Seeking Alpha
Steven Jon Kaplan
Contrarian, registered investment advisor, ETF investing, portfolio strategy
Summary

After falling to all-time lows on August 28, 2019, yields on the 10-, 20-, and 30-year U.S. Treasuries have been rebounding.

All of a sudden, almost no one is worried about a U.S. recession anymore.

The 4-week U.S. Treasury no longer has anywhere near the highest yield in the entire Treasury curve as had been the case in the late summer.

When I wrote my last update on August 7, 2019 - I will try not to wait so long before the next one - the media were obsessed with the inverted U.S. Treasury curve, the insistence that we were headed for an imminent recession, and the "certainty" of continued all-time record low long-term U.S. Treasury yields. Practically all that anyone debated in August was when a U.S. recession would arrive and how much lower long-dated U.S. Treasury yields would drop as a result. After falling to all-time lows on August 28, 2019, yields on the 10-, 20-, and 30-year U.S. Treasuries have been rebounding. All of a sudden, almost no one is worried about a U.S. recession anymore. The 4-week U.S. Treasury no longer has anywhere near the highest yield in the entire Treasury curve as had been the case in the late summer.

Investors have shifted within four months from an obsession with recession to an even more absurd overconfidence in ever-rising U.S. asset valuations.

During recent weeks, we have experienced some of the most intense net exchange-traded fund inflows in history along with rare extremes of optimism in surveys which date back several decades. Daily Sentiment Index on Wednesday, November 27, 2019, the date of the exact top for the S&P 500 and the Nasdaq and even the Dow Jones Industrial Average, showed 89% of futures traders who were bullish toward the S&P 500 and 91% who were bullish on the Nasdaq Composite Index - and only 26% bulls toward gold. On the exact day when I had written my last update on this site on August 7, 2019, the American Association of Individual Investors (AAII) reported only 21.7% of investors who were bullish toward U.S. equities, while 48.2% had been bearish. 2019 year-to-date net inflows for U.S. exchange-traded funds set a new all-time annual record with several weeks to go, surpassing last year's peak which had been the previous high-water mark by a wide margin. Investors who shunned U.S. equities by making substantial net outflows when the S&P 500 had been below one thousand in 2008-2009 have since been making massive net inflows with the S&P 500 near and above three thousand. Selling low and buying high, as usual, is unfortunately what usually occurs in real life. After an extended pullback, assets look the most dangerous, whereas they are actually the safest and most rewarding. Buying an asset after it has already gained 373% (from 666.79 on March 6, 2009 to 3154.26 on November 27, 2019) will tend to be considerably less profitable than buying it before it has done so. Psychologically, an asset which has been climbing for more than a decade appears to exude superiority and safety when it is maximally dangerous to be long. Conversely, an asset which has suffered an extended decline as energy shares have done during the past two years makes it seem to be intrinsically inferior and dangerous when it is maximally safe and rewarding.

Small- and mid-cap U.S. companies are continuing to resist all attempts to regain their 2018 zeniths.

Throughout 1929, small- and mid-cap shares mostly never reached their highs from 1928 even while large-cap shares mostly did so; U.S. stocks, thereafter, suffered their worst percentage losses in history. Throughout 1972 and into January 1973, U.S. small- and mid-cap shares couldn't recover their 1971 highs, while the largest-cap "Nifty Fifty" names kept climbing; this was followed by the biggest stock market plunge since the Great Depression. Very few investors know or care that the New York Composite Index which has existed for decades has still not regained its January 26, 2018 top, while the Russell 2000 has not set a new all-time high since August 31, 2018. The most severe bear markets in U.S. history all have in common an extended period of underperformance by smaller and medium-sized companies relative to their large-cap counterparts. The markets are telling you loudly and clearly what is going to happen next; all you have to do is respect history and listen.

The U.S. dollar index climbed to its highest point since May 2017 and has begun a major multi-month decline.

The U.S. dollar index completed a top of 99.667 on the first trading day of September 2019, which was nearly regained on the first trading day of October. Until it was recently surpassed by speculative bets on higher U.S. asset valuations, the most overcrowded trade worldwide was betting on a stronger U.S. dollar versus nearly all global currencies. The theory was that the U.S. economy, while far from perfect, was the cleanest dirty shirt in the laundry. This is a badly soiled theory which relies heavily on the spin cycle, since the only thing truly dynamic about the 2%-growth U.S. economy has been its outperforming U.S. assets. Whenever any sector outperforms, investors tend to invent nonexistent reasons for its having done so along with projections of unending future gains; recent extended losses will lead to nonsensical explanations about "why" any asset has retreated and why it will keep dropping in price. No one wants to admit that something has become far above or far below fair value just because herds of stupid investors have been irrationally crowding into or out of any given asset.

Energy shares remain compelling bargains, with most of them having dropped by more than half since their respective January 2018 highs.

Energy shares not only went strongly out of favor but have had among the greatest losses of all sectors since their respective January 2018 peaks and are even further below their elevated highs of June 2014. Most energy shares have lost more than half their value within less than two years. Exchange-traded funds in this sector which I have been gradually buying at first into lower lows and during the past two months into higher lows include all of the following: SPDR S&P Oil & Gas Equipment & Services ETF (XES) (oil/gas equipment/services), First Trust Natural Gas ETF (FCG) (natural gas producers), VanEck Vectors Oil Services ETF (OIH) (oil services), and Invesco S&P SmallCap Energy ETF (PSCE) (small-cap energy). PSCE has slid from its June 2014 top by (53.37 - 5.95) / 53.37, or more than 88.8%, which makes it among the worst-performing non-leveraged funds in any category over the same time period. This is because both energy and small-cap shares are simultaneously out of favor, making this a rare double play on these unpopular concepts. Other funds in this sector include Invesco S&P 500 Equal Weight Energy ETF (RYE) (equal-weight energy) and iShares U.S. Oil Equipment & Services ETF (IEZ) (oil equipment and services). All of the above funds have been forming higher lows for various periods of time. Before assets rally sharply higher, they almost always discourage investors by creating a bottoming pattern consisting of a deep nadir followed by a sequence of progressively higher lows. Instead of being encouraged by the higher lows, investors perceive these as a sequence of failed rallies, and therefore, often end up doing net selling when they should be gradually buying into all higher lows.

One worthwhile individual energy name is Matador Resources (MTDR). This little-known company is geographically surrounded by two large giants which might eventually initiate a takeover. Even if that takes years to occur, insiders including CEO/founder Joe Foran have been persistently buying near and below 14 dollars per share, including the past several trading days.

I have sold most of my developed market equity funds and a modest percentage of some emerging market equity funds if they have a strong positive correlation with U.S. equity indices.

We are likely in a period where U.S. assets including U.S. equity indices will mostly experience corrections exceeding 20% over the next several months. During the same time interval, the U.S. dollar will usually be retreating. I have been selling a large percentage of the Western European, Japanese, and related securities which I had mostly purchased at depressed prices when they progressively slid toward their Christmas 2018 bottoms. Often, I have been selling these on the exact days when they have achieved favorable long-term capital gains or shortly thereafter. The stronger their positive correlation with U.S. assets, the more essential it has been to keep selling these into strength - especially into all sharp short-term rallies.

I had also bought many emerging market securities which had mostly bottomed in October 2018 and made higher lows in December 2018. I have retained assets such as Global X MSCI Pakistan ETF (PAK), Global X MSCI Colombia ETF (GXG), iShares MSCI Chile Capped ETF (ECH), iShares MSCI Argentina Capped ETF (ARGT), along with my funds of commodity producers and related assets such as VanEck Vectors Junior Gold Miners ETF (GDXJ), Global X Copper Miners ETF (COPX), and VanEck Vectors Rare Earth/Strategic Metals ETF (REMX) - and anything where a falling U.S. dollar will have a much more positive impact than the negative drag of sliding U.S. assets.

Investing Tip #1: Respect insider activity.

In each update starting today, I will include a fundamental concept of my investing strategy, which is a combination of value and behavioral methods. I try to combine the best ideas of value giants including Benjamin Graham, John Templeton, Seth Klarman, and Ray Dalio, along with behavioral concepts from Howard Marks, Daniel Kahneman, Amos Tversky, and Gerd Gigerenzer. I gladly steal others' ideas, since they are so often better than my own.

Top executives, especially those in certain companies, tend to have a proven track record of far outperforming median investors. One key reason is that they know exactly what is going on with their companies, so if they are buying their own company's stock with their own money, it must be meaningful. Another reason is that insiders are classic value investors. They don't fret about the concerns of amateur investors such as what will happen next week, what the media are saying, whether they are buying "at the bottom," or their average purchase price. They don't do lump-sum trading: they keep gradually buying when valuations are the most in percentage terms below fair value, while gradually selling when prices are the most above fair value. Insiders couldn't care less whether they are raising or lowering their average purchase price. They don't do swing trading, don't use stops, and couldn't care less about breakouts or moving averages. Investors would be wise to follow their example.

Insider activity is the most meaningful when numerous executives of different companies within a single sector are simultaneously buying or selling in unusually intense total U.S. dollar volume. During the past half year, energy executives have smashed all-time records of insider buying, including their aggressive gradual accumulation during the past several trading days.

Summary: The two most irrational extremes today are 1) underpriced energy shares and 2) overpriced U.S. assets.

When I wrote my last update, investors were illogically obsessed with an imminent recession and had zero fear of inflation. Today, recessionary concerns have almost disappeared, but investors still don't realize that inflationary expectations are set to sharply surge higher. Investors have become dangerously complacent about the downside risks for U.S. assets, being far more afraid about missing out on future gains for U.S. equity indices than they are about the possibility of losing money. As always, capitalize upon investors' herding behavior by acting before they realize what is really going on.

The bottom line: Keep buying energy shares into additional higher lows, while selling U.S. assets into lower highs.

Tax-loss selling has been especially rough on energy shares and could potentially continue through the end of December 2019. Meanwhile, investors encouraged by their 2019 gains will periodically create upward surges for U.S. assets, including equity index funds, high-yield corporate bonds, and related assets. Keep buying energy shares into higher lows and selling U.S. assets into rallies.

Disclosure of current holdings:

From my largest to my smallest position I currently am long GDXJ, 4-week U.S. Treasuries yielding 1.649%, the TIAA-CREF Traditional Annuity Fund, SIL, XES (some new), ELD (some new), FCG (some new), SEA, SCIF, OIH (some new), PSCE (some new), ASHS, GDX, VNM (some sold), ASHR (most sold), bank CDs, money-market funds, GXG, I-Bonds, URA, SLX, PAK, EPOL, EZA (some sold), ECH, LIT, HDGE, TUR (some sold), FM (some sold), EPHE (some sold), MTDR (some new), EGPT, REMX, FXF, COPX, WOOD, ARGT, GOEX, BGEIX, NGE, EWW (some sold), AFK, RSXJ, FXB, EWM, GREK (some sold), EWG (most sold), EWU (most sold), EWI (most sold), JOF (most sold), EWD (most sold), EWQ (most sold), EWK (most sold), EWN (most sold), RGLD, WPM, SAND, SILJ, IDX (some sold), CHK.

I have a significant short position in XLI, a moderate short position in SMH, and a modest short position in CLOU. My cash and cash equivalents including bank CDs and stable-value funds (fixed principal, variable interest) comprise just about exactly 30.0% of my total liquid net worth.

"Those who cannot remember the past are condemned to repeat it" (George Santayana). "Those who can remember the past but insist that it's different this time deserve to repeat it" (Steven Jon Kaplan).

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 bottoming pattern occurring with frequent sharp downward spikes perhaps during the final months of 2020 and into the first several months of 2021. During the 2007-2009 bear market, most investors by Labor Day 2008 still didn't realize that we were in a crushing collapse, and I expect that at least until around the middle of 2020, most investors will similarly persist in believing 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 most other small- and mid-cap U.S. equity funds have persistently underperformed their large-cap counterparts except before sharp rebounds; similar behavior had ushered in the major bear markets of 1929-1932, 1973-1974, 2000-2002, and 2007-2009. The Nasdaq in 2018-2019 never quite achieved its March 10, 2000 intraday zenith in inflation-adjusted terms, and has thereby completed a historic long-term double top. A two-thirds loss from its recent zenith would put the S&P 500 near 1050, and I believe that its valuation will become even more depressed at some unknowable level below one thousand; eventual widespread fear over how much further prices will drop is likely to be accompanied by all-time record investor outflows from most U.S. equity index funds and U.S. high-yield corporate bond funds before we eventually and energetically begin the next bull market. Far too many conservative investors took their money out of safe time deposits in recent years; the incredibly long bull market has left them completely unprepared for a bear market. The behavior of the global financial markets since August 31, 2018 has been incredibly similar to the behavior in the early stages of nearly all major U.S. equity bear markets going back to the 1790s. In general, U.S. equity bear markets are far more alike than U.S. equity bull markets. Die-hard Bogleheads will probably resist selling until we are approaching the next historic bottom, but when they are perceived to be blockheads and become disillusioned by their method, they will become some of 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 their fund managers 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. The Boglehead foolishness is especially ironic since Jack Bogle himself aggressively sold U.S. equities in 2000 and again in 2018 shortly before his passing.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.