Friday, June 17, 2016

“The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.” --Seth Klarman

NEARLY ALL ASSETS ARE EITHER ABSURDLY OVERVALUED OR WORTHWHILE BARGAINS (June 17, 2016): It has been considerably less trendy to discuss the concept of fair value in recent years. Investors have been obsessed about the political situation and how that will impact the financial markets, or what is the latest trendy sector, or what will happen with Brexit, and many considerations which have nothing to do with whether something is overvalued or undervalued. If you analyze thousands of assets, both liquid and otherwise, you will soon discover that these fit into one of two categories. Either they are at or near their highest levels in history, both in absolute and relative terms, or else they had slumped to multi-decade bottoms during the first several weeks of 2016 and have since been moderately rebounding while remaining far below their tops from the past decade. Not surprisingly, most investors remain eager to buy the most overpriced assets, while remaining indifferent to accumulating true bargains.

Most people today are following the dangerous path of stretching for yield.

Many investors think to themselves or say to their financial advisors something like this: "I need income in order to meet my living expenses. I used to get 3% or 4% from my savings accounts, but now they pay less than one percent. So I want to invest in whichever are the safest and most reliable assets which will give me an income of three or four percent each year." If only a few people thought this way, then there wouldn't be a problem. However, since perhaps a billion people suffer from this exact situation and are approaching it in the same way, it has created an extremely dangerous form of herding in which assets like utilities (XLU), consumer staples (FXG, XLP), and real estate investment trusts or REITs (IYR, RWR) have become so popular that they are trading on average for about twice their usual historic ratios of prices to profits, prices to dividends, and other classic measures of valuation. Some investors have purchased commercial or residential real estate where rental yields are similarly 3% or 4%, believing they are getting a worthwhile rate of return on their capital because it is considerably more than they would receive in a money market fund. U.S. Treasuries (TLT, IEF, IEI) are also exaggeratedly overvalued as those who don't trust corporations believe the government will always pay on time. The chance of default is essentially zero, but you can still lose a huge percentage of your money from Treasury yields moving higher especially when such an outcome seems impossible to most participants. I will go way out on a limb and forecast that the yield on the 10-year U.S. Treasury bond will exceed 3% in 2017, which almost surely seems absurd to most people because we have become irrationally accustomed to a much lower yield range in recent years.

Regardless of how well-intentioned or intelligent its participants may be, any heavily overcrowded trade will always lose badly in the end.

Whenever any trade becomes incredibly crowded, there will inevitably be a subsequent severe shakeout. It's not different this time, and within a few years it is likely that those who are investing in the above assets will be severely disappointed. I expect all of the above, including listed securities and actual houses, to mostly end up losing half or more of their current valuations by the time their respective bear markets terminate in 2018 or 2019, and perhaps a year or two later for physical real estate. About a dozen people have contacted me to say they didn't personally buy these assets in order to be like everyone else, but for completely different reasons. The problem is that if you are swimming with great white sharks then it doesn't matter if you're only in the ocean to get your daily exercise; you have to deal with your fellow swimming companions. If you have been purchasing high-dividend shares for years for any reason, and all of a sudden everyone else is doing likewise, then you have to do something different until your method becomes unpopular again. The result will end up the same as it did for those who were crowding into internet shares in 1999-2000 and mortgage-backed securities in 2007. I could have also listed railroad shares in 1872 or canal companies' shares in 1836; the world may change through the centuries but the financial markets are always the same. If you own what everyone else also owns, regardless of your reasons or their reasons, you will all end up losing money together.

Commodity producers have been the biggest winners for five months, with emerging markets second.

If you were to ask most investors which assets have been the biggest percentage gainers of 2016, very few would know that commodity producers led by gold and silver mining shares have gained the most especially when compared with their intraday bottoms of January 20, 2016, while many emerging-market funds have also outperformed the broad U.S. equity market. The sole exception among the top several dozen is a lone fund of zero-coupon Treasuries. Out of all non-leveraged non-ETN funds which invest in stocks or bonds, according to, the biggest year-to-date winners of 2016 in order are SILJ, GLDX, SLVP, GDXJ, SIL, RING, SGDJ, SGDM, GDX, and PSAU, which all invest in gold and/or silver mining shares. Next are XME (metals mining), EPU (Peru), CNDA (Canada), RSXJ (Russia), SLX (steel), KOL (coal mining), NANR (natural resources), EWZ, EWZS, BRAQ, BRAZ, BRF (the last 5 all Brazil), DBS, SIVR, SLV (the last 3 all physical silver), COPX (copper mining), LIT (lithium mining), TPYP (energy pipelines), REMX (rare earth mining), and at long last ZROZ which is a fund of zero-coupon long-dated U.S. Treasuries.

While many are aware of the persistent strength of high-dividend assets in recent years, very few people are aware of how well commodity producers have been doing during the past five months. These had mostly suffered dramatic bear markets from April 2011 through January 20, 2016, and thus became extremely out of favor with nearly all investors including institutions, advisors, and analysts. Their powerful rebounds haven't encouraged very many people to jump aboard the bandwagon, at least so far. It is rare to see someone dressed in a fancy suit on cable TV extolling the virtues of energy producers or mining companies, and just as uncommon to see someone telling you why you should invest in South America, Africa, Australia, or just about anywhere outside of the best-known developed equity markets. Just five years ago, you couldn't avoid hearing analysts tell you why you should have your money in the BRICs, and which mining companies were superior to others, and which energy subsector was likely to be the biggest winner in the upcoming year.

Investors love owning whatever has been climbing for years, and shun whatever has been in an extended bear market.

The reason for the unpopularity is entirely emotional. Following the 2007-2009 bear market for U.S. equity indices in which the S&P 500 plummeted 57.7% and the Russell 2000 slumped 60.0%, no one in early 2009 wanted to hear about the latest index fund or which high-yielding securities were the best bargains. Since the bear markets for nearly all commodity-related and emerging-market assets had lasted for nearly five years, investors have emotionally concluded that they are hopeless and aren't interested regardless of the fundamentals. On the other hand, since high-dividend shares have been rallying for more than seven years while real estate in most parts of the world has surged since 2011, these assets psychologically appear to be superior and investors feel highly confident of additional increases. Paradoxically, when risk is lowest and upside potential is highest, most people are indifferent or are afraid to participate, while the situations of lowest additional upside and greatest risk of price collapse are usually greeted with sunny optimism and complacency about potential losses.

Almost nothing is trading close to its fair value.

At their intraday lows on January 20, 2016, many shares of commodity producers and emerging-market securities had traded at their lowest points since the previous century, in some cases going all the way back to the 1970s. They are almost all less glaringly underpriced today, but they remain at just one third to one half their average prices of recent decades. Thus, considerable additional upside remains in their rallies. Many people will finally discover these strong uptrends at the beginning of 2017 when they look at lists of the top-performing securities of 2016 and are surprised to see which names appear. While global equity and corporate bond markets are unlikely to collapse during the next twelve months or so, there will likely be significant declines for the most overcrowded sectors including especially the high-yielding ones mentioned near the beginning of this essay. Ironically, as investors at first gradually and later in a panic rush to get out of high-dividend assets, they will end up piling irrationally into commodity producers and emerging markets which have the potential of creating their own overvaluations perhaps in 2017. This could end up creating a situation roughly a year from now in which it will be necessary to sell commodity-related and emerging-market assets because far too many people will have jumped aboard these bandwagons. That would be especially true if investor excitement is accompanied by notable insider selling by top executives of these companies as there had previously been in years including 2008 and 2011. However, that is something to worry about next year. This year, gradually accumulate whichever undervalued assets are currently the least desired.

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. From my largest to my smallest position, I currently own GDXJ, SIL, KOL, GDX, XME, COPX, EWZ, HDGE, RSX, GLDX, REMX, VGPMX, URA, ELD, GXG, IDX, ECH, BGEIX, NGE (some new), FCG, VNM, SEA (some new), RSXJ, EPU, RGLD, SLW, SAND, GREK, NORW (new), PGAL, TUR, SILJ, SOIL, 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.