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"When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done."

John Maynard Keynes

- Enjoy more of our favorite investing quotes


NOVEMBER 22, 2015


In This Edition (Quick Links):
- Global Economic Meltdown?
- Citibank World Economic Report
- Baltic Dry Index Hits All-Time Low
- Has the Federal Reserve Manufactured Another Economic Crisis?
- Unintended Consequences Of Fed's 'Wealth Effect' Policy
- US Business Sales And Employment Have Diverged
- Corporate Debt Inventories Are Negative
- It Looks Like A Major Market Top Is Forming
- S&P 500 Fibonacci Levels
- S&P 500 Momentum Indicators
- One Indicator Can Negate This Bearish Analysis
- Portfolio Changes

10 Reasons why WE MAY BE ON

We are only about six weeks away from completing 2015, and there are a plethora of market-related factors still up in the air the signals . In last week's Intelligent Value Alert newsletter, we discussed some of the positive factors that the market had going for it ('The Good') as well as some of the negative ('The Bad' and 'The Ugly'). Here's a brief summary:


Zweig Breadth Thrust occurred on October 8. There have been 14 Zweig Breadth Thrusts (ZBT) since 1945 and each was subsequently followed by an average gain of 24.6% in the next 11 months. Bull markets have began following each of those 14 Breadth Thrusts. If the market does not go into a bull rally this time, it would be the first failure of this signal in 70 years.

Sectors that have historically been correlated with a bull market (such as Consumer Discretionary and Financials) are still doing well (price-wise) and are not signaling an imminent downturn.


The Net New Highs Percent declined sharply for the last year even as the S&P 500 was recording new index highs.

• Declining Issues have sharply outpaced Advancing Issues in the S&P 500 (and virtually every other market index) for the last year.

Economic Growth has underperformed Economic Contraction-oriented assets.

Corporate insiders are selling their stock at a very bearish rate; 35 sales for every 1 purchase.

Read the Newsletter


In the course of doing our research last week, we uncovered a cornucopia of new facts regarding the economy and the markets. Keep in mind that IntelligentValue has never been a perma-bear or a perma-bull. In our Value Alert newsletters and our model portfolios, we attempt to provide an evenly balanced review of the essential facts related to investing. Unfortunately, the vast majority of facts we discovered last week are not comforting.


According to a recent report by British banking giant HSBC, the global economy is "already in a recession. Global trade is down -8.4% this year and global GDP expressed in US dollars is down -3.4%. Here is the global GDP chart published by HSBC:

Chart 1: Global GDP in US dollars is now -3.4%. Source: HSBC bank


In its report, HSBC  said "In particular, it highlights the limited effect of global QE efforts. Over the last year, the ECB and BoJ have added about USD850bn to their reserves. The relative increase in ECB and BoJ stimulus may have exaggerated the decline in global growth due to the shift in exchange rates. However, these lower exchange rates have so far not produced sufficiently large export growth numbers to offset the wider growth story.

Also, it illustrates that the EM implication of global USD growth is only marginally negative despite significant declines in real exchange rates. The key takeaway here though as far as we are concerned is that QE policies have not generated more value than they have destroyed. It is also worth noting that this dollar recession is worse than the 2001 recession by some margin."

HSBC is not alone in this opinion, because the World Trade Organization (WTO), the Organization for Economic Cooperation and Development (OECD), as well as the Asian Development Bank (ADB), have also been on sounding the horn with warnings about the global economy.



Citibank is also on the global-recession bandwagon with a recent report by its Chief Economist Willem Buiter:

"The evidence for a global slowdown is everywhere. Global growth is weakening since 2010 as is evident from (declining) global real GDP growth since 1980 at both market and PPP exchange rates, as well as Emerging Markets (EM) and Developed Markets (DM) real GDP growth. A modest pickup in GDP growth in the DMs since 2012 is swamped by a sharp decline in EM growth.

There are other informative indicators of global weakness, notably the very weak – indeed negative - world trade growth in the first half of 2015, the continued weakening of (real) commodity prices, the weakness of the global inflation rate (measured by the GDP deflator), the recent decline in global stock prices, measured by the MSCI ACWI, plus indications that corporate earnings growth is slowing down in most countries, and (as a result there is an) unprecedented decline in nominal interest rates (as shown in Chart 2.)"

Chart 2: Interest rates in Emerging Markets and Developed Markets. Source: Citibank


Unfortunately, the US led by example and many world economies followed it into the money-printing business. Ironically, instead of the intended effect of giving the post-crisis recovery a defibrillator shock, it is now apparent that we are seeing the opposite effect. While the rest of the world is still in easing mode, the US stopped its QE program in December 2014 and said it is on the brink of increasing interest rates (mid-December 2015), which is creating a significant global policy divergence.

That divergence is contributing to the strengthening of the US dollar that is causing a drag on the global economy that QE was supposed to boost. The real risk is that a major emerging-market country that depends on exports goes into a sovereign debt crisis because of declining GDP (upon which tax revenues are based) and increasing debt costs (because much of foreign debt is financed in expensive US dollars).

There is a significant probability an increase in rates could trigger global contagion. We aren't concerned about Greece as many are because it is such a relatively small economy (less than the GDP of Connecticut). However, if Brazil, Russia, or one of many Asian countries default, it could trigger a liquidity freeze similar to 2008, but this time around it may include a deflationary global default nightmare.


One of the standard tracking signals for global economic activity is $BDI, aka the Baltic Dry Index. According to Investopedia, "the Baltic Dry Index is a shipping and trade index created by the London-based Baltic Exchange that measures changes in the cost to transport raw materials such as metals, grains and fossil fuels by sea.

Changes in the Baltic Dry Index can give investors insight into global supply and demand trends. This change is often considered a leading indicator of future economic growth (if the index is rising) or contraction (index is falling) because the goods shipped are raw, pre-production material, which is typically an area with very low levels of speculation."

On Friday, November 20, the BDI hit an all-time low at $498/share, undercutting the previous low from last February at $509/share.

Baltic Dry Index has been in steady decline since 2010. The $BDI monitors shipments of goods throughout the world.


Has the Fed MANUFACTURED Another Economic Crisis?

The US Federal Reserve has a statutory dual mandate to maintain full employment (~5%) and keep inflation at a reasonable level (~2%). This quasi-government entity was created following a severe market crash and economic contraction in 1907. From the Fed's creation in 1913 to the 1990s, its playbook for managing economic cycles was a conservative one. It would lower interbank interest rates in an economic contraction to spur demand, expansion, construction, and investment, thereby reducing unemployment. Then the Fed should slowly and steadily increase rates as the contraction abates and the US economy begins to recover.

When the economy is reaching the later stages of the business cycle, private-market interest rates usually heat up because of the demand for cheap debt financing and the Fed would begin to increase interest rates to fight the forces of inflation. However, the Fed missed its mid-cycle opportunity to start increasing rates. The robust 2013 and 2014 rallies would have been the optimum time to begin 25-basis point increases.

However, you may recall that in May of 2013, former Fed Chairman Benjamin Bernanke hinted that a tapering of Quantitative Easing (QE) was coming, and an increase in interest rates would follow. As a result, US equity markets pulled back in what was christened a 'taper tantrum.' Dr. Bernanke, still in the long shadow of his mentor and previous Fed Chairman Alan Greenspan, embraced Greenspan's 'Wealth Effect' philosophy. That meant keeping the markets churning higher, and subsequently the Fed continued the QE program all the way until December 2014. We now have almost seven years since QE began and at least two years since interest rates should have started to move up.

However, the Fed didn't follow its playbook and missed the opportunity to slowly increase rates mid-cycle. Now it is in a very serious liquidity box. Employment has steadily improved since the economic bottom in 2009, and the US is now considered to be at 'full employment' with an unemployment rate near a 42-year low (see Chart 3, below for 1985-to-present trends). Based on jobs data, the Fed has a green light for increasing interest rates.


Chart 3: US unemployment claims, 4-week average. Unemployment is currently at its lowest level since 1985.


On the other hand, the Fed is falling far short of its stated goal of 2% inflation. The latest inflation rate for the United States is 0.2% for the 12 months ended October 2015 as published by the US Bureau of Labor Statistics (BLS) on November 17, 2015. Chart 4 shows the annual inflation levels in the US for the last decade.

US Inflation Rates
Chart 4: US inflation rates have declined from a post-crisis high of 3% in 2011, now reaching 0.2%.

However, there is now a significant anticipated policy divergence between the US and other world economies (which are still easing/stimulating). The US spawned the global financial meltdown and was the first economy to begin to contract. It makes sense that the US would be the first economy to recover. However, this divergence in monetary policy is creating an abundance of unintended consequences.


It is becoming very apparent that global economic growth is deteriorating. However, policymakers have boxed themselves into a classic liquidity trap. The stimulative effect of 0% Fed Funds rates is now producing little or no economic benefit, but the withdrawal of these measures and an increase in interest rates could set off a global financial disaster that could make the 2008/2009 crisis seem like a speed bump.

In our September 15 issue of a special three-part Value Alert newsletter, we addressed the pressure being put on emerging market economies by this policy divergence. One of the critical unintended consequences is a strengthening of the US dollar. As discussed in the September 15 issue, one of the results of US tightening and the rest of the world still stimulating is that the US dollar becomes a stronger currency. Pumping money into an economic system has the effect of decreasing the value of a country's currency. This can have a positive impact because declining exchange rates increase a country's exports (US products are cheaper for the rest of the world to buy).

However, since mid-2014, the value of the US dollar has moved higher by about 20% compared to a basket of foreign currencies. While this may not sound like a significant amount, the effect on exchange rates is multiplied, and the result is a decline in the revenues generated by the commodities upon which many emerging markets depend. The value of commodities is almost a direct inverse of the value of the US dollar (see Chart 5, below).


  Chart 5: Effect of value of US dollar ($USD) on commodity prices (DBC).


We have seen this dollar-inverse effect on many commodities such as oil, corn, sugar, soybeans, copper, precious metals, coffee, livestock, and many others. This dramatic drop in the revenues generated by EM exports, combined with foreign corporate and sovereign debt repayments that are usually based on the US dollar, threatens to send emerging markets into financial catastrophe. We are not talking about Greece here because its GDP is only $238 billion and it does not export much. In fact, the annual GDP of Greece is less than the annual GDP of Connecticut. The more severe economic contractions are occurring in Brazil, Russia, and many Asian economies.

The effect of additional increases in the exchange rate for the US dollar also results in declining profits for US companies that have a significant percentage of sales coming from foreign markets. We have seen this in the steady decline of sales and profits for publicly traded US multinational corporations, especially since mid-2014 when the dollar began to strengthen.

Many believe that everything will be okay if the Fed can maintain domestic price stability, but that logic is fundamentally flawed. If the economy can be propped up only through monetary, credit and debt expansion, the result will be an increased risk of systemic crisis. Gross international capital flows pose just as many (and perhaps more) dangers than high unemployment or low inflation in the US.

Another unintentional consequence of not increasing rates is that the Fed continues to create a bubble in asset prices (especially stocks). The US Federal Reserve's QE programs pumped $80 billion per month into buying bonds and mortgage-backed securities. The Fed's bond purchases were favorable to the stock market because the purchases removed bonds from the private sector. This created a bond shortage for investors, and that $80 billion per month leaked into other markets and created buying pressure. These flows primarily went into the stock market, where returns were higher.

In the chart below we can see the effects of QE 1, QE 2, and QE 3 on the equities market. Notice that each time the Fed tried to back out of stimulation through QE, the equity market struggled to move higher. On the far right of the chart you can see that following the Fed's termination of QE 3 in December 2014, the S&P 500 flatlined through most of 2015, then sold off in August based on the prospects of increased interest rates:


Chart 6: The correlation between the Fed's balance sheet and the stock market is unmistakable. Source:


Since 2008, central banks 'printed' $10 trillion in money around the world and $4.4 trillion in the US alone, just to keep the world's economies afloat. However, that money printing, along with the continuous, massive Chinese stimulus, may have created the largest market bubble in world history. In the US, that $4.4 trillion of private investor funds had to either stay in cash or find something else that was more appealing. That 'something else' was usually the stock market.

To repeat this week's 'Quote of the Week:' "When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done."  John Maynard Keynes

The unintended consequences of a Fed rate hike might burst that bubble and could result in a 1) severe market correction (or even a bear market), 2) a continued increase in the strength of the dollar, 3) the prospect that a stronger dollar could cause a catastrophe for emerging markets (which will directly affect the US and every other developed country), and 4) declining revenues for multinational US companies.

The unintended consequences of not increasing rates are that equity markets and other asset classes that are affected by low-interest rates will continue higher to levels that will be in historically unprecedented bubble territory (the PE of the Russell 2000 is currently at 144!). Also, savers and institutional investors such as pension funds that rely on interest-rate income will continue to be punished.

The Fed is so boxed in that it froze in its last two meetings. We may very well see that same freeze occur again at the December 16 Fed meeting. This is the date when the majority of analysts and futures traders are expecting the Fed to increase rates for the first time since June 2006. However, even if the Fed passes again on a rate increase, there is no evidence that a continued 0% Fed Funds interest rate will spur economic growth. So far it has not done much in that regard as demonstrated by the analysis above.



Business revenues and employment have always tracked closely together. When sales fall, companies lay off workers and stop hiring. In the chart below, notice the tight correlation in the three lines before and during the financial crisis. Year-over-year (YOY) change in business sales in red, YOY change in employment reported by businesses in green, and YOY change in employment reported by households in blue. Following the 2008/early 2009 meltdown, business sales surged to even higher levels than before the crisis (because of pent-up demand). However, since 2010 company revenues have steadily declined.

Also, since 2010 the correlation between business sales and employment have diverged. In late-2009 and 2010, sales outpaced employment because business were unsure of the future and were hesitant to start hiring. What is a strange is that YOY business revenues have steadily declined since 2010 while YOY hiring increased. However, since late 2014, YOY hiring began to decline. In September 2014, the YOY employment growth rate was 24%. The most recent YOY employment data for October shows a growth rate of just 14%, so the decline in jobs growth may already be starting.

Chart 7: Employment has always tracked business revenue until the last few years as business sales
fell sharply and employment increased.
Source: Michael Pollaro/John Rubino

Employment is a classic lagging indicator. This divergence cannot continue much longer, and since revenues are not under the control of a company (businesses are usually doing all they can to optimize sales), it's a virtual certainty that hiring will soon start to be cut. In fact, if you notice the YOY employment gains on the far right of the chart, you can see that the comps with last year are starting to fall.



Corporate bond inventories have turned negative for the first time in history. This should this be important to you for these reason:

Primary dealers are a group that includes banks and broker-dealers that act as market makers for the Fed and individual corporations selling bonds. They buy and then sell bonds, making them available to their clients. In the process of being a middleman, they hold inventories of bonds and historically have stepped in when liquidity is drying up to shore up the bond market.

As the chart of 2015 (Chart 8, below) shows, in mid-year the inventories held by these primary dealers was near $13 billion but has been in decline ever since. In the most recent weekly data, it appears that primary dealers are shorting bonds for the first time ever.

Chart 8: Bond inventories have Been declining since mid-2015 and have gone negative in the last weekly data. Source: Bloomberg.

The only reason primary dealers would short corporate debt is because they believe the value of bonds is set to decline. Should economics or markets turns sour, investors will want to convert their bonds to cash or money-market funds. However, if brokers and banks are not buying, it could result in a liquidity squeeze and the collapse of the bond market.

Many professional investors consider the bond market to be 'smart money.' Trends in bond markets typically lead trends in equity markets. If these primary dealers are concerned about a crisis that causes a panic of selling, they know that liquidity will dry up quickly. As a result, they have drastically cut their inventories and are holding cash.

Many have learned their lesson from the collapse of 2008 and are very tentative when financial markets begin to look threatened. We've had a much longer than average bull market (6.7 years versus a historical average of 4.5 years), and this 'smart money' may believe we are at the end of an economic cycle. They are getting out of the market ahead of the less sophisticated crowd of investors.


It Looks Like A Major Market Top Is Forming

Let's turn our attention from the overall economic aspects that affect stocks to some technical patterns we can identify in the charts.
First, we will turn our attention to a comparison between market price patterns at the 2007 top and current market price patterns.

In 2007, the market took a significant dive in August before recovering to prior highs in mid-October (sound familiar?). Prices started falling after that second top was logged, but quickly bounced back upward (red dotted line in chart 9). That last effort by the bulls to go higher failed and the market collapsed quickly after that, ultimately losing 56% of its value.

Chart 9: Notice the dotted red line that highlights the double top in 2007. In November that year the bulls made one last effort
to return to prior highs (red dotted line), ultimately failing.


Today's scenario in late 2015 is eerily similar because the market recovered from a severe correction to return to the area of prior highs before pulling back again. The red dotted line shows the current market situation as of last Friday. If this plays out like 2007, that red line may signify the last gasp for the bulls.

However, should the rally continue, break through significant overhead resistance and set new highs, then there is a substantial chance of a continuation of the rally. However, with so many economic challenges (as discussed above) and stock prices relative to fundamentals still incredibly high (according to the WSJ, the current PE of the S&P 500 is 24, and the PE of the Russell 2000 is a whopping 145), probabilities favor the bears.

Chart 10: In 2015 we have a very similar-looking chart With another potential double top. Is last week's rally a similar last-ditch effort
by the bulls to keep this market going? Where the red dotted line goes from here will determine the story of this market.




While many fundamental-oriented investors consider Fibonacci levels to be the market equivalent of 'voodoo,' a large number of technical traders swear by them. Also, many computerized trading programs incorporate them into their algorithms. Therefore, with a great deal of activity focused on the Fibonacci levels they tend to be important regardless of their objective credibility.

According to Investopedia, "Leonardo Fibonacci was an Italian mathematician born in the 12th century. He is known to have discovered the "Fibonacci numbers," which are a sequence of numbers where each successive number is the sum of the two previous numbers; e.g. 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. These numbers possess a number of interrelationships, such as the fact that any given number is approximately 1.618 times the preceding number."

"Fibonacci Extensions are levels used in retracement to forecast areas of support or resistance. Extensions consist of all levels drawn beyond the standard 100% level and are used by many traders to determine areas where they will wish to take profits. The most popular extension levels are 161.8%, 261.8%, and 423.6%."

In 2015, the S&P 500 completed a 161.8% Fibonacci Extension of the entire downturn from 2007 to 2009. For the full year, the S&P 500 has been unable to break through this level. We do not believe that is a coincidence.

Chart 10: The S&P 500 has reached a 161.8% extension of the entire market selloff from 2007 to 2009. This is an area that is frequently resistance following a strong rally. The S&P 500 has been unable to break through this level all year.



In addition to the S&P 500 floundering at its 161.8% retracement level, the Nasdaq 100 ($NDX) and Nasdaq Composite ($COMPQ) both appear to be topping out near the same level they were at during the 2000 highs. We do not consider this a coincidence, either.

Nasdaq 100 ($NDX) and Nasdaq Composite ($COMPQ) are both having trouble moving above the 2000 highs.


We will review one last chart before concluding this newsletter. IntelligentValue places a great deal of emphasis on trends and momentum of trends. The chart below shows the S&P 500 SPDR ETF (SPY) in the top panel, the Price Momentum Oscillator (PMO) in the second window, and On Balance Volume (OBV) in the bottom window. 

The Price Momentum Oscillator (PMO) is an oscillator based on a Rate of Change (ROC) calculation that is smoothed twice with exponential moving averages that use a custom smoothing process. On Balance Volume (OBV) measures buying and selling pressure as a cumulative indicator that adds volume on up days and subtracts volume on down days.  We watch for divergences between OBV and price to anticipate future price movements or use OBV to confirm price trends.

The chart below shows three concerning indicators of market strength based on technical analysis:

1) In the top chart, we can see that SPY has touched the 211 level four times in 2015 and has been unable to break through on any of those efforts. Should the rally that began last week continue, it is going to have a great deal of resistance again at the 211 area.

2) The Price Momentum Oscillator (PMO) in the middle panel shows that the primary line (black) has been flat during the last week's rally. Also, it is below its red signal line, which indicates a divergence with the most recent market strength.

3) The On Balance Volume (OBV) indicator in the bottom window shows that volume has steadily moved downward throughout 2015 as the volume on declining days was consistently stronger than on advancing days. Most significantly for the current market uptrend is that On Balance Volume has remained flat since the low set in late August. The reason OBV is flat is because the volume on up days was not high enough to overcome the volume on down days. This occurred even during the October rally and the recent upturn in prices. Therefore, this indicator is showing a bearish divergence with price.

Chart 11: The two momentum indicators in the bottom two windows are showing a divergence with price during the recent upturn.


This week we brought to your attention some of the many critical factors that are becoming apparent in global growth, US growth, and the US stock market. We compiled a very long list of negatives from which to choose, but the analysis above was getting quite lengthy already. In the spirit of expediency, we will save those discussions for another day.

However, there is one indicator that will trump all the challenges the US and world face: a break-out to new highs. Should last week's rally continue and surpass 2134 on the S&P 500, we would have cause to re-examine the bearish scenario.

However, if the rally continues even in the face of a declining global economy, downtrending US corporate revenues and profits, and institutional bond broker/dealers as a whole going short for the first time in history, then we can probably lay the blame (or credit, depending on how you view it) on the doorsteps of yet another Federal Reserve intervention.

A continuation of the rally is only likely to occur if the Fed continues to turn the stock market into a giant casino. In this case, it is a bait-and-switch scheme we have seen twice before in the last 15 years. The Fed lures investors and corporations into the equity markets with cheap rates and stimulus measures that eventually result in an unsustainable bubble. Then when that house of cards gets hit by a light breeze, similar to 2008, it all crumbles down because there are no buyers of financial assets in a meltdown.

The Fed took extraordinary measures to provide ample liquidity to the markets starting in 2009, and there was good reason to take rates to zero. However, the economy and the stock market have steadily improved since 2009 and the stock market was very strong a few several years ago. However, as we approach the end of an economic cycle and a likely recession, the Fed has no other tools to use. It cannot legally set rates in negative territory, which would be tantamount to paying individuals and companies to accept more debt.

You've heard it before but it bears repeating: the Fed is 'out of bullets.' Should a recession materialize, it can not decrease rates as it has so many times since 1913 when a recession hits. Could they do more QE? Of course, but the effectiveness QE was diminishing when the Fed ended QE-3 in December 2014. That lack of effectiveness is likely to pick up where it left off a year ago.

If the market breaks through to all-time highs, it will likely be the result of central banks coming up with even more creative ways to turn the markets into an even larger casino than they are today, as referenced in the 'Quote of the Week' warning by economist John Maynard Keynes.


The analysis in this newsletter is quite negative, but that doesn't mean there isn't money to be made in the market. Premium Members can jump to the Portfolio pages for details on any changes we will make for Monday's market open based on the analysis discussed above.

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.