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Tuesday, April 22, 2014

The Stock Market Recovers Sharply – Once Again!

By Louis Navellier

The market had some scary moments last week, with NASDAQ dipping to 3946 in mid-day trading on Tuesday, but the overall market picked up in the second half of the holiday-shortened week, with the S&P 500 rising 2.7% for the week, while the Dow and the beleaguered NASDAQ index each gained 2.4%.

The Tuesday turnaround seemed to stem from a variety of positive economic indicators, which I’ll discuss in more detail below, but the most encouraging news came out on Wednesday, when the Fed released its Beige Book survey, showing that 10 of its 12 Fed districts reported “modest to moderate” improvement. Consumer spending perked up in most districts, especially in vehicle sales and other forms of retail sales.

Despite that relatively healthy report card, Fed Chairperson Janet Yellen implied on Wednesday that the Fed would remain accommodative due to low inflation and slack in the labor force. In a speech before the Economic Club of New York, Yellen said she was more worried about inflation getting too low than too high. She even said the Fed’s focus should be on raising inflation to 2%, not holding it down. For reasons I’ll explain below, I think she better watch what she wishes for. She might get it.

In other news, the Russian/Ukrainian conflict is escalating, despite a Geneva peace declaration. We’re seeing divergent reactions in the stock and bond markets, as Ivan Martchev reports below. Then, Gary Alexander examines the recent NASDAQ decline in light of history, and I’ll return to offer a rundown of several key economic statistics typically released around the middle of each month.

Happy Earth Day!

In This Issue

Income Mail:

Bonds' and Stocks' Opposing Geopolitical Views

by Ivan Martchev

A Cheap P/E Does Not Always Mean “Buy”

The Only Sector with Positive EPS Growth for Q1: Utilities

Growth Mail:

Are We Experiencing More than a “Rotational Correction”?

by Gary Alexander

The Now-Forgotten Tech Stock Crash on “Earth Day” 1970

A Similar Tech Stock Crash Took Place in April, 2000

Stat of the Week:

March Retail Sales: Best in 18 Months

by Louis Navellier

Low Inflation in Europe, High Growth in China, and Higher Taxes in Japan

Income Mail:

Bonds' and Stocks' Opposing Geopolitical Views

By Ivan Martchev

Last Thursday the Russian market had its biggest post-Crimean one-day advance on the heels of a Geneva declaration looking to find a political solution to the Ukrainian crisis. I read the declaration, and it sounds rather dignified. The problem is: I do not believe a word of it. The Crimean annexation played out according to a well-calculated plan that seems to have been developed over a considerable period of time.

Russia took control of the gigantic peninsula without any real combat and not a single casualty on its side. The disturbances that have been happening over the past week in Eastern Ukraine bear resemblance to the actions in Crimea before the annexation. The only difference is that Russian troops are not officially on the ground, while in Crimea they conveniently had the base of their Black Sea fleet.

NATO Secretary General Anders Fogh Rasmussen observantly noted that “the reappearance of men with specialized Russian weapons and identical uniforms without insignia, as previously worn by Russian troops during Russia’s illegal and illegitimate seizure of Crimea, is a grave development.”

The unrest in Eastern Ukraine so far has seen more deadly combat and some army defections. If the Russians have planned this for so long, it would be interesting to see if they have managed to arrange a mass defection plan, which would greatly disorganize the weak Ukrainian military.

While Russian equities were euphoric on Thursday, indicating investor hope that the worst of the Ukrainian crisis may be over, Ukrainian credit default swaps completely yawned at the Geneva declaration and remained at elevated levels, having resumed a trend of expanding 1Yr/5Yr CDS spreads, indicating that it is a lot more likely for the Ukrainian government to default on its debts in the next 12 months than in the next five years. The normal relationship is for 1Yr. CDS to be priced below 5 Yr. CDS—just like typically short maturity bonds have lower coupons than much longer maturity bonds.

The situation on the ground is causing this CDS inversion, in my opinion, indicating that the chances of a meaningful military conflict are high. Let’s examine the conflicting signals between bonds and equities regarding the same important event, starting with bonds. (Note: the time scale of the CDS spread below is much longer (c. two years) than the scale of actual 1 Yr. and 5Yr. CDS prices (c. three months)).

Ukraine Credit Default Swaps Chart

Graphs are illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The horrendous gap between 1Yr. and 5Yr. Ukrainian government CDS closed significantly after the IMF accord at the end of March, which provides the necessary short-term funding to the tune of $18 billion to implement unpopular reforms which could (theoretically) set the country on the right course. The CDS spread began to dramatically narrow before the official IMF announcement, so the market “knew” that substantive financial aid was coming.

The Ukrainian sovereign CDS spread went parabolic on the Yanukovytch ouster, but the dramatic narrowing on the heels of the IMF deal did not last for long, as expected in our April 1 MarketMail, given the peculiar plural usage of the word referendum by Mr. Yanukovytch himself. That plural “slip of the tongue” marked the low in the 1Yr/5Yr Ukrainian CDS spread, as we have seen a marked increase in violence and separatist activity in Eastern Ukraine since the start of April.

A Cheap P/E Does Not Always Mean “Buy”

Still, the widening spreads on Ukrainian CDS' give the opposite message to the one delivered by the Russian stock market via the Market Vectors Russia ETF (RSX), where the trading volume on the rally was heavier than on the first day the stock market opened after the Crimean invasion had begun. Traders say volume means validity, so who is right here—Ukrainian CDS or Russian stocks?

The RSX ETF is so cheap that a strong rebound might be tempting to buy. The RSX trades at a P/E of 5.5 and a price-to-book of 0.7. This is a rare valuation, similar to the one RSX got in late 2008 when the Russian market crashed after Lehman collapsed. The issue with RSX is that it is dominated by energy (42.4%) and materials (16.4%), which are also exposed to global demand (or lack thereof, given China’s slowdown). Some could read that such heavy volume means the worst is over for the Ukrainian crisis.

RSX Market Vectors Russia ETF Trust - NYSE Chart

Source: Graphs are illustrative and discussion purposes only. Investment in equity strategies involves substantial risk and has the potential for partial or complete loss of funds invested. Performance results presented herein do not necessarily indicate future performance. Please read important disclosures at the end of this commentary.

The Market Vectors Russian Small-Cap ETF (RSXJ) rallied a bit less on the Geneva news, indicating that market action was concentrated in more liquid large caps where foreign investors typically play a larger role. The Russian small-cap sector had been underperforming large caps for three years and that underperformance rapidly accelerated over the past six weeks. Still, RSXJ seems better balanced than RSX, with energy only 17.1% of assets, utilities 17.0% ,and materials 16.4%. The massive energy skew is missing from the RSXJ mix, which makes it a more reliable representative the real economy of Russia.

Peculiarly, the heavy volume seen in RSX last week is missing in RSXJ, so I don’t think one should not get too excited for the moment. Some of the biggest one-day advances come in bear markets as there are too many short positions and too may towels being thrown in. This occasionally results in selling exhaustion, or a vacuum, which results in market rebounds being overblown due to short covering while sellers have stopped selling temporarily. The action in Russian stocks feels exactly like a bear market short-term sharp rebound.

If I had to decide if I should pay more attention to the reaction to the same event of Ukrainian CDS (which is a professional-only market) and Russian stocks, I would go with the CDS market. It seems to me that protecting the rights of the Russian minority in Ukraine (and securing Gazprom's* pipelines) is similar to looking for weapons of mass destruction in Iraq (and for ways to tap the country's vast undeveloped oil reserves that were impossible to reach with the previous regime). Both military campaigns are equally ugly, but one so far has played out with minimal force – as if a champion chess player had been planning it.

I had to comment last week on the situation in Russia as people around the office are amazed how President Putin enjoys an 80% approval rating at home. I pointed out the similarity between securing Gazprom's pipelines and Iraq's then-untapped oil reserves: “Look, things in Russia work the same way as in the rest of the world—it's just that the Russians are more obvious and less refined. And not because they can't be more refined; they just don't care as they clearly have the upper hand in this situation.”

The Only Sector with Positive EPS Growth for Q1: Utilities

According to folklore, if it is cloudy when a groundhog emerges from its burrow on February 2, spring will come early. On the other hand, if it is sunny on February 2, then the groundhog will see its shadow and retreat back into its burrow, indicating winter will last for six more weeks. With rough winter weather lasting into March, it must have been quite sunny in Punxsutawney, Pennsylvania on February 2, 2014.

In a rather amusing comedy by the name of Groundhog Day, Bill Murray plays Phil Connors, a TV weatherman who, during a hated assignment covering the annual Groundhog Day event in Punxsutawney, finds himself in a time loop repeating the same day again and again. After numerous suicide attempts, he begins to re-examine his life and his priorities.

When I went through the consensus estimates for the different sectors in the S&P 500 recently, I felt like Phil Connors in Punxsutawney, except that Andie McDowell (playing his news producer Rita Hanson) did not come to my rescue. For five quarters in a row, the S&P 500 EPS estimates started off on a high note on the first day of the quarter and ended up being aggressively cut until the last day of the quarter.

The opening quarter of 2014 was no different. The estimated earnings decline for Q1 2014 is now -1.2%, making it the first year-over-year decline in earnings since Q3-2012 (-1.0%). But on December 31, 2013, the earnings growth rate for Q1-2014 was expected to be +4.3%. Nine of the ten sectors have lower earnings growth rates in the quarter compared to the December 31 estimates, and the most often cited reasons for lower EPS in press releases have been the U.S. dollar and the weather—55% of companies complained about a stronger dollar in their 1Q releases while 33% complained about the weather.

The utilities sector is the only sector that has seen a slight increase in expected earnings growth (to 6.7% from 6.4%) since the start of the quarter. A bad winter is a boon for utilities, and a hot summer may be another boon. Utilities are also getting help from the realization that QE tapering is not excessively boosting long-term interest rates, as can be seen from the decline in long-term Treasury yields in 2014. Somewhat lower deficits, record tax receipts, and a shrinking Federal budget deficit are also helping the Fed in its ‘tapering’ transition.

Utilities Select Sector SPDR/S&P 500 Chart

Source: Graphs are illustrative and discussion purposes only. Investment in equity strategies involves substantial risk and has the potential for partial or complete loss of funds invested. Performance results presented herein do not necessarily indicate future performance. Please read important disclosures at the end of this commentary.

Utilities have now underperformed the S&P for about two years. They have just begun to outperform with falling long-term yields (see chart above)

Growth Mail:

Are We Experiencing More than a “Rotational Correction”?

By Gary Alexander

“Indexing is a waste heap – information so merged and muffled that it hides knowledge rather than reveals it. All beta, no alpha.”

— Andy Kessler, in a preface to George Gilder’s Knowledge and Power.

Early on the morning of Tax Day, last Tuesday, NASDAQ touched an intra-day low of 3946, down nearly 10% from its intraday high of 4371 on March 7. Many previously-hot NASDAQ stocks fared worse. A chilling chart on Page 1 of last Thursday’s Wall Street Journal showed declines of 39.4% in Twitter (TWTR), 32.9% in Yelp (YELP), and 27.2% in Netflix* (NFLX) from early March to last Wednesday.

A week earlier, on Thursday, April 10, Bespoke Investment Group (BIG) wrote, “We saw bid-ask spreads on a variety of names that usually have adequate liquidity blow out to around 1% on our screens at various points of the trading day. Liquidity, that oft-discussed quality that’s been so avidly discussed recently thanks to the release of Michael Lewis’ Flash Boys, is a tricky beast; it’s never there when you need it most. Liquidity also becomes more expensive the less available it is, so traders in names that suffered today as they have for months had an even more difficult time cleaning up positions than they otherwise would have. At the end of the carnage, the Nasdaq Composite Index was down over 3% today.”

On the previous Thursday, April 3, BIG characterized the recent reversal as a “tale of two markets,” in which “one market made up of well-established companies with solid earnings but relatively low growth has done very well since the start of March. The other market made up of relatively new companies with strong growth prospects has gotten absolutely crushed since the start of March. In the Russell 3000, which contains 98.5% of stocks traded in the US, stocks with no earnings (no P/E ratio) are down an average of 4% since the start of March. Stocks in the index that have earnings are up 1.5% over the same time period….In 2013 and early 2014, the stocks with high growth prospects surged, while low-growth names underperformed. That trend has been flipped on its head over the last few weeks.”

All of this reminded me of the tech-stock crash of April 1970 and the NASDAQ crash of April 2000.

The Now-Forgotten Tech Stock Crash on “Earth Day” 1970

I would hazard a guess that not one in 10 of my readers remembers the stock market crash on Earth Day, 1970. If you Google “Tech stock crash 1970,” you will see precious few entries that directly address that specific crash. The first two Google entries I saw came from our own article on the subject in April 2010, on the 40th anniversary of that crash – “(Back to) Earth Day” – reprinted by Investorplace and NASDAQ.

In writing that 2010 article, I found precious few resources to consult. Due to a lack of online sources, I used a faded old Dun’s Review article from 1971 and a 1973 book, The Go-Go Years: The Drama and Crashing Finale of Wall Street’s Bullish 60s, by New Yorker financial writer John Brooks. The 1997 reprint of that book includes a forward by best-selling author Michael Lewis. Here’s how the book starts:

“On April 22, 1970, Henry Ross Perot of Dallas, Texas, one of the half-dozen richest men in the United States…suffered a paper stock-market loss of about $450 million.” This amounted to “more than the annual welfare budget of any city except New York; and more – not just in figures, but in actual purchasing power – than J. Pierpont Morgan was known to be worth at the time of his death in 1913.”

Furthermore, the collapse of Perot’s EDS stock “was not based on any bad news about the company’s operations. To the contrary, the news was all spectacularly good; per-share earnings for 1969 were more than double those for 1968, and even for the first quarter of 1970 – a time of fast-deepening general business recession – EDS showed a 70% profits increase over the same period for 1969.” The EDS crash, the book shows, was a “bear raid” based upon the narrow float of available shares of EDS at the time.

Perot’s big loss came on the first Earth Day, so I characterized the 1970 stock market collapse as “back to earth” day for tech stocks, which had been the darlings of the late 1960s. Perot was not alone. Many tech stocks fell by 80% or more from 1969 to mid-1970, with the core losses coming in five weeks, April 21 to May 26, 1970. Perot’s EDS fell a total of 85%, from a peak of $162 to $24, while Control Data fell 83%.

In the aftermath of that crash, financial consultant Max Shapiro constructed a list of 30 leading “glamour stocks” and their fate. He picked 10 leading conglomerates (like LTV), 10 computer stocks (led by IBM), and 10 hot technology stocks (Polaroid, Xerox, etc.). In Dun’s Review in January 1971, he showed that the 10 conglomerates fell by an average 86%, the computer stocks fell 80%, and the tech stocks fell 77%.

The overall market did not collapse at anywhere near those levels. The S&P 500 fell 9% in April 1970, another 6% in May, and 5% in June, for a cumulative 19% drop in the second quarter of 1970. The Dow lost just 13% in the second quarter and 35% from peak to trough. But second-tier stocks fared worse. According to Go-Go Years author John Brooks, “a portfolio consisting of one share of every stock listed on the Big Board was worth just about half of what it would have been worth at the start of 1969.”

At the time, the tech stock crash of 1970 was overshadowed by troubling national news. Not only did the Earth Day celebration of April 22 take Ross Perot off the front pages the next day, but there was also the dramatic news of Apollo 13’s near-fatal moon mission (April 11-17), followed by President Nixon’s incursion into Cambodia (April 29), resulting in campus riots and shootings at Kent State (May 4) and Jackson State (May 14), amidst a recession engineered by Nixon as a way to fight inflation by “cooling the economy.” In the week of May 4-8, over 80 college campuses were completely closed down, and a violent conflict between students and “hard hats” took place in the shadow of Wall Street on May 8, 1970.

A Similar Tech Stock Crash Took Place in April, 2000

The NASDAQ crash of 2000 is far fresher in the minds of most investors than the tech stock crash of 1970, but the forensic evidence is similar. NASDAQ peaked at 5046.86 on March 9, 2000. Its fall was slow at first. But after closing at 4446 on Friday April 7, NASDAQ fell 25.3% in one horrendous week:

NASDAQ’S Week from Hell: April 10-14, 2000

Day Point drop (percent)
Data source: The Almanac Investor
Monday, April 10 -258.25 (-5.81%) to 4188.20
Tuesday, April 11 -130.30 (-3.11%) to 4057.90
Wednesday, April 12 -286.27 (-7.06%) to 3769.63
Thursday, April 13 -92.85 (-2.46%) to 3676.78
Friday, April 14 -355.49 (-9.67%) to 3321.29

The crash of 2000 impacted NASDAQ stocks far more than the blue chip indexes. The Dow actually rose 75 points on Monday, April 10, and it rose another 100 points on Tuesday, April 11, before finally falling.

In the six months between February 29 and August 31, 2000, the S&P 500 and Dow gained 11.1% and 10.7%, respectively, while NASDAQ lost 10.4%. (Eventually, NASDAQ lost nearly 80% by late 2002).

In Mid-2000, Blue Chips Rose While NASDAQ Fell

Index February 29 August 31 Change
Data Source: The Almanac Investor and Yahoo Finance
S&P 500 1366.42 1517.58 +11.06%
Dow Jones 10128.31 11215.10 +10.73%
NASDAQ 4696.69 4206.35 -10.44%

NASDAQ’s peak came on March 6 & 7 in 2014 vs. March 9 & 10 in 2000. So, will history repeat itself? Perhaps in future years, but I don’t believe we are near overall P/E “bubble” territory now. Louis Navellier has characterized the recent market swoon as “a big rotational correction out of stocks with high PEG ratios (price/earnings to growth) to more conservative, low P/E stocks.” Bespoke agrees with us: “Companies with strong balance sheets should continue to hold up better than stocks with sky-high valuations.”

As earnings season reaches its full stride this week, we believe it’s more important than ever to be selective. Examine each stock for its inherent value.

Stat of the Week:

March Retail Sales: Best in 18 Months

By Louis Navellier

The evidence is mounting that the spring economic “thaw” has begun. The Commerce Department announced last week that March retail sales rose 1.1%, the strongest monthly gain since September 2012. Excluding a stunning 3.7% rise in vehicle sales, March retail sales still rose by an impressive 0.7%, which is the strongest growth rate since February 2013. If you exclude declining sales at gas stations (off 1.3% in March), retail sales rose 1.4%, the biggest monthly increase in four years (since March 2010). So no matter how you slice it, a spring thaw is beginning – which bodes well for second-quarter GDP growth.

Also indicative of improving economic growth, the Fed reported on Wednesday that industrial production rose 0.7% in March, significantly higher than economists’ consensus forecast of a 0.5% rise. The major components of industrial production – namely, manufacturing, mining, and utility output – rose 0.5%, 1.5%, and 1%, respectively. Overall, industrial production rose at a 4.4% annual pace in the first quarter. Capacity utilization rose to 79.2% in March, the highest rate since June 2008, up from 78.8% in February.

On the inflation front, the Labor Department reported on Tuesday that the Consumer Price Index (CPI) rose 0.2% in March. Food prices rose 0.4%, while energy prices declined 0.1%. Excluding food and energy, the core CPI also rose 0.2%. In the past 12 months, the CPI has risen 1.5%, while the core CPI is up 1.7%, so inflation remains just below (but very close to) the Fed’s 2% target range. However, since food and energy prices have risen substantially so far in April, I expect to see a big surge in the April CPI.

There is more evidence of inflation brewing. On Thursday, the Labor Department announced that new jobless claims declined to 304,000 in the latest week, the lowest level since 2007. Normally, as the job market tightens, wage inflation heats up and that is already happening, since on Thursday, the Labor Department announced that wages grew at a 2.7% annual pace in the first quarter, the fastest rate since the fourth quarter of 2008. Naturally, this is good news for workers, but it also points toward higher inflation.

Low Inflation in Europe, High Growth in China, and Higher Taxes in Japan

Interestingly, while a weak U.S. dollar is causing the price of commodities and imported goods to rise, a strong euro is suppressing prices. As a result, the euro-zone is now bordering on deflation. Last week, Eurostat announced that consumer inflation was running at only a 0.5% annual pace in March, the lowest rate since November 2009. Excluding food and energy, the core consumer inflation rate was 0.7%.

Since deflation typically causes businesses and consumers to postpone their purchases, the European Central Bank (ECB) is carefully monitoring the deflation situation. At an IMF news conference, ECB President Mario Draghi said, “a strengthening of the (euro) exchange rate requires further monetary stimulus” to promote “price stability.” Translated from central banker lingo, Draghi implied he will keep pumping out money in an attempt to keep key interest rates low and maybe weaken the euro a bit.

In other global news, China announced on Wednesday that its GDP grew at a 7.4% annual pace in the first quarter, down from a 7.7% annual pace in the previous quarter. This GDP deceleration may seem like bad news, but it was above economists’ consensus expectations. Fixed income investment in machinery, land, and buildings surged 17.6% in the first quarter. The components of China’s GDP growth were also impressive: March industrial production rose 8.8% and retail sales rose 12.2%. Overall, China remains on track to continue to lead the world in both trade volume and domestic GDP growth rates.

Speaking of central bank pumping, Japan downgraded its economic outlook on Thursday for the first time since November 2012. Even though the Bank of Japan’s aggressive quantitative easing weakened the yen and boosted exports, the government of Japan apparently shot itself in the foot after it raised its national sales tax from 5% to 8%, which caused domestic consumption to suddenly decline. Economic minister Akira Amari said the effect of the recent sales tax increase has already been felt in the retail sector. For example, sales of home electronics fell 20% in the first week of April vs. the same period a year ago.

The primary reason Japan implemented its first sales tax increase in 17 years was because it has to pay for its rising social security costs and service on its huge public debt, which stands at approximately 200% of GDP, the largest percentage of debt load among rich industrialized nations. Interestingly, the Japanese government plans to raise its national sales tax again to 10% in October 2015. Japan’s economy is also hindered by its high median age, so Japan is almost entirely dependent on exports for GDP growth.

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