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Updated @ 4:15 a.m. EST, Tuesday, February 6, 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.

Luck never gives; it only lends. --Swedish proverb

WATCH OUT BELOW (February 6, 2007): At the present time, the percentage of cash in U.S. equity mutual funds has fallen to its lowest level ever recorded, which is less than 3.8% in most reliable surveys. The reason that cash is so important is that on any day when there are more redemptions from any mutual fund than new deposits into the fund, such redemptions are paid from this cash. In that way, a mutual fund manager hopefully is never forced to sell the actual stocks or other securities that the fund owns.

Since mutual fund managers are always highly conscious of their net annual returns, which they often display boldly in advertising both in print media and on the internet, they wish to have as little cash as possible during a market upturn, so that they are able to outperform their competitors. The recent all-time record number of consecutive trading days without a 2% decline in the S&P 500, as well as extreme complacency among investors worldwide, has encouraged mutual fund managers to continue to reduce their cash, since it serves as a drag on performance.

However, this is a most dangerous game, as there have been a number of occasions in the past where such net redemptions have continued for a period of months or even years. If investors continue to withdraw money from any fund or group of funds, then cash reserves will soon be depleted, after which fund managers will be forced to sell the stocks they own in order to meet redemptions. If fund managers around the world are forced into this predicament simultaneously, to whom will they be able to sell all of these shares?

The present level of risk is greatly magnified by the increased presence of hedge funds and other pools of private capital, which are largely unregulated. No one even knows how much cash these funds own, although one can be certain that in the current highly competitive environment, it is probably even smaller than the percentage for registered mutual funds. There are likely many hedge funds which are using so much leverage that they actually contain a net negative cash balance. That's fine as long as the global equity market is rising--but when it begins to decline, withdrawals from these funds are likely to put serious pressure upon worldwide equity indices.

One often hears about companies being bought out by private capital funds that didn't even exist a few years ago. The assumption in the media is always that these funds are a net positive for the worldwide equity market, but that is only true when prices are rising and these funds are gaining in assets. Once a correction or a true bear market is underway, these funds may experience unanticipated net redemptions, which will eventually force the fund managers to begin unloading their holdings.

It is scarcely remembered today that net redemptions from mutual funds were lamented endlessly in 1981 and 1982 as forced fund selling continued to put a drag on the worldwide equity market and caused the inflation-adjusted value of most U.S. equity indices in 1982 to be at their lowest levels in decades. In 1987, forced fund selling exacerbated that year's sharp October correction. The same forced redemptions happened again in 1990, especially with more illiquid smallcap equities--after which fund managers simultaneously raised their cash levels to much higher percentages of their total assets.

As is always the case in the financial markets, this margin of safety was created when it was no longer needed. By the first quarter of 2000, the percentage of mutual fund cash was back to the levels at the start of 1973, just before one of the biggest two-year declines in the past century. From 2000 to 2002, persistent fund withdrawals continued to depress equities, especially those in technology funds as the Nasdaq eventually plunged by 79%. Once again, fund managers after October 2002 sharply raised their cash balances just when they were least useful.

Currently, the level of cash in mutual funds is even lower than it was in 2000, while the new presence of hedge funds as a major source of investment dollars is almost certainly at a simultaneously dangerous level. There are also billions of people in countries like China and India who have recently entered the middle class, and who have invested their money in the financial markets for the first time. These folks have never personally experienced a decline in their portfolios. It is doubtful that they will be able to avoid panic and will thereby accelerate any downturn that develops.

With the fewest people of participants in the financial markets expecting a worldwide market correction at this time, combined with the lowest level of cash being held by fund managers in anticipation of such a downturn, we have the ideal recipe for what is likely to be a punishing worldwide equity market pullback in 2007.

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    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.

    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 (February 6, 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%), 8.5%; 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 IEI and IEF, 11.5%; 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 February 6, 2007)
  • REMINISCENCE OF THE WEEK (February 6, 2007): About a decade ago, I booked an airport rental car at a surprisingly low rate from a well-known nationwide chain. When I arrived after my flight to pick up the automobile, the manager asked with a smile, "Would you like to upgrade from your compact car to an Oldsmobile Cutlass S to make your ride more pleasant? It will only be an extra ten dollars a day." I thought about it for a moment, then politely declined. Barely a few seconds later, the manager tried again. "Surely, sir, you would prefer a more comfortable and luxurious method of transportation. You can have the Cutlass S for just five dollars more per day." "No, thank you," I insisted, "I'll just stick with my compact car, but I appreciate your offer." "How about a mere two dollars a day extra--you can't beat that for a deal!" "Thanks, but no thanks." I asked the attendant for the keys, and he walked me over to my vehicle--which was an almost new Oldsmobile Cutlass S. The only cars remaining on the entire lot were all of that model.

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

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