optimism, which will eventually drive down the economy.” In June, four of the index’s 10 components increased, while five declined and one remained unchanged.

Sentiment among consumers also declined, according to the latest preliminary survey from the University of Michigan. Confidence in future economic prospects continued to decline in early July pushing the University of Michigan’s Consumer Sentiment index down to 93.1. Economists had expected sentiment to hit 95 this month. Richard Curtin, chief economist for the University’s survey said in its statement, “Overall, the recent data follow the same pattern repeatedly recorded around past cyclical peaks: expectations start to post significant declines while assessments of current economic conditions continue to reach new peaks.” Mr. Curtin hastened to clarify the statement, saying the current data does not suggest an impending recession, “much steeper declines in expectations typically precede recessions.”

Sales at retailers across the country fell 0.2% last month marking their second consecutive drop and matching their biggest decline of the year, according to the Commerce Department. The disappointing sales figures suggests that the U.S. has not rebounded quite as strongly in the second quarter following tepid growth in the first quarter. In the details of the report, most retail segments posted weaker results last month. Gas station sales saw the biggest drop, falling 1.3%, followed by sales at grocers, restaurants, book stores, sporting-goods stores, and department stores. Of note, auto dealers reported only a slight increase in sales, but they are not selling cars as quickly as they were a year ago. Slower auto sales can have a powerful impact on the economy since they account for about 20% of all retail spending.

Inflation at the wholesale level rose slightly last month but its rate of rise slowed from recent readings. According to the Bureau of Labor Statistics, the producer-price index (PPI) rose just 0.1% last month—economists had predicted no change in the PPI. After rising steadily last year and the first half this year, inflation has slowed down in recent months. The decline has senior central-bank officials questioning whether further rate increases in the near future are warranted. Other inflation indicators such as the Consumer Price Index and the Federal Reserve’s preferred gauge, the Personal Consumption Expenditures (PCE) index also show inflation stalling. The PCE has slowed to an annualized rate of 1.4%, from the 2.1% high set earlier this year. Ryan Sweet, director of real-time economics at Moody’s Analytics stated, “The PPI suggests that there isn’t a significant amount of price pressures in the pipeline.”

At the consumer level, the prices Americans paid for goods and services were unchanged in June according to the Bureau of Labor Statistics. The Consumer Price Index (CPI), known also as the cost of living index, slowed to an annualized 1.6% in June, down 0.2% from May’s reading and down from its five-year high of 2.7% five months ago. In the details of the report, energy prices declined 1.6% as Americans paid less for gasoline, natural gas, and electricity. In addition, the cost of food leveled off after five consecutive increases. Stripping out the volatile food and energy categories, inflation rose 0.1% in June. Over the past 12 months the so-called core CPI is up 1.7%.

The Federal Reserve said that a shortage of qualified workers in the U.S. has “limited” hiring and that companies don’t appear to be raising wages to attract jobseekers. The remarks came from the Federal Reserve’s so-called “Beige Book” - its regular survey of business conditions around the country. The report said economic growth was “slight to moderate” from late May through June—slightly less upbeat compared to May’s report. The ultra-tight labor market with unemployment near a 16-year low of 4.4% was frequently given as a headwind by respondents to the survey. The Minneapolis Federal Reserve said “Employment was held back by tight labor availability”, while the Philadelphia Fed said “Workers appear to have less loyalty on the job, and more job-hopping is showing up on resumes.” While companies have offered more pay to some workers with specialized skills, the Fed found no broad increase in wages. One reason offered is that companies feel they can’t pass costs onto price-conscious consumers. With wages rising only modestly, some senior Fed officials believe inflation is likely to remain on the low side for a longer period than the central bank now predicts. The weak inflation data gives the Fed more latitude with the timing of its next interest rate hike.

International Economic News: The Bank of Canada raised its benchmark interest rate for the first time in seven years, to 0.75%. The 0.25% rate hike came amid expectations of stronger economic growth this year. The bank had cut interest rates by a quarter of a percentage point twice in 2015 to help the economy deal with the plunge in oil prices. In its release the bank stated that “Growth is broadening across industries and regions and therefore becoming more sustainable.” In its outlook for the Canadian economy, the Bank of Canada estimated growth to be 2.8% this year, 2.0% next year, and 1.6% in 2019. The rate increase was widely expected following “hawkish” comments by Bank of Canada governor Stephen Poloz and senior deputy governor Carolyn Wilkins in recent weeks.

The U.K. economy is slumping as business output falls and consumer spending continues to shrink, according to two sets of data released this week. The latest BDO Output index, which measures how businesses expect their order books to develop over the next three months, fell half a point to 94.9 in June leaving business output at a four-year low. The reading puts UK business into contraction, which is measured as any figure below 95.0. In addition, the UK services sector, which represents the bulk of the economy, is also experiencing stagnant economic growth. The latest Markit PMI data showed a 0.4 point drop to 53.4 for June. Duncan Brock, director of customer relations at CIPS, which helps compile the Markit survey, said political uncertainty related to Brexit and June's general election had driven the slowdown.

Across the channel on Europe’s mainland, France will cut the processing time for asylum requests and boost housing for refugees while “systematically” deporting illegal economic migrants Prime Minister Edouard Phillipe said. France received over 85,000 asylum requests last year and is struggling with its system that President Emmanuel Macron described as “completely overwhelmed”. France has been criticized by charity groups for its inadequate facilities leading to the formation of camps in northern France and around Paris. In striking a balance between humanitarian concern for refugees and observing a tough policy on handling economic migrants, Philippe said “We are not what France should be.”

French President Emmanuel Macron admonished Germany for benefiting from the troubles of other euro countries and warned that the Eurozone cannot survive on such foundations. Mr. Macron said the monetary union has become a deformed project that is corrosive to the weaker economies to the advantage of the creditor states. Mr. Macron insisted that the EU must be rebuilt in a radically different way, requiring wholesale changes to the EU Treaties. “It doesn’t work because it has brought about divergences. Those that are already indebted have become more indebted: and those that are competitive have become more competitive,” he said. The remarks came as German exports rose even more strongly in May than previously expected. Germany’s Federal Statistics Office reported seasonally adjusted exports climbed for a fifth consecutive month, rising 1.4%, while imports also rose 1.2%.

In Asia, a new survey from the Pew Research Center reveals that the prevailing view among people around the world is that the U.S. is still the world’s leading economic power, but a surprising number of nations said China. Furthermore, many of the respondents live in nations that are key U.S. trading partners and allies. Of the 38 nations polled, a median 42% said the U.S. is the world’s leading economy, while 32% named China. However, in a lopsided seven of the ten European Union nations in the study (including Spain, France, and Germany), China is considered the world’s leading economic power. In Australia, a nation with heavy trade with China, China leads the U.S. by a shocking two-to-one margin. Emerging market countries such as Brazil, Mexico, and the Philippines also now see China as the top economic power in the world. "Following the onset of the financial crisis nearly a decade ago, Europeans increasingly named China, rather than the U.S., as the world's leading economic power," the report said.

The Japanese government and the European Union agreed in principle to a trade pact after more than four years of talks. The announcement on the Economic Partnership Agreement (EPA) was hailed by an official Japan-EU statement as “highly ambitious and comprehensive”. Japanese Prime Minister Shinzo Abe remarked, “Amid moves of protectionism, we demonstrate our commitment to raising the banner of free trade.” Proponents said the deal would significantly lower trade barriers between Japan and the EU for a wide array of products. Japan had previously focused much of its efforts on the Trans-Pacific Partnership trade pact, until U.S. President Donald Trump quickly decided to pull the U.S. out of negotiations over the pact. Trump’s move accelerated talks between Japan and the EU.

Finally: July 11^th, Tuesday of this past week, was the third annual “Amazon Prime Day”. This year’s Prime Day smashed last year’s Prime Day sales record by more than 60% and now stands as the biggest sales day in Amazon’s entire history. Even more remarkable, as research firm Morningstar points out, is that the number of households with Amazon Prime video streaming is nearing the total number of homes with cable or satellite TV. According to estimates from Morningstar, nearly 79 million households now have an Amazon Prime membership, up from 66 million at the end of 2016. This compares to a projected 90 million households that pay for cable or satellite TV. Amazon doesn’t disclose the number of Prime members, so Morningstar’s estimates are based on an analysis of Amazon’s cash-flow statements. On the day after Prime Day, Amazon said they had more new members joining the Prime subscription service on Prime Day than any other single day in history. The following chart, from tech-industry commentary site “recode.net”, shows the skyrocketing Prime membership nearly intersecting the flat-to-declining cable-TV subscribership.

(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 fell to 16.25 from the prior week’s 15.00, while the average ranking of Offensive DIME sectors rose to 15.50 from the prior week’s 17.00.  The Offensive DIME sectors have taken the lead from 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 fell to 16.25 from the prior week’s 15.00, while the average ranking of Offensive DIME sectors rose to 15.50 from the prior week’s 17.00. The Offensive DIME sectors have taken the lead from the Defensive SHUT sectors. Note: these are “ranks”, not “scores”, so smaller numbers are higher ranks and larger numbers are lower ranks.