JUMPING OFF A ROOF (September 17, 2017): When I was in kindergarten the boys used to get together during recess and play word games. A popular one was to suggest two methods of dying and ask which one we would prefer: would we rather be slowly eaten by ten thousand fire ants or burned at the stake by cannibals who planned to devour us afterward? Another popular game was to pose rhetorical questions about unpalatable situations: if one of us jumped off a roof of a tall building downtown then would the rest of us also jump to show solidarity? On the way down, would we say to ourselves, "everything's fine so far"? I often wondered, and still do, if girls similarly engage in such whimsical disaster banter.The financial markets today are serving as a repeat of my impossible childhood decisions. Would I rather buy Amazon with a price-earnings ratio above 500 (they earned 40 cents per share last quarter) or would I prefer to own Netflix at merely 222 times earnings? Would I rather purchase real estate in Vancouver or San Francisco, given that housing prices in many neighborhoods in those cities are selling for more than ten times the household income in those neighborhoods?
If everyone is jumping off the roof, my favored bet is assuming that they will fall to the ground rather than ascending into the sky.
Call me Ishmael or call me misguided, but I have no doubt that eventually investors won't be willing to pay any price for today's Nasdaq favorites. Exactly how depressed Amazon, Netflix, and Nvidia will become is uncertain but I think that 2000-2002 and 2007-2009 are useful guides to the future since the past repeats itself a lot more consistently than most people realize. I began selling short Amazon above one thousand, shorted it all the way up, and continue to add to my short position whenever Amazon reaches one thousand as it did during the past week. I believe that Netflix and Nvidia are also absurdly overvalued, and have begun shorting it less aggressively than I am doing with Amazon. If Amazon and Netflix want to be able to grow at a sufficiently rapid rate to justify their current prices, then they will have to go well beyond the solar system and find a new batch of intergalactic consumers. Even if this happens, the free shipping to another solar system might erode profit growth.
A friend of mine has owned Amazon shares for years, even suffering through their 94% collapse near the beginning of the century. I asked him why and he told me that there will always be another batch of stupid people who will pay a higher price for it. Somehow I don't think that's sufficient reason to own anything. Given the trillions of dollars which have exited bank accounts in recent years where such people have never previously invested in fluctuating assets, it is hardly surprising that they would select names like Amazon and Netflix with which they are personally familiar. If they order packages from Amazon--as I also happily do since they don't mind operating that business at a loss--and they pay 7.99 per month for Netflix, then it's hardly surprising that they would prefer to purchase those shares rather than those of far more compelling energy shares. As usual, the media has been happy to parrot meaningless and misleading hype about an alleged energy glut and why prices will remain low indefinitely--until after they soar higher, at which point they'll talk about a "global energy shortage" and give you plenty of plausible-sounding but false reasons why it was inevitable that energy rallied strongly.
Investors are too easily misled by whatever has happened during the past few years.
Without thinking about it, nearly all investors are overwhelmed by the recency bias in which their decisions are heavily influenced by whatever has happened lately. They are also easy prey for believing nonsensical price targets by anyone who wishes to proclaim them--with many of these so-called gurus having recently graduated from MBA programs and who were busy studying for their SAT tests in high school when the last bear market occurred. If someone throws around a meaningless 250-dollar price target for Nvidia then that becomes the anchor upon which millions will make buying and selling decisions; this partly explains how Amazon was able to reach one thousand.
In 2009-2012, the 2007-2009 bear market was fresh in people's memories and there were mostly net withdrawals from U.S. equity funds. Now that more than 8-1/2 years have passed since the bear market, it seems emotionally as far away as the era of the dinosaurs and thus investors are completely unconcerned with taking risks. This is evident in VIX plummeting to an all-time bottom of 8.84 on July 26, 2017, minutes after the Fed's 2 p.m. rate announcement. Since then, VIX made a higher low of 9.52 on August 8 and is completing another higher low in September. Only the most experienced investors are bothering to hedge themselves against a downturn, with many institutions figuring that doing so is an unnecessary waste of money. After hurricanes Katrina and Rita devastated the southeastern U.S., prices for hurricane insurance quintupled which encouraged Warren Buffett to sell it the following year. Investors will once again be eager to insure their portfolios against loss, but only after there has already been a substantial correction and such insurance becomes outrageously expensive. Protecting against a disaster is seen as irrelevant until it is too late to act.
Precious metals mining shares and energy companies are among the best remaining bargains.
In late 2015 and early 2016, nearly all commodity-related and emerging-market assets had become irrationally undervalued, with some of them trading at their lowest prices in decades. Emerging-market securities enjoyed one more period of notable underpricing shortly following Trump's election when the media were almost universally bearish toward them, but now that they have far outperformed most other investments in 2017 the media have turned almost unanimously favorable toward them. The main negativity remains with gold mining and silver mining shares which aren't as frequently derided as they had been around January 20, 2016 before they mostly doubled, but are usually dismissed as being unpredictable or worse. As for energy shares, the Wall Street Journal devoted its entire back page on Monday, August 28, 2017 to the hopelessness of purchasing anything in this sector. Since then there have been moderate rebounds from deeply undervalued levels. FCG, a fund of natural gas producers, is one of my favorite choices in this sector with OIH, URA, and KOL also worthwhile. FCG could double or triple from its recent bottom and would still be far below its top of June 23, 2014, while the others above could enjoy dramatic gains during the upcoming year. Insiders of energy companies during the past several trading days have been notable buyers of their own shares.
Energy shares have almost always been lagging performers, being among the last winners immediately before any severe bear market is approaching its downward accelerating phase. In years including 1981 and 2008, energy shares were among the biggest winners after the Russell 2000 had already begun its downtrend. In 2017, it is possible that the Russell 2000 and its funds including IWM peaked on July 25, 2017, the day before that month's Fed meeting. Even though the S&P 500 and many other large-cap equity indices have repeatedly set new all-time highs since then, the Russell 2000 has so far been unable to do so. This was also a feature in 2007 in which the Russell 2000 completed a double top on June 1 and July 9 while the S&P 500 completed its intraday zenith on October 9, 2007 and the Nasdaq did so on October 31. A look back at 1929, 1937, and 1973 shows nearly identical behavior prior to a severe bear market each time.
Very few investors pay attention to fund flows.
Fund-flow data has been available for open-end mutual funds for decades and for exchange-traded funds since their inception. However, similar to insider buying and selling, hardly anyone pays attention to it. It has been proven academically that all-time record inflows consistently precede periods of poor performance, whereas all-time record outflows are almost always followed by huge bull markets. The biggest monthly outflow in history from most U.S. equity funds was in February 2009, while the biggest inflows have mostly been in 2017 which surpassed their previous all-time record inflows from 2016. According to Barron's, total net inflows into U.S. exchange-traded funds during the first eight months of 2017 totaled 295 billion dollars, thereby outpacing the total net inflow of 285 billion for all of calendar year 2016. Top corporate insiders have not been so easily fooled, with among the highest ratios of total selling to buying ever recorded for top corporate executives for 2017.
We had all-time record outflows for precious metals shares during the second quarter of 2017 and all-time record outflows for most energy funds throughout 2017. For example, the outflows from both GDX and GDXJ were four to five times their previous records.
Real estate remains among the most overpriced in history in many parts of the world.
In 2001, there were numerous neighborhoods in Arizona, Florida, Nevada, and elsewhere where housing prices sold for less than 1.5 times average household incomes. In 2017, there are places where this ratio is greater than ten to one. The long-term historic average is almost exactly three, so this does not bode well for real-estate prices. This poses a serious problem to the economy since many people have purchased real estate almost entirely using borrowed money, and will thus be underwater even with moderate price losses. While there aren't as many subprime loans in 2017 as there had been in 2007, valuations are in many cases far higher and thus present much greater percentage risks to the downside.
You might think that the average 34% decline for U.S. housing prices in 2006-2011 would convince people that housing prices don't always go up, but apparently the latest fantasy is that the previous bear market was the only one in their lifetimes and from now on housing prices will keep climbing indefinitely. If reality were presented as a television mini-series then no one would believe it. Truth is indeed stranger than fiction.
There are other worthwhile short positions besides AMZN, NFLX, and NVDA.
Obviously the above three Nasdaq favorites are far from the only irrationally overpriced securities today, although they are among the most extreme. Utilities have never been more expensive in history, making funds like XLU worthwhile shorts, while funds of industrial shares including XLI are also ideal short positions. For pure diversification, selling short IWM which matches the Russell 2000 capitalizes upon the average price-earnings ratio for that basket of two thousand U.S. companies sporting by far its highest-ever price-earnings ratio in history.
In kindergarten we would always ask ourselves, "How terrible can it get?" While being devoured by wild beasts may have been our biggest fear in those days, it is far more perilous to be blissfully unconcerned with dangerously high overvaluations. Investors often mention in surveys that they are worried about terrorism, Chinese GDP growth, or whichever monsters are most frequently mentioned in the mainstream financial media. Hardly anyone is terrified as I am by the greatest overvaluations in history for most assets, the greatest-ever reliance on borrowed money, and especially the pervasive lack of worry.
We have nothing to fear but complacency itself.
Disclosure of current holdings:
There are numerous ridiculously overvalued sectors in the world today and fewer undervalued ones. The incredible bargains of late 2015 and early 2016 are gone, but I have been continuing to gradually purchase energy shares along with funds of gold mining and silver mining companies whenever they are most gloomily reported in the media and when investor outflows have been maximally intense. 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 very early stages of transitioning to a completely new set of investors' darlings. The election of Donald J. Trump as U.S. President initially led to a "yuge" surge in investors' expectations which have not been validated by reality; soaring price-earnings ratios have caused the U.S. stock market to become the most dangerous game. It is timely to sell short those Nasdaq favorites which are most overpriced, along with 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 net investor inflows into many U.S. equity funds. I have recently purchased FCG, OIH, GDXJ, HDGE, and URA in that order while selling short XLU, XLI, AMZN, NFLX, NVDA, and IWM. I had also bought EWZ when it suddenly plummeted over 21% to 31.78 on May 18, 2017 due to a political scandal which as with nearly all geopolitical developments exerts essentially zero impact on Brazilian corporate profits. From my largest to my smallest position, I currently am long GDXJ (some new), TIAA-CREF Traditional Annuity Fund, KOL, SIL, XME, HDGE (some new), GDX, EWZ, URA, REMX, NGE, RSX, GXG, I-Bonds, ELD, GOEX, FCG (many new), bank CDs, VGPMX, money market funds, BGEIX, OIH (some new), SEA, NORW, VNM, TLT, PGAL, EPU, RGLD, WPM, SAND, SILJ, and FTAG. I have short positions in AMZN (many new), IYR, XLU (some new), XLI (some new), NFLX (some new), FXG, NVDA (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 only modestly 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. While the S&P 500 has made numerous higher highs since July 25, 2017, the Russell 2000 and IWM have not surpassed their zeniths from that day. 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 to roughly 833 or lower 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. They have no concept of valuation or historical behavior and have been purchasing Amazon and Netflix because they are familiar with those names from their daily lives. It is the best of times and it is the worst of times.
