Tuesday, January 26, 2016

"In the short run, the market is a voting machine, but in the long run it is a weighing machine." --Benjamin Graham

ALL ASSETS WILL CONTINUE TO SWING TO IRRATIONAL EXTREMES (January 26, 2016): As Benjamin Graham notably stated in the above quote, in the short run the market is driven by investors who will be especially eager to purchase trendy assets near tops and to sell unpopular assets near bottoms. In the long run, the most undervalued assets will climb the most while the most overpriced ones will suffer the greatest percentage losses. This is evidenced by the all-time record outflows from U.S. equity index funds during the first quarter of 2009, and all-time record inflows into most of these funds during 2014-2015. Naturally, this means that most investors were selling the S&P 500 around 800 or below, while buying it near 2000 or above. This is true of virtually all sectors: you can see huge outflows from U.S. Treasury funds in late 2010 and early 2011 the last time they were completing a multi-year bottoming pattern, and all-time record inflows into the same funds in late 2014 and early 2015 when they were peaking. It will always be this way, because investors will always want to own whichever assets have already enjoyed the most extended uptrends and are thus maximally vulnerable to a significant drop to reach fair value, while they will flee those assets which have suffered the most severe and long-lasting bear markets and are thus the most likely to rebound strongly.

If we look at the state of the global financial markets, we can see that there have already been tentative and not-so-tentative moves toward fair value for those securities which had been among the most popular investor favorites of 2015. Apparently "unstoppable" names including the "fang" four, Facebook (FB), Amazon (AMZN), Netflix (NFLX), and Google/Alphabet (GOOG) have been among the biggest losers. Even these have rebounded in recent days, indicating that investors aren't willing yet to give up on their darlings even if they are barely profitable and have irrationally high price-earnings ratios. Some of the most undervalued emerging markets around the world, including Russia (RSX) where price-earnings ratios had dropped to an average between four and five, were also affected by the selloff as many investors dumped everything which is easy to do on the internet, only questioning their rash decisions later. In the short run, panic usually leads to a partial recovery, but the U.S. equity markets aren't going to go back to new all-time highs. Small-cap shares had outperformed from March 2009 through March 2014 and have since notably underperformed their large-cap counterparts, which historically has almost always been followed by a severe bear market. 2016 isn't likely to be either the horrible year which some are anticipating for U.S. equity indices, nor is it likely to be flat like 2015. It will be a moderate down year, with the bear market accelerating as usual in its final months which will likely occur in 2017 or 2018 when we could go below the deep nadirs of March 2009.

Among the least popular assets today are shares of companies which produce commodities or are located in emerging markets. Some shares fit into both categories and are unusually undervalued. Even the highest-quality names in these sectors have mostly been devastated, because investors have concluded that they only move in one direction which is lower. It is the opposite of a bubble, which interestingly has no word in the English language to express it precisely. The increasingly optimistic expectation of continued gains for the U.S. dollar, which had been especially strong until the middle of March 2015 and has mostly moved sideways since then, is probably misplaced partly because it is such a popular bet with a recent all-time record total of speculative bets on a higher greenback, along with unusually strong commercial accumulation of nearly all other global currencies. Commercials, or insiders who trade currencies for a living as part of their job, have been especially eager to buy the Canadian dollar, with aggressive accumulation of other currencies including the Australian dollar and the Mexican peso. It's not that they necessarily know something that others don't, but that they aren't nearly as easily swayed by media coverage of an "unstoppable" U.S. dollar and are much more concerned with the fundamental facts on the ground.

One asset which has barely been discussed as being overvalued is real estate in many parts of the world. As recently as 2011, there were many neighborhoods in U.S. states including Florida, Arizona, and Nevada where the ratio of housing prices to household incomes was less than 1.5 to 1. Today, there are cities including San Francisco, Vancouver, Tel Aviv, and others where some neighborhoods have ratios which exceed 10 to 1. As with all other assets, real estate prices which appear extreme can become even more extreme, but eventually fair value will reign and prices will have to revert toward their normal levels of 3:1 which have prevailed at least since the time of Julius Caesar. The percentage declines implied by these losses will shock those who are residents of these and many other global cities. As with everything else in the financial world, until it has happened almost no one can imagine it occurring, and after it happens everyone will say how obvious it had been that prices would have to collapse. This is part of a human tendency to repeatedly project the recent past into the indefinite future, even when making such an assumption is inherently illogical.

For the past two decades, perhaps because of the existence of the internet, the financial markets have swung to much more frequent extremes than they had done for the previous several decades. The internet allows people to get and to act upon information rapidly, which is both a blessing and a curse. For most people, it is unfortunate that they can find out everything so fast, because this causes their emotions to get ahead of their brains. If you hear a stream of bad news, you will be more likely to take an action which you wouldn't likely have done if you had more time to think it over. I know people who have literally sold everything in their brokerage accounts within minutes because they were able to do so and because they were responding to news reports or listening to financial TV radio or television. If it is March 6, 2009 and you hear an incredibly negative U.S. employment report, you are likely to place sell orders even before the market has opened, as many did on that day when the S&P 500 completed its historic bottom at 666.79. Throughout almost all of 2014 and 2015, you heard almost entirely optimistic forecasts of future U.S. stock market performance which encouraged many to buy near their most inflated levels and which dissuaded many from selling U.S. assets at clearly overpriced levels. The same will happen with real estate: people aren't going to consider seriously selling until after prices have already slumped and houses are trading well below their asking prices, instead of above their asking prices as is currently the case in the most popular areas.

Prices which have strayed far from fair value, and then regress to fair value, rarely stop there. Whatever had been absurdly overvalued usually ends up becoming ridiculously undervalued and vice versa. This makes it emotionally difficult to sell, because you will be tempted to reduce your holdings when they reach a level you know is too high, and then if you don't sell you will see prices climb more and more and eventually you won't be able to sell at any price because you have received so much positive psychological feedback for doing nothing. Similarly, if you are considering buying something which is blatantly undervalued, but you do nothing and it gets even cheaper, then you won't be able to buy no matter how low it goes because you will have told yourself a dozen or more times how brilliant you were by waiting longer. This is a major reason why even the most experienced investors can rarely bring themselves to buy low or to sell high, because they were rewarded for not acting earlier.

As usual, it makes sense to gradually buy a little of whatever is the most below fair value, while gradually selling whatever has surged far above fair value. In the short run you will almost always feel foolish as extreme trends tend to become even more extreme, but eventually everything will regress toward the mean and usually beyond the mean by an amount which is roughly proportional to the extent which it had been illogically pushed in the opposite direction. It is like a pendulum, which will move most violently away from a point which is the farthest away from equilibrium.

Disclosure: Whenever they have appeared to be especially depressed, I have been buying the shares of funds which invest either in emerging-market assets or in the shares of commodity producers, since I believe these are among the two most undervalued sectors in a world where real estate and U.S. equity indices remain dangerously overvalued. As the extremely popular U.S. dollar stuns investors by suffering a bear market instead of continued gains as almost everyone is expecting, this will lead to a major upward revision in global inflationary expectations. From my largest to my smallest position, I currently own GDXJ, KOL, SIL, XME, COPX, GDX, HDGE, EWZ, RSX, REMX, GLDX, URA, FCG, IDX, GXG, VGPMX, ECH, VNM, BGEIX, NGE, RSXJ, PLTM, EPU, TUR, SILJ, SOIL, EPHE, and THD. I expect the S&P 500 to eventually lose roughly two thirds of its May 20, 2015 peak valuation of 2134.72, with its next bear-market bottom perhaps occurring in late 2017 or early 2018. The Russell 2000 Index and its funds including IWM had handily outperformed the S&P 500 from March 2009 through March 2014, and have subsequently dramatically underperformed, recently trading at their lowest levels in 2-1/2-years. Small-cap U.S. equities typically lead the entire U.S. equity market lower as they have done in past decades 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. Confirmation of an impending end to the wildly popular deflation trade has been the notable decline for high-yielding shares since they had mostly achieved all-time peaks in January 2015, including utilities (XLU), REITs (IYR), and U.S. Treasuries (TLT).