Dear subscribers,
This is update #1145 for Thursday evening, March 18, 2010.
VIX, probably the best-known measure of implied volatility, slumped to a late afternoon bottom of 16.31, its lowest level since May 19, 2008, before closing down 29 cents at 16.62. While even lower readings for VIX have occurred after several years without a serious market correction or bear market, such a low reading is extraordinary so soon after a major bear market. VIX has dipped below 16 only once since July 20, 2007, when it bottomed at 15.82 on May 19, 2008. Since the recently depressed level for VIX is reflecting almost a complete lack of investors' fear of a second bear market, a huge global equity decline is far more likely to occur. When investors have such low fear, this means that they have already committed to the stock market whichever funds they have considered using for that purpose, leaving no money "on the fence" with which to make future purchases. If you are still holding equities or equity funds for any reason, be certain to sell them as soon as possible.
The U.S. dollar index climbed back above the key 80 level after having touched its lowest point yesterday (79.507) since February 4. The U.S. dollar index has thus completed yet another higher low in its bullish pattern which dates back to the evening of November 25, 2009. If you live in a country with a high ratio of commodities to people, like Canada, Australia, South Africa, Brazil, Russia, or New Zealand, then you should shift your time deposits into U.S. dollars as soon as possible. Some Canadian subscribers have been waiting for the loonie to achieve parity with the greenback; while that would indeed be a powerful signal to switch, other traders have already been front-running this idea. With the loonie reaching 99.27 cents U.S. early yesterday afternoon, it makes little sense to try to squeeze out that extra one percent and thereby risk missing a prime opportunity to accumulate U.S. dollars. The importance of doing this trade is 7 on a scale of 0 to 10.
TLT, a fund of U.S. Treasuries averaging 25 years to maturity, has continued to form a bullish pattern of higher lows since it had bottomed at 88.51 on February 18. Investors have been purchasing long-dated U.S. Treasuries even in the face of repeated media hype about a future surge in U.S. government borrowing; while the future borrowing is quite real, it is already fully known and has been more than fully priced into long-dated U.S. Treasury valuations. Whenever global equity indices and TLT are rising or falling in tandem, usually global equities eventually reverse direction to follow TLT's lead.
The S&P 500 index yesterday climbed to an early afternoon peak of 1169.84, its highest level since September 29, 2008. The S&P 500 continues to blissfully ignore an increasing number of important negative divergences and stands at one of its most overbought levels of the past several decades. Well-established leading indicators including SMH and GDX have completed important lower highs as compared with their early January peaks, with GDX having completed its cycle high way back on December 2, 2009 (which itself was below its March 2008 zenith). Today, GLD (gold bullion) gained two thirds of one percent, and still GDX struggled and ended up with a net loss.
Natural gas fell to its lowest level since September 16, 2009. For reasons which are not entirely understood, natural gas tends to often perform well during the spring and sometimes also the early summer, when there is the least demand for it. Since the ratio of crude oil to natural gas is unusually elevated, eventually either crude oil will have to collapse in price or natural gas will have to surge higher in order to regress toward a normal historic ratio.
While most general equity indices were barely changed, my list of thirty commodity-share and emerging-market funds showed every single of one of them ending the day with a net loss. The ratio of insider selling to insider buying by top corporate executives has reached its highest point since the summer of 2008, and is especially elevated for those insiders who have the best historic track record of buying low and selling high.
Today's main topic is embracing uncertainty.
In my opinion, one of the clearest differences between a novice investor and an experienced one is that an experienced investor has learned not only to accept uncertainty, but to embrace it. A novice is always nervous about what is going to happen: what the stock market will do next week; how this or that asset will perform over the next few months; at what price he or she should sell something; when it will be time to start buying or selling shares in a particular sector; and so on. Novices fear the unknown, whereas experienced investors are glad that the future is uncertain since it means they are on an equal footing with the world's most knowledgeable investors. Warren Buffett doesn't know what the market will do next week, so we're all on a level playing field. Investing is thus one of the very few fields of endeavor in which all participants can compete equally.
The reason it is necessary to have a detailed plan of action at all times is because the future is always unknown. The best way to deal with uncertainty is knowing in advance precisely how you will invest no matter what the market does. This does not mean that you know when or at what price you will buy or sell, or even which particular securities you will buy or sell. It means that there is a combination of signals which will tell you whenever you have to take action of any kind under any circumstances, no matter what happens in the financial markets.
In June 2008, I had no idea that I would be buying KOL five months later. In fact, I stated in an update exactly why I would almost certainly not be buying funds like KOL, RSX, or EWZ even if we had a stock-market collapse, since these funds would have to plunge by more than 75% to make them worthwhile for purchase, and I thought the chance of that large a percentage decline was somewhere between slim and none. As it turned out, many energy and emerging-market funds lost more than 80% of their value, and therefore I began to formulate ladders of orders to buy them. While I bought some shares of KOL and RSX very close to their multi-year bottoms, I did not do so because I knew where these funds would bottom, but because I did not. I placed deep ladders of orders so that even if KOL and RSX had slumped to 5, I would still have been buying them aggressively. I didn't have any idea what week, month, or even which year would begin the rallies for these funds. All that mattered to me was that I could triple my money even if these funds merely returned to half of their recent peaks. For a pure equity fund, that itself is reason enough to buy aggressively during any era of stagnation when those funds which have fallen the most in percentage terms are almost always those which will rally the most in percentage terms during the subsequent bull market.
I can only guess today which funds will be ideal for purchase at the next global equity bottom. There is no guarantee that we will have the kind of stock-market collapse that I have been predicting for the next two years, although the most reliable signals all seem to be pointing in the same direction. Exactly when any given fund will bottom is only a guess, which could be off by several months or more. The ultimate nadir for any given fund is also completely uncertain. Sticking with KOL and RSX, perhaps both will make higher lows somewhere around 12 or 13, which appears at the present time to be the most likely possibility. However, perhaps instead they will both set lower lows as compared with their late 2008-early 2009 bottoms, or perhaps the anticipation of higher inflation will prevail and they will bottom near 14-16. Once there is heavy insider buying by top executives of the individual companies in these sectors; once we see heavy outflows by amateurs from the same sectors; whenever the media are intensely gloomy about the future of these sectors; these will all be useful clues, but they still won't tell us that a bottom has necessarily been reached--only that a favorable buying opportunity exists.
Most investors become upset when they buy something for 15 dollars per share and it later retreats to 10 dollars per share before rallying to 30 or 40. They would prefer that the price gradually rise without going below 15. However, the decline to 10 is a gift, giving you a chance to add additional shares at more favorable prices. If a particular fund becomes cheaper than I had expected, I always see that as an opportunity for greater profits rather than as a negative event. The only truly negative event is when I begin to purchase a fund in a particular sector and it immediately rallies before I have a chance to accumulate it in a significant quantity. In 2006, for instance, I made two purchases of GDX on June 13, which was its lowest point of the entire year. I never got more of it, since it rallied thereafter and it never touched any of the other orders in my ladder. Part of the reason for this behavior is that even though we were in an era of stagnation, the market's behavior from late 2003 through early 2007 was much more like its action during a period of prosperity, when volatility was unusually low and the most difficult challenge on most days was trying not to fall asleep due to the dull market action. I don't think that falling asleep is going to be a problem during the next five years; while most investors appear to be prepared for a repeat of 2003-2007, we are much more likely to experience an approximate repeat of 1930-1934 when we had a huge plunge followed by the biggest stock-market rally in history.
Whenever someone asked J.P. Morgan what the financial markets were going to do, his response was inevitably "the market will fluctuate". His point was that those who were asking him this question usually wanted an answer about exactly what would happen, especially in the short run, and he knew that no one could possibly have a correct answer to such a question. He was also trying to gently point out that the wrong question was being asked. In several past updates, I have listed amateur questions next to expert ones, in order to illustrate the difference. An experienced investor knows that the future is always unknown, and the short-term future is the most unknown of all. What is most important is which relationships in the financial markets are so far away from their historic norms that they represent an ideal investment opportunity. For example, I have spoken about the average gross annual rental return of 7.5% which has applied for centuries. Knowing that this ratio is close to 4% in many parts of the world is thus a clear indication that housing prices will have to decline substantially over the next several years. One cannot know exactly when this will happen, or which areas will suffer the biggest declines, or when the ultimate bottom prices are finally reached, since this ratio by itself doesn't tell you any of that information. It is very likely the case that if prices have already fallen by half in a certain city of Florida, thereby creating an average gross rental return of 6%, then prices in this city will decline significantly less than in a city where the gross rental rate is only 3%. However, the details of timing, how wealthy neighborhoods where most residents have a significant percentage of their net worth in the stock market will fare compared with working-class neighborhoods where residents have almost no money in the stock market, and so on, require other methods of analysis.
There is a rule during each era of stagnation since the late 1700s, which has so far not seen a single exception, in which the dividend yield for most general equity indices in the U.S. eventually exceeds 6%. On March 6, 2009, the dividend yield on the S&P 500 peaked at 3.5%. While this is enormously above its yield of March 2000, it is also far below 6%. Therefore, especially since the current yield on the S&P 500 has slid to 1.9%, we can be pretty confident that U.S. equities will have to decline substantially at some point during the current era of stagnation in order to eventually exceed 6%. Of course, you can choose to believe that this will be the first-ever exception to the rule, just as you could have chosen two years ago to think that we would have the first Presidential term since the Civil War to not have an important equity bottom. It wasn't different last time, and it's not going to be different this time either. The current level of VIX is only one of several critical reasons why I believe a major worldwide stock-market collapse is much more likely to happen sooner rather than later. You can also believe that the current era of stagnation ended in March 2009, and therefore lasted for only nine years as compared with its historic average of eighteen. I also reject such a claim. As a rule, you have to have an extremely compelling case to believe that behavior which has persisted for many decades or longer is going to suddenly be different. "Because we have the internet to allow unlimited access to information", "since railroads were invented which permit goods to be shipped anywhere", "because we have automobiles to enable full mobility", "now that we live in an age of computers" are all reasons which have been given in the past to explain why "a new paradigm" existed that enabled all of the old rules to be ignored. In all cases, of course, the old rules prevailed, and since so many had deluded themselves into believing that we really did have a new paradigm, the surprise emergence of ordinary reality caused confusion and panic. If you're thinking to yourself now that the dividend yield is not going to exceed 6% during the current era of stagnation, then you should have a backup plan just in case history repeats itself one more time as it has always done, and as it almost surely always will do.
While the future of the financial markets is always unknown, there are always certain patterns of behavior such as the dividend yield which will consistently follow well-known rules. Interestingly, it is those elements of behavior such as the dividend yield which are the most certain to reoccur, and yet are most consistently ignored by most investors. In other words, where the market's behavior is most predictable is what most investors generally choose to believe cannot be predicted, and where the market's behavior is most uncertain is where most investors like to pretend that it will follow a reliable pattern. Many investors have faith in certain chart patterns implying certain behavior in the future, whereas this is among the least reliable methods of analysis and in fact probably has a notable negative correlation since so many amateurs are all following the same charting rules. The financial markets will inevitably ensure that any dangerously overcrowded trade will always lose money--another very reliable guideline which, by definition, nearly all investors repeatedly ignore to their detriment. As much as I loved commodity-share and emerging-market funds since I was aggressively buying them in the autumn of 2008, I had to sell them in early January 2010 since amateurs were flooding so eagerly into the top-performing funds of 2009. Any trade which had become that overcrowded could only be detrimental for KOL, EWZ, RSX, GDX, etc.
Because most investors fear uncertainty, they are psychologically far more favorable toward purchasing an asset which has already completed a bottoming pattern and has experienced its first sharp rally following such a bottom, rather than buying into extended weakness in advance of this bottom. Therefore, if you can embrace uncertainty, you can buy in advance of a bottom rather than following its first strong rally after a bottom. If you do so, you will discover that generally several weeks or even several months of declines are regained within a very short period of time following any important nadir, as chartists, momentum players, and hedge funds all crowd into these securities virtually simultaneously. Waiting "just a little longer, just to be sure" in late 2008 meant paying more than 30 dollars per share for GDX rather than less than 20 dollars per share, and thereby yielding less than half the total profit in percentage terms. The same was true with KOL, RSX, etc. At a market top, those who waited to sell Chinese or Indian equities until after they had completed their bubble peaks in 2007-2008 ended up receiving about 20% less than those who steadily sold in advance of the eventual top. There will be exceptions to this rule on rare occasions, but they are notable precisely because they are so unusual.
Uncertainty is an advantage to an experienced investor, not a handicap, since uncertainty encourages most investors to make consistently unfavorable decisions such as buying after a rally following any major bottom rather than obtaining much more favorable average prices by purchasing in anticipation of a bottom. Uncertainty also causes many amateurs to sell in panic or despondency, since they become impatient at the market rather than accepting its actions as typical behavior. Those features of the financial markets which are most predictable, such as dividend yields during eras of stagnation, are those which are usually least respected by most investors. Whenever the vast majority of investors begin to question principles which have been valid for decades or even centuries, that is when those principles will surely reassert themselves in a highly visible manner. Most amateurs who purchase any security would prefer to see it simply move higher, rather than first declining further and allowing the opportunity to buy at a more favorable price before recovering. Nearly all investors have insufficient concern about being part of a dangerously overcrowded trade; I will always exit any position if it becomes far too popular since that is when the greatest losses almost always ensue. Uncertainty keeps amateurs away from buying near bottoms and selling near highs, since they fret at a bottom about how much lower it could go rather than welcoming the opportunity to buy at a multi-year bargain price--while they refuse to sell near a multi-year or even a multi-decade peak as they fantasize about even greater gains instead of seizing the opportunity to sell at a highly overvalued level. Because of uncertainty, you know as much about what the market will do as Warren Buffett or anyone else. The question is whether you will form a detailed plan to handle all future possibilities; Warren Buffett has such a plan and is continuously refining it as circumstances dictate. The secret to being a successful investor is not in eliminating or even reducing uncertainty, but in learning how to embrace uncertainty to your maximum advantage.
Take care.
--Steve