BULLISH HORNS ARE HONKING (November 26, 2018): One common characteristic of a bear market for U.S. equities is that it requires roughly two years for the Russell 2000 to go from its top to its bottom. Along the way investors will become progressively discouraged by recent extended losses and will become gloomiest prior to each powerful bear-market rally. Bear-market rebounds tend to be more intense and rapid than bull-market uptrends and are more clearly signaled by reliable indicators, and thus often provide superior investing opportunities with higher annualized gains and lower downside risk on the long side than bull markets do. This fact is underappreciated by most investors.
The sequence in which assets complete their respective bottoms is well established but is not often used as a guide, partly since investors seem emotionally reluctant to admit that we are in a bear market and to use the proven experience of past bear markets as the most reliable guide to making money in the current bear market.
The recent progression of higher lows and lower lows is typical of an intermediate-term bottoming process.
There are two major kinds of bottoming patterns during bear markets: 1) intermediate-term bottoms that demonstrate similar behavior to each other and which are almost always followed by dramatic recoveries for certain securities; and 2) the final bottoming process which behaves very differently with huge short-term percentage losses and which is followed by a much choppier and shakier recovery that denotes the beginning of the next major bull market. The bottoming pattern we have been experiencing during the past several weeks clearly fits into the first category. It is thus worth examining in detail and analyzing as to the most likely follow-up pattern.
The securities I had recommended for purchase in my previous update have mostly rebounded even when U.S. equity indices were continuing to slide lower.
Emerging-market equity funds from those countries which tend to bottom earliest in the current cycle, including EZA, SCIF, EPHE, ARGT, and ASHR, have already climbed since my previous posting on the morning of October 30, 2018. Most of these had bottomed around the middle of October and then began quietly forming higher lows during the final days of October when most U.S. and some other equity indices continued to make lower lows. The total percentage declines from their peaks of January 2018 had approached one-third of their peak valuations and for SCIF had dropped by nearly half. While these and closely-correlated emerging-market assets have been forming higher lows, other sectors including many western European stock markets and energy shares continued to drop toward or below multi-year lows during November. Meanwhile, gold mining and silver mining shares had been in bull markets for even longer periods of time mostly dating back to 2-1/2-year bottoms which had been completed on September 11, 2018.
Emerging-market government bonds had also bottomed near September 11, 2018 and have mostly formed several higher lows since then, as you can see from charts of funds including ELD and LEMB. However, only a few emerging-market countries completed bottoms for their stock markets more than two months ago including Brazil (EWZ) and Turkey (TUR).
Some equity bourses have continued to lag and several of them represent worthwhile bargains.
Possibly due to above-average negative media coverage of the caravan in Mexico, along with political uncertainty, equity valuations in that country and its exchange-traded fund EWW have fallen to lower lows today while an increasing number of emerging-market equity funds have been forming higher lows. GXG and ICOL, both funds of Colombian shares, have also been lagging in forming higher lows.
When investing there is an important tug-of-war between buying those assets which have already been forming higher lows versus those which are still making lower lows. In general a combination of these is ideal, but finding the proper balance is challenging. By making small commitments for each individual trade you will have the flexibility to continue to gradually accumulate both kinds of securities during a bottoming process.
Investors have been unusually fearful by many established measures.
Daily Sentiment Index for several decades has surveyed futures traders regarding their opinion about the upcoming behavior of numerous futures contracts. As of the close on Tuesday, November 20, 2018, a surprising number of readings were near multi-year or multi-decade extremes. Only 8% of traders were bullish toward both the S&P 500 Index and the Nasdaq Composite, while 8% were also bullish toward gasoline. 9% of futures traders were bullish toward crude oil and heating oil, and 10% were bullish toward the CRB Index of commodities. 10% of traders were bullish toward the British pound, no doubt negatively influenced by Brexit uncertainty. A slightly larger 12% were bullish toward the Nikkei in Japan, while 20% were bullish toward both gold and silver. 84% were bullish toward VIX which tends to peak whenever fear is highest about the possibility of a U.S. equity bear market becoming more severe. 81% of futures traders were bullish toward the U.S. dollar index.
The above readings have generally become less extreme since November 20 while remaining far from their typical levels.
Other measures of sentiment have been sending similar signals.
A recent article on Seeking Alpha observed that gloom toward U.S. equities has approached multi-year extremes:
Western European shares took longer to complete their bottoming patterns.
While most emerging-market bourses had completed their bottoming patterns during the final trading days of October 2018, western European shares primarily did so two or three weeks later. There have been unusually extended pullbacks from their January 2018 tops for nearly all countries in Western Europe, with especially large losses for EWG (Germany), EWI (Italy), and EWU (the United Kingdom). In all cases these losses had almost nothing to do with lower potential corporate profits and almost everything to do with geopolitics. It is usually most profitable to buy whenever political wrangling and scandals dominate investors' outlook rather than economic reality. Angela Merkel's decision not to stand for re-election in Germany, uncertainty concerning Italy's relationship with the EU, and the Brexit infighting in the U.K. have all made widely-broadcast headlines but are unlikely to meaningfully impact the profits of companies in these countries. I therefore purchased all of these in November. Other countries were also lagging in their bottoming processes including Vietnam (VNM) which is often overlooked by many investors even if they otherwise favor Asian equities.
Energy shares, as is typical, have been among the slowest sectors to complete their bottoming patterns.
The rotational pattern tends to be similar during both topping and bottoming patterns. For example, in 2007 the Russell 2000 completed a double top on June 1 and July 9. Most gold/silver mining shares completed their highs in the middle of March 2008, while emerging-market equities did likewise in May-June 2008 and energy shares were the most lagging sector to top out during June-August 2008. Many energy funds including OIH and FCG slid toward multi-year lows during the past week when I was gradually accumulating them. OIH in particular has fallen sharply from its January 2018 zenith, and even that top wasn't anywhere near its much higher peak from the middle of 2014.
Even though the same patterns keep repeating themselves through the decades, investors are always convinced that it's different this time.
Currencies have been sending a similarly bullish signal regarding global equities.
Very few investors realize or appreciate that most emerging-market currencies completed their bottoming patterns versus the U.S. dollar somewhere around the middle of October and have since formed several higher lows. Most European currencies have taken longer to complete their respective intermediate-term bottoms but have mostly done so during the past few weeks. One notable bargain has been the Swiss franc which during the past decade has rarely traded at a price below the U.S. dollar, but which fell as low as .987987 U.S. dollars in November 2018 before once again barely regaining parity.
VIX keeps making lower highs which is historically very bullish for global equities.
One of the earliest signals that global equities were set for strong rallies was when VIX in November 2008 didn't surpass its peak from October 2008. Similar behavior has been occurring in recent weeks as VIX soared to 28.84 on October 11, 2018 and then completed a lower high of 27.86 on October 29, 2018 when most U.S. equity indices made lower lows. On the following day, October 30, 2018, VIX climbed as high as 25.55 and then registered an additional lower high of 23.81 on November 20, 2018. These lower highs almost all represent essential buying opportunities for equity funds. The most recent lower high for VIX was 22.65 on Friday, November 23, 2018.
The relative behavior of IWM vs. SPY is especially useful in determining key turning points for U.S. equity indices.
I believe that U.S. equity indices are especially overvalued relative to most global equities and thus I am not planning to purchase them until they complete major bottoms perhaps in 2020. However, they send useful signals for stock markets worldwide since the world is so closely interconnected. Whenever the Russell 2000 and its funds including IWM are notably underperforming the S&P 500 and its funds including SPY and VOO then it is likely that any downtrend will continue; as soon as this pattern reverses then a rebound is closely approaching. After topping out at an all-time zenith on August 31, 2018, IWM made several lower highs while SPY was still making higher highs for three weeks. Then, after bottoming on October 26, 2018, IWM has been forming higher lows more frequently than SPY. Whenever IWM begins to persistently underperform SPY again, which will likely occur during the first half of 2019, it will likely be signaling the next intermediate-term downtrend for U.S. equities.
Too many investors are obsessed with their opening prices which should be completely irrelevant when making trading decisions.
Most people are illogically concerned about their opening prices or their personal history with a given asset when deciding whether or not to trade it. All that should matter is its future behavior. The past is a useful guide to its behavioral pattern but your personal history should be completely ignored. Far too many people won't sell because something is at a loss, thereby inviting much larger future losses. Others don't want to raise their average purchase price and thus miss out on ideal opportunities to buy at higher lows. I have been intentionally accumulating more EZA each time it drops to 49.99 regardless of the fact that my original purchases had all been at lower prices.
Investors also obsess about "why" such-and-such has moved higher or lower recently or what is "really going on" with a particular security.
If you are looking for anything then you will find it one way or another. If you are looking for reasons why Chinese or Indian equities have dropped over one-third from their January 2018 peaks then you will end up concluding that it has something to do with Chinese tariffs or the 2019 Indian elections and you will wrongly conclude that you shouldn't buy. When investors have reasons to sell near multi-year or multi-decade lows then they will be far more likely to do so because we like to think that we do everything for a reason. Investors repeatedly overreact to supposedly negative news which rarely has any impact on corporate profits. Investors often sell when a currency has become depressed due to political reasons, as for many emerging-market currencies and the U.K. in recent months.
A depressed currency stimulates exports and reduces local wages and thus increases rather than decreases total profits.
The bottom line: as is usually the case, investors have been reducing risk when they should be substantially increasing it.
Investors were most excited about owning U.S. equities in the late summer when they should have been aggressively selling, and recently they have been selling stocks worldwide and thus registering all-time record outflows from many emerging-market and commodity-related funds. At the same time, the ratio of insider buying to insider selling for sectors including energy has set or approached multi-year highs. Investors tend to overestimate future gains at market peaks and to even more irrationally underestimate gains just before large percentage increases are maximally likely to occur. Many of the funds I have purchased, all of which are listed below in my disclosure, could gain 30% or 40% over the next half year alone and could continue to climb perhaps as late as the beginning of 2020 depending upon how aggressively they rebound and how trendy they become in 2019.
Disclosure of current holdings:
Due to all-time record outflows and rare extremes of fear, I have completed the closing of all of my short positions while progressively and gradually buying into both higher lows and lower lows for emerging-market, energy, and related sectors including sea shipping. During the past two weeks I have been emphasizing ASHR (Shanghai A-shares), OIH (oil services), EPOL (Poland), VNM (Vietnam), EWG (Germany), EWU (U.K.), EWI (Italy), FCG (natural gas production), SEA (sea shipping), EZA (South Africa), FM (frontier markets), and EWW (Mexico) which I purchased this afternoon. I am also buying a little GDXJ each time it drops below 27. I sold VGPMX since Vanguard seems to be clueless about buying low and selling high.
Funds I am considering for purchase during the remainder of 2018 include ASHS (Shanghai small-caps), GREK (Greece), PAK (Pakistan), COPX (copper producers), RSXJ (Russian small-caps), EGPT (Egypt), AFK (Africa), Indonesia (IDX), GXG (Colombia), ECH (Chile), EWK (Belgium), and EWY (South Korea).
From my largest to my smallest position, I currently am long GDXJ (some new), the TIAA-CREF Traditional Annuity Fund, TLT, SIL, ELD, GDX, URA, I-Bonds, bank CDs (some new), money-market funds (some new), EZA (some new), SCIF, ASHR (some new), OIH (many new), SEA (some new), EPHE, EPOL (many new), ARGT (some new), VNM (all new), FCG (some new), EWG (all new), EWU (all new), EWI (all new), EWW (all new), GOEX, BGEIX, MTDR (all new), RGLD, WPM, SAND, and SILJ. I have no current short positions.
Those who respect the past won't be afraid to repeat it.
I expect the S&P 500 to eventually lose more than 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 nadir occurring maybe in 2020. During the 2007-2009 bear market, most investors in August 2008 still didn't realize that we were in a crushing collapse, and I expect that well into 2019 most investors similarly will think that the U.S. equity bull market is alive and well. After reaching its all-time zenith on August 31, 2018, the Russell 2000 Index and related funds including IWM generally underperformed their larger-cap counterparts into late October 2018; similar behavior had ushered in the major bear markets of 1929-1932, 1973-1974, and 2007-2009. Meanwhile, the Nasdaq climbed to an all-time peak in nominal terms on August 30, 2018--although the Nasdaq never surpassed its March 10, 2000 intraday zenith in inflation-adjusted terms and perhaps never will. There is also a little-known megaphone formation in which the S&P 500 has been making higher highs and lower lows since 1996. A two-thirds loss from its recent zenith would put the S&P 500 near 980 and I believe that its valuation will become even more depressed to create all-time record investor outflows before we eventually and energetically begin the next bull market. Far too many conservative investors took their money out of safe time deposits; the incredibly long bull market has left them completely unprepared for a bear market. Die-hard Bogleheads will probably resist unloading perhaps until late 2019 or early 2020, but when they are perceived to be blockheads and become disillusioned by their method they will be among the biggest net sellers of passive equity funds. Because so much money exists today in exchange-traded and open-end funds, as they decline in value they will be forced to destroy shares which will compel them to sell their components, thus depressing prices further and creating more share destruction in a dangerous domino effect.
Recent extreme fear combined with additional lower highs for VIX are both likely signaling an intermediate-term rebound for some unknown period of months into 2019. I therefore progressively closed all of my short positions and have been gradually purchasing the most undervalued shares which are primarily emerging-market and commodity-related securities.
Investors should be buying global stocks now not because we are allegedly still in a bull market--which we are not--but because we are in a bear market where the most reliable rebounds occur with significant annualized gains and limited potential downside as long as fear remains elevated.
I appreciate Seeking Alpha reprinting these updates.
All of my updates are posted originally on my blog at truecontrarian.com and are then reprinted by Seeking Alpha which has a nicely-moderated forum for making comments. If you want to see my ideas as close as possible to when I am writing them then be sure to go to my web site first because it will take time for Seeking Alpha to be able to properly reformat them for publication.
