GOLDILOCKS AND THE THREE BEARS (May 28, 2019): Beginning around the end of 2006 it was common to hear that the U.S. stock market would keep climbing because the U.S. economy was neither too hot nor too cold; it was just right. This was often called the Goldilocks economy on cable TV in honor of the young girl who wanders into a strange home and discovers porridge which is neither too hot nor too cold but just right for her to eat. What the commentators failed to mention was that Goldilocks is followed by three bears: baby bear, mama bear, and papa bear, in that order. That is exactly what we got in 2007-2009, and what also began on August 31, 2018 when the Russell 2000 again led other U.S. equity indices in completing a historic top.
Here is a past update in which I mentioned Goldilocks and the three bears at a very different juncture for global assets:
We experienced baby bear during the final months of 2018. Mama bear probably started around the end of April and the beginning of May 2019.
Investors made all-time record inflows into many U.S. equity index funds near their highest levels of 2018 which were also close to all-time record overvaluations. Although semiconductor shares, the Russell 2000, VIX, and several other reliable indicators warned of trouble ahead, very few investors were prepared for the pullback during the fourth quarter of 2018. Investors then reduced risk very close to the Christmas bottom just in time to miss a powerful intermediate-term rebound. In April 2019 investors once again piled into U.S. equity index funds along with new record inflows into many U.S. high-yield corporate bond funds. In addition to semiconductor shares, the Russell 2000, and VIX once again warning of a likely sharp correction, U.S. housing prices have been dropping in far more neighborhoods than had been the case last summer. It is likely that the total percentage pullbacks during the next several months will exceed the total losses of 20%-30% for U.S. equity indices from their late-summer 2018 highs to their Christmas 2018 lows.
Many global assets are out of synchronization with U.S. equity indices.
Sometimes global assets tend to rise and fall in tandem while other times they behave quite differently. At the end of 2017 and the beginning of 2018 nearly all risk assets rallied together around the world, and then they began to diverge sharply in January 2018 as U.S. equity indices and U.S. high-yield corporate bonds continued to mostly climb while nearly all other worldwide assets experienced sharp losses. This divergence continued as many emerging-market government bonds and gold/silver mining shares bottomed in September 2018 while many other emerging markets completed their 2018 nadirs during October. U.S. assets completed historic topping patterns from late August through early October 2018 and then plummeted choppily through Christmas, with energy shares experiencing especially sharp December losses.
Starting in early January 2019 there was a nearly synchronous global uptrend, and then divergences began again as non-U.S. assets mostly began notable corrections around the beginning of the second quarter. U.S. equities and high-yield corporate bonds either made lower highs in late April through early May 2019 versus their late-summer tops for small- and mid-cap shares, or else they achieved nominally higher highs for large-cap holdings compared with 2018. Most of the 2019 new large-cap highs for U.S. equity indices and funds including the S&P 500 and the Nasdaq exceeded their 2018 peaks by about a half percent which makes them actually lower highs after adjusting for inflation. Currently we have a situation which is somewhat analogous to roughly the middle of October 2018 where U.S. assets have begun downtrends which are still in their early stages, while many emerging-market stocks, bonds, and commodity-related assets have either recently completed important 2019 lows or will soon do so. Several sectors including India, Brazil, rare-earth extraction, and several non-greenback currencies including the Swiss franc have probably already begun significant uptrends.
Long-dated U.S. Treasuries are an example of how many categories of assets aren't behaving according to traditional bull-market scripts.
Long-dated U.S. Treasuries and their funds including TLT often behave quite differently from U.S. equity indices and U.S. high-yield corporate bonds, but TLT has been approaching its 2017 highs with notable heavy net inflows, deteriorating traders' commitments, and 83% bulls at Friday's close for the Daily Sentiment Index. Funds like TLT and ZROZ will likely end up declining along with U.S. equity indices, U.S. high-yield corporate bonds, and U.S. real estate. The U.S. dollar is probably also completing a topping pattern in preparation for a substantial decline during the upcoming nine to fifteen months.
Uptrends for emerging markets will likely prevent papa bear's emerging [pun probably intended] from hibernation, but mama bear is no sweet gal.
The collapsing phase of any U.S. equity bear market is usually postponed until nearly all worldwide risk assets are set to plunge together. A classic example is 2007-2009 when the Russell 2000 completed a double top on June 1 and July 9, 2007, followed by the S&P 500 on October 9, 2007 and the Nasdaq on October 31. Many commodity producers and emerging markets didn't complete their highs for the cycle until May-June 2008 or the summer of 2008 for many energy shares. As long as many emerging-market securities and commodity producers are mostly forming higher lows, U.S. assets can experience periodic sharp losses which will usually be followed by powerful recoveries such as the post-baby-bear rebound from December 26, 2018 through May 1, 2019. Eventually papa bear will arrive and nearly all worldwide assets will experience dramatic percentage losses, but I don't expect this to occur prior to the spring of 2020.
Each of the three bears along with other bear-market pullbacks will be followed by a powerful rebound, especially after the ultimate bear-market nadir, although volatility will remain elevated with especially sharp moves in both directions.
Any U.S. equity bear market is actually a series of corrections, each one of which is followed usually but not always by a sharp rebound, with the most intense pullbacks generally experiencing the most energetic recoveries. Volatility in both directions will remain especially high for an extended period of time particularly when the bear market has either ended or has a few more scary downward spikes remaining before it is finished, since that is when valuations are most compelling and bargains will eventually lead to triple-digit percentage gains. To discourage as many investors as possible into selling instead of buying, all recovery attempts during a bottoming process will be accompanied by frightening corrections, huge down days, and anything else which will cause most people to want to reduce risk instead of increasing it. I remember a friend who had considered buying risk assets many times in late 2008 and early 2009 but couldn't bring herself to do so because there was no calm entry point which appeared to be emotionally safe. When she was finally ready to more seriously invest near the end of March 2009, April 1 ended up being a sudden and severe down day which once again discouraged her from participating.
Outflows for U.S. equity index funds and U.S. high-yield corporate bond funds will probably approach or set new all-time records for net outflows during the bottoming process when papa bear is roaring at full blast. This will likely occur in 2020 and perhaps also in 2021 as U.S. pre- and post-election uncertainty encourages intense emotional buying and selling.
A weakening U.S. dollar is one characteristic feature of the mama-bear portion of a bear market.
Looking back at 2007-2009, the U.S. dollar slid to an all-time low versus many currencies in March 2008 and then completed a vital double bottom mostly at higher lows in July 2008. As long as the greenback remained well above its bottom there was no reason to sell most global assets. Once the U.S. dollar began to surge higher in July 2008 it served as a warning that the clock was ticking for all risk assets. Papa bear began shortly after a brief post-opening-bell ascent on September 2, 2008. The U.S. dollar index reached its high for that cycle on March 4, 2009, two days ahead of the ultimate 666.79 nadir for the S&P 500 Index. It is likely that in the current mama-bear environment we will mostly experience lower highs for the U.S. dollar versus nearly all worldwide currencies until we are experiencing a sharp U.S. equity intermediate-term bounce, at which point the greenback will probably rebound convincingly from multi-year and multi-decade lows as a useful advance warning of the upcoming papa bear. The U.S. dollar tends to be especially robust as a safe haven during papa bear, usually more than completely reversing its mama-bear losses versus most currencies.
VIX has been forming higher lows for 1-1/2 years since late 2017, just as it had previously done starting in late 2006.
In December 2006 VIX dropped below 10 and thereafter formed higher lows. VIX was still relatively depressed in August 2008, trading periodically below 20, but it thereafter soared to a multi-decade top just below 90 in October 2008 before forming numerous lower highs thereafter. VIX is doing the same in recent years, trading on an intraday basis below 9 several times near the end of 2017 and the first two trading days of 2018, then forming progressively higher lows including numerous dips below 15 during the past several trading days. Eventually VIX will peak at its highest point since 2008 or earlier and will thereafter form numerous lower highs prior to U.S. equity indices probably completing their respective bottoms several weeks or months afterward. The relentless sequence of higher VIX lows for 1-1/2 years while still remaining subdued means that mama bear is almost certainly here but so far remains incognito.
Most investors believe that we are still in a Goldilocks economy and won't recognize the three bears until the bitter end.
One reliable characteristic of U.S. equity bear markets is that investors don't believe they really exist until it is far too late to sell at favorable prices. During the 2000-2002 bear market, investors in January 2002 remained confident that the uptrend was still intact, and the same was true during the 2007-2009 bear market as late as Labor Day 2008. Most people can't perceive the existence of baby bear or mama bear and only notice papa bear after a crushing collapse when the overall bear market has already experienced most of its losses and when some leading sectors have already completed their bottoms just as investors are making all-time record net outflows while insiders are aggressively accumulating their own shares. There are many Boglehead devotees which is ironic since John Bogle himself sold heavily near bull-market peaks including 2000 and in 2018 shortly before his passing. These folks are convinced that they should keep buying U.S. equity index funds and U.S. high-yield corporate bond funds no matter how overvalued they are, because they are overconfident that they will have to come out ahead in the long run. This attitude will discourage Bogleheads from selling anywhere near the top but just as with equally committed Nifty Fifty and similar investors from past decades they will eventually unload massively out of disillusionment when we get close to the lowest bottoming prices near the end of papa bear.
U.S. housing prices have been falling in an increasingly widening range of neighborhoods.
Near the end of 2018 there were not many neighborhoods where U.S. housing prices had been dropping on a year-over-year basis, whereas in recent months the total has been climbing sharply with month-over-month losses becoming more common. U.S. housing prices overall are moderately less overvalued than they had been at their all-time 2005-2006 peaks averaging more than twice fair value. However, housing prices reached all-time highs during the past year or two even after adjusting for inflation in many central urban neighborhoods. Down payments remain essentially zero so that a moderate decline will leave many homeowners underwater and reluctant to pay their mortgages which will lead to another round of widespread defaults. A repeat of the 2006-2011 bear market, in which the average U.S. house lost 34% of its value (not adjusting for inflation), is likely to occur during the next four years or so with greater percentage pullbacks generally prevailing in the most overvalued regions. As compared with a historic average of 3:1 for housing prices relative to average household incomes, and bargain ratios of 1.5:1 in many parts of Arizona, Florida, and Nevada during 2010-2012, there are numerous neighborhoods in San Francisco, Los Angeles, Seattle, Portland, Vancouver, and elsewhere which sport ratios of 9:1 or even 10:1 and are thus roughly triple fair value.
Cryptocurrencies' 2019 surge confirms that investors remain eager to chase as is characteristic of a post-baby-bear rebound.
Investors become dangerous complacent following a lengthy bull market, and the bull market for U.S. equity indices which began in early March 2009 certainly fits all criteria of having been absurdly overextended. Just as with Beanie Babies in the 1990s, cryptocurrencies were late to the bull-market party but caught up with ultra-trendy action until December 2017. They thereafter acted as all bubbles inevitably do: they plummeted over 80% and then rallied strongly after Christmas 2018. Cryptocurrencies have once again become trendy and were even featured in a recent episode of "60 Minutes" highlighting a fellow who went from rags (almost nothing) to amazing riches to rags (washing dishes) to riches--and will surely go to rags yet another time. His lavishly leveraged lifestyle is typical of people who are about to suffer serious losses. The South Sea Trading Company followed a nearly identical chart pattern three centuries ago--spoiler alert: it collapsed horribly in its final months.
Semiconductor shares and their funds continue to give a valuable foreshadowing of both uptrends and downtrends.
SMH, a fund of semiconductor shares, had peaked on July 17, 2007 at 41.41--almost three months before the S&P 500 did likewise on October 9, 2007. SMH similarly gave advance notice of the subsequent bull market by completing its bottom for the cycle on November 21, 2008 at 14.45; the S&P 500 didn't complete its historic nadir of 666.79 until March 6, 2009 which was 3-1/2 months later. This pattern has continued in modern times with SMH topping out in March 2018 with lower highs in June 2018 and afterward while the S&P 500 didn't reach its highest point until September 21, 2018. This year, SMH rose to an all-time zenith shortly after the opening bell on April 24, 2019, several trading days ahead of the S&P 500's May 1, 2019 top. Whenever we are in the papa-bear phase of the current bear market it is probable that SMH will bottom by an indefinite period of time prior to most U.S. equity indices. As of the close on Friday, May 24, 2019, SMH had fallen over 17% while SOXX was down 18% relative to their April 24, 2019 intraday zeniths.
Small- and mid-cap U.S. equity baskets never got anywhere near their 2018 all-time highs during 2019.
One classic divergence from history is whenever smaller U.S. companies are underperforming their large-cap counterparts. In 1929 this became an increasingly notable development which led to the worst bear market in U.S. history, and in 1972 a similar growing divergence between smaller and larger U.S. socks presaged the worst post-Great Depression bear market of the 20th century. In 2007, most baskets of smaller companies peaked relatively early in the year, such as the June 1/July 9 double top for the Russell 2000, versus the S&P 500, the Nasdaq, and other large-cap indices which mostly didn't peak until the fourth quarter of 2007 and in some cases around the opening bell on Christmas Eve. It is probably not a coincidence that most baskets of small- and mid-cap U.S. companies including the Russell 2000, the S&P SmallCap 600, and related baskets had peaked on or near August 31, 2018 and didn't get anywhere close to those levels thereafter, even at the highest points of 2019. By diverging negatively from the S&P 500 and the Nasdaq, this common pattern from past U.S. equity bear markets has been repeated.
The relatively few investors who have noted this behavior have mostly concluded that for one reason or another "it's different this time" or have recommended shifting from smaller to larger U.S. companies rather than selling.
Gold/silver mining, energy, and numerous emerging-market funds will likely be among the biggest winners in the upcoming year, while the most overvalued U.S. equity and high-yield bond funds will be among the most notable losers.
GDXJ (mid-cap gold/silver mining) is likely completing important higher lows along with other gold mining and silver mining shares, while XES (oil and gas equipment and services) remains among my favorite energy funds with a ten-year high in the purchases of its components by top corporate insiders in December 2018 and recent additional insider buying at modestly higher lows. Many emerging-market and commodity-related funds have suffered substantial net outflows with GDXJ setting a new all-time record. Among other emerging markets, funds of Chinese A-shares including ASHR (A-share large-cap), ASHS (A-share small-cap), and KBA (A-share diversified) are especially worthwhile with negative media headlines obscuring unusually cheap valuations with high-single-digit price-earnings ratios. Other compelling emerging-market funds include TUR (Turkey), PAK (Pakistan), GXG (Colombia), and EPOL (Poland). SCIF (small-cap India) had been a worthwhile bargain although it has been climbing as election results in India were being tabulated. TUR as of its close on May 23, 2019 sported a price-earnings ratio of 5.64 and a price-to-book ratio of 0.92.
Most U.S. technology shares and U.S. high-yield corporate bonds are unusually overpriced even compared with previous bull-market peaks. One common characteristic of U.S. equity bear markets is that high-P/E shares usually end up with dramatic losses not because of falling earnings but due primarily to compressing price-earnings ratios.
Inflationary expectations have become nearly extinct with a recent Bloomberg Businessweek cover asking "Is Inflation Dead?"
Inflationary fears had become almost nonexistent in 2007 which had almost completely reversed during the first several months of 2008. Inflation was also a serious concern in 2000, 1972, 1929, and during the early stages of nearly all major U.S. equity bear markets. Mama bear tends to feature rising wage and price inflation and we are just beginning to see some pressure on the wage front with hardly any price worries so far. This is likely to change considerably between now and the early months of 2020 as inflationary fears become far more prevalent.
Buying U.S. equity index funds and U.S. high-yield corporate bonds today is like trying to reach the top of Mount Everest at the same time as everyone else.
Some people recently died climbing Mount Everest--mainly because they became a dangerously overcrowded herd. Here is an actual photo of Everest Bogleheads which seems unbelievable:
The bottom line: Goldilocks is always followed by three bears, both in the children's story and when investing. We adored baby bear in the fourth quarter of 2018. Mama bear likely arrived at the beginning of May 2019.
U.S. equity bear markets are far more alike than U.S. equity bull markets. One common characteristic is the existence of three bearish phases, of which baby bear ended shortly after the opening bell on December 26, 2018 while mama bear probably emerged from hibernation shortly after the opening bell on May 1, 2019. Many investors believe that U.S. equity indices are still in bull markets, but the behavior of the Russell 2000 in 2018-2019 and the failure of nearly all U.S. equity indices in 2019 to surpass their 2018 peaks after adjusting for inflation makes it probable that we are already nearly nine months into the current U.S. equity bear market. Mama bear tends to be accompanied by outsized losses for previous top investor favorites along with a generally retreating U.S. dollar versus most global currencies. Inflationary expectations tend to climb when mama bear is present. Emerging-market stocks and bonds, along with commodity-related assets, are often among the top performers until the U.S. dollar finally terminates its downtrend and begins a strong upward surge which heralds the eventual arrival of papa bear. Most likely we are at least several months away from observing the ursine father.
Disclosure of current holdings:
Besides 4-week U.S. Treasuries which I purchase every week, I own numerous exchange-traded and closed-end funds which are listed below. I frequently update my outlook and asset allocation on SeekingAlpha.com.
From my largest to my smallest position I currently am long GDXJ (some new), 4-week U.S. Treasuries (some Thursday, May 23, 2019 yielding 2.378%), the TIAA-CREF Traditional Annuity Fund, SIL, SCIF, ELD, ASHR, XES (some new), SEA (some new), OIH, FCG, ASHS, VNM, GDX, bank CDs, money-market funds, GXG (some new), URA, I-Bonds, PAK, EPOL, EZA, EPHE, SLX (some new), LIT (some new), TUR (some new), ARGT, FM, ECH, EGPT, MTDR, EWG, EWU, EWI, EWW, REMX, FXF, JOF, AFK, RSXJ, COPX, EWD, EWQ, EWK, GREK, HDGE, EWM, CHK, EWN, GOEX, BGEIX, NGE, IDX, 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 bottoming pattern occurring with frequent sharp downward spikes during the final months of 2020 and perhaps into 2021. During the 2007-2009 bear market, most investors by Labor Day of 2008 still didn't realize that we were in a crushing collapse, and I expect that as late as the winter or spring of 2020 most investors will similarly persist in believing 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 most other small- and mid-cap U.S. equity funds have generally underperformed their large-cap counterparts; similar behavior had ushered in the major bear markets of 1929-1932, 1973-1974, and 2007-2009. Both the S&P 500 and the Nasdaq surpassed their 2018 peaks in 2019 but only by a half percent each, thereby making lower highs after adjusting for inflation. The Nasdaq in 2018-2019 never surpassed its March 10, 2000 intraday zenith in inflation-adjusted terms and has thus completed a historic long-term double top. A two-thirds loss from its recent zenith would put the S&P 500 just below 985 and I believe that its valuation will become even more depressed; fear over how much further prices will drop is likely to be accompanied by all-time record investor outflows from most U.S. equity index funds and U.S. high-yield corporate bond funds 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.
