Monday, February 9, 2015

"Long ago, Ben Graham taught me that 'Price is what you pay; value is what you get.' Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down." --Warren Buffett

DEFLATION IS THE MOST POPULAR AND MOST MISGUIDED BELIEF TODAY (February 8, 2015): If you were to interview a hundred or more people about the global financial markets, they would disagree about some topics. Some believe that the price of crude oil has bottomed and will continue to rebound, while others expect it to remain low for an extended period of time. Some expect interest rates to rise while others expect rates to keep dropping. Some expect the global economy to continue to grow in the coming year, while others are concerned about a slowdown. However, almost everyone agrees that inflation is not a serious concern and that one of the safest bets you can make is to assume that inflation will stay extraordinarily low or even possibly go negative throughout the world.

Whenever there is a nearly unanimous consensus that a particular kind of behavior will prevail in the financial markets, almost everyone will have already made portfolio allocations to match this expectation, leaving almost no one left to actually cause the anticipated event to occur. If everyone has already purchased U.S. dollars in the belief that the greenback will continue to climb against nearly all other global currencies, then who will be left to buy it? There currently exist all-time record speculative positions on a higher U.S. dollar, along with similar records or near-record bets on lower currencies in almost all other countries. Almost no one is taking steps to hedge their portfolios in the event of rising inflationary expectations. The surprise for which almost no one is prepared is the one which is most likely to actually happen.

As a result of the nearly universal belief in deflation, investors have crowded into assets which will benefit from continued declines for commodities. The shares of most commodity producers recently set or approached six-year bottoms, as have the shares of many emerging markets which are connected directly or indirectly with commodity production. The outperformance of U.S. stocks, bonds, and the U.S. dollar has created its own dangerously exaggerated situation, by convincing most investors that this outperformance will continue indefinitely. You often hear nonsensical comments such as the United States being the cleanest dirty shirt, and other theories which attempt in hindsight to explain what has already happened as logically as possible. In reality, if you had arrived on Earth from the planet Mars, you would immediately recognize that it makes no sense for average U.S. price-earnings ratios to be above 18 while Russian companies have an average P/E of only 4. Companies in nearly identical industries, such as Ecopetrol (EC) versus Exxon-Mobil (XOM), demonstrate an irrational overvaluation for the U.S. counterparts as compared with those in almost any other part of the world.

It is particularly ironic that seven years ago--and again four year ago--investors assumed the exact opposite: that growth outside the United States would perpetually outperform growth within the U.S., and that commodities would continue to climb in price because of an irreversible increase in demand from two billion people who had moved into the middle class. These people wanted to drive automobiles, and to have real copper pipes in their houses, and to eat the same food as those in developed countries. Since 2008 or 2011, there hasn't been any change in the fundamental situation; those in emerging markets haven't decided that they prefer poverty or wish to give up their recent prosperity. However, a new myth has been created in which the U.S. economy will allegedly continue to outperform the rest of the world for many more years, which is just as illogical as the opposite myth which had existed previously.

Nearly all funds of commodity producers and emerging-market equities have begun to rebound from six-year lows, while a few including Brazil (EWZ) and Nigeria (NGE) have lagged in their recoveries. In general, the best investment strategy will continue to be to purchase whatever is least popular at any given time and is assumed to be the most "hopeless" in being able to enjoy a rebound. The most severe bear markets are almost always followed by the strongest recoveries, and yet most investors incorrectly perceive that any uptrends following major downtrends will be muted or insignificant. The most difficult perception problem for most investors in early 2009 was in realizing that the huge collapse for global equities ensured an equally outsized and dramatic regaining of those losses, because emotionally a big drop creates the illusion that there is some kind of inherent inferiority which can't be easily overcome. We have already experienced three energetic rallies for commodity producers and emerging-market equities since 2000, but investors mistakenly believe once again that the chance of a fourth such rally is highly unlikely.

Summary: Everyone is convinced that deflation will rule worldwide and that U.S. assets will outperform those in the rest of the world, because they're looking back at the recent past and wrongly extrapolating it into the indefinite future. Take the opposite point of view and you will prosper greatly in 2015-2016.

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. I have reduced my total cash position since June 2013 to approximately 4%-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.