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Updated @ 9:00 p.m. EDT, Sunday, June 17, 2007.


WELCOME TO TRUE CONTRARIAN! I will attempt to create an entertaining, readable, and hopefully refreshing viewpoint roughly once per week [sorry that it has been less frequent recently]. Each issue will feature my intermediate-term financial outlook, my long-term financial outlook, and a personal reminiscence.

A purse is doubly empty when it is full of borrowed money. --Anonymous

BASE METALS POINT THE WAY LOWER (June 17, 2007): There has been a lot of talk in the media about the supposedly expanding global economy. However, precious metals and their shares have been declining since May 11, 2006, while base metals have fallen significantly since they peaked on May 9, 2007. Base metals in particular have a very strong correlation with worldwide growth prospects, since they are so heavily used in industrial production. Manufacturing has been the mainstay especially of emerging-market economies which have seen by far the strongest GDP growth rates and equity price increases since the spring of 2005. China's stock market has quadrupled just in the past two years.

If you hear base metals mentioned in the media, it is always about their "powerful rally" which intensified two years ago--at the exact same time that emerging market equities accelerated their rally. Because the two are so closely intertwined, the recent pullback in base metals could be an important omen signifying a parallel decline for emerging-market equity indices. Nickel has already dropped more than 15% since its all-time peak on May 9, with zinc, tin, lead, and copper also noticeably lagging in recent weeks.

No doubt there are those who believe that the retreat for base metals is temporary. However, as central banks raise interest rates worldwide, this is sure to slow global growth prospects. The housing bubble, which has contributed to the base-metal rally, is now a worldwide phenomenon, and has been fueled primarily by the easy availability of borrowed money and very relaxed lending terms that have often included zero-money-down arrangements. If lenders begin to demand higher down payments as defaults and foreclosures have been increasing in many areas including the U.S., and housing prices thereby suffer a substantial reversal, it will have a profound contractionary and recessionary impact on the entire worldwide economy.

Base metals prices are an important leading indicator. As they have been falling, the U.S. dollar has been quietly rallying. U.S. Treasuries often complete an important multi-year bottom in advance of a major worldwide equity decline, and such a nadir may have been achieved during the past week. They say "the bell doesn't ring at the top", but all three of these events happening simultaneously are warning that Goldilocks is likely to soon be followed by the three bears.

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    THE MAINSTREAM FINANCIAL MEDIA GET IT WRONG AGAIN (June 10, 2007): The mainstream financial media, baffled as ever, have completely misinterpreted the important events of the past week. The media believe that inflation and economic growth worldwide are accelerating, so investors should sell U.S. Treasuries which stand at a five-year low, and increase their purchase of stocks which are at a five-day low. The mantra is that we had a "healthy equity correction" which is now over. The media are also telling us that housing prices have bottomed and will soon head higher once again.

    The media can get away with this kind of nonsense, because who, after all, is going to question the media about themselves? Any person with a brain, however, can figure out what the recent sharp increase in mortgage rates is going to do to a housing market which is already saddled with tightening lending standards, above-average inventories, and an all-time record nationwide vacancy rate.

    Meanwhile, in case anyone hadn't noticed, stock markets have begun to decline all around the world. The great Chinese equity bubble reached its final peak on May 29, while the U.S. stock market began to decline on June 1. Instead of "sell in May and go away", it looks like "sell at the start of June and enjoy the summer swoon, by the light of the silvery moon".

    Even more quietly, the U.S. dollar has mounted its sharpest rally in more than two years. Has anyone heard on a cable TV station about "why the dollar is rising"? Does anyone who doesn't work in a foreign exchange office know that the euro recently touched its lowest level against the U.S. dollar since April 3? A rising U.S. dollar has preceded every global economic slowdown since the greenback was delinked from gold in 1971.

    Speaking of gold, it has reached its lowest point in two months. Gold mining shares also touched their lowest point in two months. Commodities of all kinds, including metals and energies, have been declining for several consecutive weeks, with zero of the fanfare that had accompanied their rise. This is not a coincidence. Inflation is not rising; it is falling at its most rapid pace in many months.

    Everyone thinks that emerging-market economies will grow at 11% or 13% or 15% over the next year, whereas we are likely to experience only single-digit GDP growth in countries like China and India. While a growth rate of 6.5% may have seemed wonderful a decade ago, if everyone is expecting twice as much, there's going to be a sharp pullback in those securities which have priced in the anticipation of continued rapid emerging-market expansion.

    The worldwide economy is contracting, not accelerating. Commodities like gold and base metals have been telegraphing this pullback for two months. The U.S. dollar has been saying so since May 1. Equities have recently joined in the chorus. Only the media and most investors aren't listening.

    IT'S OKAY TO BUY THE U.S. DOLLAR (May 28, 2007): Do you know anyone who is bullish on the U.S. dollar these days? I don't mean wishy-washy bullish, or not terribly bearish, but "let's go greenback, rah rah" bullish? Probably not. However, the U.S. dollar has been steadily rallying since the first day of May, and as important technical resistance levels have been steadily broken one after the next, this rally is likely to accelerate into a major surge in the very near future. I am still expecting the U.S. dollar index to go above 90 before the year is over.

    IT'S ALSO OKAY TO SELL SHORT (May 28, 2007): One rarely reads in the financial media about recommendations for selling short, and when one does encounter such advice, it is almost always to point out companies which have already been out of favor for months or even years and are about to rebound in a big way. It is extremely rare to see someone talking about selling short mutual funds, but that is exactly what I am about to do.

    When you sell short any security, you have to pay all dividends that are credited to owners of that security. However, when you sell short, you get to continue collecting 5% interest or whatever your broker pays on your cash balance, since your cash balance is not reduced by funds which are used for short sales. In addition, all mutual funds have a management fee. [Of course, if your short positions move adversely, then your cash balance will be reduced, but only by the magnitude of the adverse move itself.]

    Therefore, let's compare what happens when you establish a long position versus a short position. A long position is the same thing as buying a stock or fund. Let's suppose that you buy ten thousand dollars of mutual fund ABC. You immediately give up the 5.0% interest that you had been collecting on that ten thousand dollars. You also have to pay the fund's management fee, which we'll assume is exactly 1.0%--just about the median fee for a mutual fund these days. On the plus side, you get to collect the dividends--which if it is a typical technology or "hot" fund, is likely only about 0.5%.

    Let's assume that the assets of fund ABC increase by 5.5% in one year before expenses. At first, you probably think--hey, that's not so bad. But since you gave up 5.0% in interest, and you also have to pay 1.0% in fees, then after collecting your 0.5% dividend, you end up with $10,500. That is the same amount of money you would have had if you had simply kept your money in cash and collected the 5% interest--with much greater volatility, of course.

    Now suppose that you had sold short fund XYZ, and its assets remain exactly unchanged after one year. Notice that after collecting 5.0% interest, and gaining an extra 1.0% from the management fee [which causes the net asset value of the fund to decline], then after paying the 0.5% in dividends, you end up with $10,500.

    This shows that when you sell short a given mutual fund, there is a powerful wind at your back, so favorable that if the particular asset that you are selling short remains unchanged in value, you will end up with the same amount of money as if you had purchased a different mutual fund whose assets had gained 5.5%. Stated another way, by being a short seller, you get a head start of 5.5% annualized over someone who insists on buying stocks instead of selling them. The gain can be even larger if your broker pays you a "short interest credit"--which unfortunately is usually only available to those with an account balance in excess of one million dollars.

    Of course, one does not sell short with the object of simply doing as well as someone who simply left the money in cash. If you sell something short which falls by 10% in one year, your total gain will actually be 15.5%. More importantly, there are absurd bubbles all around the world these days which are just begging to be sold short, such as Chinese equities which are on the verge of collapsing by 50% or more. So you can sell short QQQQ, or EEM, or FXI--the list of favorable funds to sell short goes on and on for pages.

    The financial markets are feast or famine. Right now, it's famine for long-side buyers who must spend hours trying to find something which is less ridiculously overvalued than everything else. But why struggle? You can sell short with impunity, and get an extra 5.5% as a bonus.

    AS CHINA GOES, SO GOES THE WORLD (May 8, 2007): The great unreported financial story of 2007, (May 28, 2007) now finally getting some well-deserved attention, is the wild bubble in Chinese equities, which on average have quadrupled in the past two years. If the Chinese stock market were to lose half of its value, it would still be far above where it had been in August 2006--and there's no international law which says that it must remain above that particular support level. Buying the Nasdaq in March 2000, when it was above 5000, was an example of ultraconservative behavior compared with buying Chinese equities today. The number of working-class (May 28, 2007) and very recently even lower-class Chinese who are literally lining up at brokerages to buy stocks because their names sound lucky (May 28, 2007) or their numeric identifiers contain 8s and other fortuitous digits would in sheer numbers exceed the total number of participants in all previous worldwide asset bubbles combined.

    While this is the most important financial story of the year, it's not considered "news" by the mainstream media. It will only be reported once the Chinese stock market collapses--and then every single commentator will say "it was blatantly obvious that their market was way overdue for a serious correction". Okay, if it's so obvious, then how come no one is saying it now--BEFORE it happens? Ha! These so-called analysts are all afraid of stating the obvious; it's the emperor's new clothes all over again. No one wants to be the first on their block, because they honestly have no idea what's happening in China, and if the Chinese stock market moves up another 10% or 20% or 50%, they're worried that they'll be thought of as idiots instead of geniuses.

    To be fair to the media, this story was reported in the New York Times and elsewhere for three whole days near the end of February--only to be completely abandoned thereafter in favor of puff pieces about "the Chinese miracle" and plenty of nonsense about "why the Chinese stock market will remain strong for the next century".

    Because the worldwide financial markets are so closely interconnected, the world's stock markets no longer have to automatically follow what happens in the U.S. When China's stock market plunges, the rest of the world will follow--including the United States. That's one of the beauties of globalization and the internet--a financial collapse in one part of the world immediately leads to a financial collapse everywhere. Those who recently purchased real estate or modern art may want to keep this in mind.

    So remember, after the Chinese stock market collapses by more than half before the year is over--you heard it here loudly and clearly, with no punches pulled.

    HOW LOW WILL HUI GO? (September 10, 2006): HUI is the Amex Index of Unhedged Gold Mining Shares. How low will HUI eventually go, exactly, over the next several months? One very useful guide is to observe that on December 2, 2003, HUI reached a peak of 258.60 which was not exceeded for about two years. (November 28, 2006) As a rule, during its bull market which began on November 25-26, 2000, HUI has gone modestly below each such high-water mark during each subsequent extended correction. Another guide is found by measuring the entire gain in HUI from its May 16, 2005 bottom of 165.71 to its May 11, 2006 peak of 401.69. If HUI surrenders exactly 61.8% of this increase--known as the key Fibonacci retracement--it would put HUI at 255.85. It's no coincidence that these two numbers are so close. If history is any guide--which it almost always is--then HUI should move a few percent below each of these numbers, and bottom near 248.

    CURRENT ASSET ALLOCATION (June 17, 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%), 3.5%; long-dated U.S. Treasuries and their funds, and long-dated municipal government bonds, including TLT and MYJ, 34.5%; Treasuries between 2 and 10 years in duration, such as IEI and IEF, 12.5%; TOC, 0.5% (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, negative 30.5%; SHORT POSITIONS: Nasdaq-equivalent (QQQQ, SMH, NDX, GOOG) and related shorts, 50.5%; short CFC, 3%; short GLD, 17.5%; short GDX, 2%.

  • Overview of Gold Mining Shares (updated June 17, 2007)
  • REMINISCENCE OF THE WEEK (June 17, 2007): I was hiking one day with some friends in a forest located on top of a ridge. We had a wonderful time, but it became dark sooner than we had anticipated, and it was clear that we had not allowed sufficient time to return to the starting place of our hike before it got dark and the trails would become very difficult to follow. There was a town below us which had well-lit streets, so we decided to quickly descend before we had difficulty finding our way. Fortunately, we found a relatively easy path that was not too steep and did not have any poisonous plants or sharp thorns. Just when we thought everything was going to be fine, we discovered a very large dog, weighing at least 150 pounds, that was too eager for us to reach the bottom. We tried to distract him by throwing some sticks in the opposite direction, but that had no effect. Soon the dog started barking loudly, which attracted the attention of the owner of the property. Fortunately, the owner did not begin shooting! He was rather startled to see the seven of us suddenly appear on his land at dusk, but he was gracious enough to grab his dog and permit us to cross through his house into one of the streets of the town. We apologized for causing him trouble, and he said it was the first time that such an event had happened in the fifty years that he had been living there. We later discovered that he was a rather famous person who had moved to the U.S. from Europe shortly after World War II. The next time we hiked in the same forest, we made sure to check the time of sunset before we began.

  • Best of Previous Reminiscences
  • (c) 1996-2007 Steven Jon Kaplan Your comments are always welcome.

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