One feature of the global financial markets since the internet became popular in the mid-1990s has been an unusual concentration of irrational extremes in both directions. Partly this is because, with ordinary investors being able to buy or sell literally within seconds of hearing information or analysis, there is no longer any time for thought between an investor getting an idea to buy or sell and executing that idea. This encourages wild overcrowding into overly popular investments and equally illogical mass selling of out-of-favor assets. It is no coincidence that since 1996, the S&P 500 has traced a megaphone formation of higher highs and lower lows. Recently, technology shares and several other sectors became their most overpriced in history with a few exceptions from late 1999 and early 2000, while energy and some other commodity-related assets have been trading near multi-year lows. Investors adore stocks like Tesla (NASDAQ:TSLA) with price-earnings ratios near 300 while disdaining commodity-related companies with single-digit price-earnings ratios including Matador Resources (NYSE:MTDR) and Alcoa (NYSE:AA) which have enjoyed heavy insider buying.
How can one explain such strange divergences? Ordinary mortals have no clues, but fortunately, some of our favorite detectives agreed to return from their hidden places (mostly in remote corners of town libraries) to help us in locating the suspects who created this incoherent mess. Let’s see what they have to say.
Join our unexpected detective reunion.
Sherlock Holmes: How often have I said to you that when you have eliminated the impossible, whatever remains, however improbable, must be the truth? I must conclude that the invention of this fascinating internet has indeed eliminated the essential mental pause between thought and action, thereby causing humans to behave precisely as apes. Put that in your book, Watson, you have always been a man of immediate direct action. When one billion men and women of action all buy or sell before thinking it over then you get the mispriced chaos we have now.
Sherlock Holmes: Precisely, my dear Watson. It is the triumph of instinct over intellect. I have seen it many times in my day, but this is the first time I can recall an instance of society as a whole acting so singularly. Charles Mackay was right in his “Extraordinary Popular Delusions” about people going mad in herds.
Dr. Watson: Did he not say specifically that men – not people – think in herds?
Sherlock Holmes: Excellent recall, Watson, but nowadays the fairer sex has the right and perhaps the mandate to make equally inferior trading decisions as their male counterparts. That’s true women’s liberation.
Miss Marple: Indeed, Mr. Holmes, I believe you are being a bit unfair to us. However, your main observation is accurate. The situation reminds me of a naughty boy I knew once in my village. Before his fifth birthday, he was already taking the wings off of bugs and destroying birds’ nests. Before he reached the age of majority, he had already committed a few murders. And he had such a sweet angelic face too, making everyone think he was just an ordinary nice chap.
Joe Friday: Just the facts, ma’am.
Sherlock Holmes: That is most edifying, Miss Marple, but how does that relate to the global financial markets in February 2020?
Miss Marple: My inference should be clear, especially to you, Mr. Holmes. The market pretends that everything is normal and permanent when it is the opposite. Popular overpriced favorites are just beginning what will become a historic collapse, while the most-hated securities will double and triple within a couple of years.
Hercule Poirot: It is essential to use the little grey cells, n’est-ce pas? Investors should be doing what the insiders are doing and the opposite of what the unwashed masses are doing. Instead, they have it backwards. C’est dommage.
Captain Hastings: Now look here, Poirot, I just bought some of those newfangled technology shares for my own account. Are you telling me I shouldn’t have done?
Hercule Poirot: It is not for me to play the fortuneteller, mon ami, but alas I see some losses in your future. You must recall how your last dozen or so ventures panned out in the end.
Captain Hastings: Just bad luck each time, Poirot. Surely, it’s different this time: the Fed, Brexit, the Chinese virus, Trump…
Hercule Poirot: There’s nothing new under the sun, Hastings.
Dr. Watson: I personally experienced violent conflicts in the days of the British Empire but I couldn’t have imagined this strange Brexit phenomenon. What’s next? Is Scotland going to break away from the United Kingdom?
Sherlock Holmes: Actually, that is a distinct possibility, my dear Watson, as regrettable as that would be. More relevantly, we must stop thinking about the future as an extension of the recent past. If the stock market on the other side of the Atlantic regresses to its average bear-market bottom then this will imply a loss of more than 70% from top to bottom for the S&P 500 Index.
Dr. Watson: I don’t know that index, Holmes. I always heard about the Dow Jones Industrial Average.
Sherlock Holmes: Indeed, the antiquated Dow Jones index, idiosyncratically modified, remains with us, Holmes, for better or for worse. That one will probably also drop 70% from its recent top, as unlikely as that would seem to most investors who have not studied history. There is a lesser-known index called the Russell 2000 consisting of U.S. companies 1001 through 3000 by market capitalization; in spite of large-cap indices frequently setting new highs since August 31, 2018, the Russell 2000 and the S&P 5mallCap 600 have never surpassed their zeniths from that day.
Dr. Watson: Is there a reason that would be meaningful, Holmes?
Sherlock Holmes: The worst American bear markets have always begun that way.
Hercule Poirot: Plus ça change, plus c’est la même chose, eh, Holmes? Our thoughts are very much alike on this subject.
Inspector Clouseau: I am searching for the clues in the room. Where is the scene of the crime?
Sam Spade: So sorry, sweetheart. I think you missed your train a long time ago. It’s a tough world out there and there’s no room for sugarcoating the truth. The assets everyone loves are going down, hard. My pals and I are buying up what no one seem to want because they have no idea what they should be looking for.
Dr. Watson: I don’t believe we’ve been formally introduced. Call me Watson. What is it that your “pals” are buying?
Sam Spade: I keep it simple. Energy. Mining. Base-metals production. Emerging-market government bonds. With a martini chaser and a broad.
Captain Hastings: I still don’t see what you all have against technology. What’s wrong with investing in something I can’t possibly understand?
Hercule Poirot: It’s not technology that’s the problem, per se, but the fact that investors are willing to pay far too much for each dollar of technology earnings. I can’t bring myself to say “euro” without blanching. Energy’s share of the S&P 500 is below 4% – it was above 16% in the summer of 2008. Except for gold mining and silver mining shares which have been strong for over four years, and a few environmentally-trendy companies, most commodity-related assets have been given up as hopeless. Sensationnel.
Lieutenant Columbo: Mrs. Columbo was telling me just the other day that so many people we know seem to have their money in U.S. index funds these days. We’re boring – we have everything in bank CDs and money-market funds.
Sam Spade: Boring is underrated.
Lieutenant Columbo: Maybe when everyone else asks me about how much interest we’re getting, it will be time to buy some of those stock index funds.
Captain Hastings: You can hang up your raincoat near the door, sir. Usually, everyone agrees with me – I’m not used to so much contrarianism.
Hercule Poirot: Indeed, we live in a world of many Hastings and few Poirots. Tel est le monde. I am enjoying the challenge. Épatant.
Lieutenant Columbo: [whistling “This Old Man”] Come here, dog, and meet all these nice detectives.
Captain Hastings: Keep your raincoat, then. Don’t you think technology shares have unlimited potential?
Lieutenant Columbo: Does that include the potential to drop in value? No one seems to be thinking about that these days. All I hear is about fear of missing out. Seems to me that was a familiar tune from 2000 and 2007.
Hercule Poirot: With all due respect, I am probably the greatest detective in the world. But I, Poirot, have been so stupid. If I purchase some of these gas and oil shares then I won’t have to spend so much time chasing these perplexing clues. Tres bien, that is what I will do.
Inspector Clouseau: I have found the clues. They are here. No, they are there. They are somewhere.
Lieutenant Columbo: Just one more thing. Where were all of you at the opening bell on Friday, January 24, 2020? That is when the latest stock-market murder occurred.
How will the bear market end? Tune in next week to find out – same contrarian time, same contrarian channel.
If we’re in a true bear market for U.S. equities then we’ll continue to enjoy numerous sharp short-term rallies. Don’t be fooled: within a few years, the S&P 500 will eventually trade 70% or more below its recent zenith which means below one thousand. Along the way, commodity-related assets, currently, mostly sporting single-digit price-earnings ratios will likely be among the few outperformers while technology favorites with triple-digit price-earnings multiples will be among the biggest losers. Bear markets usually consist of numerous corrections interrupted by powerful rebound attempts, so intermediate-term buying opportunities may occur at various points in 2020-2021 for unknown sectors.
Investing Tip #2: when you are opening any position, gradually accumulate risk using ladders of good-until-canceled orders, not with lump-sum lucky strikes.
There is no way to know in advance how extreme any given asset will get when it is completing a topping or a bottoming process, nor is it possible to determine when the ultimate zenith or nadir will occur. Therefore, you must avoid dangerously accumulating risk with lump-sum opening positions. Occasionally you will get lucky, but if you buy too much at once and underpriced assets become even more absurdly undervalued – as they usually do – then you won’t have enough cash to keep steadily buying. In addition, once any security completes a major bottom it usually forms several higher lows before it rallies strongly. These higher lows should be used as opportunities to keep adding to your position. Think of investing as adding one grain of sand at a time to each pile, not a whole bag at once, and to keep gradually adding until prices become too expensive.
Perhaps the simplest way to accomplish this objective is to place a ladder of small orders, with each rung in the ladder consisting of roughly 1/1000 (one-thousandth) of your total liquid net worth. Each order can be placed roughly 1% apart from each other order. If an asset worth buying keeps dropping in price, you will buy more of it each time it falls another 1%. If the security rebounds, then you can replace orders which were already filled with identical orders at the same prices and quantities, so that if there is another pullback then you will gradually buy more of it into weakness. This is how many top corporate insiders and market makers accumulate their positions.
The basic idea is that a topping or bottoming pattern is usually a process, not an event. Instead of trying to use magic market timing or mystically guessing when a top or bottom is occurring, gradually scale into any position in which you are increasing your risk.
Summary: a surprising number of assets are either far below or far above fair value.
Today, we have numerous energy and related commodity securities trading at less than half fair value while many other assets including U.S. equity indices and coastal real estate remain at roughly double fair value. Mean regressions are often unexpected and especially disruptive events because too many investors are anticipating that the trends of recent years will continue even though they have already been reversing.
The bottom line: keep buying commodity-related securities into extended weakness and keep selling overpriced assets into strength.
The next two or three years will likely be accompanied by a massive shift away from the biggest winners of recent years into the most notable losers. This process is barely underway so there is plenty of time to double or triple your money by capitalizing upon it.
Disclosure of current holdings:
From my largest to my smallest position I currently am long GDXJ, 4-week U.S. Treasuries yielding 1.573%, the TIAA-CREF Traditional Annuity Fund, SIL, XES (some new), ELD, FCG (some new), OIH (some new), PSCE (some new), bank CDs, money-market funds, GDX, I-Bonds, SCIF, MTDR (some new), URA (some new), PAK, EPOL, ECH, COPX, REMX, HDGE, LIT (most sold), EZA (most sold), GXG (most sold), ASHS (most sold), ASHR (most sold), SEA (most sold), VNM (most sold), TUR (most sold), FXF, EGPT, GOEX, BGEIX, NGE, FXB, EWM, RGLD, WPM, SAND, SILJ, AA (brand new), SLX (most sold), FM (most sold), ARGT (most sold), EWW (most sold), RSXJ (most sold), GREK (most sold), and CHK. I am completely sold out of EWU, EWG, EWI, EWD, EWQ, EWK, EWN, WOOD, EPHE, JOF, AFK, and IDX.
I have a significant short position in XLI, a slightly larger short position in SMH, and a moderate short position in CLOU. As always, my short positions are notably smaller than my more meaningful long positions. My cash and cash equivalents including bank CDs and stable-value funds (fixed principal, variable interest) comprise 33.5% of my total liquid net worth, continuing to retreat from a two-year high as I have been persistently purchasing energy shares especially into early morning weakness.
“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 70% 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 second half of 2022. During the 2007-2009 bear market, most investors by Labor Day of 2008 still didn’t realize that we were in a crushing collapse, and I expect that by early 2022 many Boglehead investors will stubbornly 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 and have never surpassed their zeniths from that day; similar behavior had ushered in the major bear markets of 1929-1932, 1973-1974, 2000-2002, and 2007-2009. The Nasdaq has completed a historic double top with its March 10, 2000 zenith in inflation-adjusted terms. A 70% loss from its recent zenith would put the S&P 500 near one thousand and I expect it to go even lower than that by some unknowable percentage. 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.
Here is the rationale between my timing guess of the next bear-market bottom for U.S. equity indices: the two previous longest bull markets in U.S. history occurred in 1921-1929 which was followed by a bear market of over 34 months from September 1929 through July 1932. The other long bull market was from October 1990 through March 2000 which was followed by a bear market of 30-31 months in duration (exactly 31 for the Nasdaq). The current lengthy bull market which began for the S&P 500 on March 6, 2009, and which may have ended for that index on January 22, 2020, might, therefore, last for 30-36 months, implying a bottom around the second half of 2022.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.