February 21, 2016
ACCOMMODATING OUR EXPERIENCED Subscribers
SELLING WHEN WE SHOULDN'T
Last Tuesday (because Monday was a holiday) we regrettably sold our two small positions in each of our portfolios which were designed to profit from a continuation of the downturn. We correctly anticipated that there would be a counter-trend rally to the bear market conditions that we have been documenting for months now and sold our inverse positions because we were concerned about our subscribers taking losses from a brief market rally. This is the second time this year that we have correctly anticipated a countertrend rally.
In the modern era, there is no justification whatsoever for investors to sit on the sidelines (or worse, stay invested in long positions) while the market heads downward for months at a time. For this reason, we utilize inverse ETF's and other means to profit from severe corrections or bear markets. However, just as bull markets are regularly accompanied by corrections, long downtrends are invariably accompanied by sharp countertrend rallies.
These bear-market countertrend rallies can be challenging for opportunistic investors who intend to profit from a lengthy downward slide by using inverse ETFs. However, our subscribers who have minimal experience with inverse positions, or are new to IntelligentValue, get nervous when these countertrend rallies cause temporary drawdowns, regardless of how minute they may be.
Having published IntelligentValue since 2004, we are especially cognizant of the realities of some of our less-experienced subscribers, who tend to pull the plug on their subscription to IV whenever there is the slightest hint of a loss. Particularly with the AGGRESSIVE Portfolio, since it uses 2x leveraged, inverse ETF's during a selloff, paper losses can mount quickly upon the occurrence of a counter-trend rally. However, those drawdowns are usually short-lived. The reason they are short lived is because we expect the downturn to continue. If our analysis suggests the market is close to a bottom, we would not be holding inverse positions.
We have spent a significant portion of our last 30 years as professionals in the market focused on mastering the identification of market turnpoints. We realized fairly early that a reduction of drawdowns could dramatically enhance returns, and the study of ways and means to identify and eliminate market risk became as critical, if not more, than any other aspect of successful investing.
In the face of all the so-called 'experts' who say "you can't time the market," we do. What those 'experts' really mean to say is "I can't time the market." Based on the published track record of IntelligentValue over the last 12 years, we have proven the market CAN be timed – and we don't mind saying that we're pretty damn good at it.
The decision to close our inverse positions last week was motivated by a desire to handle with kid gloves those subscribers who are inexperienced with inverse positions, bear markets, or simply new to IntelligentValue. However, we have undertaken any marketing efforts in many years and we realized that the vast majority of subscribers who are with us today have been with us for many years.
With this in mind, we recently conducted a study of our subscriber records and determined that the average length of time since our current customers joined IV now stands at 8.4 years. We decided that perhaps we should focus as much or more attention to our loyal subscribers who trust our decisions rather than the new ones who may not yet have gained that trust.
For this reason, we are making a significant change in our portfolio policy. First we will discuss what we see coming for the market, and later we will address the change we are making to our portfolio management approach.
INTELLIGENTVALUE WAS EARLY IN RECOGNIZING THIS BEAR MARKET
Many investment advisors are now turning bearish, and some now even think the US could see a recession. Also, many now believe the Federal Reserve got it wrong when they raised rates and that China is becoming a mess. All of those insights would have been more helpful if they had advised their clients about these factors earlier, but now it may be a little late.
IntelligentValue DID advise our subscribers about those views earlier; in fact, much sooner. IntelligentValue started raising awareness of the risks to the economy and the stock market by publishing a Value Alert newsletter on June 28, 2015, in which we identified:
• The S&P 500 and was losing momentum and appeared to be rolling over
• Volatility had reached one of the lowest levels in the last 20 years, and a big move was likely forthcoming
• We identified there was a strong probability of that move being downward based on sector analysis
• We showed that
S&P 500 operating earnings had begun heading sharply lower
• We advised our readers that a business-cycle contraction was overdue and that the Fed was 'out of bullets;' still with a zero-interest rate policy 6+ years after the recovery had begun
• We implemented a strategy to move towards cash and placed tight stops on the remaining positions
Subsequently, we documented what we felt would be a severe downturn in 2016 as risks continued to develop. Starting in August 2015, we published a 3-Part article titled, "Where is the Market Headed From Here?" This white paper, released long before most advisors jumped on the selloff bandwagon, outlined many of the risks for the economy and the stock market and laid the groundwork for our risk-off strategy and later, utilization of inverse ETFs to profit from the downturn.
In subsequent newsletters, we documented additional market risks. Our paid subscribers were able to access our Intelligent Market Risk Analysis (IMRA), and regular updates to our two model portfolios which have annualized returns of 80% and 130%.
So what do we see ahead for the US stock market?
DOWNTREND SET TO RESUME
Unlike the majority of talking heads on CNBC or the internet 'experts,' we do not think the recent downturn was a mere market correction. All facts suggest we are seeing the initial stages of a severe bear market. Keep in mind that despite the sharp decline since late December, the P/E ratio on the S&P 500 is still at about 21.82, and the P/E ratio of the Russell 2000 (small-capitalization stocks) still stands at a mind-boggling 152.85. The downturn so far has not made a dent in those P/E ratios. In fact, they are at the same level or higher than they were a year ago. One year ago the S&P 500 P/E ratio was at 20.53 and the Russell 2000 P/E ratio was at 59.29. The Russell 2000's PE ratio is now more than 2.5 times greater than it was a year ago, despite a six month 22% decline in the index!
It is important to keep the big picture in mind as we make investment decisions, and the weekly chart below of the S&P 500 shows the bull market has progressed into a long, slow, rollover topping pattern. The June 28, 2015 note near the middle of that topping pattern shows where we first identified the market risks and made a strategic decision to move towards cash, assuming a defensive position toward the market. Also, note the bottom window showing the weekly MACD that was losing momentum since the beginning of 2015 and dropping below zero in mid-August 2015 and again in late December 2015. This chart also identifies the current support level (green-shaded area) which stands at about 1867 and present resistance (red dot line) at the 1950 level.
We are going to wait until we see this index head towards that 1867 level before buying inverse positions. If you notice, there are no additional levels of support below 1867. If the S&P 500 drops below 1867, it's look out below!
Chart 1 of the S&P 500 shows how the bull market has ended in a long role-over topping pattern.
Below 1867 there is no additional support and if it's look-out below!
By chance we are wrong (and that is a possibility we always have to consider), we need to see the S&P 500 index break above the 1950 level. This level is identified by a red-dotted line on the right side of the main window of the chart and is the current resistance level established in the recent market turmoil.
INVERSE ETF PERFORMANCE THROUGH VOLATILE DOWNTURNS
In a section titled, "Leveraged ETFs are the Worst Investment Ever" in our February 7 Value Alert newsletter, we
made the point that inverse and leveraged ETFs do NOT have the 'compounding error' that is frequently used to 'warn' investors away from ETFs. The typical warning states that not only will the ETF not show the return you were expecting, but can actually lose money for you, even if the index upon which the ETFs are based moves in the direction you were expecting.
Invariably, these 'warnings' come from individuals who's livelihood is derived from shilling for stock or mutual fund companies. The reason these 'warnings' are so passionate is because ETFs are eating their lunch as investors recognize the clear advantages inherent in ETFs. Advantages such as instant diversification in a single position, massive liquidity, a clear (daily) disclosure of the constituent stocks in an ETF, intra-day trading ability, and many more.
In fact, if we look at the returns for an inverse ETF during the most recent highly volatile down period that most of us can remember, i.e., the 2008-2009 market crash, we can clearly see that ETFs sometimes performed even better than the index upon which they are based - not far worse as is broadly and falsely claimed.
Chart 2 (below) is the chart we depicted in the Feb. 7 newsletter. It 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).
2: 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. That's a return of 1.60 times the the return of the index upon which it is based.
Chart 3 shows a similar result for the Russell 2000 small-cap index and its inverse, the ProShares 1x Short Russell 2000 ETF (RWM). In this case, the index lost -58% while the inverse ETF gained 46%. This situation did not produce a premium over the index as is shown in the previous example (Chart 2 above), but it did provide a significant, positive return.
3: Depicts the Russell 2000 and the 1x inverse Russell 2000 ETF (RWM) during Oct. 2007 - March 2009. There is a 104% combined difference between the two positions during this period.
That's a 104% total reversal of fortune compared to a buy-and-hold investor invested in the Russell 2000 and waiting out the downturn, as is commonly recommended by the mutual fund and stock-investment communities. This admonishion that investors stay invested is primarily because these firms earn a commission on assets-under-management. If investors pull their money out, these company's revenue plummets.
If you think that no one could have accurately predicted these turnpoints in real time to take advantage of these scenarios, you would be wrong. IntelligentValue published a 'Market Down' signal on October 12, 2007, and a 'Market Up' signal on March 9, 2009, in our IMRA technical analysis and also in our newsletters and portfolios.
PORTFOLIO POLICY CHANGE
We are making a significant change to our portfolio policy. We are going to focus more on the experienced investor with less attention to the inexperienced. This means that we are going to stop worrying about cancellations or blowback from subscribers who are inexperienced with inverse ETF's and the temporary drawdowns that can come from them during volatile downturns. Instead, when we see a long-term decline ahead we are going to continue to hold those ETFs through the brief, but sometimes violent, volatile periods that can occur.
Subscribers who have experience with IntelligentValue know that our identification of market turnpoints is very accurate. It IS possible to 'call a bottom' and 'catch a falling knife' and we have proven it time and again. While we fully expect there will be exceptions in the future, we always protect our positions from significant loss by identifying and diligently adhering to strict closing-price stop levels. We make no decisions based on 'judgement.' Emotion seriously flaws human reasoning when it comes to money matters and we are keenly aware of that fact. For this reason, we stick to rule-based, algorithmic decisions and do not override the system with our judgement.
For the inexperienced investor or a subscriber who is new to IntelligentValue, we will advise them to hold cash during volatile periods of downturn in the market. The bottom line is that there will be less trading and more holding of our inverse investments through volatility when we know that a market bottom is not imminent.
OUR PLAN FOR THIS WEEK
We will remain in cash in our model portfolios until we see the S&P 500 with a confirmed break below the 1867 level. When that event occurs, for the CONSERVATIVE Portfolio we will purchase a full set of inverse ETFs based on major market indices as well as inverse ETFs for specific sectors. ETFs for the Conservative Portfolio will not be leveraged. For the AGGRESSIVE Portfolio, we will be purchasing leveraged (2x) inverse ETFs based on more aggressive indices as well as inverse ETFs based on select industries or sectors that are the most likely to experience the most severe selloffs based on our analysis.
Should the S&P 500 close the week above the 1950 level, it will be cause to reassess the market's conditions. It is possible that we could see the market move sideways or even higher until the falling 50-week moving average (red line in top window of Chart 1 above) gets closer to current price levels.
As always, we will send an email notice to paid subscribers when this condition is triggered with details on each position. Each equity's entry price will be adjusted to the actual opening price of the ETF the day after we recommend its purchase.
Best Wishes for Another Week of Intelligent Value Investing,
Not an IntelligentValue Member?
Limited time only.
Don't have an IntelligentValue membership? Now would be the perfect time to take advantage of our 20th Anniversary Special and SAVE 80% on our insightful market/equity analysis and our three high-performance portfolios which have produced high double-digit annual returns. Get the price roll-back to 1997 levels!
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.