APRIL 24, 2016
BULL RALLY TAKES A BREATHER - WHAT NOW?
STUDY: FED IS RESPONSIBLE FOR 93% OF MARKET RETURNS SINCE 2008
It is evident that the Federal Reserve plays a very direct role in the performance of the stock market. While its statutorily mandated purpose is to attempt to maintain 'full employment,' (the previously mentioned level of about 5%) and to 'price stability' (generally accepted to mean about 2% annual inflation), these two objectives have been put on the back burner as the Fed seems to have changed its focus to micro-managing the outcome of the stock market.
This change of informal purpose (the Fed's formal, 'for the record' purpose must remain employment and price stability according to Federal law) is a result of current (Yellen) and past (Bernanke) Fed chiefs operating in the long shadow of former Fed Chairman Alan Greenspan. Greenspan believed that the best way to manage employment and inflation was to maintain what he called the 'wealth effect' by keeping the stock market percolating. Therefore, whenever the market began to slump, he trotted out a dovish policy and whenever it started to get too hot, he would raise rates or jawbone that was the plan, whatever it took until he got the desired level of stockmarket prices.
Not surprisingly, according to economist Brian Barnier, principal at ValueBridge Advisors and founder of FedDashboard.com, measured the effects of four different economic forces on the market since the 1950s and found through regression analysis that the Federal Reserve is responsible for 93% of the stock market's returns since 2008. This explains why there has been massive volatility and a significant selloff to start 2016; because the market fears the Federal Reserve 'put' will soon be withdrawn as the US attains 'full employment' and inflation has begun to increase.
CHART 1: A study of market growth drivers has concluded that Federal Reserve monetary policy
is responsible for 93% of
stock market returns since 2008.
At this point, the Federal Reserve has severely boxed itself into a corner. Asset prices continue to climb higher as a result of low interest rates and the speculation that has resulted from the Fed's stimulative/accommodative policies. However, now it cannot increase rates to reduce that speculation for fear of setting off a global calamity as a result of a rapid appreciation of the dollar. That gain in the value of the dollar would cause US companies to be uncompetitive in world markets, severely reducing US corporate profits. It would also cause a resurgent collapse in the price of commodities, thereby severely damaging emerging-market economies and potentially creating defaults on dollar-denominated debt, as well as upsetting the fragile balance in the FX markets. The price of oil would collapse again, and energy companies that have been hanging on to life by their fingernails would likely crash and burn.
It's clear the Federal Reserve missed its window of opportunity to increase rates when the economy was still growing in 2013 or 2014. We pointed this out at the time. As in previous iterations of the Fed's monetary over-accommodations in the late 1990s and 2007, it is causing an increasingly elephantine asset bubble. This one by far the largest bubble ever created and when pricked, the outcome could be staggering for the world's economy, potentially wiping out the assets and savings of millions of baby boomers just as the bulk of them are entering their retirement years. This would be the third Fed-created financial disaster in the last 16 years, and may be the last straw. It is clear the Federal Reserve does not have the capabilities to 'manage' something as complex as the largest economy in the world (and now it is taking on worries about global markets). However, removing power from a group of individuals, once it has been granted and wielded for many years, rarely occurs throughout history.
Currently, the Federal Reserve has accomplished its stated goals. The US has 'full employment' of 5% or less and also has an inflation rate of 2% (recently inflation is in a range from 1.56% to 2.4%). Yet the US central bank continues to threaten to raise rates and when that didn't cool off the highly overvalued market (S&P 500 PE of 24), it did a very mild increase of 0.25%. That barely there rate increase resulted in a rapid selloff to start 2016. Thereafter, following the market's tantrum, the Fed backed off any suggestion of raising rates again this year.
Having achieved its employment and mild inflation goals, the Fed should be ignoring the stock market. Instead, the market is the first and foremost concern of the Federal Reserve. This is pure policy madness; the tail is wagging the dog!
On the other hand, should the US Federal Reserve raise rates while other central banks keep rates low or even negative, this will increase the capital outflows from other countries to the US and result in a major decline in those country's stock markets. Currency traders will short those currencies and hedge funds will short those markets. The US Federal Reserve has created its own nightmare (again), and now must live with it. Unfortunately, so must we.
HERE’S WHY STOCKS HAVE SHOT BACK NEAR RECORD HIGHS
The recent rally that began February 12 was preceded by three prior violent swings, both upwards and downwards, greater than 12% since late-July 2015. What's important to recognize is that each of these dramatic moves was closely correlated with either anticipated or announced changes in interest-rate policy by the US Federal Reserve. The chart below shows these moves and the points when the Fed made announcements that affected the market, while the narrative below documents each announcement:
CHART 2: The US Federal Reserve caused four violent whipsaws of the market during the last eight months, including the recent 15% rally.
We'll go through each change in the Federal Reserve's policy and why it caused these dramatic swings in the market over the last eight months (the descriptions below correlates with the chart above, with red denoting hawkish Fed statements and green denoting dovish Fed statements):
August 2015 Market Selloff: By late summer 2015, investors (and the Fed Futures market) widely anticipated a Federal Reserve increase in interest rates because of the steady decline in unemployment each month, finally reaching lower than 5.0% (from near 10% when George W. Bush left office in early 2009). Most economists consider 5% unemployment to be 'full employment,' and the US had reached that point by mid-2015. The Fed had been preparing investors for an imminent rate increase for months. In anticipation of a widely forecast increase in interest rates at the Fed's September 16-17 meeting, combined with fears coming out of China and emerging markets because of a strengthening dollar, most US market indices sold off hard in August 2015.
September 16-17 Federal Reserve Meeting/Statement: The Fed, shaken by the August selloff which anticipated its rate increase and worried about the global anticipation which had already resulted in a dramatic increase in the strength of the dollar, made a dovish announcement that surprised the market: "Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term. The Committee is maintaining its existing policy..."
October 27-28 Meeting/Statement: "To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate." The result of these two statements was a rally of +12.9% from late-September to early November 2015.
December 15-16 Meeting/Statement: In its last chance to raise rates in 2015 (as it had promised all year) the Fed finally followed through and enacted its first interest-rate increase in nearly a decade:
"The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective. Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate from 1/4 to 1/2 percent. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate..."
Following this meeting, at the end of December 2015 and in a conventional method used to announce informal Fed policy, a few select Federal Reserve Governors made public 'opinion statements' saying that they expected four additional rate increases in 2016 with rates increasing by 200 basis points (2%). This combo of a very minor rate increase (0.25%) and estimates of four more is what sent the market into a severe downturn in January 2016 that totaled -13%. The Fed wanted to cool off the market, but they got more than they expected!
January 26-27 Meeting/Statement: Frightened by the reaction to their very mild interest-rate increase in December, the Fed became blatantly dovish and put the weight back on a target of higher inflation and didn't mention employment. "Given the economic outlook, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation."
Following the January 27 Fed Meeting and Statement, several Fed Governors made 'opinion statements' that revised the previous estimate of four rate increases and said there may only be one or two additional Fed Funds increases in 2016 rather than the previous speculation of four. The Federal Funds Futures market is now only estimating one additional rate increase late in 2016. This combination of dovish statements and reduced estimates of future rate increases triggered the rally that began on February 12, 2016.
March 15-16 Meeting/Statement: "...the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run."
So the Fed's quarter-point interest rate increase in late December 2015, accompanied shortly after by 'opinion statements' from regional Fed Governors that there would be four additional interest-rate increases in 2016 was the source of the massive selloff that began in the last week of December 2015 through the first six weeks of 2016.
However, the Federal Reserve was caught off-guard by the ferocity of the market selloff, and subsequently unleashed a series of dovish statements and vacillation on whether or not there will be additional interest-rate increases in 2016. This dovish reversal resulted in the phenomenal rally since mid-February.
What happens to the market from here, assuming the Federal Reserve stays quietly on the sidelines with its tail tucked between its legs, is likely subject to other forces. Happily, these financial pressures will have more to do with first-quarter earnings reports and other non-subjective data rather than interpretations of the pronouncements from the central bank's acolytes. We will address the issue of corporate sales and profits later on this page.
ADDITIONAL REASONS STOCKS HAVE RALLIED
1) The Global Economy Has Not Crashed (Yet)
Late last year there were extensive worries about the health of emerging markets as a result of a rising dollar and skidding commodity prices. Europe, Japan, and China were also generating fear among investors because of weakening economies and unique concerns about each. In particular, China was a cause of worry resulting from a tanking stock market that regulators closed whenever a selloff began. Also, to support the market, the Chinese government was openly buying billions of dollars worth of the stocks that were dropping the most. Moreover, the amount of debt that China's government and Chinese companies have accumulated is mind-boggling (more on this in next week's newsletter).
2) The Dollar Has (at Least Temporarily) Fallen from Its Highs
The US Dollar Index ($USD), which tracks the dollar against a basket of other major currencies, closed at 95.08 on Friday, down from 100.5 in December. It also touched this high-water mark at 100 last March. The index has been in a range between 93 and 100 since the beginning of 2015. Before that there was an astounding rise from a steady level around 88 the index had been at for the prior four years (following convulsions related to the financial crisis).
Chart 2 below shows that a robust dollar has a negative effect on the stock market. Since the rise in the dollar that began in mid-2014, the S&P 500 has been in a 200-point range between 1900 as support and 2100 as a ceiling. This adverse effect is largely the result of multi-national US companies and exporters less able to compete in the world market because of the exchange rate.
CHART 2: The value of the US dollar compared to other currencies has a very strong effect on the stock market.
Notice the dollar fell from 100 to 95.5 in early February 2016, which coincides with the rally in the market that began in mid-February. After a brief rise to 98 at the start of March, the value of the dollar has dropped as low as 94 last Tuesday. However, by the close on Friday the dollar was back up a bit to 95.08. These may not sound like dramatic percentage changes, but for a currency they certainly are important because currency changes are small relative to most other markets.
A substantial rise in the dollar is typically the result of favorable comparisons of US economic strength to other countries. For example, it is important to notice that the dollar surged during the 2009 financial crisis and also at its echo in 2010 because most considered the US the strongest economy on earth, regardless of the fact that the economic turmoil originated in the US.
Likewise, beginning in mid-2014, the US was thought to be pulling out of the financial crisis first with steady employment gains and many countries and FX traders anticipated the US Federal Reserve would increase interest rates while other nations were still deeply mired in recession and were experimenting with even more drastic financial engineering and stimulus measures. The widely anticipated increase in US interest rates spurred the dramatic 20% increase in the value of the dollar from 80 to 100 spanning from July 2014 to April 2015.
This increase wreaked chaos on commodity prices worldwide since the vast majority of commodities are denominated in dollars. The effect was most acute in emerging market countries where the jump in the dollar caused their products to be more expensive for other countries to purchase, and their debts (which were also denominated in dollars) more costly to pay. Declining profits and increasing expenses are not a good combination for most companies. The frustrating part for most was that there was nothing they could do about it.
3) The Price of Oil Has Stabilized
Many traders and investors consider the price of oil as a barometer of the health of the global economy and say that the newfound strength in the price of oil is cause to hope for global growth. Regardless, this credit given to global growth is misguided. While supply and demand of oil does play some role in its price, 80% to 90% of the price of oil can be attributed to the value of the dollar (since the wordwide pricing of oil and most other commodities is in dollars).
The recent stability in the price of oil is largely the result of the stabilization of the value of the dollar, and particularly the -6% decline in the value of the dollar since late January. Since the value of the dollar is at the bottom of its current range (around 94), there's a reasonable chance that the trend will reverse higher from this point, assuming it remains in that 100 to 94 range it has been in for the last year.
From a technical analysis standpoint, the range-bound prices from early 2015 to present is a consolidation of the massive increase from 80 to 100 from mid-2014 to early 2015. Following a consolidation, the larger trend of higher prices is likely to resume.
Chart 3 below shows the inverse relationship between the price of the dollar and the price of oil (West Texas Intermediate Crude, $WTIC):
CHART 3: Shows the inverse correlation between the value of the dollar (green) and the price of oil (red).
BUSINESS SALES AND INDUSTRIAL PRODUCTION CONTINUE TO DECLINE
Provided by the Federal Reserve Bank of St. Louis (FRED), Chart 4 shows US corporate sales began to decline in mid-2014, then following a brief upturn in mid-2015, resumed heading sharply lower through today:
CHART 4: US Total Business Sales began declining from a high reached in 2014. After a brief upturn in 2015, sales are now heading lower.
According to Chart 5 by the Federal Reserve Bank of St. Louis (FRED), Industrial Production began turning down before each of the last three recessions and recently has been declining for more than a year. Are we headed into another recession, or is this time different?
CHART 5: US Industrial Production is sinking again as it did before the recessions in 1990, 2001, and 2008.
LEADING ECONOMIC INDICATOR SUGGESTS BUSINESS-CYCLE DOWNTURN
Another piece of evidence in the totality that argues for a defensive rather than offense market posture is the Economic Cycle and Research Institute (ECRI) Weekly Leading Index (WLI). ECRI founder Geoffrey Moore first developed his business cycle and leading indicators in the 1920s, refining them over the decades. Many professional money managers carefully follow the ECRI's subscription-based Weekly Leading and Coincident Indicators.
The chart below shows that the ECRI's Weekly Leading Indicator (WLI in blue) turns downward before a business cycle contraction. You can see that it successfully marked the last two recessions before their beginning. Also, notice that the WLI had been heading downward since mid-2014, when many of the other indicators we have discussed (such as business sales and industrial production, above) marked their peaks.
CHART 6: The ECRI Weekly Leading Indicator has been declining since mid-2014.
REAL-TIME GDP TRACKER POINTS TO JUST 0.3% GROWTH IN US
On April 10 we first reported on the real-time GDPNow tracker provided by the Federal Reserve of Atlanta.
Many economists and market watchers follow the Gross Domestic Product (GDP) number as an indicator of the strength or weakness of a country's economy. However, in the US, that number is released with a substantial lag. An initial 'advance' number is issued a month after the end of a quarter; then it is revised two times. That means that the most accurate readings come out well past the period in question.
Most economists define a recession as two quarters of negative GDP. However, the call on when a recession occurs can be quite delayed. For example, the last recession which started in December 2007 wasn't identified until December 2008 – one year after the fact.
To the rescue comes the Federal Reserve Bank of Atlanta with its 'GDPNow' Forecast. Introduced in 2014, the GDPNow tracker is a model that attempts to mimic the government's estimate of real GDP growth but with rapid updates. The Federal Reserve Bank of Atlanta inputs economic data points as soon as they are released and uses a formula that projects GDP for the current quarter. It updates the GDP estimate shortly after each piece of new data, offering a real-time projection of the pace of US economic growth.
What is shocking to some, but confirmation of our recent documentation of a radical decline in S&P 500 large-cap earnings and negative Russell 2000 small-cap earnings, is that the GDPNow tracker plummeted from a relatively healthy estimate in mid-February of 2.7% (when the rally began) to the most recent reading of just 0.3% last Tuesday (April 19).
Chart 7 below shows an update of the progression of the reading and how it has dramatically dropped off since early March:
CHART 7: The Atlanta Fed's GDPNow tracker has plummeted to an estimated GDP of 0.3%.
Notice that consensus estimates (gray area) are also dropping rapidly.
What is very clear from this graph is that the economic environment, at least based on current data, is rapidly weakening. Notice also that the range of estimates of the GDP by conventional analysts (gray-shaded area) is now also rapidly declining.
The next updates to the real-time GDPNow tracker will be following the Advance Durable Manufacturing report on 2/25/2016 at 8:30 a.m. and also following the Personal Income and Outlays report on 2/26/2016 at 10:00 a.m.
EARNINGS HEAD DOWNWARD AND PE RATIOS CONTINUE HIGHER
We show an updated version of Chart 8 (below) every few weeks and the data continues to get more exteme. The S&P 500 Index prices appear in the top window. Earnings are shown in the bottom window and continue to drop every quarter since the beginning of 2015. However, with prices within 2% of all-time highs (top window), the PE ratio has now also reached extreme highs. As of Friday, the PE Ratio of the S&P 500 hit 24.11, which is the second highest level recorded and higher than the PE of the market just before the 1929 crash that sparked the Great Depression.
CHART 8: The S&P 500 earnings continue to decline and its PE Ratio continues to climb, hitting the 2nd highest level ever!
OUR PLAN FOR THIS WEEK
In the mainstream view, recessions occur following unexpected exogenous shocks that reverberate throughout an economy, bringing it to its knees. Most believe these shocks cannot be anticipated, and thus, there is no way to prepare for them. Take, for example, the subprime mortgage crisis in the US in 2008, which when first making news, Federal Reserve Chairman Ben Bernanke promised it would not spread to other parts of the financial system and posed no threat to the markets.
The next thing we knew, one of the top investment banks (Lehman Brothers) had collapsed, money market funds had 'broke the buck,' and there were the beginnings of 'runs' on main street banks. The S&P 500 had dropped from a high around 1,550 in October 2007 to a low of the 'devilish' number of 666 in March 2009 – a 57% loss in the S&P 500, the most-owned equity index in the world, with daily volume that accounts for 80%-plus of the activity of the entire market.
ON HIS KNEES, BEGGING...
As told by those present at the time, Treasury Secretary Paulson was supposedly on his knees, begging Congressional leaders for bailout money to save the US financial system. That may have been true, because Warren Buffett said in a later interview that we came within a few hours of the financial system collapsing and our ATM cards being worthless.
Whether it is possible to anticipate these shocks is an important question, because otherwise they would not be considered 'shocks.' However, IntelligentValue is tireless in attempting to identify internal cyclical forces that periodically make an economy (and the markets) vulnerable to exogenous events; i.e., shocking events that then can quickly lead to recessions and accompanying bear markets under certain conditions. Absent this underlying cyclical weakness, many surprise economic or other exogenous events do not result in market selloffs or recessions.
Beginning professionally as an individual stock and overall market analyst for a major Wall Street investment house in the early 1980s, there are stock-market days you always remember. I certainly remember multiple fateful days during the period between July 2007 to March 2009 very well. Involved in many exciting market events over the last 35 years that began with an initial shock, I have witnessed many emotional highs and lows from investors, and similar price volatility in the market.
However, I especially remember the July 2007 to March 2009 period the most because it was my first time executing a plan to identify the market's weakness proactively. This source of motivation for this effort were the losses I and my clients incurred during the 2000-2003 market selloff.
Going forward, I sought to recognize, on an ongoing basis, times of potential market fragility and the possible shocks that could trigger a violent selloff as those periods were occurring. If shocks did happen during a period of market lassitude, the objective was to make an accurate decision to move from a 100% invested to a 100% cash position in a portfolio of quality, undervalued companies that I was confident would garner astronomic gains in a short period. The resu!ts of this approach were amazingly profitable!
IntelligentValue identified the internal cyclical weaknesses beginning in the market all the way back in mid-2007, identified the exogenous shocks that were occurring in the economy, and based on technical analysis, exited our stocks in October that year, saving our subscribers from a 56% loss of portfolio value that an average investor experienced. Again, based on well-developed technical analysis, we re-entered the market with our model portfolios on March 9, 2009, and logged a return of 693% in our Conservative Portfolio and 1,649% in our Aggressive Portfolio for the remainder of 2009.
For many of the reasons we have documented over the last weeks and months in our Value Alert Newsletters and Market Risk Analysis (IMRA), we believe the US (and world) economy is cyclically weak and very vulnerable to an exogenous shock that could quickly lead to economic contraction and a market collapse. An exogenous shock could come from any myriad of threats have been well documented, such as a series of defaults on the massive amounts of debt in China.
In that country, the government is forcing banks to lend even more money to otherwise insolvent companies just so they can pay the interest on previously acquired debt. Also, any of many potential large geopolitical or terrorist threats could be the catalyst for a market shock. However, the risks that affect the market are usually totally unexpected, i.e., a 'black swan' event; otherwise, they would not be an 'unforeseen shock' of such magnitude that it causes capacious fear and voluminous selling by frightened investors.
For the reason that the financial system is currently weak and prone to a shock, we believe the proper portfolio positioning is protective/defensive, and possibly we will remain in cash until we have reason to believe that this period of risk has passed. Should an incident occur, one which that causes a bear market to commence when prudently appropriate we will purchase inverse ETFs to take advantage of what will likely be a lengthy selloff.
We would like to say that should the other outcome occur, i.e., a strengthening of the economy and a reduction in risk, we would invest in new long positions. However, with the S&P 500 P/E ratio currently at 24.11 and the Russell 2000 P/E ratio at 'nil' (because the composite earnings of its 2000 companies are negative), it is unlikely we would take a chance on such richly valued markets.
There needs to be a robust and lengthy correction or preferably a bear market. Fortunately, we are quite overdue for one. It may seem unusual for a market advisory website to be hoping for a selloff, but such a severe downturn would create the opportunities upon which savvy investors can thrive. In that situation, IntelligentValue will provide profit-making portfolio guidance during the selloff, identify the bottom, and then select the most profitable undervalued equities for the run back to new highs, just as we did in 2009, which resulted in 600%+ and 1,600%+ returns.
OUR PLAN FOR THIS WEEK
We will remain in cash and will be watching the markets closely. Most indices are losing momentum and may be near rolling over in the thrid leg down of a multi-teired selloff. In order to maintian the established lower-highs and lower-lows pattern that is consistent with a long-term selloff, the next leg down should be much longer then the last two.
The S&P 500 topped out with an all-time high at 2130.82 in May 21, 2015. The first lower high was 2128.28 in July 20, 2015. The next lower high was 2109.79 on November 3, then 2102.63 on December 1. The most recent rally, which started from a low of 1829.08 on February 11 ran to a high of 2102.40 on Wednesday, April 20. That last lower high was just 43 cents lower than the prior lower high, but the critical point is that the series of lower-highs and lower-lows remains intact, and so does the selloff. In order to attain a new lower-low than the low set on Feburary 11, the market would have to drop by at least -13% to below 1829.08 (the previous lower-low set on February 11, 2016).
We hope that we have competently discussed the issues addressed 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.