Wednesday, November 11, 2015

"Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery." --Charles Dickens

LOST IN ROTATION (November 11, 2015): Imagine if a weather forecaster were to announce in August that because the usual cooling that month hadn't occurred and temperatures were even hotter than in July, we must be making a decisive upside breakout and we won't need cold-weather clothing for several more years. Or imagine an astronomer announcing that we won't have the usual appearance of Halley's Comet because the core nature of the universe which had been established over billions of years has permanently changed during the past decade. While most cyclical phenomena are accepted as an inherent part of life, in the financial markets there are a surprising number of analysts, advisors, and others who refuse to acknowledge that there is a rotation which has existed for thousands of years and will continue to exist as long as humans are populating planet Earth. Each time we have an economic boom, many believe that we are not going to experience another recession--or that somehow an especially powerful or extended era of prosperity will magically be followed by an especially mild downturn. Pointing to history carries a lot of weight in some fields of endeavor, but in the financial markets it doesn't exert much impact because so many people will always think that "it's different this time." In 2000, many believed that technology shares could only go up because we never had the internet before, and then the Nasdaq suffered its worst-ever percentage decline of more than three fourths of its value. In early 2009, perhaps even more people were convinced that global stock markets would take years to even moderately rebound, because we had never suffered a subprime asset collapse before. Looking back at previous centuries, many pointed to canals, railroads, and other phenomena as evidence that the world had completely changed, and therefore well-established patterns--the earliest known writing consists of a sequence of grain trades--had become obsolete and had to be replaced by an entirely different set of theories. In the end, the strongest and most extended bull and bear markets will continue to be followed by the most powerful moves in the opposite direction, just as had been the case a decade or a century ago.

We are currently in the process of another typical rotation from a bull market for U.S. equity indices including the Russell 2000 (IWM), the S&P 500 (SPY), the Nasdaq 100 Trust (QQQ), and the Dow Jones Industrial Average (DIA) into a bear market for the same assets. One common sign that a transition has occurred is when the smallest stocks as a group have been struggling to achieve historic peaks, while the largest stocks have been able to do so. QQQ reached an intraday top of 115.47 on November 4, 2015, which it had not previously touched since March 28, 2000 and which in dividend-adjusted terms had been a new all-time high if you don't adjust for inflation. However, the highest that IWM could get in recent weeks was 119.36 on November 6, 2015, which was considerably below its all-time top of 129.10 from June 24, 2015. Currently, IWM is trading below its highs from the first week of March 2014 which was more than 20 months ago, indicating that it has actually been underperforming for an extended period of time. This kind of underperformance by thousands of small U.S. companies had also occurred in 2007 as the 2007-2009 bear market was beginning, and had been a key feature of the U.S. stock market in 1971-1972 prior to the 1973-1974 bear market. The same had been true in the late 1920s prior to the worst bear market in U.S. financial history, and on several occasions in the 1800s. What is fascinating is not only how consistently this pattern tends to appear, but how investors behave each time. You would expect investors to look back at the past and say to themselves, "A common pattern of lagging small-stock behavior is probably signaling that we are transitioning to a bear market for U.S. equities. So it makes sense to gradually sell into all rallies." Instead, most investors tell themselves, "The past doesn't matter, because we never had (canals) (railroads) (automobiles) (semiconductors) (the internet) before. So a completely different set of rules are in force." Technical traders insist, "Since larger stocks are continuing to outperform, continue to sell small stocks and move the money into large-cap U.S. equities." Sometimes this technical pattern becomes so widespread, as in January 1973, that an astonishing percentage of investors end up crowding into a narrower and narrower set of stocks. To a less dramatic extent, but no less dangerously, this occurred near the end of 2007 and has been happening in recent months. It is no coincidence that Marc Andreessen, a founder of Facebook (FB), recently sold nearly half of his total position in that company which he had held throughout the bull market. Insiders in many large-cap names have accelerated their selling relative to buying in recent weeks, in order to take advantage of many investors making a rotation but going about it in a dangerous way. Shifting from large-cap to small-cap U.S. equities is like noticing that some first-class passengers on the Titanic have decided to abandon ship; instead of finding out why, you happily move into their vacant deluxe cabin. Investor inflows into large-cap U.S. equity funds have been especially intense in recent weeks, with many of them concluding that we had already experienced our correction for 2015 and that it will be sunshine and chocolate cookies from now on. Whenever too many people are expecting smooth sailing, watch out for rough seas.

A common rotational pattern during the early stages of a bear market is for inflationary expectations to increase. This was clearly evident in 2007-2008, 2000-2001, 1978-1980, 1972-1974, 1936-1937, 1928-1929, and during many other previous transitions to bear markets. Any economic expansion which lasts more than a few years will eventually lead to the ability of companies to raise prices and for workers to demand higher wages to allow them to share in the economy's prosperity. According to U.S. government data contained in the employment report released on Friday, November 6, 2015, average U.S. hourly wages have been growing at 2.5% annualized which is the fastest pace of increase since 2009. Other signs of inflation have been more difficult to find due to extended bear markets for most commodities, but historically this is the time when commodities and the shares of their producers will tend to strongly outperform other assets. It is highly likely that many investors who had money in commodity producers or emerging markets in recent years ended up selling them and using the money to buy U.S. equity funds--not because it was logical to sell the most undervalued securities to buy the most overvalued ones, but because emotionally people hate holding onto anything which has been in an extended bear market and love to own anything which has enjoyed an extended bull market, which in this case had become among the lengthiest and strongest bull markets in U.S. history. While there have been problems with subpar growth and political turmoil in many emerging markets--with the former usually contributing significantly to the latter, since prospering economies will overlook political shenanigans--the relative price-earnings ratios and other measures of valuation are far out of line with what they should be based upon corporate profit growth. It isn't logical that U.S. equities should still be more than three times as expensive as they had been at their lows in early March 2009, while many emerging-market bourses are trading near or below their lowest levels of the previous recession--and in several countries even lower than the recession before that. Especially undervalued bourses include those in Latin America (ILF), including Brazil (EWZ) and Colombia (GXG), along with many African (AFK) economies including Nigeria (NGE) and others near and south of the equator such as Australia (EWA) and South Africa (EZA).

The real reason that investors haven't been accumulating the most undervalued securities is that most people are afraid to buy anything which has suffered an especially severe and lengthy downturn. They will usually change their mind once there has been a significant percentage rebound such as 50% for some investors and 100% for others. In addition, as long as they hold out hope that U.S. equity indices will remain in uptrends, they will be reluctant to sell something with which they are very familiar in order to buy something with which they intuitively feel less comfortable. Nonetheless, during nearly all previous transitions from a bull to a bear market, investors eventually crowded into commodity producers and emerging markets, so what is really required is for this process to reach a more advanced stage where investors feel that they are missing out on a fantastic opportunity by not participating along with their friends who have recently been making money in those assets. Eventually, fear about buying something which has been in a crushing downtrend is replaced by a greater concern of having a major bull market in something passing them by without their being part of it. Rotations begin with an inevitable shifting out of the most overpriced assets into the most underpriced securities, and usually ends with the previous big losers becoming the strongest percentage winners. Funds which had been especially unpopular and have likely completed or will soon complete historic bottoms include silver mining shares (SIL), copper mining shares (COPX), coal mining companies (KOL), uranium mining companies (URA), and natural gas producers (FCG).

Other events tend to happen when this transition is underway. As inflationary expectations increase, assets which benefit from deflation will notably underperform. These primarily include high-dividend shares of all kinds, including utilities (XLU), REITs (IYR), long-dated U.S. Treasuries (TLT, VUSTX), and preferred stocks (SPFF). The fact that all of the above sectors have been in downtrends is probably not a coincidence, since they will typically begin bear markets prior to broader-based U.S. equity funds as they had done in each of the past several transitions to bear markets. I have seen a lot of commentary about how "there is no sign of rising inflation anywhere," but the behavior of the above equity groups serves as a compelling omen of what is most likely to occur.

It is important to note that since the financial markets have been and always will be cyclical, a period of rising inflationary expectations will not last indefinitely. In a typical transition, U.S. equity indices are in a bear market but contrary to popular perception rarely end up crashing. Instead, there is a sequence of several or more corrections, each one which is followed by a sufficiently convincing rebound to discourage most investors from selling. A pattern of several lower highs is thus established. At the same time, high-dividend sectors including U.S. Treasuries continue in their bear markets, while previous losers including commodity producers and emerging markets will often transform themselves from the least popular to the trendiest assets. Whenever Treasuries are least desired and commodities are back in favor, you will see projections by the same analysts who had been simultaneously forecasting gold (GLD) at 1000 U.S. dollars per troy ounce or lower and crude oil (USO) at 30 U.S. dollars per barrel or lower competing with each other to give the most aggressive upside targets for commodity prices. Whenever this happens, it usually makes sense to gradually sell the shares of commodity producers and emerging markets to purchase very unpopular U.S. Treasuries especially on the longer end of the curve and particularly if Treasuries are trading at their lowest points in several years or more. The reason is that, during any U.S. equity bear market, the first 70-80% of the transition is one where many equity sectors underperform while a minority of sectors are dramatically surging higher. In the final 20%-30% of the bear market, it is usually the case that almost all risk assets will plummet simultaneously--not necessarily by the same percentages, but with nearly all of them suffering substantial percentage losses. During this collapse phase of a bear market, among the few winners will tend to be funds like TLT, other long-dated U.S. Treasury securities, and not much else. Perhaps the second or plunging phase of the current bear market will begin at some point during 2017. During such a collapse, the risk-off behavior is so predominant that it is usually folly to try to pick the very few risk assets which will be climbing in price.

Investors always want to know what is unknowable, which is how extended any given trend will become, how high or low any given asset will get, and when it will happen. The same people rarely respect even the best-established historic patterns, so that they believe that each time it is completely different from the past when it is almost always an approximate repeat. Therefore, it is like a horse race in which the selections which should be odds-on favorites instead end up sporting the odds of true dark horses with incredible long-shot payoffs. Most investors currently believe that broad-based U.S. equity indices will continue to outperform while commodity producers and emerging markets will continue to retreat, while the opposite is likely to prove true primarily because such behavior has almost always been the case for many decades. The world has certainly changed, but the financial markets tend to behave almost exactly the same.

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.

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