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Glancing at the news most days, it's hard not to feel
like Bill Murphy's character in Groundhog Day. In the event you are
unfamiliar with the movie, in it Murphy's character
becomes trapped in the same day… day after day.
In the current circular condition, we have the
powers-that-be assuring us that the next high-level meeting will finally
produce a permanent fix to the broken economy, essentially solving the
sovereign debt crisis. Then, in no more than a few days, or at most a couple
of weeks, the fix is revealed to be flawed and the crisis again sparks into
flames. Followed shortly thereafter by yet another high-level meeting –
and the cycle begins anew.
While the characters may change – one week it is
Greece, the next it is Spain, the next it is France, the next it is the US,
the next it is Greece again, etc., etc. ad nauseam – the detached
observer who steps back to a distance sufficient to view the larger picture
can only come to the conclusion that we are now well outside of the bounds of
the normal business cycle.
As we here at Casey Research have written on this topic
at great length, I don't intend to dwell on this topic today, but I did want
to loop back in just long enough to comment on the recent price action in
commodities, especially gold, in the face of the continuing crisis.
Today, a glance at the screen reveals that gold is
trading for $1,565. For comparative purposes, as revelers warmed up their
vocal chords to sing in the New Year on the last trading day of 2011, gold
exchanged hands at $1,531. And exactly one year ago to the day, gold traded
at $1,526 for a one-year gain of a modest 2.6%.
A year ago, the S&P 500 traded at 1,325, while
today it trades at 1,318, a small loss. Yet, have you noticed we don't hear
much about the imminent collapse of the US stock market, as we do about gold?
This perma-bear sentiment about gold on the part of
what some people lump together under the label "Wall Street" is
especially apparent in the gold stocks.
Using the GDX ETF as a proxy for the sector, we see
that the shares of the more substantial gold producers are off by an
unpleasant 24% over the last year. More on the topic of gold shares
momentarily, but first let's round things out by also looking at the price
action of a couple of other core components of the global economy.
For instance, a year ago, a barrel of WTI crude sold
for a tick over $100. A couple of weeks ago, it was still selling for $102,
though it has slid a bit to $91 today. Even so, that is still considerably
higher than where it traded as recently as New Year's 2008, when it was just
$38 per barrel. Since that low, the price of oil has made a steady advance
and for the last year and a half has traded right around $100/bbl.
Then there is the matter of base metals. Copper, for
example, traded at $8,980 per tonne a year ago, and
is today at $8,289, a loss of almost 11%. Likewise, the iron ore price is off
by 15% over the last year, and zinc is off by 13%. Even the minor monetary
metal with industrial applications, silver, is off 8.39%.
With that "baseline" in place, I would like
to now turn to the current outlook for gold, and touch on some of the other
commodities as well.
- Gold. In the context of its secular bull market, and given that
absolutely nothing has gotten better about the sovereign debt crisis
– only worse – gold's correction is nothing to be concerned
about.
I know the technical types will point to levels such as $1,540 as
important resistance points – and there's no question that if gold
was to break decisively below that level, and especially below $1,500
– that a lot of autopilot trades would kick in and put further
pressure on gold.
Yet, when you view the market through the lens of hard realities, which
is to say, by focusing on the intractable mess the sovereigns have
gotten the world into… in Europe, in Japan, in China and here in
the US… then viewing gold at these levels as anything other than
an opportunity is a mistake.
- Gold Stocks. As far as the gold stocks are concerned, I
consider today's levels to be extraordinarily compelling for anyone
looking to build up a portfolio, or to average down an existing
portfolio.
I say this for a number of reasons, starting with the contrarian
perspective that this may now be the most unloved sector of the stock
market. No one wants anything to do with gold stocks, and hasn't for
some time now. As a consequence, the sellers will soon dry up, leaving
almost nothing but buyers to push the sector back to the upside.
This contrarian perspective is important because in today's world
literally thousands of competent equities analysts plop down at the desk
each trading day with the sole purpose of searching for prospective
investments. Many of these analysts are backed by huge firms with
billions of dollars at risk in the markets, and so are armed with
high-powered computational tools of the sort that was unimaginable even
a few years ago. All of these analysts, armed with all their
computational power, habitually scan a universe that totals about 4,000
publicly traded companies. Realistically, however, even a thin
analytical screen will weed out all but perhaps 400 of those companies
as being potentially suitable for investment.
Thus, you have thousands of high-priced and well-armed securities
analysts crunching pretty much the same data on a very small universe of
possible investments. Given this reality, is it any surprise that
securities are so tightly correlated? Which is to say, is it any
surprise that these securities all trade right in line with the
valuations that the analytical screens ultimately derive that they
should? Which means there are really only two possible circumstances
under which any of these stocks move up, or move down, by any
significant degree:
1.
Broad market
movements. The saturated
levels of analysis mean that, within a fairly tight range, all the stocks now
move more or less together. Thus, with few exceptions, a big upswing or
downswing in the broader market will send almost all stocks up or down
together. To help make the point, I randomly pulled a chart of IBM and
compared it against SPY (the S&P 500 tracking ETF) for the last year.
Note the lockstep price movements:
2.
3.
OK, IBM is a big company, so it will have a lower beta than many companies,
but the point remains that saturated coverage of the stocks greatly reduces
the odds of any one issue breaking free from the larger herd, unless there
is…
4.
5.
A surprise. All of these analysts, and all of their computerized
analysis, help form a certain future price expectation for each security
based on past financial metrics (earnings growth, return on equity, and so
forth). Other than the broad market movement just referenced, or moves in
line with a sub-sector of the larger market (e.g., if oil falls, oil-sector
stocks will move up or down in sync), for a company to deviate in any
substantial way from analyst expectations, by definition requires a
"surprise" to occur.
Of course, such a surprise can be positive, but because these companies are
so closely watched, it is more likely to be negative. In the former category,
a positive surprise might come in the form of an unexpectedly strong new
product launch á la the iPad. In the latter,
less happy category of surprise, it can be the blow-out of a big well in the
Gulf of Mexico… or any one of a million other unanticipated vagaries of
fate.
6.
As investors, recognizing these fundamental realities
is important because it points to where above-average market opportunities
are most likely to be found (or not). And that brings us back to the whole
idea of being a contrarian. As I mentioned, "Wall Street" has never
much liked the precious metals, and by extension the gold stocks. Given the
length of the gold bull market – which, in our view, reflects
systematic risk in all the fiat currencies, but which Wall Street views as an
indication of a fatiguing trend confirmed by the underperformance of the gold
stocks – traditional portfolio managers are unhesitant in giving the
boot to the few gold shares that somehow made it into their portfolios
against their better judgment.
If our thinking is not clouded by our own bias, then it
would behoove us as good contrarians to buy these shares from the eager
sellers at such unexpectedly favorable prices. So, is our own bias leading us
to believe in gold and gold stocks when virtually the entire army of analysts
won't even consider them? Some inputs:
- Gold prices remain near historic highs – and that has a
significant impact on the bottom line of the gold producers. Barrick Gold Corp. (ABX), for example, currently
boasts a profit margin of over 30%, better than twice that of IBM and
almost ten times that of Walmart. While ABX
sells for just 1.6 times its book value, IBM sells for 10X.
- Interest rates remain at historic lows, producing
a negative real return for bond holders. Unless and until investors are able to capture a
positive yield – a potential stake through the heart of gold
– there is no lost-opportunity cost for holding gold. And bonds
are increasingly at risk of loss should interest rates be pressured
upwards, as they inevitably will be.
- Sovereign money printing continues – because
it must. In
today's iteration of Groundhog Day, the Europeans are once again
meeting in an attempt to fix the unfixable, but the growing consensus
– because there is no other realistic option left to them –
is that they will have to accelerate, not decelerate the money printing.
Ditto here in the US, where a fiscal cliff is fast approaching due to the trifecta
of the expiring Bush tax cuts, mandated cuts in government spending from
the last debt-ceiling debacle and the new debacle soon to begin as the
latest debt ceiling is approached. The problems in important economies
such as China and Japan are as bad, and maybe
even worse (in the Weekend Reading section at the end of this
edition is a very worthwhile article on the Chinese economic slowdown.)
- Debt at all levels remains high. With historic levels of debt,
rising interest rates are a no-fly zone for governments, because should
these rates go up even a little bit, the impact on the economy and on
the ability of these governments to meet their obligations would be
dramatic and devastating. This fundamental reality ensures a
continuation of policies aimed at keeping real yields in negative
territory, meaning that the monetization/currency debasement in the
world's largest economies will continue apace.
To get a sense of just how bad things are and how soon the wheels might
come off, sending gold and gold stocks to the moon as governments throw
all restraint in money printing to the wind to save themselves and their
overindebted economies – here's a
telling excerpt and a chart from a recent article by Standard &
Poor's titled, The Credit Overhang: Is a $46 Trillion Perfect
Storm Brewing?
Our study of
corporate and bank balance sheets indicates that the bank loan and debt
capital markets will need to finance an estimated $43 trillion to $46
trillion wall of corporate borrowings between 2012 and 2016 in the U.S., the eurozone, the U.K., China, and Japan (including both
rated and unrated debt, and excluding securitized loans). This amount
comprises outstanding debt of $30 trillion that will require refinancing (of
which Standard & Poor's rates about $4 trillion), plus $13 trillion to
$16 trillion in incremental commercial debt financing over the next five
years that we estimate companies will need to spur growth (see table 1).
You can read the full article here. While the authors of the
S&P report try to find some glimmer of hope that roughly $45 trillion in
debt will be able to be sold off over the next four years – even their
base case casts doubt on the availability of the "new money" shown
in the chart above. Note that this is the funding they indicate is required
to fund growth. Which is to say that should the money not
be found, the outlook is for low to no growth for the foreseeable future.
It is also worth noting that the analysis assumes that
something akin to the status quo will persist – which is very unlikely
given the pressure building up behind the thin dykes keeping the world's
largest economy's intact. The landing of even a small black swan at this
point could trigger a devastating cascade.
We have said it before, and we'll say it again: there
is no way out of this mess. At least not without acute pain to a wide swath
of the citizenry in the world's most developed nations. While this pain will
certainly be felt by sovereign bond holders (and already has been felt by
those who owned Greek issues), it will quickly spread across the board to
banks, businesses and pensioners – in time wiping out the lifetime
savings of anyone who is "all in" on fiat currency units.
In this environment, gold isn't just a good idea
– it's a life saver. And gold stocks are not just a good contrarian opportunity, they are one of the few intelligent
speculations available in an uncertain investment landscape. By speculation,
I mean that, at these prices, they offer an understandable and reasonable
risk/reward ratio. Put another way, every investment – even cash
– has risk these days. With gold stocks, you at least have the
opportunity to earn a serious upside for taking the risk… and the risk
is much reduced by the correction over the last year or so.
Now, that said, there are some important caveats for
gold stock buyers.
- With access to capital likely to dry up, any
gold-related company you own must be well cashed up. In the case of the producers,
this means a lot of cash in the bank, strong positive cash flow and a
manageable level of debt. (Our Casey BIG GOLD service
– try it risk-free here
– constantly screens
the universe of larger gold stocks for just this sort of criteria, then
brings the best of the best to your attention.)
In the case of the junior explorers that we follow in our International
Speculator service (you can try that service risk-free as well), the
companies we like the most have to have all the cash they need to clear the
next couple of major hurdles in their march towards proving value. That's
because a company can have a great asset but still get crushed if it is
forced to raise cash these days… and the situation will only get more
pronounced when credit markets once again tighten as the global debt crisis
deepens.
- Beware of political risk. Despite the critical importance of the extractive
industries to the modern economy, the industry is universally hated by
politicians and regular folks everywhere. If your company –
production or exploration – has significant assets in unstable or
politically meddlesome jurisdictions, tread carefully. And it's
important to recognize that few jurisdictions are more politically risky
than the US. This doesn't mean you need to avoid all US-centric resource
stocks – but rather that you need a geopolitically diversified
portfolio that you keep a close eye on at all times (something we do on
behalf of our paid subscribers every day).
- Know your companies. Some large gold miners are also large base-metals
miners. And at this juncture in time, personally I'm avoiding
base-metals companies like a bad cold. While most base-metals companies
have already been beaten down – and hard – over the last
year and a half, the fundamentals remain poor. Specifically, they not
only have the risk of rising production costs and political meddling,
but unlike gold – where the driving fundamental is its monetary
role in a world awash with fiat currency units – the base-metals
miners depend on economic growth to sustain demand for their products.
In a world slipping back into recession – or perhaps, in the case
of Japan and China, tripping off a cliff – betting on a recovery
in growth is not a bet I'd want to make just now.
Having gone on longer than anticipated, I will now edge
for the exit on this topic by pointing out that while it is hard to
accurately predict the timing of major developments in any one economy, let
alone the global economy, there are a number of tangible clues we can follow
to the conclusion that the next year will be a seminal one in terms of this
crisis.
For starters, there is the next round of Greek
elections on June 17, the result of which is likely to be the anointment of
one Alexis Tsipras as the head of state. An
unrepentant uber-leftist whose primary campaign
plank is to tell the rest of the EU to put their austerity where the sun
doesn't shine, the election of Tsipras would almost
certainly trigger a run on the Greek banks, followed by a cut-off of further
EU funding and Greece's exit from the EU. And once that rock starts to slide
down the hill, it is very likely that Spain and Portugal will follow…
after that, who knows? As I don't need to point out (but will anyway), June
17 is right around the corner, so you might want to tighten your seat belt.
A bit further out, but not very, here in the US we can
look forward to the aforementioned fiscal cliff. Or, more accurately, the
political theatrics around the three colliding
co-factors in that cliff (the approach once more of the debt ceiling, the
expiring tax cuts and mandated government spending cuts). While the outcome
of the theatrics has yet to be determined, it's a safe bet that the
government will extend in order to pretend while continuing to spend –
and by doing so, signal in no uncertain terms that the dollar will follow all
of the sovereign currency units in a competitive rush down the drain.
Bottom line: Be very cautious about industrial commodities as a whole, at least until
we see signs of inflation showing up in earnest, but don't miss this opportunity
to use the recent correction to fill out that corner of your portfolio
dedicated to gold and gold stocks.
(Silver? Personally, I own some silver investments and
believe it will do just fine over time – but I see no big rush to build
a bigger position today as the metal's industrial applications are likely to
be a drag on its price for the next little while.)
And now, a quick detour for a look at the downgrade of
Japan this week, then on to the controversial article I mentioned at the
onset of this week's musings.
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