Monday, April 4, 2016

"No price is too low for a bear or too high for a bull." --Anonymous

MOST INVESTORS MISUNDERSTAND BEAR MARKETS (April 4, 2016): If there is one defining characteristic of bear markets for U.S. equities, it is the failure of nearly all participants to recognize when they exist, to acknowledge that they require asset reallocation, and to make appropriate changes to their portfolios. If we look back at all of the past bear markets in U.S. history, then even when they had been underway for a year or more, the vast majority of investors continued to act as though nothing had changed. They continued to buy and sell as though we were still in the previous bull market. Finally, when the bear market was in its final stages, it was usually accompanied by a collapse which at long last awakened people with the realization that we weren't in a bull market anymore. By then, however, it had become far too late to sell at anything close to favorable prices. Once a collapse becomes particularly extended or severe, or both, investors will end up doing the exact opposite of intelligent reallocation by emotionally selling during a bottoming process instead of increasing their risk to accumulate compelling bargains.

The bear market of 2007-2009 serves as a useful illustration of some of the above points. That bear market began, as so many do, with initial weakness for high-yielding securities including utilities and REITs. Soon afterward, high-yielding junk bonds completed their peaks and began underperforming. After June 1, 2007, small-cap U.S. equity indices notably underperformed their large-cap counterparts. By August 2008, nearly all U.S. equities and corporate bonds had been in downtrends marked by numerous lower highs, but most investors continued to behave as though we were still in a bull market. Whenever U.S. equity indices and their funds like QQQ would rebound from any intermediate-term low along the way, there would be significant inflows into equity funds because investors had learned during 2002-2007 to buy into rallies which followed all corrections. Of course they had finally learned the wrong lessons, and acted as they should have done five years earlier when legitimate bargains were easy to find but almost no one wanted to participate. Then we had September-November 2008, which finally achieved clarity when it was far too late to be able to sell at worthwhile high prices. Especially when the S&P 500 was down by more than half, investors ended up making their greatest outflows in history from most sectors, with these withdrawals even exceeding those which had occurred during the Great Depression. During the first quarter of 2009, when investors should have been buying left, right, and center, people mostly sold instead of making purchases at the lowest inflation-adjusted valuations since the early 1980s.

In case you think that investors learned from their experience of 2007-2009, their behavior demonstrates that they are making the same mistakes again. From early March 2009 through early March 2014, small-cap U.S. equities outperformed large-cap counterparts by a ratio of roughly 3 to 2. During this five-year period, investors continued to mostly make net outflows instead of buying, partly because they were frightened by above-average volatility. From early March 2014 through May-June 2015, most U.S. equity indices continued to make higher highs, but the Russell 2000 (IWM) gained progressively less than the S&P 500 (SPY) in percentage terms. There have been all-time record inflows into most equity funds in recent years, with huge net deposits occurring during the past several weeks. Since the second quarter of 2015, nearly all U.S. equity indices have been in little-recognized and unappreciated bear markets. The financial media a month ago loudly trumpeted the alleged "seventh anniversary" of the bull market even though the uptrends for U.S. equity indices had nearly all ended the previous year.

On December 15, 2006, VIX completed a historic bottom at 9.39 and thereafter formed several higher lows even as U.S. equity indices including the S&P 500 continued to climb for most of the following year. This was a valuable warning signal that we were getting set to transition from a major bull market to a severe bear market. When the bear market was in its final months, VIX topped out at 89.53 on October 24, 2008, and continued to make several lower highs even as the S&P 500 itself continued to grind to lower 12-1/2 year lows through its 666.79 nadir on March 6, 2009. This process has repeated in the current cycle, with VIX bottoming at a 7-1/2-year low of 10.28 on July 3, 2014. As in 2006-2009, VIX foreshadowed the end of the bull market by a little less than a year. On Friday, April 1, 2016, VIX slid to 13.00 as it is completing yet another higher low. Eventually, VIX will achieve some kind of elevated zenith and will begin to form a pattern of lower highs, thereby signaling that the current bear market--which by then will likely have intensified sharply--will be several months away from beginning its next strong bull market.

However, instead of recognizing these cyclical patterns and acting upon them, most investors end up repeatedly and foolishly projecting the recent past into the indefinite future. This is partly because our brains are hardwired to do this as it served as a useful way for groups of humans to survive in prehistoric times. Thus, many investors today are eagerly crowding into utilities (XLU), real estate investment trusts or REITs (IYR), and consumer staples (XLP), even though all of these have never been more overvalued in history. Therefore, we are going to suffer especially large percentage declines for these sectors relative to the overall U.S. stock market which itself is perched precariously roughly 50% above fair value. In many global cities, real estate is at double or triple fair value. Paradoxically, most people will want to sell their stocks and corporate bonds two years from now when they should be aggressively buying, and will want to do no selling of real estate or stocks today when they could obtain highly favorable prices for both.

The following link highlights how investors were making significant outflows near the beginning of the year when stocks and corporate bonds were much lower than they are now, and have recently been eagerly pouring back into U.S. assets at overvalued prices:

  • Investors Pull $24 Billion from Equity Funds in January

  • Now is an excellent time to be a true contrarian. When everyone you know is eagerly "getting back into the market," progressively sell your U.S. stocks, bonds, and real estate. Put some money into cash or a government-guaranteed bank account, and slowly accumulate shares of the most undervalued assets in emerging markets along with the shares of commodity producers, especially as these are forming additional higher lows following their respective multi-decade bottoms which were mostly completed on or around January 20, 2016. Perhaps in a year or so it will make sense to gradually unload these holdings so you are almost entirely in cash, with the important exception of buying TLT and other long-dated U.S. Treasury securities if they should slump to multi-year lows. Almost no one expects TLT to drop to 120, much less a far lower target like 100, so if there is panic and gloom in the U.S. Treasury market then prepare to be a big buyer in another year when everyone else is telling you why you should be selling.

    Do not rely too heavily on the assumption which others will be making, which is that if we are in a true bear market then it will likely be a repeat of 2007-2009. That bear market lasted for only 17 months, so instinctively people will assume that the recent past will repeat itself. Most bear markets are longer, and it will take time to flush out millions of those investors who would usually have their money in bank accounts but who have foolishly concluded that it is almost as safe to have their money in various stock and bond sectors. Assuming that most U.S. equity indices had topped out in May or June 2015, the ultimate bear-market bottoms might occur during 2018. Each time we slide to a lower low and rebound sharply, many will proclaim that we had reached "the bottom" and will be eagerly buying. Within a few months or less, we will slump to another lower low. Eventually, almost everyone will be exhausted from making additional purchases and soon finding themselves deeper in the red, and will refuse to buy when a strong recovery is underway. This, combined with extreme gloom and doom in the media and by nearly all analysts and advisors recommending that their clients "take steps to reduce risk" will signal that the next powerful bull market is truly underway. If such a bull market begins around 2018 then it could persist until 2021-2023.

    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 may end up buying HDGE which I had sold in its entirety during the third week of January 2016. 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. The most overvalued sectors rely on the overhyped deflation trade and money which was withdrawn from safe bank accounts by conservative investors deluded into believing that these were nearly as safe as government-guaranteed time deposits.

    Special note: if you enjoy theater and you would like to attend an evening of my original "true contrarian" playwriting, you are invited to join us at the end of the month:

  • Original Parodies of Corporate Life