Wednesday, April 20, 2016

"Sometimes the bulls win; sometimes the bears win; but the hogs never win." --Anonymous

IT IS TIME TO BE BEARISH TOWARD MOST U.S. ASSETS (April 20, 2016): It is fascinating how nearly all investors, analysts, advisors, and the media had been negative toward risk assets in January and early February 2016 and talked about "reducing risk," and now the same people have been talking about "getting back into the market" and what you should buy now. People will repeatedly buy high and sell low, because it is emotionally so difficult to do the opposite of the thundering herd. Therefore, having sold all of my HDGE shortly before it peaked near 13, which had represented roughly 8% of my total net worth, I began repurchasing it again during the past week into all pullbacks and plan to continue to buy it as long as it remains below 11 dollars per share. I also entered my first-ever short positions in FXG and IYR and plan to sell short XLU soon.

The reasons for my being bearish are not primarily about price or timing, although it is true that many U.S. sectors have never been more overvalued in their entire history including years like 2007, 2000, 1972, and 1929. Among those sectors experiencing record overpricing are consumer staples (XLP, FXG), utilities (XLU), and real estate investment trusts or REITs (IYR). Consumer staples are extremely popular for two reasons: 1) they had enjoyed among the biggest percentage gains for all sectors outside of biotechnology during the past five years, in spite of mediocre profits for these companies; and 2) they have become the darlings of people who took their money out of bank accounts paying 1% or less in order to capture their modest dividends which have never been lower in percentage terms. Everyone loves a winner, so people have ignored the mediocre profit growth in consumer staples and concentrated instead on the stock price appreciation. Buying any sector with especially oversized gains and lackluster earnings is never a recipe for success, since this signifies a dangerous overvaluation. I have sold short FXG rather than the more popular XLP because it has a much higher expense ratio. IYR is also an excellent short position due to real estate having become even more overvalued in many parts of the world than it had been during the 2006 bubble. Utilities have also become the darlings of those chasing yield, making this sector more overvalued than at any time in its long history. There have been times when almost everyone was bearish toward utilities and I felt as though I was the only one in the world who was buying. Today, it is just about the exact opposite.

There are many reasons why U.S. assets, other than commodity producers which mostly remain compelling bargains, became so overvalued in recent years. Persistent underperformance and price/earnings ratio collapses for emerging-market equities, combined with a generally climbing U.S. dollar, made U.S. stocks seem like the safest game in town. Recently, the greenback has been in a downtrend since the U.S. dollar index had peaked on December 2, 2015 at 100.51, thereby exposing the irrational overvaluation of U.S. equities, corporate bonds, and other assets relative to those in most other parts of the world. While the S&P 500 Index has more than tripled from its March 6, 2009 nadir of 666.79, many emerging-market equity bourses on January 20, 2016 were trading even lower than at their most depressed points of late 2008 and early 2009, and even compared with previous bear-market bottoms in 2002, 1998, 1994, and 1990. Whenever you can buy a basket of assets which are trading near 20- and 30-year bottoms, it is almost always a good idea to do so regardless of the alleged reasons for such undervaluation. Similarly, whenever you can sell something like a house in San Francisco or a basket of biotechnology shares which are trading at incredibly overpriced levels, you should accept the market's gift and take advantage of others' temporary folly.

HDGE is the only exchange-traded fund which sells short directly instead of using various artificial preservatives for doing so. Therefore, it has a somewhat higher expense ratio. This should not be an obstacle to purchasing it, and if you hold it for more than a year you will achieve favorable U.S. federal long-term capital gains tax treatment. Selling short directly is a reasonable alternative, which is why I mentioned my favorite overvalued funds in earlier paragraphs. If you have money in general U.S. equity and corporate bond funds, then now is an excellent time to sell them to take advantage of valuations which are close to their all-time highs and are likely to drop by 60% or more.

Many people don't believe that U.S. equities can decline by 60%, even though we have already experienced two severe bear markets since 2000. From March 10, 2000 through October 10, 2002, the Nasdaq plummeted 78.4%. In the 2007-2009 bear market, the S&P 500 lost 57.7% while the Russell 2000 declined by a total of 60.0%. I expect somewhat greater losses this time primarily because we had become more overvalued, so we have to drop by a greater percentage to roughly match the March 2009 lows. The Nasdaq is an especially glaring case of overpricing. As you can verify by going to and entering ^IXIC, if the Nasdaq were to merely return to its October 31, 2007 top of 2861.51 then it would represent a plunge of 45.3% from its July 20, 2015 zenith of 5231.94. And this would be if it were to merely return to its previous bull market peak, not if it were to follow a much more likely route of approaching a previous major bottom. Biotechnology shares, which have been the biggest percentage winners of the past five years in spite of inconsistent earnings growth in this sector, have already been in downtrends along with many other equity sectors which had previous been leaders. When the former winners are pointing the way lower, that is an especially dangerous time to participate.

We have also experienced many of the classic signs of a market top. The ratios of insider selling to insider buying have approached their unusually high levels from the middle of 2015 and are usually only seen just before a major bear market. Investor inflows into most U.S. stock and bond funds surpassed all-time records for thousands of such funds during the past two months. The media, which for part of January and early February had featured more bearish than bullish articles about risk assets, have recently stopped even asking about whether you should be a buyer and have instead focused on what you should buy now for the biggest gains. VIX dropped below 13 for the first time since October 2015, indicating that investors have lost nearly all their fear of lower valuations.

I plan to remain long outperforming commodity producers and emerging-market assets. These will periodically suffer sharp short-term pullbacks, but have all begun powerful bull markets after having suffered extended, severe bear markets from April 2011 through January 20, 2016 when many of them registered multi-decade lows. Whenever other risk assets are attempting to rebound, mining and energy shares will continue to be among the biggest percentage gainers for approximately one more year until they become incredibly popular with investors, analysts, advisors, and the media. This is still a long way off: GDX, the most popularly traded fund in these sectors by average daily volume, has continued to experience outflows nearly every single day during the past several weeks in spite of being among the top-performing funds of 2016. As long as a bull market is greeted with intensified outflows instead of inflows, it will continue and will accelerate until disbelievers are finally converted into new buyers.

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, VGPMX, URA, GXG, FCG, IDX, ECH, BGEIX, NGE, VNM, RSXJ, EPU, TUR, SILJ, SOIL, EPHE, and THD. Yes, HDGE is back on the list; I just added very small short positions in FXG and IYR, and I am currently buying HDGE this week after having sold all of it just before it had peaked above 13. 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 2018. As with all bear markets, the biggest losses will likely occur in its final months, and won't even be acknowledged as a bear market until then--as is evidenced by the media falsely proclaiming in March 2016 that the bull market had celebrated its seventh birthday. 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, trading at their lowest levels during January 2016 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. Excellent short positions include FXG, IYR, and XLU.

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