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Blog

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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:

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.

Fig. 1

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 27.68, down from the prior week’s 27.99, and now exceeding 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).

Fig 2

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 60.30, down from the prior week’s 62.01.

Fig. 3

In the intermediate and Shorter-term picture:

The Shorter-term (weeks to months) Indicator (see Fig. 4) turned positive on November 10th.  The indicator ended the week at 29, unchanged from the prior week.  Separately, the Intermediate-term Quarterly Trend Indicator – based on domestic and international stock trend status at the start of each quarter – was positive entering January, indicating positive prospects for equities in the first quarter of 2017.

Fig. 4

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.  In the intermediate timeframe, the Quarterly Trend Indicator (months to quarters) is positive for Q1, and the shorter (weeks to months) timeframe (Fig. 4) is positive.  Therefore, with all three indicators positive, the U.S. equity markets are rated as Very Positive.

In the markets:

Stocks declined in light trading over the holiday shortened week.  Having neared the closely watched 20,000 level the previous week, the Dow Jones Industrial Average fell -171 points to record its first weekly loss since early November, down -0.86% to 19,762.6.  The tech-heavy NASDAQ Composite had its first down week in 4, falling ‑1.46% to 5,383.  The LargeCap S&P 500 index retreated -1.1%, while MidCaps and SmallCaps fell ‑0.78% and ‑1.05%, respectively.  Utilities and Transports were both negative, with Transports falling -1.6% and the defensive Utilities ended down only -0.18%.

In international markets, Canada’s TSX gave up a portion of last week’s gains by falling ‑0.26%, while the majority of European markets rose for the week.  The United Kingdom’s FTSE 100 gained +1.06%, along with France’s CAC 40 that added +0.47%.  Germany’s DAX notched its fourth straight week of gains by adding +0.27%, but Italy’s Milan FTSE was unable to add a sixth week of gains, retreating‑0.57%.  In Asia, China’s Shanghai Composite fell ‑0.21%, while Japan’s Nikkei retreated ‑1.6% after seven straight weeks of gains.  Hong Kong’s Hang Seng rebounded +2% after two weeks of losses.  As a group, emerging markets (as measured by the MSCI Emerging Markets Index) rose +2.13%, while developed markets (as measured by the MSCI Developed Markets Index) gained +0.09%.

In commodities, Gold had its first up week after 7 consecutive weeks of losses, rising +$18.10 to $1,151.70 an ounce.  Silver also rose for the week, up +1.46% to $15.99 an ounce.  In energy, West Texas Intermediate crude oil continued to break out of the last 6 month’s $50 a barrel range, rising $0.70, or 1.32%, to $53.72 a barrel.  Overall, the Commodity Research Bureau’s CRB Index was up +1.04% for the week.

The month of December was positive for all U.S. equity indexes.  The Dow showed the way, up +3.34%, SmallCaps and MidCaps followed with gains of +2.63% and 2.03%, LargeCap S&P 500 returned +1.82% and the NASDAQ comp trailed the pack with a gain of +1.12%.  The MSCI Developed Markets Index did well, too, up +2.7%, but the MSCI Emerging Markets Index trailed with a negative return of -0.26%.

The fourth quarter of 2016 showed a wide disparity in returns among U.S. and international indexes.  SmallCaps rocketed +8.43%, narrowly beating out the Dow which returned +7.94%.  Not too far behind was the MidCap index, which gained +6.98%.  However, the LargeCap S&P 500 lagged behind at +3.25%, and the NASDAQ Composite eked out a minor gain of +1.34% (the narrower NASDAQ 100 was actually negative for the fourth quarter, losing -0.25%).  International indexes ran far behind the U.S. for the quarter.  The MSCI Developed Markets Index fell -1.35%, and the MSCI Emerging Markets Index dropped -5.46%.  Gold was the largest casualty of the quarter, losing almost -13% – largely a victim of the strengthening post-election dollar.

2016 again showed the futility of predictions – particularly in investing and politics.  Virtually no one predicted the election of President-elect Trump, and absolutely no one predicted the market’s post-election response.  Investors who acted on actual data did fine, but those acting on the vast majority of predictions did poorly.  In the U.S., SmallCaps led the way with a gain of +19.48%, followed closely by MidCaps at +18.73%.  The Dow was also in double digits, rising +13.42%.  The LargeCap S&P 500, with a gain of +9.54%, returned half that of SmallCaps.  Bringing up the rear for 2016 was the NASDAQ Composite with a rise of “only” +7.5%.  International markets were mixed for 2016.  The MSCI Emerging Markets Index gained +9.9%, but the MSCI Developed Markets Index lost ‑0.7%.  Major international markets were bracketed at the upper end by the U.K., which gained +14.4%, and at the lower end by China’s Shanghai market, which lost -12.3%.  The U.S. has been much stronger than non-U.S. markets for the past 5 years; for example, the broad FTSE Global All-Cap ex-US Index has still not yet exceeded its peak of 2007, in contrast to the U.S. which has forged ahead to numerous new highs in that period.

In U.S. economic news, the number of Americans who applied for unemployment benefits last week fell back to the extremely low levels that have been the norm for much of the year.  Initial claims for unemployment fell last week by 10,000 to 265,000.  Initial claims have remained below the key 300,000 level for 95 straight weeks, the longest streak in 46 years.  With the unemployment rate below 5%, businesses have reported having a difficult time finding skilled workers.  The less-volatile 4-week moving average of claims fell 750 to 263,000.

Demand in the housing market continues to be the strongest in years, according to the latest S&P Case-Shiller national home price index reading.  U.S. home prices hit a new peak in October, up +5.6% from a year earlier and setting another new high from the previous month.  In addition, all 20 cities in the Case-Shiller 20-city home price index saw annual home price increases, and 15 out of the 20 also posted month-over-month increases.  Seattle, Portland, and Denver posted the largest year-over-year price gains, with Seattle and Portland rising over +10%, and Denver up +8%.  David Blitzer, managing director and chairman of the Index Committee at S&P Dow Jones Indices warned that the current pace of growth can’t continue forever writing, “Home prices and the economy are both enjoying robust numbers.  However, mortgage interest rates rose in November and are expected to rise further as home prices continue to out-pace gains in wages and personal income.”  The home price index tracks prices on a rolling three-month average.  October’s reading represents the three-month average of August, September, and October prices.

The National Association of Realtors’ (NAR) Pending Home Sales Index fell ‑2.5% in November to a seasonally-adjusted 107.3.  The index measures homes under contract that have not yet closed.  Despite the fall, the NAR noted that the reading still marked the index’s 31st straight month above its baseline reading of 100.  The baseline reading is the rate at which homes went to contract in the year 2001, the first year in which the index was published and itself a good year for U.S. housing.  Therefore, the current reading is seen as “exceptional” by the NAR, despite the drop.  By region, pending home sales were mixed.  The Northeast region was up +5.7% from the prior year, while the Midwest region declined -2.4%, and the South and West regions were each down ‑1%.

Confidence among American consumers surged in December to 113.7, reported the Conference Board – the highest level since 2001.   Lynn Franco, the Conference Board’s director of economic indicators, attributed the strong reading to a “post-election surge in optimism for the economy”, citing strong jobs and income prospects, all-time highs in the stock market, and a new President and administration.  The present situation index, which measures Americans’ current confidence, fell almost -6 points to 126.1, but that’s still near its highest level in 9 years.  A measure of expectations over the next six months rose over +10 points to its highest level since 2003.  Stephen Stanley, chief economist at Amherst Pierpont Securities said, “The election of Donald Trump has raised household expectations for the economy to a very high level.  It remains to be seen whether Trump can deliver, but the ground would certainly appear to be ripe for a pickup in consumer spending based on this confidence data.”

In the Windy City, manufacturing activity fell more than expected in December, retreating from last month’s highest reading since January of 2015.  The Institute for Supply Management (ISM) said its index decreased ‑3 points to a seasonally-adjusted 54.6 this month.  Analysts had expected only a ‑0.6 point drop.  In the details of the report three out of the five components decreased.  New orders led the decline, losing ‑6.7 points to 56.5, while employment and supplier deliveries components remained positive.  Economist Jamie Satchi reported, “Most firms are upbeat going into 2017 and believe new and better things are to come under the new administration.”

The U.S. trade deficit increased +5.5% last month to a seasonally adjusted annual $65.3 billion, according to the Commerce Department.  A stronger U.S. dollar could weigh on U.S. exporters, as the dollar has surged +5% since Trump’s victory.  Imports rose +1.2% to $187 billion, while exports were up +1% to $121.7 billion.  This difference between imports and exports is known as the “trade gap”.  Economists suggest that Trump’s proposals will lead to wider budget deficits which may trigger higher inflation and interest rate increases by the Federal Reserve.

In Canada, the U.K.’s Centre for Economics and Business Research had some bad news for Canadians.  In a new report, the group stated Canada’s economic growth is set to flatline at 2% or less per year over the next 15 years, leading the country to lose ground in the ranking of the world’s economies.  The forecasts call for Canadian GDP growth of just +1.8%/yr. from 2016-2020, then +2%/yr. growth from 2021 to 2030.  The group is concerned with Canada’s public sector deficit which has risen to 2.5% of GDP, and its gross debt as a percentage of GDP of 92%.

Across the Atlantic, Britain’s corporate finance chiefs are more optimistic about the future than at any point over the past 18 months, according to a survey of chief finance officers by Deloitte.  Overall companies remain cautious about launching big new investments, but their appetite for hiring is rebounding.  Ian Stewart, Deloitte’s chief economist stated, “The economy has accelerated in the second half of the year and is stronger than people expected even before the referendum, so I think the resilience of the economy has boosted that measure of confidence.”  Deloitte’s optimism index, which measures the proportion of CFO’s who are more optimistic than they were three months ago turned positive for the first time since the middle of last year.

On Europe’s mainland, German industry leaders warned in 2017, to “expect the unexpected”.  The leaders of the German Industry Association (BDI), the Chamber of Commerce (DIHK) and the Employers’ Association all expressed fears about uncertainties, especially surrounding elections in Germany and France, and protectionist trends in other countries.  In addition, BDI President Ulrich Grillo stated “The level of global uncertainty has increased as has the unpredictability. Unfortunately I fear that won’t change very much in 2017.”

In Italy, the world’s oldest and very troubled bank Monte dei Paschi di Siena (BMPS) said that the European Central Bank (ECB) has called for it to receive a bailout of $9.2 billion.  The BMPS’ reported need for recapitalization was over 3 billion euro more than previously thought necessary.  BMPS cited letters from the ECB to the Italian Ministry of Finance and Economy indicating that the results of 2016 stress tests showed the capital needs of BMPS at €8.8 billion.  The ECB also noted that the bank’s liquidity had deteriorated between November 30th and December 21st.  According to the Italian economic newspaper Il Sole 24 Ore, the Italian government will need to invest some six billion euros in the lender and the rest would be raised through the forced conversion of bonds into equity.  “With these figures, the bank will in effect be nationalised, given that the state will own more than 67 percent,” the newspaper calculated.

China’s state news agency Xinhua reported China will meet its growth target of +6.5 to +7% this year, adding that the country’s stable growth will be reassuring to a “weak and vulnerable” global economy.  Xinhua noted that unlike other countries, China has the flexibility to defend against sharp economic decline as it restructures its economy toward consumption and services.  Chinese officials are confident in the country’s economy, says Xinhua, saying the positive trends of this year will continue into next year.

In Japan, the stagnant economy may finally be showing some tangible signs of life.  Factory output data released by Japan’s trade ministry shows signs of economic recovery.  Industrial production grew by +1.5% this month over November.  That followed a +0.6% gain in September and a flat reading in October.  In addition retail sales increased, while inventories dropped for three straight months.  The data supports the Bank of Japan’s view that growing global demand will support a steady improvement in the economy.  Takeshi Minami, chief economist at Norinchukin Research Institute stated, “While domestic demand still lacks strength, a pick-up in exports is driving up production.  Output will likely continue recovering moderately ahead.”

Finally, a major part of American belief is that each generation should do a bit better than the preceding one.  The Census Bureau released data this past week showing that on several measures, millennials are well behind the preceding generation.  The Census Bureau compared today’s 30-year-olds with 30-year-olds of 1975, revealing that millennials are less likely to have reached many of the milestones of adulthood than their 1975 counterparts.  In 1975, 75% of 30-year-olds had married, had a child, were not enrolled in school, and had lived on their own.  In 2015, just 33% could make that claim.  In addition, a survey by Washington D.C.-based think tank Pew Research Center showed that living with parents is now “the most common young adult living arrangement for the first time on record” and that millennials are less likely to be married by the time they are 34 than any previous generation.  One possible major cause for the delay in reaching these milestones may be student loan payments.  In a survey from bankrate.com, more than 56% of millennials said they have delayed a major life event because of their student loan debt.  The following chart, from marketwatch.com, details these “milestone” discrepancies.

(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)

Fig. 5

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

*****************************************************

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.

fig-1

Fig. 1

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 26.90, nearly unchanged from the prior week’s 26.86, and only a little lower than 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).

Fig 2

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 63.77.

fig-3

Fig. 3

In the intermediate picture:

The Intermediate (weeks to months) Indicator (see Fig. 4) turned positive on June 29th.  The indicator ended the week at 31, unchanged from the prior week.  Separately, the Quarterly Trend Indicator – based on domestic and international stock trend status at the start of each quarter – was positive entering October, indicating positive prospects for equities in the fourth quarter of 2016.

fig-4
Fig. 4

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 Q4, and the Intermediate (weeks to months) timeframe (Fig. 4) is also positive.  Therefore, with all three indicators positive, the U.S. equity markets are rated as Very Positive.

In the markets:

Stocks finished the week modestly higher for the most part, but the tepid numbers masked the high day-to-day volatility.  The Dow Jones Industrial Average experienced triple digit moves every day of the week, ending with a +164 point rally on Friday to close at 18,308, but ended up just +0.26% for the week.  The NASDAQ Composite was likewise modestly higher for the week, adding just +0.12%.  The LargeCap S&P 500 index gained +0.17%, the S&P 400 MidCap index rose only +0.09% and the SmallCap Russell 2000 index fell -0.24%.

In international markets, Canada’s TSX rose +0.19% but elsewhere markets were mostly in the red.  The United Kingdom’s FTSE was off slightly, down -0.15%.  On the mainland, France’s CAC 40 was off -0.9%, Germany’s DAX fell -1.09%, and Italy’s Milan FTSE was down -0.32%.  In Asia, China’s Shanghai Composite fell -0.96%, along with Japan’s Nikkei which ended down -1.8%, and Hong Kong’s Hang Seng index lost -1.64%.  Broadly speaking, developed countries were down -0.22% while emerging markets were down -0.48%, as measured by the ETFs EFA and EEM.

Commodities were mixed for the week.  Precious metals lost some of their shine, as gold ended the week down ‑1.8% to $1,317.10 an ounce, and silver fell -3% to $19.21 an ounce.  Oil had a strong week, with the price of a barrel of West Texas Intermediate crude oil surging +8.45% to $48.24.  The industrial metal copper was also positive, up +0.43%.

The month of September saw modest moves among U.S. stock indexes.  The Dow Industrials, the LargeCap S&P 500, and the MidCap S&P 400 were all down less than -1% for the month (-0.50%, -0,12%, and -0.80% respectively) , while the SmallCap Russell 2000 and the NASDAQ Composite were both positive for the month (+0.95% and +1.89%, respectively).  International markets outstripped U.S. markets for September.  Developed International, represented by the ETF EFA, gained +1.34% and the best performance came from Emerging Markets, represented by the ETF EEM, rising +2.52%.

The third quarter saw gains in stock markets around the world.  The Dow Jones Industrial Average gained +2.1%.  That gain was eclipsed by a +9.7% surge in the NASDAQ composite.  The LargeCap S&P 500 index added +3.3%, while the S&P 400 MidCap index rose +3.7%, and the SmallCap Russell 2000 vaulted +8.7%.  Canada’s TSX rose +4.7%.  Developed International, represented by the ETF EFA, added +5.93%, and Emerging Markets, represented by the ETF EEM, added a handsome +8.99% for the quarter.

In U.S. economic news, applications for unemployment benefits rose slightly to 254,000 last week, according to the Labor Department.  The number remains below the 300,000 threshold that economists use to indicate a healthy labor market.  Initial claims first fell below 300,000 last year and have remained there for 82 straight weeks.  In addition, new claims have numbered less than 270,000 for 3 months, an event not seen since 1973.  The economy has added an average of 182,000 new jobs per month this year and the unemployment rate is at 4.9% – an 8-year low.

Sales of new homes fell in August, but the reading was the second-highest since the end of the Great Recession.  According to the Commerce Department, sales of newly constructed homes ran at a seasonally-adjusted 609,000 annual rate exceeding economist forecasts of 600,000.  At the current sales pace, there is a 4.6 month supply of homes available.  The median sales price last month fell to $284,000, the lowest since September 2014 and -5.4% below year-ago levels.  The lower median sales price is welcome news to a market short on affordable housing, and indicates more sales in the lower half of home prices.  In August, Richard Moody, chief economist at Regions Financial noted that homes priced in the upper half ($300,000 or above) made up 44% of all sales—the lowest since February of 2014.

Pending home sales, which tracks real estate transactions in which a contract has been signed but the deal has not closed, fell -2.4% to 108.5 last month.  It was the lowest reading in 7 months.  The National Association of Realtors stated that without more inventory, the housing recovery ‘could stall’.    Economists had forecasted a gain of +0.5%.  Of all the regions, only the Northeast saw an increase, up +1.3%.  It was also the only region in which the index reading was higher than its level this time last year.

Home prices in the Pacific Northwest saw the biggest gains according to the latest numbers from the S&P CoreLogic Case-Shiller home price index.  Overall, house prices were up +0.6% in July and +5.0% from this time last year.  Portland and Seattle led the 20-city index with the greatest annual price increases of +12.4% and +11.2%, respectively.  One notable change was the formerly white-hot market of San Francisco, which was essentially flat for the month.  San Francisco has had double-digit annual price increases for quite some time, but that appears to be moderating.  Overall, the Case-Shiller National Index is near its high previously set in 2006.

In U.S. manufacturing, orders for durable goods (items expected to last at least 3 years) stagnated following a strong July reading.  Orders fell -22% for large commercial aircraft, a volatile category that frequently exhibits large swings in orders received.  Stripping out transportation, orders were down just -0.4%, according to the Commerce Department.  Demand for heavy machinery, electrical equipment, and computers all declined.  Shipments of core capital goods, a category used in the calculation of GDP, fell -0.4%, which was its fourth straight decline.  However, on a more positive note, orders for core capital goods rose +0.6%, its third straight increase.  Orders for core capital goods are frequently considered a proxy for business investment.

In Chicago, the Chicago regional Purchasing Managers Index (PMI) rose +2.7 points to 54.2 in September.  The gains were led by an improvement in production, which was up +7.3 points to the highest level since the beginning of the year.  PMI readings above 50 indicate improving conditions.

Consumer sentiment improved in September according to the University of Michigan’s index which showed a gain in September to 91.2, up +1.4 points.  Households with incomes over $75,000 were responsible for the gain.  On an annual basis, however, the trend has been basically flat as September’s number was the same as September 2015’s number.

Americans were the most optimistic about the economy since the summer of 2007 according to the Conference Board’s Consumer Confidence index.  The index climbed to 104.1 this month, up +2.3 from August.  Consumers were more upbeat about the strong labor market, in which the unemployment rate has held below 5% and millions of people have been added to payrolls.  In addition, a shortage of skilled labor has forced companies to raise wages.  Lynn Franco, director of economic indicators at the Conference Board stated, “Consumers’ assessment of present-day conditions improved, primarily the result of a more positive view of the labor market.”  The present situation index, which measures current conditions, climbed to 128.5, up +3.2 points.  That measure is also at its highest level since August of 2007.  Analysts note that the rise in confidence could benefit the incumbent Democratic Party in the upcoming presidential election.

However, American’s rising confidence in the economy wasn’t reflected in consumer spending, which was barely changed in August according to the Commerce Department.  A decline in sales of cars and trucks failed to offset an increase in services such as education and health care.  The flat reading for August was the weakest since March and missed estimates of a +0.2% gain.  Factoring in inflation, spending actually fell slightly in August.  Incomes rose only +0.2% in August, the smallest increase in 7 months.  The slower spending and modest growth in income did appear to have a positive impact on personal savings, however, which rose +0.1% to 5.7% for the typical consumer, a 3-month high.

Inflation as measured by the Personal Consumption Expenditure Index (PCE) rose +0.1% in August, according to the Commerce Department.  The so-called “core” rate of inflation that strips out the volatile categories of food and energy increased +0.2%.  The PCE index, the preferred Federal Reserve inflation barometer, rose 1% over the last 12 months as of the end of August.  It rose +0.2% from July.  Annualized core inflation was up +1.7%.  At this point, inflation remains below the 2% target desired by the Federal Reserve—one reason that the Federal Reserve has been reluctant to raise interest rates.

Second quarter GDP rose +0.3% from earlier estimates to 1.4% as business investment in the second quarter was actually much better than had been previously reported.  The improvement in GDP reflected stronger investment by companies than earlier government estimates showed.  Investment excluding housing actually rose +1% instead of falling -0.9%, as previously reported.  Excluding mining and drilling, investment was up a solid +10% in the second quarter.  The all-important American consumer continues to be the growth engine of the economy.  Consumer spending accounts for about 2/3’s of the economy and consumer spending increased +4.3% in the second quarter.  Loretta Mester, president of the Cleveland Federal Reserve, stated “Based on incoming data, growth is poised to rebound in the second half of the year.”

The Canadian economy grew +0.5% in July, according to Statistics Canada, predominantly due to a rebound in oil and gas production.  Activity in the oil and gas extraction and mining sectors was up +3.9% from June.  The goods-producing sector of the economy rose +1% while the services side increased +0.3%.  Economists had expected a gain of only +0.3%.  Toronto Dominion (TD) bank economist Brian DePratto said “Today’s report points to a healthy, if somewhat artificially boosted, economic momentum for the third quarter. We are currently tracking economic growth of roughly 3.0 per cent for the third quarter.”

According to the UK Office for National Statistics (ONS), Britain’s economy was stronger than previously thought leading up to the EU referendum. The ONS figures suggested that the economy had a decent start in the third quarter, with the services sector (which accounts for almost 80% of the UK economy) growing by +0.4% in July.  According to the ONS there was no sign that Britain leaving the EU triggered any immediate shock to the economy.  Economists largely agree that Britain will almost definitely avoid a recession this year, but that in 2017 the economy could slow down due to uncertainty.

In France, the Labor Ministry said the number of jobless people registered as out of work rose 50,200 to 3.5 million, an increase of +1.4% from July.  The increase was the steepest since late 2013 and brought the total closer to the record 3.59 million set in February.  Labor Minister Myriam El Khomri said the tourism sector suffered after a terrorist attack in the city of Nice that killed 86 people.  French President Francois Hollande has given hints that he intends to run for re-election, but only if unemployment could be brought down.  The latest increase is another blow to Hollande’s bid for re-election amid a term marred by low growth and high unemployment.

In Germany, all eyes have been on Deutsche Bank as questions have arisen regarding its liquidity position following multi-billion dollar judgements against the company in the United States and its derivatives exposure.  Deutsche Bank is the region’s biggest investment bank.   In addition, German car-manufacturer Volkswagen also faces multi-billion dollar fines in the United States related to an emissions issue.  Together the two companies employ more than 700,000 and further weakening of these two major companies would impact growth in Germany and around the world.  Horst Loechel, economics professor at the Frankfurt School of Finance and Management stated, “With two heavy-weights shaking, that could lead to a setback in consumption and investment.”  Deutsche Bank (symbol DB) shares hit a record low Thursday.

The World Trade Organization cut its forecast for global trade growth this year by more than a third, prompting China’s Commerce Ministry to declare that China’s economic fundamentals are sound and it remains a contributor to global growth.  China’s growth target for this year is 6.5-7%.  Last quarter, the world’s second largest economy grew 6.7% from a year earlier, according to official data.  Imports and exports both showed improvement last month.  Imports were boosted by demand for coal and other commodities, and exports fell less than expected, down -2.8%, as demand in the United States, Europe and Japan was firmer than predicted.

Japanese Prime Minister Shinzo Abe pledged Monday to accelerate his policies to support Japan’s economic recovery and to speed up approval of the Trans-Pacific Partnership trade pact.  In his policy statement, Abe outlined stimulus measures to help the recovery and spur more consumer and corporate spending.  His proposal tacked on an additional 28 trillion yen ($2.8 billion) to the group of economic stimulatory measures that have become commonly known as ‘Abenomics’.

Finally, when asked to name the most unaffordable place to live in the United States, you would be forgiven for declaring locations like Maui, San Francisco, or the Napa Valley.  But the answer is…..Brooklyn, NY.  A person earning the average salary in Brooklyn cannot come close to affording to buy the average home there, according to a study by real estate data company ATTOM Data Solutions.  The study looked at home sales price data in 414 of the most populous counties in the U.S. and corresponding wage data from the Bureau of Labor Statistics.

Home sale prices were compared to average wages in each locale to create a scale of “Home Prices as % of Average Local Wages”.  For comparison, the U.S. Department of Housing and Urban Development recommends a maximum of 30% of household income should be spent on housing or one runs the risk of having “difficulty affording necessities such as food, clothing, transportation, and medical care.”  The chart below lists the 10 most unaffordable places to live in America, and by that Department of Housing and Urban Development yardstick, homebuyers there must be going without food, clothing, transportation and medical care!

itm

(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)

fig-5

Fig. 5

*****************************************************

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

*****************************************************

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.

Fig 1

Fig. 1

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 26.17, up from the prior week’s 25.35, after having earlier reached the level also 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).

Fig 2

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) turned negative on January 15th, and remains in Cyclical Bear territory at 53.66, up from the prior week’s 50.56 and very close to the Bull level of 55.

Fig 3

Fig. 3

In the intermediate picture:

The Intermediate (weeks to months) Indicator (see Fig. 4) turned positive on June 29th.  The indicator ended the week at 20, down from the prior week’s 28, after a violent drop to 18 followed by a rebound that turned it positive.  Separately, the Quarterly Trend Indicator – based on domestic and international stock trend status at the start of each quarter – gave a positive indication on the first day of July for the prospects for the third quarter of 2016.

Fig 4 Fig. 4

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 may have arrived.   The Quarterly Trend Indicator (months to quarters) is positive for Q3, 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:

U.S. stocks traded higher for a fourth consecutive day Friday, with the S&P 500 regaining almost all of the Brexit-related declines.  All major U.S. indexes were up, with the Dow Jones Industrial Average, rallying +548 points to 17,949, a healthy gain of +3.15%.  The tech heavy NASDAQ composite and LargeCap S&P 500 notched gains of +3.2%.  MidCaps and SmallCaps were not quite as strong, with the S&P 400 MidCap index gaining +2.92% and the Russell 2000 SmallCap index rising +2.59%.  Despite the “risk-on” nature of the week, even the defensive Dow Utilities index rallied over +4.4%.

In international markets, Canada’s Toronto Stock Exchange rose +1.24% on the heels of renewed strength in energy.  In Europe, the United Kingdom’s FTSE surged +7.15% to reach its highest level in a year, confounding doomsayers by exceeding pre-Brexit highs.  On the mainland, France’s CAC 40 rose +4.07%, Germany’s DAX gained +2.29%, and Italy’s Milan FTSE added over +3.6%.  In Asia, China’s Shanghai Composite Index added +2.7%, Hong Kong’s Hang Seng rose +2.64%, and Japan’s Nikkei surged +4.89%.

In commodities, precious metals continued to shine, with silver surging over +11.4% to $19.86 an ounce.  Gold gained +$25.80 ending the week at $1,344.90 an ounce, up +1.96%.  Oil continued its rise nearing the $50 a barrel mark, up 3.59% to $49.28 a barrel for West Texas Intermediate crude oil.  The industrial metal copper surged over +4.89%.

The month of June was tumultuous, to say the least, but the whole-month results were almost boring.  In the U.S., the worst performing index was the NASDAQ Composite, at -2.13%, while all other U.S. indices were within the narrow range of flat plus or minus 1% – remarkable given all the late-month volatility: LargeCap S&P 500 +0.09%, Dow Jones Industrial +0.80%, MidCap S&P 400 +0.23%, SmallCap Russell 2000 -0.23%.  International indexes were both the best and the worst: Developed international markets (EFA) lost -2.42% while Emerging International markets (EEM) gained +4.56%.  The shiniest return for June was in Gold, which gained +8.47%.

For the Second Quarter, the MidCap S&P 400 paced U.S. indexes with gains of +3.55%, the SmallCap Russell 2000 not far behind at +3.40%, the LargeCap S&P 500 positive at +1.90%, the Dow Jones Industrials positive at +1.38%, but the Nasdaq Composite was negative at -0.56%.  Canada’s TSX enjoyed a strong quarter at +4.22%, much better than both Developed International (EFA) at -0.34% and Emerging International (EEM) at +1.11%.  The biggest gusher of the quarter was oil, returning +16.85!

In U.S. economic news, initial jobless claims rose by 10,000 to 268,000 last week, exceeding economists’ forecasts of 265,000.  New claims remained below the benchmark 300,000 mark for the 69th straight week, the longest streak of sub-300,000 since 1973.

U.S. house prices, according to the S&P/Case-Shiller 20-City Index, were up +5.4% versus a year earlier.  As usual, there was sharp division among metro areas.  Super-hot metro areas like Portland, Seattle and Denver continue to see double-digit annual price gains, while home prices in legacy cities like New York and Washington rose only +2%.  None of the 20 cities showed a decline last month.  Nationally, prices are still about 11% lower than the peak in 2007, although 7 of the 20 cities have notched new highs.

Home sales, on the other hand, posted their first annual decline in nearly 2 years, due in part to a tighter home inventory.  The National Association of Realtors’ index fell -3.7% to 110.8 in May, from a downwardly-revised 115.0 in April.  Economists had forecasted a 1.0% decline.  The Realtors index forecasts future sales by tracking transactions in which a contract has been signed, but not yet closed.  NAR chief economist Lawrence Yun blamed the decline on an increasingly tight inventory rather than waning interest.  “There are simply not enough homes coming onto to the markets to catch up with demand and to keep prices more in line with inflation and wage growth,” he wrote.

Consumer confidence rose to an eight-month high in June as Americans became more optimistic about the economy, according to The Conference Board.  The “Confidence Index” subcomponent rose to 98 last month, beating forecasts by 4.5 points.  The “Consumer Expectations Index” for the next 6 months climbed to a five-month high of 84.5, up +6 points.  The “Present Conditions Index” also advanced to 118.3, the second strongest reading since the fall of 2007.  Respondents to the survey said they anticipated more job and income gains in the coming 6 months, which should help lift spending after the first-quarter slowdown.

Personal spending moderated in May following April’s strong +1.1% rise.  The Commerce Department reported that spending by Americans’ rose +0.4% in May, matching analyst expectations.  Incomes climbed less-than-expected, up 0.2%.  Jim O’Sullivan, chief U.S. economist at High Frequency Economics stated “The pick-up in consumption is a big plus for [second quarter] GDP growth.”  Purchases rose +0.3% in May after a +0.8% increase in April.  Durable goods spending (items meant to last more than 3 years), climbed +0.6% after adjusting for inflation following April’s +2.6% advance.  Non-durable goods spending rose +0.5%.  Ex-food and energy, the price measure rose +0.2%, matching expectations, and is up +1.6% year-over-year through the end of May.

An indicator of economic activity in the Chicago-area surged in June, as a greater number of purchasing managers signaled improving production and new orders.  The Chicago Purchasing Managers Index (PMI) rose to 56.8, up +7.5 points into expansion (>50) territory.  The new orders sub-index rose to the highest level since fall of 2014, and order backlogs were the strongest since spring of 2011.  For the 2nd quarter as a whole, the Chicago PMI index fell -0.1 point to 52.2.

National U.S. manufacturing grew at the fastest pace in over a year according to the Institute for Supply Management (ISM) manufacturing index, which jumped to 53.2% in June from 51.3%.  The ISM reading is back to its highest level since February of 2015.  U.S. manufacturers are on their fourth straight month of growth following five months of negative readings (which was the weakest stretch since the Great Recession).  Companies have benefitted from recent mild weakness in the value of the U.S. dollar, which makes their goods cheaper overseas.  The ISM new orders gauge also increased to a 3-month high of 57% in June, up +1.3% from May.  The ISM report agreed with the Purchasing Managers Index (PMI) of national manufacturing conditions, which also hit a 3-month high in June, rising to 51.3 from 50.7.

Canada’s economy rebounded +0.1% in April, in line with analysts’ forecasts.  According to figures from Statistics Canada, the economy grew at +0.1% in April following a decline the previous month.  Economic output improved in the manufacturing and service sectors, but the important mining and oil and gas extraction segments continued to fall, putting a drag on overall gross domestic product.  Manufacturing rose by +0.4% for the month and +1.4% in the last year, driven mainly by transportation equipment manufacturing and primary metal manufacturing.

In the United Kingdom, Bank of England Governor Mark Carney warned that further stimulus measures may soon be needed for the United Kingdom, following the country’s vote to leave the European Union.  In a speech at the Bank of England in London he stated “the economic outlook has deteriorated and some monetary policy easing will likely be required over the summer.”  Some good news was also revealed, as the UK’s PMI manufacturing index increased to a five month high of 52.1 for June, up from 50.4 the previous month.  The International Monetary Fund said that Britain’s exit from the EU poses a “downside risk” to Germany’s economic outlook and that it may lower growth forecast for Europe’s biggest economy in the coming weeks.  The IMF’s mission chief for Germany Enrica Detragiache stated that “Britain is an important trade partner for Germany, and significant changes in the economic relationship between the two countries will have repercussions for Germany.”

In Asia, Chinese stocks posted their biggest weekly gain in a month as investors bet that China’s central bank would loosen monetary policy to cushion a possible drop in European demand for Chinese exports resulting from the Brexit vote.  In manufacturing, two gauges weakened in June, suggesting that China’s economy slowed in the second quarter.  The official manufacturing Purchasing Managers Index (PMI) fell -0.1 point in June from May, while the nonmanufacturing PMI, which measures service sector activity, rose +0.6 point to 53.7.  In a separate private manufacturing gauge compiled by Caixin-Markit, manufacturing declined last month at the fastest pace in four months.  Taken together, the data suggests that China’s second quarter GDP may trail the first quarter’s annualized +6.7% rise.

Japanese industrial output fell for the sixth consecutive month, down -2.3% in May from April, according to the Ministry of Economy, Trade and Industry.  The miss was larger than almost all private forecasts.  Factories were affected by weak international demand and the aftershocks of a recent earthquake near the country’s manufacturing center.  Retail sales were flat in May and showed a monthly drop in exports, leading to analysts’ concerns that Japan’s recovery is unstable.

Finally, as we reach the halfway point of the year we can now look back and ask the question “where in the world were the best places to be invested in the first half of 2016?”

The answer is – as shown in the chart below – in some pretty unexpected places.

Argentina led the study with a gain of over +25%.  The nation’s Merval index recovered after President Mauricio Macri took office in December.  True to his campaign promises, Marci eliminated most capital controls in the country and moved to make deals on debts still lingering from the country’s 2001 default.

Next on the list is Russia, up almost +23%.  Some might remember that President Obama’s White House Press Secretary Jay Carney proved that he should not be in the stock prediction business when he proclaimed in March 2014 that investors should “not invest in Russian equities right now.”

Note that the returns would not be easily available to a U.S. investor, as they are expressed in each country’s own currency.

ITM

(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)

Fig 5

Fig. 5

*****************************************************

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

*****************************************************

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.

Fig 1.png

Fig. 1

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 26.18, 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 return for all ten year periods that began with a CAPE around this level have been just 3%/yr (see Fig. 2).

Fig 2

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) turned negative on January 15th, and remains in Cyclical Bear territory at 51.21 up from the prior week’s 49.03.

Fig 3

Fig. 3

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.


Fig 4
Fig. 4

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.”

itm

(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)

Fig 5

Fig. 5

*****************************************************

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

*****************************************************

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.

Fig 1

Fig. 1

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 25.9, down from the prior week’s 26.1, and approximately at the level reached at the pre-crash high in October, 2007.  In fact, 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).

Fig 2

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) is at 57.51, down from the prior week’s 57.70, and continues in Cyclical Bull territory.

Fig 3

Fig. 3

In the intermediate picture:

The intermediate (weeks to months) indicator (see Fig. 4) turned negative on Friday, December 11.  The indicator ended the week at 19, up from the prior week’s 17.  Separately, the quarter-by-quarter indicator – based on domestic and international stock trend status at the start of each quarter – gave a negative indication on the first day of January for the prospects for the first quarter of 2016.


Fig 4
Fig. 4

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.  In the Cyclical (months to years) timeframe (Fig. 3), the US is the only major market still firmly in Bull territory.  In the Intermediate (weeks to months) timeframe (Fig. 4), US equity markets are rated as Negative.  The quarter-by-quarter indicator gave a negative signal for the 1st quarter:  neither US equities nor ex-US equities were in an uptrend at the start of Q1 2016, sufficient to signal a higher likelihood of a down quarter than an up quarter.

In the markets:

On Thursday, stocks closed the last trading session of 2015 with losses across the board.  The Dow Jones Industrial Average lost -0.7% on the week, down -2.23% for the year.  The LargeCap S&P 500 retreated ‑0.83% on the week, and finished the year down -0.73%.  The S&P 400 MidCap index declined -1.24% last week, and was down -3.71% for the year.  The SmallCap Russell 2000 was down -1.63% last week, and was the laggard among US indices for the year, down -5.48%.  The lone major US index to finish up for the year was the Nasdaq, which dropped -0.81% on the week, but was up +5.7% for the year.  Canada’s TSX lost -2.25% on the week, ending a disappointing year that returned -11.09%.

International markets were mixed for the week.  Germany’s DAX was up +0.14%, France’s CAC40 down ‑0.56%, Italy’s Milan FTSE up +1.7%, and the UK’s FTSE down -0.2%.  In Asia, China’s Shanghai Stock Exchange was down -2.03%, Japan’s Nikkei was up +0.78%, and Hong Kong’s Hang Seng was down ‑1.01%.

In commodities, precious metals remained under pressure as Gold sold off $15.30 down to $1060.50 an ounce.  Silver was down -3.86% and now under $14 to $13.82 an ounce.  A barrel of West Texas Intermediate crude oil lost a -$1.05 to $37.07 a barrel.­

The month of December was a negative one for all U.S. and almost all international stock indices, but nonetheless ended a positive fourth quarter whose gains all came in the month of October.  November was mostly flat, and December negative, but they added up to a decent fourth quarter even though ending with a whimper.  For the year, the Nasdaq Composite was up +5.7%, as noted above.  The rest of the major US and international equity indexes were negative for the year, with the worst being Emerging Markets, finishing the year at -16.2%.  Inside the Emerging Markets group, among the poorest performers was Brazil, at -42% for 2015.  Commodities suffered another poor year, with crude oil down almost ‑31%, gold -11%, silver -12% and copper (thought by some to be a harbinger of future global economic activity) -24%.

In U.S. economic news, underlying inflation is either (a) rising to historically-normal levels, or (b) not picking up at all—depending on which data series you look at.  The core Consumer Price Index, which removes food and energy prices, increased +0.5% to an annualized 2% last month.  However, looking at the Federal Reserve’s favorite price gauge–core personal consumption expenditures, the divergence is the widest it’s been since 2002.  Core PCE inflation remained unchanged last month, and at 1.3% annualized.  Analysts suggest that as long as the PCE inflation data remains below the 2% Fed target for inflation, policymakers will be cautious hiking rates.

Initial jobless claims rose by 20,000 last week to 287,000, the most since early July—economists had been expecting only 270,000.  The smoothed 4-week moving average rose to a 5-month high of 277,000.  On a positive note, claims remain near a 4-decade low.  The concern in the jobs market has been more about a lack of expansion in hiring through the recovery, rather than people being fired.  According to the Labor Department, the U.S. added about 2.5 million jobs in 2015.  That figure is acceptable, but 2014 had over 3.1 million jobs added.

U.S. home prices rose +5.2% in October versus a year earlier, according to S&P/Case-Schiller data.  It was the fourth straight month of acceleration and the best gain since the summer of 2014.  Portland, San Francisco, and Denver led the rankings with 10.9% advances.  Economic conditions are supportive of housing demand, but limited inventory is leading to higher prices.  But the Commerce Department reported that single-family housing starts rose to an 8-year high last month, so the additional supply is expected to help handle the demand.  Pending home sales fell -0.9% in December, the 3rd drop in the last 4 months.  The National Association of Realtors attributed the fall to higher home prices and the limited supply of homes.  The pending home sales index is up +2.7% versus the previous November, the smallest annual gain since October of 2014.

A surprising drop occurred in the December Chicago Purchasing Managers Index (PMI), which fell deeper into contraction territory, to 42.9 from 48.7 – much worse than the improvement to 50 expected by economists.  The -5.8 point drop was the largest contraction since July 2009.  Worse, order backlogs plunged -17.2 points to 29.4, which was the worst drop in backlogs since 1951.  Nonetheless, 55% of the survey’s respondents reported that they expect strong demand in 2016.

In international economic news, IMF Managing Director Christine Lagarde stated in an article for the German newspaper Handelsblatt that she believes global economic growth will be “disappointing” in 2016.  Higher interest rates in the United States and the continuing economic slowdown in China are contributing to a decline in global trade and weak raw materials prices for commodity-producing nations, she said.

Finally, 2015’s increase in the value of the dollar relative to other global currencies has made a win-or-lose difference in the returns of many popular international investments vehicles.

The vast majority of American investors make their international investments in “unhedged” ETFs and Mutual Funds, where “unhedged” means that there is no attempt to offset (i.e., “hedge”) the effects of the dollar’s ups and downs on the value of the investments.

The dollar gained value in 2015, causing “unhedged” foreign investments to be negatively affected and frequently made the difference between an annual gain or loss for American investors.  Here are two examples:

iShares MSCI Germany ETF – unhedged (EWG)
vs
WisdomTree Germany Hedged Equity ETF – hedged (DXGE)

and

iShares MSCI EAFE ETF – unhedged (EFA)  (EAFE = Europe, Australia and Far East)
vs
Deutsche X-trackers MSCI EAFE Hedged ETF – hedged (DBEF)

In the markets

(sources: 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 3-5 source W E Sherman & Co, LLC)

Summary:

The US has led the worldwide recovery, and continues to be among the strongest of global markets.  However, the over-arching Secular Bear Market may remain in place globally even through new highs were reached in the US earlier this year. Because the world may still be in a Secular Bear, we have no expectations of runs of multiple double-digit consecutive years, and we expect poor market conditions to be a frequent occurrence.  Nonetheless, we remain completely open to any eventuality that the market brings, and our strategies, tactics and tools will help us to successfully navigate whatever happens.

Fig 5

Fig. 5

 

 

 

 

 

 

 

 

 

 

 

 

Below is an excerpt from the Dorsey Wright blog, sharing evidence of almost nine decades of relative strength momentum outperformance.

 

89 years of momentum.png

In 1937 Cowles and Jones shared their findings that “taking one year as the unit of measurement for the period 1920 to 1935, the tendency is very pronounced for stocks which have exceeded the median in one year to exceed it also in the year following.”

The key here is that it doesn’t work 100% of the time. Listen to Jim O’Shaughnessy discuss this here. Jim was comfortable writing “What Works on Wall Street” because he knew the tendency of humans to abandon strategies as soon as they went through a drawdown or period of relative under performance. It’s just human nature, and he knows that will never change. This is a key belief to why simple strategies can continue to persist in a world of competitive markets. Since nothing works (meaning producing profits and/or outperforming a benchmark) 100% of the time, the weak hands will eventually drop out.

This is why we believe in combining together a few simple strategies where you have done a high degree of due diligence, and then follow them faithfully. When the next strategy of the month is in favor, you treat it with a high degree of caution and skepticism before even considering adjusting your plan. So what does Bernie Madoff have to do with any of this? We all want to believe that the perfect strategy exists somewhere. I found it interesting as I read Ben Carlson’s book that the largest Ponzi Scheme in history, run by Bernie Madoff, did not promise investors excessively high returns. It promised very good returns, but with almost no risk. Bernie was not stupid, he knew very well that humans desperately want to believe in the idea of making very good returns with little or no risk.

From Ben’s book: “The beauty in Madoff’s scam was the fact that he never promised home runs to his investors. Over an 18-year period, Madoff claimed to offer 10.6 percent annual returns to his investors, fairly similar to historical stock market gains. But the annualized volatility was under 2.5 percent, a fraction of the variability seen in the stock market, or the bond market for that matter. And what do investors want more than anything? If you answered a stock market return profile minus the stock market risk profile, you answered correctly. Investors want to believe this is possible.”

We are advocates of momentum investing, utilizing it throughout many of our portfolios in different ways. Just make sure you have realistic expectations.

Living through a track record is very different than viewing it on paper. Even the most efficient track records in history have periods where they would have been very uncomfortable to stick with. Warren Buffett has had multiple 30-50% drawdowns in his career. In the world of indexing, there is nothing magical about the S&P 500. Yet it’s well known how difficult it is for a fund manager to beat it over the long term. A big part of the reason why the S&P 500 beats most fund managers is because of its simple discipline. It continues to apply the same set of rules over and over again. The whole concept of “smart beta” shows numerous ways to create indices that would have beat the market cap weighting process of the S&P 500 over long periods of market history. Perhaps the greatest form of alpha is the ability to follow a simple approach with rigid discipline over the long term. Howard Lindzon of StockTwits recently shared his top ten takeways of the Stocktoberfest conference. Here was #5.

 

JP on SPY

 

I found this Forbes interview with Jim O’shaughnessy on February 23, 2009 particularly interesting. Keep in mind, February 23, 2009 was within a couple weeks of the market bottom. The Dow was trading around 7,000, more than 50% below its October 2007 high. Predictions for Dow 5,000, 3,000, even 1,000 were being made. With recency bias clouding our better judgement, many investors saw this as all but certain and needed to do something to intervene. The fear in the marketplace was unbelievable and people were in the process of officially devastating their life savings by abandoning their long term plan and selling towards the bottom. This is also a great example, which I wrote about here, on why you can’t rely exclusively on historical data. Given enough time, your maximum drawdown is always ahead of you. Yet read how Jim is telling the exact same story as he always does as a true quant, whether at new highs, or in this case, during a record drawdown. Keep it simple, trust your exhaustive research and data, and follow your plan. It’s simple, but not easy.

 

 

JO Forbes

*****************************************************

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

*****************************************************

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.

Fig 1

Fig. 1

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 24.8, up from the prior week’s 24.5, and approximately at the level reached at the pre-crash high in October, 2007.  In fact, since 1881, the average annual returns for all ten year periods that began with a CAPE at this level have been just 3%/yr (see Fig. 2).

Fig 2

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) is at 51.81, up a little from the prior week’s 51.12, and continues in Cyclical Bull territory.  Several of the world’s major markets have entered Bear territory, most notably Germany, China and Brazil, while many of the world’s other markets – including some US indexes – are in “correction” territory (10% or more from their highs).

Fig 3

Fig. 3

In the intermediate picture:

The intermediate (weeks to months) indicator (see Fig. 4) turned Negative on September 25, after being Positive since August 26.  The indicator ended the week at 7, down from the prior week’s 13.  Separately, the quarter-by-quarter indicator – based on domestic and international stock trend status at the start of each quarter – gave a negative indication on the first day of October for the prospects for the fourth quarter of 2015.


Fig 4
Fig. 4

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.  In the Cyclical (months to years) timeframe (Fig. 3), a majority of major equity markets still remain in Cyclical Bull territory, although numerous others have moved to Bear status.  In the Intermediate (weeks to months) timeframe (Fig. 4), US equity markets are rated as Negative.  The quarter-by-quarter indicator gave a negative signal for the 4th quarter:  neither US equities nor ex-US equities were in an uptrend at the start of Q4 2015, sufficient to signal a higher likelihood of a down quarter than an up quarter.

In the markets:

The major market indexes were mixed as worries over China’s economic slowdown and potential new rules in drug pricing gave way to a strong Friday afternoon rally that allowed many indexes to regain positive territory for the week.  The Dow Jones Industrial Average gained 157 points for the week to close at 16472, a +0.97% advance.  Large caps fared the best as the LargeCap S&P 500 gained +1.04%.  The MidCap S&P 400 declined -0.15%, and the SmallCap Russell 2000 declined -0.77%.  Recent sector losers – particularly Biotech, Energy and Basic Materials – all rallied hard into the end of the week.  Whether these turnabouts are dead-cat bounces or genuine bottoms will not be known for a while.

In international markets, Canada’s TSX declined -0.29%.  In Europe, France’s CAC 40 lost -0.49%, Germany’s DAX gave up -1.4%, while the United Kingdom’s FTSE gained +0.34%.  In South America, Brazil’s Bovespa Stock index rallied +4.9%, after being deeply oversold and deep in “Bear” territory.

In commodities, silver added +0.93% to end the week at $15.23 an ounce.  Gold diverged from silver and lost ‑$7.90 for the week, closing at $1137.60 an ounce despite a gain of $24.90 on Friday.  A barrel of West Texas Intermediate crude oil gained +0.71% to $45.66 a barrel.

For the month of September, losses were booked in every market segment, but LargeCaps did better by far than SmallCaps.  While the LargeCap Dow only lost -1.47% in October, the SmallCap Russell 2000 dropped -5.07%, cementing its position as the US market laggard at the ¾ marker of the year 2015.  International investors were not spared any pain, either, as Developed International retreated -4.42% and Emerging International slipped ‑3.13% (with Brazil leading the Emerging category to the downside, plunging -11. 78%).  Gold and Oil were also down for the month, but by lesser amounts than many recent months, at -1.80% and ‑7.61%, respectively.

The 3rd Quarter looked like a larger version of September, with losses across the board.  Like September, the LargeCap Dow and S&P indexes lost the least, at -7.58% and -6.94% respectively, while the SmallCap Russell 2000 lost the most, at -12.22%.  Canada’s TSX was in between, at -8.56%.  Developed International lost -9.72%, but that looks good compared to Emerging International, which sank -17.26% during the Quarter. Brazil, the worst of the category in September, was also the worst of the Emerging group for the 3rd Quarter, losing a whopping ‑33.02%.

In US economic news, Friday’s Non-Farm Payrolls (NFP) report was the biggest single economic piece of news of the week.  Nonfarm payroll jobs added in September were 142,000, nowhere near the 203,000 consensus estimate.  The Labor Department reported that the official unemployment rate remained unchanged at 5.1%.  The labor participation rate fell to just 62.4% — a 38-year low.  Global economic weakness and a stronger dollar were cited as reasons for the decidedly poor numbers.  The report was perceived as reducing the chance the Federal Reserve will raise interest rates this month.  Last month, the Fed held off on raising rates citing global economic concerns, and those concerns were not allayed by any news since then – and most certainly not by the NFP report.  Nonetheless, New York Federal Reserve President William Dudley stated that the Federal Reserve will likely raise rates this year, as the effects of cheaper oil and a stronger dollar play out.  He reiterated that the Fed remains data-dependent, and that the hike could even come at this month’s meeting.

US factory orders fell -1.7%, worse than the consensus estimate of a -1.3% decline.  Durable goods orders fell ‑2.3%.  Ex-transportation, orders fell -0.8% in August.  Consumers spent more than expected as incomes strengthened and inflation remained tame.  On Monday, the Commerce Department reported that personal incomes rose +0.3% in August, just slightly below the +0.4% gain expected.  Spending was stronger than expected with a +0.4% gain in August.  Core inflation rose +0.1% in August, which is 1.3% higher versus a year ago.

Mortgage applications fell -6.7% last week, according to the Mortgage Bankers Association.  Applications to purchase were down -6% and applications to refinance fell -8%.  Home sales declined as contract signings fell ‑1.4% in the National Association of Realtors Pending Home Sales Index.  This vastly missed expectations, which had been for a +0.5% gain.  The West was the only region to see a gain in August home sales.  The Federal Reserve is hoping a rebound in housing will offset the current decline in manufacturing activity in the United States.  Home prices in the S&P/Case-Shiller index declined -0.2% in July.  The 20 city index rose +5% for the year, slightly missing expectations.  Dallas, Denver, and San Francisco continue to see the strongest price gains.  Overall, prices remain about 12% below 2006 peaks, even while higher prices have been constraining more robust growth in the market.

Consumer confidence improved as the Conference Board’s sentiment gauge jumped to 103 from 101.3.  Expectations had been for a continued decline to 96.  The “present situation” component of consumer confidence increased to 121.1 from 115.8, but the “future expectations” component declined a half point to 91.

The Institute for Supply Management (ISM) Manufacturing Index fell -0.9 point to 50.2, the lowest since May 2013 and just barely above the 50 dividing line between expansion and contraction.  ISM’s export orders gauge remained at 46.5, matching the worst reading since July 2012.  The Chicago Purchasing Managers Index (PMI) fell into contraction at 48.7 from 54.4.  Forecasts had been for a slight downturn, but that the index would still remain in expansion (i.e., above 50).  It was the PMI’s fifth time below 50 in 2015 and an accompanying note said “the speed of the September descent is a source of concern.”  The reading follows other regional contraction-level readings in New York, Philadelphia, Richmond and Texas.

In Canada, industrial producer prices declined -0.3% in August, beating expectations of a -0.5% decline.  For the year, prices are -0.4% lower, led by a -14.8% plunge in energy prices.

In the Eurozone, a tiny bit of recent inflation has turned back into deflation.  Consumer prices went negative in September, falling -0.1% versus a year ago.  It was the first negative reading in the six months since the ECB launched a bond buying program.  Expectations had been for an unchanged reading.

Germany’s PMI was revised downward in September to 52.3.  The average PMI for the months comprising the third quarter was 52.5, the strongest reading in more than a year, but the lower reading for September indicates a slowdown in momentum heading into the fourth quarter.

Finally, the general perception among many investors is that the place to find growth is in the Emerging Markets, which presumably are expanding more rapidly than their developed-world counterparts.  Sometimes, this is a correct perception – such as during the Bull Market running from 2003 to 2007.  However, it has most definitely not been true for the last couple of years.  In fact, growth has turned to contraction in many Emerging Market countries, and the Manufacturing PMI readings for Emerging Markets have fallen sharply into the sub-50 contraction territory.  Stock prices, too, have reflected this unhappy state, with most Emerging Markets indexes lower than their levels of 5 years ago.  This chart, from Markit, shows that the Emerging Market Manufacturing PMI is now at a 6-year low and back to the same level reached in Q2 of 2009 when Emerging Markets were first exiting from the Great Recession.

In the markets

 

(sources: 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; Figs 3-5 source W E Sherman & Co, LLC)

Summary:

The US has led the worldwide recovery, and continues to be among the strongest of global markets.  However, the over-arching Secular Bear Market may remain in place globally even through new highs were reached in the US earlier this year. Because the world may still be in a Secular Bear, we have no expectations of runs of multiple double-digit consecutive years, and we expect poor market conditions to be a frequent occurrence.  Nonetheless, we remain completely open to any eventuality that the market brings, and our strategies, tactics and tools will help us to successfully navigate whatever happens.

Fig 5

Fig. 5

Our LC Momentum model holds stocks as its core position. Long term empirical evidence across global equity markets shows equities significantly outperform all other major asset classes since 1900[1]. Morgan Housel recently published an article about the last seventy years of US stock market returns, and how they have to regularly climb the wall of worry.

http://www.fool.com/…aasitlnk0000003

From Morgan’s article:

_____________________________________________________________________

 

The S&P 500 rose 1,100-fold over the last 70 years, including dividends. But look what happened during that period:

 

  • May 1946 to May 1947. Stocks decline 28.4%. A surge of soldiers return from World War II, and factories across America return to normal operations after years of building war supplies. This disrupts the economy as the entire world figures out what to do next. Real GDP declines 13% as wartime spending tapers off. A general fear that the economy will fall back into the Great Depression worries economists and investors.
  • June 1948 to June 1949. Stocks decline 20.6%. A world still trying to figure out what a post-war economy looks like causes a second U.S. recession with more demobilization. Inflation surges as the economy adjusts. The Korean conflict heats up.
  • June 1950 to July 1950. Stocks fall 14%.North Korean troops attack points along South Korean border. The U.N Security Council calls the invasion “a breach of peace.” U.S. involvement in the Korean War begins.
  • July 1957 to October 1957. Stocks fall 20.7%. There’s the Suez Canal crisis and Soviet launch of Sputnik, plus the U.S. slips into recession.
  • January 1962 to June 1962. Stocks fall 26.4%. Stocks plunge after a decade of solid economic growth and market boom, the first “bubble” environment since 1929. In a classic 1962 interview, Warren Buffett says, “For some time, stocks have been rising at rather rapid rates, but corporate earnings have not been rising, dividends have not been increasing, and it’s not to be unexpected that a correction of some of those factors on the upside might occur on the downside.”
  • February 1966 to October 1966. Stocks fall 22.2%. The Vietnam War and Great Society social programs push government spending up 45% in five years. Inflation gathers steam. The Federal Reserve responds by tightening interest rates. No recession occurred.
  • November 1968 to May 1970. Stocks fall 36.1%. Inflation really starts to pick up, hitting 6.2% in 1969 up from an average of 1.6% over the previous eight years. Vietnam War escalates. Interest rates surge; 10-year Treasury rates rise from 4.7% to nearly 8%.
  • April 1973 to October 1974. Stocks fall 48%.Inflation breaks double-digits for the first time in three decades. There’s the start of a deep recession; unemployment hits 9%.
  • September 1976 to March 1978. Stocks fall 19.4%. The economy stagnates as high inflation meets dismal earnings growth. Adjusted for inflation, corporate profits haven’t grown for eight years.
  • February 1980 to March 1980. Stocks fall 17.1%.Interest rates approach 20%, the highest in modern history. The economy grinds to a halt; unemployment tops 10%. There’s the Iran hostage crisis.
  • November 1980 to August 1982. Stocks fall 27.1%. Inflation has risen 42% in the previous three years. Consumer confidence plunges, unemployment surges, and we see the largest budget deficits since World War II. Corporate profits are 25% below where they were a decade prior.
  • August 1987 to December 1987. Stocks fall 33.5%. The crash of 87 pushes stocks down 23% in one day. No notable news that day; historians still argue about the cause. A likely contributor was a growing fad of “portfolio insurance” that automatically sold stocks on declines, causing selling to beget more selling — the precursor to the fragility of a technology-driven marketplace.
  • July 1990 to October 1990. Stocks fall 19.9%. The Gulf War causes an oil price spike. Short recession. The unemployment rate jumps to 7.8%.
  • July 1998 to August 1998. Stocks fall 19.3%. Russia defaults on its debt, emerging market currencies collapse, and the world’s largest hedge fund goes bankrupt, nearly taking Wall Street banks down with it. Strangely, this occurs during a period most people remember as one of the most prosperous periods to invest in history.
  • March 2000 to October 2002. Stocks fall 49.1%.The dot-com bubble bursts, and 9/11 sends the world economy into recession.
  • November 2002 to March 2003. Stocks fall 14.7%.The S. economy puts itself back together after its first recession in a decade. The military preps for the Iraq war. Oil prices spike.
  • October 2007 to March 2009. Stocks fall 56.8%.The global housing bubble bursts, sending the world’s largest banks to the brink of collapse. The worst financial crisis since the Great Depression.
  • April 2010 to July 2010. Stocks fall 16%. Europe hits a debt crisis while the U.S. economy weakens. Double-dip recession fears.
  • April 2011 to October 2011. Stocks fall 19.4%.The U.S. government experiences a debt ceiling showdown, U.S. credit is downgraded, oil prices surge.
  • June 2015 to August 2015. Stocks fall 11.9%. China’s economy grinds to a halt; the Fed prepares to raise interest rates.

____________________________________________________________

I like Morgan’s article, it reminds us that economic uncertainty has always been a regular part of the past along with frequent corrections (10%+ declines) and deep bear markets (20%+ declines). His intention is to help us have a long term perspective. Many times throughout the past seven decades, “this has never happened before”.  Yet the US continued to show its strength and resiliency. For some, this is effective. For others, they need something more to help them follow their plan.

Dual Momentum

In the equities portion of our dual momentum model, we rotate among US Large, US Small, and International stocks based on twelve month relative strength momentum[2]. When all three asset classes have negative absolute momentum[3], we switch into bonds. The idea here is to earn the risk premium in stocks with less exposure to the downside volatility and bear market drawdowns that frequently have occurred in the past and will frequently occur in the future. We emphasize less in an effort to promote proper expectations. Empirical data suggests that dual momentum can be used to earn higher returns with less risk than buy and hold, but it’s not a Holy Grail. Holy Grail strategies tend to fall apart in real time because they were over fit to a limited amount of past data with no economic argument to support why they work. Researchers refer to this as data-mining. With dual momentum, we believe having a proven rules-based method in place to exit equities ahead of the majority of major bear market declines can be all that is needed to help investors have the confidence to stick with their strategy for the long term. And the right strategy for every investor is the one they will stick with. This is key.

Since Morgan is using data since 1946, we thought it would be fun to look at showing our dual momentum equities model during this same period (note: international is excluded in this example due to lack of data prior to 1970 although we use it in our actual trading model).

 

equity chart.png

stats

 

Here are a few things to take notice of on both the chart and in the statistics. On the chart, it’s important to notice that our dual momentum approach did NOT outperform an equal weighted buy and hold portfolio in the first thirty years, but slightly lagged or matched buy and hold for most of the period. Thirty years is the investment time horizon for many investors, not seventy. If only relative strength momentum would have been used during this period, outperformance would have occurred. Absolute momentum, or trend following momentum, will take you out of the market at times when doing nothing would have ended up being the better short term outcome. We call these whipsaws, and they are expected as a short term price to pay for risk management that can allow us to sidestep the majority of painful bear market drawdowns.

Over the long term, relative strength and absolute momentum tend to contribute fairly equally to excess returns. If the future ends up looking more like this specific period of the past, we still would prefer dual momentum’s slight underperformance as a small cost to pay for the psychological comfort of knowing a plan is in place to protect capital against 50% drawdowns. The total outperformance of dual momentum in the last seven decades comes in the more recent four decades where three separate bear markets of 50%+ losses occurred for buy and hold investors. Two of these occurred in the last fifteen years. This is when absolute momentum does its job of taking us out of equities in the early stages of bear markets. Even during the first thirty year period, dual momentum still produced lower volatility and maximum drawdown[4], and a higher Sharpe Ratio. The period of 1946-1972 produced an annualized return of 12.1% for buy and hold and 11.78% for dual momentum, while over the entire duration dual momentum produced both higher returns and less risk.

We make clear to our clients that beating the market isn’t a financial goal, and it would be intellectually dishonest for us to suggest we can guarantee anything about the future. What we can guarantee is that we have vigorously researched a robust investing plan supported by decades of historical data and third party validation. When combined with disciplined execution and realistic expectations, we believe the probabilities are highly in favor of a successful long term investing experience.

  1. Investigate carefully
  2. Choose wisely
  3. Follow faithfully

Fama/French (2008): Momentum is “the center stage anomaly of recent years…an anomaly that is above suspicion…the premier market anomaly.”

[i]

[1] The Credit Suisse Global Investment Return Yearbook shows how both US and World ex-US (in USD) equity risk premiums have far exceeded those of bonds and bills since 1900 forming the portfolio theory basis for focusing on equities in our dual momentum model.

[2] Relative strength momentum compares total returns of one asset class to another over an applicable lookback period. The asset class that has risen the most is held for the next month.

[3] Absolute momentum is defined as having a total return less than the risk free rate (such as US T-bills) over the applicable lookback period.

[4] Maximum drawdown measures total peak to trough loss suffered prior to reaching new equity highs. Maximum drawdown is much more important to most investors than the more frequently mentioned measure of risk known as standard deviation or annualized volatility.

[i] Past performance doesn’t guarantee future results. The concepts of dual momentum were pioneered by the research of Gary Antonacci. We recommend using his best-selling book and blog as an additional resource for studying momentum. This is a hypothetical model intended to show the efficacy of dual momentum, and is not intended to represent specific investment advice. Data is gross of any applicable taxes and transaction costs, and investors should always consult with their tax advisor before investing. All investments carry risk, may lose value, and are not FDIC insured. We provide the hyperlink to Morgan Housel’s article as a convenience and do not endorse nor guarantee the accuracy of any information he has presented.

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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:

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.

Fig 1

Fig. 1

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 26.7, down from the prior week’s 27.0, and approximately at the level reached at the pre-crash high in October, 2007.  In fact, since 1881, the average annual returns for all ten year periods that began with a CAPE at this level have been just 3%/yr (see Fig. 2).

Fig 2

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) is at 50.4, down from the prior week’s 51.7, and continues in Cyclical Bull territory.  The current Cyclical Bull has taken the US and some of Europe to new all-time highs, but many of the world’s markets have yet to top 2007’s levels – particularly in the Emerging Markets area.

Fig 3

Fig. 3

In the intermediate picture:

The intermediate (weeks to months) indicator (see Fig. 4) is Negative and ended the week at 23, down from the prior week’s 26. 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 July for the prospects for the third quarter of 2015.

 
Fig 4
Fig. 4

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.  In the Cyclical (months to years) timeframe (Fig. 3), all major equity markets are in Cyclical Bull territory.  In the Intermediate (weeks to months) timeframe (Fig. 4), US equity markets are rated as Negative.  The quarter-by-quarter indicator gave a positive signal for the 3rd quarter:  US equities were in an uptrend at the start of Q3 2015, sufficient to signal a higher likelihood of an up quarter than a down quarter.

In the markets:

U.S. stocks were unable to resist the pressure of falling global markets and fell for a second week as the debt crisis in Greece took center stage.  Most of the damage occurred on Monday, when the S&P 500 had its largest one-day drop since October of last year.  For the week, the Dow Jones Industrial Average dropped 216 points and is now negative for the year down -0.52%.  The S&P 500 lost 24 points, or -1.18%, closing at 2076.  The tech-heavy Nasdaq lost 71 points, but was still able to hold on to the 5000 level at 5009.  MidCaps and SmallCaps, leaders of the US market so far this year, lost -1.75% and -2.46% respectively.  Canada’s TSX shed -1.15%, the eighth loss of the last ten weeks.

In commodities, Gold declined $8.50 an ounce to $1165, and silver dropped 10 cents to $15.65.  Oil broke out of its consolidation but to the downside, shedding -5.28% to end the week at $56.50 a barrel.

In international markets, Developed International declined -2.68% and Emerging Markets ended down -0.45%.  Driven by the twists and turns in the Greek saga, declines in Europe were widespread and significant as London’s FTSE dropped -2.49%, Germany’s DAX dropped ‑3.42%, and France’s CAC dropped -4.42%.  In Asia, China’s plunge continues as the market that had ended the week 4 weeks ago at over 5000 now stands at 3912, plunging -6.68% for the week and now well within “Bear Market” territory.

For the month of June, markets were nearly all lower.  The exception in the US was the SmallCap Russell 2000, eking out a +0.6% gain.  The Dow and the S&P 500 were both lower by -2.1%.  The Toronto Composite was off by ‑3.1%, and both Developed International and Emerging International were similarly down by -3% each.  Gold and Silver dropped -2.1% and -6.1%, respectively, and oil shed more than -6%.

Second quarter (April, May, June) returns were much more mixed than were June’s.  In the US, the Dow and S&P 500 were both lower for the quarter, at -0.23% and -0.88% respectively, but the Nasdaq Composite (+1.75%) and the Russell 2000 (+0.09%) both gained.  Canada’s TSX shed -2.34%, Emerging International lost ‑0.54%, but Developed International rose by +0.61% for the quarter.  The prize for the wildest ride during the quarter goes to the Shanghai market, which gained a whopping +37% from March 31st to the high of June 12, then gave it all up in less than 3 weeks in a nearly straight plunge into the end of the quarter.

In US economic news, employers added 223,000 jobs in June, in line with estimates.  The headline jobless rate fell to 5.3%, a 7-year low.  Beneath the headlines however the details weren’t as optimistic–labor force participation rate plunged and wage growth slowed.  Small business continued to dominate hiring, now with five straight months of gains over 100,000.  In the details, construction and manufacturing both added jobs.  Manufacturing ended a 3-month losing streak and added 7000 jobs in June.  There were 281,000 initial claims for unemployment in the June 27 week, up 10,000 from the prior week.  Continuing claims rose 15,000 to 2.26 million.

Pending home sales reached nine-year highs and scored a fifth straight monthly increase as contract signings rose +0.9% in May, according to the National Association of Realtors.  “The steady pace of solid job creation seen now for over a year has given the housing market a boost this spring,” said NAR Chief Economist Lawrence Yun.  The index is +10.4% above year ago levels, and has shown year-over-year increases for nine straight months.

Consumer confidence gained almost 6 points to 101.4 nearing the high reached in January.  The present situation index rose to 111.6 from 107.1 and the expectations index jumped over 8 points to 94.6.

US Manufacturing improved in June as the Purchasing Managers Index (PMI) was stronger than expected in June at 53.5, a +0.7 point gain from May. The report supports the belief that the economy has moved past its winter weakness and further opens the door for the Federal Reserve to start hiking interest rates as soon as September.  However, export orders slipped into contraction below 50 concurrent with the strengthening dollar.  Factory orders overall declined -1% in May, falling further from April’s -0.7% decline.

Federal Reserve Vice Chairman Stanley Fischer said that the US consumer is making a comeback and that economic growth is improving.  According to Mr. Fisher, “the latest monthly data on real consumption provide welcome evidence that consumer demand is rebounding.”  “Our policy will be data dependent, and the FOMC (Federal Open Market Committee) at upcoming meetings will weigh possible adjustments to the level of the target federal funds rate, based on its assessment of incoming data and the economic outlook,” Fischer said. He also noted that the FOMC decided at its June 16-17 meeting not to include time-based guidance about when the policy change is coming.

Economic sentiment in the Eurozone dipped in May according to the European Commission’s survey.  Across the Eurozone, the harmonized consumer price index gained +0.2% for the year in June, lower than the +0.3% in May.  The unemployment rate for the Eurozone was unchanged at 11.1% in May – Germany had the lowest jobless rate at 4.7%, and Greece, the highest at 25.6%.

Factory PMI in the Eurozone was 52.5 in June according to Markit.  France and Germany both showed expansion at 50.7 and 51.9, respectively.  Eurozone producer prices fell -2% in May, less than the -2.1% in April but still deflationary.

The European Central Bank will expand its QE program to include state-backed corporate bonds.  The amount of debt being issued by sovereign countries remains too low to absorb the banks €60 billion per month program.  The ECB had previously stated it would step up bond purchases before liquidity fell during July and August.

China’s central bank cut interest rates 25 bps last weekend in response to the plunge in its equity market.  It was the fourth rate cut since November and it affected two rates.  The last time China took such a step was in the financial crisis of 2008. It also eased margin requirements for investors, which seemed puzzling to most outsiders, since runaway use of margin by individual investors was a primary cause of the market’s recent overheating and subsequent bursting.  This graphic shows how the use of margin, and the opening of new stock-trading accounts, has skyrocketed in recent months as huge numbers of individual speculators have plunged into the Chinese market.

in the markets 1

All during the coverage of the Greek crisis, writers and commentators have frequently used “Eurozone” and “European Union” interchangeably.  However, they are not the same.  There are 28 member countries in the European Union, but only 19 are users of the Euro currency – i.e., they are members of the “Eurozone”.  The 9 members of the European Union who are NOT members of the Eurozone are: United Kingdom, Denmark, Sweden, Poland, Czech Republic, Hungary, Romania, Bulgaria and Croatia.  Interestingly, Switzerland, although it is located in the heart of Europe, is neither a member of the European Union nor the Eurozone.  This map, from the Washington Post, illustrates the differences.


in the markets 2.png

 

(sources: 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, wantchinatimes.com, BBC, 361capital.com, pensionpartners.com, cnbc.com, Goldman Sachs, Washington Post; Figs 3-5 source W E Sherman & Co, LLC)

Summary:

The US has led the worldwide recovery, and continues to be among the strongest of global markets.  However, the over-arching Secular Bear Market may remain in place globally even as new highs are reached in the US.

Because the world may still be in a Secular Bear, we have no expectations of runs of multiple double-digit consecutive years, and we expect poor market conditions to be a frequent occurrence.  Nonetheless, we remain completely open to any eventuality that the market brings, and our strategies, tactics and tools will help us to successfully navigate whatever happens.

Fig 5

Fig. 5

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