Wednesday, May 27, 2015

"When herd behavior takes over, people don't realize when they are taking risks. They stop analyzing the situation, and go with the group, with the plan, with the familiar way. That makes it easy to drift into disaster without ever being aware that they're in danger." --Esther Inglis-Arkell

2015-2016 IS NOT GOING TO BE A REPEAT OF 2013-2014 (May 26, 2015): Most investors have positioned their portfolios in the anticipation that 2015-2016 will be nearly identical to 2013-2014. Therefore, they are emphasizing the theme of a rising U.S. dollar, falling commodities and commodity producers, slumping emerging markets, outperforming U.S. stocks and bonds, surging global real estate, outperforming high-dividend assets including utilities and REITs, and retreating currencies of commodity-producing countries. However, now that roughly one hundred central banks around the world are fighting deflation, we have begun to experience a global inflationary resurgence which will continue and intensify into 2016. Because most people don't expect significant changes from last year or the year before, they have bid up deflation-loving assets to the point where most of them are far above fair value, while causing inflation-correlated securities to trade near their respective six-year nadirs. There is a lot of money to be made from reallocating your portfolios for an opposite alignment, since if commodity producers and related emerging market equities merely regain half of their losses since April 2011 then they will enjoy dramatic percentage increases from their current valuations.

The primary reason that investors don't modify their portfolios when it is optimal to do so is psychological. People don't like to tamper with the status quo when they are satisfied with it. If an asset has become especially overpriced, and may even be in a bubble, people won't be eager to sell it out of concern that it may eventually return to fair value. Instead, they will observe how nicely and smoothly it has enjoyed an extended price increase, and will either buy more or do nothing. Several people I know have recently been purchasing real estate in the most overvalued parts of the world, because they can't imagine that a wildly overpriced house must eventually return to fair value--and will likely continue to decline well below fair value just as any asset usually does. As with most investors, they repeatedly project the recent past into the indefinite future. If something hasn't recently slumped in price, or hasn't recently rallied strongly, then most people will have great difficulty imagining that it can do so. This is true even if the same currently undervalued asset has rallied several times in recent decades. Each time it emotionally seems completely different, so that investors don't conclude that what happened numerous times in the past will most likely occur again.

Large-cap U.S. equity indices have so frequently set new all-time highs in recent years that it is challenging for most investors to imagine that we are very likely to experience a repeat of 2007-2009 with the possibility of even greater percentage losses for the S&P 500 and the Nasdaq primarily because they became more overvalued in 2015 than they had been in 2007 by nearly all historic measures. VIX has been forming higher lows since July 3, 2014 when it had bottomed at a 7-1/2 year nadir; the last time it had behaved the same way was when it had plummeted to a multi-year bottom on December 15, 2006 and thereafter began to complete several higher lows. Similarly, many commodity producers have been in downtrends which didn't end until recent months and which in a few cases may not be over. A four-year bear market is long enough to emotionally convince most people that an upcoming extended uptrend is highly unlikely. Even though the most severe bear markets are almost always followed by the strongest bull markets, investors will almost always emotionally conclude that it will take years for a recovery to occur and that it will be tentative and tepid. In February and early March 2009, even optimistic investors couldn't imagine that U.S. equity indices would rebound in a meaningful way until many years had passed. Instead, after the bottoms on March 6 and March 9, 2009, we had one of the biggest two-month percentage gains for U.S. equity indices since the Great Depression.

The U.S. dollar index had rallied in the middle of March 2015 to its most elevated point since March 2003, thereby marking a 12-year top. It thereafter slumped for two months, and recently rapidly recovered more than half of its decline. Most investors have concluded that it is merely a matter of time before the greenback sets new multi-year zeniths versus most global currencies, not recognizing that there has been a dramatic shift which has impacted all assets. Central bank efforts to combat deflation have been succeeding, even in places like the eurozone where economic growth has accelerated at its fastest pace in two years. Since we haven't experienced surging inflation since the first several months of 2008, most people have forgotten how it occurs and psychologically don't fear it because it hasn't happened lately. Anything which has occurred recently has far more emotional impact than something which hasn't existed for years or decades. With almost no one being concerned with the possibility of an inflationary resurgence, rising wages and prices could reach a very advanced stage before most people would perceive it negatively. Recently, all signs of rising inflation are greeted happily by central banks and by nearly all analysts and advisors. Until this situation changes, which it must because it is so abnormal, inflation will be able to increase as much as it wants since no one is going to do anything to slow it down.

Most overvalued assets are likely to lose 60% or more of their value. This seems unimaginable to most people, but whenever something has become especially overpriced then it almost always first slumps to fair value and then continues to decline until it is selling at a significant discount. During the 2007-2009 equity bear market, no bourses fell to fair value and then went sideways. Instead, the discounts to fair value at the previous bear-market bottoms averaged between 30% and 50% in most countries including the United States. Similarly, when U.S. real estate was slumping in 2007-2009, many neighborhoods in states including Arizona, Nevada, and Florida didn't merely slide to fair value and then stop. They continued to decline until the ratios of prices to incomes in many areas was between 1.0 and 1.5 times average household income versus a normal average of between 2.5 and 3.0 times. Today, in cities including Vancouver, BC and San Francisco, some neighborhoods have ratios of prices to incomes which exceed 10. The most likely continuation is therefore a collapse of perhaps two thirds for residential real estate in these and similarly overpriced cities, which almost no one can imagine because people are only able to foresee any given outcome when it is an extension of recent behavior.

Utilities and REITs have been among the poorest-performing assets since they had peaked in January 2015, and this pattern will likely continue and spread to other high-dividend securities which tend to perform worst whenever inflationary expectations are accelerating. These are not merely corrections; high-dividend securities have probably begun multi-year bear markets which will continue into 2017 and perhaps also 2018. Even with their recent retreats as the U.S. dollar index has sharply rebounded in recent weeks, many of the best-performing securities of 2015 are emerging-market stocks and the shares of commodity producers which had almost all been especially elevated in April 2011 and had slumped toward six-year bottoms from November 2014 through May 2015. With little fanfare, U.S. equities are among the worst-performing global stock markets during the current calendar year. U.S. bonds, especially long-dated U.S. Treasuries, have slumped in recent months along with most high-dividend securities. The currencies of commodity-producing countries have mostly been the biggest gainers in recent months. While these patterns may not immediately seem to be interrelated, what they all have in common is that they are all anticipating worldwide inflation to become more clearly evident. Just when most investors have become convinced that deflation is a serious threat, the reality is the opposite.

If you are betting on a horse race, the ideal scenario is when an odds-on favorite is being priced as though it were a highly unlikely long shot. That is currently the situation in the global financial markets, where many commodity producers are among the most likely securities to benefit from rising worldwide inflationary expectations along with a retreating U.S. dollar. Most emerging markets have already been rebounding for several weeks or longer from their respective six-year lows. Because it is psychologically easier to stick with the favorites you know rather than having to research new ones, most investors have decided that 2015-2016 will be almost exactly like 2013-2014 and have therefore made very few changes to their portfolios. The majority of people will end up with net losses for both stocks and bonds by the end of 2015, which will progressively encourage them to eventually buy the best bargains especially if they have recently been among the latest hot performers. These will consist primarily of those assets which benefit from rising inflationary expectations, and which will--with periodic sharp corrections such as the one we have experienced recently--climb toward the top of the best-performing lists for the current calendar year. These trends are likely to become even more pronounced in 2016.

Tax tip: If you own shares or funds which are trading near six-year bottoms and you are a U.S. resident, you can take advantage of their currently depressed prices if these assets are in your 401(k), 403(b), SEP-IRA, Keogh, traditional IRA, or other non-Roth retirement account. You can convert these shares from your account to a Roth IRA and pay taxes based upon their present low valuations. As these eventually rebound, all future gains will be completely tax free. In the event that these shares don't recover but end up retreating further in price, you can choose to undo your conversion, which is known as a recharacterization. You can then wait at least 30 days, or until the following calendar year--whichever is later--and then convert them again. There is no limit to how many times you can repeat this process and there are no income or other restrictions in making such conversions and recharacterizations, as long as each recharacterization is done on or before October 15 of the year following the date when the conversion had been done. It's like being able to go back in time and "unbuy" something which doesn't go up in price. It's heads you win, and tails you also win. Unfortunately, I do not know of an equivalent strategy which is permitted in any other country.

Disclosure: In August-September 2013, and at various points during 2014 through March 2015, I had been buying the shares of emerging-market country funds whenever they had appeared to be most undervalued. Since June 2013, I have added periodically to funds of mining shares--and more recently energy shares--especially following their most extended pullbacks. I have also been accumulating HDGE which is an actively managed fund that sells short various U.S. equities, because I believe that U.S. assets of almost all kinds have become dangerously overvalued. From my largest to my smallest position, I currently own GDXJ, KOL, XME, HDGE, GDX, SIL, COPX, REMX, EWZ, RSX, IDX, GXG, ECH, GLDX, URA, FCG, VGPMX, BGEIX, VNM, NGE, PLTM, EPU, TUR, SILJ, SOIL, EPHE, and THD. In the late spring of 2014, I sold all of my SCIF which had briefly become my fourth-largest holding, because euphoria over the Indian election was irrationally overdone and this fund had more than doubled. I have reduced my total cash position since June 2013 to less than 4% of my total liquid net worth in order to increase my holdings in the above assets. I sold all of my SLX by acting whenever steel insiders were doing likewise. I also sold all of my FCG but I repurchased it following its recent collapse. I expect the S&P 500 to eventually lose about two thirds of its recent peak value--with most of that decline occurring in 2016-2017. The Russell 2000 Index (IWM) has only modestly surpassed its high from the first week of March 2014, while the Russell Microcap Index (IWC) barely surpassed its zenith from March 6, 2014. The S&P 500 Index set a new all-time high on numerous occasions during the same period. This marks a classic negative divergence which previously occurred in years including 1928-1929, 1972-1973, and 2007. Those who have "forgotten" or never learned the lessons of previous bear markets are doomed to repeat their mistakes.