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Updated @ 5:45 a.m. EDT, Tuesday, July 1, 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.

If it looks like a bubble, and it sounds like a bubble, and it feels like a bubble, and it tastes like a bubble, and everyone is telling you it's not a bubble, then it's a bubble! --Steven Jon Kaplan

COMMODITIES STAND AT THE CROSSROADS (July 1, 2008): It was less than one year ago when the greatest short-term commodity rally in history began on August 16, 2007. Crude oil has gotten the majority of the public's attention, but we have also experienced the first powerful surge higher in the price of wheat since the nineteenth century, as well as corresponding huge percentage increases for commodities ranging from soybeans to silver to cocoa to natural gas to some metals that were only names on a periodic table before their sharp price increases.

It is no coincidence that global equity markets began to decline at virtually the same time that commodities began to ascend. Normally, a slowing worldwide economy would be negative for both stocks and commodities, as a contraction in demand leads to less physical consumption. If one looks at the actual supply/demand fundamentals, they have clearly deteriorated virtually across the board in the commodity sector.

However, there is a second source of demand besides physical demand, which is investment demand. As it became increasingly clear that even the formerly hottest equity markets such as China and India were reversing historic uptrends, many financial advisors recommended "diversifying away from equities into commodities". Thus, these commodity rallies which would otherwise have long since terminated had become amazingly extended. The more that commodities rose, the more analysts appeared on financial cable TV and in the newspaper to insist that you "had to get aboard the commodity train before it left the station". [Where have we heard this railroad analogy before? Oh, yes, with the Nasdaq eight years ago, and with real estate three years ago. We all know how those turned out!]

The real question is whether commodities have become so overbought due to investment rather than physical demand that they now represent a bubble which is about to burst just as the Nasdaq and homebuilder bubbles--as well as hundreds of other bubbles through the centuries--had burst before them. To answer that question, it is instructive to examine some interesting facts about the behavior of commodities during the past year.

If one looks at the shares of commodity producers, one notices an interesting common pattern. As the prices of gold and silver surged by well over 50% from November 7, 2007 through March 17, 2008, the prices of gold funds such as GDX barely achieved gains of less than 10% over the same period of time, while top gold mining insiders became significant sellers of their shares. Since the middle of March, precious metals have been experiencing a notable decline which has received far less media attention than their prior much-heralded ascent.

Similarly, while the price of crude oil has more than doubled during the past year, the prices of energy-share funds such as OIH have risen by less than 10% from their peaks of October 11, 2007, while there has similarly been correspondingly strong insider selling by top energy producers. The shares of agricultural-commodity producers have also been lackluster even with recent record prices for many "ag" commodities including corn, soybeans, and cocoa.

It is probably no coincidence that the most informed insiders across the commodity-producing spectrum have been skeptical about the future prospects for their respective commodities.

It is also significant that investors appear to have become increasingly optimistic about commodities' prospects even as their prices have been making a pattern of lower highs. There was a lot more hype about agricultural commodities in June than in February, with especially intense media coverage of flooding in the U.S. Midwest, and significantly more buying of agricultural-commodity funds such as DBA by amateurs in June than in February. Yet if you look at a chart of DBA, you will see that it completed a lower high in June than it did in February. Greater bullishness at a lower price, combined with a bearish-looking double top, is a dangerous combination.

It is also interesting to observe that DBA and other agricultural-commodity funds were among the first major groups of commodities to decline in 2008, by peaking on February 27. Within a few weeks, most other commodities had joined them in a major short-term pullback. In a fascinating parallel, on Thursday, June 26, 2008, DBA once again began to decline as most other commodities continued to surge higher, and DBA has continued its descent--albeit with virtually zero media mention of its decline.

Therefore, it seems possible that agricultural commodities as a group are serving as a reliable leading indicator for the entire commodity sector, just as the shares of commodity producers and insider behavior are sending a confirming warning message.

There are also powerful fundamental reasons for a decline in commodity prices. With crude oil, demand is lower than it was a year ago, while supply is higher--and yet prices have doubled. One is saturated even in the non-financial media with forecasts of $200 oil or higher in the imminent future. The more that the price of crude oil diverges from fair value, the more prevalent is the belief that this disparity will persist permanently or even become more extreme. This is classic bubble psychology.

With precious metals, the most important physical buying has always come from India--which is now suffering from the Indian rupee reaching its lowest level since the spring of 2007, and Indian equities having plummeted to their lowest levels also since the spring of 2007. As a result, Indian buying of precious metals has reached its lowest point in several years, with a pullback of more than half from just one year ago. Similar data shows that the supply/demand situation for all metals has tilted sharply in the direction of weaker demand and greater supply.

With agricultural commodities, demand is flat except for population increase, while high prices have encouraged increased crop planting worldwide. All-time record harvests are being forecast by the most reliable sources. Record supply and flat demand, combined with prices that have doubled, tripled, or quadrupled is likely to lead to only one possible outcome.

Therefore, commodities stand at a crossroads. While investment demand has been able to overwhelm physical demand in the short run, it is actually a source of potentially accelerated selling. If commodities are physically consumed, they are taken away from the open market. But if they are bought strictly for investment purposes, then they suffer the danger of investors deciding to sell at any time. With record accumulation by amateurs, the effect of the greatest simultaneous speculative selling in history would likely overwhelm most commodity markets that are simply not designed to handle such a massive unloading.

One need only look at the Chinese or Indian stock markets at the end of 2007, and to see what happened to them over the next half year. These were considered to be the hottest investments around, and the fact of sky-high P/E ratios was considered irrelevant as long as people were buying. Analysts who had never recommended these markets in their lives were touting them left and right. Eventually, though, the fundamentals asserted themselves and declines exceeded 40%--with some bourses such as Vietnam plummeting by 60% or more.

Since emerging markets have been among the most significant factors that have stimulated the increase in commodity prices, it stands to reason that the first-half collapse in emerging-market equities will likely lead to a second-half plunge for commodities. The game has already entered extra innings, and with supply/demand fundamentals continuing to deteriorate, net investment buying is likely to translate into net investment selling.

The final factor that should prevent any possibility of an alternative scenario for commodities is the behavior of the U.S. dollar index, which has been quietly forming a pattern of numerous higher lows since it completed its historic bottom on March 16, 2008. The U.S. economy has generally underperformed that of the rest of the world, but that is mostly because it simply contracted first. As the rest of the world begins to show increasing signs of economic weakness, this will strongly support the U.S. dollar--as will the anticipation that the next U.S. President will curtail war spending and raise marginal tax rates, both of which will cause the U.S. budget deficit to narrow sharply.

Therefore, while the total magnitude of the U.S. dollar's increase since the middle of March has been anemic, the greenback will likely accelerate its rally throughout the second half of 2008 and into the first several months of 2009. This will provide a strong psychological excuse for speculators to exit the commodity markets, and will therefore likely ensure the demise of the current commodity bubble.

  • Special Overview of Gold Mining Shares, updated on July 1, 2008.
  • Learn more about Steven Jon Kaplan and watch a live interview on MarketWatch.
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    BE CAREFUL WHAT YOU WISH FOR, AS IT MAY COME TRUE (June 26, 2008): Investors and just ordinary folks around the world alike are hoping against hope that the price of crude oil declines sharply in the near future. The good news is that the price of crude will soon rapidly plummet to $100 per barrel, and will eventually reach $60. The bad news is that the global economy will simultaneously contract.

    Many investors naively assume that the economy would be in pretty good shape, if only the price of oil were to retreat. However, a decline in the price of crude oil will coincide with a steep pullback for stock markets around the world and a recession in many countries including the United States.

    One important reason for crude's imminent collapse is that anticipation of future demand is significantly higher than what it actually will be. That is because projected double-digit growth rates for emerging markets are far too optimistic. As the world continues to struggle with declining real-estate prices and tighter lending standards, this will cause the formerly hottest economies to experience the most severe slowdowns. This is already clearly foreshadowed in the huge pullbacks in stock markets throughout the developing world. Those which had enjoyed the greatest increases have been plunging in recent months by more than one third for many countries including India and China and even more than 50% for some including Vietnam. Most observers have not yet adjusted to this reality, and keep talking about the so-called economic miracles in these places.

    As a result of this global contraction, demand for crude oil is less than it was a year ago, while supply is greater. In spite of this, the price has doubled in the past year--which means that there is no fundamental basis for this increase, and thus the entire gain will be wiped out sooner or later.

    As the crude oil price declines, it will likely do so in spectacularly erratic fashion, with sharp plunges toward $100 followed probably by a sharp rebound to around $120, then a choppy pullback to $90, back to $100, then to $80, and so on, until its price is eventually near $60 per barrel. These wild fluctuations, even though they will progressively lead to significantly lower prices for gasoline, will unsettle the markets. In addition, a contraction in equities historically has always been followed by a delayed pullback for commodities. Instead of being positive for the stock market, rapidly falling oil prices will signal that the global economy is contracting more rapidly than had been anticipated, and will therefore coincide with the greatest percentage pullback for equities since 2002.

    As a result, in a few months, stock markets around the world will return close to their respective support levels from 2005 and 2006.

    U.S. TREASURIES REPRESENT A FANTASTIC BARGAIN (June 15, 2008): What do June 2006, June 2007, and June 2008 all have in common? I'm not talking about weddings, the summer solstice, or the start of the summer break for students, as important as all of those may be to some.

    The answer is that in the month of June for each of the past three consecutive years, investors have become irrationally fearful of rising inflation and the risk of the U.S. Federal Reserve raising interest rates. This caused U.S. Treasuries to slump to multi-year lows one year ago, and also two years ago.

    This time, concerns over Fed rate hikes are particularly misplaced. The U.S. economy is not only suffering from rising unemployment and falling housing prices, but also from an equity market which has been progressively declining since October 2007. And that's not even considering that this is a Presidential election year. The chance of the Fed raising rates under this combination of conditions is about the same as the likelihood that there will be a blizzard in Manhattan this summer.

    As a result, U.S. Treasuries represent a terrific bargain across the yield curve. Of all of the possible Treasury investments that are available at this time, my favorite is TLT, which is an exchange-traded fund of U.S. Treasuries averaging 25 years to maturity.

    As global equities continue their decline, while the commodity bubble bursts in spectacular fashion, U.S. Treasuries and other government-guaranteed bonds will be among the few asset classes which are rising in value. It is likely that TLT will gain roughly 10% in just three months, which represents an annualized yield well in excess of 40%.

    The U.S. dollar index, which began a major one-year rally on March 16, 2008, will soon accelerate its uptrend. While most government bonds around the world will benefit from falling equities and commodities, the rising U.S. dollar will make U.S. Treasuries the superior choice for hedge-fund managers and other asset allocators.

    GDX, a popular exchange-traded fund of gold mining shares, has slumped by more than 24% since it peaked on March 17. This confirms the equity and commodity downtrend, and is signaling clearly that inflation is an overblown concern. Federal-funds futures show that investors are anticipating not just one, but two rate hikes from the Fed by October 29. Don't believe it for a moment. While all of your friends are buying agricultural-commodity funds or Brazilian equities, purchase U.S. Treasuries instead and enjoy enormous annualized gains with limited downside risk.

    FINALLY, A SINCERE THANK YOU to Barron's for featuring me on page 50 of their November 19, 2007 issue, and then again on February 25, 2008 (page M14) and June 2, 2008, page 41.

    CURRENT ASSET ALLOCATION (July 1, 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%), 1.5%; municipal bonds, including MYJ, 2.5%; TLT, 1.2%; other U.S. Treasury funds, 3%; 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, 1.3%; 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 (July 1, 2008): My wife and I went hiking several years ago on a steep trail in a town called Gold Bar, Washington. We had just completed most of the ascent, when we realized that it was about to turn nearly vertical. We took a break to admire the marvelous view, and wondered whether we should continue to the top of the mountain. Just then, a fellow who must have been in his 80s rapidly approached behind us, and without hesitation, continued rapidly toward the summit. We were astonished, and wondered who he might be. When he passed us again on the way down, we asked him if he had hiked this mountain before. "Only about a dozen times a day, nowadays," he responded as he continued to quickly descend. "As you can see, I'm not as young as I used to be, and I carry this walking cane with me most of the time. But the view is as magnificent as ever, and I'm not going to allow myself to deteriorate without a fight."

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