THE FIRST AND THIRD SHALL BE FIRST, WHILE THE SECOND SHALL BE LAST (August 1, 2016): There is a fascinating pattern to the trading during the first seven months of 2016. The strongest sectors by far have exclusively been silver and gold mining shares, in that order, followed primarily by other commodity producers and mining-related emerging-market equities. The second-biggest percentage winners have mostly been high-dividend, low-volatility assets including consumer staples, utilities, REITs, tobacco shares, telecommunications companies, and long-dated U.S. Treasuries. The third-best performers of 2016 have been mostly energy companies and a variety of emerging-market stocks and bonds.
This is puzzling is because the first and third groups are inflation-loving assets, whereas the second group performs well when deflation reigns. How can the financial markets be both inflationary and deflationary?
The deflation trade is nearly over, but it has remained in a bull market due to huge inflows from investors desperate for yield.
High-dividend and low-volatility assets including FXG and XLP (consumer staples), IYR and RWR (REITs), XLU, IDU, FXU, and VPU (utilities), along with TLT and ZROZ (long-dated U.S. Treasuries) have been among the second-best performers of 2016. They have also been among the top winners of the past five years. Many of those who have retired or who need to pay their monthly expenses have become overly dependent upon income-producing investments to generate yield. That's fine as long as high-dividend assets are either bargains or reasonably priced, but it creates a dangerous situation when they are trading at all-time highs even compared with previous historic peaks. There have been all-time record inflows into high-dividend and low-volatility funds which have far outpaced their previous records. A person who has retired with a half million or a million dollars might perceive that he or she "needs income" in order to maintain a basic lifestyle, and most of these investors don't realize that if everyone goes to their financial advisors and wants the same level of "safe" income then they are all going to end up owning the exact same assets. What would be reasonable for a tiny minority of investors has become an inevitable catastrophe since millions of others are acting similarly without realizing the consequences of collectively being in such an overcrowded trade.
The inflation trade has only been in a bull market since January 20, 2016, and has a long way to go to recover its losses since April 2011.
Unlike most high-dividend assets which had bottomed in the first quarter of 2009, most commodity producers and emerging markets had been in severe downtrends from April 2011 through January 20, 2016, and even after their subsequent strong rebounds remain far below their previous peaks. Earlier this year, many of these assets completed multi-decade nadirs, with some of them touching levels not seen since the 1970s. Therefore, they remain substantially below fair value. Silver and gold mining shares including GDXJ, SIL, GLDX, SILJ, and GDX have tripled on average in just over a half year, and have thereby outpaced nearly all energy producers which had initially rallied but have gone out of favor along with most emerging-market equities during the past several weeks. This has created the best bargains for those assets which are in the process of completing important higher lows including URA (uranium), GXG (Colombia), FCG (natural gas), and FENY, a more diversified and less volatile fund of energy producers.
The Daily Sentiment Index for crude oil, indicating the percentage of traders who are bullish toward any asset, plummeted to 10% at the close on Monday, August 1, 2016. This is an incredibly low level for anything which is in a primary bull market, as energy commodities have been since February 11, 2016. The shares of energy producers mostly approached or reached multi-decade bottoms on January 20, 2016. Whenever it is possible to buy at higher lows during a major uptrend, this is ideal because a sequence of several higher lows is often followed by an accelerated rally.
The high-dividend and low-volatility bull markets are very stale and incredibly popular, while few know about the uptrends for commodity producers or emerging markets.
Almost everyone knows that high-dividend shares have been the biggest winners of the past several years and are still eager to jump aboard the bandwagon, while few realize how overcrowded this bandwagon has become. Historically, the most wildly trendy and popular trades have always proven to be disappointing. Although it is rarely compared with the internet bubble of 1999-2000, the Nifty Fifty overvaluation of 1972-1973, or the blue-chip top of 1929, high-dividend and low-volatility names have become the bubble of the decade. The total assets in USMV, a frequently-touted low-volatility fund, have tripled in one year. Just as in 2000, almost no one who has invested in these securities realizes that they can lose half or more of their money. Almost no analysts, even those who know how overvalued these popular securities have become, can emotionally imagine them plummeting. They might know intellectually that it is possible, but they can't really imagine it happening any more than anyone at the beginning of the century could envision the Nasdaq plunging by more than 75% within three years. Alas, a similar fate awaits those who are participating in high-dividend and low-volatility shares and funds.
Just because you're in the water to get exercise doesn't mean you can ignore the great white sharks.
When I point out the dangerous of owning high-dividend and low-volatility shares, I often hear the refrain that "I'm not in these due to their extreme popularity" or "I only own these to generate the income I need to pay my expenses." The market won't treat you differently just because your motivations are allegedly pure. You might be the nicest person on your block, you might generously donate to charities, and you might frequently help old ladies to cross busy streets. Even if you're swimming in the water just to get your daily exercise, you're not magically exempt from being eaten by hungry great white sharks that are lurking nearby. If any given trade has become desperately overcrowded, then no matter why you're involved in it, you're going to be as badly hurt as the ignorant buyer who is doing it to keep up with his poorly-informed friends. As Warren Buffett has stated, when we strip off the clothing and pretense, we're all fully exposed underneath. When the U.S. housing bubble collapsed in 2006-2011, as it about to do again in 2016-2021, it won't spare those who are nice to animals or who do good deeds. I will discuss real estate in more detail in the near future.
Disclosure of current holdings:
Whenever they have appeared to be irrationally depressed, I have been buying the shares of funds which invest either in emerging-market assets or in the shares of commodity producers, since I believe these are among the two most undervalued sectors in a world where real estate and U.S. equity indices remain wildly overvalued. As the greenback surprises most investors by accelerating its bear market, with the U.S. dollar index moving below 80 instead of climbing back above 100 as almost everyone is still expecting, this will lead to a major upward revision in global inflationary expectations. The latest pullback for energy-related assets has created some compelling buying opportunities, so be sure to seize them before they disappear. I was a very heavy buyer on June 27, 2016 when I made my largest total purchases since October 4, 2011 to capitalize upon the ridiculous post-Brexit panic. From my largest to my smallest position, I currently own GDXJ, SIL, KOL, GDX, XME, COPX (some new post-Brexit), EWZ, RSX (some new post-Brexit), GLDX, REMX, URA (many new), VGPMX, HDGE (very new), ELD, GXG (many new), IDX, NGE (many new), BGEIX, ECH, FCG, SEA (some new post-Brexit), VNM, NORW (many new), DXJ (all new post-Brexit), BCS (all new post-Brexit), PGAL (mostly new post-Brexit), GREK (mostly new post-Brexit), EPOL (all new post-Brexit), EWW (all new post-Brexit), RBS (all new post-Brexit), TUR (mostly new post-coup), RSXJ, RGLD, SLW, SAND, SILJ, EPU, FTAG (previously PLTM), SOIL, EPHE, and THD. I have very recently increased my moderate short positions in FXG, IYR, and XLU, in that order, largest to smallest.
I expect the S&P 500 to eventually lose roughly two thirds of its May 20, 2015 peak valuation of 2134.72, with its next bear-market bottom perhaps occurring near the end of 2018. As with all bear markets, the biggest losses will likely occur in its final months, and won't even be acknowledged as a bear market until then. While the media have been quick to trumpet new all-time highs for the Dow Jones Industrial Average and the S&P 500 Index, hardly anyone has pointed out that the Russell 2000 Index and its funds including IWM had handily outperformed the S&P 500 from March 2009 through March 2014, and have subsequently dramatically underperformed, trading at their lowest levels during January 2016 in 2-1/2 years. The top for the Russell 2000 had occurred in June 2015 and is not likely to be surpassed in this cycle. Small-cap U.S. equities typically lead the entire U.S. equity market lower whenever we are transitioning from a major bull market to a severe bear market. This has happened in past decades 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. The most overvalued sectors rely on the overhyped deflation trade and money which has been withdrawn from safe bank accounts by investors who begin with the premise that they want to generate income of 3%-4% and look for the most stable securities which can generate such yields. This popular and extraordinarily dangerous method of investing has created valuations at roughly double fair value for most consumer staples (FXG, XLP), real estate investment trusts (IYR, RWR), and utilities (XLU), all of which will likely slump by half or more within three years or less.
