Wednesday, October 21, 2015

"He who wishes to be rich in a day will be hanged in a year." --Leonardo da Vinci

INVESTORS ARE FINALLY PUTTING THEIR CASH TO WORK, PRIMARILY INTO TWO CATEGORIES OF ASSETS (October 20, 2015): The title of my previous posting was "investors have been selling but haven't yet decided what to buy." I had studied published fund flows and discovered that money had mostly gone out of equity and corporate bond funds into money market funds and bank accounts, but very little of that money had been shifted into other assets. I speculated that, as is typical in the early stages of any U.S. equity bear market, investors were nervous about a global stock-market decline, so their first reaction was to sell without buying anything with the money. I concluded that this decision not to buy anything was temporary, and that they would soon decide to make purchases which would mostly end up surprising many analysts. During the past few weeks, investors have indeed been making clear decisions about what they most wanted to accumulate. These decisions have primarily benefited two major kinds of risk assets. It is worth examining how this will affect the financial markets going forward.

Only a relatively small percentage of this money which had come out of U.S. equity funds has gone back into the previous favorites, which includes funds based upon the Dow Jones Industrial Average, the S&P 500, the Nasdaq, the Russell 2000, and similar index-based choices. Investors are progressively concluding that the best-known best-known benchmark U.S. equity indices are unlikely to keep making new all-time highs as they had routinely done in 2013-2014 and during the first several months of 2015. This is significant, because it probably means that we have transitioned from a bull market which lasted for roughly 6-1/4 years to a bear market which could persist for roughly another two years. It is also noteworthy that investors haven't just kept their money in cash, not just because cash pays almost zero interest, but because the overall percentage declines in their overall net worth have been modest. Investors tend to pile into cash when losses have been so dramatic that they are concerned more about additional red ink than they are about making money or anything else.

Investors' tend to usually be obsessed with not missing out on rallies for the latest hot assets. Since their respective bottoms primarily in the late summer and early autumn of 2015, there have been two primary groups of outperforming securities: 1) the most popular individual names which have been soaring in recent weeks amidst widespread glowing media coverage; and 2) especially oversold and undervalued assets, some of which had suffered bear markets for several years. The second category includes most shares of commodity producers and emerging markets which mostly began their respective bear markets in April 2011 and which had generally suffered substantial losses of more than half and in some cases of more than three fourths.

Let us consider each of these kinds of decisions. It is easy to see why investors would embrace the latest trendy names on Wall Street. With Oprah Winfrey buying a much-publicized stake in Weight Watchers (WTW), who could resist such a celebrity-laden endorsement? Similarly upbeat media coverage has also boosted the shares of stocks including Amazon (AMZN), Facebook (FB), and Google (GOOG). The kinds of investors who have been buying these shares are generally amateurs who watch cable TV and browse the internet periodically, and are especially attracted to stocks which have easily remembered stories and are familiar to them in their daily lives. Whenever a bull market is transitioning to a bear market, there will be fewer and fewer winners, so more and more people will want to own whatever is going up.

There is a second group of securities which is much less widely known and which so far has continued to receive mostly gloomy media coverage and negative analysts' commentary. This includes the shares of nearly all commodity-related assets, including commodity producers and emerging-market shares. Since these achieved their respective multi-year and multi-decade bottoms primarily during the summer and early autumn of 2015, they have been among the most notable outperformers especially in subsectors including gold and silver mining which have been the biggest percentage winners during the past several weeks. Besides being much less well known than the securities listed in the previous paragraph, these have been far more popular with insiders and institutions rather than with individual investors. From a fundamental point of view, the big-name stocks listed in the previous paragraph are probably significantly overvalued and sport unusually high price-earnings ratios in the cases where they are actually making money. In sharp contrast, most commodity-related and emerging-market assets have especially low historic price-earnings ratios and are mostly trading far below their respective fair-value levels. These are compelling bargains in both absolute and relative terms.

As more time passes, I believe that most of the widely popular favorites will tend to fade as they usually do as a bear market experiences a natural state of maturing. On the other hand, since they had become so unpopular, even a reduction in the gloomy tone of the media and analysts' commentary could be accompanied by substantial percentage gains for commodity-related and emerging-market assets. Since most of these have slumped so dramatically during their extended bear markets, many of them could double and even triple while still remaining far below their peaks of recent years. For example, FCG, a fund of natural gas producers, had plummeted by more than three fourths from its June 2014 top to its September 29, 2015 bottom of 5.43. If it merely regains half its June 2014 high then those who bought it near the bottom will end up doubling their money on those purchases which were made close to the nadir. Another example is GDX, which had slumped by roughly 80% to its September 11, 2015 nadir of 12.62 and has since been among the biggest winners of all exchange-traded funds. Funds of junior producers such as GDXJ had suffered even greater percentage declines and could thus be especially impressive in the intensity of their rebounds. Gains of hundreds of percent are possible without new highs having to be achieved. Similarly outsized percentage increases could be the most likely scenario for many subsectors related to mining and energy. If this were a horse race, these should be favorites but instead carry the odds of long-shot dark horses.

It is noteworthy that the kinds of behavior which typified the bear markets for commodity producers and emerging markets have been much less prevalent in recent weeks. Early intraday lows tend to be followed more frequently by rebound attempts. Many of these shares have formed several higher lows in recent weeks. Insiders had mostly been significant buyers near all low points during the past several months, while fund outflows had reached all-time record extremes for many subsectors. Most analysts and brokerages have continued to reiterate the downside targets for these generally unpopular assets, so that hasn't yet been transformed into progressively more bullish commentary which will likely begin to occur more frequently in the near future. Since many of these securities have been among the biggest percentage winners in recent weeks, they are slowly attracting the attention of momentum players and other groups of potential buyers. Some of their purchases have been especially untimely, tending to occur following recent extended short-term strength which usually leads to a rapid short-term correction in order to shake out the sell stops which so many of these kinds of traders tend to employ. We saw such a rapid correction especially on Friday, October 16 and Monday, October 19, 2015, and there will likely be more of them whenever people have become too optimistic toward their short-term behavior. Eventually, I expect to see amateurs following insiders and institutions in becoming buyers, since they will observe that many of these assets have doubled, tripled, or better, and will hate to miss out completely on such strong rallies.

As is usually the case during any bull market, the earliest buyers tend to be insiders and deep value accumulators. This tends to be followed by a wide range of buyers at each step on the way up, until finally amateurs are eagerly participating while insiders begin selling. I think that we are probably a very long way from having to be concerned that these rallies are over or nearly so--especially since so much of the commentary on the internet in recent days has suggested that these rebounds are finished and that these assets should be sold short. A rally for anything doesn't end with most people believing that new historic lows lie shortly ahead, but when almost everyone is asking themselves how much higher it is likely to go and how long it will take for various upside targets to be surpassed.

Disclosure: In August-September 2013, and at various points during 2014-2015, I have been 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 more recently energy shares--especially following their most extended pullbacks. I have also been accumulating HDGE whenever U.S. equity indices are near their peaks; HDGE is an actively-managed fund that sells short U.S. equities. I believe that U.S. assets of almost all kinds have become dangerously overvalued. From my largest to my smallest position, I currently own GDXJ, KOL, SIL, XME, HDGE, COPX, GDX, EWZ, RSX, REMX, GLDX, URA, FCG, IDX, GXG, VGPMX, ECH, VNM, BGEIX, NGE, RSXJ, 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 to roughly 3% 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 also sold all of my FCG when insiders were unloading, but I repurchased FCG in recent months following its collapse of more than three fourths of its June 2014 peak because there had been intense buying by top corporate insiders of companies which produce natural gas. I expect the S&P 500 to eventually lose about two thirds of its May 2015 peak valuation, with its next bear-market bottom occurring within several months of October 2017. The Russell 2000 Index and its funds including IWM had only modestly surpassed their highs from the first week of March 2014, while the Russell Microcap Index (IWC) marginally surpassed its zenith from March 6, 2014. The S&P 500 Index set a new all-time high on numerous occasions during the same period, and may have completed its final top for the cycle at 2134.72 on May 20, 2015. 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 previous bear markets are doomed to repeat their mistakes.