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Updated @ 11:00 p.m. EST, Sunday, March 4, 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.

Which is the abnormal occurrence: millions of working-class people in China speculating for the first time with their accumulated life savings, or a 10% decline in a market which had risen nearly 170% in one year? --Steven Jon Kaplan

THE RECENT EMERGING-MARKET EQUITY PULLBACK IMPLIES A SUBSTANTIAL DECLINE FOR BOTH GOLD AND SILVER (March 4, 2007): Recently, we have seen the earliest stages of a correction for emerging-market equities around the world. Attention has been centered mostly in China, where before the recent decline, working-class people had lined up at brokerage offices across the country to speculate with their lifetime of slowly accumulated savings. In addition to China, other emerging-market countries including India, Malaysia, Singapore, and many of those in the Middle East had experienced astonishing percentage increases which left equities absurdly overvalued by any traditional measures. These bourses are therefore vulnerable to a punishing retreat which has just recently begun in earnest and will likely continue in a very choppy fashion for at least the next several months.

What is not usually mentioned is that these are the same countries which have the highest per-capita consumption of gold and silver, and which were also significantly responsible for the sharp increases in price of copper, nickel, zinc, tin, lead, and similar metals. Many people in these countries had recently gone from real poverty to a middle-class lifestyle, and are now about to experience their first-ever portfolio losses. In established markets such as in the U.S., Western Europe, and Japan, there is a reliable historic pattern in which people who lose money in financial assets tend to psychologically feel less affluent, and therefore spend less. This is commonly known as the "negative wealth" effect. For the first time in history, perhaps more than one billion people in emerging markets are about to experience this same phenomenon.

When the negative wealth effect is in progress, people continue to consume the same quantities of food, shelter, and other basics, since they are able to afford them without a problem. It is nonessential spending of all kinds that is most sharply curtailed. For many in India and China, gold and silver have been among the most sought-after discretionary items purchased in recent years. These metals, most commonly used for jewelry and as gifts for special occasions such as weddings and holidays, will likely see substantially lower total purchases than had been anticipated. The myth that gold and silver are a safe haven during a time of asset devaluation will be convincingly exploded as demand for physical precious metals from these countries falls sharply over the next several months. As demand fails to meet anticipated levels, prices will be forced to decline in order to restore equilibrium. Gold will likely fall to about $560 or $570 U.S. dollars per troy ounce, a level which was touched three times in 2006, while silver will likely decline to its major support level slightly below $10 an ounce.

Much later in 2007, as central banks around the world cut interest rates, there will be declining real interest rates obtained from time deposits in countries such as the United States. Eventually, the real interest rate, which is the nominal rate minus the inflation rate, will become close to zero or even negative. When that happens, a new source of demand for gold and silver from investors eager to obtain a positive rate of return will emerge, and will begin to meaningfully offset the decline in demand from emerging-market economies. However, since a sharp drop in time-deposit rates will likely not happen until the U.S. Federal Reserve begins to cut rates, such a rebound in demand will likely not materialize for at least several more months.

In summary, gold and silver will most likely retreat toward important lows in the spring or summer of 2007 as reduced physical buying from emerging markets creates a negative surprise for the precious metals markets. These prices will thereafter rebound, perhaps quite sharply, as the potential for negative real interest rates in developed countries spurs a new critical source of demand.

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    WHY NOT PAY $1.03 FOR A ONE-DOLLAR BILL? (February 19, 2007): One truly amazing feature of the current worldwide asset bubble is that behavior that was thought to be "insane" back at the peak in March 2000 seems downright ordinary, even boring, in comparison to today's multi-decade extremes. To be more accurate, the March 2000 behavior wasn't considered insane until AFTER the Nasdaq had collapsed 79%. When it was actually happening, it was considered completely normal. But my point is not to rehash the past, only to point out that the mispricings seven years ago were touchingly quaint in comparison with today's more exaggerated foolishness.

    The recent level of insider selling relative to insider buying by top corporate executives is far above that seen at any peak in 2000; historically, insiders don't sell unless they are concerned about a decline of 25% or more. The percentage of cash in equity mutual funds is substantially below its lowest point from 2000, so if there are even moderate unexpected outflows later in 2007, mutual fund managers will have to sell their stocks--and to whom will they do so if all other managers are simultaneously selling? Volatility indices are enormously below where they were at any time in 2000, showing all-time record complacency toward the possibility of a substantial stock market correction. (February 21, 2007) Total margin debt by all brokers doing business on the New York Stock Exchange now exceeds the previous all-time record from March 2000.

    If these multi-decade extremes do not provide sufficient evidence of why we will likely experience one of the sharpest corrections in recent memory, consider this fact: the average closed-end mutual fund, according to the latest official statistics, is now selling for a 3% premium to its net asset value. This is the first time in history that closed-end funds as a group have ever sold at a premium. A closed-end fund is a mutual fund which by law must make its assets public, so it is easy to figure out its precise market capitalization, and therefore its true price per share. Now why would anyone pay $1.03 for one dollar of assets, if he or she can easily buy exactly the same assets using exchange-traded or open-end funds, or even by purchasing the underlying holdings directly in the open market? The answer is simple: such an absurd transaction can only occur when valuation is no longer a serious concern to the vast majority of investors. It can only happen when the most respected financial theory is the greater fool theory: when each willing participant sincerely believes that it makes sense to purchase any ridiculously overvalued asset, because someone else will be willing to pay an even more inflated price for it in the foreseeable future.

    The biggest surprise to investors will be how much more rapidly the worldwide equity markets decline in 2007 than they did in 2000-2002. The total percentage decline will almost surely be less, but the average slope of the pullback will likely be steeper.

    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.

    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 (March 4, 2007): 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 March 4, 2007)
  • REMINISCENCE OF THE WEEK (February 21, 2007): I have only played golf twice in my entire life. The second time, which happened a couple of months ago, will be described in a future reminiscence; now, I will concentrate on the first time, which was way back in June 1978. I had just graduated from high school a week earlier, and my girlfriend invited me to spend several days with her and her brother in their cabin on an island in Virginia, immediately adjacent to Chincoteague (of "Misty" fame). When we arrived the first evening, her brother asked if I would like to play golf with him at 4:30 a.m. the next morning. That sounded ridiculously early to me, but I didn't want to seem like a sissy, so I immediately responded, "Certainly." When it was time to head to the course, I observed that he was wearing high boots more suitable for duck hunting than for golfing, and a very ragged pair of old blue jeans. I also noticed that we had plenty of clubs, but only a handful of balls, so I politely inquired if we were going to pick up some extra balls along the way. "Yes, we are," he laughed, "you'll be quite a busy bee. I may not play golf very well, but I always run a surplus." I had no idea what he meant, but went with him willingly. I thought I would show how generous I was by bringing enough money to cover both of us, but the clubhouse looked abandoned. "Don't we have to pay something to golf here?" I asked, puzzled. "I see a list of prices." "Oh, just forget about that, no one charges on Wednesdays. The course is completely trimmed and cleaned from 9 a.m. to 5 p.m. each Wednesday, so no one is around to collect the fees. Those of us locals who appreciate the true meaning of frugality always play early Wednesday morning. There's nothing like high, tall grass to separate the men from the boys!" I didn't want to appear to be a spendthrift, so I kept my mouth shut as we went to the first tee and started to play. As we walked down the first fairway, he pointed out a water trap just to our left. "I don't think we have to worry about that one--we've already gotten past these hazards," I pointed out. "I never skip a water trap!" he boasted. "Let's go." He then proceeded to walk right into the pond, all the way to its deepest point. Now I understood why he was wearing those boots and jeans. Naturally, I had only my regular shoes and designer pants, which were about to become quite soaked. "Put your arms in all the way as though you really mean it," he exclaimed, and soon we had found five thoroughly dirty balls that had gone into the muck. "Wonderful! Right over there is a sand trap, so let's get ready to dig." I cannot even remember how well I played, since the entire morning was a blur of bending over in smelly, muddy, algae-ridden pools of something like water, and plowing through sand mingled with bird droppings. We ended up staying more than four hours and playing all 18 holes. We also ended up bringing back well over a hundred golf balls, which left my golfing buddy absolutely delighted. Ironically, to this day, the only thing I remember vividly about the entire vacation was the golfing experience.

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

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