MAY 2017: Commodity Weakness Continues in the Energy Sector

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NOTE: Areas with blue text show the most recent market updates since the March 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 29.49, up from the prior week’s 29, 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 67.34, up from the prior week’s 65.67.

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 29, up 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 April, indicating positive prospects for equities in the second 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: Major market indexes ended the week mixed. The Dow Jones Industrial Average breeched the 21,000 level for a second time this year, rising 66 points to close at 21,006. The technology-heavy Nasdaq Composite added 53 points, or 0.9%, to end the week at 6100. By market cap, the larger cap S&P 500 and mid cap S&P 400 led the way with 0.6% and 0.3% gains respectively, while the small cap Russell 2000 retreated -0.2%.

International markets: Canada’s TSX was essentially flat, falling just 4 points. The United Kingdom’s FTSE booked a second week of gains by rising 1.3%, while on Europe’s mainland major markets notched a second week of even stronger gains. France’s CAC 40 index rallied 3.1% along with Germany’s DAX that rose 2.2%. Italy’s Milan FTSE surged 4.2%. In Asia, China’s Shanghai Composite Index fell -1.6%, logging its fourth straight weekly loss, but Japan’s Nikkei scored its third straight weekly gain, rising 1.3%. As grouped by Morgan Stanley Capital International, developed markets rose a very strong 2.8%, their third straight weekly gain, while emerging markets rose just 0.3%.

Commodities: Weakness continued in the energy sector. Oil fell a third straight week with a steep drop of -6.3%. A barrel of West Texas Intermediate crude oil now sells for $46.22, a loss of -$3.11. Precious metals were also weak. Gold had its worst week of the year by plunging -3.26%, or -$41.40 an ounce to close at $1226.90. Likewise, Silver retreated a third straight week, falling -5.7% to $16.27 an ounce. Copper, known also as Dr. Copper—market lingo for the base metal purported to have a PhD in economics because of its ability to predict turning points in the global economy, erased last week’s gain by dropping -3%. U.S.

Economic News: The number of people who applied for new unemployment benefits last week fell sharply as the labor market continued to show strength. Initial claims for unemployment fell 19,000 to 238,000 the final week of April according to the Labor Department. Economists had expected a drop of only 12,000. Claims continue to remain below the key 300,000 threshold that analysts consider a “healthy” job market. Applications for unemployment benefits have remained below 300,000 for 113 straight weeks, its longest run since the early 1970’s. The four-week moving average of claims, used to smooth out the weekly volatility, rose by 750 to 243,000. Continuing claims, those people already receiving unemployment benefits, fell by 23,000 to 1.96 million—a 17 year low. That number is reported with a one-week delay.

Hiring in the private sector slowed last month to its slowest pace in four months, according to payroll processor ADP. ADP’s report showed employers expanded their workforce by a seasonally-adjusted 177,000 jobs last month—the fewest since December. Economist had expected a gain of 170,000. By size, private-sector job gains continued to be at small employers where 61,000 workers were added. Mid-size employers added 78,000 and large employers hired 38,000.

The monthly government Non-Farm Payrolls (NFP) report revealed that around 211,000 people found new jobs last month as hiring rebounded, an indication that the economy is still growing and giving the Fed the green light for further rate hikes. The Bureau of Labor Statistics reported the unemployment rate fell to 4.4% reaching its lowest level since before the Great Recession. The increase in jobs was broad-based with white-collar, hotels, restaurants, and health-care providers leading the way. Economists had only expected 190,000 new jobs. The April reading made up for the weakness in the March reading which had led to concern among analysts. Stephen Blitz, chief U.S. economist at TS Lombard said, “April employment data should put to rest concerns that somehow the economy was slowing to a complete stall.” A broader measure of unemployment, one frequently ignored by the mainstream financial media, is the U-6 unemployment rate. That rate includes the unemployed, plus marginally attached workers and workers who were forced to take part-time work for economic reasons. This rate is now at its lowest level since the Great Recession, down to 8.6% - well below the 17.1% peak it reached at the onset of the recession.

The services sector of the U.S. economy, which makes up almost 80% of the nation’s GDP, grew faster in April and indicated an overall strong performance for the first quarter according to the Institute for Supply Management’s (ISM) non-manufacturing index. The index rose to 57.5% last month, a gain of 2.3% from March, marking its second-highest reading in 18 months. Economic activity in the non-manufacturing sector grew in April for the 88^th consecutive month. Anthony Nieves, Chair of the ISM committee that runs the survey said, “Respondents’ comments are mostly positive about business conditions and the overall economy.” All of the seventeen non-manufacturing industries reported growth last month except for one, “Agriculture, Forestry, Fishing & Hunting”.

On the manufacturing side of the economy, hiring plans were scaled back and demand for new products weakened but overall most companies said business was still quite brisk according to the Institute for Supply Management (ISM). ISM’s manufacturing index fell 2.4% to 54.8% in April missing economists’ expectations for a reading of 56.5%. Out of the eighteen industries tracked by ISM, the only industry that reported contraction in April compared to March was “Apparel, Leather & Allied Products”. Bradley Holcomb, Chair of the Institute for Supply Management Manufacturing Business Survey Committee stated that comments from the panel “generally reflect stable to growing business conditions, with new orders, production, employment, and inventories of raw materials all growing in April over March.”

On the negative side, productivity of American firms and their employees fell at its fastest rate in a year in the first quarter. Productivity declined at a 0.6% annual pace in the first three months of the year. Productivity has been weak since the end of the financial crisis, averaging an anemic 1.2% annual increase, while the long-term average since World War Two is 2.1%. Economists at Oxford Economics wrote “the underlying trend in productivity remains disappointing.” In addition, labor costs rose at its fastest rate in nine years last year, a sign companies have to pay more for employees at a time when a shrinking pool of labor makes good help harder to find. The nasty combination of rising wages and lower productivity could spell trouble for the economy. Wages can’t continue to rise without an improvement in worker productivity.

A measure of inflation fell slightly in March after hitting a multi-year high in February, according to the Commerce Department. The Personal Consumption Expenditures price index fell -0.2% marking its first decline in over a year. The Core PCE, which strips out the volatile food and energy components, retreated -0.1% -its largest decline since 2001. On an annualized basis, the rate of PCE inflation fell back below 2% to 1.8%. The Federal Reserve has indicated it prefers inflation to run about 2% a year so the lower reading gives the Fed some breathing room regarding its next rate hike.

Americans’ spending was flat in March making the most recent two-month spending stretch the weakest since the end of 2014. For the first quarter, consumer outlays rose just 0.3%, a significant drop from last year’s fourth quarter 3.5% increase. Analysts note that the drop off in spending appeared to result from temporary influences that are expected to fade. Millions of Americans are believed to have held back spending because of delays in processing tax refunds. Americans also spent less on fuel because of lower oil prices and unseasonably warm weather.

American automakers reported steep sales declines last month. GM and Ford reported declines of 5.8% and 7.1% respectively last month compared to April of 2016. Fiat Chrysler reported a 7% decline as the Jeep brand continued to weigh on the automaker. Another troubling sign is the glut of unsold cars and trucks sitting on dealership lots. GM, the number 1 U.S. automaker, has almost 1 million unsold vehicles sitting on its dealer lots and its inventory consequently increased to 100 days. Analysts say an overall level of 60 to 70 days of inventory is healthy, but 100 is not. Detroit is hoping for strong summer sales, spurred by hefty dealership discounts and low gas prices.

The Federal Reserve’s Federal Open Market Committee (FOMC) voted unanimously to leave its benchmark interest rate unchanged at 0.75-1%, but reiterated its intentions to raise interest rates two more times in 2017. The Fed said the sharp slowdown in first-quarter GDP resulting from the drop in consumer spending is “likely to be transitory”. The central bank also commented that “the fundamentals underpinning the continued growth of consumption remains solid.” In its statement, the FOMC, in addition to viewing the slowing growth in the first quarter as “transitory”, noted that job gains and the fundamentals underpinning the economy were “solid”. Kathy Bostjancic, head of U.S. macro investor services at Oxford Economics stated “The main takeaway is full steam ahead” with rate hikes.

International Economic News: Canadian exports rebounded to a record high last month as exports in energy and consumer goods narrowed the trade deficit more than expected. Statistics Canada reported the merchandise trade deficit fell to just $135 million from a revised $1.08 billion in February. Exports rose 3.8% to a record $47 billion. Most of the gains were due to stronger volumes, which increased 2.5%, although prices also increased 1.3%. Energy shipments were up 7% to $8.75 billion. Canadian Imperial Bank of Commerce economist Nick Exarhos remarked, “Exports in March were hot, and that’s an early sign that the Canadian economy carried some momentum into the second quarter, after a scorching start to the year.”

In the United Kingdom, Bank of England’s Chief Economist Gabriel Fagan told the Irish Legislature (“Oireachtas”) that Ireland stands out as the EU economy most likely to be affected by Brexit. Fagan said that Ireland was more reliant on UK export markets than any other EU country. In the event of a hard-Brexit, meaning no UK-EU trade agreement, Mr. Fagan warned that GDP would fall by 3%. He also highlighted the fact that UK financial firms would suffer as UK firms would lose “passporting rights”. Those rights allow firms registered in the European Economic Area (EEA) to do business in any other EEA state without needing further authorization in each country.

Across the channel in France, the most important presidential election in decades happens this Sunday. The country’s economic malaise is a big factor, as well as the direction of the country as a whole. Emmanuel Macron, a former investment banker and centrist, is up against far-right nationalist Marine Le Pen. Each offers radically different solutions to the same problems. Ms. Le Pen intends to put France first by dumping the euro and returning to the French franc, France’s old currency. She has promised French voters the freedom to vote to quit the European Union. In contrast, Macron is a staunch defender of the EU. Macron believes that leaving the euro would actually hurt French workers by lowering their purchasing power. Jobs are an important part of the French election where unemployment among youth stands at 23%. (Editor’s note: as this report goes to press on Sunday May 7th, the election results are in and Macron has won by a substantial margin.)

German-Russian relations were praised by Russian President Vladimir Putin, stating that Germany remains Russia’s leading economic partner (mostly by purchasing more Russian natural gas than any other country). After a meeting with German Chancellor Angela Merkel, Putin remarked that bilateral trade turnover has increased by over 40% between the two countries. Putin stated, “Russia seeks to build cooperation with the Federal Republic of Germany on the principles of mutual benefit, respect, equality and consideration of each other's interests. Despite the known political difficulties and fluctuations in the global economic environment, Germany remains the leading foreign policy partner of our country.”

The two Asian powerhouses, Japan and China, held their first bilateral financial meeting in two years. In the meeting, they agreed to bolster economic and financial cooperation. The two nations had much to discuss as the U.S. grows more protectionist under the Trump administration and tensions remain high on the Korean peninsula. Japanese Finance Minister Taro Aso told reporters after the meeting, “We actively exchanged views on economic and financial situations in Japan and China, and our cooperation in the financial field." The two countries agreed to launch joint research on issues of mutual interest - without elaborating - and report the outcomes at the next talks, which will be held next year in China.

Finally: RBC Global Asset Management released a research note with an interesting insight. They found that when the Conference Board’s Leading Economic Indicators (LEI) index was rising month-to-month and was already above zero year-over-year, the stock market averaged an 11.8% gain in the following 12 months. The last time this happened was just before the U.S. presidential election - and the strong market rally then followed. From the RBC note: “Improvement in the LEI is meaningful because stocks have returned an annualized average of 11.8% in periods where the LEI is positive and rising as it is now, compared with just 0.3% when the LEI is positive but falling, which was the case prior to the start of the latest rally.” As of its latest reading, the LEI continued to strengthen from an above-zero condition. According to this measure, at least, it seems there are prospects for more gains. As always, past performance is no guarantee of future results.

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 fell rose to 14.25 from the prior week's 15.25, while the average ranking of Offensive DIME sectors fell to 13.75 from the prior week's 13.00. The Offensive DIME sectors, maintain a slim lead over Defensive SHUT. Note: these are “ranks”, not “scores”, so smaller numbers are higher ranks and larger numbers are lower ranks.