Bear Market

So barring any huge negative developments, the markets should rally over the next few weeks based on historical and seasonal patterns.

There are multiple signs of a top forming. And even stock bulls are sitting on cash. What's next?

• BAD TRADE #1 For 2014: Ignoring Mean Reversion
• BAD TRADE #2 For 2014: Which-flation?
• BAD TRADE #3 For 2014: Forgetting Late Cycle Dynamics
• BAD TRADE #4 For 2014: Blind Faith In Policy
• BAD TRADE #5 For 2014: Reaching for Yield During Late Cycle

One of the singular best investment strategies is to buy assets/asset classes which are most reviled by investors. Right now, junior gold miners fit the bill.

Many investors argue that Gold has no intrinsic value. I disagree with this assessment as it does not consider the nature of the financial system.

The markets are in a perilous condition today. We’ve been noting for months that the markets were displaying signs of a top.

Western central banks have tried to shake off the constraints of gold for a long time, which have created enormous difficulties for them. They have generally succeeded in managing opinion in the developed nations but been demonstrably unsuccessful in the lesser-developed world, particularly in Asia. It is the growing wealth earned by these nations that has fuelled demand for gold since the late 1960s. There is precious little bullion left in the West today to supply rapidly increasing Asian demand, and it is important to understand how little there is and the dangers this poses for financial stability.

The Hong Kong branch of Spink & Son, a British firm originally founded in the mid-1600s, was putting a series of Bruce Lee memorabilia under the hammer.  When the bidding for the first lot opened, the price immediately surpassed the auctioneer’s initial estimates. It was a frenzy. Now, we know that modern auctions are supposed to be a pure form of the free market– buyers from around the world meeting for the purpose ‘price discovery’, with the item eventually going to the highest bidder. Further, economists and university finance often teach that such markets are ‘efficient’, meaning that prices always reflect the most relevant information and are hence an accurate reflection of an asset’s value. But in reality, nothing could be further from the truth. The auction was an emotional frenzy. It’s not an efficient market. It’s full of fear, euphoria, and aggression. The stock market is the same way. Even though just about every rational metric suggests that many global markets (especially the US) are absurdly overvalued, emotional investors keep bidding prices up.

If you want to make a killing in the markets, you need to be willing to see the world the way it really is, NOT how you THINK it is. Most investors think the VIX measures the market’s risk, but really, it’s almost the opposite: a spike in the VIX almost always picks market bottoms!

UPDATE: BTC has rallied 26% off its lows in the last 55 minutes

From it's gold-matching highs at $1242 on Thursday night, the price of Bitcoin has collapsed over $400 (32%) to $840 on heavy volume. Of course, this is only a one-week low for the exuberant digital currency but still a significant plunge (as its smaller brethren Litecoin has collapsed 51% from its highs). Interestingly, this drops the price of Bitcoin in USD below the 'arb'-based price of Bitcoin in China ($965). It seems, all coincidence aside, that the BIS infamous plunge-protection-team has been re-trained...

Think of it this way: You’re a baseball player trying to break into the majors despite mediocre fielding skills, no foot speed, and a batting average that hovers around 250. Egged on by your friend, A-Rod, you think you can make it by using steroids and turning yourself into a power hitter. But it doesn’t work out as planned. After a year, you’re losing hair, your skull’s gotten bigger, there’s fatty tissue on your chest that wasn’t there before, and you’ve still only managed 18 home runs in a season. You finally accept that it’s not going to happen for you. In the baseball scenario, steroids didn’t show enough payoff before the side effects told you enough was enough. And you can say pretty much the same thing about our economic scenario and monetary steroids.  We’re seeing dubious benefits and fast developing side effects from the Fed’s actions, causing many observers to recommend a rethink of the Big Experiment. Yet, the experiment continues...

This brings me back to an earlier point, that profits and earnings are likely peaking. All of these point to a top forming.

The correlation between stock prices and margin debt continues to rise (to new records of exuberant "Fed's got our backs" hope) as NYSE member margin balances surge to new record highs. Relative to the NYSE Composite, this is the most "leveraged' investors have been since the absolute peak in Feb 2000. What is more worrisome, or perhaps not, is the ongoing collapse in investor net worth - defined as total free credit in margin accounts less total margin debt - which has hit what appears to be all-time lows (i.e. there's less left than ever before) which as we noted previously raised a "red flag" with Deutsche Bank. Relative to the 'economy' margin debt has only been higher at the very peak in 2000 and 2007 and was never sustained at this level for more than 2 months. Sounds like a perfect time to BTFATH...

Valuations still matter. Assuming that one is 'investing' as opposed to 'speculating', initial valuation (i.e. the price you pay for the investment) remains the single most important characteristic of whatever one elects to buy. And at the risk of sounding like a broken record, “initial valuation” in the US stock market is at a level consistent with very disappointing subsequent returns, if the history of the last 130 years is any guide. Without fail, every time the US market has traded on a cyclically-adjusted P/E (CAPE) ratio of 24 or higher over the past 130 years, it has been followed by a roughly 20 year bear market... but there are plenty of other fish to fry...

Once Gold was no longer pegged to world currencies there was only a single period in which stocks outperformed the precious metal. That period was from 1997-2000 during the height of the Tech Bubble (the single biggest stock market bubble in over 100 years).