A true contrarian look at investing and at life in general.
A special thanks to Mr. Don McEachern for designing the beautiful banner at the top of the web site, and a slightly different one seen on the back issue list.
A sincere note of appreciation to my internet host, DirectNIC, located in downtown New Orleans, for remaining in their offices continuously throughout the disaster, keeping their web sites up and running during almost the entire time of the hurricane and flood. That is service above and beyond the call of duty.
WELCOME TO TRUE CONTRARIAN! I will attempt to create an entertaining, readable, and hopefully refreshing viewpoint roughly once per week. Each issue will feature my intermediate-term financial outlook, my long-term financial outlook, and a personal reminiscence from my journal.
Recent comments are in boldface. Using an excellent suggestion of Mr. Dmitry Bouzolin, I am labeling each paragraph with the date on which it was written, beginning with my last update.
U.S. EQUITIES TAKE A FINAL BREATHER BEFORE COLLAPSING (May 29, 2006): According to the Investment Company Institute, inflows into U.S. equity funds from January 2006 through March 2006 reached their highest three-month total since the previous 3-month record, which had been set from February 2000 through April 2000. As investors will recall, that was when the Nasdaq peaked at 5132.50, just before plunging 79%. The greatest 3-month period of withdrawal was August through October 2002, which was the best buying opportunity for U.S. equities since 1990. In addition, the percentage of cash in equity mutual funds currently stands at an all-time low, even below the previous record level of 2000. Equities are entering their strongest time of the month, but once that passes next week, they are likely to plunge to new lows. SMH, an exchange-traded fund of semiconductor shares, has already broken below major support, while QQQQ, an exchange-traded fund of the top 100 stocks in the Nasdaq, is just above its recent 7-month low. Since World War II, every even-numbered year which is not divisible by 4 has seen a sharp decline in U.S. equities from January through October. QQQQ peaked on January 11 and, right on schedule, has been forming a bearish pattern of lower highs all year.
U.S. REAL ESTATE BECOMES A SPECULATIVE ASSET CLASS FOR THE FIRST AND PERHAPS THE ONLY TIME EVER (May 29, 2006): In 1997-1998, a number of Asian financial markets fell sharply. Alan Greenspan decided to cut U.S. interest rates in 1998 as a "pre-emptive strike" against a potential recession, and to encourage banks and brokerages to lend money for equity purchases. This led to the famous Nasdaq bubble of 2000, which was followed by a 79% collapse in the Nasdaq. As U.S. equities fell in 2000-2002, as a direct result of his own actions three years earlier, Greenspan decided once again to make a "pre-emptive strike" against a severe recession, by encouraging banks and mortgage companies to lend mortgage money in any amount to anyone who wanted it. The result: a second bubble, this time in residential real estate. According to Yale professor Robert J. Shiller, this is the first-ever U.S. bubble in real estate. He has a chart in the latest revised edition of his famous work, "Irrational Exuberance", showing that, in real terms, U.S. real estate was virtually static from 1890 through 2000. According to Professor Shiller, we are therefore going to get the first-ever substantial percentage decline in U.S. real estate prices--an outlook which I share wholeheartedly, if not more so, as all bubbles inevitably lead to collapses which are roughly proportional to the magnitude of the bubble's overvaluation. Charles MacKay already considered it old information when he published his famous book on financial bubbles in 1841. My own coda to this theory is that, once this plunge has run its course to deeply depressed levels about a decade from now, and prices eventually rebound to normal valuations a decade or so later, we will not for at least two centuries experience another bubble in U.S. real estate. Having been a strange aberration from the norm, it will remain a very rare historical occurrence.
PRECIOUS METALS MINING SHARES SET A NEW UNDERVALUATION RECORD RELATIVE TO THE METALS THEMSELVES, BEFORE RECENTLY BEGINNING TO STEADILY REVERSE THIS UNDERVALUATION (May 23, 2006): Over the past several months, and especially in the past few weeks, there had been an astonishing decline in the relative valuations of precious metals mining shares versus the prices of precious metals. If one takes the price of gold, which is equal to GLD times 10, and subtracts HUI, which is the Amex Goldbugs Index of Unhedged Gold Mining Shares, one would have gotten an average spread of 237 for the calendar year 2005. This spread did not deviate much throughout 2005 until the very end of last year, at which point it began to expand. By last Thursday, this spread had widened all the way to the low 350s--an increase of nearly 50%--before beginning to contract at the very end of last week, and then contracting again today after failing to regain last week's highs.
When anything in the financial markets reaches its highest level in history, and then begins to reverse, watch out, as this reversal is likely to continue until the spread is once again at last year's average of 237--or very nearly so. Therefore, I covered all of the substantial short positions that I had held in precious metals shares, and replaced 2/3 of them with a short position in GLD itself, intending to do the other 1/3 as the gold price likely attempts to rebound in the short run. For the first time that I can remember, there is more downside potential in gold and silver bullion than in gold and silver mining shares, in absolute percentage terms. (May 29, 2006): The proof of the pudding is in the eating. As gold was flat in the past week, and even retreated modestly from its Tuesday high of $671.60, gold mining shares as measured by HUI rose by nearly 8% from their Monday low of 305.23. It still makes sense to be short the metal rather than the shares, although less markedly so.
HUI plunged more than 24% from its peak of 401.69 on Thursday, May 11, 2006 to Monday morning's low of 305.23. If the gold price were to drop $100 in the next week, while HUI remained unchanged, the spread between gold and HUI would revert to last year's average level! Obviously, such a drastic move is not going to happen so quickly; it will likely take several weeks or even months for the "normal" spread to reassert itself. Since the decline in commodities which began on May 11 has just begun, and likely has several months to go, it makes sense at this time to be short these commodities directly, rather than shorting the shares of commodity producers.
The media has recently promoted the idea that left-wing or potential left-wing governments in Bolivia and Peru are going to nationalize their silver mines. This and plain disappointment over recent share price declines has caused silver mining shares across the board to plunge to their lowest levels in several months, in some cases returning to their levels of the autumn of 2005. Such concerns are way overblown. Comparisons to Fidel Castro are inherently flawed. Castro is the only true communist alive today. The rest of the world's leftist leaders can be easily bought with a combination of higher taxes and sufficient bribes. Silver mining companies in Bolivia and Peru may have to cough up some extra moolah for the new ruling class, but they will surely be allowed to continue to operate, since they are one of the primary sources of income for the country, and these rulers cannot risk causing a rise in unemployment or any serious social unrest.
Therefore, even though I believe that the price of silver will eventually go below $9 later in 2006, I have begun to make small purchases of the shares of silver mining companies.
THE ASSET BUBBLE OF THE PAST DECADE WILL TRANSFORM ITSELF INTO THE ASSET COLLAPSE OF THE COMING DECADE (May 19, 2006): The key feature of the worldwide financial markets in the past fifteen years has been the complete reversal from extremely tight lending standards in the early 1990s, to the all-time record easy lending standards that exist today. For the first time in history, emerging-market citizens can borrow almost as much money as they would like, while in the U.S., virtually anyone can borrow a million dollars, especially if the loan is backed by a piece of residential property. As U.S. housing prices have modestly declined in the past several months, banks have relaxed their mortgage lending standards, rather than making them more stringent.
The effect of all of this borrowing has not been lost on the asset prices of virtually everything. Artwork of all kinds is at an all-time high, a substantial multiple of where it was just four years ago. Racehorses are selling at all-time peaks. Stamps, coins, and virtually all collectibles have seen astonishing gains just in the past few years. A Stradivarius violin sold for $3.5 million at Christie's a few days ago, the highest price ever paid for any musical instrument at auction. U.S. residential real estate prices, while modestly lower in most places than they were last summer, are still close to all-time record ratios to incomes and rents. Not surprisingly, multi-year highs were also experienced recently in most worldwide equity markets, with most emerging markets reaching all-time peaks within the past several months. Many of these bourses sported higher P/E ratios than the New York Stock Exchange for the first time in history. Investors have not only been clamoring for the equities of emerging markets, but also their currencies, which in several dozen countries hit all-time record peaks recently versus the U.S. dollar. Commodities, adjusted for inflation, reached their highest levels since the early 1980s.
To everything there is a season. The great worldwide asset bubble is now transitioning to a great worldwide asset collapse. Real estate has been dropping in the U.S. since the summer of 2005, by a modest percentage. QQQQ has made a pattern of several lower highs since January 11. An increasing number of emerging markets, such as Dubai, have seen a sharp decline from their January peaks. Several small-country currencies have collapsed, including the Icelandic krona. It is only a matter of time before virtually all other asset classes join in the downturn. Of course, there will be sharp rebounds along the way, to confuse the unwary. But, a decade from now, credit will probably be extremely difficult to obtain around the world, and most assets will be at their lowest real levels in more than two decades.
The persistent increase in asset valuations has led to a public anticipation of increased inflation. Just as deflation was all the rage five years ago, now inflation is the flavor of the year. The media is full of stories about why prices will accelerate higher. Popular theories have recently abounded about how the government is intentionally understating the official inflation figures. A week ago, yields on long-dated U.S. Treasuries reached their highest levels in four years, while sentiment toward U.S. Treasuries was its most bearish in more than six years. More money flowed into commodity funds in 2006 than in the previous two decades combined. Even Bill Gross, one of the few public champions of the thesis of falling interest rates, admitted publicly this week that he was "wrong" about his prediction of lower Treasury yields.
Back in the land of facts, which few people are interested in visiting at any time, the commitments for U.S. Treasury bonds recently showed an all-time record long commercial position. The respected ECRI survey of inflation has been showing progressively declining readings for several months. Worldwide physical buying of commodities has declined by the greatest percentage since the early 1980s. The exchange-traded fund TLT, consisting of Treasuries with between 20 and 30 years to maturity, has been making a pattern of higher lows for one week, thereby returning to its levels of late April, not even counting a large dividend paid at the beginning of the month. The U.S. dollar has also been completing an important bottoming pattern against most worldwide currencies, especially versus the currencies of commodity-producing nations such as Canada and Australia.
The media is almost never interested in facts which do not support recent market behavior. So the media tells you why the U.S. dollar will continue to decline, why long-term interest rates will continue to rise, why the bull market in commodities has just begun, why real estate prices cannot possibly fall significantly, and why the recent decline in U.S. equities will soon be reversed and lead to new all-time highs.
The past week has served as a reminder that the truth will eventually assert itself. HUI, the Amex Index of Unhedged Gold Mining Shares, plunged from a peak of 401.69 in the morning of Thursday, May 11, 2006 to an intraday low of 323.77 yesterday, a retreat of 19.4%. This is the greatest-ever one-week pullback for this index, and ranks among the sharpest short-term declines for gold mining shares ever recorded.
There is an important distinction between the behavior of commodities and the performance of other asset classes. Most assets have recently begun a decline which will probably continue for several years or more. Real estate worldwide may decline for a full decade, as probably will artwork, racehorses, and so on. Equities, which traditionally lead the economy, usually bottom several years before most assets, so they will probably make their deepest nominal lows in four or five years.
A useful parallel would be a comparison with 1987. In 1987, worldwide equities had been in a bull market for five years. They would continue in a bull market for another 12-1/2 years, but before that, they would undergo two sharp corrections in 1987 and in 1990. Commodities today are similar to U.S. equities in the summer of 1987. The long-term outlook is excellent, but the short term is going to be quite unpleasant for those on the long side.
Secular bull and bear markets in commodities usually last for an average of about two decades. Since the recent bull market began about five years ago, this leaves another fifteen years to go. However, given the recent incredible bullish outlook on commodities--such as Market Vane recording 97% of traders bullish on silver, and 96% bullish on copper--the behavior of almost all commodities over the next half year is likely to consist almost entirely of declines, with occasional sharp bounces. The early stages of bear markets in equities reliably coincide with declines in commodities, as was seen in previous equity bear markets that began in 1980, 1990, and 2000. Since most commodities have risen so sharply in the past half year, even a 40% pullback for many of them would not violate their long-term upward trends.
At this point, if you haven't fallen asleep, you're probably thinking: "The Canadian dollar will fall? How loony! Everyone knows that inflation is rising, so how can you state that it's not? Interest rates are obviously going higher, since I hear them say so every day on the radio. My broker told me last week to put some of my money in commodities, since they're going up. And if real estate prices have a little drop, they'll be at new all-time highs in another year or so."
It's never easy to go against a 97% consensus. But this is likely to be one of the most profitable times in history to do so, since the overvaluations in so many asset classes are at such rare and exaggerated extremes.
HUI CORRECTIONS IN THE PAST 4 YEARS (February 5, 2006): HUI, the Amex Goldbugs Index of Unhedged Gold Mining Shares, has experienced four corrections averaging more than 1/3 in magnitude in the past four years. Here are the precise dates and figures of each such pullback:
2002: 154.99 on June 4, 2002 to 92.82 on July 26, 2002: 40.1%.
2003: 154.92 on January 6, 2003 to 112.61 on March 13, 2003: 27.3%.
2003-2004: 258.60 on December 2, 2003 to 163.81 on May 10, 2004: 36.7%.
2004-2005: 248.18 on November 17, 2004 to 165.71 on May 16, 2005: 33.2%.
CONSIDER FUNDS FIRST: Most readers will probably be interested in purchasing gold funds for the majority of their investment, either not having a brokerage account or not wishing to assume the increased risk and volatility of owning shares of individual companies. There are several dozen gold funds. (May 29, 2006) As of May 22, 2006, there is a new exchange-traded fund of gold mining shares called GDX, which is intended to track the Amex-listed index GDM. More information on GDX can be found at http://www.vaneck.com/gdx. The management fee for GDX is currently only 0.55%, which may be increased to 0.79% in another year. Since GDX has the lowest fee of all true gold funds, and can be traded intraday, it is currently my favorite gold fund. All but three of the open-end gold funds charge more than 1.2% percent of the total assets each year as a management fee, in some cases two or three percent annually. Some of these funds even charge significant upfront or redemption fees. If you feel that a particular fund manager has a track record which justifies such a high expense ratio, then please continue to invest in such a fund. However, it is possible that such a manager may not continue his winning streak, or that his success may encourage him to leave for another company or to start his own hedge fund, and the subsequent management will not necessarily be as competent, and may charge a significant fee for switching out of the fund. Caveat emptor. The two funds which charge the most reasonable fees are BGEIX, the American Century Global Gold Fund (current annual expense ratio 0.67%), and VGPMX, the Vanguard Precious Metals and Mining Fund (current ratio 0.48%). I have a strong preference for BGEIX over VGPMX, for the following reasons: 1) BGEIX charges a redemption fee of 1% only if the shares are held for less than 60 calendar days. VGPMX charges a 1% fee if the shares are held for less than a year. 2) BGEIX contains all pure gold mining companies. VGPMX contains several energy and base metal producers. If there is a fear of a recession, or similar economic developments, energy and base metal producers will likely underperform ordinary gold mining shares. Besides, I do not want diversification if I am purchasing a gold fund; I want gold mining shares, period. 3) BGEIX has always been open for new investment. VGPMX sometimes is closed for new investment, even if one has a considerable current holding in the fund. Appendix (May 30, 2005): One of my readers, Mr. Alan Sorin, pointed out that FSAGX, the Fidelity Select Gold Fund, has an expense ratio of 0.89% and a short-term trading fee of 0.75% for shares held less than 30 days. While this is not as low a fee as BGEIX, there is one big advantage: FSAGX is priced every hour on the hour, beginning at 10 a.m. New York time, rather than only at 4 p.m. As readers who have been tracking gold mining shares for many years already know, being able to buy and sell at 10 a.m. is worth a lot, since it is around this time of day that gold mining shares usually make their lows when they are forming an important bottom. Sometimes HUI will rise several percent between 10 a.m. and 4 p.m., as it did on May 10, 2004 (when HUI made its nadir of 163.81). Once it is appropriate to sell gold mining shares, it is also usually advantageous to do so at 10 a.m., when they generally peak during the formation of market tops.
CURRENT ASSET ALLOCATION (May 29, 2006, marked to market): My own personal funds are currently allocated as follows: LONG POSITIONS: stable value fund (retirement fund with stable principal paying variable interest, currently 5.00%), 31.5%; silver mining shares, 1%; BEGBX (American Century International Bond Fund), 1%; long-dated U.S. Treasuries and their funds, and long-dated municipal government bonds, including TLT and MYJ, 20%; gold and silver coins and related metals collectibles, 7%; other collectibles, 0.5%; cash and cash equivalents, negative 30%; SHORT POSITIONS: Nasdaq-equivalent (QQQQ, NDX) and related shorts, including short SMH, 44%; short CFC, 3%; short GLD, 22%.
GOLD AND REALITY: Gold and gold mining shares often correlate closely to the real rate of return for short-term U.S. time deposits. The lower the real rate of return, the better for gold and its shares, and vice versa. The real rate of return is equal to the nominal time deposit rate (roughly equal to the anticipated Federal funds rate) minus the inflation rate. (April 3, 2006) At the current time, inflation is about 3.10% while the anticipated Federal funds rate is approximately 5.10%, yielding a real rate of return of positive 2.00%, its highest positive level in five years. Since gold and silver strongly prefer a negative real interest rate to a positive one, this is bearish for precious metals. Investors in gold appear to have entirely forgotten its important negative correlation with the real rate of return, making it that much more important at this time. It should be noted that when gold experienced its lowest point in 1999-2001, the inflation rate averaged 2.0% while the anticipated Federal funds rate was as high as 6.5%, yielding a real rate of return of as much as positive 4.5%. This positive 4.5% rate of return is the primary reason why gold fell all the way to $252 per troy ounce, not because of some ridiculous manipulation theory.
LOOKING FORWARD TO 2060: I'll make a very far forward prediction by stating that I believe U.S. equities will make a double bottom in 2010 and 2018, with the Nasdaq bottoming below 400 in 2010, more than doubling sometime thereafter, and then making a final double-bottom retreat to below 550 in 2018, followed by a roaring bull market that will bring the Nasdaq to the 3000-3500 level by perhaps 2035, followed by a relatively mild bear market. The all-time Nasdaq high of 5132 from March 2000 will probably not be seen again until 2060 at the very earliest. (February 5, 2006) Amazingly, Jeremy Grantham, in the February 6, 2006 edition of Barron's, makes the exact same timewise prediction: U.S. equities will achieve their deepest nadir in 2010. His logic is that any asset class typically takes about one decade to go from top to bottom (U.S. equities peaked in March 2000). U.S. residential real estate lovers, take heed: the peak in August 2005 [National Association of Realtors] implies that the bottom for U.S. housing prices will occur near 2015.
LONG-TERM GOLD OUTLOOK: Gold will continue to make a pattern of higher lows as its strong bull market from a nadir of $254.00 in April 2001 to the present continues throughout the next decade or so. Important higher lows included $319.10 on April 7, 2003; $371.25 in the morning of Monday, May 10, 2004; $410.75 on February 8, 2005; and $428.00 on August 30, 2005.
YOUR TYPICAL GARDEN-VARIETY SEVERE BEAR MARKET BOTTOM: U.S. equities in general will continue to decline until the dividend yield on the S&P 500, currently at 1.91%, is between 6.5% and 10.5%. Great bull excesses are usually followed by equally severe recessions.
REMINISICENCE OF THE WEEK (May 29, 2006): In my second year of college, I was required to take a course in quantum mechanics. I always liked math, but this particular topic stretched my affinity of the topic to its limits, and then some. By the time the final exam came around, all that I had really learned well was a few basic topics, and also how to make minor modifications to differential equations. On the exam, there were three questions, the first two of which were easy, and the last which was a very difficult proof requiring the student to demonstrate how differential equation A was identical to differential equation B. This last question was worth 50% of the total exam, and about one third of the total grade for the semester, so I couldn't afford to get too many points off. For a few minutes I wrote nothing, not knowing what to do. I certainly had no idea how the two equations were in any way similar. Finally, I thought of a brilliant, if somewhat sneaky, idea. I put equation A on the top of the next page, about halfway through the exam book, and put equation B on the very bottom of the final page of the book. Being an expert in making minor changes to equations, I then proceeded to spend the next hour (we had three hours for the total exam) making minor changes to equation A, going down the page, down the next page, down the next page, and so on, covering about half of the remaining pages. Each step was accurate. I then spent an hour doing the same with equation B, moving up the page, then up the next page, and so on, working steadily backward through the exam book. Eventually, the two equations met somewhere in the middle; even Einstein could not have figured out the sudden jump between the two threads. Fortunately for me, the professor had a graduate student grade the exam, and this student, no doubt starved for time, must have looked only at selected lines, rather than at the proof as a whole. He didn't discover the fatal leap in the middle, so I got an A for the class. That was certainly the least-deserved A that I ever received.
AUTOBIOGRAPHICAL SKETCH: I was born and raised in Baltimore, Maryland, U.S.A., and was graduated from the Johns Hopkins University with a Bachelor of Engineering Science degree in May 1982. I have been studying the precious metals markets since the 1970s, and began this web site in August 1996. I have been writing music and short stories since the mid-1960s. I maintain a fiercely independent stand toward the financial markets and toward everything else in life, and am not compensated for my writings by any person or organization with the exception of the advertising banners posted on this site. I am also a pianist, computer programmer, music composer, bridge player, and runner, and enjoy world travel. I appreciate all those who have quoted the various sayings on my web site over the years, which have wound up in some pretty interesting collections.
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