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Please note: The Frank Talk articles listed below contain historical material. The data provided was current at the time of publication. For current information regarding any of the funds mentioned in these presentations, please visit the appropriate fund performance page.

Minute with the Analyst: Meet Joanna Sawicka
October 3, 2018

Meet Joanna Sawicka – an emerging Europe research analyst at U.S. Global Investors. Prior to joining our team in 2007, Joanna was part of Soros Fund Management in New York and JP Morgan in San Antonio. Since 2015, she has worked on the Investment team and currently is primarily responsible for analyzing companies in emerging European countries.

In this brief Q&A, I invite you to learn more about Joanna’s path to becoming an emerging Europe analyst and read what she sees on the horizon for this region as we head into year end.

What made you want to become an investment analyst?

I always knew that I wanted to pursue a career in finance. However, I didn’t know which section of the industry would suit me best until I visited the New York Stock Exchange (NYSE) for one of my classes at Baruch College. During this visit, we went to the floor of the exchange and toured a huge vault full of gold. Watching the trading and experiencing the atmosphere firsthand left a huge impression on me. It was after this trip that I moved steadily over to investments.

While working on my investment specialization in school, I especially enjoyed my simulation class. In it, we were given half a million dollars to grow. If I remember correctly, I invested in oil futures and bought Disney stock. I actually made a lot of money!

What was the most memorable trip you’ve taken for your job?

While I have traveled to many fascinating places, like the Warsaw Stock Exchange, to me, the most interesting trip was to the Wood & Company CEE Investor Days Conference in New York earlier this year. I was very surprised by how many people at the conference wanted to learn more about eastern Europe. The number of attendees speaking Polish also caught me off guard, though it makes sense since Wood & Company has a big presence in Poland.

You took a trip to Poland this summer. Did you notice any changes in the country since your last time there?

For the past three years, I have made an annual trip to Poland. Being there so frequently makes it a bit harder to see changes. Having said that, I did notice quite a bit of construction, in particular highway construction. Two years ago, when my flight landed in Warsaw, it took three or four hours to drive to my hometown, Bialystock, because the highway was not complete. This year, the drive only took two hours. There is still a lot of construction, especially on the east side, but the improvements are very apparent.

Many new businesses, small and large, began to appear starting 10 years ago, resulting in new construction projects like shopping centers. People are actually spending a lot of money. That is the most notable change to me in the last decade or so.  

Poland was recently upgraded to a developed market by FTSE Russell. What is on the horizon for Poland? Do you believe its growth is sustainable?

The upgrade to a developed market is very positive for Poland. The next step would be updating the country on the MSCI Emerging Markets Index. It’s my understanding that Poland is only missing one factor – gross domestic product (GDP) per capita. That isn’t quite strong enough yet. Once that happens, there will be more inflows into Polish equities.

Joanna Sawicka emerging europe research analyst U.S. Global Investors

It is important to mention that Poland is very strong in central emerging Europe and has the largest stock markets. There are more than 350 stocks trading on the Warsaw Stock Exchange, compared to only a handful in other central emerging European markets. Most of the stocks in other geographically similar markets, like Hungary and the Czech Republic, are not very liquid. The large equity market in Poland makes it much more accessible for larger investors.

Additionally, Poland is growing at around 5 percent, has stable inflation, low unemployment and solid consumer spending. Given these facts, I believe Poland’s growth is sustainable.

Do you see growing nationalism as a risk?

In central emerging Europe, nationalism has always had a presence, such as the Law and Justice in Poland (PiS) and Fidesz in Hungary. However, this trend is not specific to the region. In fact, it has spread into Western Europe. A far right government came into power in Austria last year. The elections in Italy, Germany and Sweden saw similar movements. I do not currently believe this is a threat, but we will have to see how it develops.

The recent emerging market sell-off has captured a lot of headlines. What is your outlook on emerging markets for the rest of 2018?

Emerging markets peaked around mid-January this year and, since then, stocks are down about 20 percent. Emerging markets were suppressed by dramatic currency depreciation in Turkey and Argentina.  At one point, we saw the lira drop about 25 percent in a couple days. Argentina experienced a huge drop as well, though the central bank of Argentina was a little more supportive with its rate hikes.

I think we are at a turning point now and emerging Europe will rebound. The Turkish bank just recently hiked rates by 625 basis points, which is very supportive of the lira. Additionally, when the price crosses above the 50-day moving average, we expect inflows. I noticed a cross in emerging markets and emerging Europe, so I think this uptrend will continue towards the end of the year.

With oil on the rise, Turkey looks even more vulnerable. Should investors be concerned?

Brent moving higher is certainly negative for Turkey, since it’s a major importer of crude oil, but a bigger concern is the weakening lira. Year-to-date, the lira has depreciated around 40 percent. So there is more to it than just higher oil prices, especially considering Turkey’s geopolitical situation.

U.S. sanctions are weighing heavily on Russia’s economy. What is Russia doing to counteract the slowdown?

U.S. sanctions have a significant impact, not only on Russia’s economy, but all of Europe’s growth, as these countries’ economies are interrelated. The latest set of sanctions was the most severe, disallowing American investors to own certain Russian equities which resulted in a sharp sell-off. There may be additional sanctions on the horizon, though no one is sure yet.

In the interim, Russia is taking measures to protect its economy. For example, the government is essentially supporting the ruble by hiking rates and discontinuing weekly forex buying. In March, Vladimir Putin won another presidential term and announced infrastructure reform, which may be supportive for the economy.

Russia is also trying to develop a better relationship with Asia. There is discussion about potentially building a pipeline through North Korea since the situation there has improved somewhat. Acquiring new “friends” could be positive for the Russian economy. 

Want to learn more about emerging Europe? Subscribe to the award-winning Investor Alert newsletter for a weekly recap of the biggest market-moving events.

 

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

A basis point, or bp, is a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001).

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

None of the U.S. Global Investors funds held any of the securities mentioned in this article as of 6/30/18.

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Gold's Bottom Could Be Investors' Lost Treasure
October 1, 2018

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Get ready, gold bulls: The precious metal could be close to finding a bottom.

The price of gold fell back below $1,200 an ounce again last week as the U.S. dollar advanced following another federal funds rate hike. The precious metal logged its sixth straight month of declines, its longest losing streak since 1989.

That gold’s not trading below $1,150 is, I believe, remarkable. There’s a lot motivating the bears right now. Besides a stronger dollar and higher interest rate, stocks are still going strong, buoyed by record buybacks and massive inflows into passive investment products. In the week ended September 20, investors poured as much as $34.3 billion into ETFs, taking year-to-date inflows to nearly $215 billion, according to FactSet data.

This makes gold mining stocks look especially attractive by comparison. Relative to U.S. blue chips, the FTSE Gold Mines Index is now at its most discounted level in over 20 years.

gold stocks at their most discounted level in over 20 years, relative to the market
click to enlarge

Gold Industry Ready for Consolidation?

There are other signs that a bottom is near.

For one, Vanguard just restructured its precious metals mutual fund, slashing its exposure to the industry from 80 percent to only 25 percent. This means the world’s largest fund company will no longer offer its investors a way to participate in a potential rally in metals and mining stocks.

The last time Vanguard made a change like this, it coincided with a huge run-up in metal prices. In 2001, gold was just as unloved as it is now, prompting Vanguard to drop the word “Gold” from what was then the Gold and Precious Metals Fund.

Bad move—the precious metal went from under $300 an ounce to as high as $1,900 in September 2011.

Last week, mining giants Barrick Gold and Randgold Resources announced an $18 billion merger that, once complete, will create the world’s largest gold producer. An “industry champion for long-term value creation,” according to BMO Capital Markets, the resultant company will “operate five of the 10 ‘tier one’ gold mines on a total cash cost basis and possess numerous projects with potential to” deliver sustainable profitability.

the barrick-randgold merger will create the world's largest gold miner, valued at $18 billion

Historically, a telltale sign that an industry has found a bottom is consolidation. Just look at the wave of mergers and takeovers in the then-struggling airline industry following the financial crisis.

Other financial firms and analysts also find the Barrick-Randgold news positive, for the two senior producers as well as metals and mining as a whole. Scotiabank believes the merger “improves [Barrick’s] overall asset quality, balance sheet, free cash flow profile, technical expertise and management team, with no takeout premium paid.” The deal, says the Royal Bank of Canada (RBC), “could spur a pick-up in M&As, which in our view could result in a turnaround in mining equity performance.”

Good news indeed as inflation continues to ramp up. The price of Brent oil, the international benchmark, closed above $80 a barrel last week for the first time since November 2014. That’s an incredible threefold increase from its recent low of $27 a barrel, set in January 2016.

The Incredible Shrinking Stock Market Is Shrinking Even Faster

As you already know, one of the key reasons why gold has been so highly valued for centuries—as a commodity and currency—is its scarcity. It makes up roughly 0.003 parts per million of the earth’s crust. According to the World Gold Council (WGC), an estimated 190,040 metric tons of the stuff have been mined since the beginning of time, leaving only 54,000 metric tons in the ground for producers to dig up, at greater and greater expense.

“Peak gold,” as some experts call it, is a real concern, one that could rocket the price of the yellow metal into the stratosphere on a supply-demand imbalance.

Scarcity, after all, is what’s helping to drive the equity bull market even higher right now. Over the past 20 years, the number of listed companies has steadily been shrinking, mostly as a result of tougher securities regulations.

And now, those companies—flush with cash thanks to last year’s corporate tax reform—are buying back their own stock at record and near-record levels.

stock buybacks have soared faster than capital spending
click to enlarge

Just how much? I shared with you recently that in the June quarter alone, S&P 500 companies spent a record $190.6 billion on stock repurchases, an increase of almost 60 percent from the same quarter a year ago. Apple led the pack, taking $21.9 billion worth of stock out of circulation. That’s down slightly from the record $22.8 billion in the first quarter.

In general, Wall Street likes buybacks, which lower the number of shares outstanding. As a result, earnings per share (EPS) and dividends available per share increase even when there isn’t any profit growth.

But there are a couple of issues. First, buybacks require capital that could have otherwise been spent on investing, upgrading equipment, giving workers raises and the like. For the first time in 10 years, according to Goldman Sachs, buybacks have outstripped capital spending so far in 2018. The S&P 500 is already trading at overinflated prices, meaning companies like Apple are buying high.

Second, buybacks take shares off the market. Over the past decade, companies have bought back $4.4 trillion as historically low interest rates created, for some, a more favorable environment to float debt instead of equity. Below, I chose to highlight the consumer staples sector because the decline in shares since 2006 has been so dramatic, falling from around 32.5 billion shares to 27.5 billion shares—a decrease of more than 15 percent.

total shares outstanding of S&P 500 consumer staples companies are plunging
click to enlarge

Today, “not enough shares are being issued to offset those being withdrawn from circulation,” according to Reuters. Net equity supply turned negative for the first time ever in 2016, and it could end in negative territory again by the end of this year.

Coupled with the ticking passive index bomb I wrote about earlier in the month, fundamental investing is changing. It’s hard to say where this will end—when there’s only one share of Apple left? Prices would explode, and investing would become even more out-of-reach for many than it already is today.

Click here to get my thoughts on why I think the market could correct between 10 percent and 20 percent early next year, and what investors can do now to prepare!

 

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

The S&P 500 Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. The FTSE Gold Mines Index Series encompasses all gold mining companies that have a sustainable and attributable gold production of at least 300,000 ounces a year, and that derive 75% or more of their revenue from mined gold.

Free cash flow represents the cash a company can generate after required investment to maintain or expand its asset base. Total cash cost refers to the cost per payable unit of metal sold during the life of the commercial operations of a mine. There is no guarantee that the issuers of any securities will declare dividends in the future or that, if declared, will remain at current levels or increase over time.

Holdings may change daily. Holdings are reported as of the most recent quarter-end. None of the securities mentioned in the article were held by any accounts managed by U.S. Global Investors as of 6/30/2018.

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Two Big Reasons Why I Believe China Looks Attractive Right Now
September 25, 2018

emerging markets look like a buy after decoupling from the U.S. market

Emerging markets continue to decouple from the U.S. market, making them look attractive as a value play—particularly distressed Chinese equities. Below I’ll share with you two big reasons why I think China is well-positioned to outperform over the long term.

So far this year, the MSCI Emerging Markets Index has given up about 10 percent, mostly on currency weakness and global trade fears. The S&P 500 Index, meanwhile, has advanced roughly 9 percent as a flood of passive index buying pushes valuations up and companies buy back their own stock at a record pace.

emerging markets look like a buy after decoupling from the U.S. market
click to enlarge

S&P Dow Jones Indices reported this week that buybacks in the second quarter increased almost 60 percent from the same three months a year ago to a record $190.6 billion. For the 12 months ended June 30, S&P 500 companies, flush with cash thanks to corporate tax reform, spent an unprecedented $645.8 billion shrinking their float. In the first half of 2018, in fact, companies spent more on buybacks than they did on capital expenditures.

As I told CNBC recently, this, combined with fewer stocks available for fundamental investing, could contribute toward a massive selloff when it comes time for multibillion-dollar index funds to rebalance at year’s end.

But let’s get back to emerging markets.

The Selloff Is Overdone, According to Experts

Again, China in particular looks like a buying opportunity with stocks down near a four-year low. Speaking with CNBC last week, chief executive of J.P. Morgan Chase’s China business, Mark Leung, said that the emerging market selloff is largely overdone. “If you look at the positioning and also the fundamentals side, we think there are reasons to start going into emerging markets for the medium and long term,” Leung said, adding, “China is a big piece.”

This view was echoed by Catherine Cai, chairman of UBS’s Greater China investment banking arm, who told CNBC that she believes “among all the emerging markets, China’s still representing the most attractive market.”

The U.S. just imposed tariffs on as much as $200 billion worth of Chinese imports, which will have the effect of raising consumer prices. Among the retailers and brands that have already announced they will be passing costs on to consumers are Walmart, General Motors, Toyota, Coca-Cola and MillerCoors. China plans to retaliate with tariffs of its own on $60 billion in U.S. exports. 

Despite this, the tariffs’ impact on the Chinese economy will be “very small,” Cai said, as the country’s government is now “prepared” to handle the additional pressure.

The Power of 600 Million Millennials

The two reasons I find China so compelling right now are 1) promising demographics, and 2) financial reform.

As for the first reason, there’s really no arguing against the sheer math of Asia’s exploding population. You’ve heard the expression “There is strength in numbers,” and nowhere is that more apparent than in China and India, affectionately known as “Chindia,” where 40 percent of all humans live.

But there’s more. According to a recent report from CLSA, the entire continent of Asia is now home to nearly one billion millennials, or people aged 20 to 34. China and India alone contribute more than 600 million millennials, the youngest of whom will “start to hit their ‘peak’ earning capacity” over the next 10 years, says CLSA.

Asian millennials are changing global consumption
click to enlarge

“Millennials are more affluent, better educated with difference perspectives and priorities than their parents’ generation, which tends to sacrifice present consumption for the future,” CLSA writes. “Millennials care less about saving.”

This translates into not only the largest consumer class the world has ever seen, but also the most eager to spend their money on goods and services their parents and grandparents could never have imagined.

Consumption, in fact, now accounts for nearly 80 percent of China’s gross domestic product (GDP) growth, helping the country become less dependent on capital input and foreign trade.

China’s Capital Markets Continue to Mature

chinese premiere li keqiang: the pool is full of water and the challenge is to unblock the channels. As for my second reason, financial reform, Premier Li Keqiang recently pledged to give equal treatment to foreign investors in capital markets, all in the name of bolstering confidence among investors who may have been rattled lately by the U.S.-China trade dispute.

“The pool is full of water,” Li said, “and the challenge is to unblock the channels.”

China A-shares, those traded in the Shanghai and Shenzhen stock exchanges, were once available only to Chinese citizens living on the mainland. But as a sign of the financial market’s maturation, last week marked the first time that foreign investors living in mainland China, as well as employees of listed Chinese firms living overseas, could freely trade A-shares.

Many A-shares have already been added to indexes provided by MSCI, and FTSE Russell said it will decide soon whether to do the same.

As we’ve seen in the U.S. market and elsewhere, a stock’s inclusion in a major index has meant, for better or worse, that it automatically gets an infusion of investors’ money, regardless of fundamentals.

That Premier Li plans to open China’s market up even further is exciting, and makes its investment case even stronger.

To learn more about investment opportunities in China and the surrounding region, watch our short video by clicking here.

 

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. By clicking the link(s) above, you will be directed to a third-party website(s). U.S. Global Investors does not endorse all information supplied by this/these website(s) and is not responsible for its/their content.

The MSCI Emerging Markets Index captures large and mid-cap representation across 24 Emerging Markets (EM) countries. The S&P 500 index is a basket of 500 of the largest U.S. stocks, weighted by market capitalization. 

Gross domestic product (GDP) is the total value of goods produced and services provided in a country during one year.

Holdings may change daily. Holdings are reported as of the most recent quarter-end. The following securities mentioned in the article were held by one or more accounts managed by U.S. Global Investors as of 6/30/2018: Coca-Cola Bottling Co. Consolidated.

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The Best Time to Prepare Is While the Bull Runs
September 24, 2018

how to manage your risk

In case you couldn’t tell from the ubiquitous political ads and yard signs, midterm elections are right around the corner. Historically, volatility has increased and markets have dipped leading up to midterms on uncertainty, but afterward they’ve outperformed.

Of especially good news is that we’re entering the three most bullish quarters in the four-year presidential cycle, according to LPL Financial Research. The fourth quarter of the president’s second year in office, which begins next month, and the first and second quarters of the third year have collectively been the best nine months for returns, based on 120 years of data.

the next three quarters have historically been bullish for stocks
click to enlarge

It makes sense why this has been the case. Following midterms, the president has been motivated to “boost the economy with pro-growth policies ahead of the election in year four,” writes LPL Financial.

Government Policy Is a Precursor to Change

Should Republicans manage to hold on to both the House and Senate—which Wells Fargo analysts Craig Holke and Paul Christopher estimate has a 30 percent probability—it’s likely they’ll try to pass “Tax Reform 2.0,” with an emphasis on the individual tax side. We can also probably expect to see additional financial deregulation.

Cornerstone Macro is in agreement, writing that “the better Republicans do in the election, the more confidence investors will have that [President Donald] Trump could be reelected and the business-friendly regulatory practices will remain in place.” A GOP Congress, the research firm adds, would be supportive of banks and energy, specifically oil, gas and coal. Since Trump’s inauguration, the Dow Jones U.S. Coal Index has climbed nearly 60 percent, double the S&P 500’s performance.

Back from the dead: coal stocks have risen since inauguration day
click to enlarge

The more likely outcome, according to Holke and Christopher, is a divided Congress, with Democrats taking control of the House. In such a scenario, financial deregulation would slow, but Trump, who’s pushed hard for aggressive infrastructure spending, might find the support he needs for a bill from Democrats. This would help increase demand for commodities and raw materials, but “additional stimulus in an economy already near capacity may result in higher inflation, negatively affecting fixed income,” Holke and Christopher write.

On the other hand, higher inflation has historically meant higher gold prices. After climbing for 12 months, year-over-year change in consumer prices cooled in August to 2.7 percent, from July’s 2.9 percent.

Government policy is a precursor to change, as I often say. It’s not the party that matters but the policies, and there are ways for investors to make money however the midterms unfold.

Money Managers and Banks Are Adding Safe Havens at a Faster Pace

With the bull run now the longest in U.S. stock market history, there’s a lot of talk and speculation about when the next major pullback will happen. I’ve discussed a number of possible catalysts with you already, from record levels of global debt to the flattening yield curve. Recently I shared with you that Goldman’s bull/bear indicator hit its highest level in nearly 50 years.

Even as markets closed at fresh all-time highs, essentially ignoring the intensifying U.S.-China trade war, Bank of America Merrill Lynch (BofAML) called the bull run “dead” last week, due to slowing global economic growth and the end of monetary stimulus. “The Fed is now in the midst of a tightening cycle, ignoring structural deflation, focusing on cyclical inflation,” writes BofAML chief strategist Michal Hartnett.

Against this backdrop, a growing number of money managers hold a dim view of continued economic growth. September’s Bank of America Merrill Lynch Fund Manager Survey found that a net 24 percent of fund managers believe global growth will slow over the next 12 months. That’s the highest percentage of managers with such a view since December 2011, the height of the European debt crisis. Reasons given for this bearishness are the U.S.-China trade tensions and, again, the end of central bank accommodation.

Fund managers are raising their cash levels, Hartnett says, as well as their exposure to fixed income, which has traditionally been used as a safe haven in times of uncertainty. In July, the most recent month of Morningstar data, bond funds attracted the greatest amount of any asset class in the U.S., with taxable and municipal bonds seeing a collective $28.5 billion in inflows. U.S. equity funds, meanwhile, collected a little under $3 billion, and in fact have seen $11 billion in outflows in the 12 months through July 31.

Getting even more specific, U.S. actively-managed ultrashort bond funds were the biggest winner, attracting over $6 billion in July, according to Morningstar.

You can read more about short-term bond funds by clicking here.

Central banks added gold in first half at fastest pace since 2015
click to enlarge

Gold demand among central banks has also accelerated this year. According to the World Gold Council (WGC), banks added a net 193.3 metric tons of gold to their reserves in the first half of the year, an 8 percent increase from 2017. This was the most purchased in the first six months since 2015.

Watch my interview with Kitco News to learn why now might be a good time to follow the “Golden Rule.”

The Next Crisis Could Be Triggered by Passive Indexing

One of the biggest risks right now, I believe, is the explosion in passive, “dumb beta” indexing. Trillions of dollars have poured into products that track indices built not on fundamental factors like revenue, cash flow and return on invested capital (ROIC), but on simple market capitalization. A piling on effect has occurred, whereby multibillion-dollar funds are buying more and more of the most expensive stocks. This has resulted in overinflated valuations.

The big risk is when these funds rebalance, which could happen as early as the beginning of next year. Last year, junior mining stocks got crushed after the VanEck Vectors Junior Gold Miners ETF (GDXJ) restructured its portfolio. Imagine what could happen if all passive index funds did the same simultaneously.

Last week I wrote more in depth about the risks passive indexing poses. If you didn’t get a chance to read it, I invite you to do so by clicking here.

 

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. By clicking the link(s) above, you will be directed to a third-party website(s). U.S. Global Investors does not endorse all information supplied by this/these website(s) and is not responsible for its/their content.

The Dow Jones Industrial Average (DJIA), or simply the Dow, is a stock market index that shows how 30 large, publicly owned companies based in the United States have traded during a standard trading session in the stock market. The S&P 500 index is a basket of 500 of the largest U.S. stocks, weighted by market capitalization. The Dow Jones U.S. Coal index is a subindex of the Dow Jones U.S. Indices and seeks to track all stocks classified in the coal subsector (1771) of the Dow Jones Sector Classification Standard traded on major U.S. stock exchanges.

Cash flow is the total amount of money being transferred into and out of a business, especially as affecting liquidity. Return on invested capital (ROIC) is a calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Holdings may change daily. Holdings are reported as of the most recent quarter-end. None of the securities mentioned in the article were held by any accounts managed by U.S. Global Investors as of 6/30/2018.

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Are We Headed for a Passive Index Meltdown?
September 19, 2018

Without Googling, try to guess who said the following quote: “If everybody indexed, the only word you could use is chaos, catastrophe. The markets would fail.”

Give up?

The speaker, believe it or not, is John Bogle, founder of Vanguard, which has been at the forefront of indexing. Bogle made the comment last year at the Berkshire Hathaway shareholder meeting, basically admitting that there’s a limit to the amount of passive investing the market can handle and still function efficiently.

The thing is, we’re testing that limit more and more every day as passive mutual funds and ETFs—those that seek not to “beat the market” but track an index—take up a larger slice of the pie. The share has increased dramatically in the past 10 years, rising from only 15 percent in 2007 to as much as 35 percent by the end of 2017.

Index funds have grown as a share of the fund market
click to enlarge

As for when passive investments will overtake the active market, Moody’s Investors Service estimates we’ll see this happen sometime between 2021 and 2024. Markets simply wouldn’t be able to function without active managers calling the shots—rewarding good corporate governance and punishing the bad—so Bogle’s what-if scenario of 100 percent indexing is, for now, purely hypothetical.

Nevertheless, the seismic shift into indexing has come with some unexpected consequences, including price distortion. New research, which I’ll get into below, shows that it has inflated share prices for a number of popular stocks. A lot of trading now is based not on fundamentals but on low fees. These ramifications have only intensified as active managers have increasingly been pushed to the side.

Watch Out for Rebalance Risk

This could end very badly for some investors, as I told CNBC Asia last week. It’s possible we could see a correction when it comes time for a number of multibillion-dollar funds to rebalance at year’s end. The same thing happened to the tech bubble in 2000, when everyone rebalanced after a phenomenal run-up in tech stocks.

And remember what happened to small-cap gold stocks last year when the massive VanEck Vectors Junior Gold Miners ETF (GDXJ) was forced to restructure its portfolio? They were knocked down despite having incredible fundamentals.

Take a look at the following chart. Internet commerce stocks—Apple, Amazon and the like—are up nearly eight times since May 2010.

Ecommerce is the second largest bubble of the last four decades
click to enlarge

This isn’t just the second largest bubble of the past four decades. E-commerce is also vastly overrepresented in equity indices, meaning extraordinary amounts of money are flowing into a very small number of stocks relative to the broader market. Apple alone is featured in almost 210 indices, according to Vincent Deluard, macro strategist at INTL FCStone.

If there’s a rush to the exit, in other words, the selloff would cut through a significant swath of index investors unawares. And just as Warren Buffett once said, “Only when the tide goes out do you discover who’s been swimming naked.”

A Huge Opportunity in Under-Indexed Stocks

Deluard’s research also suggests that passive index investors could be missing the hidden gems. After analyzing returns in the Russell 3000 Index, he found that stocks that are overrepresented in indices—again, think Apple—have been underperforming those in fewer indices. Despite lagging for the past five years, stocks that were in 75 indices or fewer returned more than 60 percent for the 12-month period, while the performance of stocks featured in 200 indices or more was around half that. Over-indexed stocks were also 2.5 times more expensive, Deluard found.

Stocks that are included in fewer indexes have outperformed over the last 12 months
click to enlarge

Whether we’re dealing with causation or correlation is probably too complex for me to get into here. The implication, as I see it, is that there’s huge potential for gains in stocks that are least loved by index providers. Talented active managers who are able to uncover these hidden gems and make the appropriate allocations are worth every cent investors pay them in fees.

In the Race to the Bottom, Everyone Ends Up Last

As I said earlier, a lot of trading now is based not on fundamentals but expense ratios. There’s been a race to the bottom to see who can provide the lowest fees. Fidelity appears to be first to introduce a no-fee fund—the catch being the investor must use Fidelity’s brokerage firm. Some industry experts now believe it’s only a matter of time before we see an index fund with negative fees.

You get what you pay for, as the saying goes, and buying cheap often comes with a high price in the long run. A tummy tuck in Tijuana costs a whole lot less than one in L.A., but you might end up having to pay far more in medical expenses should a mishap occur.

The same thinking applies with certain passive mutual funds and ETFs.

Recently Ray Dalio, billionaire founder of Bridgewater Associates, told CNBC that we’re in the “seventh inning” right now, and as such, investors should probably get “more defensive.” In addition, the Goldman Bull/Bear Indicator just hit its highest level since 1969.

Investors who feel this bull run might be getting long in the tooth would be prudent to make sure they have their recommended 10 percent weighting in gold and gold stocks, as well as a position in short-term, tax-free municipal bonds. Both assets have long been sought as safe havens in times of economic uncertainty and have performed well even when markets are down.

 

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The Russell 3000 Index is a market-capitalization-weighted equity index maintained by the FTSE Russell that provides exposure to the entire U.S. stock market. The index tracks the performance of the 3,000 largest U.S.-traded stocks which represent about 98% of all U.S incorporated equity securities. The Nikkei 225 Stock Average is Japan's premiere stock index. It includes the top 225 blue-chip companies listed on the Tokyo Stock Exchange. The SET Index is a Thai composite stock market index which is calculated from the prices of all common stocks (including unit trusts of property funds) on the main board of the Stock Exchange of Thailand (SET), except for stocks that have been suspended for more than one year. The Nasdaq 100 Index is a basket of the 100 largest, most actively traded U.S companies listed on the Nasdaq stock exchange. The S&P Homebuilders Select Industry Index represents the homebuilding sub-industry portion of the S&P Total Markets Index. The SSE Composite, which is short for the Shanghai Stock Exchange Composite Index, is a market composite made up of all the A-shares and B-shares that trade on the Shanghai Stock Exchange. The NASDAQ Biotechnology Index is a stock market index made up of securities of NASDAQ-listed companies classified according to the Industry Classification Benchmark as either Biotechnology or Pharmaceuticals. The Dow Jones Internet Commerce Index is designed to measure the 15 largest and most actively traded internet commerce stocks. The Goldman Sachs bull/bear indicator takes into account five factors: growth momentum (measured by the average percentile for U.S. ISM indexes), the slop of the yield curve, core inflation, unemployment and stock valuations as measured by the Shiller price-earnings multiple.

Holdings may change daily. Holdings are reported as of the most recent quarter-end. None of the securities mentioned in the article were held by any accounts managed by U.S. Global Investors as of 6/30/2018.

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Net Asset Value
as of 03/22/2019

Global Resources Fund PSPFX $4.51 -0.07 Gold and Precious Metals Fund USERX $7.38 -0.14 World Precious Minerals Fund UNWPX $2.79 -0.04 China Region Fund USCOX $8.50 -0.19 Emerging Europe Fund EUROX $6.59 -0.16 All American Equity Fund GBTFX $23.42 -0.49 Holmes Macro Trends Fund MEGAX $16.70 -0.31 Near-Term Tax Free Fund NEARX $2.21 0.01 U.S. Government Securities Ultra-Short Bond Fund UGSDX $2.00 No Change