Summary

Hardly anyone today thinks that we are in a bear market, and perhaps this will continue to be the case as late as the second or third quarter of 2019.

One set of assets today is ridiculously overvalued: these consist primarily of the most popular sectors which have been in bull markets mostly since the end of 2008 or the beginning of 2009.

During any topping process, investors won't sell, because they are convinced that they will come out ahead "in the long run" by being nearly fully invested. Assets which are out of favor often become even more unpopular, as investors want to crowd into whatever has been outperforming.

Some assets fit into a third category, where they are neither low enough to buy nor high enough to sell.

As is often the case in the early stages of a U.S. equity bear market, several typical characteristics can be observed. Hardly anyone thinks we are in a U.S. equity bear market, and that is par for the course. As a result of an unusually lengthy bull market for U.S. equities, unsustainable distortions have been created, which almost everyone thinks are permanent, even though current valuations are highly unstable and unsustainable. Recognizing what should be bought and sold today is an important step in being one of the few investors to make money during the next several years.

If it's a real bear market, then almost no one believes that it exists even after a year or more since it began.

Almost no one believed that we were in a U.S. equity bear market in March 1930, January 1974, January 2002, or August 2008. Hardly anyone today thinks that we are in a bear market, and perhaps this will continue to be the case as late as the second or third quarter of 2019. Only when it becomes far too late to sell U.S. equities and high yield corporate bonds at favorable prices will most investors realize what they should have done. The first step is to observe characteristic signs which have heralded past bear markets for U.S. equities. History almost always repeats itself with minor variations.

Assets which haven't experienced bear markets since early 2009 are especially overpriced and are vulnerable to huge declines.

One set of assets today is ridiculously overvalued: these consist primarily of the most popular sectors which have been in bull markets mostly since the end of 2008 or the beginning of 2009. Passive index funds of U.S. equities and U.S. corporate bonds tend to be especially overpriced, since investors have gotten into the habit of purchasing them almost without thinking about their valuations or future prospects. Once formed, habits are difficult to change. Since we have had such mild pullbacks for most U.S. equity and corporate bond sectors since late 2008 or early 2009, investors have almost no concern about the possibility of a dramatic decline or with how much more they are paying in 2018 than they had done several years ago for the same assets. The bear markets of 2007-2009 and 2000-2002 seem emotionally distant and irrelevant to the current situation, making a repeat performance especially likely.

If a frog is slowly boiled, then it won't recognize that the temperature is far too high to be safe; if stocks climb steadily and persistently, then investors similarly lose their concern about possible losses and will get boiled alive. Most investors barely bother to examine their portfolios, except perhaps to check their total balances to make sure that they are still going up. If you still own wildly overpriced securities, it is essential to gradually sell them, especially when they have enjoyed extended gains.

U.S. real estate is roughly as dangerously overvalued as it had been at the 2005-2006 bubble peak, except there is a different and more perilous geographic distribution.

Even at the highest points in 2005-2006, there were no U.S. neighborhoods where the average housing price divided by the average household income exceeded 8. Today, there are many neighborhoods where these ratios have surpassed 10 and some where they have moved above 11. as compared with historic averages of 3:1 which even Julius Caesar would recognize, since this ratio hasn't changed through the millennia. The most glaring overvaluations tend to be concentrated in the most popular cities for real estate as an investment rather than as merely a place to live. In 2010-2012, there were numerous regions of Arizona, Nevada, Florida, and elsewhere with ratios of housing prices to average household incomes of 1.5 or below; today, there are almost no such bargains below 3. Because prices have mostly been increasing for about seven years, people have become accustomed to them and don't stop to think how absurd they are relative to logic or fundamentals.

During the bear market from October 2006 through October 2011, the average U.S. house lost 34% of its value; the total pullback from now through 2022 or 2023 is likely to be greater in many cities, since valuations, especially along the West Coast of the U.S., are mostly higher than they were at their 2006 peaks. In cities such as Seattle, San Francisco, and Los Angeles, prices are higher today than they had been at their 2006 tops, even after you adjust for inflation.

Precious metals mining shares are an especially undervalued sector.

During any topping process, investors won't sell, because they are convinced that they will come out ahead "in the long run" by being nearly fully invested. Assets which are out of favor often become even more unpopular, as investors want to crowd into whatever has been outperforming. As a result, gold mining and silver mining shares have moved mostly flat after having roughly tripled from January 20, 2016, through the summer of 2016, and then surrendering roughly half of those gains before the end of 2016. Hedge funds have never been more net short gold, while commercials (miners, fabricators, jewelers, and others who use physical gold in their lines of business) in the most recent traders' commitments were net short fewer than 48 thousand contracts, which is more extreme than the 99th percentile of historic readings.

From their lows of January 20, 2016, funds like GDXJ have gained far more than gold bullion, while from their intraday lows of February 9, 2018, funds like GDXJ have moved higher, while gold bullion has dropped over one hundred U.S. dollars per troy ounce. This bodes well for the upcoming year, especially since commercials in nearly all non-U.S. dollar currencies are heavily betting on a falling greenback from now into 2019.

Besides GDXJ, worthwhile alternatives in this sector include SIL, SILJ, GDX, SGDJ, and SGDM. Vanguard is significantly reorganizing its VGPMX fund to drastically reduce its exposure to gold mining and silver mining companies after having maintained its investment consistency for decades; such rare events tend to occur just before major rallies.

Long-dated U.S. Treasuries are also notably undervalued.

You might think that an asset like the 30-year U.S. Treasury, which has gained more than every other sector worldwide since September 1981 and which has thus been in a bull market for nearly 37 years, would be very popular with investors. You would be wrong, since for whatever reason, everyone seems to think that U.S. Treasuries are in a bear market. TLT dropped to 116.09 on May 17, 2018, and may have completed its latest higher low at 118.07 on August 1, 2018. Especially whenever investors are finally selling their overpriced assets, investors won't have many places to go. U.S. Treasuries are highly liquid and will end up absorbing much of the asset reallocation which is exiting previously popular assets.

Emerging market government bonds could yield even higher total gains than U.S. government bonds.

While TLT and other funds of long-dated U.S. Treasuries are worth buying at current levels, a strong argument can be made for purchasing government bonds of emerging market countries. There have been geopolitically inspired sell-offs of numerous emerging market currencies since January 2018. Most of these declines are temporary, because geopolitical events, no matter how exciting, rarely affect corporate profits or other economic fundamentals. Countries which have experienced the greatest percentage losses for their currencies are in the favorable situation of having lower U.S. dollar wages for their employees in those countries, while continuing to sell their goods and services at the same U.S. dollar prices. This will lead to expanding profit margins, which will translate eventually into significant gains for those countries' stock markets.

While emerging market stocks will often drop during downtrends for U.S. equities, emerging market government bonds tend to perform best under the same circumstances. Funds of emerging market government bonds, including ELD, have fallen from important highs in January 2018 to retest their lowest points since the early months of 2016. Many investors are unfamiliar with this asset class. This gives an ideal opportunity to accumulate bargains, diversifying among emerging market countries which have experienced the greatest percentage declines due to spectacular headlines but little actual change in their economies.

Some assets fit into a third category, where they are neither low enough to buy nor high enough to sell.

Emerging market equities are generally much cheaper than U.S. equities, but especially after having moderately rebounded in recent weeks, I am mostly avoiding them for now. I wouldn't sell them, but I wouldn't buy them either. The same is true for most energy shares and their funds, including FCG, OIH, and KOL, which had been especially unpopular in the summer of 2017 but rebounded strongly from August 2017 through January 2018 and have remained trendy throughout 2018.

Unlike gold mining and silver mining, where the shares of the producers have been far outperforming bullion prices for most of 2018, crude oil and related commodities have frequently set multi-year highs during 2018, while the shares of energy producers have mostly made lower highs since January 2018. This is a negative divergence which is pointing the way lower for both energy commodities and the shares of their producers. I am also mostly avoiding mining companies which are not connected with gold or silver; these and their funds, including REMX, COPX, and XME, had soared to multi-year highs in January 2018, but like energy shares, have mostly been forming lower highs since then. Uranium shares and their funds, including URA, have remained strongly out of favor in recent years and might be worth holding for another year.

Since U.S. midterm elections are scheduled for November 6, 2018, the U.S. financial markets are likely to become more volatile out of concern about the results.

It is usually the case that midterm U.S. elections create uncertainty and, therefore, often lead to a stock market pullback in the months leading up to the election - until the final weeks, when investors become more excited about the upcoming end to uncertainty and push prices higher. That is one reason why the stock market often drops to October lows during midterm years, as we had previously experienced in years including 2002, 1998, and 1990; the 1994 and 1982 bottoms were in August rather than October. Hardly anyone has been discussing this topic, thereby making it increasingly likely that it will become an important factor. This could be especially true in 2018, since both the Senate and the House of Representatives following the November 6, 2018 elections could end up with either Democratic or Republican majorities (assuming that the two Senate independents continue to caucus with the Democrats), while the margins of victory could be quite narrow.

VIX has been frequently dropping below 12, which is likely also signaling upcoming U.S. equity weakness, along with a diminishing number of new 52-week highs and frequent intraday strength near the opening bell. The least-experienced investors tend to place market orders outside of regular trading hours, which crowd together at the open and thereby trigger stops, often causing the highest prices to occur shortly afterward. This is common behavior during a topping pattern.

A correction for U.S. equity indices could significantly alter the behavior of all three asset classes.

I believe that we will experience double-digit corrections possibly exceeding 20% for U.S. equity indices and high yield U.S. corporate bonds as they retreat toward important intermediate-term bottoms during the second half of 2018. This will probably be followed by a multi-month rebound to lower highs by the first or second quarter of 2019.

Deeply undervalued assets, including gold/silver mining shares, long-dated U.S. Treasuries, and emerging market government bonds, could rally moderately during the next few months, as U.S. equities are mostly declining. If government bonds from any country become unusually popular, they might even be worth selling later in 2018; otherwise, most assets in this category could end up outperforming sufficiently to gain investors' attention and encourage new net inflows. If these inflows become substantial and are combined with heavy insider selling during 2019, then it might be necessary to sell some or all of these assets next year.

Assets in the in-between sectors, including energy and emerging-market shares, will mostly decline along with U.S. equities during the next few months, and could thereby present some compelling buying opportunities later in 2018 in anticipation of a rebound into the first half of 2019.

The bottom line: Since nearly everyone wants to be fully invested in the most popular sectors, remain heavily in cash and only purchase the least-popular securities.

Whenever the herd is closest to being unanimous, it is most dangerous to run with it. While most investors are eager to hold popular Nasdaq shares, stick with gold mining and silver mining shares, along with long-term government bonds of both the U.S. and emerging markets. If you have real estate which you can sell, then do so, since housing prices are likely to be substantially lower by 2022-2023, especially where the ratios of housing prices to average household incomes are currently highest.

Disclosure of current holdings:

Because of an unprecedented investor surge into risk assets in January 2018, I unloaded most of my long positions that month. Half of my total liquid net worth is in cash, consisting of U.S. Treasury money-market funds and high-interest guaranteed time deposits. In a world where U.S. equity indices, junk bonds and real estate have finally begun major bear markets amidst massive all-time record inflows mostly from investors taking money out of their bank accounts, the post-election love affair with wildly overpriced favorites is in the early stages of what will eventually become a historic collapse and should end perhaps around the middle of 2020. The election of Donald J. Trump as U.S. President led to a "yuge" surge in investors' expectations, which, following a surge to all-time record highs, will become transformed into the most severe overall U.S. equity bear market since 1929-1932. The absurd popularity of cryptocurrencies until December 2017, with no intrinsic value, was characteristic of a generational peak such as we had previously experienced for tulips, canals, railroads, internet shares and Beanie Babies. I purchased more GDXJ below 32 several times and also added to TLT below 119, while shorting IWM at and modestly below 170. After having sold ELD near 40 in January 2018, I have been buying it below 35. Other funds of emerging market government bonds, including PCY and SOVB, are also worthwhile; select those which are commission-free with your broker.

From my largest to my smallest position, I currently am long GDXJ (some new), the TIAA-CREF Traditional Annuity Fund, SIL, HDGE (some new), GDX, TLT (some new), ELD (some new), URA, I-Bonds, bank CDs (some new), money-market funds, GOEX, VGPMX, BGEIX, RGLD, WPM, SAND and SILJ. I have short positions in IWM (some new), XLI, AMZN (some new), NFLX, NVDA, IYR, FXG and SPHD, in that order, largest to smallest.

Those who respect the past won't be afraid to repeat it.

I expect the S&P 500 to eventually lose more than two thirds of its value from its all-time top, whether that level has or hasn't already been reached, with its next bear market nadir occurring probably during 2020. During the 2007-2009 bear market, most investors in August 2008 didn't realize that we were in a crushing collapse. We already have numerous classic negative divergences, including junk bonds forming lower highs for several months. The S&P 500, the Dow Jones Industrial Average and several other large-cap U.S. equity indices haven't surpassed their all-time tops of January 26, 2018, even though they have come close. The Russell 2000 has retested nearly matching intraday highs during the past several weeks, while the Nasdaq climbed to an all-time peak in nominal terms on July 25, 2018 - although the Nasdaq never surpassed its March 10, 2000 intraday zenith in inflation-adjusted terms and perhaps never will.

The number of daily 52-week lows on U.S. exchanges sometimes surpasses the number of daily 52-week highs, even though most large-cap U.S. equity indices are much closer to their all-time highs than they are to their lowest levels during the past year. Semiconductor shares have been a leading indicator since the 1960s and have been flashing danger signals. The strongest intraday behavior usually occurs just after the opening bell, when amateurs are the most eager buyers, while closed-end fund discounts have been progressively climbing from rarely experienced lows. Some all-time record inflows were recorded during the first quarter of 2018, along with the most bullish net investor sentiment in many surveys throughout their multi-decade histories. VIX has been forming higher lows since the start of 2018. There is also a little-known megaphone formation in which the S&P 500 has been making higher highs and lower lows since 1996. A two-thirds loss from its January 26, 2018, zenith would put the S&P 500 near 950, and I believe that its valuation will become even more depressed to create all-time record investor outflows before we eventually and energetically begin the next bull market. Far too many conservative investors took their money out of safe time deposits; the incredibly long bull market has left them completely unprepared for a bear market. Die-hard Bogleheads will probably resist unloading for a while, but when they are perceived to be blockheads and become disillusioned by their method, they will be among the biggest net sellers of passive equity funds.