Tuesday, August 12, 2014

"Carpe per diem--seize the check." --Robin Williams

THE SHORT-TERM REBOUND FOR U.S. EQUITY INDICES HAS A WEEK OR SO TO GO, BUT AFTER THAT, LOOK OUT BELOW (August 12, 2014): U.S. small-cap equity indices and their funds including IWM had substantially outperformed their large-cap counterparts including SPY and VOO for exactly five years, starting in early March 2009 and ending in early March 2014. From the first week of March 2014 through the end of July 2014, small-cap funds dramatically diverged from their previous behavior by retreating even as the S&P 500 continued to repeatedly set new all-time highs. IWM barely set a new all-time top on July 1, 2014, and then resumed its lackluster ways. This kinds of divergence had always previous occurred just before a severe bear market, including most recently 2007 and 2000, and before that as we were on the verge of other major downtrends including 1972-1973 and 1928-1929. This was one of the clearest signs that we were transitioning from a powerful bull market to what will likely become an equally dramatic bear market.

So far during August 2014, this behavior has reversed: IWM has consistently been behaving more bullishly than SPY and VOO in August 2014, first by declining less and repeatedly making higher intraday lows, and more recently by gaining more in percentage terms during rally days. Combined with the sudden surge for VIX to a multi-month peak earlier this month, it indicated that U.S. equities weren't yet ready for a serious correction. The recovery is likely to choppily continue for another week or two, or as long as it takes for VIX to return to roughly 12.50--when most investors will foolishly conclude that they had their pullback for the year and that it will all be sunshine and chocolate cookies from now on. Once we experience such a degree of irrational complacency, the next and more severe correction will start and will reach some kind of important intermediate-term low probably in the early autumn of 2014. This will be followed by a classic up-and-down bear market in which some investors will sell because they hadn't expected such dramatic volatility in both directions, and then other investors will sell because they're starting to lose money in the U.S. stock market, and then others will sell because they don't understand what's happening, and then finally a much larger group of participants will sell their stocks because investors repeatedly buy near the top and sell near the bottom of all cycles.

Besides VIX slumping sufficiently to indicate that the recent bout of fear has dissipated, expect to see IWM soon underperforming SPY again. If this happens especially on up days when small-cap equities should be gaining more in percentage terms as they had mostly done for five years, then this will provide what will likely be a final opportunity to establish positions which will gain from an extended bear market. As with most bear markets, including the ones in 2000-2002 and 2007-2009, there is unlikely to be a dramatic crash or anything similar; instead, we'll get a moderate downtrend for one to 1-1/2 years, and then an accelerated pattern of more substantial percentage losses interspersed with periodic sharp rebounds whenever tardy short sellers pile on too late. After the sudden plunge of September-November 2008 and the grinding up-and-down continuation through March 2009, the relatively few investors who are correctly anticipating a serious bear market are probably expecting something similar to 2007-2009, rather than a more likely repeat of a much older downtrend pattern such as 1930-1932 or 1937-1939.

As we are transitioning over the next year or so, some assets will continue to climb, especially those which had become so unpopular that they had suffered bear markets of their own and which in June 2013 through July 2014 had plummeted toward or below their lowest levels in approximately five years. This includes most shares of mining companies and emerging-market equities. The biggest winners of 2014 are primarily in these two categories, and this pattern will likely continue for the remainder of 2014 and perhaps for half of 2015.

I have been buying the actively managed exchange-traded fund HDGE each time it drops another 10 cents. My highest purchase was at 12.99 and my lowest fill was at 11.59. After each bounce for HDGE (i.e., each time U.S. equities retreat), I plan to continue to accumulate HDGE into weakness. I am still losing money overall on this investment so far, but I expect it to be among the best-performing funds through 2016 or 2017. I plan to eventually make HDGE probably my second- or third-largest holding, although that will likely not occur until perhaps the spring or summer of 2015.

Disclosure: In August-September 2013, and again during the first several months of 2014, I had been aggressively buying the shares of emerging-market country funds whenever they appeared to be most undervalued. Since June 2013, I have added periodically to funds of mining shares and related assets especially following their most extended pullbacks. Starting in December 2013 I have been buying HDGE whenever it has traded below 13 dollars per share, and more recently whenever it has retreated below 12, with the idea of selling it in 2016-2017 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, HDGE, REMX, EWZ, RSX, IDX, GXG, ECH, GLDX, URA, VGPMX, BGEIX, VNM, ZJG (Toronto), PLTM, EPU, TUR, 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; since then, SCIF has been one of the biggest losers of all emerging-market funds. I have reduced my total cash position since June 2013 to approximately one eighth of my total liquid net worth in order to increase my holdings in the above assets. I have now sold all of my SLX by acting whenever steel insiders were doing likewise. I expect the S&P 500 to eventually lose about two thirds of its 2014 peak value--with most of that decline occurring from some point around the middle of 2015 through late 2016 or early 2017. The Russell 2000 Index barely achieved a new all-time top on July 1, 2014 compared with its early March 2014 highs, while the S&P 500 did so numerous times over the same four-month period. This marked 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 past bear markets are doomed to repeat their mistakes.