QUOTE OF THE WEEK
“Losing money is the least of my troubles. A loss never troubles me after I take it. I forget it overnight. But being wrong – not taking the loss – that is what does the damage to the pocketbook and the soul.”
- Enjoy more of our favorite investing quotes
NOVEMBER 15, 2015
THE GOOD, THE BAD, AND THE UGLY
This past week saw the markets reverse course dramatically, with many major indices dropping sharply and some plummeting below their 200-day moving average, which for most analysts is the 'line in the sand' between bull and bear status. This significant downturn comes after a whipsaw with a significant downturn in August and then a sharp upturn in October.
After observing strong bullish signals in major market sectors and unable to find any qualified undervalued stocks, on October 25 we chose a set of ETF's for our portfolios so that we could participate in what appeared to be a fresh bull run. However, the stops we placed on each of those ETF's for the preservation of capital was pierced last week as the market sold off and we closed each position on Friday.
In this newsletter, we are going to attempt to explain what is occurring in the market to cause such extreme volatility. We will look at the positive aspects of the market that argue for a continued bull run (THE GOOD), the negatives that suggest we are in for a major market selloff (THE BAD), and some indicators that many never consider (THE UGLY). After covering this territory, at the end of the article we will tell you our plan going forward.
a) ZWEIG BREADTH THRUST
One of the indicators that convinced us to purchase ETF's in the anticipation of a continuation of the bull market is called the Zweig Breadth Thrust. Martin Zweig is a famous investor and author ("Winning on Wall Street") who was well known for his appearances on the show 'Wall Street Week with Louis Rukeyser,' which at one time (believe it or not) was the only TV show devoted to the stock market. It was broadcast for one hour on Friday evening on PBS. I remember being glued to the TV for that hour every Friday evening in the 1970s and 1980s. Zweig was famous for his exhaustive data studies and his lavish lifestyle, which included at one time owning the most expensive real estate property in America (a condo on 5th Ave in NY).
One of Zweig's legacies that are still with us today is his identification of an eponymous technical indicator called a 'Zweig Breadth Thrust.' This 'thrust' occurs when the advancing NYSE issues divided by the total NYSE issues goes from a ratio of 0.40 to 0.615+ in a span of 10 days or less. This rare development only happens when the market moves from extremely oversold to a massive number of advancing stocks within a span of just ten days.
There have been 14 Zweig Breadth Thursts (ZBT) since 1945, each subsequently followed by an average gain of 24.6% in the next 11 months. Zweig pointed out that bull markets frequently begin with these patterns, and a bull market did, in fact, begin following each of the prior 14 occurrences. The chart below goes back to 2009 and shows the last four Zweig Breadth Thrusts (red vertical lines). Each was followed by what could be considered bull markets, especially following the 2009 and 2011 thrusts. We used the ZBT signal as one of several that conviced us to issue a major MARKET UP signal on March 9, 2009 and October 9, 2011 and load up on undervalued stocks.
Importantly, the last such thrust developed near the beginning of the recent market rally, on October 8, as shown on the chart below. We show the Zweig Breadth Thurst Indicator as both analog (gray) and digital (red) to make it easier to see the specific signals:
The Zweig Breadth Thrust has identified the start of 14 of the last bull markets. The chart above shows the last four Zweig Breadth Thrusts. Gray lines are analog version and red lines are digital (binary) versions of ZBT.
OCTOBER 2015 ZBT
However, following the most recent Zweig Breadth Thrust (Oct 8, 2015), the market has done anything but proceed in a bullish pattern. The ZBT indicator is not looking very accurate right now:
FAILURE? Following the October 8 Zweig Breadth Thrust, the market proceeded higher, then sharply downward. Gray lines are analog version and red lines are digital (binary) versions of ZBT.
OCTOBER 2011 ZBT
On the other hand, consider the market pattern following the Zweig Breadth Thrust in October 2011. At that time, the Zweig Breadth Thrust also appeared to be failing because an immediate downturn in the market followed. In fact, after the mid-October ZBT signal, the market dropped 12.5% for the month of November 2011. However, towards the end of November 2011, the market took off with a strong bull run that many might say lasted until the recent selloff in August 2015. There were some dips along the way, but following the 2011 ZBT, the market didn't experience even a 10% correction until recently. So we can see that sometimes the ZBT indicator has a delayed reaction before liftoff occurs, but over the long term, it has proven to be very accurate. Is the current signal, followed by an immediate downturn, one of those instances?
October 2011 ZBT signal was followed by a market selloff in November. However, the market then took off for nearly four years without even a 10% correction. Gray lines are analog version and red lines are digital (binary) versions of ZBT.
B) SECTOR PERFORMANCE REMAINS BULLISH
One of the ways we can identify when the market is about to enter a bearish period is by observing the action of the nine sectors that make up the S&P 500. Through much of a bull market, you'll see the companies that grow their earnings faster during an economic boom lead the way while others struggle. Three sectors can do well regardless of what the overall market is doing. The sectors are (followed by their ETF in parenthesis): Technology (XLK), Industrials (XLI), and Healthcare (XLV).
Many place Technology and Industrials in the economic growth group and Healthcare in the defensive group, but we regularly see these three sectors not correlated with the others mentioned below. They seem to go up and down based on their internals and are not good leading indicators of the market.
There are two sectors that consistently do well during a boom and fall in anticipation of bear markets. They are (with their ETF's): Cyclical/Consumer Discretionary (XLY), and Financials (XLF). Cyclical/Consumer Discretionary include products that people want (not necessarily what they need), including restaurant dining, hotels, cosmetics and leisure items. In a recovery, the Financials sector benefits from more capital projects and increased personal investing. New projects or new homes require financing, which usually leads to a larger number of loans.
There are two defensive sectors that fall during recoveries and do well during recessions: Consumer Staples (XLP) and Utilities (XLU). Consumer Staples are products that people must have to live, such as food and goods that people are unable or unwilling to cut out of their budgets regardless of their financial situation. Utilities do well in recessions because they are stable and often provide a higher dividend than bonds. The actions of these sectors frequently lead overall market downturns or upturns. We know that the stock market is a leading indicator of the economy, and we also know that certain sectors are leading indicator of the stock market.
We can tell which type of market is coming, bull or bear, by observing the actions of the different sectors. First I'm going to show you the action of two of the sectors (Cyclicals/Consumer Discretionary and Financials) that do well during bull markets for the five-year bullish period of 2002-2007, then we will take a look at what those two sectors are telling us today.
BULL MARKET 2002-2007
Two sectors; Cyclicals/Consumer Discretionary and Financials frequently provide leading indicators of the overall market.
As you can see from the chart above, in the bull market of 2002-2007, two of the bullish sectors, Cyclical/Consumer Discretionary and Financials, turned down sharply at the start of 2007, one year ahead of the beginning of the 2008 – 2009 bear market. Also, notice that they started doing well early – before the bull market began in October 2002.
So what are those sectors doing today?
BULL MARKET 2009-2015
The Consumer Discretionary and Financial Sectors are still doing well, even as the overall market experiences turbulence.
As you can see, these two 'canaries in the coal mine' have not stopped chirping yet. While Financials are not going gangbusters, these charts show each sector relative to the S&P 500, so Financials have at least maintained apace with the gains of the S&P 500. Although we aren't going to show their charts, the two sectors that turn up when a bear market is upon us, Utilities and Consumer Staples, are falling fast, so that's not an indication of an imminent bear market either.
A) RETAIL STOCKS ARE COLLAPSING
While the charts above show that the Consumer Discretionary (XLY) sector is holding up well, one very important industry portion of that sector is collapsing. The following comes from Friday's Market Message by John Murphy at StockCharts.com:
||RETAILERS TUMBLE... Retail stocks are in free-fall. The daily bars in Chart 2 show the S&P Retail SPDR (XRT) gapping nearly 4% lower today and threatening to close at the lowest level in a year. It's also in danger of breaking a support line drawn under its 2014 lows. Volume has been heavy over the last two days as prices have fallen. Big names like Macy's and Nordstrom are grabbing most of the attention. But a lot of retailers are being sold heavily. How bad the group is doing relative to the rest of the market can be seen by the falling XRT/SPX ratio on top of the chart. It is in danger of falling below its 2014 low. That's not good for retailers or the stock market. Consumer spending is two-thirds of the economy. Since the direction of retail stocks often tells us something about the strength of consumer spending, this serious a breakdown is a big source of concern.
B) IS THE MARKET IN THE PROCESS OF ROLLING OVER?
If we simply look at the price pattern of the 2015 market, represented here by the S&P 500, which is the strongest index of any of the major indices (benefited by exclusively holding large-cap stocks), it appears to be rolling over. Notice the two crosses below the 200-day moving average (red circles), one of which occurred last Thursday.
In fact, this pattern bears a strong resemblance to the 2007 market top:
And this is how the marketprogressed in 2007 in subsequent months...
C) NEW INDEX HIGHS WITH DECLINING INDIVIDUAL STOCK HIGHS
Many investors rely on the S&P 500 price trends when gauging the market. However, this approach can lead to erroneous decisions. The S&P 500 and many other indices are market-capitalization weighted, which allows larger companies to mask the underlying action that is actually taking place across all stocks in the indices. For instance, just the top 10 names in the S&P 500 comprise almost 20% of the S&P 500's total market value. Investors can see beyond the market capitalization distortion by focusing instead on breadth.
When reviewing the S&P 500's historic new highs, each time 4% or less of its component issues are also reaching new highs is the mark of an imminent decline. Every time this situation has occurred over the last 25 years correlates with a market top. It is worth noting that a warning was signaled on July 21, which is the first time this has occurred since October 18, 2007 (the top prior to the credit-crisis crash). The warning previous to that happened on September 26, 2000 (the top before the dot-com crash).
The chart below shows the trend of new highs in the S&P 500 has sharply declined since the start of 2015, even as the S&P 500 was recording new all-time highs. In early November, the S&P 500 was back within 2% of an all-time high, while net new highs of individual components were near 0%. Obviously, this lack of breath is not bullish for the market.
Net new high percent declined sharply for the last year as the S&P 500 was recording new index highs.
D) ADVANCING VS DECLINING ISSUES
Since the middle of 2014, the number of advancing issues has steadily decreased while declining issues has steadily increased. Obviously, this is not the sign of a healthy market and in fact, is the sign of a market running out of steam and possibly in the process of rolling over. However, notice that since mid-September, these two measures have been reversing direction. It remains to be seen whether or not this is a temporary development or something that signals a positive trend change.
20-day moving average of advancing (green) vs. declining issues on the NYSE.
These are indicators that do not fit in a typical technical market analysis. However, as you can see, a review of them results in a fairly 'ugly'
A) BETS ON ECONOMIC GROWTH VS CONTRACTION
The earnings of small-cap stocks are usually US-centric and do well at times when the US economy is growing. Analysts frequently watch the action of small companies for a read on the US economy versus their larger brethren because about 33% of larger companies receive their revenues from multinational sources. The best index that represents small-cap stocks is the Russell 2000 small-cap ETF (IWM). On the other hand, the 20-year Treasury bond ETF (TLT) is a go-to investment at times of caution or in recessionary environments. Running a chart showing a ratio of these two ETFs can give us a measure of the 'risk-on' and risk-off' sentiment currently in the market. After a 'Risk Off' trend since mid-June 2015, at present, this index is not providing guidance for a direction and could go either way.
Investor's bets on economic growth vs contraction
can be measured by the movements of small-cap compnies vs risk-free bonds.
B) DECLINING INSIDER BUYS
Overall insider buy and sell moves are an indicator we watch for market insight. Insiders have their fingers on the pulse of their company's prospects for the future. Based on their inside information, they regularly buy their company's stock when they see it is cheap and sell when they see it is richly valued. When the ratio of cumulative insider sales to buys becomes high, it is a sign that the market is expensive.
According to Thompson Reuters, the Insider Transactions Ratio is currently very bearish, after being bullish as recently as the market lows at the end of August. There will always be more sales than purchases because stock options are frequently used as a form of incentive compensation for corporate officers. However, history has shown that insider transactions below 12:1 buys/sales is bullish. Readings above 20:1 buys/sales are bearish. The latest measure (from early November) is a ratio of 35:1, with 303 million sales and 8.7 million buys, which is extremely bearish. Insiders were bailing out of the market at the last high based on their perception of their company's value compared to the value the market was placing on its stock.
Insider Transactions Ratio: Below 12:1 buys/sales is bullish. Above 20:1 buys/sales is bearish.
The current ratio is 35:1 sales to buys.
Last Thursday afternoon we sent out an email to subscribers letting them know that we were selling each of our ETFs at the open on Friday. Fortunately, there were no substantial losses, with the largest one being -4% for the Regional Banking ETF (KRE) in the AGGRESSIVE Portfolio. In the CONSERVATIVE Portfolio, the largest loss was on XLF at -2.8%.
While some subscribers to our members-only AGGRESSIVE Portfolio and CONSERVATIVE Portfolio and our Intelligent Market Risk Analysis (IMRA) may be frustrated by our brief, three-week holding of these ETFs, our policy is to sell our positions without hesitation when there is risk of loss of capital. This can sometimes happen whenever there is a violent whipsaw in the market, as occurred last week. While some investors believe that buy-and-hold is a better policy than actively controlling risk, the costs of holding through a major-market selloff is far higher than the cost of selling during a whipsaw.
For example, buy-and-hold investors sustained an average -56% loss in the bear market from October 2007 to March 2009. The gain required to recover from that -56% loss is 127.30% just to get back to even. Just for the record, our primary portfolio made a profit of about 24% during the October 2007 to March 2009 selloff, in which the broad market sustained a loss of -56%. The table below shows the costs of being a buy-and-hold investor versus the cost to recover from a whipsaw-based sale, like the one occurred last week.
Gain required to get back to even after a bear market loss vs. being active to contain risk of loss in a whipsaw. While moving in and out of the market in a whipsaw is frustrating to some investors, the gain required to get back to even is miniscule compared to the gain required following a bear-market loss.
We did not make the decision to utilize ETF's until October 25 when the utter frustration of being unable to find good undervalued stocks for many months forced our hand. Our private ETF portfolios have produced excellent returns during that time, and we made the decision that subscribers should also be able to profit from ETF's during periods like this when undervalued stocks that meet our requirements are not available. To summarize the profit and loss for our AGGRESSIVE Portfolio during that three-week period, from the time we purchased ETF's on October 26, we made a gain of about +2.2%. After the violent whipsaw last week, that portfolio sustained a total loss of just -2.1%. For our CONSERVATIVE Portfolio, it logged a gain of about +1% before we had to sell last week and lost a total of -1.7%.
We don't know what the market is going to do from here, but we made the decision, based on clear evidence, that risk had increased substantially in a very short period of time. To protect capital, we could no longer continue to hold our positions. The time it might take to recover that -2.1% and -1.7% loss might be just a day or two. On the other hand, when a whipsaw dramatically increases risk, the cost to hold onto those positions out of stubbornness or ego should the whipsaw be the beginning of a bear market can be disastrous.
Our quote of the week (at the top of this page) by famous investor Jesse Livermore sums up our policy: “Losing money is the least of my troubles. A loss never troubles me after I take it. I forget it overnight. But being wrong – not taking the loss – that is what does the damage to the pocketbook and the soul.”
No one has a crystal ball, and there is always a chance that the market will resume its upward trend after we have issued a sell signal. As outlined in this newsletter, the market is not giving a clear indication of its future direction. It is also possible that we will repurchase the equities we just sold should market analysis indicate that is the proper course of action. That can cause consternation among some subscribers, but our primary objective first and foremost is the preservation of capital. When we see indications that there is a substantial risk of loss of capital, we will pull the plug quickly, as we did last week.
In light of the issues discussed in this newsletter, we will be making no position changes to our portfolios. We will hold cash until we see a definite outcome of the current volatile market environment; either obviously heading higher or obviously heading lower. We will keep you abreast of developments and subscribers will receive our specific stock or ETF recommendations in the Member's Area of the site.
We will publish an updated Intelligent Value Alert newsletter with a fresh analysis of the market when the development of a trend is apparent.
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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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