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“In times of change, learners inherit the earth, while the learned find themselves beautifully equipped to deal with a world that no longer exists.”

—Eric Hoffer

– Enjoy more of our favorite investing quotes –


DECEMBER 6, 2015


In This Edition (Jump Links):

- Is Volatility a Sign of the Bull Shape-Shifting Into a Bear?
- Extremely Expensive Market
- Unprofitable IPO Activity Signaling Danger
- M&A Activity at Record Highs
- Insider Sales Accelerating
- High Yield Bond Index - Negative Divergence With S&P 500 
- Perhaps The Scariest Chart You Will Ever See


This newsletter takes a look at volatility near market tops, the sky-high PE ratios that are accompanying declining corporate revenues and earnings, the historical pattern of the market following records set in IPOs, M&A activity, and insider sales of stock (all of which we have seen recently). We also take a look at the message that the high-yield corporate bond market is sending, and conclude with what may be the scariest chart you will ever see.



Last Monday the S&P 500 opened the week at a price of 2090. By Thursday, it had dropped -2%, down to 2049. However, Friday saw prices surge sharply by more than 2% and the S&P 500 closed one point higher than it opened the week, at 2091. Last week's volatility was not unusual. Last June, as the market reached levels of the lowest volatility in many years, and we published a newsletter titled, "Big Change Coming to the Market This Week." The following week the market began to decline and since then volatility has been a featured trait of equities.

Most of us have images seared into our brains from dozens of horror movies of the intense convulsions an actor goes through when an innocent, relatable character uncontrollably turns into a werewolf or some other wild creature. So it also goes with equity markets as bull rallies peter out and bear markets begin to claw and roar to life. Bull markets also make convulsive attempts to hang on to life at the end before they shape-shift into an angry bear.

For this reason, one of the classic 'tells' we watch for when identifying the end of a bull market is volatility expansion. Extreme volatility is frequently the result of an intense disagreement between bullish and bearish investors.

Are we on the cusp of a severe bear market?

Bullish investors invariably see blue skies ahead; i.e., employment continuing to improve, the Federal Reserve and central banks around the world still stimulating with hyper-low rates and QE, sectors that thrive in good times (such as Financials and Consumer Discretionary) still climbing, and a US economy that is doing fairly well, especially considering where it was seven years ago.

Bearish investors, on the other hand, see dark clouds ahead; market breadth deteriorating, investors shunning small-cap stocks and seeking refuge in the safety of big companies, corporate sales and earnings declining for the first time since 2009, forward estimates regularly revised downward, companies borrowing money at a record pace to buy shares and improve PE ratios before interest rates increase, while simultaneously the insiders of those companies are selling their shares at a near-record pace, M&A activity setting all-time records using borrowed money, and global GDP compressing.

These two opposed views of the market frequently result in a cognitive dissonance within the collective investment community and the result is intense volatility. Bull markets don't go out with a whimper; they usually go out with a bang.

One of the ways we monitor volatility expansion is through the Average True Range (ATR) indicator on technical charts. We have found that when the market is above the 200-day moving average (which generally means bullish conditions), and ATR is above 20, it is a signal of a battle between the bulls and bears at the top (typically because prices have become stretched). In the past, it has been a harbinger of a forthcoming selloff. Chart 1 below depicts the ATR indicator in the bottom window, with blue shading in the top price chart showing times when bullish conditions combined with extreme price volatility:

Click to Enlarge
ATR Indicator of selloffs

Chart 1: The Average True Range indicator when greater than $2 while the market is above the 200-day moving average
is frequently the harbinger of a selloff. Chart courtesy (Click chart to enlarge.)


We identified internal US market weakness as far back as late June and moved toward cash at that time. Since our June 28 warning about the market, we have documented a significant number of negative fundamentals that we (and others) are noticing, with very few offsetting positive factors to provide optimism.

However, we know it pays to be an optimist when it comes to investing. After all, equities have been in a bull market 76% of the time since 1929 and 84% of the time since 1980. Therefore, the prudent investor is wise to err on the side of optimism. We like to think of ourselves as unbiased; neither perma-bulls nor perma-bears. We make every attempt stay open-minded towards the possibilities in either direction and capture profits when it is safe.

However, almost all the data we analyzed in the last few months is bearish. Investors must recognize that bull markets have a shelf life. They do not last forever. In the post-war era, most bull markets last 4.5 to 5 years. The current one is getting long in the tooth at 6.5 years.


In our November 11 Value Alert newsletter, we published a section titled, "An Inconvenient Truth: Expensive Prices + Poor Fundamentals = Disaster." At that time, the S&P 500 had a PE of 23.81, and the small-cap Russell 2000 had a PE of a whopping 188! In the last month, those P/E ratios have come down – but only by a bit. According to the Wall Street Journal Market Data Center, the PE of the S&P 500 is now at 22.95 and the Russell 2000 PE stands at 144.68.

Chart 2: PE Ratios for the three main stock indices are very high, with the Russell 2000 all the charts. Source: Wall Street Journal.

Those PE levels are significantly higher than they were a year ago (the S&P 500 was at 19.54 and Russell 2000 at 60.92) and are significantly higher than the average PE in the last 50 years. How could the P/E ratios have increased so substantially (especially for small-capitalization stocks) when prices are now almost the same as they were one year ago?

    One Year Price Change  
Dec. 6, 2014
Dec. 6, 2015
1-Yr % Gain
  S&P 500:
  Russell 2000:

The reason PEs have increased so substantially while prices have stayed the same is because sales and earnings have declined! S&P 500 real corporate profits fell by -$22.7 billion (-4.7%) for Q3 and fell by-$41 billion (-8.54%) for Q4 compared to the same two quarters in 2014.

WSJ/Reuters tracks the change in revenues and earnings from the prior year as shown in Chart 3:

Chart 3:
Year-over-year (YOY) earnings have been falling since 2010. Source: Wall Street Journal.


High prices and declining sales/earnings may not be enough to cause the market to crash. As Keynes famously remarked, "Markets can stay irrational for far longer than you can stay solvent." However, when combined with a substantial number of other markers that are proven harbingers of selloffs, it is important to take notice.

These three historically accurate indicators that are also flashing a red warning signAL:


According to, 2015 has set a new record for the percentage of unprofitable companies doing an initial public offering of stock (IPO's). At the 2000 peak, 76% of companies going public were unprofitable. Near the 2007 peak, 65% of IPO's were of unprofitable companies. In 2015, a record high 78% of companies going public are unprofitable. Is this is a big warning sign that another major market peak is at hand? Maybe not by itself, but when combined with all the other factors, it probably is pertinent data.


M&A activity reached $4 trillion in volume in 2015 and has set a new record. Record-setting M&A levels frequently precede market tops. Previously, levels of M&A activity peaked in 1999 and 2007, just before significant, -50% bear markets. This record-setting level of M&A activity is occurring because companies cannot find organic growth opportunities or don't have the confidence to use the funds to expand their business or add capacity.

Companies also bought back almost $4 billion per day of their own stock in the third quarter. Near-record buyback activity is another traditional sign of a market top. Both of these activities are fueled by low-interest borrowing, with rates expected to increase in 2016.


Overall insider buying and selling is also an indicator we watch closely. 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. 

In our November 15 Value Alert Newsletter, we published a brief on the direction of insider sales to insider buys. Since then, the stats have become even more lopsided.

November saw insider selling reaching $7.8 billion or $430 million per day. This is $2 billion more than September and October insider sales combined, when insiders sold $2 and $3.8 billion, respectively. The last record of insider selling was in May of 2011, just before a -20% slide in the market. Insiders are engaging in the massive sale of their stock while their companies are using shareholder funds to buy back stock in record amounts to prop up earnings-per-share and stock prices. This is not a confidence-inspiring statistic.



While bonds are generally considered to be a very conservative, income-paying investment, not all bonds are created alike. There are federal government bonds issued by the US Treasury, as well as city, state, and municipal government bonds. These bonds are backed by taxpayer revenue streams. One step up the ladder of risk (and with commensurate higher returns) we find investment-grade corporate bonds. However, the high-paying, red-headed stepchild in the bond market is high-yield corporate bonds.

This market is frequently called 'junk bonds' because the companies that issue them do not have strong balance sheets or a long history of revenues and profits to ensure their repayment like AAA-rated companies have. For this reason, they must pay a higher yield than investment-grade or government bonds. In fact, the market for high-yield corporate bonds behave in a similar way to other higher-risk investments such as stocks.

For decades the bond market has been called the 'smart money' because investors in bonds are usually one step ahead of equity investors, and that nomenclature includes high-yield bond investors. Worldwide, the bond market is valued at $98.2 trillion, with the US contributing $35.2 trillion of that amount. In comparison, the world stock capitalization stands at about $55 trillion, with the US contributing roughly $18 trillion of that total. As you can see, the bond market is almost double the size of the equity market.

Tomi Kilgore of recently published an article titled, "This Chart Warns That Stock Market Investors Should Be On High Alert." The article explained why the market for high-yield corporate bonds is regularly a 'canary in the coal mine' for the stock market. According to Mr. Kilgore,


The continued downtrend in the high-yield bond market is warning that liquidity is drying up, which could bode very badly for the stock market.

When financial markets are flooded with liquidity, investors tend to feel safer about investing in riskier, higher-yielding assets, like noninvestment grade, or “junk,” bonds, and stocks. When the flow of money slows, the appetite for risk tends to decrease as well.

That’s why many stock market watchers keep a close eye on the longer-term trends in the high-yield bond market. If money is flowing steadily into junk bonds, investors are likely to be just as willing, if not more willing, to buy equities. When money is coming out of junk bonds, like the chart below shows, many see that as a warning that investors could start selling stocks.

The market in high-yield corporate bonds is frequently a harbinger for the stock market when they diverge. Bonds have been in a decline since 2013 as the stock market continued to climb.

We can take a closer look at this dichotomy using a different representative of high-yield bonds, the Credit Suisse High Yield Bond Fund (DHY) compared to the S&P 500. Chart 5 shows that DHY began to sell off at the end of 2014 while the S&P 500 continued rising to all-time highs throughout 2015. If the bond market is the 'smart money,' then these charts show smart money is heading for the exits.

Chart 5: High-yield corporate bonds began to sell off at the end of 2014 while the S&P 500 went on to record record highs.

With the Federal Reserve all but locked into raising interest rates in about ten days, investors should not expect liquidity conditions to improve anytime soon. Rising rates tend to sap stock-market liquidity, as interest returns on cash increases and competes for investor's capital. It is for this reason that many stock investors fear a Federal Reserve rate hike will crash the market.


The ETF Top 5 Momentum Index was created by Carl Swenlin of DecisionPoint/ in the 1990s to track the top five (out of 100) ETFs with the strongest momentum. The index is rebalanced daily to determine the five highest-momentum ETF's. Initially intended to be a portfolio that could beat the market by exploiting the momentum anomaly, Swenlin soon discovered that the top five would frequently perform worse than the market following a strong run, and sometimes precede a market downturn. Of course, veteran momentum-oriented investors know that when things turn sour for a momentum stock (or the market in general), that strong upward momentum quickly turns into strong downward momentum.

While the concept of a high-momentum, Top-5 ETF rotation portfolio was a non-starter, Swenlin realized that the index had value as a confirming or leading indicator of overall market turnpoints.

Chart 6 below shows that this index (top window) correctly called the 2000–2003 market crash in advance of the top, the 2007–2009 crash at the top, and also the corrections in 2010 in 2011.

Currently, this index has plummeted 48% since mid-2014 while the S&P 500 is still near all-time highs. The most alarming take away from this chart is that the downturn in the Top-5 Momentum Index was accelerating even as the S&P 500 rebounded in October!

Perhaps the scariest chart you'll ever see: The Top-5 ETF's (by Momentum) Index accurately identified the last four market selloffs since 2000, and on each occasion was a leading indicator (sometimes more than others). Source: DecisionPoint/


Premium Members can jump to the Portfolio pages for details on changes we will make at 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 and get access to our high-return portfolios.


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.