Commodity Producers' Rallies Don't Get No Respect

by: Steven Jon Kaplan

If you sort all unleveraged exchange-traded funds based upon their percentage increases from their respective 52-week lows, then you will discover that the top 50 are all involved with commodity production or emerging markets. The top three funds consist of silver mining companies (SILJ, SLVP, SIL), followed by coal mining KOL, then junior gold mining (GDXJ, GOEX, SGDJ), then general metals mining XME, steel SLX, gold mining RING, Brazil and Russia (EWZS, EWZ, RSXJ, BRF), large-cap gold mining GDX, SGDM, copper mining COPX, Brazil again BRAQ, gold mining again PSAU, more Brazil FBZ, BRAZ, Peru EPU, base metals mining PICK, Canadian commodity production CNDA, and then a mix of commodity producers, master limited partnerships, and emerging-market equities including ILF, FCG, GML, PSCE, XOP, and ENY. However, most of these funds have continued to experience outflows whenever they are experiencing short-term corrections. Partly this is because they had been in bear markets from April 2011 through January 20, 2016, so most investors don't trust their 2016 rebounds. Partly it is because they remain highly volatile, so that after they surge for some period of time they will slump by 20% or 30% and discourage participants into believing that they are incapable of sustaining bull markets. Even those funds which have more than doubled from their January 20 nadirs have mostly suffered from periodic outflows and are almost never recommended in the mainstream financial media.

The longer that investors ignore the best-performing funds of 2016, the more extended their uptrends will become. From September 2008 through December 2012, nearly all U.S. equity index funds based upon the S&P 500 or some other benchmark equity index continued to suffer more outflows than inflows. This was partly because many investors had lost more than half their money in these funds during the crushing 2007-2009 bear market, and partly because these securities remained highly volatile even after they had begun bull markets in early March 2009. The strongest percentage increases usually occur when investors don't trust recent gains and are unwilling to participate. So far, there are no clever acronyms for commodity producers, and the only well-known acronym for emerging markets is BRICs which have been out of favor for 5-1/2 years.

High-dividend shares have been in bear markets since July 2016. In sharp contrast to the choppy fund flows for commodity producers and emerging-market securities, high-dividend and low-volatility funds had enjoyed all-time record inflows in recent years. These including IYR, XLU, FXG, and SPHD had become so popular that their total inflows in many cases had sent new all-time records for all sectors, even surpassing the huge inflows into technology shares in 1999-2000. Partly this is because normally conservative investors who for decades would put their money into bank accounts to get 3% or 4% couldn't accept getting only 1% or less from such time deposits, and decided to do the same as everyone else and pile into funds paying similar yields as dividends. These incredibly trendy funds have been underperforming since July 2016, experiencing mostly double-digit percentage declines. However, investors haven't yet figure out what to do with their money; they haven't made notable inflows into any major asset class during the second half of 2016. Selling has begat selling; even ordinary U.S. equity index funds have mostly experienced outflows in recent months. Investors are taking their money out of most stocks and bonds, but so far they haven't decided what to do with it. The money is mostly sitting in cash, waiting for a particular concept to become popular.

We have the ingredients for a perfect storm: plenty of buying power among investors, no conviction about what to do with it, and a compelling list of 2016 winners. One characteristic of any transition from a U.S. equity bull market to a bear market is that, as the months pass, fewer and fewer securities are setting new all-time or 52-week highs. This process of the narrowing of the equity base has been underway for almost 1-1/2 years. The Russell 2000, which can be measured by IWM, has never surpassed its June 2015 top even as the S&P 500 and most other well-known U.S. benchmark indices did so repeatedly during the first several months of 2016. This is how bear markets classically have always begun. Investors will ultimately gravitate toward the biggest winners, which in this case are nearly all commodity producers and emerging markets. With so much money sitting around looking for a home, sooner or later those investors who tend to act first will notice what is going on and act accordingly, with everyone else eventually climbing aboard the bandwagon. Many investors won't realize which funds are 2016's top performers until they see the lists of such funds when they become widely publicized around the beginning of 2017.

Both mining and energy producers have experienced multi-month corrections and are likely resuming their powerful uptrends. Most shares of gold and silver mining companies had peaked on August 11 or 12, 2016 and slumped for several weeks, bottoming on or around October 6, 2016. GDXJ slid from 52.50 to 36.96 over this time period, which is a total loss of 29.6%. Such a steep pullback discouraged many recent buyers from remaining committed to these and related assets. Energy shares including URA, FCG, KOL, OIH, and TAN also suffered corrections, with the price of the December 2016 crude oil futures contract falling to 43.57 U.S. dollars per troy ounce on Friday, November 4, 2016, which was its lowest point since June 11, 2016. Between now and the end of 2016, the shares of commodity producers will likely improve both their relative and absolute positioning even further, so they end up as almost exclusively the biggest winners of the year when people are deciding how to make allocations for 2017. Emotionally, many people like to use the new calendar year as an impetus to changing their asset allocation and revamping their portfolios. This will probably result in even more money being withdrawn from retreating high-dividend and low-volatility shares, with some of it going into commodity producers and emerging-market stocks and bonds.

The greenback seems to have completed additional lower highs as it has been doing for nearly one year. If you mention the U.S. dollar to most people, they will tell you that it is in an uptrend. As measured by the U.S. dollar index, a 12-2/3-year top of 100.51 was reached on December 2, 2015, and has been followed by a pattern of several lower highs. Two additional lower highs were just completed, with the U.S. dollar index touching 99.119 at 10:15 A.M. on October 25, 2016, and then another lower high of 99.026 at 12:40 P.M. on October 27, 2016. Since then, the greenback has continued its choppy descent, which will lead to additional lower highs and eventually a downside acceleration. Instead of climbing above 100 as most are anticipating, is much more likely that the U.S. dollar index will plummet below 80 within 1-1/2 years or less. While this probably sounds like an irrationally aggressive projection, the U.S. dollar index was below 80 at least part of each year from 2007 through 2014. As emerging markets went out of favor worldwide during 2011-2015, many currency traders crowded irrationally into the U.S. dollar, but that is unsustainable as emerging markets have been experiencing higher GDP growth rates along with stronger stock and bond gains than their U.S. counterparts for most of 2016. This pattern is likely to continue into 2017 and perhaps into early 2018, thereby encouraging investors to move progressively away from the safe haven of the greenback. This will serve as a supportive factor for assets which correlate inversely with the U.S. dollar, including most shares of commodity producers and emerging-market securities.

There has been far too much media hype about how assets will allegedly "respond to" the U.S. presidential election. There is usually a brief, intense emotional reaction to any widely-broadcast news, and that will likely also be the case with Tuesday's November 8, 2016, U.S. elections for president, the Senate, and the House of Representatives. However, even the extreme post-Brexit excesses were mostly resolved relatively quickly, while any alleged post-election response has already been mostly factored into current asset valuations. If there is any activity which goes in the opposite direction of their established trends, such as unusual lows for commodity producers or strong rebounds for high-dividend shares, then these should be used as opportunities to buy whichever commodity producers become most oversold and to sell short whichever high-dividend assets bounce the most euphorically. In general, the more that any news event is believed to exert a "permanent" influence on asset valuations, the more likely that trends which were in place prior to these events will resume shortly thereafter. The strong bull markets for commodity producers and emerging markets, which began on January 20, 2016, will probably continue for another year or more in spite of periodic sharp corrections, while the bear markets for high-dividend and low-volatility shares which mostly began in July 2016 will continue perhaps into 2019 with occasional upward bounces. There was a fascinating academic study published recently about why most people make inferior investing decisions:

Disclosure of current holdings: Whenever they have appeared to be irrationally depressed, I have been buying the shares of funds which invest either in the shares of commodity producers or emerging-market stocks and bonds, since I believe these remain the two most undervalued sectors in that order. In a world where real estate and U.S. high-dividend securities are wildly overvalued, these irrational favorites will accelerate their bear markets which aren't even recognized by most investors. As the greenback surprises most investors by accelerating its bear market, with the U.S. dollar index moving below 80 instead of climbing above 100 as almost everyone is expecting, this will lead to a major upward revision in global inflationary expectations. The latest multi-month pullback for many commodity producers has created some compelling buying opportunities, so be sure to seize them before they disappear. I was a very heavy buyer on June 27, 2016, when I made my largest total purchases since October 4, 2011, to capitalize upon the ridiculous post-Brexit panic. From my largest to my smallest position, I currently am long GDXJ (some new including today at 39.99), SIL (some new), KOL, GDX (some new), XME (some new), COPX (some new), EWZ, RSX, GOEX, URA (many new), REMX, VGPMX, HDGE, ELD, GXG (some new), IDX, NGE, BGEIX, ECH, FCG (some new), SEA (some new), VNM (some new), NORW, DXJ, BCS, PGAL, GREK, EPOL, EWW, RBS, TUR, RSXJ, RGLD, SLW, SAND, SILJ, EPU, FTAG, SOIL, EPHE, and THD. I have short positions in IYR, XLU, FXG, and SPHD, in that order, largest to smallest. I expect the S&P 500 to eventually lose two thirds of its August 23, 2016, intraday top of 2193.81, with its next bear-market bottom perhaps occurring near the end of 2018. As with all bear markets, the biggest losses will likely occur in its final months, and won't even be acknowledged as a bear market until then. While the media have been quick to trumpet new all-time highs for the Dow Jones Industrial Average, the Nasdaq, and the S&P 500 Index, hardly anyone has pointed out that the Russell 2000 Index and its funds including IWM had handily outperformed the S&P 500 from March 2009 through March 2014, and have subsequently dramatically underperformed, trading at their lowest levels during January 2016 in 2-1/2 years. The top for the Russell 2000 had occurred in June 2015 and so far has not been surpassed in this cycle. The failure of small-cap indices to reach new all-time highs as a group has frequently signaled major bear markets in past decades 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. The most overvalued sectors rely on the overhyped deflation trade and money which has been withdrawn from safe bank accounts by investors who begin with the premise that they want to generate income of 3-4% and look for the most stable securities which can generate such yields. This popular and extraordinarily dangerous method of investing had created valuations in July 2016 at roughly double fair value for most consumer staples, real estate investment trusts, utilities, and low-volatility shares, all of which have been underperforming most other sectors since then and will eventually lose 60% or more of their peak valuations.