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.
IF H&R BLOCK IS LOSING MONEY FROM NEGATIVE-AMORTIZATION MORTGAGES, THEN WHO'S NEXT TO GET THE AX? (August 27, 2006): H&R Block announced late last week that they suffered huge losses from servicing negative-amortization mortgage loans. And you thought they only did tax returns. How quaint and 20th century! Just imagine how many other companies out there are either directly or indirectly exposed to the vast U.S. subprime mortgage market. Banks and mortgage companies promote negative-amortization loans as "freedom loans"--obviously meaning freedom from actually having to ever pay off one's mortgage. Isn't it wonderful that anyone in the U.S. can buy a house for $700,000, no money down, no questions asked, and owe $800,000 on the house the next year, $900,000 a year later, and one million dollars the year after? That's the American way!
Is anyone a fan of the great TV show 60 Minutes? A year from now, one can easily imagine a half-hour special report interviewing "innocent" homeowners who took out freedom loans from "greedy" mortgage companies, and who are now losing their homes to foreclosure. The real danger to the U.S. economy is not just the army of people who will lose their homes, but the fact that shareholders of the banks and other lenders, once they see rapidly building losses, will force these banks and other lenders to sharply tighten their lending standards. Today, anyone who wants to can borrow a million dollars to buy a house. A few years from now, when negative-amortization loans have been outlawed by Congress and browbeaten mortgage lenders are reluctant to extend credit to the Rockefellers, even the most distinguished borrowers will be forced to pay 30% or more down and have a very limited choice of fixed-rate mortgages.
That will sharply reduce the already diminishing demand for real estate. As foreclosures continue to rise, this will put an even greater supply of homes on an already saturated market. When I walked around downtown Baltimore earlier this summer, the most desirable neighborhood of Federal Hill had multiple houses for sale on every block--and when I turned the corner to approach the harbor itself, I saw five--five!--huge condominium buildings under construction. Each of these was planned to contain thousands of housing units, and each of the five was scheduled for completion in 2007. Who is going to buy all of these new properties, when the supply for sale in the adjacent, well-established neighborhood is already at a record high?
In two years, the U.S. will have enough housing to last until at least the year 2018, if not later. That's great if one is worried about the housing supply running out, but not so great if one owns a home. If prices merely return to their normal ratios of prices to rents or prices to incomes, there will be an average decline of 40% in housing prices in most U.S. coastal cities over the next several years. However, any asset which is strongly overvalued almost never just drops to fair value and just sits there. Following any asset bubble, there is almost always a state of powerful undervaluation which is just as ridiculous as the overvaluation which preceded it. Think of gold in 1980-1982. Think of the Nasdaq in 2000-2002. Assets can lose 3/4 of their value; real estate is likely to decline in many neighborhoods by more than half. That's not a misprint; I really mean more than half. Don't forget that the average nationwide decline in Japan was 64%. A decade from now, people in many neighborhoods will be able to buy houses and rent them immediately for more than the total operating expenses--but folks will be afraid to do so, with the memory of the collapse still fresh in their minds.
RUMBLE IN THE JUNGLE: THE FIGHT FOR SUPREMACY PLAYS OUT UPON THE COMMODITY STAGE (August 27, 2006): There are four big, mean animals on the commodity stage right now, and each of them is vying for supremacy of the market. Let's look at each of these growling beasts, and determine which one will rule the jungle over the next few years.
The first beast, a huge white elephant, is the collapse of the housing market, as just discussed. Mortgage money has been the primary contributor toward consumer spending, which constitutes 2/3 of the entire U.S. economy. As mortgages become less available, the liquidity in the financial markets that these mortgages create will dry up substantially. Also, as people see their housing prices decline, they will perceive themselves to be poorer, and will spend less on everything; this is known as the "negative wealth effect". So the collapse in housing prices will have a powerful contractionary and deflationary impact on the U.S. economy. As Americans can afford fewer imports, emerging markets will be forced to produce less, which will sharply reduce their demand for commodities, and will cause their economies to slow, thus further reducing the demand for commodities. So falling housing prices are very bad for commodity prices.
The second beast, a pack of fierce wolves, is the concerted effect of worldwide central banks. As the worldwide economy slows, central banks will be likely to cut interest rates in an attempt to reduce the severity of the worldwide recession. Lower interest rates are strongly supportive of commodities, since commodities pay no interest, and will therefore have less competition with short-term time deposits. Also, whenever interest rates are reduced to a point below the rate of inflation, known as a negative real return, this causes money in banks and other time deposits to lose purchasing power. This encourages investors to switch from time deposits to assets which maintain their value during such periods, such as commodities. So lower short-term interest rates are very good for commodity prices.
The third beast, a pride of lions, is the growth of emerging nations around the world, as the ratio between the GDP of the U.S. and the GDP of these countries continues the contraction which began a half century ago, and which accelerated rapidly over the past several years. Consumers around the world will demand automobiles and other "luxuries" that first-world consumers have taken for granted for several decades. These items all require commodities to produce and commodities to use. So the growth of emerging nations is strongly positive for commodity prices.
The fourth beast, a giant chameleon, is the four-year equity cycle, known most commonly as the Presidential cycle, in which equities since World War II--and even before then-- tend to make a deep low every four years in even-numbered years which are not multiples of four, such as 1974, 1982, 1990, and 2002. This beast is strongly supportive of commodities when equities are rising, but will push down commodities whenever equities are declining. Notice that especially severe nadirs tend to occur roughly every eight years.
The key is to understand the interplay of these forces over the next decade or so. The most sensitive index to relative changes in these factors is likely to be HUI, the Amex Goldbugs Index of Unhedged Gold Mining Shares. For basis of comparison, HUI is currently at 344.89. On May 11, it had peaked at 401.69; last October 20, 2005, HUI touched a low of 214.30.
In the short run, meaning the next two or three months of 2006, falling housing prices in conjunction with the reliable four-year Presidential cycle will likely dominate the financial markets, causing both equities and commodities to decline over the next several months. Over this period of time, HUI will probably fall to around 248.
From late 2006 through the Presidential election in 2008, the Federal Reserve and other central banks will rule the roost, dominating the market with their rate-cutting and liquidity injection. After all, the Republican administration will do whatever it can to have its party re-elected, even though Bush himself cannot run again. The chameleon will turn commodity friendly. This will likely cause HUI to more than double, reaching some level between 500 and 600, depending upon how aggressive the central banks decide to be.
From late 2008 through late 2010 or early 2011, the election will be history, and central banks will be done with their rate cuts, while housing prices will continue to decline significantly. Exit the pack of wolves. The chameleon will change color and become decidedly commodity hostile, as the next Presidential cycle downturn is in full negative force. The white elephant will rule. Therefore, the downswing in the worldwide economy, and especially in commodities, will resume once again. HUI will probably return close to its current level four years from now.
By early 2011, the average person in the street will gloomily anticipate continued substantial real-estate declines for the next several years. When everyone expects any particular event to happen, its actual occurrence has no impact. Therefore, falling housing prices will no longer exert any negative effect on the economy. Exit the white elephant. The lions will be set to roar, while the chameleon turns friendly once again. The combined forces of these beasts should cause commodity prices to powerfully resume their long-term bull market which began in 2001, with periodic sharp upward spikes. By 2013, HUI may exceed 700.
EQUITIES WORLDWIDE, INCLUDING GOLD MINING SHARES AND THE SHARES OF OTHER COMMODITY PRODUCERS, ARE SET TO LOSE 25% OF THEIR VALUE IN JUST THREE MONTHS OR LESS (August 14, 2006): One of the most reliable cycles in the financial markets is the four-year equity cycle, often called the "Presidential cycle". Every four years since World War II, without exception, U.S. equities have made an important bottom, usually in the autumn. Some of these lows have been especially notable as major bear-market nadirs, including 1974, 1982, 1990, and 2002.
To me, the most amazing thing is that, even with this pattern as reliable as the four seasons, investors continue to ignore it. It is as though, every July, people convinced themselves that since it is so hot, we are unlikely to have snow the following winter.
It is now August 2006, so we are right on schedule for another deep low this autumn. Between now and late October or early November, we are likely to have a 25% decline for most major midcap equity indices. Some largecap indices will fall by slightly less, while many smallcap indices will decline by a greater percentage, as largecaps move back into phase for a period of several years, and smallcaps move out of phase.
Have you looked at a chart of the Dow Jones Industrial Average lately? Check this out:
Thanks to a subscriber for sending this fascinating chart. Now, at a first glance you may say to yourself, "Okay, I see the Dow peak in May, and its decline later in the spring, continuing into summer . . . but what is this with the chart going all the way to the end of August, and then into the autumn . . . . Is this a trick, or a computer projection into the future? Is it some kind of fantasy projection?
Actually, it is none of the above: it is a chart of the Dow Jones Industrial Average from 1946! It is especially interesting to notice the sharp collapse in late August, as well as the final bottom on the second-to-last trading day in October. A lot has changed in the world since 1946, but the Presidential cycle has remained exactly the same as it was six decades ago. Just as in 1946, look for a sharp collapse in 2006 for the remainder of August, especially near the end of the month.
My projections are that the Nasdaq will bottom near 1555 this autumn; HUI, the Amex Goldbugs Index of Unhedged Gold Mining Shares, near 248; and OSX, the Philadelphia Oil Service Sector Index, near 147. Below is a one-year chart of HUI, courtesy of http://freerealtime.com/:
Notice the very bearish head-and-shoulders peak [described in more detail several paragraphs down]. The traders' commitments for precious metals continue to show commercial indifference in covering their short positions, indicating that the eventual low for precious metals is still far away pricewise.
A 61.8% Fibonacci retracement of the entire gain in HUI from its nadir of 165.71 on May 16, 2005, to its peak of 401.69 on May 11, 2006, would put HUI at 255.85. Interestingly, the initial resistance level for HUI, from December 2, 2003, which was not exceeded for about two years, was 258.60. Notice that both of these numbers are nearly identical. Since a Fibonacci retracement level is usually broken by a few percent to the downside, while former resistance--now support--is often also broken by a similar percentage, both of these methods yield a final HUI low of 248. This bottom will probably be nearly simultaneous with the 2006 autumn nadir in the Nasdaq.
QQQQ, an exchange-traded fund of the top 100 companies in the Nasdaq by market capitalization, has been making a bearish pattern of lower highs since January 11. The sharpest part of the decline is about to begin. If you're doing a lot of short selling, lean back, open up a cold beer, and enjoy. Otherwise, I would recommend getting up off your rear end and rearranging your portfolio to position yourself in a proper defensive mode. Those who don't kick butt are about to have their butts thoroughly kicked.
(August 14, 2006) HUI, the Amex Index of Unhedged Gold Mining Shares, has fully and convincingly completed a very bearish head-and-shoulders top with 2 left shoulders and 4 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.
Third right shoulder: 348.84, August 9, 2006.
Fourth right shoulder: 354.16, August 23, 2006.
HUI is also completing a long-term bullish interlocking head-and-shoulders bottom with 3 left shoulders and 1 right shoulder, as follows:
First left shoulder: 278.47, March 10, 2006.
Second left shoulder: 270.54, June 13, 2006.
Third left shoulder: ???.??, September ??, 2006 (274.5 estimated).
Head: 2??.??, October ??, 2006 (248 estimated).
Only right shoulder: 2??.??, November ??, 2006 (282.5 estimated).
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 open-end 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 (August 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%), 15%; 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, 9%; 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 28.5%; SHORT POSITIONS: Nasdaq-equivalent (QQQQ, SMH, NDX, GOOG) and related shorts, 43%; short CFC, 3%; short GLD, 19%; short GDX, 1%..
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. (August 27, 2006) At the current time, inflation is about 3.00% while the anticipated Federal funds rate is approximately 5.25%, yielding a real rate of return of positive 2.25%, its highest positive level in 5-1/2 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 in 2010, more than doubling sometime thereafter, and then making a final double-bottom retreat in 2018, followed by a roaring bull market that will (August 4, 2006) create a very long-term double top for the Nasdaq just above 5000 by perhaps 2037, followed by the next secular bear market. The all-time Nasdaq high of 5132.50 from March 2000 will probably not be seen again until around 2060, six decades after it had previously visited that mark, and obviously representing a much lower real level because of inflation. (February 5, 2006) 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.
REMINISCENCE OF THE WEEK (August 27, 2006):
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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