Friday, September 19, 2014

"Somebody said to me, 'But the Beatles were anti-materialistic.’ That’s a huge myth. John and I literally used to sit down and say, 'Now, let’s write a swimming pool.'" --Paul McCartney

MOST GLOBAL ASSETS ARE ABSURDLY OVERVALUED, WHILE A FEW SECTORS ARE RIDICULOUSLY UNDERVALUED (September 19, 2014): We have experienced numerous bubbles throughout financial history, where various assets have become irrationally overvalued. Often this occurs because an especially popular new technology inspires investors into believing that traditional measures of valuation "no longer matter" because the new technology has "completely changed" the financial landscape. Through the centuries, this has caused investors to believe that assets including tulips, funds which invest in the New World, railroad shares, and internet stocks will keep rising indefinitely and that no price is too high. What makes the current situation particularly problematic is that bank accounts paying almost nothing around the world have encouraged millions of investors to take their money out of safe time deposits and to put them into far riskier stocks, bonds, and real estate. Most people don't even realize how much money they might lose, foolishly projecting their recent steady gains into future years. The problem with so many assets being simultaneously overpriced is that whenever the stock market suffers a significant decline, most other assets could end up declining in tandem rather than behaving inversely. Many investors have portfolio blends of 60% stocks and 40% bonds, or perhaps the reverse, and believe that if stocks retreat then bonds will advance or vice versa. However, there have been times in history when stocks, bonds, and real estate have all plummeted simultaneously. If that happens again, with so many people having crowded into these assets without understanding their risks, this creates a serious possibility of a dramatic total loss of wealth. When people's net worth slumps, even if their incomes remain constant, they tend to spend much less. This is known as the negative wealth effect, and it could be one of the most serious problems facing the economy around the world during the next bear market.

Probably I should call it the current bear market, rather than the next one, because if you look at a chart of small-cap U.S. equities you will see that these have already been in downtrends since March 6, 2014. IWC is a fund of micro-cap U.S. equities, meaning shares of companies with a total market capitalization of less than one billion dollars apiece, which has dropped about 10% from its March 6 top. IWM, a fund which tracks the Russell 2000, hasn't lost as much but has substantially underperformed the S&P 500 Index since March 6, 2014 after having outperformed the S&P 500 for five consecutive years. The financial markets are thereby giving us a useful advance warning, which almost everyone is completely ignoring. Those who have realized that small U.S. company shares are in downtrends have mostly recommended shifting into their large-cap counterparts. This is like being on the Titanic and learning that it has struck an iceberg--and therefore recommending leaving a second-class cabin to move into a first-class cabin which has recently been vacated, rather than heading for the lifeboats. By the time that most investors realize that they should sell many of their risk assets, it will be far too late to obtain favorable prices for them. I'm sure you remember many people prior to September 2008 who insisted that they would know when we had entered a "real" bear market and would be able to get out in time--only to discover after September 2008 that they had badly misjudged the financial markets. Being proactive is almost always rewarding because so few are willing to plan in advance; almost everyone ends up trying to respond to what has recently occurred.

Many measures of valuation have reached all-time highs, including record low yields on many classes of corporate bonds and all-time record or near-record ratios of prices to earnings and prices to book value for many equity sectors. A few measures are still below their all-time zeniths from March 2000, but are above peak valuations for nearly all other bull-market tops including 2007. Whenever too many investors are following nearly identical paths, they almost always end up losing a substantial percentage of their net worth. Many people have deluded themselves into believing that traditionally volatile assets are somehow almost as safe as a bank account, and are about to pay dearly for their willful ignorance.

In an interesting paradox, at the same time that so many stocks, bonds, real estate, collectibles, and other assets are dangerously overvalued by historic measures, a few sectors are especially undervalued. Most emerging-market shares suffered substantial bear markets which began during or near April 2011, and which mostly ended between August 2013 and July 2014. Many of these funds lost more than half their value during this period. Investors are instinctively reluctant to purchase anything which has recently suffered a substantial percentage decline, regardless of how compelling it might be. Nearly all emerging-market funds have been rebounding in recent months, generally gaining more than U.S. equity funds, but continue to mostly be avoided.

Many shares of commodity producers also suffered bear markets which began on or around April 2011, which slid to four- and five-year bottoms from June 2013 through the present time. The total percentage losses, as with emerging-market equities, was more than half for many commodity sectors and more than three quarters for the hardest-hit subsectors. A few of these including GDXJ have rebounded significantly from their lowest levels of the past year, while continuing to receive persistently negative media coverage and with almost all analysts and advisors recommending that their clients avoid them. There's a strange irony in advisors and analysts recommending that investors own dramatically overpriced assets which have tripled or quadrupled since early 2009, while not wanting them to buy the relatively few securities which are trading close to important 2009 lows. Emotionally, investors would almost always prefer to buy something which has been climbing for several years and which has been especially calm in recent months, because it intuitively seems to be safer and superior. Investors dislike buying something which has significantly lost value in recent years and which is experiencing sharp fluctuations in both directions, because something which behaves in this manner appears to be inferior and unpredictable. Not surprisingly, those assets which tend to rally the most are almost always those which recently suffered notable bear markets and which have gyrated choppily rather than rising smoothly in recent months. This ensures that very few people will benefit from the financial markets as nearly everyone ends up buying high and selling low.

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, HDGE, SIL, COPX, 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 ninth 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. The Russell Micro-cap Index has been even weaker since it completed a historic top on March 6, 2014. 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.