REACT TO OVERREACTIONS (March 24, 2019): Bear markets for U.S. equities, including the one which began on August 31, 2018 for the Russell 2000, feature repeated market overreactions which occur much more rapidly and consistently than in bull markets. Investors will become increasingly confused as to what is happening and will repeatedly believe one foolish myth after another. In October 2018 most analysts insisted that we were merely experiencing a brief correction and that supposedly we were still in a U.S. equity bull market. Around Christmas the drops of more than 20% for the S&P 500 and the Nasdaq convinced almost everyone that we were in a bear market from which a short-term rebound was supposedly impossible. Naturally we experienced a huge short-term recovery--after which almost everyone became convinced once again that we must be in a bull market after all. Many investors falsely celebrated the phony ten-year anniversary of the U.S. equity bear market earlier this month. A misguided Fed and an inverted U.S. Treasury yield curve have suddenly made it popular to declare that a global recession is imminent. Long-dated U.S. Treasuries which were hated when they were true bargains less than five months ago near important lows are now being eagerly chased at inflated prices. Why does the consensus keep changing and why is it always wrong?
U.S. equity bear markets are far more alike than U.S. equity bull markets, but hardly anyone pays attention to their most typical patterns.
Imagine if each winter people had totally forgotten that they wore heavy clothing and owned snow shovels the previous winter. They would end up feeling cold from wearing thin shirts and short pants and never realizing that winter reoccurs each year with nearly identical behavior. Oddly enough, investors in 2018 aren't looking back to 2000-2002 or 2007-2009 or 1972-1974 and concluding that we are in a similar pattern. Instead, they are convinced that it must be completely different this time and that there is nothing to be learned from the past. There are many common features of U.S. equity bear markets, one being that bear markets aren't acknowledged until they experience their collapsing phases--which are usually far into the bear market after it has already existed for one or two years. The Russell 2000 reached its all-time top on August 31, 2018, experienced a drop of 27.3% from 1742.09 to 1266.92, and then rebounded to a February 25, 2019 recovery high of 1602.10 before once again forming lower highs. Whenever the Russell 2000 forms lower highs while the S&P 500 is making higher highs, this is usually a warning that a more severe drop is approaching. However, because investors have concluded that 2018 is nothing like 2000 or 2007 or 1973, they didn't observe this obvious parallel.
Like nearly all assets, long-dated U.S. Treasuries were hated when they were compelling buys a year ago and now they are suddenly beloved as they are once again becoming dangerously overpriced.
When I was purchasing TLT near its lows of 2018, nearly everyone was convinced that long-term U.S. interest rates had to move higher because the Republican tax cuts combined with increased government spending supposedly meant lower taxes and higher spending and sharply increasing deficits--therefore meaning that the government would have to pay higher interest rates to borrowers. Ironically, the biggest U.S. monthly deficit occurred during the past month when U.S. long-term interest rates experienced one of their sharpest percentage decreases in history. This shows first of all that analysts have no idea what they are talking about, and secondly that there isn't a simple interrelationship between deficits and interest rates. It also means that when everyone is telling you that interest rates will keep moving higher then they are likely set to drop substantially, whereas when everyone is expecting lower rates--like right now--they are probably set to soon move sharply higher over the next year or so.
Sometimes an apple is simply an apple.
If you see a woman holding an apple in her hand, what does it mean? Maybe it means that she symbolizes the birth of all existence. Perhaps it means that she has eaten from the tree of knowledge which she will share with Adam. Perhaps it means that life is inherently cyclical. Or, maybe it just means that she wants to eat an apple. I prefer the latter explanation.
An inverted U.S. Treasury yield curve could simply mean that the 28-day U.S. Treasury is paying too much, while the 30-year U.S. Treasury is paying too little.
The U.S. Treasury yield curve can always be found at the following official U.S. government web site:
Simplicity trumps brilliance.
Many analysts are stating that the inverted U.S. Treasury curve means that we will experience an imminent U.S. recession. Others see it as a symptom of massive global change which is visible in everything from increased flooding worldwide to more frequent market fluctuations.
While Armageddon is fun to talk about, here's a simpler explanation: short-term U.S. Treasuries are paying too much and you should invest in them. Long-term U.S. Treasuries are paying too little and you should avoid them. Yes, that's far too easily understandable to be fabulously mystical and holistic, but it is common sense--which as usual is none too common.
There is a typical bear-market shift out of wildly overpriced U.S. assets into bargain non-U.S. assets.
By all fundamental measures U.S. assets in nearly every broad-based asset class including general equity indices, technology shares, and high-yield corporate bonds are far too expensive compared with their counterparts in the rest of the world. Since the last week of October 2018, investors have been progressively shifting out of U.S. assets into non-U.S. stocks--especially into emerging-market securities and the shares of commodity-related assets. This shift hasn't received nearly as much media attention as many other financial events during the past five months but that doesn't mean that it wasn't of equal or greater importance. Emerging-market shares and commodity producers have achieved approximately double the returns of U.S. equity indices since late October with generally less volatility. A powerful uptrend isn't less significant just because it isn't widely known by most U.S. investors. As with all market developments, the most experienced and wealthiest investors are the first to recognize any trend change and to adjust their portfolios accordingly, gradually moving to the least-experienced investors who are desperately trying to figure out what to do with their 401(k) plans. By the time any idea becomes widely known it is far too late to capitalize upon it.
Gold mining and silver mining shares have been quietly rebounding since they had slid to 2-1/2-year bottoms on September 11, 2018 more than a half year ago.
Hardly anyone realizes that two of the biggest net outflows out of all exchange-traded funds in calendar year 2019 have been GDX and GDXJ. The first is a fund of large-cap gold mining and silver mining shares, while the second is in the same industry but is concentrated in mid-cap shares. The total outflow for GDXJ has been approximately one-seventh of its entire market capitalization. Most investors have already forgotten or didn't realize that U.S. equity index funds mostly continued to experience net outflows not only during late 2008 and early 2009 when they were collapsing but all the way through the end of 2012. Investors didn't want to participate in the early years of the lengthy U.S. equity bull market when prices were experiencing their best bargains. This is due to several reasons: 1) the 2007-2009 collapse was fresh and painful in investors' minds through 2012; 2) when U.S. assets were truly compelling they were also highly volatile as deeply underpriced assets almost always are, thereby frightening away nervous investors; 3) since the media kept telling them that the recovery was unsustainable, investors hesitated more than they acted. The most money flowed into stocks in 2018-2019 when prices were near their highest levels in history. Whether they realize it or not, investors keep buying high and selling low and repeating this process over and over again.
Emerging-market stocks and bonds remain worthwhile, while many commodity producers have been quietly rebounding but are still compelling for purchase.
Emerging-market funds including TUR, PAK, SCIF, and EPOL are hardly known to most investors but they represent some of the best values available in the world. SEA is a fund of sea shipping shares which also is not widely discussed but has deep bargain fundamentals. Commodity producers including LIT, REMX, GDXJ, SIL, SILJ, and XES have been rallying in recent months with periodic sharp corrections. All of the above will probably be among the top-performing exchange-traded funds into early 2020.
If everyone is worried about anything then you don't have to be concerned with it. If almost no one is worried then you should be.
Think about all the top concerns which investors have been fretting about during the past half year: tariffs, a Chinese slowdown, Brexit, Fed rate hikes, and recently the flattening U.S. Treasury curve. How many of these actually changed the fundamental situation? So far, none--and the inverting U.S. Treasury curve will prove to be equally groundless. Sure, we will eventually have a recession as is inevitable since the previous one had ended nearly a decade ago, but it won't happen soon with everyone talking about it.
Here are legitimate worries which no one is concerned with: a falling U.S. dollar, rising U.S. inflation, overheating global economies including China, falling housing prices, increasing defaults, and rising interest rates.
You will hardly see anyone being concerned with sharp increases in defaults, interest rates, and inflation, and yet those are far more serious concerns during the upcoming year than tariffs, a Chinese slowdown, or the inverted U.S. Treasury curve. We are at that stage of the U.S. equity bear market where historically we are most likely to experience increasing defaults in mortgages and high-yield corporate bonds and other loan agreements, while inflation and interest rates stage surprise increases when everyone is gazing lower. During the bear markets of 2007-2009, 2000-2002, and 1972-1974, investors went from almost zero fear of these events to becoming wildly obsessed with them. High-yield corporate bonds in particular, which sport near-record narrow spreads relative to U.S. Treasury yields, will likely suffer much wider spreads as lenders become increasingly reluctant at the same time that borrowers are desperately trying to lock in low yields. Investors, analysts, and the Fed are nearly unanimous in anticipating too low a rate of inflation in the United States. It has been a long time since we have experienced stagflation--a combination of slowing U.S. growth and rising U.S. inflation--but that would be par for the course at this stage in the U.S. equity bear market now that it has existed for nearly seven months.
The bottom line: as has been the best advice since the U.S. equity bear market began in late August 2018, prepare for what has happened most frequently at this stage in previous U.S. equity bear markets.
Instead of expecting 2019 to be completely different from the past, you should anticipate it to be a nearly exact repeat of what has happened at this stage during past U.S. equity bear markets through the decades. Emerging-market securities and commodity producers will likely continue to be among the top performers as they have already been since the last week of October 2018. Investors will be shocked, shocked as the past repeats itself and we experience a combination of a falling U.S. dollar, rising corporate and mortgage defaults, falling housing prices, rising U.S. inflation, and an acceleration in the underperformance of U.S. assets compared with their counterparts in the rest of the world. Fade the inverted-yield-curve blather by purchasing the high-paying 28-day U.S. Treasuries yielding nearly 2.5% while avoiding long-term U.S. Treasuries which are currently paying far too little for the interest-rate risk involved.
Disclosure of current holdings:
I have sold all of my TLT and related long-term U.S. Treasury holdings and used most of the money to buy short-term (28-day) U.S. Treasuries yielding roughly 2.5% along with selected emerging-market equities and commodity producers. You can find my more frequent comments on SeekingAlpha.com and in other media web sites.
From my largest to my smallest position I currently am long GDXJ (some new near 31), short-term U.S. Treasuries (many new), the TIAA-CREF Traditional Annuity Fund, SIL, SCIF (many last month), ELD, ASHR, OIH, FCG, XES, ASHS, VNM, SEA (some new), GDX, bank CDs (some new), money-market funds (some new), GXG, URA (some new), I-Bonds, EPOL (some new), PAK (some new), EZA, EPHE, ARGT, FM, SLX, ECH, LIT (some new), TUR (some new), EGPT, MTDR, EWG, EWU, EWI, EWW, JOF, AFK, REMX, FXF, RSXJ, COPX, EWD, EWQ, EWK, GREK, EWM, CHK, EWN, GOEX, BGEIX, IDX, NGE, 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 or early 2021. 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 into early 2020 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 have generally underperformed their larger-cap counterparts including not surpassing their more recent lower highs of February 25, 2019; 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. 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 in recent years; the incredibly long bull market has left them completely unprepared for a bear market. The behavior of the global financial markets since August 31, 2018 has been incredibly similar to the behavior in the early stages of nearly all U.S. equity bear markets going back to the 1790s. In general, U.S. equity bear markets are far more alike than bull markets. Die-hard Bogleheads will probably resist selling until we are approaching the next major bear-market bottom, but when they are perceived to be blockheads and become disillusioned by their method they will become some of 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 their fund managers 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. The Boglehead foolishness is especially ironic since Jack Bogle himself aggressively sold U.S. equities in 2000 and again in 2018 shortly before his passing.
