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.
THE U.S. STOCK MARKET IS SET FOR A DRAMATIC PLUNGE (August 10, 2008): The S&P 500 index has been declining for ten months--and yet the incredibly low levels of implied volatility indices including VXO and VIX show that the vast majority of investors still do not believe that an additional pullback is likely. This state of denial is especially dangerous now that emerging-market equities and commodities have joined developed-market equities in their downtrends, demonstrating beyond any shadow of a doubt that the worldwide economy has been noticeably contracting.
QQQQ makes an excellent short position at this time. It has fallen only 14% since October 31, 2007, even with the worst housing collapse in U.S. history and a major global credit crisis. The recently rising U.S. dollar will cause significantly lower profits for many U.S.-based technology companies which derive a substantial percentage of their total profits from overseas sales. The dividend yield on the top 100 Nasdaq companies is also absurdly low by historic standards--unless of course you are comparing it with the Nasdaq's bubble peak from March 2000.
With the U.S. Presidential election arriving on November 4, 2008, there are fewer than three months to go until that important event. U.S. equities generally rally in anticipation of any Presidential election, and that is likely to be especially true this year when a very unpopular incumbent is about to be replaced. Therefore, whatever pullback we get as a result of the global slowdown has to happen now or never.
In case you're tempted to place your money on "never", keep in mind that in years including 1997, 1998, 2001, and 2002, the U.S. stock market was not able to rally until VXO moved above 55 each time. This elevated level of fear showed that enough investors had panicked so that they had created an essential source of additional buying power in money-market funds and similar safe time deposits. Until we see a similar level of panic in 2008, the U.S. stock market will have to continue to form a pattern of lower lows as it has been doing consistently since October 2007.
The media will tell you that lower commodity prices are positive for equities. Don't believe it for a moment--remember that just one month ago they were claiming that lower equity prices were positive for commodities. The media are simply attempting to create a plausible explanation for whatever has just happened--they have no ability to put two and two together to tell you what is just around the corner. Bet on lower U.S. stock prices and you will profit handsomely over the next several weeks.
THE EQUITY/COMMODITY ENDGAME CLOSELY APPROACHES (August 5, 2008): With a severe global economic slowdown and record highs for commodity prices, analysts have been "shocked, shocked" to discover that this has led to a sharp drop in physical demand for commodities, while supply has been progressively increasing to capitalize on their inflated valuations. Investors who listened to the media and "diversified away from equities into commodities" are suffering the same well-deserved fate which greeted those who diversified away from developed markets into emerging markets (and which have since plummeted by half).
The moral of the story is the same that investors learned the hard way in all previous bubbles: logic still applies, and common sense still matters (and is not so common after all).
What is the most shocking undervaluation today is the level of implied volatility indices including VXO and VIX. As of this writing, both of these are below 25. In 1997, 1998, 2001, and 2002, VXO went above 55, as investors panicked out of equities. Now, even after more than nine months of terrible economic news and an average U.S. stock-market decline from the peak of 20%, investors are still not worried about the possibility of a significant additional pullback--thereby making it a virtual certainty.
While there will continue to be sharp single-day rallies for U.S. equities, as is typical of all bear markets, the next several weeks should be accompanied by the steepest slope of the decline for the entire one-year correction. Once today's Fed meeting provides its usual brief oasis of hope, the market will be wandering in the desert with scarcely any food or water until the next meeting on September 16, 2008.
Whenever a continued pullback generates almost no rise in fear, the market will always punish participants by continuing to decline until enough people begin to panic. Far too many analysts keep saying that the last minor low was "the bottom". Only when they agree that the market is too dangerous to even think about calling a bottom will the retreat finally be over. That will not occur until VXO is at least above 50, and perhaps above 60.
The ratio of gold mining shares to the price of gold currently stands at its lowest point since the beginning of the decade. This implies that either these shares are about to rally sharply--which would be highly uncharacteristic of their historic tendency to closely track the general equity market--or else the price of gold is about to collapse. I believe the latter is far more likely, and that gold will rapidly plunge to below $800 per ounce over the next several weeks. This analysis is confirmed by physical gold buying for India throughout 2008 having slumped by more than half from the same period in 2007. India is not only the world's largest consumer of gold, but also has a reliable track record of forecasting price trends.
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.
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 (August 10, 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%), 0.6%; municipal bonds, including MYJ, 2.5%; TLT, 2.4%; 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, 1.0%; 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 (August 10, 2008): Two decades ago, I worked for a company which sent me on a business trip to a suburb of Albany, New York one weekend per month. One autumn Sunday, I decided to explore downtown and walked around the area near the state office buildings. I was carrying a small bag of food, and stopped for a break on a park bench before continuing with my tour. I was startled to observe that a squirrel, spotting my food, scampered within an inch or two of my fingers--as though he expected me to feed him. I withdrew a cracker from my bag and, sure enough, he gently took it from me. I was quite surprised by this, until I realized that I was seated in an enclosed, tree-shaded area of about a dozen closely-spaced benches where the local office workers probably took their daily lunch breaks. Over a period of weeks or months, they must have domesticated this squirrel to the point where he no longer feared humans and expected them to give him treats. I went back the next month and he was there waiting to receive my goodies. After that, though, even though I returned to the same bench several more times, I never saw him again.