A CONSEQUENTIAL, MARKET-MOVING EVENT IS IMMINENT

There is one clear and present danger for stocks in the week ahead: the first presidential debate on Monday, September 26 (9 pm EST). Hillary and Donald will face off in an event that rivals the hoopla around Ali and Frazier. Many experts expect TV ratings to top the all-time high of the 2015 Super Bowl, which had 114 million viewers. With Trump now virtually tied with Clinton in many national polls and even ahead in several key battleground states, the fallout on stock prices from the debates could be profound.

Here’s how professional investors are handicapping the binary outcomes from this event: If Trump is the definitive winner of the debate, there could be financial bedlam the next day.

That is not a statement of political preference. The fact is that investors abhor uncertainty, and The Donald brings an almost unprecedented supply of incertitude to the table if elected. Not only does he not have a political history upon which to base an expectation of his future presidential decisions, but the man is known for publicly switching positions on a subject within a single sentence.

Also, many (on both the left and right) consider the potential for global geopolitical turmoil with a Trump presidency to be high, since one of Trump’s main appeals to his supporters is his contempt for other nations and making America “strong again.” During the Republican primaries, he even boasted, “I love war, in a certain way.” Even if Trump is not a trigger-happy Commander-in-Chief, the increased possibility of that risk will bring uncertainty to markets.

On the other hand, Clinton is considered to be a known commodity and “more of the same old politics” by her detractors. After all, she has been in the public eye for a quarter of a century. For these reasons, it is likely that investor uncertainty associated with a Clinton presidency is quite low, and stocks will not be any more affected by a Clinton presidency than any other presidency (except Trump).

Because of the unprecedented TV viewership expected and the potential for virtually anything to happen, the Sept. 26 debate will be an event that many experts believe will determine the outcome of November’s election. While many voters have already made their decision, many others have not and Monday night’s debate will be critical for the two candidates.

With voters having low expectations for him, many experts say that all Trump needs to do to win the debate is to keep his head on his shoulders and act “semi-presidential.” On the other hand, Clinton is a policy wonk and knows the government inside and out. Compared to Trump, voters standards for her presentation are quite high.

An enormous number of investors, both professional and nonprofessional, will pay close attention to the debate and will use the Tuesday’s market open to begin discounting the future certainty/uncertainty of a Clinton/Trump presidency. On a fundamental basis, stocks are extremely overvalued; the S&P 500 is at its second highest, non-recession P/E level since its creation. Also, as discussed above, stocks are at a critical technical tipping point. With a “Bearish Rising Wedge” above and “Triple Bullish Support” below, the tension is palpable.

Should Trump clearly win the debate, we could see a significant sell-off beginning on Tuesday. Depending on how long this selloff continues, it might provide a distinct opportunity to purchase stocks at a discount, which is our specialty. Should Clinton clearly win the debate, we may see a powerful relief rally. There may have never been a more important TV event in the history of America than Monday night’s debate. In many ways, the future of America depends on it – and the near-term future of the stocks might also.

BAD NEWS = GOOD NEWS, YET AGAIN

(This is an excerpt from a recent Value Alert Newsletter, 11/8/2015)

When it comes to stock prices, how much do the anticipated movements of central banks matter when compared to the fundamentals of publicly traded corporations?

Did it matter that in Caterpillar’s (CAT) recent conference call with investors, it disclosed that 2016 revenue would collapse by 5% across all of its market segments? Did investors worry about 3M’s (MMM) intention to reduce its global workforce by 1500 positions because of lousy earnings? No way. Investors now expect substantial financial rewards for taking a risk when central planners engage in what is clearly blatant price manipulation.

Ironically, declines in revenue and earnings from companies like Caterpillar and 3M only confirms the weakness in the global economy, which investors now take as good news. Weaker results increase the likelihood that central banks will step up their stimulus measures.

So does central bank stimulus and low rates make that big of a difference? Just how powerful is the combination of quantitative easing (QE), zero-percent rate policy and even negative-percent rate policy? Omnipotent.

As an example, let’s use the performance of Vanguard Total Stock Market Index (VTI) as it relates to the activities of central banks engaging in QE. As a specific example, in mid-December of 2012, the U.S. Federal Reserve increased its QE3 program to $85 billion per month to buy U.S. Treasuries and mortgage-backed securities. The effect on the stock market, as measured by VTI, was impressive.

All-market index (VTI) 2013-2014

VTI made an average annual return of 24% per year during 2013/2014 with QE3 underway.

VTI opened 2013 at $70.78 and closed 2014 at $104.52. That’s a 48% gain for those two years or an average of 24% return per year. Those are impressive numbers when the long-term annual market average return is closer to 7%. But what happens when the Federal Reserve removes the punch bowl of stimulus?

The US Fed stopped its QE-related asset purchases in mid-December of 2014. The 2015 performance for VTI without QE should give us a clear measure of the effect of the stimulus. VTI opened 2015 at $105.01 and closed on Friday at $107.84 following a wild ride of volatility during Aug, Sept, and Oct. That’s a gain of only 3.2% year-to-date when QE isn’t a factor affecting prices, compared to 24% per year with QE. Imagine what could happen if the Fed soon increases interest rates.

All-stock index (VTI) 2015

However, during 2015, with no QE working, VTI logged a gain of just 3.2%.

These extraordinary financial shenanigans that have carried the market to within a few percent of its all-time high continue to override what have been deteriorating economic fundamentals. Tightening financial market conditions in the form of an interest rate increase will reduce speculation, and market prices will plummet. Because of this, merely the discussion of a rise in interest rates causes the market to dive, as it did in August.

The stock market has been robust with QE in place and sideways and extremely volatile without QE. The single most important factors (sales and profits) used to determine stock valuations and forecast future prices have been in decline on a year-over-year basis since the beginning of 2014 and negative in 2015. Still, stock prices continue to remain near all-time highs based on the ‘Fed Put’ that has been in place since the Alan Greenspan era in the Federal Reserve began.

Most market historians hold former Fed Chairman Greenspan responsible for the low-interest-rate-sparked market bubble associated with the internet enthusiasm in the late 1990′s, as well as the housing-related bubble created in the mid-2000′s by super-low rates that ultimately resulted in the Financial Crisis when the Fed steadily increased rates to a level that was too high. The Federal Reserve has an undeniable history in the last 20 years of creating bubbles, and then in attempting to cool off the overvalued assets, crashing the economy and causing the financial displacement of millions of families. What is their solution to this history? Apparently, more of the same, and this time it could be a real doozy since now we have the entire world on the ‘bubble-creation program.’

AN INCONVENIENT TRUTH: EXPENSIVE PRICES + POOR FUNDAMENTALS = DISASTER

When we made the decision to use ETF’s instead of value stocks in our October 25 Value Alert newsletter, it was a decision based on practicalities. Value stocks have simply stopped working as the bull market has matured. However, we now feel that the entire market is reaching valuations that may be closing in on obscene. Here’s why…

When the October 25, 2015 newsletter (in which we lamented the overvalued conditions) was published, we commented that the S&P 500 P/E ratio was at 18.23 and the Russell 2000 P/E ratio was at 71.7. The average P/E ratio for the S&P 500 since the 1870′s has been about 15.5, so the S&P 500 was slightly elevated two weeks ago. Data for the Russell 2000 is not as readily available, but according to Russell Investments, which introduced the indices in 1984: “The average P/E of the Russell 2000 since 1998 has been approximately 17.0, vs. 13.5 during the period (from 1984 to) 1998.” Therefore, the Russell was extremely overvalued two weeks ago. But now, it has a valuation that is jaw-dropping.

In writing today’s article, I just checked in with the Wall Street Journal Market Data Center to get an update. The S&P 500 P/E ratio is now significantly higher at 23.41, and the Russell 2000 P/E ratio is at a mind-boggling 188.46. Check for yourself.

EARNINGS AND REVENUE RECESSION CONTINUES

Those incredibly high prices are accompanying declining revenues and profits, a trend that we have discussed several times in previous newsletters.

In the current earnings reporting period, nearly one-third of S&P 500 corporations have reported earnings and revenue from the third quarter. With 147 companies reporting so far, profits are down -0.6% and sales are down -2.7% from a year earlier.

151108_declining_revenues_and_earnings_smIt seems logical that several quarters of contraction in earnings and revenue would have weakened stocks. After all, if robust sales and healthy profits are the primary drivers behind price appreciation for publicly traded companies, shouldn’t diminishing sales and dwindling profits lead to price drops for publicly traded corporations?

Welcome to the bizarre world of central-bank planning, worldwide stimulus, and currency wars in a race to the bottom. Despite the plummetting fundamentals, the S&P 500 is within 2% of its all-time high and the Nasdaq 100 set a new all-time high last week. And, of course, the Russell 2000 has the highest PE ratio ever recorded!

The Problem with the Shiller CAPE

Shiller’s “CAPE” Ratio Has Been in “Overvalued” in 24 of the Last 25 Years

There has been no dearth of articles in the business press about how overvalued the market is today. Many of these articles cite the Shiller Cyclically Adjusted P/E ratio (CAPE) as evidence of the overvaluation.  This article looks a little deeper:

Since the historic mean of Shiller’s CAPE is 16.58, last week’s CAPE ratio of 27.52 is a whopping 66% above the mean. However, we’re still far below the all-time high CAPE ratio of 47.2, set intraday on Friday, March 24, 2000 – a peak day for the S&P 500, right before the dot-com bubble burst in April.

The second-highest cyclical P/E peak came in September 1929 at 32.6. The market fell nearly 90% from there, so today’s 27.52 reading seems risky. But times have changed. Since the Berlin Wall fell in 1989, earnings have sustained a higher average plateau. As a result, CAPE has traded above “average” for 97% of the last 25 years, including three long, strong bull markets in 1990-2000, 2003-07, and 2009-15.

Last July, economist and Reuters columnist Anatole Kaletsky dissected CAPE in The New York Times:

“Since 1989, the S&P 500 has multiplied eightfold, while total returns, including dividends, have increased the value of an average equity investment 12-fold. But investors who followed Mr. Shiller’s methodology would have missed out on almost all these gains, since the Shiller P/E showed the stock market to be overvalued 97% of the time during this 25 years. And even during the two brief periods when the Shiller P/E was below its long-term average, in early 1990 and from November 2008 to April 2009, it never sent a clear buy signal. Instead, Mr. Shiller’s approach suggested that the valuations in 1990 and 2009 were only just below fair value, implying there was very limited upside at the beginning of bull markets in which prices multiplied fivefold from 1990 to 2000 and threefold from 2009 to 2014 (so far).

“The Shiller P/E’s predictive performance would have been just as bad in earlier decades. During the equity bull market of the 1950s and 1960s, for example, the Shiller P/E would have shown Wall Street to be overvalued for 96% of the 19-year period from early 1955 to late 1973. Only in January 1974 did the Shiller P/E move below what was then its long-run average, implying that it might finally be a ‘safe’ time to buy stocks. Straight after the Shiller P/E sent this first ‘buy signal’ in almost two decades, Wall Street crashed by 40% in 12 months.”

In addition, Deutsche Bank’s Stuart Kirk wrote, “The trouble is that the last two times the CAPE crossed 25 (in 1996 and 2003) the bull market was just getting started and ran for another four years.” In the first example, the S&P 500 went from 614 in December 1995 to 1,485 in August 2000 for a 141% rally. In the second example, the S&P 500 went from 1,038 in September 2003 to 1,520 in 2007 for a 46% gain.

Courtesy https://navellier.com

The Market Is In a Steady, Upward Trend Channel

The volatility in September and October 2014 brought out the usual ‘the end is near’ crowd calling for a collapse of the bull market.  However, our technical analysis of the market shows that the rally that began in early 2009 is on sound footing and stable.  In this article, we’ll demonstrate that the rally is in a healthy uptrend as well as a clear, rules-based signal to know then the rally is over.

While IntelligentValue.com is devoted to value investing, it is our opinion that technical analysis (TA) – as an adjunct to value analysis – dramatically improves returns in the context of modern equity markets.  We have a substantial amount of empirical evidence, including ten years of market-tromping portfolio performance in IntelligentValue.com with 100%+ annual returns for our two model portfolios that back up that opinion.

Generally speaking, the vast majority of value investors do not give credence to technical analysis.  Most well-known value investors follow the mantra of buying a stock when it is significantly undervalued, then holding it until that value is realized, no matter how long it takes.  For example, Warren Buffet says his favorite holding time is “forever.”

However, today that attitude towards technical analysis is becoming antiquated.  The broad acceptance of the Internet and widespread availability of TA websites for individual investors, as well as  a plethora of TA-based algorithmic hedge-funds and TA-oriented computerized trading centers have inherently turbo-charged the accuracy of technical analysis.

As a result of the internet, there is a massive quantum factor of additional individuals utilizing TA in their investing today than there was even a half-dozen years ago.  The consequence is that investing decisions based on TA are more accurate than ever.

After all, the ‘market’ is simply the collective decisions of many millions of individuals (and computers).  As more follow technical analysis and are using it in their stock purchase and sale decisions, the more those TA techniques become applied to individual stocks and the broad market.  If, for example, the majority of savvy investors believe the market will consolidate at a 50-day moving average, then typically it does just that, regardless of value or news considerations.

We mentioned computers a moment ago.  There is also an enormous effect on the market from computerized trading algorithms, many of which use TA is a cornerstone.  As a result of today’s wide acceptance and use, technical analysis has almost become a ‘self-fulfilling prophesy.’

For this reason, as well as a simple fact that it truly works, IntelligentValue.com uses technical analysis as an adjunct to our fundamental value approach.  Please notice that we emphasized the word adjunct, which means that TA is an enhancement to, not a driver-of our returns.  Fundamental value investing the driver of our returns, but TA goes a long way toward optimizing entry points and minimizing drawdowns.

USING TECHNICAL ANALYSIS IN LONG-TERM INVESTING

It could reasonably be said that the majority of people using technical analysis are short-term traders.  In fact, if you go to a technical-analysis website (Stockcharts.com has a free area), almost all of the default settings on the various indicators apply short-term settings to daily charts.   However, those same technical principles that work on trades using daily, hourly, or even shorter settings also work with weekly and monthly charts.

Since we rebalance our portfolios each weekend for IntelligentValue.com, we base our market timing system on weekly charts.  We publish the results of that rebalance, with analysis of the stocks in our portfolios each Saturday/Sunday. We have found that an intermediate-term investing approach is, by far, the optimum for maximum performance. We are not buy-and-hold value investors, because we cannot achieve the incredible returns we do by holding for extensive periods of time.

We utilize technical indicators to minimize market-related drawdowns, but we are not short-term trading the market. We modify the standard settings of technical indicators to make our entry/exit system investment-oriented instead of trading-oriented. For example, for one technical indicator we use that normally has a standard setting of 20 days, we use a setting of 500 days.

With a weekly rebalance and modified technical indicators, since 2004 we have an average of 1.4 market-risk-related closed positions per year. We hold our stocks an average of 3.6 months and both our portfolios generate long-term annual returns greater than 100%.

We find that technical analysis, when used as an adjunct to a fundamental value investing approach, substantially turbo-charges our performance.  Returns increase by a factor of 300-500% over a system with no consideration of technical entry and exit points and no market timing.

For example, a well-designed value approach without TA may yield 20-40% per annum, but with carefully-crafted TA-based entry and exit points added to take advantage of long-term market volatility, annual returns can reach 150% or more (our DEEP VALUE Portfolio has a long-term annual return of 185%).

WE’RE NOT EVEN CLOSE TO A MARKET COLLAPSE

Many of the pundits who appear in the media continue to forecast a collapse of the U.S. stock market.  The most recent calls for calamity came in the late-September/early-October downturn. While these self-appointed ‘experts’ have been predicting it for years, it just isn’t happening.

The fear that still grips experts and mainstream investors alike following the 2008 crash has caused many to lose money by staying out of the market or even shorting it. This fear has affected both individual and professional investors and is the motivation behind the speculative disaster prophesies. It does not take much at all for the market boo-birds to come out calling for another crash.

A LOGICAL APPROACH FOR DETERMINING WHEN TO EXIT THE MARKET

In the section below, we have charted the small-capitalization Russell 2000 index and the large-cap S&P 500 since the September 2008/March 2009 lows. (NOTE: We use the Russell 2000 small-cap index, with substantial minimum volume requirements for liquidity, as the stock universe for our DEEP VALUE Portfolio.   We use the Russell 1000 mid/large-cap index as the stock universe for our RELATIVE VALUE Portfolio).

As you can see from the charts of these indices below, prices are well within an upward-sloping Trend Channel that we have plotted for the last six years. The channel for each chart has a Primary Trend Line (blue dotted line in the center) with a multitude of touch points (highlighted in yellow) beginning with the 2008/2009 lows and continuing through last week.

There is a parallel Support Line (green dotted line) below the blue Primary Trend Line that runs from the 2008/2009 lows to the present.   For the small-cap Russell 2000, this Support Line is touched at the early October 2014 low.  For the S&P 500, the last time this index touched the green Support Line was in late 2013.   It has stayed above the blue Primary Trend Line for the last year.  For this reason, we believe that this index may be overdue for a correction down to the green Support Line.

We have also plotted a parallel Resistance Line (red dotted line) that runs above the blue Primary Trend Line in both charts.  This line designates the upper resistance to price gains.   The last time the small-cap Russell 2000 touched this line was March 2014.  It has been working its way lower to the green Support Line throughout 2014 and finally reached that level in October 2014.  For this reason, we believe that small-cap stocks may be due for outsized performance gains compared to large-cap stocks.

We show two charts below, one of small-cap stocks (Russell 2000 in Chart 1) and one of large-cap stocks (S&P 500 in Chart 2). Both categories of stocks are well within these precise six-year Trend Channels, and neither index is threatening to break out of those channels to the downside.

CHART 1: RUSSELL 2000 (SMALL-CAP) SIX-YEAR TREND CHANNEL

Russell 2000 Six Year Trend Channel

CHART 1 (click to enlarge): The Russell 2000 index is in a steady uptrend since the 2008/2009 market lows. The touches of the Primary Trend Line with the index have yellow highlights. This chart shows that the rally is healthy.  Chart courtesy of StockCharts.com.


CHART 2: S&P 500 (LARGE-CAP) SIX-YEAR TREND CHANNEL

CHART 2: The S&P 500 index is also in a steady uptrend since the 2008/2009 market lows. Notice that the S&P 500 has been bumping along  the upper Resistance Line for all of 2014, with the exception of the mid-October 2014 drop to the middle Primary Trend Line (blue). There is no sign whatsoever that the six-year bull rally is threatened. Chart courtesy of StockCharts.com.

CHART 2 (click to enlarge): The S&P 500 index is also in a steady uptrend since the 2008/2009 market lows. Notice that the S&P 500 has been bumping along the upper Resistance Line for all of 2014, with the exception of the mid-October 2014 drop to the middle Primary Trend Line (blue). There is no sign whatsoever that the six-year bull rally is threatened.

Using the trend lines shown in the charts above, we can see a very precise channel from the September 2008/March 2009 lows to present with a multitude of touch points over the course of six years.   You have to admit; the accuracy of these trend lines is compelling.

In a trend channel, the upper and lower Resistance and Support Lines as well as the Primary Trend Line must all be parallel to one another.   The market does not necessarily have to stay within the channel 100% of the time.  In fact, the Trend Lines are more of a general area around which prices coalesce.  Sometimes prices will stay just above a Trend Line and sometimes just below.

However, a Trend Channel should provide a clear demarcation of Support and Resistance levels over long periods of time. The channels in the two charts above accomplish that objective and provide us with a clear basis for stating that the bull market rally that began in 2009 is alive and well!

Investors would be wise to rely on these channels to determine when to exit stocks, rather than rely on speculation of coming developments or valuation measures that historically have low correlation to future stock prices.

WHAT WILL THE MARKET DO FROM HERE?

After bouncing off the green Support Line in mid-October 2014, the Russell 2000 Index rose recently to just above its Primary Trend Line (blue line in the middle of the channel). For the S&P 500, prices are dropping from the upper Resistance Line (red line at the top of the channel), but this index has not seen prices drop to the lower Support Line (green) since late 2012. As long as prices stay above the green Support Line, the uptrend will remain intact, so there is plenty of room to maneuver while staying within this range.

It is possible for us to estimate a range of prices for the market within the trend lines. We measure upper Resistance Line (dotted red line) being 12% above the Primary Trend Line while the lower Support line (dotted-green line) is 9% below the center Primary Trend Line.   In prices, that calculates out to be a current upper range around 1316 and the current lower range down to 1070 on the Russell 2000.

For the S&P 500, the current upper range in its trend channel tops out around 2040, where it peaked recently.  The lower Support Line of the channel is all the way down at about 1800.  Is it possible that large-cap stocks, which have done extremely well over the last two years, are now due for a selloff?  It appears that’s exactly ehat’s happening.  Will small-cap Russell 2000 stocks now take the lead in a ‘great rotation’ of market cap stocks?

No predictions here.  Our policy is to observe and react, not speculate.

However, both the small-cap Russell 2000 and the large-cap S&P 500 (and all other indices) are clearly moving within these very steady Trend Channels.   Until we see a change in that dynamic, we don’t expect a major disruption of the market.  Volatility within the Trend Channel, yes. But a crash?   We’re not even close.

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