Saturday, March 4, 2017

“Thus in order to be a 'radical' one must be open to the possibility that one's own core assumptions are misconceived.” --Christopher Hitchens

FROM RICHES TO RAGS (March 3, 2017): During the past week, some amazing historic tops have been formed for well-known U.S. equity indices. The S&P 500 (SPY, VOO) soared above 2400 for the first time in history, representing a huge gain from its 666.79 intraday bottom of March 6, 2009. The Nasdaq (QQQ) is trading for double its previous top from 2007, while the Dow Jones Industrial Average (DIA) made headlines by surpassing 20 thousand and then 21 thousand in rapid succession. Since a sharp surge higher began on the day after Donald J. Trump was elected as U.S. President, many investors have concluded that this uptrend will continue for four or eight years depending upon whether or not Trump is reelected. However, this logic is just as misguided as when investors in early 2009 had nearly unanimously decided that the stock market would keep dropping because we had never experienced a subprime mortgage collapse before. There are clear signs that the post-Trump buying surge is entirely emotional and that we have already begun what will become the worst bear market since the Great Depression.

Investors keep buying prior to major tops and selling shortly before historic bottoms.

One sad truth is that the average investor ends up actually behind after inflation, even with assets such as stocks and bonds which have long-term net gains after inflation. The reason is that investors emotionally buy high and sell low and keep repeating this pattern. Prior to 2017, the biggest inflows generally occurred in months including February 2000 when most funds of technology shares experienced their heaviest inflows ever recorded, before or since. Afterward, from March 10, 2000 through October 10, 2002, the Nasdaq plummeted 78.4%. In February 2009, most funds of U.S. equities experienced their largest-ever monthly outflows. Not surprisingly, this was followed by the eight-year bull market which stands as one of the longest in history and which may have finally begun to reverse. Thus, investors have a proven track record of buying shortly before each top and selling within weeks of any ultimate nadir.

Who do you think will be right, top corporate insiders or average investors?

While investors have made all-time record inflows into U.S. equity funds at various periods in recent months, especially those funds which are expected to benefit the most from the "Trump trade," top corporate insiders have rarely been more aggressively selling. The ratio of insider selling to insider buying in recent months, and especially during the past few weeks, has surpassed most benchmarks going back to when insiders were first required to report their buying and selling during the Great Depression. There are all kinds of excuses being offered on the internet, such as insiders selling to take advantage of expected lower tax rates in 2017, or because they want to step up their buying of luxury goods, and naturally to help all of their children and grandchildren struggle through college, but the real reason is that they're selling because they expect prices to move lower--and in this case enormously lower. The Nasdaq has to drop by roughly half--not to reach its previous bottom, but amazingly to revisit its previous top from October 31, 2007. Throughout its history, no basket of small-cap stocks has ever had a price-earnings ratio above 30 prior to the final weeks of 2016, but currently the median P/E ratio in the Russell 2000 is near 31. Here is another analyst's computation of how recent valuations were even more extreme than they had been at previous all-time tops:

  • Second to None--a Look at Valuations Vs. Fundamentals

  • Small stocks are underperforming, which also happened in 1929, 1973, and 2007 prior to severe bear markets.

    One reliable historic gauge of a transition from a bull market to a bear market can be found in the behavior of small-cap U.S. equities versus their large-cap counterparts. While the Dow Jones Industrial Average, Nasdaq, and the S&P 500 have been setting numerous new all-time highs in recent months, the Russell 2000 and funds which track it including IWM have barely surpassed their December 9, 2016 highs. IWM reached 138.82 on December 9; it climbed as high as 140.86 on March 1, 2017 but is now trading near its December 9 level again. IWC, a fund of 1,359 microcap U.S. shares, topped out at 87.82 on December 20, 2016 and hasn't moved above that level since then. This is similar to the divergences which have usually occurred prior to the worst bear markets in U.S. history.

    Sentiment is unusually extreme on the bullish side toward large-cap U.S. equity indices.

    According to Daily Sentiment Index which has been around for several decades, 92% of traders were bullish toward the S&P 500 and 92% were similarly bullish toward the Nasdaq on March 1, 2017. Readings this high are rarely seen even during strong bull markets. There has also been a pattern of higher lows for VIX, which is a gauge that measures the average implied volatilities of a basket of options on the S&P 500 Index. When numerous higher intraday lows for VIX occur, it means that the most knowledgeable investors are increasingly eager to hedge their portfolios even when new all-time highs are being achieved. This is in sharp contrast to the sharp overall drop in short selling, indicating that less-experienced traders are concluding that since the U.S. stock market only goes up it is a waste of money to hedge on the potential downside.

    Many alternative investments are positioned to pick up the slack in the event of a U.S. equity downtrend.

    Bear markets for U.S. equity indices are more likely to occur if there is a set of highly liquid alternative investments where investors can put their money which they get from selling U.S. stocks. In this case, you don't have to look any farther than the U.S. Treasury market for such an alternative. The total value for all U.S. Treasuries and related assets is surprisingly close to the total value for U.S. equities and U.S. equity funds. TLT, a popular fund of long-dated U.S. Treasuries averaging 28 years to maturity, has slumped since its 143.62 top of July 8, 2016 and traded as low as 118.55 on Friday, March 3, 2017. Investors will eventually realize that it makes sense to sell especially overvalued U.S. stocks to purchase TLT and other U.S. Treasury funds. Other than U.S. Treasuries, many energy funds and precious metals producers have rebounded smartly from their multi-decade bottoms on January 20, 2016, but still are sufficiently undervalued historically to present worthwhile and more volatile opportunities with substantial potential upside based upon their previous peaks from years including 2014 for energy and 2011 for mining. Emerging-market bonds are a lesser-known alternative which are below their historic average valuations due primarily to overoptimism over the likelihood of a higher U.S. dollar.

    The greenback remains incredibly popular even though it has barely gained in the past two years and has probably begun a key downtrend.

    On March 13, 2015, the U.S. dollar index reached 100.39. It surpassed this mark by achieving a 14-year top of 103.82 on January 3, 2017. This is indeed a higher high, but the total gain from March 2015 was about the same as for boring U.S. Treasury notes. Since then, the U.S. dollar index has touched several key lower highs including 102.95 on January 11, 2017 and perhaps an additional lower high on March 2, 2017 at 102.26. Much of the excitement over U.S. equities has been from non-U.S. residents who receive extra gains when the greenback climbs versus their home currency. If the U.S. dollar moves lower, then many non-U.S. investors will perceive total losses when measured in their own currencies and will become increasingly likely to sell their U.S. assets. The only reason the greenback has remained high for so long is a continued misunderstanding of the Fed's rate-hike cycle. Historically, rising rates are not bullish for the U.S. dollar as is clear when studying a multi-decade history of Fed activity and overlaying it with the U.S. dollar index.

    The Presidential cycle is especially strong when a Republican becomes U.S. President following a Democrat.

    The U.S. Presidential cycle is a pattern in which the stock market tends to correlate with geopolitical developments. Looking back at the last four Republicans who took over from Democrats, the stock market moved lower in 1953 after Eisenhower took charge, again in 1969 after Nixon's election, in 1981 when Reagan became the chief, and once again in 2001 with George W. Bush at the helm. It is highly unlikely that Donald J. Trump will end this streak. In addition, it is common for the lowest point of any U.S. Presidential term to coincide relatively closely with the next midterm (non-Presidential) elections for the Senate and the House of Representatives which will occur on November 6, 2018. If a moderate decline for U.S. equity indices in 2017 becomes a full-fledged bear market in 2018 as I am expecting, then this could lead to key bear-market bottoms in late 2018 or early 2019.

    Recent discussion is almost entirely about how much higher U.S. equity indices can climb and when they will do so, rather than whether the U.S. stock market will move higher or lower.

    Have you read lately about forecasts of when the Dow will reach 19 or 18 thousand the next time? I thought not. However, there are all kinds of predictions about when the Dow will climb to 22, 23, 24, 25, or 30 thousand. When the nature of the debate about any financial asset is only about how much higher or lower it will go and when it will occur, then almost always it does the exact opposite.

    Gold mining and silver mining shares are once again worthwhile for purchase.

    Whenever it is timely to purchase gold mining and silver mining shares, I always know it on Seeking Alpha since there is a sudden brief wave of trolls who inform me that I have no idea what I am talking about. The last time this happened was in December 2016 when GDXJ had bottomed at 27.37. The same trolls appeared in force on a single day, which was today (March 3, 2017) primarily in the morning when GDXJ slid to an intraday low of 33.59--its most depressed point since January 4, 2017. The intraday pattern has been bullish for more than a year in which the greatest weakness for this sector occurs near the opening bell, with each selling wave followed by fresh buying from a combination of value investors and other strategic money managers. It isn't widely known that gold mining and silver mining shares have been among the biggest percentage winners from their intraday lows of January 20, 2016, with this bull market likely continuing for perhaps another year. Eventually, these shares will plummet along with the overall stock markets in most countries, but that is likely something to be concerned with a year from now rather than in the near future. Recent hype over a likely March Fed rate hike has greatly assisted in providing the most recent buying opportunities in this sector, just as it did in December 2015 and January 2016 and again in December 2016.

    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 12 to 15 months 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 natural gas producers, has encouraged me to add to these sectors, while recent overvaluations for base metals producers along with overpriced industrial and financial shares combined with huge inflows and a sharp rise in insider selling has encouraged me to sell those. Thus, I have recently purchased GDXJ, FCG, and HDGE while selling COPX, BCS, RBS, EPOL, ECH, EPU, and THD. From my largest to my smallest position, I currently am long GDXJ (some new), SIL, KOL, XME, GDX, EWZ, RSX, URA, HDGE (many new), ELD (some new), GOEX, REMX, VGPMX, GXG, FCG (some new), IDX, NGE (some new), BGEIX, SEA, VNM, NORW, EWW, TUR, RSXJ, PGAL, GREK, RGLD, SLW, SAND, SILJ, FTAG, SOIL, EWI, and EPHE. I have short positions in IYR, XLU, FXG, XLI (many new), and SPHD, in that order, largest to smallest. U.K. banks in particular were huge winners, with BCS (Barclays) enjoying an enormous increase since June 27, 2016 from 6.89 to 11.61 plus some dividends as shares along the way. This highlights the advantage of buying most aggressively into the most severe panic selloffs while selling into the most intense excitement.

    Those who respect the past won't be afraid to repeat it.

    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 eight-year 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 early March 2009 through early March 2014, with IWC--a fund of even smaller U.S. companies--also significantly outperforming the S&P 500 in percentage terms. Since then, both IWM and IWC have struggled, with IWM barely surpassing its December 9, 2016 intraday high of 138.82 while IWC still hasn't moved above its December 20, 2016 all-time top of 87.82. Small-cap shares similarly underperformed at numerous past stock-market zeniths prior to severe bear markets including September 1929, January 1973, and October 2007. There is also 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.