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SITREP for Week Ending 6/21/19

| June 24, 2019
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The SITREP for the week ending 6/21/2019

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

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The very big picture:

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”).  The market is currently at that level.

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 30.09, up from the prior week’s 29.73, above 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).

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 58.73, up from the prior week’s 56.87.

In the intermediate and Shorter-term picture:

The Shorter-term (weeks to months) Indicator (see Fig. 4) turned positive on June 4th.  The indicator ended the week at 19, up from the prior week’s 14.  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 2019.

Timeframe summary:

In the Secular (years to decades) timeframe (Figs. 1 & 2), the long-term valuation of the market is historically too high to sustain rip-roaring multi-year returns.  The Bull-Bear Indicator (months to years) remains 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 Q2, and the shorter (weeks to months) timeframe (Fig. 4) is positive.  Therefore, with three indicators positive and none negative, the U.S. equity markets are rated as Positive.  Learn more at Market Conditions Explained.

In the markets:

U.S. Markets:  The Federal Reserve held rates steady and reinforced investor expectations for an interest rate cut later this year, powering strong gains for stocks and lifting the large cap S&P 500 index to a new record high.  The Dow Jones Industrial Average surged 629 points to 26,719, a gain of 2.4%.  The technology-heavy NASDAQ Composite rose over 3% regaining the 8,000-level and closing at 8031.  By market cap, the large cap S&P 500 index rose 2.2%, while the mid cap S&P 400 gained 1.5% and the small cap Russell 2000 added 1.8%.

International Markets:  Canada’s TSX rose 1.4% while the United Kingdom’s FTSE gained 0.8%.  On Europe’s mainland, France’s CAC 40 added 3.0%, Germany’s DAX rose 2.0%, and Italy’s Milan FTSE gained 3.8%.  In Asia, China’s Shanghai Composite surged 4.2% and Japan’s Nikkei rose 0.7%.  As grouped by Morgan Stanley Capital International, developed markets rose 2.5% last week, while emerging markets jumped a robust 4.9%.

Commodities:  Gold surged to a multi-year high, rising $55.60 to $1400.10 per ounce, a gain of 4.1%.  Silver also finished the week up, rising 3.3% to $15.29 an ounce.  Oil surged 9.4% as tensions with Iran spiked and a refinery fire broke out in Philadelphia.  West Texas Intermediate crude oil ended the week at $57.43 per barrel.  The industrial metal copper, watched by analysts as an indicator of global economic health due to its variety of uses, finished the week up 2.9%.

U.S. Economic News:  The number of Americans applying for first-time unemployment benefits fell last week to a one-month low and holding near their lowest level in decades.  The Labor Department reported initial jobless claims fell by 6,000 to 216,000.  Economists had estimated new claims would only decline by 2,000.  The more stable monthly average of new claims, used by analysts to smooth out the more volatile weekly number, edged up by 1,000 to 218,750.  Continuing claims, which counts the number of people already receiving benefits, declined by 37,000 to 1.66 million.  These claims are near their lowest level since the early 1970’s.

Builders broke ground on fewer homes last month, as housing starts slipped, but the number of building permits rose indicating stronger growth ahead.  The Commerce Department reported builders started new homes at a 1.269 million annual pace in May, down 0.9% from April’s pace and down 4.7% from the same time last year.  However, the number of applications for permits rose to a seasonally-adjusted 1.3 million annual rate—0.3% higher than April’s rate.  The government’s reports on new-home construction and sales are collected from small samples and are often volatile.  To get a better read, analysts often look at the year-to-date number, which in this case shows starts are 3.0% lower than during the same period last year.

Sentiment among the nation’s home builders declined this month as old worries continue to weigh on the construction industry.  The National Association of Home Builders (NAHB) reported its builder sentiment index fell 2 points to 64, missing the consensus forecast of a one-point increase.  The NAHB attributed the decline to the same now-familiar headwinds: the cost of labor, materials, and land.  In the latest report, the group also added “excessive regulations” to the list.  In the details, the gauge of current sales conditions fell one point to 71, while expectations of sales over the coming six months fell 2 points to 70.  Buyer traffic declined a point to 48.

Despite the pessimism among builders, real estate agents report the housing market remains strong.  The National Association of Realtors (NAR) reported sales of previously-owned homes were 2.5% higher in May, at a 5.34 million seasonally-adjusted annual pace.  The reading beat the consensus forecast of a 5.28 million rate.  In addition, the median selling price in May was $277,700—a 4.8% annual increase and the 87th consecutive month of annual price increases.  By region, the Northeast saw a 4.7% jump in sales, while in the Midwest sales were up 3.4%.  In the South and West sales also ticked up, but by a lower 1.8%.  At the current pace of sales, it would take 4.3 months to exhaust available supply, still well below the 6-month threshold that’s traditionally been considered a marker of a balanced market.  Properties stayed on the market for an average of 26 days in May, up a bit from 24 days in April but still a sign of a strong seller’s market.

In a pair of reports from research firm IHS Markit, both its flash manufacturing and services Purchasing Managers Indexes (PMIs) dropped to multi-year lows.  IHS Markit said its flash manufacturing PMI dropped 0.4 point to 50.1 in June—its worst reading since September of 2009.  In addition, its flash services PMI fell to 50.7 from 50.9—its worst reading since March 2016.  In its release, Markit noted private-sector output growth has lost momentum in each month since February.  In addition, production volumes barely rose and respondents noted “greater risk aversion”.  Chris Williamson, chief business economist at Markit tweeted, the “big change since Q1 is that US manufacturing weakness has now spread to services”.

Manufacturing activity in the New York region took a sharp turn for the worse according to the latest data from the New York Federal Reserve.  The New York Fed’s Empire State business conditions index posted its largest-ever drop into negative territory this month, declining 26 points to -8.6—its first negative reading in more than two years.  Economists had expected a decline of “only” 7.8 points to positive 10.  Readings below zero indicate a contraction in activity.  The last time the index was negative was in October of 2016.  In the details, there was broad-based weakness in the report.  The key new-orders index plunged 21.7 points to -12, shipments fell 6.6 points to 9.7, while the index of future activity fell 4.9 points to 25.7.  Josh Shapiro, chief U.S. economist at MFR Inc. stated the Empire State index result “was shockingly weak, raising a caution flag about the prospects for other manufacturing data later in the month.”

In the Philadelphia region, manufacturing conditions tumbled to just barely positive in June after registering a four-month high the previous month.  The Philadelphia Fed reported its manufacturing activity index came in at just 0.3—down from 16.6 the prior month.  In the details, the components declined in June, but remained in positive territory.  The new orders index fell 2.7 points to 8.3, while shipments dropped 11 points to 16.6.  The current price index plunged 17 points to just 0.6—its lowest reading since October of 2016.  However on a positive note, 49% of firms surveyed expected acceleration in the growth rate of production in the third quarter. 

In a move that was widely expected, the Federal Reserve left its key interest rate unchanged and signaled it is unlikely to cut borrowing costs for the rest of the year.  However, the central bank also left itself plenty of room to maneuver by removing its pledge to be “patient” and stated it would “closely monitor” the economy in light of waning inflation and growing “uncertainties”.  At the conclusion of its two day meeting the Fed held its benchmark fed funds rate steady between 2.25% and 2.5%, noting that the labor market “remains strong” and the economy continues to expand at a “moderate” pace.  Inflation has tapered off and is running below the 2% level that the Fed considers healthy for the economy.  The central bank has now cut its forecast for inflation in 2019, using its preferred gauge, to 1.5% from 1.8% — well below its 2% target.  In addition, the Fed indicated if the economy weakens significantly or inflation continues trending lower, the Fed would be prepared to act.  “The FOMC will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion,” the Fed said in a statement, dropping its recent buzzword about being “patient.”

International Economic News:  While recent data suggests the U.S. economy appears to be slowing, Canada’s economy is showing renewed strength.  Inflation in Canada rose 2.4% in May from the same time last year, according to Statistics Canada, a 0.4% increase from the previous month.  In addition, Statistics Canada reported the price increases were broad-based with increases in all 8 of its major categories.  The largest increase was in the price of food, led by a 16.7% spike in the cost of fresh vegetables from a year ago, as well as a 2.9% increase in the price of meat.  Canada’s core inflation rate came in at 2.1%, the highest on record since 2012.  The strong inflation reading means the Bank of Canada may be less likely to hike its own benchmark interest rate when it meets to set policy next month.

The Bank of England’s nine-member Monetary Policy Committee (MPC) voted unanimously to leave its interest rates on hold at 0.75%, while it cut its growth forecast to zero.  The Bank of England warned economic growth in Britain could grind to a halt during the second quarter amid mounting risks to the economy from a “no-deal” Brexit.  Warning that downside risks to growth had increased as the threat of crashing out of the EU without a deal has risen, it said that companies expect uncertainty would persist and that there were no clear signs that firms would increase investments in Britain.  In the first quarter, GDP was boosted by a rush to build up emergency supplies of goods and raw materials prior to the original Brexit deadline of March 29th.  However, some companies are now running down those stockpiles as the deadline is now delayed until the end of October—a move that will likely weigh on economic growth in the future.

French President Emmanuel Macron is preparing to cut the country’s unemployment benefits as the French leader seeks to renew his economic overhauls following months of often violent “yellow-vest” protests.  The government said it planned to issue a decree next month capping the amount people can claim in unemployment benefits and extending the period people must work to qualify for the aid.  The government will also increase payroll taxes on companies that use too many short-term contracts—a practice the government blames for creating an underclass of “precarious” workers.  Macron appears to be seizing the opportunity to resume his economic overhauls as public support for the yellow-vest protest movement dwindles.

In the latest worrying sign for Europe’s largest economy, Germany saw its manufacturing downturn continue into June.  IHS Markit reported its manufacturing Purchasing Managers Index (PMI) for Germany was higher than in May, but the sector still contracted for the fifth consecutive month.  Activity in the services sector edged higher, however, rising slightly to 55.6 from 55.4 in May.  The results left the composite PMI index unchanged at 52.6.  The latest numbers suggest an easing in the decline rather than a complete return to growth.  Trevor Balchin, Economics Director at IHS Markit, said: “Service sector growth remains above-trend and although the manufacturing downturn continued into June, there are tentative signs that the worst has passed.”  After a modest expansion of 0.4% in the first quarter of 2019, the German government has slashed its growth forecast for the full year to just 0.5%.

Japan’s government left its assessment of the economy unchanged after revising it down twice in the past three months.  “Japan’s economy is recovering at a moderate pace, while weakness in exports and industrial production continues,” the government said in the June report.  The economy expanded an annualized 2.2% in the first quarter due to robust capital spending, though analysts expect trade tensions to remain a drag on growth.  The government’s plan to raise the sales tax to 10% from 8% in October could also hurt consumption at a time overseas headwinds weigh on exports, some analysts say.

Finally, since 2010 the United States and China have had the world’s largest economies by GDP.  The U.S. is the world’s largest importer, while China is the world’s biggest exporter.  Although most Americans know that the U.S. runs a trade deficit with China, surveys show that relatively few know just how big the trade deficit is or how fast it has been growing.  As the chart shows, every year from 2009 to 2018 the U.S. has imported far more goods from China than it has exported to China.  The trade deficit has grown in 9 of those 10 years and has almost doubled in that time.  (Chart from howmuch.net)

(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 ("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 slipped slightly to 9.75 from the prior week’s 9.50, and the average ranking of the Offensive DIME sectors slipped slightly to 14.00 from the prior week’s 13.75.  The Defensive SHUT sectors’ lead over Offensive DIME sectors is unchanged.  Note: these are “ranks”, not “scores”, so smaller numbers are higher ranks and larger numbers are lower ranks.

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Fig. 5

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