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QUOTE OF THE WEEK

"The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor."

Jesse Livermore

- Enjoy more of our favorite investing quotes

 


SEPTEMBER 15, 2015

 


In This Edition:
- The Global Tug-Of-War Between Established Economies and Emerging Markets
- Steady Growth and Low Unemployment Justifies a US Interest Rate Increase
- Emerging Market Economies are in Dire Straits:
   - Currency Valuation and Devaluation  - US Interest-Rate Increase Will Hurt Emerging Economies  - Commodity Meltdown
- Reasons Why There May Be No Recession/Market Crash
- Positives in the Market
- The Bottom Line
- What's the IntelligentValue Strategy for Profiting From These Potential Outcomes?
- Technical Analysis Shows Bearish Divergence and Failure at Resistance Levels

(Read Part 1, Read Part 2)


WHERE IS THE MARKET HEADED FROM HERE?

 
WHAT ARE THE RISKS, THE OPPORTUNITIES, and how can you make money?

PART 3 of 3
 

 

In Part 1 of this series (Aug 24), we covered the largest ever spike in the volatility index ($VIX) during the week of August 16 and the most volatile day in the history of the Dow Jone Industrials (August 24). We discussed the barrage of financial-fright stories in the media and the fact that not all the news is grim.

In Part 2 of this series (Sept 1), we addressed some of the very real challenges faced by world markets, including the enormous debt burden in the world. We discussed the severe slowdown in the Chinese economy, anemic US economic growth including a decline in operating earnings, and we pointed out 23 emerging market countries where the markets have been crashing for months. We also covered the fact that worldwide quantitative easing is becoming ineffective after six years of application.Central banks are effectively out of ammunition with interest rates still at emergency levels near zero should the world economy turn down again.

In this issue, Part 3 of this series, we will attempt to make this a balanced presentation. That said, it remains much harder to find positive opportunities than it is to find dangerous risks across the world's markets. The reason we're focusing on global markets instead of just the US is because now more than ever the US economy is dependent upon and intertwined economically with the rest of the world. In this issue, we will address what is by far the most dangerous threat to global financial markets and outline the factors that could trigger it. However, we will also wrap up this series with the positives that come from widespread investor fear and market volatility, and will discuss the opportunities those factors present to us as value-oriented investors.

THE GLOBAL TUG-OF-WAR BETWEEN ESTABLISHED ECONOMIES AND EMERGING MARKETS


Global markets are engaged in a economic tug-of-war that threatens to profoundly affect each of us financially. The force that wins this battle will have a dramatic impact on the daily lives of hundreds of millions of people, not just affecting our investments. The reason is that the forces involved in this financial conflagration could influence the average world citizen's bank account more than has ever occurred before in the past, with the possible exception of the Great Depression. We believe that what happens in China or Brazil or any of a dozen emerging countries in the next six months will dramatically affect the average citizen in both developed and developing nations. Here is a synopsis of the tug-of-war that is taking place today...

STEADY GROWTH AND LOW UNEMPLOYMENT JUSTIFIES A U.S. INTEREST RATE INCREASE


This global tug-of-war boils down to the forces of healthy growth now taking root in developed economies and the forces of potential deflation and financial calamity in emerging market economies.

On one hand is the steady, if unspectacular growth in developed economies like the U.S. and England. Even Europe is finally beginning to register economic gains. This growth is prompting the US Federal Reserve and the Bank of England to consider increasing interest rates for the first time since 2007 when the global credit crisis began.

The US Federal Reserve has been suggesting for some time now that the first rate increase could be announced at their September 16-17 Federal Open Market Committee meeting. However, based on the US Employment Situation Report released on Friday, September 4, whether there will be a rate increase or not is still anybody's guess.

US EMPLOYMENT GAINS SHORT OF EXPECTATIONS, BUT...

Jobs gains in the US for August totaled 173,000, short of the 220,000 consensus estimate and well below even the low end of the consensus forecast. This report was supposed to be the most important one in years. Many expected it would be the final indication as to whether the Fed would finally move in September, but it provided no relief for the Fed's quandaries.

Private sector hiring led the unanticipated shortfall in jobs added, manufacturing jobs declined, and the labor participation rate remained at the lowest level since 1976. So, even while the Fed is indicating that it is still on track for a rate hike, all the conditions that Fed Chair Janet Yellen wanted to see confirmed before an increase are not materializing. This is a recipe for more uncertainty.

On the other hand, although the job additions were less than expected, employment statistics are subject to seasonal adjustments and for six years there has been a consistent under-reporting bias for the month of August. Each month there is a revision of prior months for more accuracy, and next month's revision could easily move the jobs-added data for August up to the 220,000 consensus estimate or beyond. Also, the critical unemployment rate fell more than anticipated.

The unemployment rate dipped to 5.1%, which is within the Fed's estimated range of full employment of 5.0% to 5.2%. Therefore, the Federal Reserve has already achieved one-half of its mandate to maintain full employment. The Fed is facing an unemployment rate potentially lower than 5% in October, and an unemployment rate with a 4%-handle by December. The Fed had previously not forecasted the unemployment rate to be this low until the end of 2016.

Also, there was an increase in hours worked and an uptick in wages as employment conditions are now, finally, beginning to tighten. In more good news, on September 9 it was announced by the Labor Department that job openings in the US had increased by 430,000 to a record of 5.7 million.

Historically, if this trend continues, inflation rooted in wage increases is always the outcome. The Federal Reserve wants some inflation, with a target of ~2%, but it has been running well below that goal since the financial crisis. However, they don't want inflation to get out of hand. That can happen quickly, especially with the $3.7 trillion in stimulative funds that have been pumped into the economy for the last seven years still floating around and the US employment situation quickly tightening.

EMERGING MARKET ECONOMIES ARE IN DIRE STRAITS


On the other side of global tug-of-war is the fear of deflationary forces emanating from a severe deceleration in China and emerging-market economies. The primary reason for this worldwide slowing is related to 1) a dramatic increase in the value of the dollar compared to other currencies, 2) expectations for the long-anticipated interest-rate increase in the US, and 3) the slowing of the Chinese economy and its reduced need for raw products from emerging markets. (We discussed the slowing China economy in Part 2 of this series, Will China be the Source of the Next World Economic Downturn?)


EMERGING MARKET CURRENCY DEVALUATION

For the last year, the perceived strength of the US economy and the much-anticipated interest-rate increase has significantly boosted the value of the US dollar compared to the world's other currencies.

Many countries, especially Japan, the EU, and emerging markets have ramped up stimulus as the US is preparing to tighten, and the result is a dramatic gain in the value of the US dollar. Stimulus tends to flood the market with the currency of the country doing the stimulus, and the result is the devaluation of that currency. In fact, the change in the value of the dollar compared to a basket of other currencies has been the most rapid in 40 years. For example, from July 2014 to April 2015, the dollar moved from $80 to $100 compared to a basket of world currencies. Since then, it became volatile and has moderated a bit, but still holds at $96, which amounts to an overall 20% boost in comparative value from a year ago.


The US Dollar has increased in value 20% in the last year compared to a basket of world currencies.

 

The result of this increase in the US dollar, which serves as the world's reserve currency has been dramatic economic displacements. Emerging market currencies can't keep up with the dollar's speed of change. The dollar has gained 8% compared to the major emerging currencies over the last 12 months, according to the St. Louis Federal Reserve Bank.

But looking closer, it gets much worse for some. America's greenback has gained 61% compared to Russia' ruble, 43% on Brazil's Real and 19% on Turkey's Lira in the past year. According to a September 10 article in the Wall Street Journal, "Investor bets that Brazil and South Africa will default on their debt hit their highest level since the financial crisis, underscoring the stress mounting on emerging-market economies heading into the most anticipated Federal Reserve meeting in years. Currencies in Turkey, South Africa, and Malaysia have plunged to the weakest levels in many years against the dollar."

The most significant problem for emerging market economies is that the country's governments and their businesses have a great deal of debt denominated in US dollars. Repaying the debt becomes a significant problem as their currency loses value relative to their dollar-denominated debt.

In addition, because of the increase in the value of the dollar, which is the reserve currency in which almost all world commodities are denominated, emerging market countries have experienced dramatically reduced prices for their commodity production. The chart below shows how commodity prices have dropped by 45% from the 2011 high as prices moved in the exact inverse of the value of the dollar:


Commodity prices have dropped by 45% from the April 2011 peak to September 2015 as the dollar has strengthened. While many argue that commodity prices are most affected by supply and demand considerations (such as we hear now about oil), there is almost a perfectly inverse, mirror relationship between the dollar and commodity prices. Supply and demand considerations affect commodity prices to a minimal degree compared to the value of the dollar.

 

The CRB Commodity Index comprises 19 commodities: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gas and Wheat.

The vast majority of reports you hear in the media blame oversupply, for example, the glut of oil for the sharp decline in that commodity, but this assumption is inaccurate. Historically, the supply/demand imbalance in any commodity only accounts for about 5%-15% of the change in the price of oil (or any of the other commodities in the index). 90% of the change in the price of commodities is always primarily related to the strength of the US dollar.

At this time, because of the very persistent factors causing an increase in the value of the dollar, there is no indication that the dollar will weaken, or commodity prices will rebound. We can expect this trend to continue for the foreseeable future, worsen, continue to affect significantly commodity-producing countries, and possibly be the source of the next economic Armageddon.


US INTEREST-RATE INCREASE WILL HURT EMERGING ECONOMIES

Emerging markets have benefited from the Fed's near-zero rates since 2008. Many investors seeking more robust returns than were available in the US bought emerging market bonds, which provided higher interest rates to accompany their higher risk. However, with the pending interest rate increases coming in the US and the economic slowdown in emerging markets (see next section), investors have significantly cut back on purchases of bonds from emerging-market countries and stock from emerging-market companies.

An increase in the US interest rate would effectively be akin to a margin call for debtors in emerging markets with $4.5 trillion of US dollar liabilities. According to the Institute of International Finance (IIF), investors withdrew -$8.7 billion from emerging market stocks in August 2015. Debt flows softened but remained positive at $4.2 billion, so net outflows from emerging markets totaled -$4.5 billion. Since 2010, emerging markets have averaged about $22 billion per month in inflows, so the decrease is dramatic. This change in investment patterns is starving emerging-market countries and companies for cash.

COMMODITY MELTDOWN

Accompanying a prostration in emerging market currencies is another force causing swiftly dropping commodity prices: decreased demand based on the economic slowdown in China. We cannot underestimate how significant the slowdown in China is to the rest of the world. China now accounts for 15% of global GDP and about half of global growth. In 2009, China stepped into a stimulus mode that created the largest misallocation of capital in world history. Preparing for a massive influx of new workers migrating to the cities and suburbs from rural areas, China built hundreds of what are mostly empty 'ghost towns.'

Remember, China is a communist country, so it was up to the government to build the cities to accommodate the people that they expect to move from the countryside over the next 20 years. Now experiencing significant debt problems, the Chinese government has drastically cut the spending on additional, unoccupied cities. We addressed more of the economic slowdown in China in Part 2 of this series of articles.

With the economy of China slowing severely, the demand for imported raw materials from emerging market countries has also been dramatically reduced. This slowdown in buying is having a far-reaching effect on those emerging economies.

In addition, with crude oil prices falling to a six-year low of $45 per barrel compared to the $105 per barrel price it commanded last June, that's a big problem for oil-producing countries, especially Russia. Beyond oil, the global currency devaluation is pushing prices of everything from metals to crops off a cliff. Several South American exporting countries (especially Brazil) are being decimated by a collapse in prices for products such as coffee, sugar, and soy. A broad index of 22 commodities compiled by Bloomberg is at its lowest level since 1999.

For emerging-market countries, the combination of products being exported going down in value and liabilities that are denominated in dollars increasing in cost is a very dangerous combination. The default of one or more emerging market countries could easily set off a worldwide contagion and holds the real potential for global financial catastrophe. This is the single greatest risk that exists in global financial markets.

REASONS WHY THERE MAY BE NO RECESSION/MARKET CRASH


At the beginning of this 3-Part series of articles, we promised the provision of a balanced approach that would include the positive aspects of the market and economy along with the risks. You have waited a while to get to this part, but we are going to turn now to the positive aspects we see in the US economy and the market.

A bear market is not inevitable. If it happens, this would be the first bull market in history to end without a single instance of Federal Reserve interest rate tightening. There have been eight interest rate cycles since the mid-1950s, and the market went up for 30 months on average after each initial rate hike. Also, on average the market was up 9½% one year after liftoff across those eight tightening cycles.

While the Federal Reserve has held the federal funds rate near zero since 2008, it could raise it for the first time in more than nine years when the Federal Open Market Committee meets on Sept. 16-17. We believe it's likely that if there is an increase, the rate hike will be tiny, perhaps only 10 to 15 basis points. In this way, the Fed can say that it raised rates, but it will be so small that it shouldn't frighten investors. The other possible scenario is that the Fed puts off a rate increase until its October or December meeting. However, should the Fed delay interest rate hike indefinitely, it will spook investors about the severity of the world economic conditions and also cost the Federal Reserve credibility.

While we have seen some serious volatility and what amounts to a correction (-11%) in the stock market recently, it's currently unlikely that US equities will enter into a bear market (greater than -20% decline). Bear markets don't materialize by immaculate conception, but because investors anticipate the onset of recession based on the facts at hand. There has never been a bear market in the United States without the accompaniment of a significant recession.

The real question is whether or not there will be a default from an emerging country that could severely impact the world economy and make investors believe that the risk of recession is real and significant. While the US economy and markets are still firm, a default of an emerging market country could quickly change that dynamic.

POSITIVES IN THE MARKET


There a several data series that strongly argue against a recession call. One is the labor market. Only when we see the U3 unemployment rate jump more than 7.5% on an annual basis or the 4-week moving average of jobless claims jump north of 15% on a yearly basis should we begin to worry. Of note is that both annual rates are nowhere close to hitting recessionary thresholds. In fact, the unemployment rate (top chart) continues to fall while jobless claims (lower chart) remain well below risk levels:

CLICK TO ENLARGE
U3 Unemployment Rate

U3 Unemployment Rate, Y/Y % Change. Courtesy of Bloomberg. (Click to enlarge.)

 

CONFERENCE BOARD'S EMPLOYMENT TRENDS INDEX

Another view of the employment situation in the United States is based on the Conference Board's Employment Trends Index. This index aggregates eight labor-market indicators that provide a very robust view of the employment situation. The chart below shows the rate of change in the index going back to 1975. When the index dips below zero, the US tends to be in a recession within a few months. The last such times were 2007 and 2001, providing lead times of three months and four months, respectively. The current reading is 5.81%, so we are nowhere close to a recessionary signal.


CLICK TO ENLARGE
Employment Trends Index
Conference Board's Employment Trends Indexannual rate of change. Courtesy of Bloomberg. (Click to enlarge.)


DISCRETIONARY SPENDING INCREASING

The US consumer, while not demonstrating the robustness associated with some prior economic booms, is making progress as confidence in the economy improves. Discretionary expenditures are one valuable way to track the progress of the consumer, and statistics based on eating out at restaurants is a key measure.  As one of the most discretionary items, dining out is doing quite well. A dip below 100 indicates recessionary conditions, and this chart has not shown a drop below 100 since mid-2009. In fact, while not exploding in growth, restaurant performance expectations are steadily increasing and are now hitting a six-year high.

CLICK T0 ENLARGE
Restaurant Expectations Index

Restaurant Expectations Index, courtesy of Bloomberg and PFS Group.


ADDITIONAL POSITIVE FACTORS

In addition to these US economic indicators, the following factors are significant positives for the world markets:

• Foreign economies are not nearly as levered to currency risk as they were during the 1997/1998 Asia and Russian currency crisis and may be able to better withstand devaluation this time around.

• China has a great deal of additional firepower it can throw at an economic downturn. Unlike America and most other democracies, China does not have to answer to taxpayers about how the government spends the country's wealth.

• Tuesday's report for retail sales showed robust growth. Even with a decline of 1.8% in the cost of gasoline factored in, August retail sales showed a 0.2% gain for an annualized growth of 2.4%. Store Sales excluding car dealerships, building supply and gasoline station sales — the so-called control group that economists use to gauge consumer spending — rose by 4.8% annualized. June and July numbers were also revised higher.

MORGAN STANLEY ISSUES A 'FULL HOUSE' BUY ALERT

According to a September 1 article in The Telegraph, US investment bank Morgan Stanley has issued what they call a 'full house' buy alert for international stock markets for the first time since early 2009. It is known as a 'full house' alert because five indicators are all simultaneously signaling the markets are ripe for gains. The indicators are 1) Composite Valuation Indicator, 2) Fundamentals Indicator, 3) Risk Indicator, 4) Capitulation Indicator, and 5) Equity Dividends Relative to Bond Yields.

According to the article, "The US investment bank said that all five of its market-timing signals are now flashing a buy signal as selling-fever reaches capitulation levels. This is a rare occurrence, typically leading to a V-shaped recovery that delivers a 23pc gain in stock prices over the following 12 months.

Graham Secker, the bank’s chief European equity strategist, said the sell-off over recent weeks is primarily driven by emotion and has little to do with the underlying outlook for the world economy. “Equities remain very cheap relative to government bonds and there remains a lot of liquidity around that is looking for a home,” he said.

Morgan Stanley’s bold call has raised eyebrows since the bank caught the exact top of the European equity market in June 2007 using the same timing indicators, on that occasion issuing a "full house" sell alert.


LONG-TERM UPTREND STILL IN PLACE

Don't forget that we pointed out in Part 1 of this series that the market's long-term support is still in place. Notice that stock prices dropped precisely to the 6+ year support line at the depths of the downturn last month before rebounding higher. It is inevitable that prices will always revert back to a mean after rising too far above it:


Market uptrend still in place, but for how much longer?



THE BOTTOM LINE


We believe that what's happening in the world's financial markets has made currency devaluation and global deflation the primary economic risks of a Federal Reserve interest rate increase. However, this entire problem, which could cause a global economic hardship is the Fed's creation. The markets are essentially experiencing taper tantrum v2.0. The first so-called 'taper tantrum' occurred in mid-2013 when then-Fed Chairman Ben Bernanke announced that the Federal Reserve planned to cut gradually back (taper) on quantitative easing in preparation for an interest rate increase.

As with many of the speeches and interviews by Fed voting members prior to taking action, this statement was essentially a test of the receptivity to an idea. However, the reaction was quite troubling to the Fed as the US equity market took a downturn for several months. This Federal Reserve regime, being more focused than is justified on elevating market prices, blinked and decided to reinstate another round of QE stimulation. Of course, we now know that the last round of QE did not end for another 1.5 years, in October 2014.

Now, with the Federal Reserve planning on raising interest rates as soon as this week, the markets are rebelling again. The actual jawboning of the idea for interest rate increases began a year ago, and that's precisely when the world's economic problems started with a dramatic rise in the value of the US dollar relative to other country's currencies.

The real risk the markets face is not a gradual interest rate increase; it is the risk of a further currency devaluation that might drive one or more marginal emerging-market countries over the edge into default. The result of that occurrence may begin a contagion that will severely impact financial markets and economies across the world.

FEDERAL RESERVE NOT SERVING ITS INTENDED FUNCTION

The Federal Reserve's primary function according to law is a dual mandate to keep inflation low (~2%) and attempt to maintain full employment (~5% unemployment is considered full employment) in the United States. The primary tool to accomplish these feats is monetary central planning through the crude instrument of interest rate pegging in the overnight funding/money market rate. The overnight funding market is where trillions of dollars of bank inventory and trader positions are financed.

However, in 2008 under the leadership of Federal Reserve Chairman Alan Greenspan, the Fed undertook a task that was not remotely included in its mission statement. Greenspan formulated the philosophy of inflating the stock market as a way to stimulate the economy, through what he called the 'wealth effect.' The concept was that if people feel wealthy, they will spend more, and the economy will prosper. This same approach was adopted by Greenspan's chosen successor, Ben Bernanke, and apparently even the current Fed Chair, Janet Yellen.

To accomplish this objective, the Federal Reserve lowered interest rates to zero when many would argue there was no reason whatsoever to do so. Worse, it is maintained a zero interest rate policy (ZIRP) since 2008. The bottom line is that the current Fed approach of endlessly preserving interest rates at zero to elevate the stock market has created potentially disastrous unintended consequences. When you deny price discovery with the overnight rate pegged at zero for 80 months running, it is a massive subsidy for speculation. The Fed has no reason to be pegging interest rates at zero in the first place. It just doesn't work in a world that is already drowning in debt.

The only reason to peg the overnight rate at zero is if you are trying to incentivize businesses and households, as an emergency measure, to borrow as a way stimulate the economy. However, companies in America have all the debt they will ever need. In the fact, instead of using the nearly free money to expand and grow, businesses have used the debt to buy back their stock and engage in record-setting levels of mergers and acquisitions. According to FactSet, in the last year 362 companies (or 72%) of the S&P 500 participated in share buybacks. In the last 12 months companies spent $564 billion on share repurchases, which was a year-over-year increase of 18%.

By reducing the number of their shares outstanding, corporations have ostensibly taken this route as a way to increase EPS because they are unable to achieve organic growth. Half the market gains since 2008 have come from corporations borrowing nearly free money to buy back their stock to cause their earnings per share to appear to increase.

RECORD M&A DEALS

In addition, companies are turning to mergers and acquisitions, utilizing low-cost debt as a way to acquire other companies and grow. Global mergers and acquisitions are on pace this year to hit the highest level on record, thanks to a buying spree from companies on the hunt for growth using the lowest cost debt ever available. Takeover-deal announcements would reach $4.58 trillion this year if the current pace of activity continues, according to data provider Dealogic. That tally would comfortably exceed the $4.29 trillion notched in 2007, a record year for deal making.

Concerning households, individuals and families cannot use the inexpensive debt because they are already at peak debt. 90% of American households cannot qualify to borrow more money based on their debt-to-income ratio.

 

The primary thing that zero interest rates have accomplished is incentivizing Wall Street to take ever-increasing risks. 

The Open Market Committee of the Federal Reserve has essentially abolished the free market mechanisms for price discovery for the cost of money. The Federal Reserve was created to provide liquidity in emergency situations, not micromanage the stock market for the benefit of the wealthy as it has been doing for nearly seven years now.

The Fed's mission is simpy to keep inflation at a low, reasonable rate and keep employment as close to full as possible.The Fed's mission is NOT to boost the economy or create a wealth effect. The Federal Reserve is effectively attempting to emulate communist China's command-and-control economic policies. The consequences of these actions have caused massive financial dislocations already and may ultimately result in worldwide economic disaster. If so, this will be the third Federal Reserve instigated economic wreck in 15 years.

IS THE FEDERAL RESERVE GOING TO INCREASE INTEREST RATES?

Yes. Definitely. Whether it is in September, October or December, the Fed will raise rates. To retain any semblance of integrity and credibility, they must do so. However, in all likelihood, the rate increase will be so minor that it will make no difference at all. Yes, there will be endless fretting and second-guessing about whether the Fed's actions were proper. It may even cause the market to decline in the short term, but will a 10 basis point, or even a 25 basis point increase make any difference?

Consider the possibility the Fed takes a more aggressive approach and increases rates by 50 or 75 basis points between now and the end of the year. If there is a subsequent collapse of an emerging market economy or an onset of deflation across the globe, will 0.75% be enough for the Fed to reduce rates and stimulate their way out of a severe event? No, absolutely not.

Federal Reserve is trapped. If they raise rates, they are worried about what the consequences might be, if they keep rates low, they must worry about inflating more asset bubbles and distortions.

Since the Fed withdrew from quantitative easing at the end of 2014, the market moved sideways through all of 2015 until the correction in August. If the Fed increases interest rates now, it will undoubtedly be faced with lower stock prices and could even trigger even a potentially calamitous situation in one or more emerging markets. If it doesn't raise rates, it will be continuing an untenable situation with no room for adjusting rates downward should another crisis strike. It also risks triggering wage-based inflation from a too-tight labor market and the risk of inflating ever-increasing bubbles in asset prices. With the Fed's back against the wall, there are no viable options for Janet Yellen and company.

Nevertheless, as investors we find ourselves in the position of needing to anticipate and be prepared to react to the contingencies we just discussed. How shall we handle these risks or opportunities in a manner that preserves funds and preferably, makes a profit?

WHAT'S THE INTELLIGENTVALUE STRATEGY FOR PROFITING FROM THESE POTENTIAL OUTCOMES?


Unlike the approach used by the majority of investors, at IntelligentValue.com we do not base our investment decisions on opinion or speculation about what may or may not happen, no matter how thorough we believe the logic. We base our investment determinations on two techniques that serve our members well.

Our approach is to 1) adjust market exposure based on rules-based technical analysis, and 2) choose undervalued stocks based on quantitative analysis. The combination of choosing stocks that are selling at a discount to their intrinsic value when both the timing of the market and the timing of the individual equity is favorable is a can't-miss approach. We use carefully crafted quantitative algorithms to eliminate discretionary descision-making as much as possible to avoid human, emotional errors that are rife when it comes to money issues. As a result, IntelligentValue has produced a powerful return, beating the market benchmarks by a wide margin and producing profits every year (including 2008) since our founding in 2004.

MARKET EXPOSURE

What does our technical analysis tell us is the appropriate market exposure for the current challenging environment?  Since 2006, we have successfully used our weekly Intelligent Market Timing Analysis (IMRA) to determine our level of market exposure. For those reading this who are not IntelligentValue members, a free edition of the IMRA from September 12 is posted here.

Currently, the IMRA is telling us to remain on the sidelines in cash. It's possible we will see a change of that status following this week's Federal Reserve meeting. If the market breaks through current resistance levels (see below), we will be buying a new set of undervalued stocks for our two portfolios.

WHEN TO STAY ON THE SIDELINES IS AS VALUABLE INFORMATION AS A BUY OR SELL SIGNAL

Technical analysis can tell us when NOT to buy, and that's just as valuable as a signal to buy or sell. At this time, there are two additional types of charts we would like to show you that are recommending that we do not enter the market yet. When those conditions change, it will be an all-clear to buy undervalued stocks again.

SUPPORT MORPHS INTO RESISTANCE WHEN BROKEN

One of the primary tenets of technical analysis is that previous support levels morph into the first resistance level when broken. For example, the S&P 500 has well-established support going back to January at about the 2000 level. That support was broken in the August sell-off, and the market is now having difficulty breaking back above this new resistance. The chart below showing the S&P 500 demonstrates this dynamic. It is unlikely that the market will give us an 'all clear' until that new resistance level is pierced to the upside.


A primary tenet of technical analysis is that a support level morphs into the first resistance level when broken.
The current resistance stands at about 2000 for the S&P 500.

 

BEARISH DIVERGENCE

A bearish divergence is a pattern in technical analysis when a technical indicator moves in the opposite direction of an increasing price trend. A substantial divergence is a clear warning sign that a change is coming with a fall in prices.

Many technicians use the Relative Strength Index (RSI) as an indicator because it measures the magnitude of recent gains with the magnitude of recent losses. In this way, chart watchers use RSI to gauge the momentum of a trend.

When RSI is moving in the opposite direction of a bullish price trend, it is called a bearish divergence. It implies that the uptrend is losing momentum and could reverse course at any time. For the S&P 500 charts shown below, RSI has been moving down for months as prices continued to rise to all-time highs.

 The chart below shows examples of bearish divergences at the peaks of the last three bull market tops. You can clearly see the prices continue to rise as the RSI declined. We used RSI is one of our indicators to determine to exit the IntelligentValue model portfolio stocks starting with our June 28 newsletter ("Big Change Coming in the Market This Week").

 

The Market Technicians Association describes divergences pictured in the chart above as the most-bearish type, a “Class A bearish divergence.” This class is defined as prices climbing to record highs while RSI hit distinct lower highs and lower lows.

BULLISH DIVERGENCE

A bullish divergence is the opposite of a bearish divergence. It means that when prices are trending down, the RSI indicator begins trending up. This tool can be used as an indication of a bottom developing. A bullish divergence can be a strong buy signal, as shown in the chart below by the two bear market bottoms of the last 15 years. IntelligentValue used the clear bullish divergence on March 9, 2009, to call for an 'all in' bullish signal and we loaded up on deeply undervalued stocks for our two value-based portfolios.

While most investors were still frightened of the market, we were able to produce a 1600% return for our Deep Value Portfolio in 2009 because technical analysis was telling us 'the coast is clear' for buying stocks.

 

WHAT IS TECHNICAL ANALYSIS TELLING US NOW?

As you can see from the lower-right side of the chart above, the declining RSI suggests that a bottom may be some time away before a bullish divergence develops. It is possible that we will see continuing declining prices for some time. If that's the case, we will be purchasing conservative, inverse ETF's to profit from the downturn.

Many investors eschew technical analysis in favor of fundamental analysis. However TA is not voodoo. As discussed in the charts above and our weekly Intelligent Market Risk Analysis (IMRA), TA's objective is to avoid losses and maximize returns by identifying inflection points in pricing that quantitative fundamental analysis cannot.

As an independent source on this statement, there was an interesting article by Mark Hulbert on MarketWatch.com last week, titled "Technicians vs. analysts in a CNBC stock-picking slapdown: Who wins?" The answer may surprise you.

IntelligentValue's
'unfair advantage' is that we combine both technical analysis and fundamental analysis to avoid significant losses by timing the market in our favor. We also maximize profits by purchasing undervalued stocks, at the appropriate time, when they have the best chance for success.

If we see a signal after Wednesday/Thursday's Fed meeting, we will notify subscribers and update our IntelligentValue model portfolios (either bearish or bullish) in this weekend's edition.


(Read Part 1, Read Part 2 of this series)



We hope that we have thoroughly discussed the issues in this Value Alert, and you can implement these ideas to your benefit. Our objective is to give you the best value-oriented investment information possible, with ease of use, timely identification of the issues that affect our portfolio positions, and a full understanding of our approach.  If you have any questions or comments, please contact us with a support ticket.

Best Wishes for Another Week of Intelligent Value Investing,
IntelligentValue.com

 

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Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Shareholders, employees, and writers associated with IntelligentValue, Inc. may hold positions in the securities that are discussed. If you are not sure if value investing or a particular investment is right for you, we urge you to consult with a Certified Financial Advisor. Neither IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.