MARCH 27, 2016
CONFIRMING THE BEAR CASE
IntelligentValue is unusual in the realm of market analysis services. Unlike others, we combine both fundamental analysis and technical analysis to inform our market positioning and exposure to risk. Most providers of market analysis and/or model portfolios focus on either one or the other approach, but rarely both. In fact, each side regularly pronounces the other as being an unproductive waste of time. Nevertheless, we find that a combination of the two disciplines, using both fundamental and technical analysis to compliment one another, provides us with a great advantage and is primarily responsible for the extraordinary returns of our two model portfolios.
Currently, many of the top technical analysts we read are making the case that the bull market that began in 2009 is still alive and well. To a great degree, the breadth of the recent rally off the February lows has them convinced that the S&P 500 is poised to make fresh all-time highs in the coming weeks and months. There is no doubt that there has been robust breadth to accompany the powerful surge that began February 12 through last week. This might cause many (who are not familiar with the declining fundamentals) to consider these analyst's case as reasonable.
Still and all, we are watching the steadily declining profits of US corporations and don't see how it's possible that a market that is already expensive can now get dramatically more expensive. A continuation of the bull market, with new, higher highs and accompanied by declining profits, could move the S&P 500's current very high P/E ratio of 23.53 into the stratosphere that we last saw at the dot-com top.
Alas, today there is no fever-pitched, bullish 'new-economy' madness to fuel a rally of that nature. Likewise, the central-bank stoked bull run from 2009 to 2015 is today without meat on its bones. Interest rates remain near the zero boundary, so they cannot be lowered further unless it is into negative levels (which would inevitably trigger a catastrophe worse than the one at hand). To those who believe a renewed QE effort would save the day, its important to remember that when the Fed stopped QE in December 2014, it complained that it had become ineffective. However, the case can easily be made that it was never truly effective in the first place. Granted, stock investors have profited handsomely, but the economy is barely simmering, and by some measures is even at levels lower than the Great Depression (see last week's article on the velocity of money).
In addition, from technical charts we can identify a clear downward trend channel in the market with lower highs and lower lows. When accompanied by declining corporate profits (discussed below), we believe that the probabilities going forward favor a continuing decline. Based on technicals alone or fundamentals alone, the case could be made for just about any conclusion. However, when combining both approaches as IntelligentValue does, the path forward is relatively clear.
In today's newsletter, we are going to provide you with some of the details of those declining corporate profits. We will also show you charts that present what we think is an unbiased interpretation showing the market's technical probabilities strongly lean toward a continuing downturn and likely an extended bear market. Not to fear, in today's world we can make profits in either direction. We just need a direction to take hold and last a while. The extreme volatility we have seen in the last seven months is common at the beginning of bear markets as the bulls put up a mighty fight. However, there is usually a dive off a cliff once the writing is on the wall... writing we think will be clear from the evidence below.
CORPORATE PROFITS FALL YET AGAIN
The Commerce Department on Friday presented corporate profits for 2015′s fourth quarter and the full year. The after-tax adjusted (with inventory valuation and capital-consumption adjustments) profit reading is the most closely watched and makes media headlines. It is the most meaningful number for Wall Street because it reflects something similar to the business equivalent of take-home pay. For the 4th quarter 2015, after-tax adjusted profits fell -15% from a year earlier to $1.380 trillion. It was the steepest year-over-year drop in a quarter since 2008 when the U.S. was mired in a deep recession.
Corporate profits before tax with inventory valuation and capital consumption adjustments totaled $1.890 trillion. This figure is another one of the Commerce Department’s most-watched numbers because the figure is comparable to changes in GDP, which measures all output in the economy. According to this measure, fourth-quarter profits dropped -11.5% from the same period a year earlier, the steepest fall since the fourth quarter of 2008.
A strengthening dollar, a slight upturn in wage pressures, and the sharp decline in energy prices all contributed to declining corporate profits.
The chart below depicts the earnings decline in the S&P 500 from the fourth quarter 2014 the fourth quarter 2015. Importantly, according to accurate, real-time data to which we subscribe, there has now been a further decline in profits of approximately -34% from the end of 2015 to present!
CHART 1: There was a -15% decline in S&P 500 earnings per share from 4Q14 to 4Q15. Alarmingly, according to our real-time data source, there is been a -34% decline from the end of 2015 to present.
In our opinion, this fundamental data regarding profits is the deal-breaker in any analysis where a continuation of the seven-year bull rally is presented as a possibility. Markets do not continue to climb higher on declining earnings when they are already expensive, regardless of the misguided efforts of central banks to prop them up.
In this section, we will present a series of technical charts with brief explanations of their implications. We believe that once you view this set of graphical depictions of various technical aspects of the stock market, you will agree that probabilities favor a scenario in which we are just beginning a bear market that will likely stretch into the foreseeable future.
LONG, ROUNDED MARKET TOP
From time to time over the last six months, we have presented a chart which shows the S&P 500 with a long, rounded top that began in late 2014, peaked in mid-2015, and is now heading downward in 2016. We present the chart below to provide an update on current developments and to show that nothing has changed despite the February/March rally; the long, rounded top is still in place.
Notice in the lower window that the Moving Average Convergence Divergence (MACD) indicator dropped below zero in August 2015, briefly moved above it last November, and has been back below zero since late December 2015. An MACD below zero is a relatively common and fairly accurate indicator of a bear market used by chart watchers.
CHART 2: Long, rounded market top is depicted in upper window along with the MACD indicator below zero in the lower window.
This pattern of a long, rounded top following a bull market is quite common. Historically, market indices begin to lose steam as the forces that powered the bull rally gradually ebb away. The business cycle does not last forever, and investors eventually realize that conditions have changed, exiting stocks in clumps, which causes index prices to steadily lose momentum and eventually head downward. As investors see their portfolios shink and losses mount, they invariably pull the plug and lock in those losses.
For the sake of comparison, Chart 3 below shows a similar long, rounded top in 2007–2008.
CHART 3: Long, rounded market top in 2007-2008
Also, notice in the lower window of Chart 3 that the MACD indicator dropped below zero in December 2008, signaling to armchair investors that the bear market had officially commenced.
We could display additional charts for 1999–2000 and virtually any other years that were the demarcation between a bull market and a bear market, but we will spare you the monotony.
As Oliver Wendell Homes quipped, "A page of history is worth a volume of logic." Historical charts testify to prior bulls morphing into bears in the form of long, rounded topping patterns, and outweigh any convoluted logic a bullish investor or perma-bull stock-promotion shills can throw at them.
MAJOR INDEX RESISTANCE ZONES
Last week we presented a chart showing the overhead resistance zones for the S&P 500, the S&P 500 Equal Weight Index, the NASDAQ composite, and the Russell 2000 small-capitalization index. In last weekend's published chart, each market index during the week of March 13–17 was still marching higher towards those resistance zones with no sign of abatement in their progress. Nevertheless, last week each of these indices turned downward precisely at the resistance zones we identified, as shown in Chart 4 below:
CHART 4: The S&P 500, the S&P 500 Equal Weight Index, the NASDAQ composite, and the Russell 2000 small-capitalization index is depicted with the identification of appropriate resistance zones. Last week each index turned down at those resistance zones.
For the bull market rally that began in 2009 to resume, each of these resistance zones would have to be pierced to the upside. Also, each window shows that the indices have additional resistance zones at higher levels that would also need to be shattered for the bull rally to resume. That's not likely, especially without a compelling bullish catalyst.
DOWNWARD-SLOPING TREND CHANNEL
A zoom into the last 12 months of the S&P 500 shows a downward-sloping trend channel and a series of lower-highs and lower-lows. Following the all-time high set in May 2015, the markets set two slightly lower highs in June and July before the big selloff in August. That event, and its rebound, marked the beginning of the downward trend channel that we display in red in Chart 5 below.
CHART 5: A zoom into the last year of the S&P 500 shows a downward-sloping trend channel and a series of lower-highs and lower-lows.
You can also see that there are a series of four lower highs in a row (labeled in blue) starting in early November, then the beginning of December, late December, and last week. The high of the February–March rally that was set last Monday at 2051 was a pivot point where prices turned downward precisely at the upper Trend Channel line. Lower-lows have also been established in January and February to form a parallel lower line (in red) for the Trend Channel starting from the September 2015 low.
RSI LEVELS ARE IN BEAR-MARKET RANGE
One of the most popular indicators in technical analysis is the Relative Strength Index (RSI). RSI is a momentum oscillator that measures the speed and change of price movements. It oscillates between zero and 100. According to Wells Wilder, the indicator's creator, RSI can be used to signal overbought and oversold conditions when above 70 and below 30, respectively. We can also identify signals by looking for divergences, failure swings and centerline crossovers.
Most pertinent to the current discussion, the RSI stays within certain ranges during bull markets and bear markets. On a weekly chart, the lower boundary for bull markets is around 40 while the upper boundary for bear markets is about 60. A move below or above these levels, would signal a change in market conditions to bearish or bullish, respectively.
Chart 6 below shows identification of bull and bear market ranges in the RSI (lower window) based on the S&P 500 from 2004 to present. As you can see from the far right of the lower window, the S&P 500 RSI has been in the 30 to 60 (bear market) range since mid-2015. This was also when the S&P 500 broke its upward-sloping trendline.
CHART 6: The RSI of the S&P 500 has been in the bear market range of 30 to 60 since mid-2015.
Savvy investors will not invest in long positions until the weekly RSI (among other indicators discussed) moves back into bullish territory.
CONSUMER DISCRETIONARY/CONSUMER STAPLES RATIO
The consumer sector of the market consists of both discretionary and non-discretionary items. We can best chart these two sectors using the Consumer Discretionary ETF (XLY) and the Consumer Staples ETF (XLP).
Consumer Discretionary refers to the sector of the economy that consists of businesses that sell nonessential goods and services. Companies in this sector include retailers, media companies, consumer services companies, apparel companies, automobiles and components companies. This sector performs best at times when the economy is expanding, with confident consumers that have disposable income in their pockets.
Consumer Staples are goods that people are unable or unwilling to cut out of their budgets regardless of their financial situation. Consumer staples stocks are considered non-cyclical, meaning that they are always in demand, no matter how well the economy is performing. This includes food, beverages, household products, and personal care items. Interestingly, it also includes alcohol, tobacco, and gambling, so apparently it is perspective-dependent. The Consumer Staples sector usually continues to perform well even in recessionary times and, because of this, is usually a traditional defensive investment.
By using the ratio between the Consumer Discretionary ETF (XLY) and the Consumer Staples ETF (XLP), we can get a good indicator of investor's appetite for risk. This ratio can then be used to gauge whether the market is likely to soon move higher or lower.
Chart 7 below shows the XLY/XLP Ratio in the top window stretching back to 2003. Notice that in late 2007, the XLY/XLP Ratio broke its support line and began heading sharply lower. That was also a good signal that the S&P 500 would soon head lower, which it proceeded to do. In March 2009, when the S&P 500 set a new lower-low, the XLY/XLP Ratio showed a positive divergence and subsequently advanced sharply higher. That was one of the multiple signals at that time to get fully invested (IntelligentValue bought full portfolios of undervalued stocks on March 9, 2009).
From 2010 through 2015 the XLY/XLP Ratio was in an upward-sloping Trend Channel, which was a key confirmation that the long bull market was intact. However, the XLY/XLP Ratio broke below its Trend Channel to start 2016 and doesn't appear able to recover. It rallied tepidly while the market surged starting in mid-February, but lost steam in the last few weeks. We will not be surprised if the XLY/XLP Ratio continues downward from here, and will be watching it closely for any change.
CHART 7: The XLY/XLP Ratio is a consistent identifier of bull and bear markets. The ratio broke down to start 2016.
All in all, we believe the information presented in this edition of the Value Alert Newsletter, as well as our past editorials since June 2015, make the case that we are likely in for further declines. We believe the burst of higher prices from mid-February through last week was a bear market rally, not a robust resumption of the bull market that many would have you believe.
Investors have experienced many bear markets over the decades, and about four times as many bear-market rallies (there are an average of four bear-market rallies during bear markets). Bear market rallies are usually very sharp and fast (sound familiar?), converting unsure investors into new bulls who unwittingly hop on board the happy-talk bandwagon.
In the end however, bear-market rallies always fail, leaving the newly converted bulls 'holding the bag,' so to speak. If the powerful market rally that started February 12 was in fact a bear rally, that may be what we will see this coming week: a large number of bagholders holding long positions that are now losers.
OUR PLAN FOR THIS WEEK
We will make no changes to our model portfolios this week. If the S&P 500 drops below its 200-day moving average (only 20 points below), we will likely be purchasing additional inverse ETFs for our portfolios.
Of course, if technical or fundamental conditions reverse course, it will call for a re-assessment of our analysis. Some of the things that could change our fundamental analysis would be an increase in the rate of inflation, a drop of the dollar below its current trading range, a continuing recovery in the price of oil, or a dramatic reversal of the decline in corporate profits.
From a technical perspective, we will be watching to see if the S&P 500 will bounce higher off its 200-day moving average this week. If it moves above last Monday's high at 2051, that would be a reason to give it extra attention to see if it can surpass the prior high at about 2082.
We will enter the week with our current strategy of holding 80% cash and a 20% inverse exposure. If we see support levels break, we will be aggressive in adding inverse positions to capture downside profits from what will likely be a sharp selloff. On the other hand, if we see breaks of overhead resistance, we will take the opposite approach. The market is truly at a pivotal point right now.
We will send an email to IntelligentValue members with specific details of our purchases when we update our model 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,
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 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 IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.