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Updated @ 10:10 p.m. EST, Sunday, November 19, 2006.


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.

There is no conversation more boring than the one where everybody agrees. --Michel de Montaigne

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    THE U.S. TREASURY YIELD CURVE BECOMES ITS MOST INVERTED IN NEARLY SIX YEARS, WHILE EURO GOVERNMENT BONDS ALSO SHOW AN INVERSION (November 19, 2006): The yield on the 2-year U.S. Treasury briefly exceeded the yield on the 10-year Treasury by more than .20% during the past week, its greatest such spread in nearly six years. Historically, whenever the U.S. Treasury yield curve has been this inverted, it has always been followed by both a substantial economic slowdown and also a significant correction in U.S. equity indices. Most of the time, there has also been an actual economic recession within one year or less of such an inversion. For the first time since 2000, euro-zone government bonds are showing a similar inversion, which is an even more rare event that an inverted U.S. curve. Therefore, the upcoming recession is likely to be a worldwide event.

    Interestingly, as reliable indicators show the greatest risk of an economic slowdown, most economic participants are at a point of maximum complacency regarding such a risk, as indicated by investor surveys including Investors' Intelligence showing near-record highs of bulls to bears. VXO, a measure of implied volatility, reached 9.74 on Friday, November 17, 2006, its lowest mark of the year, and one of its lowest readings in the past few decades. In addition, the interest-rate spread between "junk" (low-grade corporate) bonds and Treasuries of identical duration is close to an all-time record low. When no one is afraid of an economic slowdown, that is when it is most likely to occur.

    GOLD MINING SHARES ARE HEADING AT LEAST 25% LOWER (November 12, 2006): Gold mining share indices and funds attempted to break and hold above their 200-day moving averages in the past week. This false "breakout" will soon be reversed sharply to the downside. As the financial markets slowly but surely realize that U.S. political gridlock means substantially less spending and higher taxes, and therefore a significantly lower budget deficit, the U.S. dollar will progressively strengthen, which will depress the prices of precious metals and their shares. Simultaneously, the Congress will tilt toward stricter environmental regulations, which will erode the profit margins of all hard-asset producers. Most importantly, equities worldwide will be experiencing a sharp decline in price-earnings ratios as we experience a global economic slowdown, which means lower prices for all equity sector groups, including gold mining shares. I am still expecting HUI, the Amex Index of Unhedged Gold Mining Shares, to reach 248, probably by the spring of 2007. This week's intraday peak for HUI was 341.31 and its closing price was 332.39.

    LESS PRIVATE BORROWING AND LESS GOVERNMENT BORROWING MEANS A WEAKER U.S. ECONOMY (November 12, 2006): We are about to experience an extended period of significantly lower private borrowing combined with surprisingly lower U.S. government borrowing. As a result, the U.S. economy will become noticeably weaker, and will likely enter a recession in 2007.

    Whenever there is consumer borrowing, an individual person receives funds from a bank or mortgage company or similar institution. This money immediately goes into the economy in one form or another, whether it is new investment or new spending. Over the period of the loan, the borrower must use part of his earnings to repay the money which is borrowed, which prevents this money from being used for more productive purposes. Therefore, whenever there is borrowing of any kind, it has a strongly positive short-term effect, and a modestly but persistently negative long-term effect until the loan is repaid.

    In recent years, with the "help" of the U.S. residential housing bubble that has seen real-estate prices at double their historic norms, the amount of borrowing using one's house as collateral has been multiplied by a factor of more than ten. Therefore, the U.S. economy has been heavily stimulated by this borrowing, especially in the past four years. As housing prices have begun a steady decline which will likely persist for several years, the amount of this borrowing will progressively contract toward more normal historic levels. Thus, the economy, which has become accustomed to the stimulation from this borrowing, will be receiving a much smaller injection of mortgage capital over the next several years. Since consumer spending constitutes 2/3 of the U.S. economy, the drag on GDP will be quite considerable from this factor alone. Reliable data shows that a decline in mortgage borrowing from peak levels reached about a year ago is already clearly measurable.

    Adding to the drag on U.S. economic growth will be the new gridlock in Washington. Democrats are eager to spend much less on the war in Iraq. Most of the newly elected Democrats are "blue dogs" whose primary objective is to reduce government spending. In addition, many Democrats are committed to not allowing Bush to extend his tax cuts which, mainly because of the alternative minimum tax, truly benefit only the top one half of one percent of the population. With a combination of less spending and higher taxes, there will be considerably less government borrowing.

    Just as with private borrowing, all borrowed money immediately flows into the economy in one form or another. Therefore, less government borrowing will contribute to the slowdown already underway from the reduction in private borrowing. The cumulative effect will be so powerful that, in my opinion, the only question is how bad the 2007 recession will become, rather than whether it will occur.

    Historically, whenever the U.S. economy transitions from a period of normal growth to a recession, there are predictable trends in asset prices. One can use 1980, 1990, and 2000 as recent past years in which the U.S. economy experienced exactly such a slowdown. Equities, commodities, and related assets will decline substantially in value, including commodity shares such as oil shares and gold mining shares. U.S. Treasuries will continue to increase in popularity as investors seek a safe haven from declining equity valuations and compressed price-earnings multiples. The U.S. dollar will benefit from the sharp reduction in government borrowing and the perception that the U.S. offers a competitive real return by any worldwide standards.

    MORE DEMOCRATS MEANS GRIDLOCK, WHICH MEANS A STRONGER U.S. DOLLAR, WHICH MEANS A LOWER PRICE FOR GOLD (November 5, 2006): Sometimes the most obvious conclusions seem to be the hardest for the mainstream financial media to understand until it is too late to profit from them. Why this is, I have no idea--but it happens over and over again.

    There is no question that, even if the Democrats do not regain control of either the House of Representatives or the Senate in Tuesday's elections, they will have an enhanced numeric presence. With the Democrats either in control of one or both branches of Congress, or with the Republicans having a narrower majority, far fewer spending bills will be passed. Since the Republicans will obviously retain control of the Presidency, even if the Democrats obtain majorities in both the House and the Senate, President Bush will be able to veto any Democratic spending bills. Admittedly, Bush has never vetoed any spending bill during his entire term in office--a new all-time record for profligacy--but he will likely have far less compunction about doing so if the Democrats are in charge.

    Here's the main point: the next session of Congress will pass fewer and smaller spending bills. Less spending means a smaller budget deficit. A lesser deficit means that the U.S. dollar, which already pays among the safest and highest real rates of return in the world, will become even stronger.

    Now, one reads many viewpoints in the financial media--but just as the mainstream media did not permit opinions about falling real estate prices a couple of years ago, they suppress all ideas about a stronger U.S. dollar today. I realize that there is a tendency among some to claim "manipulation" whenever the financial markets go against them. In this case, though, I have facts to back up my claim. In the past several days, I have been asked by several writers in the financial media for quotes on gold, on the U.S. dollar, and on the stock market. In each case, I gave lengthy quotes on why the U.S. dollar would go higher, and tried to make them interesting. And, in all cases, all of these comments were eliminated from any of the media stories on this topic.

    It is obviously forbidden to even suggest that the U.S. dollar will go higher--even though the dollar has been doing exactly that since May 12, which was nearly five months ago. Over that stretch of time, the dollar has been continuing to trace a very bullish pattern of higher lows, including another higher low just in the past week. For three years, the media has been talking about a "falling dollar", and for three years, the dollar has done everything but fall.

    Well, the media may be able to keep me out of the mainstream, but--so far at least--they cannot prevent me from updating my web site. So here it is, probably the only bullish article on the U.S. dollar that you have read for several years.

    Getting back to Congress, it has always been the case that, whenever Congress is the most evenly split, the fewest spending bills get passed, and the stronger that the U.S. dollar has become. A situation in which the Democrats and Republicans are sharing power is sometimes called "gridlock". Whenever there has been gridlock, there has always been less government spending. Perhaps gridlock is the ideal state of affairs, since regardless of whether the Democrats or the Republicans are in charge, bad things seem to happen when either one side or the other is in true control. They end up passing a lot of bills which waste a lot of taxpayer's money, and the greenback progressively declines, making all Americans poorer.

    There is another important reason that, if the Democrats regain control of either the House or the Senate, the budget deficit will decrease, and probably substantially. That reason is taxes. In order to understand taxes, a little historical context is useful.

    In 1993, President Clinton, a Democrat, took advantage of the Democratic majorities in both houses of Congress to pass new legislation that substantially increased income taxes, especially among the wealthy. This tax plan survived until 2001, when the current President Bush took advantage of Republican majorities in the House and Senate to pass a significant income tax reduction.

    However, Bush got greedy and made a major miscalculation. He could have proposed a tax plan which simply reversed the Clinton increases. Instead, he and his advisers decided to propose a much deeper and more sweeping tax cut. There was a lot of opposition to this plan back in 2001, even among Republicans, since it would so obviously cause the budget deficit to balloon to all-time record highs. Therefore, in order to get these deep cuts passed, Bush decided to make them temporary, rather than permanent. He felt that once people became accustomed to lower tax rates, they would become so enamored of them that no one would want to return to the previously higher rates. Bush figured that in a few years, there would be great public support for passing legislation to have these temporary cuts made permanent.

    However, the Iraq war came along, with its huge deficits, and Bush couldn't find a single spending bill he didn't like. So the Clinton budget surplus turned into a huge deficit, and Bush lost any chance of having the temporary cuts made permanent. Here's something which very few people realize: all of the 2001 Bush tax cuts will expire no later than December 31, 2010. Not just some or even most of them--ALL of them. If no new tax legislation is passed by that date, then the ENTIRE Clinton tax package from 1993 once again becomes law!

    So here's the situation: if the Democrats regain control of the House, they will have the Republicans over a barrel. The Democrats will propose an entirely new, entirely Democratic tax package, oriented toward their pet causes, and no doubt with substantial tax increases on capital gains, on dividends, and on the wealthy. If the Republicans agree, fine. If they don't go along, then the Democrats will say, "No sweat. We'll just wait another few years, and then by default we'll revert to the Clinton tax rules." Eventually, unless the Republicans gain control of the Presidency, the House, and the Senate in the 2008 elections, the Republicans will grudgingly have to agree to the new Democratic plan, no matter how much they dislike it.

    So, as of early 2007, the Democrats will be in complete control, taxwise. However the situation is finally resolved--probably with a bone or two given to the Republicans to enable them to save face--there will be higher income taxes, and thus a smaller budget deficit.

    Meanwhile, there's no question that whatever happens in these elections, there will be less financial support for the war in Iraq. Regardless of the actual timetable for withdrawal, once the money dries up, eventually the troops will be on their way out. They're not going to fight without the dollars to support them.

    So, over the next several years, there will be fewer and smaller government spending bills passed, less money pumped into the Iraq war, and higher taxes. All three of these mean a lower budget deficit, and therefore a higher U.S. dollar. Since precious metals have historically moved in the opposite direction of the greenback, this means that once the financial media finally wakes up to this reality, gold and silver prices will decline.

    2006, THE YEAR OF THE FAILED BREAKOUT (October 23, 2006): One very unusual feature of 2006 is that it has seen so many failed breakouts across asset classes. Most of these have been failed upside breakouts. A failed breakout is defined as any security surging to a new multi-year high, then collapsing to a level below where it was when the rally originally began.

    HOW LOW WILL HUI GO? (September 10, 2006): HUI is the Amex Index of Unhedged Gold Mining Shares. How low will HUI eventually go, exactly, over the next several months? One very useful guide is to observe that on December 2, 2003, HUI reached a peak of 258.60 which was not exceeded for about two years. Another guide is found by measuring the entire gain in HUI from its May 16, 2005 bottom of 165.71 to its May 11, 2006 peak of 401.69. If HUI surrenders exactly 61.8% of this increase--known as the key Fibonacci retracement--it would put HUI at 255.85. It's no coincidence that these two numbers are so close. If history is any guide--which it almost always is--then HUI should move a few percent below each of these numbers, and bottom near 248.

    CURRENT ASSET ALLOCATION (November 19, 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%), 10.5%; long-dated U.S. Treasuries and their funds, and long-dated municipal government bonds, including TLT and MYJ, 31%; Treasuries between 2 and 10 years in duration, such as IEF, 10%; 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 29.5%; SHORT POSITIONS: Nasdaq-equivalent (QQQQ, SMH, NDX, GOOG) and related shorts, 46.5%; short CFC, 3%; short GLD, 18%; short GDX, 2%.

  • Overview of Gold Mining Shares
  • REMINISCENCE OF THE WEEK (November 19, 2006): There's an old saying that a man may be a king to some, and a pauper to another. When I was thirteen, I was involved with a youth orchestra that was conducted by a dynamic, fiery leader whom everyone in the group loved and followed without question. He demanded very high standards and his young followers consistently exceeded them. His teenage orchestra met across the street from the Peabody Institute of Music each Saturday afternoon and won many state and even national awards over the decades. Unfortunately, this same fellow had a thankless, but higher-paying, "day job" at a public junior high school as the conductor of each grade level's own band. All of the classical music that he loved had to be "dumbed down" repeatedly so that it could be followed by the students--many of whom were, shall we say, less than talented. He was derided by many, including some loudly complaining parents, as out of step and "into" the wrong kind of music. He frequently became frustrated with some who never practiced and others who repeatedly hit glaringly misplayed notes. The lowlight of his career was one day when he became particularly irritated at one indifferent kid who was beyond incompetent. While in a raging tirade, his toupee flew off flying into the front row of band members, exposing his bald head to a raucous cacophony of dissonant jeers.

  • Best of Previous Reminiscences
  • Learn more about Steven Jon Kaplan and watch a live interview on MarketWatch.
  • (c) 1996-2006 Steven Jon Kaplan Your comments are always welcome.

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