Wednesday, December 21, 2016

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

DOLLAR SHMOLLAR (December 21, 2016): Whenever anything is repeated frequently enough, most people will end up believing it even if it is a preposterous concept. In early 2009, investors were bombarded with "experts" telling them why the U.S. economy and stock market would remain depressed for many more years because we had never experienced a subprime mortgage collapse before. Instead, we enjoyed one of the most powerful short-term rebounds in history and subsequent huge gains for U.S. equity indices. In 2011, analysts kept insisting that inflation would keep rising, commodities would soar, and emerging-market shares would remain the biggest percentage winners; all of those were the opposite of what actually happened between April 2011 and January 20, 2016. Recently, it's all about how the U.S. dollar is allegedly going to keep setting historic peaks and gaining against nearly all other world currencies. However, this is just as misguided as the other examples. The U.S. dollar has likely already begun a vital bear market.

Tiny gains are trumpeted as allegedly being huge historic events.

If you scan media headlines about the U.S. dollar, they emphasize how the U.S. dollar index has reached a new 14-year high, how the greenback hasn't been so elevated against most global currencies since December 2002, and why these increases will continue for many more years. While the first two statements are both technically true, they are misleading, while the inevitable conclusion of a perpetually-rising U.S. dollar is the opposite of what is going to happen during the next two or three years. First, let's look at the claim that the U.S. dollar is at a 14-year high. Against most currencies, this is correct; however, the total increase during the past couple of years has been tiny. On March 13, 2015, the U.S. dollar index achieved a peak of 100.39 which was slightly surpassed near the end of last year when it reached 100.51 on December 2, 2015. The recent top for the U.S. dollar index was 103.65 at 7:40 a.m. on Tuesday, December 20, 2016. If you do the math you can see that this is an increase of less than 3.25% over a period of more than 21 months, or about the same total gain as a U.S. Treasury note. If you look at currencies of commodity-producing countries including Australia, Canada, Brazil, and Russia, then they have not fallen to multi-decade lows but have been forming several higher lows from their bottoms which had mostly occurred in January 2016. Recent currency losses have mostly been confined to developed-market currencies such as the Japanese yen, the Swiss franc, the euro, and the British pound. As a result, the last four have all become incredibly disliked by investors while just about all speculators have been crowding into the U.S. dollar.

Thus, while frequent media stories about "new 14-year highs for the U.S. dollar" are technically accurate, they create the illusion among most investors that these have gained 30%-40% in recent years rather than just 3%-4%, while a modest pullback would wipe out all of the gains since March 2015.

Quantitative evidence supports the concept of a wildly overvalued U.S. dollar.

On Thursday, December 15, 2016, 96% of professional futures traders surveyed by Daily Sentiment Index, which has been conducting such surveys for decades, were bullish toward the U.S. dollar index. On the same day, only 4% of such traders were bullish on gold and only 6% were bullish on silver. There were 7% bulls toward the Japanese yen and the euro and only 9% who were bullish on the Swiss franc. Interestingly, there were only 9% bulls on U.S. Treasury bonds (10-30 years to maturity) and 8% bulls on U.S. Treasury notes (2-10 years to maturity), indicating that oversold and widely-detested bonds are likely to rebound during the next several months along with a retreat for the U.S. dollar. Even non-financial web sites have been hyping the strength in the greenback, assuming that it will continue indefinitely. Travel channels on cable TV are telling you why U.S. residents should go overseas during the next few years to capitalize upon the strong U.S. dollar, while programs about cooking and leisure will frequently make comments such as "due to a continued climb for the U.S. dollar, such-and-such will likely become even more affordable." When non-financial commentators start taking a rising U.S. dollar for granted, you know that its rally has become very mature and is likely set for a major reversal of fortune.

If the U.S. dollar is really going to plummet instead of surging, then your investment allocations will have to be entirely different.

Weakness for the greenback will mean that recent all-time record inflows into U.S. industrial-related and other highly popular equities are likely to be badly misguided. A drop for the greenback will likely also help to ease pressure on interest rates, thereby causing yields to decline and prices to rebound for most bonds including U.S. Treasuries, emerging-market government bonds, and corporate bonds of companies which will be helped by a weaker greenback. Instead of betting on a stronger U.S. dollar and higher U.S. interest rates, investors should be doing the opposite.

Gold mining and silver mining shares have been among the biggest winners of all sectors in 2016, and will likely achieve even greater percentage gains in 2017.

Gold mining and silver mining shares in particular have been hard hit by expectations of continued gains for the U.S. dollar. After having collapsed by 80%-90% from their April 2011 tops to their multi-decade bottoms of January 20, 2016, gold mining and silver mining shares and their funds including GDXJ and SIL generally more than tripled by August 11 or 12 before thereafter suffering significant downside corrections. While they remain far above their January nadirs, they once again represent compelling values and are likely to more than triple again during the next year or so. In addition to GDXJ and SIL, funds in this sector include the relatively speculative SILJ, SLVP, SGDJ, and GOEX, along with somewhat less volatile large-cap alternatives including GDX, RING, SGDM, and PSAU. Even if a fund like GDXJ tripled in value from its current price, it would still be only about half its historic top from April 2011.

Emerging-market bond funds are strongly out of favor, pay high yields, are not nearly as volatile as equity funds, and have been making higher lows since January 20, 2016.

Emerging-market bond funds including ELD, LEMB, PCY, and EMLC are barely known by most investors. At least with funds like GDXJ and GDX there are huge daily volumes even if most investors swing emotionally from loving to hating them based upon their recent performance. With emerging-market bond funds, hardly anyone knows of their existence. Their yields are usually in the 6%-7% range on average, while prices have been forming several higher lows since January 20, 2016 as is characteristic of a meaningful bull market. Each of the above funds has the additional advantage of being commission-free with one or more major U.S. brokers. The strong U.S. dollar has discouraged investors from participating in emerging-market securities of all kinds, even though a weak Brazilian real means lower wages in U.S. dollar terms for Brazilian workers and thus higher profit margins--thereby explaining why Brazilian equities have been among the biggest winners of all exchange-traded funds (not just emerging markets) in 2016 with Russian equities similarly enjoying outsized gains. As a group, emerging-market equities are roughly 30% underpriced relative to U.S. equities, thereby providing an additional motive for value investors to accumulate them into weakness. As investors progressively move out of overpriced U.S. equities into emerging-market stocks and bonds, emerging-market government bonds are an excellent and less volatile way of participating in this transition.

Several emerging-market equity funds are once again worthwhile for purchase at higher lows.

For those who are willing to accept greater risks, many emerging-market equity bourses have become compelling bargains. Most prices are above their multi-decade bottoms of January 20, 2016, but EWW (Mexico) has become especially cheap due to overblown fears about Trump's frequent negative public comments about that country. A depreciated Mexican peso means that Mexican companies are paying wages in much lower U.S. dollars, thereby leading to wider profit margins which will soon be evident in rising corporate earnings. TUR (Turkey) with numerous political scandals and VNM (Vietnam) primarily out of unpopularity have also become worthwhile bargains for purchase. Whenever there is geopolitical upheaval or some kind of scandal in any emerging market, its stocks will often plummet even though such events rarely have any impact on corporate profit growth. A good rule is to buy on fear and uncertainty and to sell into excitement. Track the fund flows: huge inflows tend to precede market tops and lead to declines, while record outflows usually occur prior to major bull markets.

The most popular sectors since Trump's election are not ideal for purchase, including most base metal producers and steel manufacturers.

Following the election of Donald J. Trump as U.S. President, some commodity-related assets have surged including funds of base-metal producers like COPX (copper mining) and SLX (steel manufacturers). Therefore, I have stopped buying these, although I haven't sold them because they remain generally undervalued on a long-term basis. In general, it makes sense to purchase whichever assets are currently the least popular, which have the heaviest insider buying, which have suffered recent historic outflows, which are wildly unpopular in the media, and which have especially bearish sentiment. If you only buy such securities, while selling whatever has become trendiest with the heaviest inflows, the most positive media coverage, and the most intense insider selling, then your portfolio will perform impressively in the long run.

Investors become irrationally obsessed with myths like interest-rate differentials.

Two years ago, the highest interest rates in the world were almost entirely in emerging-market countries including Russia and Brazil. If investors had purchased those currencies with the highest interest rates, then those would have been among the worst currency performers in 2015. I am not sure why the myth persists about investors seeking out the highest yields when making currency trading decisions, but it has no basis in the historical record. U.S. interest rates are currently above those in most developed countries, which is used by many analysts and brokerages as an excuse for anticipating a higher U.S. dollar. However, following their recommendations would be a major error. The most successful currency investors look at relative valuation which has no correlation with interest rates. I will now explain a simple method of computing such relative valuation.

The Big Mac tells the truth.

One well-known but little-used indicator to determine which global currencies are too high or too low is the Big Mac indicator. This was discovered by some clever person several decades ago. A Big Mac contains almost identical ingredients no matter where in the world it is made or consumed. If the price of a Big Mac sandwich at a number of McDonald's restaurants in any given country is significantly higher or lower than it is somewhere else, then it usually indicates that the country with the higher price has an overvalued currency while the cheapest Big Mac sandwiches can be found in the countries with the most underpriced currencies. Today, you can get good bargains on a Big Mac in countries including Japan, the U.K., most of the EU, and Switzerland. This is not usually the case. Among the highest Big Mac prices are those in the United States, which is also not typically true. In 2011, a Big Mac was unusually costly in cities including Sao Paulo and Moscow, which contradicted most analysts' expectations of continued gains for overpriced emerging-market currencies and led to some of the biggest losses for these currencies in their entire histories between April 2011 and January 2016. Today's Big Mac message is that the U.S. dollar will retreat while the currencies of nearly all developed markets will rebound.

How long will these reversals persist?

Since January 20, 2016, most funds of commodity producers and emerging-market equities have been among the top-performing winners from their respective 52-week lows out of all exchange-traded funds. This pattern will likely continue in 2017, but it won't persist forever. Eventually, heavy insider buying of these securities will become transformed into substantial insider selling, just as has occurred recently with twice the usual ratio of insider selling to insider buying for overall U.S. equities. The media will change their tune and will invent a new series of meaningless myths--just as they did in the first half of both 2008 and 2011--which everyone will believe about commodities and emerging markets continuing to climb forever. This will encourage all-time record inflows into most funds of commodity producers and emerging-market securities. Such a dramatic transformation probably can't happen soon, but it could occur by the first half of 2018.

Aging bulls lead to fewer and fewer stocks remaining in bull markets.

One consistent pattern is that as U.S. equity indices try to extend their longest-ever bull markets, fewer and fewer stocks will continue to climb while others gradually begin bear markets. Whenever such a transition occurs from a major bull market to a major bear market for U.S. equity indices, most investors are reluctant to embrace a bearish thesis. Instead, they will crowd more and more frenetically into whichever sectors and shares are the biggest percentage winners. So far, hardly anyone has been pouring into most of the top gainers of 2016, but this will likely happen at some point during 2017-2018. Therefore, whatever continues to climb next year will likely enjoy far more positive investor attention than usual, especially as rising shares face less and less competition. This kind of narrowing reached its all-time extreme in January 1973 when only about 75 shares (known popularly as the "Nifty Fifty") were continuing to climb while thousands of U.S. equities had already begun major bear markets. Eventually, from January 1973 through December 1974, we experienced the most crushing bear market since the Great Depression with the Nifty Fifty stocks being among the greatest percentage losers.

It is likely that before we enter the next global recession we will have a final surge for whichever assets are continuing to set new 52-week highs several months or a year from now, and perhaps also into the early months of 2018. At that time it will probably be essential to sell all risk assets, because a very undervalued and pummeled U.S. dollar in 2018 could be setting the stage for its next powerful bull market. Just when everyone will have concluded that the greenback will keep slumping, it will probably enjoy even greater gains than it has achieved in the current cycle.

Disclosure of current holdings:

Whenever they have appeared to be especially irrationally depressed, I have been purchasing the shares of funds which invest either in the shares of commodity producers or emerging-market stocks and bonds, since I believe these remain the two most undervalued sectors in that order. In a world where real estate and U.S. high-dividend securities have finally begun major bear markets from ridiculous overvaluations and all-time record inflows, these irrational favorites of recent years and the brief post-election love affair with overpriced industrial shares will transition to a completely new set of investors' darlings. As the greenback surprises most investors by accelerating its bear market, with the U.S. dollar index moving below 80 within 1-1/2 years instead of continuing to rally to new 14-year peaks as almost everyone is expecting, this will lead to a major upward revision in global inflationary expectations. The election of Donald J. Trump as U.S. President means "yuge" U.S. government spending and modestly lower taxes which is a combination for a massive rise in the deficit. The latest illogical pullback for most gold mining and silver mining shares, along with undervalued emerging-market bonds, has created some compelling buying opportunities, so be sure to seize them before they disappear. From my largest to my smallest position, I currently am long GDXJ (many new), SIL (some new), KOL, GDX (some new), XME, COPX, EWZ, RSX, GOEX, URA, REMX, VGPMX, ELD (some new), HDGE (some new), GXG, IDX, NGE, BGEIX, ECH, FCG, SEA, VNM (some new), NORW, BCS, EWW (some new), PGAL, GREK, EPOL, RBS, TUR (some new), RSXJ, RGLD, SLW, SAND, SILJ, EPU, FTAG, SOIL, EWI, EPHE, and THD. I have short positions in IYR, XLU, FXG, and SPHD, in that order, largest to smallest. I recently sold DXJ because I believe the uptrend for Japanese equities and the downtrend for the Japanese yen have both been overdone.

I expect the S&P 500 to eventually lose 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 bottom perhaps occurring near the end of 2018 or in early 2019. 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 it is nearly over--just as most investors in August 2008 didn't realize that we were well into the crushing 2007-2009 bear market. The current U.S. equity index bull market is already the longest on record; expecting several more years of gains is like anticipating that a 100-year-old marathon runner will continue to run marathons for a few more decades. While the media have been quick to trumpet new all-time highs for many U.S. equity indices throughout 2016, almost no one has noticed that fewer and fewer individual shares have set new 52-week highs especially as compared with previous peaks including June 2015, and with generally reduced overall participation. While many investors expect the surge following the election of Donald J. Trump as U.S. President to usher in four or eight more years of a bull market, nearly all of those gains have likely already occurred. Following the election of Narendra Modi in India on May 16, 2014, many analysts expected a bull market to continue for a full decade. The fund SCIF of a hundred small-cap Indian equities actually peaked on June 9, 2014 which was 24 days later; it has made a series of lower highs since then. IWM, a fund of the two thousand companies in the Russell 2000, had been outperforming the S&P 500 by roughly 3:2 from the nadir in March 2009 through March 2014, but thereafter has gained less than the S&P 500 and many other large-cap indices. The most recent high for IWM occurred on December 9, 2016, making the total post-Trump rally less than 31 days. At least you can say that it lasted a week longer than India's "decade-long" bull market. There is a little-known megaphone formation in which the S&P 500 has been making higher highs and lower lows since 1996, so it shouldn't be a shock to investors if the current or upcoming bear market for U.S. equity indices results in the S&P 500 approaching or sliding below its March 6, 2009 nadir of 666.79.