Seeking Alpha

Ripe Harvest For Asset Pairs

by: Steven Jon Kaplan

“Now, it's that dispersion that's at the moment probably the most interesting opportunity in the market — start putting money to work in the losers and start taking a preference in the winners, because there's probably going to be a mean reversion in both sectors going either way over next 12 to 18 months.” - Ralph Jainz

Most investors are used to thinking about the financial markets as a collection of individual decisions. Should I buy more of this or sell some of that? However, often the most important clues can be found when there are unusually outsized ratios between assets which have been closely correlated for decades or longer. Commodity producers generally move in tandem, so it is rare to have energy shares being so strongly desired while gold mining and silver mining shares and their funds including GDXJ until very recently had been dramatically out of favor.

Investors continue to strongly favor high-yield U.S. corporate bonds which are sporting their lowest-ever spreads relative to U.S. Treasuries, while shunning the government bonds of numerous countries including the United States and some especially attractive yields from emerging-market government paper. Stocks which comprise numerous passive indices have mostly become notably overpriced, while those which are scarcely represented in indices can be undervalued.

U.S. assets of all kinds tend to be close to all-time record highs, while many emerging-market securities have fallen by more than one-third or in some cases by nearly half since January 2018. The U.S. dollar has become a widely-desired currency worldwide while the Swiss franc (which can be purchased via the fund FXF) and many emerging-market currencies are near multi-year lows. These irrational divergences have created some compelling investment opportunities.

Investors love energy assets even though the shares of the producers have steadily been lagging the commodities themselves since January 2018.

One of the least-logical developments of 2017 was the outflow from energy commodities and the shares of their producers until the final week of August, when 1-1/2-year lows were completed and investors finally began purchasing these again. Today, the situation is almost the exact opposite with investors eager to own this sector even though many funds of energy producers including FCG, OIH, and KOL have been steadily forming lower highs since January 2018.

When any sector of commodity producers makes lower highs while the commodities themselves are forming higher highs, this is almost always a negative divergence which is followed by lower valuations for the entire sector. According to the Daily Sentiment Index, at the close on October 1, 2018 there were 96% of futures traders who were bullish toward crude oil. It is likely that with investors just as eager to own energy shares today as they were reluctant to participate last summer, they will be disappointed once again with subsequent underperformance.

As much as investors adore anything connected with energy, they are avoiding anything related to precious metals.

Many precious metals and the shares of their related funds slid to 2-1/2-year bottoms in recent weeks with GDXJ touching 25.91 on September 11, 2018. Commercials in gold and silver, which are those who trade gold and silver futures while actually holding the physical metal - mostly miners, jewelers, fabricators, and similar industry professionals - have actually gone simultaneously net long gold and silver for the only time in history.

Usually commercials are net short because they want to partially or fully hedge their often-large inventories to protect themselves against losses in the event of a price decline for precious metals. If they not only aren't hedging, but are actually betting on a higher price, then that shows the highest degree of confidence in their history that they have nothing to fear on the downside.

At the same time that commercials have been steadily buying, most investors were making all-time record outflows from GLD and related bullion funds. We also had intensified insider buying of gold mining and silver mining shares by top corporate insiders when GDXJ was below 30.

At almost their exact multi-year lows during the late summer, the Vanguard fund VGPMX sold off most of its gold mining and silver mining shares to purchase other kinds of securities; when a major financial player like Vanguard is surrendering then you know a major rally must be closely approaching. By an interesting coincidence, the last time Vanguard made such a radical change for this sector was almost at the exact bottom at the turn of the century after which the original fund holdings would have quintupled in value in less than 19 months.

If we have begun a bear market for U.S. equity indices then this could signal a powerful uptrend for this sector. Previous major surges higher occurred during late 1972 through early 1974 and during November 2000 through early June 2002 when HUI and other gold-share indices had soared.

Investors adore overpriced U.S. high-yield corporate bonds but are shunning undervalued government bonds of many countries including the U.S. and emerging markets.

When you hear investors' reasons for purchasing U.S. high-yield corporate bonds which have their lowest spreads ever to U.S. Treasuries of similar maturities, the reason usually given is that these investors are desperate for yield. Besides being desperate they must also be poorly informed, since many government bonds especially in emerging markets have higher yields than U.S. high-yield bonds - plus the historic default rates especially during recessions are substantially lower for foreign government bonds than for U.S. high-yield corporate bonds.

There is currency risk in owning bonds which are not denominated in U.S. dollars, but this can also become currency gain when the U.S. dollar is dropping in value which it is likely to do versus most currencies from now through perhaps the summer or autumn of 2019. One reason that U.S. high-yield corporate bonds are so widely owned is that many employers offer them for their employees' retirement accounts, whereas buying foreign government bond funds requires self-directed effort.

I give a list of several emerging-market government bond funds near the bottom of this update. Most investors don't appreciate that if default rates merely return to their average historic levels then it will lead to huge losses for U.S. high-yield corporate debt. In a recession the total pain could roughly approximate the collapse for U.S. high-yield corporate bonds during the second half of 2008 when many high-yield bonds and related funds lost roughly half their value.

Here is a recent useful link about non-U.S. bonds:

Almost everyone thinks that safe U.S. Treasury yields are going higher.

Perhaps because the U.S. Federal Reserve is committed to gradually raising the rate at which banks borrow money overnight from each other or from the Fed, they have concluded that all U.S. government interest rates will move higher. It is much more likely that, after climbing to their highest points since the early summer of 2014, long-dated U.S. Treasury yields for the 10- and 30-year bonds will move lower - and perhaps a lot lower over the next couple of years.

As with gold and silver, evidence can be found in the traders' commitments where commercials have established their greatest-ever net long position in the 30-year U.S. Treasury bond since July 3, 2007 - about 11-1/2 years ago. Such a rare lopsided reading is not likely to be merely a coincidence, and illustrates that those who are most closely connected with this asset are especially bullish toward long-dated U.S. Treasuries and expect their yields to retreat rather than rising further.

The easiest way for investors to participate is by purchasing TLT - or else ZROZ which is roughly twice as volatile as TLT in both directions without using artificial leverage. ZROZ is a fund of long-dated U.S. Treasury zero-coupon bonds, while TLT consists of actual 30-year U.S. Treasuries which were purchased in recent years and are sold once they have 25 years remaining to maturity.

U.S. equities are highly popular, while emerging-market shares have mostly been slumping after achieving multi-year highs in January 2018.

Emerging-market shares enjoyed spectacular gains for two years after they had mostly slid to multi-year lows on January 20, 2016. Since then they have entered outright bear markets in many cases including China, India, South Africa, and several smaller countries including Egypt and Argentina where they have dropped by one-third or more. SCIF, a fund of 210 small companies in India, fell by almost exactly half from its January 2018 top to its recent intraday low.

Many theories have been offered to explain "why" this odd divergence has become so glaring in 2018, but the primary explanation is that as emerging-market equities have continued to generally underperform while U.S. shares have been outperforming, most investors want to sell what "isn't working" in order to purchase what seems as though it is still going higher. It has nothing to do with logic or common sense or anything resembling rational trading decisions - just as most of the fluctuations for emerging markets in recent decades have had little or nothing to do with logical behavior.

There are several ways to capitalize upon this situation by doing the opposite of the thundering herd and buying emerging-market stocks while selling U.S. equities. Some emerging-market bourses have already begun to rebound from important bottoms which in many cases have represented key higher lows when compared with their deeper nadirs from January 20, 2016. As with gold mining and silver mining shares or with government bonds, it often makes sense to purchase assets which are trading near one- or two-year lows while remaining above previous support levels.

Securities which are heavily represented in passive U.S. equity and high-yield bond funds are among the world's most overpriced assets.

It has become so popular for ordinary investors to take money out of bank accounts and other safe time deposits - often yielding above 2% in recent months - to put into fluctuating U.S. passive index funds that this Boglehead approach is often taken for granted as a sensible and even a safe strategy for the long run. Near a market top in anything it seems secure to be heavily invested, whereas that is always the most dangerous time to participate.

Conversely, following a severe bear market when it is safest to make purchases, most investors are afraid to do so. Because so many investors blindly pile into their 401(k) equity fund choices or other passive index funds, the shares which comprise the most indices are the most frequently bought and many of these have become wildly overpriced. Meanwhile, assets which are more difficult to purchase and are less popular simply because they aren't represented in many of the most widely-bought funds tend to be almost forgotten and in some cases have become worthwhile bargains.

This is partly a warning for the overall market because it means that most people couldn't care less whether their portfolio consists of worthwhile holdings or not; they want to participate at any price with blatant disregard for the serious risks which these investments entail.

Already we have experienced two major bear markets for U.S. equities since 2000. With many of the most popular securities more overvalued than they have ever been in history in both absolute and relative terms, the likelihood of a decline of two-thirds or more will force investors to question their basic investment philosophy and to punish them for being part of a massively overcrowded trade.

Many of those who have been buying near the 2018 peaks will end up making all-time record withdrawals near the next bear-market bottoming pattern. Such record outflows will assist us in knowing when to gradually buy when almost everyone else wants to sell.

A few other analysts have noticed recent rare disparities and have commented on them - here are two which make worthwhile reading.

Below are two links about how unusual today's disparities are and why it is worthwhile to capitalize upon them. The first one concludes in the final paragraph that a contrarian approach is ideal for such an environment:

The next article is more academic and was discovered outside of the mainstream financial media:

The bottom line: purchase gold/silver mining shares, government bonds, and the least popular emerging-market securities while selling the most over-owned U.S. stocks and high-yield corporate bonds.

Most investors want to sell whatever has been underperforming since January 2018 in order to buy whatever has been outperforming. It is important to do the exact opposite in many cases, because we have all-time record disparities between assets that have powerful historic correlations with each other and will sooner or later return to their long-established interrelationships.

No one wants to be among the first to make the switch, thereby causing many disparities to become more extreme than they have been in several years and in some cases in several decades. If we began a bear market for U.S. equities when the Russell 2000 topped out on August 31, 2018, which is becoming increasingly likely, then global asset reallocation is going to be a major theme of the next couple of years.

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 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 and marijuana shares during 2018, the first with no intrinsic value and the second behaving as a classic late-cycle bubble, were characteristic of a generational peak such as we had previously experienced for tulips, canals, railroads, internet shares, and Beanie Babies. I purchased more GDXJ several times as it completed a classic head-and-shoulders bottom, with GDXJ falling to a 2-1/2-year nadir of 25.91. I also added repeatedly to TLT near its lowest points since July 2014--including this morning--while shorting IWM near its all-time highs in late August 2018. I have also purchased ELD repeatedly after having sold all of it in January 2018. In addition to ELD, other funds of emerging-market government bonds including PCY, LEMB, 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, TLT (many new), SIL (some new), GDX (some new), ELD (some new), HDGE, URA, I-Bonds, bank CDs (some new), money-market funds (some new), GOEX, VGPMX, BGEIX, RGLD, WPM, SAND, and SILJ. I have short positions in IWM, XLI, AMZN, 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 maybe in 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 an increasing number of former leading sectors which have been forming lower highs for several months. After reaching its all-time zenith on August 31, 2018, the Russell 2000 Index and related funds including IWM have generally underperformed their larger-cap counterparts which also ushered in the major bear markets of 1929-1932, 1973-1974, and 2007-2009. Meanwhile, the Nasdaq climbed to an all-time peak in nominal terms on August 30, 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 their lowest levels since the 2007 topping pattern. 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 recent zenith would put the S&P 500 near 980 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. Because so much money exists today in exchange-traded and open-end funds, as they decline in value they will be forced to destroy shares which will compel them to sell their components, thus depressing prices further and creating more share destruction in a dangerous domino effect.