Tuesday, July 11, 2017

“Value investing is at its core the marriage of a contrarian streak and a calculator.” --Seth Klarman

OVERLAPPING OVEREXTENDED OPPORTUNITIES (July 10, 2017): Some investors who are momentum players attempt to identify the most overextended trends and to chase after them in the hope that they become even more extreme. Others attempt to identify key turning points so they can buy or sell near the exact bottom or top. I prefer a different approach: identifying trends which have already been underway for weeks, months, or years, but aren't acknowledged because they go against the popular myths of the day. It thus becomes possible to bet on a horse which is a favorite when everyone is giving it unusually long odds against it happening. In this way, bets which should be even money will pay off far more than the downside risk you are assuming in your trading. Fortunately, we have more than the usual number of trends which fit into this ideal category at the present time.

U.S. equities have been in stealth bear markets since December 2016, but almost no one recognizes them because a tiny number of very popular shares have enjoyed huge gains so far in 2017.

Is the U.S. stock market up or down from its highs of December 2016? Most investors would immediately respond that it was higher, because they are bombarded with media stories proclaiming new all-time highs for the Dow, for the Nasdaq, for the S&P 500, and for seemingly just about every other U.S. index. However, if you examine the data more carefully you will soon realize that these well-known benchmarks have been able to achieve repeated higher highs almost entirely because of only one or two dozen huge winners which are disproportionately represented in these indices.

Take a look at IWM, a fund which invests in the Russell 2000 and which had reached a high last year of 138.82 on December 9, 2016. This fund is higher today--but by only about one percent even if you include all reinvested dividends. A one-percent climb in seven months is not much of a bull market, especially since the two thousand companies represented in this index total more than half of the 3599 total listed U.S. companies. If you prefer, you can look at IWC which had reached 87.82 on December 20, 2016, and which has similarly gained only about one percent since then. Many investors intuitively realize that this must be the case, because when they look at their quarterly statements ending June 30, 2017 they discover that their accounts have barely increased from their levels of the end of 2016.

Underperformance by smaller U.S. companies is much more bearish than simply fewer stocks remaining in bull markets.

It's not just a case of fewer U.S. stocks being in bull markets; what is essential is that when small stocks are notably underperforming large-cap favorites then this behavior is almost always followed by a severe bear market. If you look back at August 1929, January 1973, and October 2007, what all of these have in common is that small stocks had already been underperforming the best-known favorites by anywhere from several months to more than a year. Once funds like IWM and IWC struggle to make new all-time highs while the S&P 500 does so routinely, the clock is ticking on the bull market and a significant correction or worse lies just around the corner. While this is one of the most reliable patterns in the financial markets, it is also among the least appreciated.

Here is a quiz: which are the top-performing funds since late 2015 and early 2016?

If you were to ask ten thousand people this question, most of them would probably respond that technology shares were the biggest winners, with some perhaps guessing industrial or infrastructure shares. Almost no one would correctly state that commodity producers and commodity-related emerging market equities have been almost exclusively the only funds represented in the top 50 and predominantly in the list of the top 100 unleveraged funds going back to the early weeks of 2016. The reason is primarily that big-name technology shares including NVDA and NFLX have received persistently positive media coverage, whereas the media rarely talk about mining or energy companies. In addition, since most commodity producers and emerging markets had suffered multi-year severe downtrends from April 2011 through January 20, 2016, many analysts who used to follow these sectors ended up switching to other sectors or haven't been taken as seriously by most media outlets since then. A list of those funds which have doubled since their intraday lows of January 20, 2016 would be populated almost entirely with unfamiliar sectors including gold mining, silver mining, coal mining, base metals mining, along with stocks in countries such as Peru, Brazil, and Russia.

Record inflows into U.S. equity funds in 2017 have been combined with all-time record insider selling.

The best time to buy into any sector is when top executives of companies in that sector have been heavy buyers of their own shares, while most investors are aggressively unloading them. This applies to nearly all energy shares in recent weeks, with all-time record outflows from many energy-related funds including FCG which is a fund of natural-gas producers that if it quintupled in price would still be below its top of June 23, 2014--just over three years ago. FCG has unusually intense buying of its components by insiders. There have been all-time record outflows from mining funds including actively-traded gold-mining funds GDX and GDXJ during the second quarter of 2017. GDXJ had a net outflow of more than 27% of its total market capitalization during April through June 2017. This did not stop GDXJ from making additional higher lows including 27.37 on December 20, 2016, 29.33 on May 4, 2017, 30.89 on May 24, 2017, and 30.97 at today's open (July 10, 2017).

For most non-commodity sectors, insiders have never been heavier sellers than they have been in 2017, while investors have made all-time record inflows this year into most U.S. equity funds. Whenever insiders are doing the exact opposite of the public is when insiders are most likely to be proven right while the vast majority of investors will be on the wrong side. This is one reason that the rich get richer and the poor get poorer--the rich only follow each other, while the poor (really the working- and middle-class) do whatever just about everyone else is doing and which must therefore fail. Most investors are excited about buying stocks near all-time highs, while the most experienced investors are cautious and have been progressively selling into the most extended uptrends.

One sure sign of a bull market for commodity producers is when the shares of the producers far outpace their respective commodities.

How can we tell whether gold mining shares or natural-gas producers are in true bull markets? One way is by measuring the percentage increase in a basket of producers versus the increase in the commodity itself. For gold mining, for example, GDXJ is a fund of junior gold mining companies which trades millions of shares daily. On January 20, 2016, GDXJ slumped to an all-time bottom of 16.87. Since then it paid a dividend of 1.507 U.S. dollars per share in December 2016. Meanwhile, GLD which tracks gold bullion slid to an intraday low of 104.94 also on January 20, 2016. If we compute the ratio of how much each of these has gained since then, we see that GLD or gold bullion using today's closing numbers (July 10, 2017) is up by (115.47-104.94)/104.94 = 10.03% while GDXJ has gained (32.06-16.87+1.507)/16.87 = 98.97%. The ratio between these two is over 9.86 to 1. This is more than twice its historic average and thereby signals that the rally for precious metals and the shares of their producers is likely to continue. Additional supporting evidence can be seen in the Daily Sentiment Index, a survey of futures traders that has been tracked for decades; as of July 7, 2017 it showed only 10% of investors who were bullish toward gold and 9% who were bullish on silver.

The traders' commitments are at simultaneous historic extremes for gold, silver, and platinum.

The traders' commitments last week showed that commercials--the equivalent of insiders for any futures contract--were net short (238,416-131,190) or 107,226 contracts. This was their lowest total since February 9, 2016 when the rallies for precious metals and their producers had barely begun. For silver, commercials were net short 39,228 contracts, their lowest net total since January 19, 2016. For platinum, commercials were only net short 12,598 contracts which is their lowest reading since the last recession. You can see a chart of gold's traders' commitments here: notice the shrinking maroon bars. Substitute SI.png and PL.png for GC.png to see silver and platinum respectively:

  • Gold's Traders' Commitments, Current

  • VIX has been forming a pattern of higher lows from a multi-decade bottom, which historically is especially bearish for U.S. equity indices.

    People are often confused by VIX. Its most bullish behavior is when it has been forming a pattern of lower highs following a multi-decade top, as it did starting in October 2008. This was an early signal that we were transitioning from a major bear market to a powerful bull market. Now we have the exact opposite situation, where VIX slid to 9.37 on June 9, 2017--the same day that the Russell 2000 and the Nasdaq completed their respective zeniths (so far). On that day, VIX slid to 9.37 where it hadn't traded since it had touched 8.89 on December 27, 1993--almost 23-1/2 years earlier. Since then, VIX has made several higher lows including 9.68 on June 26, 2017 and 9.73 on June 29, 2017.

    Until VIX climbs to another multi-decade high and begins to form lower highs over a period of weeks or months, it is probably premature to purchase most funds of U.S. equities.

    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 along with U.S. equities and junk bonds 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 wildly overbought four-letter favorites is in the process of transitioning to a completely new set of investors' darlings. The election of Donald J. Trump as U.S. President has led to a "yuge" surge in investors' expectations which have not been validated by reality; soaring price-earnings ratios are far more dangerous than rising earnings. The latest illogical pullbacks for most commodity producers has encouraged me to add to these sectors. It is timely to sell short those funds with the heaviest insider selling and the most intense all-time record investor inflows. So far in 2017, we have experienced new all-time records for total insider selling of U.S. equities and all-time record inflows into many U.S. equity funds. I have recently purchased GDXJ, FCG, OIH, URA, and HDGE while selling short XLI and AMZN. I also bought EWZ when it suddenly plummeted over 21% to 31.78 on May 18, 2017 due to a political scandal which will have essentially zero impact on Brazilian corporate profits. From my largest to my smallest position, I currently am long GDXJ (some new), SIL, KOL, XME (some new), GDX, EWZ (some new), RSX (some new), URA (some new), HDGE (some new), ELD, FCG (many new), GOEX, REMX, VGPMX, GXG, NGE, OIH (many new), BGEIX, SEA, VNM, NORW, PGAL, RGLD, SLW, SAND, TLT, SILJ, and FTAG. I have short positions in IYR, XLU, XLI (some new), FXG, AMZN (some 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 when I sold it in early February, plus some dividends as shares along the way. In 2017, EWW and TUR went from being widely detested in January to being eagerly purchased a few months later. This highlights the advantage of buying 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 probably occurring at some unknown point in 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 (or recently ended) 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 in recent months, 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 continue as long as he is in office, nearly all of the anticipated future gains have likely already occurred. 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 several times and always falling back afterward, while IWC marginally surpassed its December 20, 2016 peak of 87.82 several times before failing to follow through each time. Small-cap shares similarly underperformed at important 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. Even if it doesn't plummet that deeply, I expect a two-thirds loss from 2454 to 818 for the S&P 500. Far too many conservative investors took their money out of safe time deposits since they didn't want yields of 1% or less; they have no idea what to do during a bear market.