THE ROLLERCOASTER CONTINUES

After a bevy of positive news stories that brought clarity to the market on Thursday afternoon, the price action on Friday was disastrous for long-only investors. The S&P 500 and other market indices sold off virtually all day. The S&P lost 32 points on its way down to 1,064, losing 2.88%.

Since the S&P 500 closed at a rally high in late April, it has changed direction, on a week-to-week basis, nine times out of the last twelve weeks. This wild, rollercoaster pattern has been constrained only by a series of lower highs and lower lows, creating whipsaws within a severe downtrend.

The S&P 500 is in a clear downward trendline since the late April high. Chart courtesy of StockCharts.com.

Should the downward trend continue with yet another lower low, the current trend channel would put the low at around 800 on the S&P 500. That's about 25% lower than today's price - an enormous drop that would devastate the economy. What's more likely is that the downtrend will stop, at least temporarily, at the 1040 or 1010 level, previously established support levels of the S&P 500.

Providing further technical support at 1010 is the fact that it's a 61.8% Fibonacci retracement of the rally from the low at 666 on March 9 to the peak at 1220 on April 26. Should this level be broken, the next support level is at 940, a 12% decline from current levels.

Breadth Indicators Remain Bearish

The chart below shows the S&P 500 on top, with the Advance/Decline line, the A/D Volume line, and the Net New Highs-New Lows below. The top chart shows that market participants are still paying close attention to the moving averages. The S&P 500 traded right to the 50-day Moving Average on the top side three times since the late April high, then quickly reversed course lower. On the downside, the flattening red lines show that the severe downtrend may be slowing.

The second chart shows that the net Advances/Decliners has been in a flatline since the late April high, but appears to be turning down with Friday's big selloff.

The third chart is of the Advance/Decline Volume, which has been steadily declining since the April high; this is very bearish.

The bottom chart of Net New Highs/Net New Lows has also been showing weakness, based on the red area indicators and a very constrained ceiling to the upside. This chart would need to show a breakout above 100 in order to indicate that a reversal is possible. The level is currently at 70 and dropping.

GOOD NEWS QUICKLY SQUELCHED

I mentioned good news at the end of the day on Thursday. This included news that the BP oil well in the Gulf of Mexico had been successfully capped with test equipment designed to measure the well's pressure. Although this story is far from over, it was a very positive development.

The second news item pertained to the Goldman Sachs fraud case. The SEC announced that the case had been settled, and settled very much in Goldman's interest. The company, indisputably the premier franchise in the world of investment banking, did not have to admit wrongdoing (they only admitted a 'mistake' in the marketing materials) and paid a fine of just $550 million, or about 2.5% of just one month of the firm's revenue. Goldman had to admit that there was a "mistake" in their marketing literature on the fund in question.

The final news was that the Senate had passed the final version of the massive regulatory reform bill, which gave clarity to the limitations that would be placed on the banking system. With these announcements on Thursday afternoon, the markets shot sharply higher, from a low of 1080 on the S&P 500 to close the day higher at 1096.

In the middle of the day on Thursday, we were holding short positions in our MARKET TRENDS and TURBO TRENDS Portfolios on Collective2. These positions were fragile, because although the long-term (weekly) trend was down, the short-term (daily) trend was higher. When the market reversed course on Thursday afternoon, we were whipsawed in the wrong direction on our short positions and we closed them out to avoid further losses. We opened the short positions again on Friday because the weekly and daily indicators are now synchronous (declining).

With the very positive earnings reports and the clarity on these three issues (supported by the very positive market price action), it appeared that the market had a strong chance of moving higher. The fact that the 50-day EMA held as support for the market indices would usually be a signal of a likely positive breakthrough. Obviously, it didn't play out like this, as the market plummeted down sharply on Friday.

Investors Intelligence, the highly regarded technical newsletter with whom we have a reciprocal relationship, also made a (contingent) bullish call after Thursday's market action: "Indexes are still all up for the week. Providing they can hold out into the close today, then the week has been encouraging for the short-term, given the negative news flow and avoidance of profit taking following the sharp gains of last week."

The firm noted that 5 out of 6 of its proprietary indicators were either "Bull Confirmed" or "Bull Alert." The new indicators we are now watching are also showing that the prospects for a bullish turn higher have improved. We may see a reversal this week.

dissapointing economic news

While a 2.5% decline is bad enough, it could have been a lot worse. In the S&P 500, only 10 stocks traded higher on Friday and 489 traded lower (one was unchanged). Every single one of the 30 Dow Industrial stocks were lower, led by Bank of America with a decline of -9.2%, Cisco with a decline of -4.9%, American Express with a decline of -4.7%, and General Electric with a decline of -4.6%. These four companies cover the spectrum of what should be the industries leading the economy higher, i.e., Financials, Communications/Internet, Transportation/Shipping, and Industrials, respectively.

In March 2009, at the very bottom of the bear market selloff, economists had very low expectations. Economic indicators were routinely coming in better than expected because economists extrapolated the previous weak indicators even further down. These surprises, as well as very aggressive moves by the Federal Reserve, fueled the about-face in the equities market and the start of a one-year bull rally.

On the other hand, recent economic reports have been struggling to live up to expectations. A study by market-analysis firm Bespoke shows that "in the last two weeks, 11 of the 21 indicators released were weaker than expected. Three reports were inline with estimates, and 6 were better than expected.  It now appears that economists have been too slow to pull back estimates as well, and this is weighing on the market."

In particular, an increase in continuing jobless claims, declining retail sales figures, the lowest pending home sales on record, a whipsaw down in the ECRI growth of the economy, and an enormous drop in consumer confidence has both me, and apparently the market, concerned.

Was the rally that began in March 2009 just a bounce in bear market that will take stocks down even lower than the March 2009 low? It's possible, but statistically unlikely. The stock market regularly goes through 17 years of range-bound, sideways consolidation following 17 years of growth. The last consolidation period was from 1966 to 1982. The last secular bull period was from 1982 to 2000. At that time, the market gained 66% from its low to the high about 1-1/2 years later, followed by a decline of about 50% before resuming higher.

We are currently in another consolidation that started in 2000. It is possible that the Dow could head back down to the March 2009 low of 6600, but history shows that the downturn in the middle of these long-term consolidations is usually the worst. The bad news is that there haven't been many of these long-term trends on which to base expectations. In one ominous series, the Great Depression, the market did decline below the initial low. Let's hope that doesn't happen again.

As I noted in a prior newsletter, NIPA profits, based on the U.S. Bureau of Economic Indicators data, and totally independent from S&P analysts estimates, is showing the equivalent of a $92 profit on the S&P 500 earnings. That is a yield of a whopping 8.63% for the S&P 500 based on Friday's close. Compared to the 2.9% yield on 10-year Treasuries, the stock market should move higher after the most recent downturn. The opposing argument is that after the thrashing of the last few years, investors are more interested in return OF investment than they are in return ON investment. This makes estimating the bottom of the May-June-July selloff difficult.

DO THE OLD RULES NO LONGER APPLY?

In a market dominated by high-frequency, option, and computer-controlled trades, it has been extremely difficult for an individual investor to navigate to profits. In a Barron's article this weekend, options guru Bernie Schaeffer pointed out that many of the investing rules that used to work so well before, are no longer viable; for example:

When a stock breaks out and makes a 52-week high, the previously successful trade was to jump on board and buy the stock for the big follow-through rally. In the last year, that trade has not worked as high-frequency and computer-based traders used 'mean reversion' statistical algorithms to create enough selling pressure to turn the 'breakout' into a 'breakdown.'

Extremely 'oversold' stocks were usually a solid bet if an investor would simply hold onto the position long enough to allow it to have an oversold bounce. Excessive selling used to clear out the overhead resistance, allowing buyers to move in and move the stock higher. This trade is now working the opposite of the first example, as overextended put sellers reverse their option positions to short the stock in hopes of avoiding heavy losses.

Blake LeBaron, a finance prodessor at Brandeis University, has extensively analyzed various technical indicators and is seeing some concerning trends. Professor LeBaron believes that using moving average systems for estimating future stock price performance have stopped being profitable - the result of too many people trying to use them. As individual investors flocked to personal computers in the late 1980s and 1990s, accompanied by a plethora of software programs and websites devoted to investing, the moving average became an easy way to estimate where prices would be at some point in the future. I agree with Professor LeBaron. I haven't done a scientific study, but I do know that the signals we used to get have failed to pan out at an increasingly concerning rate of frequency.

The value-based investor has historically purchased stock of companies that are showing a disparity between the price of the stock and various fundamental factors, such as earnings, sales, cash flow, or book value. Value investors try to find companies that are underpriced compared to other stocks in the same industry or the market as a whole. This is also a 'mean reversion' trade as investors buy the stock on the cheap and hope other investors will recognize that fact - or that there will be a catalyst that boosts the stock higher.

VECTORVEST ISN'T DOING TOO WELL

Starting as a value-oriented newsletter, we have been severely challenged in the last two years as the rules of investing changed. We aren't the only investment newsletter that's been challenged. I checked in with the famous Dr. Bart DiLiddo, founder of VectorVest.com this weekend to see what kind of performance his portfolios were providing to his subscribers in 2010.

VectorVest advertises extensively on the television investment stations, especially CNBC. But lately I haven't seen any claims of performance in the company's advertising campaigns. There's a reason: the annualized return of the company's premier portfolio ("Riding the Wave") is only 0.43% for 2010. Their other model portfolios are not any better. "High Income Stocks" has a return of -2.19, "Premier Growth Stocks" has a return of 2.13%, and "Yellow Brick Road" has a return of -6.55%.

VectorVest has been struggling this year, with returns in each of their model portfolios ranging from a high of 2.13%
and a low of -6.55%. Chart courtesy of Vestorvest.com.

The company puts in a lot of time with professional weekly videos that show investors how well their systems work in picking stocks. But those videos are always done with the benefit of hindsight. If only we could invest using next week's news!

That's not to put down VectorVest. The point is to show that this market has been incredibly difficult to navigate for value-oriented investors. VectorVest's approach is to buy undervalued small-cap-stocks when both the price of the stock and the markets are rising. It's essentially the same approach IntelligentValue has used to generate outstanding returns in our model portfolios prior to the last year. The problem is that the market has not supported a classic value w/momentum approach.

That doesn't mean we should throw up our hands and give up on investing or our approach (although many have). We've been working hard to find a refinement to our approach that works in this market environment. We think we've found it and it will work very well for us going forward!

REFINED APPROACH

A few weeks ago I let subscribers know that we were working on refining our approach to get some strong returns rolling. We've spent hundreds of man-hours "in the lab" so to speak, looking for refinement to our scientifically based "Dynamic Value Investing" approach that should produce excellent returns in the current challenging environment.

Here what we've found from our extensive research:

1) Buy and Hold Investing should be labeled with the acronym 'DNW,' i.e., 'Does Not Work.' Investing in the current environment requires a more active approach using market timing. Investing in the two decades from the early 1980's to the late 1990's was a piece of cake compared to the most recent decade:

Many investors long for the easy days of 'Buy and Hold' investing that dominated the two decades prior to the last one. Chart courtesy of StockCharts.com.

We can't invest in the market we wish for. It will likely take another 6-8 years before the market resumes a bull trend where Buy-and-Hold works again. In the meantime, we're going to use a new, revised approach to market timing. Chart courtesy of StockCharts.com.

2) Classic Value Investing Approaches Are Struggling. Extensive studies done by IntelligentValue show that commonly accepted Value Criteria such as Price-to-Earnings (P/E) no longer work well to identify undervalued companies. The chart below shows the results of a Price-to-Earnings ranking system run on stocks over the past year. The top ranked stocks by P/E over the last year are on the far right. The top 1% of stocks shows a return of -17% based on this factor:

Classic value criteria such as Price-to-Earnings and PEG are not working. The far right bar indicates the top ranked stocks by P/E over the last year. The rest of the chart is all over the board. Chart courtesy of Portfolio123.com.

3) Criteria Using Price/Sales, Price/Free Cash Flow Are Performing Best. In the current environment, investors are skeptical of reported earnings and earnings growth. The fundamental criteria of Price/Sales and Price/Free Cash Flow are working best. These two criteria provide investors with confidence that the companies are truly undervalued relative to top-line performance and are also generating strong cash flow from their sales. This differs from payroll cuts that can result in strong bottom-line earnings, but are temporary. Investors are placing a higher value on organically grown top-line revenues, rather than savings derived by cutting staff.

The chart below shows the top ranking system we have uncovered through extensive research and number crunching to assure robustness. This ranking system emphasizes five basic, fundamental-value criteria: a) Price/Sales, b) Price/Free Cash Flow, c) Price/Book Value, d) Return On Equity, and d) Free Cash Flow/Assets. The return over the last year is an astonishing 238% for stocks ranked in the top 1% (far right bar):

This simple 5-factor ranking system emphasizing Free Cash Flow, Sales, and Book Value shows an astonishing return of almost 240% in the top 1% of stocks. Chart courtesy of Portfolio123.com.

4) A Portfolio Based on This System is Extraordinary. Running this ranking system with criteria that eliminates stocks that are too small or with poor liquidity results in a performance chart that is amazing. The chart below shows the performance of this system over the last year:

A portfolio based on the DVR 5-Factor System is amazing. Chart courtesy of Portfolio123.com.

In backtesting, the portfolio produces a return of 406% with a maximum drawdown of 24%. Overall winners were 75% of the portfolio and the Sharpe Ratio is an astonishing 6.54%. The average stock was held 47.27 days with the biggest winner gaining 119.35% and the biggest loser at -26.90%.

5) Too Much Drawdown. However, as amazing as this 406%-annual-return portfolio is, its not good enough. Many investors would gladly trade the risk of a 24% maximum drawdown for a return of 406%. But our experience, after 5-1/2 years of publishing IntelligentValue, subscribers will NOT tolerate a drawdown this high. Previously, when there was anything over a -15% drawdown, subscribers leave in high numbers.

There seems to be a pain threshold among individual investors at about the -15% level. Therefore, we have spent a huge amount of time revising the market timing system we use in hopes of reducing drawdown without losing much return. That system is now ready to be unveiled.

6) Revised Market-Timing System. We have used multiple market timing indicators over the years to try to satisfy subscriber's drawdown threshold while still providing solid returns. That objective has been met over the years with various levels of success. In the market crash of 2008, we were able to sidestep the big sell-off because we

Previously, we used Moving Average lines, trendlines, MACD indicators, Stochastic Oscillators, and other technical approaches to try to get a handle on the direction of the market. None have been good enough to satisfy us or our subscribers. Even with a 400% annual return, subscribers will leave if the drawdown gets even close to 24%. Unfortunately, the last time indicators appeared to signal a move higher, we purchased five stocks using this stock-ranking system and the market suddenly whipsawed violently, resulting in our losing both money and several long-time subscribers.

But now we've developed a new system from the ground up and nothing we did before comes close to the system we are going to use going forward.

7) Here's How It Works: Recently we came across some new scientific tests of various technical indicators and it was an eye opener. The study showed that Wells Wilder's Relative Strength Index (RSI) and his Directional Movement Indicator (DMI) were the only two technical indicators that truly showed significant returns over a buy-and-hold investment approach. That was surprising in and of itself!

Since coming across this information, we have been working hard to find the appropriate settings for the Directional Movement Indicator (DMI) and Relative Strength Index (RSI) so we can consistently use them as Buy/Sell signals. Simply stated, in the chart below, when the green line (+DI) moves above the red line (-DI), and is confirmed by a second day with a price that moves higher than the signal day, it is a 'buy' indication for the market. Vice-versa for a short signal when the red line (-DI) moves below the green line (+DI).

To eliminate whipsaws at inflexion points, the system needs confirmation from a second day of prices in the same direction and surpassing the signal day. You can see this indicator in the middle chart of the graphic below. The thick, vertical red and green lines show the buy and sell signals given by the system. (Going forward, this system will also be used with the 'real-time' portfolios on Collective2.)

Our revised market timing system show excellent results over multiple years. Chart courtesy of StockCharts.com.

But it's not enough to have a single signal indicator. To make sure the signal was valid, we needed more than the DMI indicator (with confirming day) to issue a buy or sell signal. With a lot of man-hours, we've put together a confirming indicator that we believe is a breakthrough variation on the Relative Strength Index (RSI).

This indicator, shown above in the bottom chart of the graphic above, identifies when the RSI is moving up from oversold levels (0.2) and down from overbought levels (0.8). This is different from the standard RSI as it adds an oscillating property showing overbought and oversold as well as Bollinger Bands to help define the signal trend. I have never seen this RSI hybrid used elsewhere, but it certainly shows outstanding results when it is used as a confirming indicator for the DMI signal.

8) The Results Are Astonishing. When these timing inputs are used in the value-based stock-selection system discussed above, the drawdown is halved! That's excellent news!

But when you reduce drawdowns (risk), the result is usually lower returns. 'No pain, no gain' as they say. So how much are returns lowered? None. Zip. Squat. Nada.

In fact, returns are increased by 300% to a 705% annual return! In more than 35 years, it's one of the few times I've seen risk reduced and reward increased in an investment context. And never at this level, which nearly doubled the original reading.

The return of the backtest of this portfolio over the last year jumps to 705% while the drawdown is reduced to just -11.17%. Overall winners are 80% with the highest gain being 125%. The average hold time is a bit shorter than the system without timing, at 31 days, and the Sharpe Ratio is a whopping 12.46% - the highest I have ever seen! Here's a chart of the last year through the end of April:

Double the return with half the drawdown. Chart courtesy of Portfolio123.com.

The one facet of the system that subscribers will have to accept, one which is difficult for many subscribers, is that we have to be out of the market for what can sometimes seem to be long periods of time. I have found that some subscribers will cancel if we're out of the market for more than a week when the market is rallying.

For example, in the last two weeks, from July 5 to July 16, 2010, the stock market shot sharply higher (before Friday's sell-off) in a very strong oversold bounce and some subscribers cancelled because we were not in the market. They actually told me that. These subscribers couldn't stand to see the market go higher without them in it. That's understandable, I guess: it's human nature to not want to miss an opportunity. Extensive scholarly studies have been done of humans responses related to their avoidance of loss and pursuit of opportunity which confirms the feedback I have received from some subscribers.

8) The System is Robust Over Time. We have examined the system using hundreds of different start and end dates, eliminated the top 10% of winners, started and stopped it in down periods as well as up periods, but the result is always the same: Rocket-to-the-Moon Returns and minimal drawdowns - a maximum drawdown of 14% in backtests done even in the worst selloffs.

The chart below shows a five-year run of the portfolio from April 2005 to April 2010. The portfolio returned +4,221.66% over those five years compared to the S&P 500 return of just 4.03%. An investment of $100k would return $4,171,001.25 in just five years. If that last sentence didn't make you do a double take, you might want to read it again - an investment of $100k becomes $4.2 MILLION in just five years. But you shouldn't expect that, of course. Divide the return in half, and then for good measure divide it by half again. You're still looking at a return of 1,055% in five years, a return greater than one than any hedge fund, top guru, or even Uncle Buffett could ever come close to. It's still a 211% return per year, even after wiping out 3/4 of the returns that are produced when using a very frugal, i's dotted and t's crossed testing with tons of hoops that the system would have to jump through, and it came through with flying colors.

BUT THE PAYOFF IS FANTASTIC!

But the chart above under point #7 gives clear evidence why we did not get back into the market in the last week. Under the new system, we would have been out of the market since the start of May. That's a long time for many investors. Hopefully, subscribers will understand that this is a part of the new system and it's a necessary ingredient to get the astonishing returns the model promises.

The previous five picks in the Aggressive Portfolio were from the new ranking system, but we were not using the new market-timing aspect (otherwise I wouldn't have bought the positions). There have not been any new picks to replace the last five because I decided to go with the revised market-timing system after the last group of stocks hit their stops. Antsy, trigger-happy subscribers will just have to grit their teeth when we go to cash in the Aggressive Portfolio. The returns are so astonishing with this new system, that it would be ludicrous to try and select short positions when the signal goes red. The system is the ultimate in combining high return with low risk. There may be a free lunch after all!

If you would like to have exposure in both directions, long and short, we will also be using this new market timing system with the ETF-based MARKET TRENDS and TURBO TRENDS portfolios on Collective 2. As you can see from the chart in #5, the signal is now red and is saying that we should be on the sidelines in the Aggressive Portfolio and short in the MARKET TRENDS and TURBO TRENDS portfolios (we are).

It's exciting to look forward to using this system going forward. We'll allow the market to tell us when to get back in the market and you'll get an Action Alert when it happens. As you can see if you study the market-timing chart above, the Directional Indicators are very near a bullish crossover and the RSI Oscillator just peeked above the oversold line (0.2) last week, so we may be picking stocks sooner than you think!

Sincerely,

Christopher Michaels
IntelligentValue.com

MEMBER'S HOME PAGE
NEWSLETTER INDEX PAGE

SELL Members ONLY BUY: Members ONLY Learn about the high-profit stocks we're riding to extraordinary profits now. You can take advantage of the performance of the #1-ranked investment newsletter that's being published today. Sign up now for a 1-month TRIAL.

GET INSTANT ACCESS - Just $4.95 FOR A MONTH'S SUBSCRIPTION

- SATISFACTION GUARANTEED -

Read our LEGAL DISCLAIMER, TERMS and CONDITIONS, or PRIVACY POLICY. You can also CONTACT US. Copyright © 2004 - 2012 IntelligentValue.com, published by MoneySuccess, Inc. All rights reserved.
MoneySuccess, Inc., 1630 30th Street, #115, Boulder, CO 80301