Editor's note: Originally published on July 9, 2014
Most investors have behaved as though the bull market for U.S. equity indices, which began in early March 2009, will continue for several more years. Already, this extended uptrend has lasted longer than 90% of previous U.S. equity bull markets, and we have experienced an increasing number of negative divergences. The number of new 52-week highs has continued to contract. The number of investors who are hedging their portfolios against a decline has been sharply reduced, even among institutional investors who routinely use hedging but have decided recently that it's "a waste of money". Investors who were burned by the last bear market, and who made massive net withdrawals in the fourth quarter of 2008 and the first quarter of 2009 have been among the most eager to "get back into the stock market" since the beginning of 2013. The ratio of insider selling to insider buying has recently been increasing, especially among those traders with the best track records. Those groups and individual shares which had been among the leaders in recent years have recently been among the biggest losers, while lagging securities have been the most likely to catch up, especially for inflation-favoring assets, including mining shares. All of these tend to occur whenever a major bull market is transitioning to a major bear market.
Very few investors pay attention to the Russell 2000 Index and its relation to the S&P 500 Index. From early March 2009 through early March 2014, the Russell 2000 consistently outperformed the S&P 500 during uptrends, gaining nearly 100% more overall in percentage terms from their respective bottoms. Since the first week of March 2014, however, the Russell 2000 barely eked out a new all-time high on July 1, 2014, and rapidly moved lower again. During the same four-month period, the S&P 500 achieved numerous all-time highs.
Whenever small-cap equities in any sector are persistently underperforming their large-cap counterparts, a major bear market is usually imminent. One common characteristic of 1928-1929, 1972-1973, and 2007 was the sudden shift from outperformance to underperformance for small stocks prior to the eventual stock market collapse on all three of the above occasions. The mainstream financial media have barely paid attention to this key negative divergence, thereby making it even more likely to prove to be a significant omen.
Do you know anyone who has been selling stocks to take advantage of their overvaluation? Almost everyone I have met seems to believe that the good times will last indefinitely. Part of this is the human tendency to project the recent past into the indefinite future, which is probably the most consistently negative habit of most investors. As measured by Tobin's Q, the U.S. equity market overall has only been more dangerously overpriced once in its history, which was during the first quarter of 2000.
There is another pattern which is persistently underestimated by investors, which is the S&P 500 megaphone. Since 1996, the S&P 500 Index has made a sequence of several higher highs and lower lows. For example, the lows of 2002 were below the lows of 1998, while the lows of 2009 were below the lows of 2002. In early 2009, many believed that this trend was broken, but it once again proved to be reliable in forecasting the powerful bull market rally in recent years, and especially the new all-time highs. The next step, for better or worse, is therefore breaking below the 666.79 nadir of March 6, 2009, which would represent a decline of nearly two-thirds from its July 3, 2014 zenith of 1985.59. Of course, the S&P 500 could set one or more new all-time peaks before collapsing, but if any asset is likely to lose two-thirds of its value, then it is far too dangerous to hold onto it merely to eke out perhaps a few additional percent. The risk-reward ratio for the U.S. stock market has rarely been more unfavorable.
I have been buying the actively managed exchange-traded fund HDGE each time it drops another 10 cents. My highest purchase was at 12.99, and my lowest fill was at 11.59. After each bounce for HDGE (i.e., each time U.S. equities retreat), I plan to continue to accumulate HDGE into weakness. I am still losing money overall on this investment so far, but I expect it to be among the best-performing funds through 2016 or 2017. I plan to eventually make HDGE probably my second- or third-largest holding, although that will likely not occur until perhaps the spring or summer of 2015.
Disclosure: In August-September 2013, and again during the first four months of 2014, I was aggressively buying the shares of emerging-market country funds whenever they appeared to be most undervalued. Since June 2013, I have added periodically to funds of mining shares and related assets, especially following their most extended pullbacks. Starting in December 2013, I have been buying HDGE whenever it has traded below 13 dollars per share with the idea of selling it in 2016-2017, as we are completing the next U.S. equity bear-market bottoming pattern; HDGE is an actively managed fund which sells short various U.S. equities. From my largest to my smallest position, I currently own GDXJ, KOL, XME, GDX, SIL, COPX, HDGE, REMX, EWZ, RSX, IDX, GXG, ECH, GLDX, URA, VGPMX, BGEIX, VNM, ZJG (Toronto), PLTM, EPU, TUR, SLX, SOIL, EPHE, and THD. I recently sold all of my SCIF, which had briefly become my fourth-largest holding, because euphoria over the Indian election is almost certainly overdone. I have reduced my total cash position since June 2013 to approximately one-seventh of my total liquid net worth in order to increase my holdings in the above assets. I sold almost 90% of my SLX near 49 dollars per share in November-December 2013, because steel insiders were doing likewise. I plan to buy more HDGE each time it drops below 13 dollars per share, because I expect the S&P 500 to eventually lose about two-thirds of its peak value - with most of that decline occurring during the second quarter of 2015 and extending into 2016 or 2017. The Russell 2000 Index barely achieved a new all-time top on July 1, 2014, compared with its early March 2014 highs, while the S&P 500 did so numerous times over the same four-month period. This marked a classic negative divergence, which previously occurred in years including 1928-1929, 1972-1973, and 2007. Those who have "forgotten" the lessons of past bear markets are doomed to repeat their mistakes.