Wednesday, April 25, 2018

“Investing is the intersection of economics and psychology.” --Seth Klarman

AU WOW (April 25, 2018): Investors in 2018 have been behaving very differently than they have done in recent years. We started with a surge for many risk assets to new all-time highs, followed by choppy daily behavior which is common during bear markets for U.S. equity indices and is serving as a warning that the nine-year bull market for U.S. equity indices is transitioning to an ursine scenario. Most investors are not familiar with bear-market patterns, of which a common one is that any bear market consists of two major stages. In the first stage, investors who took a substantial percentage of their money out of bank accounts and other safe time deposits to purchase various fluctuating assets--even when their former favorites have become far less reliable--aren't eager to put their money back into the bank. Partly they perceive such an action as admitting failure, and partly the lengthy bull market has convinced most investors that they can make significant percentage gains as long as they're in the "right" securities. It is the first stage of a bear market where investors are most eager to buy something with which they aren't familiar, as long as that asset has been outperforming most other assets and has recently received increasingly favorable media coverage. In this essay I will examine one sector which I think is ripe for receiving major inflows during the upcoming year.

It will probably be a year or more before most investors pile back into safe havens.

During the final months of a bear market, it enters a second stage where investors finally realize too late that asset valuations have plummeted and are anxiously crowding into the safest havens available. However, we will probably not reach that stage of the current bear market for roughly another year or more. This leaves plenty of time for asset reallocation.

Since January 20, 2016, most commodity producers have outperformed the S&P 500, the Nasdaq, and similar funds of U.S. equities.

It is not widely known by the public, but the sectors with the greatest percentage gains from their intraday lows of January 20, 2016 are primarily commodity producers and emerging-market shares which are closely connected with commodity production. Funds including KOL, COPX, REMX, XME, LIT, EPU, and EWZ, all of which I had sold in January 2018, far outpaced nearly all other sectors worldwide with many of them more than tripling from their lows within two years. Another sector which has roughly doubled from its January 20, 2016 nadir has been gold mining and silver mining shares. These had more than tripled initially from their lows, including GDXJ and SIL, with SILJ more than quadrupling, but have generally underperformed since the summer of 2016 and have gone mostly sideways since the final months of 2016. This lengthy flat period has knocked out nearly all of those who had jumped aboard the bandwagon hoping for a quick buck, with periodic sharp pullbacks causing most other uncommitted holders to get out of this sector during the past 1-1/2 years. Exchange-traded funds in this sector including GDXJ and GDX experienced all-time record net outflows in 2017. Meanwhile, media coverage has been generally neutral to bearish except when there has been a recent upsurge when there will be a brief flurry of positive coverage which disappears as soon as prices head lower again.

Gold mining and silver mining shares will likely be among the biggest percentage winners during the upcoming 12-month period.

What evidence is there that gold mining and silver mining shares are likely to outperform once again as they had done during the first half of 2016? One clue can be found in the relative behavior of GDXJ, a fund of mid-cap gold mining shares, versus GLD, a fund of gold bullion. Whenever gold mining shares are about to enjoy a truly powerful rally, they will dramatically outperform gold bullion. Whenever a period of weakness in this sector is about to become more pronounced, GDXJ will underperform GLD. Therefore, let us examine how these two funds have performed in recent months relative to each other to see what is likely to happen next.

GDXJ has dramatically outpaced GLD from their respective intraday lows of February 9, 2018.

On February 9, 2018, GDXJ completed an important higher intraday low at 29.88. On the same day the intraday low for GLD was 124.39. As of the close today, April 25, 2018, GDXJ was at 32.78 while GLD closed at 125.41. Therefore, the total percentage gain for GDXJ has been (32.78-29.88)/29.88 or just over 9.7% while GLD has climbed by (125.41-124.39)/124.39 or just over 0.8%. The exact ratio between these two is more than 11.8 to 1. This ratio is far above the historic average for mid-cap gold mining shares which tends to average roughly three through the decades (since GDXJ hasn't existed for such an extended period of time, older indices like HUI and XAU or the even more venerable closed-end fund ASA should be used to compute historic averages). Besides being far above average, this ratio has risen dramatically from where it had been in the second half of 2016 through early 2018, and is on par with where it had been in the early months of 2016 and during other periods when this sector was enjoying some of its most pronounced uptrends.

During past bear markets, investors have often embraced gold mining and silver mining shares except during the final months of those bear markets.

During the last bear market in 2007-2009, gold mining and silver mining shares were notable winners from the summer of 2007 through the middle of March 2008. In 2000-2002, this sector soared from the last week of November 2000 through early June 2002 before sharply sliding along with just about everything else in the final months of that bear market. In 1973-1974, gold mining and silver mining shares similarly enjoyed very strong gains until the final months of that bear market where they plummeted along with just about everything else. Other past bear markets have also experienced visible reallocation from previous favorites into the precious metals sector. There could be several reasons for this behavior including how investors behave when the U.S. Treasury yield curve is generally flattening or how investors tend to act prior to an impending recession. Rate hikes near the end of bull markets also tend to be accompanied by gains for precious metals and the shares of their producers. In my opinion, historic parallels are much more important than reasons. With a consistent pattern of this sector outperforming at some point during a bear market for U.S. equity indices, combined with the recent outperformance of these shares relative to bullion, a classic bullish setup appears to be underway.

I am a personal fan of GDXJ, but SIL, SILJ, GDX, GOEX, ASA, and many other funds in this sector are also compelling.

GDXJ and GDX are the most liquid exchange-traded choices in the gold mining sector, with each of them trading millions of shares daily. There are several companies which can be found in both GDXJ and GDX, with GDX mostly emphasizing the largest global producers while GDXJ includes some small producers and many mid-cap shares. I expect GDXJ to generally outperform GDX for the same reason that mid-cap indices in any sector usually gain more than large-cap shares during most bull markets usually until their final stages. With silver being even more out of favor than gold, funds of silver producers including SIL and SILJ could gain more than gold mining shares as they had done during the months after January 20, 2016. As long as any fund is concentrated entirely in gold mining and silver mining shares, there should be significant gains especially once there have been recent increases which will create a rise in positive media coverage. Being human, many investors don't want to participate in anything until they see others doing likewise. If you wait for this sector to become popular again then prices are likely to be well above their current levels.

Adjusted for dividends, GDXJ almost exactly touched 50 in both August 2013 and again in August 2016, and was roughly thrice as elevated near the end of 2010 and in April/September 2011.

Adjusting for all dividends which are generally paid annually near the end of the year, GDXJ reached 50 in August in both 2013 and 2016. Perhaps it will make another August visit in 2018 to that level. In both 2013 and 2016, U.S. equity indices thereafter achieved new all-time highs which diminished investors' interest into switching into gold mining and silver mining shares, thereby causing them to decline afterward. If U.S. equity indices don't set new all-time highs later in 2018, then investors are likely to accelerate their reallocation into alternatives rather than switching back into their former favorites. If this occurs, then the price of GDXJ could end up anywhere from roughly 75 to 150. The latter price, adjusting for dividends, had been reached near the end of 2010 and again in both April and September of 2011. Unlike gold bullion which ascended to its all-time high in September 2011, GDXJ made a lower high that month which confirmed that both were set for a major downtrend.

Psychology will determine the extent of any extreme in the financial markets including how high gold mining and silver mining shares climb toward their bull-market tops perhaps in the first half of 2019.

The final high for gold mining and silver mining shares in the current cycle, which might be reached in roughly one year, will be much more influenced by the level of excitement and other emotional considerations rather than due to fundamentals.

Disclosure of current holdings:

Because of the unprecedented investor surge into risk assets in January 2018, I unloaded most of my long positions that month. Half 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 eventually become a historic collapse and should end in the final months of 2019 or the first half of 2020. 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 will become transformed into the most severe overall U.S. equity bear market since 1929-1932. The absurd popularity of cryptocurrencies until very recently, with no intrinsic value, was characteristic of a generational peak such as we had previously experienced for tulips, canals, railroads, internet shares, and Beanie Babies. During the winter I purchased more GDXJ below 32 several times and once below 30. I recently bought more TLT below 117.50 and shorted more IWM above 155.00.

From my largest to my smallest position, I currently am long GDXJ, the TIAA-CREF Traditional Annuity Fund, SIL, HDGE, GDX, TLT (some new), URA, I-Bonds, bank CDs, money-market funds, GOEX, VGPMX, BGEIX, RGLD, WPM, SAND, and SILJ. I have short positions in IWM (some new), XLI, AMZN, NFLX, NVDA, IYR, FXG, and SPHD, in that order, largest to smallest.

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 forming lower highs for several months. The Russell 2000 and its associated funds including IWM have made several key lower highs since the all-time intraday top for this index on January 24, 2018. The number of daily 52-week lows on U.S. exchanges 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 rarely-experienced lows. Some all-time record inflows were recorded during the first quarter of 2018 along with 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. A two-thirds loss from its January 26, 2018 zenith would put the S&P 500 near 950 and I believe that its valuation will become even more depressed to create all-time record investor outflows before we eventually and energetically begin the next bull market. Far too many conservative investors took their money out of safe time deposits since they didn't want guaranteed yields near one percent; they have no idea what to do during a bear market. Die-hard Bogleheads will probably resist unloading for awhile, but when they are perceived to be blockheads and become disillusioned by their method they will be among the biggest sellers of passive equity funds.