Sunday, February 4, 2018

“When the tide goes out you can see who isn't wearing a bathing suit.” --Warren Buffett

WILE E. COYOTE LOOKS DOWN--OOPS! (February 4, 2018): In the famous Road Runner cartoons, Wile E. Coyote is frequently tricked into going off the edge of a huge cliff. However, nothing bad happens immediately--until he looks down. Once he realizes that there is nothing below him but air, he collapses in a heap toward the ground far below, always landing with a satisfying thud. This is exactly what occurred in January 2018 as investors smashed all previous benchmarks to make all-time record withdrawals from safe time deposits in order to purchase fluctuating assets. Many historic benchmarks approached or set new all-time extremes including sentiment surveys and valuation measures. This was equivalent to Wile E. Coyote surging off the mountain's end, but just as in the cartoon nothing terrible occurred immediately. Then the coyote couldn't help but look down, and during the past week the collapse began. Unlike the cartoon it will take roughly two years before we hear the sound of the U.S. stock market finally hitting the earth far below. Whenever that occurs, we will almost certainly experience all-time record outflows which crush the previous records from the first quarter of 2009, along with incredibly bearish sentiment, massive insider buying, and the media telling everyone why it will take years for the U.S. stock market to recover. Naturally this will be followed by one of the strongest multi-month rallies in history.

Almost no one is talking about the possibility of a multi-week correction, thereby making it far more likely to occur.

Have you heard a lot about how the past week's pullback was a "healthy" event, as though it were as necessary as eating tofu or bean sprouts? Whenever a bear market begins in earnest, most observers are convinced that it's actually a good thing. In retrospect I doubt that many people believe that the 1929-1932, 1973-1974, 2000-2002, or 2007-2009 plunges were healthy or nutritious. In a parallel to Newton's Third Law, one extreme is usually followed by a nearly equal and opposite extreme. Many measures of U.S. equity valuations have never been higher in history or had closely revisited multi-decade overpricings, so now we are going to progressively move toward the reverse situation in which we are likely to suffer the lowest price-earnings, price-to-book, and other measures since the Great Depression. The dividend yield on the S&P 500 had slid so steeply that it had moved significantly below the yield on the 2-year U.S. Treasury note.

Bears have been almost completely ignored even though they have impressive ammunition in their corner.

The bull market for U.S. equities, partly since it had existed for nearly nine years, made more and more participants convinced that all negative information could be ignored. Now that investors are able to purchase U.S. Treasuries and other safe time deposits at their highest yields in a decade, investors will have a valid reason to get out of the stock market in order to pounce on these yields. Because new all-time highs for the Dow Jones Industrial Average, the Nasdaq, and the S&P 500 occurred so frequently, investors began to take them for granted and to ignore whatever else was occurring in the financial markets. Many yields on safe time deposits soared with almost no attention being paid to this occurrence. Whenever an important financial development is being widely ignored it usually proves to be far more important than something which everyone is following. Even "boring" bank certificates of deposit are paying nearly two percent for one year and more than two percent for longer maturities.

Watch for important intermediate-term bottoms on the way down, and a multi-decade array of buying opportunities in roughly two years.

Bear markets don't nearly resemble anything close to a straight line. Many commodity-related and emerging-market assets experienced lengthy bear markets which began around April 2011 and mostly ended on January 20, 2016. Those bull markets are mostly incomplete but are being interrupted as these assets slide lower along with nearly all other global risk assets. Eventually fear will reach a typically elevated level while classic leading sectors like IWM and perhaps SMH will begin to form higher lows which are mostly ignored as fund outflows reach multi-year highs. Whenever that happens, which could perhaps occur this spring but could happen at almost any time, it will become timely to purchase whichever energy, mining, and emerging-market shares have become the most oversold and undervalued while continuing to form additional higher lows in their bull markets. These purchases could yield significant double-digit gains by the first several weeks of 2019 when they will likely complete their respective bull markets about one year after most U.S. equity indices have ended their multi-year uptrends in early 2018.

Everyone is used to allegedly buying on dips which will therefore lead to ruin.

When a bull market continues for nearly nine years, investors begin to "learn" habits which later prove to be highly destructive during the subsequent bear market. One of these is the mantra to "buy on dips" which in real life never happens; investors hate to buy into weakness. Instead of buying on dips they end up chasing the rallies which follow the dips. In a bear market, uptrends tend to be especially sharp and powerful so investors will be consistently buying following all huge up days as they become convinced that the previous pullback was "the bottom." They will be repeatedly disappointed as U.S. equity indices continue to form lower lows instead of higher lows, but they will keep buying into the rallies which follow all pullbacks. Finally, when the bear market is almost over roughly two years from now, investors will have been so thoroughly discouraged by losing money over and over again that they won't buy when prices are forming their lowest points of the cycle probably near multi-decade bottoms. This is what happened in both 2002 and 2009 as investors gave up on the idea of buying at all and ended up making dramatic outflows instead.

My object all sublime I shall achieve in time--to let the punishment fit the crime.

Here is one little-appreciated fact about the financial markets: they will always harm the greatest number of investors. The markets waited for the maximum intensity of inflows before starting to move lower. Whenever there have been recent massive outflows the next rebound will begin. Before the final bottom of the bear market we will have by far the biggest outflows so that most investors sell just before the biggest percentage gains occur. This pattern has been true for centuries and is an inherent feature of the financial markets which they usually don't teach you in school when you are learning about the glories of capitalism.

The U.S. dollar is likely to rebound significantly versus European currencies.

The same investors who were wildly bullish toward the U.S. dollar when it was completing a major topping pattern versus European currencies at the start of 2017 are now almost unanimously bearish toward the greenback. Therefore, expect the U.S. dollar to score meaningful gains against the euro and nearly all European currencies during the next several weeks or months as U.S. equity indices are retreating. If you see the U.S. dollar forming an important intermediate-term high and then begin to progressively retreat, it will probably be signaling that the U.S. stock market is set to rebound.

The January 2018 tops will end up being all-time record highs in many cases when measured in inflation-adjusted terms.

It is likely that some U.S. equity indices aren't going to revisit their recent nominal levels for several more years. Just as the March 2000 highs for many technology indices including the Nasdaq may never occur again in real terms, some January 2018 peaks may never be retouched again in inflation-adjusted valuations. Record overvaluations are usually followed by record undervaluations.

Disclosure of current holdings:

Because of the unprecedented investor surge into risk assets in January 2018, I unloaded nearly all of my long positions starting on the first trading day of January and ending on February 1, 2018. The only shares I am still holding are my gold mining, silver mining, and uranium mining shares, along with a modest allocation to U.S. Treasuries and an increasing collection of short positions especially in IWM which tracks the Russell 2000. About 4/7 of my total liquid net worth is in cash consisting of U.S. Treasury money-market funds and high-interest guaranteed time deposits. 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 what will become a historic collapse and should continue for roughly two years altogether. 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 until very recently, with no intrinsic value, is highly characteristic of a generational peak in anything from tulips to worthless canal/railroad/internet shares. I recently bought some HDGE, while my largest recent short additions have been IWM which tracks the Russell 2000 and XLI which is invested in industrials; both briefly soared to new all-time highs.

From my largest to my smallest position, I currently am long GDXJ, the TIAA-CREF Traditional Annuity Fund, SIL, HDGE (many new), GDX, URA, I-Bonds, TLT (some new), bank CDs, money market funds, GOEX, VGPMX, BGEIX, RGLD, WPM, SAND, and SILJ. I have short positions in IWM (many new), XLI (some new), AMZN (some new), NFLX (some new), NVDA (some new), IYR, FXG, and SPHD, in that order, largest to smallest. I sold all of my KOL, XME, EWZ, REMX, NGE, RSX, GXG, ELD, FCG, OIH, SEA, NORW, VNM, PGAL, EPU, and FTAG, and I very recently covered my short position in XLU.

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 on February 2, 2018 moved below its December 4, 2017 intraday high and thereby surrendered two months of gains in 1-1/2 weeks. The number of daily 52-week lows on the New York Stock Exchange sometimes surpasses the number of daily 52-week highs even though most large-cap U.S. equity indices are much closer to their all-time highs than they are to their lowest levels during the past year. Semiconductor shares have been a leading indicator since the 1960s and have been flashing danger signals. The strongest intraday behavior usually occurs just after the opening bell when amateurs are the most eager buyers, while closed-end fund discounts have been progressively climbing from rare lows. January 2018 was accompanied by all-time record inflows and by the most bullish net investor sentiment in many surveys throughout their multi-decade histories. 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 from its recent zenith would put the S&P 500 near or below 950. I believe that such an event is nearly certain but almost no one currently thinks that the S&P 500 below one thousand 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.