NOVEMBER 8, 2015
CHANGES ARE COMING
STRONG EMPLOYMENT REPORT SIGNALS RATE INCREASES, MARKET CHANGES
FRIDAY'S OCTOBER EMPLOYMENT REPORT
Following an anemic employment report for September, U.S. employers hired workers at their strongest pace this year in October. Wage growth also picked up. These were both signs of reassurance for Federal Reserve officials as they weigh an interest-rate increase before year’s end.
The Bureau of Labor Statistics said Friday that nonfarm payrolls rose a seasonally adjusted 271,000 in October. This strong number compares to an anemic report for September of only 142,000 jobs added. Friday's revisions showed employers added a combined 12,000 more jobs in September and August than previously estimated, bringing the three-month average through October to 187,000.
Average hourly earnings of private-sector workers increased in October by 9 cents to $25.20 and are up 2.5% from last year. That’s a striking increase from the 2% average pace during the economic expansion. This increase suggests that the economy is gaining traction, and the steady pace of hiring is finally translating to long-awaited wage growth.
The unemployment rate fell slightly to 5.0% in October, the lowest reading since April 2008 and down from 5.1% the prior month. It’s also a notch closer to Fed officials’ 4.9% median projection for what it considers a 'normal,' long-run unemployment level.
FED NOW WIDELY EXPECTED TO RAISE RATES IN DECEMBER
During testimony before the House Financial Services Committee last Wednesday, Fed Chairwoman Janet Yellen said that December would be a "live possibility" for a rate hike if the upcoming data are supportive. The strong October jobs report on Friday is likely to give Federal Reserve officials the assurance they need as they weigh an interest rate increase before year's end.
"From all sides, the October employment is very strong, painting a bright outlook for the economy,” said AllianceBernstein economist Joseph Carson in an analyst note. “The Federal Open Market Committee has no more excuses of delaying a gradual normalization of official rates.”
With the economy essentially at full employment, officials at the FOMC have achieved one-half of their legally mandated objective. The second goal of the central bank is to manage inflation, with a stated target of about 2%. Typically, when employment is at or near full capacity, the economy is hitting on all cylinders and the central bank must increase interest rates to hold inflation at bay. That's not happening now, and, in fact, many are worried about global deflation. (See our three-part series on global challenges and the potential effect of the US raising interest rates.)
The FOMC has hoped that inflation will soon reach the 2% target before they raise interest rates for the first time since 2006. However, in recent months, weakness in the leading overseas economies like China, Brazil, and the euro zone has spilled into the U.S. economy, hitting firms with international exposure and contributing to weak employment reports in August and September.
The Fed is not getting the inflation they want. In fact, US inflation fell for a second straight month in September as American consumers once again paid more for food but a lot less for gas. However, in rounding out the Labor Department’s report, core US inflation increased to 1.9% on an annual basis after three straight gains of 1.8%. The improvement was the most since July 2014. This development, along with the strong employment report, is likely all the FOMC hawks need to lobby for a small rate increase at its December 15-16 meeting.
The CME Group 30-Day Fed Fund futures prices have long been used to reveal the likelihood of changes in U.S. monetary policy. The FedWatch futures allows market participants to view the probability of an upcoming Fed Rate hike. Early Friday morning, the Fed future's likelihood of a rate increase stood at 30.3%, but after the employment report had come out, prospects for a December increase jumped dramatically to 69.8%.
The likelihood of a rate increase by the Federal Reserve in mid-December completely changed the ballgame in the stock market on Friday. In the next sections, we will discuss many of these changes, the likely inter-market effects, and how we can profit from these changes.
BULLS ARE CHARGING, BUT...
As anyone attuned to the market knows, October was an incredible month for a significant portion of the market. Large-cap stocks, Nasdaq 100, large-cap technology, and large-cap consumer discretionary stocks, in particular, had a great October. On the other hand, small-cap stocks did not break out and in fact, on Friday just cleared above their 400-day moving average (still below their 200-day moving average). Commodities, materials, and oil continue to be a drag on the indices, but the surge in October stock prices was the strongest in many years.
IntelligentValue made a significant decision, which we discussed in detail in our October 25 Value Alert newsletter, to purchase Exchange Traded Funds (ETF's) instead of continuing to search in vain for good undervalued stocks or remain in cash for months at a time until they appeared. We based this decision on a year and a half of underperformance following five years of annual returns totaling, on average, greater than 100% per year. Value stocks have simply stopped working as the 6-1/2 year bull market has matured.
This weekend, as we conduct technical analysis on the overall conditions and specific indices, we see that some of the main ETFs that have done so well during the October run-up are bouncing off of very substantial overhead resistance. For example, SPY, the ETF for the large-cap S&P 500 (and the first ETF ever created back in 1993) has bounced precisely off its prior high levels set three times previously this year; in May, June, and July, at just below 212.
Chart 1: SPY, the S&P 500 ETF is bouncing precisely off the highs it set three previous times in May, June, and July.
The upshot is that this strong, month-long rally has achieved a real 'non-accomplishment': the index got back to the level at which it previously failed.
A CLOSER VIEW OF THE SAME CHART WITH ADDITIONAL INDICATORS
Let's take a look at a closer, three-month view of the same ETF (SPY), with some of the technical indicators we watch. This chart shows SPY gaining nicely from the point that we mark as the beginning of the rally on September 29. Notice that there was a black doji (spinning top) on that day that occurred just below the lower Bollinger Band line. We have circled the doji in green and have a green arrow showing the break below the lower Bollinger band.
Doji's are classic indicators of indecision and a fight between the Bulls and Bears. They commonly mark points where there is going to be a change in direction. In this case, it was at a level that was a retest of the August 24 low. The index made a classic W-pattern bottom before heading sharply higher (12.5%) over the subsequent 5.5 weeks. There has been a 3-day downturn, but that's normally nothing to get excited about... until you combine the overhead resistance shown in Chart 1 with the weak indicators shown in the lower windows of Chart 2, below.
Chart 2: This chart of SPY
shows more detail and three of the indicators that we watch, 3 Trendlines, On Balance Volume, and RSI.
Notice in the indicator windows below the main chart that our Trend Indicator is showing that the short-term trendline (gray) is dropping below the medium-term trend line (green). This pattern indicates the obvious; that the short-term trend is declining faster than the other term periods. Short-term trendlines dropping below longer-term trendlines can sometimes be a signal to exit an ETF, depending on other indicators.
On Balance Volume, in the second window, is also declining now and RSI, in the bottom window, is declining off of a level that many consider to be where overbought conditions begin; at 70.
On the plus side, you can see that in Chart 2 prices are still above its rising 20-day moving average (blue line in upper window), and in Chart 1 the 200-day moving average has turned slightly higher. The market has momentum going for it right now. However, the technical analysis of these charts can be summarized as "strong negative price action at key resistance and near overbought levels."
That makes near-term moves higher far more unlikely. What is more likely is a pullback, at least to the 20-day moving average and possibly to the 200-day moving average. In Chart 1, notice that there is a gap just above the 200-day MA. Gaps tend to get filled at some point in the future because there are usually a significant number of investors left hanging at the time when that gap occurred. A pullback to the 200-day MA would allow that gap to get filled and those investors to get out (or in) at those prices.
We logged a decent 2-week return of 1.32% with SPY for our CONSERVATIVE Portfolio and 3.6% with SSO (the leveraged version of SPY) for our AGGRESSIVE Portfolio. In the Portfolio section of the IntelligentValue Member's Area we will have instructions for our subscribers on what to do next to continue making profits. In fact, each of the ETFs we recommended two weeks ago have profited nicely, and in fact each of the other ETFs we hold has done better than our SPY and SSO positions. We'll have new recommendations this week to keep the profits coming.
AN INCONVENIENT TRUTH: EXPENSIVE PRICES + POOR FUNDAMENTALS = DISASTER
When we made the decision to use ETF's instead of value stocks in our October 25 newsletter, it was a decision based on practicalities. Value stocks have simply stopped working as the bull market has matured. However, we now feel that the entire market is reaching valuations that may be closing in on obscene. Here's why...
When the October 25 newsletter (in which we lamented the overvalued conditions) was published, we commented that the S&P 500 P/E ratio was at 18.23 and the Russell 2000 P/E ratio was at 71.7. The average P/E ratio for the S&P 500 since the 1870's has been about 15.5, so the S&P 500 was slightly elevated two weeks ago. Data for the Russell 2000 is not as readily available, but according to Russell Investments, which introduced the indices in 1984: "The average P/E of the Russell 2000 since 1998 has been approximately 17.0, vs. 13.5 during the period (from 1984 to) 1998." Therefore, the Russell was extremely overvalued two weeks ago. But now, it has a valuation that is jaw-dropping.
In writing today's newsletter, I just checked in with the Wall Street Journal Market Data Center to get an update. The S&P 500 P/E ratio is now significantly higher at 23.41, and the Russell 2000 P/E ratio is at a mind-boggling 188.46. Check for yourself.
EARNINGS AND REVENUE RECESSION CONTINUES
Those incredibly high prices are accompanying declining revenues and profits, a trend that we have discussed several times in previous newsletters.
In the current earnings reporting period, nearly one-third of S&P 500 corporations have reported earnings and revenue from the third quarter. With 147 companies reporting so far, profits are down -0.6% and sales are down -2.7% from a year earlier.
It seems logical that several quarters of contraction in earnings and revenue would have weakened stocks. After all, if robust sales and healthy profits are the primary drivers behind price appreciation for publicly traded companies, shouldn’t diminishing sales and dwindling profits lead to price drops for publicly traded corporations?
Welcome to the bizarre world of central-bank planning, worldwide stimulus, and currency wars in a race to the bottom. Despite the plummetting fundamentals, the S&P 500 is within 2% of its all-time high and the Nasdaq 100 set a new all-time high last week. And, of course, the Russell 2000 has the highest PE ratio ever recorded!
BAD NEWS = GOOD NEWS, YET AGAIN
When it comes to stock prices, how much does the anticipated movements of central banks matter when compared to the fundamentals of publicly traded corporations?
Did it matter that in Caterpillar's (CAT) recent conference call with investors, it disclosed that 2016 revenue would collapse by 5% across all of its market segments? Did investors worry about 3M’s (MMM) intention to reduce its global workforce by 1500 positions because of lousy earnings? No way. Investors now expect substantial financial rewards for taking a risk when central planners engage in what is clearly blatant price manipulation.
Ironically, declines in revenue and earnings from companies like Caterpillar and 3M only confirms the weakness in the global economy, which investors now take as good news. Weaker results increase the likelihood that central banks will step up their stimulus measures.
So does central bank stimulus and low rates make that big of a difference? Just how powerful is the combination of quantitative easing (QE), zero-percent rate policy and even negative-percent rate policy? Omnipotent.
As an example, let's use the performance of Vanguard Total Stock Market Index (VTI) as it relates to the activities of central banks engaging in QE. As a specific example, in mid-December of 2012, the U.S. Federal Reserve increased its QE3 program to $85 billion per month to buy U.S. Treasuries and mortgage-backed securities. The effect on the stock market, as measured by VTI, was impressive.
VTI made a avg. return of 24%
per year for investors during 2013/2014 with QE3 underway.
VTI opened 2013 at $70.78 and closed 2014 at $104.52. That's a 48% gain for those two years or an average of 24% return per year. Those are impressive numbers when the long-term annual market average return is closer to 7%. But what happens when the Fed's removes the QE punch bowl?
The US Fed stopped its QE-related asset purchases in mid-December of 2014. The 2015 performance for VTI without QE should give us a clear measure of the effect of the stimulus. VTI opened 2015 at $105.01 and closed on Friday at $107.84 following a wild ride of volatility during Aug, Sept, and Oct. That's a gain of only 3.2% year-to-date when QE isn't a factor affecting prices, compared to 24% per year with QE. Imagine what could happen if interest rates are increased next month.
However, during 2015, with no QE working, VTI logged a gain of just 3.2%.
These extraordinary financial shenanigans that have carried the market to within a few percent of its all-time high continue to override what have been deteriorating economic fundamentals. Tightening financial market conditions in the form of an interest rate increase will reduce speculation, and market prices will plummet. Because of this, merely the discussion of a rise in interest rates causes the market to dive, as it did in August.
The stock market has been robust with QE in place and sideways and extremely volatile without QE. The single most important factors (sales and profits) used to determine stock valuations and forecast future prices have been in decline on a year-over-year basis since the beginning of 2014 and negative in 2015. Still, stock prices continue to remain near all-time highs based on the 'Fed Put' that has been in place since the Alan Greenspan era in the Federal Reserve began.
Most market historians hold former Fed Chairman Greenspan responsible for the low-interest-rate-sparked market bubble associated with the internet enthusiasm in the late 1990's, as well as the housing-related bubble created in the mid-2000's by super-low rates that ultimately resulted in the Financial Crisis when the Fed steadily increased rates to a level that was too high. The Federal Reserve has an undeniable history in the last 20 years of creating bubbles, and then in attempting to cool off the overvalued assets, crashing the economy and causing the financial displacement of millions of families. What is their solution to this history? Apparently, more of the same, and this time it could be a real doozy since now we have the entire world on the 'bubble-creation program.'
THE 'WEALTH EFFECT' LIVES ON
Fed Chairman Greenspan famously believed in the 'wealth effect,' which he articulated as the association that people have with their financial well-being based on their 401(k) and other stock-based assets. Greenspan believed that if people feel they are wealthy, they spend as if they are and the economy thrives. His handpicked successor, Ben Bernanke, as well as Bernanke's hand-picked successor, Janet Yellen, all apparently were inoculated with a 'wealth effect' mantra and believed that the stock market must be propped up no matter what the cost. This policy is the 'put' that investors believe has been placed under the markets by the US Federal Reserve for the last 20+ years. It is a policy has now migrated to the world's other economies, and virtually every major central bank is attempting to ease financial conditions to 'manage' their stock market's prices and stimulate their country's economies.
However, these manipulations by the central banks to try to control the natural ebb-and-flow of economic expansion and contraction have only resulted in extraordinary financial bubbles and catastrophic busts during that 20-year, Greenspan-influenced period here in the US. The same policy of using QE in Japan since the early 1990s has gone nowhere toward improving that country's economy or sparking even mild inflation. To show for their efforts, Japan has the highest debt-to-GDP ratio in the world.
Extreme stock valuations and declining fundamentals may be what bursts this bubble despite the efforts of the Fed to not allow that to happen. Warren Buffett’s favorite measure of stock valuation, Total-Market-Cap-to-GDP, sits at 117.7%. That is the second highest in history, and it is greater than the 2007 peak of 110.7%, just before the largest stock crash of this generation (so far).
Total Market Cap-to-GDP ratio is at the second highest level in history.
The bull market is unlikely to carry on indefinitely regardless of how much central banks try to manipulate prices, especially in an environment with deteriorating corporate fundamentals. This situation is very similar to what happened to trigger the last Fed-created crash. In the mid-2000's, low-interest rates artificially increased U.S. housing prices to phenomenal levels because of cheap mortgages given to anyone who walked through the door.
The low interest-rate environment and the go-go housing sector pushed stock prices to overvalued levels. However, in 2006 the value of homes began to decline. One reason was because a vast number of the unqualified buyers could not pay their mortgages. By mid-2007, the unravelling of the financial sand castle had begun. AAA-rated, mortgage-backed securities based on mortgages that were essentially worthless began to fall apart, and soon thereafter the collapse in home prices and the stock market to levels that were half of their prior highs took place.
What we have witnessed in the current stock bubble is the artificial, manipulated increase in the prices of stocks as a result of zero interest rates and QE over the last 6.5 years, and now we will find out what happens when the fundamental value of companies decline based on deteriorating sales and earnings. If the US Federal Reserve even implies it will increase interest rates in December, it will result in the same outcomes that occurred last August.
We will see an increase in the value of the dollar, which causes US multi-national sales to decline, commodity prices to decline further causing potential emerging-market defaults, and of course, the stock market to plummet. When the brain-trust at the central bank decided in 2008 that the sure-fire cure for the financial collapse was to stimulate the stock market's prices artificially using taxpater money, was there really no one to ask "what happens when we stop?"
The fears of a Federal Reserve interest-rate increase in September was the trigger for the dramatic correction that occurred in late August. The Fed backed off of announcing a September rate increase, likely because of what was occurring in the market. That decision to not raise rates was the spark that started the October rally. Investors became convinced the party would continue - the Fed had their back. However, the bullish jobs report last Friday, accompanied by a 30% jump in investors anticipating a rate increase in December, may result in another steep decline of stock prices just like in August. If that occurs, it will be another roller coaster ride like we just had to end 2015.
There will be opportunities for profits regardless of whether the market continues higher or plummets lower. In fact, we welcome the bipolar antics of the investing world. By using ETF's, we can target specific sectors that do well in different market environments, and we can also utilize inverse ETF's should a serious downturn take root. We will continue to be opportunistic in our selection of ETF's, and intend to maintain portfolio profitability and minimize downside risk through the prudent use of cash when appropriate.
There is a significant likelihood that the equities market will pull back this coming week based on the expectation of an interest rate increase in mid-December. This scenario opens up all of the worries that dominated in August which caused the market correction; i.e., strength in the dollar compared to foreign currencies, a war of devaluation of currencies to maintain competitiveness, deterioration in the price of commodities, the effect of that deterioration on emerging-market economies and the risk of a country default, etc. We covered all these issues in our three-part series titled, "Where Is The Market Headed From Here?" Please review that set of articles as a reminder of the risks that are now back on the table.
In our October 25 announcement, we opened IntelligentValue up to an alternative approach to investing profits based on ETFs during this period when valuations have gotten very extended. We have extensive experience with ETFs going back 18 years and have previously (and successfully) used inverse ETFs in the IntelligentValue portfolios during periods of significant drawdowns. The application of ETF's during upward-trending markets, when undervalued stocks that meet our criteria are not available, is new.
However, the challenges addressed in the paragraphs above actually provide opportunity to investors who are willing to put the extensive selection of ETF's to use in achieving their investment objectives. That is exactly what we will be doing with IntelligentValue's portfolios during what we anticipate will be upcoming periods of significant volatility.
In light of the issues discussed in this newsletter, we will be making position changes to our portfolios. Members can jump to the Portfolio pages for details on what we will do for Monday's market open.
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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 IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.