Thursday, May 11, 2017

“I've never walked the same path other people found comfortable and I'm not going to start now.” --Lora Leigh

THE PIT AND THE PENDULUM (May 11, 2017): It is relatively rare to have one group of assets being incredibly overvalued and another group being simultaneously underpriced, but that is the situation which has existed in May 2017. U.S. stocks, corporate bonds, and real estate have all never been higher in their entire histories even if you adjust for inflation--with the exception of the Nasdaq which in real terms had been higher on March 10, 2000 but has already surpassed twice its previous top on October 31, 2007. Real estate in many U.S. cities is at double or triple fair value based upon historic ratios of housing prices relative to household incomes. At the same time, we have experienced incredibly low prices for many shares of companies involved with commodity production. Most mining companies slid to their lowest points in early May since December or November 2016, while many energy shares recently traded close to one-year bottoms. Nearly all commodity-related securities had completed severe extended bear markets which had lasted in most cases from April 2011 through January 20, 2016, but their bull markets have been almost completely forgotten due to their extended corrections since the second week of February 2017.

Some funds of commodity producers have suffered all-time record outflows and have enjoyed significant insider buying of their components.

For the one-month period ending Wednesday, May 10, 2017, the total net outflow from GDX was 1.72 billion--a new all-time record. The net outflow from GDXJ was also an all-time monthly record of 790.21 million--and since the total market capitalization of GDXJ at the close on May 10 was only 3.8 billion, this represented more than 20% of the entire fund which was withdrawn by a combination of panicked investors, momentum players switching to the short side, and some long-term holders disappointed that last year's strong initial rebound from January 20 through August 11, 2016 didn't last longer and emotionally seemed to have run into a wall. Other funds of commodity producers have also been weak since the second or third week of February 2017, with some of them trading at their lowest levels in more than a year. FCG, a fund of natural-gas producers, had the heaviest insider buying of all exchange-traded funds' components in 2017, and recently traded at less than one-fifth its June 23, 2014 dividend-adjusted peak of 113.84 (see or any other reliable charting site).

The funds with the biggest outflows are generally the biggest percentage winners of all funds since January 20, 2016.

The irony is that investors aren't unloading lagging shares--they are selling those funds which had generally been the biggest winners from their historic bottoms of early 2016. If you look at a list of the top fifty funds from January 20, 2016, they consist almost entirely of securities which are primarily or entirely involved directly or indirectly with commodity production. They have gained far more than even the most aggressive technology sectors. However, most investors have remained obsessed with their favorites of recent years and after a brief fling with alternatives during the first several months of 2016--probably encouraged by weakness for U.S. equity indices around that time--they have mostly gone back into their old favorites again. This has caused already oversold and undervalued commodity-related securities to become even more compelling bargains, while many well-known U.S. equity indices have been setting frequent new all-time highs in recent months.

Negative divergences for all U.S. assets are being widely ignored.

If you didn't hear about the Dow surpassing 20 and then 21 thousand, while the Nasdaq topped six thousand and then 6100, it's likely that you almost never check the internet or cable TV. These round-number benchmarks were so widely reported that it was the first time since the last bull-market top that these were often quoted in non-financial news headlines briefs. The Nasdaq surpassing six thousand was announced during a break in the Yankees' radio broadcast on WFAN. However, you hardly heard anyone mentioning that thousands of smaller U.S. companies were struggling to surpass their respective December 2016 highs. Almost no one discussed how many previous severe bear markets began similarly with ignored underperformance by smaller companies. The number of new 52-week highs has also been diminishing.

Fewer and fewer shares are propelling well-known benchmark U.S. equity indices higher in 2017.

The S&P 500 consists of 500 stocks (a related puzzle: who's buried in Grant's tomb?) but what is amazing is that only ten stocks out of that five hundred are responsible for 46% of the entire 2017 increase in this index:

  • Just These Ten Companies Account for 46% of the S&P 500's 2017 Gains

  • VIX slid all the way down to 9.56 on May 9, 2017 for the first time since 2006.

    The last time VIX was at 9.56 or lower was when it had completed a multi-year bottom of 9.39 on December 15, 2006. A VIX reading below 10 signals that most investors who have been hedging their portfolios through insurance every single year since 2009 have decided that it is a waste of money and unnecessary. Naturally, when the fewest investors have their portfolios insured, they are maximally likely to decline so the fewest participants make money (as always). One can perhaps understand how investors today would repeat the mistakes of 1929-1932 or 1973-1974 since those earlier episodes had occurred decades ago and getting detailed information about them is challenging. However, everyone today either remembers or can easily access voluminous information about 2000-2002 and 2007-2009. I guess they figure that we'll somehow miraculously avoid a third 21st-century collapse, but unfortunately it's already baked in the cards no matter what Trump, the Fed, Putin, or anyone else does. The Fed kept rates so low for so long that companies routinely borrowed very cheap money for a very long time and used it to purchase their own shares at inflated prices. Even the most frequently repeated games have to end sometime.

    I have done more selling than buying in 2017.

    Especially if you count selling short as selling, I have done more selling than buying in 2017 which is a dramatic departure from 2016 when we had three key buying opportunities--during the first several weeks of the year for essentially all commodity producers and emerging-market securities, on June 27, 2016 for those assets which plunged the most in response to the Brexit vote, and near the end of the year when disappointed long-term holders did tax-loss selling and otherwise impatiently closed out positions just before strong early 2017 rallies. In most cases with some key exceptions like COPX, I didn't sell out of expectation of an impending collapse but due to previous worthwhile bargains becoming much less worthwhile. My guess is that the upcoming year will require even more selling than buying, especially as we approach the spring of 2018 when seasonally commodity producers often complete important topping patterns. As always, I will never sell because a particular price or time target is achieved, but only when there is aggressive selling by top corporate insiders in the sectors I own, massive fund inflows, especially optimistic sentiment, and persistently positive media coverage.

    The loonie remains the most compelling currency for purchase.

    One can make an argument for the Australian dollar and even for several others, but the Canadian dollar has become one of the world's most detested assets. It's like Rodney Dangerfield--the loonie "can't get no respect." In the early morning of May 5, 2017, the loonie slid to 72.52 U.S. cents. This was shortly after crude oil had bottomed at its lowest point (43.76 U.S. dollars per barrel) since April 18, 2016 and the day after GDXJ had completed a key higher low at 29.33 while July platinum had similarly bottomed at 894.50 U.S. dollars per troy ounce for the first time since February 2016. When it rains, it pours. Nonetheless, the Canadian dollar has a history of enjoying especially strong uptrends as we are transitioning from a bull market to a bear market for U.S. equity indices. Partly this is since Canada has an unusually high ratio of commodities to people, and commodities--especially in the energy sector--often tend to be among the last assets to complete their bull markets prior to a global recession.

    Disclosure of current holdings:

    Whenever they have appeared to be especially irrationally depressed, I have been purchasing the shares of funds which invest either in the shares of commodity producers or emerging-market stocks and bonds, since I believe these remain the two most undervalued sectors in that order. In a world where real estate and U.S. high-dividend securities have finally begun major bear markets from ridiculous overvaluations and all-time record inflows, these irrational favorites of recent years and the brief post-election love affair with overpriced industrial shares will transition to a completely new set of investors' darlings. As the greenback surprises most investors by accelerating its bear market, with the U.S. dollar index moving below 80 within roughly one year instead of continuing to rally to new 15-year peaks as almost everyone is expecting, this will lead to a major upward revision in global inflationary expectations. The election of Donald J. Trump as U.S. President means "yuge" U.S. government spending and modestly lower taxes which is a combination for a massive rise in the deficit. The latest illogical pullback for most gold mining and silver mining shares, along with natural gas producers, has encouraged me to add to these sectors, while some emerging markets have become no longer undervalued and were ripe for selling. As in late winter, it is once again timely to sell short those funds with the heaviest insider selling and the most intense all-time record investor inflows. So far in 2017, we have experienced new all-time records for total insider selling of U.S. equities. Thus, I have recently purchased GDXJ, FCG, URA, HDGE, GDX, and NGE while selling EWW, EWI, TUR, GREK, IDX, SOIL, RSXJ, and EPHE, and selling short XLI. From my largest to my smallest position, I currently am long GDXJ (many new), SIL, KOL, XME (some new), GDX (some new), EWZ, RSX, URA (some new), HDGE (some new), ELD, FCG (many new), GOEX, REMX, VGPMX, GXG, NGE (some new), BGEIX, SEA, VNM, NORW, PGAL, RGLD, SLW, SAND, SILJ, and FTAG. I have short positions in IYR, XLU, XLI (some new), FXG, and SPHD, in that order, largest to smallest. U.K. banks in particular were huge winners, with BCS (Barclays) enjoying an enormous increase since June 27, 2016 from 6.89 to 11.61 when I sold it in early February, plus some dividends as shares along the way. In just three months during 2017, EWW and TUR went from being widely detested in January to being eagerly purchased. This highlights the advantage of buying most aggressively into the most severe panic selloffs while selling into the most intense excitement.

    Those who respect the past won't be afraid to repeat it.

    I expect the S&P 500 to eventually lose two thirds of its value from its all-time top, whether that level has or hasn't already been reached, with its next bear-market bottom perhaps occurring near the end of 2018 or during the first several months of 2019. 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 it is nearly over--just as most investors in August 2008 didn't realize that we were well into the crushing 2007-2009 bear market. The current (or recently ended) U.S. equity index bull market is already the longest on record; expecting several more years of gains is like anticipating that a 100-year-old marathon runner will continue to run marathons for a few more decades. While the media have been quick to trumpet new all-time highs for many U.S. equity indices in recent months, almost no one has noticed that fewer and fewer individual shares have set new 52-week highs especially as compared with previous peaks including June 2015, and with generally reduced overall participation. While many investors expect the surge following the election of Donald J. Trump as U.S. President to usher in four or eight more years of a bull market, nearly all of those gains have likely already occurred. Following the election of Narendra Modi in India on May 16, 2014, many analysts expected a bull market to continue for a full decade. The fund SCIF of a hundred small-cap Indian equities actually peaked on June 9, 2014 which was 24 days later; it has made a series of lower highs since then. IWM, a fund of the two thousand companies in the Russell 2000, had been outperforming the S&P 500 by roughly 3:2 from the nadir in early March 2009 through early March 2014, with IWC--a fund of even smaller U.S. companies--also significantly outperforming the S&P 500 in percentage terms. Since then, both IWM and IWC have struggled, with IWM barely surpassing its December 9, 2016 intraday high of 138.82 twice and falling back both times, while IWC barely surpassed its December 20, 2016 peak of 87.82 and soon resumed its downtrend. Small-cap shares similarly underperformed at numerous past stock-market zeniths prior to severe bear markets including September 1929, January 1973, and October 2007. There is also a little-known megaphone formation in which the S&P 500 has been making higher highs and lower lows since 1996, so it shouldn't be a shock to investors if the current or upcoming bear market for U.S. equity indices results in the S&P 500 approaching or sliding below its March 6, 2009 nadir of 666.79. Even if it doesn't plummet that deeply, I expect a two-thirds loss from 2400 to 800 for the S&P 500. Far too many conservative investors took their money out of safe time deposits since they didn't want yields of 1% or less; they have no idea what to do during a bear market.