Buy Because It's A Bear

by: Steven Jon Kaplan

“Investment success doesn’t come from 'buying good things,' but rather from 'buying things well.'” - Howard Marks

During any market-topping process you hear almost nothing about the possibility of a bear market, even a mild one, since investors are so excited about the potential upside and become irrationally complacent about losing money. One shared characteristic of 2000, 2007, and 2018 is that very few bothered to consider the potential downside risk. This was especially true in 2018 since we had experienced U.S. equity bull markets which had lasted for roughly 9-1/2 years and seemed as though they might continue forever - or at least as long as Donald J. Trump was the U.S. President. Recently the dialogue has changed so that many investors are asking whether we are in a bear market. While there isn't a consensus on that issue, investors are far more worried and many have been "reducing risk" - a phrase which is utilized primarily to justify selling something at a low price which should have been sold much earlier at a high price when investors had been so pleased with their results that they weren't even bothering to log into their accounts. Analysts have become increasingly bearish for technical or other reasons, with a few holdouts insisting that we are still in a bull market and that therefore you shouldn't sell too much.

I have an entirely different viewpoint: it is precisely because we are in a U.S. equity bear market, and probably a severe one, that you should be buying now instead of selling. The biggest short- and intermediate-term stock-market rallies in history have generally occurred during bear markets. If the current bear market ends up being as dramatic as I expect it will eventually become, then the most unpopular shares including emerging-market securities and many commodity producers should perform especially well from now into early 2019 and perhaps in some cases into early 2020 depending upon what happens next year. Bear markets almost always provide the best trading opportunities for those who aren't afraid of short-term capital gains. With the lower U.S. taxes which will persist at least through 2020, you also shouldn't fear short-term capital gains which as a U.S. resident will be taxed at their lowest levels in several decades.

Bear markets tend to be badly misunderstood.

If you were to ask most investors about bear markets then they would give wildly inaccurate responses based upon their emotional memories rather than fact. For example, the bear market of 2007-2009 was the most severe since the Great Depression. It began with the Russell 2000 completing a double top with nearly matching highs on June 1, 2007, and July 9, 2007. Many other U.S. equity indices topped out later as they often do, with the S&P 500 reaching its highest intraday point on October 9, 2007, while the Nasdaq did likewise on October 31, 2007. The U.S. stock market experienced several sharp plunges during the first part of its bear market and rebounded sharply after each one. By the middle of August 2008, roughly 14-1/2 months after the Russell 2000 had ended its uptrend, most investors had no fear of an extended downtrend and thought that we were still in a bull market. This was true even into early September 2008. Only after the huge collapse from the 1303.04 intraday peak for the S&P 500 on September 3, 2008, through its November 21, 2008, intraday bottom of 741.02 - a total plunge of more than 43% - did investors finally wake up and realize what was happening which of course was far too late to be able to sell at favorable prices. Not that this stopped anyone, as we had all-time record outflows from most U.S. equity funds during the lowest points in the fourth quarter of 2008 and the first quarter of 2009 when for two weeks the S&P 500 was trading below its November 2008 bottom.

The 2000-2002 bear market was similar; almost no one acknowledged it even in January 2002 when it had been underway for nearly two years. Investors are attuned to being overly optimistic when they should be pessimistic and vice versa, which is an important lesson today when fear and gloom have quickly taken over where they had been almost non-existent several weeks ago. Talk about a crash, pending doom, and similar topics which had been completely absent two months ago are now being routinely debated in the mainstream financial media. In all previous bear markets this was what had happened prior to each strong bear-market rebound, and that is what is likely to occur this time also. The past almost always repeats itself with some variations - some refer to this process as rhyming with the past.

The Russell 2000 Index and VIX have been demonstrating classic signs of a sharp "surprise" recovery for stock markets worldwide.

The Russell 2000 Index consists of U.S.-headquartered companies 1001 through 3000 in total market capitalization. This is in contrast to the much more widely-followed S&P 500 Index which represents companies 1 through 500 in total market capitalization. While almost no one tracks the Russell 2000 unless they own it in the form of a fund such as IWM, it is important because it serves as a valuable leading indicator. In 2007 and 2018, as well as in past bear-market preludes including 1929 and 1972, mid- and small-cap U.S. stocks began to decline more substantially than their larger-cap counterparts as a warning that a major bear market was beginning. Look at how the Russell 2000 or IWM behaved after August 31, 2018, versus the S&P 500 or SPY over the same period of time. Indeed, I had pointed this out in my last update and some readers dismissed it as being unimportant - just as they had done in prior bear markets. The Russell 2000 following its high on August 31, 2018, has dropped far more than the S&P 500 until recent days when it has been more energetically recovering from intraday lows and reversing its previous underperformance to outperform most other U.S. equity indices. If this outperformance continues then it will confirm that a rebound is imminent and will likely intensify. At some unknown future point the Russell 2000 will start underperforming again over a period of weeks and this will tell us that it is time to do some selling in preparation for the next downward wave. Since we are likely in a severe bear market for U.S. equities, any downward wave could become the "big Kahuna" and must therefore be respected. However, since everyone now is worried about a big drop, we will end up with some big up days instead until once again investors have lost their fear of potential significant losses. While we will surely have some sharp short-term pullbacks whenever investors are becoming overconfident, we will not likely resume the bear market until some point in early 2019 - and perhaps later in 2019 if it takes time for investors to become fully complacent once again.

Just as almost no one is watching the Russell 2000 versus the S&P 500, the VIX is badly misunderstood as a leading indicator.

One reason it was so compelling to purchase U.S. equities when they were bottoming around November 19-21, 2008, and again in late February and early March 2009, is because lower lows for the S&P 500 were encountered by lower highs for VIX rather than higher highs. In other words, VIX peaked in October 2008 and made a lower high in November 2008 even though the S&P 500 and most U.S. equity were much lower during the third week of November 2008 than they had been at any point in October 2008. Then, in late February and early March 2009 when the S&P 500 finally broke below its November 21, 2008, bottom of 741.02, VIX continued to form significantly lower highs. This means that the most informed participants, who are those who tend to hedge with options and other derivatives, were becoming increasingly sure that we were approaching a worthwhile buying opportunity for U.S. equities when the public was most afraid of participating and was making all-time record outflows from most U.S. equity funds.

VIX touched 89.53 on October 24, 2008 which was its top for the entire bear market. On November 20, 2008 it reached 81.48 which was considerably lower; the S&P 500 ended up bottoming the following day. On March 6, 2009 when the S&P 500 completed its infamous nadir of 666.79, the intraday high for VIX was only 51.95 which was enormously lower. We appear to be having similar behavior in October 2018 although of course the future is always unknown especially in the short run. VIX had reached 28.84 on October 11, 2018; when the S&P 500 was much lower during the afternoon panic on October 29, 2018, VIX only rose to 27.52. If this pattern of lower highs for VIX continues then it increases the likelihood that a rebound for the U.S. stock market is approaching.

Investors fear sharp downward spikes but those often mark intermediate-term bottoms especially when they are followed by intraday recoveries.

Investors tend to become the most frightened by sharp downward moves which are followed by meaningful percentage rebounds, including the behavior in the afternoon on Monday, October 29, 2018. However, that is when investors should become most bullish since that is how bottoming patterns are classically formed. Sharp drops are very effective in knocking out sell stops, while subsequent rapid rebounds ensure that those who were stopped out will have to pay higher prices in order to re-establish their long positions. The more sudden the pullbacks and the more energetic the subsequent intraday recoveries, the more likely that a rally is closely approaching. Repeated downward spikes tend to especially unnerve investors who will often be induced to sell when they should be buying.

The upcoming winners will not mostly be the previous top performers or favorites - it will be assets like SCIF which had become most irrationally undervalued due to herd following.

Throughout 2018, investors have been frantically chasing outperformance. After nearly all risk assets began the year with sharp gains, most emerging-market shares and commodity producers started significant downtrends in January 2018 which have persisted until the past month. Investors responded to this behavior by progressively selling more and more of whatever was underperforming in order to buy more and more of whatever was outperforming. This kind of activity is common whenever we are transitioning to a major bear market. As a result, numerous sectors have lost one-third or more of their January 2018 peak valuations. I have begun to purchase these and in general they have been holding up much better than most other risk assets. A classic example is SCIF, a fund of 210 small-cap companies headquartered in India. This fund had climbed to an intraday high of $72.57 on January 12, 2018, and then slid as low as $36.58 on October 8, 2018 - a total decline of ($72.57 - $36.58) / $72.57 or nearly 49.6%. Since then it has resisted the pullback for most other global risk assets and has been moving generally sideways. Whatever might or might not be happening with such a large group of Indian companies, it is surely the case that the selling is due to investors acting out of disappointment, fear of additional losses, wanting to own something else which seems to be surging, and similar emotional reasons. This is precisely the kind of investment that I am eager to find especially when fear has gripped the global financial markets and almost everything is likely to rebound for an unknown period of weeks or months.

Other emerging-market stocks and bonds will likely rally in upcoming months along with most commodity producers.

When the word China is mentioned, what is the first thing you think of nowadays? Is it ancient temples, their amazing rate of growth in recent decades, or the complexity of their government organization? Most likely the first word you thought of was "tariffs" which even kids know about these days. It is astonishing how so many investors are convinced that because of tariffs the Chinese stock market should be as depressed as it has been in 2018. ASHR, a fund of Chinese equities which had soared to $34.89 on January 26, 2018, sank to a low of $22.00 on October 18, 2018. Like SCIF and many other emerging-market funds it has held up well since then compared with U.S. equities, but this pullback had been ($34.89 - $22.00) / $34.89 or almost 37%. Surely, some minor tariffs can't account for such a huge loss; the impact has been entirely psychological. If people think there is a reason to sell, even if that reason hardly warrants such an overreaction, then they will sell first and ask questions later.

Gold mining and silver mining shares remain unpopular and undervalued.

Most emerging-market government bonds and the shares of precious metals producers simultaneously bottomed on September 11, 2018. GDXJ, a fund of junior gold mining shares, touched 25.91 which had marked a 2-1/2-year low. This fund has begun to rebound and has formed several higher lows since then including $26.25 on September 12, $26.74 on September 14, $26.79 on September 27, and $26.92 on October 10, 2018. It is probably close to completing another key intraday high in preparation for a more energetic move higher. During past U.S. equity bear markets including those in 1929-1932, 1972-1974, and 2000-2002, gold mining and silver mining shares were among the biggest winners once those bear markets began to be recognized by investors. At the turn of the century when GDXJ did not yet exist but the index HUI was already in existence, HUI skyrocketed from its intraday nadir of $35.31 on November 15-16, 2000, to an intraday high of $154.99 on June 4, 2002 - a total increase of 438.94%.

The bottom line: purchase the most undervalued emerging-market securities and energy shares as I have listed under my disclosure below - not because we are "still in a bull market" but because these shares generally outperform strongly during the first year of a true U.S. equity bear market.

Most investors are "reducing risk" or "considering buying once we have clarity." Once we have clarity it will be too late to make purchases at compellingly low valuations; the financial markets are almost always most volatile whenever we are completing any kind of bottoming pattern in order to discourage all but the most experienced traders from taking advantage of the best prices. Investors already disliked emerging-market and energy shares which have mostly fallen by irrationally large percentages since they had topped out in January 2018 as investors sold underperforming emerging-market securities in order to purchase their outperforming U.S. counterparts. Lately the outflows have mostly become intense with dozens of emerging-market equity funds losing between one-third and one-half of their net asset value from their respective January 2018 peaks, while an increasing number have been quietly forming higher intraday lows. Following a one-year period of increasing inflows into energy shares after they had bottomed amidst wide unpopularity in late August 2017, investors have recently given up on those also. Gold mining and silver mining shares remain unpopular and have finally been forming several higher lows following their 2-1/2-year bottoms including GDXJ touching $25.91 at 9:55 a.m. on September 11, 2018.

Disclosure of current holdings:

Due to the recent panic, I have gradually closed all of my short positions and completed this process in the afternoon of October 29, 2018. During the past week I have been progressively purchasing the most undervalued emerging-market equity funds which have been among the biggest losers since their respective January 2018 peaks, including SCIF (small-cap India), EZA (South Africa), ASHR (Shanghai A-shares), EPHE (Philippines), SEA (sea shipping), and ARGT (Argentina). As the pullback on October 29 intensified during the afternoon I began to buy OIH (oil services) and FCG (natural gas production) in small quantities. Other worthwhile funds which I am considering for purchase include IDX (Indonesia), ASHS (small-cap Shanghai A-shares), PAK (Pakistan), EGPT (Egypt), and AFK (Africa).

From my largest to my smallest position, I currently am long GDXJ, the TIAA-CREF Traditional Annuity Fund, TLT, SIL, ELD, GDX, URA, I-Bonds, bank CDs (some new), money-market funds (some new), SCIF (all new), EZA (all new), ASHR (all new), EPHE (all new), SEA (all new), GOEX, VGPMX, BGEIX, OIH (all new), ARGT (all new), FCG (all new), RGLD, WPM, SAND, and SILJ. I have no remaining short positions.

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 still didn't realize that we were in a crushing collapse, and I expect that well into 2019 most investors similarly will think that the U.S. equity bull market is alive and well. After reaching its all-time zenith on August 31, 2018, the Russell 2000 Index and related funds including IWM generally underperformed their larger-cap counterparts into late October 2018; similar behavior had 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. 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.

Very recent extreme fear combined with lower highs for VIX is likely signaling an intermediate-term rebound for some unknown period of months into 2019. I have therefore gradually closed my short positions and have purchased the most undervalued shares which are primarily emerging-market securities and gold/silver mining shares, with energy shares finally becoming worth buying also.