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Updated @ 7:45 a.m. EST, Monday, November 19, 2007.


WELCOME TO TRUE CONTRARIAN! I will attempt to create an entertaining, readable, and hopefully refreshing viewpoint a few times each month. Each issue will feature my intermediate-term financial outlook, my long-term financial outlook, and a personal reminiscence.

Win or lose, everybody gets what they want out of the market. --Ed Seykota, as quoted by Jack Schwager in "Market Wizards"

EMERGING MARKETS ARE SET FOR A HUGE PULLBACK (November 19, 2007): Emerging markets around the globe rose by an average of more than 40% from their lows of August 16 to their peaks of late October and early November. Some major subsectors, such as Latin American equities, had risen by more than 60% over this period of time. Since then, they have experienced modest pullbacks, but the lion's share of their decline still lies ahead. Although fundamentals have certainly improved in recent years, price/earnings ratios and other classically reliable measures have surged much faster than profit growth, as "hot money" speculators and momentum players have flooded into these markets. This has made their valuations roughly twice what would be considered fair value in any other year in the past few centuries.

For this reason, I began last week to sell short several emerging-market equity funds, as shown under my "current asset allocation" that always appears near the bottom of each update. As long as these markets remain sufficiently inflated, I intend to add to these positions.

Numerous commodities also remain at unsustainable levels. While precious metals plummeted during the past week, crude oil remains not far below its all-time peak. Since the shares of energy producers have made a clear bearish pattern of progressively lower highs since October 11, this is a historically reliable signal that energy commodities will soon join them in a powerful downtrend that will probably result in crude oil losing more than one third of its recent peak valuation by the spring of 2008.

THE FEWEST POSSIBLE NUMBER OF PEOPLE WILL CONTINUE TO BENEFIT FROM THE FINANCIAL MARKETS (November 19, 2007): In his classic book "Market Wizards" by Jack Schwager, legendary trader Ed Seykota makes the important point that the fewest possible number of people will continue to benefit from the financial markets. In recent years, an increasing number of traders have taken beginners' technical analysis courses, or have subscribed to advisory services and newsletters which use purely technical methods of determining when to buy and sell. Is it possible, therefore, that due to this spread of knowledge, a greater percentage of investors will benefit from the markets?

In my opinion, the answer is emphatically "no". If an increasing number of people are adopting a particular strategy, then the financial markets, like a clever virus, will simply mutate so that such a strategy is doomed to failure.

A simple example can be seen in the way in which technical chart patterns have changed in recent years. A few decades ago, very few investors were able to determine past support and resistance levels, since the internet did not exist, and one had to subscribe to rather costly chart services in order to get this information for most securities. Therefore, professionals tended to place sell orders just below the levels that had been reached during the previous cycle, in order to frontrun other professionals who were among the few participants who knew their exact levels. This caused double tops to be a common topping pattern, and double bottoms to be a common bottoming pattern. The rule of thumb was that if a previous peak was surpassed, this signified an upside breakout, and was a signal to add to one's long positions.

However, now that every amateur is buying upside breakouts and selling downside breakouts, the financial markets have mutated. Instead of forming a double top just before a major pullback, it is much more common to see a brief move above the previous peak, in order to fool these chartists into thinking that there has been a true upside breakout. After a brief surge higher, the market then plummets lower, just as it would have done otherwise. In this way, the minimum number of people continue to benefit from the market's volatility.

Eventually, traders will adjust to these mutations, but it will likely take many years since those who have developed trading strategies have been startlingly slow in adapting to the new behavior in the financial markets. Therefore, as amateurs continue to buy upside breakouts and sell downside ones, it is usually profitable to take the exact opposite of their positions.

After another decade or two of losing money, these charting folks will grudgingly adopt to these newer patterns--at which time the financial markets will once again mutate in order to always prevent the majority from benefiting from the financial markets. It's survival of the fittest--make sure that you are not a Neanderthal.

FINALLY, A SINCERE THANK YOU to Barron's for featuring me on page 50 of their November 19, 2007 issue, which is currently on newsstands worldwide.

  • Overview of Gold Mining Shares (updated on November 19, 2007)
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    NEGATIVE DIVERGENCES DO INDEED MATTER AFTER ALL (November 11, 2007): The numerous negative divergences which I pointed out in my last update turned out to be pretty important after all. FXI, an incredibly popular fund of Chinese shares, slumped just over 20% from its October 31 peak to its recent short-term low on November 8. Most other global equity indices have intensified their declines. Many broad-based indices such as the Russell 2000 (RUT) and funds of semiconductor shares including SMH have plunged far below their respective 200-day moving averages.

    Even red-hot commodity indices and funds have begun to retreat from multi-decade and even all-time highs. Energy shares have mostly been making a pattern of progressively lower highs since October 11, while precious metals shares surged to a new all-time high on November 7 and have since begun a sharp descent. The next step is for gold, silver, and crude oil to retreat substantially. This is likely to happen soon, as gold commercials have never been so heavily net short Comex gold futures since the modern traders' commitments began to be tabulated in 1986. As speculators' sell stops begin to be triggered, it will create a rapidly engulfing cascade similar to an avalanche. The media will be "shocked, shocked" by sudden declines of several percent for gold and silver bullion, accompanied by major downward moves for the prices of crude oil and similar energy products. No doubt the media will call it a "healthy correction" and will state that it was "inevitable given its overbought condition". I think it's rather interesting how these so-called inevitable moves are never mentioned before they happen, but only in hindsight. I would also like to see a single correction described as unhealthy.

    The biggest shock for most investors will be a rally in the U.S. dollar which will likely persist until the U.S. Presidential election in November 2008. The U.S. dollar index dipped just below 75 on November 9, and will probably rally to above 90 over the next year. The first several months of this rebound of more than 20% will greatly surprise nearly all investors, and will therefore have a disproportionately strong effect--including a decline in the price of gold bullion of at least 20% from its recent peak. Whatever is the most surprising development generally has the greatest impact on the financial markets.

    NEGATIVE DIVERGENCES ABOUND IN THE GLOBAL FINANCIAL MARKETS (October 28, 2007): There are numerous negative divergences that are pointing the way toward sharply lower worldwide equities and commodities prices. I will point out those which historically have been the most significant.

    Semiconductor shares have been a reliable leading indicator of the overall stock market, and especially of the technology sector, for nearly four decades. Most broad-based equity indices had recently come close to their mid-July peaks, while some had surpassed those levels to set new seven-year highs. However, semiconductor funds and indices such as the exchange-traded fund SMH recently broke below their August 16 lows, and currently stand at their most depressed valuations in more than a half year. This is one of the clearest early-warning signs that equity markets around the world are set for a substantial pullback that will probably persist (with periodic minor upward bounces) until the spring of 2008.

    Funds and indices of commodity producers have been consistently underperforming their respective commodities. For example, as the price of gold has frequently set higher peaks in the past few weeks, gold funds such as GDX have struggled to approach their levels from more than two weeks ago. Similarly, even as crude oil has surged well above $90 per barrel, energy indices and funds such as OSX are noticeably lower than they had been on October 11. For several decades, producers' shares have been the single most reliable leading indicator of commodities' behavior both on the upside and also on the downside.

    Internal measures of market performance have been deteriorating on a global basis. Even in the hottest markets, the number of stocks advancing has been progressively sliding, while the number of stocks declining has been rising. The ratio of new 52-week highs to new 52-week lows on all major worldwide exchanges has been progressively tilting in favor of new lows for several months. With each new seven-year peak by well-known equity indices, fewer and fewer names have been able to continue rising. A narrowing of the bullish rotational pattern is a reliable omen of trouble for global equities.

    Market sentiment has continued to set bullish records even as equity sectors have struggled to surpass their peaks from earlier in the month. When optimism is increasing, while prices are beginning to form a pattern of lower highs, this is a classic sign that the average market participant has overly rosy expectations of future performance at a time when reducing positions would be a far more prudent course of action.

    The U.S. dollar index is likely completing a major bottom virtually coincident with the October 31, 2007 meeting of the U.S. Federal Reserve. The mainstream media has propagated the absurd myth that Fed rate cuts are bearish for the U.S. dollar, whereas the historic record over the past 36 years when the greenback was delinked from gold prove that exactly the opposite is generally the case. Approximately 80% of the time, Fed rate cuts have led to a higher U.S. dollar and lower prices for gold and silver. The current all-time extreme negative sentiment toward the U.S. dollar ensures that a strong rebound in the greenback will likely continue for roughly one year, and will power the U.S. dollar index to rally above 90 from its recent low under 77.

    CURRENT ASSET ALLOCATION (November 19, 2007): My own personal funds are currently allocated as follows: LONG POSITIONS: stable value fund (retirement fund with stable principal paying variable interest, currently 5.00%), 7.5%; long-dated U.S. Treasuries and their funds, and long-dated municipal government bonds, including TLT and MYJ, 2.5%; Treasuries between 2 and 10 years in duration, such as IEI and IEF, 1.0%; TOC, 1% (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 and in the PayPal money-market fund, 7%; SHORT POSITIONS: Nasdaq-equivalent (QQQQ, SMH, NDX, GOOG, in that order) and related shorts, 50.5%; short EWM, 1%; short ILF, 1%; short GLD, 17.5%; short GDX, 2.5%; short USO, 2.0%.

    REMINISCENCE OF THE WEEK (November 11, 2007): When I was studying at Peabody Institute in Baltimore, there was a fellow who used to hang out with me named David Buechner. Even in those days, he was a sensitive and intelligent performer who often discovered nuances of interpretation that I had overlooked, and therefore I often asked his advice before important piano recitals. One day more than three decades ago, I forgot my library card, but I wanted to borrow Debussy's beautiful "Estampes", with my favorite "Gardens in the Rain". I asked David if I could borrow his library card, and he said okay. When I offered to return it to him later, however, he insisted that I keep it. I thought he might change his mind, so I kept it at all times on the top of my dresser.

    The library card expired in May of 1976, but I couldn't bring myself to discard it. I have relocated more than a dozen times since then, and yet David's library card has always remained on my dresser. Various people through the years have asked me why I have someone else's library card so prominently displayed. I do not even have my own library card or almost anything else from those days, so it is rather difficult to explain. A couple of years ago, I saw David mentioned on the front page of the New York Times magazine. Unlike myself, he is still performing full time, although life has changed for him in rather unexpected ways. If he wants his library card back, I'd be delighted to return it to him.

  • Best of Previous Reminiscences
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