Thursday, January 8, 2015

"Be a contrarian. Buy when others are smiling at you. Keep purchasing as they snicker at you. As they start laughing at you, become fully invested. It might not be apparent to the financial markets now, but in all probability, gold is in the initial stages of a major bull cycle." --Irwin T. Yamamoto

IN 2015, THE LAST SHALL BE FIRST AND THE FIRST SHALL BE LAST (January 8, 2015): What do most investors expect in 2015? If you look at the comments of most advisors and analysts, or you speak with your friends and neighbors, you will soon realize the following: consciously or subconsciously, people expect the behavior in the financial markets in the final months of 2014 to prevail throughout 2015. This isn't because of any kind of scientific method or algorithmic extrapolation, but because it's human nature to almost always project the recent past into the indefinite future. Therefore, nearly all investors anticipate worsening deflation; a continued rise in the U.S. dollar; new all-time highs for most bond funds; additional significant gains for the S&P 500 Index; large-cap U.S. equities outperforming their small-cap counterparts; additional meaningful declines for commodities and the shares of their producers; further losses for most emerging-market shares; and for central bankers around the world to continue to try to increase inflation at almost any cost.

Before the end of 2015, it will become apparent that the above expectations are all badly off course. Already, all of the assets described in the previous paragraph have achieved multi-year, multi-decade, or all-time extremes, although investors don't appreciate how lopsided these valuations have become because everything which exists at any given time is believed to be reasonably priced. When the Nasdaq was above five thousand in early 2000 it was assumed that it would remain elevated indefinitely, and now that the Nasdaq is not far below five thousand today most investors assume that it will soon reach a new all-time zenith. However, the Nasdaq, the S&P 500, and all other U.S. equity indices and funds have become dangerously overvalued. Before they more than tripled, U.S. equities were a compelling bargain; now that their prices have surged far more rapidly than the profits of their underlying companies, the U.S. stock market is more vulnerable to a multi-year bear market than at any time in its past history. This is evident from fund flow data for U.S. equity funds, which mostly approached or set new records for total investor inflows during the past two years. The all-time record monthly inflow was in February 2000, just before a severe bear market, while the all-time record monthly outflow was in February 2009, just before one of the strongest bull markets in history. If most investors are piling into or out of anything, then the market is set to punish them rather than to reward them.

There is an unusually sharp dichotomy between two sets of assets worldwide today: those which are close to all-time peaks, and those which are trading near six-year bottoms. While the latter don't receive nearly as much media attention as the former, most shares of commodity producers and many emerging-market equities have traded sometime since early November 2014 at or near their lowest levels since the final months of 2008 or the early months of 2009. In most cases, emerging-market bourses have enjoyed roughly similar overall GDP growth as compared with the United States, but instead of more than tripling in value as U.S. equity funds have done since early 2009, they have barely moved higher during the past six years. This has resulted in an irrational situation where a company like Ecopetrol (EC) in Colombia, merely because it is in Colombia, with more consistent profit growth, lower debt, and stronger earnings than Exxon Mobil (XOM), has moved net sideways. This is true for entire stock markets including Russia (RSX), Brazil (EWZ), Nigeria (NGE), Portugal (PGAL), Norway (NORW), and most others in South America, Africa, and much of Europe. Asian and Australian shares are somewhere in between. You'll almost never hear a media recommendation to purchase equities in Colombia or Norway or Nigeria, but that is where some of the best global bargains currently reside.

With the U.S. dollar index reaching its highest point since November 2005, investors assume that it will continue to rally. However, we currently have an all-time record number of speculators betting on a continued climb for the greenback. Any time that a given trade becomes its most overcrowded in several decades, it becomes especially dangerous to assume that it will continue. The relevant question to ask is this: why is the U.S. dollar so strong? A response is usually in the form of some nonsense such as the U.S. being the least dirty shirt in the laundry, but in reality there is no logical reason for the greenback to be so powerful unless a worldwide recession is imminent. The same is true with commodities which are mostly trading at their lowest prices since the early months of 2009, as well as many global currencies which are doing likewise. If we are about to experience a deflationary depression which begins during the next few months, then this behavior is sensible. Otherwise, it is a glaring mispricing combination which will be followed by huge gains for commodity producers and emerging-market equities in particular, along with moderate losses for both U.S. stocks and bonds.

It is rare to find an analyst or advisor who expects declines for both U.S. equity funds and U.S. bond funds during 2015. As unlikely as this may seem, it is the most probable outcome for the calendar year. Bonds have surged not because they represent any kind of fundamentally worthwhile investment choice, but because investors unhappy with yields of less than one percent in bank accounts have chased after yield without regard for risk. U.S. stocks have rallied because they continue to move higher, so those who are invested almost anywhere else in the world and have been disappointed with apparent "losers" have decided to eventually give in and to switch to the "winning" team. The more eagerly investors dump the most undervalued stocks to chase after the most overvalued ones, the greater the disparity has become between these groups. Finally, just in the past several weeks, the weakest names have been among the biggest winners, while the most popular indices including the S&P 500 have begun showing signs of early weakness. There continue to be sharp up days for U.S. equity indices, just as there had been throughout 2007 and during the first eight months of 2008, to discourage investors from selling U.S. stocks anywhere near the top. By the time investors realize that they should have sold, they will likely already have lost half or more of their money, just as had occurred during the 2007-2009 bear market.

As for U.S. bonds, they seem to be in an unending uptrend. Anything which appears to be unstoppable eventually stops, and then dramatically reverses as the psychology becomes transformed from "bonds are just as safe as a bank account and will give me more income" to "get me out of these bonds at any price, because they've lost so much and I can't afford to keep losing more while I'm waiting for a rebound." This is of course exactly what happened with U.S. corporate bonds in 2007-2008, and the next year or two will be similar. U.S. Treasuries are in a different category from corporate bonds, but TLT recently surged to a new all-time high and Treasuries have become far too popular. With all-time record inflows into many U.S. Treasury funds in recent weeks, expect them to disappoint investors from now through early 2016 when they may once again become sufficiently cheap to justify purchasing.

If you look at charts of GDX, SIL, GLDX, or SILJ, they have this feature in common: they all bottomed on November 5, 2014. Many other funds of commodity producers and emerging-market equities completed their lowest points in the morning of December 16, 2014. Some of these shares slumped to new six-year lows in January 2015, thereby providing additional good buying opportunities. Whenever it appears that bargains will last forever, they soon rapidly disappear.

Summary: Investors are expecting additional 2015 gains for both U.S. stocks and bonds, as well as a continued rise in the U.S. dollar. All of the above will end up behaving exactly the opposite. The least-loved securities in the world, consisting primarily of the shares of commodity producers and emerging-market equities which are mostly near their lowest points in six years, will likely be among the biggest percentage winners throughout 2015 and into the early months of 2016.

Disclosure: In August-September 2013, and throughout 2014 into early 2015, I have been aggressively buying the shares of emerging-market country funds whenever they have 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 had 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 perhaps in 2017 or whenever 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, HDGE, GDX, SIL, COPX, REMX, EWZ, RSX, IDX, GXG, ECH, GLDX, URA, FCG, VGPMX, BGEIX, VNM, ZJG (Toronto), NGE, 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 5% of my total liquid net worth in order to increase my holdings in the above assets. I 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 December 29, 2014 peak value--with most of that decline occurring in 2016-2017. The Russell 2000 Index (IWM) barely achieved a new all-time top on July 1, 2014 and again on December 31, 2014, but these were both less than 1% above its March 6, 2014 high. The Russell Microcap Index (IWC) has never surpassed its zenith from March 6, 2014. Meanwhile, the S&P 500 Index set a new all-time high on numerous occasions during the same ten-month period. This marks 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.