Dear subscribers,
This is update #1536 for Friday evening, October 14, 2011.
Risk assets have continued to generally stage net daily gains even after frequent intraday pullbacks, thereby frustrating many who have been patiently waiting for a meaningful decline to add to their long positions or to close their misjudged short sales. According to recently released exchange data, a huge number of new shorts were entered during the beginning of October: these investors will be coming under additional pressure each time the stock market rallies and their losses continue to widen. Eventually, they will likely end up covering virtually simultaneously, probably producing a nearly vertical rise in equity valuations perhaps as soon as the next few weeks. Whenever too many momentum players eventually jump aboard the long side, the chance of a rapid pullback also increases substantially, in order to shake out any uncommitted holders before continuing the current uptrend. Buying stocks and other risk assets now would be equivalent to going swimming outdoors on the New Jersey shore in late November--not as bad as January or February, but definitely untimely.
Many investors don't trust the stock market's recent sharp rebound, and combined with the huge new shorting of risk assets when many key support levels were broken to the downside on October 3-4, 2011 have thereby driven the total level of short selling to its highest point since the middle of 2009. The article below shows that some other measures recently slumped to their most extreme readings since March 2009:
I usually ignore sentiment surveys except when they are at multi-year extremes, since what people do is a lot more important than what they say. Since the weekly NAAIM survey of [Money] Manager Sentiment was created in July 2006, there have only been three occasions when the money managers surveyed were net short equities--once in August 2007, once again in October 2008, and most recently on October 5, 2011. The October 5 reading was the most heavily net short ever recorded, and has already switched to being net long in just one week (download Excel data from the link just below the displayed info):
One problem with tightening lending standards in China is that since the government essentially controls all banks directly or indirectly, those businesses who cannot obtain a loan from one bank will essentially be refused by all. Such businesses may thereby be forced to go to loan sharks:
The U.S. dollar index slid to a mid-morning bottom of 76.508, its lowest level since September 16, before ending the day significantly lower near 76.60. The greenback likely began an intermediate-term downtrend on October 4, 2011 which could continue into the first quarter of 2012. The U.S. dollar index has been in an important long-term bull market since March 16, 2008, when it had completed an all-time bottom at 70.698. Since then, the U.S. dollar index completed its first higher low of 71.314 on July 15, 2008; its second higher low of 72.696 on May 4, 2011; its third higher low of 73.421 on July 27, 2011; its fourth higher low of 73.452 on August 17, 2011; and its fifth higher low of 73.525 on August 29, 2011. On October 4, 2011, the U.S. dollar index rallied to a mid-morning peak of 79.838, its most elevated point since January 14, 2011. On August 29, 2011, the U.S. dollar index slid to a very early morning bottom of 73.525, its lowest point since August 17, 2011. On August 17, 2011, the U.S. dollar index slumped to a mid-morning bottom of 73.452, its lowest level since July 27, 2011. On July 27, 2011, the U.S. dollar index retreated to a very early morning bottom of 73.421, its most depressed mark since May 5, 2011. On May 4, 2011, the U.S. dollar index slid to a mid-morning bottom of 72.696, its lowest point since July 29, 2008. On January 10, 2011, the U.S. dollar index climbed to an early morning peak of 81.313, its most elevated level since December 1, 2010. On November 30, 2010, the U.S. dollar index rallied to an early morning peak of 81.444, its most elevated level since September 20, 2010. Relevant past peaks for the U.S. dollar index include 88.708 on June 6, 2010, 89.624 on March 4, 2009, 92.63 on November 16, 2005, 99.49 on August 26, 2003, and 120.99 on July 5, 2001. I expect the U.S. dollar index to peak in 2013 or 2014 between 100 and 120.
TLT, a fund of U.S. Treasuries averaging 28 years to maturity, dropped to an early morning low of 113.61, just above its 4-week low from Wednesday, before closing down 1.68 at 113.95. The nearly vertical ascent for TLT from July through early October was typical of a blowoff top which inevitably leads to a substantial plunge. After spending 4-1/2 months below its 200-day moving average, TLT had struggled for more than three months with this key level before knocking out many who sold short because Bill Gross had recommended such foolish action. TLT thereby soared to a double top with its all-time zenith of 123.15 which had been achieved on December 18, 2008. During late September and early October 2011, Bill Gross was aggressively buying Treasuries: you can reach your own conclusions. TLT is likely to slump back to about 96 and possibly lower where I will progressively repurchase it, probably during the fourth quarter of 2011 and/or the first quarter of 2012. I had repeatedly bought TLT into weakness near and below 92 dollars per share, usually using 0.42% of my net worth per trade, between mid-December 2010 and mid-April 2011. I also bought VUSUX almost every day that TLT was near 92 dollars per share or below, with the largest purchases at the lowest prices. Both VUSUX (VUSTX < 50k) and FLBAX (FLBIX < 100k) are nearly identical to TLT, except they average about 22 years to maturity instead of 28 years; they are ideal for accounts where you are not permitted to own TLT. Non-U.S. residents will enjoy even greater gains in home-currency terms as the U.S. dollar rallies strongly during the next two years. On October 12, 2011, TLT plummeted to a mid-afternoon bottom of 113.48, its lowest mark since September 16, 2011. On October 4, 2011, TLT rallied to a 10 a.m. all-time zenith of 125.03. On July 25, 2011, TLT slumped to a pre-market bottom of 94.75, its most depressed reading since July 7, 2011. On June 30, 2011, TLT slumped to a mid-morning bottom of 93.29, its lowest level since May 2, 2011. On April 8, 2011, TLT slid to a pre-market bottom of 89.64, its lowest level since February 18, 2011. On February 10, 2011, TLT retreated to a late morning bottom of 88.14, its lowest point since April 7, 2010. On August 25, 2010, TLT surged to an early morning peak of 109.34, its highest level since January 28, 2009. On April 7, 2010, TLT slumped to an early morning bottom of 87.30, its lowest point since September 20, 2007.
VIX is probably the best-known measure of equity index implied volatility, which is synonymous with investors' fear of an upcoming bear market. VIX slid to a late afternoon bottom of 28.08, its lowest mark since August 5, before closing down 2.46 at 28.24. On October 4, 2011, VIX climbed to a 10 a.m. peak of 46.88, its highest level since August 9, 2011. On August 9, 2011, VIX rallied to a post-Fed-announcement high of 47.56. On August 8, 2011, VIX soared exactly 50% to its intraday peak of 48.00, its highest reading since May 21, 2010. On July 22, 2011, VIX dropped to a noon bottom of 17.14, its lowest reading since July 8, 2011. On July 1, 2011, VIX slumped to a mid-afternoon bottom of 15.12, its most depressed mark since May 2, 2011. On April 28, 2011, VIX plummeted to a late afternoon bottom of 14.27, its lowest reading since June 21, 2007. VIX dropping below 15 on an intraday basis demonstrates an astonishingly dangerous level of investor complacency toward the potential of a double-dip recession, and is similar to the VIX levels in 2007-2008 preceding the last severe global equity bear market. This makes a major bear market in global risk assets even more likely through 2012-2013. On May 21, 2010, VIX soared to an early morning peak of 48.20, its most elevated mark since March 10, 2009.
The S&P 500 index rallied to a late afternoon peak of 1224.61, its highest point since September 1, before closing up 20.92 at 1224.58. Because of the extreme pessimism and recent heavy selling by amateurs, while top corporate insiders have demonstrated an unusually high ratio of buying to selling since early August and with VIX repeatedly climbing above 45, a counter-rally toward and probably beyond 1300 is likely during the next few months with a possible double top during the first quarter of 2012. Its long-term bear market will remain intact until the S&P 500 ultimately completes a nadir below 500 and possibly below 400, perhaps in 2013. The S&P 500 has not been below 500 since March 31, 1995, and it has not been below 400 since October 5, 1992--before Bill Clinton was first elected President of the United States. On October 4, 2011, the S&P 500 plummeted to a 10 a.m. bottom of 1074.77, its lowest mark since September 1, 2010. On August 31, 2011, the S&P 500 rallied to a mid-morning peak of 1230.71, its most elevated mark since August 4, 2011. On August 9, 2011, the S&P 500 slumped to a post-Fed mid-afternoon bottom of 1101.54, its most depressed reading since September 9, 2010. On July 21, 2011, the S&P 500 climbed to a mid-afternoon peak of 1347.00, its highest mark since July 8, 2011. On July 7, 2011, the S&P 500 surged to a mid-afternoon peak of 1356.48, its most elevated reading since May 10, 2011. On May 10, 2011, the S&P 500 rallied to a late afternoon peak of 1359.44, its highest level since May 3, 2011. On May 2, 2011, the S&P 500 rallied to a mid-morning peak of 1370.58, its highest level since June 9, 2008. On August 27, 2010, the S&P 500 retreated to a mid-morning bottom of 1039.70, its lowest point since July 7, 2010. On July 1, 2010, the S&P 500 slid to a late morning bottom of 1010.91, its lowest mark since September 4, 2009.
GDX, a fund of primarily large-cap gold mining shares, rallied to a late afternoon peak of 58.00, its most elevated level since September 27, before closing up 1.68 at 57.96. On October 4, 2011, GDX plummeted to a late afternoon bottom of 50.42, its lowest mark since August 25, 2010. On September 21, 2011, GDX rallied to a mid-afternoon (pre-Fed) peak of 66.90, just 8 cents below its all-time high from September 9, 2011. On September 9, 2011, GDX climbed to a mid-morning all-time high of 66.98. On June 16, 2011, GDX slumped to a late afternoon bottom of 51.10, its most depressed reading since August 25, 2010. On December 7, 2010, GDX rallied to an early morning zenith of 64.62, a new all-time high. On July 28, 2010, GDX retreated to an early morning bottom of 46.80, its lowest point since May 21, 2010.
On Tuesday, September 6, 2011, December 2011 gold futures soared to a very early morning all-time zenith of 1923.70 U.S. dollars per troy ounce. On Monday, April 25, 2011, May 2011 silver futures achieved a post-midnight zenith of 49.820 U.S. dollars per troy ounce, the highest level for silver since it completed a nearly identical intraday peak on January 21, 1980. So far, the highest point in the cycle for SLV was its April 28, 2011 late morning zenith of 48.35. SLV would have traded at 48.71 if it had been available for trading in the early morning of April 25, 2011 when silver futures completed their historic double top. On April 21, 2011, Market Vane reported a 96% bullish consensus on silver, one of the highest readings ever recorded since silver began trading on the first business day of 1972. Silver's behavior in 2008-2013 has so far been quite similar to that of the Nasdaq in 1998-2002; if you divide the Nasdaq by 100, you will see some amazing parallels. This is primarily because all bubbles behave nearly identically. I am also expecting gold to plummet dramatically from its peak level, perhaps by more than 50%, within two years, with numerous strong upward bounces along the way.
Today's main topic is pudding.
There's an old saying that "the proof of the pudding is in the eating". While I often advance various hypotheses about the financial markets, it is only meaningful if my ideas are later proven to be correct by actual events. It is therefore useful to review how these concepts applied during the past year and especially since early August 2011.
In early November 2010, Chinese and Indian equities were among the earliest global equity bourses to begin important bearish patterns of lower highs. Over the next several months, an increasing number of risk assets began similar leisurely downtrends. This was a sign that stock markets worldwide would eventually suffer sharp losses at some point--but there was no clue as to when this would occur, only that its likelihood was extremely high. Beginning in late July 2011, we experienced a sharp pullback which persisted until August 8, 2011 for nearly all risk assets. At that point, we began to see an increasing number of risk assets which were forming bullish patterns of higher lows, including QQQ which bottomed at 49.53 in the after-hours session on August 8. The S&P 500 and many other traditional lagging assets broke below their summer support levels on October 3-4, 2011, giving chartists and other foolish investors more than ample incentive to sell and to sell short when they should have been doing their most aggressive buying of the year.
One moral of this story is that even if you are pretty sure that a given asset will go either up or down, you don't know exactly when that will happen. It will most often go to an even greater extreme first in order to confuse as many investors as possible to jump to the wrong side of the trade shortly before the biggest percentage price change occurs. The greater the number of highly correlated assets which have switched from uptrends to downtrends, or vice versa, the more likely that a reversal is increasingly imminent, but you still won't get any reliable timing clues. Therefore, don't buy options or make other bets which are time-dependent. Allow your positions as much time as they need to profitably mature.
During the spring of 2011, and again in July 2011, insiders demonstrated some of the highest ratios of selling to buying ever recorded. After the summer slump, the ratio of buying to selling by top corporate executives soared to one of its most elevated levels in history. In both cases, insiders were generally ignored or derided by analysts, and later proved to be absolutely right. Insiders don't care about whether they could achieve even more favorable prices by waiting, or whether they could have done this or that. They act incrementally by buying more into pronounced weakness and selling more into extended strength, and always buy in advance of a rally or sell prior to a decline rather than after it has already started. All they care about is making money, which they do consistently well. This is why I attempt to mimic insider behavior with my own trading system.
Recently, insiders have been essentially doing nothing. That is why I am also doing nothing. At some point within the next several months, and perhaps within the next several weeks, they will likely demonstrate an unusually elevated level of selling to buying. That will be an important signal to do likewise.
VIX formed a classic pattern of lower highs, beginning at 48.00 on August 8, 2011 and continuing with a lower intraday high of 47.56 on August 9 and an even more important lower high of 46.88 on October 4. Earlier in 2011, VIX had slumped into the mid-teens several times, each of which not coincidentally was soon followed by a meaningful pullback. Eventually, VIX will slump to 13-18: there is no way to know where in this range it will eventually bottom, but it is certain that the lower it gets, the more important it becomes to sell your equity funds and other risk assets. Especially if VIX is near 15 and below, it becomes especially dangerous to continue to hold onto equities. You might get away with it in the short run, but you'll eventually end up losing money if you keep stubbornly waiting for additional gains especially during any era of stagnation.
Imagine a sports stadium filled with one hundred thousand people for a major event. Now imagine that there is only one narrow door by which you can exit that stadium. Additionally imagine that each of those one hundred thousand people is positive that once the final bell rings, he or she will have no trouble being among the first to reach that exit safely. Are these folks deluded or what? And yet that is exactly what nearly all investors believe they are able to do in the financial markets. They think they can magically determine when a reversal has just begun, and they can therefore buy all of their favorite securities just above their multi-year lows. I would like to hear from a subscriber who patiently waited until the S&P 500 reached 1075 on October 4, 2011, and then piled into all of the most undervalued and oversold equity funds pennies above their one- and two-year nadirs. I know quite a few people who said they would wait for 1075 and then buy--which is a start. But it's one thing to say something, and another to actually do it. When all is said and done, a lot more is said than done.
From my email correspondence I know for certain that many investors during the past several trading days wanted a time machine to go back to the beginning of the month. Unfortunately, my DeLorean has already been rented out and it doesn't look as though it's going to be returned to me any time soon. So you're going to have to learn to live in the present instead of being magically transported in time. Top corporate insiders have always acted in advance of any major market bottom or top--since even with all of their influence and connections and other privileges, they know it's simply impossible to try to be among the first people through that narrow door. If CEOs don't believe they can wait for a reversal before acting, and you think you can out-trade them, then good luck. (You'll need it.)
Many people talk about "the lessons of 2008", which are almost always the wrong lessons. One of the most important features of 2007-2010 was that the biggest percentage losers for pure equity and bond funds in the last bear market were almost universally the biggest winners in the subsequent bull market. The same has been true during the most recent cycle. Whenever most investors are selling out of panic or fear or despondency or other emotional reasons, a larger pullback is almost always due to irrational behavior rather than some fundamental reason. Therefore, if you capitalize on this illogical activity by purchasing those assets which have dropped the most, you will almost always gain more than through purely random selection or the even worse idea of buying into relative strength.
You often read in the financial media about "how to seek alpha" or "secrets for identifying fundamentally undervalued securities". If you think you can outperform the market by carefully scrutinizing annual reports and visiting companies in person, then be my guest--at least you'll accumulate some frequent-flyer miles and have some fun adventures. I will continue to seek beta, which is a measure of the volatility of any given subsector relative to a benchmark such as the S&P 500. It sounds overly simplistic, but success doesn't have to be unnecessarily complex.
Just like the folks who think they can be among the first to leave a crowded stadium by a single narrow door, there are many who believe they can place timely market orders near important bottoms in order to capture ideal prices. I challenge anyone, even the world's fastest typist who also happens to be the world's most capable trader, to tell me with a straight face that he [no woman would make such a foolish claim] was able to act successfully in buying near the bottom on October 4, 2011. On days like November 19-20, 2008 or October 3-4, 2011, many securities suddenly plummeted and just as rapidly recovered. Such behavior was especially pronounced for closed-end mutual funds, many of which you could not have bought within several percent of its intraday low even if you were literally doing nothing all day but waiting for a given closed-end fund to suddenly plummet before placing a market order to buy it. Even with more liquid exchange-traded funds, prices can move several percent within one minute or less on such volatile trading days. Look back at a chart of GDXJ or SLX beginning at 3:10 p.m. on October 4: the move higher was almost literally vertical.
It is true that you can sometimes enhance a ladder of good-until-cancelled purchase orders by sprinkling in an occasional market buy order. However, you cannot hope to get anywhere close to the lowest price of the day--merely a favorable price if you want to make a somewhat greater commitment to a given subsector than you had anticipated in advance. The only exception to this rule is during after-hours trading on a sleepy evening, especially on a Friday, when you can sometimes play a cat-and-mouse game with an especially eager trader who wants to take the other side in order not to have to hold a position into the weekend or for other emotional reasons. Even then, you almost always have to place limit orders rather than market orders in order to get the best prices.
It also doesn't make sense to have to rely on being alert and able to place trades frenetically during a major market reversal. If your orders were entered days or weeks in advance, you can be enjoying lunch or taking a walk or engaging in many other activities instead of watching the financial markets. The only reason I usually pay close attention is in order to send timely intraday updates; I rarely log into any of my accounts during the most hectic periods.
One of the most important lessons of the past five years has been the principle that it is usually best to gradually accumulate risk assets as a bottom is being formed, rather than jumping in with lump-sum purchases. There are several reasons: 1) you never know which specific assets will become the most undervalued during the next panic; 2) you want to be sure to have sufficient cash to buy more when an undervalued extreme becomes even more undervalued; 3) you will likely get more than one chance to buy your favorite securities, although you won't enjoy infinitely many opportunities, If you don't get something at a favorable price the first time, patiently wait for its next pullback. Allow the market to come to you rather than chasing after it.
KOL and RSX, my two biggest winners from the last bull market, both fell below 11 dollars per share numerous times from October 2008 through March 2009. GDX dropped below 20 several times. Recently, all of my recommended assets offered multiple occasions for very good prices. Of course, we won't always experience six panics in less than two months. However, if you review the fourth quarter of 2008 and the first quarter of 2009, including April 1, 2009, you will see numerous buying opportunities rather than just a few. The more frequently you are able to buy at favorable prices, the more frequently that amateurs will be selling at those lows for emotional reasons--and therefore the most you will gain in a subsequent rally when those amateurs are punished for their ill-timed behavior. Therefore, if the market does make only one bottom and you miss out, you probably would not have gained that much anyhow.
Before the financial markets have moved in my favor, I will hear from many readers who tell me I'm becoming too heavily invested. After there is a convincing reversal, I receive even more email telling me that I shouldn't have kept so much money in cash. On principle, I will always have too much uninvested cash in my accounts. That's because there is no way to know in advance how many very good opportunities will present themselves. Did you think at the end of July that we would have six panics by early October? I certainly did not. In fact, if you had told me prior to August that general equities would suffer six sharp pullbacks, then I would have told you that you were making a ridiculous prediction. If you had shown me at 3 p.m. on October 4 where my recommended equity funds would be exactly one week later, I would have laughed out loud and called you an idiot. Besides demonstrating that I'm often clueless about the future behavior of important details in the financial markets, this illustrates how many unknowns there always are. Because you can't possibly figure out what is going to happen, you must keep a lot of cash around just in case. I will always happily accept that I could have made more money in theory if I had been more heavily invested, knowing that I was able to be properly aggressive whenever there was additional weakness in my favorite holdings.
The lower that equities slumped during each of their respective panics, the more insistently the financial media broadcast negative news and featured bearish analysts to "explain" why the markets had plummeted. Each time that equities rebounded, the media would suddenly bury all negative stories and would feature only positive statistics and bullish analysts. It is obviously ridiculous to think that the fundamentals changed so frequently during a two-month period that it made sense for such volatile fluctuations to occur for logical reasons. When the financial markets made their false downside breakouts at the beginning of October 2011, the media responded with their most insistent forecasts for the likelihood of a double-digit recession. Watch how these economic forecasts progressively improve over the next several weeks, so that whenever equities achieve their intermediate-term peaks, we suddenly see numerous analysts raising their growth forecasts and earnings estimates for 2012. How many analysts raised their forecasts and estimates while the market was dropping? Exactly zero. That tells you all you have to know about whether the markets act first. If the markets followed the news, then the most bullish projections and data would have been released immediately prior to the biggest percentage equity gains--instead of right before the most severe losses.
Many investors--especially those who are not consistently successful--believe that the reason for their subpar performance is their inferior market timing. However, what they are almost surely lacking is a highly disciplined plan which has precise contingencies for action no matter what the market does. If you always know in advance how you will respond to any move in the markets, then you will consistently make a profit regardless of whether your predictions are accurate or not. You will also remain in firm control, for a simple reason: you can't possibly know what the market will do, but you can know exactly what you will do in any situation. Understanding this is the single most important distinction between a professional investor and an amateur. I had no idea how low GDXJ or SLX or any of my other recommended funds would eventually slump since early August 2011--I can tell you that I wrote down my projections privately and several of them were pretty far off the mark both price-wise and time-wise. My only really accurate guesses were for QQQ and GDX, and I didn't buy either of them. (I closed my short position in QQQ on August 8, 2011.)
A useful analogy is duplicate bridge. In any duplicate bridge match or tournament, the cards are shuffled only once--at the very beginning before everyone has taken their seats. The cards are passed from one table to another, until everyone in the room has played exactly the same hands. Therefore, it doesn't matter whether you get excellent deals or poor ones--it's what you do relative to everyone else in the room. A poor duplicate-bridge player complains that he had inferior cards or bad luck; an expert knows that since everyone else had to bid and play with exactly the same hands, it's how you handle the cards you're dealt which matters. Whether you live in Mongolia or Montana, the prices of silver and the Shanghai "A" Index and the FTSE-100 are going to do exactly the same thing for all seven billion of us on this planet. Those who have the best long-term track records are those who respond most intelligently to the market's fluctuations. I could also use my favorite sailing analogy, but I'll resist doing that this time.
Perhaps you think I'm joking, but the above statement is important. Nothing really changes in the financial markets, even over a period of many decades or centuries. For example, there are only two safe-haven assets worldwide: the U.S. dollar, and U.S. Treasuries. That's all, folks. Some deluded themselves during the summer into believing that precious metals and their shares had magically become safe-haven assets, just as some folks had foolishly believed the same fairy tale at the end of 2007 and the first 2-1/2 months of 2008. In the end, it took longer for gold and silver to decline as compared with the S&P 500, but they caught up in a big way by plummeting in just two weeks from an all-time high for GDX to its lowest level in more than a year. In early 1973, those who deluded themselves into thinking that the "Nifty Fifty" would keep rising even as the overall equity market kept falling ended up losing far more than those who were invested in broader-based equity funds.
Historical relationships exist for a reason. If a particular interrelationship has been true for four decades, and suddenly it appears to be different, then this apparent "decoupling" is almost certain to be temporary rather than permanent. Sometimes these interrelationships can persist for a lengthy period of time, such as the continued depressed performance of natural gas relative to crude oil. However, if you conclude that natural gas will remain indefinitely far below its normal ratio to crude oil, then you will end up being badly burned. Sooner or later, proven relationships will reassert themselves. The fundamental things which have reliably applied in the past will continue to apply in the future, as time goes by.
Take care and enjoy your weekend.
--Steve