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"When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done."

John Maynard Keynes

– Enjoy more of our favorite investing quotes –


APRIL 3, 2016




Jump Links:

- Small Company Profits Now Negative
- Manipulated Employment And Weak Labor Force Participation
- Our Plan for This Week



In last week's Value Alert Newsletter, we discussed the declining profitability of the S&P 500. We pointed out that S&P 500 profits had dropped -15% from 4Q2014 to the most recently reported quarter, 4Q2015. Also, since the end of 2015, it appears that earnings have dropped an additional -34%, which is not yet reflected in the soon-to-be-released 1Q2016 corporate earnings announcements. As those earnings reports begin appearing in the coming weeks, it may be a rude awakening for investors.

This week, we would like to focus on the Russell 2000 (small-capitalization stock) index, which is in much worse shape than the S&P 500. Smaller companies are usually dependent on the US for their sales and are a much more sensitive barometer of US economic conditions than their larger brethren in the S&P 500.

Our data provider updates the fundamentals on more than 8000 companies each weekend. Therefore, the data that we are providing here is ahead of the 1Q2016 earnings announcements that will begin flowing in coming weeks.

'EPS Including Extraordinary Items' is the standard GAAP measure that all corporations are required to provide in quarterly reports. The data source is CompuStat, one of the most highly regarded point-in-time providers. According to CompuStat, "EPS Including Extraordinary Items is earnings per share including all expenses, including those deemed extraordinary. It is calculated with net income, including all expenses and extraordinary items, and using fully diluted shares."

As of today (April 3, 2016), these are the statistics for the S&P 500 and the Russell 2000:

S&P 500
S&P 500 Profitable Companies: 423
S&P 500 Unprofitable Companies: 76 (15%)
(Refer to last week's Value Alert for S&P 500 charts)

Russell 2000
Russell 2000 Profitable Companies: 1,192
Russell 2000 Unprofitable Companies: 721 (38%)
Total Russell 2000 Earnings per Share: -48.35

As you can see from these statistics, the 38% of unprofitable companies in the Russell 2000 overwhelm the remaining 62% of profitable (but struggling) companies, pulling total profitability of the entire index into the negative area.

We had been wondering why the Wall Street Journal had been reporting such incredibly high (and climbing) P/E ratios for the Russell 2000 throughout 2015, reaching a PE as high as 698. In recent weeks, the WSJ has been reporting a P/E ratio of 'NIL' for the Russell 2000. Doing some investigation, we found out why. Chart 1 shows the cumulative Russell 2000 Earnings per Share (in red) dropping below zero in early 2016. The negative earnings of the losing 38% of companies overwhelmed the positive earnings from the other 62%:

CHART 1: Russell 2000 Earnings Per Share (EPS) dropped into negative territory in early 2016.


Notice that while earnings continued downward over the last two months, the price of the Russell 2000 (in blue) surged sharply higher. This is one more reason we consider the recent market bounce that began in mid-February to be a classic bear-market rally and is likely to turn back South soon. Simply put: markets cannot continue higher on declining earnings.

To present a more even-handed take on this analysis for those who are of an optimistic bent, Chart 2 shows the number of Russell 2000 companies with negative Operating Income. Based on Total Revenues minus the Cost of Goods Sold as well as Administrative Expenses, Operating Income does not include one-time nonrecurring events, discontinued operations, interest expense, or extraordinary items.

As you can see from Chart 2 below, the number of Russell 2000 companies with negative operating income has climbed steadily higher since mid-2014. Almost 1/4th (468) of the businesses in the Russell 2000 now have negative Operating Income. It is nearly impossible to generate positive, bottom-line earnings when you have negative Operating Income.

CHART 2: Number of Russell 2000 Unprofitable Companies on the basis of Operating Income: 468

We will show one final chart to highlight the increasing number of publicly traded companies that are losing money. Chart 3 below depicts the universe of all stocks that provide complete fundamentals and are profitable (in red). These are not just small-cap companies; it includes all publicly traded companies that provide regular reports to shareholders. We compare this to the Russell 3000 index (in blue), which is the broadest index we can use as a comparison.

Notice that at the beginning of this chart in 1999, there were about 5,300 profitable companies (83%) out of the 6,385 in the database. That number has steadily dropped in the ensuing 17 years so that today there are only 3,388 (53%) profitable companies. Nearly half of all publicly traded businesses that report fundamentals are losing money today!

Nevertheless, we see the Russell 3000 index (in blue) set new, all-time highs in early 2015 before beginning to struggle. Notice that the number of profitable companies (red) dropped off sharply since a temporary high in January 2015, and that decline appears to have accelerated in the last few months, even as most indices have recorded powerful rallies since mid-February:

CHART 3: The number of profitable companies (red) continues to decline, while the Russell 3000 Index (blue) is still near highs.


We continue to believe the market surge since mid-February was a classic bear-market rally and not a resumption of the bull market. Again: markets do not climb higher on the back of declining earnings!


Last Friday the US Bureau of Labor Statistics (BLS) released its employment report for March and announced that the economy had added 215,000 jobs. However, it is always important to keep in mind that this number is adjusted by 1.7 million individuals who wanted and were available for work, but for one reason or another had not searched for work in the preceding four weeks. A slight variation in that 1.7 million figure could have made the number of jobs added 400,000 or zero or even negative. Nevertheless, it is amazing how much weight investors place on this highly massaged monthly employment number.

In addition, there are about 93.9 million Americans that are considered not in the labor force (data here). When added to the 8.1 million Americans that are considered 'unemployed,' the total is 102 million (almost 1/3rd!) working age Americans that do not have a job right now.

Chart 4 below shows that the Civilian Labor Force Participation Rate has continued to decline since its peak around 2000. We can see there was a surge since late 2015, but we can see other temporary surges in the series before the decline resumed, so let's avoid extrapolating a favorable outcome at this point.


CHART 4: Civilian Labor Force Participation Rate. Chart courtesy Federal Reserve Bank of St. Louis.


Even more telling, as a percentage of the total population, only about 60% are employed. Since the end of the Great Recession, there's only been about a 1.5% improvement in the employment participation rate.


CHART 5: Civilian Labor Force Participation Rate. Chart courtesy Federal Reserve Bank of St. Louis.


It is tough for an economy to grow based upon such low employment participation, minuscule corporate capital investment, all-time low interest rates on savings, barely-there inflation, cliff-diving corporate profits, a global economic slowdown, and other headwinds. For this reason, we continue to be skeptical of an improving US economy and therefore, also skeptical of the prospects for improving stock prices.


Our status is the same as the last few weeks. We will make no changes to our model portfolios at this time. If major indices begin to drop, we will likely be purchasing additional inverse ETFs for our portfolios.

Of course, if technical or fundamental conditions reverse course higher, it will call for a re-assessment of our analysis. Some of the things that could change our primary analysis would be an increase in the rate of inflation, a drop in the dollar below its current trading range, a recovery in the price of oil (although it dropped again recently), or a dramatic reversal of the decline in corporate profits (which we discussed to start this page).

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 may take the opposite approach. As we noted last week, 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.

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.