Monday, October 6, 2014

"I've found that when the market's going down and you buy funds wisely, at some point in the future you will be happy. You won't get there by reading 'Now is the time to buy.'" --Peter Lynch

THE U.S. DOLLAR IS TODAY'S BUBBLE (October 6, 2014): During the current century, there has been an incredible procession from one bubble to the next. Everything from the Nasdaq to Canadian housing prices to small-cap U.S. equity indices achieved multi-decade peaks in both absolute and relative terms. Each time, investors have assumed that it's "the new normal" or that "we've never had this situation before, so it makes sense." The latest absurd overvaluation has occurred for the U.S. dollar, also known as the buck or greenback. Is it different this time?

The correct answer, of course, is that it was created in the same fashion as all of the above extremes, and will be resolved with a similar slump. Especially against emerging-market currencies including the Brazilian real and the Russian ruble, the U.S. dollar has become ridiculously overpriced. The greenback has been in such a strong uptrend that most analysts are no longer debating whether it will continue, and are taking it as an "obvious" assumption that it will keep climbing indefinitely. When a consensus is building, its momentum often carries it forward. However, once such a consensus becomes nearly unanimous, as the bullish consensus is today for the U.S. dollar, then it begins a dramatic reversal which nearly always ends up with a nearly opposite extreme to the one which had previously existed.

Thus, all of the above bubbles slumped after their creation. After reaching an all-time top in March 2000, the Nasdaq plunged 78.4% by the time it bottomed in October 2012. U.S. housing prices lost an average of 34% nationwide following their 2006 bubble top, and Canadian housing prices will likely plummet by an even greater percentage over the next three or four years. Small-cap U.S. equities plummeted in 2007-2009 and will almost surely lose as much in 2014-2017--in case you haven't noticed, they began bear markets on March 6, 2014 with IWC, a fund of U.S. companies with less than one billion dollars apiece in market capitalization, already down by a double-digit percentage. The U.S. dollar index will likely retreat to its lowest level since the fourth quarter of 2011; if this takes about a year, then this will generate a four-year bottom.

If the U.S. dollar is on the verge of a significant decline, then numerous inversely correlating assets are set for dramatic rallies and are worth buying at currently depressed levels. Many commodities and the shares of their producers have gone strongly out of favor during the third quarter of 2014, with many emerging-market assets doing likewise. Numerous securities in these sectors have fallen so sharply that they are approaching or have already reached their lowest levels since the first several months of 2009 when they were completing their previous bear-market nadirs. The mainstream financial media coverage has been almost uniformly positive toward the U.S. dollar and persistently negative toward commodity-related assets and anything related to emerging markets.

Historically, gold and silver mining shares are among the most reliable winners during periods of U.S. dollar weakness. With these assets having rebounded only modestly from their respective 2013 bottoms, they will likely be among the biggest winners for the remainder of 2014 and for at least part of 2015. Other mining shares, many of them near their lowest points in more than five years, will likely gain significantly in percentage terms during the upcoming year. Previously popular emerging-market equities in countries including Russia, Brazil, and most of South America have only moderately rebounded from multi-year lows reached during the first quarter of 2014, and have substantial remaining upside. While almost everyone is bailing out of these securities as quickly as possible, now is the time to gradually accumulate a variety of these assets.

Inflation is a problem which is so certain by most investors to be "solved" that the risk of deflation is considered to be far more serious. In the past, whenever we have experienced a consensus on either side, the opposite behavior has always occurred. Thus, deflationary panic in late 2008 led to a dramatic inflationary climb by 2011; at that point, the belief that inflation would continue indefinitely led to major bear markets for the shares of commodity producers and emerging-market equities. Now we've swung all the way back again, with almost no one concerned about rising inflationary expectations. Historically, whenever U.S. equities are transitioning from a multi-year bull market to a bear market as they have been doing recently, there is a corresponding inflationary surge. Of course many people believe that "it's different this time", and of course it very rarely is different. History repeats itself with boring predictability.

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, SILJ, 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 tenth 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.