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“You need to have a passionate interest in why things are happening. That cast of mind, kept over long periods, gradually improves your ability to focus on reality. If you don’t have that cast of mind, you’re destined for failure even if you have a high I.Q.”

—Charlie Munger

- Enjoy more of our favorite investing quotes

OCTOBER 25, 2015

In this issue we cover the following topics:


- Our June 28 Warning Proved Prescient
- Has the Situation Now Changed?
- Market Breadth Has Dramatically Improved
- Another Accurate Call: "Rising Wedge Pattern is Bearish"
- So What Actually Happened?
- Support/Resistance - and Now - Support Line
- Undervalued, High-Quality Stocks Losing to Expensive, Low-Quality Stocks
- The End of a Period When Value Dominated?
- The Dramatic Effect of Index and Sector Investing
- Not Abandoning Our Value-Based Approach
- How We Will 'Harness The Change'
- What are the Advantages of ETF's Over Individual Stocks?
- Example ETF Portfolios
- ETFs Selected For This Week's Portfolios




We believe that the market weakness we identified in late June, which played out with a significant market correction, is now complete. The market is telling us that there are some opportunities for profitable investing, but they are probably not ones you might expect from IntelligentValue. In this newsletter, we will discuss what occurred since our June 28 warning of inevitable market losses and what the markets are telling us now. We will also be introducing a new way we can profit from current circumstances in the markets. We will be buying positions and will present two full portfolios for subscribers this weekend in the Members Area.


began exiting the market by placing stops on each of our positions following our June 28 Intelligent Value Alert, which we titled, "Big Change Coming to the Market Starting This Week." As IntelligentValue members have come to expect, our timing was quite accurate because that following week the markets began to slump downward. The 'slump' gathered steam through July and turned into a cliff in late August.  Most investors related these developments as being the result of worries about China and emerging markets which came to a head after China's devaluation of their currency in August.

There always seems to be a news-worthy explanation for the machinations of the markets, but the truth is that the news organizations trumpet the news after the event, and the story gets false credit for what naturally occurs in the financial markets. For example, in that June 28 Alert, we identified six main reasons why we believed the equity markets were going to head downward, none of which had to do with China:

1) Volatility had disappeared ($VIX was very low, and Bollinger Bandwidth narrowed dramatically) and was likely to reverse sharply with increased price swings (which then occurred).
2) The equities market was losing momentum, and advance/decline breadth was heading downward.
4) The nine S&P sectors were showing that the business cycle had turned negative with defensive sectors dominating.
5) A 'Big Picture' monthly view of technical analysis showed that the market was close to rolling over.
6) US corporate Operating Income turned downward to begin 2015, and we predicted declining profits in upcoming quarterly reports.


In some regards, the situation has changed, but in other ways it has not. We will explore both in this article. However, anytime there is a change in the markets, there is an opportunity for profit. Our philosophy is not to hide from change, but to harness it. We will cover what has changed and what has not, then focus on how we can profit from the current conditions.


The breadth of a large portion of the market has significantly improved since our June 28 warning letter. Market Breadth is derived from a mathematical formula that uses advancing and declining issues to calculate the amount of participation in the movement of the stock market. By evaluating how many stocks are increasing or decreasing in price and how many trades investors are placing for these stocks, breadth indicators can show whether overall market sentiment is bullish (positive market breadth) or bearish (negative market breadth). Investors can also use breadth indicators to evaluate the behavior of a particular industry or sector, or to analyze the magnitude of a rally or retreat.

As you can see from the 10-year chart ( below) of the advance/decline line of the New York Stock Exchange, breadth can play a key role in helping us identify and avoid periods of market weakness. The top window of the chart shows the advance/decline line, and the lower window shows the NYSE prices. In the top window, we have overlaid a 20-week moving average, which is a reasonably effective threshold for the identification of potential downturns in market prices.  (NOTE: We're using the NYSE in this example because it is a well-established index with a broad range of stocks in virtually every market sector and every company size. Specific breadth indicators are available for many other indices, and there are several types of breadth indicators from which investors can choose.)

For example, notice the downturn in breadth that started in mid-2007 – months before the markets themselves began a selloff in what eventually became the worst financial collapse since the Great Depression. Downturns in market breadth are frequently a precursor of price declines. Upturns in breadth also identify upturns in market prices. Notice that the Advance/Decline line crossed above the 20-week moving average in March 2009, accurately signaling when to reenter the market. Recognizing and using these breadth indicators can frequently give you warning of potential future risks, helping you avoid them, as well as giving you the confidence to start buying again (even if everyone around you is still hiding under their bed).

When we combine the advance/decline data with the other market indicators used in our members-only Intelligent Market Risk Analysis (IMRA), we can avoid most market downturns and dramatically increase our annualized returns. The chart below shows the last ten years of NYSE Advance/Decline Breadth accompanied by the red 20-week moving average line in the upper window, and the New York Stock Exchange prices in the lower window:

10-year chart of the New York Stock Exchange Advance/Decline line (upper window) and the NYSE and the lower window.


The following chart is a Zoom into the last six months of the far right side of the 10-year chart above:

Six-month Zoom into the previous 10 year chart. Advance/Decline Line shown in the upper window and NYSE in the lower window.

As you can see from the chart, Market Breadth has improved dramatically for the NYSE starting the first week of October. The same scenario applies to other large-capitalization indices such as the S&P 500 and the Russell 1000. However, small-capitalization stocks, such as those in the Russell 2000, are still not showing an improvement in Breadth. Value-based stocks are showing even less improvement. We discussed this situation in detail in the October 24 Intelligent Market Risk Analysis (IMRA) in the Member's Area of IntelligentValue.



We regularly conduct a post-mortem on the forecasts we make to test the accuracy of our indicators and confirm the methods we have developed over the last 30 years. Since we are using technical analysis, fundamental analysis, and 30+ years of experience, you might say our predictions can be an unfair advantage. But for our subscribers, it's an unfair advantage in your favor that you can immediately put to use!

At the time we published our Sept. 20 Intelligent Value Alert, the S&P 500 had been rising for about a month following the August 24 low. We had read several other well-regarded advisors who were predicting a continuation of that rise and recommendations to "buy, buy, buy!"

IntelligentValue had a different opinion, and this is what we said at the time:


"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 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 you take a look at the updated chart (below) from today, you will see that our analysis turned out to be correct in our forecast of the events to unfold. Purchasing stocks, as many advisers were recommending would have resulted in immediate losses. On September 22, the S&P 500 began declining after breaking below the lower rising trendline of the bearish wedge pattern and dropped to a level close to the same level as the August 24 low. (Side note: This retest of the Aug 24 low was actually a bullish indicator because it was a higher low than the August 24 low.) Since that retest, the S&P 500 has been on a solid run higher, which broke through an important level in the last two days.

The S&P 500 followed through on the retest of the Aug 24 low we predicted. It has now moved solidly higher and has broken through the Resistance Level at about 2045. This is a bullish development and mean the 2045 is now the new Support Level.



Notice that there is a horizontal line drawn across this new chart at the level around 2040/2050. This line was the Support Level for the S&P 500 through the summer before it was broke in the late-August selloff. An essential tenet of technical analysis is that a Support Level, when broken, becomes the first Resistance Level for now-lower prices.

As you can see on the chart above, the line is drawn in green from the left side through to the August breakdown (representing Support), then becomes a red Resistance Line through September and most of October. The exciting, bullish development that has occurred in the last two days is that this Resistance Level has now been broken, and 2050-ish has become the new, green Support Level for the S&P 500. It is unlikely that prices will drop below this new Support Level without a fight. So we can now purchase some investments (in this case, some from within the S&P 500) with confidence that another decline is probably not immediately forthcoming.


In our June 24 issue of the Intelligent Value Alert newsletter, we showed you that small-capitalization value stocks had been struggling compared to the overall market since the middle of 2014, and mid/large-cap value stocks had been floundering throughout all of 2015. Of course, as we predicted in late-June, everything then fell apart for the entire stock market – including (and especially) for value stocks.

Recently, our friends at wrote a blog that confirmed our research. Their blog article was titled, "Value Investing: The Pain Train has Arrived and it Sucks." Their research showed that since the beginning of 2015, expensive, low-quality stocks were beating the pants off of undervalued, high-quality stocks by a spread of 30%. Here's the chart they provided to demonstrate the point:

The conclusion by was as follows:

As we’ve said time and time again, active value investing has been digging manager graveyards since 1900…but that is the nature of the active value investing game…long horizons are required and volatility relative to the standard benchmarks can be expected.


So essentially, their advice is to stick with the program, and value investing will win out in the long run. However, we have come to a different conclusion at We feel that value doesn't have to appear strictly in the form of financial appreciation in an individual company's stock. In fact, in the current and future environment for the next few years, gains in a particular company's stock may be one of the most challenging ways to profitably invest.


At IntelligentValue, we believe we are coming to the end of a period in which a proven approach to the selection of individual, undervalued stocks will not be as productive as it has been in the last 6.5 years. When we launched our current two portfolios (Deep Value and Relative Value) in 2009, we knew we were at the beginning of what was likely a generational low in the markets. It was an incredible opportunity to put a proven value-investing approach to work in a way that has never been so effective in the current era (our investing lifetimes), and may never be quite as powerful again in the future. Don't misunderstand, we believe value investing will work in the future, but it probably won't work again as well as it has in the last 6.5 years.

In March 2009, our Intelligent Market Risk Analysis (IMRA) identified a very clear, compelling MARKET UP signal. We loaded up on the best, most undervalued stocks we could find. At that time, with fear so palpable that the proverbial "blood running in the streets" was present more than at any time we could remember, there were excellent companies with solid prospects selling with a stock price that was a discount to the cash on their balance sheet. Ol' Benjamin Graham would have been thrilled at the opportunity, and so were we. Today, about 6-1/2 years later, we believe we are near the top of the current market cycle and near the end of that generational, value investing opportunity.

Our portfolios, which made returns of 1600%-plus and 600%-plus in 2009, have been struggling for the last two years. The reason is that undervalued companies with significant prospects for a correction of fundamental mispricing are becoming extremely difficult to find. In general, companies have reached fully-valued levels.  As clear evidence, the overall PE level of the S&P 500 index is now at 22.07, while the PE of the Russell 2000 index stands at a mind-boggling 83.33. One year ago, the S&P 500 PE was at 18.43 and the Russell 2000 PE was at 71.70. Therefore, despite the recent selloff in stock prices, the price-to-earnings ratio of these two benchmark indices are higher than they were one year ago! (This PE information comes from a reliable source: the WSJ Market Data Center.)

We feel the recent market turbulence is a harbinger of even more difficulty ahead for investors in individual stocks. We have entered a new dynamic in the market environment, one characterized by record-low interest rates, quantitative easing and stimulus programs across the world. Many aspects of the economic environment which received blame for the crash of 2008/2009, including high levels of debt, are now even more extreme than during that prior period.

In fact, much of the so-called 'toxic' private debt that was on the balance sheets of banks and other financial institutions have now been transferred to the balance sheets of sovereign governments. We are entering a new era of investing, with new challenges and new opportunities. As cited previously, our philosophy is "Don’t hide from change; harness it."



The future prices of individual stocks are now far more affected by the movements of the sectors or indices to which they belong rather than their fundamentals, competitive advantage, or value proposition. Because of the mind-boggling success of Exchange Traded Funds and Index investing, company management now has far less ability to maximize the price of their stock.

Likewise, investors in individual companies are less likely to see an undervalued stock pick rise if it happens to have fallen into a group or sector that is currently out of favor. Is a prime example, from April 2014 through mid-July 2015, investors in the biotechnology sector saw that group surge by 90%. However, from mid-July to present, that same sector has lost 25%. It didn't matter if you owned stock in the top-rated biotech company or if that company's share prices were priced at a deep discount to the company's intrinsic value. The value of your shares in that company likely plummeted along with every other biotechnology stock during those three months.

The fact is that the biotechnology sector moved out of the top of the sector rotation and it may be some time before it returns back to the top of the sector rotation. Sector, industry and other rotations (small-cap, large-cap, etc.) have more to do with the future value of your share prices than do the fundamentals of that company.

However, by staying open-minded and nimble, with a proven system of selecting the sectors or indices that are moving higher now and next, we can capitalize on this new investing environment instead of being left behind by it.



Please don't get the impression that we are completely abandoning our value-based approach to investing. However, during this period when value is underperforming, we are adding a second approach that we feel will significantly enhance returns with much lower risk, fewer transactions, and dramatically increased diversification during periods when value-based stocks are not able to excel. These periods when value underperforms usually occur near market tops, and that is the likely situation in which we find ourselves today.

Market top-type conditions can last for a while, so we make no projections of how long the value-approach will be constrained. However, we will continue to monitor the performance of value approaches compared to other approaches, and when the tables turn back in favor of value, we will once again add high-return, value-based stocks to our portfolios.


To 'harness this change,' we are going to target a different group of opportunities other than the now-rare, high-quality but undervalued individual business. It's possible that the next great opportunity in undervalued stocks may not occur again until after there is another serious market crash. With the dramatically increased volatility and turbulence that is likely to be ahead, we need to find value in other ways; not in individual stocks but perhaps in other approaches. There is always an opportunity to profit in different groups of investments as conditions change, and conditions are definitely changing now. While value is underperforming, we can find these opportunities in readily available and highly liquid Exchange Traded Funds (ETFs).

For example, the selection of an asset class or a particular group of stocks that provides us with a higher return over a shorter time frame is an extremely desirable alternative. If we can utilize a consistent, proven approach to identifying the group that is most likely to outperform next, it can provide significant returns to our subscribers.  A robust system that consistently and profitably switches from one group of investments to another, reducing drawdowns and maximizing gains with minimal volatility provides a wonderful alternative to investors. If accomplished with very few transactions, even better!

What are the Advantages of ETF's Over Individual Stocks?

Before investing in a particular stock, there is a multitude of considerations; from earnings expectations to management quality, industry forecasts, cash flow ratios, quality of assets on the balance sheet, quality of income and cash flow, competition (not just current but also prospective competition), and dozens of additional considerations. In fact, it always requires many hours of in-depth analysis each time we chose an individual company for our portfolios in an effort to determine if there are any 'skeletons' in the corporate 'closets.' Of course, from time-to-time, skeletons appear from previously secret closets of which we weren't aware of in these sprawling corporate houses.

Once purchased, investors in individual companies are constantly being buffeted by unexpected announcements, including earnings misses, restatements of prior accounting reports, changes in top management, re-pricing of assets, changes in guidance by stock analysts, announcements of investigations by regulatory bodies, approvals or denials by the pertinent authorities. The list could go on and on for many paragraphs, but as an investor you surely are familiar with the many financial surprises that can occasionally spring from unexpected places.

However, when investing in an ETF, our primary consideration is simply determining the direction of the asset group being considered. The chances of being blind-sided by an individual company have reduced a thousand-fold because we are buying an asset that is frequently the total of the prospects of hundreds of companies. The failure of one company in the S&P 500, for example, will never crash the entire S&P 500, but that one company failure could destroy a portfolio consisting of a small number of individual stocks, such as the individual stock portfolios that have been the basis of IntelligentValue's approach. 

There is no longer a need to invest in a smorgasbord of individual companies to avoid the risk of one bad apple driving the portfolio down. A diversified ETF portfolio can consist of just one position since that single ETF usually holds the stocks of hundreds of companies!

As our IntelligentValue subscribers who have been with us for years know, our analysis and determination of the direction of markets, indices, and groups of companies is probably more accurate than our identification of an individual undervalued company that will garner stock-price profits. In fact, we provided you with two recent examples of our accurate market calls earlier in this newsletter (here and here).

While we cannot provide you with accurate details of the kinds of returns to expect with ETF-only portfolios, we have been working with ETFs since launching IntelligentValue in 2004. At times, we have successfully used substantive inverse ETFs, such as SH (the ProShares inverse S&P 500 ETF) when we anticipated lengthy downturns in the markets. As the current equity markets get closer to topping and possibly heading into a prolonged bear market, we will put inverse ETFs to use at the appropriate time to generate profits even during downturns. We will also use suitable ETF's in defensive sectors or equity-alternative ETFs (such as bond-based ETFs) when the next downturn begins.

In the meantime, we intend to utilize sector-rotation approaches that we have spent extensive time developing and which we feel confident using in the current market environment. The Portfolio pages will provide current IntelligentValue members with the selections we will purchase at the market open on Monday (Oct. 26) for our two portfolios.

We want to assure you that we have spent a great deal of time developing ETF-based portfolios. As examples of what we have been able to achieve in careful backtests of ETF portfolios, we can present a couple of examples.

These portfolios show the type of gains and drawdowns that could be obtained using a 1- or 2-ETF portfolio in combination with our proven Intelligent Market Risk Analysis (IMRA) system. Long-time subscribers know that the IMRA system has a substantial track record of consistently avoiding market-related risk.



This portfolio shows the potential profits and drawdowns that might be achieved with a single ETF in combination with our proven Intelligent Market Risk Analysis (IMRA) system. By using a single, S&P 500-based 2x leveraged long ETF (SSO) in conjunction with the IMRA system determining the appropriate time to move to cash, the back-tested results can be represented by the following chart and data. The statistics show an annualized return of 35% with 100% winners over 16 years with very low risk compared to the market and a resulting Sharpe ratio of 1.76. Remember that this is a hypothetical backtest and is not indicative of the actual results that may be achieved. Actual results may be higher or lower than these results, and future conditions may not be similar to the 16-year period depicted.

Notice that this portfolio holds just one position and shows an average of just two trades per year (i.e., "Annual Turnover = 200.12%"), with 100% winners (27/27) over the 16-year period. The hypothetical backtested Sharpe ratio is 1.76 because of the extremely limited risk (max drawdown is 18.8%) and very high relative return (15,849% compared to 72% for the benchmark S&P 500over 16 years). By using this type of portfolio instead of one populated by multiple individual stocks, we dramatically reduce transactions, instantly increase diversification by using only one position, significantly reduce drawdowns, and profoundly simplify the prospect of successful investing results.



This portfolio shows the potential profits and drawdowns that might be achieved with a two-ETF system based on the two best-performing sectors, in combination with our proven Intelligent Market Risk Analysis (IMRA) system. Subscribers who have experience with IntelligentValue know that the IMRA system has a substantial track record of consistently avoiding market-related risk. Remember that this is a hypothetical backtest and is not indicative of the actual results. Actual results may be greater or less than these outcomes, and future conditions may not be similar to the last 16 years depicted below.

Notice that this portfolio holds just two positions when it is not in cash. It goes to cash to avoid market downturns and shows and an average of just two trades per position per year, a 55% annual return, and 96.43% winners (27/28) over the 16-year period. The hypothetical backtested Sharpe ratio is 2.40 because of the limited risk inherent in the use of our Market Risk Analysis (IMRA) system is much lower than the market's risk. It shows a max drawdown of 21.67% compared to the 53% drawdown for the benchmark. The lower risk is accompanied by much higher returns than the market. Again, these are hypothetical results and may not match actual returns going forward.



Our Intelligent Market Risk Analysis (IMRA) system (members only) is recommending that we purchase long positions for our CONSERVATIVE/RELATIVE VALUE Portfolio this week. But we are not able to identify undervalued mid/large-cap stocks that meet our stringent company quality and value criteria. However, for the reasons discussed above, for this portfolio this week we will be able to add three large-cap, sector ETFs that are outperforming the broad market as well as two broad market ETFs.

Our IMRA is also recommending that we stay in cash for our small-cap value stock portfolio. However, because of the changes we are making this week, we will also be able to add ETF selections to the AGGRESSIVE/DEEP VALUE Portfolio. For this portfolio, we will be selecting three smaller-capitalization, industry-based ETF's that are in strong upward trends, and we will also be including two leveraged broad-market ETFs for a total of five new positions.

This current ability to populate our portfolios with promising investments instead of being forced once again to remain in cash is a major improvement that this week's update will accomplish. We will no longer have to sit on the sidelines when value stocks are not moving or when we cannot find undervalued stocks that meet the strict value or company-quality criteria for our portfolios. There are always sectors in rotation, even in downward-trending markets, and there are also inverse ETFs that can take advantage of downward-trending markets. All of these equities are allowed in tax-advantaged retirement portfolios since they do not 'short' the market or a particular stock.

We based the ETFs selected for this week's portfolios on a combination of the two approaches discussed in the section above, titled "Example ETF Portfolios." (These will include sector leaders, industry leaders, and market-cap leaders). There will be five ETF's selected for each portfolio this week.

 Members can jump to the Portfolio pages for details on our picks for Monday's market open.

Not an IntelligentValue member? This would be the perfect time to take advantage of our 15-day free trial!


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,


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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, nor any of its employees or affiliates are responsible for losses you may incur.