May 29, 2009 – I’ve received more than my usual share of emails over the past several weeks. Not all of them are a result of gold’s climb to $700 and its subsequent setback. Some of the questions address issues relating to money in general and the dollar in particular, and are very interesting. So I want to share them – and my answers – with you. As a result, I have expanded this newsletter from its usual four pages to six.
Q. Is it your position that hyperinflation is the likely end game for the dollar?
We need to define hyperinflation. I agree that we are going to see massive prices increases. But it won’t come from a huge increase in the quantity of money like Weimar Germany. I expect that hyperinflation will result from a falling demand for dollars, not a rising supply of dollars.
The best example is Argentina. During the peso crisis several years ago, prices there rose dramatically even though the quantity of pesos declined by 30%. But there wasn’t a massive deflation in Argentina from this 30% decline in the money supply like there was in the US in the 1930s when the quantity of dollars declined by 30%. The reason is that the demand for pesos fell even more rapidly than the supply of pesos, with the net result the peso lost purchasing power, i.e., prices in terms of pesos surged.
That’s why I use the term “flight from currency” to describe what is already happening to the dollar. The demand for dollars is declining. People are looking at other alternatives (like gold) in order to meet their needs for money.
Q. How do you measure the demand for the dollar?
We can’t easily measure the decline in the demand for dollars, but we know it is happening. For example, central banks around the world are diversifying into other currencies and reducing their dollar balances. Other examples include Warren Buffett’s well publicized diversification resulting in reduced dollar holdings by him. These examples show that the demand for dollars is falling.
Q. Do you recommend everyone trade gold?
No, definitely not. Trading is not for everyone. My only recommendation that applies to everyone is to simply buy and accumulate gold while it is good value, which is not only the safer route than trading. It is also the strategy that is in harmony with the major trend.
The following comments by Richard Russell (Dow Theory Letters, ww2.dowtheoryletters.com) in his May 12th letter clearly explain my thinking here: “Suffice it to say that gold is in a powerful primary bull market, and my advice in a bull market has always been to put on your chaps and leather vest and boots and ride the bull. But wait, you prefer to trade? You think you can beat the bull via in-and-out trading? Then good luck…The way to make money in a bull market is to load up early on the favored items, buy a bit more on the corrections, and hang on to the bull like grim death. The bull will do everything in his power to shake you off his back. To hell with what the bull wants- you stick with what you want, and what you want is to harness the full power and profitability of the primary bull trend.”
I agree 100% with Richard, so I wouldn’t get sidetracked with trading. Just continue to accumulate gold (and gold mining stocks if you are inclined to take the risk) and sit with these assets while this precious metal bull market continues to unfold. Only try trading if you have the temperament and deep pockets to take the risk, and only after you have accumulated what you consider to be an adequate weight of gold sufficiently large enough to provide you with the financial protection you require in the tough times ahead.
Q. The euro has started rising again against the US dollar, so shouldn’t I be holding some euros?
Rightly or wrongly, for now the euro is perceived to be safer. Look at it this way.
Assume you are European, and you hold dollars. You hear that central banks are reducing their dollar holdings, like Sweden which just recently announced a huge reduction in the relative dollar portion of its currency portfolio. You hear all the other problems with the dollar. What do you do?
It’s only natural to bring your money home – you sell your dollars and buy euros. Later (after gold rises some more and grabs more attention) you will learn that euros aren’t as good as gold, but that comes later.
Q. The world’s central banks are all monetizing together. Is the U.S. dollar the worst of a lousy bunch?
Yes, according to the market. In other words, that’s what the market is telling us by a rising gold price and a sliding dollar against the other currencies. And what the market is telling us is what really matters.
Remember too, a lot of the money growth we are seeing in national currencies around the world is due to the huge dollar balances ending up in foreign central banks. These central banks are not only absorbing the dollars landing overseas from the huge US trade deficits, but they are also picking up the flows from foreign citizens exiting the dollar.
Consequently, all the currencies are being debased by what is happening to the dollar. It is therefore not surprising that gold is rising against all of the world’s currencies.
Q. Bursting bubbles tend to be deflationary, i.e. mal-investments of the previous boom are liquidated when debtors default. Admittedly, this is not your grandfather’s monetary system, but given that the bubbles keep getting bigger, aren’t the deflationary forces their bursting unleashes getting bigger?
What deflationary forces? I don’t see them? Everywhere you look prices are going up, and not necessarily because of increases in the quantity of dollars. Rather, they are going up in part because of decreases in the demand for dollars.
We’re in stage 2 of a flight from currency, a flight out of the dollar into things perceived to be safer, like gold. The probability that we will see dollar deflation is near zero.
Q. The housing bubble peaked last summer, but why hasn’t it burst?
I think the housing bubble has already burst, but why expect a huge collapse in prices like would occur if there were a stock market collapse? There will be some isolated pockets of declines, i.e., special cases of forced selling that might cause a price collapse in some localized areas. But people will try to hold on to their homes. If they lose their house, then the bank will try to hold on to the price to avoid booking a loss.
I expect housing prices will collapse in gold terms, but not in dollar terms. In fact, housing prices are already collapsing in gold terms as the price of gold has risen in recent months.
Q. Are commodities in a bubble? What about the equities of commodity producers?
It’s better to own $1 million of equity in a commodity producer than to own $1 million of dollar denominated paper, like T-Bills. Maybe the stock market is rising because of the flight out of the dollar. Look at what happened to Weimar Germany – the stock indices there soared during the collapse of the Reichsmark. Consequently, you were better off owning equities than Reichsmarks.
The important point is that these are not bubbles. That distinction goes to the dollar. And the dollar bubble is now popping. What’s more, the dollar bubble is the biggest bubble of them all.
What’s frightening is that not 1 in 100 Americans recognize that the dollar even is a bubble, but that ironically is what makes it a bubble. Only after the bubble has popped is it seen to be a bubble.
Q. Today’s monetary system is much different that the 1930s, but is it really that far removed from 1998, when global speculators and credit providers were brought to their knees?
Well, that’s an important question, and we’ll soon find out what’s the answer. I think it is indeed different for many reasons, which can be summed up with the single observation that back in 1998 the dollar was in the Clinton/Rubin bull market, and now it’s in the Bush/Snow bear market.
To make a long story short, this downtrend in the dollar will gain momentum. So we should be preparing for capital controls. The US will impose them to maintain the illusion that the dollar still has value, by using restrictive controls to artificially prop up the demand for the dollar. Therefore, I think the prudent strategy is to not only get out of dollars, but to get as much wealth as possible out of the States now while the window is still open.
Think of it like Nixon closing in 1971 the dollar’s “gold window” – Bush I expect will close the dollar’s “convertibility window”. The mechanisms to do so are already in place with the Patriot Act and various anti-money laundering and anti-privacy regulations. All Bush has to do is flip the switch, and you won’t be able to send money outside the US – or maybe even buy gold and silver within the US.
Q. Can you please explain whether we are going into deflation or inflation?
To answer this question one has to define the currency being used to measure prices. Prices are rising in dollar terms, so we are experiencing dollar inflation. But if you measure prices in ounces or grams of gold you get a different picture. When you do that, you can see the growing deflation that is unfolding everyday.
If the dollar were still defined as a weight of gold as it was in the 1930s, then there would be a dollar deflation too. But of course there is not any dollar deflation today, nor do I suspect will there ever be.
There are many ways to define deflation. We normally think of it as falling prices. But to better understand the point I am making, look at deflation instead as the increasing purchasing power of money, or more to the point that I would like to make, deflation means your money buys more.
In short, deflations don’t have to be nightmares, like we are all led to believe was the case in the 1930’s. If one is prepared, they can be very rewarding. Of course all one has to do for today’s growing gold deflation is to hold gold, and then spend it. I’ll give you a real example.
My wife and I have been discussing (for a few years actually) replacing her SUV (now 12-years old) when price of SUVs came down. I’ve been saying that we should wait and only buy when the price of the SUV she wanted to purchase fell to 2,000 goldgrams. I’ve been saying this since the price was 4,000 goldgrams.
Fortunately, she has been patient, so we waited. But the week before last when gold climbed to $716 ($23.02/gg), she exchanged 2,000 goldgrams for $46,000 which she used to buy a new SUV. In dollar terms, the price of gold doubled.
So when measured in gold terms, she bought her SUV at half the price from a few years ago. Now that’s deflation.
Q. Ludwig von Mises said, “There is no means of avoiding the final collapse of a boom brought about by credit expansion.” If Mises is right, won’t we have an epic global recession that will surely disappoint the commodity bulls’ visions of endlessly increasing demand?
Mises is of course right, but remember, he was writing during a period when national currencies were still defined in terms of gold (at least nominally). We’re now in a new era. As Mark Twain observed so presciently, history doesn’t repeat – it rhymes. So we have to fit basic principles to today’s circumstances.
My expectation is that even if we get a global recession, one would be better off owning commodities and other tangible assets rather than dollars. A weakened US economy that is part of a global recession will decrease US government revenues, which will cause widening budget deficits, putting more nails in the dollar’s coffin. Also, a recession will hurt the loan portfolios in the banks, which will cause further concerns about the dollar’s viability.
So even if commodity demand proves to be less than expected, I think commodity bulls will do much better than people who put their faith in the dollar.
Q. In a deep global recession won’t the overly-indebted fire-sell assets to avoid bankruptcy? Or will people try to convert their paltry savings into tangible goods/assets to avoid the ravages of Bernanke’s printing press?
I expect it will be the latter. Hold tangible assets instead of dollar denominated assets.
Q. I think Greenspan and now Bernanke have laid the foundation for a consumer/housing bust. Have Greenspan and Bernanke distorted the world so much that even this feeble tightening cycle has gone too far?
Tightening cycle? What tightening cycle? Real interest rates (adjusted for inflation) are flat, or perhaps negative if you use John Williams CPI measures, which show that inflation is about 8%: www.gillespieresearch.com
Until real interest rates climb to 4-5% at least, there is no tightening cycle. There’s a lot of tightening talk from the Fed (from both Greenspan before and now Helicopter Ben) but watch what they do, not what they say. They can’t tighten (like Volcker did back in 1980) because high real interest rates will collapse the mountain of debt and financial derivatives, killing the banks and US economy. So we’ll get talk/propaganda, but not high real interest rates.
That’s bad news for the once almighty buck. And that bad news just adds to the multitude of reasons why people are dumping the dollar, reflecting the reduced demand for the dollar.
Right now the demand for dollars is only falling gradually, but the demand for dollars I expect will soon start collapsing. That will probably happen when the US Dollar Index slides below 80, or about 6% from its current level. That’s just a hair’s breadth away.
Q. What is being accomplished by flooding the market with billions of extra dollars? What would be happening without these extra dollars?
The Federal Reserve is trying to add liquidity to the economy. Their objective is to make sure that the US economy does not tank. But in the end, a flood of newly printed dollars won’t help, simply because there already is too much debt.
The huge level of existing debt cannot be serviced in an orderly way, particularly at the federal government level. As it becomes increasingly clear that the level of debt is unmanageable, the flight from the dollar will increase in intensity.
Q. You have stated in the past that you don’t recommend companies like BHP Billiton because they are not pure gold plays. So why do you recommend Freeport (FCX) because they have substantial copper production?
Diversification and dividends. Its revenue is split roughly 50/50 between copper and gold, depending on their relative prices. I have nothing against the base metals. For example, Goldcorp also produces copper, as does Newmont. And Agnico’s name reflects its polymetallic past, Ag-Ni-Co.
Q. I heard that Barrick Gold (ABX) was unhedging its production. Should we buy it?
No, I don’t recommend it. Though they covered the hedge book that came with their acquisition of Placer Dome, they still have the largest hedge book in the industry. I estimate that at current prices their hedge book is $4 billion negative. That $4 billion is going to banks who hold the hedge, and not to shareholders. For every $10 rise in the gold price, some $140 million goes to banks instead of shareholders.
When I buy a gold mining company, I want upside exposure to the gold price. I also want a company without derivative exposure because derivatives are liabilities of a company, and who knows what the banks will do to the company in a derivative crisis. So stay away from the hedgers, including Barrick.
Q. Yamana Gold (AUY) has announced that it is hedging some of its copper production. Isn’t this a bad thing, just like Barrick hedging gold?
It’s hard to understand the fatal attraction some mining company managements have to hedging. They just seem to think they can outsmart the market.
Fortunately, the AUY hedge is not as bad as it could be. They’ve sold forward none of their gold and only part of their copper production. What’s more, they bought calls to cover what they sold forward.
I guess they had their reasons for hedging. I wouldn’t have done it, and it makes me question management’s judgement. But it’s not enough reason to take AUY off of my recommended list. In fact, I still expect AUY to be one of the better performers in the years ahead because of its rising production profile.
Q. The new silver ETF (SIL) is up and running. Should we avoid it like you recommend avoiding the gold ETF (GLD)?
I haven’t studied SIL’s prospectus in detail yet, so I may have more comments on it at a later date. But basically, I see ETFs as a way to speculate on metal prices, not an alternative to owning physical metal. Even if the metal supposedly backing the ETFs really exists, there are too many parties between you and the metal, which introduces too much risk to your metal, which as the bedrock asset in your portfolio should be completely safe.
Q. Are you worried about Peru’s election on June 4 and what might happen to mining companies operating there?
Yes, but then I am worried about political risk in every country. Political risk is a concern for every stock (and not just mining stocks) everywhere in the world.
For example, there is political risk in the US. Look at all the anti-oil company talk in Congress. There is a risk that US politicians may again impose some windfall profit tax on oil companies. It’s nationalization by a different name, US-style rather than Peruvian or Venezuelan-style.
Peru is the world’s second-biggest producer of silver and fourth-biggest producer of copper. Two of my recommended mining stocks, Newmont Mining (NEM) and Pan American Silver (PAAS), generate substantial revenue from their mines there. Both of these stocks have been underperforming in recent months, no doubt because the market is discounting their exposure to Peru.
The upshot of this discussion is that political risk is one reason why I recommend having a diversified portfolio of companies. Don’t just buy one or two mining stocks.
And Peru? I really doubt that the mining companies will be nationalized, so I think both NEM and PAAS will outperform on the next precious metal rally after Peru’s June 4 election.
Q. Newmont performed well for awhile, but lately it’s performing poorly. Why are you still recommending NEM as a buy?
NEM’s underperformance is explained above, that more than one-third of its revenue is derived in Peru. Regardless, anyway you look at it, NEM is a world-class company. It’s a company that anyone would want to own in any well diversified portfolio of gold mining stocks. But there’s another aspect to your question that I consider to be more important.
I have a simple strategy for all the mining stocks in my recommended portfolio (except the ones on hold). It is to continue accumulating them while they are relatively cheap and undervalued. So each month as you accumulate funds for investing, just keep buying. When they get relatively overvalued, I’ll put them on hold, as I have done from time to time in the past.
Q. Why don’t you recommend US Gold (USGL) which is managed by Rob McEwen, the former CEO of Goldcorp?
Only one reason. It’s too early stage and therefore too speculative and risky for me. I first met Rob McEwan some 15 years ago, and I have been a keen supporter of Goldcorp since it’s early days. Rob is one of the best mining execs in the business, and I am therefore following US Gold.
I hope Rob finds some gold (on the lower plate, according to the theory he is pursuing). If he does, I will probably get involved in US Gold at some future date. ¤