A true contrarian look at investing and at life in general.
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.
GLOBAL ASSETS ARE PRICING IN A MOST DANGEROUS ASSUMPTION (November 26, 2007): The prices of everything from crude oil to gold mining shares to emerging-market equities to Chinese art to Dublin real estate are all making the same basic assumption: that the U.S. dollar will continue to decline in value. While this appears to be the safest bet imaginable, it also seemed to be a "sure thing" in December 2004, just before the U.S. dollar staged a strong rebound which lasted for nearly a year and which had a profound effect on the global financial markets.
This time, there are even more people who are "certain" of a continued decline in the U.S. dollar, and literally trillions of dollars worldwide that has been invested directly or indirectly upon that expectation. In fact, the anticipation of a weaker greenback is so ingrained in the minds of many global investors that practically everyone has acted to protect their portfolios against a falling U.S. dollar, even though a rising U.S. dollar is likely a far greater threat. Multi-decade peaks for most commodities and for many equity sector groups would soon lead to sharp pullbacks if the U.S. dollar were to suddenly rally over the next several months.
Whenever a nearly unanimous consensus of investors is lined up on the same side of any given trade, it is virtually always the point at which it is most likely that the market will move sharply in the opposite direction. Just a few months ago, many amateur currency traders such as Japanese housewives were betting on a weaker Japanese yen and a stronger Australian/New Zealand dollar. The sudden resurgence in the yen and a decline for the Australian and New Zealand dollars forced this "yen carry trade" to be busted, but instead of closing their positions entirely, these speculators after being badly burned (financially speaking, of course) merely switched to being short the U.S. dollar and long various emerging-market currencies such as the Brazilian real and the South African rand. You can easily guess whether they will be burned yet again.
The financial markets always load up with the maximum possible number of participants before they then frustrate the collective expectations of those participants. This is not going to be the first exception to the rule. With so much money betting directly or indirectly on a weaker U.S. dollar, the financial markets are poised to move dramatically in precisely the opposite direction. Exactly when this will happen is uncertain, but since so few are prepared for it to occur, it is likely to be sooner rather than later.
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.
CURRENT ASSET ALLOCATION (November 26, 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%), 6.5%; 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, 0.5%; 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, 3.5%.
REMINISCENCE OF THE WEEK (November 26, 2007): When we were growing up together in Baltimore, my sister had a close friend for many years named Janet. Unfortunately for my sister, Janet's father was given a promotion which involved moving to Buffalo, New York, which is several hundred miles away. About two years after they moved away, our family drove to Toronto to visit our cousins. As we pulled into a motel in a small town called Painted Post, New York, the immediately adjacent parking place was simultaneously taken by Janet and her family, who--unknown to us--were driving to Virginia Beach for a vacation. That remains to this day as the most remarkable coincidence that I have personally experienced. It was a somewhat embarrassing event for Janet's father who was scolding Janet as we got out of the car, not realizing that we were right next to them quietly watching--except for my sister who was jumping excitedly up and down.
The same evening, our two families enjoyed a wonderful dinner together. Afterward, having forgotten that we had driven so far during the day, I turned on my favorite radio which I had packed and which was tuned as usual to listen to the Baltimore Orioles' baseball game. In another surprise, the game came in almost as clearly as if we had been in Baltimore--I guess the same AM radio frequency was not used for a very long distance north of my home town.
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