Thursday, April 3, 2014
"A fool and his money are lucky enough to get together in the first place." --Stanley Weiser, screenwriter for Gordon Gekko of Wall Street
While the media have been trumpeting recent all-time highs for the Dow Jones Industrial Average and the S&P 500, almost no one has pointed out that the Russell 2000 Index has failed to surpass its highest levels from early March 2014. IWM, a fund which tracks the Russell 2000, reached 120.58 on March 4, 2014 and a lesser-known 120.64 at 8:43:34 a.m. in the pre-market session on March 6, 2014--just after the monthly U.S. employment report was released. Since then, IWM has surpassed 120 several times, although not during April. The media rarely discuss the Russell 2000, which is a shame since one of the earliest clear signs that we had entered the previous bear market was when the S&P 500 and the Dow Jones Industrial Average surged to new all-time highs in October 2007 while the Russell 2000 refused to surpass its July 2007 zenith. In past decades, a similar pattern has also prevailed: the crushing 1973-1974 bear market was preceded by notable underperformance by indices of small- and mid-cap securities in 1972, while the worst bear market in world history during 1929-1932 was foreshadowed by small-cap securities lagging during 1928-1929.
A confirming signal of an impending bear market can be seen with VIX. The most valuable use of VIX is its uncanny ability to tell us whether a major market transition is underway. If we are transitioning from a bull market to a bear market, then VIX will signal this far in advance by first touching a multi-year bottom, and then making higher lows over a period of several months or longer. If we are transitioning from a bear market to a bull market, the VIX does the exact opposite by first touching a multi-year top, and then making lower highs over a period of several months or longer.
Let's test this theory to see how it held up during the past decade. VIX bottomed at 9.39 on December 15, 2006, which was a multi-year bottom. After that, it began to form about a dozen higher lows. Therefore, when we reached June 1, 2007 and the Russell 2000 reached a new all-time high, the failure of VIX to slump to a new low was a warning that the bull market was in its final stages. In October 2007, when the S&P 500 and the Nasdaq reached new all-time peaks, while the Russell 2000 completed a lower high, additional higher lows for VIX ensured us that the negative divergence with the Russell 2000 should be taken seriously, since VIX by then had failed to register a new low for ten months. By the time we reached August 2008, when almost everyone else was overly complacent about a worsening bear market, VIX had been forming higher lows for more than 20 months. This was a loud and clear signal to get out of the market, buy U.S. Treasuries, sell short, or do something other than literally getting sunburned on the beach as most money managers did that month.
Now let's look at the opposite side of the coin. What did VIX do after the U.S. equity (and global stock market) collapse which began in September 2008? VIX peaked at 89.53 on October 24, 2008. While GDX bottomed at the open that day, nearly all other equity sectors weren't done with their declines. On November 20, 2008, when KOL and numerous other shares of commodity producers completed their nadirs for the cycle, VIX made a lower high of 81.48. This was one of the first clear signs that we were in a transition from a bear market to a bull market. If VIX had made a higher high, then it would have signaled that the downturn was still intact. By the time the S&P 500 slumped to its 12-1/2-year bottom shortly after the U.S. employment report on Friday, March 6, 2009--notice the perfect inverse parallel with the first Friday of 2014--the high for VIX was 51.95 on March 6, the same as it had been the previous day, and 51.34 on March 9, 2009. These numbers were enormously lower than their highs from the fourth quarter of 2008, and signaled that a bull market was more closely approaching. Since then, the VIX hasn't reached 50, although it almost did so in both 2010 and 2011 and will almost surely dramatically surpass that level during 2015-2016. Even if you weren't tracking the surge in insider buying, or the sharp decrease in the number of new 52-week lows, or the all-time record outflows from equity funds (admittedly the last one was a huge reason to buy stocks in the first quarter of 2009), VIX gave you valuable signals.
If we look at VIX since the start of 2013, we can see that it reached its lowest point in more than six years on March 14, 2013, when it bottomed at 11.05. Since then, it has formed several higher lows, and is probably completing an additional higher low this week or next week. Even though some U.S. equity indices have recently reached new all-time highs, VIX is putting its foot down and saying "no". By continuing to form higher lows for more than a full year, VIX is stating unequivocally that we are well into in the process of transitioning to a bear market and that selling funds closely correlated with general U.S. equity indices is well advised.
You may be wondering: what does all of this have to do with the mining and emerging-market sectors, most of which at some point during the past year traded at or near five-year lows? The answer is that, as long as the Russell 2000 is continuing to set new all-time highs every several weeks or so, and is gaining maybe 20% annually, then almost no investors--institutional or individual--are going to be interested in looking elsewhere. It's much simpler and effective to stick with your favorites when they're working reasonably well. However, if the Russell 2000 has already begun a bear market which will result in a total 2014 calendar year loss of more than 10%, as I am anticipating, then investors will become progressively more eager to seek alternatives. As a result, more and more people will gradually purchase the least popular securities of 2013 which suddenly turned hot in 2014, including mining and emerging-market names, until eventually investors are buying these precisely because of their recent outperformance. Thus, there is a direct connection between investors wanting to get out of previous winners that are no longer winning into former big losers which have suddenly become the darlings of the financial markets.
Disclosure: In late August and early September 2013 I was aggressively buying the shares of emerging-market country funds. Since early December 2013, I have added moderately to my funds of the most undervalued mining shares and emerging-market equities, especially during their most extended pullbacks. Most recently, I have been buying HDGE whenever it has traded below 13 dollars per share with the idea of selling it in 2016 as we are completing the next U.S. equity bear-market bottoming pattern; HDGE is an actively managed fund which sells short various U.S. equities. From my largest to my smallest position, I currently own GDXJ, KOL, XME, GDX, SIL, COPX, SCIF, REMX, EWZ, RSX, IDX, GXG, GLDX, VGPMX, HDGE, ECH, BGEIX, VNM, URA, ZJG (Toronto), PLTM, EPU, TUR, SLX, SOIL, EPHE, and THD. I have significantly reduced my total cash position since June 2013 in order to increase my holdings of the above assets, and currently hold about 18% of my total net worth in cash and its equivalents. I sold almost 90% of my SLX near 49 dollars per share because steel insiders were doing likewise. I plan to buy more HDGE each time it suffers a short-term pullback, because I expect the S&P 500 to eventually lose more than half of its current value--with most of that decline occurring during 2015-2016.
Posted by TrueContrarian at 9:43 PM