CALDRON BUBBLE (January 17, 2023): We are in the second year of the collapse of the "everything bubble." Unless you are in your 90s or over 100 years old and you were trading during the Great Depression, or you're in kindergarten and you could be trading into the 22nd century, this will end up being the biggest bubble collapse of your lifetime.
U.S. stocks, high-yield corporate bonds, real estate, art, used autos, baseball cards, and of course cryptocurrencies are all declining almost the same way that they did following a similar bubble in Japan which had peaked at the end of 1989. As for the U.S. stock market, there are many parallels in 2022-2025 with 2000-2003 which we will discuss in more detail later in this essay.
The most important characteristics of bubbles is that regardless of how or why they form, they all collapse nearly identically. This was first chronicled in detail by Charles Mackay in his 1841 classic publication, "Extraordinary Popular Delusions and the Madness of Crowds."
2023 will likely have a very different shape from 2022 although it will also primarily be a bear-market year.
Bear markets for all assets usually feature the most sharp rebounds within the context of dramatic long-term declines.
The lion's share of the market's losses in 2022 occurring in the most overvalued shares. High-P/E large-cap technology shares in 2022, just as in 1973 and 2000, were among the biggest percentage losers. From its March 10, 2000 intraday top to its October 10, 2002 intraday bottom, QQQ, a fund of the top 100 Nasdaq companies, lost 83.6% of its value which is more than 5 dollars out of 6. It is likely that a similar percentage decline is in progress following QQQ's all-time zenith in November 2021, with the losses for QQQ ending up twice or thrice as much as many other U.S. equity index funds.
We could get a much higher VIX and a much deeper pullback for U.S. equities in 2023 as compared with 2022.
I expect the S&P 500 Index to probably drop below three thousand at some point during 2023. If this occurs around mid-year rather than near the end of the calendar year, and if it is accompanied by the highest level for VIX since March 2000, massive investor outflows, and heavy insider buying, then this could provide our first opportunity to actually close out short positions and go heavily net long many deeply-undervalued securities. This would not be because the bear market will be over, as 2024 will almost surely feature the greatest percentage losses of the entire bear market. However, it could be possible to make numerous diversified purchases of washed-out securities around the middle of 2023 which could be huge winners within several months at which time most of them should be sold.
Even in the most severe bear markets, you can often make more money by going long prior to the bounces following deeply-oversold bottoms than from going short into the declines themselves.
Remember your favorite kindergarten story: Goldilocks and the Three Bears.
If March 2020 through January 2022 was Goldilocks, then 2022-2025 will feature the inevitable starring roles for the Three Bears. Baby Bear is an apt description of 2022, with numerous equity pullbacks each followed by a sharp rebound. Mama Bear should be an apt description of 2023 with a much more severe parental punishment, followed by a motherly strong rebound. This still leaves Papa Bear's powerfully destructive grip for 2024, of which we will talk more in future updates.
Investors on the equivalent of the Titanic prefer to upgrade their cabins rather than to head for the lifeboats.
In early 2001 investors had been migrating away from slumping large-cap tech shares and moving into energy, industrials, healthcare, and whatever else had been outperforming in 2000. Similar behavior has been occurring recently, with funds including XLI (industrials), XLV (healthcare), and XLF (financials) only modestly below their all-time tops. Last week XLI had the biggest net inflow of all exchange-traded funds. Just as in 2001, investors in early 2023 are unwilling to accept that we could be in a bear market and that they should therefore purchase something safe like 26-week U.S. Treasuries yielding between 4.8% and 4.9%. Instead, they think they are immune to losing money if they are in the "right" sectors.
As in all bear markets, most analysts are emphasizing "looking for quality" instead of diversifying into safer assets. The problem is that they're looking for quality in all the wrong places.
Bogleheads will be Bogleheads.
Near the end of 1999 I was working for a company in Manhattan which offered 401(k) options to its employees. Two of these choices were entirely invested in Nasdaq shares, one with large-caps and one which was more diversified but still highly speculative. The custodian of these assets sent a representative to "educate" (i.e., brainwash) employees on their options, failing to mention that these Nasdaq funds featured fees which were triple those of more conservative bond funds in the plan. They also did typical Boglehead tricks like showing charts of how these funds had performed--but going back to 1982 rather than some other year. I was upset enough to write a written complaint to the head of human resources and copy the CEO, and also to point out that they were subjecting themselves to potential legal action in a future year. They dismissed my complaints as being absurd.
In response, I organized a meeting of my co-workers in which I arranged to give a lecture about how the financial markets work. I was already teaching a class in the financial markets to new employees, so people were familiar with my experience. I gave one of my most eloquent explanations of how the Nasdaq and its funds were very dangerously overpriced. Many people commented that they had no plans to change their allocations since "the market always goes up in the long run" and this kind of commonly-heard nonsense, but over the next few years quite a few people came up to me privately and told me that they paid attention to my advice and reduced their risk.
The most reliable bear-market signals are ringing loudly of further losses.
VIX, an important signal of investor fear, hasn't even approached 40 so far in the current bear market. VIX slid to an intraday low of 18.01 on January 13, 2023, a one-year bottom. VVIX, also known as the VIX of VIX, has recently been rebounding from a multi-year nadir. We haven't had anywhere near the typical heavy net outflows that have characterized every bear-market bottom in history, nor the intense levels of buying by top corporate executives which had featured so prominently at major bottoms including March 2009 and March 2020 and were far more prevalent at minor bottoms such as December 2018. The failure by average investors to be worried about additional losses, and the indifference by insiders in accumulating shares near recent lows, are both clear signs that additional substantial losses still lie ahead.
In 2021 we had greater net exchange-traded fund inflows than during the entire twenty-year period from 2001 through 2020 combined. In 2022, even with notable declines for equity valuations, we had the second-highest total after 2021.
Fundamental valuations for most assets remain enormously above long-term historic averages.
QQQ and the S&P 500 have dropped from all-time record overvaluations a year ago but are still both trading at more than double their average ratios relative to the profits of their components. Real estate has fallen modestly from its all-time highs in recent months, but is about 75% overpriced on average in U.S. cities and more than that in many parts of the world. Assets in true bear markets don't just retreat somewhat and then resume their uptrends. They usually bottom well below fair value as we had seen for stocks in late 2002 and early 2003 as well as late 2008 and early 2009. For real estate we had many deeply undervalued neighborhoods at various points from 2010 through 2012.
After experiencing an extended correction since its September 28, 2022 two-decade high, the U.S. dollar index could be ready for its next multi-month uptrend.
Some undervalued assets including U.S. Treasuries have probably begun multi-year bull markets.
U.S. Treasuries, including their funds like TLT, fell to multi-decade lows in the autumn of 2022 and have begun forming several higher lows. Each week I have been buying 26-week U.S. Treasury bills along with other short-term Treasury securities as they have been enjoying their highest yields in 15-1/2 years. One consistent winner in bear markets going back to the late 1700s has been U.S. Treasuries of nearly all maturities.
Gold mining and silver mining shares likely resumed their bull markets in September 2022, right on schedule.
In March 2000 the S&P 500 completed its top and initiated a huge bear market which didn't end until October 2002. Gold mining and silver mining shares, as measured by $HUI and other reliable indices and funds, bottomed in mid-November 2000 which was eight months later. Fast forward to 2022. The S&P 500 completed its top on January 4, 2022 while GDXJ and related funds slid to multi-year lows (although remaining well above their March 2020 bottoms) in September 2022, once again eight months following the S&P 500 top. Looking back at 2000, gold/silver mining shares were among the top-performing sectors over the next three years and over the next decade. This is likely to be the case over the next several years also.
Gold mining and silver mining shares will dramatically outperform in the upcoming decade with periodic pullbacks of 15% to 25%. Only buy them after such pullbacks.
I have been maintaining my long positions in gold mining and silver mining funds including GDXJ, ASA, GDX, and BGEIX in that order. These consistently outperform following the collapse of U.S. growth bubbles, although they will periodically suffer moderate pullbacks of 15% to 25% just as they had done during November 2000 through December 2003.
I have been steadily adding to my short positions and reducing my long positions in preparation for the next downward trend for U.S. equities.
While I have been maintaining my short positions in XLK and QQQ, in recent months I have been adding to short positions in XLI, XLV, and SMH whenever VIX is below 20 and in XLE whenever insiders are heavily selling energy shares.
We had an all-time record level of insider selling of the largest global energy companies in recent months, so I began selling short XLE near 93 and 94 and have been continuing to add to this short position into its recent lower highs near 90 and 91. XLE has been one of the biggest outperformers since its March 2020 bottom and is therefore likely to be one of the biggest losers until insiders are once again heavy buyers. During several periods in 2020, including the spring and early autumn, we had the heaviest-ever insider buying of energy shares. Energy insiders seem to be especially astute in buying low and selling high.
Here are some useful charts which illustrate the above points.
The following chart highlights that the 2022 U.S. housing bubble surpassed the previous dangerous bubble peak of 2005-2006:
The Nasdaq in recent years has very closely tracked the Nikkei in the late 1980s as all true bubbles collapse identically:
The S&P 500 Index is its most overvalued in its entire history relative to risk-free U.S. government bonds:
Measured using price-to-sales, the S&P 500 has been far more overpriced recently than at any time in recent decades including 1999-2000:
Commercials, the equivalent of insiders for futures trading, have approached multi-year highs in accumulating the 30-year U.S. Treasury bond:
Lengthy bull markets from August 1921 through September 1929 and October 1990 through March 2000 were both followed by bear markets which lasted over 2-1/2 years apiece, therefore likely setting the stage for a repeat:
The bottom line: expect two more bear-market years through late 2024 or perhaps 2025.
Numerous analysts have declared that "the bear market is over" and use as "evidence" the hilarious proclamation that down years are followed by up years a large percentage of the time. This is like concluding that you don't need to take an umbrella when you go outside, since it will usually not be raining--except when it is. Checking the weather forecast or actually going outdoors to see for yourself is much more reliable than going by irrelevant long-term statistics, and there can be no doubt that stormy weather in the financial markets will be with us for roughly another two years. If you're very conservative then put all of your money in U.S. Treasury bills up to 52 weeks while emphasizing the weekly 26-week auctions. If you're willing to assume greater risk than gradually sell short the most-overvalued large-cap U.S. equity funds including XLI, XLE, XLV, and SMH.
Disclosure of current holdings:
Here is my current asset allocation as of the close on Tuesday, January 17, 2023:
TIAA(Traditional)/VMFXX/FZDXX/SPRXX/Savings/Checking long: 34.54%;
XLK short (all shorts currently unhedged): 17.52%;
QQQ short: 6.23%;
XLE short: 4.61%;
XLI short: 2.24%;
XLV short: 1.53%;
SMH short: 0.06%;
GDXJ long: 10.84%;
ASA long: 6.77%;
GDX long: 2.88%;
BGEIX long: 1.48%;
2-Year/3-Year/52-Week/26-Week/13-Week/5-Year TIPS long: 10.04%;
I Bonds long: 9.19%;
TLT long: 8.65%;
Gold/silver/platinum coins: 5.55%;
HBI long: 0.30%;
WBD long: 0.25%;
EWZ long: 0.08%;
EWZS long: 0.04%;
The numbers add up to more than 100% because short positions only require 30% collateral (by SEC regulations; some brokers require more) to hold them with no margin required.
