Thursday, November 8, 2012

"The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up." --Howard Marks

HEADLINE WEAKNESS IS MASKING INTERNAL STRENGTH (November 7, 2012): Think back to late February and early March 2009. The media were excited about "historic lows for the Dow" and "a new 12-1/2 year bottom for the S&P 500 index". Once you looked beyond the headlines, however, there were numerous positive divergences. Cyclical assets had been rallying mostly since November 20, 2008, with semiconductor, mining, and energy companies among the leaders. There were far fewer new 52-week lows in February and March 2009 than there had been in October and November 2008. The majority of leading assets had been forming bullish patterns of higher lows for several months. Most people couldn't get past the headlines, and ended up selling when they should have been buying.

A similar situation exists today. Cyclical assets, which had been near all-time record undervaluations relative to defensive equities three months ago, have been consistently outperforming the broader equity market in recent weeks. While the S&P 500 on November 7, 2012 slumped to its lowest intraday point since August 3, 2012, most funds of commodity shares and related subsectors held above their lows from the previous week and have formed numerous higher lows since the summer. A daily chart of EWZ barely registers the allegedly sharp drop on November 7, with funds of gold mining shares like GDX and GDXJ enjoying net gains the same day. SLX, a fund of steel manufacturers and one of the most consistent cyclical groups, has completed a dozen higher intraday lows during the past several months. Semiconductor shares, which have been a reliable leading indicator for the broader equity market since the late 1960s, have been rallying steadily for two weeks. Coal mining shares were among the biggest one-day losers on November 7 in a likely emotional reaction to Obama's reelection, but from a chart of KOL you can clearly see that this has been one of the strongest equity groups overall since early September.

Meanwhile, safe-haven assets have been struggling to rally even on days when equities and commodities have plummeted. VIX has rebounded in recent days, but hasn't yet surpassed its October 23 high. TLT, a fund of U.S. Treasuries averaging 28 years to maturity, couldn't surpass its intraday peak from October 12 and has formed several lower highs since it had achieved an all-time zenith on July 25, 2012. The U.S. dollar index gained ground on November 7, but has been in a downtrend marked by several lower highs since it had achieved a two-year top on July 24.

Once you get beyond the surface of superficially lower prices for widely broadcast benchmarks, you discover that cyclical equities have been steadily gaining ground with almost zero fanfare, while much-touted safe havens have been moving progressively lower since July. Funds of commodity producers are especially compelling, since most of them had slumped to three-year lows this past summer and are likely to gain another 20%-30% during the next several months. Mining, energy, agriculture, semiconductors, and materials manufacturing, all of which remain dramatically out of favor, provide the best value choices in the financial markets. While far too many investors are quixotically searching for yield and are eagerly purchasing ridiculously overvalued assets because they pay above-average dividends, you should be investing in the most profitable companies which are being virtually ignored by financial advisors, analysts, and practically everyone else except for top corporate insiders who have been repeatedly buying them into weakness.

Disclosure: During the past half year I have been progressively accumulating long positions in funds of commodity producers into pullbacks and especially whenever they are forming higher lows. From my largest to my smallest position, I own GDXJ, VFWPX, KOL, XME, EWZ, REMX, SLX, VEMPX, VINIX, RERGX, RSX, VGPMX, TNRPX, TRIEX, FCG, TAN, GDX, ACTIX, TRSPX, and NLR.