Tuesday, June 28, 2016

“Generally, the greater the stigma or revulsion, the better the bargain.” --Seth Klarman

WHO'S AFRAID OF A BIG BAD BREXIT? (June 28, 2016): It is amazing that after centuries of history which investors can peruse at their leisure to see how the global financial markets have behaved in past decades and centuries, people keep repeating the same mistakes and experiencing identical emotional reactions. In the U.K., the day after the Brexit vote, the most commonly googled question was "What is the EU?" The overall impact will be zero, as these kinds of news headlines usually are; the only difference is the degree to which it has been broadcast around the world and how many people are convinced that something has actually changed. If you believe that a vote by confused citizens in the U.K. will impact corporate profits in Mexico or Poland, to cite two countries whose equity markets have been most negatively affected by the panic in recent days, then you can ignore the rest of this essay. Otherwise, you can take advantage of some amazing bargains in assets which had already been in bull markets since January 20, 2016, and which are likely to soon experience accelerations in their uptrends due to the reality--rather than the fantasy--of a falling U.S. dollar and a significant asset reallocation into emerging markets and commodity producers which in hindsight will have been one of the key themes of 2016-2017.

Brexit is one of a series of periodic panics which have no long-term impact and are totally forgotten afterward.

It is interesting that Brexit was reported early on Friday, since that is the time of the week when news events tend to exert their greatest psychological impact on the markets. People begin to panic immediately, and then after a sharp drop on Friday they have the whole weekend to fret about how much worse things are going to be. This will consistently lead to a follow-through plunge on Monday, sometimes just during the first hour of trading, and on other occasions persisting throughout the trading day. Sometimes this will carry through further into Tuesday, as it had done during the October 1987 stock-market collapse and again at the beginning of October 2011, each of which were preceded by substantial gains. On other occasions, the panic ends at some point on Monday and is soon followed by an energetic recovery.

The most compelling choices for purchase had been in bear markets since April 2011, are historically undervalued, and have been in bull markets since January 20, 2016.

I have recently been buying mostly funds of emerging markets and commodity producers which had been in severe extended bear markets since April 2011 which finally ended on or around January 20, 2016, and which had caused these securities to become dramatically undervalued and out of favor. Since then, many of them have made several or more higher lows which is characteristic of the early months of a bull market, while sentiment remains generally gloomy and had worsened considerably after Brexit. These include URA, a fund of uranium producers; COPX, a fund of copper mining companies; and the emerging-market funds GREK (Greece), EPOL (Poland), NORW (Norway), PGAL (Portugal), GXG (Colombia), and RSX (Russia). Most of the above, except perhaps for RSX, aren't even familiar to most investors and wouldn't be considered under most circumstances. Another fund which is rarely followed is SEA, a fund of sea shipping companies which has been almost entirely forgotten and is dramatically oversold. I purchased all of these on Monday (June 27, 2016) due to the likelihood that they are completing important higher lows in their bullish patterns of higher lows which had begun on January 20.

Many British financial institutions have been incredibly punished merely for being headquartered in the U.K.

As proof of the highly emotional nature of investors' response to Brexit, the companies which are best known and which are most closely associated with Great Britain have experienced the biggest losses. Everyone has heard of BCS (Barclays), Royal Bank of Scotland (RBS), and Lloyd's of London (LYG), so these have been unusually hard hit since the Brexit vote. There have been an astonishing number of brokerage, analyst, and advisor downgrades of these and similar companies, even though their corporate profits will likely be almost completely unaffected by the news. As usual, if the actual impact is one or two tenths of a percent, the market reaction is twenty or thirty percent (or more, in some cases), thereby providing an ideal buying opportunity in all of the above and in similar companies.

The Brexit overreaction has been even greater than for events which actually impact corporate profits.

Sometimes there is an event which will negatively impact a company's stock price and receives worldwide media coverage, such as the Exxon Valdez disaster or the British Petroleum catastrophe in the Gulf of Mexico. Other examples would include drug companies which don't receive approval for a particular drug, or which will have to pay money for widespread side effects. Even though Brexit is meaningless, it had roughly the same percentage effect on many companies as the above events which actually did affect corporate profits--although even in those cases the overreaction by investors was so severe that they presented worthwhile buying opportunities. A meaningless panic which is widely believed to be important is an even better buying opportunity than when there is something which will affect corporate profitability. In general, political events are treated with a much stronger emotional response than economic ones, and almost always have essentially zero impact on earnings growth. High-profile resignations, impeachments, elections, accusations of corruption, and similar news reports, especially when they are widely broadcast to the public, often provide the best opportunities to make money. In India, there was persistently negative political news in the summer of 2013 which created historic bargains, and then incredibly positive coverage of Modi's election in the spring of 2014 which caused most small-cap stocks in India to more than double in price within a year without anything actually changing for India's corporate profits.

Ignore the hype and accumulate the most oversold securities.

Most funds of emerging markets and commodity producers had been at or near multi-decade bottoms on January 20, 2016, and have since begun what will likely become major bull markets. It had appeared that the best buying opportunities had already passed and would not likely be seen again, but Brexit has provided an opportunity to purchase many of these at true bargain levels. There are exceptions such as gold and silver mining shares, which is only because some media types recommended buying gold bullion after having disparaged this idea for many months. GDXJ is a fund of junior gold and silver producers. From their respective intraday lows (1067 for gold bullion, 16.87 for GDXJ) on January 20, 2016 through the close on Thursday, June 23, 2016, GDXJ had gained over 7.5% for each 1.0% rise for gold bullion which can be measured by GLD or IAU. Since then, however, the post-Brexit behavior has shown roughly a 1:1 ratio, indicating that gold will soon slump below 1300 U.S. dollars per troy ounce and could retreat further in order to shake out recent buyers who acted totally out of emotion and have no commitment to this sector; they will be out of the market as soon as their sell stops are triggered near 1300 and perhaps in smaller numbers near 1275 or thereabouts. In general, whenever gold and silver mining shares far outperform gold bullion, a major uptrend is underway; the recent underperformance by the shares of the producers is thus a warning not to chase after this sector until the shares once again outperform bullion. This will likely happen as funds like GDXJ, SIL, GDX, GLDX, and SILJ repeatedly recover from early intraday selloffs during the next several trading days even as gold bullion continues to generally slump lower. Once the ratios of June 23 are restored, this sector will be ready to enjoy the next phase of its powerful uptrend.

I closed out my position in HDGE, but retained and added to my short positions in high-dividend shares.

I sold all my HDGE between 11.20 and 11.29 on Monday which I had purchased earlier in the month between 10.06 and 10.29. The intensity of the fear in the global financial markets made this action necessary, as I had similarly done when I sold all of my HDGE in early February 2016. There will be a better opportunity to repurchase HDGE at some point during the next several weeks or whenever VIX is near 13 again. I have continued to hold and to periodically add to my short positions in XLU (utilities), IYR (real estate investment trusts or REITs), and FXG (consumer staples), because these continue to be irrationally owned by millions who are desperate to achieve the 3%-4% yields they used to get from safe bank accounts and don't appreciate the extreme danger of participating in one of the world's most incredibly popular and therefore soon to be devastatingly money-losing trades. I am short FXG instead of XLP, a similar fund of consumer staples, because FXG has a much higher expense ratio.

When in doubt, do the opposite of whatever you hear most frequently.

In the early months of 2009, this was the most common refrain: "I sold all my stocks and I'm cutting back as much as I can with my spending, and I can't understand why the economy has become so bad." If you hear every day, several times a day, why the global economy won't recover for many years, you will do exactly the opposite of what you should be doing. If all you read about is how Brexit means that the sky is falling and the end of the world will soon arrive, then you're likely to sell in a panic rather than buying aggressively. Those who voted for Brexit mostly had no idea what they did, and if they had to vote again many of them would choose not to leave. Even if Britain does leave the EU, the only impact will be a complex series of negotiations which will last for years or decades and will have close to zero impact on corporate profits or the interrelationships between assets. It is puzzling why so few people are able to realize the obvious, but that just makes it better for those who understand reality because it has created compelling buying opportunities for many emerging-market securities, the shares of commodity producers, and numerous British-related securities--as well as anything else which has suddenly plummeted in price since Friday morning. June 27, 2016 was my single heaviest day of buying since October 4, 2011. Be sure to gradually accumulate the most worthwhile assets before everyone else gradually realizes that the world will continue and the sun will keep rising in the east even over the U.K.

Since the reaction by many assets is even greater than it had been during World War II, 9/11, and some "real" news instead of this meaningless vote, the following song by Dame Vera Lynn should inspire you to do some buying:

  • Dame Vera Lynn: White Cliffs of Dover

  • 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 wildly overvalued. As the greenback surprises most investors by suffering a bear market, with the U.S. dollar index moving below 80 instead of climbing back above 100 as almost everyone is expecting, this will lead to a major upward revision in global inflationary expectations. The latest Brexit panic has created a new set of compelling buying opportunities, so be sure to seize them before they disappear. From my largest to my smallest position, I currently own GDXJ, SIL, KOL, GDX, XME, COPX (some new), EWZ, RSX (some new), GLDX, REMX, VGPMX, URA (some new), ELD, GXG (some new), IDX, ECH, BGEIX, FCG, NGE (some new), SEA (some new), VNM, RSXJ, EPU, RGLD, SLW, SAND, GREK (some new), NORW (some new), PGAL (some new), EPOL (all new), TUR, SILJ, SOIL (some new), BCS (all new), EPHE, and THD. I have continued to increase my modest short positions in FXG, IYR, and XLU. 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 whenever we are transitioning from a major bull market to a severe bear market. This has happened 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 has been withdrawn from safe bank accounts by investors who begin with the premise that they want to generate income of 3%-4% and look for the most stable securities which can generate such yields. This popular and extraordinarily dangerous method of investing has created valuations at roughly double fair value for most consumer staples (FXG, XLP), real estate investment trusts (IYR), and utilities (XLU), all of which will likely slump by about half within three years or less.

    Question: What are the main implications you see Brexit having on the U.S. Economy?