SEPTEMBER 27, 2015
LOOK OUT BELOW?
BEARISH SIGNALS, BOTH TECHNICAL AND FUNDAMENTAL
As Buffett said in our quote of the week (above), the view ahead is frequently not clear. Let's see if we can clean that windshield a bit this week.
IntelligentValue is a unique for a stock advisory in that we combine both technical analysis (to determine our portfolio exposure levels) and fundamental analysis (for individual, value-based stock selection). Most newsletter and other services specialize in one or the other, but not both. We have found that the combination produces outstanding returns with minimal drawdowns, and our exceptional model portfolio performance reflects that philosophy.
In our June 28 newsletter, titled "Big Change Coming to the Market This Week," we forecast that a downturn in the market was imminent. We were correct because volatility started to increase the following week, equities began losing significant momentum in July, and in August the big selloff began. Per the recommendations of our Intelligent Market Risk Analysis, we had subscribers ease out of the market through the month of July. We accomplished this by placing closing-price stops on each of our positions and were completely out of the market well before the August downturn began.
While a rules-based technical analysis system immensely aids in determining market-related risk and limiting losses, sometimes the market is 'sitting on the fence' and could go either way.
That is the exact situation in which we find ourselves presently. Is the market going to continue the selloff that began at the end of August, or will it rebound from oversold levels? We have discovered that objective analysis of overall, macroeconomic conditions can help anticipate whether the technical charts are going to move higher or lower when they are 'sitting on the fence.'
For our premium subscribers, we provide updated chart analysis of both small-cap and mid/large-cap value stock indices in our weekly Intelligent Market Risk Analysis (IMRA). We use those charts to help determine the exposure levels in our two value-based portfolios.
However, in today's issue of the Intelligent Value Alert newsletter, we will look at two charts of the broad market. For that analysis, we will first use a long-term monthly chart of the S&P 500 large-cap index. The second chart will be of the Russell 3000 index, which combines small, medium, and large-cap stocks for a total of 3,000 companies.
Timing METHOD with 100% WINNERS OVER 55 YEARS says bear market has begun
When we first warned of an impending downturn in our June 28 newsletter, we published a very simple, 'big picture' monthly chart of the S&P 500 going back to the late 1990s. The chart showed three basic technical indicators that can be used as signals for major market turning points. Each indicator provides a different type of approach and confirms the results of the other two indicators. We base the chart on monthly price data and use moving averages to establish momentum-based signals. This type of indicator is often late in its recommendations, which is why we don't use it on a regular basis. However, its effectiveness over the long term in identifying important market turnpoints is exceptional. We will show you in a moment that it has a 100% perfect record of winning trades over the last 50-years.
At that time of publication on June 28, only one of the three indicators had turned down, but it looked as if the other two were close to sell signals. Today the updated version of that chart shows that all three indicators have now rolled over and are warning that a bear market has started.
Monthly momentum signals, 1997 – present. All three indicators have now rolled over and are signaling the start of a bear market.
This approach uses a 10-month moving average, the MACD indicator, and our Market Risk Oscillator, all on a monthly basis. The system is at a disadvantage because it is slow to give signals. Moving averages are inherently slow with their signals because they are backward-looking, and using them on a monthly basis makes it even more so. Therefore, this market timing system is not quick to respond when it comes to timely entry and exit of the market. However, we have recently completed a study of the same S&P 500 index run with these three indicators over the course of 50 years. The results were surprisingly good!
Because this chart contains 50 years of price data, we had to break up the screen capture into two images. Click each chart to see a full-size view:
LONG TERM MONTHLY TIMING SYSTEM (1964-1987)
Click to Enlarge
Long-Term Monthly Timing System, 1964-1990
LONG TERM MONTHLY TIMING SYSTEM (1991-Present)
Click to Enlarge
Long-Term Monthly Timing System, 1991-Present
100% WINNING TRADES OVER THE LAST 50 YEARS
The system, which will call 'Simple Monthly Timing,' had a total of just 15 trades over the last 50 years and all 15 were profitable. The winning trades lasted an average of 29.67 months, and there were no losing trades. Time in the market is 69.76%, leaving 30.24% of the time in cash. The system produced a total return of 8,742% for an annual return of 8.70% (this return does not include dividends).
While that return may not sound like much, a lump-sum starting investment of $100k becomes $8.7 million over the period reviewed. While there were no ETFs for the purpose until 1993, the return from this basic market timing system compares very favorably to a theoretical buy-and-hold return of 7.44% for the S&P 500 over the same period. At that annual return, the ending balance of a buy and hold of the S&P 500 over the last 50 years would be valued at $3,509,217 (does not include dividends). The difference between a buy-and-hold of the S&P 500 or an approach using this Simple Monthly Timing system is $5,233,278. The Simple Monthly Timing provides 2.5 times the return of buy-and-hold at the end of the 50-year period!
While not providing perfect timing on entry and exit, an investor using it can feel confident that our Simple Monthly Timing system works. Also, an investor using the quantitative Simple Monthly Timing would avoid the significant drawdowns that can destroy confidence as well as avoid the stress and inevitable human errors that come with financial decision-making.
What conclusion can we draw from this system today? The message from this 100% winning-trade system, applied to the current conditions, is that a bear market has begun. The system gave a signal at the start of September to exit the market. That said, we do not use this system we've dubbed the Simple Monthly Timing. We can do better than that, and have been doing better since we launched IntelligentValue in 2004.
Now let's take a look at a tighter running system that uses weekly prices rather than monthly. Note: We never use daily prices in a chart analysis because of the tendency for short-term price charts to whipsaw and give false signals.
Weekly Indicators SITTING ON THE FENCE: BULL OR BEAR MARKET Ahead?
The following chart shows a broad-market index. The settings are similar to the market-timing approach used in our weekly Intelligent Market Risk Analysis (IMRA) which is available to subscribers. Please note that our IMRA system uses six different indicators to cross-confirm market exposure decisions. However, we only display three of them (pertinent moving average lines, Bollinger Bands, and our Market Risk Oscillator) in the charts, as shown below.
For this example of current market timing applied to the broad market, we will use the Russell 3000 index ($RUA). The Russell 3000 index combines small, medium, and large-cap stocks and has a total of 3,000 companies in the index:
Russell 3000 Index with our basic IMRA settings applied. This chart shows that the broad market is teetering just above the 120-week moving average.
This chart shows that with the exception of October 2014, for the last two years the broad market (Russell 3000) was staying above its 20-week moving average (dotted blue line). Then in late June, the index dropped below its 20-week moving average, and our Market Risk Oscillator (lower window) dropped out of the Bullish Zone. It was at this time that we gave subscribers notice that we would be exiting the market, based on the application of tight closing-price stops on each stock in our portfolios.
The message today from this market timing system is less apparent than it was last June. The Russell 3000 is staying just above its 120-week moving average (green line, top window), and our Market Risk Oscillator (lower window) has been in oversold territory for the last month. Will stocks rebound from here and the bull market resume, or is there more downside ahead? One way to answer that question is to have a closer look at macroeconomic factors that will affect stocks going forward.
HEADWINDS FOR THE MARKET
In our September 13 Intelligent Value Alert newsletter, we published a section that discussed several of the positive aspects of the US economy.
The economic positives include:
• The unemployment rate continues to fall while jobless claims remain well below risk levels
• The Conference Board's Employment Trends Index is nowhere near indicating that a recession is imminent
• US discretionary expenditures continue to increase
Retail sales are showing robust growth
Also, the yield curve on US Treasury bonds can be an excellent recession indicator. When the yield curve becomes flat or even inverted (short-term rates are higher than long-term rates), a recession is virtually certain. Presently, while not showing a robust curve, yields are nowhere near being inverted:
Yield curve, Sept. 27, 2015
For comparison purposes, this is how the yield curve appeared in the summer of 2007, preceding the Great Recession crash 2008-2009:
Yield curve, 2007
However, outside of unemployment and the yield curve, there are a number of macro-economic measures that are causing us concern.
The economic negatives include:
• While a continuing decline in the unemployment claims record are very positive for the US, it has now entered territory where a reversal is sure to signal an imminent recession. In the past, after the four-week average of unemployment claims dipped below 325,000, a subsequent reversal signaled the beginning of a recession. The average for unemployment claims dropped below 325,000 in early 2014 and have now reached an average of 267,000, so it would not be surprising for it to reverse course at any time. See the chart below for a clear picture of this dynamic.
Unemployment claims continue to drop, but that situation also brings with it risks. Any reversal will likely signal that a recession is soon to follow.
We will carefully watch this unemployment data series because any flattening or reversal will bode ill for the US economy and stocks. With unemployment claims at the lowest level of the last 30 years, there is not much lower it can go. Despite criticisms of the slow pace of economic growth, the current economic recovery is one of the the longest in US history. There are only two likely trajectories for unemployment claims from here: flat or higher, and each will be a harbinger of a recession.
• Revenue Recession: Some would say that a recession is already upon us if viewing corporate revenues. S&P 500 revenue for the third quarter is on pace for a -3.3% decline, which would mark the third straight quarter of declines. This shortfall will mark the first time since the depths of the Great Recession in 2009 that S&P 500 revenues have fallen for three straight quarters. The revenue declines have now become a significant issue for corporate America.
• Earnings Recession: Along with revenue declines, Thomson Reuters forecasts for third-quarter S&P 500 earnings now call for a -3.9% decline from a year ago with half of the S&P sectors estimated to post lower profits thanks to falling oil prices, a strong U.S. dollar and weak global demand. Without some improvement it's going to be difficult to justify prices that are 20.59 times trailing earnings on the S&P 500.
Note: The Russell 2000 small-cap index still has a PE ratio of 81.69, despite the recent selloff!
• Investors moving to cash: We pulled the plug on our stocks before the selloff, but apparently moving to cash is getting to be popular. According to Bank of America Merrill Lynch, $17 billion was pumped into money market funds last week while investors pulled $3.3 billion out of stocks through ETF's and mutual funds. Meanwhile, bond funds saw just $400 million in inflows over the same period, meaning cash (money market) is outperforming both asset classes in flow of funds for the first time since 1990.
• Last month U.S. factory orders plummeted -14.7% year-over-year, making it nine months in a row that factory orders have declined year-over-year. Historically, this type of performance has only occurred during a recession or in the lead up to a recession.
• Despite the positive individual numbers in select data series, the 'real' economy may be much weaker than headline statistics suggest. This is clearly showing up in the Economic Output Composite Index, which is comprised of the Chicago Fed National Activity Index (a broad measure of 85-subcomponents), the Fed regional manufacturing surveys, the NFIB survey, Leading Economic Index (LEI), and the Chicago PMI. Historically, the correlation between this index and economic activity is very high. However, following the 2008-2009 crash, the index
Click to Enlarge
The Economic Output Composite Index is showing that the 'real' economy is running at levels previously considered to be recessionary.
How can the market move higher when all of these signals are showing very little prosperity, revenues and earnings are decreasing, and markets are still overvalued, even after the recent selloff?
OUR PLAN TO PROFIT FROM CURRENT CONDITIONS
We intend to stick with our previously stated plan: We will carefully watch to see if the value-based indices we track break below established support levels shown in our Intelligent Market Risk Analysis (IMRA). If so, we will purchase conservative, inverse ETFs to profit from the continuing downturn.
On the other hand, if the indices move above overhead resistance levels, we will select two full portfolios of undervalued stocks and profit from their gains. Either way, we should be able to fill our portfolios again soon and we can make profitable progress. In fact, there will likely be a resolution to the question of the direction of the market this week. The market, not analysis, opinion, or speculation will drive our decisions. We will send a notice if there is a mid-week change. Otherwise, we will analyze conditions again next weekend.
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,
Not an IntelligentValue Member?
Get instant access to our weekly Market Timing report and powerful Value-based portfolios.
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.