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Updated @ 4:00 p.m. EDT, Sunday, April 27, 2008.


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.

Investing based upon recent performance is like driving with your eye firmly in the rear-view mirror. You have a great view of where you've been, but sooner or later you're going to crash. --Steven Jon Kaplan

THE FEW REMAINING PEAKS ARE CONFIRMING THE MAJOR REVERSAL IN COMMODITIES (April 27, 2008): Most investors have been highly skeptical of claims by myself and a few other analysts that the U.S. dollar bottomed on March 16, 2008 and began a powerful one-year rally. The media hype about a falling greenback has been so pervasive that dissenting voices have been almost completely suppressed until very recently.

However, in addition to making a bullish pattern of progressively higher lows over the past several weeks, gold mining funds and indices including GDX and HUI have recently touched four-month lows. Lower prices for gold producers are a reliable confirmation of a U.S. dollar rally. Prices for nearly all commodities have joined in the downtrend, with gold, silver, platinum, palladium, cocoa, wheat, corn, and soybeans among the vast majority of commodities that have been in multi-week downtrends after having rallied to multi-decade peaks in February and March.

I know you're thinking, wait just one minute--the media keeps saying that commodities are still going higher. What about crude oil and rice? This raises a critical point--the very few commodities which are still touching new multi-decade highs have gotten so much media attention that they have completely crowded out the true story, which is that more than 80% of all commodities have been moving substantially lower over the past several weeks.

The much-hyped minority of divergences, in other words, are distracting the average investor from the majority which constitute the main trend. This kind of behavior is quite common in the financial markets. By January 1973, for example, thousands of U.S. equities were already in major downtrends, but a tiny group of several dozen stocks, known popularly as the "Nifty Fifty", continued to set new highs amidst much media fanfare. These stocks, which supposedly "couldn't go down", thereafter plunged far more than the overall market.

The same is about to happen now with crude oil and related energy commodities. The current fantasy about how crude oil prices "can't meaningfully decline" or "can only experience temporary brief pullbacks" is identical to the nonsense about the Nifty Fifty 35 years ago, or real estate two years ago. If something is fundamentally overvalued, overbought, overhyped, and overloved, then it will surely plummet in price. The total decline for crude oil is likely to be about 50% over the next half year or so, which will make it one of the worst-performing global asset classes over that period of time.

The same will be true with rice. Just as wheat and soybeans and corn have initiated important downtrends, rice will not be a magical exception to the rule. There has been a lot of media foolishness about supply shortages, whereas actually there is more supply and less demand than there was a year ago.

The reason that we have had these divergences is that there is a lot of money worldwide which is currently invested in commodity funds. The fund managers see that gold, silver, cocoa, and wheat are falling in price, so they shift into the few commodities which are still rising, such as crude oil and rice. This has nothing to do with fundamentals and everything to do with fund managers trying to outperform each other to grab investors' money.

Remember that just six weeks ago, data showed that Indian gold demand had plunged by more than 80%. Many analysts insisted that "it doesn't matter--fund demand for gold will make up the difference". Now gold mining shares are at four-month lows. Physical demand for commodities always matters; artificial demand by fund managers can only create a temporary move higher.

Agricultural commodity funds were not actually consuming wheat or soybeans, so their prices eventually were forced to start declining--and have been doing so for two months. Oil hedge-fund managers are not consuming oil; they are just artificially pushing up its futures prices. Once they start selling, the truth of the situation will become clear and prices will rapidly plummet.

HOW DID THE PRICE OF CRUDE OIL GET SO HIGH IN THE FIRST PLACE? (April 27, 2008): The following is an explanation in a nutshell. In the middle of July 2007, the broad U.S. equity market began a multi-month downtrend. One month later, money which had previously gone into the stock market began to progressively move into commodities. As equities accelerated their downtrend around the world later in the year and in early 2008, commodities enjoyed a massive fund transfer. Many amateur investors bought commodity funds for the first time in their lives. By the middle of March 2008, as global stock markets had plummeted, many commodities enjoyed multi-decade peaks.

The U.S. dollar index bottomed on March 16, 2008. As it subsequently began to recover, one commodity after the other began a downtrend--gold, silver, corn, and so on. Some commodities such as wheat and soybeans had already peaked in February. Since crude oil was still rising in price, commodity fund managers and hedge-fund managers began to sell most commodities to buy those few which were still rising in price--especially crude oil.

In other words, it has nothing to do with logic--it's just that crude oil was in the right place at the right time. Falling stock markets around the world stimulated a massive investor shift into commodities, while the subsequent commodity collapse induced massive commodity fund buying of the few remaining commodities which were still rising in price.

Now, crude oil and rice will soon catch up to equities and other commodities by staging a dramatic collapse. That's how the financial markets have always behaved--and how they will always behave.

  • Special Overview of Gold Mining Shares, updated on April 27, 2008.
  • Learn more about Steven Jon Kaplan and watch a live interview on MarketWatch.
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    COMMODITIES JOIN EQUITIES IN A MAJOR GLOBAL DOWNTREND (March 31, 2008): The "outlandish" predictions in my previous update, stating that the U.S. dollar would begin a major rally while commodities undergo a historic collapse, is already well underway. The greenback's rally will likely continue through the first quarter of 2009, and will see a total gain of at least 20% and perhaps even more than 30% against most currencies. Meanwhile, commodities had become the last refuge of amateur speculators around the world, and are now in the early stages of punishing these folks for assuming foolishly that a global economic contraction would magically allow commodities to avoid the same inevitable fate as equities. In a worldwide downturn, everything that falls must converge. [My sincere apologies to Flannery O'Connor.]

    Congratulations to Barron's for essentially repeating the message of my previous update in their cover story of this week's issue. While they were two weeks late, they were otherwise absolutely on the money in all aspects.

    REAL ESTATE WILL LEAD TO REAL SUFFERING (March 31, 2008): It is becoming understood that the real-estate bubble will cause severe consequences for the global financial markets. However, there are two critical points which most investors have missed regarding this bubble.

    The first point is that the real-estate debacle is not a subprime issue. While lending to noncreditworthy borrowers has certainly exacerbated the problem, the real dilemma is that no one--not even a person with an excellent credit history and a solid, dependable income--wants to pay off any loan which exceeds the value of the asset on which the loan is based.

    If someone has bought a property for $700,000 on zero money down, then even if that person is unemployed and has a terrible credit rating, and has an adjustable-rate mortgage which is about to reset at a much higher interest rate, the primary difficulty is not the loan itself. If the house is now worth $2,000,000, that person will likely be able to get favorable credit terms one way or another. In the worst case, he or she can simply sell and pocket the $1.3 million profit, and find another place to live.

    However, if someone has bought a house for $700,000 on zero money down and that house is now worth only $500,000, then the risk of default is enormous even with a fixed-rate, prime mortgage. Who would want to pay off a loan on a depreciating asset? That's like flushing money down the toilet. And if this person sells the property, will the bank forgive the $200,000 difference? The more that real-estate prices decline, the more that supposedly "good" mortgages will find themselves in foreclosure.

    The second point is that it is not a U.S. problem, but a global issue. While there were probably more subprime loans in the U.S. than elsewhere, the average price of a U.S. home after recent pullbacks is roughly 70% above its fair value. While this is dangerous, there are many countries such as Ireland and the U.K. where housing prices--even after recent pullbacks--are still at roughly triple fair value. Since all assets eventually regress to fair value sooner or later, the ensuing decline will be much worse in many countries outside the U.S. in percentage terms.

    Most importantly, as real-estate prices plunge worldwide, this will create less prosperity. The "negative wealth" effect from people feeling poorer as a result of the reduced equity in their homes will cause the current global slowdown to eventually become a major worldwide recession. This may not happen immediately, but it will surely happen within a year or two at most.

    FINALLY, A SINCERE THANK YOU to Barron's for featuring me on page 50 of their November 19, 2007 issue, which appeared on newsstands worldwide, and then again on page M14 of their February 25, 2008 issue.

    CURRENT ASSET ALLOCATION (April 27, 2008): 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%), 2.5%; municipal bonds, including MYJ, 2.5%; KRE, 1%; XRT, 0.5%; TOC, 1.5% (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 and in the PayPal money-market fund, 4.5%; SHORT POSITIONS: Nasdaq-equivalent (QQQQ, NDX, GOOG, in that order), 38.5%; short EWM, 1%; short ILF, 1%; short GLD, 20%; short GDX, 3%; short USO, 5.5%; short SLV, 2%; short DBA, 8%; short BIK, 1%; short EWZ, 1%.

    REMINISCENCE OF THE WEEK (April 27, 2008): When I was a student at Johns Hopkins, my academic adviser was Dr. Jan Minkowski. He was the kind of person who cared about not just the obvious academic achievements of his students, but also their lives as a whole. When I was having difficulty deciding which classes to take in my sophomore year, he suggested, "Take differential equations--that's something you'll use over and over again." I responded naively, "I'm sure that once I finish my final, I'll never see another differential equation in my life." I was wrong; for more than a decade, I have been working with differential equations every day in computing options prices. He knew exactly which professors made their classes interesting, and who made their students learn how to think. Dr. Minkowski also made sure that I was introduced to ideas and people who later made a major difference in my life. On graduation day, he somehow located me amidst the massive crowd of students to give me some final words of encouragement. Sadly, Dr. Minkowski died before I had a chance to go back and thank him.

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