Monday, December 4, 2017

“The hard part is discipline, patience, and judgment.” --Seth Klarman

TAXES DROP; STOCKS DROP MORE (December 3, 2017): The financial markets have behaved very differently during the past week than they have done during the entire bull market which began in early March 2009, and the anticipated "success" of the Republican tax plan is largely responsible for it. From now on, any negative economic event or trend will be blamed on the new U.S. tax rates. If we have inflation, recession, rising unemployment, or even a lengthy losing streak by the New York Yankees, it will have been "caused" by Trump and the Republicans. In case you think this is an exaggeration, Barack Obama was able to win the U.S. Presidency in November 2008 partly from blaming the recession on the 2001 tax cut which had occurred 7-1/2 years earlier. The Republicans have taken charge and responsibility for everything that happens with the U.S. stock market going forward, and at the worst possible time. The legislation also provides a convenient excuse which millions of investors will use as justification for selling. Whenever investors have a reason to act, they will be far more likely to do so.

The past week was accompanied by several key reversals.

FAANG and similar stocks, which had been among the top performers in 2016-2017, suddenly began to struggle during the past week. Semiconductor shares behaved likewise. The most undervalued stocks were among the biggest winners. The Russell 2000, which had been persistently lagging the S&P 500, briefly soared to a new all-time top before once again sliding lower and pointing the way down for everything else. Just when investors have become convinced that the U.S. stock market can only go up as long as Donald J. Trump remains the U.S. President, we have probably begun some of the largest percentage declines for most U.S. equity indices since the 1929-1932 collapse which was the worst in U.S. history. By many measures, the U.S. stock market has never been more overvalued even including 1929 and 2000, and we are likely to reverse toward a roughly equal and opposite extreme of undervaluation in roughly two years.

Any non-bipartisan tax plan must fail, because so many people want it to do so.

The next recession will give Democrats enormous voter support in upcoming elections as the Republican tax bill will be given almost all of the credit for the economic slowdown. We would have suffered a stock-market slump and a recession even with the old tax code, but people love to imagine nonexistent cause-and-effect relationships in the financial markets because as humans we prefer easily repeatable stories to reality. The Republican tax plan is the perfect excuse for inventing a new set of myths about why the U.S. stock market is behaving differently and why it will experience an accelerating downtrend. A "surprise" decline for U.S. equity indices in 2018, especially as it will immediately follow the tax cut chronologically, will almost surely cause Democrats to regain control of the House of Representatives following the November 6, 2018 elections. The Senate is less certain since only 8 Republicans are up for re-election versus 25 Democrats, but there is probably more than a 50-50 chance that Democrats will prevail there also. As long as Trump remains President, this won't result in significant legislative changes in 2019 or 2020, but on November 6, 2020 we could have the Democrats sweeping the Senate, the House of Representatives, and the Presidency. Even though that is far from certain and almost anything can happen in three years, a tax cut almost always leads to increased selling as experienced long-term investors decide to capitalize upon lower rates to unload assets which they have held for years or decades. Knowing what might happen in November 2020, and especially the likelihood of much higher U.S. taxes becoming law in 2021, this leaves only a three-year window to get out at favorable rates. Thus, the Republican tax cut will encourage investors to sell first to get out ahead of everyone else. The market probably won't even be able to sustain itself until the lower rates become effective on January 1, 2018, since experienced investors know that many others will try to get out in early 2018. This could lead to meaningful losses in the final weeks of 2017, which is perhaps partly responsible for why we began to see new intraday behavior during the past week which had been almost completely absent for the entire calendar year. In general, the most bearish intraday behavior consists of strength near the opening bell and progressive choppy weakness thereafter.

Previous tax cuts have almost always led to lower prices for U.S. equity indices.

The 1981 and 2001 tax cuts were followed by lower prices as the most experienced investors sold first, gradually working its way down to the least-knowledgeable participants bailing out just before the subsequent rebound began. It will likely be the same this time, with top corporate insiders being the first to sell and average investors roughly two years from now probably making their largest outflows in history and thus surpassing the previous all-time records--which not surprisingly were mostly set during the first quarter of 2009. Amateurs will repeatedly buy high and sell low. The 1986 tax cuts were followed by only a moderate correction and eventual (although temporary) new highs the following year, but in that case the tax cuts were expected to persist for the long run since they were bipartisan. Democrats can't wait to enact completely new and higher taxes as soon as they have sufficient numbers to be able to do so. With just three years to get out, it will be a race where the losers will be anyone who plans to hold U.S. assets for the long term. This includes not only stocks but corporate bonds, real estate, and most other U.S.-based assets.

Surging deficits will translate into significant changes for asset valuations.

Rising inflation hasn't been a serious concern for U.S. investors since the 1980s. That is going to change and probably quickly, as the tax cut adds over one trillion additional dollars to the total U.S. debt obligation. If U.S. stocks quickly retreat then U.S. Treasuries might benefit as a safe-haven alternative in the short run, but over the next year it is likely that the U.S. Treasury yield curve will continue to flatten and that most U.S. Treasuries could climb to their highest yields in several years. This will end up slowing the U.S. economy even more than a tax hike would have done, and it will have a more lasting effect. Companies like commodity producers along with emerging-market stocks which benefit from rising inflationary expectations will likely be among the biggest winners. Many gold mining and silver mining companies, along with energy shares, rebounded energetically during the first several months of 2016 from multi-decade bottoms. Afterward, they stalled as investors' favorites dominated the list of winners from the summer of 2016 until recently. The leadership is likely to shift back into commodity producers and other inflation-loving assets during the upcoming year, partly from the tax cuts and partly from the fact that these are typically outperforming securities whenever we are transitioning from a bull market--especially a hugely overextended one--to what will likely become an especially severe bear market.

The dividend yield on the S&P 500 dropped to 1.89% during the past week.

Many historic valuations have never been more extreme in their entire history including a dividend yield of merely 1.89% for the S&P 500 during the past week. Whether you look at the margin-adjusted Case-Shiller price-earnings ratio, or the differential between bulls and bears in various investment surveys, or the all-time record low ratios of bank accounts and other safe time deposits to fluctuating assets, or whatever is your favorite indicator, you will see extremes that have never been previously experienced even if you go back to 1790 when the Philadelphia Stock Exchange was founded (the New York Stock Exchange took two more years before they officially began in 1792).

I haven't even discussed the unfairness of the Republican tax plan.

Cutting corporate tax rates too drastically, disproportionately favoring certain people, and treating different kinds of income with a complex series of diverging tax rates are just a few of the serious problems with the latest legislation. If it had been bipartisan then there would be some incentive to improve it, but the Republicans will be happy to live with it regardless of its serious defects while the Democrats will be thoroughly delighted to leave it alone so it can fail and be blamed for just about everything which goes wrong. It is a formula for disaster and that is exactly what we will get.

It's going to be a long bumpy road to the bottom.

Disclosure of current holdings:

There are numerous ridiculously overvalued assets today and a few undervalued sectors. The multi-decade commodity-related and emerging-market undervaluations of late 2015 and early 2016 are gone, but I have been continuing to gradually purchase energy shares along with funds of gold mining and silver mining companies whenever they are most gloomily reported in the media, are forming higher lows, and when investor outflows have been maximally intense. In a world where U.S. equity indices, junk bonds, and real estate have finally begun major bear markets amidst massive all-time record inflows mostly from investors taking money out of their bank accounts, the post-election love affair with wildly overpriced favorites is in the early stages of transitioning to a new set of investors' darlings which will persist for most of 2018 followed by a synchronized collapse in 2019. The election of Donald J. Trump as U.S. President led to a "yuge" surge in investors' expectations which following a one-year surge to all-time record highs is being transformed into the most severe U.S. equity bear market since 1929-1932. The absurd popularity of cryptocurrencies, with no intrinsic value, is highly characteristic of a generational peak in anything from tulips to worthless canal/railroad/internet shares. I have recently purchased GDXJ which remains a compelling bargain below 32 and which historically performs well following Fed rate hikes, and had been buying URA prior to its recent uptrend primarily because it had been underperforming other energy producers. Energy shares had been among the biggest winners since late August after spending the first eight months of 2017 as the worst-performing major sector. I also bought a little HDGE as it dropped below 8 for the first time. My largest recent short addition has been IWM which tracks the Russell 2000 and which briefly soared to a new all-time high. I had been selling short NFLX, NVDA, and AMZN until all three of these huge favorites began forming lower highs during the past several trading days. I also added new short positions in XLI. From my largest to my smallest position, I currently am long GDXJ (some new), TIAA-CREF Traditional Annuity Fund, KOL, SIL, XME, HDGE (some new), GDX, EWZ, URA (some relatively new), REMX, NGE, RSX, GXG, I-Bonds, ELD, FCG, GOEX, bank CDs, VGPMX, money market funds, BGEIX, OIH, SEA, NORW, VNM, TLT, PGAL, EPU, RGLD, WPM, SAND, SILJ, and FTAG. I have short positions in IWM (many new), AMZN (some new), NFLX (some relatively new), NVDA (some relatively new), IYR, XLU (some relatively new), XLI (some new), FXG, and SPHD, in that order, largest to smallest.

As a general principle, I strongly believe in buying into the most panicked all-time record outflows while selling into the most intense inflows. Not counting short sales, during the past year I have done my heaviest selling since the first half of 2008 to close out profitable long positions which suddenly became trendy including COPX, BCS, RBS, EWW, TUR, LIT, EPOL, and BRF. I plan to sell even more aggressively in 2018 whenever the public makes all-time record inflows into my holdings while insiders have greatly increased their selling relative to buying. This is partly because I own many securities which tend to perform most strongly when we are transitioning to a major U.S. equity bear market, and partly because I expect 2019 to eventually transition to a full-fledged collapse for nearly all global assets. With my short positions, whenever VIX surges upward I will do a combination of partially covering and partially selling covered puts, depending upon how high their implied volatilities climb during any correction.

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

I expect the S&P 500 to eventually lose more than 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 nadir occurring roughly two years following its zenith. During the 2007-2009 bear market, most investors in August 2008 didn't realize that we were in a crushing collapse. We already have numerous classic negative divergences including junk bonds sliding to multi-month lows, the Russell 2000 struggling to keep up with new all-time highs for better-known large-cap U.S. equity indices (Dow, S&P, Nasdaq), semiconductors suddenly reversing their extended uptrends, previous investors' favorites underperforming, fewer 52-week highs and more 52-week lows, the strongest intraday behavior near the opening bell when amateurs are the most eager buyers, and closed-end fund discounts climbing from rare lows. Expecting several more years of gains for the U.S. stock market is like anticipating that a 100-year-old marathon runner will continue to complete marathons for a few more decades. Far too many investors--even the most left-wing Democrats--believe that U.S. assets will keep climbing as long as Donald J. Trump remains the U.S. President. 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 quite that deeply, a two-thirds loss would put the S&P 500 below 900 which I believe is nearly certain but which almost no one currently believes is remotely possible. Far too many conservative investors took their money out of safe time deposits since they didn't want guaranteed yields of one percent; they have no idea what to do during a bear market and will inevitably end up making all-time record outflows as we are approaching the next historic U.S. stock-market bottoming patterns.