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QUOTE OF THE WEEK

"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. There must be some wisdom in the folk saying: 'It's the strong swimmers who drown.'"

—Charlie Munger

- Enjoy more of our favorite investing quotes

 


SEPTEMBER 20, 2015

 


In This Edition:
- Retest Of Correction Lows, Maybe More
- Has the Fed Assumed a Third Mandate?
- Why the Fed Is Trapped
- What's Likely Next?
- How Can We Profit From This Market?


ON TAP: RETEST of correction lows, MAYBE MORE

 
INVESTORS GOT A RUDE AWAKENING LAST THURSDAY

 

The big news last week was the very closely observed Federal Reserve meeting on Wednesday and Thursday, for which many market-watchers were waiting with bated breath. This was supposed to be the week when there was a good chance the Federal Reserve would announce the first interest rate hike in nearly a decade. Note: Last Tuesday we published the final segment of special three-part series titled, "Where is the Market Headed From Here?" in which we discuss the risks and opportunities that accompanied a rate hike or lack thereof.

The Federal Reserve's Thursday afternoon announcement shocked many investors. The surprise came not from the fact of the FOMC's inaction on rates (which a slight majority of analysts anticipated), but with the very dovish statement, lowered economic expectations, and narrative of reasoning which focused on global risks. 

As a result of the anticipation beforehand and the surprising outcome of the event, the week was highly volatile. The three days leading up to the Fed announcement each saw gains totalling about 3.3%. Then, immediately following the Fed press conference on Thursday afternoon, trader's knee-jerk reaction to maintaining near zero rates was to spike equity prices higher. They must have figured the free money, rising stock-price party would keep rolling. The S&P 500 shot up 1.5% to 2020, above the critical 2000 level that we identified in our Tuesday, Sept. 15 newsletter as an significant level of resistance.

However, that high-five reaction was short-lived. Most investors felt that a rate increase would signal the Federal Reserve's optimism about growth and a return to normalcy. Instead, they got a rude awakening about just how difficult it will be for policymakers to go back to normal conditions in an environment where global considerations are now just as important as the US economy. It sunk in late Thursday and all day Friday that the Fed believes the US, and particularly the global economy, is too weak to tolerate a rate increase.

The Fed also lowered its forecast for the long-run growth outlook, saying the U.S. economy would grow annually from 1.8% to 2.2%, down from its June forecast of 2.0% to 2.3%.

The downturn from the highs on Thursday to the close on Friday totalled about -3% on the S&P 500. More than 10.5 billion shares changed hands on Friday, registering the third-largest daily volume of the year. Since the all-time high set in May, the S&P 500 initially dropped -12.35%, but has rebounded to be down now by -8.24%. For the year, the S&P is down -4.9%.

For a perspective on the S&P 500 downturns since the high prior to the Great Recession, this excellent chart by Doug Short shows the details:

CLICK TO ENLARGE
S&P 500 Downtunrs

S&P 500 downturns since high prior to Great Recession. Chart courtesy Advisor Perspectives. Click to enlarge.


HAS THE FED ASSUMED A THIRD MANDATE?


The Fed has two legal mandates: maximizing employment and maintaining price stability.

During the press conference following the two-day meeting, several times Fed Chair Janet Yellin mentioned weakness in the world's economy as a reason for not raising rates. For example, “A lot of our focus has been on risks around China, but not just China—emerging markets more generally and how they may spill over to the U.S.,” said Fed Chairwoman Janet Yellen, noting “the significant economic and financial interconnections between the U.S. and the rest of the world.”

This week is light on economic news, and there will be no shortage of criticism from Fed watchers. One of those criticisms will surely be whether or not the Fed has assumed a third mandate; to maintain the world economy in addition to attempting to optimize economic conditions in the US. However, there will also be no shortage of Fed representatives speaking about the reasoning behind the Fed's decision in an effort to soothe markets. Essentially, it will all be noise that we should ignore.


WHY THE FED IS TRAPPED


As discussed in our three-part series "Where is the Market Headed From Here," the Federal Reserve is trapped in a situation of their making.

We said, "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."

We believe the Fed missed an interest-tightening cycle, optimally in 2014 when growth was robust, and now it will be nearly impossible for the Fed to raise rates. With an inability to raise rates, the Fed has no bullets left should another recession hit. That contingency may be much closer than many of us want to believe.

As we pointed out in last week's newsletter, there are a good number of positive factors in favor of the US economy. However, benign inflation is not one of them. One of the real risks facing policymakers is global deflation. Commodity prices are already melting down and significantly harming emerging market economies. In an effort by many countries to boost their own exports, a worldwide currency war with countries competing in a race to the bottom has broken out. The recent Chinese devaluation of the yuan was a wake-up call that triggered the August selloff.

But the risk of deflation is not just overseas. In the US, inflation expectations continue to plummet. One of the best ways to demonstrate this fact is by using a market-based approach to analyzing inflation expectations. It is far superior to surveys or other methods.

One of the best bond-based ETFs that is intended to hedge against inflation is the iShares Barclays Inflation Protected Bond Fund ETF (TIP). It is an excellent way to track market participant's inflation expectations because its price increases as fears of inflation increase. If we compare the price of that ETF with a typical Pimco 7-15 Year Treasury Bond ETF (TENZ), we can see what market participants expect regarding inflation risk. If investors were expecting inflation, the TIP security would be outpacing the TENZ ETF.

Actually the opposite is occurring. As you can see from the chart below, even as everyone is talking about a Fed rate hike, inflation expectations are imploding on the far right of the chart:


The ratio of the Inflation Protected Bond Fund (TIP) to the 7-10 Year Treasury Bill (TENZ) shows that inflation expectations continue to plummet.


WHAT'S LIKELY NEXT?


We believe that the broad market will return to test its late August low. The reason for this is based on technical analysis. Here's a brief TA lesson using the S&P 500 as an example. The S&P 500 is showing a classic 'Rising Wedge' pattern. The Rising Wedge is a bearish pattern that begins wide at the bottom and contracts as prices move higher and the trading range narrows.


The S&P 500 is showing a 'Rising Wedge' pattern, which is bearish.

 

The upper resistance line and lower support line converge as the pattern matures. The advances from the reaction lows (lower support line) become shorter and shorter, which makes the rallies unconvincing. This creates an upper resistance line that fails to keep pace with the slope of the lower support line and indicates a supply overhang as prices increase.

In the vast majority of cases, a Rising Wedge pattern resolves bearishly. In this instance, it would be a continuation to the downside of the August selloff. The question becomes how far down? In technical analysis it is quite common for the market to test prior levels. In this case, we would be looking at a test of the late August lows around 1865 on the S&P 500.

If that's the case, sometime in near future we should have a great opportunity to buy stocks. However, there is a caveat…

 

HOW CAN WE PROFIT FROM THIS MARKET?


In our June 28 Intelligent Value Alert newsletter we made the case for a potential market downturn and showed a Big Picture, monthly chart of the S&P 500 from 1995 to present. This chart included three proven indicators for determining significant market turnpoints. It clearly identified the downturns as they began in 2000 and 2007. It also identic the upturns with perfect timing in 2003 and 2009.

When we published the chart in late June, we said that the market was losing momentum and that a downturn was very possible in the near future. However, at that time only one of our three major indicators had rolled over to signal a potential market downturn.

That is now no longer the case. Now all three indicators, the 10-Month Moving Average, the Moving Average Convergence Divergence (MACD), and our Intelligent Market Risk Oscillator™ have all rolled over and are signaling that a selloff has begun. These are not signals of a correction, they are signals of a long-term, significant downturn. The two charts below show the signals with vertical red and green lines showing the turnpoints determined by the signals:


All three of our long-term, Big Picture Monthly Indicators have rolled over.

 

 This chart is a zoom into the three indicators shown above:

 

One option to profit from a downturn would be to purchase inverse ETF's or other ETF's that will profit when stocks decline (such as various bond or utility/consumer staples sector ETFs, etc). However, we feel that it is still a bit early to make that purchase decision. In addition, all ten S&P sectors are in downtrends, so there are no alternative sector ETF's that will currently profit from a continuing downturn in stocks. That will change if the market downturn continues, so we will stay abreast of the ETF situation.

It is still very early in the game to state definitely that a significant, long-term selloff has begun and it is still possible for the indicators shown above to reverse course. In addition, if a major selloff begins, it would be the first time in history without an indication of an imminent recession on the horizon. In particular, unemployment is still improving and there is no inversion of interest rates.

Of course, we are no longer living in an investment world where the US is the center of the universe. It is certainly possible for an event to occur on the other side of the planet that will cause investors to pull money out of the US market, frighten consumers and create an immediate recession here. The US has been doing that to the rest of the world for years, so maybe karma will catch up with us.

Should the market go through a period of volatility in the next month or so that works off the excessive valuations, and certain risks are taken off the table (such as risk from the Chinese and emerging-market economies), it's possible that we will see the bull market resume. If so, we will be selecting a new group of undervalued stocks for our two portfolios at the appropriate time.

Value investing takes advantage of the sub-optimal behavior of investors when they oversell the stock of sound companies, usually a result of fear. If conditions work out properly, that will be the exact situation we will take advantage of in the near future.

However, in the meantime it is prudent to maintain a 100% cash position in both our portfolios. Those subscribers who are not content to remain on the sidelines are seriously risking their financial fates by remaining in this market. If there were safe and profitable investments available right now, we would already be in them. We will let our subscribers know as soon as that situation becomes available. Note: Only paid subscribers will have access to our real-time stock/ETF selections.



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.