RING IN VALUE, WRING OUT GROWTH (January 2, 2022): It is human nature to assume that the recent past will continue into the indefinite future. However, successful investing in 2022 requires identifying similar past historic parallels rather than assuming that 2022 will be like 2021.
Many investors not only don't realize how much large-cap growth shares decline following bubble peaks, but also how poorly they behave for several years after they collapse.
If you had been invested in QQQ at its intraday top on March 10, 2000 then by its intraday bottom on October 10, 2002 you would have lost 83.6% of your money assuming that all dividends were reinvested. What is perhaps just as bad, if not worse, was that the subsequent rebound for QQQ only returned it to 48.63% of its original peak by October 31, 2007, and then QQQ slid another 54.4% in just over one year to its November 21, 2008 nadir. Similar behavior had occurred in 1929-1932 and 1972-1974 and twice during the 19th century beginning in 1837 and 1873.
Perhaps you want to believe that for some reason it's different this time. Albert Einstein defined insanity as repeating a similar set of circumstances and expecting completely different results.
Here is a chart of QQQ, adjusted for dividends all being fully reinvested, highlighting its previous two 21st-century bear markets as we begin the third:
Insiders and billionaires have never sold more of their assets than they had done in 2021.
Both top corporate insiders and billionaires made all-time record sales and exhibited the highest-ever ratios of insider selling to insider buying in their entire history. It isn't likely that this is a coincidence. Some top insiders also sold real estate aggressively as they hadn't done since 2005-2006, with Elon Musk doing both on a grand scale with the heaviest-ever selling of any single company's stock in world history along with unloading all of his houses including his primary residence. You can believe that Musk only sold shares because Twitter fans made him do it, and that he only sold his houses because he's a simple guy who prefers fewer possessions. You might also want to believe in the tooth fairy.
Value shares overall have never been more underpriced relative to large-cap growth shares, nor have they ever experienced greater net outflows relative to the all-time record inflows for large-cap growth shares.
How popular were U.S. exchange-traded funds in 2021? They had more inflows for the entire calendar year than twenty combined years of inflows from 2001 through 2020. Meanwhile, value shares have never been more underpriced in both absolute and relative terms. By my definition this includes not only classic value sectors but also Chinese internet companies, telecommunications shares, and almost anything where prices have been far below fair value. At the same time, U.S. large-cap growth shares by most benchmarks have never been more overpriced than they were in recent months.
The following chart highlights how U.S. equity indices have behaved in recent decades following powerful outperformance by the ten largest companies by market capitalization:
Whenever large-cap deflation-loving U.S. growth favorites have such a wide disparity with small- and mid-cap inflation-loving emerging-market value shares, the same subsequent behavior has always occurred as in 1837, 1873, 1929, 1972, and 2000.
Since the second week of February 2021 we have experienced major downtrends for exchange-traded funds ranging from MJ (marijuana) to KWEB (Chinese internet shares) to EWZ, ECH, TUR, PAK, NGE (all emerging markets) to GDXJ, GDX (gold/silver mining shares). In the United States we have seen moderate downward behavior for IWC (small-cap U.S.) and mostly sideways movement for IWM (the Russell 2000). Investors have crowded into fewer and fewer large-cap growth shares in almost the exact same way they had previously done in years including 1929, 1972, and 1999-2000. The subsequent behavior is likely to be nearly identical to the above three examples from the past century, with losses of 80% or more for large-cap growth shares over the next few years.
The market's behavior over the past decade is a remarkable repeat of its action at the end of the 20th century:
Options activity has never been more extreme than it was in 2021.
We had all-time record speculative call buying relative to put buying, and for several months more people sold puts to "generate income" than bought puts as a hedge against a market decline. We also had record-low ratios of emerging-market valuations relative to U.S. valuations and VIX generating numerous higher lows throughout 2021 including the wildly-depressed reading of VIX at 16.62 which it had registered at 2:46 p.m. on December 30, 2021. Investors are excited about certain future gains for their favorite stocks, indifferent toward protecting the gains they already have, and complacent about the possibility of a serious downtrend. This is an especially dangerous combination.
Numerous sectors have never been cheaper than they were at their lowest points over the past two years, with some of those bargains still existing in a compelling fashion.
Gold mining, energy, and travel shares are three sectors which had never been more undervalued than they had been at their March 2020 lows. Chinese internet shares reached all-time record low valuations relative to their profit growth during the final week of December 2021. Except for parts of 1932, AT&T had never been as undervalued relative to its profitability in its entire existence dating back to 1877.
Investors have been exhibiting classic herd mentality in desiring to own shares in the biggest U.S. corporations with massive insider selling by its top executives than to purchase the best global bargains which have suffered massive price declines. People want to own what the least-knowledgeable investors widely own rather than following experienced insiders and billionaires. Guess whether the "little guy" or the wealthiest investors will get richer over the next few years.
Generally-rising inflation will be the most harmful to the most-overvalued assets.
The market's first response to the recent rise in inflation, especially in the U.S., has been for investors to crowd even more frenetically into the fewer and fewer assets which remain in uptrends. These are primarily the most-overpriced shares and other dangerously-overvalued assets of all kinds including real estate. This is almost surely the opposite of what will happen sooner or later, which will be that just as in all past episodes where inflation emerged from a lengthy period of dormancy, these assets were almost always the biggest percentage losers. Without exception, value shares have always trounced growth in an environment where inflation is a notable economic factor, although often growth wins out over an initial short time period.
One possible explanation for this behavior is that any significant unexpected change in the real economy, such as inflation suddenly moving higher, is greeted by confusion. People have no idea what to do so they look to see what others are doing and they blindly follow. Only later on do the well-established interrelationships and mathematical necessities become evident.
It's not just large-cap U.S. growth shares which have become dangerously overpriced.
Cryptocurrencies will likely plummet more than large-cap U.S. growth shares during the next few years, partly because the earliest one, Bitcoin, didn't even exist during the previous two bear markets. Owning cryptocurrencies is like owning an outdoor plant transported from a much warmer climate which has never experienced its first winter. Real-estate prices in most countries have reached all-time highs relative to average total household incomes in most neighborhoods. Many works of art, automobiles, and other collectibles have also reached unprecedented levels even if you adjust generously for inflation. Much of these occurred due to the unusual, temporary ease in obtaining borrowed money for just about any purpose.
The following chart highlights the most-popular trades among investors in both November and December 2021:
Anyone in the U.S. with a solid credit rating can purchase any property with zero net worth.
Here is a true story: I was scanning Zillow.com in one part of the United States where desirable houses tend to average about 600 to 700 thousand dollars. After ten to twelve minutes I started getting a sidebar questionnaire asking me about my job, my net worth, my credit score, and similar personal data. I responded (untruthfully) that my wife and I both worked for Amazon full time as package deliverers, that we had both been recently promoted to make twenty dollars per hour, that we had excellent credit ratings in the low 800s (the only honest piece of data and which could be easily verified), that we never owned property before, and that our net worth was literally zero. Within a half hour I received multiple email offers from lenders guaranteeing a mortgage of up to 750 thousand dollars for nearly any house we wanted to buy, and promised that all closing costs would be included in the mortgage financing. The next day I got several telephone calls about mortgage approval and none of them were the least bit discouraged about our complete lack of savings, nor our absence of history in paying a mortgage. Perhaps subprime mortgages or loans where the potential buyer lies about his or her income are no longer commonplace as they had been in the U.S. during 2005-2006, but the current situation seems even more perilously lenient.
Not surprisingly, mortgage debt has reached all-time record highs by huge ratios to their previous records in dozens of countries.
The bottom line: far too many investors have become converts to the Boglehead myth that if you keep buying U.S. large-cap growth equity funds then you have to come out ahead in the long run. While this might be true over thousands of years, humans alas don't live that long. Those who believed in the Boglehead method in August 1929, when John Bogle himself was a baby, were behind by 38% on average in real terms by August 1982 which was 53 years later (see chart from my November 24, 2021 update highlighting the exact data points). U.S. large-cap growth shares are significantly more overpriced now than they had been in August 1929 so expect similar losses for the masses of current investors who refuse to sell even a modest percentage of their holdings. History demonstrates that most of them will give up in disappointment following massive declines of 70%, 80%, or 90%, and will end up selling during the next major bottoming pattern just as Bogleheads (if by another name) had done in 1932, 1974, and 2002-2003 following similar growth-stock post-bubble collapses.
After each of these previous growth-stock bubbles we experienced huge declines for large-cap growth shares followed by subsequent extended underperformance. Large-cap U.S. growth shares may not regain anything close to their recent dominance until the 2030s when nearly everyone today will have give up on Boglehead methods.
Disclosure of current holdings (most recent purchases in red):
Here is my asset allocation with average opening prices adjusted for all dividends: 43.3% cash including I Bonds paying 7.12% guaranteed, TIAA Traditional Annuity paying 3% to 5% (only available for legacy retirement accounts), and Discover Bank high-yield savings paying 0.40% (available for all U.S. residents with retirement and ordinary savings accounts); 19.7% short XLK (112.7737); 18.0% short QQQ (309.7504); 17.4% long TLT (148.259); 7.0% short TSLA (494.9721); 5.8% long GDXJ (40.86); 5.55% long GEO (7.65); 2.4% long GDX (29.55); 1.25% long TUR (17.17); 1.05% long ASA (19.43); 0.95% long KWEB (35.94); 0.9% short AAPL (125.5481); 0.6% long ECH (22.98); 0.55% short IWF (223.0119); 0.45% short SMH (170.7813); 0.125% long T (23.17); 0.1% long UGP (2.565); 0.075% long ITUB (3.83); 0.0375% long BBD (3.39); 0.0125% long TIMB (9.99). It doesn't add up to 100% since short positions require less cash; there is no margin involved.
