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QUOTE OF THE WEEK

"I can't change the direction of the wind, but I can adjust
my sails to always reach my destination."


Jimmy Dean

– Enjoy more of our favorite investing quotes –

 


MAY 10, 2016

 

THE FED AND HOW TO PROFIT FROM ITS MANIPULATION

 


Jump Links:

- 19 Months of a Market Going Nowhere
- The Federal Reserve and Its Goals
- The Insanity of Federal Reserve Policy
- Interest Rates at the Zero Bound for 90 Months
- Is a Recession on the Horizon?
- An Inverted Yield Curve Unlikely During This Market Cycle
- Our Plan for this Week

 

 

Over the weekend, we anticipated purchasing some positions that would produce profits if the overall market continued to decline as we expected. We first needed to see the broad indices drop below established support levels, then identify the sectors that were outperforming (selling off more than) the indices of which they are a part. From there we select the best industries that were outperforming their sectors. This can include inverse ETFs but also can include long positions in defensive ETFs or stocks (in a down-trending market).

However, the broad market indices did not follow through with the script for a continuation of the downturn that began following the market high on April 19. They stopped their slide (for now) at their 50-day moving average. We are now glad that we waited to publish this week's Value Alert Newsletter until Tuesday. Otherwise, we may have incurred losses. Such is the nature of this bizarre market in which diverse assets that normally move in opposite directions, such as stocks, bonds, and gold – can all rise at the same time. It is a market that is both confused and confusing.

In this week's newsletter, we provide you with some suggestions for how to profit from such a market. These ideas come from 35 years experience as a professional in the investment world. We hope you find it useful.


19 MONTHS OF A MARKET GOING NOWHERE


When the US Federal Reserve concluded their QE program on October 29, 2014, the S&P 500 closed that day at 1982.30. At the end of last Friday's session (May 6, 2016), the S&P index stood at 2057.14. That is a gain of just 74.84 points in 18 months for America's premier, blue-chip companies, or an average gain of about 20 cents per market session. Put another way; it was an annualized return of only 2.5%. As a comparison, in the year before the end of QE, the return of the S&P 500 was 12.85%.

To make matters worse, the Russell 2000 (small-company index), which is expected to outgrow the more established and much larger S&P 500 companies, fell to 1114.72 last Friday from 1146.37 on October 29, 2014, for a total loss of -2.76% over those 19 months. Again as a comparison, the Russell 2000 index averaged a return of about 20% per year for the two years before the end of QE.

To point out the obvious, the market's performance since the end of QE is disappointing. Needless to say, it is quite difficult for an advisory service such as IntelligentValue.com to achieve positive performance gains in a market that is moving sideways in a very volatile, unpredictable pattern. However, these volatile, unpredictable, sideways patterns are typically consolidations as markets digest the high gains of the recent past. In the last eight months, the S&P 500 has had four swings, both higher and lower, of greater than 12%, and eventually ended where it started.

Nevertheless, we have recently had several Members cancel their subscriptions, stating the reason was our "lack of performance." It would be wonderful if we could pull rabbits out of the proverbial investment hat, but without a trend (either upward or downward) virtually all investment services are dead in the water, and IV is no different in that regard. It is difficult to outperform the market if the market is going nowhere, as has been the case for the last 19 months.

This situation won't last forever. Furthermore, patient investors are invariably the ones who win by sticking with a service that has a successful long-term track record – instead of jumping around and chasing performance from one service to another.

Performance-chasing is a classic error made by inexperienced (and even experienced) investors. Whether it is chasing the performance of a single stock or chasing the performance of a newsletter, mutual fund or hedge fund, human beings are subconsciously wired to buy after returns have been going up (typically near the top) and sell after things have been going down (invariably near the bottom).

This one innate human behavioral error is likely the primary reason that investors lose money in the stock market. Investors are instant-gratification monsters, demanding results NOW and moving on if they don't get them.

THE FEDERAL RESERVE AND ITS GOALS


The US Federal Reserve regularly states that it is serving the goals of its two statutory mandates; 1) to ensure price stability (represented as an inflation target rate of about 2%) and 2) to maintain full employment (an unemployment rate of 4.5% to 5% is generally considered to be 'full employment', i.e., all those who want a job are able to find a job). However, the Federal Reserve has also assumed a third, unwritten goal: 3) inflate the US stock market to create a 'wealth effect' for America's savers and speculators.

It is this third, unwritten goal that the Federal Reserve will never publicly admit to pursuing (although former Fed chairman Alan Greenspan discussed it at length). It is certainly not codified in any statutory language. This third goal of inflating the stock market is unwritten, whispered behind closed doors, and perhaps signaled to one another with a secret handshake, but it might dominate the Fed's thinking far more than its publicly stated objectives.

The Fed's QE program is incredibly useful if the goal was to artificially and temporarily disconnect stock prices from underlying fundamentals or valuation. For example, the Price/Earnings ratio of the S&P 500 is currently near 24 while the PE ratio of the Russell 2000 is at an amazingly high 425. More recently the Russell PE was listed as 'nil' because the total cumulative earnings of America's 2000 small-capitalization, publicly traded companies was negative! Throughout the lives of these indices, their average PE has been around 15. Now it is 24 and 425 thanks to the Fed's manipulation of stocks prices. It is also this manipulation of prices that has caused all the trouble in the investment markets. As is said, "you reap what you sow."

 

A BRIEF HISTORY LESSON ABOUT THE LAST MARKET TOP

The last top of the market was on October 9, 2007. On that date, the S&P 500 closed at 1,556.15. It's a little-known fact that the PE of the S&P 500 on that date was 18.08. Today the S&P 500 P/E ratio is 33% or 1/3rd higher at a PE of 24. The P/E ratio of the small-cap Russell 2000 on October 9, 2007, was 41.42 while today the P/E ratio is more than ten times higher at 425! You can see documentation of these facts for October 9, 2007, using the internet-based Wayback Machine to pull up the Wall Street Journal's page for that date. The current WSJ PE ratios can be found here.

We believe that what the market has experienced over the last 19 months is the summit and initial decline of the third overbought, overvalued market bubble in the last 16 years. A long, rounded, volatile top occurred at the peak of each of the last three Fed-created bull markets. These long, rounded tops are commonly characterized by violent swings higher and lower as the bulls refuse to give up easily, but the bears inevitably win the tug of war based on fundamentals (in today's instance, the second highest market valuation ever recorded is pulling prices downward).


CHART 1: The long, rounded, violent tops have been the result of a Federal Reserve experiment to manipulate market prices.


In multiple Value Alert newsletters since last June (when we called the market peak and began easing out of positions), we have discussed the reasons we believe we were witnessing a classic market top. The market is now entering into a steeper downside phase of that topping pattern, as it loses altitude and gathers momentum. If you have ignored our advice to withdraw your long-only investments, one day soon you are likely going to discover that you are on the wrong side of this trade and will regret it.

Let's take a look at what caused this situation (hint: it is the same thing that caused the last two crashes in 16 years), and see what we can do to profit from the situation. Yes, we actually can make money when the market is heading downward, in significant amounts and in ways you are probably not expecting!


THE INSANITY OF FEDERAL RESERVE POLICY

As we mentioned in our April 24 newsletter, there was recently a substantive study published by ValueBridge Advisors to identify the particular economic forces responsible for significant market rallies since the 1950s. After scouring hundreds of factors that could be responsible for the rallies, based on regression analysis, the firm found four factors that were highly correlated.

One of the discoveries by the folks at ValueBridge was that the Federal Reserve's asset purchases were 93% correlated to the stock market's returns since 2008. The US stock market doubled from the time Quantitative Easing (QE) started in November 2008 to its conclusion in October 2014, but since QE ended 19 months ago, the market has gone nowhere.

During the period that QE was in place, the Federal Reserve effectively flooded the equity market with dollars looking for a return through the mechanism of buying all available short-term bonds at a pace of $85 billion per month. By October 2014, the Fed's balance sheet swelled to $4.3 trillion and succeeded in effectively doubling the level of the stock market. There have been many analysts who have documented the close relationship between QE1, QE2, and QE3 with the market's corresponding surges – and during lapses between each of those programs, market slumps. Chart 2 below shows the growth of the Federal Reserve's balance sheet as it purchased all those bonds and mortgage-backed securities (MBS).

 


CHART 2: The Federal Reserve balance sheet has grown to $4.3 trillion since QE began in 2008. Gray bars indicate recessions.

 

The amount of money the Fed poured into the markets to purchase bonds, thereby forcing private money to find a return elsewhere, is astounding. Uncle Sam was able to build highways, buy weapons, and pay government salaries without having to use taxes or other sources of productivity to finance them. In the words of former Reagan Budget Director David Stockman, the QE program was effectively a $4 trillion free lunch.

Uncle Sam “bridge financed” these expenditures on real goods and services by issuing US Treasury bonds on a interim basis to clear his checking account. But these expenses were then permanently funded by fiat credits conjured from thin air by the Fed when it did the “takeout” financing. Central bank purchase of government bonds in this manner is otherwise and cosmetically known as “quantitative easing” (QE), but it’s fraud all the same.

In essence, Uncle Sam has gotten $4 trillion of “something for nothing” during the last 16 years, while the Washington politicians and policy apparatchiks were happy to pretend that the “independent” Fed was doing god’s work of catalyzing, coaxing and stimulating more jobs and growth out of the US economy.

No it wasn’t! What it was actually doing was not stimulating the main street economy, but falsifying and inflating the price of financial assets.

 – former Reagan Budget Director David Stockman

 

The Federal Reserve's blatant attempts at market manipulation involved creating trillions of dollars in 'electronic credits' (no actual dollars were printed) to buy bonds and effectively reduce interest rates even further than the zero bound currently allowed by law. Interest rates this low for this long is unprecedented and was never envisioned at any time in history. Conservative investors, instead of finding a satisfactory return in the safety of Treasury bonds, were forced instead to place those dollars into the equity market seeking a better return in riskier dividend-paying stocks, thereby creating what Alan Greenspan, the father of this modern-day Fed policy called the "wealth effect." Greenspan's acolytes, Ben Bernanke and now Janet Yellen, have carried on the Grand Wizard's plan.

Greenspan's 'big idea' was that if people feel wealthy as a result of their 401k/investment account balance (and real estate values), they more freely spend money; thereby creating demand and making the economy percolate. Talk about "trickle down economics!" This is a new version, never before envisioned by Reaganites. Therefore, the Fed's modus operandi became an effort to fuel the stock market to bubblicious heights! How anyone, especially a vetted, seasoned economic professional, could come to this circuitous conclusion and continuously place the health of American commerce in jeopardy by creating recurring equity market bubbles (and their inevitable crashes) is flabbergasting. That his two indoctrinated successors (Bernanke and Yellen) would enthusiastically follow the same path is equally mind-boggling, especially after they witnessed the prior crashes in 2001-2003 and 2007-2009 following previous Fed-induced market bubbles.

The current plan apparently includes keeping short-term interest rates near the zero bound, where it has lingered for an astonishing 90 months now. At the end of December when the Fed raised rates a very modest 0.25%, followed by jawboning about the prospect for an additional four more raises in 2016, the market plummeted sharply for six weeks. That caused the various Fed-Governor spokesmen to back off the possibility of further rate increases first to two and then (maybe) one. Subsequently, the market came roaring back during February to April. (See our documentation of the Fed-created roller-coaster from August 2015 to present.)

 

INTEREST RATES AT THE ZERO BOUND FOR 90 MONTHS


What is the great financial emergency that justifies interest rates near zero for 90 continuous months? There is not one! There is a structural growth problem that is part and parcel of the aging of the baby boom, which for 60 years was the bulge of a large economic rodent moving through the Python of time. However, interest rates at zero have little or no effect on structural situations of this type. Demand slumps as people age; it is a fact that will never be ameliorated by any accommodative Federal Reserve policy. America has substantively and structurally changed, and Fed autocrats need to accept that fact.

The same thing has happened in Japan. Japan's biggest economic problem is that it has an aging population, the birth rate is extremely low, and it does not allow immigration. In summary: the country is not growing, it is steadily dying. However, similar dull minds in that country's government are stubbornly trying to re-create the glory days of the Empire of the Sun by submerging the country under enormous amounts of debt to 'stimulate the economy.' Sound familiar? This has been going on since the early 1990s in Japan. The debt-to-GDP ratio in that country is at an obscene 220%, and the country is still pushing deeper into efforts at economic manipulation, now with negative interest rates.

To put today's US yields in perspective, at the start of the Great Depression, the 10-year yield was about 5%. By the end of the Great Depression (usually marked as 1941), the yield was at 2.5%. Today the 10-year Treasury bond yield stands at just 1.78%, lower than it ever was during the Great Depression (and we are nowhere near Great Depression conditions).

The Fed's goal was ostensibly an attempt to stimulate demand and spark new life into the economy, thereby increasing demand for labor, increasing wages, and prompting mild inflation. However, in that regard, it has seemingly accomplished little or nothing. The chart below shows that in the last 16 years, total employment hours have increased a total of only 2%; not even keeping up with population growth:



CHART 2: Employment hours have only increased by about 2% since 2000, despite the massive Fed intervention.

 

The only thing that interest rates at the zero bound have accomplished is to increase debt dramatically, at least for corporations and the government. If you make money practically free to borrow, both companies and governments are going to do 'financial restructuring' that benefits themselves. Individuals and families are still deleveraging since the crisis and are showing no interest in assuming more debt. Therefore, the Fed's efforts at stimulating demand through increased borrowing are failing miserably. That said, personal debt is still 175% greater than total wages and salaries (down from a peak of 220% in 2007), so individuals and families continue to be mired in too much debt.

The current economic cycle is one of the least potent of any recovery since the Great Depression. Many on the right blame this on President Obama, but that is absurd. After a financial crisis such as occurred in 2008, it will probably require 10-15 years from which to recover, regardless of who holds office. That said, the gridlock in Washington that blocked bills to rebuild America's crumbling infrastructure could have turbocharged the US out of the Great Recession. The election that is occurring now is a reflection of America's frustration with a do-nothing Washington that was more concerned with shutting down the government than with getting anything done that could have helped people.

The Fed's repeated unusual approach to try to stimulate the economy has only succeeded in producing the third massive asset bubble of the last 16 years. However, apparently pricked by a typical business-cycle downturn rather than Fed interest-rate increases, the current asset bubble may be in the early stages of deflating.

While surely well-meaning, the Keynesian knuckleheads at the Fed are doing the devil's work once again. They are still living in a Keynesian paradigm they apparently were taught in grad school 40-50 years ago. America is no longer an economy based on manufacturing where low-interest rates would allow investment in plant and equipment that wouldn't otherwise occur. Americans no longer want anything to do with the real-estate boom and crash that accompanied the last Fed-produced interest rate manipulation.

Companies are borrowing money at low rates, but it is primarily being used for the purpose of buying back stock. Even Apple, Inc. (AAPL), which has hundreds of billions of dollars of cash on its balance sheet, was convinced by corporate activists to issue long-term bonds at super-low rates to buy back their stock. None of this borrowed money is being put to use in ways that will enhance future growth. Why? Because America's companies know that the era of increased demand and growth is behind us!

The next stock market crash may be just beginning and could again devastate the fragile US and world economy. The violent rumbling began last August. The cornice has slid off the top of the mountain. It will soon become a massive, roaring stock market avalanche, picking up steam and accumulating energy as it accelerates downward, creating an economic alluvial fan that spreads wide and decimates the hard-earned savings of the oblivious townspeople below – for the third time in 16 years.

Will the Fed learn after this and stop the blatant but unsuccessful attempts at manipulation of the financial markets? We think that is very likely. Power is a difficult thing to give up once one has acquired a taste for it and especially if that group of people believe they are doing work that is profoundly important for the success of the world (they do).


IS A RECESSION ON THE HORIZON?

 

We keep a list that we regularly check to determine if a recession is imminent:

1) Is the Federal Reserve tightening rates?  Yes.  It tightened in December 2015 and is stating that next month (June) there is the possibility for another increase and still another later in the year. (It is yet to be determined if this is real or just talk intended to subdue overvalued markets.)

2) Are valuations stretched? Yes.  The PE ratio of the S&P 500 is at 24, the second highest PE level* in the last 100 years. Other measures, such as the PE10 (Shiller PE), Total Market Cap/GDP (Buffett's favorite), and Total Mkt Cap/Corporate Value Added, and other measures are all at their highest or second highest level in history. Each market cycle when these measures reach overvalued levels is followed by a market decline that averages 40%-60%. (*Excludes the brief period in the 2008/2009 crash when earnings temporarily dropped to near zero, thereby spiking the PE ratio based on anomalous data.)

3) Is there investor euphoria? Moderate.  The majority of articles we read, commentary by advisors on TV, and analysts on the internet are bullish. There are some pockets of concern, but most are looking for another upturn similar to the February–April rally instead of a continuation of the risky/bearish conditions we believe began at the high in May, 2015.

InvestorsIntelligence.com Advisor's Sentiment reading is published every Wednesday and is watched closely by industry professionals. Advisor Sentiment is a contrary indicator and while it closely tracks the ups and downs of the broad market, the higher the reading (bulls significantly outnumbering bears), the more likely there will soon be a market downturn. Conversely, the more that bears outnumber bulls (such as late 2011, August 2015, and February 2016, the more likely we are near a turning point and the market will soon shoot higher.




CHART 3: Advisor's Sentiment is moderately high; still below the danger zone above 30.


According to Investor's Intelligence Editor John Gray, currently the number of Bullish advisors stands at 39.2, down from the 2016 high of 47.4% set in mid-March, and down from 40.2% last week. The Bull/Bear spread narrowed last week to 17.6%, which is neutral. Highs above 40% call for serious concern while negative reading, such as -14.5% in early February 2016 was favorable for accumulation. We have seen some criticize the tool as useless because it 'just follows the market,' but its value comes in the height of the spread between bears and bulls.



4) Are Transportation and Financial stocks declining?  Yes. These two sectors, more so than others, are bellwethers of the economy. If commerce is not healthy, then businesses and individuals no not need loans or other financial services to expand and grow. Transportation is also a key industry to monitor because it is a leading indicator of economic health based on its intermediary position as the mover of goods between businesses and consumers. Both sectors are in downtrends, as shown in the charts below:

 


CHART 3: Transportation stocks are in a downtrend.

 


CHART 4: Financial stocks are in a downtrend.

 

5) Is the yield spread inverted? No, but heading that direction.

A chart of the US 10-year Treasury bond yield versus the two-year Treasury bond yield has historically been a valuable tool for predicting recessions. The yield on a 10-year bond is typically much higher than that of a short-term bond because you are tying your money up by lending it to the government for a longer period of time. There must be compensation for this inconvenience. However, as times begin to look more troubling, investors seek safe havens for their money and the demand for longer-term bonds (such as 10-year Treasury bonds) declines, which forces their yields to decline. Investors are more interested in short-term investments because the future is uncertain.

Also, late in the business cycle the Federal Reserve is frequently fighting against overheated markets including stocks, real estate, and sometimes inflation is an issue. The Fed's tool of choice to fight overheated conditions and inflation is to raise the interest rate on short-term (two-year and under) Treasury-bonds. The classic sign that a recession is imminent is when the two-year Treasury yield surpasses the yield on the 10-year Treasury bond. This is called an 'inversion of the yield curve.'

In the chart below, you can see that there was an inverted yield curve in 2000-2001 preceding the 2001–2003 recession. The yield curve also inverted starting in 2006 and 2007 before the Great Recession hit at the end of 2007 through early 2009.

Chart 5: The yield curve is not yet inverted, but is because the Federal Reserve still has rates pegged near zero 90 months after first dropping them to near zero in late 2008.


AN INVERTED YIELD CURVE UNLIKELY DURING THIS MARKET CYCLE


Since modern-day Keynesian manipulation of interest rates became a method for central banks to attempt to manage economic cycles, an inverted yield curve has always been a consistent harbinger of a recession. However, we are not yet seeing an inversion of the yield curve at this time. There still is at least a 1% gap between the short-term and longer-term yields. That said, in this market cycle we don't believe there is any chance we will see an inverted yield curve. For perhaps the first time ever, we can legitimately say that 'this time is different.'

Read more about how yield curves work and why it is extremely unlikely we'll see an inverted yield curve this time around in the Supplemental section of this newsletter.


OUR PLAN FOR THIS WEEK


We were planning on purchasing inverse ETF's or defensive positions for both of our portfolios this week. However, charts showed that prices had not pierced key moving averages, and we chose to wait a day or two to see if that would occur. With millions of technical-oriented investors watching these important moving averages, it is critical to making sure that we are on the right side of the trade with regards to all of these other millions of investors.

Unlike fundamental-based investing, which includes factors and formulas such as P/E ratios, price-to-sales ratios, net assets-to-operating income, and thousands of other variations, technical analysis is not subject to curve fitting or data mining. When choosing stocks while using fundamental analysis, we want to make sure that we do not base our backtesting on spurious correlations that will not stand up in the future.

That said, when backtesting using technical analysis formulas, we want to find those that consistently worked in the past on as many different stocks, indices, or ETFs as possible. Technical analysis is different from fundamental analysis in that decision made based on price and volume do not go out of style for lengthy periods such as decisions made based on growth or value factors.

For example, value-based fundamental factors and formulas produced lousy returns from the mid-90s through mid-2000. Growth-based fundamentals were king during that period, but after mid-2000, value factors worked wonders for a while. Nonetheless, formulas based on technical analysis, price, and volume, operated well throughout that entire period without fail and worked throughout any period, whether we are talking about decades, years, months, weeks, days, 10-minute periods, or one-minute periods. Technical analysis is fractal in nature and infinitely malleable relative to scope and time-frame.

Here's what we saw over the weekend with the S&P 500 that made us hold off on picking ETF's that were bets on a continuing downturn. The S&P 500 index had formed a very clear head and shoulders pattern, was directed towards its 50-day moving average (blue dotted line) just below the right shoulder but had not broken through yet:




CHART 6: At least for now, the S&P 500 bounced off its 50-day moving average. We need to see it break below both the 50-day and the 250-day MA before proceeding with the purchase of defensive/inverse positions that will profit.


Similarly with the Russell 2000, the index bounced off of its 200-day moving average (red-dotted line) on the upside, and it's 50-day moving average (blue-dotted line) on the downside. It is trapped between those two lines and we do not want to make a recommendation to subscribers until we see it break one direction or the other:


CHART 7: The Russell 2000 Index is trapped like a ping-pong ball between the 50-day moving average (blue-dotted line) and the 200-day moving average (red-dotted line).

 

Should we get a break in either direction from either of these two indices, we will next look at the sectors that are outperforming (leading) the index in that direction. Then, based on that analysis, we can drill down even further to identify the industries that are contributing the most to the leading sector's performance.

We find that by identifying the smaller components that are making the strongest contribution to the movements of larger indices, we can substantially increase the returns of our portfolios over simply buying an inverse ETF of the broad index. If you have questions about this approach, please feel free to contact us.

Best Wishes for Another Week of Intelligent Value Investing,
IntelligentValue.com

 

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DISCLAIMER
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.