Tuesday, February 23, 2016

"Our party has been accused of fooling the public by calling tax increases ‘revenue enhancement’. Not so. No one was fooled." --Dan Quayle

NUMEROUS NEW TRENDS HAVE QUIETLY BEGUN (February 23, 2016): One of the most underappreciated features of 2016 has been the number of trend reversals which are already underway but which have been ignored by most investors or dismissed as being temporary deviations which will soon return to their previous behavior. Because so few accept these new bull and bear markets as being significant, only the few who recognize their importance have been investing in the anticipation that these newer trends are likely to continue, with their usual backing and filling, until they eventually accelerate and force nearly all investors to acknowledge their existence. It is worthwhile to point out which of these trends have reversed direction after years of moving the other way, and what is likely to happen during the next year or so.

Some of these trends have already been underway for a year or more. Small-cap U.S. equity indices and their funds, including IWM which tracks the Russell 2000, had been outperforming the S&P 500 and similar large-cap indices for five years. From early March 2009 through early March 2014, IWM tended to gain about 3 dollars for each 2-dollar increase in the S&P 500, thereby enabling it to approximately quadruple while the S&P 500 was tripling. However, since the first week of March 2014, IWM and other small-cap baskets have been notably underperforming the S&P 500, with most of them slumping to 2-1/2-year bottoms during January 2016. Whenever they are temporarily oversold and there is too much gloom and doom in the media, these indices will rebound for several weeks or so, but their primary trend remains firmly downward and will likely surprise everyone with the total percentage losses which they suffer by the time they complete their next bottoming patterns perhaps in 2018. IWM topped out in June 2015, and it has become increasingly likely that the S&P 500 reached its highest point of 2134.72 on May 20, 2015.

Some assets began bear markets even earlier than the above well-known U.S. indices and funds. Most high-yielding shares including utilities (XLU), REITs (IYR), and U.S. Treasuries (TLT) were extremely popular in 2014 and completed important topping patterns in January 2015. Utilities and Treasuries have been outperforming the broader market in recent months, as they often do during a flight to defensive sectors, but all of the above sectors are likely to soon resume their downtrends even if general equities are able to enjoy a more sustained recovery during the next several weeks. These sectors tend to signal changes in inflationary expectations, so especially if they resume their downtrends and retreat to lower lows, it will signal that the widespread belief in deflation will eventually give way to the realization that inflation has been quietly rising worldwide.

While most investors continue to believe that the shares of commodity producers and emerging markets are continuing their bear markets which mostly began in April 2011, it is likely that most or all of these have reversed during the past several weeks. Some of the assets in these sectors have already rebounded dramatically, including gold and silver mining shares which have mostly gained more than 40% from their respective bottoms from the third week of January. It is common for gold and silver mining shares to lead energy and emerging-market assets both higher and lower, and it appears that although they remain very choppy in the short run, the shares of energy and emerging-market securities mostly bottomed in the second half of January or the first half of February 2016. Media coverage had been persistently negative toward the above assets, with most analysts and brokerages continuing to project aggressive downside targets as recently as a month ago. As the prices of commodity-related assets have been progressively rising, most of those in the media and financial industries have been very slow to adjust their previous forecasts and portfolios to reflect what could end up being a dramatic change of fortune. As is usually the case, the best-informed insiders and their wealthy friends have been among the first to make appropriate asset reallocations, while most investors won't do so until these trends have already become too powerful to ignore and more than half of the potential percentage profit from these opportunities will have already passed.

After moving mostly sideways for roughly nine months, the U.S. dollar index has been forming a notable pattern of lower highs since it had finally surpassed its March 2015 peak to register a key top on December 2, 2015 at its highest point since April 2003. This pattern of lower highs is likely to continue for roughly another year and perhaps a few months longer than that. Throughout 2015 there had been an increasing number of speculative bets on a higher U.S. dollar along with more intensely bullish market commentary and analysts raising their upside targets for the greenback. As a rule, increasing excitement and optimism combined with flat prices is a dangerous combination. It will take time before investors recognize that this long-term pattern since 2011 has also reversed; when they are finally forced to acknowledge that life in 2016 is not the same as it had been in recent years, the downtrend for the U.S. dollar could accelerate. Even if it continues in leisurely fashion, it will exert a meaningful influence on all other assets.

There hasn't been much discussion about real estate in recent months, although Tuesday morning's report on U.S. existing homes showed the 47th-consecutive month of year-over-year gains for U.S. housing prices. In most of the rest of the world, real estate has been climbing for a similarly extended period of time. As we have seen with many other trends described above, anything which lasts for four or five years tends to eventually be accepted as some kind of "permanent" situation whenever it is most likely to soon reverse. I expect that just as almost everyone is expecting housing prices to continue to climb indefinitely, we will experience massive losses in most parts of the world during the next four or five years. Instead of housing prices to household incomes demonstrating their normal historic ratios of 3:1 which have existed for centuries or millennia, and which had been lower than 1.5 to 1 in many regions in 2011, there are neighborhoods in cities including San Francisco, Vancouver, and Tel Aviv where ratios are greater than 10:1. Many other cities are more than double their normal levels, which creates a bubble which is just as dangerous as the one in 2005-2006 and which has been fueled mostly by borrowed money which tends to suddenly become scarce during an economic downturn.

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, EWZ, RSX, REMX, GLDX, URA, FCG, IDX, GXG, VGPMX, ECH, VNM, BGEIX, NGE, RSXJ, 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 in 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).