BIG BOTTOMS (October 16, 2022): Most investors misunderstand bear markets. Bear markets create opportunities for much greater and much faster profits than bull markets. This is because 1) bear markets on average last about one-third the total time of bull markets; and 2) the annualized percentage fluctuations in bear markets are roughly triple those during bull markets.
A bear-market bottom is a lengthy process, not an event.
During bear markets some assets tend to complete their lowest points within one year of the original top. If we begin counting this bear market starting with the S&P 500 all-time zenith of 4818.62 on January 4, 2022 then the bear market is 9-1/2 months old. This is roughly the time when a wide variety of assets including U.S. Treasuries, gold mining and silver mining shares, and some currencies including the Swiss franc and Japanese yen often complete their bottoms prior to powerful uptrends.
Most investors don't respect fair value or differentiation.
Fair value refers to the price at which any asset precisely reflects its fundamentals. Currently the price at which the fund QQQ would exactly match its historic average valuations relative to the profit growth of its components would be about 114. This is very far from its all-time record overvaluation of 408.71 less than one year ago. While QQQ has slumped below 260 several times in recent days, this is still far above 114, so the overall long-term downward trend for QQQ must remain lower for another two or three years until it is trading at a typical discount of 30% to 50% below fair value.
Investors are as baffled about bear-market rebounds as they are about bear markets.
One of the least-understood characteristics of any true bear market is that these feature frequent intense rebounds. Already in 2022 we had two surges higher, from mid-March to late March and then from mid-June to mid-August. We are probably transitioning to the third powerful surge higher of 2022. This recovery has been clearly signaled with the highest put-call ratios ever recorded in the history of the stock market (see chart near the bottom of this update), all-time record net outflows from many U.S. equity funds, the highest ratio of insider buying to insider selling since March 2020, and other reliable rebound foreshadowing. The U.S. dollar index and VIX have formed lower highs since September 28, 2022 which, in an environment of generally falling stock prices, usually indicates that equity prices are set for a sharp bounce higher.
Here is an example of the huge frequent bounces for QQQ during its 2000-2002 bear market when it had lost 83.6% of its value in 31 months:
Differentiation is likely to be among the top stories of the next two years.
What has happened so far in 2022? Investors have sold everything, especially in recent months: stocks, bonds, gold, currencies, real estate, art, etc. Almost nothing has been spared. This is common to the way that bear markets behave: in their early stages, investors are so confused that they sell everything and ask questions later.
Sooner or later, assets which classically bottom earliest tend to recover sharply. This usually includes U.S. Treasuries of all maturities, gold mining and silver mining shares, and safe-haven currencies like the Swiss franc and Japanese yen--and in this case also the British pound due to its widespread unpopularity. The more these assets diverge from QQQ and SPY, the more that investors will pay attention to them. Since very few assets are rallying in any bear market, the few which are climbing enjoy outsized attention and enthusiastic participation. Once funds like GDXJ have gained 50% or 100%, investors will be eagerly chasing after them because they desperately want to own something that is rising when almost everything else is falling.
Energy shares have been outperforming so far in 2022, thereby enjoying far too much attention relative to their fundamentals.
Why have energy shares been among the few winners so far in 2022? You will hear lots of explanations in the media, but the real reason is that they have been one of the few assets with positive gains in this calendar year. Investors are therefore crowding into them because they want to own something which is going up instead of going down. I believe this will end badly so I am staying away from energy until we have much lower valuations and much heavier insider buying in the energy sector. The lows in 2021 for funds including XLE and XES are warning of trouble ahead, representing a drop of almost half from their current levels whenever their 2021 lows are revisited eventually.
Gold mining shares and U.S. Treasuries will probably be among the biggest winners of the next two to three years.
Funds like GDXJ could triple or more from their recent lows including 25.80 for GDXJ, while "boring" U.S. Treasury funds like TLT will probably return 50% or more including reinvested dividends. This would not put either GDXJ or TLT anywhere near their respective historic highs. The more these ascend, the more that people will notice this behavior and will want to jump aboard the bandwagon. The secret to success with investing is to purchase these classic early-bottoming shares far ahead of everyone else, relying on their consistent bear-market outperformance to shine sooner or later. Investors become overly obsessed with only buying an asset which has already been rising, thereby causing such investors to miss out on half or more of their total percentage gains.
Selling puts on oversold but still-overvalued assets is a little-appreciated method which is even more profitable than selling covered calls.
Put prices tend to be their most overvalued when investors are panicking. If you are short something which is likely to eventually drop by 80% or more from its zenith--think QQQ--but which is temporarily being sold in a panic, then instead of covering your short position consider selling covered puts against it. This will allow you to capture temporarily-inflated time premium while retaining your short position. If there is an imminent collapse then you won't make as big a profit as you would have done otherwise, but you will usually get much more up front than you deserve in options premiums. Far more investors buy options instead of selling them, causing their prices to be inflated. Options buyers in general are buying hope via expensive lottery tickets, while options sellers tend to be more-experienced successful long-term options traders.
Long bull markets are followed by long bear markets.
The bull market which lasted from August 1921 through September 1929 was followed by a bear market which ended in July 1932, 34 months later. The bull market from October 1990 through March 2000 was followed by a bear market from March 10, 2000 to October 10, 2002, 31 months later. We just had the lengthiest bull market in history from March 2009 through January 2022, so expect the current bear market to last for at least 2-1/2 years and perhaps longer.
This gives us numerous opportunities to profit from--or to lose money by misreading--both the long and short sides.
Many assets will not bottom until 2024 or 2025.
The Nasdaq and the S&P 500 Index, along with related funds including QQQ and SPY, will probably not bottom until late 2024 or early 2025. Real estate, art, collectibles, and other non-financial assets will probably bottom several months later than U.S. equity indices just as they had mostly peaked several months later in 2022.
Here are five useful charts.
Investors are suddenly chasing after downside protection at a more frenetic pace than at any time in the 21st century:
The average investor has been panicking out of the market as aggressively as they were piling in near the end of 2021 and the start of 2022:
Commodity trading advisors are repeatedly buying near tops and selling near bottoms:
Gold's traders' commitments recently achieved a four-year bullish net extreme:
Commercials for the 2-year U.S. Treasury note reached an all-time extreme of net accumulation:
The bottom line: expect a powerful rebound but the U.S. equity bear market will not end for another two years or more.
Only buy something if it is historically likely to be in the process of completing a bottom which will be followed by dramatic percentage gains. Gold mining and silver mining shares often bottom within a year following a topping pattern for large-cap growth favorites, while U.S. Treasuries and safe-haven currencies also tend to bottom early. Most assets will not likely bottom for another two or three years.
Disclosure of current holdings:
Here is my current asset allocation, with the funds in each group ordered from my largest to my smallest positions:
VMFXX/FZDXX/Savings/Checking long: 33.4%;
XLK/QQQ/TSLA short, hedged with covered puts: 27.9%;
TLT/I Bonds/2-Year/3-Year/52-Week/26-Week long: 23.5%;
GDXJ/ASA/GDX/BGEIX long: 19.2%;
Gold/silver/platinum coins: 5.3%;
INTC long: 2.21%;
TKC long: 1.67%;
GEO long: 1.50%;
TEI long: 1.29%;
KWEB long: 1.17%;
FXY/FXB/FXF long: 1.16%;
VZ long: 0.63%;
EPOL long: 0.29%;
T long: 0.20%;
WBD long: 0.20%;
LEMB long: 0.04%;
PCY long: 0.03%;
NGL.PR.B long: 0.03%;
CEE long: 0.02%.
The numbers add up to more than 100% because short positions only require about 30% to hold them with no margin required.
