Tuesday, January 26, 2016

"In the short run, the market is a voting machine, but in the long run it is a weighing machine." --Benjamin Graham

ALL ASSETS WILL CONTINUE TO SWING TO IRRATIONAL EXTREMES (January 26, 2016): As Benjamin Graham notably stated in the above quote, in the short run the market is driven by investors who will be especially eager to purchase trendy assets near tops and to sell unpopular assets near bottoms. In the long run, the most undervalued assets will climb the most while the most overpriced ones will suffer the greatest percentage losses. This is evidenced by the all-time record outflows from U.S. equity index funds during the first quarter of 2009, and all-time record inflows into most of these funds during 2014-2015. Naturally, this means that most investors were selling the S&P 500 around 800 or below, while buying it near 2000 or above. This is true of virtually all sectors: you can see huge outflows from U.S. Treasury funds in late 2010 and early 2011 the last time they were completing a multi-year bottoming pattern, and all-time record inflows into the same funds in late 2014 and early 2015 when they were peaking. It will always be this way, because investors will always want to own whichever assets have already enjoyed the most extended uptrends and are thus maximally vulnerable to a significant drop to reach fair value, while they will flee those assets which have suffered the most severe and long-lasting bear markets and are thus the most likely to rebound strongly.

If we look at the state of the global financial markets, we can see that there have already been tentative and not-so-tentative moves toward fair value for those securities which had been among the most popular investor favorites of 2015. Apparently "unstoppable" names including the "fang" four, Facebook (FB), Amazon (AMZN), Netflix (NFLX), and Google/Alphabet (GOOG) have been among the biggest losers. Even these have rebounded in recent days, indicating that investors aren't willing yet to give up on their darlings even if they are barely profitable and have irrationally high price-earnings ratios. Some of the most undervalued emerging markets around the world, including Russia (RSX) where price-earnings ratios had dropped to an average between four and five, were also affected by the selloff as many investors dumped everything which is easy to do on the internet, only questioning their rash decisions later. In the short run, panic usually leads to a partial recovery, but the U.S. equity markets aren't going to go back to new all-time highs. Small-cap shares had outperformed from March 2009 through March 2014 and have since notably underperformed their large-cap counterparts, which historically has almost always been followed by a severe bear market. 2016 isn't likely to be either the horrible year which some are anticipating for U.S. equity indices, nor is it likely to be flat like 2015. It will be a moderate down year, with the bear market accelerating as usual in its final months which will likely occur in 2017 or 2018 when we could go below the deep nadirs of March 2009.

Among the least popular assets today are shares of companies which produce commodities or are located in emerging markets. Some shares fit into both categories and are unusually undervalued. Even the highest-quality names in these sectors have mostly been devastated, because investors have concluded that they only move in one direction which is lower. It is the opposite of a bubble, which interestingly has no word in the English language to express it precisely. The increasingly optimistic expectation of continued gains for the U.S. dollar, which had been especially strong until the middle of March 2015 and has mostly moved sideways since then, is probably misplaced partly because it is such a popular bet with a recent all-time record total of speculative bets on a higher greenback, along with unusually strong commercial accumulation of nearly all other global currencies. Commercials, or insiders who trade currencies for a living as part of their job, have been especially eager to buy the Canadian dollar, with aggressive accumulation of other currencies including the Australian dollar and the Mexican peso. It's not that they necessarily know something that others don't, but that they aren't nearly as easily swayed by media coverage of an "unstoppable" U.S. dollar and are much more concerned with the fundamental facts on the ground.

One asset which has barely been discussed as being overvalued is real estate in many parts of the world. As recently as 2011, there were many neighborhoods in U.S. states including Florida, Arizona, and Nevada where the ratio of housing prices to household incomes was less than 1.5 to 1. Today, there are cities including San Francisco, Vancouver, Tel Aviv, and others where some neighborhoods have ratios which exceed 10 to 1. As with all other assets, real estate prices which appear extreme can become even more extreme, but eventually fair value will reign and prices will have to revert toward their normal levels of 3:1 which have prevailed at least since the time of Julius Caesar. The percentage declines implied by these losses will shock those who are residents of these and many other global cities. As with everything else in the financial world, until it has happened almost no one can imagine it occurring, and after it happens everyone will say how obvious it had been that prices would have to collapse. This is part of a human tendency to repeatedly project the recent past into the indefinite future, even when making such an assumption is inherently illogical.

For the past two decades, perhaps because of the existence of the internet, the financial markets have swung to much more frequent extremes than they had done for the previous several decades. The internet allows people to get and to act upon information rapidly, which is both a blessing and a curse. For most people, it is unfortunate that they can find out everything so fast, because this causes their emotions to get ahead of their brains. If you hear a stream of bad news, you will be more likely to take an action which you wouldn't likely have done if you had more time to think it over. I know people who have literally sold everything in their brokerage accounts within minutes because they were able to do so and because they were responding to news reports or listening to financial TV radio or television. If it is March 6, 2009 and you hear an incredibly negative U.S. employment report, you are likely to place sell orders even before the market has opened, as many did on that day when the S&P 500 completed its historic bottom at 666.79. Throughout almost all of 2014 and 2015, you heard almost entirely optimistic forecasts of future U.S. stock market performance which encouraged many to buy near their most inflated levels and which dissuaded many from selling U.S. assets at clearly overpriced levels. The same will happen with real estate: people aren't going to consider seriously selling until after prices have already slumped and houses are trading well below their asking prices, instead of above their asking prices as is currently the case in the most popular areas.

Prices which have strayed far from fair value, and then regress to fair value, rarely stop there. Whatever had been absurdly overvalued usually ends up becoming ridiculously undervalued and vice versa. This makes it emotionally difficult to sell, because you will be tempted to reduce your holdings when they reach a level you know is too high, and then if you don't sell you will see prices climb more and more and eventually you won't be able to sell at any price because you have received so much positive psychological feedback for doing nothing. Similarly, if you are considering buying something which is blatantly undervalued, but you do nothing and it gets even cheaper, then you won't be able to buy no matter how low it goes because you will have told yourself a dozen or more times how brilliant you were by waiting longer. This is a major reason why even the most experienced investors can rarely bring themselves to buy low or to sell high, because they were rewarded for not acting earlier.

As usual, it makes sense to gradually buy a little of whatever is the most below fair value, while gradually selling whatever has surged far above fair value. In the short run you will almost always feel foolish as extreme trends tend to become even more extreme, but eventually everything will regress toward the mean and usually beyond the mean by an amount which is roughly proportional to the extent which it had been illogically pushed in the opposite direction. It is like a pendulum, which will move most violently away from a point which is the farthest away from equilibrium.

Disclosure: Whenever they have appeared to be especially depressed, I have been buying the shares of funds which invest either in emerging-market assets or in the shares of commodity producers, since I believe these are among the two most undervalued sectors in a world where real estate and U.S. equity indices remain dangerously overvalued. As the extremely popular U.S. dollar stuns investors by suffering a bear market instead of continued gains as almost everyone is expecting, this will lead to a major upward revision in global inflationary expectations. From my largest to my smallest position, I currently own GDXJ, KOL, SIL, XME, COPX, GDX, HDGE, EWZ, RSX, REMX, GLDX, URA, FCG, IDX, GXG, VGPMX, ECH, VNM, BGEIX, NGE, RSXJ, PLTM, EPU, TUR, SILJ, SOIL, EPHE, and THD. I expect the S&P 500 to eventually lose roughly two thirds of its May 20, 2015 peak valuation of 2134.72, with its next bear-market bottom perhaps occurring in late 2017 or early 2018. The Russell 2000 Index and its funds including IWM had handily outperformed the S&P 500 from March 2009 through March 2014, and have subsequently dramatically underperformed, recently trading at their lowest levels in 2-1/2-years. Small-cap U.S. equities typically lead the entire U.S. equity market lower as they have done in past decades including 1928-1929, 1972-1973, and 2007. Those who have "forgotten" or never learned the lessons of previous bear markets are doomed to repeat their mistakes. Confirmation of an impending end to the wildly popular deflation trade has been the notable decline for high-yielding shares since they had mostly achieved all-time peaks in January 2015, including utilities (XLU), REITs (IYR), and U.S. Treasuries (TLT).

Wednesday, January 6, 2016

"I'm living so far beyond my income that we may almost be said to be living apart." --e e cummings

FAIR VALUE, LIKE A RELIABLE BUT TARDY GUEST, IS ALWAYS LATE AND ALWAYS ARRIVES (January 6, 2016): Many investors like to repeat John Maynard Keynes' overquoted quip about how the market can remain irrational longer than you can remain solvent. There are numerous problems with this saying, especially when taken out of context, since as long as you don't use margin you should always remain solvent. Those who go overboard with investing, as with anything else in life, will sometimes be rewarded in the short run but will inevitably fail in the long run. Those who bet on extremes becoming more extreme will similarly often prosper for some unknown period of time, but will eventually lose in the end because all assets eventually revisit fair value. After doing so, whatever had been previously wildly trendy and overvalued usually ends up becoming roughly equally despised and underpriced. Thus, if you can consistently buy gradually into whatever has become the greatest percentage below its fair value, and sell whatever has become the most stretched above its fair value, you will have a method which will be highly successful in the long run. It will also be consistently unpopular for others to follow, because you will be buying near the end of an extended bear market when everyone is gloomy and you will be selling anything when its recent outperformance encourages almost everyone to anticipate indefinite additional future gains.

If we look at U.S. equity indices through the decades, there is a pattern in which nearly all bear markets and especially the most severe ones often begin with underperformance by thousands of small-cap shares. IWM tracks the Russell 2000 which represents U.S. companies 1001 through 3000 by market capitalization. IWM moved above 120 in early March 2014, having enjoyed a powerful bull market for just about exactly five years. Since then, it has fluctuated in both directions and briefly set a new peak in June 2015, but is now trading below 120. Most investors are unaware of this development, but ignorance is certainly not bliss as this persistent underperformance by small-cap U.S. equities relative to their large-cap counterparts is classically how bull markets transition to bear markets. Until nearly the end of 2015, investors responded to this divergence by crowding increasingly intensely into fewer and fewer advancing securities--much as they had previously done in years including 1929, 1972, and other periods when buying U.S. stocks was especially popular and ultimately disastrous. Even in 2007, small-cap U.S. indices peaked in the spring and early summer while many of the most popular names continued to climb until almost the end of that year.

If investors believe they can remain ahead of the game by shifting from small caps to large caps, it is similar to switching into a first-class cabin on the Titanic instead of heading for a lifeboat. You will enjoy fine luxury for awhile, but in the end you won't survive. Those who have been buying the "fang" stocks (FB, AMZN, NFLX, GOOG) did wonderfully in recent months, but will end up in the poorhouse because wildly overvalued and trendy names in each generation end up just like the "Nifty Fifty" did during 1973-1974, collapsing far worse than the broader market during a sustained downturn. Already in 2016 we are getting a taste of what is in store for the next two years or so for what had been the most popular securities of 2015. This is appropriate, since the high-dividend favorites of 2014 including utilities (XLU), REITs (IYR), and U.S. Treasuries (TLT) slumped throughout most of 2015 after having briefly climbed to even more overvalued peaks in January 2015.

If money is coming out of nearly all of these former investor favorites, where is it going to go? Real estate has also become irrationally overvalued and will eventually suffer the same fate as Netflix and Amazon. Even the relatively steady S&P 500 Index has been repeatedly unable to set new all-time highs since it had topped out on May 20, 2015. Investors have been continuing to abandon the least popular sectors of recent years, making all-time record outflows from nearly all assets involved with commodity production and emerging markets. However, even the worst bear markets end eventually, and since they represent a high percentage of the bargains which are currently available, they will ultimately rebound enough to attract the attention of momentum players and many others who don't like to buy into the cheapest prices but wait until they observe that a recovery has been "confirmed." Of course there is no such thing as true confirmation, since anything can rise or fall at any time. However, whenever any asset has become so cheap that it could double or triple and still be below fair value, then it will often behave in a subsequent bull market by being among the top performers and eventually becoming as irrationally overvalued as it had been previously undervalued. It works the other way too, so that the most popular assets often become the least popular a few years later.

The U.S. dollar is a classic example of a wildly loved currency that climbed to its highest point in 2015 since April 2003, but has been unable to remain above its highs from March 2015. The U.S. dollar index has repeatedly climbed toward or above 100 and has failed to hold above that level. Investors have flooded into bets on a higher greenback while sentiment has rarely been more bullish, but market behavior hasn't responded by staging an appropriate rally extension. Instead, resistance keeps reappearing and investors keep getting more optimistic. This is how major tops are formed. Instead of rising further to 110 or 120 as most observers currently expect, an equal move the opposite way to 90 and then 80 is a far more likely scenario for the U.S. dollar index in 2016 and perhaps the early months of 2017. Even mentioning to someone that you are anticipating a significantly lower U.S. dollar will get people seriously questioning your sanity, which thereby makes it far more likely to occur.

Ultimately, whatever is last shall be first and vice versa. Expect to see the least popular assets of recent years finally enjoying a year or more in the sunshine of strong bull markets, while the most sought-after assets of recent years will severely disappoint holders with losses generally exceeding half. Probably most investors can't imagine their Nasdaq favorites or San Francisco/Vancouver/Tel Aviv real estate losing more than half their current valuations, but that is what is going to happen. Fair value seems elusive and unachievable, until it is inevitably achieved and usually far surpassed in the opposite direction.

Disclosure: Whenever they have appeared to be especially depressed, I have been buying the shares of funds which invest either in emerging-market assets or in the shares of commodity producers, since I believe these are among the two most undervalued sectors in a world where real estate and U.S. equity indices remain dangerously overvalued. As the extremely popular U.S. dollar stuns investors by suffering a bear market instead of continued gains as almost everyone is expecting, this will lead to a major upward revision in global inflationary expectations. From my largest to my smallest position, I currently own GDXJ, KOL, SIL, XME, HDGE, COPX, GDX, EWZ, RSX, REMX, GLDX, URA, FCG, IDX, GXG, VGPMX, ECH, VNM, BGEIX, NGE, RSXJ, PLTM, EPU, TUR, SILJ, SOIL, EPHE, and THD. I expect the S&P 500 to eventually lose roughly two thirds of its May 20, 2015 peak valuation of 2134.72, with its next bear-market bottom perhaps occurring in late 2017 or early 2018. The Russell 2000 Index and its funds including IWM are trading below their levels from the first week of March 2014; small-cap U.S. equities typically lead the entire U.S. equity market lower as they have done in past decades including 1928-1929, 1972-1973, and 2007. Those who have "forgotten" or never learned the lessons of previous bear markets are doomed to repeat their mistakes.

Question: Do you plan to take advantage of the impending real estate collapse? If so, how? Please email answers to sjkaplan@truecontrarian.com.

Tuesday, November 24, 2015

"I am not worried about the deficit. It is big enough to take care of itself." --Ronald Reagan, March 24, 1984

STOPPING STOPS (November 24, 2015): The following news article appeared earlier this month:

  • NYSE Joining Nasdaq in Eliminating Stop Orders


  • Here is a continuing blog on this ban, which oddly also applies to good-till-canceled (GTC) orders starting on February 26, 2016:

  • NYSE to End GTC and "Stop Orders"


  • Stop orders still exist on many other exchanges in the United States and elsewhere, so I think it remains important to discuss why they are so dangerous even though they seem so safe. I will also give my opinion about why good-till-canceled orders are important and why I hope that several U.S. and other exchanges will change their plans to eliminate them.

    In the financial markets, no one likes risk. Therefore, all kinds of methods have been designed in an attempt to minimize it. One method which sounds good is to place a stop-loss order after you have bought anything. If you have purchased a particular security at a price of 20, and you place a stop-loss order at 19, then you believe that you won't lose more than 5% on that particular trade. Your expectation is that once the price drops to 19, you will sell it and thus avoid potential future losses.

    The reason why this is appealing is that it creates the internal illusion that you are controlling your risk. Consider the fate of two gamblers, each of whom decides to play roulette continuously from 8 a.m. to noon, then to take a one-hour break for lunch, and then to resume play from 1 p.m. to 5 p.m. Gambler #1 remains at the same roulette wheel all day, since he knows all of the people there and enjoys chatting with them as he is betting. Gambler #2 has a rule: whenever she is behind by more than fifty dollars at any given roulette wheel, she immediately moves to the next roulette wheel. Throughout the day, both make bets of equal sizes, both make the same kinds of bets, and both also make the same total number of bets. Which gambler is likely to have the best result at the end of the day?

    If you are reasonably knowledgeable about probability, then you know that both gamblers have the same expected average outcome. They are making the same number of equal-sized and equal-odds bets, and therefore it doesn't matter which roulette wheel they choose or how often they switch from one to another. The average outcome can be precisely computed with this kind of information. The actual results can very tremendously from this average, so both gamblers are likely to end up with very different net results--but it will have nothing to do with the strategy which they have implemented. Because the results are entirely due to chance, there will be no difference in the long run. The gambler who continued to change from one wheel to another may tell herself that she was limiting her losses as a result of her method, but there was actually no such effect.

    The same would be true in theory if the financial markets behaved continuously--in other words, if prices smoothly moved up or down at any given instant in time. One person may feel emotionally more comfortable closing out his position whenever he is losing 5% on any given trade, so he always places a stop-loss order 5% below his purchase price. However, if he immediately takes the money from that sale and purchases another security of equal volatility, then the long-term result will be exactly the same as if he had done nothing. At any given time, he is just as fully invested as the person who simply buys and holds on, and therefore whether he restricts his loss to a particular percentage or not, the combined effect will be the same. If there is a long losing streak for both kinds of participants, then one person will lose 5% on each of a dozen different trades while the other investor loses 60% on a single trade. Either way, the actual expected outcome is identical in both cases.

    In the real world, there are other factors to be considered. Traders who frequently buy and sell will usually have to pay higher commissions than those who trade less frequently. In countries including the United States and Australia, but not in Canada, there are favorable long-term capital gains tax rates which are about half the short-term rates and which only apply to positions which have been open for more than a year (one year and one day or more in the U.S.; one year or more in Australia). Therefore, in the long run, the difference in strategy will be unfavorable to the person who frequently uses stop-loss orders and other methods which encourage frequent trading, because the commissions will usually be higher and the total taxes owed will also be greater.

    What is much more serious than these problems is the fact that the financial markets don't behave continuously. Price movements often make sudden lurches both higher and lower. These are not necessarily due to any rational behavior, but because humans will emotionally crowd into a security which has suddenly announced positive news and will panic out of the stock market when there has been a recent sharp correction and everyone decides nearly simultaneously that they want to get out. The most common time for a sudden slump tends to be on Monday morning following a downtrend, because many people will brood in an atmosphere of media gloom and doom throughout the weekend and will often place market sell orders. Those who have placed stops will end up finding that their stop-loss orders combined with market sell orders will trigger a domino effect, thereby causing lower-priced stop-loss orders to be triggered and new market sell orders to occur from panicked holders who don't understand what is happening and prefer to sell first and ask questions later.

    You may be thinking that this only occurs for the most illiquid and infrequently traded securities, but shortly after the open on Monday, August 24, 2015, it happened for hundreds of popular exchange-traded and many closed-end funds. Yesterday, I was looking at a chart of various sectors and discovered this behavior for First Trust Consumer Staples AlphaDEX Fund (FXG):


    Some investors in FXG must have decided that it would be a good idea to place stop-loss orders. Some likely did so in the low 40s or the high 30s, while others placed orders closer to 35 or 30. On August 24, 2015, the price opened below 40 which caused some people to simply panic and place market sell orders, while meanwhile those who had placed stop-loss orders were already having their orders processed. In the rapid plunge, even those who had placed stops in the low 30s or high 20s ended up selling in some cases below 28. As happens with all rapid collapses, eventually the number of limit buy orders--many of which were good-till-canceled--finally overwhelmed the combined selling of market orders and stop-loss orders. Once that happened, the vacuum reversed and incredibly quickly FXG surged into the high 30s and then the low 40s once again. This was wonderful for those who bought it in the high 20s, but for those who were stopped out at 29 or 28, they had to decide whether to get back in at 41 or 42 and thus pay perhaps 40% more for this fund than they had just sold it for a short while earlier.

    You might think that I intentionally chose FXG because it was the most extreme example of fund behavior that day, but actually I was just reviewing the recent behavior of various market sectors and this one caught my attention. FXG was not even on the lists of the biggest deviations from net asset value which were described in the following three links:

  • 5 Lessons from the S&P 500 Market Crash for ETF Portfolios


  • Market Plunge Provides Harsh Lessons for ETF Investors


  • The Great ETF Crash of 2015


  • From the above links, you can see that some funds which are much more diversified, more liquid, with greater total assets, and with much higher daily volumes than the one I cited ended up experiencing even larger percentage fluctuations shortly after the open on August 24, 2015. Funds like iShares Select Dividend ETF (DVY) and Guggenheim S&P 500 Equal Weight ETF (RSP) were especially volatile early that morning, and are considered by most analysts to be among the most predictable and consistent long-term U.S. exchange-traded fund performers. The most liquid exchange-traded funds including Power Shares QQQ Trust Series 1 (QQQ) and iShares S&P 100 ETF (OEF) experienced notably less intraday volatility than the funds listed above, but even these suffered dramatic plunges following the open on August 24, 2015.

    Of the three links above, the one at the bottom is perhaps the most useful because it lists those which had the largest percentage dislocations from net asset value. It should be made clear that the actual assets which constitute these exchange-traded funds had also fluctuated much more than they would on a normal trading day, but the real issue was how steeply many funds' discounts to net asset value soared and then collapsed within minutes and sometimes within seconds. If you were fully prepared in advance to take advantage of these kinds of mispricings, if you hired others to watch for you, and all of you were doing nothing but scanning multiple monitors with one eye while placing trades with the other, then you still would have had extreme difficulty in placing orders fast enough to be executed near the most favorable prices. Only those who had placed limit orders in advance would have received the most favorable fills.

    The above behavior is the primary reason why exchanges are progressively banning the use of stop-loss orders. Panics and sharp corrections will periodically happen, and those who use these orders will get burned and will complain the most to their brokers and to the exchanges. With the introduction of the internet, stop-loss orders have become far more popular than they had been in pre-internet times. If only a few traders are using any strategy, stops or otherwise, then it will have less of an impact. If many are placing stop-loss orders and they are triggered in a cascade, then paradoxically the wish to limit losses ends up ensuring even larger losses.

    There are other drawbacks with using stop-loss orders. Most traders place these near similar prices, generally close to round numbers to make them easier to remember. As a result, securities will often slump just enough to knock out these stops and will thereafter rebound rapidly. Those who were stopped out then have to decide whether to buy back their positions at significantly higher prices, or to buy something else instead which might then suffer a similar fate. In many markets, floor traders and others who pay for the information can actually see others' stops, so they know exactly when they can temporarily place some sell orders just to trigger a cascade of stops, thereafter buying back their positions at lower prices. This happens routinely with some securities and more choppily with others. In addition to this behavior occurring frequently with exchange-traded and closed-end funds, it happens with individual securities on various occasions. If a stock is about to double from 22 to 44, it will sometimes briefly slide below 20 to knock out sell stops which are often placed close to such a round number. I have seen instances in which there was a rapid price drop that was reversed within seconds, so that it lasted just long enough to knock out sell stops. It also happens the other way for securities which are popular with short sellers; there will be a temporary short squeeze where the price will rise just enough to knock out buy stops, cause a rapid cascade of buying to reach a price which will force out some short sellers who are using margin, and will then collapse back to the original price shortly thereafter. Several years ago there was a particularly spectacular instance of this with Volkswagen which is a highly liquid stock and which therefore wasn't expected to behave in such a manner by most short sellers at that time.

    Good-till-canceled orders are most popular with highly disciplined investors who will construct ladders of GTC orders to gradually purchase a security into weakness whenever it unexpectedly plunges in price as I often recommend near the end of any extended bear market. Because they help to balance the market on both ends and to prevent extremes from becoming even more ridiculously extreme, it is puzzling why some exchanges are considering removing them. Perhaps some traders had placed orders and forgot about them, and then when they were filled several months later these folks ended up complaining that they hadn't intended for their orders to persist for so long. Possibly there will be a compromise where instead of being truly good-till-canceled they will be valid for six months or some other period of time as many brokers already do to control such orders. The biggest advantage of GTC orders is that they permit gradual rebalancing of portfolios to take advantage of the best bargains and to sell the trendiest holdings while acting in small steps. It isn't practical or logical for traders to have to re-enter dozens or hundreds of orders every single day. Since good-till-canceled buy orders placed well below the bid are the primary source of support to prevent even worse intraday plunges, and since GTC orders placed well above the ask price are an important source of selling to keep some equilibrium during a euphoric uptrend, the exchange should be encouraging greater use of good-till-canceled orders instead of planning to get rid of them. As bad as stop-loss orders are in accelerating the most irrational behavior, GTC orders used properly are among the best kinds of market balancing which exist. I am therefore campaigning to get the NYSE, Nasdaq, BATS, and other exchanges to change their plans to remove good-till-canceled orders which the NYSE wants to eliminate starting on February 26, 2016.

    A useful corollary is that there is no magic bullet to reducing risk. Being diversified helps, but sometimes numerous assets will rise or fall together even if they may seem to be unrelated. Whether it makes sense to have a combination of historically overvalued assets is also questionable, since assets which are significantly above fair value tend to eventually become roughly equally undervalued. Buying lots of small quantities of undervalued securities, especially those which historically have the least correlation with each other, is probably the best long-term approach and is used by a number of long-term fund managers including Howard Marks. In the end, the only real protection against loss is having a lot of money in safe time deposits like bank accounts which are derided when they are paying one percent interest or less but which are the only true protection against market fluctuations. The main problem with gimmicks like stop-loss orders and various kinds of technical methods is that they can create the illusion of stability, safety, and loss aversion when it doesn't exist. This can psychologically encourage some traders to take dangerous risks which aren't appreciated until we have days like August 24, 2015. If you are taking on too much risk, then you may end up dumping assets which are underperforming, or not purchasing bargains which you know to be compelling, or otherwise becoming emotionally influenced in your trading decisions. One useful test is what I call the thousand-dollar test: if you only had a thousand dollars or less in any given security instead of whatever you have now, would you trade it differently? If so, then you are taking on too much risk no matter what you think your risk tolerance is. The level which would make you uncomfortable is entirely due to psychological factors, so it will vary considerably from one person to another. I once did an experiment where I asked people before playing Monopoly to give me twenty dollars for dinner; I gave each person five dollars back and pointed out that since they had 1500 play dollars in the game then these represented fifteen actual dollars. Even at a penny per dollar, players ended up making absurdly poor decisions such as not buying enough property or avoiding trades because they kept fretting about the "real money" they would be spending. Eventually I gave everyone back their original money because they became so emotional about the progress of the game.

    Disclosure: Whenever they have appeared to be especially depressed, I have been buying the shares of funds which invest either in emerging-market assets or in the shares of commodity producers, since I believe these are among the two most undervalued sectors in a world where real estate and U.S. equity indices remain dangerously overvalued. As the extremely popular U.S. dollar stuns investors by suffering a bear market instead of continued gains as almost everyone is expecting, this will lead to a major upward revision in global inflationary expectations. From my largest to my smallest position, I currently own GDXJ, KOL, SIL, XME, HDGE, COPX, GDX, EWZ, RSX, REMX, GLDX, URA, FCG, IDX, GXG, VGPMX, ECH, VNM, BGEIX, NGE, RSXJ, PLTM, EPU, TUR, SILJ, SOIL, EPHE, and THD. I expect the S&P 500 to eventually lose roughly two thirds of its May 20, 2015 peak valuation of 2134.72, with its next bear-market bottom perhaps occurring within several months of October 2017. The Russell 2000 Index and its funds including IWM had only modestly surpassed their highs from the first week of March 2014 and are currently trading below those levels; small-cap U.S. equities typically lead the entire U.S. equity market lower as they have done in past decades including 1928-1929, 1972-1973, and 2007. Those who have "forgotten" or never learned the lessons of previous bear markets are doomed to repeat their mistakes.

    Wednesday, November 11, 2015

    "Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery." --Charles Dickens

    LOST IN ROTATION (November 11, 2015): Imagine if a weather forecaster were to announce in August that because the usual cooling that month hadn't occurred and temperatures were even hotter than in July, we must be making a decisive upside breakout and we won't need cold-weather clothing for several more years. Or imagine an astronomer announcing that we won't have the usual appearance of Halley's Comet because the core nature of the universe which had been established over billions of years has permanently changed during the past decade. While most cyclical phenomena are accepted as an inherent part of life, in the financial markets there are a surprising number of analysts, advisors, and others who refuse to acknowledge that there is a rotation which has existed for thousands of years and will continue to exist as long as humans are populating planet Earth. Each time we have an economic boom, many believe that we are not going to experience another recession--or that somehow an especially powerful or extended era of prosperity will magically be followed by an especially mild downturn. Pointing to history carries a lot of weight in some fields of endeavor, but in the financial markets it doesn't exert much impact because so many people will always think that "it's different this time." In 2000, many believed that technology shares could only go up because we never had the internet before, and then the Nasdaq suffered its worst-ever percentage decline of more than three fourths of its value. In early 2009, perhaps even more people were convinced that global stock markets would take years to even moderately rebound, because we had never suffered a subprime asset collapse before. Looking back at previous centuries, many pointed to canals, railroads, and other phenomena as evidence that the world had completely changed, and therefore well-established patterns--the earliest known writing consists of a sequence of grain trades--had become obsolete and had to be replaced by an entirely different set of theories. In the end, the strongest and most extended bull and bear markets will continue to be followed by the most powerful moves in the opposite direction, just as had been the case a decade or a century ago.

    We are currently in the process of another typical rotation from a bull market for U.S. equity indices including the Russell 2000 (IWM), the S&P 500 (SPY), the Nasdaq 100 Trust (QQQ), and the Dow Jones Industrial Average (DIA) into a bear market for the same assets. One common sign that a transition has occurred is when the smallest stocks as a group have been struggling to achieve historic peaks, while the largest stocks have been able to do so. QQQ reached an intraday top of 115.47 on November 4, 2015, which it had not previously touched since March 28, 2000 and which in dividend-adjusted terms had been a new all-time high if you don't adjust for inflation. However, the highest that IWM could get in recent weeks was 119.36 on November 6, 2015, which was considerably below its all-time top of 129.10 from June 24, 2015. Currently, IWM is trading below its highs from the first week of March 2014 which was more than 20 months ago, indicating that it has actually been underperforming for an extended period of time. This kind of underperformance by thousands of small U.S. companies had also occurred in 2007 as the 2007-2009 bear market was beginning, and had been a key feature of the U.S. stock market in 1971-1972 prior to the 1973-1974 bear market. The same had been true in the late 1920s prior to the worst bear market in U.S. financial history, and on several occasions in the 1800s. What is fascinating is not only how consistently this pattern tends to appear, but how investors behave each time. You would expect investors to look back at the past and say to themselves, "A common pattern of lagging small-stock behavior is probably signaling that we are transitioning to a bear market for U.S. equities. So it makes sense to gradually sell into all rallies." Instead, most investors tell themselves, "The past doesn't matter, because we never had (canals) (railroads) (automobiles) (semiconductors) (the internet) before. So a completely different set of rules are in force." Technical traders insist, "Since larger stocks are continuing to outperform, continue to sell small stocks and move the money into large-cap U.S. equities." Sometimes this technical pattern becomes so widespread, as in January 1973, that an astonishing percentage of investors end up crowding into a narrower and narrower set of stocks. To a less dramatic extent, but no less dangerously, this occurred near the end of 2007 and has been happening in recent months. It is no coincidence that Marc Andreessen, a founder of Facebook (FB), recently sold nearly half of his total position in that company which he had held throughout the bull market. Insiders in many large-cap names have accelerated their selling relative to buying in recent weeks, in order to take advantage of many investors making a rotation but going about it in a dangerous way. Shifting from large-cap to small-cap U.S. equities is like noticing that some first-class passengers on the Titanic have decided to abandon ship; instead of finding out why, you happily move into their vacant deluxe cabin. Investor inflows into large-cap U.S. equity funds have been especially intense in recent weeks, with many of them concluding that we had already experienced our correction for 2015 and that it will be sunshine and chocolate cookies from now on. Whenever too many people are expecting smooth sailing, watch out for rough seas.

    A common rotational pattern during the early stages of a bear market is for inflationary expectations to increase. This was clearly evident in 2007-2008, 2000-2001, 1978-1980, 1972-1974, 1936-1937, 1928-1929, and during many other previous transitions to bear markets. Any economic expansion which lasts more than a few years will eventually lead to the ability of companies to raise prices and for workers to demand higher wages to allow them to share in the economy's prosperity. According to U.S. government data contained in the employment report released on Friday, November 6, 2015, average U.S. hourly wages have been growing at 2.5% annualized which is the fastest pace of increase since 2009. Other signs of inflation have been more difficult to find due to extended bear markets for most commodities, but historically this is the time when commodities and the shares of their producers will tend to strongly outperform other assets. It is highly likely that many investors who had money in commodity producers or emerging markets in recent years ended up selling them and using the money to buy U.S. equity funds--not because it was logical to sell the most undervalued securities to buy the most overvalued ones, but because emotionally people hate holding onto anything which has been in an extended bear market and love to own anything which has enjoyed an extended bull market, which in this case had become among the lengthiest and strongest bull markets in U.S. history. While there have been problems with subpar growth and political turmoil in many emerging markets--with the former usually contributing significantly to the latter, since prospering economies will overlook political shenanigans--the relative price-earnings ratios and other measures of valuation are far out of line with what they should be based upon corporate profit growth. It isn't logical that U.S. equities should still be more than three times as expensive as they had been at their lows in early March 2009, while many emerging-market bourses are trading near or below their lowest levels of the previous recession--and in several countries even lower than the recession before that. Especially undervalued bourses include those in Latin America (ILF), including Brazil (EWZ) and Colombia (GXG), along with many African (AFK) economies including Nigeria (NGE) and others near and south of the equator such as Australia (EWA) and South Africa (EZA).

    The real reason that investors haven't been accumulating the most undervalued securities is that most people are afraid to buy anything which has suffered an especially severe and lengthy downturn. They will usually change their mind once there has been a significant percentage rebound such as 50% for some investors and 100% for others. In addition, as long as they hold out hope that U.S. equity indices will remain in uptrends, they will be reluctant to sell something with which they are very familiar in order to buy something with which they intuitively feel less comfortable. Nonetheless, during nearly all previous transitions from a bull to a bear market, investors eventually crowded into commodity producers and emerging markets, so what is really required is for this process to reach a more advanced stage where investors feel that they are missing out on a fantastic opportunity by not participating along with their friends who have recently been making money in those assets. Eventually, fear about buying something which has been in a crushing downtrend is replaced by a greater concern of having a major bull market in something passing them by without their being part of it. Rotations begin with an inevitable shifting out of the most overpriced assets into the most underpriced securities, and usually ends with the previous big losers becoming the strongest percentage winners. Funds which had been especially unpopular and have likely completed or will soon complete historic bottoms include silver mining shares (SIL), copper mining shares (COPX), coal mining companies (KOL), uranium mining companies (URA), and natural gas producers (FCG).

    Other events tend to happen when this transition is underway. As inflationary expectations increase, assets which benefit from deflation will notably underperform. These primarily include high-dividend shares of all kinds, including utilities (XLU), REITs (IYR), long-dated U.S. Treasuries (TLT, VUSTX), and preferred stocks (SPFF). The fact that all of the above sectors have been in downtrends is probably not a coincidence, since they will typically begin bear markets prior to broader-based U.S. equity funds as they had done in each of the past several transitions to bear markets. I have seen a lot of commentary about how "there is no sign of rising inflation anywhere," but the behavior of the above equity groups serves as a compelling omen of what is most likely to occur.

    It is important to note that since the financial markets have been and always will be cyclical, a period of rising inflationary expectations will not last indefinitely. In a typical transition, U.S. equity indices are in a bear market but contrary to popular perception rarely end up crashing. Instead, there is a sequence of several or more corrections, each one which is followed by a sufficiently convincing rebound to discourage most investors from selling. A pattern of several lower highs is thus established. At the same time, high-dividend sectors including U.S. Treasuries continue in their bear markets, while previous losers including commodity producers and emerging markets will often transform themselves from the least popular to the trendiest assets. Whenever Treasuries are least desired and commodities are back in favor, you will see projections by the same analysts who had been simultaneously forecasting gold (GLD) at 1000 U.S. dollars per troy ounce or lower and crude oil (USO) at 30 U.S. dollars per barrel or lower competing with each other to give the most aggressive upside targets for commodity prices. Whenever this happens, it usually makes sense to gradually sell the shares of commodity producers and emerging markets to purchase very unpopular U.S. Treasuries especially on the longer end of the curve and particularly if Treasuries are trading at their lowest points in several years or more. The reason is that, during any U.S. equity bear market, the first 70-80% of the transition is one where many equity sectors underperform while a minority of sectors are dramatically surging higher. In the final 20%-30% of the bear market, it is usually the case that almost all risk assets will plummet simultaneously--not necessarily by the same percentages, but with nearly all of them suffering substantial percentage losses. During this collapse phase of a bear market, among the few winners will tend to be funds like TLT, other long-dated U.S. Treasury securities, and not much else. Perhaps the second or plunging phase of the current bear market will begin at some point during 2017. During such a collapse, the risk-off behavior is so predominant that it is usually folly to try to pick the very few risk assets which will be climbing in price.

    Investors always want to know what is unknowable, which is how extended any given trend will become, how high or low any given asset will get, and when it will happen. The same people rarely respect even the best-established historic patterns, so that they believe that each time it is completely different from the past when it is almost always an approximate repeat. Therefore, it is like a horse race in which the selections which should be odds-on favorites instead end up sporting the odds of true dark horses with incredible long-shot payoffs. Most investors currently believe that broad-based U.S. equity indices will continue to outperform while commodity producers and emerging markets will continue to retreat, while the opposite is likely to prove true primarily because such behavior has almost always been the case for many decades. The world has certainly changed, but the financial markets tend to behave almost exactly the same.

    Disclosure: In August-September 2013, and at various points during 2014-2015, I have been buying the shares of emerging-market country funds whenever they have appeared to be most undervalued. Since June 2013, I have added periodically to funds of mining shares--and more recently energy shares--especially following their most extended pullbacks. I have also been accumulating HDGE whenever U.S. equity indices are near their peaks; HDGE is an actively-managed fund that sells short U.S. equities. I believe that U.S. assets of almost all kinds have become dangerously overvalued. From my largest to my smallest position, I currently own GDXJ, KOL, SIL, XME, HDGE, COPX, GDX, EWZ, RSX, REMX, GLDX, URA, FCG, IDX, GXG, VGPMX, ECH, VNM, BGEIX, NGE, RSXJ, PLTM, EPU, TUR, SILJ, SOIL, EPHE, and THD. In the late spring of 2014, I sold all of my SCIF which had briefly become my fourth-largest holding, because euphoria over the Indian election was irrationally overdone and this fund had more than doubled. I have reduced my total cash position to roughly 3% of my total liquid net worth in order to increase my holdings in the above assets. I sold all of my SLX by acting whenever steel insiders were doing likewise. I also sold all of my FCG when insiders were unloading, but I repurchased FCG in recent months following its collapse of more than three fourths of its June 2014 peak because there had been intense buying by top corporate insiders of companies which produce natural gas. I expect the S&P 500 to eventually lose about two thirds of its May 2015 peak valuation, with its next bear-market bottom occurring within several months of October 2017. The Russell 2000 Index and its funds including IWM had only modestly surpassed their highs from the first week of March 2014, while the Russell Microcap Index (IWC) marginally surpassed its zenith from March 6, 2014. The S&P 500 Index set a new all-time high on numerous occasions during the same period, and may have completed its final top for the cycle at 2134.72 on May 20, 2015. This marks a classic negative divergence which previously occurred in years including 1928-1929, 1972-1973, and 2007. Those who have "forgotten" or never learned the lessons of previous bear markets are doomed to repeat their mistakes.

    How do YOU personally handle being "lost in rotation"?  Have you switched strategies or are you standing your ground? 

    EMAIL your answer to sjkaplan@truecontrarian.com 

    Sunday, November 1, 2015

    "What is a cynic? A man who knows the price of everything and the value of nothing." --Oscar Wilde

    GOLDMAN SACHS IS WRONG; THE U.S. DOLLAR IS IN A DOWNTREND WHICH WILL ACCELERATE (October 30, 2015): Goldman Sachs (GS) announced on Thursday, October 29, 2015 that the U.S. dollar would achieve parity with the euro before the end of 2015. Goldman Sachs is also bearish toward the currencies of commodity-country and emerging-market currencies including the Canadian and Australian dollars, expecting the loonie and aussie to retreat significantly versus the greenback during the next several months. Goldman Sachs believes that the price of crude oil will plummet to 20 U.S. dollars per barrel and that gold will slump below one thousand U.S. dollars per troy ounce. What the above outcomes all have in common is the anticipation of intensifying deflation and a surging greenback, along with continued declines for commodity prices. It is interesting to note how bullish Goldman Sachs was toward all of the above during the first half of 2008, just before they all plummeted by historic percentages within less than a year. More importantly than their track record, however, is the logic which is used by Goldman Sachs and many other analysts to justify their expectations for a stronger U.S. dollar and lower commodity valuations.

    One popular myth is that currencies with rising interest rates will outperform those with falling interest rates. If the U.S. Federal Reserve is considering raising the overnight lending rate, while the European Central Bank is considering lowering it, then supposedly this means a higher U.S. dollar versus the euro. However, it usually works the opposite way. Emerging-market currencies have among the highest interest rates in the world, and their currencies have slumped versus the greenback especially when their rates were ascending the most. Rate increases generally reflect an anticipated rise for inflation, and global investors tend to avoid countries with rising wholesale and retail inflation which will erode the value of their holdings. Therefore, it is often the countries where rates are declining that will attract the strongest worldwide inflows. Those emerging markets where interest rates have been slashed the most in recent weeks have generally enjoyed the most powerful rebounds in their currencies.

    One measure of purchasing power parity can be achieved by calculating how much it costs in U.S. dollars to buy a particular item which is virtually identical around the world. For example, a Big Mac at McDonald's (MCD) in one country is essentially indistinguishable from a Big Mac ordered in a McDonald's in a completely different continent. Therefore, you would expect their prices to be almost identical, but there are actually substantial differences in price in varying cities. Wherever the prices of Big Macs have been cheapest in past decades, the currencies later climbed higher; where the Big Macs were most expensive, the currencies retreated in price. This didn't always happen immediately, and sometimes the extremes first became even more extreme, but eventually there was some kind of global parity. Currently, the cheapest Big Macs are in emerging-market economies. Below-average prices can also be found in countries with high ratios of commodities to people including New Zealand, Australia, and Canada.

    Some emerging-market and commodity-country currencies recently slumped to their most depressed levels in history versus the U.S. dollar, while others fell to their lowest points in many years. In the middle of March 2015, the U.S. dollar index climbed to a 12-year top. Extremes can often become even more extreme, but a scan of brokerages and other institutions shows that nearly all of them are on the same side as Goldman Sachs even if their short-term forecasts are less drastic. Almost all of them are expecting a generally rising U.S. dollar, and almost all of them are also expecting lower prices for commodity-related assets including currencies of commodity-producing countries, the shares of commodity producers, and commodities themselves. Any nearly unanimous consensus generally proves to be wrong sooner or later, because everyone trades on the same side in anticipation of a particular outcome which thereby makes such an outcome much less likely to occur. For example, if nearly all futures traders are expecting a higher U.S. dollar, they will have already bought a large quantity of greenbacks. This leaves far fewer new potential buyers, while many who had bought U.S. dollars in anticipation of higher prices will be in position to sell them whenever they become disenchanted with their failure to behave as had been expected.

    There is an intuitive emotional tendency to project the recent past into the indefinite future, especially when recent behavior has remained generally consistent for an extended period of time. If there has been a bear market for several years or more, then one begins to take for granted that it will continue for several more years. Most emerging-market currencies and equity markets had peaked during or near April 2011, and therefore had been in bear markets for more than four years by the time that these assets completed historic bottoms during the past summer or early autumn. It is possible that some commodity-related assets haven't yet achieved their ultimate nadirs for the cycle, although their patterns consisting mostly of higher lows during the past several weeks tend to signal that their trends have already reversed. Looking at charts of natural gas producers (FCG), gold and silver mining companies (GDX, SIL, and GDXJ), and Latin American equities (ILF, EWZ, and GXG), these vary somewhat but all have in common that 1) they lost dramatic percentages since April 2011; 2) they reached multi-year, multi-decade, or all-time bottoms from July through September 2015; and 3) following their respective bottoms, they appear to have formed several higher lows in the kind of choppy trading with frequent corrections which tends to characterize the early months of any powerful bull market. Media and analysts' coverage has remained almost universally gloomy toward all of the above securities with very few agreeing that these and similar assets may have begun important bull markets. The most common explanation by many bearish analysts is that since those who are bullish have been wrong recently, they will continue to be wrong. Similar arguments would lead to not buying near the bottom for anything, because those who have been bullish will always have been recently "wrong" at any nadir.

    Because most U.S. equity indices have rebounded smartly in recent weeks, many investors and analysts have concluded that their corrections are over and that the next few years will enjoy frequent new all-time highs. I think this is a seriously flawed conclusion, since we have experienced classical divergences which generally indicate that we are already in a bear market. Fewer stocks have been able to accomplish new all-time highs than had been the case a half year ago, while indices of the smallest companies are still trading below their levels from early March 2014 which was more than 1-1/2 years ago. Just as in 2007-2009 or 2000-2002 or 1973-1974--or any past severe bear market--investors aren't worried about the possibility of the existence of a bear market, figuring that all corrections are good buying opportunities and that new all-time highs for the S&P 500 (SPY), the Nasdaq (QQQ), and the Russell 2000 (IWM) must lie just around the corner. Thus, the vast majority of participants are convinced that the U.S. stock market is still rising and that the U.S. dollar is doing likewise, even though both have probably already begun important downtrends. There are many brokerages and analysts which have forecast the price of gold to drop by roughly 150 U.S. dollars per ounce or more, while almost none of them expect the gold price to rise by a similar amount. Whenever almost everyone is aligned on the same side of any trade, the opposite almost always occurs so that the majority of investors repeatedly end up losing money.

    Many media commentators and others misinterpreted the Fed's latest rate announcement. The Fed declared that they would decide at the next meeting about whether or not to raise the overnight lending rate--but nearly all analysts left out the second part of this statement which explicitly stated that they would only do so if inflation had reached or exceeded two percent. Regardless of what happens between now and December 2015, there are very few scenarios where the rates of inflation which are tracked by the Fed for this purpose could realistically surge to 2.0% or above. Therefore, the Fed isn't announcing that they might raise rates at the next meeting--they are telling you why they aren't going to do so! I didn't see a single media outlet explaining this in its proper detail.

    As a result, all of the deflationary forecasts by Goldman Sachs will prove to be as misguided as their inflationary predictions had been in 2008 and 2011. Gold (GLD) will rally instead of retreating to one thousand, crude oil (USO) will similarly climb, and nearly all other commodities including metals (XME) and energy assets (XLE) will recover half or more of their losses which they had suffered in recent years. Emerging-market assets (EEM), which had also experienced severe multi-year percentage declines, will enjoy analogous rebounds. The U.S. dollar (UUP), which is widely expected to resume its former uptrend, will instead retreat to a multi-year bottom versus most global currencies including the Canadian dollar (FXC) and the Australian dollar (FXA). I am less of a fan of the euro (FXE) or yen (FXY), but even these two popular currencies will move higher versus the U.S. dollar as investors become increasingly eager for alternatives to a sliding greenback for the remainder of 2015, probably for most or all of 2016, and perhaps into early 2017.

    Disclosure: In August-September 2013, and at various points during 2014-2015, I have been buying the shares of emerging-market country funds whenever they have appeared to be most undervalued. Since June 2013, I have added periodically to funds of mining shares--and more recently energy shares--especially following their most extended pullbacks. I have also been accumulating HDGE whenever U.S. equity indices are near their peaks; HDGE is an actively-managed fund that sells short U.S. equities. I believe that U.S. assets of almost all kinds have become dangerously overvalued. From my largest to my smallest position, I currently own GDXJ, KOL, SIL, XME, HDGE, COPX, GDX, EWZ, RSX, REMX, GLDX, URA, FCG, IDX, GXG, VGPMX, ECH, VNM, BGEIX, NGE, RSXJ, PLTM, EPU, TUR, SILJ, SOIL, EPHE, and THD. In the late spring of 2014, I sold all of my SCIF which had briefly become my fourth-largest holding, because euphoria over the Indian election was irrationally overdone and this fund had more than doubled. I have reduced my total cash position to roughly 3% of my total liquid net worth in order to increase my holdings in the above assets. I sold all of my SLX by acting whenever steel insiders were doing likewise. I also sold all of my FCG when insiders were unloading, but I repurchased FCG in recent months following its collapse of more than three fourths of its June 2014 peak because there had been intense buying by top corporate insiders of companies which produce natural gas. I expect the S&P 500 to eventually lose about two thirds of its May 2015 peak valuation, with its next bear-market bottom occurring within several months of October 2017. The Russell 2000 Index and its funds including IWM had only modestly surpassed their highs from the first week of March 2014, while the Russell Microcap Index (IWC) marginally surpassed its zenith from March 6, 2014. The S&P 500 Index set a new all-time high on numerous occasions during the same period, and may have completed its final top for the cycle at 2134.72 on May 20, 2015. This marks a classic negative divergence which previously occurred in years including 1928-1929, 1972-1973, and 2007. Those who have "forgotten" or never learned the lessons of previous bear markets are doomed to repeat their mistakes.

    Do YOU engage with media from mainstream corporate sources such as Goldman Sachs, and if you do, how does the information you find factor into your overall opinions?

    EMAIL sjkaplan@truecontrarian.com with your answer. 

    Wednesday, October 21, 2015

    "He who wishes to be rich in a day will be hanged in a year." --Leonardo da Vinci

    INVESTORS ARE FINALLY PUTTING THEIR CASH TO WORK, PRIMARILY INTO TWO CATEGORIES OF ASSETS (October 20, 2015): The title of my previous posting was "investors have been selling but haven't yet decided what to buy." I had studied published fund flows and discovered that money had mostly gone out of equity and corporate bond funds into money market funds and bank accounts, but very little of that money had been shifted into other assets. I speculated that, as is typical in the early stages of any U.S. equity bear market, investors were nervous about a global stock-market decline, so their first reaction was to sell without buying anything with the money. I concluded that this decision not to buy anything was temporary, and that they would soon decide to make purchases which would mostly end up surprising many analysts. During the past few weeks, investors have indeed been making clear decisions about what they most wanted to accumulate. These decisions have primarily benefited two major kinds of risk assets. It is worth examining how this will affect the financial markets going forward.

    Only a relatively small percentage of this money which had come out of U.S. equity funds has gone back into the previous favorites, which includes funds based upon the Dow Jones Industrial Average, the S&P 500, the Nasdaq, the Russell 2000, and similar index-based choices. Investors are progressively concluding that the best-known best-known benchmark U.S. equity indices are unlikely to keep making new all-time highs as they had routinely done in 2013-2014 and during the first several months of 2015. This is significant, because it probably means that we have transitioned from a bull market which lasted for roughly 6-1/4 years to a bear market which could persist for roughly another two years. It is also noteworthy that investors haven't just kept their money in cash, not just because cash pays almost zero interest, but because the overall percentage declines in their overall net worth have been modest. Investors tend to pile into cash when losses have been so dramatic that they are concerned more about additional red ink than they are about making money or anything else.

    Investors' tend to usually be obsessed with not missing out on rallies for the latest hot assets. Since their respective bottoms primarily in the late summer and early autumn of 2015, there have been two primary groups of outperforming securities: 1) the most popular individual names which have been soaring in recent weeks amidst widespread glowing media coverage; and 2) especially oversold and undervalued assets, some of which had suffered bear markets for several years. The second category includes most shares of commodity producers and emerging markets which mostly began their respective bear markets in April 2011 and which had generally suffered substantial losses of more than half and in some cases of more than three fourths.

    Let us consider each of these kinds of decisions. It is easy to see why investors would embrace the latest trendy names on Wall Street. With Oprah Winfrey buying a much-publicized stake in Weight Watchers (WTW), who could resist such a celebrity-laden endorsement? Similarly upbeat media coverage has also boosted the shares of stocks including Amazon (AMZN), Facebook (FB), and Google (GOOG). The kinds of investors who have been buying these shares are generally amateurs who watch cable TV and browse the internet periodically, and are especially attracted to stocks which have easily remembered stories and are familiar to them in their daily lives. Whenever a bull market is transitioning to a bear market, there will be fewer and fewer winners, so more and more people will want to own whatever is going up.

    There is a second group of securities which is much less widely known and which so far has continued to receive mostly gloomy media coverage and negative analysts' commentary. This includes the shares of nearly all commodity-related assets, including commodity producers and emerging-market shares. Since these achieved their respective multi-year and multi-decade bottoms primarily during the summer and early autumn of 2015, they have been among the most notable outperformers especially in subsectors including gold and silver mining which have been the biggest percentage winners during the past several weeks. Besides being much less well known than the securities listed in the previous paragraph, these have been far more popular with insiders and institutions rather than with individual investors. From a fundamental point of view, the big-name stocks listed in the previous paragraph are probably significantly overvalued and sport unusually high price-earnings ratios in the cases where they are actually making money. In sharp contrast, most commodity-related and emerging-market assets have especially low historic price-earnings ratios and are mostly trading far below their respective fair-value levels. These are compelling bargains in both absolute and relative terms.

    As more time passes, I believe that most of the widely popular favorites will tend to fade as they usually do as a bear market experiences a natural state of maturing. On the other hand, since they had become so unpopular, even a reduction in the gloomy tone of the media and analysts' commentary could be accompanied by substantial percentage gains for commodity-related and emerging-market assets. Since most of these have slumped so dramatically during their extended bear markets, many of them could double and even triple while still remaining far below their peaks of recent years. For example, FCG, a fund of natural gas producers, had plummeted by more than three fourths from its June 2014 top to its September 29, 2015 bottom of 5.43. If it merely regains half its June 2014 high then those who bought it near the bottom will end up doubling their money on those purchases which were made close to the nadir. Another example is GDX, which had slumped by roughly 80% to its September 11, 2015 nadir of 12.62 and has since been among the biggest winners of all exchange-traded funds. Funds of junior producers such as GDXJ had suffered even greater percentage declines and could thus be especially impressive in the intensity of their rebounds. Gains of hundreds of percent are possible without new highs having to be achieved. Similarly outsized percentage increases could be the most likely scenario for many subsectors related to mining and energy. If this were a horse race, these should be favorites but instead carry the odds of long-shot dark horses.

    It is noteworthy that the kinds of behavior which typified the bear markets for commodity producers and emerging markets have been much less prevalent in recent weeks. Early intraday lows tend to be followed more frequently by rebound attempts. Many of these shares have formed several higher lows in recent weeks. Insiders had mostly been significant buyers near all low points during the past several months, while fund outflows had reached all-time record extremes for many subsectors. Most analysts and brokerages have continued to reiterate the downside targets for these generally unpopular assets, so that hasn't yet been transformed into progressively more bullish commentary which will likely begin to occur more frequently in the near future. Since many of these securities have been among the biggest percentage winners in recent weeks, they are slowly attracting the attention of momentum players and other groups of potential buyers. Some of their purchases have been especially untimely, tending to occur following recent extended short-term strength which usually leads to a rapid short-term correction in order to shake out the sell stops which so many of these kinds of traders tend to employ. We saw such a rapid correction especially on Friday, October 16 and Monday, October 19, 2015, and there will likely be more of them whenever people have become too optimistic toward their short-term behavior. Eventually, I expect to see amateurs following insiders and institutions in becoming buyers, since they will observe that many of these assets have doubled, tripled, or better, and will hate to miss out completely on such strong rallies.

    As is usually the case during any bull market, the earliest buyers tend to be insiders and deep value accumulators. This tends to be followed by a wide range of buyers at each step on the way up, until finally amateurs are eagerly participating while insiders begin selling. I think that we are probably a very long way from having to be concerned that these rallies are over or nearly so--especially since so much of the commentary on the internet in recent days has suggested that these rebounds are finished and that these assets should be sold short. A rally for anything doesn't end with most people believing that new historic lows lie shortly ahead, but when almost everyone is asking themselves how much higher it is likely to go and how long it will take for various upside targets to be surpassed.

    Disclosure: In August-September 2013, and at various points during 2014-2015, I have been buying the shares of emerging-market country funds whenever they have appeared to be most undervalued. Since June 2013, I have added periodically to funds of mining shares--and more recently energy shares--especially following their most extended pullbacks. I have also been accumulating HDGE whenever U.S. equity indices are near their peaks; HDGE is an actively-managed fund that sells short U.S. equities. I believe that U.S. assets of almost all kinds have become dangerously overvalued. From my largest to my smallest position, I currently own GDXJ, KOL, SIL, XME, HDGE, COPX, GDX, EWZ, RSX, REMX, GLDX, URA, FCG, IDX, GXG, VGPMX, ECH, VNM, BGEIX, NGE, RSXJ, PLTM, EPU, TUR, SILJ, SOIL, EPHE, and THD. In the late spring of 2014, I sold all of my SCIF which had briefly become my fourth-largest holding, because euphoria over the Indian election was irrationally overdone and this fund had more than doubled. I have reduced my total cash position to roughly 3% of my total liquid net worth in order to increase my holdings in the above assets. I sold all of my SLX by acting whenever steel insiders were doing likewise. I also sold all of my FCG when insiders were unloading, but I repurchased FCG in recent months following its collapse of more than three fourths of its June 2014 peak because there had been intense buying by top corporate insiders of companies which produce natural gas. I expect the S&P 500 to eventually lose about two thirds of its May 2015 peak valuation, with its next bear-market bottom occurring within several months of October 2017. The Russell 2000 Index and its funds including IWM had only modestly surpassed their highs from the first week of March 2014, while the Russell Microcap Index (IWC) marginally surpassed its zenith from March 6, 2014. The S&P 500 Index set a new all-time high on numerous occasions during the same period, and may have completed its final top for the cycle at 2134.72 on May 20, 2015. This marks a classic negative divergence which previously occurred in years including 1928-1929, 1972-1973, and 2007. Those who have "forgotten" or never learned the lessons of previous bear markets are doomed to repeat their mistakes.

    Saturday, September 26, 2015

    "The stock market is almost magical because it always leads the economy. It goes down long before the economy drops and then heads higher long before the economy rebounds. It always has." --Kenneth L. Fisher

    INVESTORS HAVE BEEN SELLING BUT HAVEN'T YET DECIDED WHAT TO BUY (September 25, 2015): If you look at the details of fund flows during the last several months, then you will discover that there have been net outflows from many funds of U.S. risk assets. This includes most U.S. equity and U.S. bond funds. As more and more time passes from the all-time peaks for many U.S. equity indices, investors are progressively realizing that the likelihood for additional gains is less than the probability that we have begun what could eventually become a full-fledged bear market. The S&P 500 reached its highest point of 2134.72 on May 20, 2015, which was more than five months ago.

    Investors hate to tamper with the status quo if they are comfortable with it, so very few people sold near the spring highs. In recent weeks, there have been notable outflows especially on days when U.S. equities have been declining. The more that time passes and additional lower highs are registered for the S&P 500, the Nasdaq, the Russell 2000, and similar indices, the more that people will realize that their portfolios are losing money rather than making money. Since the losses have been modest overall, these outflows haven't nearly approached the record withdrawals which were made during the first quarter of 2009. However, there has been a notable total decline in the money committed to U.S. risk assets, while the amount of money in safe deposits including money market funds has surged in recent months.

    One interesting observation is that, prior to the recent climb in the popularity of safe time deposits, these had reached all-time low levels relative to the amount of money invested in riskier assets. It is likely that, obtaining only around one percent interest or less on their bank accounts and near zero in their money market funds, many investors were encouraged to shift into far more speculative alternatives. They convinced themselves, with the able assistance of financial advisors, that they were nearly as safe in high-dividend blue chip U.S. stocks or high-yield corporate bonds as they were in the bank. In reality, they have been taking enormously greater risk, because most of these assets lost more than half their value during their respective bear markets of 2007-2009. However, most advisors politely didn't bring up this inconvenient fact, and most people would rather not think about what is possible while focusing instead on what is ideal.

    Now that reality has slowly begun to reassert itself, investors have been moving back into time deposits--but haven't yet taken more than a tiny percentage of this money and invested it in other assets. Historically, whenever there is a recent surge in safe time deposits, most of the money ends up being reallocated into securities which are perceived to contain greater upside potential. The only exception tends to be near the very end of a bear market, when risk assets are plummeting and investors are frightened into safety at any cost. Since we are far from such a situation today, asset reallocation usually means chasing after whatever has recently been climbing the most in percentage terms. If 2015 ends with a net loss for most U.S. equity and bond funds, then those funds which have enjoyed net gains will stand out noticeably among a sea of red. Other investors look for whatever has rebounded the most from its recent bottom, or for various kinds of moving average crosses and other signals. Therefore, whichever assets outperform from now through the end of 2015 are likely to be especially visible and to receive increasingly positive media, analyst, and advisor coverage. The persistence of such upbeat discussion will be accompanied by strong inflows.

    So far, there haven't been any sectors which have featured many such standout assets. However, this could change soon, because there is such a huge disparity between the world's most overpriced assets and the most undervalued ones. The list of overvalued securities includes many U.S. stocks and bonds and global real estate. The most compelling bargains can generally be found among commodity-related and emerging-market assets which in many cases have been trading at lower prices than during their worst levels of 2008-2009. Because they are so inexpensive, they can gain enormously in percentage terms and yet remain far below their respective peaks from the first half of 2008 or in many cases from April 2011. If this happens, then they will be able to continue to gain dramatically until the final months of 2016 or the early months of 2017.

    It is too early to say whether this kind of activity will occur or not, although historically most U.S. bull markets end with a period of rising inflationary expectations. It is rare for the economy to go into a recession without first experiencing an inflationary binge. During the most recent bear market of 2007-2009, we had a sharp and unexpected inflationary climb for roughly one year from the summer of 2007 through the summer of 2008. Since literally a hundred central banks worldwide including the U.S. Federal Reserve are eager for higher inflation, we are likely to get exactly what they want. Wage inflation has been moderately accelerating in the U.S., while prices have been generally slower to follow suit. Most investors are continuing to moderately sell their previous favorites, while sitting on the fence in indecision about what to do with the money. If you follow the fund flows during the next few months, you are likely to learn a lot about what will happen for another year or more.

    There are supporting clues from the media, which have become less enthusiastic about U.S. assets but continue to generally favor them because they appear to many to be the only game in town. Most news articles regarding commodities or emerging markets are gloomy, especially when there have been recent price declines for anything in these sectors. It appears that precious metals and the shares of their producers may already have bottomed, while energy producers are possibly following suit while emerging markets are mostly bringing up the rear. If all of these are able to outperform, then especially with the best-known U.S. benchmark indices continuing to struggle, investors will begin to take notice of the top-performing securities and will become increasingly eager to own them.

    The financial markets have always been a paradox, in which more people are eager to buy something after it has doubled than before it has done so. It is surely the same this time, so most people won't actually participate until it is too late to enjoy the lion's share of the potential percentage gains. If an asset goes from 10 to 50, then buying it at 20 might seem to surrender only one fourth of the profit since 20 is one fourth of the way from 10 to 50. However, the gain from 10 to 50 is 400% while the increase from 20 to 50 is 150%, so you actually give up 5/8 of the total profit instead of just 1/4. The financial markets are inherently geometric rather than arithmetic, which is why it works out this way. The key is that those who buy before a rally end up gaining far more than those who wait until a rebound has been "confirmed". Also, there is really no such thing as confirmation; whenever something has allegedly established a new uptrend, it often first suffers a sharp short-term correction to punish those who were tardy in jumping aboard the bandwagon.

    Tax tip: If you own shares or funds which are trading near multi-year bottoms and you are a U.S. resident, you can take advantage of their currently depressed prices if these assets are in your 401(k), 403(b), SEP-IRA, Keogh, traditional IRA, or other non-Roth retirement account. You can convert these shares from your account to a Roth IRA and pay taxes based upon their present low valuations. As these eventually rebound, all future gains will be completely tax free. In the event that these shares don't recover but end up retreating further in price, you can choose to undo your conversion, which is known as a recharacterization. You can then wait at least 30 days, or until the following calendar year--whichever is later--and then convert them again. There is no limit to how many times you can repeat this process and there are no income or other restrictions in making such conversions and recharacterizations, as long as each recharacterization is done on or before October 15 of the year following the date when the conversion had been done. It's like being able to go back in time and "unbuy" something which doesn't go up in price. It's heads you win, and tails you also win. Unfortunately, I do not know of an equivalent strategy which is permitted in any other country besides the United States.

    Disclosure: In August-September 2013, and at various points during 2014-2015, I have been buying the shares of emerging-market country funds whenever they have appeared to be most undervalued. Since June 2013, I have added periodically to funds of mining shares--and more recently energy shares--especially following their most extended pullbacks. I have also been accumulating HDGE whenever U.S. equity indices are near their peaks; HDGE is an actively-managed fund that sells short U.S. equities. I believe that U.S. assets of almost all kinds have become dangerously overvalued. From my largest to my smallest position, I currently own GDXJ, KOL, XME, COPX, SIL, HDGE, GDX, REMX, EWZ, RSX, GLDX, URA, IDX, GXG, VGPMX, ECH, FCG, VNM, BGEIX, NGE, PLTM, EPU, TUR, SILJ, SOIL, EPHE, and THD. In the late spring of 2014, I sold all of my SCIF which had briefly become my fourth-largest holding, because euphoria over the Indian election was irrationally overdone and this fund had more than doubled. I have reduced my total cash position to roughly 3% of my total liquid net worth in order to increase my holdings in the above assets. I sold all of my SLX by acting whenever steel insiders were doing likewise. I also sold all of my FCG but I have been repurchasing it following its recent collapse because there has been intense buying by top corporate insiders of companies which produce natural gas. I expect the S&P 500 to eventually lose about two thirds of its recent peak value, with its next bear-market bottom occurring within several months of October 2017. The Russell 2000 Index and its funds including IWM have only modestly surpassed their highs from the first week of March 2014, while the Russell Microcap Index (IWC) marginally surpassed its zenith from March 6, 2014. The S&P 500 Index set a new all-time high on numerous occasions during the same period, and may have completed its final top for the cycle at 2134.72 on May 20, 2015. This marks a classic negative divergence which previously occurred in years including 1928-1929, 1972-1973, and 2007. Those who have "forgotten" or never learned the lessons of previous bear markets are doomed to repeat their mistakes.