“Macro worries are like sports talk radio. Everyone has a good opinion which probably means that none of them are good.” --Seth A. Klarman
SAFE HAVENS SHUNNED (June 21, 2022): Since January 4, 2022 large-cap growth funds like SPY finally joined the bear market which began in February 2021 when stocks in the U.S. and worldwide began shifting from uptrends to downtrends. It took several months longer for assets like the Nasdaq and QQQ to reach their respective peaks on November 22, 2021 at all-time record overvaluations roughly 3.75 times fair value. Whenever a popular fund like QQQ with its current fair value near 116 is trading at 408.71, as it had been at its peak on November 22, 2021, then it's like drinking an entire fifth of Scotch at one go. It might be a special single malt which has been lovingly aged for decades but you're still going to first get drunk and then suffer a severe hangover. Right now we're 5-1/2 months into that hangover which will likely persist until 2024 or 2025. I expect QQQ to ultimately bottom somewhere around 70, of course with numerous strong bounces along the way including one which is probably happening right now.
I have continued to progressively shift my equity short:long ratio toward the long side and have now become 5:4 short to long versus 2:1 in my previous update.
Especially during the past week we have experienced historic bargains for many individual shares and sectors including GDXJ, GDX, ASA, XBI, INTC, TKC, TLT, and VMBS, thereby encouraging me to add to all of the aforementioned. There is also an above-average likelihood of a quarter-end bounce which could persist into July; 9 of the past 10 quarters have behaved in that manner regardless of whether or not we were in a bear market, plus we are finally seeing some short-term bullish signals. Most likely QQQ will climb to perhaps 310 before continuing its downtrend to its 2022 intermediate-term bottom somewhere around 210. Most investors expect neither a strong rebound nor a continued severe downtrend, thereby making both much more likely than usual.
For those who have not read my numerous previous postings, this does not mean that I have closed out my large short positions in QQQ and related shares. Instead I have added aggressively to the long side in my favorite undervalued holdings with low price-earnings ratios, heavy insider buying, and intense outflows. I have no intention of closing out my shorts just because I think the chance of a short-term bounce are higher than usual. When VIX doubles from its current level it might be time to consider closing short positions. I had previously closed out all of my short positions and related short funds in March 2020, December 2018, and January 2016.
If VIX surges higher, but I don't believe that we are approaching a major intermediate-term bottom for QQQ, then I will likely sell covered out-of-the money puts against some of my short positions.
Gold mining and silver mining shares are especially compelling, not only because they have been trading at their lowest levels in more than two years but because they have consistently and dramatically outperformed during three previous bear markets for large-cap U.S. growth shares.
We had important peaks or lower highs for large-cap U.S. growth shares on January 4, 2022. Previous similar tops include March 2000, January 1973, and September 1929. In all of the above cases, large-cap U.S. growth shares ended up losing more than 80% from their respective zeniths, while gold mining shares after an initial delay ended up gaining hundreds of percent.
Let's look back at 2000-2003 since it is easiest to find free chart data compared with the 1970s or 1930s. HUI ($HUI on stockcharts.com) bottomed at 35.31 on November 15 and 16, 2000 and climbed to 258.60 by December 2, 2003. This is a total percentage gain of (258.60 - 35.31) / 35.31 or 632.37%. Perhaps we won't repeat that exact percentage surge but, especially as we had similar impressive rallies for gold/silver mining shares during the 1930s and 1970s, an outsized gain is more likely than not over the next several years. I prefer GDXJ to other funds in this sector since its mid-cap focus tends to outperform large-cap shares like GDX especially when fund managers no longer fear repeated net outflows and are confident enough to diversify into holdings other than the biggest and most liquid names.
Here are two useful charts.
We are at the point in a typical bear market where a rebound has become much more likely than usual. If this rebound becomes sufficiently extended so that VIX moves back below 20 then this will be my signal to add to my short positions, as has been the case during the past several months especially in late March when VIX dropped below 19. In general this is a useful guideline during all true bear markets including 2000-2003 and 2007-2009:
At the beginning of 2021 almost everyone in the media and elsewhere had been bearish toward the U.S. dollar. This has been replaced by a nearly opposite consensus about a powerful greenback:
Recently I have been buying shares of FXY (Japanese yen), FXF (Swiss franc), and FXB (British pound). This leads to the next topic which is how safe havens are currently incredibly unpopular.
Investors have been making net ouflows from safe havens of all kinds including U.S. Treasuries like TLT, the above-mentioned currencies, emerging-market government bond funds including TEI, LEMB, PCY, and ELD, as well as other government-guaranteed funds like VMBS.
Investors have become so accustomed to the failed Boglehead approach that they've actually been net sellers of gold/silver mining shares, government bonds of all countries including the United States, safe-haven currencies, and related assets like U.S. government-guaranteed mortgage-backed securities (VMBS). Most of this money has gone into buying still-very-overvalued large-cap growth shares and funds. This has created compelling opportunities for safe-haven sectors which in many cases have been trading near multi-year lows. Long-dated U.S. Treasuries haven't sported such high yields in more than eight years, including TLT which traded at 107.78 at 7:47 a.m. in the pre-market session on June 16, 2022. This marked the lowest point for TLT since April 3, 2014.
TEI is a compelling fund of emerging-market government bonds with a discount that is 50% above its long-term average.
TEI recently traded with a discount of more than 13% versus its long-term average near 8%. Emerging-market government bonds aren't well known to most investors and are usually ignored regardless of their valuations. This fund has been actively managed by the same lead advisor since 2006 and is well-diversified internationally.
Some aggressive underpriced assets have become worthwhile for purchase.
Companies including INTC, TKC, and GEO have recently been trading at unusually low price-earnings ratios relative to their profit growth. Some entire exchange-traded funds including XBI have also been periodically underpriced, with XBI also experiencing very heavy insider buying of many of its components including notable CEO purchases. KWEB had experienced a deep undervaluation earlier in 2022 but has now rebounded sufficiently so that I will continue to hold it but I will not add to my position unless it retreats to an important higher low later in the year.
Considering that we are in a severe bear market, VIX has been peculiarly low so far in 2022.
VIX has remained irrationally depressed throughout 2022, indicating that much greater losses lie ahead even if--or especially if--we have powerful upward bounces along the way which cause VIX to drop below 20. I am baffled by the failure of VIX so far in 2022 to reach 40, not to mention a much higher level like 60 or 70.
If you and I both had perfect advance knowledge at the beginning of 2022 regarding what QQQ and SPY would do during the first half of 2022 then I would have bet you a lot of money that I could forecast the behavior of VIX. And I would have been dead wrong. I have been puzzled that 1) VIX hasn't touched 40 so far in 2022; and 2) VIX has retreated below 20 several times in recent months. Both of these phenomena indicate that even professional investors are mostly unafraid or oblivious to the possibility of a significantly extended downtrend in 2022. It's not going to be different from every other bear market in history: eventually VIX will rally to double or more its current level and when that occurs it may become timely to finally close out some or all of our short positions.
Too many investors are comparing current valuations with their all-time peaks of 2021-2022 and drawing faulty conclusions.
I have met dozens of people who tell me something like this, "Look how much QQQ has dropped from its top. If it's down 30% then it has to be a great bargain." This is like announcing while you're descending from the peak of Mount Everest: "I've come down seven thousand feet so far, so I have to be very close to the bottom." If we look back at the highest-ever peaks for U.S. equities in their entire history then the beginning of 2022 is by far the all-time record, followed by March 2000, September 1929, and January 1973. (You could also count the railroad bubble of 1873 and the canal bubble of 1837 but let's skip those for now.) As of today's closing prices, large-cap growth shares overall were almost exactly matching their January 1973 tops and weren't far below their September 1929 zeniths which many people in the Great Depression believed would never be exceeded. In other words, what looks at first glance like a great discount compared with the top is still enormously above fair value and historic averages. If QQQ were to drop 75% more then it would be at the average level of a bear-market bottom at roughly 40% below fair value.
The bottom line: as the current bear market progresses in typical fashion with periodic sharp surges higher, there are opportunities to make money on both the long and the short side. Be persistent, gradual, and disciplined at all times and continually rebalance your portfolio to adjust to these fluctuations.
Disclosure of current holdings:
Here is my asset allocation in order from largest to smallest position: cash including I Bonds paying 9.62% guaranteed (available to anyone with a U.S. social security number); TIAA Traditional Annuity paying an average of about 3% (for legacy retirement accounts); long TLT (some new); short XLK; short QQQ; long GDXJ (many new); long GEO (some new); short TSLA; long GDX (many new); long KWEB; long EWZ; long ASA (many new); long INTC (many new); long TKC (many new); long XBI (some new); long TEI (all new); long EPOL (some new); long LEMB (all new); long TUR; short AAPL; long T; long ECH; short XLU; short XLE; long PCY (all new); long VZ; short IWF; short SMH; long WBD; long VMBS (all new); long FXF (all new); long FXY (all new); long FXB (all new); long UGP; long ITUB; long BBD; long TIMB.
Steven Jon Kaplan runs True Contrarian where this article appeared first.