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

– Robert Arnott

– Enjoy more of our favorite investing quotes –


MARCH 13, 2016




Jump Links:

- Reasons For Being Bearish
- S&P 500 Income Continues To Decline
- The Russell 2000'S Unprofitable Company Problem
- The Big Picture Remains Stubbornly Bearish
- S&P 500 Trend Channels
- S&P 500 Daily Chart Analysis
- Our Plan for This Week


Unlike most other advisories, our approach to investing integrates both technical and fundamental analysis. We see technical forces as global, macro, top down, and multi-asset-class. A number of studies and academic papers have proven that approximately 70-80% of stock price movement is due to macro factors rather than company-specific information.

For this reason, we believe it is imperative to track technical developments of the overall market and take proactive action to eliminate significant drawdowns. Portfolio drawdowns are the primary reason for poor returns. By mitigating these drawdowns, we have been able to increase significantly our results. Reducing the number and size of drawdowns also alleviates much of the stress and emotional damage that accompanies portfolio losses. Our subscribers sleep better at night.

Last week, stocks continued higher yet again, this time finishing above the area that we previously called 'strong resistance.' In last weekend's Value Alert, we posed this question:

Was the rally that began on February 12 the incipient beginning of a new leg higher in the seven-year bull market? Alternatively, is 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...

Surprised by the continuing show of price strength in the face of slowing global growth and declining corporate earnings, it is time to dig in and determine what to do next. Therefore, let's try once again to answer the question we asked last week, this time in light of the latest developments. In this issue, we will re-analyze a critical aspect of the market's fundamentals and summarize the most salient technical analysis components. At the end of this issue, we will provide guidance for changes we will make to our two model portfolios this week.


IntelligentValue has been bearish on the market since late June 2015. At that time, we started moving our two model portfolios towards cash and kept tight stops on our remaining positions. That timing was fortuitous because we were able to miss the significant downturn in stocks that started the following week.

The June 28 newsletter, titled "Big Change Coming to the Market Starting This Week" provided the reasons we believed that a significant transformation 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.

The primary reasons we have been very concerned over the last 8.5 months about a possible prolonged, multi-year bear market are the following:

• Earnings Decline: Corporate earnings started descending in early 2015 and have not stopped yet
• Dollar Strength: 23% increase in the value of the dollar since mid-2014 has caused US products to be expensive and conversely, a dramatic deflation in the price of commodities that threaten the financial viability of emerging market companies and countries
• Asset Prices: The prices of stocks and other assets, continuously manipulated higher by extreme, experimental Keynesian monetary policies at the Federal Reserve and other central banks around the world, have concocted the third enormous asset bubble in 18 years and are ripe for a dramatic, prolonged corrective period.

There are a number of additional reasons we are concerned about the future direction of the stock market, but we will not delve into them here. There is a list of additional material from our past newsletters at the bottom of this page if you would like further information on the economic and exogenous threats to the equities market.


Rather than reviewing bottom-line earnings, we prefer to focus on operating income. Operating Income gives a more balanced interpretation across sectors and asset classes without including one-time charges and exclusions. Since the start of 2015, S&P 500 Operating Income has rapidly declined. Reaching a high of $1.69B on Jan 1, 2015, it has dropped to $1.49B or an 11.8% decline. This compared to a market decline of just 1.37% during the same period.


Chart 1: S&P 500 Operating Income continues to plummet.


According to the Wall Street Journal, the current S&P 500 PE ratio is 23.02. One year ago the reading was a less extreme, but still unacceptably high 20.19. This is concerning because a PE of 23 is the second highest PE ratio in the S&P 500's 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, about the same as the S&P 500 P/E ratio one year ago (before the earnings decline and the extreme volatility over the last six months).


Last week we quoted the Wall Street Journal printing a P/E ratio for the Russell 2000 small-capitalization companies at a mind-boggling 688. That ratio increased from 34 in 2013, 80 in early 2015, 152 in January this year, and 296 on February 28, 2016. One of the primary reasons the Russell 2000 P/E ratio is so extraordinarily high is because of the number of companies in the index that are unprofitable. This chart shows the number of profitable firms in the Russell since January 2, 1999:

CHART 2: Number of profitable companies in the Russell 2000 index has been wildly volatile, ranging from a high around 1600 in 1999 and 2006 to a low of 1050 in late 2009. The current number of profitable companies stands at 1243.


How can the cumulative P/E ratio for small-cap stocks be so high? Because nearly 40% of them are not making money! The number of profitable companies in the Russell 2000 index has been wildly volatile, ranging from a high of about 1,600 in 1999 and 2006 to a low of 1,050 in late 2009. The current number of profitable companies stands at 1,243 and appears to be heading sharply lower. 757 money-losing companies could explain the dramatically high P/E ratio. The growing number of unprofitable and nearly unprofitable companies could explain the weekly PE-ratio increases.

Despite our concerns about valuations, we do not use a composite P/E ratio of any index or sector as a timing tool. As John Maynard Keynes is famously quoted, “The market can stay irrational far longer than you can stay solvent.” We use rules-based technical indicators to inform our market timing decisions. Keeping fallible human judgment out of the picture is very critical to us. We apply fundamental analysis (combined with technical analysis) only when selecting individual stocks.


Let's focus in on technical analysis now and see what it can tell us about probabilities for the market direction. However, keep in mind that technical analysis is more like a windsock than a crystal ball. It can help us determine which outcome is more likely over another, but nothing is definitive, especially in the short run.

For this reason, we frequently review long-term, monthly charts to get a big-picture perspective on the market. Chart 3 shows the monthly S&P 500 from January 2013 to present.

Chart 3: A monthly view of the S&P 500 (top window) displays the long rounded top that is still in place. The lower window shows
that the MACD is below zero, which is bearish, but now has a bullish crossover with the signal line (at the question mark).

In the top window, we can see that the long, rounded rollover pattern that we have discussed for months is still in place, despite the sharp, four-week rally. In fact, there have been two extreme, violent selloffs and rebounds since the rollover peaked near the May 2015 market high. The other was in August to October 2015.

These rollover patterns are typical after a long bull market. Following a long bull run, the market tends to gradually lose steam as growth declines and valuations become questioned. In Phase 2, it enters a period of volatile convulsions as bulls and bears battle for control. Inevitably there is a Phase 3 waterfall selloff period when panic sweeps investors, both amateur and professional, and a panicky race for the exits ensues. We believe we could be in Phase 2 of this pattern.

The bottom window of Chart 3 shows the Moving Average Convergence/Divergence (MACD). When the MACD is below its zero line, it is considered bearish. Notice that the MACD was gradually declining since 2014 and first dropped below zero in mid-August 2015. On the far right of the lower window, we can see that the MACD has just crossed above its signal line. The fact that the MACD is still below zero is the over-arching force that dominates the signals from this indicator, but the signal line crossover can be significant in the short term if it develops further.

One of the most important takeaways from this long-term, monthly chart is that the March bar on the far right of the upper window has moved just above its 40-week (200-day) moving average. While that bar is not fully formed (March is not over), it is also touching the bottom of our long, blue arch. This arch is not scientifically derived but is the line of best fit over the upper range of prices since late 2014. A definitive break above this arch will be a reason to reconsider our bearish thesis.

Since this is a monthly chart, it does not provide timely signals but is useful for determining the overall forces. We do not use monthly charts for our rules-based analysis, but we present the monthly chart above to provide readers with the overall, dominating trend of the market. That overall trend remains down.


Bringing our technical analysis back to a shorter-term weekly chart, we can draw trend lines that define the channel of the market since its 2009 low. Chart 4 shows the S&P 500 using a standard-scale presentation. In a standard-scale chart, a move of 10 points appears as the same distance whether prices move from 10 to 20 or from 100 to 110 (10 points for each movement).

 In this chart, we can see that a long-term support line stretches from the 2009 low, along the bottom of the 2011 correction, the two 2012 lows, and finally to the August/September 2015 lows. There is also a resistance line at the top of the channel that runs from October 2008 to early 2015 before market prices begin to head downward.

On this standard-scale chart, the lower support line was broken at the start of 2016. The S&P 500's prices have remained below the lower channel line since the break. However, it is now challenging that support line (at the red question mark). If prices move above this support line and stay there long enough to provide confirmation, then the case could be made that the bull market has resumed.


CHART 4: A standard-scale chart of the S&P 500 shows the trend channel for the last seven years.


If we change to a logarithmic scale, as shown in Chart 5, the picture is not as promising for the bulls. Logarithmic charts show prices on a percentage basis. For example, the change of an equity's price from 90 to 100 (10 points or 10%) appears the same distance as when that investment moves from 200 to 220 (20 points or 10%).


CHART 5: On a logarithmic scale, the S&P 500 chart is not as promising. Prices would have much further to go to reenter the Trend Channel.


On the logarithmic scale chart (above), prices first broke below the lower support line in August 2015. That lower support line was challenged in November 2015 but could not break through. Currently, prices are quite a distance from the lower support line and would need to move much, much higher to re-attain the bullish Trend Channel.


Chart 6 shows SPY, the S&P 500 SPDR ETF, on a daily basis for the last six months. We prefer to use ETFs when we examine daily candlestick charts because they show actual price and volume records of an individual equity, rather than a computerized composite of the prices of 500 different companies. With more than $2 trillion invested in Exchange Traded Funds, technical patterns on the major ETFs now drive the indices, rather than the reverse – as was the case for many years. Most professional investors use ETFs for accurate technical analysis, and so do we.

The upper window of Chart 6 shows the resistance zones for SPY that we first mapped out in mid-February. These resistance zones include the 1) Fibonacci Retracement levels (at 38.2%, 50%, and 61.8%), which coincided with 2) zones of support and resistance (green and red shaded) established by changes in prices, and 3) the 50 and 200-day moving averages. There is nothing special or mysterious about these three indicators. However, they are used by a vast majority of both professional and amateur investors. For this reason, it is important to identify them and use them as part of our toolbox. (We'll keep our 'special' and 'mysterious' indicators to ourselves.)

CHART 6: A daily view of the S&P 500 ETF (SPY) with Fibonacci levels, moving averages, and resistance zones in the upper window.
In the lower two windows our Short-Term Direction and Long-Term Trend indicators are displayed.

Notice that the three indicators, i.e.; Fibonacci Retracements, support/resistance zones, and the 50/200-day moving averages, all coincided at two separate levels in the past month. The rally kicked off on February 12 and ran into the first resistance zone in late February. This first resistant occurred where the 50-day moving average, the 50% Fibonacci Retracement, and the price gap of January 6/7 all aligned.

After five days of struggling around the 195 area starting on February 23, SPY broke through the first resistance zone on March 1 with a substantial 1.6% surge up to 198 to kick off the month of March. We bought our inverse ETF's on March 24 as the struggle around the 195 price point ensued and the rally appeared to be failing.

With only three points above before SPY hit the second resistance zone around 201, we decided to hold on to those inverse ETFs. Then, as expected, SPY began to struggle at the second resistance zone starting on March 7. For four days last week, the bulls and bears battled and ETF appeared to be stalling out at the 200-day moving average. Probabilities were strong that the rally was over, and SPY would begin heading downward.

Alas, Friday was a game changer. The ETF open the day at 201.26, just above its 200-day moving average. Then it surged higher in both the morning and afternoon sessions to close the day at 202.76, an impressive gain of 1.61% on the session. That close established SPY well above all three indicators we had been watching; the 200-day moving average, the 61.8% Fibonacci Retracement zone, and the support break/resistance zone near 200. The second and final Resistance Zone is now broken. However, the one thing that is missing from this significant breakthrough is confirmation. We will see if that comes in the following days.


If you do day trading for fun and excitement (not recommended), it is a virtual certainty that SPY will drop tomorrow (Monday, March 14). Short-term indicators are very overbought and the singular, most accurate indicator we watch for short-term movement is dictating a down day. However, we are not day traders. Our average hold time for a position in each of our two model portfolios is more than three months.

When we bought the two inverse positions for each portfolio (leaving 60% of each portfolio in cash), we said would keep clear and definitive closing-price stops on each equity. If any of our holdings broke a closing-price stop, we would sell the ETF the following day. In the section above, 'S&P 500 Chart Analysis,'

we identified the step-by-step pricing and decision process regarding the two inverse ETFs (one in each portfolio) based on the S&P 500. We will sell those positions at Monday's open and will adjust the pricing of those closed positions to the actual opening price on Monday. We make every effort to ensure our portfolio performance matches yours.

Regarding the other two positions (one in each portfolio) based on the Russell 2000, there is a different story. The Russell 2000 (small-cap) index is down far more than the large-cap S&P 500. In the last month, it has not recovered like larger stocks. It is also nowhere close to re-attaining its 200-day moving average. Therefore, we will hold those positions for now.

It is certainly possible, considering the overbought nature of the four-week rally, that we will get a whipsaw and prices will head back downward. However, we are not hoping for lower prices (which would produce gains from our inverse ETFs). 'Hope' is not an investment strategy. If the S&P 500 does reverse course from here and head downward, we will make a decision determined by rules-based indicators and possibly repurchase those same positions (and more). Having the discipline to stick with a proven strategy is all-important in volatile times like this.

We are also open to the possibility of an opposite outcome for the market. One of the sections in this issue is titled, "Reasons For Being Bearish." However, there are also a number of technical and fundamental reasons an investor could reasonably be bullish. Alas, at this time we feel the weight of the evidence is one the side of the bears. We have also run out of space and may be trying our reader's patience if we were to present the opposite (bullish) story at this time. We will see how things develop this week and promise to address the bullish narrative should that result prove to carry the day.

As every investor should be, we are open and objective to the possibility of various investment outcomes and will follow where our rules-based decision algorithms lead us.


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

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.