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QUOTE OF THE WEEK

"In investing, what is comfortable is rarely profitable."

—Robert Arnott

– Enjoy more of our favorite investing quotes –

 


FebruARY 7, 2016

 

BEAR MARKET SET TO RESUME

 


Jump Links:

- Downtrend Continues After Two-Week Rally
- The Real, Unadjusted Jobs Number Is -2 Million Lost
- Our Approach For Profiting in This Environment
- "Leveraged ETFs are the Worst Investment Ever"
- The Critical Number For The Stock Market
- Our Plan For This Week

 

 

 


DOWNTREND CONTINUES AFTER TWO-WEEK RALLY

After a two-week rise in prices that began the week of January 19, many commentators were declaring that "the bull market in stocks has resumed." However, last week the major indices dropped yet again. We have depicted this action in Chart 1 below, using three major index ETF's: the S&P 500 ETF (SPY), the Nasdaq 100 ETF (QQQ), and the Russell 2000 small-cap ETF (IWM). As you can see from each ETF, their charts were forming upward-angled wedges in the two weeks before last.

This rising-wedge pattern is considered bearish by technical analysts. Sure enough, the primary trend – downward – resumed last week as the bottom edge of the wedges were broken. The red bar on the right side of each chart shows the first level of resistance that now stands at the point where the wedge broke. We expect this primordial resurgence of the downturn to be just the beginning. There is much further to go, and more profits to be made from that trend.


Chart 1 above shows the S&P 500 ETF (SPY), the Nasdaq 100 ETF (QQQ), and the Russell 2000 ETF (IWM). Each chart shows a rising, bearish wedge starting the week of January 19, and a breakout below that wedge last week. We believe the downturn is now ready to resume.

 

We exited our inverse-ETF positions a few weeks ago based on our anticipation of the countertrend rally that appeared as scheduled. However, as shown by the charts above, that wedge-shaped countertrend rally is now completed and stocks are headed downward again, in synch with the primary trend. We believe this downturn will continue for longer than you think. Inevitably, selloffs extend far too deep, just as bull rallies run far too high.

The most recent Fed-induced bubble (the 3rd massive overvaluation in the last 16 years) carried asset prices to astronomical levels. The mid-2015 level was the second highest market valuation on record and higher than the level before the 1929 crash and the Great Depression. Today the PE ratio of the S&P 500 is still 21.40 and the Russell 2000 PE is at a breathtaking 110.28, even after prices have dropped since the middle of 2015. One reason for this is that corporate earnings are plummetting.

In the coming months, we are likely to see stock prices drop much lower as the downturn gathers momentum, fear becomes contagious, and more and more investors liquidate their portfolios. Ultimately, serious selloffs lead to extreme capitulation, and amateur investors will be the last to puke up their stock holdings as they see their 401k statements plummet; typically pulling the plug near the bottom of the market's selloff.

That capitulation will be a heads-up for savvy investors to get their buy list ready. But it will likely be months from now before that capitulation occurs. In the meantime, we can profit from inverse ETFs and bond funds. Yes - bond funds; because interest rates will be dropping, not rising as is the is the 'conventional wisdom.'

In several of our past issues, we reported on the challenges facing both the US and world economies which are likely to lead to a new recessionary period. Some of these articles include:

• Our 3-Part Feature starting August 24, titled, "Where is the Market Headed from Here?"
• Our November 8, 2015 newsletter titled, ''Changes Are Coming"
• Our December 6, 2015 newsletter, titled, "The Last Gasps of a Dying Market?"
• Also, of great interest is our June 28 newsletter, titled "Big Change Coming to the Market Starting This Week." This newsletter gave the reasons we believed that a significant change was imminent and marked the point where we exited long positions in our model portfolios. We were accurate in our timing, and June 28 turned out to be the start of the market downturn, as shown in Chart 2 using the Russell 2000:


Chart 2: Our June 28, 2015 newsletter, titled "Big Change Coming to the Market Starting This Week" market the start of the selloff.

 

The last recession began about eight years ago, in January 2008, and we are long overdue for a business-cycle contraction (which occur about every 4.5 years on average). However, we would never attempt to time the market based on the average length between recessions, or a relative or absolute valuation of the market.

Many investors have lost a great deal of money attempting to anticipate market turns based on economic fundamentals or PE ratios. Those who try to do this should remember the quote by J.M. Keanes; "Markets can remain irrational far longer than you can remain solvent." We utilize advanced technical analysis (80%) combined with fundamentals (20%) to determine market turnpoints, thereby reducing drawdowns, increasing real returns, and maximizing risk-adjusted returns.


THE REAL, UNADJUSTED JOBS NUMBER IS -2 MILLION LOST


Last Friday was the first Friday of February, and that means the BLS released its monthly jobs report that states the number of jobs lost or gained in the US economy the prior month. The report on Friday indicated that the US economy produced a gain of 151,000 jobs in January. That number was fewer than expected, which is the widespread story that the media reported. There was a short-term rally based on this disappointing number, ostensibly because investors think weak jobs numbers could mean the Fed will continue to prop up asset prices with yet another QE program.

However, the truth of the matter is that there is a massive adjustment for seasonality in each of the monthly jobs reports, and the real numbers bear no relation to what is reported. In fact, the seasonal adjustment for January totaled +2.165 million! The truth is that the US economy lost nearly -2 million actual jobs in January! The headline jobs number of a gain of 151,000 was only 7% of the seasonal adjustment. Anyone who understands math knows that a slight change in the extraordinarily high adjustment amount would make a massive difference in that headline number.

More concerning, the number of jobs lost this January was -173,000 more than the jobs lost last January (2015). Therefore, employment conditions are getting worse, not better. The total number of jobs lost this December and January combined amounted to about -3 million. The January 2016 job loss was the largest January jobs decline since the -3.69 million job loss in January 2009, at the worst depths of the Great Recession.

We are getting nowhere near the economic improvement represented by the US government. In fact, former Reagan Administration Budget Director David Stockman says, "...you can look at years of seasonal adjustment factors for January (or any other month) and not find any consistent, objective formula. They make it up, as needed."

Stockman also warns the next crash will be bigger than any other in history;

“I think we have been building a bubble year by year since the early 1990’s. The earlier crashes that we are so familiar with, Dot Com and the Housing Crash, were only interim corrections that were not allowed to work their way clear. The rot was not effectively purged from the system because central banks jumped back in within months of the corrections and doubled down in terms of the stimulus and liquidity that they pumped into the market.”


OUR APPROACH FOR PROFITING IN THIS ENVIRONMENT


While we do take fundamental and the macroeconomic conditions into consideration in our decisions, what ultimately determines whether and when we will pull the trigger on a long or short position is technical analysis. IntelligentValue is unique in this approach. Most advisors, money managers, newsletter publishers, and others either fall into the fundamental or the technical camp and rarely the twain meet. However, our firm has achieved great success by utilizing the complimentary synergy of both approaches in our investment decision-making.

Right now our analysis is telling us the appropriate strategy is to be short the overall market because it is on the verge of resuming a downturn – perhaps for a significant amount of time. In a down-trending overall market environment, we never want to invest in individual corporations. Selecting the few winners in a downward-trending market is nearly impossible. Instead, highly liquid, inverse exchange traded funds (ETFs) have proven their advantage and stability during severe selloffs, such as the crash from October 2007 to March 2009.

For this reason, on Monday morning we will be purchasing three inverse ETFs and a bond ETF for our two portfolios; the Conservative Portfolio and Aggressive Portfolio. Each position will be selected to fit the portfolio's namesake designations; either conservative or aggressive in performance and risk profile. If indices break lower by the end of this week, we will purchase a full contingent of additional inverse ETFs for our portfolios and will be fully invested. Paid subscribers can read the details of our investment choices on the Portfolio pages in the Member's Area.

However, first take a moment to read the section below and allow us to clear up some common misunderstandings about about Exchange Traded Funds:

"ETFs are the Worst Investment Ever"

 

MISINFORMATION ABOUT LONG-TERM HOLDINGS OF ETFS

Recently a friend and fellow investor emailed me about the risks of loss from compounding error when using inverse or leveraged ETFs. He noted, "Good timing is essential. Even if the market is lower on the exit than it was on the entry of your inverse ETF position. The profit might have been eaten up by the compounding error."

This is an important issue to address, especially when we are using inverse ETFs in the Conservative Portfolio and leveraged inverse ETFs in the Aggressive Portfolio in the current downtrending market environment.

There have been many articles written over the last few years about this so-called 'compounding error,' as ETFs have become more and more popular. Many of these writers state, as my friend noted, that an investor could rack up a loss in spite of the index upon which the ETF is based going in the expected direction.

In an articled titled, "Leveraged ETFs are the Worst Investment Ever," MarketWatch's Howard Gold says, "...the structure of leveraged funds makes it extremely likely that investors who hold them for more than a day will lose money, even if the market goes their way."

Other articles criticizing ETFs include the following:

• ETFs and especially leveraged ETFs can return less of a profit than you expected or a loss you weren’t expecting.Sam Montana, Knoji Consumer Knowledge

• Retail investors looking for long term performance should stay as far away from these instruments as possible. –Jacob Ross, Capital Cube

• It is my fiduciary duty to inform you as to why [leveraged and inverse ETFs] do not work exactly like their names imply, and I urge everyone in the ETF industry to embark on a similar public awareness campaign.Paul Justice, Morningstar

• Over time, with the ups and downs in the market, these products are designed to underperform.Steve Claussen, Options House


However, this common argument against using ETFs for more than a day to profit from market direction is also the least credible. This argument invariably gives an example of an index moving in a very volatile manner over a period of time, finally ending at the level where it started. Take the example from the Morningstar article mentioned above titled, "Warning: Leveraged and Inverse ETFs Kill Portfolios."

The author compares a $100 investment in an index to that same investment in a 2X ETF and a 2X inverse ETF.

If you were to repeat 10 consecutive days of up 10% days followed by down 10% days, both of the leveraged funds would end up at $81.54, which is a sizable difference from the $95.10 the index would end at.

It would be amazing to see a 10% move in 10 consecutive days. In fact, it would be impossible. In the history of the S&P 500, there have been exactly three days when the index moved by at least 10%. There have certainly never been anything close to two days in a row when this happened, so it's virtually impossible for that scenario to occur.

Later in the same article, the writer makes this statement: "Repeat this process for only six months, and your 'investment' in either of these leveraged funds would stand at only $2.54. Yes, that's a -97.46% loss."

The examples being given by these writers in an attempt to 'warn' investors are just absurd. The reason for such audacity is the usual culprit: self-interest. Morningstar has made its name by tracking and documenting mutual fund returns. The amount of money flowing into ETFs is rapidly eclipsing that of mutual funds because, for a variety of good reasons, ETFs are superior products.

The individuals who earn their living from the stock picking and mutual fund industries are feeling very threatened by ETFs. Therefore, they regularly put out these type of 'warnings' to investors, using unrealistic statistical representations to make their preposterous points. Unfortunately, there are a great number of investors who believe these articles, to their financial detriment.

Dane Van Domelen wrote an interesting article on this subject in which he gave a more realistic example of an index going through a period of high volatility and how a 2X and 3X ETF would respond:

Let's consider a more realistic scenario for how 2x and 3x leveraged ETFs might deteriorate due to volatility. Since 1950, the S&P 500 has gained or lost at least 1% on 20.2% of trading days. What would happen if we had an extremely choppy period where the index lost 1%, then gained back 1.010101% (to get back to its starting value), and repeated this pattern over 20 trading days (about 1 calendar month)? A 2x ETF would finish at $99.80 and a 3x ETF at $99.40. In what would be a very volatile month with no net change in the index, 2x and 3x leveraged ETFs would deteriorate by 0.2% and 0.6%, respectively. Not negligible, but not crushing, and anyways you wouldn't expect this type of volatility very often.


Other mutual fund and stock-oriented propagandists use specific examples from history when inverse or leveraged ETF's performed poorly compared to an index. However, if we look at a concrete example of one of the most volatile, frightening periods in recent market history (the financial crisis from 2007-2009), we can see that inverse and leveraged inverse ETF's performed phenomenally well – in fact, they performed far better than an investor might expect based on their name.

Chart 2 below shows the return of the S&P 500 Index ($SPX in black) and the inverse-S&P 500 ETF (SH in blue) from October 2007 to March 2009. As you can see from the chart, the S&P 500 dropped -58% in those 17 months. In this case, since the inverse ETF is of the -1X variety, you might expect a return of +58%. However, even though it went through some heinous volatility in that period, the inverse ETF (SH) produced a buy-and-hold return of +93%! That's fully 60% more than the inverse of the loss of the index upon which it is based (S&P 500).


Chart 2: This chart depicts the S&P 500 and the 1x inverse S&P 500 ETF (SH) during Oct. 2007 - March 2009. The index lost -58% while the inverse ETF gained +93% during the same period.


So in a high-volatility market-crash environment, the inverse ETF produced a much higher return than would be expected, not less.

Similarly, Chart 3 shows the same period with the S&P 500 losing -58% while the 2X inverse ETF (SDS) gained +208% from October 2007 to March 2009. Obviously, these statistics and charts provide contradictory evidence of the points put forth by writers and TV commentators with self-interest in keeping investors involved with stocks and mutual funds to the exclusion of ETFs. Exchange Traded Funds offer the advantages of instant diversification, low costs (0.01% for ETFs vs. 6% for mutual funds), tax advantages, strong liquidity, and both long and inverse positions in virtually every market segment.


Chart 3: This chart depicts the S&P 500 and the 2x inverse S&P 500 ETF (SDS) during Oct. 2007 - March 2009. The index lost -58% while
the 2x inverse ETF gained +208% during the same period.

 

THE CRITICAL NUMBER FOR THE STOCK MARKET


We believe that stocks will enter into a full-fledged bear market should the S&P 500 drop below the level at which it closed on Friday, at 1,867. This is the level the S&P 500 closed Below that level, it is a big drop to the next support level, which would be the previous S&P 500 all-time high at 1,575, which was first surpassed in March 2013. That would mark a 26% decline from its June 2015 all-time high.

When you combine a struggling global economy, declining corporate earnings and a strong dollar that detrimentally impacts commerce, it is likely to be enough to push stocks into the next bear situation. It is unclear how far down a bear market may continue, but a -26% decline may be appropriate since it is unlikely we will see the type of financial crisis that occurred with US banks in 2008. However, there are always unknown factors, and the amount of debt that has accumulated over the last eight years is phenomenal. (A future issue of the Value Alert newsletter will cover this potentially severe economic danger.)

OUR PLAN FOR THIS WEEK


While the S&P 500 has not closed below our 'line in the sand' at 1880, we are going to purchase two inverse ETF positions for each portfolio at Monday's open in preparation for that contingency. We will place closing-price stops on each so that if the break below does not occur, we will have little if any loss. If the downturn picks up steam, we will add to our holdings and position our portfolios with 100% exposure to profit from a selloff.

Best Wishes for Another Week of Intelligent Value Investing,
IntelligentValue.com

 

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DISCLAIMER
Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Shareholders, employees, and writers associated with IntelligentValue, Inc. may hold positions in the securities that are discussed. If you are not sure if value investing or a particular investment is right for you, we urge you to consult with a Certified Financial Advisor. Neither IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.