Thursday, January 3, 2013

"The most exciting phrase to hear in science, the one that heralds new discoveries, is not 'eureka' (I found it) but 'that's funny'." --Isaac Asimov

INCREASING DIVERGENCES WILL SOON CONVERGE (January 3, 2013): There has been an important intensification in the degree to which numerous key assets have been diverging in recent weeks. TLT, a fund of U.S. Treasuries averaging 28 years to maturity, has plummeted to its lowest level since May 10, 2012. Usually, when investors are fleeing U.S. government paper, they also sell the U.S. dollar--but the U.S. dollar index today climbed to its highest point since December 7. The S&P 500 today rose to its most elevated mark since October 5, while VIX, a well-respected gauge of fear based upon options volatility for the S&P 500, similarly slumped to its lowest point since October 5.

Gold mining shares remain among the least popular equity subsectors. GDXJ is a fund of 80 junior gold mining companies which has climbed more than 18% including reinvested dividends from its May 16, 2012 bottom, but has lagged nearly all other industry groups since the middle of November. Part of the weakness for gold mining shares is due to the strength in the U.S. dollar, as the two have a well-established inverse correlation because gold is essentially a currency which competes with all fiat currencies. However, most of the weakness in gold mining shares is due to investors selling them out of disappointment over their underperformance. Other cyclical equities, including companies involved with metals mining or energy products, are close to their highest prices since the early spring of 2012 and have climbed by double-digit percentages from their intermediate-term bottoms of November 16, 2012. As the U.S. dollar index eventually resumes its downtrend which began on July 24, 2012, gold mining shares will likely converge with other commodity-related companies. If all commodity-related subsectors regain their peaks from February-March 2012, then gold mining shares will climb more than twice as much as other cyclical assets, potentially gaining 50%.

It is likely that the recent downtrend for gold and its shares will soon transform itself into a rally. In the early stages of this rally, most other equities will probably retrace some of their recent sharp gains. Afterward, nearly all equities will climb together until the S&P 500 achieves a new all-time peak above its October 11, 2007 top of 1576.09. However, the eventual zenith for the S&P 500 won't be a new high if you adjust for inflation. This will be similar to the way in which the 2007 peak for the S&P 500 was above its 2000 top, but was not higher if you adjust for inflation. The Russell 2000 has been outpacing the S&P 500, which is a sure sign that the stock market is far from done with its bull market. When the last long-term bull market ended in October 2007, the Russell 2000 was already forming a bearish pattern of lower highs. That is how we can be sure that the current global stock-market uptrend remains intact.

There has been a lot of talk about the implications of the recent increase for U.S. taxes. The most important feature of this agreement is not that it was done in a bipartisan manner, but that so many critical issues were completely ignored. There has been no discussion of spending cuts, and a lot of pork was included in the legislation. Instead of addressing important issues about whether various kinds of deductions such as the mortgage interest write-off should be a part of the tax code, these considerations were completely swept aside in favor of raising marginal rates especially for investment income. The new 23.8% tax rate for long-term capital gains is the highest since 1996, while the 43.4% short-term capital gains tax rate hasn't been experienced since 1980--when Jimmy Carter was in the White House. Discouraging investment by raising taxes on interest, dividends, and capital gains, while doing nothing to address spending or to reduce wasteful deductions, will prove to be a serious mistake.

Disclosure: Since May 2012 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, TNRPX, VGPMX, TRIEX, FCG, TRSPX, ACTIX, TAN, GDX, and NLR.