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Updated @ 5:30 a.m. EST, Monday, January 29, 2007.


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.

A thing long expected takes the form of the unexpected when at last it comes. --Mark Twain

HAS U.S. RESIDENTIAL REAL ESTATE BOTTOMED? YOU HAVE TO BE KIDDING! (January 29, 2007): In recent weeks, there has been a lot of talk in the media about how U.S. residential real estate may have bottomed. This makes about as much sense as saying in 2000 that the Nasdaq, which peaked at 5132.50, had bottomed once it fell all the way to 5000. According to Professor Robert Shiller of Yale University, the average price of a house in the U.S. was virtually constant in inflation-adjusted terms from 1890 through 1997, but by the beginning of 2006, had risen to 199% of its 1890 level. In other words, after being nearly constant for more than a century, real estate suddenly surged to twice this level in real terms.

If something which has been at a particular valuation for over a century suddenly doubles, then one should be instinctively suspicious. More importantly, it is absurd to think that a 4% or 5% decline from such a level represents anything close to fair value. Of course, nothing moves in a straight line; that is how the financial markets have always worked. But one must remember why real estate became so overvalued in the first place. The Federal Reserve intentionally engineered the real-estate bubble in order to counteract the negative effect of the collapse of the Nasdaq's bubble--a euphoria which the Federal Reserve had also created, although that's a story which I (and many others) had already told years ago.

Banks and mortgage companies changed their entire way of doing business. For centuries, they would determine a potential buyer's income and assets, and say to that buyer: here's your income, here's your assets, this is what we think you can afford, so you can buy anything up to this amount but not any more--typically twice the total annual household income. The down payment would average about 25%.

Beginning several years ago, bankers had a new approach; they would say: okay, here's your income, here's your salary, now don't let those numbers worry you, just buy whatever house you always dreamed you could own, however expensive it may be, and we'll tailor our loan to fit your needs. If you can afford a traditional mortgage, fine--we hardly see folks like that anymore. If you can't afford a traditional mortgage, then we'll make you an interest-only mortgage. And if you can't afford an interest-only mortgage, don't fret, because we'll make you a negative-amortization mortgage. Sure, your mortgage balance will rise every month, instead of falling, but, hey, times have changed. You don't drive your father's Buick, so why get your father's kind of mortgage where you actually pay off the loan eventually? That's terribly old-fashioned. And, by the way, we expect that you won't be able to afford any down payment, which is fine, because no one makes those nowadays. In fact, we don't even ask for one.

There's a saying among poker players that if you sit down at a table and can't tell after a few minutes who the "patsy" is--that means the player who doesn't know what is going on and is about to go broke--then you're the patsy. If you're a banker or a mortgage broker and you lend money to a house buyer who cannot make the mortgage payments and defaults on the loan, then you have to foreclose. If you've given that buyer a negative-amortization loan on a $700,000 house, and meanwhile the mortgage balance is now $800,000 while the house price has fallen to $650,000, and you have no down payment from that buyer, then it's not the buyer who will suffer, except for his or her credit rating. It's you--the banker--who's the patsy! Because now you have a $150,000 loss, even assuming that you can sell the house immediately, which is not so easy these days. Once investors wake up to this reality, they will force the boards of these banks and mortgage companies to make future loans much more difficult to obtain. Congress may even outlaw negative-amortization loans, as occurred in Japan during their 64% collapse in real-estate prices. The immediate impact of tightened standards will be fewer buyers that qualify to purchase any given house, which will further depress housing prices. It's not going to be a pretty picture, and prices are not going to bottom anytime soon.

In Japan, residential housing prices declined for fifteen consecutive years, from 1990 through 2004. That's not a misprint or an exaggeration. In Japan, where one brings shame upon one's entire family for defaulting on a mortgage, there was no panic in the market, just a continuous decline. In the U.S., where defaulting will become a nationwide pastime in the next decade, there will likely be a much more rapid and chaotic situation, which will likely take quite a bit less than fifteen years, but which could be equally devastating.

So until you see banks demanding a 25% down payment and offering only traditional mortgages, you can be sure that the housing market is far from bottoming. In other words, once mortgage standards return to their 1999 levels, so will housing prices return to their 1999 levels.

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    BECKHAM MARKS A MULTI-DECADE PEAK IN LIQUIDITY (January 16, 2007): In each era, there is often a defining event which is so extreme that it demonstrates an incredible distortion of the financial markets just before a major shift in the opposite direction. Sometimes the event underlines how out of favor a particular asset class has become, such as in the late 1990s when an Australian gold mining company closed its mine and opened an online shop selling sex toys. Its stock price immediately quadrupled. [No, I'm really not making this up.]

    More recently, in 2005 to be exact, one saw the literal day trading of residential real estate in the U.S., in which people in Naples, Florida were buying houses in the morning and, in some instances, selling those same houses in the afternoon. In 2006, the same city of Naples experienced one of the sharpest pullbacks in housing prices in the U.S. in percentage terms. One might look in amazement at the recent record prices for racehorses, which will never be compensated even by winning the Triple Crown. No doubt one could write an entire book about the overvalued, overspecialized, overhyped state of modern art throughout most of the world. What all of these have in common is that people are paying extraordinarily inflated prices for assets, partly because they are completely indifferent to what is supposed to be the prime principle behind investing, which is the likely return on those assets over the next several years. It's liquidity gone amok.

    The greater fool theory states that any ridiculously priced asset should still be bought, because someone else will be willing to pay an even more absurd price for it in the near future. This theory seems downright old-fashioned when compared with the recent decision by the Los Angeles Galaxy soccer team--has anyone ever even heard of the team's name before?--to pay David Beckham 250 million dollars over a five-year period to play soccer. If one does not live in the U.S., it should be understood that soccer is hardly ever even shown on television, or broadcast on the radio. When such broadcasts are made, their viewer ratings are notoriously low. As with someone buying a piece of obscure modern art for millions of dollars, the team's owners have given zero thought to the actual return on equity. It almost makes one nostalgic for the good old days when the Nasdaq above 5000 was considered a fabulous long-term investment.

    GO GREENBACK GO (December 8, 2006): There are currently many differences of opinion in the financial markets. Some, like myself, believe that equities have completed a major peak in advance of a significant correction; others have given optimistic forecasts for a much higher stock market in 2007. There are many diverse opinions on interest rates and commodities. However, one thing on which everyone seems to agree is that the U.S. dollar will decline. The Economist is so certain of this that they made it a feature story last week.

    As far as I know, although the U.S. dollar is the world's foremost reserve currency, it has no web site. There are no greenback chat sites. There is no U.S. dollar fan club, and there is not even one U.S. dollar guru to quote on those days when the dollar is higher, to tell you why it will continue to rise in value. The U.S. government may spend billions on defense and has literally an army of employees on its payroll worldwide, but it hasn't spent a penny to promote its own currency.

    Nonetheless, even without a PR man (or woman) to pump (or should I say pimp?) the U.S. dollar, it will gain substantially in value over the next half year or more. The U.S. has the highest rates on time deposits in the developed world. With a Democratically-controlled House of Representatives and a Republican President, there will be much less spending and higher taxes, which means a lower budget deficit and therefore a stronger greenback. The U.S. dollar also has a history of gaining in value in advance of a recession, as was seen in 1980, 1990, and 2000.

    Most importantly, however, is the sentiment itself. When there is a virtually unanimous consensus on anything in the financial markets, the opposite inevitably occurs. It's not different this time. As everyone is waiting for the U.S. dollar to collapse, it will stage a strong rally that will likely bring the U.S. dollar index close to 90.

    As the dollar rises, most equities and commodities will decline. If you want to know when to buy gold and silver, just turn on your TV. No, don't waste your time watching CNN or CNBC. Look at the travel shows instead. When they tell you that because of the strong dollar it's a great bargain to visit Europe, that will be your signal to purchase precious metals and their shares.

    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.

    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. (November 28, 2006) As a rule, during its bull market which began on November 25-26, 2000, HUI has gone modestly below each such high-water mark during each subsequent extended correction. 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 (January 29, 2007, 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%), 9%; 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 IEI and IEF, 11%; TOC, 2.5% (bought at a 15% discount); gold and silver coins and related metals collectibles, 6%; other collectibles, 0.5%; cash and cash equivalents including a long position in VMSXX, negative 30.5%; SHORT POSITIONS: Nasdaq-equivalent (QQQQ, SMH, NDX, GOOG) and related shorts, 48%; short CFC, 3%; short GLD, 17.5%; short GDX, 2%.

  • Overview of Gold Mining Shares (updated January 1, 2007)
  • REMINISCENCE OF THE WEEK (January 16, 2007): When I was in Tokyo in October and November of 1987, I walked east of the Sumida River late one afternoon into a working-class neighborhood where few tourists bother to go. I found a small park where there is a bronze statue of a bull. It is considered good luck to rub the part of the bull which corresponds to that part of your body which is feeling pain. The brightness or dullness of each area showed where most people had chosen to touch the bull. After examining this, I decided to slowly wander around the park, not having any particular purpose in mind. I saw a park bench and decided to take a break. Soon afterward, an old man who was similarly wandering around the park sat next to me. Neither of us said anything for a few minutes. Finally, I decided to attempt my very poor Japanese and remarked, "Good day, is your health well?" To my great surprise, the man responded in fluent, unaccented English, and proceeded to tell me his story. His parents had been killed by the atomic bomb in Nagasaki, so he was raised in an orphanage by Americans for several years during the occupation. He had always been interested in visiting the U.S., but had been poor his entire life, and so never had the money to afford such a journey. The man told me I was the first American he had ever met in that park. I hardly knew how to respond, so I told him that I just wanted to learn more about the world. He responded with a nod. We each sat in silence for a few more minutes, and then slowly went our separate ways.

  • Best of Previous Reminiscences
  • (c) 1996-2007 Steven Jon Kaplan Your comments are always welcome.

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