Monday, February 23, 2015

"Never accept 'conventional wisdom' when it comes to finance. If others keep failing, why do you want to follow them?” --Ziad K. Abdelnour

U.S. ASSETS OF ALL KINDS ARE DANGEROUSLY OVERVALUED (February 23, 2015): From time to time, investors around the world become irrationally obsessed with certain assets, thereby causing them to become extremely far above or far below fair value. Such a situation exists today, as rising U.S. assets especially since November 2012 have encouraged many to sell almost all other kinds of investments to own the U.S. dollar, U.S. stocks, U.S. bonds, U.S. real estate, and almost everything which is closely related to any of the above. This has caused a chain reaction whereby those who are invested in far more compelling securities become upset with their underperformance relative to a benchmark like the S&P 500 or a plain vanilla U.S. corporate bond fund, and thereby end up switching their allocation to be more heavily invested in the United States. The end result has been a bubble which like all true bubbles is barely recognized as such because it seems like logical behavior. There are even cute sayings, such as the United States being the cleanest dirty shirt in the laundry, which encourages uncertain investors to take the leap and to put more of their money into the United States than would be prudent. Most U.S. assets have experienced all-time record inflows and are trading near all-time highs, while many emerging markets, commodity-related securities, and similar unpopular assets are trading near their lowest points in six years. Naturally this encourages many others to sell whatever is close to a six-year bottom to buy something in the U.S. which is near an all-time high rather than doing as I recommend and taking precisely the opposite course of action.

Price and time can't tell you when a given trend is going to end, but fund flows and insider behavior tend to be consistently reliable indicators. There have been record inflows into nearly all open-end and exchange-traded funds of U.S. stocks and bonds since the beginning of 2013, while there have been record outflows from many emerging-market and commodity-related funds in recent months. In the long run, selling whatever is most popular and buying whatever is least favored has been a strategy which has made fortunes for many of history's most consistently wealthiest investors. Chasing after recent performance has never yielded a single billionaire or anyone who is remotely close to that status. Therefore, it is especially timely to consider making a gradual asset reallocation away from the S&P 500, the Nasdaq, the U.S. dollar, and U.S. bond funds in order to purchase emerging-market assets especially in countries south of the equator where valuations have generally been near generational lows relative to corporate profits. This includes Brazil (EWZ and BRF), Colombia (GXG), Nigeria (NGE), Australia (EWA and KROO), Peru (EPU), and similarly disliked funds. It also includes funds of commodity producers such as junior gold mining shares (GDXJ), coal mining (KOL), copper mining (COPX), rare-earth extraction (REMX), uranium mining (URA), platinum producers (PLTM), and almost all other funds related to energy, mining, agriculture, and similar securities.

If you own shares or funds of depressed assets and you are a U.S. resident, you can take advantage of their currently depressed prices if you own such assets in your 401(k), 403(b), SEP-IRA, Keogh, traditional IRA, or other non-Roth retirement account. You can convert these shares from your account to a Roth IRA and pay taxes based upon their present low valuations. As these eventually rebound, all future gains will be completely tax free. In the event that these shares don't recover but end up retreating further in price, you can choose to undo your conversion, which is known as a recharacterization. You can then wait at least 30 days, or until the first day of the following calendar year--whichever is later--and then convert them again. There is no limit to how many times you can repeat this process. It's like being able to go back in time and "unbuy" something which doesn't go up in price. It's heads you win, and tails you also win. Unfortunately, I do not know of any equivalent in any other country. It's ironic that this situation exists for U.S. residents who are mostly overinvested in U.S. assets which are dramatically overvalued and are therefore inappropriate for doing such conversions.

Brad Lamensdorf has done such an excellent job detailing why U.S. equity indices have become absurdly overvalued that there is no better way to illustrate this than to present his recent essay in its entirety:

  • Overvalued Fundamentals Outline Big Picture

  • If you want to know how much the least popular assets could potentially rally, all you have to do is to compare their current valuations with their monthly highs from January 2013. While there is no guarantee that these assets will return to where they had been just over two years ago, by historic standards this would be a relatively moderate rebound from such a level of extreme unpopularity. Almost all shares of commodity producers and emerging-market equities had been far higher than their January 2013 peaks in 2012--especially in the first quarter of that year--with many of them trading at even higher levels near the end of 2010 and at various points in 2011. If an asset has lost more than half of its value and it regains only half of its loss, then you will still end up with a profit of more than 50%. The last time that many of these assets were similarly depressed six years ago, many of them ended up more than tripling. In recent months, partly from investors chasing after U.S. assets, outflows have been even greater from most funds related to emerging markets and commodity producers than they had been in late 2008 and early 2009. Insider buying for many of these subsectors has generally been more aggressive and more pervasive in recent months than it had been at almost any other time since the early part of the century when we had similarly irrational disparities especially between technology shares and "old economy" shares. The more things change, the more they remain the same: the Nasdaq is almost all the way back to five thousand again and is set for another plunge of 60% or more during the next few years.

    During the final months of 1999 and the early months of 2000, there were numerous financial analysts and advisors who said something like this: "There are some people out there who told us that the Nasdaq was overvalued when it went above four thousand, and yet it kept going up. Then they told us it was overvalued when it reached 4500, and it kept going higher. Now the Nasdaq is above five thousand, so you should completely ignore those bears who have been wrong time after time, and listen to us when we tell you that even greater Nasdaq gains lie ahead for many more years." What did the Nasdaq do after that? It plunged 78.4% from March 10, 2000 through October 10, 2002. The bears who were "always wrong" ended up being most right when almost no one believed them. Making a trading decision based upon recent behavior is almost always a serious mistake, because any asset almost always makes a final sharp surge higher before it experiences a severe bear market. Similarly, almost any asset which is about to enjoy a powerful rally almost always first slumps to a new multi-year bottom in order to discourage investors from buying it at its most compellingly undervalued levels. Don't be fooled into believing something based upon recent performance, especially whenever something is at or near an especially lopsided historic extreme. If you had arrived on planet Earth from Mars--assuming you had terrible internet reception on Mars--you'd have no difficulty in recognizing today's asset valuations as being ridiculous. Only when you have time to emotionally adjust to any irrational situation, and time to be repeatedly brainwashed by almost everyone around you, do you progressively perceive the most absurd situation as being normal.

    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 11, 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% 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 recent peak value--with most of that decline occurring in 2016-2017. The Russell 2000 Index (IWM) has barely surpassed its high from the first week of March 2014, while 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 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.