QUOTE OF THE WEEK
“There never was a sounder logical maxim of scientific procedure than Ockham’s razor: 'Entia non sunt multiplicanda praeter necessitatem.' That is to say; before you try a complicated hypothesis, you should make quite sure that no simplification of it will explain the facts equally well.”
—Charles Sanders Pierce
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MAY 2, 2016
WILL THE BEAR MARKET RESUME?
Following a powerful but not unusual bear-market rally of nearly 15% that started with the S&P 500 low on February 11 at 1829 and apparently concluding on April 20 with a high of 2102, objective evidence points to the bear market that began with the all-time high last May now heading lower (again).
If we see further confirmation of the downturn and some critical support levels broken, we will add inverse ETFs to our portfolios. In a bear market, which we believe started at last summer's highs, the only options are either to sit on the sidelines in cash or to make money from the decline in prices by using inverse ETFs (we don't use other shorting methods). Subscribers have the option to disregard our inverse ETF recommendations if they are uncomfortable with that type of investment. The value of your subscription then becomes one of using IV for accurate timing of the markets.
We have nailed market exposure decisions with a near-100% track record since we began to use technical analysis for market timing in late 2006. In 2007, we exited all of our positions in mid-October and in 2009, we famously called for an upturn and bought full portfolios of stocks on Monday, March 9. Those decisions resulted in 600%-plus and 1,600%-plus annualized returns in our two model portfolios for the remainder of 2009. We still have double and triple digit gains in our portfolios seven years since those decisions, so we have correctly made decisions to be fully invested, partially invested, or out of the market multiple times since 2009.
We will first begin with a review of the three most relevant market indices, the S&P 500, the Russell 2000, and the Nasdaq 100 to determine if there are currently any low-risk opportunities to profit in this market. We say 'low risk' opportunities because bear markets are notoriously volatile. As we documented last week, there have been four violent moves greater than 12% in the S&P 500 index since August 2015. Bear markets provide ample opportunity to get trapped in bad trades because of their unpredictable 'stairstep up' and 'elevator down' pattern.
S&P 500 (LARGE-CAP) INDEX
The S&P 500 is the index least likely to sink in a bear market. The reasons for this are three-fold; 1) the index contains the largest, most well-established companies, 2) it is the index most widely used as a benchmark by institutional investors, and 3) during a bear market, money flows out of more risky investments and into the highest-quality, safest investments available. This group of safe investments is rather small and would include US Treasury bonds (on the extremely safe end) and the S&P 500 index (on the more risky end) as examples.
Nevertheless, after setting an all-time closing high at 2130.82 last May 2015 and a lower high of 2109.79 in November 2015, last week the S&P 500 logged its third lower high in the past year at 2095.15. Chart 1 below shows the succession of these three lower-highs, accompanied by two lower-lows in August 2015 and February 2016. A series of lower-highs and lower-lows is the definition of a market in a downturn. After steadily climbing since 2011, we believe the S&P 500 is in the violent death throws that regularly occur when bull markets morph into bear markets.
CHART 1: The S&P 500 Index is setting a series of lower-highs and lower-lows. Has the next big leg downward begun?
RUSSELL 2000 (SMALL-CAP) INDEX
In a downturn, we are more likely to see rapid and severe selling in indices that contain more risky investments, and that is exactly the case with the Russell 2000 small-capitalization index. Chart 2 below shows the Russell 2000 index with a series of lower-highs and lower-lows, this time in a much more apparent downturn than the S&P 500.
The Russell index set its all-time high last June at 1284.66, proceeded to set a lower high at 1202.38 last November, then went on to set a low at 972 in early February. That's a -24.34% loss before the Russell index also went on a 19% February-to-April, bear-market rally to 1154.15, where it peaked last week before turning downward.
CHART 2: The Russell 2000, small-cap index has set a series of lower-highs and lower-lows since its all-time high last June.
You might reject these series of lower-highs and lower-lows as insufficient evidence that a bear market is in place. Moreover, you would be correct – except for the fact that there are a significant number of additional data points that tell us we are in a bear market.
One example of those data points is the weekly RSI. As shown in the lower windows of Charts 1 and 2 above, the weekly RSI for both the S&P 500 and the Russell 2000 is vacillating below the 60 level following their peaks last summer. During bear markets, the weekly RSI stays in a range below 60 (in bull markets it remains in a range above 40). There are many other technical indicators we could identify, but regular readers know we have discussed them in previous issues of our Value Alert newsletters (see the 2016 index).
NASDAQ 100 INDEX
Not to be left out are the 'cool kids' on the block, the Nasdaq Composite, and the Nasdaq 100 indices, which feature technology, e-commerce, social media, biomedicine, and other contemporary businesses. Nasdaq stocks are also on board the bearish train and last week may have started another leg down following its previous downturn in December/January.
Chart 3 shows that our Intelligent Trend Indicator (lower window) gave a 'Sell Signal' for the Nasdaq 100 (QQQ) at the beginning of last week. The Intelligent Trend Indicator (ITI) measures changes in price momentum in a stock or an ETF and identifies, with a red signal line, the points when the trend changes from bullish to bearish (and vice-versa).
We believe that this index has room to run at least -8.5% lower based on the current position of the lower Bollinger Band. Notice that when an index breaks below the lower Bollinger Band, as occurred most recently in the second week of February, it is very likely to begin a strong rally afterward. The Nasdaq 100, which includes the 100 largest Nasdaq stocks, has room to run downward for multiple weeks from here. Of course, a 'geared' or leveraged inverse ETF can capture double the price change in the index upon which it is based. That could result in a quick gain of about 16% for a 2x leveraged inverse ETF, such as QID, based on the Nasdaq index declining -8.5%.
CHART 3: The Nasdaq 100 ETF (QQQ) recently received a Sell signal from our 'Intelligent Trend Indicator.'
That said, at this time we will not be investing in an inverse ETF tracking the Nasdaq 100 or inverse ETF of any of the other primary indices, for that matter. Our plan for magnified profits is to invest (when appropriate) in inverse ETFs of the sectors and industries that are providing the greatest relative outperformance compared to their index. In this way, we can achieve much higher returns, regardless of whether market movements are to the downside or the upside, as well as reducing risk.
However, the time for putting money to work is not yet at hand. We need to see the development of further downward momentum, as well as see indices and sectors/industries break key support levels.
DECLINING PROFITS + HIGHER PRICES = SKYROCKETING PE RATIO
Every few weeks we present an updated version of Chart 4 (below), and the data continues to get more bizarre. S&P 500 Index prices appear in the top window while we show S&P 500 earnings in the bottom window. As you can see in the bottom window, there was a drop in earnings every quarter since the beginning of 2015. Anyone who is keeping tabs on the current earnings reports for 1st quarter 2016 knows that corporate profits are coming in much lower once again. For example, Apple, Inc. reported overall revenue down 12.8% and net profit down 22.8%.
The chart below reflects the fact that at the end of April on Friday, earnings appear to be declining again for the 2nd quarter of 2016, possibly making it the 5th quarter in a row. This is unprecedented in the history of the market!
Nevertheless, speculation (apparently based on the greater fool theory and belief in the Fed 'put') pushed S&P 500 prices back within 2% of all-time highs last week (top window). A combination of rising prices and declining earning has resulted in a Price-to-Earnings ratio for the S&P 500 that has now reached extraordinary levels. As of Friday, the PE Ratio of the S&P 500 was 24.12, which is the second highest level recorded since 1900 (highest was at the dot-com bubble) and higher even than the PE of the market before the 1929 crash that sparked the Great Depression. (*Note: We are exluding the anomalous period in 2009 when S&P earnings went to near-zero, thereby causing the PE to temporarily shoot sharply higher based on spurious data.)
CHART 4: The S&P 500 earnings continue to decline and its PE Ratio continues to climb, hitting the 2nd highest level ever!
Small-cap companies are always trying to outdo their larger brethren, and after weeks of being reported as 'nil,' the Russell 2000 cumulative earnings finally broke above zero. The Wall Street Journal is now reporting the Russell PE ratio as being 401.25. In that light, the S&P 500 PE of 24.11 is not so bad after all. At least that's how the perma-bulls would justify it, right?
At this time, declining earnings and record-setting PE ratios are probably not something that can be adjusted away with expense cuts or employee layoffs. The reason for this is that US public corporations are also experiencing a rapid decline in revenues since late 2014 to accompany those declining earnings discussed in the last section.
The chart below shows that the decline in sales is not as fast-paced as the one during the 'Great Recession' in 2008-2009, but still much steeper than the flat sales that occurred in the second half of the prior market crash in 2001-2003.
CHART 5: The
top-line revenues of US corporations are declining precipitously. Interestingly, the market has not (yet) sold off sharply to accompany the declining sales and earnings.
What's different this time around is that there is not (yet) a severe market selloff to accompany the rapid decline in both sales and earnings. In fact, S&P 500 prices are still within 2% of their all-time high. Does this mean that a market crash is forthcoming? Alternatively, perhaps that the perceived Fed 'put' is responsible for the levitation of the market based on the prospect of lower or negative interest rates (as is being tried, unsuccessfully, in other countries)? Alternatively, could investors even consider that the Fed might reinstate the QE program, which Fed Chair Janet Yellen recently hinted was a possibility?
As we discussed in last week's Value Alert newsletter, a study by FedDashboard.com measured the effects of four different economic forces to see what was responsible for various bull markets since the 1950s and found through regression analysis that the Federal Reserve is responsible for 93% of the current stock market's returns since 2008. The prospect of the Fed coming 'to the rescue' of the markets is the only logical reason that can justify such expensive market prices in the face of declining fundamentals.
RECORD CORPORATE DEBT LEVELS
The prospect of everything coming unwound all at once is frightening when you consider the amount of debt that is currently on the balance sheets of US corporations.
Corporate leverage reached an all-time high in December and dropped only slightly in the last four months. Based on data provided by Compustat, CapitalIQ, and Standard and Poors, our analysis shows there is about $23 trillion in cumulative debt for 8,960 US-based publicly traded companies in our database. Standard and Poors estimates that total corporate debt is even higher, totaling about $29 trillion.
The chart below shows this cumulative debt was on a very steady growth track through mid-2007, reaching about $14 trillion. Then in late 2007, debt shot up sharply by $5.5 trillion and peaked at about $19.5 trillion. It is unclear what the impetus was for this growth in additional debt, but it was the fastest growth of corporate debt in any single year on record.
However, following the credit/debt-based market crash in 2008, corporations began to deleverage, and the amount of debt dropped back to about $16 trillion. Regardless, the Federal Reserve didn't want companies to de-lever, as that would contract the economy further. Therefore, they offered corporations and other borrowers a deal they couldn't refuse; interest rates at record lows. Borrowing began to get popular again, and (as shown in the chart below) the amount of debt increased sharply higher in 2010.
As you can see from Chart 6 below, the growth of corporate debt since 2012 has been relatively steady and then actually flattened since the middle of last year:
CHART 6: The amount of corporate debt has reached an all-time high at about $23 trillion. Standard & Poors estimates the amount of corporate debt is even higher, at about $29 trillion.
Could this slight decline in debt be a result of the Fed stopping its QE program in late 2014? Or could it be because corporations are finding it more difficult to make the payments on their debt? Chart 7 below shows the amount of corporate debt relative to total sales (red line) for all stocks:
CHART 7: The amount of corporate debt relative to corporate sales shows that there has been a sharp spike in this measure since late 2014.
It is evident that there was a sharp rise in the amount of debt relative to sales beginning in late 2014. If you compare Chart 6 (total corporate debt) to Chart 5 (total corporate sales), you see that debt remained reasonably steady while corporate revenues plummeted beginning in late 2014. The reason we are using sales as the denominator is that it is the most consistent measure available that doesn't include negative numbers (which occurs in Net Income and even in Operating Income).
Here's Why You Should Be Concerned About Corporate Debt:
According to Standard and Poors, one of the world's leading rating companies, in 2015 debt at global companies rose to 300% of earnings before interest, tax, depreciation and amortization. S&P downgraded 863 corporations in 2015; the most downgrades since 2009.
The reason for companies taking on so much debt is because central banks have made it so cheap to do so. Regardless, most of that debt has been spent on short-term boosts that provide no long-term growth, such as a $3.8 billion M&A binge, share buybacks and temporary dividend increases.
All the rage is 'financial engineering,' which even the largest company in the world, Apple, Inc. (AAPL), was forced to do under the pressure of corporate activist Carl Icahn. Companies borrow money at low-interest rates for the purpose of getting brief increases in share prices, thereby allowing the corporate officers to trigger incentives in their compensation package that rewards them for higher stock prices. It is a strange world engineered by the Federal Reserve in which corporations are buying their shares to juice the price and corporate officers are then dumping their shares on the market at the new higher prices.
OUR PLAN FOR THIS WEEK
Will make no changes to our model portfolios at this time. We need to see more confirmation of downward prices and a break through some key support levels. Once that occurs, we will likely be purchasing inverse ETFs to profit from what we continue to believe is a classic bear market. On average, bear markets last 14 months, so there is plenty of time to get on board the selloff trade when we see a clear signal.
However, as discussed in detail in last week's newsletter, market prices currently seem to be more dependent on Federal Reserve monetary policy that on actual corporate sales and earnings. This situation cannot last forever, but how long can it last? That is unknown; we have never experienced a situation similar to this in the past where Keynesian-bureaucrat talking points are stronger than stock fundamentals, but that may be what is happening.
That said, technical analysis of market prices continues to work in any environment – regardless of whether fundamentals, government policies, or anything else are the drivers of price levels. We are closely watching those important technical levels for a signal to enter a high-probability trade. We will send an email notice to IntelligentValue Members when we see a clear opportunity for profits and add new positions to our model portfolios.
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 the market and 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,
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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 IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.