Signal Type	Trade Date	Return since issued
		World	U.S.
			Nasdaq 100 (QQQQ) Russell 2000 (IWM) S&P 500 (SPY)

Market Update

The major averages gave up ground during this holiday-shortened week. A jump in oil prices boosted energy stocks Monday, helping the S&P 500 gain 0.9% during the session. The market surrendered its gains the next day, however, following a disappointing consumer confidence report. Positive economic news helped stocks to a strong start Wednesday: pending home sales for May topped views while the ISM index of manufacturing activity came in better than expected at 44.8. Yet, the early gains were trimmed by day's end, with the Nasdaq Composite settling for a modest 0.6% gain. The Labor Department released its much-anticipated May employment report Thursday morning. The data disappointed investors as the economy shed 467,000 jobs last month, topping expectations of 365,000 losses, while the unemployment rate hit 9.5%, marking a 25-year high. Not surprisingly, investors disregarded other economic news that showed a 1.2% increase in May factory orders to instead focus entirely on the negative employment headlines and decided to take profits. Stocks immediately dropped at the open and then remained stuck in a narrow trading range to finish with steep losses, as all major averages shed in excess of 2.4% on the day. Thursday's session was the last one of the week as U.S. markets were closed Friday in observance of the Independence Day holiday.

The Nasdaq 100 (QQQQ), S&P 500 (SPY) and Russell 2000 (IWM) respectively lost 2.12%, 2.21% and 2.23% on the week. The Nasdaq 100 remains located above both its 50-day and 200-day exponential moving averages (EMAs) while the Russell 2000 rests in-between its two EMAs. As for the S&P 500, it now sits below its two EMAs.

For its part, our World portfolio outperformed its U.S. counterparts this week with a 1.68% loss. The portfolio consists of the 5 top-ranked world ETFs as of June 19, which marked the beginning of the current 4-week holding period.

Our current Buy signal remains in effect.

Trend Timing School

The force behind secular market cycles

Secular market periods are long periods of generally similar market behavior, typically lasting 15-20 years. During a secular bull market, stock prices rise almost without pause, at least when viewed on an annual basis. In fact, during secular bull markets, there is only a 4% chance of having an annual loss greater than 10%. Sharply negative market events, such as the October 1987 market crash, occurred during secular bull markets. So there are day-to-day and month-to-month swings of some magnitude. But in a secular bull market, there is a tendency for investors to quickly recover from their fears and return to stocks.

During a secular bear period, by contrast, stock markets have trouble holding on to any significant gains. There is a one in three chance that any given year during a secular bear period will deal investors a >15% loss. It is a classic situation of two steps forward, one big step back over and over throughout the bear period. The net result is a market this is flat when viewed over several years despite periods of seemingly good growth (such as 2003-2007 in recent market history). Chart 1 from Ned Davis Research provides a good picture of the secular market periods over the past century.

Chart 1: Secular market periods over the past century


Note: Chart is logarithmic with vertical scale compressed to show changes in percentage terms. A rise from 100 to 110 takes the same space as a rise from 10000 to 11000, since both are 10% changes.
Sources: Ned Davis Research (secular bears); WSJ Market Data Group (DJIA)

Though some might think that economic cycles are the driving force behind these extended market periods, the willingness of investors to embrace risk, and therefore invest in stocks, appears to be a much stronger influence.

We can contrast the end of the last secular bull market in 1999 with the recent market lows earlier this year to get a glimpse of these extremes of investor behavior. In 1998 and 1999, people who have never invested in stocks were willing to dive in. Online brokers sprouted up to support this surge in trading from individual investors seeking to cash in on the huge surge in stock prices. The fact that Price-to-Earnings (P/E) ratios were at all-time highs did nothing to dampen the enthusiasm. Every dip in the market was just an opportunity to buy more stock. The secular bull market period was entering its final stage where even "marginal" or novice investors are piling into stocks seeking to get rich. This buying frenzy occurred without regard to a historically rich market by any fundamental measure.

Fast forward past two devastating market swoons and look at investor behavior this March 2009. Concerns about the imminent failure of the nation's largest banks and a possible further economic decline (remember the "coming depression" scenario?) sent investors scurrying to the sidelines once again. With many venerable firms trading for single digits were investors licking their chops over the bargains? Hardly. They were instead embracing 1-2% money market yields because that, at least, was better than losing more money. Stocks were not attractive at almost any price.

Those two markets exemplify the extremes of investor behavior. In a secular bull market, investors are largely willing to shrug off disappointing news and use any market weakness as another opportunity to push more money into stocks. This enthusiasm pushes P/E ratios ever higher. By contrast, a secular bear market finds investors increasingly disenchanted and eventually disgusted with stocks. It gets to a point where you cannot give the stocks away, regardless of how cheap they are. With investors avoiding stocks, P/E ratios get pushed lower and lower as time wears on until they ultimately reach single digits. Every secular bear market has reached its nadir with P/E ratios in single digits.

Chart 2 shows how the trend of P/E ratios is the defining mark of a secular market cycles, with a secular bull market's P/E ratios reflecting increasing investor willingness to pay more and more for a dollar of corporate earnings. Secular bear periods exhibit declining P/E ratios reflecting the "I won't buy it at ANY price" reluctance of investors; risk aversion rules the day.

Chart 2: S&P 500 P/E Ratio



Where are we now? Despite the pain of the past year, the average market P/E ratio stands at a fairly normal 15 times earnings. This puts us still in the middle of a secular bear market. This does not mean we won't have any strong rallies. Indeed, we have just seen one and should expect a cyclical uptrend to begin in earnest sometime this year (if it has not already started). What being in a secular bear market means is that there is a predominant tendency for investors NOT to pay up for earnings. They will be reluctant to consistently chase after stocks and bid them higher and higher. The market will likely continue to deliver two steps forward and one big step backward. It is during secular bear markets, with their fickle nature, that trend following investors can really shine. With our eye always trained on the emergence of a new trend, up OR down, we will delight while other investors become disenchanted with stocks. Of course, we do not wish ill on investors of any stripe. We hope they will all join us to benefit from the market's inevitable swings rather than becoming increasingly disgusted by them.

FAQ of the Week

Question: How are P/E ratios calculated?

In basic terms, a P/E ratio is simply a company's stock price divided by its annual earnings per share. However, there are many ways to calculate this simple ratio. Most commonly, P/E ratios take the current stock price and divide by the most recent four quarters of earnings. In periods of accelerating or declining earnings, this approach can give very skewed results. As earnings increase, P/E ratios can naturally fall unless stock prices rise at a similar pace. P/E ratios typically rise (sometimes sharply) in periods where earnings are falling. To avoid this problem, some investors look to projected earnings to calculated a "forward" P/E ratio arguing that investors are really buying future earnings after all, not what's happened in the past. The forward P/E ratio uses the next four quarters worth of projected earnings as the denominator in the calculation. To get a better sense of the underlying trends behind the market, Yale professor Robert Shiller popularized using a 10-year rolling average of earnings to calculate P/E ratios. This takes the economic cycle swings out of the calculation and focuses attention on how much investors are truly willing to pay for earnings over time. It is this calculation that is used in our commentary above mentioning that the current market P/E ratio stands at 15 times earnings. Finally, analysts often talk about the "earnings yield" of the market. This measure is simply the P/E ratio flipped on its head (earnings divided by price). This metric provides a theoretical return or yield inherent in buying stocks allowing a direct comparison with yields offered by other investments, namely bonds. In short, the P/E ratio is popular because it is an easy calculation that provides a widely understood shorthand for market valuation. But sometimes simplicity masks the underlying complexity rather than illuminating it. Thus, the P/E ratio endures many variations and attendant theories.

Warm wishes and until next week.

The TimingCube Staff