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.
COMMODITIES AND EQUITIES ARE SET TO PLUMMET IN TANDEM (July 27, 2008): In my previous update (from July 13, see below), I pointed out how most investors had turned strongly negative toward the stock market, while almost everyone was wild over commodities. This sent a clear signal that U.S. stocks would enjoy a sharp two-week bounce to shake out amateurs who decided to finally sell short, which is exactly what happened. During just the past two weeks, many have suddenly turned positive toward equities, talking loudly about how "we've bottomed". Meanwhile, excitement over commodities remains alive and well.
Remember how most analysts said at the end of January that "we've bottomed; buy stocks"? They said it again at the end of March, and yet again at the end of July. Don't believe it for a moment! At a true bottom, you get massive withdrawals from equity funds because the average investor has given up and wants the safety of U.S. Treasuries at any cost. Even at the lowest point in July 2008, the outflows from most equity funds were barely noticeable--and many of them continued to enjoy net inflows. Meanwhile, U.S. Treasury prices are just above their lowest levels since October 2007. That doesn't show either panic or a clamoring for safety--quite the opposite.
More importantly, there has not been nearly enough fear in the worldwide equity markets to mark any kind of bottom. One of the most reliable indicators through the decades has been the behavior of VXO, a measure of implied volatility of the S&P 100. (VIX, which measures implied volatility of the S&P 500, is similar to VXO, but is less consistently reliable.) In 1997, 1998, 2001, and 2002, VXO went above 55 each year, and slightly exceeded 60 in 1998. In all four of those years, VXO gave a loud and clear message that it was safe to buy stocks.
In 2008, VXO has not reached anywhere close to 55. In January, it almost touched 40, but couldn't quite make it. On Wednesday, July 23, 2008, VXO fell to an intraday low of 21.20! 21.20 is an incredibly long way from 55--and just goes to show how amazingly complacent most investors are toward the stock market. Even after a steep nine-month plunge since October 2007, not to mention a 3-year low for the S&P 500 that was touched earlier this month, the average investor has no fear of a further pullback. Why? Because the media keep telling them that the worst is over, and they're gullible enough to believe it.
Don't be so naive. If almost no one is afraid that a nine-month downtrend will continue, then it is likely to not only keep going but accelerate, as most trends do before they violently reverse. Until you see VXO reach at least 50, don't even think about buying stocks--not the S&P 500, not emerging markets, and certainly not commodity shares.
Speaking of commodity shares, the media have barely mentioned how far they have plummeted. Precious metals shares have fallen all the way back to their levels from September 2007. Agricultural-commodity shares, which were all the rage a month ago, stand at their lowest levels since early April. Even oil shares--with crude oil recently soaring to a new all-time peak amidst intense media coverage of that event--have recently slumped to their lowest levels since early April. This is not a coincidence. For decades, the shares of commodity producers have led their respective commodities both higher and lower. The recent underperformance by commodity shares is sending a loud and clear message that commodities are set for a historic plunge over the next several months.
Another big surprise for most investors will be how the U.S. dollar accelerates its rally. The U.S. dollar index has been forming a very bullish pattern of higher lows since it completed a historic bottom on March 16, 2008. Since that time, the greenback has reached multi-year highs against most emerging-market currencies including the Indian rupee, the Korean won, and the South African rand. As it becomes increasingly clear that global economies are contracting by even greater percentages than the U.S. economy, the U.S. dollar will surge higher.
THE MARKET'S MOOD SIGNALS TWO MAJOR REVERSALS (July 13, 2008): The mood of the financial markets sometimes becomes so extreme that it gives much more valuable clues than any fundamentals ever could.
Such a situation exists at the present time. The mood toward global equities has become gloomier than it has been since the spring of 2005. Persistent declines, with especially dramatic plunges in emerging markets which were thought by many to be immune to the global contraction, have caused armies of amateur investors to begin selling their stocks and switching to the short side in recent days.
Meanwhile, the mood in the commodity markets has become outright giddy, with even greater optimism among participants than when commodities were completing higher peaks in the late winter.
The stage is therefore set for a perfect reversal of fortune, in which stock markets enjoy a powerful short-term rebound, while commodities confirm their recent lower highs and plummet to the downside.
Several recent events confirm this outlook. The currencies of emerging-market currencies including the Korean won, the South African rand, and the Indian rupee have all plummeted to multi-year lows. This means that there will be much less demand for commodities from those countries which had experienced the greatest per-capita percentage increases in commodity consumption in recent years. The stark underperformance of commodity shares relative to their respective commodities, such as oil shares (see OIH, XOI, or OSX) which have barely risen by single-digit percentages since October 11, 2007 even with far higher energy prices, is also a reliable leading indicator of a commodity plunge.
Meanwhile, reliable sentiment surveys and confirming technical indicators show deeply unloved and oversold equities worldwide. While the equity bounce will likely persist for less than two weeks, it will probably be quite violent with huge one-day upward surges. Amateurs will eventually surrender and switch once again to the long side, just in time for the global equity markets to plummet to fresh three-year lows later in the summer.
It's rare that you see such a perfect confluence of rabid bullishness toward commodities and pervasive gloom toward equities as we are experiencing at the current time. Carpe diem!
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.
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 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%), 0.9%; municipal bonds, including MYJ, 2.5%; TLT, 1.8%; 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 27, 2008): When I was in my senior year in high school, I took a class entitled "Introduction to Computer Programming". The course was so new that the teacher had to take a special intensive summer class to understand the material. At that time, there was only one computer in the entire county where I lived, so our class had to get there via a bus ride once every second Monday. There weren't enough keypunch machines for us to punch our old-fashioned Hollerith cards, so we had to buy black Sharpee markers to construct our program "decks". If we needed extra time to finish our work, we had to arrange for private carpools on Wednesday afternoons for those of us who were fortunate enough to have both drivers' licenses and automobiles. Every now and then, a hapless student would instruct the printer to spew out reams of paper at a time, which always caused the computer operator to become incredibly enraged and to treat our entire class to a stern lecture. Fortunately, our teacher maintained a wonderful sense of humor throughout the year, which contributed greatly to our interest in the topic.
After having so much fun in high school, I decided to take a somewhat more advanced class during my first semester at college. Unfortunately, the professor was far less inspired and interested in his students than my high-school teacher had been, so the class (for me, at least) soon deteriorated into boredom and confusion. When it was time for the final exam, we were supposed to find a computer terminal and figure out how to write a computer program to accomplish a particular task. I was rather slow in getting to the computer room: by the time I arrived, all of the terminals were taken except for some ancient machines that loudly clanged with each keystroke and printed out cheap, faded yellow paper. So I was stuck having to work for eight consecutive hours with paper constantly pouring out and forming a huge yellow mass that soon covered my entire working area.
By the time I was finished, I had no idea how to arrange my work into a coherent summary. So I just played around with the massive paper roll for about a half hour, and finally figured out how to roll it into a scroll somewhat resembling a Torah (and nearly as thick). I found a huge rubber band that held it in one piece, and handed it in. Being completely indifferent at that point, I figured the professor may as well fail me if he wanted to. Amazingly, I got a better grade than most other students--since I was "humble enough to do my work using a permanent medium--and to show, step by step, all the mistakes I had made before I finally figured out a correct solution."