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"I conceive that the great part of the miseries of mankind are brought upon them by
false estimates they have made of the value of things."

—Benjamin Franklin

- Enjoy more of our favorite value-investing quotes


DECEMBER 13, 2015


In This Edition:
- Fed Announcement Forthcoming
- Our Financial Well-Being is at the Mercy of Inept Bureaucrats
- Raising Rates Into the Teeth of an Imminent Recession?
- Business Inventories-to-Sales Surge to Cycle Highs
- Manufacturing Report Disappoints
- The Incredibly Bearish Bull Market
- Yield Curve Would Be Deeply Inverted Under Normal Conditions
- Our Plan for This Week








The US Federal Reserve's announcement on an interest rate increase is anticipated to be coming this Wednesday, December 16. By the time of this Wednesday’s announcement, the Federal Funds rate will have been pinned at an unprecedented low level of about 10 basis points (0.10%), or effectively zero, for 84 straight months. During that same period, consumer prices have risen by 1.75% per year.

The Fed's "accommodative" monetary policy (aka 'quantitative easing') of manufacturing electronic credits used for the purchase of Treasury Bills and Mortgage Backed Securities effectively ended in August 2014 when the monthly monetary base peaked at $4.095 trillion (it is still at $4.076 trillion as of November 2015). This artificial increase in the demand for Treasury Bills was designed to reduce interest rates even more than was possible from a 0% Federal Funds rate. Despite this withdrawal of QE stimulus, over the past 15 months the yield on 10-year Treasuries has declined to 2.18% from 2.35%, and expected 5-year inflation has fallen from 1.76% to 1.30% (month-end numbers). The decline in interest rates in the open market and without synthetic demand is a signal that bodes ill for the economy.


The US Federal Reserve, ostensibly the most powerful economic force in the world, is apparently staffed with bumbling fools. How else can we explain waiting for 80+ months in a business expansion to end 'emergency policy' with short-term rates at just 0.10%? The average of the ten business expansions in the post-war era since 1948 has been 61 months long. The only expansion that was longer than the current one was the 119-month stretch in the 1990s. However, back in the 1990s, the Fed's balance sheet was just $300 billion. Today it is a mind-boggling $4 trillion.

The incredible market turmoil that investors have lived through three times in the last 15 years is the result of a terribly misguided monetary policy, courtesy of the US Federal Reserve:

(1) First we had the all-time high PE, Internet bubble speculation in 1998-2000 which was largely the result of the Fed dropping interest rates because of the 'Asian Contagion' market correction in 1998. That led to a 50% market selloff when the Fed tried to cool down the internet/technology speculation by increasing rates in 2000. Subsequently, that disaster was followed by...

(2) The credit-fueled bull market of the mid-2000's (again a result of ultra-low interest rates meant to battle the previous 2000-2003 Fed-induced recession) and subsequent 'credit-crisis' collapse from December 2007 to March 2009 following the Fed steadily increasing rates each month in an effort to once again "cool-off speculation," and...

(3) The current 6.5-year run-up with the market at the second-highest valuation in history, again based on ultra-low interest rates meant to battle the near-Great Recession disaster caused by the Fed in the last crisis.

The US and world economies, as well as individual and family financial conditions, have been torn asunder for the last 17 years with incredible financial and personal hardship placed on the shoulders of hard-working individuals. The Fed is an incompetent, quasi-government-sanctioned bureaucracy that regularly toys with the finances of the world (US policy affects the world because of its relative size) with consistently disastrous results.

You would think that the governors of this institution would by now realize the folly of their ways in trying to micro-manage the level of stocks, and instead allow market forces to control conditions. That scenario could hardly be worse that what we currenty experience. Alas, it is not to be as we now enter into what will probably be another Fed-engineered, drop from nose-bleed heights in stock prices (S&P 500 PE is 23 and Russell 2000 PE is 144).


The Fed has waited 80+ months to raise rates from emergency levels but many investors are fine with this, believing the economy is percolating along and a steady, nominal increase in rates will be okay. According to most of the common leading economic indicators, there is no recession imminent and at 5% unemployment, the US has reached the definition of 'full employment.' However, inflation is well below the 2% target. Is the strong employment picture enough justification to raise rates at this time? What about the risk of a recession?

Many optimistic economists and economy-watchers tout the following reasons why there is no recession forthcoming:

1) The employment rate continues to improve each month with 211,000 jobs added in November and October revised upward to 298,000 jobs added from 271,000. The average job growth in 2015 is 218,000/month.

2) Interest rates on the spectrum from short-term (90-days) to long-term (30-years) are nowhere near being inverted (a classic sign of a coming recession).

3) Leading economic indicators are mostly still positive.

Yes, these three classic markers of coming recessions are still in reasonably good shape – but perhaps not for long. The reason is that the historic indicators of recessions have been modified and no longer accurately reflect the state of the economy in a way provided previously. Concerning employment, it is a lagging indicator or the economy, not a leading indicator. We may soon see a very rapid change in the numbers, turning the tables on the steadily declining unemployment rate. Here's why:



This article is from, which has almost single-handedly cornered the market on doom-and-gloom forecasts on the internet. However, the writer has made a very relevant point with this particular analysis:

Following the wholesale inventories-to-sales jump, business inventories-to-sales just shifted once again to cycle highs, deep in recessionary territory. With inventories unchanged in October, slightly lower than the expected 0.1% increase, Q4 GDP will start to be affected (and Q3 as prior data was revised lower). Nevertheless, with sales dropping 0.2%, with manufacturers tumbling 0.5% MoM, the looming production cuts set up the Fed for (another) epic policy error.

The Wholesale Report for November was a blaring alarm that something is rotten in America. The chart below shows that recessions regularly occur when the inventory-to-sales ratio gets out of whack.

Invesntories to Sales Ratio
Business inventories are skyrocketing compared to sales.


Consumers have apparently cut back on purchases and because of this, inventories have increased dramatically. The last few quarterly earnings reports from retailers confirmed the reduction in consumer spending. To adjust for this imbalance of inventories-to-sales, businesses must cut back on production and that means laying off workers. Do not disillusion yourself; a decline in employment is coming and will likely be seen starting with the next employment report. Unfortunately, the next report will not be released for another four weeks.



On the first day of each month, the Purchasing Manager's Index (PMI) is provided by the Institute for Supply Management (ISM). Based on five critical readings: new orders, inventory levels, production, supplier deliveries and the employment environment, the PMI is an indicator of the economic health of the manufacturing sector.

The last release on Tuesday, Dec. 1 revealed a PMI disappointment for November. Economic activity in the manufacturing sector contracted in November for the first time in 36 months, since November 2012. The overall PMI reading came in at 48.6 vs. the Wall Street consensus estimate of 50.5 and was a full point below the lowest estimate of 49.7. The November reading was a decline from 50.1 in October and 50.2 in September. The November PMI was also the lowest PMI reading since the bull market began in 2009.

A PMI of more than 50 represents an expansion of the manufacturing sector compared to the previous month. A reading under 50 represents a contraction while a reading at 50 indicates no change. The table below shows the current levels for each series, prior month's reading, percentage change, direction, and rate of change.

• The PMI registered 48.6 percent, a decrease of -1.5 percentage points from the October reading of 50.1 percent.

• The New Orders Index registered 48.9 percent, a decrease of -4 percentage points from the reading of 52.9 percent in October.

• The Production Index registered 49.2 percent, -3.7 percentage points below the October reading of 52.9 percent.

• The Employment Index registered 51.3 percent, 3.7 percentage points above the October reading of 47.6 percent.

• The Prices Index registered 35.5 percent, a decrease of -3.5 percentage points from the October reading of 39 percent, indicating lower raw materials prices for the 13th consecutive month.

• The New Export Orders Index registered 47.5 percent, unchanged from October, and the Imports Index registered 49 percent, up 2 percentage points from the October reading of 47 percent.

Ten out of 18 manufacturing industries reported contraction in November, with lower new orders, production and raw materials inventories accounting for the overall softness in November."

Needless to say, this report was bearish. However, last Tuesday when it was released the market surged higher. We are definitely in that weird world where bad news is good news; ostensively because investors believe there is a greater likelihood of the Fed maintaining zero-percent interest rates as a result of bad news.


Lance Roberts, who operates, published a chart and article several months ago in which he labeled the bull market from 2009 to present the "Incredibly Bearish Bull Market."

Roberts makes the point that the bull market from 2009 to 2015, which gained a whopping 300% in 6.5 years (from about 700 to about 2100 on the S&P 500), was the result of anxiety rather than enthusiasm about the strength of the economy, job security and global stability.

Robert says the "anxiety" has been one of missing out on further gains. Fueled by Central Banks, this fear created a liquidity driven (rather than profit-driven) economic environment. The excess liquidity manifested itself in surging levels of subprime auto loans, student debt, corporate share repurchases, rising levels of margin debt and record levels of mergers and acquisitions. Says Roberts:

Economically speaking, the story isn't getting much better as economists and bureaucrats scramble to find ways to adjust reported data to make it appear stronger than it likely is. However, the recent string of macroeconomic data points from durable and factory goods orders to retail sales, personal consumption expenditures and import/export data are all suggesting that the "real" economy is much weaker than headline statistics suggests.

This is shown clearly in the Economic Output Composite Index, which is comprised of the Chicago Fed National Activity Index (a broad measure of 85-subcomponents, the Fed regional manufacturing surveys, the NFIB survey, LEI index, and the Chicago PMI. The correlation between this index and the real economic activity is very high." - Lance Roberts

Click to Enlarge
Prior to the 2008 crash, two economic leading indicator series, the LEI (dotted red) and the EOCI (dark blue line) stayed mostly in synch. However, post-2008 the Census Bureau adjusted the LEI to reflect monetary stimulus and there is a distinct disconnect with the below-zero performance of the EOCI indicator.

Roberts continues in explaining the chart above:

Notice in the chart above the detachment of the EOCI index from the Leading Economic indicator (LEI) following the financial crisis. This clearly shows what I meant earlier by reporting bureaus adjusting their reporting to obtain better results. Following the financial crisis, the Census Bureau modified the contents of the index to reflect more of the monetary influences in the economy. This has made the LEI much less reliable as an indicator of the real economy hence the detachment between real economic activity and the indicator itself."

For the first time, the Census Bureau adjusted the LEI to reflect the artificial, Fed-induced stimulous! It is for this reason that most leading economic indicators have (so far) not been forecasting recession: the indicators were modified in the last market crash to weight more heavily Fed monetary policy!



One of the points that economists and bullish investors have been making is that the yield curve is not inverted (an historically accurate signal of an imminent economic downturn). In fact, they claim, it is 'relatively steep.' defines an inverted yield curve as:

Inverted Yield Curve: An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.

The yield curve or the difference between the yield on short-term debt instruments (usually three months) and the yield on long-term debt instruments (usually 20 or 30-year) typically features higher long-term rates over short-term rates. This difference is called the 'term risk premium.' This makes economic sense because anyone buying a bond seeks compensation for the use of their money over a given period of time. A person loaning their money to the government or a corporation to use for a longer periods should expect a higher reward than a person lending their money for a few months. The shortest Treasury Bill term is 90 days. The Federal Reserve lowers short-term rates during recessions via the mechanism of its overnight, intra-bank Federal Funds rate. The Fed Funds rate affects the rate paid on short-term bonds and the rate banks can charge for short-term loans.

The Federal Reserve commonly lowers its short-term, Fed Funds interest rates to facilitate commerce during a recession. This decrease in the cost for banks to transact with the Fed and other banks reduces interest rates across the board and is considered a way to lubricate economic growth. Low rates cannot make an economy grow, but it provides more liquidity to an economy when cash is scarce and results in less expense to repay loans. Less-expensive repayment of loans means more profits for businesses and more money in the pockets of families when they use loans for homes or cars, etc. Those savings can be spent elsewhere in the economy and typically are used for increased consumption, which (in theory) expands the economy.

At the bottom of a recession, when the Federal Reserve has short-term rates at their lowest, long-term rates will still be much higher and the yield curve is called 'steep.'

However, as the economy improves in the following expansion, the Federal Reserve has historically gradually raised short-term rates back up toward a normal level. As the economy matures and becomes long-in-the-tooth, demand for long-term loans declines and long-term interest rates come down as a result.

If the Fed keeps short-term rates at 'normal' levels too long, the yield curve can become 'inverted,' meaning that long-term rates drop below short-term rates. While the Fed controls short-term rates, market forces control long-term interest rates. As an economic cycle plays out and sputters, there is less demand for loans and capital investment. Therefore, interest rates must decline to incentivize individuals and companies to continue to borrow. An inverted yield curve means there is little demand for long-term loans and bonds and is a classic signal that a recession is forthcoming.


Many economists and analysts are pointing out that the yield curve is currently nowhere near inversion; hence, we are nowhere near another recession. However, at 2.4%, long-term interest rates are much lower than their historical average (5% - 8% since the 1980s). The only reason rates are not inverted is because the Federal Reserve has kept short rates at zero for nearly 80 months.

To demonstrate this dynamic, we will show examples of a yield curve chart at various points in the last three economic cycles. We will include a yield chart at an economic/market top (inverted), a yield chart at the bottom of a recession, a yield chart at the middle of an expansion, and the current yield chart.

First, we will start by showing you the appearance of a prototypical inverted yield curve. The first chart is from July 2000 when the Yield Curve was inverted (click chart to enlarge):

Click to Enlarge

July 2000 showed a classic inverted yield curve (left window), which
was a loud warning to savvy investors that the '90s bull market was over.


The second chart is from the bottom of the 2000 – 2003 recession. At that point, the Federal Reserve had lowered interest rates to about 1% on the short end of the curve (3 months, left-side of left window) and at the long end (30 years, right-side of left window) interest rates were set by the market at about 5%. This is considered to be a 'steep yield curve.'

Click to Enlarge

December 2002 was the bottom of the recession and the yield curve (left window) was steep.


Half-way through the 2003 to 2007 expansion, we can see that the short-term yield had risen to about 3% (left side of left window) while the long end of the yield curve remained at about 5%. Here you can see that as an economy progresses, the Federal Reserve raised short-term interest rates while competition and demand contain the long-term interest rates. At this point, the yield curve is still healthy but deteriorating.

Click to Enlarge

June 2005 featured a typical, healthy yield curve halfway through an economic expansion.


April 2007 MARKET TOP
While most don't mark the beginning of the last market collapse until October/December of 2007, by April of that year the yield curve had already become inverted. It is for this reason that savvy investors watch the yield curve for signs that things are about to change for the worse. When it becomes inverted, it is only a matter of time before the market and economy begin to contract.

Click to Enlarge
April 2007 MARKET TOP

April 2007 shows a classic inverted yield curve a full six months before the market began to sell off.



December 2008 MARKET BOTTOM
At this point, the market had collapsed to near its nadir. The yield curve was relatively steep because the Federal Reserve lowered rates to an unprecedented 0%. With very little demand for bonds (or any other investment) at all, the interest paid on 30-year bonds was only 2.4%. Nevertheless, the chart on the left is considered a steep yield curve and is typical for the bottom of a recession.

Click to Enlarge
December 2008 MARKET BOTTOM

December 2008 featured a stock-market catastrophe near its nadir. The Federal Reserve had already lowered
short-term rates to zero, and long-term (30-year) rates were very low at 2.4%.



December 2015 - ???
This brings us to the present time. As you can see, the yield curve shown in the chart below looks almost identical to the yield curve in the chart from 7 years ago, in December 2008! The short end of the yield curve (three months) is still at 0% and the long end of the yield curve (30 years) is still at 2.4%. This does not look like the inverted yield curves we saw at market peaks in July 2000 or April 2007, above! However, it is important to keep in mind that the Federal Reserve has consistently manipulated the short end of the yield curve for 80+ months with unprecedented efforts to keep it at (or effectively below) 0%, including America's first effort at quantitative easing (QE). 

The most important point is that in the earlier displays of an inverted yield curve, the Fed had been steadily increasing short-term interest rates for months or years and had brought that rate up to near 5% by this time in the cycle. When the economy reached a recession, the long-term yield had dropped below 5%, which made the yield curve inverted. Today, neither end of the yield curve is even close to 5%, which is a very discouraging signal to investors. It means we are possibly on the verge of another recession – especially considering the declining sales and earnings of US companies, declining world GDP, declining commodity prices, and the precarious position in which emerging markets find themselves today.

Click to Enlarge
December 2015 - ???


The most frightening thing to notice from this last chart is that the Federal Reserve is still at 0% on the only part of interest rates it can affect. It is literally impossible for interest rates to ever be inverted under current conditions. We also pointed out earlier on this page that the economy appears to be floundering and we may be headed into the teeth of another recession. With short-term interest rates already at 0%, what recourse does the US Federal Reserve have at its disposal to try to accomodate the economy out of a recession?

Answer: None. The Fed discontinued quantitative easing in late 2014 with the explanation that it was providing little or no benefit. It is hard to imagine what else could work unless it is government printing of money and just sending thousands of dollars to every citizen. That could stimulate consumption as well as increase inflation. Amazingly, this crazy idea has already been proposed in Europe! However, it would surely have no long-term effect unless repeated. This reminds us of the 'Quote of the Week' accompanying a newsletter from a couple of weeks ago:

"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


Last week we said that should the S&P 500 drop below 2020, we would consider inverse or other investments that will benefit from a selloff following the break of that support level. On Friday the S&P 500 closed at 2012.37, so that qualification was met.

However, while the S&P 500 finished below our 'line in the sand' at 2020, it was a one-day occurrence with no follow through yet. Short-term indicators are showing that prices are slightly oversold and futures for Monday's open are currently in the green (slightly). At the present time, we are going to sit on the sidelines, in the comfort of cash and with peace of mind. Should the downturn evolve into a true selloff this week, we will take action to profit from it.

The announcement by the Federal Reserve on an interest rate increase is a big unknown at this time, and we see no reason to begin gambling now. Fed rate announcements entail a great deal of uncertainty and volatility, and this being the first one in nearly a decade may have more surprises than most. Typically, there is a relief rally the days before a Fed announcement, so if one occurs the first two days this week, don't get your hopes up. Depending on how dovish the statement is, there could be a continuation of a short-term rally.

However, with stock valuations near all-time highs (PE ratios are at the second highest ever and the Price/Sales ratio is at the all-time highest), it is unlikely that there is much of a chance of a rally continuing into 2016. In fact, we expect a big selloff at the start of the New Year. Extremely expensive stocks and declining fundamentals do not make for a rising market. Prudence is the better part of valor, as they say, so we will remain in cash until the smoke clears.

Should we see a solid opportunity to take advantage of the market in either direction this week, we will notify paid subscribers via email of our choices.

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 competently discussed the many 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.