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“The market can stay irrational longer than you can stay solvent.”

– John Maynard Keynes

- Enjoy more of our favorite value-investing quotes


MARCH 06, 2016




Jump Links:

- Investment Advisors: Bull Market Set To Resume!
- Does The Recent Rally Mean The Bear Market Is Over?
- Current Market Valuations Are Difficult To Comprehend
- More Signs of a Bear In Our Midst
- Another Look at Key Resistance Levels
- Our Plan For This Week
- Additional Reading


Many internet-based 'experts' and TV talking heads want us to believe the recent three-week rally is the start of a resumption of the bull market. They postulate that the downturn to start this year was a mere correction, and the rally is destined to become a great, long-term moneymaker for investors, setting all-time highs in the coming weeks and months.

However, when reading or listening to a so-called expert's investment forecast and theories, we must always take into consideration that person's underlying motivations. Unfortunately, many in the investment business have interests that conflict with those of their clients.

For example, the brokerage houses and investment banks are rewarded for new money collected and get a commission when there is turnover of your stocks in a portfolio. Mutual funds are motivated to keep clients fully invested in their funds, regularly preaching 'buy-and-hold.' The reason is that they earn a commission that is a percentage of assets under management. Investment newsletter publishers know that bull markets sell subscriptions (because they usually don't have stock advice to offer during bear markets).  Even cable TV channels such as CNBC and Bloomberg sell more advertising when the market is in rally mode.

In fact, practically the entire investment industry is rewarded when stocks churn steadily higher during a bull market. Unfortunately, the business cycle has other plans as it regularly (about every 4.5 years) oscillates in cycles of expansion and contraction, and the prices of corporate equities fluctuate right along with it.

There have been 15 bear markets since 1928. On average, those bear markets declined 44% and lasted 20 months. On the other hand, during severe corrections the market dropped about 28% and lasted six months. The difference is whether or not there was a recession associated with those downturns.

Typically, the bear markets extracted 50% or more of the previous bull market's gains. The market has consistently punished buy-and-hold investors with exciting, profitable bullish stretches followed by dramatic and lugubrious bear markets. In the past nine decades, the only bear market that didn’t return half the bull market’s gains was in the 1950s. In the last 20 years, there have been three enormous bull markets followed by two (and we believe the beginning of the third) bear markets that destroyed that wealth.

IntelligentValue has no motivation to keep your money in a fund or to churn your stocks with 'new ideas.' We are only rewarded when subscribers do well with their portfolios, find value in our research and insights, and stick with us for the long haul. We recently conducted a study of our subscriber list and were pleased to find that the average length of time customers stayed is 9.84 years. It was very rewarding to see that because it means we must be doing something right!

We perform well for you by 1) accurately calling the start of bull markets so you can get get fully invested in the profitable undervalued equities we identify, and 2) determining times of risk when it is wise to move our model portfolios to cash to avoid losses. We also 3) provide value by recommending inverse ETFs so subscribers can profit when the market has entered a lengthy bearish phase, as we believe it has now.


Most stock indices, sectors, and risk-on asset plays have been in a sharp, upward rally for the last three weeks. The strength of the gains has been impressive. The market (S&P 500) surprised investors by dropping -10.5% from the first session of the year through February 11, but then it gained 9.6% through the close last Friday. For the year, the S&P 500 is now down less than two percent:


However, if we consider the downturn beginning from the May 2015 high, the S&P lost -14.5% through the February low before gaining back 9.6% in the last three weeks. While it's still an impressive gain, it is certainly nowhere close to setting new highs or even moving above the previous high near 2075 at the end of December:


Moving above that 2075 mark would be a good beginning as the market would then be breaking its streak of setting lower highs and lower lows. As most investors know, lower highs and lower lows are the hallmarks of a declining market.

Was the rally that began on February 12 the incipient beginning of a new leg higher in the seven-year bull market? Alternatively, was it merely another violent, multi-week whipsaw which is characteristic of the death-throws of a bull as it transmogrifies into a bear? We will try to answer that question in today's publication...


• According to the Wall Street Journal, this week the raw Price/Earnings (PE) ratio of the S&P 500 is 23.08, up from 22.44 last week. That in itself is big news because this index is at the second highest PE ratio in its history and higher than the market PE just before the 1929 crash. The PE ratio of the S&P 500 in September 1929 was 20.20. Today it is 23.08.

• Amazingly, the small-cap Russell 2000 PE now stands at a mind-boggling 687.84! That is up from last week's reading (at what we thought must be a one-time record that would never be repeated) of 295.81.

You must be thinking that this is clearly a mistake. The Journal must have a key stuck in their presses(!) or some other innocent explanation. However, the number is accurate. Here is a run-down of Russell 2000 PE readings we reprinted from the Journal over the last several years:

April 25, 2013:        34.16
April 25, 2014:       101.65
March 6, 2015:        80.40
Jan 3, 2016:          152.54
Feb. 7, 2016:         110.28
Feb. 21, 2016:       152.85
Feb. 28, 2016:       295.81
Mar. 6, 2016:         687.84

The incredibly high PE ratios starting in 2014 are simply an increase in the prices of companies with no actual earnings combined with an increase in the number of those companies relative to the 2000 firms in the index.

Small businesses have always been more subject to changes in the macro environment than large corporations, such as those in the S&P 500. For this reason, when the overall market is in 'bull mode,' small companies handsomely outperform their larger brethren. However, investors have to be aware that when the economy and macro environment for stocks gets dicey, it is small firms that get hit the hardest.

The reason for the astronomical P/E ratios for the Russell 2000 is that there are an ever-increasing number of companies that are losing money now. Many of these businesses are likely in the energy space, but virtually all sectors are suffering losses.

How could this happen, you may ask? How could stock prices continue to go up when earnings were declining, and the number of companies losing money is increasing? The only logical explanation is that it is a world-class bubble blown by the Federal Reserve, similar to the last two bubbles which peaked in 2000 and 2007. The difference, this time, is that the bubble is much larger because the Fed went to zero interest rates and QE in an effort to micromanage stock market prices. Whenever stock prices dipped over the last seven years, the Fed reacted by reinstating QE.

The Federal Reserve's bubble-blowing accumen has reached Olympian proportions.

This massive experiment with investor's money and the lives of working-class Americans is likely to end in disaster for an enormous number of people. However, we intend to capitalize from the market crash that we believe is only beginning to materialize.

Let's examine some more valuation measures to drive home why we believe there will be a gigantic reversion-to-the-mean:

• Using a valuation measure variously called the 'Shiller PE,' 'PE10,' or 'CAPE,' the US market is the second most expensive in the world.

• Based on S&P 500 market capitalization to US Gross National Product (GNP), the ratio is the highest in history.

• Revenues and earnings for the S&P have declined every quarter since the start of 2015. Furthermore, as of September 25th, the 2016 Q1 EPS estimates have imploded from a +5% expected gain to a -7.4% loss. 88 companies in the S&P500 have already issued negative guidance, and seven out of ten sectors are expected to post annual EPS declines.

• Equity markets can only grow in price based on either increasing earnings or multiple (P/E) expansion. There are no alternatives to those two paths. With profits declining steadily each quarter, the first scenario is off the table. Moreover, with P/E ratios already at or near all-time highs, it is impossible for there to be multiple expansion.

The only logical direction for the market is down. This time, there will be no Federal Reserve to bail it out. Why? Because interest rates are already near zero and the Federal Reserve noted before they concluded QE that it was becoming ineffective. Furthermore, is the Fed really going to attempt to blow this asset bubble even bigger?

It is for this reason that we are invested in two inverse ETF's in each of our portfolios. We also have 60% of each portfolio in cash, waiting for the downturn to resume to put that money to work.


Another indication that the bear market is going to resume is that inflation expectations are declining and since mid-2014, accelerating lower. Bear markets typically are characterized by declining inflation expectations. During bull markets, prices usually rise.

The chart below shows the ratio of the Barclays inflation-protected bonds (TIP) to the 7-10 year Treasury bond. A declining chart indicates that the inflation-protected bonds are losing value faster than traditional government bonds. This suggests that investors believe that not only is inflation unlikely, but deflation may be possible.

The ratio of the Barclays inflation-protected bond ETF to 7-10 year Treasuries shows that inflation expectations were declining from early-2011 to mid-2014 and downward expectations have accelerated since then.



Last week the S&P 500 ETF (SPY) moved sharply above the first resistance level at 1950 (shown in the upper window of the chart below) that we identified a couple of weeks ago. We said last week that we expected the S&P to move through this first resistance, and that happened the next day. We also pointed out that the next critical resistance was near the 200 level for SPY, and this is precisely where the ETF finished last week (200.43).

The S&P 500 index ended the week at 1999.99. That's as close as it is possible to get to the 2000 mark without crossing over it. Many uninformed investors say that market prices are random, but this closing level is an example that indicates just how much attention technical analysis receives from millions of investors and institutional algo programs.

The area around 200 contains a confluence of three critical resistance levels. These include 1) the broken support zone below the November/December market highs (shown with green shading) which then turned into resistance at the same level (shown with red shading) when it was broken at the start of this year. This level is also 2) a 61.8% Fibonacci Retracement Zone of the downturn from December 1 to February 11. Moreover, 3) the critical 200-day moving average is hovering just above this ETF's Friday close at 200.97.


In the lower two windows of the chart above show the Short-Term Direction and the Long-Term Trend of the ETF. Notice that the LT Trend indicator in the bottom window is still in the Bearish Zone below the zero level. This indicator is dominant and weighs on all other aspects of the chart.

The middle window shows the Short-Term Direction indicator, which is in bullish territory above zero. It is still climbing higher, and some readers may be nervous about this. However, as long as the LT Trend is bearish, the ST Direction indicator above zero is a bearish setup.

Because of all the signals we have identified above, we believe we are likely to see SPY struggle around the 200 level before heading lower this week. There are other factors that have informed our decision to stay with our inverse ETFs while they moved the wrong direction last week. These include:

• We are focusing on larger trends and not attempting to time the market in the short term.

• Several momentum oscillators (not shown) indicate that the S&P 500 index/SPY is overbought and likely to reverse course soon.

• The percentage of New Highs relative to New Lows is not reaching levels that indicate a continuation of the upward trajectory.

• The volume of the S&P 500 index/SPY during the three-week climb, as measured by the On-Balance Volume Indicator, is not showing that institutional traders support for the market's move higher.

A bullish move higher that breaks out into a new rally needs to be supported by robust volume, a sizable number of new highs that are much greater than new lows, and momentum oscillators that are hitting the meat of their rise, not topping out and ready to roll over as they are currently.

Be aware that big rallies of the kind we’ve seen in the past few weeks are typical of bear markets. Bear markets can last longer than most anticipate and can be very deceiving as they unfold. Rallies like the one we have witnessed the last three weeks can convince investors that the way higher is clear. Then just when you jump in with new long positions, the market reverses course back downward. It is important to have an experienced hand to guide you through these turbulent times.


We will continue to hold our two inverse positions in each portfolio. However, the market has been very unpredictable with extremely violent movements since last summer. It is possible that our analysis is erroneous, and the market rally that began in mid-February will continue to new highs.

However, we would be shocked and amazed to see a market that is so expensive (2nd highest level in history), with declining sales and earnings and a global slowdown in growth, go on to set new all-time highs. It would be a first, but supposedly anything is possible.

Should the S&P 500 surge higher above 2000 on strong volume, we will exit our inverse ETFs and take the loss. We will have to go back to the drawing board to determine what has happened, but the impact of fairly minor losses on the two ETFs is not severe (because we intentionally limited our exposure).

On the other hand, should market indices resume their downward path, we will select the most optimum inverse sector and industry ETFs to profit from a continuation of what could be a very long, volatile bear market.


In several of our past issues, we reported on the challenges facing both the US and world economies which could lead to a recession. These articles include:

• Our 3-Part Feature starting August 24, titled, "Where is the Market Headed from Here?"
• 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."

The June 28 newsletter provided the reasons we believed that a significant change was imminent and marked the point where we began to exit the 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 this chart of the Russell 2000:

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

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 subjects discussed, market environment, company or ETF SEC filings. Investors may wish to consult a qualified investment advisor. The information in this material was obtained from sources believed to be reliable, but were 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. Neither, nor any of its employees or affiliates are responsible for losses you may incur.