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.
THE FUEL GAUGE IS CLOSE TO EMPTY FOR U.S. EQUITIES (July 27, 2006): The most reliable gauge of how much further U.S. equities are capable of increasing at any given time is expressed in a precise quantitative measure known as VXO. VXO measures the average implied volatility of at-the-money options on the S&P 100 Index. While this sounds complicated, it basically shows how much fear investors currently have regarding the possibility of a significant pullback in U.S. large-cap equities. The more fear that exists, the more that the stock market is capable of rallying. That is primarily because, when fear is high, investors put money into money market funds and similar safe harbors, instead of putting it into equities. The more money that is in money market funds as a percentage of assets, the more money is available that can be switched from money market funds into equity funds to power the stock market higher.
What has been happening throughout 2006 is that, as largecap U.S. equity indices and their funds such as OEX and QQQQ have been progressively declining, each downward leg is accompanied by a slow, gradual rise in VXO. Then, when the stock market has a rebound for just one or two days, VXO suddenly collapses, giving up weeks of gains within a matter of hours. Thus, the current level of VXO is identical to where it was in the third week of May, when the equity decline in the U.S. had just begun.
When the level of fear remains constant as the market moves systematically lower, with a clear pattern of lower highs and lower lows, this is what constitutes a true bear market. In a bear market, investors are not worried when they see a continued decline, since they think that every dip is a great buying opportunity. This enables the market to continue its inexorable descent.
For a graphic illustration of this phenomenon, look at a chart of QQQQ, an exchange-traded fund of the top 100 Nasdaq companies by market capitalization. QQQQ is currently just above its lowest level in 14 months. Notice that each rebound attempt in QQQQ since its peak of January 11, 2006 has been increasingly feeble. The latest few bounces, including the so-called "rally" this week, are ones that only QQQQ's mother could love.
In the final weeks of any true bear market, there is a sudden collapse which finally causes a sharp rise in fear. When such a sharp pullback occurred in 1997, 1998, 2001, and 2002, VXO moved above 50 each time; this would represent a tripling from its current price. The same surge in VXO will eventually occur in 2006, probably in October, which is the most common month for an equity bottom.
The Presidential cycle is a reliable pattern in which U.S. equities make an important nadir every four years. This pattern has held consistently since World War II; those even-numbered years which are not multiples of four are those years in which the deepest bottoms are made, usually in the late summer or early autumn. 2006 is going to be another such year. Look out below.
THOSE COUNTRIES WITH THE WEAKEST CURRENCIES USUALLY DO THE MOST BUYING OF GOLD (July 27, 2006): The media often mentions how much money has gone into exchange-traded commodity funds such as GLD, IAU, and SLV, or how much new interest there is in gold futures and options trading. However, when money goes into gold futures or options, or into an exchange-traded commodity fund such as GLD, this represents strictly temporary speculative buying, not true physical buying. If investors sell GLD in a downturn, all of the money which had gone into GLD comes out and floods the physical market. This is exactly what happened from May 12 through June 13; during that 32-day period, gold plunged from $727.50 to $540.00 an ounce, its biggest dollar decline since 1981. This collapse was largely caused by billions of dollars exiting commodity funds and exchange-traded funds such as GLD. Since then, gold has regained almost exactly half of its losses.
True physical buying only happens when gold is purchased for jewelry, industrial use, or other similar purposes, thus removing it from the market. The largest per-capita purchases of gold and silver are made by emerging-market countries, especially India, China, Turkey, the Middle East, and similar places where more than a billion people have gone from poverty to the middle class in less than a generation.
The problem for gold in the short run is that, in 2006, the gold price has risen sharply, while--with the sole exception of China--the currencies of these countries have fallen sharply versus the U.S. dollar. Therefore, gold is much less affordable in terms of Indian rupees or Turkish lira or Indonesian rupiah today than it was a year ago, when there was record gold buying in these emerging nations.
It is also true that that between now and late November is historically the sparsest period for purchases of precious metals, except for a brief surge in the first month of autumn.
Thus, there is a renewed interest in speculative gold buying such as GLD, which can be sharply reversed to cause gold to be dumped on the market, at the same time that the total quantity of physical buying is at its lowest level in nine years. Moreover, the traders' commitments for gold show that gold futures speculators have a large concentration of sell stops as the period of lowest annual trading volume is about to begin, making it easy for locals to gun for these stops. This combination is very dangerous, and is likely to lead to a sharp decline for precious metals over the next few months.
In confirmation with this analysis, HUI, the Amex Index of Unhedged Gold Mining Shares, has just completed a very bearish head-and-shoulders peak (see details below). HUI has also been showing a consistently negative pattern of lower highs since July 3. I expect HUI to eventually return to and to break below its previous resistance level of 258.60 from December 2, 2003, while gold itself bottoms close to $500 an ounce later in 2006.
(July 11, 2006) HUI, the Amex Index of Unhedged Gold Mining Shares, (July 27, 2006) has fully and convincingly completed a very bearish head-and-shoulders top with 2 left and 2 right shoulders, as follows:
First left shoulder: 349.48, January 31, 2006.
Second left shoulder: 354.59, April 6, 2006.
Head: 401.69, May 11, 2006.
First right shoulder: 342.68, June 5, 2006.
Second right shoulder: 353.50, July 12, 2006.
HUI is also completing a long-term bullish interlocking head-and-shoulders bottom with 2 left and 2 right shoulders, as follows:
First left shoulder: 278.47, March 10, 2006.
Second left shoulder: 270.54, June 13, 2006.
Head: 2??.??, August ??, 2006 (248 estimated).
First right shoulder: 2??.??, October ??, 2006 (282 estimated).
Second right shoulder: 2??.??, November ??, 2006 (293 estimated).
As is typical of all true bear markets, such as 2001 and 2002, there will continue to be brief, intense rebounds in equities and commodities. These will characteristically be accompanied by a sharp drop in VXO, demonstrating that the bear market is alive and well. Only when VXO finally goes above 40--and probably above 50--will the bear market be approaching its nadir. This will likely occur in early autumn. Precious metals shares might bottom in late summer, as is consistent with their historic pattern. Look for insider buying by top executives, combined with greatly improved traders' commitments for gold, to confirm a bottom in this sector.
HEAVILY BUY U.S. TREASURIES (June 27, 2006): If there's an investment class which is universally despised at this time, it has to be U.S. Treasuries of all maturities. Everyone is obsessed with the notion that inflation will continue to rise for the indefinite future, and that the Fed will continue to raise interest rates. However, there are increasing signs that recession, rather than inflation, is the most serious threat to the economy. Emerging-market equities have experienced declines usually seen only before a major worldwide slowdown, while the recent sharp peak in commodities prices often coincides with the final leg of a long-term economic expansion.
The traders' commitments for U.S. Treasury bonds, reported as of Tuesday, June 20, 2006, showed commercials long 509,147, up 30,239; short 337,095, down 42,148. Thus, commercials were net long 172,052, close to an all-time record, and representing a dramatic increase of 72,387 in just a single week. Thus, those most closely connected with the long-term Treasury market have been very heavy buyers even as the financial media have been disparaging them as an investment class. Shorter-term Treasuries also make a compelling buy at this time.
The U.S. Treasury curve is currently "inverted", meaning that the 2-year yield is higher than the 10-year yield. When this inversion first occurred in December 2005, it was discussed heavily by the media, but dismissed as a fluke, even though it has the most reliable historical record of all indicators in forecasting a recession over the subsequent 1-1/2 year period. When this inversion occurred in recent weeks, it was barely mentioned.
Thus, one of the most unusual and reliable harbingers of an economic slowdown is not even known by the general public. Such an inversion exists less than 2% of the time, and is thus something that should cause intelligent financial commentators to stand up and take notice. Even with equities and commodities generally performing poorly in the past several weeks, and the reliable Presidential cycle pointing to further weakness in both through late summer or early autumn, investors are choosing to take money out of Treasury funds rather than out of equity and commodity funds. Be a true contrarian and buy Treasuries, such as the exchange-traded fund TLT.
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%.
2006: 401.69 on May 11, 2006 to ???.?? on ??? ??, ????: ??.?% [I'm guessing the eventual low will be near 248, a decline of 38%].
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. ASA is a closed-end fund of precious metals shares, heavily weighted in South Africa. Since the management fee is currently 1.15%, I do not heavily favor it, but it does trade intraday, and so may be worth buying in small quantities whenever its discount to net asset value exceeds 15%, which happens occasionally. 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 (July 27, 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 5.25%), 16%; long-dated U.S. Treasuries and their funds, and long-dated municipal government bonds, including TLT and MYJ, 30%; Treasuries between 2 and 10 years in duration, such as IEF, 8%; TOC, 2%; gold and silver coins and related metals collectibles, 6%; other collectibles, 0.5%; cash and cash equivalents including a long position in VMSXX, negative 27.5%; SHORT POSITIONS: Nasdaq-equivalent (QQQQ, SMH, NDX, GOOG) and related shorts, 42%; short CFC, 3%; short GLD, 20%.
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. (July 27, 2006) At the current time, inflation is about 3.15% while the anticipated Federal funds rate is approximately 5.40%, yielding a real rate of return of positive 2.25%, its highest positive level in more than 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 1.95%, is between 6.5% and 10.5%. Great bull excesses are usually followed by equally severe recessions.
REMINISCENCE OF THE WEEK (July 11, 2006): When I lived in Baltimore, I used to go to several shops and restaurants for as much as two decades, and got to know the proprietors at some of them quite well. When I finally left in 1985, I didn't have a chance to say goodbye to all of them. Earlier this year, I was visiting one of my favorite delis from the old days, known as Edmart, on Reisterstown Road. They sell something called "hamish mustard" which is out of this world. I thought I recognized the person behind the counter, but I couldn't be sure. He stared at me for a minute, then exclaimed with genuine concern, "You haven't been in here in awhile. Is everything okay?"
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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