Sunday, March 24, 2019

“The intelligent investor is a realist who sells to optimists and buys from pessimists.” --Benjamin Graham



REACT TO OVERREACTIONS (March 24, 2019): Bear markets for U.S. equities, including the one which began on August 31, 2018 for the Russell 2000, feature repeated market overreactions which occur much more rapidly and consistently than in bull markets. Investors will become increasingly confused as to what is happening and will repeatedly believe one foolish myth after another. In October 2018 most analysts insisted that we were merely experiencing a brief correction and that supposedly we were still in a U.S. equity bull market. Around Christmas the drops of more than 20% for the S&P 500 and the Nasdaq convinced almost everyone that we were in a bear market from which a short-term rebound was supposedly impossible. Naturally we experienced a huge short-term recovery--after which almost everyone became convinced once again that we must be in a bull market after all. Many investors falsely celebrated the phony ten-year anniversary of the U.S. equity bear market earlier this month. A misguided Fed and an inverted U.S. Treasury yield curve have suddenly made it popular to declare that a global recession is imminent. Long-dated U.S. Treasuries which were hated when they were true bargains less than five months ago near important lows are now being eagerly chased at inflated prices. Why does the consensus keep changing and why is it always wrong?


U.S. equity bear markets are far more alike than U.S. equity bull markets, but hardly anyone pays attention to their most typical patterns.


Imagine if each winter people had totally forgotten that they wore heavy clothing and owned snow shovels the previous winter. They would end up feeling cold from wearing thin shirts and short pants and never realizing that winter reoccurs each year with nearly identical behavior. Oddly enough, investors in 2018 aren't looking back to 2000-2002 or 2007-2009 or 1972-1974 and concluding that we are in a similar pattern. Instead, they are convinced that it must be completely different this time and that there is nothing to be learned from the past. There are many common features of U.S. equity bear markets, one being that bear markets aren't acknowledged until they experience their collapsing phases--which are usually far into the bear market after it has already existed for one or two years. The Russell 2000 reached its all-time top on August 31, 2018, experienced a drop of 27.3% from 1742.09 to 1266.92, and then rebounded to a February 25, 2019 recovery high of 1602.10 before once again forming lower highs. Whenever the Russell 2000 forms lower highs while the S&P 500 is making higher highs, this is usually a warning that a more severe drop is approaching. However, because investors have concluded that 2018 is nothing like 2000 or 2007 or 1973, they didn't observe this obvious parallel.


Like nearly all assets, long-dated U.S. Treasuries were hated when they were compelling buys a year ago and now they are suddenly beloved as they are once again becoming dangerously overpriced.


When I was purchasing TLT near its lows of 2018, nearly everyone was convinced that long-term U.S. interest rates had to move higher because the Republican tax cuts combined with increased government spending supposedly meant lower taxes and higher spending and sharply increasing deficits--therefore meaning that the government would have to pay higher interest rates to borrowers. Ironically, the biggest U.S. monthly deficit occurred during the past month when U.S. long-term interest rates experienced one of their sharpest percentage decreases in history. This shows first of all that analysts have no idea what they are talking about, and secondly that there isn't a simple interrelationship between deficits and interest rates. It also means that when everyone is telling you that interest rates will keep moving higher then they are likely set to drop substantially, whereas when everyone is expecting lower rates--like right now--they are probably set to soon move sharply higher over the next year or so.


Sometimes an apple is simply an apple.


If you see a woman holding an apple in her hand, what does it mean? Maybe it means that she symbolizes the birth of all existence. Perhaps it means that she has eaten from the tree of knowledge which she will share with Adam. Perhaps it means that life is inherently cyclical. Or, maybe it just means that she wants to eat an apple. I prefer the latter explanation.


An inverted U.S. Treasury yield curve could simply mean that the 28-day U.S. Treasury is paying too much, while the 30-year U.S. Treasury is paying too little.


The U.S. Treasury yield curve can always be found at the following official U.S. government web site:

What is the significance of the yield on the 28-day U.S. Treasury being 2.49%, while the 10-year U.S. Treasury's annualized yield is 2.44%?


Simplicity trumps brilliance.


Many analysts are stating that the inverted U.S. Treasury curve means that we will experience an imminent U.S. recession. Others see it as a symptom of massive global change which is visible in everything from increased flooding worldwide to more frequent market fluctuations.


While Armageddon is fun to talk about, here's a simpler explanation: short-term U.S. Treasuries are paying too much and you should invest in them. Long-term U.S. Treasuries are paying too little and you should avoid them. Yes, that's far too easily understandable to be fabulously mystical and holistic, but it is common sense--which as usual is none too common.


There is a typical bear-market shift out of wildly overpriced U.S. assets into bargain non-U.S. assets.


By all fundamental measures U.S. assets in nearly every broad-based asset class including general equity indices, technology shares, and high-yield corporate bonds are far too expensive compared with their counterparts in the rest of the world. Since the last week of October 2018, investors have been progressively shifting out of U.S. assets into non-U.S. stocks--especially into emerging-market securities and the shares of commodity-related assets. This shift hasn't received nearly as much media attention as many other financial events during the past five months but that doesn't mean that it wasn't of equal or greater importance. Emerging-market shares and commodity producers have achieved approximately double the returns of U.S. equity indices since late October with generally less volatility. A powerful uptrend isn't less significant just because it isn't widely known by most U.S. investors. As with all market developments, the most experienced and wealthiest investors are the first to recognize any trend change and to adjust their portfolios accordingly, gradually moving to the least-experienced investors who are desperately trying to figure out what to do with their 401(k) plans. By the time any idea becomes widely known it is far too late to capitalize upon it.


Gold mining and silver mining shares have been quietly rebounding since they had slid to 2-1/2-year bottoms on September 11, 2018 more than a half year ago.


Hardly anyone realizes that two of the biggest net outflows out of all exchange-traded funds in calendar year 2019 have been GDX and GDXJ. The first is a fund of large-cap gold mining and silver mining shares, while the second is in the same industry but is concentrated in mid-cap shares. The total outflow for GDXJ has been approximately one-seventh of its entire market capitalization. Most investors have already forgotten or didn't realize that U.S. equity index funds mostly continued to experience net outflows not only during late 2008 and early 2009 when they were collapsing but all the way through the end of 2012. Investors didn't want to participate in the early years of the lengthy U.S. equity bull market when prices were experiencing their best bargains. This is due to several reasons: 1) the 2007-2009 collapse was fresh and painful in investors' minds through 2012; 2) when U.S. assets were truly compelling they were also highly volatile as deeply underpriced assets almost always are, thereby frightening away nervous investors; 3) since the media kept telling them that the recovery was unsustainable, investors hesitated more than they acted. The most money flowed into stocks in 2018-2019 when prices were near their highest levels in history. Whether they realize it or not, investors keep buying high and selling low and repeating this process over and over again.


Emerging-market stocks and bonds remain worthwhile, while many commodity producers have been quietly rebounding but are still compelling for purchase.


Emerging-market funds including TUR, PAK, SCIF, and EPOL are hardly known to most investors but they represent some of the best values available in the world. SEA is a fund of sea shipping shares which also is not widely discussed but has deep bargain fundamentals. Commodity producers including LIT, REMX, GDXJ, SIL, SILJ, and XES have been rallying in recent months with periodic sharp corrections. All of the above will probably be among the top-performing exchange-traded funds into early 2020.


If everyone is worried about anything then you don't have to be concerned with it. If almost no one is worried then you should be.


Think about all the top concerns which investors have been fretting about during the past half year: tariffs, a Chinese slowdown, Brexit, Fed rate hikes, and recently the flattening U.S. Treasury curve. How many of these actually changed the fundamental situation? So far, none--and the inverting U.S. Treasury curve will prove to be equally groundless. Sure, we will eventually have a recession as is inevitable since the previous one had ended nearly a decade ago, but it won't happen soon with everyone talking about it.


Here are legitimate worries which no one is concerned with: a falling U.S. dollar, rising U.S. inflation, overheating global economies including China, falling housing prices, increasing defaults, and rising interest rates.


You will hardly see anyone being concerned with sharp increases in defaults, interest rates, and inflation, and yet those are far more serious concerns during the upcoming year than tariffs, a Chinese slowdown, or the inverted U.S. Treasury curve. We are at that stage of the U.S. equity bear market where historically we are most likely to experience increasing defaults in mortgages and high-yield corporate bonds and other loan agreements, while inflation and interest rates stage surprise increases when everyone is gazing lower. During the bear markets of 2007-2009, 2000-2002, and 1972-1974, investors went from almost zero fear of these events to becoming wildly obsessed with them. High-yield corporate bonds in particular, which sport near-record narrow spreads relative to U.S. Treasury yields, will likely suffer much wider spreads as lenders become increasingly reluctant at the same time that borrowers are desperately trying to lock in low yields. Investors, analysts, and the Fed are nearly unanimous in anticipating too low a rate of inflation in the United States. It has been a long time since we have experienced stagflation--a combination of slowing U.S. growth and rising U.S. inflation--but that would be par for the course at this stage in the U.S. equity bear market now that it has existed for nearly seven months.


The bottom line: as has been the best advice since the U.S. equity bear market began in late August 2018, prepare for what has happened most frequently at this stage in previous U.S. equity bear markets.


Instead of expecting 2019 to be completely different from the past, you should anticipate it to be a nearly exact repeat of what has happened at this stage during past U.S. equity bear markets through the decades. Emerging-market securities and commodity producers will likely continue to be among the top performers as they have already been since the last week of October 2018. Investors will be shocked, shocked as the past repeats itself and we experience a combination of a falling U.S. dollar, rising corporate and mortgage defaults, falling housing prices, rising U.S. inflation, and an acceleration in the underperformance of U.S. assets compared with their counterparts in the rest of the world. Fade the inverted-yield-curve blather by purchasing the high-paying 28-day U.S. Treasuries yielding nearly 2.5% while avoiding long-term U.S. Treasuries which are currently paying far too little for the interest-rate risk involved.


Disclosure of current holdings:


I have sold all of my TLT and related long-term U.S. Treasury holdings and used most of the money to buy short-term (28-day) U.S. Treasuries yielding roughly 2.5% along with selected emerging-market equities and commodity producers. You can find my more frequent comments on SeekingAlpha.com and in other media web sites.


From my largest to my smallest position I currently am long GDXJ (some new near 31), short-term U.S. Treasuries (many new), the TIAA-CREF Traditional Annuity Fund, SIL, SCIF (many last month), ELD, ASHR, OIH, FCG, XES, ASHS, VNM, SEA (some new), GDX, bank CDs (some new), money-market funds (some new), GXG, URA (some new), I-Bonds, EPOL (some new), PAK (some new), EZA, EPHE, ARGT, FM, SLX, ECH, LIT (some new), TUR (some new), EGPT, MTDR, EWG, EWU, EWI, EWW, JOF, AFK, REMX, FXF, RSXJ, COPX, EWD, EWQ, EWK, GREK, EWM, CHK, EWN, GOEX, BGEIX, IDX, NGE, RGLD, WPM, SAND, and SILJ. I have no current short positions.


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 maybe in 2020 or early 2021. During the 2007-2009 bear market, most investors in August 2008 still didn't realize that we were in a crushing collapse, and I expect that into early 2020 most investors similarly will think that the U.S. equity bull market is alive and well. After reaching its all-time zenith on August 31, 2018, the Russell 2000 Index and related funds including IWM have generally underperformed their larger-cap counterparts including not surpassing their more recent lower highs of February 25, 2019; similar behavior had ushered in the major bear markets of 1929-1932, 1973-1974, and 2007-2009. Meanwhile, the Nasdaq climbed to an all-time peak in nominal terms on August 30, 2018--although the Nasdaq never surpassed its March 10, 2000 intraday zenith in inflation-adjusted terms and perhaps never will. A two-thirds loss from its recent zenith would put the S&P 500 near 980 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 in recent years; the incredibly long bull market has left them completely unprepared for a bear market. The behavior of the global financial markets since August 31, 2018 has been incredibly similar to the behavior in the early stages of nearly all U.S. equity bear markets going back to the 1790s. In general, U.S. equity bear markets are far more alike than bull markets. Die-hard Bogleheads will probably resist selling until we are approaching the next major bear-market bottom, but when they are perceived to be blockheads and become disillusioned by their method they will become some of the biggest net sellers of passive equity funds. Because so much money exists today in exchange-traded and open-end funds, as they decline in value their fund managers will be forced to destroy shares which will compel them to sell their components, thus depressing prices further and creating more share destruction in a dangerous domino effect. The Boglehead foolishness is especially ironic since Jack Bogle himself aggressively sold U.S. equities in 2000 and again in 2018 shortly before his passing.

Monday, November 26, 2018

“Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen.” --Seth Klarman



BULLISH HORNS ARE HONKING (November 26, 2018): One common characteristic of a bear market for U.S. equities is that it requires roughly two years for the Russell 2000 to go from its top to its bottom. Along the way investors will become progressively discouraged by recent extended losses and will become gloomiest prior to each powerful bear-market rally. Bear-market rebounds tend to be more intense and rapid than bull-market uptrends and are more clearly signaled by reliable indicators, and thus often provide superior investing opportunities with higher annualized gains and lower downside risk on the long side than bull markets do. This fact is underappreciated by most investors.


The sequence in which assets complete their respective bottoms is well established but is not often used as a guide, partly since investors seem emotionally reluctant to admit that we are in a bear market and to use the proven experience of past bear markets as the most reliable guide to making money in the current bear market.


The recent progression of higher lows and lower lows is typical of an intermediate-term bottoming process.


There are two major kinds of bottoming patterns during bear markets: 1) intermediate-term bottoms that demonstrate similar behavior to each other and which are almost always followed by dramatic recoveries for certain securities; and 2) the final bottoming process which behaves very differently with huge short-term percentage losses and which is followed by a much choppier and shakier recovery that denotes the beginning of the next major bull market. The bottoming pattern we have been experiencing during the past several weeks clearly fits into the first category. It is thus worth examining in detail and analyzing as to the most likely follow-up pattern.


The securities I had recommended for purchase in my previous update have mostly rebounded even when U.S. equity indices were continuing to slide lower.


Emerging-market equity funds from those countries which tend to bottom earliest in the current cycle, including EZA, SCIF, EPHE, ARGT, and ASHR, have already climbed since my previous posting on the morning of October 30, 2018. Most of these had bottomed around the middle of October and then began quietly forming higher lows during the final days of October when most U.S. and some other equity indices continued to make lower lows. The total percentage declines from their peaks of January 2018 had approached one-third of their peak valuations and for SCIF had dropped by nearly half. While these and closely-correlated emerging-market assets have been forming higher lows, other sectors including many western European stock markets and energy shares continued to drop toward or below multi-year lows during November. Meanwhile, gold mining and silver mining shares had been in bull markets for even longer periods of time mostly dating back to 2-1/2-year bottoms which had been completed on September 11, 2018.


Emerging-market government bonds had also bottomed near September 11, 2018 and have mostly formed several higher lows since then, as you can see from charts of funds including ELD and LEMB. However, only a few emerging-market countries completed bottoms for their stock markets more than two months ago including Brazil (EWZ) and Turkey (TUR).


Some equity bourses have continued to lag and several of them represent worthwhile bargains.


Possibly due to above-average negative media coverage of the caravan in Mexico, along with political uncertainty, equity valuations in that country and its exchange-traded fund EWW have fallen to lower lows today while an increasing number of emerging-market equity funds have been forming higher lows. GXG and ICOL, both funds of Colombian shares, have also been lagging in forming higher lows.


When investing there is an important tug-of-war between buying those assets which have already been forming higher lows versus those which are still making lower lows. In general a combination of these is ideal, but finding the proper balance is challenging. By making small commitments for each individual trade you will have the flexibility to continue to gradually accumulate both kinds of securities during a bottoming process.


Investors have been unusually fearful by many established measures.


Daily Sentiment Index for several decades has surveyed futures traders regarding their opinion about the upcoming behavior of numerous futures contracts. As of the close on Tuesday, November 20, 2018, a surprising number of readings were near multi-year or multi-decade extremes. Only 8% of traders were bullish toward both the S&P 500 Index and the Nasdaq Composite, while 8% were also bullish toward gasoline. 9% of futures traders were bullish toward crude oil and heating oil, and 10% were bullish toward the CRB Index of commodities. 10% of traders were bullish toward the British pound, no doubt negatively influenced by Brexit uncertainty. A slightly larger 12% were bullish toward the Nikkei in Japan, while 20% were bullish toward both gold and silver. 84% were bullish toward VIX which tends to peak whenever fear is highest about the possibility of a U.S. equity bear market becoming more severe. 81% of futures traders were bullish toward the U.S. dollar index.


The above readings have generally become less extreme since November 20 while remaining far from their typical levels.


Other measures of sentiment have been sending similar signals.


A recent article on Seeking Alpha observed that gloom toward U.S. equities has approached multi-year extremes:


Western European shares took longer to complete their bottoming patterns.


While most emerging-market bourses had completed their bottoming patterns during the final trading days of October 2018, western European shares primarily did so two or three weeks later. There have been unusually extended pullbacks from their January 2018 tops for nearly all countries in Western Europe, with especially large losses for EWG (Germany), EWI (Italy), and EWU (the United Kingdom). In all cases these losses had almost nothing to do with lower potential corporate profits and almost everything to do with geopolitics. It is usually most profitable to buy whenever political wrangling and scandals dominate investors' outlook rather than economic reality. Angela Merkel's decision not to stand for re-election in Germany, uncertainty concerning Italy's relationship with the EU, and the Brexit infighting in the U.K. have all made widely-broadcast headlines but are unlikely to meaningfully impact the profits of companies in these countries. I therefore purchased all of these in November. Other countries were also lagging in their bottoming processes including Vietnam (VNM) which is often overlooked by many investors even if they otherwise favor Asian equities.


Energy shares, as is typical, have been among the slowest sectors to complete their bottoming patterns.


The rotational pattern tends to be similar during both topping and bottoming patterns. For example, in 2007 the Russell 2000 completed a double top on June 1 and July 9. Most gold/silver mining shares completed their highs in the middle of March 2008, while emerging-market equities did likewise in May-June 2008 and energy shares were the most lagging sector to top out during June-August 2008. Many energy funds including OIH and FCG slid toward multi-year lows during the past week when I was gradually accumulating them. OIH in particular has fallen sharply from its January 2018 zenith, and even that top wasn't anywhere near its much higher peak from the middle of 2014.


Even though the same patterns keep repeating themselves through the decades, investors are always convinced that it's different this time.


Currencies have been sending a similarly bullish signal regarding global equities.


Very few investors realize or appreciate that most emerging-market currencies completed their bottoming patterns versus the U.S. dollar somewhere around the middle of October and have since formed several higher lows. Most European currencies have taken longer to complete their respective intermediate-term bottoms but have mostly done so during the past few weeks. One notable bargain has been the Swiss franc which during the past decade has rarely traded at a price below the U.S. dollar, but which fell as low as .987987 U.S. dollars in November 2018 before once again barely regaining parity.


VIX keeps making lower highs which is historically very bullish for global equities.


One of the earliest signals that global equities were set for strong rallies was when VIX in November 2008 didn't surpass its peak from October 2008. Similar behavior has been occurring in recent weeks as VIX soared to 28.84 on October 11, 2018 and then completed a lower high of 27.86 on October 29, 2018 when most U.S. equity indices made lower lows. On the following day, October 30, 2018, VIX climbed as high as 25.55 and then registered an additional lower high of 23.81 on November 20, 2018. These lower highs almost all represent essential buying opportunities for equity funds. The most recent lower high for VIX was 22.65 on Friday, November 23, 2018.


The relative behavior of IWM vs. SPY is especially useful in determining key turning points for U.S. equity indices.


I believe that U.S. equity indices are especially overvalued relative to most global equities and thus I am not planning to purchase them until they complete major bottoms perhaps in 2020. However, they send useful signals for stock markets worldwide since the world is so closely interconnected. Whenever the Russell 2000 and its funds including IWM are notably underperforming the S&P 500 and its funds including SPY and VOO then it is likely that any downtrend will continue; as soon as this pattern reverses then a rebound is closely approaching. After topping out at an all-time zenith on August 31, 2018, IWM made several lower highs while SPY was still making higher highs for three weeks. Then, after bottoming on October 26, 2018, IWM has been forming higher lows more frequently than SPY. Whenever IWM begins to persistently underperform SPY again, which will likely occur during the first half of 2019, it will likely be signaling the next intermediate-term downtrend for U.S. equities.


Too many investors are obsessed with their opening prices which should be completely irrelevant when making trading decisions.


Most people are illogically concerned about their opening prices or their personal history with a given asset when deciding whether or not to trade it. All that should matter is its future behavior. The past is a useful guide to its behavioral pattern but your personal history should be completely ignored. Far too many people won't sell because something is at a loss, thereby inviting much larger future losses. Others don't want to raise their average purchase price and thus miss out on ideal opportunities to buy at higher lows. I have been intentionally accumulating more EZA each time it drops to 49.99 regardless of the fact that my original purchases had all been at lower prices.


Investors also obsess about "why" such-and-such has moved higher or lower recently or what is "really going on" with a particular security.


If you are looking for anything then you will find it one way or another. If you are looking for reasons why Chinese or Indian equities have dropped over one-third from their January 2018 peaks then you will end up concluding that it has something to do with Chinese tariffs or the 2019 Indian elections and you will wrongly conclude that you shouldn't buy. When investors have reasons to sell near multi-year or multi-decade lows then they will be far more likely to do so because we like to think that we do everything for a reason. Investors repeatedly overreact to supposedly negative news which rarely has any impact on corporate profits. Investors often sell when a currency has become depressed due to political reasons, as for many emerging-market currencies and the U.K. in recent months.


A depressed currency stimulates exports and reduces local wages and thus increases rather than decreases total profits.


The bottom line: as is usually the case, investors have been reducing risk when they should be substantially increasing it.


Investors were most excited about owning U.S. equities in the late summer when they should have been aggressively selling, and recently they have been selling stocks worldwide and thus registering all-time record outflows from many emerging-market and commodity-related funds. At the same time, the ratio of insider buying to insider selling for sectors including energy has set or approached multi-year highs. Investors tend to overestimate future gains at market peaks and to even more irrationally underestimate gains just before large percentage increases are maximally likely to occur. Many of the funds I have purchased, all of which are listed below in my disclosure, could gain 30% or 40% over the next half year alone and could continue to climb perhaps as late as the beginning of 2020 depending upon how aggressively they rebound and how trendy they become in 2019.


Disclosure of current holdings:


Due to all-time record outflows and rare extremes of fear, I have completed the closing of all of my short positions while progressively and gradually buying into both higher lows and lower lows for emerging-market, energy, and related sectors including sea shipping. During the past two weeks I have been emphasizing ASHR (Shanghai A-shares), OIH (oil services), EPOL (Poland), VNM (Vietnam), EWG (Germany), EWU (U.K.), EWI (Italy), FCG (natural gas production), SEA (sea shipping), EZA (South Africa), FM (frontier markets), and EWW (Mexico) which I purchased this afternoon. I am also buying a little GDXJ each time it drops below 27. I sold VGPMX since Vanguard seems to be clueless about buying low and selling high.


Funds I am considering for purchase during the remainder of 2018 include ASHS (Shanghai small-caps), GREK (Greece), PAK (Pakistan), COPX (copper producers), RSXJ (Russian small-caps), EGPT (Egypt), AFK (Africa), Indonesia (IDX), GXG (Colombia), ECH (Chile), EWK (Belgium), and EWY (South Korea).


From my largest to my smallest position, I currently am long GDXJ (some new), the TIAA-CREF Traditional Annuity Fund, TLT, SIL, ELD, GDX, URA, I-Bonds, bank CDs (some new), money-market funds (some new), EZA (some new), SCIF, ASHR (some new), OIH (many new), SEA (some new), EPHE, EPOL (many new), ARGT (some new), VNM (all new), FCG (some new), EWG (all new), EWU (all new), EWI (all new), EWW (all new), GOEX, BGEIX, MTDR (all new), RGLD, WPM, SAND, and SILJ. I have no current short positions.


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 maybe in 2020. During the 2007-2009 bear market, most investors in August 2008 still didn't realize that we were in a crushing collapse, and I expect that well into 2019 most investors similarly will think that the U.S. equity bull market is alive and well. After reaching its all-time zenith on August 31, 2018, the Russell 2000 Index and related funds including IWM generally underperformed their larger-cap counterparts into late October 2018; similar behavior had ushered in the major bear markets of 1929-1932, 1973-1974, and 2007-2009. Meanwhile, the Nasdaq climbed to an all-time peak in nominal terms on August 30, 2018--although the Nasdaq never surpassed its March 10, 2000 intraday zenith in inflation-adjusted terms and perhaps never will. 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 recent zenith would put the S&P 500 near 980 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; the incredibly long bull market has left them completely unprepared for a bear market. Die-hard Bogleheads will probably resist unloading perhaps until late 2019 or early 2020, but when they are perceived to be blockheads and become disillusioned by their method they will be among the biggest net sellers of passive equity funds. Because so much money exists today in exchange-traded and open-end funds, as they decline in value they will be forced to destroy shares which will compel them to sell their components, thus depressing prices further and creating more share destruction in a dangerous domino effect.


Recent extreme fear combined with additional lower highs for VIX are both likely signaling an intermediate-term rebound for some unknown period of months into 2019. I therefore progressively closed all of my short positions and have been gradually purchasing the most undervalued shares which are primarily emerging-market and commodity-related securities.


Investors should be buying global stocks now not because we are allegedly still in a bull market--which we are not--but because we are in a bear market where the most reliable rebounds occur with significant annualized gains and limited potential downside as long as fear remains elevated.


I appreciate Seeking Alpha reprinting these updates.


All of my updates are posted originally on my blog at truecontrarian.com and are then reprinted by Seeking Alpha which has a nicely-moderated forum for making comments. If you want to see my ideas as close as possible to when I am writing them then be sure to go to my web site first because it will take time for Seeking Alpha to be able to properly reformat them for publication.

Tuesday, October 30, 2018

“Investment success doesn’t come from 'buying good things,' but rather from 'buying things well.'” --Howard Marks



BUY BECAUSE IT'S A BEAR (October 30, 2018): During any market topping process you hear almost nothing about the possibility of a bear market, even a mild one, since investors are so excited about the potential upside and become irrationally complacent about losing money. One shared characteristic of 2000, 2007, and 2018 is that very few bothered to consider the potential downside risk. This was especially true in 2018 since we had experienced U.S. equity bull markets which had lasted for roughly 9-1/2 years and seemed as though they might continue forever--or at least as long as Donald J. Trump was the U.S. President. Recently the dialogue has changed so that many investors are asking whether we are in a bear market. While there isn't a consensus on that issue, investors are far more worried and many have been "reducing risk"--a phrase which is utilized primarily to justify selling something at a low price which should have been sold much earlier at a high price when investors had been so pleased with their results that they weren't even bothering to log into their accounts. Analysts have become increasingly bearish for technical or other reasons, with a few holdouts insisting that we are still in a bull market and that therefore you shouldn't sell too much.


I have an entirely different viewpoint: it is precisely because we are in a U.S. equity bear market, and probably a severe one, that you should be buying now instead of selling. The biggest short- and intermediate-term stock-market rallies in history have generally occurred during bear markets. If the current bear market ends up being as dramatic as I expect it will eventually become, then the most unpopular shares including emerging-market securities and many commodity producers should perform especially well from now into early 2019 and perhaps in some cases into early 2020 depending upon what happens next year. Bear markets almost always provide the best trading opportunities for those who aren't afraid of short-term capital gains. With the lower U.S. taxes which will persist at least through 2020, you also shouldn't fear short-term capital gains which as a U.S. resident will be taxed at their lowest levels in several decades.


Bear markets tend to be badly misunderstood.


If you were to ask most investors about bear markets then they would give wildly inaccurate responses based upon their emotional memories rather than fact. For example, the bear market of 2007-2009 was the most severe since the Great Depression. It began with the Russell 2000 completing a double top with nearly matching highs on June 1, 2007 and July 9, 2007. Many other U.S. equity indices topped out later as they often do, with the S&P 500 reaching its highest intraday point on October 9, 2007 while the Nasdaq did likewise on October 31, 2007. The U.S. stock market experienced several sharp plunges during the first part of its bear market and rebounded sharply after each one. By the middle of August 2008, roughly 14-1/2 months after the Russell 2000 had ended its uptrend, most investors had no fear of an extended downtrend and thought that we were still in a bull market. This was true even into early September 2008. Only after the huge collapse from the 1303.04 intraday peak for the S&P 500 on September 3, 2008 through its November 21, 2008 intraday bottom of 741.02--a total plunge of more than 43%--did investors finally wake up and realize what was happening which of course was far too late to be able to sell at favorable prices. Not that this stopped anyone, as we had all-time record outflows from most U.S. equity funds during the lowest points in the fourth quarter of 2008 and the first quarter of 2009 when for two weeks the S&P 500 was trading below its November 2008 bottom.


The 2000-2002 bear market was similar; almost no one acknowledged it even in January 2002 when it had been underway for nearly two years. Investors are attuned to being overly optimistic when they should be pessimistic and vice versa, which is an important lesson today when fear and gloom have quickly taken over where they had been almost nonexistent several weeks ago. Talk about a crash, pending doom, and similar topics which had been completely absent two months ago are now being routinely debated in the mainstream financial media. In all previous bear markets this was what had happened prior to each strong bear-market rebound, and that is what is likely to occur this time also. The past almost always repeats itself with some variations--some refer to this process as rhyming with the past.


The Russell 2000 Index and VIX have been demonstrating classic signs of a sharp "surprise" recovery for stock markets worldwide.


The Russell 2000 Index consists of U.S.-headquartered companies 1001 through 3000 in total market capitalization. This is in contrast to the much more widely-followed S&P 500 Index which represents companies 1 through 500 in total market capitalization. While almost no one tracks the Russell 2000 unless they own it in the form of a fund such as IWM, it is important because it serves as a valuable leading indicator. In 2007 and 2018, as well as in past bear-market preludes including 1929 and 1972, mid- and small-cap U.S. stocks began to decline more substantially than their larger-cap counterparts as a warning that a major bear market was beginning. Look at how the Russell 2000 or IWM behaved after August 31, 2018 versus the S&P 500 or SPY over the same period of time. Indeed, I had pointed this out in my last update and some readers dismissed it as being unimportant--just as they had done in prior bear markets. The Russell 2000 following its high on August 31, 2018 has dropped far more than the S&P 500 until recent days when it has been more energetically recovering from intraday lows and reversing its previous underperformance to outperform most other U.S. equity indices. If this outperformance continues then it will confirm that a rebound is imminent and will likely intensify. At some unknown future point the Russell 2000 will start underperforming again over a period of weeks and this will tell us that it is time to do some selling in preparation for the next downward wave. Since we are likely in a severe bear market for U.S. equities, any downward wave could become the "big Kahuna" and must therefore be respected. However, since everyone now is worried about a big drop, we will end up with some big up days instead until once again investors have lost their fear of potential significant losses. While we will surely have some sharp short-term pullbacks whenever investors are becoming overconfident, we will not likely resume the bear market until some point in early 2019--and perhaps later in 2019 if it takes time for investors to become fully complacent once again.


Just as almost no one is watching the Russell 2000 versus the S&P 500, the VIX is badly misunderstood as a leading indicator.


One reason it was so compelling to purchase U.S. equities when they were bottoming around November 19-21, 2008, and again in late February and early March 2009, is because lower lows for the S&P 500 were encountered by lower highs for VIX rather than higher highs. In other words, VIX peaked in October 2008 and made a lower high in November 2008 even though the S&P 500 and most U.S. equity were much lower during the third week of November 2008 than they had been at any point in October 2008. Then, in late February and early March 2009 when the S&P 500 finally broke below its November 21, 2008 bottom of 741.02, VIX continued to form significantly lower highs. This means that the most informed participants, who are those who tend to hedge with options and other derivatives, were becoming increasingly sure that we were approaching a worthwhile buying opportunity for U.S. equities when the public was most afraid of participating and was making all-time record outflows from most U.S. equity funds.


VIX touched 89.53 on October 24, 2008 which was its top for the entire bear market. On November 20, 2008 it reached 81.48 which was considerably lower; the S&P 500 ended up bottoming the following day. On March 6, 2009 when the S&P 500 completed its infamous nadir of 666.79, the intraday high for VIX was only 51.95 which was enormously lower. We appear to be having similar behavior in October 2018 although of course the future is always unknown especially in the short run. VIX had reached 28.84 on October 11, 2018; when the S&P 500 was much lower during the afternoon panic on October 29, 2018, VIX only rose to 27.52. If this pattern of lower highs for VIX continues then it increases the likelihood that a rebound for the U.S. stock market is approaching.


Investors fear sharp downward spikes but those often mark intermediate-term bottoms especially when they are followed by intraday recoveries.


Investors tend to become the most frightened by sharp downward moves which are followed by meaningful percentage rebounds, including the behavior in the afternoon on Monday, October 29, 2018. However, that is when investors should become most bullish since that is how bottoming patterns are classically formed. Sharp drops are very effective in knocking out sell stops, while subsequent rapid rebounds ensure that those who were stopped out will have to pay higher prices in order to re-establish their long positions. The more sudden the pullbacks and the more energetic the subsequent intraday recoveries, the more likely that a rally is closely approaching. Repeated downward spikes tend to especially unnerve investors who will often be induced to sell when they should be buying.


The upcoming winners will not mostly be the previous top performers or favorites--it will be assets like SCIF which had become most irrationally undervalued due to herd following.


Throughout 2018 investors have been frantically chasing outperformance. After nearly all risk assets began the year with sharp gains, most emerging-market shares and commodity producers started significant downtrends in January 2018 which have persisted until the past month. Investors responded to this behavior by progressively selling more and more of whatever was underperforming in order to buy more and more of whatever was outperforming. This kind of activity is common whenever we are transitioning to a major bear market. As a result, numerous sectors have lost one-third or more of their January 2018 peak valuations. I have begun to purchase these and in general they have been holding up much better than most other risk assets. A classic example is SCIF, a fund of 210 small-cap companies headquartered in India. This fund had climbed to an intraday high of 72.57 on January 12, 2018, and then slid as low as 36.58 on October 8, 2018--a total decline of (72.57 - 36.58) / 72.57 or nearly 49.6%. Since then it has resisted the pullback for most other global risk assets and has been moving generally sideways. Whatever might or might not be happening with such a large group of Indian companies, it is surely the case that the selling is due to investors acting out of disappointment, fear of additional losses, wanting to own something else which seems to be surging, and similar emotional reasons. This is precisely the kind of investment that I am eager to find especially when fear has gripped the global financial markets and almost everything is likely to rebound for an unknown period of weeks or months.


Other emerging-market stocks and bonds will likely rally in upcoming months along with most commodity producers.


When the word China is mentioned, what is the first thing you think of nowadays? Is it ancient temples, their amazing rate of growth in recent decades, or the complexity of their government organization? Most likely the first word you thought of was "tariffs" which even kids know about these days. It is astonishing how so many investors are convinced that because of tariffs the Chinese stock market should be as depressed as it has been in 2018. ASHR, a fund of Chinese equities which had soared to 34.89 on January 26, 2018, sank to a low of 22.00 on October 18, 2018. Like SCIF and many other emerging-market funds it has held up well since then compared with U.S. equities, but this pullback had been (34.89 - 22.00) / 34.89 or almost 37%. Surely some minor tariffs can't account for such a huge loss; the impact has been entirely psychological. If people think there is a reason to sell, even if that reason hardly warrants such an overreaction, then they will sell first and ask questions later.


Gold mining and silver mining shares remain unpopular and undervalued.


Most emerging-market government bonds and the shares of precious metals producers simultaneously bottomed on September 11, 2018. GDXJ, a fund of junior gold mining shares, touched 25.91 which had marked a 2-1/2-year low. This fund has begun to rebound and has formed several higher lows since then including 26.25 on September 12, 26.74 on September 14, 26.79 on September 27, and 26.92 on October 10, 2018. It is probably close to completing another key intraday high in preparation for a more energetic move higher. During past U.S. equity bear markets including those in 1929-1932, 1972-1974, and 2000-2002, gold mining and silver mining shares were among the biggest winners once those bear markets began to be recognized by investors. At the turn of the century when GDXJ did not yet exist but the index HUI was already in existence, HUI skyrocketed from its intraday nadir of 35.31 on November 15-16, 2000 to an intraday high of 154.99 on June 4, 2002--a total increase of 438.94%.


The bottom line: purchase the most undervalued emerging-market securities and energy shares as I have listed under my disclosure below--not because we are "still in a bull market" but because these shares generally outperform strongly during the first year of a true U.S. equity bear market.


Most investors are "reducing risk" or "considering buying once we have clarity." Once we have clarity it will be too late to make purchases at compellingly low valuations; the financial markets are almost always most volatile whenever we are completing any kind of bottoming pattern in order to discourage all but the most experienced traders from taking advantage of the best prices. Investors already disliked emerging-market and energy shares which have mostly fallen by irrationally large percentages since they had topped out in January 2018 as investors sold underperforming emerging-market securities in order to purchase their outperforming U.S. counterparts. Lately the outflows have mostly become intense with dozens of emerging-market equity funds losing between one-third and one-half of their net asset value from their respective January 2018 peaks, while an increasing number have been quietly forming higher intraday lows. Following a one-year period of increasing inflows into energy shares after they had bottomed amidst wide unpopularity in late August 2017, investors have recently given up on those also. Gold mining and silver mining shares remain unpopular and have finally been forming several higher lows following their 2-1/2-year bottoms including GDXJ touching 25.91 at 9:55 a.m. on September 11, 2018.


Disclosure of current holdings:


Due to the recent panic, I have gradually closed all of my short positions and completed this process in the afternoon of October 29, 2018. During the past week I have been progressively purchasing the most undervalued emerging-market equity funds which have been among the biggest losers since their respective January 2018 peaks, including SCIF (small-cap India), EZA (South Africa), ASHR (Shanghai A-shares), EPHE (Philippines), SEA (sea shipping), and ARGT (Argentina). As the pullback on October 29 intensified during the afternoon I began to buy OIH (oil services) and FCG (natural gas production) in small quantities. Other worthwhile funds which I am considering for purchase include IDX (Indonesia), ASHS (small-cap Shanghai A-shares), PAK (Pakistan), EGPT (Egypt), and AFK (Africa).


From my largest to my smallest position, I currently am long GDXJ, the TIAA-CREF Traditional Annuity Fund, TLT, SIL, ELD, GDX, URA, I-Bonds, bank CDs (some new), money-market funds (some new), SCIF (all new), EZA (all new), ASHR (all new), EPHE (all new), SEA (all new), GOEX, VGPMX, BGEIX, OIH (all new), ARGT (all new), FCG (all new), RGLD, WPM, SAND, and SILJ. I have no remaining short positions.


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 maybe in 2020. During the 2007-2009 bear market, most investors in August 2008 still didn't realize that we were in a crushing collapse, and I expect that well into 2019 most investors similarly will think that the U.S. equity bull market is alive and well. After reaching its all-time zenith on August 31, 2018, the Russell 2000 Index and related funds including IWM generally underperformed their larger-cap counterparts into late October 2018; similar behavior had ushered in the major bear markets of 1929-1932, 1973-1974, and 2007-2009. Meanwhile, the Nasdaq climbed to an all-time peak in nominal terms on August 30, 2018--although the Nasdaq never surpassed its March 10, 2000 intraday zenith in inflation-adjusted terms and perhaps never will. 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 recent zenith would put the S&P 500 near 980 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; the incredibly long bull market has left them completely unprepared for 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 net sellers of passive equity funds. Because so much money exists today in exchange-traded and open-end funds, as they decline in value they will be forced to destroy shares which will compel them to sell their components, thus depressing prices further and creating more share destruction in a dangerous domino effect.


Very recent extreme fear combined with lower highs for VIX is likely signaling an intermediate-term rebound for some unknown period of months into 2019. I have therefore gradually closed my short positions and have purchased the most undervalued shares which are primarily emerging-market securities and gold/silver mining shares, with energy shares finally becoming worth buying also.


I plan to update my web site more often and I appreciate Seeking Alpha reprinting these updates.


All of my updates are posted originally on my blog at truecontrarian.com and are then reprinted by Seeking Alpha which has a nicely-moderated forum for making comments. If you want to see my ideas as close as possible to when I am writing them then be sure to go to my web site first because it will take time for Seeking Alpha to be able to properly reformat them for publication.

Thursday, October 18, 2018

“Now, it's that dispersion that's at the moment probably the most interesting opportunity in the market — start putting money to work in the losers and start taking a preference in the winners, because there's probably going to be a mean reversion in both sectors going either way over next 12 to 18 months.” --Ralph Jainz



RIPE HARVEST FOR ASSET PAIRS (October 18, 2018): Most investors are used to thinking about the financial markets as a collection of individual decisions. Should I buy more of this or sell some of that? However, often the most important clues can be found when there are unusually outsized ratios between assets which have been closely correlated for decades or longer. Commodity producers generally move in tandem, so it is rare to have energy shares being so strongly desired while gold mining and silver mining shares and their funds including GDXJ until very recently had been dramatically out of favor. Investors continue to strongly favor high-yield U.S. corporate bonds which are sporting their lowest-ever spreads relative to U.S. Treasuries, while shunning the government bonds of numerous countries including the United States and some especially attractive yields from emerging-market government paper. Stocks which comprise numerous passive indices have mostly become notably overpriced, while those which are scarcely represented in indices can be undervalued. U.S. assets of all kinds tend to be close to all-time record highs, while many emerging-market securities have fallen by more than one-third or in some cases by nearly half since January 2018. The U.S. dollar has become a widely-desired currency worldwide while the Swiss franc (which can be purchased via the fund FXF) and many emerging-market currencies are near multi-year lows. These irrational divergences have created some compelling investment opportunities.


Investors love energy assets even though the shares of the producers have steadily been lagging the commodities themselves since January 2018.


One of the least-logical developments of 2017 was the outflow from energy commodities and the shares of their producers until the final week of August, when 1-1/2-year lows were completed and investors finally began purchasing these again. Today, the situation is almost the exact opposite with investors eager to own this sector even though many funds of energy producers including FCG, OIH, and KOL have been steadily forming lower highs since January 2018. When any sector of commodity producers makes lower highs while the commodities themselves are forming higher highs, this is almost always a negative divergence which is followed by lower valuations for the entire sector. According to the Daily Sentiment Index, at the close on October 1, 2018 there were 96% of futures traders who were bullish toward crude oil. It is likely that with investors just as eager to own energy shares today as they were reluctant to participate last summer, they will be disappointed once again with subsequent underperformance.


As much as investors adore anything connected with energy, they are avoiding anything related to precious metals.


Many precious metals and the shares of their related funds slid to 2-1/2-year bottoms in recent weeks with GDXJ touching 25.91 on September 11, 2018. Commercials in gold and silver, which are those who trade gold and silver futures while actually holding the physical metal--mostly miners, jewelers, fabricators, and similar industry professionals--have actually gone simultaneously net long gold and silver for the only time in history. Usually commercials are net short because they want to partially or fully hedge their often-large inventories to protect themselves against losses in the event of a price decline for precious metals. If they not only aren't hedging, but are actually betting on a higher price, then that shows the highest degree of confidence in their history that they have nothing to fear on the downside. At the same time that commercials have been steadily buying, most investors were making all-time record outflows from GLD and related bullion funds. We also had intensified insider buying of gold mining and silver mining shares by top corporate insiders when GDXJ was below 30.


At almost their exact multi-year lows during the late summer, the Vanguard fund VGPMX sold off most of its gold mining and silver mining shares to purchase other kinds of securities; when a major financial player like Vanguard is surrendering then you know a major rally must be closely approaching. By an interesting coincidence, the last time Vanguard made such a radical change for this sector was almost at the exact bottom at the turn of the century after which the original fund holdings would have quintupled in value in less than 19 months.


If we have begun a bear market for U.S. equity indices then this could signal a powerful uptrend for this sector. Previous major surges higher occurred during late 1972 through early 1974 and during November 2000 through early June 2002 when HUI and other gold-share indices had soared.


Investors adore overpriced U.S. high-yield corporate bonds but are shunning undervalued government bonds of many countries including the U.S. and emerging markets.


When you hear investors' reasons for purchasing U.S. high-yield corporate bonds which have their lowest spreads ever to U.S. Treasuries of similar maturities, the reason usually given is that these investors are desperate for yield. Besides being desperate they must also be poorly informed, since many government bonds especially in emerging markets have higher yields than U.S. high-yield bonds--plus the historic default rates especially during recessions are substantially lower for foreign government bonds than for U.S. high-yield corporate bonds. There is currency risk in owning bonds which are not denominated in U.S. dollars, but this can also become currency gain when the U.S. dollar is dropping in value which it is likely to do versus most currencies from now through perhaps the summer or autumn of 2019. One reason that U.S. high-yield corporate bonds are so widely owned is that many employers offer them for their employees' retirement accounts, whereas buying foreign government bond funds requires self-directed effort. I give a list of several emerging-market government bond funds near the bottom of this update. Most investors don't appreciate that if default rates merely return to their average historic levels then it will lead to huge losses for U.S. high-yield corporate debt. In a recession the total pain could roughly approximate the collapse for U.S. high-yield corporate bonds during the second half of 2008 when many high-yield bonds and related funds lost roughly half their value.


Here is a recent useful link about non-U.S. bonds:


Almost everyone thinks that safe U.S. Treasury yields are going higher.


Perhaps because the U.S. Federal Reserve is committed to gradually raising the rate at which banks borrow money overnight from each other or from the Fed, they have concluded that all U.S. government interest rates will move higher. It is much more likely that, after climbing to their highest points since the early summer of 2014, long-dated U.S. Treasury yields for the 10- and 30-year bonds will move lower--and perhaps a lot lower over the next couple of years. As with gold and silver, evidence can be found in the traders' commitments where commercials have established their greatest-ever net long position in the 30-year U.S. Treasury bond since July 3, 2007--about 11-1/2 years ago. Such a rare lopsided reading is not likely to be merely a coincidence, and illustrates that those who are most closely connected with this asset are especially bullish toward long-dated U.S. Treasuries and expect their yields to retreat rather than rising further. The easiest way for investors to participate is by purchasing TLT--or else ZROZ which is roughly twice as volatile as TLT in both directions without using artificial leverage. ZROZ is a fund of long-dated U.S. Treasury zero-coupon bonds, while TLT consists of actual 30-year U.S. Treasuries which were purchased in recent years and are sold once they have 25 years remaining to maturity.


U.S. equities are highly popular, while emerging-market shares have mostly been slumping after achieving multi-year highs in January 2018.


Emerging-market shares enjoyed spectacular gains for two years after they had mostly slid to multi-year lows on January 20, 2016. Since then they have entered outright bear markets in many cases including China, India, South Africa, and several smaller countries including Egypt and Argentina where they have dropped by one-third or more. SCIF, a fund of 210 small companies in India, fell by almost exactly half from its January 2018 top to its recent intraday low. Many theories have been offered to explain "why" this odd divergence has become so glaring in 2018, but the primary explanation is that as emerging-market equities have continued to generally underperform while U.S. shares have been outperforming, most investors want to sell what "isn't working" in order to purchase what seems as though it is still going higher. It has nothing to do with logic or common sense or anything resembling rational trading decisions--just as most of the fluctuations for emerging markets in recent decades have had little or nothing to do with logical behavior. There are several ways to capitalize upon this situation by doing the opposite of the thundering herd and buying emerging-market stocks while selling U.S. equities. Some emerging-market bourses have already begun to rebound from important bottoms which in many cases have represented key higher lows when compared with their deeper nadirs from January 20, 2016. As with gold mining and silver mining shares or with government bonds, it often makes sense to purchase assets which are trading near one- or two-year lows while remaining above previous support levels.


Securities which are heavily represented in passive U.S. equity and high-yield bond funds are among the world's most overpriced assets.


It has become so popular for ordinary investors to take money out of bank accounts and other safe time deposits--often yielding above 2% in recent months--to put into fluctuating U.S. passive index funds that this Boglehead approach is often taken for granted as a sensible and even a safe strategy for the long run. Near a market top in anything it seems secure to be heavily invested, whereas that is always the most dangerous time to participate. Conversely, following a severe bear market when it is safest to make purchases, most investors are afraid to do so. Because so many investors blindly pile into their 401(k) equity fund choices or other passive index funds, the shares which comprise the most indices are the most frequently bought and many of these have become wildly overpriced. Meanwhile, assets which are more difficult to purchase and are less popular simply because they aren't represented in many of the most widely-bought funds tend to be almost forgotten and in some cases have become worthwhile bargains. This is partly a warning for the overall market because it means that most people couldn't care less whether their portfolio consists of worthwhile holdings or not; they want to participate at any price with blatant disregard for the serious risks which these investments entail. Already we have experienced two major bear markets for U.S. equities since 2000. With many of the most popular securities more overvalued than they have ever been in history in both absolute and relative terms, the likelihood of a decline of two-thirds or more will force investors to question their basic investment philosophy and to punish them for being part of a massively overcrowded trade. Many of those who have been buying near the 2018 peaks will end up making all-time record withdrawals near the next bear-market bottoming pattern. Such record outflows will assist us in knowing when to gradually buy when almost everyone else wants to sell.


A few other analysts have noticed recent rare disparities and have commented on them--here are two which make worthwhile reading.


Below are two links about how unusual today's disparities are and why it is worthwhile to capitalize upon them. The first one concludes in the final paragraph that a contrarian approach is ideal for such an environment:


The next article is more academic and was discovered outside of the mainstream financial media:


The bottom line: purchase gold/silver mining shares, government bonds, and the least popular emerging-market securities while selling the most overowned U.S. stocks and high-yield corporate bonds.


Most investors want to sell whatever has been underperforming since January 2018 in order to buy whatever has been outperforming. It is important to do the exact opposite in many cases, because we have all-time record disparities between assets that have powerful historic correlations with each other and will sooner or later return to their long-established interrelationships. No one wants to be among the first to make the switch, thereby causing many disparities to become more extreme than they have been in several years and in some cases in several decades. If we began a bear market for U.S. equities when the Russell 2000 topped out on August 31, 2018, which is becoming increasingly likely, then global asset reallocation is going to be a major theme of the next couple of years.


Disclosure of current holdings:


Because of an 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 perhaps around 2020. The election of Donald J. Trump as U.S. President led to a "yuge" surge in investors' expectations which following a 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 December 2017 and marijuana shares during 2018, the first with no intrinsic value and the second behaving as a classic late-cycle bubble, were characteristic of a generational peak such as we had previously experienced for tulips, canals, railroads, internet shares, and Beanie Babies. I purchased more GDXJ several times as it completed a classic head-and-shoulders bottom, with GDXJ falling to a 2-1/2-year nadir of 25.91. I also added repeatedly to TLT near its lowest points since July 2014--including this morning--while shorting IWM near its all-time highs in late August 2018. I have also purchased ELD repeatedly after having sold all of it in January 2018. In addition to ELD, other funds of emerging-market government bonds including PCY, LEMB, and SOVB are also worthwhile; select those which are commission-free with your broker.


From my largest to my smallest position, I currently am long GDXJ (some new), the TIAA-CREF Traditional Annuity Fund, TLT (many new), SIL (some new), GDX (some new), ELD (some new), HDGE, URA, I-Bonds, bank CDs (some new), money-market funds (some new), GOEX, VGPMX, BGEIX, RGLD, WPM, SAND, and SILJ. I have short positions in IWM, 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 maybe in 2020. 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 an increasing number of former leading sectors which have been forming lower highs for several months. After reaching its all-time zenith on August 31, 2018, the Russell 2000 Index and related funds including IWM have generally underperformed their larger-cap counterparts which also ushered in the major bear markets of 1929-1932, 1973-1974, and 2007-2009. Meanwhile, the Nasdaq climbed to an all-time peak in nominal terms on August 30, 2018--although the Nasdaq never surpassed its March 10, 2000 intraday zenith in inflation-adjusted terms and perhaps never will. 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 their lowest levels since the 2007 topping pattern. 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. VIX has been forming higher lows since the start of 2018. 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 recent zenith would put the S&P 500 near 980 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; the incredibly long bull market has left them completely unprepared for 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 net sellers of passive equity funds. Because so much money exists today in exchange-traded and open-end funds, as they decline in value they will be forced to destroy shares which will compel them to sell their components, thus depressing prices further and creating more share destruction in a dangerous domino effect.

Monday, August 6, 2018

“1.00 invested in those firms with the most negative ETF flow in January 2006 grows to 3.48 at the end of December 2017, compared to 1.40 for those firms with the highest ETF flow.” --Deutsche Bank



ALL IS DIVIDED INTO THREE PARTS (August 6, 2018): As is often the case in the early stages of a U.S. equity bear market, several typical characteristics can be observed. Hardly anyone thinks we are in a U.S. equity bear market and that is par for the course. As a result of an unusually lengthy bull market for U.S. equities, unsustainable distortions have been created which almost everyone thinks is permanent even though current valuations are highly unstable and unsustainable. Recognizing what should be bought and sold today is an important step in being one of the few investors to make money during the next several years.


If it's a real bear market then almost no one believes that it exists even after a year or more since it began.


Almost no one believed that we were in a U.S. equity bear market in March 1930, January 1974, January 2002, or August 2008. Hardly anyone today thinks that we are in a bear market and perhaps this will continue to be the case as late as the second or third quarter of 2019. Only when it becomes far too late to sell U.S. equities and high-yield corporate bonds at favorable prices will most investors realize what they should have done. The first step is to observe characteristic signs which have heralded past bear markets for U.S. equities. History almost always repeats itself with minor variations.


Assets which haven't experienced bear markets since early 2009 are especially overpriced and are vulnerable to huge declines.


One set of assets today is ridiculously overvalued; these consist primarily of the most popular sectors which have been in bull markets mostly since the end of 2008 or the beginning of 2009. Passive index funds of U.S. equities and U.S. corporate bonds tend to be especially overpriced since investors have gotten into the habit of purchasing them almost without thinking about their valuations or future prospects. Once formed, habits are difficult to change. Since we have had such mild pullbacks for most U.S. equity and corporate-bond sectors since late 2008 or early 2009, investors have almost no concern about the possibility of a dramatic decline or with how much more they are paying in 2018 than they had done several years ago for the same assets. The bear markets of 2007-2009 and 2000-2002 seem emotionally distant and irrelevant to the current situation, making a repeat performance especially likely.


If a frog is slowly boiled then it won't recognize that the temperature is far too high to be safe; if stocks climb steadily and persistently then investors similarly lose their concern about possible losses and will get boiled alive. Most investors barely bother to examine their portfolios except perhaps to check their total balances to make sure that they are still going up. If you still own wildly overpriced securities, it is essential to gradually sell them especially when they have enjoyed extended gains.


U.S. real estate is roughly as dangerously overvalued as it had been at the 2005-2006 bubble peak, except there is a different and more perilous geographic distribution.


Even at the highest points in 2005-2006, there were no U.S. neighborhoods where the average housing price divided by the average household income exceeded 8. Today there are many neighborhoods where these ratios have surpassed 10 and some where they have moved above 11 as compared with historic averages of 3:1 which even Julius Caesar would recognize since this ratio hasn't changed through the millennia. The most glaring overvaluations tend to be concentrated in the most popular cities for real estate as an investment rather than as merely a place to live. In 2010-2012 there were numerous regions of Arizona, Nevada, Florida, and elsewhere with ratios of housing prices to average household incomes of 1.5 or below; today there are almost no such bargains below 3. Because prices have mostly been increasing for about seven years, people have become accustomed to them and don't stop to think how absurd they are relative to logic or fundamentals. During the bear market from October 2006 through October 2011 the average U.S. house lost 34% of its value; the total pullback from now through 2022 or 2023 is likely to be greater in many cities since valuations especially along the West Coast of the U.S. are mostly higher than they were at their 2006 peaks. In cities such as Seattle, San Francisco, and Los Angeles, prices are higher today than they had been at their 2006 tops even after you adjust for inflation.


Precious metals mining shares are an especially undervalued sector.


During any topping process, investors won't sell because they are convinced that they will come out ahead "in the long run" by being nearly fully invested. Assets which are out of favor often become even more unpopular as investors want to crowd into whatever has been outperforming. As a result, gold mining and silver mining shares have moved mostly flat after having roughly tripled from January 20, 2016 through the summer of 2016 and then surrendering roughly half of those gains before the end of 2016. Hedge funds have never been more net short gold, while commercials (miners, fabricators, jewelers, and others who use physical gold in their lines of business) in the most recent traders' commitments were net short fewer than 48 thousand contracts which is more extreme than the 99th percentile of historic readings. From their lows of January 20, 2016, funds like GDXJ have gained far more than gold bullion, while from their intraday lows of February 9, 2018 funds like GDXJ have moved higher while gold bullion has dropped over one hundred U.S. dollars per troy ounce. This bodes well for the upcoming year, especially since commercials in nearly all non-U.S. dollar currencies are heavily betting on a falling greenback from now into 2019.


Besides GDXJ, worthwhile alternatives in this sector include SIL, SILJ, GDX, SGDJ, and SGDM. Vanguard is significantly reorganizing its VGPMX fund to drastically reduce its exposure to gold mining and silver mining companies after having maintained its investment consistency for decades; such rare events tend to occur just before major rallies.


Long-dated U.S. Treasuries are also notably undervalued.


You might think that an asset like the 30-year U.S. Treasury which has gained more than every other sector worldwide since September 1981 and which has thus been in a bull market for nearly 37 years would be very popular with investors. You would be wrong, since for whatever reason everyone seems to think that U.S. Treasuries are in bear markets. TLT dropped to 116.09 on May 17, 2018 and may have completed its latest higher low at 118.07 on August 1, 2018. Especially whenever investors are finally selling their overpriced assets, investors won't have many places to go. U.S. Treasuries are highly liquid and will end up absorbing much of the asset reallocation which is exiting previously-popular assets.


Emerging-market government bonds could yield even higher total gains than U.S. government bonds.


While TLT and other funds of long-dated U.S. Treasuries are worth buying at current levels, a strong argument can be made for purchasing government bonds of emerging-market countries. There have been geopolitically-inspired selloffs of numerous emerging-market currencies since January 2018. Most of these declines are temporary because geopolitical events, no matter how exciting, rarely affect corporate profits or other economic fundamentals. Countries which have experienced the greatest percentage losses for their currencies are in the favorable situation of having lower U.S.-dollar wages for their employees in those countries, while continuing to sell their goods and services at the same U.S.-dollar prices. This will lead to expanding profit margins which will translate eventually into significant gains for those countries' stock markets. While emerging-market stocks will often drop during downtrends for U.S. equities, emerging-market government bonds tend to perform best under the same circumstances. Funds of emerging-market government bonds including ELD have fallen from important highs in January 2018 to retest their lowest points since the early months of 2016. Many investors are unfamiliar with this asset class. This gives an ideal opportunity to accumulate bargains, diversifying among emerging-market countries which have experienced the greatest percentage declines due to spectacular headlines but little actual change in their economies.


Some assets fit into a third category where they are neither low enough to buy nor high enough to sell.


Emerging-market equities are generally much cheaper than U.S. equities, but especially after having moderately rebounded in recent weeks I am mostly avoiding them for now. I wouldn't sell them but I wouldn't buy them either. The same is true for most energy shares and their funds including FCG, OIH, and KOL which had been especially unpopular in the summer of 2017 but rebounded strongly from August 2017 through January 2018 and have remained trendy throughout 2018. Unlike gold mining and silver mining where the shares of the producers have been far outperforming bullion prices for most of 2018, crude oil and related commodities have frequently set multi-year highs during 2018 while the shares of energy producers have mostly made lower highs since January 2018. This is a negative divergence which is pointing the way lower for both energy commodities and the shares of their producers. I am also mostly avoiding mining companies which are not connected with gold or silver; these and their funds including REMX, COPX, and XME had soared to multi-year highs in January 2018 but like energy shares have mostly been forming lower highs since then. Uranium shares and their funds including URA have remained strongly out of favor in recent years and might be worth holding for another year.


Since U.S. midterm elections are scheduled for November 6, 2018, the U.S. financial markets are likely to become more volatile out of concern about the results.


It is usually the case that midterm U.S. elections create uncertainty and therefore often lead to a stock-market pullback in the months leading up to the election--until the final weeks when investors become more excited about the upcoming end to uncertainty and push prices higher. That is one reason why the stock market often drops to October lows during midterm years as we had previously experienced in years including 2002, 1998, and 1990; the 1994 and 1982 bottoms were in August rather than October. Hardly anyone has been discussing this topic, thereby making it increasingly likely that it will become an important factor. This could be especially true in 2018 since both the Senate and the House of Representatives following the November 6, 2018 elections could end up with either Democratic or Republican majorities (assuming that the two Senate independents continue to caucus with the Democrats) while the margins of victory could be quite narrow. VIX has been frequently dropping below 12 which is likely also signaling upcoming U.S. equity weakness, along with a diminishing number of new 52-week highs and frequent intraday strength near the opening bell. The least-experienced investors tend to place market orders outside of regular trading hours which crowd together at the open and thereby trigger stops, often causing the highest prices to occur shortly afterward. This is common behavior during a topping pattern.


A correction for U.S. equity indices could significantly alter the behavior of all three asset classes.


I believe that we will experience double-digit corrections possibly exceeding 20% for U.S. equity indices and high-yield U.S. corporate bonds as they retreat toward important intermediate-term bottoms during the second half of 2018. This will probably be followed by a multi-month rebound to lower highs by the first or second quarter of 2019.


Deeply-undervalued assets, including gold/silver mining shares, long-dated U.S. Treasuries, and emerging-market government bonds, could rally moderately during the next few months as U.S. equities are mostly declining. If government bonds from any country become unusually popular then they might even be worth selling later in 2018; otherwise, most assets in this category could end up outperforming sufficiently to gain investors' attention and encourage new net inflows. If these inflows become substantial and are combined with heavy insider selling during 2019 then it might be necessary to sell some or all of these assets next year.


Assets in the in-between sectors, including energy and emerging-market shares, will mostly decline along with U.S. equities during the next few months and could thereby present some compelling buying opportunities later in 2018 in anticipation of a rebound into the first half of 2019.


The bottom line: Since nearly everyone wants to be fully invested in the most popular sectors, remain heavily in cash and only purchase the least-popular securities.


Whenever the herd is closest to being unanimous it is most dangerous to run with them. While most investors are eager to hold popular Nasdaq shares, stick with gold mining and silver mining shares along with long-term government bonds of both the U.S. and emerging markets. If you have real estate which you can sell then do so since housing prices are likely to be substantially lower by 2022-2023 especially where the ratios of housing prices to average household incomes are currently highest.


Disclosure of current holdings:


Because of an 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 perhaps around the middle of 2020. The election of Donald J. Trump as U.S. President led to a "yuge" surge in investors' expectations which following a 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 December 2017, 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. I purchased more GDXJ below 32 several times and also added to TLT below 119 while shorting IWM at and modestly below 170. After having sold ELD near 40 in January 2018 I have been buying it below 35. Other funds of emerging-market government bonds including PCY and SOVB are also worthwhile; select those which are commission-free with your broker.


From my largest to my smallest position, I currently am long GDXJ (some new), the TIAA-CREF Traditional Annuity Fund, SIL, HDGE (some new), GDX, TLT (some new), ELD (some new), URA, I-Bonds, bank CDs (some new), money-market funds, GOEX, VGPMX, BGEIX, RGLD, WPM, SAND, and SILJ. I have short positions in IWM (some new), XLI, AMZN (some new), 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 probably during 2020. 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 S&P 500, the Dow Jones Industrial Average, and several other large-cap U.S. equity indices haven't surpassed their all-time tops of January 26, 2018 even though they have come close. The Russell 2000 has retested nearly matching intraday highs during the past several weeks, while the Nasdaq climbed to an all-time peak in nominal terms on July 25, 2018--although the Nasdaq never surpassed its March 10, 2000 intraday zenith in inflation-adjusted terms and perhaps never will. 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. VIX has been forming higher lows since the start of 2018. 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; the incredibly long bull market has left them completely unprepared for 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 net sellers of passive equity funds.