Wednesday, April 20, 2016

"Sometimes the bulls win; sometimes the bears win; but the hogs never win." --Anonymous

IT IS TIME TO BE BEARISH TOWARD MOST U.S. ASSETS (April 20, 2016): It is fascinating how nearly all investors, analysts, advisors, and the media had been negative toward risk assets in January and early February 2016 and talked about "reducing risk," and now the same people have been talking about "getting back into the market" and what you should buy now. People will repeatedly buy high and sell low, because it is emotionally so difficult to do the opposite of the thundering herd. Therefore, having sold all of my HDGE shortly before it peaked near 13, which had represented roughly 8% of my total net worth, I began repurchasing it again during the past week into all pullbacks and plan to continue to buy it as long as it remains below 11 dollars per share. I also entered my first-ever short positions in FXG and IYR and plan to sell short XLU soon.

The reasons for my being bearish are not primarily about price or timing, although it is true that many U.S. sectors have never been more overvalued in their entire history including years like 2007, 2000, 1972, and 1929. Among those sectors experiencing record overpricing are consumer staples (XLP, FXG), utilities (XLU), and real estate investment trusts or REITs (IYR). Consumer staples are extremely popular for two reasons: 1) they had enjoyed among the biggest percentage gains for all sectors outside of biotechnology during the past five years, in spite of mediocre profits for these companies; and 2) they have become the darlings of people who took their money out of bank accounts paying 1% or less in order to capture their modest dividends which have never been lower in percentage terms. Everyone loves a winner, so people have ignored the mediocre profit growth in consumer staples and concentrated instead on the stock price appreciation. Buying any sector with especially oversized gains and lackluster earnings is never a recipe for success, since this signifies a dangerous overvaluation. I have sold short FXG rather than the more popular XLP because it has a much higher expense ratio. IYR is also an excellent short position due to real estate having become even more overvalued in many parts of the world than it had been during the 2006 bubble. Utilities have also become the darlings of those chasing yield, making this sector more overvalued than at any time in its long history. There have been times when almost everyone was bearish toward utilities and I felt as though I was the only one in the world who was buying. Today, it is just about the exact opposite.

There are many reasons why U.S. assets, other than commodity producers which mostly remain compelling bargains, became so overvalued in recent years. Persistent underperformance and price/earnings ratio collapses for emerging-market equities, combined with a generally climbing U.S. dollar, made U.S. stocks seem like the safest game in town. Recently, the greenback has been in a downtrend since the U.S. dollar index had peaked on December 2, 2015 at 100.51, thereby exposing the irrational overvaluation of U.S. equities, corporate bonds, and other assets relative to those in most other parts of the world. While the S&P 500 Index has more than tripled from its March 6, 2009 nadir of 666.79, many emerging-market equity bourses on January 20, 2016 were trading even lower than at their most depressed points of late 2008 and early 2009, and even compared with previous bear-market bottoms in 2002, 1998, 1994, and 1990. Whenever you can buy a basket of assets which are trading near 20- and 30-year bottoms, it is almost always a good idea to do so regardless of the alleged reasons for such undervaluation. Similarly, whenever you can sell something like a house in San Francisco or a basket of biotechnology shares which are trading at incredibly overpriced levels, you should accept the market's gift and take advantage of others' temporary folly.

HDGE is the only exchange-traded fund which sells short directly instead of using various artificial preservatives for doing so. Therefore, it has a somewhat higher expense ratio. This should not be an obstacle to purchasing it, and if you hold it for more than a year you will achieve favorable U.S. federal long-term capital gains tax treatment. Selling short directly is a reasonable alternative, which is why I mentioned my favorite overvalued funds in earlier paragraphs. If you have money in general U.S. equity and corporate bond funds, then now is an excellent time to sell them to take advantage of valuations which are close to their all-time highs and are likely to drop by 60% or more.

Many people don't believe that U.S. equities can decline by 60%, even though we have already experienced two severe bear markets since 2000. From March 10, 2000 through October 10, 2002, the Nasdaq plummeted 78.4%. In the 2007-2009 bear market, the S&P 500 lost 57.7% while the Russell 2000 declined by a total of 60.0%. I expect somewhat greater losses this time primarily because we had become more overvalued, so we have to drop by a greater percentage to roughly match the March 2009 lows. The Nasdaq is an especially glaring case of overpricing. As you can verify by going to http://finance.yahoo.com and entering ^IXIC, if the Nasdaq were to merely return to its October 31, 2007 top of 2861.51 then it would represent a plunge of 45.3% from its July 20, 2015 zenith of 5231.94. And this would be if it were to merely return to its previous bull market peak, not if it were to follow a much more likely route of approaching a previous major bottom. Biotechnology shares, which have been the biggest percentage winners of the past five years in spite of inconsistent earnings growth in this sector, have already been in downtrends along with many other equity sectors which had previous been leaders. When the former winners are pointing the way lower, that is an especially dangerous time to participate.

We have also experienced many of the classic signs of a market top. The ratios of insider selling to insider buying have approached their unusually high levels from the middle of 2015 and are usually only seen just before a major bear market. Investor inflows into most U.S. stock and bond funds surpassed all-time records for thousands of such funds during the past two months. The media, which for part of January and early February had featured more bearish than bullish articles about risk assets, have recently stopped even asking about whether you should be a buyer and have instead focused on what you should buy now for the biggest gains. VIX dropped below 13 for the first time since October 2015, indicating that investors have lost nearly all their fear of lower valuations.

I plan to remain long outperforming commodity producers and emerging-market assets. These will periodically suffer sharp short-term pullbacks, but have all begun powerful bull markets after having suffered extended, severe bear markets from April 2011 through January 20, 2016 when many of them registered multi-decade lows. Whenever other risk assets are attempting to rebound, mining and energy shares will continue to be among the biggest percentage gainers for approximately one more year until they become incredibly popular with investors, analysts, advisors, and the media. This is still a long way off: GDX, the most popularly traded fund in these sectors by average daily volume, has continued to experience outflows nearly every single day during the past several weeks in spite of being among the top-performing funds of 2016. As long as a bull market is greeted with intensified outflows instead of inflows, it will continue and will accelerate until disbelievers are finally converted into new buyers.

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, VGPMX, URA, GXG, FCG, IDX, ECH, BGEIX, NGE, VNM, RSXJ, EPU, TUR, SILJ, SOIL, EPHE, and THD. Yes, HDGE is back on the list; I just added very small short positions in FXG and IYR, and I am currently buying HDGE this week after having sold all of it just before it had peaked above 13. 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 2018. As with all bear markets, the biggest losses will likely occur in its final months, and won't even be acknowledged as a bear market until then--as is evidenced by the media falsely proclaiming in March 2016 that the bull market had celebrated its seventh birthday. 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, trading at their lowest levels during January 2016 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. The most overvalued sectors rely on the overhyped deflation trade and money which was withdrawn from safe bank accounts by conservative investors deluded into believing that these were nearly as safe as government-guaranteed time deposits. Excellent short positions include FXG, IYR, and XLU.

Special note: if you enjoy theater and you would like to attend an evening of my original "true contrarian" playwriting, you are invited to join us at the end of the month:

  • Original Parodies of Corporate Life
  • Monday, April 4, 2016

    "No price is too low for a bear or too high for a bull." --Anonymous

    MOST INVESTORS MISUNDERSTAND BEAR MARKETS (April 4, 2016): If there is one defining characteristic of bear markets for U.S. equities, it is the failure of nearly all participants to recognize when they exist, to acknowledge that they require asset reallocation, and to make appropriate changes to their portfolios. If we look back at all of the past bear markets in U.S. history, then even when they had been underway for a year or more, the vast majority of investors continued to act as though nothing had changed. They continued to buy and sell as though we were still in the previous bull market. Finally, when the bear market was in its final stages, it was usually accompanied by a collapse which at long last awakened people with the realization that we weren't in a bull market anymore. By then, however, it had become far too late to sell at anything close to favorable prices. Once a collapse becomes particularly extended or severe, or both, investors will end up doing the exact opposite of intelligent reallocation by emotionally selling during a bottoming process instead of increasing their risk to accumulate compelling bargains.

    The bear market of 2007-2009 serves as a useful illustration of some of the above points. That bear market began, as so many do, with initial weakness for high-yielding securities including utilities and REITs. Soon afterward, high-yielding junk bonds completed their peaks and began underperforming. After June 1, 2007, small-cap U.S. equity indices notably underperformed their large-cap counterparts. By August 2008, nearly all U.S. equities and corporate bonds had been in downtrends marked by numerous lower highs, but most investors continued to behave as though we were still in a bull market. Whenever U.S. equity indices and their funds like QQQ would rebound from any intermediate-term low along the way, there would be significant inflows into equity funds because investors had learned during 2002-2007 to buy into rallies which followed all corrections. Of course they had finally learned the wrong lessons, and acted as they should have done five years earlier when legitimate bargains were easy to find but almost no one wanted to participate. Then we had September-November 2008, which finally achieved clarity when it was far too late to be able to sell at worthwhile high prices. Especially when the S&P 500 was down by more than half, investors ended up making their greatest outflows in history from most sectors, with these withdrawals even exceeding those which had occurred during the Great Depression. During the first quarter of 2009, when investors should have been buying left, right, and center, people mostly sold instead of making purchases at the lowest inflation-adjusted valuations since the early 1980s.

    In case you think that investors learned from their experience of 2007-2009, their behavior demonstrates that they are making the same mistakes again. From early March 2009 through early March 2014, small-cap U.S. equities outperformed large-cap counterparts by a ratio of roughly 3 to 2. During this five-year period, investors continued to mostly make net outflows instead of buying, partly because they were frightened by above-average volatility. From early March 2014 through May-June 2015, most U.S. equity indices continued to make higher highs, but the Russell 2000 (IWM) gained progressively less than the S&P 500 (SPY) in percentage terms. There have been all-time record inflows into most equity funds in recent years, with huge net deposits occurring during the past several weeks. Since the second quarter of 2015, nearly all U.S. equity indices have been in little-recognized and unappreciated bear markets. The financial media a month ago loudly trumpeted the alleged "seventh anniversary" of the bull market even though the uptrends for U.S. equity indices had nearly all ended the previous year.

    On December 15, 2006, VIX completed a historic bottom at 9.39 and thereafter formed several higher lows even as U.S. equity indices including the S&P 500 continued to climb for most of the following year. This was a valuable warning signal that we were getting set to transition from a major bull market to a severe bear market. When the bear market was in its final months, VIX topped out at 89.53 on October 24, 2008, and continued to make several lower highs even as the S&P 500 itself continued to grind to lower 12-1/2 year lows through its 666.79 nadir on March 6, 2009. This process has repeated in the current cycle, with VIX bottoming at a 7-1/2-year low of 10.28 on July 3, 2014. As in 2006-2009, VIX foreshadowed the end of the bull market by a little less than a year. On Friday, April 1, 2016, VIX slid to 13.00 as it is completing yet another higher low. Eventually, VIX will achieve some kind of elevated zenith and will begin to form a pattern of lower highs, thereby signaling that the current bear market--which by then will likely have intensified sharply--will be several months away from beginning its next strong bull market.

    However, instead of recognizing these cyclical patterns and acting upon them, most investors end up repeatedly and foolishly projecting the recent past into the indefinite future. This is partly because our brains are hardwired to do this as it served as a useful way for groups of humans to survive in prehistoric times. Thus, many investors today are eagerly crowding into utilities (XLU), real estate investment trusts or REITs (IYR), and consumer staples (XLP), even though all of these have never been more overvalued in history. Therefore, we are going to suffer especially large percentage declines for these sectors relative to the overall U.S. stock market which itself is perched precariously roughly 50% above fair value. In many global cities, real estate is at double or triple fair value. Paradoxically, most people will want to sell their stocks and corporate bonds two years from now when they should be aggressively buying, and will want to do no selling of real estate or stocks today when they could obtain highly favorable prices for both.

    The following link highlights how investors were making significant outflows near the beginning of the year when stocks and corporate bonds were much lower than they are now, and have recently been eagerly pouring back into U.S. assets at overvalued prices:

  • Investors Pull $24 Billion from Equity Funds in January


  • Now is an excellent time to be a true contrarian. When everyone you know is eagerly "getting back into the market," progressively sell your U.S. stocks, bonds, and real estate. Put some money into cash or a government-guaranteed bank account, and slowly accumulate shares of the most undervalued assets in emerging markets along with the shares of commodity producers, especially as these are forming additional higher lows following their respective multi-decade bottoms which were mostly completed on or around January 20, 2016. Perhaps in a year or so it will make sense to gradually unload these holdings so you are almost entirely in cash, with the important exception of buying TLT and other long-dated U.S. Treasury securities if they should slump to multi-year lows. Almost no one expects TLT to drop to 120, much less a far lower target like 100, so if there is panic and gloom in the U.S. Treasury market then prepare to be a big buyer in another year when everyone else is telling you why you should be selling.

    Do not rely too heavily on the assumption which others will be making, which is that if we are in a true bear market then it will likely be a repeat of 2007-2009. That bear market lasted for only 17 months, so instinctively people will assume that the recent past will repeat itself. Most bear markets are longer, and it will take time to flush out millions of those investors who would usually have their money in bank accounts but who have foolishly concluded that it is almost as safe to have their money in various stock and bond sectors. Assuming that most U.S. equity indices had topped out in May or June 2015, the ultimate bear-market bottoms might occur during 2018. Each time we slide to a lower low and rebound sharply, many will proclaim that we had reached "the bottom" and will be eagerly buying. Within a few months or less, we will slump to another lower low. Eventually, almost everyone will be exhausted from making additional purchases and soon finding themselves deeper in the red, and will refuse to buy when a strong recovery is underway. This, combined with extreme gloom and doom in the media and by nearly all analysts and advisors recommending that their clients "take steps to reduce risk" will signal that the next powerful bull market is truly underway. If such a bull market begins around 2018 then it could persist until 2021-2023.

    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, EWZ, RSX, REMX, GLDX, URA, FCG, IDX, GXG, VGPMX, ECH, VNM, BGEIX, NGE, RSXJ, EPU, TUR, SILJ, SOIL, EPHE, and THD. I may end up buying HDGE which I had sold in its entirety during the third week of January 2016. 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 in 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. The most overvalued sectors rely on the overhyped deflation trade and money which was withdrawn from safe bank accounts by conservative investors deluded into believing that these were nearly as safe as government-guaranteed time deposits.

    Special note: if you enjoy theater and you would like to attend an evening of my original "true contrarian" playwriting, you are invited to join us at the end of the month:

  • Original Parodies of Corporate Life
  • Tuesday, February 23, 2016

    "Our party has been accused of fooling the public by calling tax increases ‘revenue enhancement’. Not so. No one was fooled." --Dan Quayle

    NUMEROUS NEW TRENDS HAVE QUIETLY BEGUN (February 23, 2016): One of the most underappreciated features of 2016 has been the number of trend reversals which are already underway but which have been ignored by most investors or dismissed as being temporary deviations which will soon return to their previous behavior. Because so few accept these new bull and bear markets as being significant, only the few who recognize their importance have been investing in the anticipation that these newer trends are likely to continue, with their usual backing and filling, until they eventually accelerate and force nearly all investors to acknowledge their existence. It is worthwhile to point out which of these trends have reversed direction after years of moving the other way, and what is likely to happen during the next year or so.


    Some of these trends have already been underway for a year or more. Small-cap U.S. equity indices and their funds, including IWM which tracks the Russell 2000, had been outperforming the S&P 500 and similar large-cap indices for five years. From early March 2009 through early March 2014, IWM tended to gain about 3 dollars for each 2-dollar increase in the S&P 500, thereby enabling it to approximately quadruple while the S&P 500 was tripling. However, since the first week of March 2014, IWM and other small-cap baskets have been notably underperforming the S&P 500, with most of them slumping to 2-1/2-year bottoms during January 2016. Whenever they are temporarily oversold and there is too much gloom and doom in the media, these indices will rebound for several weeks or so, but their primary trend remains firmly downward and will likely surprise everyone with the total percentage losses which they suffer by the time they complete their next bottoming patterns perhaps in 2018. IWM topped out in June 2015, and it has become increasingly likely that the S&P 500 reached its highest point of 2134.72 on May 20, 2015.


    Some assets began bear markets even earlier than the above well-known U.S. indices and funds. Most high-yielding shares including utilities (XLU), REITs (IYR), and U.S. Treasuries (TLT) were extremely popular in 2014 and completed important topping patterns in January 2015. Utilities and Treasuries have been outperforming the broader market in recent months, as they often do during a flight to defensive sectors, but all of the above sectors are likely to soon resume their downtrends even if general equities are able to enjoy a more sustained recovery during the next several weeks. These sectors tend to signal changes in inflationary expectations, so especially if they resume their downtrends and retreat to lower lows, it will signal that the widespread belief in deflation will eventually give way to the realization that inflation has been quietly rising worldwide.


    While most investors continue to believe that the shares of commodity producers and emerging markets are continuing their bear markets which mostly began in April 2011, it is likely that most or all of these have reversed during the past several weeks. Some of the assets in these sectors have already rebounded dramatically, including gold and silver mining shares which have mostly gained more than 40% from their respective bottoms from the third week of January. It is common for gold and silver mining shares to lead energy and emerging-market assets both higher and lower, and it appears that although they remain very choppy in the short run, the shares of energy and emerging-market securities mostly bottomed in the second half of January or the first half of February 2016. Media coverage had been persistently negative toward the above assets, with most analysts and brokerages continuing to project aggressive downside targets as recently as a month ago. As the prices of commodity-related assets have been progressively rising, most of those in the media and financial industries have been very slow to adjust their previous forecasts and portfolios to reflect what could end up being a dramatic change of fortune. As is usually the case, the best-informed insiders and their wealthy friends have been among the first to make appropriate asset reallocations, while most investors won't do so until these trends have already become too powerful to ignore and more than half of the potential percentage profit from these opportunities will have already passed.


    After moving mostly sideways for roughly nine months, the U.S. dollar index has been forming a notable pattern of lower highs since it had finally surpassed its March 2015 peak to register a key top on December 2, 2015 at its highest point since April 2003. This pattern of lower highs is likely to continue for roughly another year and perhaps a few months longer than that. Throughout 2015 there had been an increasing number of speculative bets on a higher U.S. dollar along with more intensely bullish market commentary and analysts raising their upside targets for the greenback. As a rule, increasing excitement and optimism combined with flat prices is a dangerous combination. It will take time before investors recognize that this long-term pattern since 2011 has also reversed; when they are finally forced to acknowledge that life in 2016 is not the same as it had been in recent years, the downtrend for the U.S. dollar could accelerate. Even if it continues in leisurely fashion, it will exert a meaningful influence on all other assets.


    There hasn't been much discussion about real estate in recent months, although Tuesday morning's report on U.S. existing homes showed the 47th-consecutive month of year-over-year gains for U.S. housing prices. In most of the rest of the world, real estate has been climbing for a similarly extended period of time. As we have seen with many other trends described above, anything which lasts for four or five years tends to eventually be accepted as some kind of "permanent" situation whenever it is most likely to soon reverse. I expect that just as almost everyone is expecting housing prices to continue to climb indefinitely, we will experience massive losses in most parts of the world during the next four or five years. Instead of housing prices to household incomes demonstrating their normal historic ratios of 3:1 which have existed for centuries or millennia, and which had been lower than 1.5 to 1 in many regions in 2011, there are neighborhoods in cities including San Francisco, Vancouver, and Tel Aviv where ratios are greater than 10:1. Many other cities are more than double their normal levels, which creates a bubble which is just as dangerous as the one in 2005-2006 and which has been fueled mostly by borrowed money which tends to suddenly become scarce during an economic downturn.


    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, EWZ, RSX, REMX, GLDX, URA, FCG, IDX, GXG, VGPMX, ECH, VNM, BGEIX, NGE, RSXJ, 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 in 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).

    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