PERCEPTION AND REALITY CAN BE ENTIRELY DIFFERENT (August 4, 2015): Many investors believe that the financial markets are driven by fundamentals, but in reality it is perception which is far more important. For example, if we compare April 2011 with August 2015, we can see that in April 2011 many commodity-related and emerging-market assets were extremely popular while U.S. equity indices were much less trendy. Thus, even though there wasn't much difference between profit growth in Brazil versus the United States, Brazilian equities were highly priced while U.S. shares were mostly undervalued. Today, it is the opposite, where valuations for Brazilian and most other emerging-market securities and currencies are especially cheap while nearly all assets in the United States are significantly overpriced. What happens is that investors don't actually seek out whatever is most compelling according to any logical system. Instead, they want to own whatever has recently been making money for their friends, and to sell whatever has been suffering the most extended downtrends. Such herd behavior thereby causes irrational extremes to be repeatedly created, until eventually there is an inevitable mean reversion which causes those who were following the herd to once again lose money.An especially sharp contrast between the real world and popular perception can be clearly observed in the gold market. Most people today will repeat what they usually hear in the mainstream financial media which is based upon a combination of myths and half-truths. Even the most ridiculous theories will be taken seriously if they appear to coincide with recent market behavior. Many people believe that a slowdown in China's economy has somehow caused commodities and the shares of their producers to lose significant percentages of their April 2011 high-water marks. In reality, China has been around for thousands of years, and its period of fastest growth was mostly the 1980s and 1990s when commodities generally plummeted around the world. So there is no true correlation between China's economy and commodity prices. Meanwhile, Chinese residents have surpassed India as the world's largest per-capita buyers of physical gold, so actually China has been supporting the gold price rather than causing it to drop. However, the simplistic "China is slowing so commodities are falling" myth involves a story which is easy to remember and to repeat to others, instead of the much more complex reality which takes many times longer to understand and requires studying a far greater quantity of financial data. Most people prefer an easy answer even if it is horribly inaccurate.
Let's look at some of the quantifiable facts to see the actual state of the market, rather than its perceived state. For each futures contract, there are people known as commercials who are directly connected with the industry. With gold, for example, commercials include jewelers, fabricators, miners, and others who take physical possession of the metal in one way or another. Generally, commercials sell short gold in order to hedge their inventory; for example, a gold jeweler will sell short roughly the amount of their gold holdings so that, regardless of whether the price rises or falls, they don't experience either a net gain or a net loss. That way, they make a living from buying a little below the real price and selling a little higher, while not worrying about whether the gold price will rise or fall. However, from time to time, commercials don't bother to hedge because they aren't concerned about the possibility of a significant price decline. As of the most recent data which is released each Friday at 3:30 p.m. Eastern Time, gold commercials were net short 15,266 contracts. This was their smallest net short position since December 2001, more than 13-1/2 years ago, when gold was trading near 277 U.S. dollars per troy ounce.
Thus, while analysts and brokerages almost unanimously expect gold to drop to one thousand dollars or lower, commercials who are the most knowledgeable about the gold market--and who have the most to lose if they are wrong--are betting the opposite way. Historically, whenever such an extreme disparity exists, the commercials almost always end up being correct. It's not just gold which sports such unusual numbers; for the Mexican peso which correlates closely with many other emerging-market currencies, the current commercial net long position of 94,252 contracts is an all-time record. With the Canadian and Australian dollars which also have a strong positive correlation with commodity prices, commercials are net long 81,035 loonie contracts and 81,970 aussie contracts. These are not all-time records but they are far above their historic averages and have increased dramatically in recent weeks.
Because investors are bearish toward commodities, they have been making all-time record outflows from many commodity-related assets. The exchange-traded fund GLD of gold bullion has experienced the biggest-ever total outflow of any exchange-traded fund in history. For a brief period in 2011, its total market capitalization exceeded that of SPY to become the most popular ETF by market capitalization. In July 2015 alone, the net outflow from GLD was 38.74 tonnes to end July at 672.7 tonnes which marked its lowest level since March 2008. At the same time, lower prices have encouraged real buying of physical gold; according to the U.S. Mint, July 2015 coin sales increased by 469% (not a misprint) from July 2014. In other words, they were more than five times as great, representing 202,000 troy ounces of gold last month as compared with 35,500 ounces in July 2014. The total for the first seven months of 2015 was 38% higher than during the first seven months of 2014.
As unpopular as gold and other commodities have been in recent weeks, the shares of their producers have been even more undervalued. XAU is an index of gold mining shares which has existed since December 19, 1983. This afternoon (August 4, 2015), XAU slumped to 45.14 where it hasn't traded since November 27, 2000--when gold was averaging about 266 U.S. dollars per troy ounce. This index has thus surrendered nearly all of its gains of the 21st century, with some of its components including Barrick Gold (ABX) trading at their lowest levels since the 1990s or earlier. While there are many attempts to explain this depressed state for gold and silver mining shares using fundamental arguments, it is almost entirely due to herding behavior. Practically no one wants to own gold mining shares regardless of how worthwhile it might be to do so, because almost no one else whom they know or respect seems to be eager to act in a similar manner. Of course this cuts both ways: as soon as various groups of investors beginning with deep value allocators begin to buy them and thereby push their prices higher, one group of investors after another will become increasingly eager to own them and will eventually create a buying cascade. Because they plunged so much in percentage terms on the way down, they could experience dramatic percentage gains merely to revisit their levels from recent years.
The financial markets always represent the intersection of perception with reality. If investors believe that everyone else wants to own the Nasdaq but no one wants to own gold or gold mining shares, then they will sell gold and will buy the Nasdaq. Eventually, however, if the price of gold becomes absurdly low, then people can buy a lot of it to use as a store of wealth, for jewelry, for speculative investment, or for many other purposes. If the price of the Nasdaq is unreasonably high, then some companies will issue new shares to take advantage of the overpricing, while insiders will aggressively unload their own overpriced holdings. Whenever the shares of mining companies and energy producers become unreasonably cheap, then insiders will accumulate them as they have been doing. Eventually, one way or another, this will cause the most illogically underpriced and overpriced securities alike to periodically revert to fair value and usually far beyond to an equally irrational extreme in the opposite direction. Even assets which seem as though they will never become fairly valued, such as San Francisco or Vancouver real estate today, will eventually surprise almost everyone by experiencing mean reversion. It has been the nature of the financial markets to behave in this manner for millennia. No amount of technological innovation, Fed activity, or anything else can alter this basic inherent reality.
Tax tip: If you own shares or funds which are trading near multi-year bottoms and you are a U.S. resident, you can take advantage of their currently depressed prices if these assets are in your 401(k), 403(b), SEP-IRA, Keogh, traditional IRA, or other non-Roth retirement account. You can convert these shares from your account to a Roth IRA and pay taxes based upon their present low valuations. As these eventually rebound, all future gains will be completely tax free. In the event that these shares don't recover but end up retreating further in price, you can choose to undo your conversion, which is known as a recharacterization. You can then wait at least 30 days, or until the following calendar year--whichever is later--and then convert them again. There is no limit to how many times you can repeat this process and there are no income or other restrictions in making such conversions and recharacterizations, as long as each recharacterization is done on or before October 15 of the year following the date when the conversion had been done. It's like being able to go back in time and "unbuy" something which doesn't go up in price. It's heads you win, and tails you also win. Unfortunately, I do not know of an equivalent strategy which is permitted in any other country besides the United States.
Disclosure: In August-September 2013, and at various points during 2014-2015, I have been buying the shares of emerging-market country funds whenever they have appeared to be most undervalued. Since June 2013, I have added periodically to funds of mining shares--and more recently energy shares--especially following their most extended pullbacks. I have also been accumulating HDGE whenever U.S. equity indices are near their peaks; HDGE is an actively-managed fund that sells short U.S. equities. I believe that U.S. assets of almost all kinds have become dangerously overvalued. From my largest to my smallest position, I currently own GDXJ, KOL, XME, COPX, SIL, HDGE, GDX, REMX, EWZ, RSX, GLDX, URA, IDX, GXG, VGPMX, ECH, FCG, VNM, BGEIX, NGE, PLTM, EPU, TUR, SILJ, SOIL, EPHE, and THD. In the late spring of 2014, I sold all of my SCIF which had briefly become my fourth-largest holding, because euphoria over the Indian election was irrationally overdone and this fund had more than doubled. I have reduced my total cash position since June 2013 to roughly 3% of my total liquid net worth in order to increase my holdings in the above assets. I sold all of my SLX by acting whenever steel insiders were doing likewise. I also sold all of my FCG but I have been repurchasing it following its recent collapse because there has been intense buying by top corporate insiders of companies which produce natural gas. I expect the S&P 500 to eventually lose about two thirds of its recent peak value, with its next bear-market bottom occurring within several months of October 2017. The Russell 2000 Index and its funds including IWM have only modestly surpassed their highs from the first week of March 2014, while the Russell Microcap Index (IWC) marginally surpassed its zenith from March 6, 2014. The S&P 500 Index set a new all-time high on numerous occasions during the same period, and may have completed its final top for the cycle at 2134.72 on May 20, 2015. This marks a classic negative divergence which previously occurred in years including 1928-1929, 1972-1973, and 2007. Those who have "forgotten" or never learned the lessons of previous bear markets are doomed to repeat their mistakes.
